Treatment of Certain Interests in Corporations as Stock or Indebtedness, 72858-72984 [2016-25105]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 81, Number 204 (Friday, October 21, 2016)]
[Rules and Regulations]
[Pages 72858-72984]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-25105]



[[Page 72857]]

Vol. 81

Friday,

No. 204

October 21, 2016

Part II





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; Final Rule

Federal Register / Vol. 81 , No. 204 / Friday, October 21, 2016 / 
Rules and Regulations

[[Page 72858]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9790]
RIN 1545-BN40


Treatment of Certain Interests in Corporations as Stock or 
Indebtedness

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and temporary regulations.

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SUMMARY: This document contains final and temporary regulations under 
section 385 of the Internal Revenue Code (Code) that establish 
threshold documentation requirements that ordinarily must be satisfied 
in order for certain related-party interests in a corporation to be 
treated as indebtedness for federal tax purposes, and treat as stock 
certain related-party interests that otherwise would be treated as 
indebtedness for federal tax purposes. The final and temporary 
regulations generally affect corporations, including those that are 
partners of certain partnerships, when those corporations or 
partnerships issue purported indebtedness to related corporations or 
partnerships.

DATES: Effective Date: These regulations are effective on October 21, 
2016.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.385-1(f), 1.385-2(i), 1.385-3(j), 1.385-3T(k), 1.385-4T(g), and 
1.752-2T(l)(4).

FOR FURTHER INFORMATION CONTACT: Concerning the final and temporary 
regulations, Austin M. Diamond-Jones, (202) 317-5363, and Joshua G. 
Rabon, (202) 317-6938 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in these regulations has 
been reviewed and approved by the Office of Management and Budget under 
control number 1545-2267. An agency may not conduct or sponsor, and a 
person is not required to respond to, a collection of information 
unless the collection of information displays a valid control number.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

I. In General

    On April 8, 2016, the Department of the Treasury (Treasury 
Department) and the IRS published proposed regulations (REG-108060-15) 
under section 385 of the Code (proposed regulations) in the Federal 
Register (81 FR 20912) concerning the treatment of certain interests in 
corporations as stock or indebtedness. A public hearing was held on 
July 14, 2016. The Treasury Department and the IRS also received 
numerous written comments in response to the proposed regulations. All 
comments are available at www.regulations.gov or upon request. The 
comments received in writing and at the public hearing were carefully 
considered in developing the final and temporary regulations. In 
addition, certain portions of the proposed regulations that were 
substantially revised based on comments received are being issued as 
temporary regulations. The text of the temporary regulations serves as 
the text of the proposed regulations set forth in the notice of 
proposed rulemaking on this subject published in the Proposed Rules 
section of this issue of the Federal Register. In addition, this 
Treasury decision reserves on the application of certain portions of 
the proposed regulations pending additional study.

II. Summary of Section 385 and the Proposed Regulations

    Section 385 authorizes the Secretary of the Treasury to prescribe 
rules to determine whether an interest in a corporation is treated for 
purposes of the Code as stock or indebtedness (or as in part stock and 
in part indebtedness) by setting forth factors to be taken into account 
with respect to particular factual situations. Under this authority, 
the proposed regulations provided specific factors that, when present 
in the context of purported debt instruments issued between highly-
related corporations, would be dispositive.
    Specifically, proposed Sec.  1.385-2 provided that the absence of 
timely preparation of documentation and financial analysis evidencing 
four essential characteristics of indebtedness would be a dispositive 
factor requiring a purported debt instrument to be treated as stock for 
federal tax purposes. Because related parties do not deal independently 
with each other, it can be difficult for the IRS to determine whether 
there was an intent to create an actual debtor-creditor relationship in 
this context, particularly when the parties do not document the terms 
governing the arrangement or analyze the creditworthiness of the 
borrower contemporaneously with the loan, each as unrelated parties 
would do. For this reason, the proposed regulations prescribed the 
nature of the documentation necessary to substantiate the treatment of 
related-party instruments as indebtedness, including documentation to 
establish an expectation of repayment and a course of conduct that is 
generally consistent with a debtor-creditor relationship. Proposed 
Sec.  1.385-2 required that such documentation be timely prepared and 
maintained, and provided that, if the specified documentation was not 
provided to the Commissioner upon request, the instrument would be 
treated as stock for federal tax purposes.
    Proposed Sec.  1.385-3 identified an additional dispositive factor 
that indicates the existence of a corporation-shareholder relationship, 
rather than a debtor-creditor relationship: The issuance of a purported 
debt instrument to a controlling shareholder in a distribution or in 
another transaction that achieves an economically similar result. These 
purported debt instruments do not finance any new investment in the 
operations of the borrower and therefore have the potential to create 
significant federal tax benefits, including interest deductions that 
erode the U.S. tax base, without having meaningful non-tax 
significance.
    Proposed Sec.  1.385-3 also included a ``funding rule'' that 
treated as stock a purported debt instrument that is issued as part of 
a series of transactions that achieves a result similar to a 
distribution of a debt instrument. Specifically, proposed Sec.  1.385-3 
treated as stock a purported debt instrument that was issued in 
exchange for property, including cash, with a principal purpose of 
using the proceeds to fund a distribution to a controlling shareholder 
or another transaction that achieves an economically similar result. 
Furthermore, the proposed regulations included a ``per se'' application 
of the funding rule that treated a purported debt instrument as funding 
a distribution or other transaction with a similar economic effect if 
it was issued in exchange for property (other than in the ordinary 
course of purchasing goods or services from an affiliate) during the 
period beginning 36 months before and ending 36 months after the funded 
member made the distribution or undertook the transaction with a 
similar economic effect.
    Proposed Sec.  1.385-3 included exceptions that were intended to 
limit the scope of the section to transactions undertaken outside of 
the ordinary course of business by large taxpayers

[[Page 72859]]

with complex organizational structures. The proposed regulations also 
included an anti-abuse provision to address a purported debt instrument 
issued with a principal purpose of avoiding the application of the 
proposed regulations. Proposed Sec.  1.385-4 provided rules for 
applying proposed Sec.  1.385-3 in the context of consolidated groups.
    Finally, proposed Sec.  1.385-1(d) provided the Commissioner with 
the discretion to treat certain interests in a corporation for federal 
tax purposes as indebtedness in part and stock in part (a ``bifurcation 
rule'').

III. Overview of Significant Modifications To Minimize Burdens

    In response to the proposed regulations, the Treasury Department 
and the IRS received numerous detailed and thoughtful comments 
(including comments provided at the public hearing) suited to the 
highly technical nature of certain of the proposed rules. The Treasury 
Department and the IRS carefully considered these comments. Many of the 
comments expressed concern that the proposed regulations would impose 
compliance burdens and result in collateral consequences that were not 
justified by the stated policy objectives of the proposed regulations. 
In response to the comments received, the final and temporary 
regulations substantially revise the proposed regulations to achieve a 
better balance between minimizing the burdens imposed on taxpayers and 
fulfilling the important policy objectives of the proposed regulations. 
The remainder of this Part III summarizes the most noteworthy 
modifications included in the final and temporary regulations, which 
are the following:
    Changes to the overall scope of the regulations:
     Exclusion of foreign issuers. The final regulations 
reserve on all aspects of their application to foreign issuers; as a 
result, the final regulations do not apply to foreign issuers.
     Exclusion of S corporations and non-controlled RICs and 
REITs. S corporations and non-controlled regulated investment companies 
(RICs) and real estate investment trusts (REITs) are exempt from all 
aspects of the final regulations.
     Removal of general bifurcation rule. The final regulations 
do not include a general bifurcation rule. The Treasury Department and 
the IRS will continue to study this issue.
    Significant changes to the documentation requirements in Sec.  
1.385-2:
     Extension of period required for timely preparation. The 
final regulations eliminate the proposed regulations' 30-day timely 
preparation requirement, and instead treat documentation and financial 
analysis as timely prepared if it is prepared by the time that the 
issuer's federal income tax return is filed (taking into account all 
applicable extensions).
     Rebuttable presumption based on compliance with 
documentation requirements. The final regulations provide that, if an 
expanded group is otherwise generally compliant with the documentation 
requirements, then a rebuttable presumption, rather than per se 
recharacterization as stock, applies in the event of a documentation 
failure with respect to a purported debt instrument.
     Delayed implementation. The final regulations apply only 
to debt instruments issued on or after January 1, 2018.
    Significant changes to the rules regarding distributions of debt 
instruments and similar transactions under Sec.  1.385-3:
     Exclusion of debt instruments issued by regulated 
financial groups and insurance entities. The final and temporary 
regulations do not apply to debt instruments issued by certain 
specified financial entities, financial groups, and insurance companies 
that are subject to a specified degree of regulatory oversight 
regarding their capital structure.
     Treatment of cash management arrangements and other short-
term debt instruments. The final and temporary regulations generally 
exclude from the scope of Sec.  1.385-3 deposits pursuant to a cash 
management arrangement as well as certain advances that finance short-
term liquidity needs.
     Limiting certain ``cascading'' recharacterizations. The 
final and temporary regulations narrow the application of the funding 
rule by preventing, in certain circumstances, the so-called 
``cascading'' consequence of recharacterizing a debt instrument as 
stock.
     Expanded earnings and profits exception. The final and 
temporary regulations expand the earnings and profits exception to 
include all the earnings and profits of a corporation that were 
accumulated while it was a member of the same expanded group and after 
the day that the proposed regulations were issued.
     Expanded access to $50 million exception. The final and 
temporary regulations remove the ``cliff effect'' of the threshold 
exception under the proposed regulations, so that all taxpayers can 
exclude the first $50 million of indebtedness that otherwise would be 
recharacterized.
     Credit for certain capital contributions. The final and 
temporary regulations provide an exception pursuant to which certain 
contributions of property are ``netted'' against distributions and 
transactions with similar economic effect.
     Exception for equity compensation. The final and temporary 
regulations provide an exception for the acquisition of stock delivered 
to employees, directors, and independent contractors as consideration 
for the provision of services.
     Expansion of 90-day delay for recharacterization. The 90-
day delay provided in the proposed regulations for debt instruments 
issued on or after April 4, 2016, but prior to the publication of final 
regulations, is expanded so that any debt instrument that is subject to 
recharacterization but that is issued on or before January 19, 2017, 
will not be recharacterized until immediately after January 19, 2017.
    The foregoing changes significantly reduce the number of taxpayers 
and transactions affected by the final and temporary regulations. As 
narrowed, many issuers are entirely exempt from the application of 
Sec. Sec.  1.385-2 and 1.385-3. Moreover, with respect to the large 
domestic issuers that are subject to Sec.  1.385-3, that section is 
substantially revised to better focus on extraordinary transactions 
that have the effect of introducing related-party debt without 
financing new investment in the operations of the issuer. The final and 
temporary regulations thus apply in particular factual situations where 
there are elevated concerns about related-party debt being used to 
create significant federal tax benefits without having meaningful non-
tax effects.

Summary of Comments and Explanation of Revisions

I. In General

    The Treasury Department and the IRS received numerous comments 
requesting that various entities be excluded from the scope of the 
proposed regulations. After considering the comments received, the 
Treasury Department and the IRS have adopted several of these 
recommendations. As an alternative to excluding certain entities from 
the scope of the regulations, many comments also suggested adopting 
special rules or narrower technical exceptions to provide relief for 
particular issues. In many cases, adopting the broader comment to 
exclude certain entities from the scope of the final and

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temporary regulations renders such alternative proposals moot. For 
example, comments requested a rule providing that recharacterized debt 
of an S corporation will not be treated as a second class of stock for 
purposes of section 1361(b)(1)(D). This comment is moot because the 
final and temporary regulations do not contain a general bifurcation 
rule and provide that S corporations are not treated as members of an 
expanded group (as described in Part III.B.2.b of the Summary of 
Comments and Explanation of Revisions) and therefore are not subject to 
the final and temporary regulations. Although the Treasury Department 
and the IRS considered all comments received, this preamble generally 
does not discuss comments suggesting alternative approaches to the 
extent such comments are rendered moot by adopting a broader comment. 
Similarly, because the final and temporary regulations do not contain 
the general bifurcation rule of proposed Sec.  1.385-1(d), this 
preamble does not discuss that rule or the comments received with 
respect to it.
    Many comments requested that the regulations include examples 
illustrating the application of specific rules of the proposed 
regulations to specific fact patterns. Where appropriate to illustrate 
the basic application of rules to common fact patterns, the final and 
temporary regulations provide the requested examples. In some cases, 
the Treasury Department and the IRS determined that a modification of a 
rule rendered such request moot or that a clarification of a rule was 
sufficient to illustrate the point the requested example would clarify. 
In other cases, the Treasury Department and the IRS clarified the issue 
through discussion in this preamble.
    Numerous comments recommended that the Treasury Department and the 
IRS extend the deadline for receiving comments. Many of those comments 
recommended a 90-day extension. Other comments recommended that the 
Treasury Department and the IRS continue to solicit and consider 
taxpayer feedback outside of the comment period.
    The Treasury Department and the IRS declined to extend the standard 
90-day comment period because numerous detailed and substantive 
comments were received before the deadline. The proposed regulations 
provided that written or electronic comments and requests for a public 
hearing had to be received by July 7, 2016, which was 90 days after the 
publication of the notice of proposed regulations in the Federal 
Register. A public hearing was held on July 14, 2016. Sixteen speakers 
or groups of speakers spoke at the public hearing. Over 29,600 written 
comments were received, of which 145 were unique and commented on 
specific substantive aspects of the proposed regulations. Of the 
written comments, 6 were received after July 7, 2016, and all were 
considered in drafting the final and temporary regulations.
    The final and temporary regulations reserve on several issues 
raised in comments, and this preamble includes a new request for 
comments regarding the type of rules that should apply in those 
contexts. See Future Guidance and Request for Comments. The Treasury 
Department and the IRS believe that all remaining issues raised in the 
comments are appropriately addressed in the changes described in this 
preamble, and, in the time since the comment period closed, have not 
been made aware of any particular additional issues that would benefit 
from an extended comment period.
    In addition, because aspects of the final and temporary regulations 
apply to debt instruments issued after April 4, 2016, the Treasury 
Department and the IRS determined that it is important for taxpayers 
and for tax administration to issue the final and temporary regulations 
expeditiously after giving due consideration to all comments received.

II. Comments Regarding Authority To Issue Regulations Under Section 385

A. Interpretation of Authority Under Section 385
    Various comments asserted that the proposed regulations were an 
invalid exercise of regulatory authority under section 385, including 
because the regulations were motivated in part by the concern over 
excessive interest deductions and that such purpose is not authorized 
by section 385.
    The Treasury Department and the IRS have determined that the final 
and temporary regulations are a valid exercise of authority under 
section 385. Section 385(a) vests the Secretary with authority to 
promulgate such rules as may be necessary or appropriate to determine 
whether, for federal tax purposes, an interest in a corporation is 
treated as stock or indebtedness (or as in part stock and in part 
indebtedness). The final and temporary regulations exercise this 
authority consistent with Congress's mandate by providing factors that 
determine whether a purported debt interest is treated as stock, 
indebtedness, or in part stock and in part indebtedness in particular 
factual situations involving transactions among highly-related 
corporations (relatedness itself being a factor explicitly enumerated 
in section 385(b)(5)). Section 385 does not limit the Treasury 
Department and the IRS to issuing regulations only for certain 
purposes.
    Consistent with section 385(a), the Treasury Department and the IRS 
have concluded that the regulations are necessary and appropriate. With 
respect to the documentation rules in Sec.  1.385-2, as Congress 
observed when it enacted section 385, historically there has been 
considerable confusion regarding whether various interests are debt or 
equity or some combination of the two. See S. Rep. No. 91-552, at 138 
(1969). The Treasury Department and the IRS have observed that this 
uncertainty has been particularly acute in the context of related-party 
debt instruments. Section 1.385-2 of the final regulations helps to 
resolve this uncertainty with respect to the particular factual 
situation of transactions among highly-related corporations by 
providing guidance on the type of documentation that is required to 
support debt classification. Focusing on this particular factual 
situation is appropriate because such debt raises unique concerns. 
Related parties do not have the same commercial incentives as unrelated 
parties to properly document their interests in one another, making it 
difficult to determine whether there exists an actual debtor-creditor 
relationship. In addition, because debt, in contrast to equity, gives 
rise to deductible interest payments, there are often significant tax 
incentives to characterize interests in a corporation as debt, which 
may be far more important than the practical commercial consequences of 
such characterization. Accordingly, when a controlling shareholder (or 
a party related to a controlling shareholder) invests in a corporation, 
it is necessary and appropriate to require the shareholder to document 
that an analysis was undertaken to establish an expectation of 
repayment and that the parties' conduct throughout the term of the loan 
is consistent with a debtor-creditor relationship.
    With respect to the rules described in Sec. Sec.  1.385-3, 1.385-
3T, and 1.385-4T, a distribution of a note or an issuance of a 
purported debt instrument by a corporation to a controlling shareholder 
(or a person related to a controlling shareholder) followed by a 
distribution of the proceeds to a controlling shareholder, either 
actually or in substance, raises additional, unique concerns. These 
purported debt instruments have the potential to create significant 
federal tax benefits, but lack

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meaningful non-tax significance, including because they do not finance 
new investment in the operations of the borrower. In the context of 
highly-related corporations, it is a necessary and appropriate exercise 
of the Secretary's rulemaking authority to provide that when this 
factor and the relatedness factor are present, an interest is treated 
as equity rather than indebtedness.
    Various comments also asserted that the regulations are 
inconsistent with the Treasury Department and the IRS's statutory 
authority under section 385 because they fail to provide a rule of 
general application and instead address only a particular set of 
instruments that raise certain policy concerns.
    The Treasury Department and the IRS have concluded that these 
comments lack merit. Section 385 does not require the promulgation of 
rules of general applicability. Nothing in section 385 requires the 
Treasury Department and the IRS to provide a universal definition of 
debt and equity that would apply to all possible transactions. Instead, 
the statute authorizes the Secretary to prescribe factors ``with 
respect to a particular factual situation,'' as opposed to all possible 
fact patterns. The statute's legislative history reinforces the 
validity of this approach by noting the difficulty of legislating 
``comprehensive and specific statutory rules of universal and equal 
applicability'' and the desirability of addressing the characterization 
of an interest as debt or equity across ``numerous [and] different 
situations.'' S. Rep. No. 91-552, at 138.
    The regulations follow this approach by addressing the 
characterization of interests in the particular factual situation of 
transactions among highly-related corporations. This is a context in 
which there is particular confusion regarding what is required in order 
to establish that a debtor-creditor relationship exists. In addition, 
in this context there are unique issues with respect to the ability to 
claim significant federal tax benefits through the creation of 
indebtedness that often lacks meaningful non-tax effects. The use of 
section 385's regulatory authority to provide guidelines for 
documentation is necessary and appropriate to provide greater certainty 
in determining the nature of interests in a context where there are 
often no third-party checks. Further, the use of this authority to 
identify determinative factors (the lack of new capital along with 
relatedness) is also necessary and appropriate to ensure that the 
significant tax advantages that accompany debt (in particular, the 
significant deductions that can be claimed) are limited to 
circumstances in which there is a financing of new investment.
    Several comments asserted that regulations promulgated under 
section 385 must consist of a list of factors to be weighed on a case-
by-case basis, and that the proposed regulations deviated from this 
requirement by providing dispositive factors.
    The Treasury Department and the IRS have concluded that the 
authority under section 385 does not include such a limitation. Section 
385(b) authorizes the Secretary to ``set forth factors which are to be 
taken into account in determining with respect to a particular factual 
situation'' whether an instrument is debt or equity. The final and 
temporary regulations include two factors that are specifically listed 
in section 385(b) (both of which are critical factors traditionally 
relied on by courts): The presence of a ``written'' promise to pay 
(section 385(b)(1)) and the relationship between holdings of stock in 
the corporation and holdings of the interest in question (section 
385(b)(5)). Two other factors included in the regulations have been 
cited in the case law: Whether debt finances new investment in the 
operations of the borrower, and whether the taxpayer can demonstrate 
that at the time the advance was made the borrower could reasonably be 
expected to repay the loan. In the particular factual situation of 
loans between highly-related corporations, a factual situation in which 
the relatedness factor described in section 385(b)(5) is amplified, the 
final and temporary regulations appropriately elevate the importance of 
the other factors listed above.
    Section 385(b) does not require the Secretary to set forth any 
particular factors (regulations ``may include'' certain enumerated 
factors), nor does it prescribe the weight to be given to any selected 
factors, only that they ``are to be taken into account.'' Those 
decisions are left to the discretion of the Secretary. See S. Rep. No. 
91-552, at 138 (1969) (``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.''). As the legislative history 
makes clear, the Treasury Department and the IRS have the authority 
also to omit factors in particular factual situations and instead 
emphasize certain other factors. The factors identified and taken into 
account in the regulations therefore fall within the authority conveyed 
by section 385. In addition, the fact that the final and temporary 
regulations provide for particular weighting of these factors 
(including treating certain factors as dispositive in a particular 
context) is consistent with the Secretary's discretion to ``set forth 
factors which are to be taken into account.''
    Congress enacted section 385 to resolve the confusion created by 
the multi-factor tests traditionally utilized by courts, which produced 
inconsistent and unpredictable results. See S. Rep. No. 91-552, at 138 
(1969). The congressional objective of providing clarity regarding the 
characterization of instruments would be undermined if the regulations 
authorized by section 385 were required to replicate the flawed multi-
factor tests in the case law that motivated the enactment of section 
385. Nothing in section 385 requires a case-by-case approach. The 
statute does not specify what level of generality is required in 
respect of a ``particular factual situation,'' and the Treasury 
Department and the IRS reasonably interpret this phrase to include the 
subset of transactions that take place among highly-related 
corporations. Furthermore, as discussed throughout this Part II.A, the 
legislative history indicates that Congress intended to grant the 
Secretary broad authority to provide different rules for distinguishing 
debt from equity in different situations or contexts. See also S. Rep. 
No. 91-552, at 138 (discussing the need for debt/equity rules given 
``the variety of contexts in which this problem can arise'').
    To underscore the regulations' consistency with the reference in 
section 385(b) to factors that are to be taken into account in 
particular factual situations, the final and temporary regulations 
first provide in Sec.  1.385-1(b) a general rule that effectively 
implements the common law factors. Therefore, whether an interest is 
classified as debt or equity ordinarily will be determined based on 
common law, including the factors prescribed under common law. In the 
particular factual situation of a purported debt instrument issued 
between members of an expanded group, Sec.  1.385-2 provides a minimum 
standard of documentation that must be met in order for an instrument 
to be treated as debt based on an application of the common law factors 
and adjusts the weighting of certain common law factors, while Sec.  
1.385-3 elevates two particular common law factors (the lack of new

[[Page 72862]]

investment in the operations of the issuer and relatedness) into 
determinative factors. The regulations' enumeration of these factors to 
determine the characteristics of an instrument is entirely consistent 
with the plain text of section 385.
    Finally, several comments asserted that proposed Sec.  1.385-3 set 
forth an inappropriate list of factors by exclusively considering 
circumstances outside the four corners of the instrument, such as the 
transaction in which the instrument is issued and the use of the funds 
received in exchange therefor, without regard to the characteristics of 
the instrument itself.
    The Treasury Department and the IRS have concluded that the 
authority granted by section 385 is plainly broader than interpreted by 
the comments. As noted above, section 385 authorizes the Secretary to 
determine which factors must be taken into account when determining the 
nature of an interest in a particular factual situation. Nothing in the 
statute requires the Secretary to consider specific factors or, 
conversely, to disregard other factors. In any event, the factors set 
forth in the regulations derive from common law debt-equity analyses, 
which have, among various considerations, often looked beyond the 
characteristics of the instrument. For instance, Congress identified 
the relatedness of the parties to the transaction as among the factors 
that ``may'' be set forth under section 385, see section 385(b)(5) 
(``the relationship between holdings of stock in the corporation and 
holdings of the interest in question''), and this factor has been 
relied upon by numerous courts in similar factual situations. Likewise, 
the lack of new capital investment created by an issuance of debt is 
also a common law debt-equity factor. See, e.g., Talbot Mills v. 
Comm'r, 146 F.2d 809, 811 (1st Cir. 1944), aff'd sub nom, John Kelley 
Co. v. Comm'r, 326 U.S. 521 (1946); Kraft Foods Co. v. Comm'r, 232 F.2d 
118, 126-27 (2d Cir. 1956).
B. Consideration of Costs
    Various comments contended that the Treasury Department and the IRS 
failed to consider costs in the proposed regulations, that the 
consideration given to the costs imposed by the regulations was 
insufficient, or that the proposed regulations' analysis did not 
accurately reflect the costs of the proposed regulations. One comment 
cited the Supreme Court's decision in Michigan v. EPA, 135 S. Ct. 2699 
(2015), as imposing an obligation to consider costs as part of 
establishing the appropriateness of regulation, claiming that the 
Treasury Department and the IRS failed to meet this obligation in the 
proposed regulations. Another comment asserted that the proposed 
regulations failed to comply with Executive Order 12866's instruction 
to assess the costs of regulatory action.
    The Treasury Department and the IRS disagree with these comments. 
The final and temporary regulations are a necessary and appropriate 
exercise of the Secretary's authority based on the reasons described in 
Section A of this Part II and the analysis of the regulations' costs 
and benefits. The Treasury Department and the IRS do not agree with 
comments that the holding of Michigan v. EPA compels consideration of 
costs in every instance. In any event, the Treasury Department and the 
IRS analyzed the costs and benefits of the proposed regulations in a 
regulatory impact analysis. This regulatory impact analysis was 
conducted consistent with the proposed regulations' designation as a 
``significant regulatory action'' under Executive Order 12866. See 
https://www.regulations.gov/document?D=IRS-2016-0014-0001.
    The Treasury Department and the IRS received extensive comments 
regarding the costs of the proposed regulations and the regulatory 
impact analysis that accompanied the proposed regulations. The Treasury 
Department and the IRS carefully considered those comments in revising 
the proposed rules to significantly reduce compliance burdens and in 
developing the regulatory impact analysis of costs and benefits that 
accompanies and supports the final and temporary regulations. The 
regulatory impact analysis of the final and temporary regulations is 
consistent with Executive Order 12866.
    As explained in greater detail in Part I of the Special Analyses, 
the Treasury Department and the IRS estimate that the aspects of the 
regulations that will apply most broadly (Sec.  1.385-2) will impact 
only 6,300 of the roughly 1.6 million C corporations in the United 
States (0.4 percent). The total start-up expenses for these affected 
taxpayers is estimated to be $224 million in 2016 dollars, with ongoing 
annual compliance costs estimated to be $56 million in 2016 dollars, or 
an average of $8,900 per firm. By comparison, the regulations will 
significantly reduce the tax revenue losses achieved by the avoidance 
strategies that these regulations address. Annualizing over the period 
from 2017 to 2026, the regulations are estimated to yield tax revenue 
of between $461 million per year (7% discount rate) or $600 million per 
year (3% discount rate) in 2016 dollars. The analysis concludes that 
the tax revenues generated from reduced tax avoidance would be at least 
6 to 7 times as large as the compliance costs. The analysis also 
explains the additional, non-quantifiable benefits the regulations will 
generate, such as increased tax compliance system-wide, efficiency and 
growth benefits, and lower tax administration costs for the IRS. The 
analysis supports the conclusion that the regulations are an 
appropriate and effective exercise of the Treasury Department and the 
IRS's authority. The Office of Management and Budget reviewed and 
approved the analysis. The analysis and its conclusions rebut the 
assertions in comments that the Treasury Department and the IRS failed 
to consider costs, did not adequately consider costs, or did not 
accurately estimate costs.
    As set forth in this Part II.B, the Treasury Department and the IRS 
disagree with the comment that the proposed regulations failed to 
comply with Executive Order 12866. Moreover, section 10 of Executive 
Order 12866 clearly states that the Order ``does not create any right 
or benefit, substantive or procedural, enforceable at law''; rather, 
the Order ``is intended only to improve the internal management of the 
Federal Government.''

III. Comments and Changes to Sec.  1.385-1--General Provisions

A. General Approach
1. Regulations Limited to U.S. Borrowers
    The proposed regulations applied to certain EGIs and debt 
instruments issued by corporations to members of the same expanded 
group without regard to the residency of the issuer. Numerous comments 
recommended that the regulations not apply to foreign borrowers, 
including in particular transactions where both the borrower and the 
lender are foreign corporations (foreign-to-foreign transactions). 
These comments pointed to various concerns, including the complexity of 
applying the regulations to potentially hundreds of foreign entities in 
a multinational group and certain unique consequences that would follow 
from such application, such as a loss of foreign tax credits. Some 
comments also questioned the purpose of applying the rules to foreign 
borrowers. Other comments acknowledged that the United States can have 
an interest in the tax treatment of indebtedness issued by foreign 
corporations, in particular indebtedness issued by controlled foreign 
corporations (CFCs), but observed that the United States' interest is 
less direct, and of a different nature, than in the

[[Page 72863]]

case of indebtedness issued by U.S. borrowers.
    The Treasury Department and the IRS have determined that the 
application of the final and temporary regulations to indebtedness 
issued by foreign corporations requires further study. Accordingly, the 
final and temporary regulations apply only to EGIs and debt instruments 
issued by members of an expanded group that are domestic corporations 
(including corporations treated as domestic corporations for federal 
income tax purposes, such as pursuant to section 953(d), section 
1504(d), or section 7874(b)), and reserve on the application to EGIs 
and debt instruments issued by foreign corporations. The final and 
temporary regulations achieve this result by creating a new term 
``covered member,'' which is defined as a member of an expanded group 
that is a domestic corporation, and reserves on the inclusion of 
foreign corporations.
    One comment questioned how the proposed regulations would apply to 
U.S. branches of a foreign issuer. Although it is possible to increase 
the debt attributable to a U.S. branch through issuances of debt by the 
foreign owner to a related party, the various requirements on 
allocating liabilities between a branch and its home office (whether 
under the Code or a relevant bilateral tax treaty) raise unique issues. 
This preamble does not address those issues because the final and 
temporary regulations reserve on their application to foreign issuers, 
including with respect to U.S. branches of foreign issuers.
2. Treatment of Consolidated Groups as One Corporation
    Proposed Sec.  1.385-1(e) treated members of a consolidated group 
as one corporation for purposes of the regulations under section 385.
    As discussed in Part IV.B.1.b of this Summary of Comments and 
Explanation of Revisions, the final regulations do not apply the rule 
in proposed Sec.  1.385-1(e) to Sec.  1.385-2. Instead Sec.  1.385-2 
provides that an interest issued by a member of a consolidated group 
and held by another member of the same consolidated group is not within 
the scope of an applicable interest as defined in Sec.  1.385-2. As a 
result, such an interest is not subject to the documentation rules in 
Sec.  1.385-2. Sections 1.385-3, 1.385-3T, and 1.385-4T continue to 
treat members of a consolidated group as one corporation. Because the 
rule described in proposed Sec.  1.385-1(e) is now only applicable for 
purposes of Sec. Sec.  1.385-3 and 1.385-3T and relates to the 
treatment of consolidated groups, the rule is moved to Sec.  1.385-4T. 
See Part VI of this Summary of Comments and Explanation of Revisions 
for a discussion of the comments and revisions to the rules regarding 
the application of Sec. Sec.  1.385-3 and 1.385-3T to consolidated 
groups.
B. Definitions
1. Controlled Partnership
    One comment requested that the regulations clarify that non-
controlled partnerships are outside the scope of the regulations. The 
Treasury Department and the IRS have determined that proposed Sec.  
1.385-3 was sufficiently clear that the partnership-specific provisions 
only applied to controlled partnerships and their partners. Therefore, 
the regulations do not contain clarifying language to that effect. The 
application of Sec. Sec.  1.385-3 and 1.385-3T to controlled 
partnerships is discussed further in Parts V.H.3 and 4 of this Summary 
of Comments and Explanation of Revisions.
a. Determining Partners' Interests in Partnership Capital or Profits
    The proposed regulations defined the term controlled partnership as 
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.
    A comment recommended the adoption of rules for determining whether 
members of an expanded group own 80 percent of the capital or profits 
interests of a partnership. The determination of whether a partner's 
share of partnership profits or capital is above or below a threshold 
is necessary to apply various provisions of the Code or regulations. In 
most cases, neither term is defined with specificity. See, e.g., 
sections 163(j)(4)(B)(i) and (j)(6)(D)(ii)(II), 613A(d)(3)(B), 
707(b)(1) and (2), and 708(b)(1)(B), as well as Sec.  1.731-
2(e)(4)(ii). The Treasury Department and the IRS decline to provide 
more specific rules regarding the determination of profits or capital 
interests in the context of identifying a controlled partnership for 
purposes of the section 385 regulations.
    The comment also specifically recommended that, for purposes of 
measuring partners' profits interests, consideration be given to the 
use of a reasonable estimate of the partners' aggregate profit shares 
over time in order to prevent a partnership from flipping in and out of 
controlled partnership status (for example, when profit allocations are 
based on distribution waterfalls, which shift over time). This 
recommendation, made in the context of identifying controlled 
partnerships, echoed other comments regarding the determination of a 
partner's share of profits for purposes of applying the aggregate 
approach to partnerships under proposed Sec.  1.385-3. The Treasury 
Department and the IRS recognize that a partner's share of partnership 
profits may not always be knowable with certainty, regardless of the 
purpose for making such determination. However, such determination must 
always be made in a reasonable manner. In some cases, that reasonable 
determination will require a partner or the partnership to make 
estimates regarding a partnership's profitability over some period of 
time.
    The comment also recommended that the definition of a controlled 
partnership should not take percentages of capital interests into 
account, but should instead focus solely on a metric based on 
cumulative shares of profits. The Treasury Department and the IRS have 
determined that such a limitation would be inappropriate because in 
certain circumstances a partner's share of capital may be a good metric 
for identifying control.
    As an alternative, the comment recommended that a shift in capital 
that is small or transitory be disregarded for purposes of the 
controlled partnership definition. The Treasury Department and the IRS 
have determined that such a rule would be difficult to administer 
because it would result in an additional deemed fiction--that is, a 
partner's share of capital for this purpose could be different from the 
partner's actual share. The test for control looks to shares of profits 
or capital, not profits and capital, and because the threshold is 80 
percent, small or transitory shifts in capital that would result in a 
partnership becoming or ceasing to be a controlled partnership should 
happen infrequently.
b. Indirect Ownership
    A comment requested confirmation that determining the status of a 
partnership as a controlled partnership is a separate and independent 
inquiry from determining the status of a corporation as an expanded 
group member. The comment suggested that it was unclear whether, in 
applying the section 318(a) attribution rules to determine 
``partnership interest'' ownership, such partnership interests are then 
treated as actually owned for purposes of then applying the section 
318(a) attribution rules to determine ``stock'' ownership. The final 
regulations clarify that determining the status of a partnership as a 
controlled

[[Page 72864]]

partnership is a separate and independent inquiry from determining the 
status of a corporation as an expanded group member.
c. Unincorporated Organizations
    One comment requested that the regulations not treat certain 
unincorporated organizations described in Sec.  1.761-2 as controlled 
partnerships. The final regulations clarify that an unincorporated 
organization described in Sec.  1.761-2 that elects to be excluded from 
all of subchapter K is not a controlled partnership. Thus, the Treasury 
Department and the IRS anticipate that such unincorporated 
organizations will apply the rules of section 385 in a manner 
consistent with their pure aggregate treatment.
d. Treatment as a Publicly Traded Partnership
    A comment expressed concern that a debt instrument issued by a 
securitization vehicle organized as a partnership that is treated as 
stock in the expanded group partner under the proposed regulations 
could be treated as a partnership interest within the meaning of Sec.  
1.7704-1(a)(2)(i)(B) because a ``partnership interest'' for this 
purpose can include certain derivative and other indirect contract 
rights and interests with respect to a partnership. The comment stated 
that many securitization transactions require an unqualified opinion of 
tax counsel that the entity is not a publicly traded partnership 
treated as a corporation for federal income tax purposes, and that the 
recharacterization rules create uncertainty in this regard.
    Section 1.385-2 of the final regulations does not explicitly apply 
to a debt instrument issued by a controlled partnership. While such a 
debt instrument may be subject to the anti-avoidance rule in Sec.  
1.385-2(f), the concern raised in the comment would only arise under 
the final regulations if the debt instrument is issued with a principal 
purpose of avoiding the application of Sec.  1.385-2.
    Similarly, Sec.  1.385-3T(f)(4) provides that a debt instrument 
issued by a controlled partnership is not recharacterized as stock. 
Instead, as described in more detail in Part V.H.4 of this Summary of 
Comments and Explanation of Revisions, the holder of a debt instrument 
(holder-in-form) all or a portion of which otherwise would be treated 
as stock is deemed to transfer such debt instrument to the partner or 
partners in the controlled partnership in exchange for stock in the 
partner or partners. While the deemed partner stock that the holder-in-
form of the debt instrument would receive in exchange for the deemed 
transfer of all or a portion of the debt instrument to the partner or 
partners in the controlled partnership may be a non-debt financial 
instrument or contract the value of which is determined in whole or in 
part by reference to the partnership that issued the debt instrument 
pursuant to Sec.  1.7704-1(a)(2), the qualified dealer debt instrument 
exception in the final and temporary regulations is expected to address 
this issue. That exception applies to make a debt instrument acquired 
by a dealer in securities not a covered debt instrument, and therefore, 
not subject to the rules that could result in deemed partner stock.
2. Expanded Group
a. General Framework
    The proposed regulations defined the term expanded group by 
reference to the term ``affiliated group'' in section 1504(a), with 
several modifications. Section 1504(a) defines an affiliated group for 
various purposes under the Code, including for purposes of defining an 
affiliated group of corporations that are permitted to file a 
consolidated return. Comments expressed concern that the proposed 
regulations' modifications to the definition in section 1504(a) for 
purposes of defining an expanded group would treat certain corporations 
as members of the same expanded group in situations where the 
corporations are not ``highly related,'' which would not be consistent 
with the policy concerns that the regulations are intended to address. 
In particular, many comments described the proposed regulations' 
adoption of the attribution rules of sections 304(c)(3) and 318 in the 
definition of an expanded group as overly broad. Comments also 
requested that certain corporations not be included in an expanded 
group because their special federal tax status made their treatment as 
an expanded group member less relevant to the policy concerns of the 
proposed regulations.
    Many comments proposed changes to the definition of an expanded 
group to better align that definition with the regulations' policy 
concerns, with the majority of the comments recommending changes that 
would retain section 1504 as the starting point for the definition, 
including adjustments to the attribution rules of sections 304(c)(3) 
and 318. However, two comments suggested that section 1563 would be a 
preferable starting point. Section 1563 defines a ``controlled group of 
corporations'' for various purposes under the Code. One comment 
suggested that, to the extent the regulations treat corporations that 
are commonly controlled by non-corporate persons (for example, 
individuals, family members, or partnerships) as an expanded group 
(brother-sister groups), section 1563, with certain modifications, 
would be a better starting point than section 1504. Another comment 
asserted that the attribution rules in section 1563 would be more 
effective at including in an expanded group only the most highly-
related entities. Other comments recommended that brother-sister groups 
should not be treated as a single expanded group in any case.
    As described in more detail in Sections B.2.b through B.2.g of this 
Part III, the final regulations continue to define the term expanded 
group using concepts similar to those used to define the term 
``affiliated group'' in section 1504(a). However, changes have been 
made and new examples added to address concerns expressed in comments 
regarding both the asserted overbreadth with respect to the types of 
corporations included in the proposed definition of an expanded group 
and with respect to the indirect ownership rules under the proposed 
regulations. Changes also have been made in response to comments to 
clarify other situations in which entities inadvertently were not 
treated as members of an expanded group under the proposed regulations 
but where the policy goals of the regulations clearly are implicated.
    Additionally, the modifications that were made to the section 1504-
based definition of an expanded group in response to the majority of 
comments achieve the same results that the two comments proposing a 
section 1563 approach indicated would be achieved through the use of a 
section 1563 starting point. Accordingly, the Treasury Department and 
the IRS decline to adopt the recommendation to use section 1563 
concepts in defining an expanded group. The Treasury Department and the 
IRS have determined that the modifications discussed in Sections B.2.a 
through g of this Part III more precisely define an expanded group to 
address those situations in which highly-related corporations implicate 
the policy goals of the regulations.
b. Exclusion of Certain Entities
    In defining an expanded group, the proposed regulations included 
several modifications to the definition of an affiliated group under 
section 1504(a). Unlike an affiliated group, an expanded group was 
defined to include corporations that, under section 1504(b),

[[Page 72865]]

would not be included within an affiliated group, including foreign 
corporations, tax-exempt corporations, S corporations, and RICs and 
REITs. In addition, indirect stock ownership was taken into account for 
purposes of the stock ownership requirement of section 
1504(a)(1)(B)(i). Finally, the proposed regulations also modified 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 (a disjunctive test) rather than 80 percent of the vote 
and value (a conjunctive test), as required under section 1504(a).
    Numerous comments requested exclusions from the definition of an 
expanded group for entities described in sections 1504(b)(6) (RICs and 
REITs) and 1504(b)(8) (S corporations). Comments noted that RICs, 
REITs, and S corporations generally are not subject to corporate level 
taxation either because of the flow-through treatment accorded under 
the Code (in the case of an S corporation generally) or because of the 
dividends paid deduction that can have a similar effect (in the case of 
a RIC or REIT). In that respect, comments asserted that RICs, REITs, 
and S corporations are similar to non-controlled partnerships, which 
the proposed regulations would not have included in an expanded group. 
Comments also noted that the recharacterization of an instrument issued 
by an S corporation, REIT, or RIC could jeopardize the entity's federal 
tax status. Consequently, comments suggested that the regulations 
exclude S corporations, REITs, and RICs from any expanded group.
    In response to these comments, the final regulations exempt S 
corporations from being expanded group members. The final regulations 
also exempt RICs or REITs from being expanded group members unless the 
RIC or REIT is controlled by members of the expanded group. The 
Treasury Department and the IRS have determined that an S corporation, 
RIC, or REIT that otherwise would be the parent of an expanded group is 
generally analogous to a non-controlled partnership. Under both the 
proposed and the final regulations, a non-controlled partnership that 
would, if it were a corporation, be the parent of an expanded group is 
excluded from the expanded group because, by definition, the 
partnership is not a corporation and only corporations can be members 
of an expanded group. Consistent with the partnership's status 
generally as an aggregate of its owners, the partnership should not be 
a member of the expanded group if its partners would not be members. S 
corporations, RICs, and REITs have similar flow-through characteristics 
as partnerships and therefore also should not be members of the 
expanded group, despite otherwise being corporations that could own 
stock of members of an expanded group.
    However, the final regulations continue to treat a RIC or REIT that 
is controlled by members of the expanded group as a member of the 
expanded group. Similar to a controlled partnership, a controlled RIC 
or REIT should not be able to break affiliation with respect to an 
otherwise existing expanded group. Unlike partnerships, RICs and REITs 
are corporations and in certain limited cases are subject to federal 
income tax at the entity level. Therefore, the final regulations 
continue to treat controlled RICs and REITs as members of an expanded 
group, rather than as aggregates of their owners. Because an S 
corporation cannot be owned by persons other than U.S. resident 
individuals, certain trusts, and certain exempt organizations, an S 
corporation cannot be controlled by members of an expanded group in a 
manner that implicates the policies underlying the final and temporary 
regulations. S corporations are therefore excluded from the definition 
of an expanded group member for all purposes of the final and temporary 
regulations.
    Several comments specifically requested exceptions for corporations 
exempt from taxation under section 501 and insurance companies subject 
to taxation under section 801. The final regulations do not adopt the 
recommendation to exclude these corporations from the definition of an 
expanded group. Although generally exempt from taxation, section 501 
corporations may still be subject to tax on unrelated business income 
and therefore still present concerns relating to related-party 
indebtedness. In addition, while section 501 corporations are 
themselves generally tax exempt, they may own taxable C corporation 
subsidiaries. Even though S corporations and non-controlled REITs and 
RICs may also own taxable C corporation subsidiaries, in those 
situations income of the S corporation, REIT, or RIC is generally 
included in the income of their owners, whereas unrelated business 
taxable income of a corporation that is exempt from taxation under 
section 501 is not includible in another taxpayer's income. With 
respect to insurance companies subject to taxation under section 801, 
like other corporations, they may also use related-party indebtedness 
to reduce their taxable income. However, as discussed in Part V.G.2 of 
this Summary of Comments and Explanation of Revisions, the final and 
temporary regulations exclude from the application of Sec.  1.385-3 
debt instruments issued by certain regulated insurance companies, which 
generally include insurance companies subject to taxation under section 
801.
    Finally, one comment requested ``specific evidence-based findings'' 
justifying the inclusion of any entity described in section 1504(b) in 
an expanded group, while another comment asserted that defining a new 
category of related parties as an expanded group, rather than relying 
on a statutory definition such as an ``affiliated group,'' was an 
inappropriate use of the regulatory process. Section 385 authorizes 
regulations that affect the treatment of certain interests in 
corporations as stock or indebtedness. However, the regulations limit 
their application to expanded group members and are premised on a broad 
definition of expanded group that generally applies to all types of 
corporations that are closely related. In defining an expanded group, 
the Treasury Department and the IRS are not constrained to include only 
``includible corporations'' for purposes of determining an affiliated 
group of corporations under section 1504(a) or to rely on other 
predefined groups. The exclusion of specific types of corporations 
under section 1504(b) is intended to ensure that only certain 
corporations are permitted to benefit from consolidation for U.S. 
federal income tax purposes. An exclusion of a certain type of 
corporation from the expanded group definition, on the other hand, 
results from a determination by the Treasury Department and the IRS 
that indebtedness between such entity and its affiliates does not 
sufficiently implicate the policy concerns of section 385 to subject 
the corporation to the final and temporary regulations.
c. Indirect Stock Ownership
    To determine indirect stock ownership for purposes of defining an 
expanded group, the proposed regulations applied the constructive 
ownership rules of section 304(c)(3), which in turn applies section 
318(a) subject to certain modifications. This Part III.B.2.c discusses 
comments related to indirect ownership and the application of section 
318(a).
i. Indirect Ownership Under Section 1504(a)(1)(B)(ii)
    For purposes of defining an expanded group, proposed Sec.  1.385-
1(b)(3)(i)(B) modified section 1504(a)(1)(B)(i) by providing that a 
common parent must

[[Page 72866]]

own 80 percent of the vote or value of at least one other includible 
corporation (without regard to section 1504(b)) ``directly or 
indirectly'' rather than ``directly.'' The proposed regulations did not 
include a similar modification to section 1504(a)(1)(B)(ii) (relating 
to the required ownership in includible corporations (without regard to 
section 1504(b)) other than the common parent); specifically, the 
regulations required that 80 percent of the vote or value of each 
includible corporation be owned ``directly'' by one or more includible 
corporations other than the common parent. Several comments recommended 
that, for purposes of defining an expanded group, section 
1504(b)(1)(B)(ii) also be modified by substituting ``directly or 
indirectly'' for ``directly.''
    In response to comments, the final regulations extend the 
``directly or indirectly'' language to both the common-parent test of 
section 1504(a)(1)(B)(i) and the each-includible-corporation test of 
section 1504(a)(1)(B)(ii). Accordingly, the indirect ownership rules of 
section 318, as modified by Sec.  1.385-1(c)(4)(iii) (discussed in 
detail in Section B.2.c.ii of this Part III) apply for purposes of both 
tests in section 1504(a)(1)(B). However, to make clear that the 
ownership tests of section 1504(a)(1)(B) apply to all corporations that 
can be members of an expanded group (as opposed to only includible 
corporations within the meaning of section 1504(b)), the final 
regulations provide the modified section 1504(a)(1)(B) tests in their 
entirety rather than by cross-reference to section 1504(a)(1)(B). 
Therefore, federal tax principles that are applicable in determining 
whether a corporation is a member of an affiliated group under section 
1504(a)(1) and (a)(2) are generally applicable in determining whether a 
corporation is a member of an expanded group.
ii. Definition of Indirect Ownership
    As noted in Section B.2.c of this Part III, the proposed 
regulations cross referenced the rules of section 304(c)(3), which 
themselves cross reference section 318(a) (with certain modifications), 
to define indirect ownership. In order to clarify how to determine 
indirect ownership for purposes of determining an expanded group, the 
final and temporary regulations cross reference section 318 and the 
regulations thereunder with modifications, rather than cross reference 
section 304(c)(3). The regulations under section 318(a) and, with 
respect to certain options, the regulations under section 1504, apply 
when determining a shareholder's indirect ownership for purposes of the 
final regulations.
    One comment suggested that the regulations should indicate that 
indirect stock ownership is determined by ``applying the constructive 
ownership rules of section 304(c)(3),'' given that section 304(c)(3) 
refers to constructive ownership rather than indirect stock ownership. 
The final regulations do not adopt this comment and instead define 
indirect stock ownership by reference to the ``constructive ownership 
rules'' of section 318, with appropriate modifications.
iii. Stock Owned Through Partnerships
    Under section 318(a)(2)(A), stock owned by a partnership is 
considered owned ``proportionately'' by its partners. Comments 
requested guidance on how ``proportionately'' should be determined 
under section 318(a)(2)(A) for purposes of determining stock ownership 
under the proposed regulations. Comments noted that, in the partnership 
context, determining the value of a partnership interest is not always 
straightforward, which makes it difficult to determine partners' 
proportionate interests in a partnership. To address these issues, 
comments requested safe harbors, including a safe harbor based on the 
liquidation value of a partner's interest.
    The final regulations do not provide guidance on how 
``proportionately'' should be determined under section 318(a)(2)(A) for 
purposes of determining stock ownership. The proper interpretation of 
``proportionately'' in the context of section 318(a)(2)(A) is relevant 
to many provisions. See sections 304(c)(3) (providing constructive 
ownership rules for purposes of determining control), 355(e)(4)(C)(ii) 
(providing attribution rules applicable on a distribution of stock and 
securities of a controlled corporation), and 958(b) (regarding 
constructive ownership of stock for many international provisions). 
Thus, the Treasury Department and the IRS have determined that 
providing guidance on this issue is beyond the scope of these 
regulations because these regulations do not require a different 
application of section 318(a)(2)(A).
iv. Hook Equity
    A comment requested guidance regarding the application of the rules 
of section 318 to ownership structures involving hook equity. The 
comment indicated that the proposed regulations would increase the 
circumstances under which hook equity arises, increasing the need for 
guidance on the treatment of hook equity under section 318 under 
current law.
    The Treasury Department and the IRS have concluded that the 
constructive ownership rules of section 318 already address the effect 
of hook equity. In general, under section 318(a)(2), the equity in the 
entity owning the hook equity can be attributed, in whole or in part, 
to the non-hook equity holder. Under section 318(a)(5)(A), stock 
constructively owned by a person by reason of section 318(a)(2) is 
considered as actually owned by such person. Section 318(a)(5)(A) 
permits a recursive application of section 318(a)(2), pursuant to which 
a non-hook equity holder is treated as owning a percentage of the hook 
equity owned. See Examples 3 and 4 of Sec.  1.385-1(c)(4)(vii).
v. Downward Attribution and Brother-Sister Groups
    Comments recommended that, for purposes of the expanded group 
definition, the ``downward attribution'' rule of section 318(a)(3)(A) 
be modified to prevent taxpayers that are not highly-related from being 
treated as members of the same expanded group. Under section 
318(a)(3)(A), all of the stock owned by a partner is treated as owned 
by the partnership, regardless of the partner's ownership interest in 
the partnership. Thus, for example, assume that USS1 owns a 1 percent 
interest in PRS, a partnership. Further assume that USS1 wholly owns 
S1, which wholly owns S2. PRS wholly owns S3. S1, S2, and S3 are all 
corporations. Pursuant to section 318(a)(3)(A), PRS is treated as 
wholly owning S1 and S2 (after application of section 318(a)(2)(A)). 
Under section 318(a)(3)(C), S3 is treated as owning S1 and S2. As a 
result, S1, S2, and S3 would comprise an expanded group under the 
proposed regulations despite minimal common ownership between S3 and 
the other corporations.
    To address fact patterns similar to the example above, comments 
recommended that the section 318(a)(3)(A) downward attribution rule 
apply only from partners with a specific threshold ownership interest 
in a partnership, such as partners that own 50 percent or 80 percent of 
the interests in a partnership. Other comments suggested different 
solutions to the same problem, including limiting section 318(a)(3)(A) 
attribution to situations in which related parties owned 80 percent or 
more of the interests in a partnership, or modifying section 
318(a)(3)(A) attribution for these purposes such that a partnership is 
treated as owning only a proportionate amount of any stock owned by a 
partner. As an alternative,

[[Page 72867]]

one comment recommended that the regulations include an override rule, 
pursuant to which two entities will not be treated as members of the 
same expanded group unless one of the entities has a direct or indirect 
ownership interest of 80 percent or more in the other entity, while 
applying proportionality principles under this override rule. One 
comment specifically requested that the downward attribution rule of 
section 318(a)(3)(A) be limited for purposes of applying the threshold 
rule of proposed Sec.  1.385-3(c)(2).
    Comments also requested similar limits on downward attribution to 
entities other than partnerships. Specifically, comments recommended 
that section 318(a)(3) in general should apply only when the interest 
holder owns 80 percent or more of the entity, or that section 
318(a)(3)(C) be modified to provide that the corporation is attributed 
only a proportionate amount of the stock owned by its shareholder. One 
comment asserted, without explanation, that an expanded group should be 
determined entirely without reference to section 318(a)(3) or similar 
rules.
    The principal consequence of requiring downward attribution for 
purposes of determining indirect ownership under the proposed 
regulations is that an expanded group included so-called ``brother-
sister'' groups of affiliated corporations that are commonly controlled 
by non-corporate owners. Similarly, the principal consequence of 
applying section 318(a)(1) (in connection with section 318(a)(3)), 
which attributes stock owned by individual members of a family, would 
also be the treatment of brother-sister groups with non-corporate 
owners as part of an expanded group. The Treasury Department and the 
IRS continue to study the issue of brother-sister groups, including the 
implications of applying the final and temporary regulations to groups 
with identical members but different expanded group member corporate 
parents. As a result, the final regulations reserve on the application 
of section 318(a)(1) and (a)(3) for purposes of determining indirect 
ownership pending further study.
vi. Option Attribution
    A comment requested that, for purposes of determining an expanded 
group, the option attribution rule of section 318(a)(4) should not 
apply. The comment suggested that the anti-abuse rule should instead 
expressly apply to the use of options to avoid the expanded group 
definition. The comment asserted that it would not be appropriate, for 
example, to treat a 50-50 joint venture between unrelated corporations 
as an expanded group member of one or both corporations because of the 
existence of buy-sell rights that are common in many joint ventures.
    The final regulations limit the application of the option 
attribution rule of section 318(a)(4) in two respects. First, the rule 
only applies to options that are described in Sec.  1.1504-4(d), which 
can include: Call or put options, warrants, convertible obligations, 
redemption agreements, or any instrument (other than stock) that 
provides for the right to issue, redeem, or transfer stock, and cash 
settlement options, phantom stock, stock appreciation rights, or any 
other similar interests. Second, the rule only applies to the extent 
the options are reasonably certain to be exercised based on all the 
facts and circumstances as described in Sec.  1.1504-4(g). By limiting 
the application of the option attribution rule in this manner, the 
Treasury Department and the IRS intend that ownership of stock will be 
attributed to an option holder only in the limited circumstances in 
which the option is analogous to actual stock ownership.
    The final regulations also provide a special rule for indirect 
ownership through options for certain members of consolidated groups. 
Under this special rule, in applying section 318(a)(4) to an option 
issued by a member of a consolidated group (other than the common 
parent of the consolidated group), section 318(a)(4) only applies to 
the option if the option is treated as stock or as exercised under 
Sec.  1.1504-4(b) for purposes of determining whether a corporation is 
a member of an affiliated group. This rule is intended to address cases 
where, because of the reasonable anticipation requirement of Sec.  
1.1504-4(b)(2)(i)(A), members of a consolidated group could 
theoretically be treated as members of different expanded groups.
vii. Knowledge of Constructive Ownership
    A comment indicated that, under the proposed regulations' 
attribution rules, it would be difficult in certain cases to determine 
whether entities are treated as members of the same expanded group. The 
comment requested that a person should be treated as owning stock by 
reason of attribution solely to the extent such person has actual 
knowledge of a relationship or should have reasonably known of such 
relationship after due investigation. The comment did not specify the 
relationship with respect to which the proposed knowledge qualifier 
would apply (for example, whether the entities would need to have 
actual knowledge of their status as members of an expanded group, or if 
they would only require actual knowledge of the applicable relationship 
described in section 318 (as modified by section 304(c)(3)).
    The final regulations do not adopt a knowledge qualifier with 
respect to the application of the attribution rules. The attribution 
rules in the final regulations are similar to attribution rules that 
are applicable under other Code sections, which are based on objective 
metrics rather than a subjective determination that would be difficult 
for the IRS and taxpayers to administer. Furthermore, in the case of 
highly-related groups, the requisite information needed to determine 
constructive ownership should be readily available to group members. 
Therefore, the Treasury Department and the IRS do not expect there will 
be situations in which taxpayers would be unable to determine 
constructive ownership after reasonable investigation and legal 
analysis.
d. Time for Determining Member Status
    Comments requested that the regulations clarify when a 
corporation's status as a member of an expanded group is determined for 
purposes of Sec.  1.385-3. Several comments recommended that the 
regulations adopt a ``snapshot'' approach, under which a corporation's 
membership in an expanded group is tested immediately before a 
transaction that is subject to the regulations. In the alternative, one 
comment suggested that, for purposes of determining whether a 
corporation has become a member of an expanded group at the time of a 
distribution or acquisition, its membership should be determined at the 
close of the transaction or series of related transactions that include 
the distribution or acquisition. For example, assume FP, a foreign 
corporation, owns a minority equity interest in USS1, a domestic 
corporation, with an unrelated party owning the remainder of USS1's 
stock. USS1 issues a note to FP to redeem FP's stock in USS1. Pursuant 
to the same plan, FP purchases 100 percent of USS1's stock from the 
unrelated party. If this comment were adopted, FP and USS1 would be 
treated as members of the same expanded group at the time of the USS1 
redemption because at the close of a series of transactions, FP and 
USS1 are members of the same expanded group. Accordingly, the USS1 note 
would be subject to recharacterization under Sec.  1.385-3.
    The Treasury Department and the IRS have determined that a snapshot

[[Page 72868]]

approach to determining expanded group status is more administrable and 
results in more consistent outcomes than determining expanded group 
membership after the transaction and a series of related transactions. 
Accordingly, the final regulations provide that the determination of 
whether a corporation is a member of an expanded group at the time of a 
distribution or acquisition described in Sec.  1.385-3(b)(2) or 
(b)(3)(ii) is made immediately before such distribution or acquisition.
e. Exceptions for Certain Stock Holdings
i. Voting Rights Held by Investment Advisors
    A comment recommended that, for purposes of the expanded group 
definition, any vote held by an investment advisor, or an entity 
related to the investment advisor, should be ignored. The comment 
indicated that private investment funds are typically structured so 
that the fund's investment adviser, or a related entity, owns the 
voting interests in the investment fund (which may be taxable as a 
corporation for federal income tax purposes), while investors own non-
voting interests in the fund that represent most of the fund's value. 
As a result, groups of investment funds managed by the same investment 
manager may be part of an expanded group because a common investment 
adviser, or a related entity, controls all of the voting interests in 
the investment funds. Furthermore, the comment noted that because an 
investment advisor generally owes separate duties to its investment 
funds, it does not enter into transactions to shift tax obligations 
from one fund to another, in contrast to a typical corporate structure.
    The final regulations do not adopt this recommendation. The 
Treasury Department and the IRS disagree that any fiduciary duty owed 
by an investment advisor to its funds places meaningful limits on the 
ability for such funds to transact with each other through loans. To 
the extent that an investment advisor and its investment funds 
constitute an expanded group, it does not follow that intercompany 
transactions among such parties that give rise to tax benefits for one 
or more of them would be violative of fiduciary duties. In addition, 
unlike certain companies subject to regulation and oversight, see Part 
V.G.1 and 2 of this Summary of Comments and Explanation of Revisions, 
these funds are not subject to capital or leverage requirements that 
restrict their ability to issue debt. Without such restrictions, 
investment advisors that control investment funds may cause the funds 
to engage in transactions otherwise subject to the final and temporary 
regulations.
ii. Interests Required To Be Held by Law
    A comment requested that, for purposes of determining membership in 
an expanded group, stock ownership should be disregarded to the extent 
that the stock is required to be held by law. The comment offered as an 
example risk retention rules applicable to asset-backed securities, 
which generally require sponsors to retain either five percent of the 
most subordinate tranche of a securitization vehicle or to retain a 
portion of each tranche of the securitization vehicle's securities.
    The Treasury Department and the IRS decline to adopt this 
recommendation for purposes of defining an expanded group because the 
expanded group definition is already limited to corporations with a 
high degree of relatedness. However, as discussed in Part V.F.5 of this 
Summary of Comments and Explanation of Revisions, the final and 
temporary regulations adopt certain recommended changes to limit the 
application of Sec.  1.385-3 in certain securitization transactions.
f. Investment Blockers
    The preamble to the proposed regulations requested comments on 
whether certain debt instruments 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. Several comments recommended that the scope of the proposed 
regulations should not be broadened to apply to such transactions (by, 
for example, treating a partnership that owns 80 percent or greater of 
the stock of a blocker corporation as an expanded group member). The 
final and temporary regulations do not adopt special rules for debt 
instruments used by investment partnerships, including indebtedness 
issued by certain ``blocker'' entities. The Treasury Department and the 
IRS continue to study these structures and these transactions in the 
context of the section 385 regulations.
g. Overlapping Expanded Groups
    One comment requested clarification that, although a corporation 
may be a member of multiple expanded groups, any particular expanded 
group can have only one common parent, such that having a common 
expanded group member does not cause overlapping expanded groups to be 
treated as a single expanded group. For example, the comment requested 
clarification that if USS1, a domestic corporation, owned 80% of the 
value of X, a corporation, and USS2, also a corporation, owned 80% of 
the vote of X, USS1 and USS2 would not be treated as members of the 
same expanded group by virtue of being common parents with respect to 
X.
    The Treasury Department and the IRS agree that, while a corporation 
can be a member of more than one expanded group (overlapping expanded 
groups), an expanded group can have only a single common parent (an 
expanded group parent). The final regulations add an example to clarify 
that the expanded group parents of overlapping expanded groups are not 
themselves members of the same expanded group. See Sec.  1.385-
1(c)(4)(vii) Example 1.
C. Deemed Exchange Rule
    Under the proposed regulations, the recharacterization of an 
interest that was treated as debt when issued and then later 
characterized under the proposed regulations as stock gave rise to a 
deemed exchange of that interest for stock. Comments requested further 
guidance to address the tax implications of the deemed exchange of a 
debt instrument for stock under the proposed regulations. Comments 
requested clarification regarding the extent to which gain or loss 
would be recognized on the deemed exchange, as well as the treatment of 
any gain or loss recognized.
    Comments also requested clarity on the treatment of the deemed 
exchange when an interest previously treated as stock under the 
regulations ceases to be between two members of an expanded group and, 
as a result, is recharacterized as indebtedness. A number of comments 
requested that the regulations minimize the collateral consequences 
when an interest treated as equity under the regulations leaves the 
group, and urged that the consequences be similar to those occurring 
when an interest originally treated as debt is recharacterized as 
stock. Of particular concern was the treatment of accrued but unpaid 
interest; comments asked for clarification of the treatment of such 
amounts as part of the redemption price, noting that such treatment 
should be consistent with the original issue discount rules. One 
comment requested confirmation that the deemed exchange that occurs 
when an issuer or holder leaves the expanded group should be treated as 
a section 302(a) redemption with sale or exchange treatment.
    In addition, comments requested further guidance on the treatment 
of tax

[[Page 72869]]

attributes of an interest following the deemed exchange, including 
clarification of the treatment of foreign exchange gain or loss on 
qualified stated interest (QSI) and of the continued deductibility of 
QSI. Comments asked that the regulations address the various 
consequences of repayment of indebtedness that is treated as stock, 
including for example the effects on the basis of the stock upon 
redemption.
    Comments also requested that the regulations clarify that the 
deemed exchange rule applies notwithstanding section 108(e)(8), which 
treats the satisfaction of indebtedness with a payment of corporate 
stock as a payment of an amount of money equal to the fair market value 
of the stock for purposes of determining the income from discharge of 
indebtedness.
    The final regulations address these comments by adding a sentence 
to clarify that the rule that excludes QSI from the computation that 
takes place pursuant to the exchange does not affect the rules that 
otherwise apply to the debt instrument or EGI before the date of the 
deemed exchange. Thus, for example, the regulations do not affect the 
issuer's deduction of unpaid QSI that accrued before the date of the 
deemed exchange, provided that such interest would otherwise be 
deductible. The final regulations also clarify that the rule that 
treats a holder as realizing an amount equal to the holder's adjusted 
basis in a debt instrument or EGI that is deemed to be exchanged for 
stock, as well as the rule that treats an issuer as retiring the debt 
instrument or EGI for an amount equal to its adjusted issue price as of 
the date of the deemed exchange, apply for all federal tax purposes.
    A new paragraph is added to the final regulations to specifically 
provide that, when an issuer of a debt instrument or an EGI treated as 
a debt instrument is treated as retiring all of or a portion of the 
debt instrument or EGI in exchange for stock, the stock is treated as 
having a fair market value equal to the adjusted issue price of the 
debt instrument or EGI as of the date of the deemed exchange for 
purposes of section 108(e)(8). This clarification also responds to the 
treatment of foreign exchange gain or loss, which generally follows the 
realization rules on indebtedness.
    The final regulations do not otherwise change the rules in the 
proposed regulations that address the treatment of a deemed exchange. 
In particular, the regulations treat a debt instrument recharacterized 
as equity under Sec.  1.385-3 that leaves an expanded group as the 
issuance of a new debt instrument rather than reinstating the original 
debt instrument. In the case of an EGI recharacterized as equity under 
Sec.  1.385-2 that subsequently leaves the expanded group, federal tax 
principles apply to determine whether the interest is treated as a debt 
instrument and, if so, a new debt instrument is deemed exchanged for 
the EGI before it leaves the expanded group. Treating a debt instrument 
as newly issued in this context matches the treatment of an 
intercompany obligation that leaves a consolidated group in Sec.  
1.1502-13(g)(3)(ii)(A). The final and temporary regulations provide no 
additional rules because there are detailed rules in sections 1273 and 
1274 that describe how to determine issue price when a debt instrument 
is issued for stock.
    The final regulations include a rule that coordinates Sec.  1.385-
1(d) with the modified approach in the temporary regulations for 
controlled partnerships in Sec.  1.385-3T(f) and the modified approach 
in the final and temporary regulations for disregarded entities in 
Sec. Sec.  1.385-2(e)(4) and 1.385-3T(d)(4). The temporary regulations 
addressing partnerships in Sec.  1.385-3T(f)(4) provide that a debt 
instrument that is issued by a partnership that becomes a deemed 
transferred receivable, in whole or in part, is deemed to be exchanged 
by the holder for deemed partner stock. See Part V.H.4 of this Summary 
of Comments and Explanation of Revisions. The final and temporary 
regulations addressing disregarded entities in Sec. Sec.  1.385-2(e)(4) 
and 1.385-3T(d)(4) provide that an EGI or debt instrument that is 
issued by a disregarded entity is deemed to be exchanged for stock of 
the regarded owner. See Parts IV.A.4 and V.H.5 of this Summary of 
Comments and Explanation of Revisions.
D. Payments Made on Bifurcated Instruments
    Proposed Sec.  1.385-1(d) contained a general bifurcation rule that 
permitted the Commissioner to treat certain debt instruments as in part 
indebtedness and in part stock (that is, to ``bifurcate'' the 
interest). Bifurcation of an interest could occur if an analysis of the 
relevant facts and circumstances under general federal tax principles 
resulted in a determination that the interest should be bifurcated as 
of its issuance into part stock and part indebtedness for federal tax 
purposes.
    The Treasury Department and the IRS received many comments 
requesting additional guidance concerning how the portion of a 
bifurcated interest treated as stock would be determined, and how 
payments on such bifurcated interest would be treated for federal tax 
purposes. As noted in Part III of the Background, the final regulations 
do not contain a general bifurcation rule. The Treasury Department and 
the IRS continue to study the comments received. See the discussion 
regarding the treatment of payments with respect to debt instruments 
that are bifurcated pursuant to Sec.  1.385-3 in Part V.B.3 of this 
Summary of Comments and Explanation of Revisions.

IV. Comments and Changes to Sec.  1.385-2--Treatment of Certain 
Interests Between Members of an Expanded Group

A. In General
    The Treasury Department and the IRS received a significant number 
of comments on the rules of proposed Sec.  1.385-2 requiring 
preparation and maintenance of certain documentation with respect to an 
expanded group interest (EGI). As noted in Part II of the Background, 
proposed Sec.  1.385-2 prescribed the nature of the minimum 
documentation necessary to substantiate the presence of four factors 
that are essential to the treatment of an EGI as indebtedness for 
federal tax purposes. The four factors are: (1) The issuer's binding 
obligation to pay a sum certain; (2) the holder's rights to enforce 
payment; (3) a reasonable expectation of repayment; and (4) a course of 
conduct that is generally consistent with a debtor-creditor 
relationship.
    Comments received with respect to proposed Sec.  1.385-2 include 
the following:
     Comments regarding the necessity of proposed Sec.  1.385-
2;
     Requests to extend the timely preparation periods;
     Requests to reconsider per se stock treatment for an 
undocumented EGI; and
     Requests that certain issuers or interests be exempted 
from proposed Sec.  1.385-2 based on a lack of earnings-stripping 
potential.
    While a number of the comments received were critical of proposed 
Sec.  1.385-2, the Treasury Department and the IRS also received a 
number of comments that supported the goals of the documentation rules.
    As noted in Part III of the Background and discussed in the 
remainder of this Part IV, the final regulations address many of the 
concerns raised in comments by adopting the following modifications:
     First, the final regulations narrow the application of 
Sec.  1.385-2 by excluding an EGI issued by a foreign issuer or an S 
corporation, and generally excluding interests issued by REITs, RICs, 
and controlled partnerships.

[[Page 72870]]

     Second, the final regulations replace the proposed 30-day 
(and 120-day) timely preparation requirements with a requirement that 
documentation and financial analysis be prepared by the time that the 
issuer's federal income tax return is filed (taking into account all 
applicable extensions).
     Third, the final regulations provide a rebuttable 
presumption to characterization as stock for EGIs that fail to satisfy 
the documentation rules, provided the expanded group demonstrates a 
high degree of compliance with Sec.  1.385-2. If an expanded group does 
not demonstrate a high degree of compliance with Sec.  1.385-2, an EGI 
for which the requirements of the documentation rules are not satisfied 
would be treated as stock for federal tax purposes.
     Fourth, the final regulations clarify the application of 
the documentation rules to certain interests issued by regulated 
financial services entities and insurance companies that are required 
by regulators to include particular terms.
     Fifth, the final regulations clarify the ability of 
expanded group members to satisfy the documentation rules for EGIs 
issued under revolving credit agreements, cash pooling arrangements, 
and similar arrangements by establishing overall legal arrangements 
(master agreements).
     Finally, Sec.  1.385-2 applies only with respect to an EGI 
that is issued on or after January 1, 2018. The effect of this change 
in combination with the final regulations' new timely preparation 
requirements is that taxpayers will have until the filing date of their 
taxable year that includes January 1, 2018, to complete the 
documentation requirements under Sec.  1.385-2.
    This Part IV addresses these modifications and additional changes 
suggested by comments that the Treasury Department and the IRS have 
adopted or declined to adopt in the final regulations.
1. Necessity of Documentation Rules
    Some of the comments perceived the proposed documentation rules as 
beyond what would be necessary to impose discipline on related-party 
transactions, and some perceived the recharacterization of indebtedness 
as stock as a penalty disproportionate to the concern addressed by the 
proposed regulations. A number of comments considered the proposed 
documentation rules to be duplicative of existing rules and regulations 
that place on taxpayers both the burden of proof and the obligation to 
keep appropriate books and records. As a result, many of those comments 
urged the complete withdrawal of proposed Sec.  1.385-2.
    Some comments suggested that the regulatory approach of 
characterizing an EGI as stock where adequate documentation is not 
prepared and maintained should be abandoned in favor of seeking 
legislation that would provide authority to the Treasury Department and 
the IRS to impose a monetary fine in such cases. Some comments noted 
that the documentation rules are, to some extent, duplicative of 
documentation requirements under section 6662 (relating to the 
accuracy-related penalty for underpayments) and suggested the adoption 
of the principles of Sec.  1.6662-6(d)(2)(iii)(B) (providing 
documentation rules for transfer pricing analysis purposes) to give 
taxpayers more guidance on the requirements of the regulations. 
Alternatively, some comments suggested relocating the proposed 
documentation rules under sections 6662 or 482. A number of comments 
urged that, in any event, the regulations should require only that a 
taxpayer's position with respect to the characterization of an interest 
as indebtedness be reasonable based on the available facts and 
circumstances instead of requiring documentation of prescribed factors, 
regardless of whether the IRS necessarily agreed with the taxpayer's 
characterization. Comments also suggested that the documentation rules 
would need to be revised in some manner, because the comments asserted 
that such rules could not override ``substantial compliance'' 
principles under common law.
    However, in recognition of the policy concerns stated by the 
Treasury Department and the IRS, virtually all of these comments also 
suggested modifications to make the documentation rules of proposed 
Sec.  1.385-2 more reasonable and administrable for both taxpayers and 
the IRS. Provided certain modifications were made to relax the burden 
of the documentation rules, many comments stated that taxpayers could 
comply with such modified rules. A number of comments suggested 
streamlining the documentation requirements, for example, by allowing 
(i) master agreements to support multiple transactions, (ii) balance 
sheets to evidence solvency, and (iii) the advance preparation of 
credit analysis of issuers. While many comments recognized the value of 
the certainty that could come from increased specificity and objective 
rules, many comments were equally concerned that the regulations be 
flexible regarding the manner in which the documentation rules apply.
    The Treasury Department and the IRS have determined that the 
documentation rules of proposed Sec.  1.385-2 further important tax 
administration purposes. Moreover, the Treasury Department and the IRS 
have determined that the presence or absence of documentation 
evidencing the four indebtedness factors is more than a ministerial 
issue to be policed with a fine or penalty. These factors are 
substantive evidence of the intent to characterize an EGI as 
indebtedness for federal tax purposes. In addition, characterizing 
purported indebtedness as stock is not a penalty for failing to meet a 
ministerial requirement. Such characterization results from a failure 
to evidence the intent of the parties when the issuer characterizes the 
EGI for federal tax purposes or from a failure to act consistent with 
such characterization during the life of the purported indebtedness. As 
noted earlier in this Section A, the Treasury Department and the IRS 
have determined that many of the concerns raised by comments can and 
should be addressed by modifying the approach taken in proposed Sec.  
1.385-2 and, as discussed in the remainder of this Section A, that many 
of the modifications suggested by comments would enhance both the 
reasonableness and effectiveness of the final regulations.
2. Timely Preparation Requirement
    Under proposed Sec.  1.385-2, documentation of an EGI issuer's 
binding obligation to pay a sum certain, the holder's rights under the 
terms of the EGI to enforce payment, and the reasonable expectation of 
repayment under the terms of the EGI generally would be required to be 
prepared within 30 days of the ``relevant date'' to which the 
documentation relates. Documentation of actions evidencing a debtor-
creditor relationship would be required to be prepared within 120 days 
of the ``relevant date'' to which the actions relate.
    Many comments raised concerns with the proposed timeliness rules. 
Some comments noted that the documentation rules did not correspond to 
business practice, were not reasonable, and would be impossible to 
satisfy without an expense to taxpayers far in excess of any benefit to 
be achieved. Comments argued that there was no administrative need for 
the documentation to be done in the timeframes specified, as the 
documentation would not be required until requested by the IRS in 
audit.
    The timely preparation requirements in proposed Sec.  1.385-2 were 
intended to approximate third-party practice with

[[Page 72871]]

respect to contemporaneous documentation of relevant events 
demonstrating the creation of a debtor-creditor relationship. The 
documentation rules relating to post-issuance actions or inaction of 
issuers and holders were intended to demonstrate that the issuer and 
holder continued such a relationship. Thus, the Treasury Department and 
the IRS have determined that it is not appropriate for taxpayers to 
prepare documentation of the four indebtedness factors only if the IRS 
requests such information during an audit. Documentation prepared 
during an audit could not reasonably be viewed as contemporaneous 
evidence of the intent of the taxpayers when an EGI was issued.
    After consideration of the comments, however, the Treasury 
Department and the IRS have determined that the objectives of the 
proposed regulations can still be achieved while allowing taxpayers 
more time to satisfy the documentation requirements. Many comments 
suggested that a reasonable and appropriate time for requiring 
compliance with the documentation rules would be by the time that the 
issuer's federal income tax return must be filed (taking into account 
any extensions) for the tax year of the relevant date. This timeframe 
would also be consistent with the framework of section 385(c), under 
which an issuer and holder provide notice to the Commissioner of their 
characterization of an interest on their tax returns. The Treasury 
Department and the IRS have determined that documentation prepared 
within such a timeframe could provide reasonable evidence of the intent 
of the issuer and the holder in connection with the issuance of the 
EGI. Accordingly, the final regulations adopt this comment for all 
documentation required to be prepared with respect to a relevant date 
for an EGI that is subject to the documentation rules (a covered EGI).
3. Per Se Stock Treatment
    Under proposed Sec.  1.385-2, if the documentation rules for an EGI 
were not satisfied, the EGI would be automatically treated as stock for 
federal tax purposes. The overwhelming response from comments was that 
this aspect of the documentation rules was too harsh. As described in 
Part V.B of this Summary of Comments and Explanation of Revisions, 
comments noted numerous and potentially adverse consequences from 
characterizing purported indebtedness as stock, including purported 
indebtedness issued by foreign issuers.
    Comments stated that, because of the per se aspect of the 
documentation rules, the penalty of recharacterization would often be 
substantially disproportionate to the failure to comply with the 
documentation rules, as arguably minor instances of noncompliance could 
trigger a recharacterization of an interest as stock for federal tax 
purposes with potentially severe consequences. Comments also raised 
concerns that the per se aspect of the documentation rules would 
automatically treat an interest as stock for federal tax purposes 
without allowing for an alternative characterization of a transaction, 
such as, in substance, a distribution or contribution of purported 
financing proceeds.
    Comments offered various solutions to address these concerns. A 
number of comments urged that, before any consequences attached, 
taxpayers be allowed to cure any defect in their documentation. Some 
comments urged that, instead of characterization of purported 
indebtedness as stock for federal tax purposes, the penalty for a 
failure to satisfy the documentation rules could be a denial of any 
interest deduction under section 163; similarly, other comments 
suggested allowing taxpayers to make an election to forego interest 
deductions under section 163 to cure any documentation defect. Some 
comments suggested that the bifurcation rule in proposed Sec.  1.385-
1(d) could be used to reach a more proportionate characterization 
result.
    Section 385(a) directs that regulations promulgated under that 
section be applicable for all purposes of the Code. Accordingly, the 
Treasury Department and the IRS do not consider it appropriate to limit 
the federal tax consequences of the characterization of a covered EGI 
under Sec.  1.385-2 to particular Code provisions, such as section 163. 
Instead, as discussed in Part V.B of this Summary of Comments and 
Explanation of Revisions with respect to Sec. Sec.  1.385-3, 1.385-3T, 
and 1.385-4T, the final regulations generally retain the approach of 
the proposed regulations under which related-party indebtedness treated 
as stock by application of Sec.  1.385-2 is stock for all U.S. federal 
tax purposes, including for purposes of applying section 1504(a) in the 
context of Sec.  1.385-2.
    As discussed in Sections A.3.a through c of this Part IV, the risk 
of per se stock characterization as a result of a documentation failure 
is substantially reduced under the final regulations by the addition of 
rebuttable presumption rules.
a. Availability of Rebuttable Presumption
    If the expanded group demonstrates a high degree of compliance with 
the documentation rules, the final regulations provide a rebuttable 
presumption (rather than a per se characterization) that a covered EGI 
that is noncompliant with the requirements of Sec.  1.385-2 is treated 
as stock for federal tax purposes. To demonstrate a high-degree of 
compliance with the documentation rules, a taxpayer must demonstrate 
that one of two tests is met. Under the first test, a taxpayer must 
demonstrate that covered EGIs representing at least 90 percent of the 
aggregate adjusted issue price of all covered EGIs within the expanded 
group comply with Sec.  1.385-2. Under the second test, a taxpayer must 
demonstrate either that (1) no covered EGI with an issue price in 
excess of $100,000,000 failed to comply with Sec.  1.385-2 and less 
than 5 percent of the covered EGIs outstanding failed to comply with 
Sec.  1.385-2 or (2) that no covered EGI with an issue price in excess 
of $25,000,000 failed to comply with Sec.  1.385-2 and less than 10 
percent of the covered EGIs outstanding failed to comply with Sec.  
1.385-2.
    If eligible, an expanded group member can rebut the presumption 
that a covered EGI is stock with evidence that the issuer intended to 
create indebtedness for federal tax purposes and that there are 
sufficient factors present to treat the covered EGI as indebtedness for 
federal tax purposes.
    Several comments suggested that the final regulations include a de 
minimis rule excepting interests under a certain amount, specified as 
either a fixed dollar amount or a percentage of assets. The Treasury 
Department and the IRS are concerned that this would provide a ready 
method for circumventing the rules and so decline to adopt this 
suggestion. However, the rebuttable presumption rule contained in the 
final regulations would operate to mitigate these concerns. In 
particular, the second test for demonstrating a high degree of 
compliance with the documentation rules permits a simplified 
calculation based only on the number of covered EGIs that failed to 
comply with Sec.  1.385-2. This test reflects an understanding by the 
Treasury Department and the IRS that simplified compliance rules are 
appropriate where relatively smaller EGIs fail to comply with Sec.  
1.385-2.
    In cases where the rebuttable presumption rule applies, the final 
regulations provide that in applying federal tax principles to the 
determination of whether an EGI is

[[Page 72872]]

indebtedness or stock, the indebtedness factors in the documentation 
rules are significant factors to be taken into account. The final 
regulations further provide that other factors that are relevant are 
taken into account in the determination as lesser factors.
b. Ministerial or Non-Material Failure or Errors
    The final regulations adopt a rule intended to safeguard against 
characterizing a covered EGI as stock for federal tax purposes if the 
failure to comply with the documentation rules is attributable to a 
minor error of a ministerial or non-material nature, such as a clerical 
error. In such a case, if a taxpayer discovers and corrects the 
documentation failure or error before discovery by the Commissioner, 
the failure or error will not be taken into account in determining 
whether the requirements of the documentation rules have been 
satisfied.
c. Reasonable Cause Exception
    Proposed Sec.  1.385-2 included an exception that would allow for 
``appropriate modifications'' to the documentation requirements when a 
failure to satisfy the requirements was due to reasonable cause (the 
reasonable cause exception). Proposed Sec.  1.385-2 adopted the 
principles of Sec.  301.6724-1 for purposes of determining whether 
reasonable cause exists in any particular case. These principles 
provide that a reasonable cause exception will apply if there are 
significant mitigating factors with respect to the failure or if the 
failure arose from events beyond the control of the members of the 
expanded group. Moreover, these principles provide that, in order for 
the reasonable cause exception to apply, the members of the expanded 
group must act in a responsible manner, both before and after the time 
that the failure occurred. Thus, under proposed Sec.  1.385-2, if the 
reasonable cause exception did not apply, any failure to comply with 
the documentation requirements would give rise to a characterization as 
stock.
    Comments viewed the exception as unnecessarily narrow in scope and 
unclear in application and effect. Some comments suggested adding 
factors to be considered and guidance about how modifications would be 
made to the rules. Suggestions for a more lenient standard included 
exceptions for ``good cause,'' ``good faith,'' ``reasonable behavior,'' 
``innocent error,'' ``unintentional,'' ``inadvertent,'' or ``lacking 
willfulness.''
    The Treasury Department and the IRS have determined that given the 
rebuttable presumption rule and the ministerial error rule adopted in 
the final regulations, the scope of the reasonable cause exception is 
appropriate. Accordingly, the final regulations retain the reasonable 
cause exception, including its incorporation of the principles of Sec.  
301.6724-1 for guidance concerning its application. In addition, the 
final regulations provide that once a taxpayer establishes that the 
reasonable cause exception applies to an EGI, the taxpayer must prepare 
proper documentation in respect of the EGI.
4. Treatment of EGI Issued by Disregarded Entities
    Comments raised a number of questions and concerns regarding the 
characterization of an interest issued by a disregarded entity under 
proposed Sec.  1.385-2. The concerns largely centered on the collateral 
consequences of treating the interest as equity in the issuing legal 
entity, because in such a case the entity would have at least two 
members and therefore would be treated as a partnership under Sec.  
301.7701-2(c)(1) rather than as a disregarded entity under Sec.  
301.7701-2(c)(2). This change in treatment could create the potential 
for gain recognition and additional significant collateral issues.
    The Treasury Department and the IRS have determined that the 
analysis of whether there is a reasonable expectation of repayment of 
an interest must be made with respect to the legal entity (whether 
regarded or disregarded for federal tax purposes) that issued the 
interest for non-tax purposes, taking into account the extent to which 
other entities may have legal liability for the obligations of the 
issuing entity. In addition, documentation in respect of the other 
indebtedness factors must be prepared and maintained for the legal 
entity (whether regarded or disregarded for federal tax purposes) that 
issued the interest for non-tax purposes. To avoid the effects that 
could occur if an interest issued by a disregarded entity is 
characterized as equity under the documentation rules, Sec.  1.385-2 
provides, under the authority of section 7701(l), that, in such cases, 
the regarded corporate owner of the disregarded entity is deemed to 
issue stock to the formal holder of the interest in the disregarded 
entity (and, if the recharacterization occurs later than the issuance 
of the interest, in exchange for that interest). The stock deemed 
issued is deemed to have the same terms as the interest issued by the 
disregarded entity, other than the identity of the issuer, and payments 
on the stock are determined by reference to payments made on the 
interest issued by the disregarded entity.
5. Exemption Based on Lack of Earnings-Stripping Potential
    Some comments requested that the final regulations exclude from the 
documentation rules several categories of transactions believed not to 
raise earnings-stripping concerns. For example, many comments requested 
that transactions done in the ordinary course of business be exempt 
from the documentation rules. These comments argued in part that the 
sheer volume of such transactions would render any documentation 
requirement overly burdensome, especially given the proposed 30-day 
time period for the completion of such documentation and the proposed 
consequence of failing to prepare and maintain such documentation. 
These comments also asserted that the nature of ordinary course 
transactions makes them an unlikely means of accomplishing abuse and a 
poor candidate for ultimate recharacterization as stock.
    Some comments argued that this rationale would also support an 
exemption from proposed Sec.  1.385-2 for all interests created under 
cash pooling and similar arrangements. Other comments urged that all 
trade payables and any debt that financed working capital needs be 
excluded from proposed Sec.  1.385-2. A number of these comments 
recognized the difficulty of determining how such transactions could be 
identified and suggested various formulas. For example, some comments 
suggested formulas based on an average balance over a specified period 
or the average length of time outstanding. Other suggested methods 
included formulas based on the relationship of the underlying 
transaction to the operation of the business, such as financing 
inventory, services, fixed assets, rent, or royalties.
    In addition to comments based on the nature of particular 
transactions, there were requests to limit application of the proposed 
documentation rules to the extent that the terms of a particular 
arrangement do not present earnings-stripping potential. Thus, for 
example, some comments suggested exemptions be made for purported 
indebtedness that is short term, with a low rate of interest (or no 
interest), or that is issued and held within the expanded group for a 
limited period.
    The Treasury Department and the IRS considered these requests for 
exclusions from the regulations under Sec.  1.385-2, but generally 
declined to adopt them, principally because the goal of the 
documentation rules is not solely to prevent earnings-stripping. 
Rather, the documentation rules are also intended

[[Page 72873]]

to facilitate tax administration by imposing minimum documentation 
standards for transactions between highly related persons to determine 
the federal tax treatment of covered EGIs. Such minimum documentation 
standards are warranted as related-party transactions have historically 
raised concerns as to the use of purported indebtedness and the lack of 
proper documentation to verify the nature of the interest purported to 
be indebtedness. Adopting the broad exceptions urged by comments would 
undermine this goal. In addition, it is unclear how to administer an 
exemption from requirements to document ordinary course arrangements 
because, if taxpayers do not otherwise adequately document such 
arrangements, it is unclear how to determine whether they are, in fact, 
ordinary course arrangements.
B. Scope of Covered EGIs
    Many of the modifications suggested by comments would reduce the 
number of persons, types of entities, or transactions that would be 
covered by the regulations under Sec.  1.385-2. Comments regarding the 
scope of proposed Sec.  1.385-2 as applied to particular categories of 
issuers or transactions not addressed elsewhere in this Summary of 
Comments and Explanation of Revisions are addressed in this Section B.
1. Scope of Issuers
    Under proposed Sec.  1.385-2, an issuer of an interest included, 
solely for purposes of the documentation rules, a person (including a 
disregarded entity) that is obligated to satisfy any material 
obligations created under the terms of an EGI. Proposed Sec.  1.385-2 
also treated a person as an issuer if such person was expected to 
satisfy any material obligations created under the terms of an EGI. 
Comments asked for clarification regarding the circumstances under 
which someone other than the person that is primarily liable under the 
terms of an EGI (the primary obligor), including a co-obligor, would be 
expected to satisfy an obligation created under the terms of the EGI.
    Similar to the documentation rules in proposed Sec.  1.385-2, the 
final regulations provide that the term issuer means any person 
obligated to satisfy any material obligations created under the terms 
of an EGI, without regard to whether the person is the primary obligor. 
The Treasury Department and the IRS intend that the question of whether 
a person other than the primary obligor under the EGI is to be treated 
as its issuer should be analyzed under the principles of section 
357(d), which contains a similar analysis with respect to liability 
assumptions. One comment asked for clarification as to when an obligor 
could be treated as an issuer for this purpose. An issuer for this 
purpose could include a guarantor of a primary obligor's obligations 
created under the terms of an EGI if the guarantor is expected to 
satisfy any of the material obligations under that EGI. An issuer could 
also include a person that assumes (as determined under section 357(d)) 
any material obligation under the EGI, even if such assumption occurs 
after the date of the issuance of the EGI.
a. Partnerships
    Comments raised a number of concerns with the application of 
proposed Sec.  1.385-2 to controlled partnerships. Although the four 
indebtedness factors at the core of the documentation rules are 
important factors in determining the federal tax treatment of purported 
indebtedness issued by any entity, after consideration of the issues 
raised by the comments, the Treasury Department and the IRS have 
determined that the documentation rules should not generally apply to 
partnerships under the final regulations. However, the Treasury 
Department and the IRS remain concerned that expanded group members 
could use partnerships (or other non-corporate entities) with a 
principal purpose of avoiding the application of the documentation 
rules. Accordingly, such transactions remain subject to the final 
regulations' anti-abuse rule.
    In addition, because controlled partnerships are not treated as 
expanded group members under the final regulations, Sec.  1.385-2 
provides that an EGI issued by an expanded group member and held by a 
controlled partnership with respect to the same expanded group is a 
covered EGI.
b. Consolidated Groups
    For purposes of proposed Sec.  1.385-2, members of a consolidated 
group were generally treated as ``one corporation'' and so interests 
issued between members of the consolidated group were not subject to 
the documentation rules. However, as noted in Parts III.A.2 and VI.A of 
this Summary of Comments and Explanation of Revisions, the one-
corporation approach gave rise to numerous questions and concerns about 
both the implementation of the rule and the effect of this rule on the 
application of other provisions of the Code.
    There were two reasons for excluding indebtedness between members 
of a consolidated group from the application of the documentation rule. 
The principal reason was that the consolidated return regulations, 
specifically Sec.  1.1502-13(g), already provide a comprehensive regime 
governing substantially all obligations between members. This is not 
the case with respect to indebtedness between consolidated group 
members and nonmembers, even if highly related. The second reason was 
that, in the very few cases where such obligations would not be subject 
to Sec.  1.1502-13(g), the inapplicability of Sec.  1.1502-13(g) would 
generally be of limited duration and, in the meantime, all items of 
income, gain, deduction, and loss attributable to the obligation would 
offset on the consolidated federal income tax return.
    The Treasury Department and the IRS have determined that the 
existing regulations governing obligations between members of a 
consolidated group are sufficiently comprehensive to warrant the 
exclusion of these obligations from the documentation rules. However, 
the Treasury Department and the IRS have reconsidered the use of the 
one-corporation approach with respect to Sec.  1.385-2 and determined 
that a simpler, more targeted approach would be to exclude obligations 
between consolidated group members from the category of instruments 
subject to the documentation rules. This approach, as provided in Sec.  
1.385-2(d)(2)(ii)(A) of the final regulations, retains the general 
exclusion for intercompany obligations while eliminating many of the 
questions and concerns raised by comments, such as the question of 
whether a particular member of a consolidated group (or the 
consolidated group as a whole) would be the issuer of an EGI.
    The final regulations do not, however, adopt the suggestion to 
expand the exception to exclude other obligations, such as obligations 
between affiliated corporations that are not includible corporations 
under section 1504(b) (such as a REIT or RIC) or that are prohibited 
from joining the group under section 1504(c) (certain insurance 
companies) and obligations between group members and controlled 
partnerships. In such cases, even though the obligations may generate 
items that may be reflected in a consolidated federal income tax 
return, none of the obligations generating the items are governed by 
the consolidated return regulations.
    The final regulations also do not adopt the request to limit the 
consequences of characterizing an EGI as stock under Sec.  1.385-2, for 
example, by disregarding such stock for purposes

[[Page 72874]]

of determining affiliation. The Treasury Department and the IRS view 
the characterization of an EGI as stock under Sec.  1.385-2 as a 
determination that general federal tax principles would preclude a 
characterization of the interest as indebtedness. Thus, the Treasury 
Department and the IRS have determined that it is appropriate to treat 
an EGI characterized as stock pursuant to Sec.  1.385-2 as stock for 
federal tax purposes generally.
c. Regulated Entities
    A number of comments were received requesting exemptions from the 
documentation rules for various regulated entities, such as insurance 
companies, financial institutions, and securities brokers or dealers. 
Comments stated that a rationale for the proposed documentation rules, 
facilitating tax administration by imposing minimal documentation 
standards for transactions between highly-related persons, is addressed 
by existing non-tax regulations and oversight already imposed on these 
entities. The Treasury Department and the IRS recognize that the 
various requirements noted by comments, such as the Basel III framework 
and increased capitalization requirements, risk management ratios, and 
liquidity requirements that are applicable to certain regulated 
financial entities, all afford increased assurance regarding certain 
aspects of the documentation requirements, particularly with respect to 
the creditworthiness of the issuer.
    Accepting the fact that non-tax regulations may constrain the terms 
and conditions of the obligations issued and held by entities subject 
to those regulations does not, however, change the fact that a 
determination of whether an EGI is characterized as stock or 
indebtedness for federal tax purposes is made under federal tax 
principles. This determination necessarily involves the preparation of 
documentation in respect of the four indebtedness factors. In addition, 
a non-tax regulator may not have the same interests as the Treasury 
Department and the IRS. Such a non-tax regulator may not constrain (and 
in some cases may encourage) actions to lower federal tax costs for the 
entities that it regulates so that more assets may be available to the 
depositors in, or creditors of, such entities.
    Accordingly, the Treasury Department and the IRS have determined 
that it is not appropriate to exclude taxpayers from the documentation 
rules on the grounds that some of the documentation and information 
required may also be required by and provided to non-tax regulators. 
Indeed, to the extent the final regulations require documentation that 
is otherwise prepared and maintained under requirements imposed by non-
tax regulators, such as may be required under regulations under 12 CFR 
part 223 (Regulation W) issued by the Board of Governors of the Federal 
Reserve System, any additional burden imposed by the final regulations 
is reduced.
d. Expanded Groups Subject to Sec.  1.385-2
    Under proposed Sec.  1.385-2, an EGI would not be subject to the 
documentation rules unless (i) the stock of any member of the expanded 
group was publicly traded, (ii) all or any portion of the expanded 
group's financial results were reported on financial statements with 
total assets exceeding $100 million, or (iii) the expanded group's 
financial results were reported on financial statements that reflect 
annual total revenue exceeding $50 million.
    A number of comments suggested raising the asset and revenue 
thresholds, particularly for regulated businesses with high asset 
levels relative to revenue, such as banks, or for issuers with high 
amounts of revenue but low profit margins, such as construction 
companies. However, comments did not suggest particular levels to which 
the asset or revenue thresholds should be raised. As a result of the 
modifications made to Sec.  1.385-2 in the final regulations, the 
Treasury Department and the IRS have determined that the application of 
the documentation rules will be appropriately restricted to minimize 
burden and therefore decline to adopt this suggestion.
    Accordingly, the final regulations continue to provide that an EGI 
is not subject to the documentation rules unless one of the following 
three conditions is present. First, if the stock of any member of the 
expanded group is publicly traded. Second, if all or any portion of the 
expanded group's financial results are reported on financial statements 
with total assets exceeding $100 million. Or third, if the expanded 
group's financial results are reported on financial statements that 
reflect annual total revenue that exceeds $50 million.
2. Special Categories of EGIs
a. Certain Interests of Regulated Entities
    Many of the comments submitted by or on behalf of regulated 
entities requested that, if a broad exception were not adopted for 
regulated entities, certain arrangements should be excluded from the 
documentation rules. As an example, several comments requested an 
ordinary course exception to the documentation rules applicable to all 
payments on insurance contracts, funds-withheld arrangements in 
connection with reinsurance, funds-withheld reinsurance, and surplus 
notes. Comments noted the need for further guidance on the 
documentation that would be required for many of these interests, as 
they are typically executed by contract, not loan documents. The 
Treasury Department and the IRS do not agree that there is a need for 
guidance with respect to reinsurance or funds-withheld reinsurance, 
because these arrangements are not debt in form and are typically 
governed by the terms of a reinsurance contract (and other ancillary 
contracts). As such, they are not covered EGIs under the final 
regulations.
    Comments also suggested that the final regulations create safe 
harbor exceptions for instruments issued to satisfy regulatory capital 
requirements and regulatory instruments issued in the legal form of 
debt that contain required features that could impair their 
characterization as debt, such as instruments with loss-absorbing 
capacity that are required by the Federal Reserve Board. For example, 
if a borrower's obligation to pay interest or principal, or a holder's 
right to enforce such payment, is conditioned upon the issuer receiving 
regulatory approval, but the instrument otherwise satisfies the 
unconditional obligation to pay a sum certain and creditor rights 
factors, comments argued that the required regulatory approval should 
not prevent the interest from being treated as debt. Similarly, 
comments requested the final regulations provide that, if regulatory 
approval delays an action, such delay will not prevent an issuer from 
satisfying the timeliness requirement.
    The Treasury Department and the IRS agree that certain regulated 
entities may be required in some cases to issue an instrument that 
would be indebtedness under federal tax principles but for certain 
terms or conditions imposed by a regulator. To address this situation, 
the final regulations provide an exception from the documentation 
requirements for certain instruments issued by an excepted regulated 
financial company or a regulated insurance company, as those terms are 
defined in Sec.  1.385-3(g). An EGI issued by an excepted regulated 
financial company is considered to meet the documentation rules as long 
as it contains terms required by a regulator of that issuer in order 
for the EGI to satisfy regulatory capital or similar rules that govern 
resolution or orderly liquidation. An EGI issued by a regulated 
insurance

[[Page 72875]]

company issuer is considered to meet the documentation rules even 
though the instrument requires the issuer to receive approval or 
consent of an insurance regulatory authority before making payments of 
principal or interest on the EGI. In both cases, the regulations 
require that the parties expect at the time of issuance that the EGI 
will be paid in accordance with its terms and that the parties prepare 
and maintain the documentation necessary to establish that the 
instrument in question qualifies for the exception.
    The Treasury Department and the IRS are aware that certain 
instruments required by regulators raise common law debt-equity issues 
that extend beyond the scope of these regulations. The scope and the 
form of additional guidance to address these instruments are under 
consideration.
b. Certain Interests Characterized Under the Code or Other Regulations
    Several comments requested clarification that instruments that are 
specifically treated as indebtedness under the Code and the regulations 
thereunder, such as mineral production payments under section 636, are 
not treated as applicable instruments, and accordingly not treated as 
EGIs subject to proposed Sec.  1.385-2. The final regulations clarify 
that such instruments are not subject to the documentation rules.
c. Master Agreements, Revolving Credit Agreements, and Cash Pooling 
Arrangements
    Under proposed Sec.  1.385-2, members of an expanded group using 
revolving credit agreements, cash pooling arrangements, and similar 
arrangements under a master agreement were generally required to 
prepare and maintain documentation for the master agreement as a whole 
(rather than for each individual transaction), but comments contained a 
number of questions concerning the requirements applicable to these 
master agreements.
    Some comments requested that master agreements be excluded 
altogether from the documentation rules, excluded at least for specific 
activities, or excluded if their terms exceeded those given by third 
parties. These comments argued that such agreements were not likely 
vehicles for earnings stripping. The Treasury Department and the IRS 
decline to provide an exemption for these master agreements because if 
such an exemption were granted, such master agreements could replace 
all other forms of indebtedness between highly-related parties, 
resulting in avoidance of the documentation rules. In addition, 
interests issued under these master agreements must be characterized 
for federal tax purposes, and there is no clear justification for 
treating such interests as exempt from the modified documentation 
requirements in the final regulations based on the fact that these 
interests are documented under a master agreement.
    Many comments focused on solutions for making the application of 
the documentation rules to master agreements simpler, clearer, more 
workable for taxpayers, and more administrable for the IRS. Comments 
requested that the basic operation of the rules governing master 
agreements be clarified to provide certainty for taxpayers that (i) a 
comprehensive agreement such as a revolving credit agreement could 
satisfy the documentation requirements and (ii) individual draws under 
the revolving credit agreement would not be treated as separate loans 
for purposes of the documentation rules. Comments also requested 
additional definitions and rules, for example clarifying the 
interaction of the documentation rules and Sec.  1.1001-3(f)(7) and the 
treatment of a cash pool financing both ordinary course and capital 
expenditures. The Treasury Department and the IRS decline to provide 
special rules under Sec.  1.385-2 for the cash pool financing of 
ordinary course and capital expenditures. In general, the question of 
whether an EGI is ordinary course or is used for capital expenditures 
is not relevant to the question of whether the EGI is indebtedness for 
federal tax purposes. In particular, this question is not relevant to 
determine whether there is an unconditional obligation to pay a sum 
certain, whether there are creditor's rights under the EGI, whether the 
parties have a reasonable expectation of repayment, or whether the 
parties' actions are consistent with a debtor-creditor relationship. As 
a result, the final regulations provide that an EGI issued under a cash 
pool arrangement must meet the same documentation requirements 
regardless of whether the EGI funds ordinary course expenses or capital 
expenditures.
    The policy behind Sec.  1.1001-3(f)(7) is to encourage workouts 
when debtors have difficulty repaying their obligations to third-party 
creditors. In such a case, the debtor (and any shareholders of the 
debtor), have different economic interests from the creditors, and any 
modifications to a debt instrument are likely to meaningfully maintain 
the rights of the creditors. In the case of highly-related entities 
that meet the definition of expanded group, these different economic 
interests are not present. As a result, the final regulations provide 
that the rules of Sec.  1.385-2 apply before the rules of Sec.  1.1001-
3(f)(7). The final regulations therefore require documentation as of 
certain deemed reissuances under Sec.  1.1001-3 (even in cases where 
Sec.  1.1001-3(f)(7) would not require an analysis of whether a 
modification resulted in an instrument being treated as an instrument 
that is not indebtedness for federal income tax purposes).
    Many comments suggested that the number of credit analyses required 
for master agreements be limited. For example, several comments 
asserted that the time for testing the issuer's ability to repay should 
be limited to the time of an interest's issuance. Comments also 
suggested that EGIs issued under master agreements should require 
credit analysis only upon the execution of the master agreement and 
subsequently upon an increase of the credit limit under the master 
agreement, provided that the amount of credit and term of the master 
agreement is reasonable. Comments generally suggested that the credit 
analysis be required to be repeated on a specified schedule, ranging 
from three to five years. The Treasury Department and the IRS generally 
agree with a specified schedule approach for determining the required 
credit analysis with respect to master agreements but have concerns 
about potential changes in an issuer's creditworthiness over longer 
periods. Because such agreements among members of an expanded group do 
not generally contain covenants, financial information provision, and 
other protections analogous to those in similar arrangements among 
unrelated parties, it is necessary to require a credit analysis under 
these agreements more frequently than every three to five years.
    The Treasury Department and the IRS have addressed these comments 
by clarifying in the final regulations that with respect to EGIs 
governed by a master agreement or similar arrangement, a single credit 
analysis may be prepared and used on an annual basis for all interests 
issued by a covered member up to an overall amount of indebtedness 
(including interests that are not EGIs) set forth in the annual credit 
analysis. The final regulations make it clear that the first such 
annual credit analysis should be performed upon the execution of the 
documents related to the overall arrangement. The only exception to 
this annual credit analysis rule is when the issuer has undergone a 
material change within the year intended to be covered by the annual 
credit analysis. In this

[[Page 72876]]

case, the final regulations require a second credit analysis to be 
performed with a relevant date on or after the date of the material 
change. This requirement is consistent with commercial practice with 
respect to revolving credit agreements, which typically contain 
covenants requiring such terms.
    Some comments requested clarification of the treatment of notional 
cash pools, noting that such arrangements are not documented as debt in 
form between expanded group members. The final regulations do not adopt 
this comment except to clarify that a notional cash pool is generally 
subject to the same documentation requirements as other cash pools when 
the notional cash pool provider operates as an intermediary. For 
example, a notional cash pool in which the cash received by a non-
member cash pool provider from expanded group members is required to 
equal or exceed the amount loaned to expanded group members will 
generally be treated as a loan directly between expanded group members, 
even though the interests may be in form documented as debt between an 
expanded group member and a non-member facilitator. See, Rev. Rul. 87-
89 (1987-2 C.B. 195). Such arrangements present the same issues as 
other related-party instruments and arrangements transacted under a 
master agreement and should be subject to the documentation rules. 
Because these arrangements are administered by a non-member, it is 
generally expected that most of the documentation required under the 
final regulations would already be prepared, limiting the incremental 
burden of the final regulations on these arrangements.
    Several comments also suggested limiting the application of the 
documentation rules to amounts in excess of average balances. The final 
regulations do not adopt this approach because almost all provisions of 
the Internal Revenue Code pertaining to indebtedness and stock analyze 
particular interests, not average or net balances. Thus, to apply the 
documentation rules to average or net balances would not adequately 
serve the purpose of determining whether a particular interest is 
properly treated as indebtedness or stock for federal tax purposes.
    Comments also noted that coming into compliance following 
finalization of the regulations would be facilitated by allowing an 
extended time frame to document these arrangements and by excluding 
balances outstanding on the effective date of the final regulations. 
The final regulations implement this comment. Only interests issued or 
deemed issued on or after January 1, 2018, including EGIs issued on or 
after January 1, 2018 under a master agreement in place before January 
1, 2018, will be subject to Sec.  1.385-2.
C. Indebtedness Factors Generally
    While many comments acknowledged a need for documentation rules, 
there were two overarching concerns with respect to the form of such 
rules. First, comments suggested that the requirements be made as 
streamlined as possible. Second, comments requested clarification of 
the indebtedness factors so that taxpayers could have certainty about 
what information is requested and what documentation will satisfy the 
requirements of the regulations.
    Some comments suggested that the Treasury Department and the IRS 
publish a form that taxpayers could use to report new loans or 
payments, with sufficient instructions to forestall debate over whether 
adequate documentation is provided. Under such an approach, if the form 
were properly completed with respect to an interest, an audit would 
then proceed to the merits of the debt-equity determination for the 
interest. The Treasury Department and the IRS have determined that the 
modifications made in the final regulations address these concerns. 
Other comments suggested providing for a level of documentation scaled 
to the principal amount of the loan, or that would be reduced in the 
case of loan guaranteed by a solvent parent or affiliate. The Treasury 
Department and the IRS do not adopt this suggestion. Such an approach 
would allow taxpayers to use numerous smaller loans to avoid the full 
application of the documentation rules.
    Several comments suggested using a ``market standard safe harbor'' 
that would treat the documentation requirements as satisfied by the 
documentation customarily used in third-party transactions. The final 
regulations adopt this comment and provide that such documentation may 
be used to satisfy the indebtedness factors related to an unconditional 
obligation to pay a sum certain and creditor's rights.
    A number of comments also requested guidance regarding the effect 
of a significant modification of an instrument under section 1001 and 
under Sec.  1.1001-3. The consensus among comments was that the final 
regulations should provide that when there is a modification of an 
interest, as long as such modification is not very significant, no 
additional documentation should be required. The Treasury Department 
and the IRS have decided that a deemed reissuance under Sec.  1.1001-3 
represents a case where the economic rights and obligations of the 
issuer and holder have changed in a meaningful way. As a result, the 
final regulations provide that the deemed reissuance of an EGI under 
Sec.  1.1001-3 generally requires a new credit analysis to be performed 
(unless an annual credit analysis is in place at the time of the deemed 
reissuance). However, the final regulations do not require new 
documentation in respect of the factors regarding an unconditional 
obligation to pay a sum certain or creditor's rights, as of such a 
deemed reissuance, unless such deemed reissuance relates to an 
alteration in the terms of the EGI reflected under an express written 
agreement or written amendment to the EGI.
    Finally, comments noted that it was unclear who was required to 
prepare and maintain the documentation, and some of these comments made 
suggestions as to the persons that should be required to prepare and 
maintain the documentation. Proposed Sec.  1.385-2 did not include any 
requirement in this respect because the taxpayer is in the best 
position to determine who should prepare and maintain its documents; 
the IRS's interest in this respect is limited to requiring that the 
proper documentation be prepared and maintained and ensuring that the 
IRS may obtain the documentation. In addition, if the documentation 
rules contained specific requirements as to the person or persons 
required to prepare and maintain documentation, such requirements would 
imply that an interest does not comply with the documentation rules 
(even when appropriate documentation was prepared and maintained) 
merely because the wrong member of the expanded group prepared or 
maintained the documentation for the interest. Such arguments would be 
harmful to taxpayers and would not advance the policy goals of the 
documentation rules. Thus, proposed Sec.  1.385-2 was purposely silent 
on the question of who must prepare and maintain documentation. The 
final regulations continue this same approach.
1. Unconditional Obligation To Pay a Sum Certain
    Comments requested several clarifications regarding the requirement 
that there be an unconditional obligation to pay a sum certain. A 
number of comments asked for clarification that an obligation would not 
automatically fail because of a contingency or because it was a 
nonrecourse obligation. Several comments also requested a clarification

[[Page 72877]]

that the sum need only be an amount that is reasonably determinable as 
opposed to a specified total amount due on a single specified date. A 
number of other comments also requested confirmation that, if a 
borrower's binding obligation to pay under an interest is subject to 
the condition of a regulatory approval before repayment, but otherwise 
satisfies the requirement that there be an unconditional obligation to 
pay a sum certain, the fact that regulatory approval is required before 
repayment should not prevent the interest from satisfying that 
requirement. The Treasury Department and the IRS generally agree with 
these comments, and the final regulations provide rules clarifying 
these points. The effect of a contingency that may result in the 
repayment of less than an instrument's issue price has not been 
addressed by the Treasury Department or the IRS, and the documentation 
rules are not the appropriate place for guidance in that area. The 
final regulations provide that the documentation must establish that 
the issuer has an unconditional and legally binding obligation to pay a 
fixed or determinable sum certain on demand or at one or more fixed 
dates, without elaborating on the amount of the sum certain.
2. Creditor's Rights
    Comments requested a number of clarifications regarding the 
requirement that the documents evidence the creditor's right to enforce 
the obligation. The most common concern raised by comments was that the 
requirement be modified to recognize that creditor's rights are often 
established by law, and, in such cases, would not necessarily be 
included in the loan documentation. Comments requested that the rules 
treat this requirement as established in such cases, without regard to 
whether the rights are reiterated in the loan documents. In such cases, 
comments requested that creditor's rights be respected without 
requiring additional documentation.
    The final regulations adopt this comment with one modification. If 
creditor's rights are created under local law without being reflected 
in writing in a loan agreement and no creditor's rights are written as 
part of the documentation of an interest, the documentation must refer 
to the law that governs interpretation and enforcement (for example, 
Delaware law or bankruptcy law). This requirement verifies that the 
issuer and holder did intend to create creditor's rights and assists 
the IRS in confirming that such creditor's rights apply to the holder 
of the interest.
    Several comments requested clarification that the fact that a note 
is nonrecourse does not prevent the satisfaction of the creditor's 
rights requirement. Further, comments requested clarification that, if 
a creditor only has rights to certain assets under the terms of an 
interest, the reference to assets of the issuer means only those 
assets, and such a limitation would not result in the interest failing 
to satisfy the creditor's rights indebtedness factor. The final 
regulations clarify these points.
    Finally, a number of comments suggested that the final regulations 
remove the proposed prohibition on subordination to shareholders in the 
case of dissolution. The principal concern of the comments was that, 
if, for example, one EGI (EGI#1) issued by an issuer were subordinate 
to another EGI (EGI#2) issued by the same issuer, and EGI#2 were 
recharacterized as stock under the proposed Sec.  1.385-3 regulations, 
EGI#1 would fail this requirement because it would be subordinate to 
EGI#2 (which is treated as stock for federal tax purposes). In such 
case, EGI#1, because it is subordinate to EGI#2, would be subordinate 
to shareholders (the holders of EGI#2) in a dissolution of the issuer 
and would therefore violate the proposed prohibition on subordination 
to shareholders in the case of dissolution. The Treasury Department and 
the IRS have considered this comment and determined that it would be 
appropriate to disregard subordination if the recharacterization 
occurred as a result of Sec.  1.385-3 and the final regulations reflect 
that decision. However, because a characterization under the 
documentation rules speaks to the substance of the interest itself, 
including whether the interest properly could be indebtedness for 
federal tax purposes under general federal tax principles, the Treasury 
Department and the IRS do not agree that it is appropriate to disregard 
a characterization caused by the documentation rules of Sec.  1.385-2 
for this purpose.
    One comment asked for clarification that equitable subordination 
imposed by a court would not affect this determination. The Treasury 
Department and the IRS are not aware of a situation in which it would 
be appropriate to disregard equitable subordination as a factor in 
determining whether an interest is properly indebtedness or stock, and 
so the final regulations do not adopt this comment.
    Several comments noted that subordination to later issued, 
unrelated-party indebtedness is common and should not be a negative 
factor. The Treasury Department and the IRS do not expect this 
circumstance will cause a problem under the regulations, as the 
unrelated-party indebtedness is not subject to recharacterization under 
the final regulations and the documentation rules only require that an 
interest be superior to the rights of shareholders, rather than debt 
holders.
3. Reasonable Expectation of Ability To Repay EGI
    A number of comments requested clarifications regarding the 
requirement that there be a reasonable expectation of the issuer's 
ability to repay its obligation. Comments also requested that the final 
regulations clarify that the expectation is subjective and that the 
creditor should be given reasonable latitude based on its business 
judgment. In addition, comments requested that the regulations should 
specify how frequently credit analysis is required. For example, some 
comments suggested that an approach similar to that taken for master 
agreements be adopted to allow a single agreement and a single credit 
analysis (done annually or at other specified intervals) to document 
multiple loans by expanded group members to a particular member. Other 
comments requested that the regulations should clarify whether it is 
only necessary to retest credit worthiness as often as is typical under 
commercial practice, or whether an annual analysis is sufficient. In 
response to these comments, the final regulations assist in 
implementing the documentation requirements for multiple EGIs issued by 
the same issuer by making it clear that a single credit analysis may be 
prepared on an annual basis and used for all interests issued by the 
issuer, up to an overall amount of indebtedness set forth in the annual 
credit analysis.
    With respect to the time for measuring an issuer's reasonable 
expectation of ability to repay an EGI, comments presumed that the 
issue date of the interest would be the appropriate date to measure. 
Although comments also noted that there are questions as to when this 
measuring date would arise. Comments also suggested that the reasonable 
expectation of ability to repay could be reevaluated if there is a 
deemed reissuance of the interest under the rules of section 1001, 
unless the parties can show a third party would have agreed to a 
modification.
    The regulations retain the requirement that documentation be 
prepared and maintained containing

[[Page 72878]]

information establishing that, as of the date of issuance of the EGI, 
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 EGI. The rules addressing the reasonable 
expectation of repayment factor thus retain the EGI's issuance date as 
the appropriate date for measuring the issuer's financial position. 
Issuance dates are to be determined under federal tax principles.
    With respect to whether the issuer's financial position supports a 
reasonable expectation that the issuer intended to, and would be able 
to meet its obligations pursuant to the terms of the obligation, 
comments requested that the application of a creditworthiness test of 
the issuer's financial position be excluded if the indebtedness is 
secured by specific property of the issuer. In response to this 
concern, the final regulations clarify that if the EGI is nonrecourse 
to the issuer, then the documentation to support such indebtedness must 
include the value of property available to support repayment of the 
nonrecourse EGI.
    Comments suggested that the creditworthiness of the issuer could be 
determined by a confirmation of the creditworthiness of the issuer by a 
third party or internal staff of the issuer. They further suggested 
that the regulations could provide safe harbors for creditworthiness 
using ratios such as a minimum debt-to-equity or ``EBIDTA''-to-interest 
ratios. Comments also requested that the regulations provide a list of 
documents that would satisfy the reasonable expectation requirement, 
which could include documents that would be sufficient (but not 
necessary) to show that the obligation could have been issued on the 
same terms with a third party. The final regulations clarify that 
documentation may include cash flow projections and similar economic 
analyses prepared by either the members of the expanded group of the 
issuer or third parties.
    Comments also requested clarification that refinancing would be an 
acceptable method to repay an EGI and that a refinancing does not 
adversely impact and may be assumed as part of the credit analysis; in 
other words, if the issuer could have issued the obligation to a third 
party with the ability to refinance the obligation on its maturity 
date, then the issuer would satisfy this requirement. Moreover, 
comments were of the view that in fact, a borrower's ability to 
refinance obligations when due should be a positive factor in a credit 
analysis. The final regulations provide that the credit analysis may 
assume that the principal amount of an EGI may be satisfied with the 
proceeds of another borrowing by the issuer to the extent that such 
borrowing could occur on similar terms with a third party.
    Comments requested clarity as to whose credit is being analyzed, 
specifically, whether it is only the ``recipient'' of funds or, if the 
issuer is a member of consolidated group, whether it is the entire 
consolidated group. Because the final regulations remove the one-
corporation rule for purposes of the documentation rules, the member 
that is the issuer of an interest would be analyzed for this purpose.
    One comment requested that the regulations clarify limits on 
privileged documents and provide specific limitations regarding the 
ability of the IRS to request, review, and maintain such information. 
The final regulations do not adopt this comment. The IRS routinely 
reviews and maintains confidential taxpayer information as part of its 
tax administration function, and strong protections for confidential 
taxpayer information already exist.
4. Actions Evidencing Debtor-Creditor Relationship
    Comments requested clarification that certain types of payments 
such as payments-in-kind, additions to principal, and payments of 
interest could be evidenced by journal entries in centralized cash 
management systems in which payables and receivables are managed. They 
also noted that the journal entries could be made with respect to the 
treasury center in such cases. The Treasury Department and the IRS 
agree that as long as a payment is in fact made and a written record of 
the payment is prepared and maintained, the documentation rules should 
not require that the payment be made or recorded in any particular 
manner. However, the Treasury Department and the IRS have determined 
that there is no need to expressly note that payments-in-kind or 
additions to principal should be included because these actions 
generally would take place and be recorded in as a part of journal 
entries reflecting a payment of interest. As a result, the final 
regulations adopt these comments in respect of journal entries (other 
than with respect to payments-in-kind or additions to principal).
    Comments requested that the rules make clear that the existence of 
creditors' rights is more important than their exercise. They urged a 
flexible approach that included much deference to the judgment of the 
creditor, suggesting a generous period in which to act on default. 
Comments noted that common law recognizes that choosing not to enforce 
the terms of the obligation may be completely consistent with 
indebtedness treatment and does not necessarily require an interest to 
be characterized as stock. For example, if the debtor's position 
deteriorates, if a default could trigger other default events, or if 
there are reasons to expect the debtor's situation to improve, a 
creditor may be well advised to choose forbearance. There may also be 
legal constraints or obligations arising out of the relationship 
between an issuer and holder that are in an expanded group that prevent 
or forestall enforcement action, including fraudulent conveyance laws.
    Most comments, however, sought a clear affirmation that this rule 
relates only to the documentation required, not the substantive 
evaluation of the creditor's actions. The Treasury Department and the 
IRS agree that this rule addresses only the requirement to document 
actions. However, the rules also require that an explanation be 
documented for inaction by a creditor upon failure of the issuer to 
comply with the terms of purported indebtedness and that the 
explanation for such inaction is an indebtedness factor. In the context 
of highly-related parties, where economic interests of the issuer and 
holder are aligned, there is a greater need for scrutiny where there is 
nonperformance and no assertion of creditor's rights. The lack of an 
explanation for such inaction may give rise to a substantive 
determination that the parties did not intend to create indebtedness in 
substance or ceased to treat an interest as indebtedness. Thus, the 
final regulations do not provide any specific guidance that addresses 
the comments related to the substantive evaluation of the actions the 
debtor or creditor must take. The final regulations provide a cross 
reference to Sec.  1.1001-3(c)(4)(ii), which provides rules regarding 
when a forbearance may be a modification of a debt instrument and 
therefore may result in an exchange subject to Sec.  1.1001-1(a). As 
later discussed, such an exchange could be a relevant date under the 
documentation rules.
5. Requests for Additional Guidance
    Many comments requested more detail about the type and extent of 
documentation that would be necessary in order to satisfy the 
documentation rules, often suggesting that examples and specific 
guidelines should be included in the regulations. Comments expressed 
concern that the lack of such guidelines would cause administrative 
difficulties, as agents would request,

[[Page 72879]]

and taxpayers would produce, unnecessary documentation. As a result, 
time would be spent unnecessarily on disputes over whether the 
documentation rules were satisfied instead of on the underlying 
substantive determination of the character of the interest at issue.
    Comments suggested the issuance of audit guidelines, the use of 
``fast track'' review by the IRS Office of Appeals, and the admission 
of these issues relating to the satisfaction of the documentation rules 
into the pre-filing agreement program as ways to facilitate 
administration for taxpayers and the IRS alike. The IRS agrees that 
these administrative procedures could assist both taxpayers and the IRS 
in the efficient resolution of cases. They are available under 
generally applicable criteria and procedures.
    The Treasury Department and the IRS have considered these comments 
and agree that the purpose of the documentation rules is not to prepare 
and maintain unnecessary documentation. Rather, the purpose of the 
documentation rules is to provide a taxpayer with guidance regarding 
what broad categories of information are necessary to be documented to 
evidence the creation of a debtor-creditor relationship, as well as to 
facilitate tax administration.
D. Specific Technical Questions
1. Relevant Dates
    Under proposed Sec.  1.385-2, the relevant date for purposes of 
documenting the issuer's unconditional obligation to repay and the 
creditor's right to repayment was generally either the date that an 
expanded group member issued an EGI or the date that an instrument 
became an EGI. The relevant date for purposes of documenting the 
reasonable expectation of repayment was generally either the date that 
an expanded group member issued an EGI, the date that an EGI was deemed 
reissued under Sec.  1.1001-3, or the date that an instrument became an 
EGI. The relevant date for purposes of documenting actions evidencing a 
debtor-creditor relationship was generally either the date that a 
payment was made or the date on which an event of default occurred. 
Proposed Sec.  1.385-2 provided that no date before the applicable 
instrument becomes an EGI is a relevant date.
    Some comments suggested that the ``relevant date'' be the same for 
the documentation requirements regarding the issuer's obligations, the 
holder's rights, or the reasonable expectation of payment. The Treasury 
Department and the IRS have not adopted this suggestion because these 
dates will not and should not always match. For example, under a 
revolving credit agreement individual draws would typically be made at 
different times than the requisite credit analysis of the borrower. The 
Treasury Department and the IRS have determined that the appropriate 
times for retesting the reasonable expectation of repayment and for 
documenting other indebtedness factors may differ. For example, if 
there is a material event affecting the solvency or business of the 
issuer, an updated analysis of the reasonable expectation of repayment 
may be appropriate, even where the legal documents related to an 
interest have not been modified.
    In addition, proposed Sec.  1.385-2 provided that the relevant date 
with respect to cash pools, master agreements, and similar arrangements 
included the date of the execution of the legal documents governing the 
arrangement and the date of any amendment to those documents that 
provides for an increase in the permitted maximum amount of principal.
    Comments suggested that relevant dates for such arrangements should 
include only the dates that the arrangement is put into place, new 
members are added, or the maximum loan amount is increased. The final 
regulations clarify that these dates are generally the relevant dates 
for these arrangements. However, as previously discussed, an annual 
credit analysis (as well as a credit analysis as of a material event of 
an issuer) must be performed under these arrangements and, as a result, 
the final regulations provide that relevant dates for that credit 
analysis include the anniversary of the credit analysis as well as the 
date of any material event of the issuer.
2. Maintenance Requirements
    Proposed Sec.  1.385-2 provided that required documentation must be 
maintained for all taxable years that an EGI is outstanding, until the 
period of limitations expires for any federal tax return with respect 
to which the treatment of the EGI is relevant. Comments raised concerns 
that this rule was burdensome and requested that the final regulations 
include a practical way to limit the length of time that documentation 
must be maintained. The Treasury Department and the IRS do not adopt 
this request because they consider it inappropriate to permit the 
destruction of documentation while such documentation is relevant for 
federal tax purposes because this would be inconsistent with the 
requirements of section 6001 (requirement to keep books and records).
3. Period When Sec.  1.385-2 Characterization Is Given Effect
a. Debt Instrument Becomes an EGI
    Proposed Sec.  1.385-2 provided that, in the case of an interest 
that was an EGI when issued, if the EGI is determined to be stock as a 
result of the documentation rules, the EGI is generally treated as 
stock as of its issuance. The exception to this general rule was if the 
failure to comply with the documentation rules related to an action 
evidencing a debtor-creditor relationship; in that case, the EGI would 
be treated as stock as of the time that the failure to comply occurs. 
However, if the interest was not an EGI when issued but later becomes 
an EGI that is determined to be stock under the documentation rules, 
the EGI is treated as stock from the date it becomes an EGI.
    Comments urged that the documentation rules apply only once an 
interest becomes an EGI and that any characterization based on the 
application of rules be limited to the treatment of the EGI after it 
becomes an EGI. The Treasury Department and the IRS intended that the 
documentation rules would not generally apply to an interest until it 
becomes an EGI, and the final regulations clarify this point.
    Several comments also requested that the rules not apply to any 
interest if, when issued, either the issuer or holder was not subject 
to federal tax, was a CFC, or was a controlled foreign partnership. The 
final regulations reserve on the treatment of foreign issuers, and, 
other than potentially under the anti-abuse rule, do not apply to 
interests issued by a partnership. Accordingly, the final regulations 
do not adopt this comment.
    Comments suggested clarifying the treatment of an interest when its 
status changes from an EGI to an intercompany obligation subject to 
Sec.  1.1502-13(g) and when its status changes from an intercompany 
obligation subject to Sec.  1.1502-13(g) to an EGI. Some comments 
requested that in the case of an intercompany obligation becoming an 
EGI, the regulations treat the issue date as the date the interest 
ceases to be an intercompany obligation. Conversely, another comment 
urged that if an interest becomes an EGI, it should nevertheless be 
excluded from the regulations. The final regulations address this 
comment by treating such an EGI as subject to the documentation rules 
when it becomes an EGI. This approach is consistent with the

[[Page 72880]]

approach in Sec.  1.1502-13(g)(3)(ii), which treats such an EGI as a 
new obligation for all federal income tax purposes.
    Many comments urged that there was no need to impose documentation 
requirements regarding the issuer's obligations, the holder's rights, 
or the reasonable expectation of payment when a non-EGI became an EGI 
because such documentation would be done on issuance under common 
commercial practices. As such, it arguably would be adequate to police 
these requirements with an anti-abuse rule. Similarly, some comments 
urged there be no such documentation requirement when an expanded group 
acquired an EGI from another expanded group because the documentation 
rules would apply at the time the EGI was issued.
    Thus, under either suggestion, the only documentation requirement 
that would apply to such notes would be that relating to evidence of a 
debtor-creditor relationship. These comments also requested that, if 
these suggestions were not adopted, the regulations allow at least a 
year for taxpayers to bring incoming EGIs into compliance. The Treasury 
Department and the IRS have determined that the documentation 
requirements are necessary for EGIs, regardless of whether they are 
initially issued within the expanded group or whether they become EGIs 
after issuance. The fact that such interests may have been initially 
issued among less-related parties does not change the requirement that 
the interests must be characterized under federal tax principles as 
debt or equity, and the indebtedness factors in the documentation rules 
are important factors for the debt-equity analysis of any interest. 
Moreover, once an interest becomes an EGI, meaning that the issuer and 
holder are highly related, the terms and conditions may no longer be 
followed due to this high degree of relatedness. Because of this issue, 
it is necessary for such EGIs to be subject to the rules in order to 
ensure that the policy goals of the documentation rules are achieved. 
Treating a loan differently once it becomes held by an entity related 
to the issuer is not unique to these rules. For purposes of testing for 
cancellation of indebtedness income, section 108(e)(4) takes a similar 
approach by treating a purchase of a note by a party related to the 
issuer as in effect a repurchase of the note by the issuer. However, 
the Treasury Department and the IRS have relaxed the timely preparation 
requirement so that the documentation of all EGIs does not have to be 
prepared and maintained until the time for filing the issuer's federal 
income tax return (taking into account all relevant extensions).
b. EGI Treated as Stock Ceases To Be an EGI
    Comments requested that, if an EGI that was treated as stock under 
the documentation rules ceases to be treated as stock when it ceases to 
be an EGI, the recharacterization back to indebtedness is deemed to 
occur immediately after the interest ceases to be an EGI. The reason 
offered was to avoid creating a noneconomic dividend when the stock is 
deemed exchanged for the note. The final regulations do not adopt this 
comment. Under the final regulations, if an EGI that was treated as 
stock under the documentation rules ceases to be treated as stock when 
it ceases to be an EGI, the recharacterization back to indebtedness is 
deemed to occur immediately before the interest ceases to be an EGI. 
This rule is intended to ensure that the treatment of a third-party 
purchaser of the EGI is not affected by the final regulations, which 
are not intended to affect issuances of notes among unrelated parties. 
If the rule suggested by the comment were adopted, a third-party 
purchaser would be treated as purchasing stock that is immediately 
recharacterized as indebtedness for federal tax purposes. Such a rule 
would result in an issue price of the new debt instrument determined 
under section 1274, rather than section 1273, and might result in other 
collateral consequences to the third party purchaser.
4. Applicable Financial Statements
    Comments requested clarification on the definition of the term 
applicable financial statement. For example, some comments suggested 
that the regulations define the term to mean the most recent regularly 
prepared financial statements, provided that the statements were 
prepared annually and that the taxpayer was not aware of any material 
adverse decline in the issuer's financial position. Other comments 
asked for clarification on the applicable financial statement that 
should be used if more than one member of the expanded group has a 
separate applicable financial statement. Proposed Sec.  1.385-2 
referred to a combination of applicable financial statements in such a 
case. The final regulations clarify that, if there are multiple 
separate applicable financial statements that do not duplicate the 
assets or income of expanded group members, the applicable financial 
statements must be combined to determine whether the expanded group is 
under the threshold for the application of the documentation rules. The 
final regulations provide that in the case of applicable financial 
statements that reflect the total assets or annual total revenue of the 
same expanded group member, the applicable financial statement with the 
greatest amount of total assets is to be used. The final regulations 
also provide rules that address the potential double counting of assets 
or revenue when a combination of applicable financial statements is 
used. However, the final regulations retain the rule that the set of 
applicable financial statements are those prepared in the past three 
years. This rule eliminates the possibility that the most recent 
applicable statement may not be representative of the long-term asset 
and revenue history of the expanded group. The Treasury Department and 
the IRS have determined that this history is an appropriate measure of 
whether a group should be subject to the documentation rules. Because 
the expanded group definition and the consolidation rules for financial 
accounting rules differ, it will frequently be the case that applicable 
financial statements will provide information about a set of 
corporations that does not precisely match the set of corporations in 
an expanded group. Applicable financial statements therefore provide an 
approximation of the assets and revenue of the expanded group. Thus, 
even if the most recent applicable financial statement were below the 
threshold, it may not provide definitive information about the assets 
and revenue of the expanded group.
    One comment noted that, unless stock and notes of expanded group 
members were excluded from the computation of assets and income, such 
amounts could be duplicated in the calculation of total assets or total 
annual revenue. The final regulations exclude expanded group member 
stock and notes, as well as any payments with respect to such stock or 
notes to the extent that those expanded group members are consolidated 
for financial accounting purposes in the applicable financial 
statements used to calculate whether the asset or revenue thresholds 
are met.
5. Consistency Rule
    Proposed Sec.  1.385-2 provided that an EGI would be respected as 
indebtedness only if the documentation requirements were satisfied. 
Further, if an issuer treated an EGI as indebtedness, the issuer and 
all other persons, except the Commissioner, were required to treat the 
EGI as indebtedness for all federal tax purposes. Comments requested 
clarification of this rule if a taxpayer subsequently discovered that 
an interest it treated as indebtedness would be

[[Page 72881]]

treated as stock under the documentation rules. The final regulations 
adopt these comments with respect to the consistency rule and clarify 
that only the issuer and holder of an EGI are subject to the 
consistency rule. Comments also urged that taxpayers be permitted to 
treat interests inconsistently with their classification under the 
documentation rule once an interest ceases to be subject to the rule, 
provided such inconsistencies were disclosed on the taxpayers' returns. 
The final regulations do not adopt this comment because the final 
regulations, including the consistency rule, would not apply to an EGI 
for the period it were not an EGI.
6. No Affirmative Use Rule
    Proposed Sec.  1.385-2 included a rule providing that the 
documentation rules would not apply if a failure to comply with the 
rules had as a principal purpose reducing the federal tax liability of 
any person. Comments urged that this rule be removed, as they felt it 
caused significant uncertainty that could lead to conflicts with tax 
authorities. Comments also urged that the rule be limited to failures 
of the requirement to document actions evidencing a debtor-creditor 
relationship, inasmuch as taxpayers that intended an interest to be 
treated as stock on issuance could simply fashion the interest as stock 
or nonqualified preferred stock at that time.
    In response to comments, including comments about the no 
affirmative use rule creating unnecessary uncertainty, the Treasury 
Department and the IRS reserve on the application of the no affirmative 
use rule in Sec.  1.385-2 pending continued study after the 
applicability date.
7. Anti-Abuse Rule
    Under proposed Sec.  1.385-2, if a debt instrument not issued and 
held by members of an expanded group was issued with a principal 
purpose of avoiding the documentation rules, the interest nevertheless 
would be subject to the documentation rules. Comments suggested that 
this broad anti-abuse rule be removed, or at least narrowed, so that it 
would not apply to loans between unrelated parties.
    The Treasury Department and the IRS decline to remove the rule as 
it serves an important tax administration purpose. Without such a rule, 
applicable instruments not constituting EGIs could be issued, for 
example, by a non-corporate entity or a slightly less-related 
corporation to circumvent the documentation rules. Further, the 
Treasury Department and the IRS decline to adopt the suggestion to 
limit the rule to loans between related parties as that would permit 
the use of accommodation parties to avoid the documentation rules.

V. Comments and Changes to Sec.  1.385-3--Certain Distributions of Debt 
Instruments and Similar Transactions

A. General Approach of Sec.  1.385-3
1. Overview
    The proposed regulations provided that, to the extent a debt 
instrument is treated as stock by reason of proposed Sec.  1.385-3, the 
debt instrument would be treated as stock for all federal tax purposes.
    Comments requested that proposed Sec.  1.385-3 be withdrawn or 
thoroughly reconsidered before being finalized. Other comments 
recommended that proposed Sec.  1.385-3 be withdrawn and replaced with 
more limited rules, such as rules applicable solely to inverted 
entities or foreign-parented multinationals. Comments also recommended 
withdrawal of portions of the proposed regulations that would have a 
significant impact on ordinary business transactions. In some cases 
these comments specified which provisions should be withdrawn, such as 
the per se rule described in proposed Sec.  1.385-3(b)(3)(iv)(B), while 
in other cases, the comments did not specify which provisions should be 
withdrawn. In addition, comments suggested that the treatment of 
certain transactions (such as foreign-to-foreign issuances or C 
corporation-to-C corporation issuances) be excluded or reserved in the 
final and temporary regulations based on the U.S. tax status of the 
issuer or holder of the instrument, or based on whether the interest 
income from the instrument is subject to federal income tax.
    As explained in this Part V.A, the Treasury Department and the IRS 
decline to adopt the alternative approaches suggested by comments and 
have determined that the general approach of proposed Sec.  1.385-3, 
including the per se funding rule, should be retained. However, based 
on the comments received, the Treasury Department and the IRS have 
determined that it is appropriate to make significant modifications to 
the scope of transactions that must be considered in applying the final 
and temporary regulations in order to reduce the impact on ordinary 
business transactions. These modifications are described throughout 
this Part V.
    The remainder of this Part V refers to the ``per se funding rule'' 
to mean either the rule described in proposed Sec.  1.385-
3(b)(3)(iv)(B) or Sec.  1.385-3(b)(3)(iii) of the final regulations, or 
both, as the context requires.
2. U.S. Tax Status of Issuer or Holder
    The final and temporary regulations do not limit the application of 
Sec.  1.385-3 to inverted entities or foreign-parented multinationals. 
Any two highly-related domestic corporations that compute federal tax 
liability on a separate basis have similar incentives to use purported 
debt to create federal tax benefits without having meaningful non-tax 
effects if one of the domestic corporations has taxable income and the 
other does not, for example due to net operating loss carryovers. 
Moreover, while an impetus for the regulations is the ease with which 
related-party debt instruments can be used to create significant 
federal tax benefits, the final and temporary regulations are narrowly 
focused on purported debt instruments that are issued to a controlling 
corporate shareholder (or person related thereto) and that do not 
finance new investment in the operations of the issuer. In developing 
regulations under section 385, the Treasury Department and the IRS have 
determined that, when these factors are present, it is appropriate to 
treat the debt instrument as reflecting a corporation-shareholder 
relationship rather than a debtor-creditor relationship across a broad 
range of circumstances.
    Similarly, the final and temporary regulations do not adopt 
comments recommending an exception from Sec.  1.385-3 for instruments 
for which the interest income is subject to U.S. tax because it is: (i) 
Paid to a U.S. corporation, (ii) effectively connected income of the 
lender, (iii) an amount subject to withholding for U.S. tax purposes, 
or (iv) subpart F income (within the meaning of section 952(a)). As 
explained in the preceding paragraph, the Treasury Department and the 
IRS have determined that, in the context of highly-related corporations 
(where the relatedness factor is also present), whether a purported 
debt instrument finances new investment is an appropriate determinative 
factor. Whether such factors are present is not dependent on the 
federal income tax treatment of payments on the instrument. Moreover, 
in all of the situations described in the comments in which an amount 
of interest is ``subject to'' U.S. tax, tax arbitrage opportunities 
would nonetheless arise if in fact the interest were not subject to tax 
at the full U.S. corporate tax rate and thus did not completely offset 
the related interest deduction. Since the rules apply only to payments 
between highly-related

[[Page 72882]]

parties, one would expect taxpayers to seek to utilize related-party 
debt in those circumstances, so that such a broad exception would be 
inconsistent with the underlying rationale for these rules. Further, an 
exception based on the U.S. tax consequences of payments with respect 
to the instrument would require annual testing of the effective tax 
rate with respect to the payment and re-testing for any post-issuance 
transfers of the debt instrument to assess the tax status of each 
transferee and the payments thereto. This requirement could result in 
instruments that might otherwise be treated as equity pursuant to Sec.  
1.385-3 switching between debt and equity classification from year to 
year, depending on how the payment was taxed. This generally would be 
inconsistent with the purpose of section 385, which is to characterize 
an instrument as debt or equity for all purposes of the Code, and would 
be difficult for the IRS and taxpayers to administer.
    Comments also recommended that distributions that are subject to 
U.S. tax be excluded from the general rule and funding rule. Comments 
asserted that such distributions do not facilitate earnings stripping 
and therefore should not implicate the concerns targeted under the 
proposed regulations. For reasons similar to those cited above for why 
the rules do not include an exception when interest is subject to U.S. 
tax, the Treasury Department and the IRS decline to adopt these 
comments. The final and temporary regulations are intended to address 
debt instruments that do not finance new investment in the operations 
of the borrower. The consequences of a distribution or acquisition to 
the recipient, whether the transaction is taxed as a dividend 
(including as a result of withholding tax), return of basis, or gain, 
does not affect the determination whether a close-in-time borrowing 
financed new investment in the operations of the borrower.
    Thus, in general, the application of the final and temporary 
regulations to a debt instrument does not depend on the status of the 
instrument's holder, except in the case where the holder and issuer of 
the instrument are both members of the same consolidated group. As 
discussed in the preamble to the proposed regulations, Sec.  1.385-3 
does not apply to instruments held by members of a consolidated group 
because the concerns addressed in Sec.  1.385-3 generally are not 
present when the issuer's deduction for interest expense and the 
holder's corresponding interest income precisely offset on the 
consolidated group's single consolidated federal income tax return. 
Specifically, in addition to being reported on a single federal income 
tax return, the intercompany transaction rules of Sec.  1.1502-13 
operate to ensure that the timing, character, and other attributes of 
such items generally match for federal income tax purposes. For 
example, the ordinary character of a borrowing member's repurchase 
premium with respect to an intercompany obligation results in the 
lending member recognizing as ordinary income what otherwise would be 
treated as capital gain if the members were taxed on a separate entity 
basis.
    However, as discussed in Part III.A.1 of this Summary of Comments 
and Explanation of Revisions, and in response to comments received, the 
final and temporary regulations reserve on their application with 
respect to debt issued by foreign issuers due to the potential 
complexity and collateral consequences of applying the regulations in 
this context where the U.S. tax implications are less direct and of a 
different nature. In addition, as discussed in Part III.B.2.b of this 
Summary of Comments and Explanation of Revisions, the final and 
temporary regulations do not generally apply to S corporations or non-
controlled RICs and REITs. Even though these entities are domestic 
corporations that can compute federal tax liability on a separate basis 
from their C corporation subsidiaries, the general approach in the Code 
is to tax these entities at the shareholder, rather than the corporate, 
level. Accordingly, they do not raise the same type of concerns that 
underlie the final and temporary regulations.
3. Entities With Disallowed or Minimal Interest Expense
    Some comments requested an exception for U.S. issuers that are 
already treated as paying disqualified interest under section 163(j) 
(noting that United States real property holding corporations (USRPHCs) 
in particular are often subject to such disallowance). Comments 
asserted that this would mitigate the concerns of the proposed 
regulations and proposed that an issuer paying disqualified interest be 
excluded from the scope of the regulations because further base erosion 
through related-party debt is not possible. Other comments stated that 
the rules should not apply to an entity with net interest income or 
only a de minimis amount of net interest expense.
    The final and temporary regulations do not adopt the suggestion to 
exclude issuers with disqualified interest or issuers with low or no 
net interest expense because, as explained in Section A.1 of this Part 
V, the regulations are concerned about debt instruments that do not 
finance new investment, which does not depend on whether the borrower 
is excessively leveraged, has net interest income or expense, or is 
able to deduct its interest expense. The final and temporary 
regulations apply to distinguish debt from equity, whereas the rules 
under section 163(j) apply to all interest expense without the need to 
attribute interest to particular debt instruments. In addition, the 
disallowance under section 163(j) may vary from year to year, so that 
even if it were possible to trace interest limited under that section 
to a particular instrument, whether any particular instrument was so 
impacted would change from year to year. As discussed in Section A.1 of 
this Part V, annual retesting for purposes of an instrument's 
characterization would be inconsistent with the purpose of section 385 
and would be difficult to administer. For these reasons, the Treasury 
Department and the IRS have determined that it would not be practical 
or administrable to create an exception under the final and temporary 
regulations based on whether interest has been disallowed under section 
163(j).
    Furthermore, in the case of issuers with low or no net interest 
expense, a number of other exceptions provided in the final and 
temporary regulations will achieve a similar result for some entities. 
For example, as described in Section G.1 of this Part V, the final and 
temporary regulations provide an exception for debt instruments issued 
by certain regulated financial issuers, for which interest income often 
offsets interest expense. In addition, the final and temporary 
regulations expand the $50 million threshold exception in the manner 
described in Section E.4 of this Part V so that all taxpayers can 
exclude the first $50 million of indebtedness that otherwise would be 
recharacterized under Sec.  1.385-3. Finally, in order to further 
reduce compliance costs, the final and temporary regulations provide a 
broad exception to the funding rule for short-term debt instruments, as 
described in Section D.8 of this Part V, which generally applies to all 
non-interest bearing debt instruments as well as many other debt 
instruments that are short-term in form and substance. Similar to a net 
interest expense limitation, these new and expanded exceptions will, in 
combination, have the effect of exempting a number of entities with low 
net interest expense and will reduce the burden of complying with the 
final and temporary

[[Page 72883]]

regulations in cases where the U.S. tax interest is limited. See also 
Section D.9 of this Part V, which addresses a related comment 
requesting that the final and temporary regulations permit taxpayers to 
net indebtedness ``receivables'' and ``payables'' for purposes of the 
funding rule.
4. Limiting Interest Deductibility Without Reclassifying Interests
    Comments also suggested addressing the policy concerns underlying 
the regulations by issuing guidance that more closely conforms to 
concepts used in section 163(j), which limits the deduction for 
interest on certain indebtedness in a taxable year. Section 385 
authority differs fundamentally from section 163(j) because, rather 
than limiting interest deductions in a particular year, section 385 
addresses the treatment of certain interests in a corporation as stock 
or indebtedness. While rules limiting interest deductions from 
excessive related-party indebtedness might address the broader policy 
concerns described in this preamble and in the notice of proposed 
rulemaking, Congress did not delegate such authority under section 
163(j) to the Secretary. Accordingly, the final and temporary 
regulations are not intended to resolve the tax preference for using 
related-party debt to finance investment. Instead, the final and 
temporary regulations are more narrowly focused on the question of 
whether purported debt instruments issued to a controlling corporate 
shareholder (or a person related thereto) that do not finance new 
investment in the operations of the issuer reflect a corporation-
shareholder relationship or a debtor-creditor relationship for purposes 
of the Code. The Treasury Department and the IRS have determined that 
this question is appropriately addressed under section 385 and, 
accordingly, that it is appropriate to treat such debt instruments 
generally as stock for federal tax purposes.
5. Group Ratio Test
    One comment suggested that the regulations under Sec.  1.385-3 
include an exception to the extent the issuing member's net 
indebtedness does not exceed its relative share of the expanded group's 
third-party indebtedness. The comment noted that such a rule would be 
consistent with legislative proposals made by the Treasury Department 
to modify the interest expense disallowance rules under section 163(j).
    The Treasury Department and the IRS decline to adopt this 
recommendation. While reference to an expanded group's third-party 
indebtedness could be part of a comprehensive solution to address the 
tax incentives to use related-party debt to create excessive leverage, 
as discussed in this Section A.1 of this Part V, the final and 
temporary regulations are more narrowly focused on purported debt 
instruments that do not finance new investment. The Treasury Department 
and the IRS have determined that, when this factor, along with the 
relatedness factor, is present, the purported debt instrument should be 
treated as stock without regard to whether the issuer is over-
leveraged, whether by reference to the expanded group's third-party 
indebtedness or some other ratio. Furthermore, a member's relative 
share of the expanded group's third-party indebtedness generally would 
fluctuate every year as the group's income statement or balance sheet 
changes. An exception that varied based on such a ratio would therefore 
require that instruments that otherwise might be treated as equity 
pursuant to Sec.  1.385-3 instead switch between debt and equity 
classification from year to year, depending on the group's ratio for 
that year. As discussed in Section A.1 of this Part V, annual retesting 
for purposes of an instrument's characterization would be inconsistent 
with the purpose of section 385, and would be difficult for the IRS and 
taxpayers to administer.
6. Multi-Factor Analysis
    Some comments suggested that the regulations adopt a multi-factor 
debt-equity analysis similar to that traditionally undertaken by 
courts. The Treasury Department and the IRS decline to adopt a multi-
factor approach to Sec.  1.385-3. As discussed in Part II.A of this 
Summary of Comments and Explanation of Revisions, section 385 
authorizes the Secretary to prescribe dispositive factors for 
determining the character of an instrument with respect to particular 
factual situations. Further, Congress enacted section 385 to resolve 
the confusion created by the multi-factor tests traditionally utilized 
by courts, which produced inconsistent and unpredictable results. See 
S. Rep. No. 91-552, at 138 (1969). The Treasury Department and the IRS 
have determined that it is necessary and appropriate to provide a clear 
rule regarding the characterization of issuances of purported debt 
instruments that do not finance new investment in the operations of the 
issuer. In contrast, recommendations for a multi-factor approach to 
address debt instruments that do not finance new investment could 
result in increased uncertainty for taxpayers, administrative 
difficulties for the IRS, and unpredictable case law.
7. Consistency With Base Erosion and Profit Shifting Outputs
    Some comments claimed that the proposed regulations were 
inconsistent with the ``best practice'' recommendations that were 
developed as part of the G20 and Organisation for Economic Co-operation 
and Development's (OECD) Base Erosion and Profit Shifting (BEPS) 
project under Action Item 4 (Limiting Base Erosion Involving Interest 
Deductions and Other Financial Payments). The report from that project 
recommended that countries adopt limitations on interest deductions 
that incorporate general group ratio and fixed ratio rules. The 
Treasury Department and the IRS have concluded that the final and 
temporary regulations are entirely consistent with the final report for 
Action Item 4, which recommends in paragraph 173 that, in addition to 
the group ratio and fixed ratio rules, countries consider introducing 
domestic rules to address when ``[a]n entity makes a payment of 
interest on an ``artificial loan,'' where no new funding is raised by 
the entity or its group.'' Consistent with the Action Item 4 report, 
the final and temporary regulations provide targeted rules to address 
this concern.
    Some comments also noted that the recharacterization of debt 
instruments as equity instruments under the proposed regulations would 
result in a significant increase in the number of hybrid instruments, 
contrary to the United States' endorsement of Action Item 2 (Neutralise 
the effects of hybrid mismatch arrangements) of the BEPS project, which 
recommended rules for neutralizing the effects of hybrid mismatch 
arrangements. The comments also noted that foreign countries could 
apply the BEPS hybrid mismatch rules to deny foreign interest 
deductions with respect to debt instruments issued by a foreign entity 
to a U.S. parent that were treated as stock under the proposed 
regulations, which could increase the foreign tax credits claimed by 
the U.S. parent.
    The Treasury Department and the IRS do not agree that the final and 
temporary regulations are inconsistent with the goal of Action Item 2, 
which is to neutralize the tax effects of hybrid instruments that 
otherwise would create income that is not subject to tax in any 
jurisdiction, rather than to establish an international consensus on 
the treatment of particular instruments as debt or equity. Furthermore, 
because the final and temporary regulations reserve on their 
application to foreign issuers, hybrid instruments arising under the 
final and temporary regulations should

[[Page 72884]]

not result in other jurisdictions applying the hybrid mismatch rules 
described in Action Item 2, which generally apply only to instruments 
giving rise to a deduction in the issuer's jurisdiction with no 
corresponding inclusion in the lender's jurisdiction.
B. Treatment as Stock for Purposes of the Code
1. In General
    Comments requested clarification as to the extent to which an 
interest treated as stock under the proposed regulations is treated as 
stock for all federal tax purposes. The Treasury Department and the IRS 
have determined that no further clarification is needed on this point. 
Consistent with the proposed regulations, the final and temporary 
regulations generally provide that an instrument treated as stock under 
the final and temporary regulations is treated as stock for all federal 
tax purposes. However, as further discussed in Section B.2 of this Part 
V, the final and temporary regulations provide that a debt instrument 
that is treated as stock under Sec.  1.385-3 is not treated as stock 
for purposes of section 1504(a).
    Comments requested an alternative approach under which, to the 
extent a debt instrument is treated as stock under the regulations, 
equity treatment would apply solely for purposes of disallowing 
interest deductions under section 163, but the debt instrument would 
not be treated as stock for all other purposes of the Code. Other 
comments recommended that the proposed rules should not recharacterize 
a debt instrument to the extent that a taxpayer elects not to deduct 
interest otherwise allowable under section 163 with respect to a 
particular debt instrument. The Treasury Department and the IRS have 
not adopted these recommended approaches because, although section 385 
authorizes the Secretary to prescribe rules to determine whether an 
interest in a corporation is treated as stock or indebtedness, neither 
section 385 nor section 163 authorizes a broad rule that disallows an 
interest deduction under section 163 with respect to an instrument that 
is otherwise treated as indebtedness.
    Comments also observed the potential for uncertainty or adverse 
results under the proposed regulations, particularly proposed Sec.  
1.385-3, with respect to the following particular Code provisions and 
requested additional guidance or relief. In many cases, the recommended 
solution was a limited exception from equity treatment for a 
recharacterized instrument for purposes of the particular Code 
provision.
     Section 246. Comments noted that payments on a hybrid 
instrument (equity for federal income tax purposes, but debt for non-
tax purposes) that affords the holder creditor rights may not qualify 
for the dividends received deduction under section 243. See section 
246(c); Rev. Rul. 94-28 (1994-1 C.B. 86) (concluding that the holding 
period of such an instrument was reduced under section 246(c)(4)(A), 
which reduces the holding period for periods in which the taxpayer has 
an option to sell, or is under a contractual obligation to sell, the 
stock).
     Section 305. Comments requested clarification regarding 
the application of section 305 to a debt instrument recharacterized as 
stock. For example, a comment requested clarification regarding the 
application of section 305(c) to amounts that would represent accrued 
interest but for the recharacterization, which could result in a 
constructive distribution to the instrument holder. A comment also 
recommended that the final and temporary regulations provide that an 
interest reclassified as preferred stock should not cause section 
305(c) to apply as a result of any discount resulting from the fact 
that the interest was issued with a stated interest rate that is less 
than a market rate for dividends on preferred stock.
     Sections 336(e) and 338. A comment requested clarification 
regarding the qualification for, and results stemming from, asset sales 
that are deemed to occur when an election is made under section 336(e) 
or section 338. The comment posited a buyer making a section 338(g) 
election with respect to its purchase of a foreign target corporation, 
and certain of the foreign target's foreign subsidiaries, each of which 
is either the holder or issuer of an instrument that would have been 
recharacterized under proposed Sec.  1.385-3. The comment posed a 
series of questions, including whether the ``old'' and ``new'' entities 
are respected as unrelated or treated as successors, and how the 
recharacterized instruments affect calculations required under section 
338.
     Section 368. Comments expressed concern that a debt 
instrument that is recharacterized as stock would constitute a discrete 
class of nonvoting stock for purposes of determining control under 
section 368(c), which could cause a transaction to fail to satisfy the 
control requirement of numerous nonrecognition provisions. See Rev. 
Rul. 59-259 (1959-2 C.B. 115) (holding that control within the meaning 
of section 368(c) requires ownership of 80 percent of the total number 
of shares of each class of nonvoting stock). One comment observed that 
a debt instrument recharacterized as stock could also affect whether 
the continuity of interest requirement for reorganizations in Sec.  
1.368-1(e) is satisfied. Because continuity of interest is determined 
by reference to the value of the proprietary interests of the target 
corporation, a debt instrument that is treated as target stock and that 
is redeemed for cash as part of the reorganization would dilute the 
percentage of acquirer stock in relation to total consideration. See 
Sec.  1.368-1(e)(1)(ii).
     Section 382. Comments observed that the recharacterization 
of an instrument could increase an existing shareholder's ownership of 
a loss corporation or result in the creation of a new shareholder for 
purposes of section 382 testing. In addition, a corresponding decrease 
in ownership could occur when a recharacterized debt instrument is 
retired. These transactions could cause an owner shift or ownership 
change within the meaning of section 382(g), which could limit the 
ability of a loss corporation (or loss group) to utilize losses of the 
issuing entity.
     Section 1503. Comments observed that recharacterized debt 
instruments could be treated as applicable preferred stock for purposes 
of section 1503(f)(3)(D), which could result in a member of a 
consolidated group losing the ability to utilize the group's losses or 
credits.
     Section 7701(l). Comments expressed concern that an 
instrument that is treated as stock could be subject to the fast-pay 
stock rules of Sec.  1.7701(l)-3, and observed that transactions 
involving fast-pay stock are listed transactions under Notice 2000-15 
(2000-1 C.B. 826), thus imposing additional reporting requirements and 
penalties for noncompliance.
     Section 1.861-12T(f). One comment questioned whether 
treating purported indebtedness as stock would have consequences under 
Sec.  1.861-12T(f), which provides that, for purposes of apportioning 
expenses under an asset method for purposes of section 904(d), in the 
case of any asset in connection with which interest expense accruing at 
the end of the taxable year is capitalized, deferred, or disallowed, 
the adjustment or fair market value is reduced by the principal amount 
of the indebtedness the interest on which is so capitalized, deferred, 
or disallowed.
     Provisions relating to hedging transactions. Comments 
expressed

[[Page 72885]]

concern that an interest treated as stock under the final and temporary 
regulations would be ineligible for purposes of applying various 
hedging provisions in the Code and regulations that apply to debt 
instruments but not stock. See, e.g., Sec. Sec.  1.954-2(a)(4)(ii), 
1.988-5, and 1.1275-6.
    Some comments suggested that the final and temporary regulations 
exercise the authority in section 351(g)(4) in order to treat any debt 
instrument that is treated as stock under the section 385 regulations 
as not stock for purposes of the control test in section 368(c) and 
other tests that are based on the ownership of stock. Section 351(g)(4) 
provides that the Secretary may prescribe such regulations as may be 
necessary or appropriate to carry out the purposes of section 351(g) 
and sections 354(a)(2)(C), 355(a)(3)(D), and 356(e), as well as to 
prescribe regulations, consistent with the treatment under those 
sections, for the treatment of nonqualified preferred stock under other 
provisions of the Code. Some comments interpreted this authority 
broadly to authorize the Secretary to treat instruments treated as 
stock under section 385 as debt for all other purposes of the Code when 
the context suggested that the instruments were not being used to 
achieve federal tax benefits.
    The final and temporary regulations retain the approach of the 
proposed regulations under which related-party indebtedness treated as 
stock by application of Sec.  1.385-3 is treated as stock for all 
federal tax purposes, with one exception with respect to section 1504 
that is discussed in Section B.2 of this Part V. As discussed in 
Section A of this Part V, when a purported debt instrument issued to a 
highly-related corporation does not finance new investment in the 
operations of the issuer, the Treasury Department and the IRS have 
determined that it is appropriate to treat the purported debt 
instrument as stock for all federal tax purposes. Moreover, the issues 
described in the comments listed in this Section B.1 of this Part V 
generally do not arise uniquely as a result of the application of the 
final and temporary regulations but, rather, arise whenever purported 
debt instruments are characterized as stock under applicable common 
law. Several of these issues relate to longstanding uncertainties 
within those particular provisions, which are beyond the scope of the 
final and temporary regulations.
    In addition, the final and temporary regulations provide new and 
broader exceptions than the proposed regulations, including an expanded 
$50 million threshold exception, the expanded group earnings exception, 
and the new qualified short-term debt exception. These exceptions are 
intended to accommodate ordinary course loans and distributions with 
the result that the final and temporary regulations focus on non-
ordinary course transactions. Taking these exceptions into account, 
taxpayers generally will have the ability to avoid issuing debt 
instruments that will be treated as stock under Sec.  1.385-3, and 
therefore to avoid the ancillary issues described in the comments that 
are associated with recharacterization as stock. Accordingly, the 
Treasury Department and the IRS have determined that the final and 
temporary regulations do not need to provide additional guidance, or 
additional exceptions, with respect to the specific scenarios described 
above, which also arise under the common law when purported debt 
instruments are treated as stock.
2. Limited Exception From Treatment as Stock: Section 1504(a)
    Comments recommended that debt instruments treated as stock under 
the final and temporary regulations be treated as stock described in 
section 1504(a)(4), which is not treated as stock for purposes of the 
ownership requirements of section 1504(a). The recommended rule would 
prevent the recharacterization of a covered debt instrument issued by a 
member of a consolidated group under Sec.  1.385-3 from causing 
deconsolidation of the member.
    Section 1504(a)(4) provides that, for purposes of section 1504(a), 
the term ``stock'' does not include certain preferred stock commonly 
referred to as ``plain vanilla preferred stock.'' Specifically, section 
1504(a)(4) provides that for purposes of section 1504(a), the term 
``stock'' does not include any stock that meets four technical 
requirements: (i) The stock is not entitled to vote, (ii) the stock is 
limited and preferred as to dividends and does not participate in 
corporate growth to any significant extent, (iii) the stock has 
redemption and liquidation rights that do not exceed the issue price of 
the stock (except for a reasonable redemption or liquidation premium), 
and (iv) the stock is not convertible into another class of stock.
    Comments observed that, in many instances, a debt instrument 
treated as stock as a result of Sec.  1.385-3 will qualify as section 
1504(a)(4) stock; in particular, because the terms of such instrument 
often will be legally limited and preferred as to payments and will not 
participate in corporate growth to any significant extent. However, 
comments observed that in some circumstances a debt instrument treated 
as stock under Sec.  1.385-3 will not qualify as section 1504(a)(4) 
stock because, for example, the instrument is deemed reissued at a 
premium or discount or is convertible into another class of stock. 
Comments noted that section 1504(a)(5) provides that the Secretary 
shall prescribe such regulations as may be necessary or appropriate to 
carry out the purposes of section 1504(a), including by treating stock 
as not stock for purposes of that subsection.
    The final and temporary regulations adopt the recommendation that 
debt instruments treated as stock under the final and temporary 
regulations should be treated as not stock for purposes of section 
1504(a). This treatment is consistent with the statutory policy of 
treating stock that has certain legal features similar to debt as not 
stock for purposes of section 1504(a). The legislative history of 
section 1504(a)(5) indicates that Congress intended for the Secretary 
to use that authority to carry out the purposes of section 1504(a), 
including by treating certain stock that otherwise could cause members 
of an affiliated group to disaffiliate, as not stock. See H.R. Conf. 
Rep. No. 861, 98th Cong., 2d Sess. 831, 834 (1984). Accordingly, 
pursuant to the authority under section 1504(a)(5)(A), the final and 
temporary regulations provide that a debt instrument that is treated as 
stock under Sec.  1.385-3 and that would not otherwise be described in 
section 1504(a)(4), is not treated as stock for purposes of determining 
whether a corporation is a member of an affiliated group under section 
1504(a).
3. Allocation of Payments With Respect to Bifurcated Instruments
    Comments requested guidance concerning the allocation of payments 
to an instrument that is partially recharacterized as stock. For 
example, if USS borrows $100x with, which is treated as funding a 
distribution of $50x, and no exception applies, half of the debt 
instrument would be treated as stock. If USS makes a $5x coupon payment 
with respect to the purported debt instrument, the proposed regulations 
did not specify the manner in which the payment would be allocated 
between the portion of the instrument treated as stock and the portion 
treated as debt.
    Comments suggested the issuer should be permitted to determine the 
allocation of payments with respect to the portions of a bifurcated 
instrument. Comments also stated that, if an issuer

[[Page 72886]]

fails to specifically allocate the payment, the payment should be 
allocated first to the debt portion of the instrument because such an 
allocation comports with general rules of corporate law. Other comments 
noted the possibility of allocating the payments on a pro rata basis.
    The final and temporary regulations provide that a payment with 
respect to an instrument partially recharacterized as stock that is not 
required to be made pursuant to the terms of the instrument, for 
example a prepayment of principal, may be designated by the issuer as 
being with respect to the portion recharacterized as stock or to the 
portion that remains treated as indebtedness. If no such designation is 
made, the payment is treated as made pro rata to the portion 
recharacterized as stock and to the portion that remains treated as 
indebtedness.
    The Treasury Department and the IRS decline to accept the 
recommendation to provide similar optionality for payments that are 
required to be made pursuant to the terms of the agreement. In that 
situation, the Treasury Department and the IRS are of the view that, 
because the instrument will provide for payments with respect to the 
entire instrument, it is appropriate to treat those payments as made 
pro rata with respect to the portion recharacterized as stock and to 
the portion that remains treated as indebtedness.
4. Repayments Treated as Distributions
    Several comments recommended that the final and temporary 
regulations include rules to address ``cascading'' recharacterizations; 
that is, situations in which the recharacterization of one covered debt 
instrument could lead to deemed transactions that result in the 
recharacterization of one or more other covered debt instruments in the 
same expanded group. Comments generally addressed two different 
scenarios. The first scenario involved payments made by the issuer with 
respect to recharacterized instruments. Those payments would be treated 
as distributions on stock for purposes of the funding rule, which could 
result in one or more of the issuer's other covered debt instruments 
being treated as stock. Those transactions are addressed in this 
Section B.4. The second scenario involved the treatment of the lending 
member with respect to acquisitions of instruments treated as stock, 
which could also result in the recharacterization of covered debt 
instruments issued by the lending member. This second scenario is 
addressed in Section B.5 of this Part V.
    Regarding the first set of transactions, comments noted that, under 
the proposed regulations, a repayment of a debt instrument 
recharacterized as stock is treated as a distribution for purposes of 
the funding rule, and as such may cause a recharacterization of other 
debt instruments under the funding rule. Comments requested that the 
final and temporary regulations prevent this by providing that 
repayments or distributions with respect to recharacterized stock be 
disregarded for purposes of the funding rule. For the reasons set forth 
below, the final and temporary regulations do not adopt this request.
    Section 1.385-3(f)(4) of the proposed regulations defined a 
distribution as any distribution made by a corporation with respect to 
its stock. Under the proposed regulations, a debt instrument treated as 
stock under Sec.  1.385-3 was generally treated as stock for all 
purposes of the Code. As a result, a payment with respect to a 
recharacterized debt instrument was treated as a distribution for 
purposes of the funding rule. Comments asserted that the interaction of 
these rules resulted in duplicative recasts. For example, assume that a 
foreign parent corporation (FP) wholly owns a U.S. subsidiary (S1). FP 
lends $100x to S1 in exchange for Note A (transaction 1), and within 36 
months, S1 distributes $100x of cash to FP (transaction 2), resulting 
in Note A being recharacterized as stock under proposed Sec.  1.385-
3(b)(3)(ii)(A). Then, S1 repays the entire $100x principal amount of 
Note A (transaction 3), which is treated as a distribution, including 
for purposes of the funding rule because Note A is treated as stock. 
Next, within 36 months after transaction 3, FP again lends $100x to S1 
in exchange for Note B (transaction 4). The proposed regulations would 
treat Note B as funding the deemed distribution in transaction 3. 
Therefore, as a result of transaction 3 and transaction 4, Note B is 
recharacterized as stock under proposed Sec.  1.385-3(b)(3)(ii)(A).
    Comments asserted that this result is duplicative because both Note 
A and Note B are treated as stock. The Treasury Department and the IRS 
do not agree with this assertion, and as a result the final and 
temporary regulations do not provide for a different result. In this 
series of four transactions, on a net basis S1 has distributed $100x to 
FP and has outstanding a $100x loan from FP (Note B). If the final and 
temporary regulations adopted the comment and did not treat transaction 
3 as resulting in a distribution for purposes of the funding rule, then 
Note B would not be recharacterized as stock even though the series of 
transactions results in a funded distribution.
    The Treasury Department and the IRS decline to adopt this comment 
because the funding rule could be circumvented if the repayment of a 
note that is treated as stock were not treated as a distribution. 
Applying the comment's requested change to the facts above, the 
repayment of Note A would redeem that particular instrument, which 
could then be replaced with Note B in transaction 4, putting the 
parties in an economically similar position but avoiding the 
application of Sec.  1.385-3.
    One comment did not dispute the successive recharacterizations of 
Note A and Note B for the funding rule, but argued that the successive 
recasts nonetheless resulted in duplicative income inclusions, since 
each repayment would result in a dividend to the extent of current and 
accumulated earnings and profits. The Treasury Department and the IRS 
did not revise the final and temporary regulations for this comment 
because the potential for multiple dividend inclusions is a consequence 
of the subchapter C rules that treat distributions with respect to 
stock (including certain redemptions) as being made first out of the 
corporation's current and accumulated earnings and profits to the 
extent thereof, rather than a result specific to the application of 
Sec.  1.385-3.
    On the other hand, to prevent inappropriate duplication under the 
funding rule in fact patterns like the preceding example, Sec.  1.385-
3(b)(6) of the final regulations clarifies that once a covered debt 
instrument is recharacterized as stock under the funding rule, the 
distribution or acquisition that caused that recharacterization cannot 
cause a recharacterization of another covered debt instrument after the 
first instrument is repaid. Thus, the distribution in transaction 2 
that caused the recharacterization of Note A cannot cause a 
recharacterization of another covered debt instrument. For a discussion 
of a coordination rule that supersedes this non-duplication rule during 
the transition period while covered debt instruments that otherwise 
would be recharacterized as stock are not treated as stock, see Section 
B.2 of Part VIII of this Summary of Comments and Explanation of 
Revisions.
5. Iterative Recharacterizations
    The second set of cascading transactions addressed by comments 
involves a type of iterative recharacterization. Specifically, comments 
noted that when a debt instrument is recharacterized as stock

[[Page 72887]]

under the proposed regulations, the holder of the instrument is treated 
as acquiring stock of an expanded group member instead of indebtedness. 
If that holder were itself funded, the recharacterized instrument 
could, in turn, cause a recharacterization of the holder's own 
borrowing. For example, assume that P is the parent of an expanded 
group, and directly owns all of the stock of S1 and S2. If P loaned 
$100x to S1, S1 loaned $100x to S2, and S2 distributed $100x to P, S1's 
loan to S2 would be recharacterized as stock under the funding rule, 
and S1's acquisition of the S2 instrument would be treated as an 
acquisition of S2 stock that would cause S1's loan from P to be treated 
as stock under the funding rule. Comments expressed concern that an 
initial recharacterization could thus lead to a multitude of 
recharacterized instruments throughout the expanded group.
    To address this concern, comments recommended an exception to the 
funding rule when, during the per se period described in proposed Sec.  
1.385-3(b)(3)(iv)(B), a funded member makes an advance to a second 
expanded group member, and that advance to the second expanded group 
member is characterized as stock of the second expanded group member 
under Sec.  1.385-3. Comments stated that this series of transactions 
can occur frequently when the first funded member makes and receives 
advances frequently, particularly in connection with cash pooling and 
cash pool headers (as described in Section D.8 of this Part V), and 
thus could spread the recharacterizations throughout the cash pooling 
arrangement.
    The Treasury Department and the IRS expect that the changes adopted 
in the final and temporary regulations limiting the application of 
Sec.  1.385-3 to domestic issuers and providing a broad exception for 
short-term indebtedness, including deposits with a qualified cash pool 
header, should substantially address the concerns regarding iterative 
recharacterizations of covered debt instruments. Nonetheless, in 
response to comments, the final and temporary regulations include a 
limited exception to the funding rule for certain acquisitions of 
expanded group stock that result from the application of Sec.  1.385-3, 
which include not only covered debt instruments that are 
recharacterized as expanded group stock under the funding rule, but 
also acquisitions of stock of an expanded group partner and a regarded 
owner under the rules described in Sections H.4 and 5 of this Part V. 
If this new exception applies, in the example above, S1's loan to S2 
would still be treated as stock under the funding rule, but S1's 
acquisition of the S2 instrument would not be treated as an acquisition 
of S2 stock that would cause S1's loan from P to be treated as stock 
under the funding rule.
    The Treasury Department and the IRS intend for this exception to 
address the concern raised in comments about unintentional serial 
recharacterizations. Therefore, this exception does not apply if the 
acquisition of deemed stock by means of the application of the funding 
rule is part of a plan or arrangement to prevent the application of the 
funding rule to a covered debt instrument.
6. Inadvertent Recharacterization
    Comments noted that, in many instances, a borrower could trigger 
the application of the funding rule through simple inadvertence or 
genuine mistake (for example, incorrectly estimating earnings and 
profits despite reasonable effort). In addition, a taxpayer that is 
unaware that a debt instrument within the expanded group is treated as 
stock under Sec.  1.385-3 could engage in transactions that result in 
unanticipated ancillary consequences.
    One comment offered the following example: FP wholly owns both FS 
and USS1, and USS1 wholly owns both USS2 and USS3. In year 1, FS loans 
$10x to USS2. Later in year 1, USS2 distributes $10x to USS1 and, 
either through a simple mistake or a good faith but erroneous belief 
that an exception to recharacterization applies, the expanded group 
fails to take into account the treatment of the USS2 note as stock 
under Sec.  1.385-3. Subsequently, in a transaction intended to qualify 
under section 351, USS1 contributes the stock of USS3 to USS2. Because 
FS holds recharacterized stock in USS2, USS1 fails to satisfy the 
section 368(c) control requirement of section 351(a) and is thus 
subject to tax on any unrealized gain in the USS3 stock.
    Comments also included examples in which the inadvertent failure 
caused a termination of a consolidated group or of a special tax status 
of the issuer (for example, failure to qualify as a REIT). Comments 
requested that an issuer be permitted to cure the inadvertent 
recharacterization within a reasonable period after becoming aware of 
the correct treatment of the instrument under the final and temporary 
regulations. One proposal suggested that the issuer be permitted to 
eliminate the debt by cancellation or repayment within a specified time 
period, with such elimination presumably considered retroactive to the 
issuance. A similar proposal requested that an issuer be permitted to 
cure an instrument recharacterized by the funding rule by making an 
equity contribution sufficient to offset any reduction in net equity, 
regardless of whether the recharacterized instrument remains 
outstanding. As discussed in Part IV.A.3.c of this Summary of Comments 
and Explanation of Revisions, comments also suggested expanding the 
scope of the reasonable cause exception in proposed Sec.  1.385-2(c)(1) 
to apply to instruments recharacterized under the documentation rules 
by adopting a more lenient standard than those used in Sec.  301.6724-
1, that is, the presence of significant mitigating factors with respect 
to a failure or a failure arising from events beyond the control of the 
members of the expanded group.
    The Treasury Department and the IRS decline to adopt the 
recommendation to provide a general remediation rule that would allow 
certain taxpayers to mitigate the ancillary consequences of issuing 
stock beyond the specific and limited exceptions for certain iterative 
recharacterizations discussed in Section B.5 of this Part V and certain 
qualified contributions discussed in Section E.3.b of this Part V 
because of concerns about administering the regulations and concerns 
about providing taxpayers a right, but not an obligation, to 
retroactively change the character of a transaction. Moreover, the 
Treasury Department and the IRS have determined that the significant 
scope changes to the final and temporary regulations, including the 
narrowing of the regulations to only apply to covered debt instruments, 
the addition of several new exceptions to Sec.  1.385-3, the expansion 
of existing exceptions to Sec.  1.385-3, and the explicit treatment of 
recharacterized stock as not stock for purposes of section 1504(a) will 
reduce the instances of, and mitigate the effects of, inadvertent 
recharacterizations under the final and temporary regulations.
7. Hook Stock
    One comment observed that the proposed regulations would increase 
the instances in which a debt instrument issued by a corporation would 
be treated as stock held by a direct or indirect subsidiary, commonly 
referred to as hook stock. The comment recommended that the regulations 
provide rules to avoid the creation of hook stock. The final and 
temporary regulations do not generally adopt this recommendation. The 
Treasury Department and the IRS have determined that consideration of 
whether a debt issuance finances new investment, in the context of 
related

[[Page 72888]]

parties, are appropriate determinative factors with respect to debt-
equity characterization across a broad range of circumstances. However, 
as discussed in Section E.2.a of this Part V, the final and temporary 
regulations expand the subsidiary stock issuance exception in proposed 
Sec.  1.385-3(c)(3) into a new ``subsidiary stock acquisition 
exception'' that excludes from the general rule and funding rule 
certain acquisitions of existing stock from a majority-controlled 
subsidiary, which eliminates one type of transaction that otherwise 
would have the effect of creating hook stock. However, outside of the 
specific exceptions discussed in Section E of this Part V, the Treasury 
Department and the IRS have determined that special rules are not 
warranted when an issuer's direct or indirect subsidiary holds an 
interest that would be treated as stock under the final and temporary 
regulations.
8. Income Tax Treaties
    This section addresses comments received related to concerns 
regarding the impact of the proposed regulations on the application of 
the income tax treaties to which the United States is a party.
a. Limitation on Benefits (LOB) Article
    In order to qualify for treaty benefits on U.S. source income, a 
resident of a treaty partner must satisfy all of the requirements set 
forth in the applicable treaty, including the requirement that the 
resident satisfy the Limitation on Benefits'' (LOB) article, if any, of 
the applicable treaty. Among other requirements, several LOB tests 
require that the resident of the treaty partner meet certain vote-and-
value thresholds for stock ownership by certain qualified persons or 
equivalent beneficiaries. Some comments noted that, by recharacterizing 
debt into non-voting stock, the proposed regulations could cause a 
foreign corporation that previously satisfied a stock ownership 
threshold to no longer qualify for treaty benefits because of a 
dilution of the value of its stock owned by certain qualified persons 
or equivalent beneficiaries.
    The comments concerning LOB qualification arise in the context of 
foreign issuers claiming treaty benefits on U.S. source income. Many of 
the comments acknowledged that not applying the regulations to foreign 
issuers would alleviate these concerns. Accordingly, these comments are 
addressed by the decision to reserve on the application of the final 
and temporary regulations to foreign issuers.
b. Character of Payments
    Some comments noted that if the proposed regulations applied to 
recharacterize purported debt instruments as equity for all purposes of 
the Code, it would change the tax treatment of payments made by U.S. 
issuers to foreign persons that qualify for benefits under U.S. tax 
treaties. Comments expressed concern that purported payments of 
interest and repayments of principal would be treated as dividend 
payments, the taxation of which would be governed by the dividends 
article of U.S. tax treaties, which generally result in withholding at 
a higher rate (including a 15 percent rate in the case of dividends 
paid to a beneficial owner that does meet certain direct ownership 
thresholds) than withholding on interest. Comments argued that the 
definition of ``dividends'' in U.S. tax treaties should not encompass 
payments made under instruments that are recharacterized as equity 
under Sec.  1.385-3.
    The final and temporary regulations generally treat purported debt 
instruments as equity for all purposes of the Code, which often will 
result in payments under the instrument being treated as dividends, 
including for purposes of applying U.S. tax treaties. Treating the 
recharacterized instrument as giving rise to dividends is consistent 
with the manner in which U.S. tax treaties generally define the term 
``dividends'' as ``[i]ncome from shares or other rights, not being 
debt-claims, participating in profits, as well as income that is 
subject to the same taxation treatment as income from shares under the 
laws of the Contracting State of which the company making the 
distribution is a resident.'' The 1996, 2006, and 2016 U.S. Model tax 
treaties, as well as the OECD Model Tax Convention, all contain similar 
language. Because the treaty defines the term to include any ``income 
that is subject to the same taxation treatment as income from shares,'' 
and because, under the final and temporary regulations and other 
applicable Code provisions, U.S. law generally treats a payment with 
respect to an instrument recharacterized as equity as a dividend from 
shares for all purpose of the Code, dividend treatment is consistent 
with the terms of U.S. tax treaties. Further, if the treaty does not 
define the term dividends, the domestic law of the country applying the 
treaty generally prevails, unless the context otherwise requires.
c. Associated Enterprises
    Comments suggested that the proposed regulations conflict with the 
arm's length principle incorporated in Article 9 (Associated 
Enterprises) of U.S. tax treaties because a result of recharacterizing 
debt into equity is a denial of deductions for interest payments even 
though those payments were made on arm's length terms. Comments raised 
similar concerns with respect to section 482 and the arm's length 
principle outside of the treaty context, asserting that characterizing 
a purported debt instrument as stock based on another transaction 
occurring during the per se period was inconsistent with the arm's 
length principle. The Treasury Department and the IRS have determined 
that these comments mischaracterize the operation of Article 9 as well 
as section 482. Although Article 9 governs the appropriate arm's length 
terms (that is, pricing and profit allocation) for transactions entered 
into between associated enterprises, the arm's length principle 
reflected in Article 9 and section 482 is not relevant for delineating 
the transaction that is subject to the arm's length principle. Thus, 
for example, the arm's length principle may apply to determine the 
appropriate rate of interest charged on a loan, but it would not apply 
to the classification in the first instance of whether an instrument is 
debt or equity, which is a determination made under the relevant 
domestic law of the jurisdiction that is applying the treaty. Under 
federal income tax law, the characterization of transactions, including 
determining debt versus equity, is not determined by reference to the 
arm's length standard. See Sec.  1.482-2(a)(1) and (a)(3)(i). 
Furthermore, as discussed in Section B.8.b of this Part V, an 
instrument recharacterized as equity under Sec.  1.385-3 will result in 
payments being treated as dividends, including for purposes of U.S. tax 
treaties. Therefore, the arm's length principle incorporated in Article 
9 does not conflict with the characterization of a purported debt 
instrument of a U.S. issuer as equity under Sec.  1.385-3.
d. Non-Discrimination
    Several comments asserted that the proposed regulations implicate 
the non-discrimination provisions of U.S. tax treaties. These comments 
assert that the non-discrimination article generally prevents the 
United States from denying a deduction for interest paid to a resident 
of a treaty partner where interest paid to a U.S. resident under the 
same conditions would be deductible.

[[Page 72889]]

    The Treasury Department and the IRS disagree that the final and 
temporary regulations raise discrimination concerns. The regulations 
apply broadly to U.S. issuers and would recharacterize purported debt 
instruments as equity under specified conditions that apply equally 
regardless of the residence of the payee. Although debt issued by a 
member of a U.S. consolidated group to another member of the group is 
not subject to recharacterization under these rules, the 
recharacterization does not depend on whether the lender is a U.S. or 
foreign person, but on whether the lender files (or is required to 
file) a consolidated return with the issuer. For example, debt issued 
by a non-consolidated domestic corporation to another non-consolidated 
domestic corporation is subject to Sec.  1.385-3 to the same extent as 
debt issued to a foreign corporation that is unable to consolidate with 
the domestic corporate issuer. The consolidation (or other similar) 
rules of both the United States and other treaty countries, which are 
generally limited to domestic affiliates, contain numerous special 
rules that are generally understood not to raise discrimination 
concerns. See, e.g., paragraph 77 of Commentary on Article 24 of the 
OECD Model Convention with Respect to Taxes on Income and on Capital. 
Therefore, the final and temporary regulations do not implicate the 
non-discrimination provisions of Article 24 (Non-discrimination) of 
U.S. treaties.
C. Exchange Transactions That Are Subject to Sec.  1.385-3(b)
1. Overview
    The general rule under proposed Sec.  1.385-3(b)(2) treated as 
stock any debt instrument issued by a member of an expanded group to 
another member of the same expanded group in one of three transactions: 
(i) In a distribution; (ii) in exchange for the stock of a member of 
the expanded group, other than pursuant to certain identified exempt 
exchanges; and (iii) in exchange for property in an internal asset 
reorganization, but only to the extent that, pursuant to the plan of 
reorganization, an expanded group shareholder receives the debt 
instrument with respect to its stock in the transferor corporation. The 
funding rule under proposed Sec.  1.385-3(b)(3) generally treated as 
stock any debt instrument issued by a funded member in exchange for 
property that was treated as funding one of the three transactions 
described in the general rule.
    The distributions and acquisitions described in the three prongs of 
the general rule and funding rule are referred to in this Part V as 
distributions and acquisitions, unless otherwise indicated or the 
context otherwise requires. Separately, unless otherwise indicated or 
the context otherwise requires, for purposes of this Part V, 
acquisitions described in the second prong of the general rule and 
funding rule are referred to as ``internal stock acquisitions,'' and 
acquisitions described in the third prong of the general rule and 
funding rule are referred to as ``internal asset reorganizations.''
    The preamble to the proposed regulations explained the policy 
concerns underlying the three transactions described in proposed Sec.  
1.385-3(b)(2). In describing concerns involving distributions of 
indebtedness, the preamble first noted that 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. This is consistent with the relatedness factor in 
section 385(b)(5). The preamble also cited case law that has given 
weight to the lack of new investment when a closely-held corporation 
issues indebtedness to a controlling shareholder but receives no new 
investment in exchange. In addition, the preamble stated that the 
distribution of indebtedness typically lacks a substantial non-tax 
business purpose. With respect to debt instruments issued for stock of 
a member of the expanded group, the preamble noted that these 
transactions are (i) similar in many respects to distributions of 
indebtedness and therefore implicate similar policy concerns, (ii) 
could serve as a ready substitute for distributions of notes if not 
addressed, and (iii) frequently have limited non-tax significance. 
Finally, with respect to debt instruments issued in connection with 
internal asset reorganizations, the preamble explained that such 
transactions can operate similar to internal stock acquisitions as a 
device to convert what otherwise would be a distribution into a sale or 
exchange transaction without having any meaningful non-tax effects.
    Several comments requested that the second and third prongs of the 
general rule and funding rule be narrowed or eliminated. The comments 
stated that such transactions are not economically or otherwise similar 
to a distribution of a note and thus should not be subject to the 
rules. Comments distinguished a distribution of debt, which reduces the 
value in corporate solution, from a stock acquisition or asset 
reorganization, which typically incorporates an exchange of value for 
value. Other comments suggested replacing the second and third prongs 
of the general rule and funding rule with an anti-abuse rule. In 
contrast, one comment suggested that the general rule should be 
broadened to include any transaction having a similar effect to the 
transactions described in the proposed regulations.
    As explained in the remainder of this Part V.C, after considering 
the comments, the Treasury Department and the IRS, with one exception 
described in Section C.3.c of this Part V, continue to view the 
transactions described in the second and third prongs of proposed Sec.  
1.385-3(b)(2) and (b)(3) as sufficiently economically similar to 
distributions such that they should be subject to the same rules and 
should not be reduced to an anti-abuse rule or excluded altogether. 
Accordingly, the final and temporary regulations retain the second and 
third prongs of proposed Sec.  1.385-3(b)(2) and (3) with the 
modifications described in this Part V.C in response to comments 
received.
2. Definitions of Distribution and Property
    One comment recommended that the final and temporary regulations 
specifically define the term distribution. The proposed regulations 
defined the term distribution as any distribution by a corporation with 
respect to the distributing corporation's stock, and the final and 
temporary regulations retain that definition.
    A comment also recommended that the final and temporary regulations 
clarify the definition of the term property for purposes of the funding 
rule in the context of an exchange described in the second and third 
prongs of the funding rule. Consistent with the proposed regulations, 
the final and temporary regulations define the term property by 
reference to section 317(a). The comment asserts that it is not clear 
how the statement in section 317(a) that the term property does not 
include stock of a distributing corporation should be interpreted in 
the context of an exchange of property for stock or assets described in 
the second and third prongs of the funding rule. The Treasury 
Department and the IRS have determined that there is no need to clarify 
the term property in this context. The second prong of the funding rule 
applies to certain acquisitions of expanded group stock by a covered 
member in exchange for property other than expanded group stock 
(rendering moot the relevance of the reference in section 317(a) to 
stock

[[Page 72890]]

of the distributing corporation). The third prong of the general rule 
addresses acquisitions of certain assets, and includes no specific 
requirement regarding property exchanged by the acquirer.
    The remainder of this Part V.C responds to comments regarding the 
scope of the exchange transactions that are included in the second and 
third prongs of the general rule and funding rule.
3. Acquisitions of Expanded Group Stock
    The second prongs of the general rule and funding rule apply to 
certain acquisitions of expanded group stock in exchange for a debt 
instrument or in exchange for property, respectively. These rules apply 
both to acquisitions of expanded group stock other than by issuance 
(existing stock) and to acquisitions of expanded group stock by 
issuance (newly-issued stock).
a. Acquisitions of Existing Stock in General
    The Treasury Department and the IRS continue to view a transfer of 
property (including through the issuance of a debt instrument) to a 
controlling shareholder (or a person related to a controlling 
shareholder) in exchange for existing expanded group stock as having an 
economic effect that is similar to a distribution. In general, a 
distribution with respect to stock occurs when there is a transfer of 
property from a corporation to its shareholder in the shareholder's 
capacity as such--that is, other than in a value-for-value exchange. 
Although an acquisition of existing expanded group stock from a 
controlling shareholder (or a person related to a controlling 
shareholder) may, in form, be a value-for-value exchange, it generally 
does not change the ultimate ownership of the corporation whose stock 
is acquired (target). Furthermore, although neither the corporation 
that acquires the stock (the acquirer) nor the target experiences a 
standalone reduction in its assets, the combined capital of the 
acquirer and the target is decreased by the value transferred to the 
selling shareholder (in other words, by the value of the ``sale'' 
proceeds). Thus, similar to a distribution with respect to stock, the 
transaction effects a distribution of value from the acquirer to the 
selling shareholder when the post-transaction acquirer and target are 
considered together. As noted in the preamble to the proposed 
regulations, viewing the acquirer and target on a combined basis in 
this context is consistent with the enactment of section 304, which 
reflects Congress's recognition that a purchase of affiliate stock 
generally has the effect of a distribution with respect to stock. See 
S. Rep. No. 83-1622 at 46 (1954).
    For the foregoing reasons, and the reasons discussed in the 
preamble to the proposed regulations, the Treasury Department and the 
IRS have determined that acquisitions of existing expanded group stock 
should continue to be included in the general rule and funding rule. 
However, as discussed in Section C.3.c of this Part V, in response to 
comments, the final and temporary regulations provide a new exception 
for certain acquisitions of existing expanded group stock by a member 
from its majority-owned subsidiary.
b. Acquisitions of Newly-Issued Stock
    The proposed regulations applied to two categories of acquisitions 
of newly-issued stock: (i) Acquisitions of newly-issued stock from a 
member that has direct or indirect control of the acquiring member 
(hook stock); and (ii) acquisitions of newly-issued stock from a member 
that does not have direct or indirect control of the acquiring member 
(non-hook stock). While comments generally acknowledged the similarity 
between acquisitions of newly-issued hook stock and distributions, 
several comments asserted that acquisitions of newly-issued non-hook 
stock are not economically similar to a distribution and thus should be 
excluded from the second prongs of the general rule and funding rule. 
One comment recommended an exclusion for acquisitions of affiliate 
stock by issuance as long as such stock was acquired pursuant to arm's 
length terms.
    Under the proposed regulations, acquisitions of newly-issued stock, 
whether hook-stock or non-hook stock, were described in the second 
prongs of the general rule and funding rule. However, solely for 
purposes of the funding rule, the proposed regulations provided an 
exception for certain acquisitions of newly-issued stock in a majority-
owned subsidiary (subsidiary stock issuance exception), whereby an 
acquisition of the stock in the subsidiary was exempt from the funding 
rule if, for the 36-month period immediately following the issuance, 
the acquirer held, directly or indirectly, more than 50 percent of the 
total voting power and value of the stock. For this purpose, indirect 
ownership was determined applying the principles of section 958(a) 
without regard to whether an intermediate entity is foreign or 
domestic.
    Comments requested that the subsidiary stock issuance exception be 
expanded to apply to any acquisition of newly-issued non-hook stock, 
regardless of whether the acquirer owned a majority interest in the 
issuer following the acquisition. Comments reasoned that an acquisition 
of non-hook stock, unlike an acquisition of hook stock or existing 
stock described in section 304, is not economically similar to a 
distribution because (i) the acquisition is not described in a dividend 
provision of the Code, (ii) the acquiring member's equity value is not 
reduced by reason of the acquisition, and (iii) in contrast to 
transactions that are described in section 304, the combined value of 
the acquirer and the issuer is not reduced by reason of the 
acquisition.
    The final and temporary regulations do not adopt this comment. As a 
result, the second prongs of the general rule and funding rule continue 
to apply to acquisitions of newly-issued stock when the acquirer owns, 
directly or indirectly, only a minority interest in the issuer of the 
stock. Such acquisitions are economically similar to a distribution in 
that the acquirer diverts capital from its operations to an affiliate 
controlled, directly or indirectly, by the acquirer's ultimate 
shareholder in exchange for a minority interest in the affiliate. In 
the context of highly-related corporations, holding a minority interest 
in an affiliate generally lacks meaningful non-tax consequences, and 
such an interest could be structured for tax avoidance purposes. 
Accordingly, the Treasury Department and the IRS have determined that, 
if such transactions were excluded from the second prong of the funding 
rule, they would become a ready substitute for distributions as a way 
to use purported debt instruments to produce significant federal tax 
benefits without financing new investment in the operations of the 
obligor. That is, if the second prong did not apply to such 
transactions, the purposes of the final and temporary regulations could 
be avoided by having the obligor divert the proceeds of the purported 
financing to the common parent through the transfer of those proceeds 
to the common parent's majority-owned subsidiary.
c. Acquisitions of Existing Stock From a Majority-Owned Subsidiary
    Comments requested that the subsidiary stock issuance exception be 
extended to apply to an expanded group member's acquisition of existing 
stock in another expanded group member from the acquiring expanded 
group member's majority-owned subsidiary. Thus, for example, comments 
requested that an acquisition by a first-tier wholly owned subsidiary 
(S1) of the stock of a third-tier wholly owned subsidiary (S3)

[[Page 72891]]

from a second-tier wholly owned subsidiary (S2) in exchange for 
property be excluded from the second prong of the funding rule.
    The Treasury Department and the IRS have determined that an 
acquisition of existing stock, like an acquisition of newly-issued non-
hook stock from a majority-owned subsidiary, does not implicate the 
same policy concerns as other transactions described in the second 
prongs of the general rule and funding rule when the acquiring member 
owns more than 50 percent of the stock in the selling member. 
Specifically, an acquisition of existing stock from a majority-owned 
subsidiary, like an acquisition of newly-issued stock from a majority-
owned subsidiary, generally is not economically similar to a 
distribution because the consideration provided to the seller is 
indirectly controlled by the acquirer through its majority interest in 
the seller. In contrast, if the acquirer does not, directly or 
indirectly, own more than 50 percent of the seller after the 
acquisition, the acquisition has the same potential for making the sale 
proceeds available to the common parent as when funds are transferred 
in exchange for newly-issued stock that is a minority interest. 
Accordingly, the final and temporary regulations expand the subsidiary 
stock issuance exception to include acquisitions of existing stock from 
a majority-owned subsidiary under the same conditions applicable to 
acquisitions of newly-issued non-hook stock from a majority-owned 
subsidiary, and refer to the expanded exception as the subsidiary stock 
acquisition exception. The specific requirements of the subsidiary 
stock acquisition exception are discussed in Section E.2.a of this Part 
V.
d. Acquisitions of Stock in Exchange for a Debt Instrument
    Comments recommended that the subsidiary stock issuance exception 
be expanded to cover acquisitions of the stock of a controlled 
subsidiary described in the general rule (for example, when an expanded 
group member contributes its note to a majority-owned subsidiary for 
additional stock), based on the view that a transaction described in 
the general rule is economically similar to a transaction described in 
the funding rule and thus should receive similar treatment under Sec.  
1.385-3. The Treasury Department and the IRS agree with this 
recommendation. In general, the funding rule is designed to stop 
taxpayers from achieving in multiple steps what the general rule 
prohibits from being accomplished in one step. Accordingly, the final 
and temporary regulations provide that an acquisition of expanded group 
stock (both existing stock and newly issued stock) from a majority-
controlled subsidiary in exchange for the acquirer's note qualifies for 
the exception on the same terms as a funded acquisition.
4. Acquisitions of Expanded Group Assets Pursuant to a Reorganization
    Comments also asserted that the transactions described in the third 
prongs of the general rule and funding rule are not economically 
similar to a distribution and therefore should not be subject to 
proposed Sec.  1.385-3. The preamble to the proposed regulations stated 
that the third prongs of the general rule and funding rule were 
included because the issuance of a debt instrument in an internal asset 
reorganization is similar in many respects to the issuance of a debt 
instrument to make a distribution or to acquire expanded group stock. 
For the same reasons described in the preamble to the proposed 
regulations, the Treasury Department and the IRS continue to view the 
transfer of ``other property'' in certain internal asset 
reorganizations as having an economic effect that is similar to a 
distribution or an internal stock acquisition. As discussed in Section 
C.3.a of this Part V, a distribution with respect to stock generally is 
a transfer of value from a corporation to its shareholder in its 
capacity as such and therefore other than in a value-for-value 
exchange. A corporation obtains a similar result when, as part of an 
acquisitive asset reorganization, the corporation (acquirer) issues a 
debt instrument or transfers other property in exchange for the assets 
of a highly-related affiliate (target), which in turn, distributes the 
debt instrument or other property to the common shareholder with 
respect to its target stock. In such a transaction, the combined pre-
acquisition capital of the acquirer and the target is decreased to the 
extent of the value of the non-stock consideration received by the 
common shareholder in exchange for its target stock. Accordingly, 
similar to a distribution with respect to stock, the transaction 
effects a distribution of value from the combined entity to the common 
shareholder.
    Congress acknowledged that an asset reorganization between highly-
related parties can have the effect of distributing value to a common 
shareholder when it provided in section 356(a)(2) that ``other 
property'' received by the common shareholder in exchange for its 
target stock generally is treated as a dividend to the extent of 
earnings and profits. The premise of section 356(a)(2) is that, when a 
shareholder exchanges its stock in one controlled corporation for 
property of equal value from another controlled corporation, the 
property represents an extraction of value from the combined entity 
consisting of the two controlled corporations to the common 
shareholder. For the same reason, the Treasury Department and the IRS 
have determined that an internal asset reorganization in which a member 
of the expanded group receives property described in section 356 has an 
economic effect that is similar to a distribution. Thus, the final and 
temporary regulations continue to include internal asset 
reorganizations within the third prongs of the general rule and funding 
rule.
    Other comments recommended the withdrawal of the third prongs of 
the general rule and funding rule based on an asserted inconsistency 
with the ``boot-within-gain'' rule in section 356(a)(2). Under section 
356(a)(1), an exchanging shareholder is required to recognize gain 
equal to the lesser of the gain realized in the exchange or the amount 
of money or other property received by the shareholder. If the exchange 
has the effect of a distribution of a dividend, then section 356(a)(2) 
provides that all or part of the gain recognized by the exchanging 
shareholder is treated as a dividend to the extent of the shareholder's 
ratable share of the corporation's earnings and profits. Under the 
``boot-within-gain'' rule, dividend treatment under section 356(a)(2) 
is limited by the gain in the shareholder's stock in the transferor 
corporation. Comments asserted that, by converting a debt instrument 
that would constitute other property into stock, the third prong of the 
general rule effectively achieves a result that the Treasury Department 
and the IRS could not otherwise accomplish under section 356(a)(2) 
because payments of interest and principal made on the recharacterized 
debt instrument generally would be characterized as dividend income to 
the extent of the earnings and profits of the issuing corporation, 
without regard to the gain in the shareholder's stock in the transferor 
corporation. Accordingly, comments recommended that the Treasury 
Department and the IRS withdraw the third prongs of the general rule 
and funding rule. Alternatively, comments recommended that the final 
and temporary regulations include a coordination rule that would 
effectively preserve the effect of section 356(a)(2), without 
specifying how this rule would operate.

[[Page 72892]]

    The Treasury Department and the IRS decline to adopt this 
recommendation. Section 385 provides specific authority to treat 
certain interests in a corporation as stock, and this express grant of 
authority extends to the treatment of such interests as stock for all 
purposes of the Code. The Treasury Department and the IRS have 
exercised this grant of authority to treat a debt instrument as stock 
when the debt instrument does not finance new investment in the 
operations of the issuer. In addition, as discussed in this Part V, 
whether new investment has been financed does not depend on whether the 
amount transferred to the controlling shareholder (or person related 
thereto) is treated as a dividend, return of basis, or gain.
5. Acquisitions of Expanded Group Assets Not Pursuant to a 
Reorganization
    One comment questioned why the regulations apply to an acquisition 
of expanded group stock or an acquisition of business assets pursuant 
to an internal asset reorganization, but not to an acquisition of 
business assets not in connection with a reorganization, including 
through the acquisition of a disregarded entity. The Treasury 
Department and the IRS have determined that an acquisition of business 
assets in a non-reorganization transaction is not sufficiently similar 
to a distribution to be covered by Sec.  1.385-3. In a non-
reorganization transaction, the selling member continues as an entity 
separate and distinct from the acquiring member following the 
transaction, and the common shareholder receives no property with 
respect to its stock in either entity. As a result, both on a 
standalone and combined basis, the pre-equity value of the entities 
does not decrease as a result of the transaction. Moreover, the 
property transferred by the acquiring member to the selling member is 
used to acquire assets that augment the business of the acquiring 
member. This is in contrast to property transferred by an acquiring 
member to acquire newly-issued non-hook stock in exchange for a 
minority interest in an affiliate the ownership of which generally 
lacks meaningful non-tax consequences.
    One comment recommended that the final and temporary regulations 
clarify the treatment of the use of a note to acquire stock in a 
disregarded LLC. Because equity in a disregarded LLC is disregarded, 
the final and temporary regulations are not revised to address this 
comment.
6. Acquisitions of Existing Expanded Group Stock or Expanded Group 
Assets Pursuant to a Reorganization That Do Not Result in Dividend 
Income
    Comments recommended an exemption for an acquisition subject to 
section 304 or 356(a)(2) to the extent the transaction results in sale 
or exchange treatment (for example, due to insufficient earnings and 
profits).
    The Treasury Department and the IRS decline to adopt this 
recommendation. Under Sec.  1.385-3, a purported debt instrument that 
does not finance new investment in the issuer is not respected as debt. 
An issuance of a purported debt instrument does not finance new 
investment of the issuer to the extent a transaction has the effect of 
distributing the proceeds of the debt instrument to another member of 
the expanded group. The amount of dividend or gain recognized by an 
expanded group member in the transaction in which the instrument is 
issued or in a transaction that has the effect of transferring the 
proceeds is not relevant for determining whether the debt instrument 
financed new investment or, instead, merely introduced debt without 
having meaningful non-tax effects.
D. Funding Rule
1. Lack of Identity Between the Lender and a Recipient of the Proceeds 
of a Distribution or Acquisition
    The funding rule under the proposed regulations treated as stock a 
debt instrument that was 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 a distribution or 
acquisition described in the three prongs of the funding rule. The 
proposed regulations included a non-rebuttable presumption that a 
principal purpose to fund such an acquisition or distribution existed 
if the expanded group debt instrument was issued by the funded member 
during the period beginning 36 months before the funded member made the 
distribution or acquisition and ending 36 months after the distribution 
or acquisition.
    Comments recommended several limitations on the funding rule, 
including limiting the funding rule to a rule that addresses only 
circular transactions that are economically equivalent to transactions 
subject to the general rule by requiring that the lender be the 
recipient of the proceeds of the distribution or acquisition. Thus, for 
example, a comment indicated that, if FP owned USP and FS, the funding 
rule should apply when USP borrows $100x from FP and distributes $100x 
to FP, but should not apply when USP borrows $100x from FS and 
distributes $100x to FP, unless FP also transferred funds to FS.
    In the context of commonly-controlled corporations, the Treasury 
Department and the IRS have determined that there is not a sufficient 
economic difference to justify different treatment when the proceeds of 
a loan from one expanded group member are used to fund a distribution 
to, or acquisition from, that same member versus another expanded group 
member. First, and most significantly, in the example described in the 
preceding paragraph, a borrowing from FS and a distribution to FP has 
the same economic effect with respect to USP as a distribution by USP 
of a debt instrument to FP. In both cases, debt is added to USP without 
a commensurate increase in the amount of capital invested in USP's 
operations.
    Moreover, in the context of commonly-controlled corporations, there 
is insufficient non-tax significance to the lack of identity between 
the lender and the recipient of the proceeds of the distribution or 
acquisition to justify treating the two series of transactions 
differently. In this context, there can be considerable flexibility 
regarding the expanded group member used to lend funds to another 
member, since the lending member may itself be funded by other members 
of the group. Furthermore, an expanded group member that receives the 
proceeds of a distribution or economically similar transaction can 
transfer those proceeds to other entities in the group, for example, 
through distributions to a common controlling parent, which in turn can 
re-transfer the funds. Because of the ability to transfer funds around 
a multinational group, the choice of which entity will be a 
counterparty to a borrowing or transaction that is economically similar 
to a distribution may not have meaningful non-tax significance. 
Comments also suggested that this flexibility could be addressed 
through a second set of rules that would consider the extent to which 
the lender was itself funded by another member of the group and the 
extent to which the proceeds of a distribution or other economically 
similar transaction were transferred to the lender.
    After considering the comments, the Treasury Department and the IRS 
decline to adopt these recommendations. The burden that would be 
required to essentially replicate the per se funding rule with respect 
to both the lender and the recipient of the proceeds of the funded 
distribution or acquisition in order to

[[Page 72893]]

prevent such transactions from being used to avoid the purposes of the 
final and temporary regulations would far outweigh any policy 
justification for treating the two types of transactions differently, 
which, as explained in this Section D.1 of this Part V, is not 
compelling.
2. Per Se Application of the Funding Rule
a. Overview
    Several comments noted that the per se funding rule in the proposed 
regulations would be overinclusive in certain fact patterns and treat a 
purported debt instrument as equity even though the taxpayer could 
demonstrate as a factual matter that the funding was used in the 
taxpayer's business rather than to make a distribution or acquisition. 
These comments recommended that the regulations adopt a tracing 
approach to connect a funding with a distribution or acquisition by the 
funded member, including by actual tracing or by presumptions and other 
factors. Multiple comments suggested eliminating the per se funding 
rule entirely. Other comments recommended that the per se funding rule 
be altered or shortened. The range of suggestions included:
     Eliminate the per se funding rule and rely solely on a 
principal purpose test;
     Limit the per se funding rule to abusive transactions, 
such as those that lack a business purpose, or to expressly enumerated 
transactions;
     Replace the per se funding rule with a ``but-for'' 
standard;
     Replace the per se funding rule with a rule that would 
trace loan proceeds;
     Replace the per se funding rule with a facts-and-
circumstances test subject to a rebuttable presumption (such as that 
contained in the disguised sale rules in Sec.  1.707-3(c)) or series of 
rebuttable presumptions; and
     Retain the 36-month periods, but apply a rebuttable 
presumption in the first and last 12 months.
    In general, these comments suggested that the final and temporary 
regulations adopt a more subjective rule that would take into account 
particular facts and circumstances and allow taxpayers to demonstrate 
that an alternative source of cash or other property funded the 
distribution or acquisition and that the borrowed funds were put to a 
different use, rather than an objective rule based solely on whether a 
related-party borrowing and a distribution or acquisition both occur 
during a certain time interval.
    After considering these comments, the Treasury Department and the 
IRS have determined that it is appropriate to retain the per se funding 
rule to determine whether a debt instrument has funded a distribution 
or acquisition that occurs during the 36-month period before and after 
the funding transaction (the per se period). The final and temporary 
regulations reorganize the funding rule as (i) a per se funding rule 
addressing covered debt instruments issued by a funded member during 
the per se period; and (ii) a second rule that addresses a covered debt 
instrument issued by a funded member outside of the per se period with 
a principal purpose of funding a distribution or acquisition, 
determined based on all the facts and circumstances (principal purpose 
test). This reorganization is intended to clarify the purpose of the 
per se test and is not intended to be a substantive change.
    Section D.2.b of this Part V explains why the Treasury Department 
and the IRS have determined that retaining the per se funding rule is 
justified. Section D.2.c of this Part V discusses the stacking rules 
that are necessitated by any approach based on fungibility. Section 
D.2.d of this Part V responds to comments regarding the length of the 
per se period. Section D.2.e of this Part V describes the principal 
purpose test.
b. Retention of Per Se Funding Rule
    The general rule in Sec.  1.385-3(b)(2) addresses a distribution or 
acquisition in which a purported debt instrument is issued in the 
distribution or acquisition itself, for example, a distribution of 
indebtedness. In contrast, the funding rule in Sec.  1.385-3(b)(3) 
addresses multi-step transactions in which a related-party debt 
instrument is issued for cash or property to fund a distribution or 
acquisition. The proposed regulations provided a principal purpose test 
to determine whether the indebtedness funded the distribution or 
acquisition in a multi-step transaction. However, the preamble to the 
proposed regulations also observed that money is fungible and that it 
is difficult for the IRS to establish the principal purposes of 
internal transactions. In this regard, the preamble cited the presence 
of intervening events that can occur between the steps, for example, 
other sources of cash such as free cash flow generated from operations, 
which could obscure the connection between the borrowing and the 
distribution or acquisition. For this reason, the proposed regulations 
included the per se funding rule based on a 36-month forward-and-back 
testing period.
    The Treasury Department and the IRS continue to be of the view 
that, because money is fungible, an objective rule is an appropriate 
way to attribute a distribution or acquisition, in whole or in part, to 
a funding. The preamble to the proposed regulations emphasized the 
evidentiary difficulties that the IRS would face if the regulations 
relied exclusively on a purpose-based rule. Some comments suggested 
that a rebuttable presumption (such as the one contained in Sec.  
1.707-3(c)) that would require a taxpayer to overcome a presumption 
arising upon specified events by clearly establishing facts and 
circumstances to the contrary could address these difficulties.
    After considering these comments, the Treasury Department and the 
IRS have determined that, even with the benefit of a rebuttable 
presumption, a purpose-based rule that required tracing sources and 
uses of funds would present significant administrative challenges for 
the IRS. In particular, taxpayers potentially could purport to rebut 
the presumption by creating self-serving contemporaneous documentation 
that ``earmarks'' the proceeds of related-party borrowings for 
particular purposes and attributes distributions and acquisitions to 
other sources of funds.
    More fundamentally, however, because money is fungible, a 
taxpayer's particular purpose for a particular borrowing is largely 
meaningless. This is particularly true with respect to a large, active 
operating company (or group of operating companies that file a 
consolidated return) with multiple sources and uses of funds. Because 
of the fungibility of money, using loan proceeds for one purpose frees 
up funds from another source for another use. For instance, funding a 
distribution or acquisition with working capital could necessitate 
borrowing from a related party in order to replenish depleted working 
capital. For this reason, the Treasury Department and the IRS view 
tracing as having limited economic significance in the context of 
transactions involving indebtedness.
    The concept of using mechanical rules to account for the 
fungibility of money from debt is well established: Several provisions 
of the Code and regulations relating to allocation of interest expense 
are premised on the idea that, with certain narrow exceptions, money is 
fungible and therefore debt funding cannot be directly traced to 
particular activities or assets. See Sec.  1.861-9T(a) (``The method of 
allocation and apportionment for interest . . . is based on the 
approach that, in general, money is fungible and that interest expense 
is attributable to

[[Page 72894]]

all activities and property regardless of any specific purpose for 
incurring an obligation on which interest is paid''); see also section 
864(e)(2) (requiring allocation and apportionment of interest expense 
on the basis of assets); Sec.  1.882-5 (allocation of interest expense 
based on assets for purposes of determining effectively connected 
income); section 263A(f)(2)(A)(ii) (allocating interest that is not 
directly attributable to production expenditures under avoided cost 
principles). These provisions are based on the assumption that, due to 
the fungibility of money, a taxpayer's earmarking of the proceeds of a 
borrowing for any particular purpose is inconsequential for U.S. tax 
purposes.
    Accordingly, the Treasury Department and the IRS have determined 
that it is necessary and appropriate to treat a covered debt instrument 
as financing a distribution or acquisition, regardless of whether the 
issuer associates the proceeds with a particular distribution or 
acquisition or with another use. As a result, the final and temporary 
regulations do not adopt recommendations to rely exclusively on a 
purpose-based tracing rule, including one based on a rebuttable 
presumption in favor of the IRS, an anti-abuse rule, or other multi-
factor approach. In addition to the previously discussed evidentiary 
and economic reasons, a tracing, burden-shifting, or multi-factor 
approach would create significant uncertainty for both the IRS and 
taxpayers in ascertaining whether a borrowing should be considered to 
have funded a distribution or acquisition.
    In adopting a per se funding rule based on the fungibility of 
money, the Treasury Department and the IRS recognize that all 
outstanding debt, regardless of how much time has transpired between 
the issuance and the distribution or acquisition, could be treated as 
funding a distribution or acquisition. This is the case for other 
fungibility-based rules under the Code and regulations, which typically 
apply to all outstanding debt and do not depend on when the debt was 
issued. See, e.g., sections 263A(f)(2)(A)(ii) and 864(e)(2). 
Nevertheless, the Treasury Department and the IRS have determined that 
it is appropriate to limit the application of the per se funding rule 
to testing distributions or acquisitions made within a specified period 
to the debt issuance. Using a fixed per se period that is linked to the 
date of the debt issuance should address the majority of cases where 
purported debt is used to create federal tax benefits without having 
meaningful non-tax effects, since most such transactions seek to 
achieve these benefits immediately upon debt issuance. Such a rule also 
provides certainty so that taxpayers can determine the appropriate 
characterization of the debt instrument within a fixed period after it 
is issued, and need not redetermine their liability for prior taxable 
years. See also Sec.  1.385-3(d)(1)(ii) (treating a covered debt 
instrument subject to the funding rule due to a later distribution as a 
deemed exchange on the date of the distribution and not the issuance). 
Furthermore, the retention of the principal purpose test, described in 
Section D.2.e of this Part V, ensures that the rules appropriately 
apply to transactions occurring outside the per se period that 
intentionally seek to circumvent the per se funding rule.
    A comment also suggested that the final and temporary regulations 
adopt a ``but-for'' standard under which a distribution or acquisition 
would be treated as funded by a purported debt instrument only if the 
distribution or acquisition would not have been made ``but for'' a 
funding. This comment cited proposed Sec.  1.956-4(c)(3) (REG-155164-
09), which used a similar formulation to address whether a distribution 
by a foreign partnership to a related U.S. partner is connected to a 
funding of that partnership by a related CFC for purposes of section 
956. Specifically, proposed Sec.  1.956-4(c)(3) contains a special rule 
for determining a related partner's share of a foreign partnership's 
obligation when the foreign partnership distributes the proceeds of the 
obligation to the related partner and the partnership would not have 
made the distribution ``but for'' a funding of the partnership through 
an obligation held or treated as held by a CFC.
    The Treasury Department and the IRS view a ``but-for'' standard in 
this context as similar in effect to a subjective tracing approach, in 
that a ``but-for'' test would require an inquiry into what a taxpayer 
would have chosen to do in the absence of the funding. Therefore, a 
``but-for'' test contains the same shortcomings as a subjective tracing 
rule and does not adequately account for the fungibility of money. 
Alternatively, a ``but-for'' test could, in certain circumstances, 
function like a taxpayer-favorable stacking rule that would attribute a 
distribution or acquisition to a related-party borrowing only if there 
were no other sources of funding for the transaction. Significantly, 
the ``but-for'' approach in the proposed section 956 regulations 
operates only to increase the amount that otherwise would be allocated 
to a U.S. partner under the general aggregate approach of the 
regulations. That is, in the context of the proposed regulations under 
section 956, the ``but-for'' test is an anti-abuse backstop to a 
general rule that otherwise takes into account the fungibility of money 
and allocates the liabilities of a partnership pro rata based on the 
partner's interests in the partnership. Because the ``but-for'' test in 
the proposed section 956 regulations functions only as a backstop to a 
general rule that is based on the fungibility of money, the Treasury 
Department and the IRS considered the taxpayer-favorable stacking 
assumption implicit in the ``but-for'' test to be acceptable in that 
context. In contrast, if the final and temporary regulations under 
section 385 were to adopt a ``but-for'' test as the operative rule in 
lieu of a per se funding rule, a taxpayer could avoid the application 
of Sec.  1.385-3 entirely by demonstrating the presence of other 
sources of cash, notwithstanding that the cash obtained through a 
related-party borrowing facilitated a distribution or acquisition by 
allowing those other sources of cash to support other uses.
c. Stacking Rules
    Using a fungibility approach to attribute distributions and 
acquisitions to covered debt instruments necessitates stacking rules 
for attributing uses of funds to sources of funds. Some comments 
asserted that the per se funding rule under the proposed regulations 
represents an anti-taxpayer stacking provision. One comment suggested 
that, to the extent a per se funding rule is appropriate due to the 
fungibility of money, the per se funding rule necessarily should treat 
a distribution or acquisition as funded pro rata by all sources of free 
cash flow. For example, if an entity generated $500x of free cash flow 
from operating its business and borrowed $100x from another member of 
the entity's expanded group, and, during the per se period the entity 
made a subsequent distribution of $100x, the comment suggested that 
only one-sixth of the $100x should be treated as funded by the 
borrowing. Other comments noted that the proposed regulations included 
taxpayer-unfavorable stacking because they always treated a 
distribution or acquisition as funded by a related-party borrowing 
without regard to whether there were new contributions to capital or 
third-party borrowing during the per se period.
    The final and temporary regulations adopt several new and expanded 
exceptions described in Sections E, F, and G of this Part V. These 
exceptions represent taxpayer-favorable stacking rules that, in the 
aggregate, significantly reduce the extent to which distributions and 
acquisitions are attributed to

[[Page 72895]]

related-party borrowings. This exception-based approach to stacking is 
significantly more administrable than a pro rata approach, which would 
necessitate a constant recalculation of the relative amounts of funding 
from various sources.
    In response to comments suggesting that distributions and 
acquisitions should be attributed first to free cash flow, or to the 
cumulative earnings and profits of a member, before being attributed to 
related-party borrowings, the final and temporary regulations treat 
distributions and acquisitions as funded first from earnings and 
profits accumulated during a corporation's membership in an expanded 
group. See Section E.3.a of this Part V (which includes a discussion of 
why earnings and profits are the better measure for tax purposes). In 
response to comments suggesting that distributions and acquisitions 
should be attributed to new contributed capital received by a member 
before its related-party borrowings, the final and temporary 
regulations treat distributions and acquisitions as funded next from 
capital contributions received from other members of the expanded group 
within the per se period but before the end of the taxable year of the 
distribution or acquisition. See Section E.3.b of this Part V. In 
response to comments suggesting that certain borrowings should not be 
treated as funding distributions and acquisitions, the final and 
temporary regulations include a broad exception from the funding rule 
for short-term debt instruments, which effectively are treated as 
financing the short-term liquidity needs of the issuer rather than 
distributions and acquisitions. See Section D.8.c of this Part V. 
Accordingly, after taking into account the various exceptions provided, 
the final and temporary regulations generally (i) exclude certain 
short-term debt instruments from funding any distributions or 
acquisitions, (ii) exclude certain distributions and acquisitions from 
being funded by any type of debt instrument, (iii) treat any remaining 
distributions and acquisitions as funded by new equity capital, and 
(iv) only then treat any remaining distributions and acquisitions as 
funded by any remaining related party borrowings.
    Some comments suggested that the final and temporary regulations 
should treat any remaining distributions and acquisitions as funded 
first by unrelated-party debt, rather than funded first by covered debt 
instruments. The Treasury Department and the IRS decline to adopt this 
recommendation. The Treasury Department and the IRS have determined 
that it is appropriate to treat any remaining distributions and 
acquisitions as funded first by related-party debt, because the nature 
of unrelated-party lending imposes a real cost to the borrower through 
interest expense and other costs. This real cost from unrelated-party 
borrowing can be justified only if the issuer will use the borrowed 
funds to achieve a return that is greater than the interest expense and 
other costs from the unrelated-party borrowing. On the other hand, a 
borrowing among highly-related parties, such as between members of an 
expanded group, has no net cost to the borrower and the lender. Because 
the related-party borrower and lender have a complete (or near 
complete) identity of interests, the related-party borrowing imposes no 
similar economic cost on the borrower. Indeed, the pre-tax return with 
respect to a related-party borrowing can be zero, or even less than 
zero, and the borrowing can still achieve a positive after-tax return 
when the related party lender's interest income is taxed at a lower 
effective tax rate than the related-party borrower's effective tax 
benefit from interest deductions. This is true whether the related-
party lender is a U.S. corporation or a foreign corporation. In 
addition to interest and other costs, an unrelated-party lender may 
impose restrictive covenants or other legal and contractual 
restrictions that affect the borrower's business, including 
restrictions on the issuer's ability to distribute the proceeds from 
the unrelated-party debt that a related-party lender may not impose. 
For these reasons, it is appropriate to treat any remaining 
distributions and acquisitions as funded first by related-party debt, 
before treating those remaining distributions and acquisitions as 
funded by unrelated-party debt.
d. Retention of the 36-Month Testing Periods
    Several comments suggested that, if the regulations continue to 
take a per se approach, the testing period should be significantly 
shortened. For example, comments recommended testing periods of 24 
months, 18 months, 12 months, or 6 months. After consideration of these 
comments, the Treasury Department and the IRS have determined that it 
continues to be appropriate to use 36-month testing periods.
    As explained in Section D.2.b of this Part V, the Treasury 
Department and the IRS have determined that, because money is fungible, 
an objective set of rules using a fixed time period and various 
stacking rules is the most administrable approach to determine whether 
a debt instrument funded a distribution or acquisition. The Treasury 
Department and the IRS have considered several factors in determining 
that the 36-month testing periods in the proposed regulations should be 
retained, rather than adopting one of the recommendations for a shorter 
period.
    Many of the comments requesting a shorter testing period were 
concerned primarily about compliance burdens that would be imposed if 
the per se funding rule applied to ordinary course transactions that 
occur with a high frequency. These concerns are mitigated by the 
addition and expansion of numerous exceptions described in Sections 
D.8, E, F, and G of this Part V, which substantially narrow the scope 
of the per se funding rule in the final and temporary regulations. In 
particular, as discussed in Section D.8 of this Part V, short-term debt 
instruments that finance short-term liquidity needs that arise 
frequently in the ordinary course of business are excluded from the 
scope of the funding rule in the final and temporary regulations. This 
change substantially reduces the compliance burden of applying the per 
se funding rule during the 36-month testing periods. In addition, as 
discussed in Section E.3 of this Part V, the final and temporary 
regulations only take into account distributions and acquisitions that 
exceed increases to the issuer's equity while the issuer was a member 
of the same expanded group from: (i) Earnings and profits accumulated 
after the proposed regulations were published and, (ii) certain 
contributions to capital that occurred during the 36-month period 
preceding the distribution or acquisition or during the taxable year in 
which the distribution or acquisition occurred. Thus, the funding rule 
in the final and temporary regulations is focused on non-ordinary 
course covered debt instruments and extraordinary distributions and 
acquisitions.
    Taking into account the implications of the narrower scope of Sec.  
1.385-3 with respect to the issues raised by comments regarding the 36-
month testing periods, the Treasury Department and the IRS have 
determined that it is appropriate to continue to attribute 
distributions and acquisitions that exceed the relevant earnings and 
profits and capital contributions to non-ordinary course related-party 
borrowings that were made 36 months before or after the distribution or 
acquisition and that remain outstanding at the time of the distribution 
or acquisition. The Treasury Department and the IRS have determined 
that 36 months is a reasonable testing period that appropriately 
balances the need for an

[[Page 72896]]

administrable rule and the fact that transactions involving 
indebtedness are inextricably linked due to the fungibility of money. 
Furthermore, the Treasury Department and the IRS are concerned that, if 
a shorter testing period was used, such as a 24-month forward-and-
backward testing period, taxpayers could find it worthwhile to engage 
in funding transactions by waiting 24 months after the issuance of debt 
before conducting the second transaction, and that the principal 
purpose test described in Section D.2.e of this Part V, which is more 
difficult for the IRS to administer, would not be a sufficient 
deterrent in this circumstance.
    The use of a 36-month testing period for this purpose is consistent 
with, and in some cases shorter than, other testing periods that the 
IRS has experience administering in which facts and circumstances 
potentially observable by the IRS provide an inadequate basis to 
establish the relationship between two events or transactions. See, 
e.g., section 172(b)(1)(D) and (g)(2) (treating certain interest 
deductions from indebtedness in the year of a corporate equity 
reduction transaction (CERT) and the following two tax years as per se 
attributable to the CERT, in lieu of tracing interest to specific 
transactions); section 302(c)(2)(A)(ii) (10-year period for determining 
whether shareholder has terminated their interest for purposes of 
applying section 302(a) to a redemption); section 2035(a) (treating 
gifts made three years before the decedent's death as included in the 
decedent's gross estate); Sec.  1.1001-3(f)(3) (disregarding 
modifications occurring more than five-years apart when determining if 
multiple modifications are significant); see also Sec.  1.7874-8T(g)(4) 
(36-month look-back period for determining when to account for prior 
acquisitions).
    Although some comments asserted that the per se funding rule should 
be modeled on the two-year presumption rule in Sec.  1.707-3(c), the 
Treasury Department and the IRS have determined that the disguised sale 
rules under Sec.  1.707-3(c) address a different policy in the context 
of transactions between a partner and partnership (regardless of the 
level of ownership), whereas the final and temporary regulations 
address transactions between highly-related corporations. In this case, 
the Treasury Department and the IRS have determined that a 36-month 
testing period is more appropriate, taking into account in particular 
the tax consequences associated with corporate indebtedness and the 
high degree of relatedness of the parties.
    For these reasons, the final and temporary regulations retain a 36-
month testing period as the per se period.
e. Principal Purpose Test
    Because of the mechanical nature of the per se funding rule, the 
Treasury Department and the IRS are concerned that taxpayers may seek 
to intentionally circumvent the rule to achieve economically similar 
results even though the funding occurs outside of the per se period. 
Therefore, the final and temporary regulations provide that a covered 
debt instrument that is not issued during the per se period is treated 
as funding a distribution or acquisition to the extent it is issued by 
a funded member with a principal purpose of funding the distribution or 
acquisition. This determination is made based on all of the relevant 
facts and circumstances.
3. Predecessors and Successors
    Under the proposed regulations, references to a funded member 
included a reference to any predecessor or successor of such member. 
The proposed regulations defined the terms predecessor and successor to 
``include'' certain persons, without specifically stating whether other 
persons could be treated as predecessors or successors in certain 
instances. Comments requested additional clarity concerning the scope 
of the definition of predecessor and successor through an exclusive 
enumeration of entities that may be considered predecessors or 
successors.
    In response to comments, the final and temporary regulations 
replace ``include'' with ``means'' in the definitions of predecessor 
and successor, thereby limiting the transactions that create 
predecessor or successor status to those explicitly provided.
    Comments recommended that a funded member be treated as making a 
distribution or acquisition that is made by a predecessor or successor 
only to the extent that the transaction creating the predecessor-
successor relationship occurs during the per se period determined with 
respect to the distribution or acquisition. For example, assume USS1 
makes a distribution of $10x to an expanded group member in year 1. 
USS2, also an expanded group member that is not consolidated with USS1, 
borrows $10x from an expanded group member in year 2. In year 10, USS1 
merges into USS2 in an asset reorganization. Comments suggested that 
the proposed regulations arguably would treat USS2's year 2 note as 
stock because USS1 is a predecessor to USS2, and the year 2 funding 
occurred within the 72-month period determined with respect to the year 
1 distribution. One comment suggested that the predecessor or successor 
rule only apply in this context if there was a principal purpose to 
avoid the regulations.
    In response to comments, the final and temporary regulations 
provide that, for purposes of the per se funding rule, a covered debt 
instrument that is otherwise issued by a funded member within the per 
se period of a distribution or acquisition made by a predecessor or 
successor is not treated as issued during the per se period with 
respect to the distribution or acquisition unless both (i) the covered 
debt instrument is issued by the funded member during the period 
beginning 36 months before the date of the transaction in which the 
predecessor or successor becomes a predecessor or successor and ending 
36 months after the date of the transaction, and (ii) the distribution 
or acquisition is made by the predecessor or successor during the same 
72-month period. If the funding and the distribution or acquisition do 
not both occur during the 72-month period with respect to the 
transaction that created the predecessor-successor relationship, the 
covered debt instrument is not treated as funding the distribution or 
acquisition under the per se funding rule. In that case, however, the 
principal purpose test may still apply to treat the covered debt 
instrument as funding the distribution or acquisition.
    Comments questioned the application of the predecessor and 
successor rules when a funded member and either its predecessor or 
successor are members of different expanded groups. One comment 
recommended that a funded member be treated as making a distribution or 
acquisition made by a predecessor or successor only to the extent that 
the distribution or acquisition was to a member of the same expanded 
group as the funded member. Similarly, comments requested that the 
regulations clarify that a corporation ceases to be a predecessor or 
successor to a funded member when the corporation and the funded member 
cease to be members of the same expanded group.
    In response to comments, the final and temporary regulations 
provide that the distributing corporation and controlled corporation in 
a distribution that qualifies under section 355 cease to have a 
predecessor and successor relationship as of the date that the 
corporations cease to be members of the same expanded group. Similarly, 
a seller in a transaction to which the subsidiary stock acquisition 
exception

[[Page 72897]]

applies ceases to be a successor of the acquirer as of the date that 
the corporations cease to be members of the same expanded group. See 
Section E.2.a of this Part V for the new terminology. However, any 
distribution or acquisition made by a predecessor or successor of a 
corporation up to the date that the predecessor or successor 
relationship is terminated may be treated as funded by a debt 
instrument issued by the corporation after that date.
    Comments requested that the terms predecessor and successor not 
include the distributing or controlled corporation in a divisive 
reorganization described in section 368(a)(1)(D) undertaken pursuant to 
a distribution under section 355, regardless of whether distributing 
and controlled remain members of the same expanded group. The comments 
asserted that the requirements of section 355 provide sufficient 
safeguards to protect the concerns underlying the proposed regulations 
(specifically, that a taxpayer would undertake a divisive 
reorganization with a principal purpose of avoiding the regulations), 
such that it is not necessary to treat the distributing and controlled 
corporations as predecessors and successors. For example, the active 
trade or business requirement and business purpose requirement of 
section 355 limit the ability for taxpayers to engage in tax-motivated 
transactions, although comments did acknowledge that these restrictions 
could be overcome in some circumstances.
    The final and temporary regulations do not adopt this 
recommendation because the Treasury Department and the IRS continue to 
be concerned about the ability of taxpayers to issue indebtedness that 
does not fund new investment in connection with a reorganization that 
qualifies under sections 355 and 368(a)(1)(D). As discussed in Section 
D.6 of this Part V, the Treasury Department and the IRS have determined 
that distributions that qualify for nonrecognition under section 355, 
whether or not preceded by a reorganization, should not be subject to 
the funding rule because the requirements of that provision--in 
particular, the active trade or business requirement and the device 
limitation--indicate that the stock of a controlled corporation is 
likely not fungible property. However, these safeguards do not 
adequately limit the amount of liquid assets that the distributing 
corporation can transfer to the controlled corporation pursuant to the 
plan of reorganization or before the spin is contemplated in the case 
of straight section 355 distributions. Moreover, section 355 includes 
no prohibition against a post-spin distribution by the controlled 
corporation to its common shareholder with the distributing 
corporation. As a result, the proceeds of a borrowing by the 
distributing corporation can easily be transferred to a controlled 
corporation, which proceeds can then be distributed by the controlled 
corporation or used in a transaction with similar economic effect.
    One comment suggested that the predecessor and successor rules 
limit the extent to which multiple corporations may be treated as 
successors with respect to the same debt instrument issued by a funded 
member. The comment proposed that, in the event that a funded member 
has multiple successors (for example, by reason of multiple transfers 
of property to which the subsidiary stock acquisition exception 
described in Section E.2.a of this Part V applies), the successors, 
collectively, should only be successors up to the aggregate amount of 
debt instruments of the funded member outstanding at the time of the 
transactions that created the successor relationships. The comment 
further suggested that, if the recommendation were accepted, an 
ordering rule may be appropriate to treat multiple successors as 
successors to the funded member based on a ``first in time'' principle.
    The final and temporary regulations do not adopt the 
recommendation, because the Treasury Department and the IRS have 
determined that limiting the extent to which one or more corporations 
are successors to a funded member based on the member's outstanding 
related-party debt is inconsistent with the funding rule outside the 
predecessor-successor context. As discussed in Section D.2 of this Part 
V, under either test of the funding rule--the per se funding rule or 
the principal purpose test--a covered debt instrument can be treated as 
funding a distribution or acquisition notwithstanding that the 
instrument is issued subsequent to the distribution or acquisition. In 
contrast, limiting successor status to the funded member's debt 
outstanding at the time of the transaction that creates the successor 
relationship would preclude a later issued covered debt instrument from 
being treated as funding a distribution or acquisition that precedes 
it. For instance, if a funded member, at a time that it has no covered 
debt instrument outstanding, transfers property to a subsidiary in a 
transaction described in the subsidiary stock acquisition exception, 
under the proposed limitation the subsidiary would not be a successor 
to the funded member, and thus any distribution or acquisition by the 
subsidiary would not be treated as funding a covered debt instrument of 
the funded member issued thereafter but within the per se period. On 
the other hand, if, instead of transferring property to the subsidiary, 
the funded member made a distribution or acquisition itself, a 
subsequent issuance by the funded member of a covered debt instrument 
within the per se period would be treated as funding the distribution 
or acquisition under the per se funding rule. The Treasury Department 
and the IRS have determined that a distribution or acquisition by a 
predecessor or successor of a funded member should not be treated more 
favorably than a distribution or acquisition by the funded member 
itself. Furthermore, because the final and temporary regulations do not 
adopt the recommendation, no ordering rule is necessary for purposes of 
determining predecessor or successor status in the context of multiple 
predecessors or successors.
    Comments also requested clarification regarding the interaction of 
the predecessor and successor rules and the multiple instrument rule, 
which provides that when two or more covered debt instruments may be 
treated as stock under the per se funding rule, the covered debt 
instruments are tested based on the order in which they were issued, 
with the earliest issued covered debt instrument tested first. 
Specifically, comments raised the concern that, under one 
interpretation of the proposed regulations, a distribution or 
acquisition that is treated as funded by a covered debt instrument of a 
covered member could be re-tested and treated as funded by an earlier-
in-time debt instrument of another member if and when the first covered 
member acquires the other member in a reorganization.
    To address the foregoing concerns, the final and temporary 
regulations provide that, except as provided in Sec.  1.385-3(d)(2) 
(regarding covered debt instruments treated as stock that leave the 
expanded group), to the extent a distribution or acquisition is treated 
as funded by a covered debt instrument, the distribution or acquisition 
may not be treated as funded by another covered debt instrument and the 
covered debt instrument may not be treated as funding another 
distribution or acquisition. This non-duplication rule clarifies that a 
distribution or acquisition that is treated as funded by a covered debt 
instrument that is treated as stock by reason of Sec.  1.385-3(b) is 
not re-tested under the multiple instrument

[[Page 72898]]

rule because of the existence of an earlier-in-time covered debt 
instrument of the corporation's predecessor or successor, when the 
transaction that created the predecessor-successor relationship occurs 
after the first-mentioned covered debt instrument was already treated 
as stock.
4. Straddling Expanded Groups
    Multiple comments recommended that the final and temporary 
regulations provide an exception for when a funded member is funded 
within the per se period with respect to a distribution or acquisition, 
but the funding and the distribution occur in different expanded 
groups. For example, P1 and S are members of the P1 expanded group. P1 
owns all the stock of S, which distributes $100x to P1 in year 1. In 
year 2, P1 sells all the stock of S to unrelated P2, a member of the P2 
expanded group. In year 3, P2 loans $100x to S. The comments asserted 
that the borrowing and distribution by S do not implicate the policy 
concerns addressed by the funding rule because of the intervening 
change in its expanded group. Moreover, comments asserted that it would 
be difficult for P2 to determine the treatment of its loan to S as debt 
or equity without substantial due diligence with respect to the 
distribution history of S.
    The final and temporary regulations adopt the recommendation by 
providing an exception to the per se funding rule, which generally 
applies when (i) a covered member makes a distribution or acquisition 
that occurs before the covered member is funded; (ii) the distribution 
or acquisition occurs when the covered member's expanded group parent 
is different than the expanded group parent when the covered member is 
funded; and (iii) the covered member and the counterparty to the 
distribution or acquisition (the ``recipient member'') are not members 
of the same expanded group on the date the covered member is funded. 
For this purpose, a recipient member includes a predecessor or 
successor or one or more other entities that, in the aggregate, acquire 
substantially all of the property of the recipient member. If the 
requirements of this exception are satisfied, the covered debt 
instrument is not treated as issued within the per se period with 
respect to the earlier distribution. However, the principal purpose 
test may still apply so that, if the debt instrument is actually issued 
with a principal purpose of funding the distribution or acquisition, 
the debt instrument would be treated as stock under the funding rule.
    Comments also addressed a similar scenario in which the covered 
member and the recipient member are members of one expanded group 
(prior expanded group) at the time of the distribution or acquisition 
and both parties join a different expanded group (subsequent expanded 
group) before the covered member is funded by either the recipient 
member or another member of the subsequent expanded group. Some of the 
comments recommended that the funding rule, or at least the per se 
rule, not apply in this situation because the borrowing from the 
subsequent expanded group cannot have funded the distribution or 
acquisition that occurred in the prior expanded group. Comments also 
recommended a similar exception to the funding rule when the steps are 
reversed, such that the covered member issues a covered debt instrument 
to another member of the prior expanded group, and the distribution or 
acquisition occurs in the subsequent expanded group that includes both 
the funding and funded members.
    The final and temporary regulations do not adopt these 
recommendations. The Treasury Department and IRS expect that any burden 
on taxpayers to determine the history of loans originated in the prior 
expanded group would not be as significant as any burden to determine 
the distribution and acquisition history in a prior expanded group 
(that is, when the distribution or acquisition occurs in the prior 
expanded group, and the funding occurs in the subsequent expanded 
group). The Treasury Department and the IRS have determined that, when 
the distribution or acquisition occurs in the same expanded group that 
includes the funding and funded members, it is appropriate to apply the 
per se funding rule to the distribution or acquisition. Finally, the 
Treasury Department and the IRS are concerned that an exception for 
this type of transaction could lead to transactions in which taxpayers 
transfer subsidiaries between different expanded groups to accomplish 
what they could not accomplish absent such transactions.
5. Transactions Described in More Than One Paragraph
    Proposed Sec.  1.385-3(b)(3)(iii) provided 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. One comment questioned the application of 
this rule to a payment of boot in a reorganization where both the 
acquiring corporation and the target corporation in the reorganization 
have outstanding covered debt instruments.
    In response to this comment, Sec.  1.385-3(b)(3)(ii) clarifies 
that, in the case of an internal asset reorganization, to the extent an 
acquisition by the transferee corporation is described in the third 
prong of the funding rule, a distribution or acquisition by the 
transferor corporation is not also described in the funding rule. 
Accordingly, in the case of a reorganization in which both the 
transferor corporation and the transferee corporation have outstanding 
covered debt instruments, the reorganization is treated as a single 
transaction and a payment of boot in the reorganization is treated as a 
single acquisition by the transferee corporation for purposes of the 
funding rule. See Sections E.3.a.iv (regarding the application of 
reductions to certain internal asset reorganizations) and E.6.b 
(regarding the general coordination rule applicable to internal asset 
reorganizations) of this Part V.
6. Certain Nontaxable Distributions
    Comments recommended that the funding rule not apply to liquidating 
distributions described in section 332. Comments further recommended 
that the final and temporary regulations treat the 80-percent 
distributee in a section 332 liquidation as a successor to the 
liquidating corporation. Comments requested, in the alternative, that 
if a section 332 distribution is treated as a distribution for purposes 
of the funding rule, the final and temporary regulations should clarify 
whether any resulting recharacterized instruments are taken into 
account in determining whether the liquidation satisfies the 80-percent 
ownership test under section 332.
    One comment recommended that, if an expanded group member 
distributes assets in a section 331 liquidation to a shareholder that 
assumes a liability of the liquidated corporation, the liquidated 
corporation should not be treated as making a distribution for purposes 
of the funding rule to the extent of the assumed liabilities. The 
comment reasoned that, in substance, the shareholder purchased assets 
from the liquidating corporation. Consequently, the comment concluded 
that a distribution should be treated as occurring under these 
circumstances only to the extent the value of the distributed assets 
exceeds the amount of liabilities assumed.
    In response to the comments, the final and temporary regulations 
include an exception to the funding rule for a distribution in complete 
liquidation of a funded member pursuant to a plan of liquidation. This 
exception does not distinguish between a liquidation that

[[Page 72899]]

qualifies under section 332 and a liquidation that occurs under section 
331. In the case of a liquidation that qualifies under section 332, the 
acquiring corporation is treated as a successor to the liquidated 
corporation for purposes of the funding rule.
    Comments also requested an exclusion from the funding rule for 
distributions of stock under section 355 not preceded by a 
reorganization described in section 368(a)(1)(D) (a straight 355 
distribution). The comment noted that in a straight 355 distribution, 
in contrast to a distribution of a debt instrument or a distribution of 
cash, the distribution of a controlled corporation must be motivated by 
one or more non-U.S. tax business purposes and both the distributing 
and controlled corporations must own historic, illiquid business 
assets. Moreover, the comment noted that the distributing corporation 
in a straight 355 distribution cannot have contributed borrowed funds 
to the controlled corporation; otherwise, the distribution would also 
qualify as a reorganization and be subject to a different rule that 
generally only treated the amount of boot or other property received in 
a distribution that qualifies under sections 355 and 368(a)(1)(D) as a 
distribution or acquisition for purposes of Sec.  1.385-3(b).
    In response to comments, the final and temporary regulations 
provide an exception to the funding rule for a straight section 355 
distribution. As discussed in Section D.2.a of this Part V, the per se 
approach is retained by the final and temporary regulations due, in 
large part, to the fungibility of money and thus the difficulty of 
tracing the proceeds of a borrowing to a distribution. The Treasury 
Department and the IRS have concluded that, due to the heightened 
requirements for qualification under section 355 (for example, device 
limitation, business purpose requirement, and active trade or business 
requirement), the stock of a controlled corporation should not be 
viewed as fungible property. Furthermore, the Treasury Department and 
the IRS have determined that section 355 distributions should be 
subject to the same treatment under the final and temporary regulations 
as section 355 distributions that are preceded by a reorganization 
under section 368(a)(1)(D), because a distribution of stock described 
in section 355 has the same economic effect whether or not preceded by 
a reorganization. In that regard, the final and temporary regulations 
provide that a distributing corporation and a controlled corporation in 
a section 355, whether or not in connection with a reorganization 
described in section 368(a)(1)(D), are predecessor and successor to 
each other for purposes of the funding rule.
    One comment requested that distributions described in section 
305(a) (stock distributed with respect to stock not included in gross 
income) be excluded from the funding rule because the shareholders do 
not realize income and the distributing corporation's net worth does 
not decrease. The final and temporary regulations do not directly 
address transactions to which section 305(a) applies because a 
distribution of the stock of a corporation made by such corporation is 
not a distribution of property as defined for purposes of Sec.  1.385-
3, and thus is not addressed by the funding rule.
7. Secondary Purchases
    One comment requested confirmation that an expanded group member's 
secondary purchase of a debt instrument issued by a member of its 
expanded group is not an issuance of a debt instrument described in the 
funding rule. The comment further recommended that the deemed issuance 
of a debt instrument from one expanded group member to another expanded 
group member under Sec.  1.108-2(g) should be disregarded for purposes 
of the funding rule. The Treasury Department and the IRS have 
determined that no further clarification is necessary in this area. 
Consistent with the proposed regulations, Sec.  1.385-3(b)(3) of the 
final regulations provides that the funding rule applies to a covered 
debt instrument issued by a covered member to a member of an expanded 
group, and thus the funding rule generally does not apply to secondary 
market purchases. However, to the extent that any other Code section or 
regulation deems a debt instrument to be issued by a covered member to 
a member of its expanded group, that issuance could, absent an 
exception, be an issuance described in Sec.  1.385-3(b)(3).
8. Ordinary Course Exception, Cash Pooling, and Short-Term Instruments
a. Proposed Regulations and General Approach
    The proposed regulations provided that an ordinary course debt 
instrument is not subject to the per se funding rule. Proposed Sec.  
1.385-3(b)(3)(iv)(B)(2) defined 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, but only 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, and 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.
    Proposed Sec. Sec.  1.385-3 and 1.385-4 did not include special 
rules for debt instruments that are issued in the ordinary course of 
managing the cash of an expanded group. However, the preamble to the 
proposed regulations requested comments on the special rules that might 
be needed with respect to cash pools, cash sweeps, and similar 
arrangements for managing the cash of an expanded group.
    The comments regarding the ordinary course exception and the need 
for an exception to address common cash-management techniques overlap 
considerably. Accordingly, Section D.8 of this Part V addresses both 
topics. In general, comments indicated that it would be burdensome to 
apply the per se funding rule to any frequently recurring transactions, 
including both ordinary course business transactions between affiliates 
that involve a short-term extension of credit as well as debt 
instruments that arise in the context of companies that participate in 
arrangements with other expanded group members that are intended to 
optimize, on a daily basis, the amount of working capital required by 
the group. Comments also observed that the risk that such extensions of 
credit would be used for tax-motivated purposes, such as funding a 
distribution, is very low and does not justify the burdens that would 
be imposed if companies had to track these transactions and deal with 
the complexity that would follow if such routine extensions of credit 
were recharacterized into equity. Far less uniform were the 
recommendations for how to address the concerns expressed in the 
comments.
    As described in Section D.8.c of this Part V, the Treasury 
Department and the IRS have determined that the ordinary course 
exception should be an element of a broader exception that also covers 
certain other short-term loans, including debt instruments that arise 
in the context of a cash-management arrangement. In many cases the 
types of transactions covered by the ordinary course exception are in 
substance similar to the transactions that are facilitated by the 
short-term liquidity that is extended under a cash-management 
arrangement. For example, an expanded group member may

[[Page 72900]]

purchase inventory from an affiliate in exchange for a trade payable or 
using cash obtained by an extension of credit from a third group 
member. The Treasury Department and the IRS have determined that it is 
not appropriate to create a tax preference for either form of the 
transaction. Accordingly, the temporary regulations adopt a broad 
exception from the funding rule for qualified short-term debt 
instruments that is intended to address the comments' concerns 
regarding the ordinary course exception as well as the broader need for 
an exception to facilitate short-term cash management arrangements.
b. Overview of Comments Received
i. Expansion of Exception to Additional Instruments
    Numerous comments requested that the ordinary course exception be 
expanded to apply to a wider range of debt instruments. These comments 
ranged from narrow requests to expand the list of items that might be 
acquired in the ordinary course of a taxpayer's business from another 
group member to broad requests for an exception that covers any short-
term loan, including for cash.
    Some comments questioned the requirement for a debt instrument to 
be issued for goods and services in order to qualify for the ordinary 
course exception, stating that the ordinary course exception otherwise 
would not cover many regular business expenses, including some expenses 
deductible as trade or business expenses under section 162. Comments 
specifically noted that the ordinary course exception would not apply 
to instruments issued as payment for a rent or royalty due to a related 
party for the use of assets (including intangible assets) used in a 
trade or business because such payments are not in exchange for goods 
or services. Other comments recommended that the ordinary course 
exception apply to transactions involving expenses that are currently 
deductible or creditable under other sections of the Code, including 
payments (or loans to finance payments) of expenses creditable or 
deductible under section 41 (allowing a credit for increasing research 
activities), section 164 (allowing a deduction for state and local 
taxes), and section 174 (allowing a deduction for certain research and 
development expenses). Separately, comments requested that transactions 
involving expenses that are deferred or disallowed under a provision of 
the Code (for example, section 267) should nonetheless qualify for the 
ordinary course exception.
    Comments also recommended that the ordinary course exception apply 
to transactions involving expenses that are required to be capitalized 
or amortized. Along these lines, comments recommended that loans issued 
in exchange for certain business property, such as operating assets or 
tangible personal property used in a trade or business, be treated as 
ordinary course debt instruments.
ii. Facts and Circumstances
    Comments suggested that the ordinary course exception should apply 
broadly under a facts-and-circumstances test. Under one articulation of 
a facts-and-circumstances test proposed in a comment, the ordinary 
course exception would apply to any debt instrument issued for services 
or property in the conduct of normal business activities on appropriate 
terms unless the facts establish a principal purpose of funding a 
general rule transaction. The comment noted several instances in which 
such a test would apply more broadly than the test in the proposed 
rule, including certain issuances by securitization vehicles and 
dealers and issuances and modifications of intercompany debt by a 
distressed corporation in connection with an agreement with third-party 
creditors.
iii. De Minimis Loans
    Comments recommended that the ordinary course exception apply to 
all loans under a de minimis threshold. Suggestions for a de minimis 
threshold included $1 million per obligation or $5 million per entity.
iv. Working Capital Loans
    Numerous comments suggested an ordinary course exception or other 
safe harbor that would apply based on a determinable financial metric, 
such as current assets, current assets less cash and cash equivalents, 
annual expenses, or annual cost of goods sold. Representative examples 
of this approach include: An exception for aggregate loans below 150 
percent of the closing balance of current assets of the borrower as of 
its most recent financial statements; an exception for aggregate loans 
less than annual expenses; an exception for aggregate loans less than 
certain annual expenses related to ordinary course transactions, such 
as payroll and cost of goods sold; an exception for loans up to a 
certain percentage of the book value of gross assets; and an exception 
for any debt instrument with a principal amount less than the average 
principal amount of all expanded group debt instruments issued by 
expanded group members (including the borrower) in the prior 36 months, 
increased by a specific percentage to account for growth. One comment 
noted in particular that any safe harbor should not apply to the extent 
the borrower held unrestricted cash or cash equivalents available to 
pay for the goods or services. A comment also noted that the 
measurement of any specific financial metric used as the basis of an 
exception (for example, current assets) could be determined over a 
period, such as a trailing three-year average (or other period). 
Another comment noted that an exception based on a financial metric 
that is fixed in time may not work well because (i) if the metric is 
based on a specific balance sheet date, that date may not be 
representative of the working capital requirements at other times, such 
as during a peak season, and (ii) if the metric is based on the time of 
issuance of the debt instrument and that date is not a balance sheet 
date, it may not be knowable.
    Other comments recommended that all short-term debt instruments and 
all non-interest bearing debt instruments should qualify for an 
exception.
v. Net Interest Expense
    A comment requested an exception for cash pooling arrangements that 
do not give rise to net interest expense in the United States, 
determined on a taxable year basis. For a discussion of comments 
regarding exceptions based on net interest generally, see Section A of 
this Part V.
vi. Cash Pooling Arrangements
    Comments noted that the preamble to the proposed regulations 
explicitly stated that the ordinary course exception ``is not intended 
to apply to intercompany financing or treasury center activities.'' 
Several comments requested reconsideration of this restriction because 
businesses often use a treasury center or other cash-management 
arrangement (such as a cash pool) to finance ordinary course 
transactions of group members, as well as for intercompany netting 
programs, centralized payment systems, foreign currency hedging, and 
bridge financing. Accordingly, comments requested that financing of 
routine transactions qualify for the ordinary course exception, 
regardless of whether such financing is provided by a treasury center 
or other cash-management arrangement. Comments also requested that debt 
instruments issued in connection with netting, clearing-house, and 
billing center arrangements be treated as

[[Page 72901]]

ordinary course debt instruments whether or not conducted through a 
treasury center.
    The comments suggested defining a new entity such as a treasury 
center or qualified cash pool and treating loans to and from the entity 
as ordinary course debt instruments. Some comments suggested defining a 
treasury center by reference to Sec.  1.1471-5(e)(5)(i)(D), which 
generally applies to an entity that manages working capital solely for 
members of its expanded affiliated group (as defined in section 
1471(e)(2) and the regulations thereunder). An alternative proposal 
defined a qualified cash pool as any entity with a principal purpose of 
managing the funding and liquidity for members of the expanded group. 
However, some comments recommending such an approach acknowledged that 
some companies provide long-term financing for non-ordinary course 
transactions through an internal treasury center, and thus noted that 
loans to and from the qualified entity could be subject to reasonable 
restrictions on duration.
    Comments also expressed concern that recharacterization of a debt 
instrument in the context of a cash-management arrangement could result 
in a multitude of cascading recharacterizations, particularly in 
situations where a cash pool header makes and receives a substantial 
number of loans. Comments indicated that cash pools typically process 
many transactions in a single business day, with one comment stating 
that the company's cash pool processed over a million transactions in a 
year. For a summary of comments concerning iterative effects (including 
comments raising similar concerns outside the context of cash pool) and 
the final and temporary regulation's approach to mitigate those 
effects, see Section B.5 of this Part V.
    The comments suggesting relief by reference to a cash pool header, 
treasury center, or similar entity (including an unrelated entity, such 
as a third party bank facilitating a notional cash pool) also requested 
that the exception provide that instruments issued by and to such 
entity be respected and not subject to recharacterization under the 
anti-conduit rules of Sec.  1.881-3 or similar doctrines.
c. Short-Term Debt Instruments
    In order to facilitate non-tax motivated cash management 
techniques, such as cash pooling or revolving credit arrangements, as 
well as ordinary course short-term lending outside a formal cash-
management arrangement, the temporary regulations adopt an exception 
from the funding rule for qualified short-term debt instruments. The 
temporary regulations do not adopt a general exemption for all loans 
issued as part of a cash-management arrangement because, as comments 
acknowledged, such arrangements can provide long-term financing to 
expanded group members.
    Under the temporary regulations, a covered debt instrument is 
treated as a qualified short-term debt instrument, and consequently is 
excluded from the scope of the funding rule, if the covered debt 
instrument is a short-term funding arrangement that meets one of two 
alternative tests (the specified current assets test or the 270-day 
test), or is an ordinary course loan, an interest-free loan, or a 
deposit with a qualified cash pool header. The Treasury Department and 
the IRS expect that the exception for qualified short-term debt 
instruments generally will prevent the treatment as stock of short-term 
debt instruments issued in the ordinary course of an expanded group's 
business, including covered debt instruments arising from financing 
provided by a cash pool header pursuant to a cash-management 
arrangement. Furthermore, these tests generally rely on mechanical 
rules that will provide taxpayers with more certainty, and be more 
administrable for the IRS, as compared to a facts-and-circumstances 
approach that was suggested by some comments.
i. Short-Term Funding Arrangement
    A covered debt instrument that satisfies one of two alternative 
tests--the specified current assets test or the 270-day test--
constitutes a qualified short-term debt instrument. These alternative 
tests are intended to exclude covered debt instruments issued as part 
of arrangements, including cash pooling arrangements, to meet short-
term funding needs that arise in the ordinary course of the issuer's 
business. An issuer may only claim the benefit of one of the 
alternative tests with respect to covered debt instruments issued by 
the issuer in the same taxable year.
    To satisfy the specified current assets test, two requirements must 
be satisfied. First, the rate of interest charged with respect to the 
covered debt instrument must be less than or equal to an arm's length 
interest rate, as determined under section 482 and the regulations 
thereunder, that would be charged with respect to a comparable debt 
instrument of the issuer with a term that does not exceed the longer of 
90 days and the issuer's normal operating cycle.
    Second, a covered debt instrument is treated as satisfying the 
specified current assets test only to the extent that, immediately 
after the covered debt instrument is issued, the issuer's outstanding 
balance under covered debt instruments issued to members of the 
issuer's expanded group that satisfy any of (i) the interest rate 
requirement of the specified current assets test, (ii) the 270-day test 
(in the case of a covered debt instrument that was issued in a prior 
taxable year in which the issuer claimed the benefit of the 270-day 
test), (iii) the ordinary course loan exception, or (iv) the interest-
free loan exception, does not exceed the amount expected to be 
necessary to finance short-term financing needs during the course of 
the issuer's normal operating cycle. For purposes of determining an 
issuer's outstanding balance, in the case of an issuer that is a 
qualified cash pool header, the amount owed does not take into account 
the qualified cash pool header's deposits payables. (These debt 
instruments are eligible for a separate exception described in Section 
D.8.c.iv of this Part V.) Additionally, the amount owed by any other 
issuer is reduced by the issuer's deposits receivables from a qualified 
cash pool header, but only to the extent of amounts owed to the same 
qualified cash pool header that satisfy the interest rate requirement 
of the specified current assets test or that satisfy the requirements 
of the 270-day test (if the covered debt instrument was issued in a 
prior taxable year).
    The issuer's amount of short-term financing needs is determined by 
reference to the maximum of the amounts of specified current assets 
reasonably expected to be reflected, under applicable financial 
accounting principles, on the issuer's balance sheet as a result of 
transactions in the ordinary course of business during the subsequent 
90-day period or the issuer's normal operating cycle, whichever is 
longer. For this purpose, specified current assets means assets that 
are reasonably expected to be realized in cash or sold (including by 
being incorporated into inventory that is sold) during the normal 
operating cycle of the issuer, but does not include cash, cash 
equivalents, or assets that are reflected on the books and records of a 
qualified cash pool header. Thus, for example, the specified current 
assets test allows a covered debt instrument that is used to finance 
variable operating costs and that is expected to be repaid from sales 
during the course of a normal operating cycle to be considered a 
qualified short-term debt instrument. Consistent with the exclusion of 
a qualified cash pool header's deposits payables from consideration 
under the specified current assets test, specified current

[[Page 72902]]

assets do not include assets that are reflected on the books and 
records of a qualified cash pool header.
    The applicable accounting principles to be applied for purposes of 
the specified current assets test, including for purposes of 
determining specified current assets reasonably expected to be 
reflected on the issuer's balance sheet, are financial accounting 
principles generally accepted in the United States (GAAP), or an 
international financial accounting standard, that is applicable to the 
issuer in preparing its financial statements, computed on a consistent 
basis. The reference to a normal operating cycle also is intended to be 
interpreted consistent with the meaning of that term under applicable 
accounting principles. Under GAAP, the normal operating cycle is the 
average period between the commitment of cash to acquire economic 
resources to be resold or used in production and the final realization 
of cash from the sale of products or services that are, or are made 
from, the acquired resources. For example, in the course of a normal 
operating cycle, a retail firm would commit cash to buy inventory, 
convert the inventory into accounts receivable, and convert the 
accounts receivable into cash. However, if the issuer has no single 
clearly defined normal operating cycle, then the issuer's normal 
operating cycle is determined based on a reasonable analysis of the 
length of the operating cycles of the multiple businesses and their 
sizes relative to the overall size of the issuer.
    The reference to a financial accounting-based concept of current 
assets in the specified current assets test is consistent with comments 
that recommended an exception or safe harbor based on a determinable 
financial metric. The Treasury Department and the IRS have determined 
that, among the many potential metrics recommended in comments, the 
approach in the current assets test most appropriately achieves the 
goal of providing an administrable exception for variable funding needs 
during the course of a normal operating cycle. The reference to the 
amounts of specified current assets that are ``reasonably expected'' to 
be reflected on the balance sheet is intended to address concerns 
expressed by comments that any metric based on an amount reported on a 
prior balance sheet should be increased, for example, to 150 percent of 
such reported amount, in order to account for growth and seasonal needs 
that may not be reflected on the balance sheet date. The reference to 
the maximum of these amounts is intended to refer to the day on which 
the issuer is reasonably expected to hold the highest level of 
specified current assets during the designated period. Such reference 
is not intended to suggest the upper bound of the range of assets that 
might reasonably be expected to be held on any particular day. The 
reference to specified current assets in the ordinary course of 
business is intended to exclude extraordinary transactions that could 
affect the short-term balance sheet.
    As an alternative to the specified current assets test, a covered 
debt instrument may also constitute a qualified short-term debt 
instrument by satisfying the 270-day test. The 270-day test generally 
provides taxpayers an opportunity to qualify for the short-term debt 
instrument exception when the specified current assets test provides 
limited relief due to circumstances unique to the issuer, such as when 
an issuer has a relatively small amount of current assets and 
comparatively large temporary borrowing needs. The 270-day test 
reflects consideration of comments that requested, for example, an 
exception for loans of up to 180 days or an exception based on the 
issuer's number of days of net indebtedness during the year.
    For a covered debt instrument to satisfy the 270-day test, three 
conditions must be met. First, the covered debt instrument must have a 
term of 270 days or less or be an advance under a revolving credit 
agreement or similar arrangement, and must bear a rate of interest that 
is less than or equal to an arm's length interest rate, as determined 
under section 482 and the regulations thereunder, that would be charged 
with respect to a comparable debt instrument of the issuer with a term 
that does not exceed 270 days. Second, the issuer must be a net 
borrower from the lender for no more than 270 days during the taxable 
year of the issuer, and in the case of a covered debt instrument 
outstanding during consecutive taxable years, the issuer may be a net 
borrower from the lender for no more than 270 consecutive days. In 
determining whether the issuer is a net borrower from a particular 
lender for this purpose, only covered debt instruments that satisfy the 
term and interest rate requirement and that are not ordinary-course 
loans (described in Section D.8.c.ii of this Part V) or interest-free 
loans (described in Section D.8.c.iii of this Part V) are taken into 
account. A covered debt instrument with respect to which an issuer 
claimed the benefit of the specified current assets test in a prior 
year could meet these conditions and be taken into account for this 
purpose as a borrowing. Third, a covered debt instrument will only 
satisfy the 270-day test if the issuer is a net borrower under all 
covered debt instruments issued to any lender that is a member of the 
issuer's expanded group that otherwise would satisfy the 270-day test, 
other than ordinary course loans and interest-free loans, for 270 or 
fewer days during a taxable year.
    The temporary regulations provide that an issuer's failure to 
satisfy the 270-day test will be disregarded if the taxpayer maintains 
due diligence procedures to prevent such failures, as evidenced by 
having written policies and operational procedures in place to monitor 
compliance with the 270-day test and management-level employees of the 
expanded group having undertaken reasonable efforts to establish, 
follow, and enforce such policies and procedures.
ii. Ordinary Course Loans
    The temporary regulations generally broaden the ordinary course 
exception in the proposed regulations to provide that a covered debt 
instrument constitutes a qualified short-term debt instrument because 
it is an ordinary course loan if it is issued as consideration for the 
acquisition of property other than money, in the ordinary course of the 
issuer's trade or business. In contrast to the proposed regulations, 
the temporary regulations provide that, to constitute an ordinary 
course loan, an obligation must be reasonably expected to be repaid 
within 120 days of issuance. The Treasury Department and the IRS have 
determined that, based on comments received, this term limitation, in 
conjunction with the addition of the new alternatives for satisfying 
the qualified short-term debt instrument exception, will accommodate 
common business practice with respect to trade payables while providing 
both the IRS and taxpayers with increased certainty.
    In response to comments received on the ordinary course exception, 
the ordinary course loan element of the exception for qualified short-
term debt instruments is broadened so as to no longer be limited to 
payables with respect to expenses that are currently deductible by the 
issuer under section 162 or currently includible in the issuer's cost 
of goods sold or inventory. Although comments requested an expansion to 
cover debt instruments issued for rents or royalties, such debt 
instruments are already outside the scope of the funding rule because 
the funding rule applies solely to debt instruments issued in exchange 
for property. For this reason, the ordinary course exception in the 
temporary

[[Page 72903]]

regulations also does not apply to a debt instrument issued in 
connection with the receipt of services.
iii. Interest-Free Loans
    In response to comments recommending that all non-interest bearing 
debt instruments should qualify for an exception, the temporary 
regulations provide that a covered debt instrument constitutes a 
qualified short-term debt instrument if the instrument does not provide 
for stated interest or no interest is charged on the instrument, the 
instrument does not have original issue discount (as defined in section 
1273 and the regulations thereunder), interest is not imputed under 
section 483 or section 7872 and the regulations thereunder, and 
interest is not required to be charged under section 482 and the 
regulations thereunder. See, e.g., Sec.  1.482-2(a)(1)(iii) (providing 
that interest is not required to be charged with respect to an 
intercompany trade receivable in certain circumstances).
iv. Deposits With a Qualified Cash Pool Header
    Covered members making deposits with a qualified cash pool header 
pursuant to a cash-management arrangement may maintain net deposits 
with the qualified cash pool header under circumstances that otherwise 
would not allow the qualified cash pool header (which is an issuer of 
covered debt instruments in connection with its deposits payable) to 
qualify for the qualified short-term debt instrument exception with 
respect to the deposit, for instance due to the length of time the 
deposits are maintained with the cash pool. In response to comments 
requesting a specific exception for cash pool headers, the temporary 
regulations provide that a covered debt instrument is a qualified 
short-term debt instrument if it is a deposit payable by a qualified 
cash pool header and certain other conditions are met. In particular, 
the covered debt instrument must be a demand deposit received by a 
qualified cash pool header pursuant to a cash-management arrangement. 
Additionally, the deposit must not have a purpose of facilitating the 
avoidance of the purposes of Sec.  1.385-3 or Sec.  1.385-3T with 
respect to a qualified business unit (as defined in section 989(a) and 
the regulations thereunder) (QBU) that is not a qualified cash pool 
header.
    A qualified cash pool header is defined in the temporary 
regulations as a member of an expanded group, controlled partnership, 
or QBU described in Sec.  1.989(a)-1(b)(2)(ii) that is owned by an 
expanded group member, that has as its principal purpose managing a 
cash-management arrangement for participating expanded group members, 
provided that an amount equal to the excess (if any) of funds on 
deposit with the expanded group member, controlled partnership, or QBU 
(header) over the outstanding balance of loans made by the header (that 
is, the amount of deposits it receives from participating members minus 
the amounts it lends to participating members) is maintained on the 
books and records of the cash pool header in the form of cash or cash 
equivalents or invested through deposits with, or acquisition of 
obligations or portfolio securities of, persons who are not related to 
the header (or in the case of a header that is a QBU described in Sec.  
1.989(a)-1(b)(2)(ii), the QBU's owner) within the meaning of section 
267(b) or section 707(b). The Treasury Department and the IRS expect 
that the qualified cash pool header's expenses of operating the cash-
management arrangement (for example, hedging costs) will be paid out of 
its gross earnings on its cash management activities rather than from 
funds on deposit.
    A cash-management arrangement is defined as an arrangement the 
principal purpose of which is to manage cash for participating expanded 
group members. Based on comments received, the regulations provide that 
managing cash includes borrowing excess funds from participating 
expanded group members and lending such funds to other participating 
expanded group members, foreign exchange management, clearing payments, 
investing excess cash with an unrelated person, depositing excess cash 
with another qualified cash pool header, and settling intercompany 
accounts, for example through netting centers and pay-on-behalf-of 
programs.
d. Other Potential Exceptions
i. General Rule Exception
    Comments recommended that the ordinary course exception apply to 
the funding rule generally rather than applying solely for purposes of 
the per se funding rule. A few comments recommended that the ordinary 
course exception apply to both the general rule and funding rule.
    The Treasury Department and the IRS have determined that it is 
appropriate for the exception applicable to qualified short-term debt 
instruments, including debt instruments issued to acquire property in 
the ordinary course of a trade or business, to apply to all aspects of 
the funding rule because it is relatively unlikely that short-term 
financing would be used to fund a distribution or acquisition. 
Moreover, in the event that such short-term financing was issued with a 
principal purpose of avoiding the purposes of Sec.  1.385-3 or Sec.  
1.385-3T, the anti-abuse rule at Sec.  1.385-3(b)(4) may apply.
    The Treasury Department and the IRS are not persuaded, however, 
that the transactions described in the general rule occur in the 
ordinary course of business. Accordingly, the suggestion to extend the 
ordinary course exception to general rule transactions is not accepted. 
However, certain specific exceptions to the general rule are provided 
for particular ordinary course transactions that were identified in the 
comments. See, for example, the exception discussed in Section E.2.b of 
this Part V for purchases of affiliate stock for purposes of paying 
stock-based compensation to employees, directors, and independent 
contractors in the ordinary course of business.
ii. De Minimis Loans
    The final and temporary regulations do not adopt the recommendation 
to exempt de minimis loans. The Treasury Department and the IRS have 
determined that the threshold exception that applies to the first $50 
million of aggregate issue price of covered debt instruments held by 
members of the expanded group that otherwise would be treated as stock 
under Sec.  1.385-3 is an appropriate de minimis rule that will apply 
in addition to the exception for short-term debt instruments described 
in Section D.8.c of this Part V.
iii. Notional Pooling or Similar Arrangements
    The temporary regulations do not specifically address the treatment 
of loans made through a notional cash pool or a similar arrangement 
including, for example, whether such loans would be treated for federal 
tax purposes as being made between expanded group members under conduit 
principles or other rules or doctrines. As noted in Part IV.B.2.c of 
this Summary of Comments and Explanation of Revisions, however, in some 
circumstances a notional cash pool may be treated as a loan directly 
between expanded group members applying federal tax principles. To the 
extent that notional pooling or similar arrangements give rise to loans 
between expanded group members for federal tax purposes, the final and 
temporary regulations, including the qualified short-term debt 
instrument exception, would apply to such loans in the same manner that 
they apply to loans made in form between expanded group members.

[[Page 72904]]

9. Exceptions To Allow Netting Against Other Receivables
    Comments recommended that the amount of a member's debt instruments 
subject to the funding rule be limited to the excess of its related-
party loan payables over its related-party loan receivables. Comments 
asserted that, in particular, such a rule would mitigate the impact of 
the final and temporary regulations on a cash pool header that receives 
deposits from, and makes advances to, participants in a cash pool 
arrangement, in particular with respect to the potential iterative 
consequences, which are discussed in detail in Section B.5 of this Part 
V. More broadly, this recommendation equates to a request for an 
exception from the funding rule for an amount of loans payable up to 
the amount of related-party loan receivables held by a funded member.
    The temporary regulations, in effect, implement this recommendation 
with respect to short-term intercompany receivables and payables to 
varying degrees in the context of the funding rule. As discussed in 
Section D.8 of this Part V, the temporary regulations include an 
exception for qualified short-term debt instruments that allows 
taxpayers to disregard such qualified short-term debt instruments when 
applying the funding rule. In addition to special rules treating 
ordinary course loans and interest-free loans as qualified short-term 
debt instruments, a debt instrument that is part of a short-term 
funding arrangement is considered a qualified short-term debt 
instrument if it satisfies one of two mutually exclusive tests: The 
specified current assets test or the 270-day test. Both of the 
alternative tests, in effect, allow some netting of short-term 
receivables and payables. Significantly, the specified current assets 
test provides an exception for short-term borrowing up to a limit 
determined by reference to specified current assets, effectively 
permitting netting of short-term borrowing against short-term assets, 
including accounts receivables. Additionally, that limit, applied to 
short-term loans from a qualified cash pool header, is increased by 
certain deposits the borrower has made to the qualified cash pool 
header, which effectively permits the borrower to net amounts on 
deposit with the qualified cash pool header against borrowings from the 
qualified cash pool header.
    Additionally, with respect to a qualified cash pool header, the 
temporary regulations treat an amount that is on deposit with the cash 
pool header, which may persist for a longer term, as a qualified short-
term debt instrument. A qualified cash pool header, in effect, is 
permitted to net its long- and short-term receivables arising from its 
lending activities pursuant to a cash management arrangement against 
those deposit payables.
    However, the Treasury Department and the IRS decline to adopt a 
more general netting rule. The exceptions described above for qualified 
short-term debt instruments operate by excluding altogether from the 
funding rule an amount of short-term loans based on circumstances that 
exist at the time the loan is issued. This approach is administrable 
and reaches appropriate results in the context of short-term debt 
instruments. Administering a rule based on netting outside of this 
context would be difficult because of the potential variations in loans 
(including different terms, currencies, or interest rates) and could 
result in a covered debt instrument switching between debt and equity 
on an ongoing basis, depending on the terms of other loans.
E. Exceptions From Sec.  1.385-3 for Certain Distributions and 
Acquisitions and the Threshold Exception
    The proposed regulations included three exceptions to the 
application of the general rule and funding rule--the earnings and 
profits exception, the subsidiary stock issuance exception, and the $50 
million threshold exception. Numerous comments were received regarding 
these exceptions, and many recommendations were made to further narrow 
the scope of the proposed regulations.
1. Overview of the Exceptions Under the Final and Temporary Regulations
    The final and temporary regulations include two categories of 
exceptions that relate to distributions and acquisitions: (i) 
Exclusions described in Sec.  1.385-3(c)(2), which include the 
subsidiary stock acquisition exception (the subsidiary stock issuance 
exception in the proposed regulations), the compensatory stock 
acquisition exception, and the exception to address the potential 
iterative application of the funding rule; and (ii) reductions 
described in Sec.  1.385-3(c)(3), which are the expanded group earnings 
reduction and the qualified contribution reduction. The exceptions 
under Sec.  1.385-3(c)(2) and (c)(3) apply to distributions and 
acquisitions that are otherwise described in the general rule or 
funding rule after applying the coordination rules in Sec.  1.385-3(b). 
Except as otherwise provided, the exceptions are applied by taking into 
account the aggregate treatment of controlled partnerships described in 
Sec.  1.385-3T(f).
    An exception under Sec.  1.385-3(c)(2) excludes a distribution or 
acquisition from the application of the general rule and funding rule. 
The Treasury Department and the IRS have determined that, based on 
comments received, the policy for including the second and third prongs 
of the general rule and funding rule does not apply to the transactions 
identified in Sec.  1.385-3(c)(2).
    An exception under Sec.  1.385-3(c)(3) reduces the amount of a 
distribution or acquisition that can be treated as funded by a covered 
debt instrument under the general rule and funding rule. In contrast to 
an exclusion, each reduction is determined by reference to an attribute 
of a member--expanded group earnings and qualified contributions--
rather than to a particular category of transactions, and thus is 
available to reduce the amount of any distribution or acquisition by 
the member. The Treasury Department and the IRS have determined that a 
member's distributions and acquisitions, to the extent of its expanded 
group earnings and qualified contributions, should be treated as funded 
by its new equity capital rather than by the proceeds of a related-
party borrowing for purposes of the general rule and funding rule. To 
the extent the amount of a distribution or acquisition is reduced, the 
amount by which one or more covered debt instruments can be 
recharacterized as stock under the general rule or funding rule by 
reason of the distribution or acquisition is also reduced.
    The exclusions and reductions of Sec.  1.385-3(c)(2) and (3) 
operate independently of any exclusion with respect to the definition 
of covered debt instrument described in Sec.  1.385-3(g)(3) as well as 
the exclusion of qualified short-term debt instruments from the funding 
rule. Therefore, to the extent an exception applies to a distribution 
or acquisition, either (i) the distribution or acquisition is treated 
as not described in the general rule or funding rule (in the case of an 
exclusion) or (ii) the amount of the distribution or acquisition 
subject to the general rule or funding rule is reduced (in the case of 
a reduction). However, the application of an exception in Sec.  1.385-
3(c)(2) or (3) with respect to a distribution or acquisition does not 
affect whether any covered debt instrument, including one issued in the 
distribution or acquisition itself, can be treated as funding another 
distribution or acquisition under the funding rule. Thus, to the extent 
a covered debt instrument is not treated as stock by reason of the 
application of

[[Page 72905]]

an exception to a distribution or acquisition, the covered debt 
instrument remains available to be treated as funding another 
distribution or acquisition. See Section E.6 of this Part V for the 
treatment under the funding rule of debt instruments that are issued in 
a distribution or acquisition that, absent an exclusion or reduction 
under Sec.  1.385-3(c)(2) or (3), would be subject to the general rule.
    An exception under Sec.  1.385-3(c)(2) applies to distributions or 
acquisitions before an exception under Sec.  1.385-3(c)(3). A 
distribution or acquisition to which an exclusion applies is not 
treated as described in the general rule or funding rule, whereas a 
reduction applies to reduce the amount of a distribution or acquisition 
described in the general rule or funding rule. To the extent an 
exclusion exempts a distribution or acquisition from the general rule 
or funding rule, no amount of the expanded group earnings or qualified 
contributions of a covered member are used.
    A third type of exception, the $50 million threshold exception 
described in Sec.  1.385-3(c)(4), applies to covered debt instruments 
that otherwise would be treated as stock under Sec.  1.385-3(b) because 
they are treated as funding one or more distributions or acquisitions, 
after taking into account the exclusions and reductions. The threshold 
exception overrides the general consequences of Sec.  1.385-3(b) for 
the first $50 million of debt instruments that otherwise would be 
treated as stock under the general rule and funding rule. A 
distribution or acquisition treated as funded by a covered debt 
instrument under Sec.  1.385-3(b) is still treated as funded by a 
covered debt instrument notwithstanding the application of the 
threshold exception. As a result, the distribution or acquisition 
cannot be ``matched'' with another covered debt instrument to cause 
additional recharacterizations under the funding rule.
2. Exclusions Under the Final and Temporary Regulations
a. Exclusion for Certain Acquisitions of Subsidiary Stock
i. Overview
    Proposed Sec.  1.385-3(c)(3) provided an exception, the subsidiary 
stock issuance exception, to the second prong of the funding rule. The 
subsidiary stock issuance exception applied to an acquisition of stock 
of an expanded group member (the issuer) by a funded member (the 
transferor), provided that, for the 36-month period immediately 
following the issuance, the transferor held, 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 this purpose, indirect 
ownership was determined by applying the principles of section 958(a) 
without regard to whether an intermediate entity is foreign or 
domestic. If the transferor ceased to meet the ownership requirement at 
any time during the 36-month period, then on the date that the 
ownership requirement ceased to be met (cessation date), the exception 
ceased to apply and the acquisition of expanded group stock was subject 
to the funding rule. The proposed regulations also provided that, if 
the exception applied to an issuance, the transferor and the issuer 
would be treated as predecessor and successor but only with respect to 
any debt instrument issued during the per se period with respect to the 
issuance and only to the extent of the fair market value of the stock 
issued in the transaction.
ii. New Terminology
    As discussed in Section C.3.c of this Part V, the final and 
temporary regulations expand the subsidiary stock issuance exception to 
include acquisitions of existing stock of an expanded group member from 
a majority-owned subsidiary (for example, acquisitions of existing 
stock of a second-tier subsidiary from a majority-owned first tier 
subsidiary of the acquiring expanded group member) under the same 
conditions applicable to acquisitions of newly-issued stock. To reflect 
these changes, in the final and temporary regulations: The ``subsidiary 
stock issuance exception'' is renamed ``subsidiary stock acquisition 
exception''; the ``transferor'' is renamed ``acquirer''; and the 
``issuer'' is renamed ``seller.'' For the remainder of this Part, the 
terminology of the proposed regulations is used to describe the rules 
of the proposed regulations, and comments thereon. The terminology of 
the final and temporary regulations is used in responses to the 
comments, as well as to describe the provisions of the final and 
temporary regulations.
iii. Holding Period Requirement
    Comments asserted that the 36-month holding period requirement for 
the subsidiary stock issuance exception would unnecessarily restrict 
post-issuance restructuring unrelated to, and unanticipated at the time 
of, the issuance. For this reason, comments recommended that the 
regulations adopt a control requirement that incorporates the 
principles of section 351, under which the holding period requirement 
would be satisfied if the transferor controlled the issuer immediately 
after the issuance and all transactions occurring pursuant to the same 
plan as the issuance. Comments asserted that, if this recommendation 
were adopted, the regulations could retain the 36-month holding period 
as a safe harbor.
    The Treasury Department and the IRS agree that transactions 
motivated by business exigencies that are unforeseen at the time of the 
acquisition should not generally result in the inapplicability of the 
subsidiary stock acquisition exception with respect to the acquisition. 
Therefore, the final and temporary regulations provide that the 
exception applies if the acquirer controls the seller immediately 
following the acquisition and does not relinquish control of the seller 
pursuant to a plan that existed at the time of the acquisition. For 
this purpose, the acquirer is presumed to have had a plan to relinquish 
control of the seller at the time of the acquisition if the transferor 
relinquishes control of the seller within the 36-month period following 
the acquisition. This presumption may be rebutted by facts and 
circumstances that clearly establish that the loss of control was not 
contemplated at the time of the acquisition and that avoiding the 
purposes of Sec.  1.385-3 or Sec.  1.385-3T was not a principal purpose 
for the subsequent loss of control.
    In contrast to the proposed regulations, the final and temporary 
regulations do not provide that the subsidiary stock acquisition 
exception ceases to apply upon the cessation date. Instead, if the 
acquirer loses control of the seller within the 36-month period 
following the acquisition pursuant to a plan that existed at the time 
of the acquisition, the subsidiary stock acquisition exception would be 
treated as never having applied to the expanded group stock 
acquisition.
iv. Cessation of Expanded Group Relationship
    Comments requested clarification on the application of the 
subsidiary stock issuance exception if the transferor and issuer cease 
to be members of the same expanded group before the end of the 36-month 
holding period. Comments recommended that the subsidiary stock issuance 
exception continue to exempt an issuance if the transferor and issuer 
cease to be members of the same expanded group in the same transaction 
in which the transferor's ownership in the issuer is reduced to be at 
or below 50 percent. Comments also recommended that, if the transferor 
and issuer cease to be members of the same

[[Page 72906]]

expanded group, the predecessor and successor status of the transferor 
and issuer should also cease for purposes of applying the per se 
funding rule.
    As discussed in Section E.2.a.iii of this Part V, the final and 
temporary regulations eliminate the fixed holding period requirement of 
the proposed regulations. However, the issue could still arise if the 
loss of control and the cessation of common expanded group membership 
occur pursuant to a plan that existed at the time of the acquisition. 
For example, assume P borrows from a member of the same expanded group, 
and then, within 36 months of the funding, contributes property to S in 
exchange for S stock with the intent of selling 100 percent of the 
stock of S to an unrelated person. In this example, P loses control of 
S pursuant to a plan that existed at the time of the acquisition of S 
stock, but that loss of control occurs in the same transaction that 
causes P and S to cease to be members of the same expanded group.
    The Treasury Department and the IRS have determined that a 
transaction that results simultaneously in a loss of control and a 
disaffiliation of the seller and acquirer does not achieve a result 
that is economically similar to a distribution because in that 
situation no property is made available, directly or indirectly, to a 
common shareholder of the seller and the acquirer. Accordingly, the 
final and temporary regulations provide that a transaction that results 
in a loss of control is disregarded for purposes of applying the 
subsidiary stock acquisition exception if the transaction also results 
in the acquirer and the seller ceasing to be members of the same 
expanded group. For purposes of the preceding sentence, an acquirer and 
seller do not cease to be members of the same expanded group by reason 
of a complete liquidation described in section 331. Further, as 
discussed in Section D.3 of this Part V, the final and temporary 
regulations provide that the seller ceases to be a successor to the 
acquirer upon the date the seller ceases to be a member of the same 
expanded group as acquirer.
v. Indirect Ownership
    One comment requested that the indirect ownership rules used for 
the subsidiary stock issuance exception be conformed to the indirect 
ownership rules used for other purposes of the section 385 regulations, 
such as the modified section 318 constructive ownership rules in Sec.  
1.385-1(c)(4) used to determine the composition of an expanded group. 
The final and temporary regulations retain the indirect ownership rules 
of section 958(a) as the proper measure of ownership for purposes of 
the subsidiary stock acquisition exception because the Treasury 
Department and the IRS have determined that the constructive ownership 
rules found in other provisions of the Code would not properly 
differentiate an acquisition of expanded group stock that does not have 
an economic effect similar to that of a distribution from one that 
does. As discussed in Section C.3.c of this Part V, the subsidiary 
stock acquisition exception is predicated on the view that the 
acquisition of newly-issued stock of a controlled direct or indirect 
subsidiary is not economically similar to a distribution because the 
property transferred in exchange for the stock remains indirectly 
controlled by the acquirer and, likewise, the transaction does not have 
the effect of making the property available to the ultimate common 
shareholder (that is, the property is not transferred ``out from 
under'' the acquirer). In this regard, constructive ownership (for 
instance, under section 318) is appropriate for determining whether a 
common shareholder controls each of two or more corporations, but is 
inappropriate for the limited purpose of determining whether stock or 
assets are indirectly owned by one of those corporations. Therefore, to 
effectuate the policy of the exception, indirect ownership for purposes 
of the subsidiary stock acquisition exception continues to be limited 
to indirect ownership within the meaning of section 958(a).
vi. Tiered Transfers
    One comment requested that the regulations clarify the impact of 
certain transactions occurring after a funded member's transfer of 
property to a controlled subsidiary. For instance, assume that S1 
contributed property to S2, its wholly-owned subsidiary, in exchange 
for S2 stock, and S2 subsequently contributed property to S3, its 
wholly-owned subsidiary, in exchange for S3 stock. The comment 
requested that the regulations clarify that S2's acquisition of S3 
stock is not an acquisition of expanded group stock that affects the 
application of the subsidiary stock issuance exception to S1's initial 
transfer to S2.
    The Treasury Department and the IRS have determined that the 
proposed regulations already properly provided for this result. As a 
result of an issuance described in the subsidiary stock issuance 
exception, the issuer (S2) becomes a successor to the transferor (S1) 
to the extent of the value of the expanded group stock acquired from 
the issuer, but only with respect to a debt instrument of the issuer 
issued during the per se period determined with respect to the 
issuance. If the issuer (S2) engages in another transaction described 
in the subsidiary stock issuance exception as a transferor, the 
acquisition of the stock of the expanded group member (the second 
issuer) would also not constitute an acquisition of expanded group 
stock by reason of the exception. Therefore, under a second application 
of the subsidiary stock issuance exception, the acquisition of the 
stock of S3 by the issuer (S2), a successor to the transferor (S1), is 
not treated as described in the second prong of the funding rule and 
thus cannot be treated as funded by a covered debt instrument issued by 
the transferor (S1). After the second issuance, the second issuer (S3) 
is a successor to both the first transferor (S1) and the first issuer 
(S2), which remains a successor to the first transferor (S1). The final 
and temporary regulations change the terminology, but do not change the 
result of the proposed regulations in this regard.
b. Exclusion for Certain Other Acquisitions of Expanded Group Stock, 
Including in Connection With Employee Stock Compensation, and Other 
Recommendations for Exceptions for Acquisitions Described in Sec.  
1.1032-3
    Comments requested an exception from the funding rule for all 
transactions described in Sec.  1.1032-3. Section 1.1032-3 generally 
applies to an acquisition by a corporation (acquiring entity) of the 
stock of its controlling parent (issuing corporation) for use as 
consideration to acquire money or other property (including 
compensation for services). Section 1.1032-3(b) addresses the 
transaction in the context of an acquiring entity that either does not 
make actual payment for the stock of the issuing corporation (Sec.  
1.1032-3(b)(1)) or makes actual payment for the stock of the issuing 
corporation, but that actual payment is less than the fair market value 
of the issuing corporation stock that is acquired (Sec.  1.1032-
3(b)(2)). In either case, to the extent the fair market value of the 
stock of the issuing corporation exceeds the value of the consideration 
provided by the acquiring entity, Sec.  1.1032-3(b) deems a 
contribution of cash to the acquiring entity by the issuing corporation 
followed by a deemed purchase of stock of the issuing corporation by 
the acquiring entity. The majority of the comments on this issue 
recommended an exception from the funding rule to the extent that a 
purchase of expanded group stock was deemed to occur solely by reason 
of Sec.  1.1032-3(b).

[[Page 72907]]

    The final and temporary regulations provide relief for purchases of 
expanded group stock that are deemed to occur under Sec.  1.1032-3(b) 
by adopting a separate recommendation to reduce the amount of 
distributions or acquisitions described in the general rule or funding 
rule by qualified contributions. As described in Section E.3.b of this 
Part V, qualified contributions include a deemed cash contribution 
under Sec.  1.1032-3(b). Accordingly, after taking into account the new 
exception for qualified contributions, a deemed transaction under Sec.  
1.1032-3(b), regardless of how the acquiring corporation uses the stock 
of the issuing corporation, should not result in a ``net'' acquisition 
of expanded group stock for purposes of the funding rule. Therefore, 
the request for a specific exclusion for a deemed acquisition of 
expanded group stock under Sec.  1.1032-3 is rendered moot by the new 
exception for qualified contributions.
    Some comments also recommended an exception to the extent that the 
acquiring entity makes an actual payment for the stock of the issuing 
corporation that is conveyed to a person as consideration for services 
or an acquisition of assets. That actual payment could be in the form 
of cash, which could implicate the funding rule, or an issuance of a 
debt instrument, which could implicate the general rule. Several 
comments, however, specifically addressed this situation in the context 
of an acquisition of parent stock that will be transferred to an 
employee, director, or independent contractor for the performance of 
services. Comments asserted that the acquisition of newly-issued stock 
of a publicly-traded parent to compensate employees, whether in 
exchange for actual or deemed consideration, does not implicate the 
policy concerns of the proposed regulations because such transactions 
occur in the ordinary course of the group's business and for meaningful 
non-tax reasons (for example, reduced cost as compared to acquiring the 
shares from the public). One comment recommended an exception for the 
acquisition of the stock of an expanded group parent by another member 
of the group that is a dealer in securities (within the meaning of 
section 475(c)(1)) in the ordinary course of the dealer's business as a 
dealer in securities. A comment suggested that if the Treasury 
Department and the IRS are concerned about parent stock that is 
purchased for use in a transaction that resembles a reorganization, the 
exception could be limited to stock that is transferred to a person in 
connection with such person's performance of services as an employee, 
director, or independent contractor, or to a person as consideration 
for the acquisition of assets that will be used by the issuer in the 
issuer's trade or business.
    As discussed in Section C.3.a of this Part V, by itself, an 
acquisition of expanded group stock by issuance in exchange for cash or 
a debt instrument has an economic effect that is similar to a 
distribution of the cash or note used to acquire the stock from the 
controlling parent. The Treasury Department and the IRS acknowledge 
that these concerns could be mitigated in certain circumstances, for 
example, when parent stock is conveyed to an unrelated person as 
consideration for services provided to a subsidiary or as consideration 
for an acquisition of assets for use in the ordinary course of a 
subsidiary's business. However, the Treasury Department and the IRS 
also are concerned that there has been significant abuse involving 
purchases of parent stock for use as consideration in other 
transactions, particularly in the context of acquisitions of control of 
another corporation or of substantially all of the assets of another 
corporation. This is the case regardless of whether the acquisition is 
of the stock or assets of a corporation and whether the counter-party 
is a related or unrelated person. See, e.g., Notice 2006-85, 2006-2 
C.B. 677; Notice 2007-48, 2007-1 C.B. 1428; Sec.  1.367(b)-10.
    Accordingly, the Treasury Department and the IRS have determined 
that, in response to comments, it is appropriate to provide an 
exception from the general rule and funding rule for acquisitions of 
expanded group stock in the two situations where comments have pointed 
out that it is common business practice to acquire controlling parent 
stock for use as currency in another transaction. Specifically, the 
final and temporary regulations provide an exclusion from the second 
prong of the general rule and funding rule to the extent the acquired 
expanded group stock is delivered to individuals in consideration for 
services rendered as an employee, a director, or an independent 
contractor. This exclusion applies to an acquisition of expanded group 
stock regardless of whether the acquisition is in exchange for actual 
property or deemed property under Sec.  1.1032-3(b). To the extent 
parent stock is received in exchange for no consideration, the deemed 
contribution of cash used to purchase the stock under Sec.  1.1032-3(b) 
may also constitute a qualified contribution as described in Section 
E.3.b of this Part V. The second situation, involving acquisitions by 
dealers in securities, is discussed in Section E.2.d of this Part V.
    The Treasury Department and the IRS decline to adopt the 
recommendation for a broader exception that would apply whenever the 
acquiring member uses the acquired stock as currency in a subsequent 
acquisition because the Treasury Department and the IRS remain 
concerned about the potential for abuse outside of the scenarios 
identified in comments where the use of parent stock is common business 
practice. See Sec.  1.385-3(h)(3) Example 2. Furthermore, taxpayers 
that wish to use parent stock as currency for other purposes have the 
flexibility to structure the transaction in ways that do not implicate 
the final and temporary regulations. For instance, the parent can 
provide the stock to its subsidiary in exchange for no consideration 
or, in the alternative, the parent can acquire the asset with its own 
stock and transfer the asset to the subsidiary.
c. Exclusion for Distributions and Acquisitions Resulting From the 
Application of Section 482
    Comments requested that the regulations disregard distributions and 
contributions deemed to occur by virtue of other provisions of the Code 
or regulations, including distributions deemed to occur under Sec.  
1.482-1(g)(3) and adjustments made pursuant to Revenue Procedure 99-32, 
1999-2 C.B. 296, and debt instruments and contributions deemed to occur 
under section 367(d). In response to these comments, the final and 
temporary regulations provide an exception from the funding rule for 
distributions and acquisitions deemed to occur as a result of transfer 
pricing adjustments under section 482. The Treasury Department and the 
IRS decline to include an exception for transactions deemed to occur 
under section 367(d) in the final and temporary regulations because the 
regulations are limited to U.S. borrowers.
d. Exclusions for Acquisitions of Expanded Group Stock by a Dealer in 
Securities
    One comment recommended that the regulations provide an exception 
for stock issued by a member of an expanded group and subsequently 
acquired by a member of the same expanded group that is a dealer in 
securities (within the meaning of section 475(c)(1)) in the ordinary 
course of the dealer's business as a dealer in securities, provided 
that the dealer satisfies certain criteria in acquiring and holding the 
stock.

[[Page 72908]]

    In response to the comments, the final and temporary regulations 
provide an exception for the acquisition of expanded group stock by a 
dealer in securities. Under Sec.  1.385-3(c)(2)(iv), the acquisition of 
expanded group stock by a dealer in securities (within the meaning of 
section 475(c)(1)) is not treated as described in the general rule or 
funding rule to the extent the expanded group stock is acquired in the 
ordinary course of the dealer's business of dealing in securities. This 
exception applies solely to the extent that (i) the dealer accounts for 
the stock as securities held primarily for sale to customers in the 
ordinary course of business, (ii) the dealer disposes of the stock 
within a period that is consistent with the holding of the stock for 
sale to customers in the ordinary course of business, taking into 
account the terms of the stock and the conditions and practices 
prevailing in the markets for similar stock during the period in which 
it is held, and (iii) the dealer does not sell or otherwise transfer 
the stock to a person in the same expanded group, other than in a sale 
to a dealer that in turn satisfies the requirements of Sec.  1.385-
3(c)(2)(iv).
e. Exclusions for Certain Acquisitions of Affiliate Stock Resulting 
From the Application of the Funding Rule
    The final and temporary regulations include an exception for 
iterative recharacterizations discussed in Section B.5 of this Part V.
3. Reductions Under the Final and Temporary Regulations
a. Reduction for Expanded Group Earnings and Profits
    Proposed Sec.  1.385-3(c)(1) provided that the aggregate amount of 
distributions and acquisitions described in the general rule and 
funding rule for a taxable year was reduced to the extent of the 
current year earnings and profits (as described in section 316(a)(2)) 
(the earnings and profits exception). The reduction under the earnings 
and profits exception was applied to each distribution and acquisition 
based on the order in which the distribution or acquisition occurred. 
The preamble to the proposed regulations explained that the earnings 
and profits exception was intended to accommodate ordinary course 
distributions and acquisitions and to provide taxpayers significant 
flexibility to avoid the application of the per se funding rule.
i. Earnings Period
    Comments requested that the earnings and profits exception be 
expanded to include earnings and profits accumulated by a member in one 
or more taxable years preceding the current year. Comments noted that 
earnings and profits for the current year may be difficult or 
impossible to compute by the close of the year. Moreover, under certain 
circumstances, a member may not be permitted under local law to 
distribute earnings and profits for the year (for example, due to a 
lack of distributable reserves). Comments also asserted that, by taking 
into account only earnings and profits for the current year, the 
exception would inappropriately incentivize taxpayers to ``use or 
lose'' their earnings and profits through annual distributions. Also, 
comments noted that the current earnings and profits of a company do 
not necessarily represent a company's ability to pay ordinary course 
dividends, due to factors such as how earnings and profits are 
calculated and the amount of cash available from operations, and 
suggested that a longer period for the exception would mitigate the 
impact of these factors.
    Recommendations varied regarding the period for which earnings and 
profits should be taken into account for purposes of the exception, 
ranging from the current year and the immediately preceding year to the 
current year and all prior years. In addition, some comments requested 
a grace period (for example, 75 days) after the close of the taxable 
year to make distributions or acquisitions that would relate back to 
the earning and profits with respect to the previous year. Some 
comments requested that the earnings and profits exception include 
earnings and profits accumulated before the release of the notice of 
proposed rulemaking on April 4, 2016. Others stated that earnings and 
profits for purposes of this exception should include only those 
accumulated in taxable years ending after that date. One comment 
recommended that the earnings and profits exception include all 
undistributed earnings and profits of a corporation accumulated since 
April 4, 2016, but limited to the period in which such corporation was 
a member of the expanded group of which it is a member at the time of a 
distribution or acquisition. Comments also requested that, if a 
cumulative measure of earnings and profits is adopted, any years in 
which a member had a deficit be disregarded, or, in the alternative, a 
member be permitted to distribute amounts at least equal to 
distributions from other members that themselves qualify for the 
earnings and profits exception, notwithstanding that the member has an 
accumulated deficit. In addition, comments requested that the earnings 
and profits exception include previously taxed income, and that, 
regardless of the period adopted, all previously taxed income be 
permitted to be distributed without implications under Sec.  1.385-3, 
including previously taxed income accumulated before April 4, 2016. One 
comment suggested that the earnings and profits exception be 
eliminated, noting that only the threshold exception is needed.
    The final and temporary regulations adopt the recommendation to 
take into account all earnings and profits accumulated by a corporation 
during its membership in an expanded group in computing the earnings 
and profits exception, provided that the earnings and profits were 
accumulated in taxable years ending after April 4, 2016 (the expanded 
group earnings reduction). The expanded group earnings reduction 
significantly expands the exception provided in the proposed 
regulations, but also appropriately limits the reduction to earnings 
and profits attributable to the period of a corporation's membership in 
a particular expanded group. The Treasury Department and the IRS 
decline to adopt a cumulative or fixed period approach that is not 
limited upon a change-of-control because either approach would create 
incentives for acquisitions of earnings-rich corporations for the 
purposes of avoiding these regulations by having such corporations use 
related-party debt to finance extraordinary distributions rather than 
new investment. Moreover, an approach that takes into account earnings 
and profits over a fixed period, regardless of its duration, implicates 
the same ``use or lose'' concern identified with respect to the 
exception in the proposed regulations, albeit delayed until the final 
year of the period. The Treasury Department and the IRS have determined 
that the expanded group earnings reduction appropriately balances 
concerns regarding the usefulness and administrability of the reduction 
with the purpose of providing an exception only for ordinary course 
distributions.
    To effectuate this purpose, the final and temporary regulations 
provide that the aggregate amount of a covered member's distributions 
or acquisitions described in the general rule or funding rule in a 
taxable year during an expanded group period are reduced by the 
member's expanded group earnings account for the expanded group period. 
The expanded group period is the period during which the covered member 
is a member of an expanded group with the same expanded group parent. 
The expanded group earnings

[[Page 72909]]

account with respect to an expanded group period is the excess, if any, 
of the covered member's expanded group earnings during the period over 
the covered member's expanded group reductions during the period. The 
reduction for expanded group earnings applies to one or more 
distributions or acquisitions based on the order in which the 
distributions or acquisitions occur. The reduction occurs regardless of 
whether any distribution or acquisition would be treated as funded by a 
covered debt instrument without regard to the exception. The expanded 
group earnings reduction is applied to distributions and acquisitions 
by a covered member described in the general rule and funding rule 
before the reduction for qualified contributions discussed in Section 
E.3.b of this Part V.
    Expanded group earnings are generally the earnings and profits 
accumulated by the covered member during the expanded group period 
computed as of the close of the taxable year without regard to any 
distributions or acquisitions by the covered member described in 
Sec. Sec.  1.385-3(b)(2) and (b)(3)(i). Thus, for example, if a covered 
member distributes property to a member of the member's expanded group, 
the covered member's expanded group earnings are not decreased by the 
amount of the property because the distribution is described in the 
funding rule, even assuming the distribution reduces the covered 
member's accumulated earnings and profits under section 312(a). 
However, if, for example, a covered member distributes property to a 
shareholder that is not a member of the member's expanded group, so 
that the transaction is not described in the funding rule, the 
distribution generally decreases the covered member's expanded group 
earnings to the extent that the accumulated earnings and profits are 
decreased under section 312(a).
    Expanded group reductions are the amounts by which acquisitions or 
distributions described in the general rule or funding rule were 
reduced by reason of the expanded group earnings reduction during the 
portion of the expanded group period preceding the taxable year. As 
discussed in the preceding paragraph, a distribution or acquisition 
described in the general rule or funding rule does not reduce a covered 
member's expanded group earnings. However, the same distribution or 
acquisition, to the extent the amount of the distribution or 
acquisition is reduced under the expanded group earnings reduction in 
the taxable year, increases the covered member's expanded group 
reductions for the succeeding year, and thereby decreases the covered 
member's expanded group earnings account on a go-forward basis.
    The Treasury Department and the IRS decline to adopt the 
recommendation to extend the earnings and profits reduction to take 
into account earnings and profits accumulated before the release of the 
notice of proposed rulemaking. The proposed regulations included only 
current year earnings and profits for the earnings and profits 
exception. Accordingly, the earnings and profits taken into account 
under the proposed regulations were limited to those accumulated in a 
taxable year ending on or after April 4, 2016. The expanded group 
earnings reduction provides taxpayers with significantly more 
flexibility than the proposed regulations to avoid the application of 
Sec.  1.385-3 with respect to ordinary course distributions and 
acquisitions. Moreover, the Treasury Department and the IRS are 
concerned that allowing a corporation to distribute all of its historic 
earnings and profits would facilitate related-party borrowing to fund 
extraordinary distributions and acquisitions. Although allowing a 
corporation to accumulate, and later distribute, earnings and profits 
for taxable years ending after April 4, 2016, could also facilitate 
extraordinary distributions, the Treasury Department and the IRS have 
concluded that, on balance, it is preferable to avoid the incentives 
that would follow from creating a ``use or lose'' attribute. These 
incentives are not applicable with respect to taxable years ending 
before April 4, 2016. For similar reasons, dividends from other 
expanded group members are not taken into account in calculating 
expanded group earnings of a covered member unless attributable to 
earnings and profits accumulated in a taxable year of the distributing 
member ending after April 4, 2016 and during its expanded group period. 
For this purpose, dividends include deemed inclusions with respect to 
stock, including inclusions under sections 951(a) and 1293.
    The final and temporary regulations do not adopt the recommendation 
to disregard a deficit in any taxable year in calculating a member's 
expanded group earnings. The Treasury Department and the IRS have 
determined that, by expanding the reduction with respect to a 
corporation to include all earnings and profits accumulated while the 
corporation was a member of the same expanded group, the expanded group 
earnings account appropriately reflects the amount of a corporation's 
new equity capital generated from earnings that is available to fund 
ordinary course distributions. Moreover, incorporating a ``nimble 
dividend'' concept into the expanded group earnings reduction would 
convert current year earnings and profits into a ``use or lose'' 
attribute if the covered member has an overall accumulated deficit, 
which is contrary to the policy of expanding the exception to include 
all earnings accumulated during an expanded group period.
    The final and temporary regulations also do not adopt the 
recommendation to attribute to the prior year distributions and 
acquisitions that occur during a grace period following the close of 
that taxable year. The Treasury Department and the IRS have determined 
that a grace period is unnecessary because the cumulative approach of 
the expanded group earnings reduction significantly relieves the burden 
of computing the earnings and profits for the particular year of a 
distribution or acquisition.
    Because the final and temporary regulations do not apply to foreign 
issuers (including CFC issuers), the regulations no longer implicate 
the concerns regarding distributions of previously taxed income.
ii. Ordering Rule
    The proposed regulations provided that the earnings and profits 
exception applied to distributions or acquisitions in chronological 
order. Comments asserted that this ordering rule would place an undue 
premium on the sequence of distributions. For example, assume that P 
owns all the stock of S. In Year 1, S makes distributions to P 
consisting of (i) $50x cash (the funding rule distribution) and (ii) an 
S note with a $50x principal amount (the general rule distribution). S 
makes no other distributions or acquisitions during Year 1 and has not 
been funded by a debt instrument that is outstanding during Year 1. 
Under the proposed regulations, if S has $50x of earnings and profits 
for Year 1, whether the S note issued in the general rule distribution 
is recharacterized as stock would depend on the sequence of the 
distributions. If the funding rule distribution occurred first, the 
earnings and profits exception would reduce the amount of that 
distribution; however, because S has no debt instruments outstanding 
that can be treated as funding the distribution, the exception would 
provide no immediate benefit to S and P. Further, because the funding 
rule distribution would exhaust the earnings and profits of S for the 
taxable year, the earnings and profits exception would not reduce any 
amount of the general rule distribution, with the result that the S

[[Page 72910]]

note would be immediately recharacterized as stock under the general 
rule. On the other hand, if the general rule distribution occurred 
first, the amount of the general rule distribution would be reduced by 
the earnings and profits exception, which would immediately benefit S 
and P. In that case, because S has no debt instruments outstanding, the 
funding rule distribution would not cause the recharacterization of any 
debt instrument in the taxable year of the distribution even though no 
amount of the funding rule distribution would be reduced by the 
earnings and profits exception.
    To address this concern, comments recommended that, if the 
aggregate amount of distributions or acquisitions by a member in a 
taxable year exceeds the amount of a member's earnings and profits, the 
earnings and profits exception should apply to reduce either a general 
rule transaction or a funding rule transaction that was preceded by a 
funding within the per se period, before being applied to reduce a 
funding rule transaction that is not preceded by a funding, regardless 
of the sequence of the transactions. In the alternative, comments 
recommended that the regulations provide taxpayers an election to 
determine the distributions or acquisitions to which the earnings and 
profits exception would apply.
    The Treasury Department and the IRS agree that, in the absence of 
compelling administrability or policy reasons to the contrary, the 
sequencing of transactions between expanded group members within the 
same taxable year should not generally control the consequences of debt 
issuances. However, the Treasury Department and the IRS do not adopt 
either recommendation to address the significance of sequencing under 
the proposed regulations because, as discussed in Section E.6 of this 
Part V, the final and temporary regulations treat a covered member that 
issues a covered debt instrument in a distribution or acquisition as a 
funded member if that distribution or acquisition satisfies an 
exception described in Sec.  1.385-3(c)(2) and (3), including the 
expanded group earnings reduction (the funded member rule). The funded 
member rule harmonizes the application of the expanded group earnings 
reduction with respect to general rule and funding rule transactions, 
thus substantially eliminating the importance of the sequence of the 
two types of transactions within a taxable year. Accordingly, the final 
and temporary regulations retain the ``first-in-time'' ordering rule of 
the proposed regulations for the expanded group earnings reduction. A 
similar ordering rule applies for purposes of the qualified 
contribution reduction described in Section E.3.b of this Part V.
iii. Alternate Metrics
    Comments recommended that metrics other than earnings and profits 
be used as the basis for a taxpayer-favorable stacking rule. 
Suggestions included free cash flow from operations, as determined 
under GAAP; earnings before interest, taxes, depreciation and 
amortization (EBITDA); adjusted taxable income described in section 
163(j)(6)(A); and other financial metrics under International Financial 
Reporting Standards (IFRS) or foreign country statutory accounting 
requirements. The Treasury Department and the IRS decline to adopt an 
alternate metric, and the final and temporary regulations retain 
earnings and profits as the basis for determining the amount of a 
distribution or acquisition treated as not funded by a covered debt 
instrument. The expanded group earnings reduction is intended to permit 
a member to make ordinary course distributions of its business 
earnings. In this regard, and most significantly, Congress established 
earnings and profits as the appropriate measure for federal tax 
purposes of whether a distribution represents a payment of the 
corporation's earnings or is a return of a shareholder's investment. In 
addition, using a metric such as adjusted taxable income described in 
section 163(j)(6)(A) or EBITDA would, over time, significantly 
overstate the ability of many members to make ordinary course 
distributions because such computations include no reduction for 
capital investment, interest, or taxes. Moreover, U.S. issuers are 
already familiar with, and required to compute, earnings and profits 
for general federal tax purposes, and establishing a requirement to use 
an alternate metric would add administrative complexity and compliance 
burden. For the foregoing reasons, the final and temporary regulations 
retain earnings and profits as the starting point for the expanded 
group earnings reduction.
    Comments recommended an exception for ordinary course distributions 
based on the distribution history of the member. An exception for 
ordinary course distributions based on a distribution history would 
require an annual or other periodic averaging of distributions by a 
member. Because the Treasury Department and the IRS have determined 
that the cumulative approach to determining the expanded group earnings 
reduction is both more taxpayer-favorable and easier to administer than 
an approach based on distribution history, the final and temporary 
regulations reject this recommendation.
iv. Predecessors and Successors
    Comments requested clarification regarding the application of the 
earnings and profits exception to predecessors and successors. 
Specifically, comments questioned whether a funding rule distribution 
or acquisition by a predecessor or successor with no earnings and 
profits nonetheless qualifies for the earnings and profits exception 
when the member with respect to which it is a predecessor or successor 
has earnings and profits.
    In response to comments, the final and temporary regulations 
provide that, for purposes of applying the expanded group earnings 
reduction, as well as the qualified contribution reduction discussed in 
Section E.3.b of this Part V, with respect to a distribution or 
acquisition, references to a covered member do not include references 
to any corporation to which the covered member is a predecessor or 
successor. Accordingly, a distribution or acquisition by a predecessor 
or successor that is otherwise attributed to a funded member is reduced 
solely to the extent of the expanded group earnings and qualified 
contributions of the predecessor or successor that actually made the 
distribution or acquisition. The as-reduced amount of the distribution 
or acquisition is then attributed to the funded member, whose 
attributes are not available to further reduce the amount of the 
distribution or acquisition that may be treated as funded by a debt 
instrument of the funded member. The Treasury Department and the IRS 
have determined that sourcing distributions and acquisitions solely out 
of the relevant attributes of the distributing or acquiring member is 
more administrable and more consistent with the purpose of the 
reductions to permit ordinary course transactions not in excess of a 
member's new equity capital than an alternative approach such as 
calculating reductions by reference to the attributes of the other 
corporation in the predecessor-successor relationship or aggregating 
the attributes of both corporations.
    In lieu of incorporating predecessor-successor concepts, the final 
and temporary regulations provide that a member that acquires the 
assets of another member in a complete liquidation described in section 
332 or in a reorganization described in section 368 (whether 
acquisitive or divisive) succeeds to some or all of the acquired 
member's expanded group earnings

[[Page 72911]]

account. Similar provisions apply with respect to the qualified 
contribution reduction described in Section E.3.b of this Part V. This 
rule appropriately takes into account the enlarged dividend-paying 
capacity of a member that acquires the assets of another member 
pursuant to certain non-recognition transactions, and ensures that the 
expanded group earnings of a member are preserved and available for use 
after a reorganization, liquidation, or spin-off. Thus, while for 
purposes of applying the expanded group earnings reduction a reference 
to a member does not include a reference to a corporation to which the 
member is a predecessor or successor, the expanded group earnings 
account of a member may be determined, in whole or in part, by 
reference to the expanded group earnings account of a predecessor.
    As discussed in Section D.5 of this Part V, the final and temporary 
regulations provide that a reorganization with boot, to the extent 
described in more than one prong of the funding rule, is treated as a 
single distribution or acquisition for purposes of the funding rule. 
The final and temporary regulations also provide that, for purposes of 
applying the expanded group earnings reduction, a distribution or 
acquisition that occurs pursuant to an internal asset reorganization is 
reduced by the expanded group earnings account of the acquiring member, 
after taking into account the expanded group earnings account it 
inherits form the target member. A similar provision applies to the 
qualified contribution reduction described in Section E.3.b of this 
Part V.
v. Additional Recommendations To Make the Exception More Administrable
    Comments requested various safe harbors pursuant to which a 
taxpayer's determination of its earnings and profits would be respected 
if determined in good faith. One comment requested that the earnings 
and profits reflected on a timely filed tax return for an applicable 
taxable year be conclusively treated as the earnings and profits for 
such year, and any adjustments to earnings and profits for such year 
that arise out of an audit adjustment or amended tax return not be 
taken into account. A similar comment recommended that a taxpayer's 
determination of its earnings and profits be respected for purposes of 
applying the regulations, notwithstanding audit adjustments by the IRS, 
unless the determination was based upon a position for which accuracy-
related penalties could be imposed under section 6662. Comments also 
requested that the exception apply with respect to distributions or 
acquisitions that do not exceed earnings and profits by more than a de 
minimis amount.
    The final and temporary regulations do not adopt these suggestions. 
The Treasury Department and the IRS have determined that the expanded 
group earnings reduction in the final and temporary regulations 
provides taxpayers with far more latitude than under the proposed 
regulations to make ordinary course distributions while eliminating 
incentives to distribute earnings and profits in a particular year or 
every year. Because earnings and profits under the revised exception is 
not a ``use or lose'' attribute, taxpayers will be able to take a 
conservative approach to making distributions in any particular year. 
Accordingly, the Treasury Department and the IRS have determined that 
additional safeguards against taxpayer error are not warranted.
b. Reduction for Qualified Contributions
    Numerous comments recommended that capital contributions to a 
member be netted against distributions or acquisitions by the member 
for purposes of applying proposed Sec.  1.385-3(b)(2) and (b)(3)(ii) 
reasoning that, to the extent of capital contributions, a distribution 
does not reduce a member's net equity. For this purpose, some comments 
recommended a broad definition of a capital contribution to include any 
transfer of property in deemed or actual exchange for stock under 
section 1032, while other comments suggested that transfers of expanded 
group stock or a transfer of the assets of a member pursuant to an 
internal reorganization not be taken into account for purposes of the 
netting rule. Comments also differed on the period for which capital 
contributions should be taken into account. Some comments suggested 
that contributions for the entire per se period should be taken into 
account, even with respect to debt instruments that had already been 
recharacterized under Sec.  1.385-3. One comment suggested taking into 
account contributions that occur after a debt instrument otherwise 
would be recharacterized but only to the extent that, as of that time, 
there was a plan to make the subsequent contributions during the 
remainder of the per se period. Other comments suggested narrower 
approaches, such as taking into account only the contributions made 
until the close of the taxable year in which the recharacterization 
otherwise would occur, or only those made in the per se period 
preceding the potential recharacterization. Some comments recommended 
that contributions from any member of the expanded group should be 
permitted to net against distributions or acquisitions made by another 
member, while other comments suggested a member-by-member approach to 
netting.
    As discussed in Sections D.2.c and E.3.a.i of this Part V, the 
Treasury Department and the IRS have determined that it is appropriate 
to treat distributions or acquisitions as funded by new equity before 
related-party borrowings. Accordingly, the final and temporary 
regulations provide that a distribution or acquisition is reduced by 
the aggregate fair market value of the stock issued by the covered 
member in one or more qualified contributions (the qualified 
contribution reduction). A qualified contribution is a contribution of 
property (other than excluded property) to the covered member by any 
member of the covered member's expanded group in exchange for stock of 
the covered member during the qualified period. The qualified period 
generally means, with respect to a distribution or acquisition, 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, subject to two limitations. First, the qualified period in 
no event ends later than the last day of the first taxable year that a 
covered debt instrument of the covered member would, absent the 
application of the qualified contribution reduction, be treated as 
stock or, if the covered member is an expanded group partner in a 
controlled partnership that is the issuer of the debt instrument, as a 
specified portion. Second, the qualified period is further limited to 
only include the covered member's expanded group period that includes 
the date of the distribution or acquisition.
    Excluded property (that is, property the contribution of which does 
not give rise to a qualified contribution) includes expanded group 
stock and property acquired by a covered member in an internal asset 
reorganization. The Treasury Department and the IRS have determined 
that the acquisition of such assets in exchange for stock of a covered 
member should not be taken into account as increasing capital of the 
covered member that is available to make distributions for reasons 
similar to those discussed in Sections C.3 and C.4 of this Part V. In 
fact, if a covered member were given ``credit'' for contributions of 
expanded group stock, for example, the covered member could do in two 
steps (capital contribution of expanded group stock to the covered 
member followed by a distribution of a debt instrument by the covered 
member)

[[Page 72912]]

what the general rule would not permit it to do in one step (a covered 
member's purchase of that expanded group stock in exchange for a debt 
instrument).
    Excluded property also includes a covered debt instrument issued by 
a member of the covered member's expanded group, property acquired by a 
covered member in exchange for a covered debt instrument issued by the 
covered member that is recharacterized under the funding rule, and a 
debt instrument issued by a controlled partnership of the expanded 
group of which a covered member is a member. The final and temporary 
regulations exclude covered debt instruments and debt instruments 
issued by a controlled partnership because the Treasury Department and 
the IRS are concerned that taxpayers could use such property to create 
non-economic qualified contributions before such indebtedness is 
treated as stock under Sec.  1.385-3 or Sec.  1.385-3T. Further, the 
final and temporary regulations exclude property acquired by a covered 
member in exchange for its own covered debt instrument that is treated 
as stock under the funding rule. This category of excluded property 
addresses the potential circularity of treating a contribution of 
property in exchange for a covered debt instrument that is treated as 
stock under the funding rule as a qualified contribution, which could 
reduce the amount of the distribution that caused the covered debt 
instrument to be treated as stock.
    The final and temporary regulations also provide that qualified 
contributions do not include certain contributions to a covered member 
that do not have the effect of increasing the capital of the covered 
member that is available to make distributions (excluded 
contributions). The contributions that are entirely disregarded are 
contributions (i) from a member (controlled member) that the covered 
member controls (``upstream'' transfers), and (ii) from a corporation 
of which the covered member is a predecessor or successor or from a 
corporation controlled by that corporation. For purposes of the 
preceding sentence, control of a corporation means the direct or 
indirect ownership of more than 50 percent of the total combined voting 
power and more than 50 percent of the total value of the stock of a 
corporation applying the principles of section 958(a) without regard to 
whether an intermediate entity is foreign or domestic. If a 
contribution of property occurs before the covered member acquires 
control of the controlled member or before the transaction in which the 
corporation becomes a predecessor or successor to the covered member 
(transaction date), the contribution of property ceases to be a 
qualified contribution on the transaction date. If the contribution of 
property occurs within 36 months before the transaction date, the 
covered member is treated as making a distribution described in the 
funding rule on the transaction date equal to the amount by which any 
distribution or acquisition was reduced because the contribution of 
property was treated as a qualified contribution.
    The final and temporary regulations also provide, more generally, 
that a contribution of property to a covered member is not a qualified 
contribution to the extent that the contribution does not increase the 
aggregate fair market value of the outstanding stock of the covered 
member immediately after the transaction and taking into account all 
related transactions, other than distributions and acquisitions 
described in the general rule and funding rule. Thus, for instance, a 
contribution to a covered member from a member in which the covered 
member owns an interest that represents less than 50 percent of the 
total combined voting power or value does not constitute a qualified 
contribution to the extent that the contribution does not increase the 
value of the covered member.
    The final and temporary regulations generally take into account 
only contributions made during the per se period before the time that a 
debt instrument would be treated as stock. The Treasury Department and 
the IRS have determined that taking into account contributions after 
the taxable year in which a distribution or acquisition caused the 
recharacterization of a debt instrument would unduly increase the 
incidence of instruments switching between debt and equity treatment, 
leading to additional complexity and uncertainty for both the IRS and 
the taxpayer. However, in response to comments, the final and temporary 
regulations take into account contributions after a debt instrument 
would be treated as stock if the contribution occurs before the end of 
the taxable year in which such treatment begins. This rule allows 
taxpayers some ability to self-help for inadvertent distributions and 
acquisitions without implicating the same degree of uncertainty and 
administrability concerns that would occur if contributions in a 
subsequent taxable year were taken into account.
    The Treasury Department and the IRS are concerned, however, that 
taxpayers could use capital contributions to frustrate the purposes of 
the final and temporary regulations. For example, a calendar-year 
taxpayer could take the position that a distribution of a note on 
January 1, pursuant to a plan to ``undo'' the recharacterization of the 
note that otherwise would apply by making a capital contribution on 
December 31, gives rise to interest deductions without funding new 
investment during the 364-day period preceding the contribution. 
Accordingly, the final and temporary regulations provide that property 
contributed to a covered member with a principal purpose of avoiding 
the purposes of Sec.  1.385-3 or Sec.  1.385-3T is excluded property, 
and thus does not give rise to a qualified contribution. As a result, 
in the example, the contribution on December 31 would not reduce the 
January 1 distribution or any subsequent distribution. This express 
limitation (as well as other targeted anti-abuse provisions, such as 
the limitation to the special exception to iterative recharacterization 
described in Section B.5 of this Part V) should not be interpreted to 
create a negative inference that the anti-abuse provision in Sec.  
1.385-3(b)(4) would not also have addressed such a transaction.
4. Threshold Exception
    Proposed Sec.  1.385-3(c)(2) provided that an expanded group debt 
instrument would 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). The 
proposed regulations also provided that 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 were treated as 
stock, rather than only the amount that exceeds $50 million. Thus, the 
threshold exception in the proposed regulations was not an exemption of 
the first $50 million of expanded group debt instruments that otherwise 
would be treated as stock, but rather only provided an exception from 
the application of proposed Sec.  1.385-3 for taxpayers that have not 
exceeded the $50 million threshold.
    Comments suggested that the $50 million limitation should be 
increased, with the highest specific recommended threshold being $250 
million. Comments also suggested that the threshold be based on a 
percentage of the issuer's or expanded group's assets, income, or 
another relevant financial metric. One comment recommended that the 
threshold exception be

[[Page 72913]]

determined by reference to the amount by which the issuer's interest 
expense exceeds interest income. Comments also suggested that the 
threshold exception should be applied separately with respect to each 
specific issuer (or a subset of an expanded group) or specific 
instrument, which would effectively increase the $50 million 
limitation.
    The final and temporary regulations do not increase the amount of 
the threshold exception, or alter the basis for determining the 
exception except to include certain debt instruments issued by a 
controlled partnership that otherwise would be subject to the treatment 
described in Section H.4 of this Part V in the determination of whether 
the limitation has been surpassed. The scope revisions (discussed in 
Part III of the Background), the addition and expansion of exceptions 
for distributions and acquisitions otherwise described in Sec.  1.385-
3(b)(2) and (3) (discussed in Section E of this Part V), and the 
addition and expansion of exceptions for debt instruments otherwise 
subject to this section (discussed in Sections D.8 and F of this Part 
V) substantially reduce the number of instruments subject to 
recharacterization. These revisions are expected to limit the 
application of the rules to non-ordinary course transactions so that 
taxpayers will have the flexibility to avoid their application. 
Additionally, the final and temporary regulations do not adopt the 
recommendation to vary the threshold based on the size of the expanded 
group. The regulations are intended to address the use of related-party 
indebtedness that does not finance new investment. The comments do not 
establish, and the Treasury Department and the IRS have not 
ascertained, a policy justification for permitting larger expanded 
groups to issue more indebtedness that does not finance new investment, 
beyond the scaling that necessarily follows from the expanded group 
earnings reduction. Furthermore, the assets, income, and other 
financial attributes of an expanded group fluctuate, making it 
difficult for both taxpayers and the IRS to administer such a 
percentage-based threshold exception. Accordingly, the final and 
temporary regulations retain the $50 million threshold.
    Additionally, comments suggested eliminating the so-called cliff 
effect by only recharacterizing instruments in excess of the threshold. 
Alternatively, comments suggested that the cliff effect apply at a 
second, higher threshold. In response to these comments, the final and 
temporary regulations eliminate the rule providing that the exception 
will not apply to any debt instruments once the $50 million threshold 
is exceeded. The final and temporary regulations instead provide that, 
to the extent that the $50 million threshold is exceeded immediately 
after a debt instrument would be treated as stock under Sec.  1.385-
3(b), only the amount of the debt instrument in excess of $50 million 
is treated as stock.
    Comments also suggested revisions to the operation of the threshold 
exception. First, comments requested that an expanded group that 
exceeds the $50 million threshold due to reasonable cause be given a 
grace period (such as 90 days) to reduce the amount of outstanding debt 
instruments below the $50 million threshold. Second, comments 
recommended the use of an average quarterly amount outstanding to 
compute whether the $50 million threshold is exceeded. The final and 
temporary regulations do not adopt either of these recommendations. In 
light of the elimination of the cliff effect, the Treasury Department 
and the IRS have determined that neither a complex computation nor a 
special remediation rule is required or appropriate for the threshold 
exception. See Part B.6 of this Part V regarding the decision not to 
adopt a general remediation rule.
5. Requests for New Exceptions Not Adopted in the Final and Temporary 
Regulations
a. Post-Acquisition and Pre-Divestiture Restructuring
    Comments requested an exception for debt instruments issued in 
connection with the post-merger integration of a previously unrelated 
target. Comments highlighted that a purchaser can generally fund an 
acquisition of an unrelated target company entirely with related-party 
indebtedness without implicating the regulations, but that the 
realignment of such acquisition indebtedness as part of the post-merger 
integration of the newly acquired entity, including its subsidiaries, 
implicates Sec.  1.385-3. Moreover, comments asserted that transfers of 
stock and assets in exchange for debt are often the most practical 
method of realigning the stock and assets of a newly-acquired member 
for non-U.S. tax business reasons. Further, while the purchaser (or its 
subsidiaries) could acquire each target entity separately in fully 
debt-funded transactions that would not implicate Sec.  1.385-3, 
comments asserted that such a transaction structure may be impractical 
due to regulatory or financing restrictions or the inability to 
negotiate such a transaction with an unrelated seller.
    For the foregoing reasons, comments recommended that the 
regulations exempt debt instruments issued in exchange for expanded 
group stock pursuant to the integration of a newly-acquired member and 
its subsidiaries. Some comments suggested that an exception should 
apply to acquisitions from a member within one year of the member's 
acquisition from an unrelated person. One comment suggested that an 
exception should apply to acquisitions of newly-acquired members for 36 
months after the acquisition. Another comment recommended an exception 
that would be limited to debt instruments issued by a member in 
exchange for the stock or assets of the new member with a principal 
amount equal to the amount of cash, notes, or rights to future payments 
received by the unrelated seller from members of the expanded group in 
the earlier acquisition.
    Comments also recommended an exception for related-party 
indebtedness issued to acquire expanded group stock in connection with 
a plan to divest the acquiring member to unrelated persons. One comment 
suggested an exception for indebtedness issued by the departing member 
within 36 months of its divestiture, while other comments recommended 
an exception for any acquisitions of expanded group stock that occur 
pursuant to an integrated plan to dispose of the departing member. 
Another comment suggested that an acquisition of expanded group stock 
should not be described in the general rule or funding rule if the 
acquisition is part of a plan in which the acquirer, seller, and target 
cease to be members of the same expanded group.
    The final and temporary regulations do not adopt an exception for 
debt instruments issued in connection with post-acquisition or pre-
disposition restructuring. Such an exception would facilitate the use 
of related-party indebtedness to create significant federal tax 
benefits without financing new investment in the issuer. The incentives 
to create new related-party debt that does not finance new investment 
can be just as pronounced, if not more pronounced, in connection with 
post-acquisition restructuring or in preparation for a planned 
divestiture, since the new expanded group parent may have a different 
tax status that will allow the newly-configured group to use related-
party debt to achieve significant federal tax benefits that were not 
possible before the acquisition or divestiture.

[[Page 72914]]

    Moreover, the Treasury Department and the IRS do not view the close 
proximity of a third-party transaction as a basis for providing a 
special exception for the use of related-party debt in a transaction 
that does not finance new investment in the issuer. When an expanded 
group member acquires stock or assets from an unrelated third-party in 
exchange for cash or property, that acquisition is not described in the 
general rule or funding rule, even if the cash or property 
consideration is fully debt-funded by a related-party borrowing, 
because the acquisition from the unrelated third-party represents new 
investment in the issuer of the debt. The comments effectively 
recommend that, in the case of a recent acquisition, the final and 
temporary regulations extend this concept further to provide that 
subsequent transactions involving the recently-acquired members be 
provided a special exception. When those recently-acquired members 
issue related-party indebtedness to fund an internal stock acquisition 
or internal asset reorganization, the concerns set forth in Section C 
of this Part V about related-party debt that does not finance new 
investment in the issuer apply in a similar manner as in the case of 
transactions among old and cold expanded group members. Moreover, the 
Treasury Department and the IRS do not agree that because a transaction 
with a recently-acquired expanded group member could have been 
effectuated, hypothetically, with the unrelated third-party seller, the 
regulations should provide a special exception on the basis of this 
hypothetical transaction.
    Similar concerns apply in the case of pre-divestiture planning. As 
for post-acquisition restructuring, the Treasury Department and the IRS 
do not view the close proximity to a subsequent third-party transaction 
as a basis for providing a special exception for related-party debt 
that does not finance new investment in the issuer.
    Comments addressing pre-divestiture planning also observed that 
when a debt instrument is recharacterized close-in-time to the 
divestiture transaction with the unrelated third-party, the 
recharacterized debt instrument may be repaid immediately before the 
divestiture, which, as described in Part B.4 of this Section V, may 
result in a taxable sale or exchange. The Treasury Department and the 
IRS do not view the short duration of these instruments as changing the 
analysis in the preceding paragraph; however, as discussed in Part D.8 
of this Section V, the temporary regulations adopt a broad exception to 
the funding rule for qualified short-term debt instruments that may 
overlap significantly with the types of short-duration debt instruments 
issued in anticipation of a divestiture transaction that are addressed 
in comments. As a result, the final and temporary regulations provide 
greater flexibility for issuances of debt instruments that are short 
term in form and in substance.
    Comments requested other exceptions for certain restructuring 
transactions that are not undertaken in connection with a third-party 
transaction. One comment requested a same-country exception, which 
would apply to dispositions of stock or assets between expanded group 
members incorporated in the same country. The same comment requested an 
exception for internal stock acquisitions resulting in the acquired 
member joining the acquiring member's consolidated group or internal 
asset reorganizations in which the acquired member's assets are used by 
the acquirer in its business. A comment also requested that an internal 
asset reorganization be excepted if the taxpayer can demonstrate a 
business purpose for the reorganization.
    The Treasury Department and the IRS decline to accept a broad 
exception for entity restructuring, because, as discussed in Sections 
C.3 and C.4 of this Part V, an internal stock acquisition and an 
internal asset reorganization with ``other property'' has an effect 
that is economically similar to a distribution regardless of whether 
the transaction is also supported by a non-U.S. tax business purpose. 
Moreover, the regulations do not generally prohibit a taxpayer from 
restructuring its operations; they only deny the undue federal tax 
benefit from the use of indebtedness in the restructuring to the extent 
it does not finance new investment.
b. Distributions of Non-Cash Assets
    Comments recommended that distributions of ``old-and-cold,'' non-
financial assets be excluded from the funding rule because such assets 
are not fungible and thus should not be treated as funded by a related-
party borrowing. A comment suggested that the anti-abuse rule could 
adequately police distributions of property acquired with a principal 
purpose to avoid the regulations or acquired within a certain period 
before the distribution. For similar reasons, one comment recommended 
that the purchase of operating assets for a note should not be treated 
as a funding that can be matched with a distribution or acquisition.
    The Treasury Department and the IRS decline to adopt this 
recommendation because a distribution of old-and-cold non-financial 
assets presents similar policy concerns to those described in Section 
D.2 of this Part V concerning other distributions of cash and property 
by a funded member. As discussed in Section D.6 of this Part V, the 
final and temporary regulations exclude all distributions described in 
section 355, whether or not preceded by an asset reorganization, from 
the scope of the funding rule because the strict requirements of 
section 355 indicate that the stock of a controlled corporation is not 
fungible. There are no such safeguards with respect to taxable 
distributions of operating assets, which may be acquired by the 
distributing member with cash the day before the distribution and 
converted into cash by the recipient member the day after. Moreover, an 
acquisition of operating assets in exchange for a debt instrument is 
like any other debt-financed purchase, which frees up the cash that 
otherwise would be used in the acquisition for other uses by the 
issuer. For these reasons, the Treasury Department and the IRS have 
determined that transfers of old-and-cold operating assets should not 
be excepted from the funding rule, except in the narrow circumstance 
that the distribution qualifies for nonrecognition under section 355.
6. Application of the Funding Rule to Instruments Issued in General 
Rule Transactions That Qualify for an Exception
a. Treatment of the Issuer of a Covered Debt Instrument in a General 
Rule Transaction That Satisfies an Exception as a Funded Member
    Comments expressed concern that a debt instrument issued in an 
internal stock acquisition or an internal asset reorganization that 
would be recharacterized under the general rule but for the application 
of the earnings and profits exception may nonetheless be 
recharacterized under the funding rule. Comments noted that a debt 
instrument issued in one of these transactions is, in fact, issued in 
exchange for property (namely, stock or assets). Therefore, absent a 
special rule that prevents the debt from being re-tested, the member 
that engages in the transaction has been funded and the debt instrument 
may be recharacterized if the member has made, or does make, another 
distribution or acquisition described in the funding rule during the 
per se period. Comments suggested that testing the same debt instrument 
under both the general rule and funding rule amounts to ``double 
jeopardy'' and recommended that the regulations provide that, if the 
earnings and profits

[[Page 72915]]

exception applies to reduce the amount of a transaction described in 
the second or third prong of the general rule, the issuing member 
should not be treated as a funded member for purposes of retesting the 
instrument under the funding rule.
    The final and temporary regulations do not adopt this 
recommendation and instead provide that a member that issues a debt 
instrument in a general rule transaction that satisfies an exception 
under Sec.  1.385-3(c)(2) or (3) is treated as a funded member with 
respect to the debt instrument for purposes of re-testing the 
instrument under the funding rule (the funded member rule). The 
Treasury Department and the IRS have determined that the so-called 
``double jeopardy'' highlighted by comments, in fact, harmonizes the 
treatment of general rule acquisitions with funding rule acquisitions, 
and its elimination would create an undue preference in Sec.  1.385-3 
for general rule acquisitions over funding rule acquisitions. Moreover, 
the distribution of a debt instrument that qualifies for an exception 
implicates the same policy concerns, and thus the funded member rule 
applies to transactions described in all three prongs of the general 
rule.
    As discussed in the preamble to the proposed regulations, a funding 
rule transaction achieves an economically similar outcome as a general 
rule transaction. In this regard, both a general rule and a funding 
rule transaction effect a distribution of the proceeds of a borrowing, 
except that the latter does in multiple steps what the former 
accomplishes in one. Therefore, to achieve symmetry between the two 
types of economically similar transactions, an exception that would 
exclude or reduce a distribution or acquisition described in the 
funding rule should only exclude or reduce the distributive or 
acquisitive element of a transaction described in the general rule.
    To illustrate, if S issues a note in exchange for property from P 
and, during the per se period, acquires the stock of T from P, and the 
acquisition satisfies an exception in Sec.  1.385-3(c)(2) or (3), the S 
note is not treated as stock by reason of the T stock acquisition. 
However, because the S note is treated as not having funded the T stock 
acquisition, the S note may still be treated as funding another 
distribution or acquisition that occurs within the per se period. If, 
however, S acquires the T stock directly from P in exchange for its own 
note and the acquisition satisfies an exception in Sec.  1.385-3(c)(2) 
or (3), under the recommendation for eliminating ``double jeopardy,'' 
the S note would not be treated as stock by reason of the T stock 
acquisition and, moreover, the S note would not be subject to potential 
recharacterization under the funding rule if there is another 
distribution or acquisition during the per se period. Accordingly, 
under the recommendation, an exception intended solely to exclude or 
reduce a distribution or acquisition would effectively negate both the 
distributive element and the funding element of the transaction. 
Moreover, this recommendation would create divergent consequences as 
between transactions with the same economic effect--after both 
variations of the transaction, S has acquired the T stock and P holds 
an S note. To conform the application of the exceptions in Sec.  1.385-
3(c)(2) and (3) as between the S funding rule acquisition and the S 
general rule acquisition, the exceptions should apply solely to exclude 
or reduce the distributive aspect of the S general rule acquisition.
    For the foregoing reasons, the final and temporary regulations 
provide that, to the extent an exception applies to exclude or reduce 
the amount of a distribution or acquisition described in the general 
rule, the debt instrument issued in the transaction is treated as 
issued by a member in exchange for property solely for purposes of 
applying the funding rule to the debt instrument and the member. The 
funded member rule addresses the sequencing concern with respect to the 
expanded group earnings reduction discussed in Section E.3.a.ii of this 
Part V. In the example provided in that section, S distributes $50x 
cash and a note with a $50x principal amount in a taxable year in which 
S has expanded group earnings of $50x. Under the funded member rule, if 
the general rule distribution is reduced by $50x under the expanded 
group earnings reduction, S is treated as having been funded by the 
issuance of the $50x note. As a result, the ordering of the 
distributions does not materially affect the consequences of the 
transactions under the final and temporary regulations--either (1) the 
funding rule distribution occurs first, the amount of the cash 
distribution is reduced by $50x, and the S note is recharacterized as 
stock under the general rule, or (2) the general rule distribution 
occurs first, the amount of the note distribution is reduced by $50x, S 
is treated as having been funded by the note, and the S note is 
recharacterized as stock under the funding rule by reason of the cash 
distribution. In either sequence of events, the S note is 
recharacterized as stock, whether by reason of the general rule or the 
funding rule.
b. Treatment Under the Funding Rule of a Covered Debt Instrument Issued 
in a General Rule Transaction That Satisfies an Exception
    The proposed regulations provided that, to the extent a debt 
instrument issued in an internal asset reorganization is treated as 
stock under the general rule, the distribution of the debt instrument 
pursuant to the same reorganization is not also treated as a 
distribution or acquisition described in the funding rule (the 
``general coordination rule''). One comment requested that the general 
coordination rule be expanded to provide that any transaction described 
in the general rule, regardless of whether such transaction results in 
the debt instrument being treated as stock, is not also treated as a 
distribution or acquisition described in the funding rule. The comment 
questioned, for example, whether the distribution of a covered debt 
instrument could be treated as a distribution of property for purposes 
of the funding rule if the debt instrument were not treated as stock by 
reason of the threshold exception of Sec.  1.385-3(c)(4). The issue 
could also be implicated if the amount of a general rule acquisition in 
an internal asset reorganization is reduced by reason of an exception 
described in Sec.  1.385-3(c)(3). To the extent that the amount of the 
acquisition is reduced by reason of an exception (for example, the 
expanded group earnings reduction), the covered debt instrument issued 
by the transferee corporation would be respected as indebtedness, and 
thus the distribution of the covered debt instrument by the transferor 
corporation to its shareholder pursuant to the plan of reorganization 
would be treated as a distribution of property described in the funding 
rule. Accordingly, absent an expansion of the general coordination 
rule, a single transaction with an economic effect similar to a 
distribution would be treated as two transactions subject to the 
general rule and funding rule.
    The Treasury Department and the IRS adopt the recommendation to 
expand the general coordination rule to apply to all general rule 
transactions, regardless of whether the covered debt instrument issued 
in the transaction is treated as stock under the general rule. 
Accordingly, the final and temporary regulations provide that a 
distribution or acquisition described in the general rule is not also 
described in the funding rule. Moreover, the final and temporary 
regulations also provide that an

[[Page 72916]]

acquisition in an internal asset reorganization described in the 
general rule by the transferee corporation is not also a distribution 
or acquisition described in the funding rule by the transferor 
corporation. For purposes of the general coordination rule, whether a 
distribution or acquisition is described in the general rule is 
determined without regard the exceptions of Sec.  1.385-3(c). Thus, in 
an internal asset reorganization to which an exception applies, the 
distribution of a respected debt instrument by the transferor 
corporation is not also tested as a distribution or acquisition 
described in the funding rule.
    For a discussion of the general coordination rule applicable during 
the transition period, see Part VIII.B.2 of this Summary of Comments 
and Explanation of Revisions.
F. Exceptions From Sec.  1.385-3 for Certain Debt Instruments
    The final and temporary regulations limit the application of the 
general rule and funding rule by excluding certain debt instruments 
described in this Section F of this Part V from the definition of 
covered debt instruments. This Section F of this Part V also discusses 
other requests for exceptions that were not adopted.
1. Qualified Dealer Debt Instrument
    Comments recommended that the regulations provide an exception for 
debt instruments acquired and held by a dealer in securities (within 
the meaning of section 475(c)(1)) in the ordinary course of its 
business as a dealer in securities. Similarly, comments recommended 
that the regulations provide an exception for debt instruments that 
would be excluded from being investments in U.S. property if entered 
into between a controlled foreign corporation and a United States 
shareholder under section 956(c)(2)(K), which covers securities 
acquired and held by a dealer in securities in the ordinary course of 
its business.
    In response to these comments, the regulations provide an exception 
for the acquisition of debt instruments by a dealer in securities. 
Under Sec.  1.385-3(g)(3)(i), a ``qualified dealer debt instrument'' is 
excluded from the definition of a covered debt instrument. A qualified 
dealer debt instrument is defined in Sec.  1.385-3(g)(3)(ii) to mean a 
debt instrument issued to or acquired by an expanded group member that 
is a dealer in securities (within the meaning of section 475(c)(1)) in 
the ordinary course of the dealer's business of dealing in securities. 
This exception applies solely to the extent that (i) the dealer 
accounts for the debt instruments as securities held primarily for sale 
to customers in the ordinary course of business, (ii) the dealer 
disposes of the debt instruments (or the debt instruments mature) 
within a period of time that is consistent with the holding of the debt 
instruments for sale to customers in the ordinary course of business, 
taking into account the terms of the debt instruments and the 
conditions and practices prevailing in the markets for similar debt 
instruments during the period in which they are held, and (iii) the 
dealer does not sell or otherwise transfer the debt instruments to a 
person in the same expanded group, other than to a dealer that 
satisfies the requirements of the exception for qualified dealer debt 
instruments.
2. Instruments That Are Not In Form Debt
    Proposed Sec. Sec.  1.385-3 and 1.385-4 applied to any interest 
that would, but for those sections, be treated as a debt instrument as 
defined in section 1275(a) and Sec.  1.1275-1(d). Consequently, the 
proposed regulations applied not only to debt in form, but also to any 
instrument or contractual arrangement that constitutes indebtedness 
under general principles of federal income tax law. One comment 
recommended that the funding rule apply solely to instruments that are, 
in form, debt instruments. The Treasury Department and the IRS decline 
to accept this recommendation because this would fail to take into 
account the substance of an arrangement that is otherwise treated as a 
debt instrument for federal tax purposes and create an inappropriate 
preference for debt instruments that are not in-form debt.
    Comments also noted that, in certain cases, instruments (or deemed 
instruments) that are expressly treated as debt under other provisions 
of the Code and regulations should not be subject to 
recharacterization. The comments cited leases treated as loans under 
section 467; receivables and payables resulting from correlative 
adjustments under section 482; production payments under section 636; 
coupon stripping transactions under section 1286; and debt (or 
instruments treated as debt) described in section 856(m)(2), 
860G(a)(1), or 1361(c)(5). Similarly, comments requested that the 
regulations disregard debt instruments deemed to occur under section 
367(d).
    The final and temporary regulations exclude from the definition of 
covered debt instruments: Production payments under section 636; REMIC 
regular interests (as defined in section 860G(a)(1)); instruments 
described in section 1286 (relating to coupon stripping transactions) 
unless such an instrument is issued with a principal purpose of 
avoiding the purposes of Sec.  1.385-3 or Sec.  1.385-3T; and leases 
treated as loans under section 467. The final and temporary regulations 
also provide an exception for debt instruments deemed to arise as a 
result of transfer pricing adjustments under section 482. The Treasury 
Department and the IRS decline to include an exception for payables 
deemed to occur under section 367(d) in the final and temporary 
regulations because the final and temporary regulations are limited to 
U.S. borrowers.
    The final and temporary regulations do not provide an exception for 
debt described in section 1361(c)(5) because S corporations are not 
included in the definition of an expanded group in the final and 
temporary regulations. The final and temporary regulations also do not 
provide an exception for debt described in section 856(m)(2), which 
addresses certain non-contingent non-convertible debt securities held 
by a REIT that are not taken into account for one of the asset tests 
for qualified REIT status. The final and temporary regulations do not 
adopt this exception because the final and temporary regulations apply 
only to REITs that are controlled by expanded group members, and not 
parent-REITs. In this context, debt instruments described in section 
856(m)(2) that are issued to other expanded group members may present 
similar policy concerns as those presented by other expanded group debt 
instruments.
    One comment suggested that the funding rule should not apply to a 
deemed loan arising from a nonperiodic payment arising with respect to 
a notional principal contract. The comment noted that multinational 
enterprises frequently use intercompany swaps to allocate and manage 
interest rate and foreign currency risk. In some situations, one member 
of an expanded group may make a nonperiodic payment to another member 
of the expanded group that might be characterized as a loan under Sec.  
1.446-3T(g)(4). The comment asserts that it is unnecessary to apply the 
funding rule to deemed loans such as those that arise from a 
nonperiodic payment on a notional principal contract to achieve the 
policy goals of the proposed regulations.
    The Treasury Department and the IRS decline to accept this 
recommendation, because it would not take into account the substance of 
an arrangement that is otherwise treated as a debt instrument for 
federal tax purposes. Moreover, the

[[Page 72917]]

regulations referred to in the comment are not currently in effect, and 
are not scheduled to take effect until after final and temporary 
regulations are issued. The regulations under Sec.  1.446-3T(g)(4) have 
been the subject of extensive comment and are under active 
consideration. The Treasury Department and the IRS will consider 
whether it is necessary to coordinate the nonperiodic payment rules on 
swaps with section 385 when finalizing the regulations on notional 
principal contracts.
3. Significant Modifications and Refinancing
    Comments suggested that a significant modification within the 
meaning of Sec.  1.1001-3 should not implicate the funding rule because 
the debt instrument deemed issued as a result of such a modification 
should be treated as having been issued to retire the existing 
instrument instead of generating new proceeds that could fund 
distributions or acquisitions subject to Sec.  1.385-3. However, one 
comment acknowledged that such an exception may be inappropriate in 
cases where the significant modification extends the term of the 
instrument. The comment stated that, in such a case, the modified debt 
could be viewed as essentially financing activities of the borrower for 
the extended term. Other comments recommended that a similar exception 
apply to an actual refinancing whereby a new debt instrument is issued 
and the proceeds are used to repay an old debt instrument. Comments 
recommended that the borrowing to refinance an existing debt instrument 
be considered used for the same purpose as the refinanced debt, and 
thereby be subject to the funding rule to the same extent as the 
refinanced debt instrument.
    In response to comments, the final and temporary regulations 
provide that if a covered debt instrument is treated as exchanged for a 
modified covered debt instrument pursuant to Sec.  1.1001-3(b), the 
modified covered debt instrument is treated as issued on the original 
issue date of the covered debt instrument. This special rule is limited 
to situations in which the modification, or one of the modifications, 
that results in the exchange (or deemed exchange) does not include (i) 
the substitution of an obligor on the covered debt instrument, (ii) the 
addition or deletion of a co-obligor on the covered debt instrument, or 
(iii) the material deferral of scheduled payments due under the covered 
debt instrument The special rule excludes a change in obligor or 
addition of an obligor that results in a deemed exchange because the 
Treasury Department and the IRS are concerned about such modifications 
circumventing the funding rule generally. The special rule excludes a 
material deferral of scheduled payments that results in a deemed 
exchange because the Treasury Department and the IRS are concerned 
about such extensions circumventing the per se period though continued 
extensions of maturity.
    The final and temporary regulations also clarify that if the 
principal amount of a covered debt instrument is increased, the portion 
of the covered debt instrument attributable to such increase is treated 
as issued on the date of such increase.
    The final and temporary regulations do not extend the special rule 
for modifications of debt instruments to an actual refinancing outside 
of the context of a modification described in Sec.  1.1001-3(a). For 
example, the rule would not apply to a refinancing of a debt instrument 
held by one expanded group member through the issuance of a new debt 
instrument to another expanded group member. The Treasury Department 
and the IRS have determined that it is appropriate to provide this 
special rule in the context of a deemed exchange for tax purposes that 
may not be treated as an exchange for legal, accounting or other 
relevant purposes. By contrast, in a transaction that is in form a 
refinancing that involves an exchange for tax purposes without regard 
to the application of Sec.  1.1001-3(b), the Treasury Department and 
the IRS decline to provide a special rule. Furthermore, the Treasury 
Department and the IRS are concerned that the limitations to this 
special rule that would be necessary to prevent abuse would be 
difficult to administer in the context of an actual refinancing.
4. Insurance and Reinsurance Arrangements
    Comments asserted that the regulations should not apply to 
insurance or reinsurance transactions entered into in the ordinary 
course of an insurer's or reinsurer's trade or business. Several 
comments further noted that the regulations should not apply to 
reinsurance arrangements where funds otherwise due to the reinsurance 
company are withheld by the insurance company ceding risk to a 
reinsurance company.
    The final and temporary regulations only apply to interests that 
would, but for the application of Sec.  1.385-3, be treated as debt 
instruments as defined in section 1275(a) and Sec.  1.1275-1(d). As a 
result, insurance and reinsurance contracts generally would not be 
subject to Sec.  1.385-3 because such contracts are not ordinarily 
treated as debt instruments as defined in section 1275(a) and Sec.  
1.1275-1(d). To the extent that an arrangement entered into in 
connection with an insurance or reinsurance contract would be treated 
as a debt instrument, as defined in section 1275(a) and Sec.  1.1275-
1(d), that arrangement is a debt instrument for federal income tax 
purposes. As a result, the Treasury Department and the IRS have 
determined that such a debt instrument should not be treated 
differently than any other interest subject to Sec.  1.385-3. However, 
as discussed in Section G.2 of this Part V, the final and temporary 
regulations exclude debt instruments issued by regulated insurance 
companies.
5. Securitization Transactions
    One comment requested an exception for instruments issued pursuant 
to certain securitization transactions. The comment stated that in a 
common securitization transaction, an operating entity transfers income 
producing assets, such as receivables or loans, to a special purpose 
vehicle (SPV). The SPV then re-transfers the assets to a bankruptcy-
remote entity that is typically disregarded for federal tax purposes in 
exchange for tranches of instruments that the SPV sells, usually to 
unrelated parties and often utilizing an underwriter or broker. The SPV 
frequently hires a servicing agent to collect on the income producing 
assets and channel the payments to the appropriate class of securities. 
The funding rule is implicated when an expanded group member acquires 
securities of the SPV (or instruments of the disregarded entity treated 
as instruments of the SPV for federal tax purposes). This may occur in 
the normal course of the expanded group member's investment in 
portfolio securities. It may also occur when the expanded group member 
acquires the securities because the SPV cannot place them all with 
unrelated parties at the time of issuance. The comment stated that the 
rule is particularly problematic when the SPV is a member of a 
consolidated group that is itself the subsidiary of a foreign parent, 
and an expanded group member that is not a member of the consolidated 
group acquires the securities. In this case, a distribution by the 
common parent could be considered funded by the SPV's issuance of debt 
instruments acquired by related parties. The comment requested an 
exemption for such transactions because they are motivated by non-tax 
considerations and do not present the policy concerns underlying the 
proposed regulations.
    The proposed regulations do not adopt an exception for all 
securitization

[[Page 72918]]

transactions. The Treasury Department and the IRS have determined that 
related party debt issued as part of a securitization transaction 
presents the same general policy concerns as related-party debt issued 
in other contexts. This is because the proceeds from the sale of debt 
issued as part of a securitization transaction generally may be used to 
fund a distribution or acquisition. However, the final and temporary 
regulations adopt a number of exceptions for non-tax motivated 
transactions that provide relief to the transaction described in the 
comment. First, the final and temporary regulations adopt an exception 
for qualified dealer debt instruments acquired in the ordinary course 
of the dealer's business that are subsequently disposed of outside the 
expanded group. See Section F.1 of this Part V. Second, the final and 
temporary regulations do not apply to instruments issued by a foreign 
SPV. See Part III.A.1 of this Summary of Comments and Explanation of 
Revisions. Finally, the regulations continue to treat a consolidated 
group as a single corporation, such that the SPV will only be 
considered funded to the extent the securities are acquired by an 
expanded group member that is not part of the issuer's consolidated 
group. See Part III.A.2 of this Summary of Comments and Explanation of 
Revisions. To the extent such a funding occurs, the elimination of the 
cliff effect in the threshold exception also provides relief. See 
Section E.4 of this Part V. Accordingly, the final and temporary 
regulations do not provide special rules for the treatment of 
instruments issued as part of a securitization transaction, but do 
provide numerous new exceptions that will exclude many of these 
transactions.
6. Principal Motive of Tax Avoidance
    One comment recommended that proposed Sec.  1.385-3 be limited to 
debt issuances that have a principal motivation of tax avoidance. The 
comment does not elaborate on what type of transaction would constitute 
tax ``avoidance.''
    As discussed in Section A.1 of this Part V, the Treasury Department 
and the IRS have decided that consideration of whether a debt 
instrument issued to a member of the issuer's expanded group finances 
new investment is an appropriate determinative factor for whether a 
corporation-shareholder or debtor-creditor relationship exists. Such 
factor may exist regardless of whether a taxpayer is motivated 
principally by tax avoidance. Although the final and temporary 
regulations retain a principal purpose test as part of the funding 
rule, this test looks to whether the taxpayer intended for the debt 
issuance to fund a distribution or acquisition, rather than whether 
such transaction avoided tax. See Section D.2.e of this Part V.
G. Exceptions From Sec.  1.385-3 for Debt Instruments Issued by Certain 
Issuers
    The final and temporary regulations limit the application of the 
general rule and funding rule by excluding debt instruments issued by 
excepted regulated financial companies and regulated insurance 
companies from the definition of covered debt instruments.
1. Regulated Financial Groups
    Several comments requested that the proposed regulations be revised 
to exclude debt instruments issued by certain types of regulated 
financial institutions. Comments reasoned that financial institutions, 
whose core business is financial intermediation (such as the 
transmission of funds between lenders and borrowers), rely on 
intercompany loans to efficiently transfer funds among their 
affiliates, and therefore would be disproportionately affected by the 
proposed regulations. These comments also asserted that the supervision 
and regulation to which regulated financial institutions are subject 
significantly restricts their ability to engage in the types of 
transactions the proposed regulations are intended to address. 
Furthermore, the comments noted that certain regulatory and supervisory 
requirements mandate the issuance of intercompany debt and that it 
would be particularly burdensome for such debt to be subject to the 
proposed regulations. Comments in particular sought exceptions from the 
regulations for transactions that U.S. subsidiaries of foreign banks 
undertake to comply with the requirement adopted by the Board of 
Governors of the Federal Reserve System (Federal Reserve) that certain 
foreign banks reorganize their U.S. subsidiaries under a U.S. 
intermediate holding company. Comments also referred to the rules 
proposed by the Federal Reserve that would require U.S. subsidiaries of 
certain foreign banks to issue intercompany debt that could be used to 
facilitate a recapitalization of such subsidiaries in the event their 
intermediate holding company is in default or in danger of default. 
Comments recommended excluding companies described in, for example, 
section 954(h) or 904(d)(2)(C), or by reference to other provisions of 
U.S. law that describe financial entities subject to certain forms of 
federal regulation. Comments also recommended excluding certain 
transactions typically used to fund financial institutions subject to 
regulation, such as transactions of the type that are described in 
section 956(c)(2)(I) and (J).
    In response to these comments, the final and temporary regulations 
provide an exception to the definition of covered debt instrument in 
Sec.  1.385-3(g)(3) for covered debt instruments that are issued by an 
excepted regulated financial company. An excepted regulated financial 
company is defined in Sec.  1.385-3(g)(3)(iv) to mean a covered member 
that is a regulated financial company or a member of a regulated 
financial group.
    A regulated financial company is defined in Sec.  1.385-
3(g)(3)(iv)(A) by reference to certain types of financial institutions 
that are subject to specific regulatory capital or leverage 
requirements. The definition of regulated financial company is 
comprised of: Bank holding companies; certain savings and loan holding 
companies; insured depository institutions and any other national banks 
or state banks that are members of the Federal Reserve System; nonbank 
financial companies subject to a determination by the Financial 
Stability Oversight Council; certain U.S. intermediate holding 
companies formed by foreign banking organizations; Edge Act and 
agreement corporations; supervised securities holding companies; 
registered broker-dealers; futures commission merchants; swap dealers; 
security-based swap dealers; Federal Home Loan Banks; Farm Credit 
System institutions; and small business investment companies. The final 
and temporary regulations include exceptions for swap dealers and 
security-based swap dealers in anticipation of the adoption of final 
rules that would apply capital requirements to such entities.
    The Treasury Department and the IRS recognize that other types of 
companies are subject to various levels of regulation and supervision, 
including regulation designed to ensure the financial soundness of the 
company. However, the Treasury Department and the IRS have tailored the 
exception to regulated institutions that are subject to capital or 
leverage requirements because such requirements most directly constrain 
the ability of such institutions to engage in the transactions that are 
intended to be addressed by the final and temporary regulations. 
Although the specific requirements vary across the regulatory regimes 
identified in Sec.  1.385-3(g)(3)(iv)(A), in each case the regulatory 
regime imposes capital or leverage requirements that have the effect of 
limiting the extent to which a regulated company can increase the

[[Page 72919]]

amount of its debt. In contrast, institutions that are not subject to 
entity-specific capital or leverage requirements, such as certain types 
of savings and loan holding companies, are not eligible for the 
exception. Furthermore, the exception is tailored to focus on financial 
institutions that are financial intermediaries whose business 
activities require the efficient transfer of money among affiliates.
    In addition, certain financial institutions that are included in 
the definition of regulated financial company (specifically, those 
listed in Sec.  1.385-3(g)(3)(iv)(A)(1) through (10)) are subject to 
consolidated supervision with respect to the entire group, including 
consolidated capital or leverage requirements and supervision of all 
material subsidiaries. This degree of regulation and supervision 
generally places meaningful limits on the ability of subsidiaries to 
issue debt. The final and temporary regulations therefore also exclude 
from the definition of covered debt instrument debt instruments issued 
by any subsidiary of a regulated financial company that is listed in 
Sec.  1.385-3(g)(3)(iv)(A)(1) through (10), which includes bank holding 
companies and certain other types of banking organizations. With 
respect to these regulated financial companies, Sec.  1.385-
3(g)(3)(iv)(B) defines a regulated financial group to include the 
subsidiaries of the regulated financial company that would constitute 
members of an expanded group that had as its expanded group parent the 
regulated financial company. Therefore, if a regulated financial 
company is the expanded group parent of an expanded group, the entire 
expanded group constitutes a regulated financial group. On the other 
hand, if a regulated financial company is a non-parent member of an 
expanded group, then only the direct and indirect subsidiaries of such 
regulated financial company that are expanded group members constitute 
the regulated financial group.
    However, the Treasury Department and the IRS also have determined 
that certain subsidiaries of a bank holding company or savings and loan 
company that engage in a non-financial business should not be treated 
as part of a regulated financial group. Specifically, under Sec.  
1.385-3(g)(3)(iv)(B)(2), subsidiaries of a bank holding company or 
savings and loan holding company that are held pursuant to the 
complementary activities authority, merchant banking authority, or 
grandfathered commodities activities authority provided by sections 
4(k)(1)(B), 4(k)(4)(H), and 4(o) of the Bank Holding Company Act, 
respectively, are not treated as part of the bank holding company's or 
savings and loan holding company's regulated financial group. Such 
subsidiaries are engaged in non-financial businesses and have the same 
incentives as non-financial companies that are not subsidiaries of bank 
holding companies or savings and loan holding companies to use related-
party debt to generate significant federal tax benefits without having 
meaningful non-tax effects, and generally do not face significant 
regulatory restrictions on doing so. Therefore, it is appropriate to 
treat such non-financial subsidiaries comparably to non-financial 
companies that are not subsidiaries of bank holding companies or 
savings and loan holding companies.
    The final and temporary regulations do not provide a separate 
exception for debt issued to an excepted regulated financial company 
because entities included within the definition of an excepted 
regulated financial company generally are not subject to regulatory 
limits on their ability to lend. In any case, debt instruments issued 
by one member of a regulated financial group to another member of the 
group are excluded from the definition of covered debt instrument under 
the final and temporary regulations by virtue of being issued by an 
excepted regulated financial company.
2. Regulated Insurance Companies
    For reasons similar to those discussed in the immediately preceding 
section, the Treasury Department and the IRS have determined that debt 
instruments issued by insurance companies that are subject to risk-
based capital requirements under state law should be excluded from the 
definition of covered debt instrument. The Treasury Department and the 
IRS have determined that, similar to regulated financial companies, 
regulated insurance companies are subject to risk-based capital 
requirements and other regulation that mitigates the risk that they 
would engage in the types of transactions addressed by the final and 
temporary regulations.
    Therefore, the final and temporary regulations provide that a 
covered debt instrument does not include a debt instrument issued by a 
regulated insurance company. Section 1.385-3(g)(3)(v) defines a 
regulated insurance company as a covered member that is: (i) Subject to 
tax under subchapter L of chapter 1 of the Code; (ii) domiciled or 
organized under the laws of a state or the District of Columbia; (iii) 
licensed, authorized, or regulated by one or more states or the 
District of Columbia to sell insurance, reinsurance, or annuity 
contracts to persons other than related persons (within the meaning of 
section 954(d)(3)); and (iv) engaged in regular issuances of (or 
subject to ongoing liability with respect to) insurance, reinsurance, 
or annuity contracts with persons that are not related persons (within 
the meaning of section 954(d)(3)). In order to prevent a company from 
inappropriately qualifying as a regulated insurance company, the final 
and temporary regulations also provide that in no case will a 
corporation satisfy the licensing, authorization, or regulation 
requirements if a principal purpose for obtaining such license, 
authorization, or regulation was to qualify as a ``regulated insurance 
company'' under the final and temporary regulations.
    The last prong of the definition of ``regulated insurance company'' 
has the effect of not including within the exclusion certain captive 
insurance and reinsurance captive companies. Covered debt instruments 
issued by such companies are not excluded under the final and temporary 
regulations because captive insurers are not subject to risk-based 
capital requirements and are otherwise not subject to regulation and 
oversight to the same degree as other insurance and reinsurance 
companies.
    The Treasury Department and the IRS have not extended the regulated 
insurance company exception to other members of an insurance company's 
group that are not themselves regulated insurance companies. State 
insurance regulators only exercise direct authority over regulated 
insurance companies; such direct authority does not extend to other 
non-insurance entities within the group. Subsidiaries of insurance 
companies that are not themselves insurance companies are only subject 
to regulation indirectly through supervision of the affiliated 
insurance companies. Among other things, in contrast to a regulated 
financial group, such non-insurance subsidiaries and affiliates are 
generally not subject to consolidated capital requirements.
3. Instruments Issued In Connection With Certain Real Estate 
Investments and Other Capital Investment
    Comments expressed concern that a debt instrument that is treated 
as stock would not be treated as an interest ``solely as a creditor'' 
for purposes of determining whether the holder has an interest in a 
United States real property holding corporation (USRPHC) for purposes 
of sections 897 and 1445. Generally, a foreign corporation that 
disposes of stock of a domestic corporation is not subject to U.S. 
income tax on the gain realized upon

[[Page 72920]]

the sale. However, section 897(a) treats gains from the disposition of 
a United States real property interest (USRPI), which includes an 
interest in a USRPHC, as income that is effectively connected with a 
U.S. trade or business that is subject to tax under section 882(a)(1). 
A USRPHC is defined in section 897(c)(2) as any corporation more than 
50 percent of the fair market value of the business and real estate 
assets of which are USRPIs. Under section 897(c)(1)(A), an interest 
solely as a creditor in a domestic corporation does not constitute a 
USRPI. Under Sec.  1.897-1(d)(3)(i)(A), stock of a corporation is not 
an interest solely as a creditor.
    Comments requested that an instrument treated as stock under the 
proposed regulations nonetheless be considered to be an interest solely 
as a creditor for purposes of section 897(c)(1)(A). Alternatively, 
comments requested relief for a good faith failure to report and 
withhold under section 1445 with respect to a recharacterized 
instrument no longer considered to be an interest solely as a creditor. 
Comments also suggested that the proposed regulations would impact 
various ownership-based tests under section 897 (including whether a 
corporation constitutes a USRPHC and the application of certain 
exceptions to section 897) and lead to unexpected tax consequences. In 
particular, comments asserted that the proposed regulations could 
affect the application of the ``look-through'' rule in section 
897(c)(5), which could ultimately affect the treatment of unrelated 
persons with no control or knowledge of the recharacterized 
instruments.
    As discussed in Section B.1 of this Part V, the Treasury Department 
and the IRS have determined that an interest determined to be stock 
under the final and temporary regulations generally should be treated 
as stock for all federal tax purposes. Accordingly, the final and 
temporary regulations do not provide a special exception for purposes 
of section 897. The regulations are concerned with the use of related-
party indebtedness issued to an expanded group member that does not 
finance new investment in the operations of the issuer. These concerns 
are no less implicated in the case of debt issued by a domestic 
corporation investing in U.S. real estate that may be treated as a 
USRPHC as compared to any other domestic corporation.
    With respect to the application of the various ownership-based 
tests under section 897, including the look-through rule in section 
897(c)(5), to the extent any uncertainties exist, they do not arise 
uniquely as a result of the final and temporary regulations. Instead, 
such uncertainties would arise whenever purported debt instruments are 
characterized as stock under applicable common law. Section B.1 of this 
Part V illustrates other areas in which recharacterization, whether 
under the common law or under the final and temporary regulations, can 
impact the application of other Code provisions.
    The final and temporary regulations also do not adopt a special 
rule for purposes of withholding under section 1445 because Sec.  
1.1445-1(e) provides rules of general application for the failure to 
withhold under section 1445, and the application of the final and 
temporary regulations does not present unique issues in this regard. 
The concerns raised in comments related to transfers of USRPIs among 
members of an expanded group, which are, by definition, highly-related 
parties that should be able to determine whether a particular 
instrument has been recharacterized under the final and temporary 
regulations. Furthermore, any liability of the transferee will be 
potentially mitigated by Sec.  1.1445-1(e)(3), which provides that the 
transferee is relieved of liability to the extent the transferor 
satisfies its tax liability with respect to the transfer. If the 
instrument is sold outside the group, the disposition will not subject 
an unrelated person to liability under section 1445 (assuming the 
interest is an interest solely as a creditor in the hands of the 
unrelated person) because the deemed exchange described in Sec.  1.385-
3(d)(2) occurs immediately before the instrument leaves the group.
    A comment also requested an exception for qualified foreign pension 
funds described in section 897(l)(2), which generally allows such funds 
to invest in U.S. real estate without being subject to section 897. The 
comment reasoned that the effect of the regulations on interest 
deductibility could decrease the after-tax returns such funds receive 
on investments in U.S. infrastructure investments, resulting in 
decreased investment. Other comments cited similar concerns, with one 
comment recommending an exception for a newly defined infrastructure 
asset holding company and another comment recommending an exemption for 
debt tied to U.S. capital expenditure investment more broadly. The 
Treasury Department and the IRS decline to adopt these recommendations 
because the regulations are concerned in general about the creation of 
indebtedness that does not finance new investment, without regard to 
the identity of the ultimate beneficial owners of the expanded group, 
and without regard to the nature of a taxpayer's business.
H. Operating Rules
1. Timing Rules
    The proposed regulations provided that when a debt instrument is 
treated as stock under the funding rule, the debt instrument is treated 
as stock from the time 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. Comments recommended that this rule be modified such that a 
debt instrument cannot be treated as stock before the occurrence of the 
transaction that the debt instrument is treated as funding. Comments 
noted that the collateral consequences described in Section B.1 of this 
Part V (including the implications under section 368(c)) would be 
particularly burdensome in this context. Similarly, comments requested 
clarification that the timing rule did not cause a debt instrument that 
was repaid before the occurrence of a distribution or acquisition to be 
treated as funding that distribution or acquisition.
    The final and temporary regulations eliminate the timing rule under 
which a covered debt instrument that is treated as funding a 
distribution or acquisition that occurs later in the same year is 
treated as stock when the covered debt instrument is issued. As a 
result, when a covered debt instrument is treated as funding a 
distribution or acquisition that occurs later in the same year, or in a 
subsequent year, the covered debt instrument is recharacterized on the 
date of the later distribution or acquisition. Thus, when a covered 
debt instrument is repaid before a distribution or acquisition that the 
debt instrument might otherwise be treated as funding, the covered debt 
instrument is not recharacterized.
2. Covered Debt Instrument Treated as Stock That Leaves the Expanded 
Group
    In general, under proposed Sec.  1.385-3(d)(2), if a debt 
instrument treated as stock leaves the expanded group, either because 
the instrument is transferred outside the expanded group or because the 
holder leaves the 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 applying the general rule and funding rule. Comments recommended 
that, when the instrument is transferred outside the group, rules 
similar to the deemed

[[Page 72921]]

exchange rules of proposed Sec.  1.385-1(c) apply to the instrument 
treated as stock that is converted to debt upon sale outside the 
expanded group. Another comment suggested that the expanded group 
member disposing of the instrument be treated as selling stock under 
section 1001 and the acquirer treated as purchasing debt at an issue 
price determined as if the debt were respected as debt since issuance 
(that is, adjusting the actual purchase price to account for any 
accrued interest). Finally, a comment also requested a clarification 
that any stated interest that had accrued between the last payment date 
and the date of the deemed exchange should be considered a portion of 
the redemption price. As discussed in Part III.C of this Summary of 
Comments and Explanation of Revisions, the final and temporary 
regulations do not adopt these recommendations because there are 
detailed rules in sections 1273 and 1274 that describe how to determine 
issue price when a debt instrument is issued for stock. Moreover, the 
Treasury Department and the IRS are of the view that in the situation 
where a debt instrument treated as stock leaves the expanded group, 
treating that instrument as newly issued more appropriately reflects 
the characterization of the transaction in the final and temporary 
regulations.
    A comment also suggested removing the re-testing rule in the 
proposed regulations that required an issuer to re-test all outstanding 
debt instruments after a debt instrument treated as stock leaves the 
expanded group. The final and temporary regulations do not adopt this 
recommendation. The re-testing rule addresses a concern similar to that 
discussed in Section B.4 of this Part V, regarding when a debt 
instrument that is treated as stock is repaid in a transaction that is 
treated as a distribution for purposes of Sec.  1.385-3. In the context 
of a repayment of the recharacterized debt instrument, the Treasury 
Department and the IRS are concerned that, unless the repayment is 
treated as a distribution for purposes of the funding rule, the 
repayment could result in an inappropriate removal of a distribution or 
acquisition described in the general rule or funding rule from the 
funding rule. In the context of a transfer of the instrument outside of 
the expanded group, there is no repayment of the recharacterized debt 
instrument that would be treated as a distribution for purposes of the 
funding rule (although the recharacterized debt instrument is deemed 
redeemed when transferred outside the expanded group, proposed Sec.  
1.385-3(d)(2) disregarded that redemption for purposes of the funding 
rule). Nonetheless, there is a similar concern about an inappropriate 
removal of the underlying distribution or acquisition from the funding 
rule. Thus, the proposed regulations provided that, after a transfer of 
the instrument outside of the expanded group, the underlying 
distribution or acquisition that caused the disposed debt instrument to 
be treated as stock is re-tested against other debt instruments not 
already recharacterized as stock. See proposed Sec.  1.385-3(g)(3) 
Example 7. The final and temporary regulations clarify that this rule 
also applies to recharacterize later issued covered debt instruments 
that are within the per se period. Thus, this final rule provides that 
when a covered debt instrument treated as stock is transferred outside 
of the expanded group, the underlying distribution or acquisition that 
caused the disposed debt instrument to be treated as stock can cause 
any other covered debt instrument issued during the per se period to be 
treated as stock. The final and temporary regulations also apply this 
operating rule when a covered debt instrument treated as stock becomes 
a consolidated group debt instrument under Sec.  1.385-4T(c)(2).
    Another comment suggested that the re-testing rule should be 
limited to debt instruments issued in the 36 months before the re-
testing date because the re-testing rule could apply to a debt 
instrument issued many years before the disposition of the debt 
instrument treated as stock. The final and temporary regulations adopt 
this recommendation because it is consistent with the per se 
application of the funding rule as described in Section D.2 of this 
part V.
    The Treasury Department and the IRS considered an alternative 
approach that would more closely harmonize the rules for repayments and 
dispositions of debt instruments treated as stock by accepting the 
comment to eliminate the re-testing rule in Sec.  1.385-3(d)(2) when 
the instrument is transferred outside of the group and making a 
corresponding change to the funding rule to prevent inappropriate 
removal of a distribution or acquisition described in the general rule 
or funding rule. This alternative approach would require deeming a 
separate distribution that is subject to the funding rule. The Treasury 
Department and the IRS decline to make those changes because the net 
effect would extend the per se period.
3. Aggregate Treatment of Partnerships
a. Overview
    The legislative history of subchapter K of chapter 1 of the Code 
(subchapter K) 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). To prevent 
the avoidance of the application of the regulations through the use of 
partnerships, the proposed regulations adopted an aggregate approach to 
controlled partnerships.
    The proposed regulations provided that, for example, when a 
corporate member of an expanded group becomes a partner (an expanded 
group partner) in a partnership that is a controlled partnership with 
respect to the expanded group, the expanded group partner is treated as 
acquiring its proportionate share of the controlled partnership's 
assets and issuing its proportionate share of any debt instruments 
issued by the controlled partnership. For these purposes, the proposed 
regulations determined a partner's proportionate share in accordance 
with the partner's share of partnership profits.
    This aggregate treatment also applied to the recharacterization 
under proposed Sec.  1.385-3 of a debt instrument issued by a 
controlled partnership. Therefore, proposed Sec.  1.385-3 provided that 
the holder of a recharacterized debt instrument issued by a controlled 
partnership would be treated as holding stock in the expanded group 
partners rather than as holding an interest in the controlled 
partnership. The proposed regulations also required the partnership and 
its partners to make appropriate conforming adjustments to reflect this 
treatment. Comments raised concerns that neither section 385 nor the 
legislative history to section 385 suggests that Congress authorized 
regulations to determine the status of debt issued by a non-corporate 
entity and requested that any future regulations only apply to debt 
issued by corporations. Additionally, as described in Section H.4 of 
this Part V, comments expressed concern regarding the collateral 
consequences of treating a partnership instrument as stock of the 
expanded group partners under proposed Sec.  1.385-3.
    After considering the comments, the Treasury Department and the IRS 
have determined that it is necessary and

[[Page 72922]]

appropriate to adopt an aggregate approach to a controlled partnership 
in order to prevent the avoidance of the purposes of the final and 
temporary regulations through the use of a partnership. Thus, 
consistent with the longstanding practice of the Treasury Department 
and the IRS to apply aggregate treatment to partnerships and their 
partners when appropriate, and in accordance with the legislative 
history of subchapter K, the final and temporary regulations generally 
treat a controlled partnership as an aggregate of its partners in the 
manner described in the temporary regulations. However, in response to 
comments, the final and temporary regulations do not recharacterize 
debt issued by a partnership as equity under section 385. Instead, 
pursuant to the authority granted under section 7701(l) to 
recharacterize certain multi-party financing transactions, the 
temporary regulations deem the holder of a debt instrument issued by a 
partnership that otherwise would be subject to recharacterization 
(based on an application of the factors in Sec.  1.385-3 to the 
expanded group partners under the aggregate approach) as having 
transferred the debt instrument to the expanded group partner or 
partners in exchange for stock in the expanded group partner or 
partners.
    Sections H.3.b through d of this Part V, discuss the application of 
the aggregate approach to a controlled partnership for purposes of 
applying the rules in Sec.  1.385-3, both for purposes of determining 
when a debt instrument issued by an expanded group partner is treated 
as equity, as well as when a debt instrument issued by the controlled 
partnership that otherwise would be treated as equity under the 
aggregate approach should be subject to the deemed transfer. 
Specifically, Section H.3.b of this Part V discusses the aggregate 
approach to controlled partnerships generally; Section H.3.c of this 
Part V describes the extent to which an expanded group partner is 
treated as acquiring a controlled partnership's property for purposes 
of applying the rules in Sec.  1.385-3; and Section H.3.d of this Part 
V describes the rules for identifying the portion of a debt instrument 
issued by a controlled partnership that an expanded group partner is 
treated as issuing for purposes of applying the rules in Sec.  1.385-3. 
Section H.4 of this Part V explains that a debt instrument issued by a 
controlled partnership that otherwise would be treated, in whole or in 
part, as stock under Sec.  1.385-3 is instead deemed to be transferred, 
in whole or in part, by the holder to the expanded group partner or 
partners.
b. Determining Proportionate Share Generally
    Comments raised concerns regarding the proposed regulations' 
requirement to determine a partner's proportionate share based on the 
``partner's share of partnership profits,'' which applied equally to 
the determination of a partner's share of controlled partnership assets 
and the determination of a partner's share of a debt instrument issued 
by a controlled partnership. Comments requested clarity regarding the 
method for determining a partner's share of partnership profits, and 
asserted that the determination could be made in a number of different 
ways. In the context of a debt instrument issued by a controlled 
partnership, comments noted that determining a partner's proportionate 
share in accordance with its share of partnership profits may be 
inappropriate in certain cases, such as if a controlled partnership 
distributes borrowed funds on a non-pro rata basis to its partners, or 
if a minority partner guarantees a debt. Comments further asserted 
that, regardless of how a partner's ``proportionate share'' is 
determined, that share may fluctuate and rules should specify when the 
partner's proportionate share is determined.
    The temporary regulations continue to provide that, for purposes of 
applying the factors in Sec.  1.385-3 (as well as the rules of Sec.  
1.385-3T), an expanded group partner is treated as acquiring its share 
of property owned by a controlled partnership and as issuing its share 
of a debt instrument issued by a controlled partnership. Specifically, 
Sec.  1.385-3T(f)(2) provides rules for acquisitions of property by a 
controlled partnership, and Sec.  1.385-3T(f)(3) provides rules 
addressing the treatment of a debt instrument issued by a controlled 
partnership. Both sets of rules rely on a determination of a partner's 
``share'' of the controlled partnership's property or indebtedness. 
However, and as described in more detail in Section H.3.c and d of this 
Part V, ``share'' is defined differently for each purpose and, in 
response to comments, is no longer defined by reference to a partner's 
share of profits.
    When an expanded group partner is treated as acquiring a share of 
property owned by a controlled partnership or as issuing a share of a 
debt instrument issued by a controlled partnership, except as described 
in Section H.4 of this Part V, all parties apply the rules of Sec.  
1.385-3 as though the expanded group partner acquired the property or 
issued the debt instrument.
c. Partner's Proportionate Share of Controlled Partnership Property
    A member of an expanded group that is an expanded group partner on 
the date a controlled partnership acquires property (including expanded 
group stock, a debt instrument, or any other property) from another 
expanded group member is treated as acquiring its share of that 
property under Sec.  1.385-3T(f)(2)(i)(A). The covered member is 
treated as acquiring its share of the property from the transferor 
member in the manner (for example, in an exchange for property or an 
issuance), and on the date on which, the property is actually acquired 
by the controlled partnership from the transferor member. Thus, for 
example, if the controlled partnership acquires expanded group stock in 
exchange for property other than other expanded group stock, an 
expanded group partner is treated as making an acquisition described in 
Sec.  1.385-3(b)(3)(i)(B) (funding rule) to the extent of its share of 
the expanded group stock. Likewise, if a controlled partnership 
acquires a debt instrument issued by a covered member in a distribution 
by that covered member or a covered member distributes property to a 
controlled partnership, the covered member is treated as making a 
distribution described in Sec.  1.385-3(b)(2)(i) (general rule) or 
1.385-3(b)(3)(i)(A) (funding rule) to the extent of any expanded group 
partner's share of the distributed property.
    Section 1.385-3T(f)(2)(i)(C) provides that, if an expanded group 
partner transfers expanded group stock to the controlled partnership, 
the member is not treated as reacquiring (by reason of its interest in 
the controlled partnership) any of the expanded group stock it 
transferred. Thus, an expanded group partner will not be treated as 
acquiring expanded group stock that it already owned by reason of 
transferring that expanded group stock to a controlled partnership.
    Expanded group stock is the only kind of property a member of an 
expanded group is treated as acquiring if it becomes an expanded group 
partner after the controlled partnership acquired the property. Under 
Sec.  1.385-3T(f)(2)(ii)(A), a member of an expanded group that becomes 
an expanded group partner when the controlled partnership already owns 
expanded group stock generally is treated, on the date the member 
becomes an expanded group partner, as acquiring its share of the 
expanded group stock owned by the controlled partnership from an

[[Page 72923]]

expanded group member in exchange for property other than expanded 
group stock. Thus, subject to an exception described in this paragraph, 
the member is treated as making an acquisition described in Sec.  
1.385-3(b)(3)(i)(B) (funding rule) to the extent of its share of the 
expanded group stock owned by the controlled partnership, regardless of 
how the controlled partnership acquired that expanded group stock. This 
approach avoids the complexity of attempting to trace the acquisition 
of expanded group stock to certain transferors for certain 
consideration depending on whether the partnership interest was 
acquired by contribution or transfer. Section 1.385-3T(f)(2)(ii)(C) 
provides an exception to this general rule whereby a member of an 
expanded group that acquires an interest in a controlled partnership, 
either from another partner in exchange solely for expanded group stock 
or upon a contribution to the controlled partnership comprised solely 
of expanded group stock, is not treated as acquiring expanded group 
stock owned by the controlled partnership, so that Sec.  1.385-
3(b)(3)(i)(B) will not apply.
    In response to comments regarding the use of a ``partner's share of 
partnership profits'' to identify a partner's share of property, the 
temporary regulations provide that a partner's share of property 
acquired by a controlled partnership, including expanded group stock 
acquired by a controlled partnership before the member of the expanded 
group became an expanded group partner, is determined in accordance 
with the partner's liquidation value percentage. Pursuant to Sec.  
1.385-3T(g)(17), a partner's liquidation value percentage in a 
controlled partnership (which can include a partnership that is owned 
indirectly through one or more partnerships) is the ratio (expressed as 
a percentage) of the liquidation value of the expanded group partner's 
interest in the partnership divided by the aggregate liquidation value 
of all the partners' interests in the partnership. The liquidation 
value of an expanded group partner's interest in a partnership is the 
amount of cash the partner would receive with respect to the interest 
if the partnership sold all of its property for an amount of cash equal 
to the fair market value of the property (taking into account section 
7701(g)), satisfied all of its liabilities (other than those described 
in Sec.  1.752-7), paid an unrelated third party to assume all of its 
Sec.  1.752-7 liabilities in a fully taxable transaction, and then the 
partnership (and any partnership through which the partner indirectly 
owns an interest in the controlled partnership) liquidated.
    The Treasury Department and the IRS also agree with comments that 
the regulations should set forth a specific time for determining a 
partner's share of property owned by a controlled partnership. 
Therefore, if an expanded group member is an expanded group partner on 
the date the controlled partnership acquires property, then, under 
Sec.  1.385-3T(f)(2)(i)(B), the liquidation value percentage is 
determined on the date the controlled partnership acquires the 
property. Otherwise, under Sec.  1.385-3T(f)(2)(ii)(B), liquidation 
value percentage is determined on the date the expanded group member 
becomes an expanded group partner in the controlled partnership.
    The Treasury Department and the IRS determined that using 
liquidation value percentage in this context, as opposed to the test 
based on capital and profits that is used for purposes of identifying a 
controlled partnership, is appropriate because the two tests are being 
used for different purposes. On the one hand, the determination of 
whether a partnership is a controlled partnership is a threshold-based 
control determination. Thus, while there may be uncertainty as to 
ownership percentages at the margins, that uncertainty is outweighed by 
the appropriateness of using a partner's share of profits as one proxy 
for control. On the other hand, in identifying a partner's share of a 
controlled partnership's property, the precision afforded by using 
liquidation value percentage is appropriate because the test is 
intended to arrive at a specific amount of the property the partner is 
treated as acquiring.
d. Partner's Proportionate Share of Controlled Partnership Indebtedness
    Comments recommended alternative approaches to determining a 
partner's proportionate share of a debt instrument issued by a 
controlled partnership, including determining the partner's 
proportionate share by applying principles under section 752, by 
reference to the partners' capital accounts, or by reference to a 
partner's liquidation value percentage as defined in proposed Sec.  
1.752-3(a)(3) (relating to the determination of a partner's share of 
nonrecourse liabilities). Alternatively, comments suggested providing 
such methods as safe harbors. One comment suggested that the 
regulations adopt a rule similar to the tracing rule in Sec.  1.707-
5(b)(2)(i) (relating to debt-financed distributions) for determining a 
partner's share of a partnership liability.
    The Treasury Department and the IRS have determined that an 
approach based on a partner's anticipated allocations of the 
partnership's interest expense is better tailored to the purposes of 
the temporary regulations. Like the proposed regulations, Sec.  1.385-
3T(f)(3)(i) provides that, for purposes of applying Sec. Sec.  1.385-3 
and 1.385-3T, an expanded group partner is treated as the issuer with 
respect to its share of a debt instrument issued by a controlled 
partnership. Thus, for example, the determination of whether a debt 
instrument is a covered debt instrument is made at the partner level. 
Section 1.385-3T(f)(3)(ii)(A) provides that an expanded group partner's 
share of a covered debt instrument is determined in accordance with the 
partner's issuance percentage. A partner's issuance percentage is 
defined in Sec.  1.385-3T(g)(16) as the ratio (expressed as a 
percentage) of the partner's reasonably anticipated distributive share 
of all the partnership's interest expense over a reasonable period, 
divided by all of the partnership's reasonably anticipated interest 
expense over that same period, taking into account all the relevant 
facts and circumstances. This approach is premised, in part, on the 
fungible nature of interest expense. The Treasury Department and the 
IRS have determined that this rule should, in most cases over time, 
appropriately match the interest income that an expanded group partner 
will be deemed to receive under the rules described in Section H.4 of 
this Part V with respect to the portion of a debt instrument issued by 
a partnership that otherwise would be treated as stock under an 
aggregate application of Sec.  1.385-3, with a partner's allocations of 
partnership interest expense.
    The Treasury Department and the IRS also agree with comments that 
the temporary regulations should set forth the specific time for 
determining a partner's share of a debt instrument issued by a 
controlled partnership. Accordingly, Sec.  1.385-3T(f)(3)(ii)(A) 
provides that an expanded group partner's share of a debt instrument is 
determined on each date on which the partner makes a distribution or 
acquisition described in Sec.  1.385-3(b)(2) or 1.385-3(b)(3)(i). Given 
that a partner's issuance percentage is a forward-looking facts and 
circumstances determination and that it may need to be determined on 
different dates, a partner's issuance percentage may be different from 
one date to another depending on whether the facts and

[[Page 72924]]

circumstances have changed between determinations.
    The exception to the funding rule for qualified short-term debt 
instruments is applied at the partnership level by treating the 
partnership as the issuer of the relevant debt instruments. This is an 
exception to the general rule that, for purposes of applying Sec. Sec.  
1.385-3 and 1.385-3T, an expanded group partner is treated as issuing 
its share of a debt instrument issued by a controlled partnership to a 
member of the expanded group. Thus, for example, in applying the 
specified current assets test, one looks to the amount of specified 
current assets reasonably expected to be reflected on the partnership's 
balance sheet as a result of transactions in the ordinary course of the 
partnership's business.
4. Treatment of Recharacterized Partnership Instrument
a. Comments on Recharacterization Approach of Proposed Regulations
    Comments requested clarification regarding the treatment of a 
partnership instrument recharacterized as stock of the expanded group 
partners under proposed Sec.  1.385-3. A number of comments pointed out 
a variety of seemingly unintended consequences of the approach taken in 
the proposed regulations. Those consequences arose under, among other 
provisions, Sec.  1.337(d)-3T; sections 707, 752, and the regulations 
thereunder; the fractions rule under section 514(c)(9)(E); rules 
regarding tax credits; and rules regarding the capitalization of 
interest expense into cost of goods sold.
    Some comments noted that the approach in the proposed regulations 
could lead to collateral consequences for non-expanded group partners 
in a controlled partnership. Comments requested clarity regarding the 
``appropriate conforming adjustments'' required to reflect the 
recharacterization of debt issued by a partnership and further noted 
that the relationship between the partnership and the expanded group 
partners deemed to issue stock to the funding member could affect 
allocations of partnership items of income, gain, loss, deduction, and 
credit among partners, which could have economic consequences. Comments 
also asked whether the terms of additional partnership interests issued 
under the proposed regulations' recharacterization rule would be 
identical to the terms of the recharacterized indebtedness. One comment 
requested that the proposed regulations be revised to permit 
partnerships to adjust the basis of partnership property without regard 
to the rules of Sec.  1.754-1(b) (relating to the time for making a 
section 754 election to adjust basis of partnership property) when gain 
is recognized as a result of the section 385 regulations. A comment 
requested clarification of the tax consequences when a partnership pays 
interest and principal on purported debt that has been recharacterized 
as stock. Finally, comments asserted that the equity interest in the 
partnership that a partner necessarily would receive as a result of the 
``appropriate adjustments'' upon a recharacterization of a 
partnership's debt instrument could be viewed as an interest that gives 
rise to guaranteed payments, which would result in the partnership 
allocating deductions to its partners.
    Several similar comments suggested an alternative approach to the 
recharacterization of a partnership's debt instrument. Those comments 
all essentially suggested that the proposed regulations be revised to 
provide that, upon an event that otherwise would result in the 
partnership's debt instrument being treated as equity, in lieu of 
recharacterizing the debt instrument, the expanded group member that 
holds the debt instrument be deemed to contribute its receivable to the 
expanded group partner or partners that made, or were treated as making 
under the aggregate approach, the distribution or acquisition that gave 
rise to the potential recharacterization of the debt instrument (deemed 
conduit approach). The comments asserted that this deemed conduit 
approach would result in interest income from the receivable offsetting 
the interest deductions from the partnership's debt obligation that 
would be allocated to the expanded group partner or partners that made 
(or were treated as making) the distribution or acquisition that 
otherwise would give rise to the recharacterization of the debt 
instrument. Additionally, the comments asserted that, because this 
deemed conduit approach would not require the ``appropriate conforming 
adjustments'' required by the proposed regulations, the deemed conduit 
approach would mitigate nearly all of the collateral consequences 
previously described regarding the proposed regulations.
    In response to these comments, the temporary regulations adopt the 
deemed conduit approach. The Treasury Department and the IRS agree with 
comments that this approach should alleviate nearly all of the 
collateral consequences the comments identified. The Treasury 
Department and the IRS also agree with comments that this approach 
should effectively match interest income with interest expense where 
appropriate, thus addressing the policy concerns set forth in the 
proposed regulations and in this preamble. Moreover, section 7701(l) 
provides ample authority for the deemed conduit approach. The adoption 
of the deemed conduit approach renders many of the other comments 
received with respect to the application of the proposed regulations to 
partnerships moot.
b. General Framework for Deemed Conduit Approach
    The first step in applying the deemed conduit approach is to 
determine the portion of a debt instrument that is treated as issued by 
an expanded group partner and that otherwise would be treated as stock 
under the aggregate approach to applying Sec.  1.385-3(b) (specified 
portion). Section 1.385-3T(f)(4)(i) then provides that, instead of 
treating the specified portion as stock, the holder-in-form of the debt 
instrument is deemed to transfer a portion of the debt instrument 
(deemed transferred receivable) with a principal amount equal to the 
adjusted issue price of the specified portion to the expanded group 
partner (deemed holder) in exchange for stock in the expanded group 
partner (deemed partner stock). This transaction is called a ``deemed 
transfer.'' Any portion of a debt instrument issued by a controlled 
partnership that is not deemed transferred is a ``retained receivable'' 
in the hands of the holder. Because the holder-in-form of the debt 
instrument is deemed to transfer the deemed transferred receivable, if 
a specified portion is created at a time when another specified portion 
exists, only all or a portion of the retained receivable is deemed to 
be transferred to the deemed holder. This rule prevents a later 
distribution or acquisition described in Sec.  1.385-3(b)(2) or 1.385-
3(b)(3)(i) from causing a deemed transferred receivable that was 
previously deemed to be transferred to an expanded group partner from 
being deemed to be transferred again when there is a new specified 
portion with respect to a covered debt instrument. The deemed transfer 
is treated as occurring for all federal tax purposes, although there 
are special rules under Sec.  1.385-3(d)(7) for purposes of section 
1504(a) (determining whether a corporation is a member of an affiliated 
group) and under Sec.  1.385-3T(f)(4)(vi) for purposes of section 752 
(allocating partnership liabilities). The special rules regarding 
section 752 are described in more detail in Section H.4.c of this Part 
V.
    An expanded group partner that is treated as issuing part of a 
covered debt

[[Page 72925]]

instrument issued by a controlled partnership can have a specified 
portion because it actually makes a distribution or acquisition 
described in Sec.  1.385-3(b)(2) or 1.385-3(b)(3)(i), or is treated 
under the aggregate approach as acquiring expanded group stock the 
controlled partnership owns or acquires.
    Defining an expanded group partner's specified portion by reference 
to the portion of the expanded group partner's share of a covered debt 
instrument that would be treated as stock under Sec.  1.385-3(b) 
ensures that the principal amount of the deemed transferred receivable 
will never exceed the lesser of (i) the expanded group partner's share 
of a covered debt instrument, and (ii) the amount of the distribution 
or acquisition described in Sec.  1.385-3(b)(2) or 1.385-3(b)(3)(i) the 
expanded group partner made or was treated as making.
    The Treasury Department and the IRS agree with comments that the 
terms of stock deemed to exist as a result of section 385 applying to a 
debt instrument issued by a partnership along with the consequences of 
payments with respect to such an instrument should be clear. Section 
1.385-3T(f)(4)(iv)(A) provides that the deemed partner stock generally 
has the same terms as the deemed transferred receivable. Section 1.385-
3T(f)(4)(iv)(B) provides that when a payment is made with respect to a 
debt instrument issued by a controlled partnership for which there is 
one or more deemed transferred receivables, then, if there is no 
retained receivable held by the holder of the debt instrument and a 
single deemed holder is deemed to hold all of the deemed transferred 
receivables, the entire payment is allocated to the deemed transferred 
receivables held by the single deemed holder. Otherwise, if there is a 
retained receivable held by the holder of the debt instrument or there 
are multiple deemed holders of deemed transferred receivables, or both, 
the payment is apportioned among the retained receivable, if any, and 
each deemed transferred receivable in proportion to the principal 
amount of all the receivables. The portion of a payment allocated or 
apportioned to a retained receivable or a deemed transferred receivable 
reduces the principal amount of, or accrued interest with respect to, 
such item as applicable under general federal tax principles depending 
on the payment. When a payment allocated or apportioned to a deemed 
transferred receivable reduces the principal amount of the receivable, 
the expanded group partner that is the deemed holder with respect to 
the deemed transferred receivable is deemed to redeem the same amount 
of the deemed partner stock, and the specified portion with respect to 
the debt instrument is reduced by the same amount. When a payment 
allocated or apportioned to a deemed transferred receivable reduces 
accrued interest with respect to the receivable, the expanded group 
partner that is the deemed holder with respect to the deemed 
transferred receivable is deemed to make a matching distribution in the 
same amount with respect to the deemed partner stock. The controlled 
partnership is treated as the paying agent with respect to the deemed 
partner stock.
    It would be necessary to determine an expanded group partner's 
share of a debt instrument after a deemed transfer if there is a 
retained receivable and the expanded group partner makes or is treated 
as making a distribution or acquisition described in Sec.  1.385-
3(b)(2) or 1.385-3(b)(3)(i). In that case, under Sec.  1.385-
3T(f)(3)(ii)(B)(1), the expanded group partner's share of a debt 
instrument (determined as of the time of the subsequent distribution or 
acquisition) is reduced, but not below zero, by the sum of all of the 
specified portions, if any, with respect to the debt instrument that 
correspond to one or more deemed transferred receivables that are 
deemed to be held by the partner. That is, the creation of a deemed 
transferred receivable does not change the total amount of a debt 
instrument for which expanded group partners must be assigned shares, 
but it does reduce a particular partner's share of the debt instrument 
that can result in a subsequent deemed transferred receivable to that 
partner. If an expanded group partner's issuance percentage on the 
later testing date is lower than it was on the original testing date, 
it is possible that the expanded group partner's share of the covered 
debt instrument cannot be reduced by the entire amount of the expanded 
group partner's specified portion without reducing that expanded group 
partner's share below zero. In that case, under Sec.  1.385-
3T(f)(3)(ii)(B)(2), the other partners' shares of the covered debt 
instrument are reduced proportionately. Reducing a partner's share of a 
debt instrument for this purpose does not affect the amount of any 
specified portion with respect to that partner with respect to prior 
deemed transfers or any deemed transferred receivable previously deemed 
transferred. Under these rules, it is impossible for the partners' 
aggregate shares of a covered debt instrument to exceed the adjusted 
issue price of the covered debt instrument reduced by any specified 
portions of that debt instrument, and therefore, the maximum principal 
amount of all deemed transferred receivables with respect to a covered 
debt instrument will never exceed the adjusted issue price of the 
covered debt instrument.
c. Special Rules
    In response to comments regarding the treatment of debt instruments 
actually held by an expanded group partner, Sec.  1.385-3T(f)(4)(ii) 
provides that, if a specified portion is with respect to an expanded 
group partner that is the holder-in-form of a debt instrument, then the 
deemed transfer described in Section H.4.b of this Part V does not 
occur with respect to that partner and that debt instrument is not 
treated as stock. Similarly, Sec.  1.385-3T(f)(6) provides more broadly 
that as long as no partner deducts or receives an allocation of expense 
with respect to the debt instrument, a debt instrument issued by an 
expanded group partner to a controlled partnership and a debt 
instrument issued by a controlled partnership to an expanded group 
partner are not subject to the rules in Sec.  1.385-3T(f).
    Section 1.385-3T(f)(5) provides rules for events that could affect 
the ownership of a deemed transferred receivable. These events are 
called ``specified events.'' Under Sec.  1.385-3T(f)(5)(iii), a 
specified event includes the following: (A) The controlled partnership 
that is the issuer of the debt instrument either ceases to be a 
controlled partnership or ceases to have an expanded group partner that 
is a covered member; (B) the holder-in-form is a member of the expanded 
group immediately before the transaction, and the holder-in-form and 
the deemed holder cease to be members of the same expanded group for 
the reasons described in Sec.  1.385-3(d)(2); (C) the holder-in-form is 
a controlled partnership immediately before the transaction, and the 
holder-in-form ceases to be a controlled partnership; (D) the expanded 
group partner that is both the issuer of deemed partner stock and the 
deemed holder transfers (directly or indirectly through one or more 
partnerships) all or a portion of its interest in the controlled 
partnership to a person that neither is a covered member nor a 
controlled partnership with an expanded group partner that is a covered 
member; (E) the expanded group partner that is both the issuer of 
deemed partner stock and the deemed holder transfers (directly or 
indirectly through one or more partnerships) all or a portion of its 
interest in the controlled partnership to a covered member or a

[[Page 72926]]

controlled partnership with an expanded group partner that is a covered 
member; (F) the holder-in-form transfers the debt instrument (which is 
disregarded for federal tax purposes) to a person that is neither a 
member of the expanded group nor a controlled partnership.
    Under Sec.  1.385-3T(f)(5)(i), in the case of any specified event, 
immediately before the specified event, the expanded group partner that 
was deemed to issue the deemed partner stock is deemed to distribute 
the deemed transferred receivable to the holder of the deemed partner 
stock in redemption of the deemed partner stock. If the specified event 
is that the expanded group partner transfers all or a portion of its 
partnership interest to a covered member or a controlled partnership 
with an expanded group partner that is a covered member, then under 
Sec.  1.385-3T(f)(5)(ii), the holder of the deemed partner stock is 
deemed to retransfer the deemed transferred receivable to the 
transferee expanded group partner. In all cases, the redemption of the 
deemed partner stock is disregarded for purposes of testing whether 
there has been a funded distribution or acquisition. However, under 
Sec.  1.385-3(d)(2), all other debt instruments of the expanded group 
partner 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 resulted in the deemed 
transfer.
    Under Sec.  1.385-3T(f)(4)(v), a transfer of the debt instrument, 
which after a deemed transfer is disregarded for federal tax purposes 
in whole or in part, to a member of the expanded group or to a 
controlled partnership is not a specified event. Such transfers are 
excluded from the definition of specified event because all specified 
events result in deemed partner stock being redeemed for the deemed 
transferred receivable, which is unnecessary when the debt instrument 
(as opposed to an interest in the controlled partnership) is 
transferred to a member of the expanded group or a controlled 
partnership. It is consistent with the rules contained in Sec.  1.385-
3T(f) that an expanded group partner continue to own a deemed 
transferred receivable after the transfer of the debt instrument to a 
member of the expanded group or a controlled partnership. Therefore, 
upon such a transfer, the deemed partner stock is not redeemed for the 
deemed transferred receivable and instead the holder is deemed to 
transfer the retained receivable and the deemed partner stock to the 
transferee.
    Finally, Sec.  1.385-3T(f)(4)(iii) provides specificity on who is 
deemed to receive a receivable if one or more expanded group partners 
are a member of a consolidated group. That section generally provides 
that the holder of a debt instrument is deemed to transfer the deemed 
transferred receivable or receivables to the expanded group partner or 
partners that are members of a consolidated group that make, or are 
treated as making (under Sec.  1.385-3T(f)(2)) the regarded 
distributions or acquisitions (within the meaning of Sec.  1.385-
4T(e)(5)) described in Sec.  1.385-3(b)(2) or (b)(3)(i) in exchange for 
deemed partner stock in such partner or partners. To the extent those 
distributions or acquisitions are made by a member of the consolidated 
group that is not an expanded group partner, the holder-in-form is 
treated as transferring a portion of the deemed transfer receivable to 
each member of the consolidated group that is an expanded group partner 
ratably as described in Sec.  1.385-3T(f)(4)(iii).
d. Remaining Collateral Consequences
    Comments raised certain additional consequences that the deemed 
conduit approach does not mitigate.
    Comments noted that the proposed regulations could have reduced the 
debt a partnership was treated as issuing, and therefore reduced a 
partner's share of partnership liabilities under section 752. This 
reduction would be considered a distribution of money to the partner, 
which could be in excess of the partner's adjusted tax basis in its 
partnership interest and thereby result in gain recognition under 
section 731(a). The deemed conduit approach does not reduce the debt a 
partnership is treated as issuing, but does cause one or more partners 
to be deemed to be the holder of the debt. Causing a partner to be the 
holder of partnership debt, absent a special rule, could result in the 
liability being reallocated among the partners under Sec.  1.752-
2(c)(1). Under Sec.  1.752-2(a), a partner's share of a recourse 
partnership liability equals the portion of that liability, if any, for 
which the partner or a related person bears the economic risk of loss. 
Section 1.752-2(c)(1) generally provides that a partner bears the 
economic risk of loss for a partnership liability to the extent that 
the partner makes a nonrecourse loan to the partnership. If the partner 
who is deemed to own a deemed transferred receivable was not previously 
allocated all of the partnership liability represented by the deemed 
transferred receivable, the creation of a deemed transferred receivable 
can result in a reallocation of the partnership liability. This 
reallocation of the partnership liability raises a concern similar to 
that raised regarding the proposed regulations, but it is not the 
result of debt being treated as equity. This consequence only results 
from the application of these temporary regulations. For that reason, 
Sec.  1.385-3T(f)(4)(vi) provides that a partnership liability that is 
a debt instrument with respect to which there is one or more deemed 
transferred receivables is allocated for purposes of section 752 
without regard to any deemed transfer. Section 1.752-2(c)(3) contains a 
cross-reference to this rule.
    Comments also noted that the proposed regulations could have 
resulted in partners recognizing gain under Sec.  1.337(d)-3T. 
Generally, the proposed regulations could cause a corporate partner to 
recognize gain when a transaction has the effect of the corporate 
partner acquiring or increasing an interest in its own stock in 
exchange for appreciated property. For this purpose, stock of a 
corporate partner includes stock of a corporation that controls the 
corporate partner within the meaning of section 304(c), except that 
section 318(a)(1) and (3) shall not apply. The final and temporary 
regulations do not provide an exception to the application of Sec.  
1.337(d)-3T where a debt instrument held by a partnership is 
recharacterized as stock because the Treasury Department and the IRS do 
not agree that an instrument recharacterized under the final and 
temporary regulations should be treated differently for purposes of 
section 337(d) than an instrument recharacterized under common law. 
Likewise, neither the final nor the temporary regulations provide an 
exception where debt issued by a subsidiary of a partnership results in 
that subsidiary controlling a corporate partner because Treasury and 
the IRS have determined that such an event that would result in gain 
recognition under Sec.  1.337(d)-3T is not likely to occur often.
    Finally, comments asked about the interaction of the regulations 
with future partnership audit procedures under section 1101 of the 
Bipartisan Budget Act of 2015, Public Law 114-74. Because the 
regulations under this new partnership audit regime are under 
development, it is not possible to address this comment at this time.
5. Disregarded Entities
    Comments requested that the treatment of debt instruments and EGIs 
issued by disregarded entities under proposed Sec. Sec.  1.385-2 and 
1.385-3 be conformed. As noted in Part IV.A.4 of

[[Page 72927]]

this Summary of Comments and Explanation of Revisions, the final and 
temporary regulations modify the rules in Sec.  1.385-2 to generally 
conform those rules to the treatment of a debt instrument issued by a 
disregarded entity under the temporary Sec.  1.385-3 regulations.
    Proposed Sec.  1.385-3(d)(6) provided that if a debt instrument of 
a disregarded entity was treated as stock under proposed Sec.  1.385-3, 
the debt instrument would be treated as stock in the entity's owner 
rather than as an equity interest in the entity. Comments requested 
clarity regarding the mechanical recharacterization of an interest in a 
disregarded entity, particularly if the disregarded entity is owned by 
a partnership. Consistent with the proposed regulations, the temporary 
regulations generally provide that a covered debt instrument issued by 
a disregarded entity will not be treated as an equity interest in the 
entity. The final and temporary regulations also provide that, to the 
extent that a covered debt instrument issued by a disregarded entity 
would be treated as stock under the final and temporary regulations, 
then, rather than treat the covered debt instrument as stock, the 
covered member that is the regarded owner of the disregarded entity is 
deemed to issue its stock. For purposes of the final and temporary 
regulations, if the covered debt instrument otherwise would have been 
treated as stock under the general rule, then the covered member is 
deemed to issue its stock to the expanded group member to which the 
covered debt instrument was, in form, issued (or transferred) in the 
relevant general rule transaction. If the covered debt instrument 
otherwise would have been treated as stock under the funding rule, then 
the covered member is deemed to issue its stock to the holder of the 
covered debt instrument in exchange for the covered debt instrument. In 
each case, the covered member that is the regarded owner of the 
disregarded entity is treated as the owner of a debt instrument issued 
by the disregarded entity.
    This rule must be applied in a manner that is consistent with the 
principles of Sec.  1.385-3T(f)(4). Thus, for example, stock deemed 
issued by the covered member that is the regarded owner of the 
disregarded entity is deemed to have the same terms as the covered debt 
instrument issued by the disregarded entity, other than the identity of 
the issuer, and payments on the stock are determined by reference to 
payments made on the debt instrument issued by the disregarded entity. 
Under the rules in Sec.  1.385-3T(d)(4), if the regarded owner of a 
disregarded entity is a controlled partnership, then Sec.  1.385-3T(f) 
applies as though the controlled partnership were the issuer in form of 
the debt instrument. Thus, a debt instrument issued by a disregarded 
entity owned by a controlled partnership will generally not be, for 
purposes of the final and temporary regulations, treated as issued by 
the disregarded entity or the controlled partnership, and any 
recharacterization of a covered debt instrument as stock required by 
the final and temporary regulations will happen at the partner level.
6. Withholding Under Section 1441
    One comment requested that a paying agent that does not have actual 
knowledge that a purported debt instrument is treated as stock be 
exempt from liability under section 1441 for a failure to withhold on a 
distribution with respect to the recharacterized stock. The final and 
temporary regulations do not address this concern because the 
determination of whether a payment is subject to withholding requires a 
withholding agent to make a number of factual determinations. These 
determinations are not limited to whether an instrument is debt or 
equity. The uncertainties that may arise in making those determinations 
are generally addressed in Sec. Sec.  1.1441-2, 1.1441-3, and 1.1441-7. 
Accordingly, the final and temporary regulations do not adopt 
additional exemptions from liability under chapter 3 for covered debt 
instruments.
I. Anti-Abuse and Affirmative Use
1. Anti-Abuse Rule
a. In General
    Comments recommended that the anti-abuse rule in proposed Sec.  
1.385-3(b)(4) be narrowed to apply to transactions only if a principal 
purpose of the transaction is the avoidance of the purposes of the 
regulations (rather than the avoidance of the ``application'' of the 
regulations). The final and temporary regulations adopt the 
recommendation and provide that the anti-abuse rule in Sec.  1.385-
3(b)(4) applies if a member of an expanded group enters into a 
transaction with a principal purpose of avoiding the purposes of Sec.  
1.385-3 or Sec.  1.385-3T.
    Comments recommended that the anti-abuse rule be narrowed to apply 
only if ``the'' principal purpose (rather than ``a'' principal purpose) 
is the avoidance of the purposes of the regulations. This 
recommendation is not adopted because the Treasury Department and the 
IRS have determined that the anti-abuse rule should apply when a 
principal purpose of a transaction is to avoid the purposes of Sec.  
1.385-3 or Sec.  1.385-3T, even if a taxpayer can establish that it 
also had other principal purposes for the transaction. In particular, 
it is often difficult for the IRS to establish that any one purpose was 
more or less motivating than another. The requirement that the purpose 
be a ``principal'' purpose serves as a sufficient limitation such that 
the rule should only apply in appropriate cases. In addition, the use 
of ``a'' principal purpose as part of an anti-abuse rule is standard 
administrative practice and is consistent with other recent 
regulations. See Sec. Sec.  1.304-4(b); 1.956-1T(b)(4).
    Comments also suggested that, if the anti-abuse rule applies, it 
should result in the instrument being subject to the regulations, 
rather than in the instrument automatically being recharacterized as 
stock. The Treasury Department and the IRS decline to accept this 
recommendation because of the administrative complexity that would be 
involved in applying the general rule and funding rule to transactions 
that are, in form, not subject to these rules due to structuring 
undertaken by the taxpayer to intentionally avoid their application.
    Comments also requested that the anti-abuse rule be clarified in 
several respects to provide increased certainty, and that examples be 
provided of the types of transactions that are considered abusive. In 
addition, comments requested various specific exclusions from the anti-
abuse rule. The Treasury Department and the IRS decline to provide new 
limitations on the anti-abuse rule. While it is intended that the anti-
abuse rule will be applicable in cases of avoidance transactions, as 
opposed to routine transactions that happen to achieve a particular 
result, the anti-abuse rule must retain the flexibility to address 
transactions that circumvent the purposes of the final and temporary 
regulations in ways that were unexpected when the regulations were 
issued.
    The proposed regulations contained a non-exhaustive list of the 
types of transactions that could implicate the anti-abuse rule, and the 
preamble to the proposed regulations described other transactions that 
could be relevant. The final and temporary regulations include the same 
transactions listed in the proposed regulations that could implicate 
the anti-abuse rule and add additional transactions with which the 
Treasury Department and the IRS are concerned. The final and temporary

[[Page 72928]]

regulations also reorganize the anti-abuse rule to clarify that the 
principal purpose element is relevant both to issuances of a debt 
instrument as well as other transactions (including distributions or 
acquisitions); examples of both are provided. The examples listed in 
Sec.  1.385-3(b)(4)(i) and (ii) are illustrative and do not constitute 
a mutually exclusive list of the types of transactions that could 
implicate the anti-abuse rule.
b. Requested Clarifications to and Exclusions From the Anti-Abuse Rule
i. Debt Between Unrelated Parties
    Comments specifically requested clarification that the anti-abuse 
rule would not apply to bona fide debt between unrelated parties 
(provided that neither party is acting as a conduit or agent for a 
related party) while the loan is held by the unrelated party. In 
addition, comments requested clarification that guaranteed loans are 
not subject to the anti-abuse rule. In particular, one comment 
suggested that the proposed regulations could apply to a decision by a 
subsidiary to borrow directly from an unrelated bank with a parent 
guarantee rather than cause the parent to borrow from the unrelated 
bank and on-lend to the subsidiary. The final and temporary regulations 
do not adopt these recommendations. The Treasury Department and the IRS 
have determined that, in light of the revision to apply Sec.  1.385-
3(b)(4) only when a principal purpose of a transaction is to avoid the 
``purposes'' of the regulations (rather than avoiding the 
``application'' of the regulations), it would not be appropriate to 
provide a complete exception for loans with unrelated parties or 
related-party guarantees. There already is sufficient clarity under the 
regulations that, absent other facts and circumstances, borrowing funds 
from an unrelated lender including with a related-party guarantee would 
not avoid the purposes of Sec.  1.385-3 or Sec.  1.385-3T, which are 
intended to apply in the particular factual circumstance of loans 
between highly-related corporations.
    In addition, the Treasury Department and the IRS remain concerned 
about transactions with non-expanded group members that are structured 
to avoid the purposes of Sec.  1.385-3 or Sec.  1.385-3T, such as a 
transaction where the lender is a not a member of the expanded group, 
but only on a temporary basis. As in the proposed regulations, Sec.  
1.385-3(b)(4) includes two examples of this situation. In one example, 
a covered 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 purposes of Sec.  1.385-3. In the 
second example, with a principal purpose of avoiding the purposes of 
Sec.  1.385-3, a covered debt instrument is issued to a person that is 
not a member of the issuer's expanded group, and such person later 
becomes a member of the issuer's expanded group.
ii. Transactions That Meet Existing Exceptions
    Comments requested that the anti-abuse rule not apply to a 
transaction that satisfies a specific exception to either the general 
rule or funding rule. For example, the comments questioned the 
application of the anti-abuse rule when a taxpayer issues multiple debt 
instruments in multiple years, each debt instrument would, but for the 
E&P exception, be treated as stock, and some of the debt instruments 
would not have benefitted from the E&P exception if they had been 
issued during the first year. The comments asserted that none of the 
debt instruments in that example should be treated as stock under the 
anti-abuse rule (for example, by being treated as being issued all at 
once in the first year of the period). The Treasury Department and the 
IRS agree that in that example, the anti-abuse rule generally would not 
be implicated, because no purpose of the regulations has been avoided. 
As discussed in Section I.1.a of this Part V, the final and temporary 
regulations provide that the anti-abuse rule applies to transactions 
with a principal purpose of avoiding the ``purposes'' of Sec. Sec.  
1.385-3 or 1.385-3T, rather than applying to transactions with a 
principal purpose of avoiding the ``application'' of Sec. Sec.  1.385-3 
or 1.385-3T.
    However, the Treasury Department and the IRS decline to provide 
that the anti-abuse rule cannot apply to transactions that meet a 
specific exception to either the general rule or funding rule. The 
Treasury Department and the IRS remain concerned about structured 
transactions that satisfy the technical requirements for exceptions or 
exclusions but avoid the purposes of the final and temporary 
regulations. Those structured transactions may technically qualify for 
a specific exception, but would nonetheless be subject to the anti-
abuse rule. Accordingly, the Treasury Department and the IRS decline to 
adopt the specific recommendation.
    Because the final and temporary regulations significantly expand 
the exceptions and reductions in Sec.  1.385-3(c) that are discussed in 
Section E of this Part V, and because of other changes addressed in 
Sec.  1.385-4T that are discussed in Part VI of this Summary of 
Comments and Explanation of Revisions, the final and temporary 
regulations also clarify that the anti-abuse rule explicitly addresses 
distributions or acquisitions that occur with a principal purpose of 
avoiding the purposes of Sec.  1.385-3 or Sec.  1.385-3T, as well as 
other transactions that are undertaken with a principal purpose of 
avoiding the purposes of Sec.  1.385-3 or Sec.  1.385-3T.
iii. Interests That Are Not Debt Instruments
    Comments requested additional guidance concerning the application 
of the anti-abuse rule to interests that are not debt instruments, with 
specific requests for clarity concerning preferred partnership 
interests. As discussed in Section F.2 of this Part V, the Treasury 
Department and the IRS decline to adopt a recommendation to limit the 
funding rule to instruments that are, in form, debt instruments and 
also decline to adopt a recommendation to exclude from the funding rule 
a deemed loan arising from a nonperiodic payment with respect to a 
notional principal contract. The Treasury Department and the IRS 
similarly decline to narrow the application of the anti-abuse rule in 
these contexts.
    The Treasury Department and the IRS continue to study whether it is 
appropriate to subject preferred equity in a controlled partnership to 
the rules that would apply to a debt instrument issued by a controlled 
partnership. As described in the preamble to the proposed regulations, 
the IRS intends to closely scrutinize, and may challenge under the 
anti-abuse rule, transactions in which a controlled partnership issues 
preferred equity to an expanded group member and the rules of Sec.  
1.385-3T(f) would have applied had the preferred equity been 
denominated as a debt instrument issued by the partnership.
2. Affirmative Use
    The proposed regulations provided that the rules of proposed 
Sec. Sec.  1.385-3 and Sec.  1.385-4 do not apply to the extent a 
person enters into a transaction that otherwise would be subject to 
proposed Sec.  1.385-3 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 
Sec.  1.385-3.
    Comments suggested eliminating the prohibition on affirmative use 
as contradictory to the objective factor-

[[Page 72929]]

based analysis of the proposed regulations and creating unnecessary 
uncertainty for taxpayers that could lead to controversy with tax 
authorities. Comments expressed concern that determining whether a 
transaction was entered into with a principal purpose of reducing U.S. 
tax presented additional administrative difficulties, particularly if 
the expected tax benefits are realized at a future date, accrue to a 
related taxpayer, or are subject to a material contingency. 
Furthermore, a taxpayer could often issue preferred stock (or another 
form of equity) in instances where such treatment is preferable rather 
than relying on recharacterization. One comment asked how the rule 
concerning affirmative use should interact with common law and for 
clarification as to what is meant by a reduction in U.S. federal income 
tax liability.
    In response to comments, including comments about the no 
affirmative use rule creating unnecessary uncertainty, the Treasury 
Department and the IRS reserve on the application of the no affirmative 
use rule in Sec.  1.385-3 pending continued study after the 
applicability date.

VI. Comments and Changes to Proposed Sec.  1.385-4--Treatment of 
Consolidated Groups

A. Treatment of Consolidated Groups as One Corporation
    To prevent application of the proposed regulations under section 
385 to interests between members of a consolidated group, proposed 
Sec.  1.385-1(e) provided that a consolidated group (as defined in 
Sec.  1.1502-1(h)) is treated as one corporation (the one-corporation 
rule). Several comments were received requesting expansions, 
clarifications, or modifications of this rule, as described in this 
Part VI.
1. Expansion of the One-Corporation Rule
    Several comments suggested that all domestic corporations under 
some degree of common control should be treated as one corporation 
under the regulations. For example, comments suggested that a group of 
domestic entities meeting the ownership requirements of section 
1504(a)(2) connected through common ownership by a domestic corporation 
(treating a controlled partnership as an aggregate of its partners or 
as a corporation for this purpose) should be treated as one 
corporation. Other comments suggested that all members of a ``super 
affiliated group,'' as defined in proposed Sec.  1.163(j)-5(a)(3), 
should be treated as one corporation. Others suggested that multiple 
consolidated groups that are commonly controlled should be treated as 
one corporation, without specifying the necessary degree of common 
control.
    Comments also suggested that certain entities that would not be 
treated as members of a consolidated group should be treated as 
consolidated group members for purposes of the one-corporation rule. 
For example, comments suggested that the one-corporation rule should 
apply to affiliated groups determined without regard to section 
1504(b)(2) and (c) (preventing certain life insurance companies from 
joining an affiliated group) or section 1504(b)(6) (preventing RICs and 
REITs from joining an affiliated group).
    As discussed in Part V.A.2 of this Summary of Comments and 
Explanation of Revisions, the proposed regulations did not apply to 
indebtedness issued by a corporation to members of its consolidated 
group while the indebtedness was held in such group because the policy 
concerns addressed in the proposed regulations generally are not 
present when the issuer's deduction for interest expense and the 
holder's corresponding inclusion of interest income offset on the 
group's consolidated federal income tax return. For the reasons 
described in Part V.A.2 of this this Summary of Comments and 
Explanation of Revisions, the Treasury Department and the IRS continue 
to view the filing of a single federal income tax return as the 
appropriate basis for excluding transactions among consolidated group 
members, and decline to extend the treatment afforded to consolidated 
groups to expanded group members that file separate federal income tax 
returns. In addition, modifications made in the final and temporary 
regulations significantly reduce, and in certain cases eliminate, the 
application of the regulations to life insurance companies and non-
controlled RICs and REITs.
2. Clarification of the One-Corporation Rule
a. Scope
    Comments generally supported the principle-based one-corporation 
rule of the proposed regulations while recommending certain specific 
clarifications and exceptions, each of which is described in this 
preamble. One comment requested guidance regarding the interaction of 
the one-corporation rule with other provisions of the Code, 
recommending that the regulations provide an order of operations as 
follows: First, apply the provisions of the Code and the regulations 
thereunder, treating the members of a consolidated group as separate 
entities for purposes of applying the rules; second, apply the section 
385 regulations to the transaction as it is characterized under other 
provisions of the Code and the regulations thereunder, giving effect to 
the one-corporation rule. For example, assume that FP owns USP1 and 
USP2, each of which is the common parent of a different consolidated 
group. USP1, which owns USS1 and several other subsidiaries, sells USS1 
to USP2 for a note. The comment recommended that USP1 be treated as 
transferring USS1 stock, but noted that the transaction could instead 
be treated as the sale of a branch comprised of USS1's assets and 
liabilities under the one-corporation rule.
    The temporary regulations adopt this recommendation. Under the 
order of operations rule of Sec.  1.385-4T(b)(5), a transaction 
involving one or more members of a consolidated group is first 
characterized under federal tax law without regard to the one-
corporation rule, and then Sec. Sec.  1.385-3 and 1.385-4T apply to the 
transaction as characterized to determine whether the debt instrument 
is treated as stock, treating the consolidated group as one 
corporation, unless otherwise provided. Applying this rule to the 
example above, USP2's acquisition of USS1 is respected as an 
acquisition of the stock of USS1 in exchange for a note of USP2. 
Therefore, absent an exception, the note issued by USP2 is treated as 
stock under Sec.  1.385-3(b).
    Another comment stated that the scope of the one-corporation rule 
is unclear, and recommended that certain items be clearly included or 
excluded from the one-corporation rule and that a principle-based rule 
be used to address the items not expressly included or excluded. For 
example, the comment noted that, for purposes of determining the 
treatment of an interest that ceases to be a consolidated group debt 
instrument, proposed Sec.  1.385-4(b)(1)(ii)(B) respected the existence 
of the consolidated group debt instrument solely for purposes of 
determining the per se period under proposed Sec.  1.385-
3(b)(3)(iv)(B). As discussed in more detail in Section B.2 of this Part 
VI, the temporary regulations address the concern raised in this 
comment by providing that when a departing member ceases to be a member 
of a consolidated group, but remains a member of the expanded group, 
the departing member's history of transactions with other consolidated

[[Page 72930]]

group members remains disregarded. For this purpose, a departing member 
is a member of an expanded group that ceases to be a member of its 
original consolidated group but continues to be a member of the same 
expanded group.
b. Wholly-Owned Partnerships
    Comments requested clarification of the treatment of loans between 
a consolidated group member and a partnership that is wholly owned by 
members of the consolidated group. Specifically, comments requested 
clarification that any such loan would be treated as a loan from one 
consolidated group member to another consolidated group member, which 
generally would be treated as a debt instrument issued and held by 
members of the same consolidated group (a consolidated group debt 
instrument), so that the loan would not be subject to proposed 
Sec. Sec.  1.385-3 and 1.385-4. By contrast, other comments recommended 
that the regulations not apply to such a debt instrument because the 
one-corporation rule suggests that a partnership wholly owned by 
members of a consolidated group should be disregarded as a separate 
entity for purposes of proposed Sec. Sec.  1.385-3 and 1.385-4.
    The temporary regulations clarify that a partnership all of the 
partners of which are members of the same consolidated group is treated 
as a partnership for purposes of Sec. Sec.  1.385-3, 1.385-3T, and 
1.385-4T. However, Sec.  1.385-3T treats a partner in a controlled 
partnership as issuing its share of a debt instrument issued by the 
controlled partnership and holding its share of a debt instrument held 
by the controlled partnership. Accordingly, under the one-corporation 
rule, a covered debt instrument between a consolidated group member and 
a controlled partnership that is wholly owned by members of the 
consolidated group is treated as a consolidated group debt instrument.
c. Identity of Issuer
    Comments recommended that the regulations provide that a debt 
instrument issued by a member of a consolidated group, if characterized 
as stock under the regulations, is stock in the particular member that 
issued the debt instrument. Comments noted that this result was 
demonstrated by examples in the proposed regulations, but requested 
that an operative rule in the regulations confirm the outcome 
demonstrated by the examples. Other comments questioned whether this 
was the appropriate outcome, and indicated that in certain cases, the 
common parent of a consolidated group should be treated as the issuer 
when a debt instrument issued by another member of its consolidated 
group is treated as stock under the regulations. However, one comment 
noted that treating a debt instrument issued by one member as having 
been issued by another member (such as the common parent) may be 
inappropriate in certain cases, including when the issuer of the 
instrument has a minority shareholder that is not a member of the 
consolidated group.
    In response to these comments, the temporary regulations provide 
that a debt instrument issued by a member of a consolidated group, if 
treated as stock under the regulations, is treated as stock in the 
particular member that is treated as the issuer of the debt instrument 
under general tax principles.
d. Interaction With the Funding Rule
    One comment requested confirmation that an effect of the one-
corporation rule is that, under the funding rule, a debt instrument 
issued by one member of a consolidated group to a member of its 
expanded group that is not a member of the same consolidated group 
could be treated as funding a transaction described in proposed Sec.  
1.385-3(b)(3) undertaken by a different member of the same consolidated 
group, such that the debt instrument would be treated as stock. The 
temporary regulations confirm this result in Sec.  1.385-4T(b)(1).
    Another comment recommended an exception from the one-corporation 
rule which would reverse this outcome when the issuer of the debt 
instrument can demonstrate that the proceeds obtained in connection 
with the issuance of the debt instrument can be shown to have not 
directly funded the other consolidated group member's transaction. The 
temporary regulations do not adopt this recommendation, which is 
essentially a tracing approach, for the reasons described in Section 
V.D.2 of this Summary of Comments and Explanation of Revisions.
    Multiple comments were received regarding the application of the 
funding rule when a corporation joins a consolidated group. One comment 
stated that when an expanded group member engages in a transaction 
described in proposed Sec.  1.385-3(b)(3)(ii) and subsequently joins a 
consolidated group (while remaining a member of the same expanded 
group), it is appropriate to treat the consolidated group as having 
engaged in the transaction. For example, assume that FP, USS1, and USS2 
are members of the same expanded group, and that USS1 is the common 
parent of a consolidated group that, in Year 1, does not include USS2. 
If USS2 makes a distribution to FP in Year 1, and joins USS1's 
consolidated group in Year 2, the USS1 consolidated group would be 
treated as having made USS2's Year 1 distribution. The temporary 
regulations adopt this recommendation by providing that, when a member 
of an expanded group becomes a member of a consolidated group and 
continues to be a member of the same expanded group (a joining member), 
the joining member and the consolidated group that it joins are a 
predecessor and successor (respectively) for purposes of Sec.  1.385-
3(b)(3).
e. Interaction With the Reduction for Expanded Group Earnings
    Comments recommended that the regulations clarify how to apply the 
current year earnings and profits exception for a consolidated group 
treated as one corporation. Generally, comments questioned whether the 
one corporation's current year earnings and profits is based on Sec.  
1.1502-33, or whether it should instead be recalculated as though each 
member of the consolidated group other than the common parent were a 
branch. For example, under the latter approach, current year earnings 
and profits would not include worthless stock loss deductions with 
respect to stock of a consolidated group member, and certain stock 
acquisitions would be treated as asset acquisitions, which could 
produce a step-up or step-down in the basis of depreciable or 
amortizable assets.
    As discussed in Section V.E.3.a of this Summary of Comments and 
Explanation of Revisions, the earnings and profits exception has been 
modified in the final and temporary regulations. With respect to the 
expanded group earnings account, the temporary regulations provide that 
a consolidated group has one account and only the earnings and profits, 
determined in accordance with Sec.  1.1502-33 (without regard to the 
application of Sec.  1.1502-33(b)(2), (e), and (f)), of the common 
parent (within the meaning of section 1504) of the consolidated group 
are considered in calculating the expanded group earnings for the 
expanded group period of a consolidated group. The Treasury Department 
and the IRS have determined that a methodology based on modified Sec.  
1.1502-33 principles is the simplest to administer and most accurately 
reflects the treatment of all members of a consolidated group as one 
corporation for purposes of the final and temporary regulations.
    The temporary regulations provide rules for determining when, and 
to what extent, a consolidated group (treated as one corporation) or a 
departing member

[[Page 72931]]

succeeds to all or some of the expanded group earnings account of a 
joining member or a consolidated group, respectively. In this regard, a 
consolidated group succeeds to the expanded group earnings account of a 
joining member. In addition, if a departing member (including departing 
members that immediately after leaving a consolidated group themselves 
comprise another consolidated group treated as one corporation) leaves 
a consolidated group in a distribution under section 355, the expanded 
group earnings account of the consolidated group is allocated between 
the consolidated group and the departing member in proportion to the 
earnings and profits of the consolidated group and the earnings and 
profits of the departing member immediately after the transaction. 
However, no amount of the expanded group earnings account of a 
consolidated group is allocated to a departing member that leaves the 
consolidated group in a transaction other than a distribution to which 
section 355 applies. The temporary regulations provide similar rules 
with respect to the reduction for qualified contributions, discussed in 
Section A.2.f of this Part VI.
    Comments also questioned whether the issuer's earnings and profits 
or the consolidated group's earnings and profits should be used when an 
issuer makes a distribution to a minority shareholder that is not a 
member of the consolidated group but is a member of the expanded group. 
Providing each member of a consolidated group access to the 
consolidated group's earnings account with respect to a distribution or 
acquisition made by such member to or from another member of the 
expanded group is consistent with the premise of treating all members 
of a consolidated group as one corporation. Accordingly, the temporary 
regulations provide that a distribution or acquisition that a member of 
a consolidated group makes to or from another member of the same 
expanded group that is not a member of the same consolidated group is 
reduced to the extent of the expanded group earnings account of the 
consolidated group.
f. Interaction With Reduction for Qualified Contributions
    As discussed in Part V.E.3.b of this Summary of Comments and 
Explanation of Revisions, the final and temporary regulations provide 
that an expanded group member's distributions and acquisitions are 
reduced by qualified contributions for purposes of applying the general 
rule and funding rule. The temporary regulations provide that, for 
purposes of applying the qualified contribution reduction to 
distributions or acquisitions by a consolidated group, qualified 
contributions to any member that remains consolidated immediately after 
the contribution are treated as made to the consolidated group, a 
qualified contribution that causes a deconsolidation of a member is 
treated as made to the departing member and not to the consolidated 
group, and no contribution of property by a member of a consolidated 
group to any other member of the consolidated group is treated as a 
qualified contribution.
g. Interaction With Other Specific Provisions in Sec.  1.385-3
    The temporary regulations provide that the determination of whether 
a debt instrument issued by a member of a consolidated group is a 
covered debt instrument is made on a separate member basis without 
regard to the one-corporation rule. The Treasury Department and the IRS 
have determined that separate-member treatment is appropriate for 
making this determination because the exceptions to covered debt 
instrument status are tailored to specific entity-level attributes of 
the issuer. For example, because status as an excepted regulated 
financial company is determined on an issuer-by-issuer basis, the 
Treasury Department and the IRS have determined that it would not be 
appropriate to extend that special status to other members of a 
consolidated group that do not meet the specific requirements for the 
exception.
    Similarly, the determination of whether a member of a consolidated 
group has issued a qualified short-term debt instrument for purposes of 
Sec.  1.385-3(b)(3)(vii) is made on a separate member basis. The policy 
justifications for the specific tests set forth in that exception, in 
particular the specified current asset test, are more suited to a 
separate member analysis. Despite the general use of a separate member 
approach to applying the qualified short-term debt instrument tests, 
Sec.  1.385-3(b)(4)(ii)(D) specifically references situations in which 
a member of an expanded group enters into a transaction with a 
principal purpose of avoiding the purposes of Sec.  1.385-3 or Sec.  
1.385-3T, including as part of a plan or a series of transactions 
through the use of the consolidated group rules set forth in Sec.  
1.385-4T. That rule could apply, for example, to transactions in which 
two different members of the same consolidated group engage in 
``alternating'' loans from a lender that is not a member of the 
consolidated group with a principal purpose of avoiding the purposes of 
the limitations in the 270-day test in Sec.  1.385-3(b)(3)(vii)(A)(2) 
by also engaging in other intra-consolidated group transactions that 
otherwise would be disregarded under the one-corporation rule.
3. State and Local Tax Comments
    Comments noted that the regulations add complexity to state and 
local tax systems and may result in additional state tax costs and 
compliance burdens for taxpayers. In particular, a comment noted that, 
if a state applies the one-corporation rule based on the composition of 
the state filing group rather than the federal consolidated group, 
transactions could be subject to the regulations for state income tax 
purposes even when the transactions are not subject to the regulations 
for federal income tax purposes. The comment suggested that this 
concern could be mitigated in states that adhere to the literal 
language of the section 385 regulations by modifying proposed Sec.  
1.385-1(e) to provide that ``all members of a consolidated group (as 
defined in Sec.  1.1502-1(h)) that file (or that are required to file) 
consolidated U.S. federal income tax returns are treated as one 
corporation.'' The temporary regulations adopt this recommendation.
4. Newly-Acquired Life Insurance Subsidiaries
    Several comments noted the one-corporation rule in proposed Sec.  
1.385-1(e) would not apply in cases where section 1504(c)(2) prohibits 
inclusion of newly-acquired life insurance subsidiaries in a 
consolidated group. These comments asked that the regulations treat 
such newly-acquired life insurance companies as part of a consolidated 
group even when section 1504(c)(2) would not.
    The one-corporation rule is intended only to treat members of a 
consolidated group that file a single federal income tax return as a 
single taxpayer because items of income and expense with respect to 
debt instruments between such members are included and offset each 
other on the consolidated group's single federal income tax return. To 
the extent that section 1504(c)(2) prohibits recently-acquired life 
insurance companies from joining a consolidated group, the items of 
income and expense of the companies and the consolidated group are not 
included in a single federal income tax return. In this context, a 
consolidated group and its recently-acquired life insurance 
subsidiaries are not materially different from two separate 
consolidated groups are part of the same expanded group. Transactions 
between two separate

[[Page 72932]]

consolidated groups that are part of the same expanded group are 
subject to Sec. Sec.  1.385-3 and 1.385-4T. As a result, the Treasury 
Department and the IRS decline to include a special rule related to 
section 1504(c)(2) in the temporary regulations. However, as discussed 
in Part V.G.2 of this Summary of Comments and Explanation of Revisions, 
the final and temporary regulations exclude debt instruments issued by 
regulated insurance companies.
B. Debt Instruments That Cease To Be Among Consolidated Group Members 
and Remain Among Expanded Group Members
    The proposed regulations provided two rules governing the treatment 
of a consolidated group debt instrument that ceased to be a 
consolidated group debt instrument, but continued to be issued and held 
by members of the same expanded group. One set of rules (the departing 
instrument rules) addressed situations in which 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 other set of rules (the departing member rules) addressed 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). Several comments were received 
regarding the operation of these rules.
1. Departing Instrument Rules
    Under the departing instrument rules, when a member of a 
consolidated group that held a consolidated group debt instrument 
transferred the consolidated group debt instrument to an expanded group 
member that was not a member of the consolidated group, the debt 
instrument was 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 were determined in a manner that was consistent with 
treating a consolidated group as one corporation. To the extent the 
debt instrument was treated as stock upon being transferred, the debt 
instrument was deemed to be exchanged for stock immediately after the 
debt instrument was transferred outside of the consolidated group.
    Comments recommended that when a consolidated group member 
distributes a debt instrument issued by another member of its 
consolidated group to a nonconsolidated expanded group member in a 
distribution, the distribution should not be taxable as an exchange, 
but should instead be taxable in the same manner as a distribution by a 
consolidated group member of its own debt instrument to a 
nonconsolidated member of its expanded group, which would generally be 
treated as a distribution subject to section 305. The temporary 
regulations do not adopt this comment because the comment implicitly 
suggests that the regulations apply the one-corporation rule for all 
federal tax purposes, rather than as a rule for applying Sec. Sec.  
1.385-3, 1.385-3T, and 1.385-4T in the consolidated return context.
2. Departing Member Rules
a. Harmonization With the Departing Instrument Rule
    Comments recommended harmonizing the departing member rules with 
the departing instrument rules. For example, one comment recommended 
that, when a departing member of a consolidated group is the holder or 
the issuer of a debt instrument issued or held by another member of the 
consolidated group, and the departing member remains in the same 
expanded group after leaving the consolidated group, then the debt 
instrument generally should be treated for purposes of Sec.  1.385-3 as 
being reissued immediately following the member's departure from the 
consolidated group (consistent with the departing instrument rule). 
This would have the effect of harmonizing the departing member rules 
with the departing instrument rules because the departing instrument 
rules provide that when a member of a consolidated group that held a 
consolidated group debt instrument transfers the instrument to an 
expanded group member that is not a member of the consolidated group, 
the instrument is treated as newly issued by the issuer to the 
transferee. The comment suggested that, if the debt instrument was 
issued by or to the departing member of the consolidated group as part 
of a plan that included the member's departure from the consolidated 
group, then the debt should be recast as stock when the member departs 
from the consolidated group if it would have previously been recast as 
stock absent the one-corporation rule. However, the comment also 
suggested that absent a plan that included the member's departure from 
the consolidated group and the issuance of the debt instrument, the 
debt instrument should be treated as reissued immediately after the 
member's departure from the consolidated group. As discussed in more 
detail in Section B.2.b of this Part VI, the temporary regulations 
generally adopt this approach by eliminating the classification of a 
departing member's debt instruments that were previously consolidated 
group debt instruments as either exempt consolidated group debt 
instruments or non-exempt consolidated group debt instruments after 
departure. Instead, the temporary regulations treat those debt 
instruments as reissued, and thus generally do not require separate 
tracking of intra-consolidated group transactions, unless the anti-
abuse rule in Sec.  1.385-3(b)(4) applies.
    Another comment noted that, if the departing member rule and the 
departing instrument rule are not harmonized, there could be situations 
in which both rules appear to apply. For example, a consolidated group 
member that holds a consolidated group debt instrument and undergoes an 
outbound reorganization described in section 368(a)(1)(F) may be viewed 
as both transferring the consolidated group debt instrument and ceasing 
to be a member of the consolidated group. The temporary regulations add 
an overlap rule to provide that, if both the departing member rules and 
the departing instrument rules could apply to the same transaction, the 
departing instrument rules, rather than the departing member rules, 
apply.
b. Operation of Departing Member Rules
    The proposed regulations generally provided that any consolidated 
group debt instrument that is issued or held by the departing member 
and that was not treated as stock solely by reason of the one-
corporation rule (an exempt consolidated group debt instrument, under 
the nomenclature of the proposed regulations) was deemed to be 
exchanged for stock immediately after the departing member leaves the 
consolidated group. The proposed regulations also generally provided 
that any consolidated group debt instrument issued or held by a 
departing member that is not an exempt consolidated group debt 
instrument (a non-exempt consolidated group debt instrument, under the 
nomenclature of the proposed regulations) continued to be treated as 
indebtedness after the departure, unless and until the non-exempt 
consolidated group debt instrument was treated as stock under the 
funding rule as a result of a later distribution or acquisition. 
However, the proposed regulations also provided that, solely for 
purposes of applying the per se rule, the debt instrument was treated 
as having been

[[Page 72933]]

issued when it was first treated as a consolidated group debt 
instrument, and not when the departing member departed from the 
consolidated group.
    Several comments addressed the operation of the departing member 
rules. Comments requested clarification as to how the current year 
earnings and profits exception described in proposed Sec.  1.385-
3(c)(1) applied for purposes of determining whether a consolidated 
group debt instrument is an exempt consolidated group debt instrument 
or a non-exempt consolidated group debt instrument. Specifically, the 
comments noted that, in order to analyze whether a consolidated group 
debt instrument would or would not have been recharacterized under 
proposed Sec.  1.385-3(b)(3) but for the one-corporation rule, the 
issuer would need to analyze the availability of the various exceptions 
in proposed Sec.  1.385-3(c), including the current year earnings and 
profits exception in the proposed regulations. For purposes of applying 
the earnings and profits exception, comments questioned whether the 
determination should be made by reference to the specific issuer's 
earnings and profits (without regard to the one-corporation rule) or 
whether some other measure, such as the issuer's earnings and profits 
plus the earnings and profits of lower-tier group members should be 
used. Further, one comment questioned whether adjustments to an 
issuer's earnings and profits should be made based on adjustments to 
the earnings and profits of lower-tier consolidated group members if 
all exempt consolidated group debt instruments were treated as stock 
rather than debt.
    Comments also suggested that the special timing rule for non-exempt 
consolidated group debt instruments be eliminated. Specifically, 
comments noted that, because the proposed rule for non-exempt 
consolidated group debt instruments did not turn off the deemed 
satisfaction and reissuance rules of Sec.  1.1502-13(g), the deemed 
reissuance rule in Sec.  1.1502-13(g) could conflict with the special 
timing rule, and, as a result, start a new time period for the per se 
rule. See proposed Sec.  1.385-4(d)(3), Example 4. Comments recommended 
that the example be revised to take the deemed satisfaction and 
reissuance rules into account, and by implication, eliminate the 
special timing rule for non-exempt consolidated group debt instruments. 
Other comments questioned whether the interaction of the special timing 
rule for non-exempt consolidated group debt instruments and the 
ordering rule in proposed Sec.  1.385-3(b)(3)(iv)(B)(3) (multiple 
interests) could lead to inappropriate results.
    Other comments more directly recommended that the regulations 
disregard any history of transactions that occurred solely between 
consolidated group members before a departure. This approach would also 
render moot the concept of a non-exempt consolidated group debt 
instrument and an exempt consolidated group debt instrument. One 
comment noted that requiring tracking of consolidated group history is 
contrary to the notion of excluding debt instruments issued by members 
of a consolidated group from the scope of proposed Sec.  1.385-3, 
because the consolidated group would still have to monitor and analyze 
the history of intra-consolidated group transactions in the event there 
was a departing member.
    Along similar lines, other comments recommended that the 
regulations provide that unfunded distribution and acquisition 
transactions that occurred solely within a consolidated group be 
disregarded for all purposes of proposed Sec. Sec.  1.385-3 and 1.385-
4, so that the history of such intra-consolidated group distribution 
and acquisition transactions would not follow a member that leaves the 
consolidated group. For example, assume that in Year 1, DS1 makes a 
$100x distribution to USS1, the common parent of a consolidated group 
of which DS1 is a member. In Year 2, DS1 ceases to be a member of the 
USS1 consolidated group, but remains a member of the same expanded 
group as USS1. Immediately afterwards, DS1 borrows $100x from a member 
of the expanded group that is not a member of the USS1 consolidated 
group. The comments recommended that, for purposes of applying the 
funding rule in this context, DS1's distribution to USS1 in Year 1 
should be disregarded.
    Comments also requested clarification of the application of the 
funding rule to a departing member in situations in which one member of 
a consolidated group makes a distribution or acquisition to or from 
another member of the same expanded group that is not a member of the 
same consolidated group (a regarded distribution or acquisition), and 
subsequently, another member of the consolidated group departs the 
consolidated group but remains a member of the expanded group. One 
comment indicated that the departing member should not be treated as 
having made the regarded distribution or acquisition for purposes of 
the funding rule, and by implication, the consolidated group should 
continue to be treated as having made the regarded distribution or 
acquisition for purposes of the funding rule. Other comments indicated 
that, in order to prevent duplication, the departing member should be 
allocated a portion of each regarded distribution or acquisition for 
purposes of the funding rule.
    Another comment sought clarification when a member of a 
consolidated group is funded through a borrowing from an expanded group 
member that is not a member of the same consolidated group, and 
therefore the entire consolidated group is treated as a funded member 
for purposes of proposed Sec.  1.385-3(b)(3), and a different member of 
the consolidated group subsequently leaves the consolidated group. The 
comment specifically asked whether that departing member is still 
treated as a funded member after departure.
    The temporary regulations generally adopt the recommendations 
described above. Specifically, the temporary regulations provide that 
if a consolidated group debt instrument ceases to be treated as such 
because the issuer and holder are no longer members of the same 
consolidated group but remain members of the same expanded group, then 
the issuer is treated as issuing a new debt instrument to the holder in 
exchange for property immediately after the debt instrument ceases to 
be a consolidated group debt instrument. Absent application of the 
anti-abuse rule in Sec.  1.385-3(b)(4), the departing member's history 
of prior transactions with other consolidated group members, which were 
disregarded under the one-corporation rule for purposes of applying 
Sec.  1.385-3(b)(3), remain disregarded when the departing member 
ceases to be a member of the consolidated group. By giving greater 
effect to the one-corporation rule, the temporary regulations reduce 
the need to monitor transactions solely among consolidated group 
members and make the additional exceptions set forth in Sec.  1.385-
3(c) more administrable, particularly the exceptions for expanded group 
earnings and qualified contributions.
    The temporary regulations also clarify the designation of funded 
status when a member leaves a consolidated group but remains in the 
expanded group. When a consolidated group member is funded through a 
borrowing from an expanded group member that is not a member of the 
same consolidated group, and that consolidated group member later 
departs the consolidated group, the departing member continues to be 
treated as funded by the borrowing, and the consolidated group from 
which the departing member departs ceases to be treated as funded by 
the borrowing. If

[[Page 72934]]

instead a non-departing member had been funded by the borrowing, the 
temporary regulations provide that the consolidated group from which 
the departing member departs continues to be treated as funded by the 
borrowing, and the departing member ceases to be treated as funded by 
the borrowing when it leaves the consolidated group.
    Similarly, the temporary regulations also clarify the treatment of 
consolidated groups in situations when a departing member has made a 
regarded distribution or acquisition that has not yet caused a 
recharacterization of a debt instrument under the general rule or 
funding rule. The temporary regulations provide that, in such a 
situation, if the departing member departs the consolidated group in a 
transaction other than a section 355 distribution, the departing member 
continues to be treated as having made the regarded distribution or 
acquisition, and the consolidated group from which the departing member 
departs ceases to be treated as having made the regarded distribution 
or acquisition.
    For purposes of applying the funding rule when a departing member 
ceases to be a member of a consolidated group by reason of a section 
355 distribution, the temporary regulations clarify that a departing 
member is a successor to the consolidated group and the consolidated 
group is a predecessor to the departing member. Specifically, based on 
the order of operations rule of Sec.  1.385-4T(b)(5), the temporary 
regulations provide that the determination as to whether an expanded 
group member that is not a member of a consolidated group is a 
predecessor or successor of another expanded group member that is a 
member of a consolidated group is made without regard to the one-
corporation rule. Similarly, the determination as to whether a an 
expanded group member that also is a member of a consolidated group is 
a predecessor or successor to another expanded group member that is not 
a member the consolidated group is made without regard to the one-
corporation rule. The temporary regulations further provide that, for 
purposes of the funding rule, if a consolidated group member is a 
predecessor or successor of a member of the expanded group that is not 
a member of the same consolidated group, the consolidated group is 
treated as a predecessor or successor of the expanded group member (or 
the consolidated group of which that expanded group member is a 
member). Thus, a departing member that is a successor to a member of 
the consolidated group of which it ceases to be a member is treated as 
a successor to the consolidated group, and the consolidated group is 
treated as a predecessor to the departing member. Accordingly, any 
regarded distribution or acquisition by the consolidated group before 
the departing member ceases to a be a member of the consolidated group 
may be treated as made by either the departing member or the 
consolidated group, depending on the application of the multiple 
interest rule of Sec.  1.385-3(b)(3)(B).
    In connection with these and other changes in Sec.  1.385-4T, the 
final and temporary regulations add to the anti-abuse rule in Sec.  
1.385-3(b)(4) a specific reference to Sec.  1.385-4T, as well as 
specific examples where an expanded group member engages in a 
transaction with a principal purpose of avoiding the purposes of Sec.  
1.385-3, 1.385-3T, or 1.385-4T through the use of a departing member. 
The anti-abuse rule may apply, for example, if a covered debt 
instrument is issued by a member of a consolidated group (USP) to an 
expanded group member, and pursuant to a plan with a principal purpose 
of avoiding the purposes of Sec.  1.385-3, 1.385-3T, or 1.385-4T, the 
following transactions occur: (i) The proceeds of the borrowing are 
contributed by USP to its subsidiary (US1), also a member of the same 
consolidated group, (ii) US1 deconsolidates by USP transferring all of 
its US1 stock to another expanded group member that is not a member of 
the same consolidated group, and (iii) US1 makes a distribution to its 
shareholder.
    Finally, the temporary regulations clarify that if an interest in a 
consolidated group member has previously been characterized as stock 
under Sec.  1.385-3, that interest continues to be treated as stock in 
the member after the member departs the consolidated group but remains 
in the expanded group.
c. Subgroups Leaving the Consolidated Group
    Comments questioned whether the departing member rule should apply 
when an issuer and holder simultaneously depart the same consolidated 
group (the old consolidated group) and then simultaneously join another 
consolidated group (the new consolidated group), and both the old and 
new consolidated groups are in the same expanded group. Comments 
recommended that, under these circumstances, the concerns addressed in 
the proposed regulations generally are not present because the issuer's 
deduction for interest expense and the holder's corresponding interest 
income continue to offset on the new consolidated group's consolidated 
federal income tax return. Accordingly, comments recommended the 
provision of a ``subgroup exception'' under which proposed Sec.  1.385-
4(b)(1)(ii)(B) would not apply where the issuer and holder together 
depart one consolidated group and together join another consolidated 
group within the same expanded group. In response to these comments, 
the temporary regulations adopt a subgroup rule when both the issuer 
and the holder of a consolidated group debt instrument cease to be 
members of a consolidated group, but the issuer and the holder both 
become members of another consolidated group that is in the same 
expanded group immediately after the transaction. When this exception 
applies, the debt instrument between subgroup members remains a 
consolidated group debt instrument rather than a debt instrument that 
is treated as issued under Sec.  1.385-4T(c)(1)(ii) or deemed reissued 
under Sec.  1.385-4T(c)(1)(i).
3. Debt Instrument Entering a Consolidated Group
    One comment noted that the deemed exchange that occurred pursuant 
to proposed Sec.  1.385-4(c) could be treated as a divided equivalent 
redemption described in section 302(d). The comment recommended that, 
to prevent some of the ancillary consequences of such treatment (for 
example, withholding tax liability), the deemed exchange should occur 
only after the debt instrument becomes a consolidated group debt 
instrument. The Treasury Department and the IRS generally adopt this 
recommendation. The final and temporary regulations provide that, if a 
covered debt instrument that is treated as stock under Sec.  1.385-3 
becomes a consolidated group debt instrument, then immediately after 
the covered debt instrument becomes a consolidated group debt 
instrument, the issuer is deemed to issue a new covered debt instrument 
to the holder in exchange for the covered debt instrument that was 
treated as stock. In addition, the final and temporary regulations 
provide that when the covered debt instrument that previously was 
treated as stock becomes a consolidated group debt instrument, the 
underlying distribution or acquisition that caused the covered debt 
instrument to be treated as stock is re-tested against other covered 
debt instruments issued by the consolidated group following principles 
set forth in Sec.  1.385-3(d)(2)(ii)(A). For further discussion of the 
re-testing principles in Sec.  1.385-3(d)(2)(ii)(A), see Part V.H.2 of

[[Page 72935]]

this Summary of Comments and Explanation of Revisions.
4. Other Comments Regarding Proposed Sec.  1.385-4
a. Respecting Deemed Exchanges
    Comments noted that Sec.  1.1502-13(g)(3) creates a deemed 
satisfaction and reissuance of an obligation that ceases to be an 
intercompany obligation, and does so immediately before such cessation, 
while Sec.  1.1502-13(g)(5) generally creates a deemed satisfaction and 
reissuance of an obligation that becomes an intercompany obligation, 
and does so immediately after the obligation enters the consolidated 
group. The consolidated return regulations explicitly provide, in each 
case, that the deemed satisfaction and reissuance are treated as 
transactions separate and apart from the transaction giving rise to the 
deemed satisfaction and reissuance. The comments noted that, absent 
similar rules to address the deemed exchanges occurring under proposed 
Sec.  1.385-4 (including deemed exchanges occurring when a debt 
instrument becomes or ceases to be a consolidated group debt 
instrument, as well as deemed exchanges occurring under the transition 
rule described in proposed Sec.  1.385-4(e)(3)), it is possible that 
those exchanges could be viewed under general tax principles as 
transitory and thus be disregarded in certain cases. Comments 
recommended that the regulations expressly provide that any deemed 
issuances, satisfactions, or exchanges arising under Sec.  1.1502-13(g) 
and proposed Sec.  1.385-4(b) or 1.385-4(e)(3) as part of the same 
transaction or series of transactions be respected as steps that are 
separate and apart from one another, similar to the rules currently 
articulated under Sec. Sec.  1.1502-13(g)(3)(ii)(B) and 1.1502-
13(g)(5)(ii)(B). The temporary regulations adopt this recommendation in 
Sec.  1.385-4T(c)(3).
b. Terminology
    The preamble to the proposed regulations described a debt 
instrument issued by one member of a consolidated group to another 
member of the same consolidated group as a ``consolidated group debt 
instrument.'' The same term was used in the text of the proposed 
regulations, but the term was not defined. One comment recommended that 
the regulations define the term consolidated group debt instrument. The 
temporary regulations adopt this recommendation.
    Another comment recommended that proposed Sec.  1.385-4 should 
employ terminology and concepts that are consistent with those utilized 
throughout the consolidated return regulations. The comment noted that, 
consistent with the one-corporation rule, the examples in proposed 
Sec.  1.385-4 refer to a consolidated group as the issuer of a debt 
instrument, whereas the consolidated return regulations would refer to 
a particular member of the consolidated group as an issuer. Consistent 
with the one corporation rule in Sec. Sec.  1.385-3 and 1.385-4T, the 
final and temporary regulations continue to refer to a consolidated 
group as the issuer of a debt instrument.

VII. Other Comments

A. Coordination With Sec.  1.368-2(m)(3)
    One comment recommended that the regulations clarify their 
interaction with Sec.  1.368-2(m)(3)(iii), which provides that a 
transaction may qualify as a reorganization described in section 
368(a)(1)(F) (an F reorganization) even though a holder of stock in the 
transferor corporation receives a distribution of money or other 
property from either the transferor corporation or the resulting 
corporation (including in exchange for shares of stock in the 
transferor corporation). The regulations provide that the receipt of 
such a distribution is treated as an unrelated, separate transaction 
from the reorganization, whether or not connected in a formal sense. 
Thus, for example, assume that FP owns USS1, USS1 forms USS2, USS1 
merges into USS2, and FP receives USS2 stock and a USS2 debt instrument 
in exchange for its USS1 stock. Further assume that the merger would be 
treated as an F reorganization and that, under Sec.  1.368-
2(m)(3)(iii), USS2's distribution of a debt instrument would be treated 
as a separate and independent transaction to which section 301 applies.
    The comment stated that the proposed regulations' interaction with 
Sec.  1.368-2(m)(3)(iii) presented a circularity issue. Specifically, 
the comment stated that a distribution treated as a separate and 
independent transaction, such as USS2's distribution of its debt 
instrument, would result in the USS2 debt instrument being treated as 
stock, such that Sec.  1.368-2(m)(3)(iii) would no longer apply. The 
comment further stated that if Sec.  1.368-2(m)(3)(iii) did not apply, 
no separate and independent distribution would be treated as occurring, 
such that the general rule of proposed Sec.  1.385-3(b)(2)(i) would not 
apply. To address this, the comment recommended that a coordinating 
rule be added to clarify the application of the section 385 regulations 
to the issuance of a debt instrument under this and similar 
circumstances.
    The Treasury Department and the IRS decline to adopt the 
recommendation, because it is not correct that this fact pattern 
presents a circularity problem. Pursuant to Sec.  1.368-2(m)(3)(ii) and 
(iii), if a distribution of money or other property occurs at the same 
time as the transactions otherwise qualifying as an F reorganization, 
the distribution does not prevent the transactions from so qualifying. 
Pursuant to Sec.  1.368-2(m)(3)(iii), the distribution is treated as a 
separate and unrelated transaction from the F reorganization and is 
subject to section 301. Thus, the receipt by FP of the USS2 debt 
instrument in the merger would constitute a section 301 distribution of 
the instrument, which would be treated as stock of USS2 under the 
general rule.
B. Proposed Section 358 Regulations
    One comment noted that under proposed Sec.  1.358-2, a 100-percent 
shareholder in a corporation may be treated as holding multiple blocks 
of stock with different adjusted tax bases. The comment noted that the 
proposed regulations, which would treat purported indebtedness as 
stock, would increase the number of instances in which a shareholder 
has multiple blocks of stock with different adjusted tax bases. The 
Treasury Department and the IRS decline to address comments regarding 
proposed regulations under section 358, which are beyond the scope of 
the final and temporary regulations. The final and temporary 
regulations do, however, retain the proposed regulations' approach to 
treating an EGI or a debt instrument as stock under certain 
circumstances. 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. Although this rule may result in 
indebtedness that is treated as stock having a different basis than 
other shares of stock held by a shareholder, many comments expressed 
support for this rule given that it 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 
holder under section 988.

[[Page 72936]]

C. Certain Additional Guidance
1. Hook Equity
    Ordinarily, the IRS will not issue a ruling or determination letter 
regarding the treatment or effects of ``hook equity,'' including as a 
result of its issuance, ownership, or redemption. For this purpose, 
``hook equity'' means an ownership interest in a business entity (such 
as stock in a corporation) that is held by another business entity in 
which at least 50 percent of the interests (by vote or value) in such 
latter entity are held directly or indirectly by the former entity. 
However, if an entity directly or indirectly owns all of the equity 
interests in another entity, the equity interests in the latter entity 
are not hook equity. See Rev. Proc. 2016-3, section 4.02(11), 2016-1 
I.R.B. 126. One comment, noting that the proposed regulations could 
result in certain debt instruments being treated as stock that would 
qualify as hook equity, recommended that the IRS repeal its policy on 
the issuance of rulings or determination letters regarding the 
treatment or effects of hook equity. The Treasury Department and the 
IRS decline to address this recommendation, which is beyond the scope 
of the final and temporary regulations. The recommendation will be 
considered, as appropriate, in connection with future guidance.
2. Examination Guidance
    One comment recommended that the IRS should issue guidance to 
examiners concerning the interpretation and practical application of 
the regulations. The Treasury Department and the IRS decline to address 
this comment, which is beyond the scope of the final and temporary 
regulations.

VIII. Applicability Dates

A. Applicability Dates of the Proposed Regulations
    Proposed Sec. Sec.  1.385-1 and 1.385-2 were proposed to apply to 
any applicable instrument issued or deemed issued on or after the date 
that the proposed regulations were published as final regulations and 
to any applicable instrument issued or deemed issued as a result of an 
entity classification election made under Sec.  301.7701-3 that is 
filed on or after that date. For purposes of applying proposed 
Sec. Sec.  1.385-3 and 1.385-4, the provisions of proposed Sec.  1.385-
1 were proposed to be applicable in accordance with the proposed 
applicability dates of proposed Sec. Sec.  1.385-3 and 1.385-4.
    Proposed Sec. Sec.  1.385-3 and 1.385-4 were proposed to be 
applicable on the date of publication in the Federal Register of the 
Treasury decision adopting these rules as final regulations. Proposed 
Sec. Sec.  1.385-3 and 1.385-4 were 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 that 
date. However, the proposed regulations also provided that, if a debt 
instrument otherwise would be treated as stock before publication of 
the final regulations, the debt instrument would be treated as 
indebtedness until the date that is 90 days after publication of the 
final regulations, and would only be recharacterized on that date to 
the extent that the debt instrument was held by expanded group members 
on that date (the proposed transition period). This transition rule in 
the proposed regulations did not apply to debt instruments issued on or 
after publication of the final regulations.
    The proposed regulations also provided that, for purposes of 
determining whether a debt instrument is described in proposed Sec.  
1.385-3(b)(3)(iv) (the per se funding rule), a distribution or 
acquisition that occurred 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.
B. Applicability Dates of the Final and Temporary Regulations
1. In General
    The final and temporary regulations apply to taxable years ending 
on or after January 19, 2017. As described in Part IV.B.2.b of this 
Summary of Comments and Explanation of Revisions, the final regulations 
under Sec.  1.385-2 delay the implementation period described in 
proposed Sec.  1.385-2 such that Sec.  1.385-2 does not apply to 
interests issued or deemed issued before January 1, 2018. Sections 
1.385-3 and 1.385-3T grandfather debt instruments issued before April 
5, 2016 (rather than before April 4, 2016, as was provided in the 
proposed regulations). The final and temporary regulations do not 
include the special rule in proposed Sec.  1.385-3(h)(1) relating to 
entity classification elections filed on or after April 4, 2016. The 
final and temporary regulations in Sec.  1.385-3(b)(3)(viii) also 
grandfather distributions and acquisitions occurring before April 5, 
2016, for purposes of applying the funding rule.
2. Transition Rules
    The final regulations under Sec.  1.385-3 lengthen the proposed 
transition period by providing that any covered debt instrument that 
would be treated as stock by reason of the application of the final and 
temporary regulations on or before January 19, 2017 (the final 
transition period) is not treated as stock during that 90-day period, 
but rather the covered debt instrument is deemed to be exchanged for 
stock immediately after January 19, 2017, but only to the extent that 
the covered debt instrument is held by a member of the issuer's 
expanded group immediately after January 19, 2017 (final transition 
period rule). Thus, the final transition period rule addresses both 
covered debt instruments that would have been recharacterized before 
the final and temporary regulations become applicable (that is, because 
the recharacterization would have occurred during a taxable year ending 
before January 19, 2017, as well as other covered debt instruments that 
would be treated as stock on or before January 19, 2017. The Treasury 
Department and the IRS extended the final transition period, as 
compared to the proposed regulations, in response to comments that 
requested additional time for taxpayers to adjust their conduct to take 
into account the final and temporary regulations.
    Generally, under the final transition period rule, any issuance of 
a covered debt instrument during the final transition period that would 
be treated as stock under Sec.  1.385-3(b)(2) upon issuance but for the 
final transition period rule is treated as an issuance of indebtedness, 
and not an issuance of stock. The final transition period rule also 
clarifies that Sec. Sec.  1.385-1, 1.385-3T, and 1.385-4T are taken 
into account in applying Sec.  1.385-3 during the final transition 
period.
    The Treasury Department and the IRS are concerned that, under the 
final transition period rule, a taxpayer could avoid the purposes of 
the final and temporary regulations by, during the transition period, 
distributing a covered debt instrument that otherwise would be treated 
as stock under the general rule, and then issuing a second debt 
instrument to retire the first instrument (either in a direct 
refinancing or indirectly by using the proceeds from the second debt 
instrument) before the end of the transition period. If this were 
permitted to occur, a taxpayer could issue substantial related-party 
debt that does not finance new investment after having received notice 
of these final and temporary regulations, contrary to the purposes of 
the applicability dates and

[[Page 72937]]

limited grandfather rules provided in the proposed regulations and in 
these final and temporary regulations. Accordingly, the final and 
temporary regulations also add a transition funding rule. This 
transition funding rule provides that on or after the date on which a 
covered debt instrument would be treated as stock but for the 
applicability date of Sec.  1.385-3 or the final transition period 
rule, any payment made with respect to such covered debt instrument 
(other than stated interest), including pursuant to a refinancing, is 
treated as a distribution for purposes of the funding rule. This 
transition funding rule is intended to provide for the orderly 
operation of the funding rule, taking into account the combination of 
the applicability date of Sec.  1.385-3, the final transition period 
rule, and Sec.  1.385-3(b)(6).
    Section 1.385-3(b)(6) is a non-duplication rule that provides that, 
once a covered debt instrument is recharacterized as stock, the 
distribution or acquisition that caused that recharacterization cannot 
cause a recharacterization of another covered debt instrument even 
after the first instrument is repaid. The non-duplication rule in Sec.  
1.385-3(b)(6) is premised on the fact that the funding rule already 
treats the repayment of an instrument that is treated as stock as its 
own distribution for purposes of the funding rule. The rule in Sec.  
1.385-3(b)(6) prevents the funding rule from applying on a duplicative 
basis--to the repayment of the recharacterized instrument, and to the 
actual distribution or acquisition that caused the recharacterization. 
See Part V.B.4 of this Summary of Comments and Explanation of 
Revisions. The transition funding rule supersedes that non-duplication 
rule during the final transition period while the covered debt 
instrument that otherwise would be treated as stock continues to be 
treated as indebtedness. The transition funding rule treats payments 
with respect to the instrument as distributions for purposes of the 
funding rule, which is necessary because repayments during the final 
transition period are not otherwise treated as distributions.
    Consistent with this transition funding rule, the final and 
temporary regulations also provide that a covered debt instrument that 
is issued in a general rule transaction during the transition period is 
not treated as a transaction described in Sec.  1.385-3(b)(3)(i) if, 
and to the extent that, the covered debt instrument is held by a member 
of the issuer's expanded group immediately after the transition period. 
In such a case, the covered debt instrument would be deemed to be 
exchanged for stock immediately after the transition period, and no 
other covered debt instrument would be treated as funding the issuance 
during the transition period. This change addresses a comment 
concerning the interaction of the general rule and funding rule during 
the transition period.
    Covered debt instruments that otherwise would not be 
recharacterized for federal income tax purposes during the final 
transition period (due, for example, to the fact that the covered debt 
instrument was not treated as funding a distribution or acquisition 
that also occurred during the final transition period) remain subject 
to the funding rule after the final transition period. Finally, the 
final regulations clarify in Sec.  1.385-3(b)(4) that the anti-abuse 
rule in Sec.  1.385-3(b)(4) may apply if a covered debt instrument is 
issued as part of a plan or series of transactions with a principal 
purpose to expand the applicability of the transition rules described 
in Sec.  1.385-3(j)(2) or Sec.  1.385-3T(k)(2).
    The following example illustrates these transition rules: Assume 
FP, a foreign corporation, wholly owns USS, a domestic corporation. 
Both FP and USS use a calendar year as their taxable year. No 
exceptions described in Sec.  1.385-3(c) apply. Assume that on June 1, 
2016, USS distributes a $100x covered debt instrument (Note 1) to FP. 
On January 1, 2017, USS distributes a $200x covered debt instrument 
(Note 2) to FP. On January 2, 2017, USS makes a $100x repayment to 
retire Note 1.
    For USS and FP, the first taxable year to which the final and 
temporary regulations apply is the taxable year ending December 31, 
2017. Section 1.385-3 does not apply to the issuance of Note 1 because 
Note 1 is not issued in a taxable year ending on or after January 19, 
2017. Section 1.385-3 does apply to the issuance of Note 2, because 
Note 2 is issued in a taxable year ending on or after January 19, 2017.
    However, the final transition period rule applies to Note 2 because 
Note 2 otherwise would be treated as stock on or before January 19, 
2017. Accordingly, Note 2 is not treated as stock until immediately 
after January 19, 2017; and to the extent that Note 2 is held by a 
member of USS's expanded group immediately after January 19, 2017, Note 
2 is deemed to be exchanged for stock immediately after January 19, 
2017.
    The final transition period rule also applies to Note 1 because 
Sec.  1.385-3(b) and (d)(1) would have treated Note 1 as stock in a 
taxable year ending before January 19, 2017 but for the fact that USS's 
taxable year ending December 31, 2016, is not a taxable year described 
in Sec.  1.385-3(j)(1). However, because Note 1 was repaid on January 
2, 2017, Note 1 is not held by a member of USS's expanded group 
immediately after January 19, 2017 and, as a result, Note 1 will not be 
recharacterized as stock. Because Note 1 would be recharacterized as 
stock during the final transition period, but Note 1 was not 
recharacterized as stock because it was not outstanding immediately 
after the final transition period, the transition funding rule applies 
to treat the payment with respect to Note 1 on January 2, 2017, as a 
distribution for purposes of applying Sec.  1.385-3(b)(3) to USS's 
taxable year ending on December 31, 2017, and onward.
    The temporary regulations provide similar transition rules for 
transactions covered by Sec. Sec.  1.385-3T(f)(3) through (5).
C. Retroactivity
    The Treasury Department and the IRS received various comments 
regarding the applicability date of the rules in proposed Sec. Sec.  
1.385-3 and 1.385-4. Comments asserted that applying proposed 
Sec. Sec.  1.385-3 and 1.385-4 to instruments issued on or after the 
date of the notice of proposed rulemaking but before the adoption of 
final or temporary regulations would be impermissibly retroactive under 
the relevant statutory authorities.
    While the Treasury Department and the IRS disagree with these 
comments, the applicability dates of the final and temporary 
regulations have been revised. The comments regarding retroactivity 
continue to be inapposite. The final and temporary regulations under 
Sec. Sec.  1.385-3, 1.385-3T, and 1.385-4T apply only to taxable years 
ending on or after 90 days after the publication of the final and 
temporary regulations (that is, January 19, 2017. Accordingly, the 
final and temporary regulations do not require taxpayers to redetermine 
their federal income tax liability for any taxable year ending before 
January 19, 2017.
    Furthermore, as described in Section B of this Part VIII, debt 
instruments issued on or before April 4, 2016, are never subject to 
Sec. Sec.  1.385-3 or 1.385-3T, even if they remain outstanding during 
taxable years to which the final and temporary regulations apply. 
Further, any covered debt instrument issued after April 4, 2016, and on 
or before January 19, 2017, will not be recharacterized until 
immediately after January 19, 2017. Any recharacterization under the 
final and

[[Page 72938]]

temporary regulations will change an instrument's federal tax 
characterization only prospectively.
    The applicability dates governing these regulations are not 
retroactive. Regulations are retroactive if they ``impair rights a 
party possessed when [that party] acted, increase a party's liability 
for past conduct, or impose new duties with respect to transactions 
already completed.'' Landgraf v. USI Film Prods., 511 U.S. 244, 280 
(1994) (explaining retroactivity). The regulations do not impair rights 
or increase a party's tax liability with respect to a purported debt 
instrument until at least 90 days after the date of publication of the 
final and temporary regulations. Regardless of when an instrument is 
issued, beginning on the publication date of the final and temporary 
regulations, affected parties are on notice that such instrument could 
be subject to the rules described in the final and temporary 
regulations, and those instruments will only be prospectively recast as 
equity (that is, beginning 90 days after publication of the final and 
temporary regulations).
    Additionally, even if the final and temporary regulations were 
retroactive, the Treasury Department and the IRS have statutory 
authority to issue retroactive rules. Regulations which relate to 
statutory provisions enacted before July 30, 1996--such as section 
385--are subject to the pre-1996 version of section 7805(b). That 
provision provides express retroactive rulemaking authority by stating 
that the Secretary may prescribe the extent, if any, to which any 
ruling or regulation shall be applied without retroactive effect. 
Section 7805(b) (1995). Therefore, although the final and temporary 
regulations are not retroactive, section 7805(b) in any event provides 
the necessary statutory authority to issue regulations with retroactive 
effect.
    Comments also stated that the Treasury Department and the IRS 
failed to comply with the Administrative Procedure Act (APA) notice-
and-comment and delayed-applicability-date provisions by purportedly 
making proposed Sec. Sec.  1.385-3 and 1.385-4 effective as of April 4, 
2016. One comment stated that the APA's requirement of a delayed-
applicability date in 5 U.S.C. 553(d) overrides the authority provided 
by section 7805(b). This comment pointed to the provision in the APA 
that a subsequent statute may not be held to supersede or modify the 
APA's rulemaking requirements except to the extent that it does so 
expressly. 5 U.S.C. 559.
    These comments are inapposite because the final and temporary 
regulations comply with the requirement of a 30-day delayed-
applicability date in 5 U.S.C. 553(d). The final and temporary 
regulations apply only to taxable years that end on or after 90 days 
after publication of the final and temporary regulations, and only 
begin to recharacterize instruments as equity immediately after 90 days 
after publication of the final and temporary regulations. Furthermore, 
section 7805(b), which permits regulations to have retroactive effect, 
controls in these circumstances because the more specific statute has 
precedence over the general notice statute in section 553(d) of the 
APA. See, e.g., Redhouse v. Commissioner, 728 F.2d 1249, 1253 (9th Cir. 
1984); Wing v. Commissioner, 81 T.C. 17, 28-30 & n.17 (1983). Finally, 
the statutory authority contained in section 7805(b) predates the APA, 
so it is not a subsequent statute that is governed by section 559 of 
the APA.
    Comments also identified a restriction on Congress's authorization 
in section 385(a) to promulgate regulations determining whether an 
instrument is ``in part stock and in part indebtedness.'' See Omnibus 
Budget Reconciliation Act, Public Law 101-239, Sec.  7208(a)(2) 
(requiring that such authority ``shall only apply with respect to 
instruments issued after the date on which'' the Secretary ``provides 
public guidance as to the characterization of such instruments whether 
by regulation, ruling, or otherwise''). As explained in Part III.D of 
this Summary of Comments and Explanation of Revisions, the Treasury 
Department and the IRS have decided at this time not to adopt a general 
bifurcation rule pending further study. Furthermore, to the extent that 
Sec.  1.385-3 results in a partial recharacterization of a purported 
debt instrument after January 19, 2017, the final and temporary 
regulations only apply to instruments issued after April 4, 2016, which 
is the date on which the proposed regulations were filed for public 
inspection with the Federal Register. Accordingly, the final and 
temporary regulations do not apply to debt instruments issued on or 
before the date (April 4, 2016) that the Treasury Department and the 
IRS provided public guidance regarding recharacterization. Therefore, 
the final and temporary regulations comply with the restriction 
regarding section 385(a) in the Omnibus Budget Reconciliation Act.
    Some comments questioned the fairness of applying the proposed 
regulations to instruments issued before the publication date of final 
or temporary regulations, in light of the broad scope of the proposed 
rules and the complex subject matter at issue. The Treasury Department 
and the IRS have concluded that the final and temporary regulations 
adequately address these concerns. As is explained throughout this 
preamble, the scope of the final and temporary regulations is 
significantly narrower than the proposed regulations. For instance, the 
final and temporary regulations reserve on their application to foreign 
issuers and include many new exceptions, including a broad exception 
for short-term debt instruments, among others. Moreover, the final and 
temporary regulations provide that covered debt instruments (which 
excludes instruments issued on or before April 4, 2016) issued on or 
before 90 days after publication of the final and temporary regulations 
will continue to be treated for federal tax purposes as debt 
instruments until immediately after 90 days after the date of 
publication of the final and temporary regulations. To the extent such 
instruments are retired on or before 90 days after the date of 
publication of the final and temporary regulations, they will not be 
affected by the regulations.
    Finally, a comment observed that if the future regulations made 
significant changes to the proposed regulations, such that debt 
instruments that were not subject to the proposed rules would become 
subject to recharacterization under the final rules, this would create 
an impermissible retroactive effect that is not addressed by the 
proposed transition rule.
    In general, the final and temporary regulations do not adopt rules 
that would recharacterize debt instruments that would not have been 
recharacterized under the proposed regulations. However, to the extent 
a taxpayer prefers applying the proposed regulations to debt 
instruments issued after April 4, 2016, but before the filing date of 
the final and temporary regulations, the final and temporary 
regulations allow the taxpayer to apply Sec. Sec.  1.385-1, 1.385-3, 
and 1.385-4 of the proposed regulations subject to certain consistency 
requirements. In particular, Sec.  1.385-3(j)(2)(v) provides that an 
issuer and all members of the issuer's expanded group that are covered 
members may choose to consistently apply those sections of the proposed 
regulations to all debt instruments issued after April 4, 2016, and 
before October 13, 2016, solely for purposes of determining whether a 
debt instrument will be treated as stock. Taxpayers choosing to apply 
the proposed regulations must apply them consistently (including 
applying the partnership provision in proposed Sec.  1.385-3(d)(5) in 
lieu of the temporary regulations) and cannot selectively

[[Page 72939]]

choose which particular provisions to apply.
    Furthermore, because no instrument issued before the publication 
date of the final and temporary regulations will be treated as equity 
until 90 days after the publication date, taxpayers have ample notice 
as to the effect the final regulations will have on such instruments.
D. Delayed Applicability Date and Transition Rules
    Numerous comments requested that the final and temporary 
regulations' applicability date be delayed, with some comments 
requesting a delay of several years after the proposed regulations are 
finalized. Comments also requested that the final and temporary 
regulations apply solely to debt instruments issued on or after such 
delayed applicability date. Other comments suggested different 
applicability dates based on certain characteristics of the issuer (for 
example, earlier applicability dates for inverted corporations) or the 
situation in which an instrument is issued (for example, cash pooling 
arrangements, refinancings, and certain deemed issuances of debt 
instruments). Other comments discussed each section of the proposed 
regulations and suggested applicability dates appropriate for each 
section. For example, many comments were concerned that taxpayers would 
need time to design and implement systems necessary to comply with 
proposed Sec.  1.385-2 and requested the applicability date of the 
documentation rules be delayed from a few months to two years, with the 
vast majority asking for a one year delay after finalization. Comments 
also requested that the documentation rules not apply to interests 
outstanding on, or to interests negotiated before, the applicability 
date of the final and temporary regulations. A comment questioned 
whether, for purposes of applying the proposed regulations before the 
date on which the final and temporary regulations are issued, the 
issuance of a debt instrument that would be treated as stock under the 
proposed regulations should be treated as an issuance of a debt 
instrument or an issuance of stock. Similarly, a comment recommended 
clarification of the treatment of a repayment of such a debt instrument 
before the date on which the interest would be treated as stock under 
the proposed regulations.
    After considering the comments, the final and temporary regulations 
adopt the changes to applicability dates, grandfather rules, and 
expanded transition rules described in Section B of this Part VIII. 
However, the Treasury Department and the IRS do not adopt the 
recommendations to exempt covered debt instruments issued on or after 
April 5, 2016, and before October 21, 2016 for purposes of the 
regulations, or to exempt from those rules covered debt instruments 
issued for some period thereafter. The Treasury Department and the IRS 
have determined that the significant modifications made to scope of the 
proposed regulations, coupled with the expansion and addition of 
numerous exceptions, adequately address the compliance burdens raised 
by the comments with respect to the regulations. For example, many of 
the comments that requested a delayed applicability date cited 
compliance difficulties faced by CFC issuers and issues associated with 
cash pooling arrangements. The final and temporary regulations reserve 
on the application to debt instruments issued by CFCs, and include 
broad exceptions to mitigate the compliance burden for taxpayers that 
participate in cash pooling arrangements.
    Moreover, in developing the applicability dates and grandfathering 
rules for the proposed regulations, the Treasury Department and the IRS 
balanced compliance burdens with the need to prevent taxpayers from 
using any delay in implementation to maximize their related-party debt. 
If the proposed transition rules had simply exempted covered debt 
instruments issued after April 4, 2016, taxpayers would have had 
significant incentivizes to issue related-party debt that did not 
finance new investment in advance of the regulations' finalization. 
Accordingly, the Treasury Department and the IRS have determined that 
the applicability dates and transition rules provided in Sec. Sec.  
1.385-3, 1.385-3T, and 1.385-4T are necessary and appropriate.

Future Guidance and Request for Comments

    As described in this Summary of Comments and Explanation of 
Revisions, several aspects of the final and temporary regulations are 
reserved pending further study. The Treasury Department and the IRS 
request comments on all of the reserved issues, including in 
particular: (i) The application of the final and temporary regulations 
to foreign issuers; (ii) the application of Sec. Sec.  1.385-3 and 
1.385-3T to U.S. branches of foreign issuers, in the absence of more 
comprehensive guidance regarding the application of Sec. Sec.  1.385-3 
and 1.385-3T with respect to foreign issuers; (iii) the expanded group 
treatment of brother-sister groups with common non-corporate owners, 
including how to apply the exceptions in Sec.  1.385-3(c) to such 
groups; (iv) the application of Sec.  1.385-2 to debt not in form, and 
(v) rules prohibiting the affirmative use of Sec. Sec.  1.385-2 and 
1.385-3. The Treasury Department and the IRS also request comments on 
the general bifurcation rule of proposed Sec.  1.385-1(d). Any 
subsequently issued guidance addressing these issues will not apply to 
interests issued before the date of such guidance.
    The Treasury Department and the IRS also request comments on all 
aspects of the temporary regulations. In addition, regarding the 
exception for qualified short-term debt instruments, the Treasury 
Department and the IRS request comments on the specified current assets 
test and whether the maximum outstanding balance described in Sec.  
1.385-3T(b)(3)(vii)(A)(1)(iii) should be limited by reference to 
variances in expected working capital needs over some period of time, 
rather than by reference to the total amount of specified current 
assets reasonably expected to be reflected on the issuer's balance 
sheet during the specified period of time.
    The Treasury Department and the IRS also are concerned that under 
certain circumstances, such as a high-interest rate environment, an 
interest rate that falls within the safe haven interest rate range 
under Sec.  1.482-2(a)(2)(iii)(B), and thus is deemed to be an arm's 
length interest rate, may allow deduction of interest expense 
substantially in excess of the amount that would be determined to be an 
arm's length interest rate in the absence of Sec.  1.482-
2(a)(2)(iii)(B). Specifically, the Treasury Department and the IRS are 
considering whether there is a more appropriate way to allow for a risk 
premium in the safe haven rate than by using a fixed percentage of the 
applicable federal rate. The Treasury Department and the IRS are 
considering a separate project to address this issue and request 
comments on how the safe haven rate of Sec.  1.482-2(a)(2)(iii)(B) 
might be modified to address these concerns.
    Finally, the Treasury Department and the IRS request comments on 
possible future guidance to address debt instruments issued by a member 
of an expanded group to an unrelated third party when the obligation is 
guaranteed by another member of the expanded group.

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

[[Page 72940]]

from the Superintendent of Documents, U.S. Government Publishing 
Office, Washington, DC 20402, or by visiting the IRS Web site at https://www.irs.gov.

Special Analyses

I. Regulatory Planning and Review

    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 final rule is 
provided below.
A. The Need for the Regulatory Action
1. In General
    Corporations can raise money using a wide variety of financial 
instruments. But for income tax purposes, what matters is whether the 
firms borrow (issue debt) or sell ownership interests in the 
corporation (issue equity). Under U.S. tax rules, interest (the return 
paid on debt) is deductible in determining taxable income while 
dividends (the return paid on equity) are not. This implies that 
corporations can reduce their U.S. federal income tax liability by 
financing their activities with debt instruments rather than with 
equity. And this provides a strong incentive to characterize financial 
instruments issued as ``debt'' even when they have some of the 
properties of equity instruments. In most circumstances, however, the 
ability to employ debt instead of equity, and thereby reduce income 
taxes paid, is limited by economic forces and legal constraints. In the 
marketplace, the cost of debt (that is, the interest rate charged) and 
the willingness of lenders to supply credit are generally dependent on 
a borrower's creditworthiness and the terms of repayment to which the 
parties agree. It is also generally accepted that independent parties 
to a lending transaction will act in their own best interests in terms 
of honoring the terms of a debt and in enforcing creditor's rights. 
Therefore, in these circumstances where unrelated parties engage in the 
financial transactions, an individual corporation's choice to employ 
either debt or equity, and its assessment of the amount of debt it can 
take on, are decisions that are determined, and limited, by market 
forces. In this context, the ability of individual corporations to 
reduce U.S. federal income tax liability by financing their operations 
with debt issued to unrelated parties rather than equity is to a degree 
naturally limited.
    When the checks and balances of the market are removed, as they are 
when related corporations transact, there are often few practical 
economic or legal forces that constrain the choice between employing 
debt or equity. Related corporations can essentially act as a unit 
that, in effect, borrows and lends to itself without being subject to 
the forces that otherwise place limits on the cost and amount of 
indebtedness. In the context of highly-related parties, for example a 
parent corporation and its wholly-owned subsidiary, factors such as 
creditworthiness, ability to repay, and sufficiency of collateral may 
not be relevant if a decision to finance has otherwise been made. In 
these circumstances, the financing choice thus can be determined solely 
on the basis of income tax considerations, which often favor debt.
    The absence of market forces operating among related corporations 
can, in addition to influencing internal financing decisions, create 
incentives for corporations that do not require financing to incur debt 
solely for tax-related reasons. Related corporations can engage in tax 
arbitrage, among other ways, by causing profitable corporations (facing 
a relatively high marginal tax rate) to incur debt (and pay interest) 
to corporations with losses (facing a relatively low or zero marginal 
tax rate), or by causing corporations in high tax rate jurisdictions to 
incur debt and pay interest to corporations in low tax rate 
jurisdictions. In addition, because intra-group debt will often have no 
legal or economic consequences outside of the related-party group of 
corporations, related corporations can use intra-group debt to increase 
the total amount of their obligations labeled as debt well beyond the 
amount of the external, third-party indebtedness of the group. While 
such tax arbitrage opportunities have been a longstanding problem, 
their associated economic and revenue costs appear to have increased in 
recent years.
    From a U.S. tax perspective, subject to general tax principles and 
certain limited statutory constraints, corporations are generally free 
to structure their financial arrangements, even intra-group 
instruments, as debt or equity. However, the unique nature of related-
party debt presents a number of issues that the section 385 regulations 
are intended to address. At a basic level, the section 385 regulations 
require highly-related parties (meaning generally those that meet an 80 
percent common ownership test) to demonstrate that purported debt 
issued among them is properly characterized as debt for U.S. federal 
tax purposes, and thus that they are entitled to the interest 
deductions associated with such debt. An 80 percent common ownership 
threshold is often used under the tax Code and tax regulations to 
identify highly-related corporations, for example, to determine 
eligibility to file a consolidated federal income tax return or claim a 
deduction offsetting dividends received from subsidiaries. As noted, 
there are generally no external forces that constrain related-party 
debt and, as a consequence, the parties to a financing may attempt to 
characterize a transaction as tax-favored debt when it is more properly 
viewed in substance as equity. The section 385 regulations provide 
factors that are required to be used in evaluating the nature of an 
instrument among highly-related parties as debt or equity.
    The section 385 regulations require related parties to document 
their intention to create debt and that their continuing behavior is 
consistent with such characterization. With respect to unrelated 
parties, the establishment of a creditor-debtor relationship generally 
involves such documentation. In the context of related parties, that is 
not always the case, even though it is a factor indicative of debt 
under existing common law tax principles. The absence of such 
documentation can be particularly problematic, for example, when the 
IRS attempts to assess the appropriateness of tax deductions for 
interest attributable to related-party debt. The section 385 
regulations provide minimum standards, in line with what would be 
expected of unrelated parties, that related parties must observe in 
order for their debtor-creditor relationships to be respected as such 
for income tax purposes.
    In addition, the section 385 regulations recharacterize purported 
debt as equity when certain prescribed factors demonstrate that the 
interest reflects a corporation-shareholder relationship rather than a 
debtor-creditor relationship. An unrelated party would not agree to owe 
a ``creditor'' a principal amount without receiving loan proceeds or 
some other property of value in return. However, as discussed, related 
parties are not so constrained, and an unfunded promise

[[Page 72941]]

among such parties to pay some amount in the future may have little 
economic effect or legal implication. Nonetheless, that promise to pay, 
if respected, could have significant consequences for income tax 
purposes. If the interest paid on an unfunded note (a debt instrument) 
to a parent corporation from a U.S. subsidiary was taxed at a lower 
rate than the marginal tax rate faced by the subsidiary or was untaxed 
at the parent corporation level, then the parent-subsidiary group would 
have achieved a reduction of its overall tax burden without 
meaningfully changing its overall legal or economic profile. In 
characterizing an instrument as debt or equity, the section 385 
regulations consider as factors the relatedness of corporations and 
whether or not the instrument funded new investment in the issuer. If 
an instrument among highly-related parties does not finance new 
investment, the section 385 regulations treat the instrument as 
representing a corporation-shareholder relationship.
    The section 385 regulations are intended to apply to related-party 
transactions undertaken by large corporate taxpayers that are 
responsible for a majority of corporate business activity and that have 
organizational structures that include subsidiaries or affiliated 
groups. These businesses represent about 0.1 percent of all 
corporations (tax filings for consolidated groups are counted as one 
return) but are responsible for about 65 percent of all corporate 
interest deductions and 54 percent of corporate net income. It is for 
this group of corporations that the opportunity to engage in 
intercompany transactions, the scale of the business activity, and the 
potential gains from tax arbitrage create the most potential for 
mischaracterization of equity as debt.
2. Application
    Information and tax data on intercompany transactions within a 
single multinational firm is generally not reported to the IRS, making 
it harder to compile than similar information for unrelated parties. 
Nonetheless, examples of how the mischaracterization of equity as debt 
can facilitate tax arbitrage are readily available. One clear example 
can be found in the case of foreign-parented corporations that create 
debt to use interest deductions to shift income out of the U.S. tax 
base (so-called ``interest stripping''). These corporations are 
referred to in this discussion as foreign controlled domestic 
corporations (or FCDCs) because they are owned/controlled by non-U.S. 
companies and they operate in the United States. When these companies 
pay interest to affiliated companies outside the United States, the 
payments reduce taxes on income generated in the United States. This is 
an advantage to the group as a whole if it lowers the total amount of 
tax paid worldwide, which will happen to the extent that the U.S. tax 
rate exceeds the foreign tax rate that applies to the interest income. 
In a purely domestic context (a U.S. owned domestic corporation lending 
to another affiliated U.S. owned domestic corporation), such arbitrage 
possibilities also exist, for example, if the borrower has net positive 
income but the lender has a net operating loss.
    One common strategy for creating intercompany debt between related 
entities is distributing debt instruments. In a prototypical 
transaction of this type, a U.S. business distributes to its foreign 
parent a note. The U.S. subsidiary receives nothing in exchange for the 
note (in particular, it receives no cash from the parent). The parent 
can then keep the note, or transfer it to an affiliate in a low tax 
jurisdiction. The U.S. subsidiary then deducts interest on the note, 
which reduces U.S. income tax liability.
    Such a transaction has little, if any, real economic or financial 
consequence aside from the tax benefit. There are no loan proceeds for 
the U.S. subsidiary to invest, so there is no new U.S. income generated 
that could offset the tax deduction for interest paid to the foreign 
parent. In addition, the companies can set a high interest rate on the 
loan (as long as they can defend the rate under tax rules as an arm's 
length rate; the more leveraged the firm, the higher the rate that can 
be justified), in order to maximize the amount of income that is 
stripped out of the U.S. tax system. Because the income and deduction 
offset each other on the multinational company's financial statements, 
there are no practical impediments to charging a high rate (apart from 
tax audit risk related to the appropriateness of the interest 
deduction). Importantly, the note does not lead to an increase in 
investment in the United States.
    Other transactions can produce a similar tax result. For instance, 
the parent company could lend a sum to the subsidiary, but have the 
subsidiary return the amount borrowed to the parent through another 
transaction, such as a dividend of the sum lent or a purchase of the 
parent's own stock. When the borrowing and the related transaction to 
return funds to the lender are considered in their totality, this 
transaction has the same practical tax and economic effect as 
distributing a note.
    The ability of related parties to create intercompany debt 
generates undesirable tax incentives in certain contexts. For example, 
the ability of a foreign parent corporation to reduce U.S. tax 
liability by causing a U.S. business to distribute notes to the foreign 
parent gives an advantage to foreign-owned U.S. businesses over U.S.-
owned multinational businesses. U.S. multinational corporations (MNCs) 
generally cannot use related-party debt to strip earnings out of the 
United States, because interest paid from the U.S. parent and U.S. 
subsidiaries to their foreign subsidiaries is taxed when received under 
the subpart F rules, the U.S. controlled foreign corporation (CFC) 
regime that taxes currently passive and other mobile income earned 
outside the United States. (Interest paid from one U.S. subsidiary to 
another in a consolidated group would do nothing to reduce federal 
income taxes, because the recipient's tax inclusion would offset the 
payer's tax deduction in the same federal income tax return.)
    Moreover, the advantage FCDCs gain over U.S. MNCs from 
mischaracterizing equity as debt is economically significant, because 
existing limits on tax deductions from interest stripping, which 
generally impact FCDCs, are ineffective in limiting tax arbitrage 
opportunities. Under current law, the two potential limits on the 
amount of FCDC debt are a statutory limit on related-party interest 
deductions (under section 163(j) of the Code) and a general limit based 
on case law distinguishing debt from equity. The statutory limit 
(section 163(j)) restricts deductions for interest paid to related 
parties or guaranteed by related parties to the extent that net 
interest deductions (interest paid less interest received) exceed 50 
percent of adjusted taxable income (which is an expanded measure of 
income: Income measured without regard to deductions such as net 
interest, depreciation, amortization, depletion, net operating losses). 
This deduction limit applies whenever the firm's debt-equity ratio 
exceeds 1.5:1. Data from IRS Form 8926 ``Disqualified Corporate 
Interest Expense Disallowed Under Section 163(j) and Related 
Information'' shows that 50 percent of adjusted taxable income is 
roughly 100 percent of taxable income before net interest, which means 
that firms can on average strip all of their income out of the United 
States using interest deductions before the limit is reached. Case law, 
moreover, supports a wide variety of debt-equity ratios as acceptable 
for purposes of supporting debt characterization. Even when debt-

[[Page 72942]]

equity ratios are considered in the case law, they are considered on a 
facts-and-circumstances basis and as one of many factors used to 
distinguish debt from equity by the courts. Finally, as discussed 
previously, because intercompany debt does not affect the multinational 
firm's external capital structure, the amount of intercompany debt and 
the interest rate applied are not subject to the constraints that the 
market would impose on third-party loans. Because these limitations are 
not binding, the tax advantages from mischaracterizing equity as debt 
are large and unchecked.
    While interest stripping has been a longstanding problem for the 
U.S. tax system, the associated economic and revenue costs appear to 
have increased over the past several years. For example, data gathered 
by Bloomberg (https://www.bloomberg.com/graphics/infographics/tax-runaways-tracking-inversions.html) shows the pace of corporate 
inversions, which are reorganizations whereby U.S. MNCs become FCDCs, 
has increased over the past several years. One of the principal tax 
advantages obtained in an inversion is the ability to use interest 
deductions to reduce U.S. taxes by stripping income out of the United 
States. While inversions are a particularly visible example of how 
related-party debt can be used for tax avoidance purposes, other FCDCs 
have similar incentives and opportunities to use related-party debt to 
engage in interest stripping.
    The evidence suggests that FCDCs engage in substantial interest 
stripping. The best evidence for interest stripping by FCDCs is 
presented in Jim Seida and William Wempe, ``Effective Tax Rate Changes 
and Earnings Stripping Following Corporate Inversion,'' National Tax 
Journal, December 2004. In this paper, the authors found that the 
worldwide effective tax rates of inverted companies fell drastically 
after the inversion and that the reduction in tax was due to interest 
stripping. For a subsample of firms where additional information was 
available, the authors concluded that the mechanism for interest 
stripping was intercompany debt. In particular, Seida and Wempe 
estimate that the inverted companies selected in their subsample for 
detailed analysis increased U.S. interest deductions by about $1 
billion per year on average in 2002 and 2003, or about $350 million in 
tax savings at 35 percent. Seida and Wempe did not report tax savings 
from their broader group of companies (of which there were 12), only 
reductions in tax rates.
    More recently, Zachary Mider, `` `Unpatriotic Tax Loophole' 
Targeted by Obama to Cost U.S. $2 billion in 2015,'' Bloomberg BNA 
Daily Tax Report, December 2, 2014, reports a Bloomberg update of Seida 
and Wempe's broader analysis, which expands the number of inverted 
companies from 12 to 15 and finds tax savings of between $2.8 billion 
and $5.7 billion in 2015, depending on whether cash taxes paid or 
accounting tax expense is used.
    These analyses looked at only a small subset of the companies that 
have inverted. There have been at least 60 inversions by public 
corporations since 1982. In addition there have been many takeovers of 
U.S. companies by previously-inverted companies, which are equivalent 
in result. From companies associated with inversions, it is therefore 
likely that the U.S. Treasury loses tens of billions of dollars per 
year in corporate tax revenue due to interest stripping.
    Additional revenue losses come from FCDCs that have operated in the 
United States for many years or were not otherwise involved in 
transactions classified as inversions. Studies of interest stripping by 
FCDCs more generally have not been as conclusive as the studies of 
inversions. In part, this is because the level of detail in financial 
reports that is available for FCDCs generally is lower than for 
inverted companies. Nonetheless, it is likely that, given the advantage 
FCDCs have over U.S. MNCs in their ability to strip earnings using 
interest deductions, considerable additional interest stripping is 
attributable to FCDCs not associated with inversions. As one indication 
of this possibility, the most recent (2012) available data from 
corporate tax Form 1120 shows that FCDCs have a nearly 50 percent 
higher ratio of net interest deductions relative to earnings before net 
interest and taxes (EBIT) than do U.S. MNCs.
    While most of the concern about interest stripping is focused on 
interest payments made to parties outside the United States, similar 
transactions sometimes occur between U.S. companies. The scope for a 
tax advantage from such intercompany lending is limited because, in 
many cases, one company's deduction of an interest payment would be 
offset by the other company's inclusion of interest income. However, 
when the companies do not file a consolidated tax return, but 
nonetheless are members of an affiliated group, there can be tax 
benefits to intercompany lending. For example, if an affiliated group 
includes two U.S. corporations that do not file a consolidated return, 
and one corporation has $100 of taxable income and the other has $100 
of net operating losses carried over from prior years, the corporation 
with taxable income pays federal income tax and the one with losses 
does not, nor does it get a tax refund. Collectively, the $100 of 
income is taxed. However, the overall federal income tax liability of 
the affiliated group can be reduced using an intercompany loan that 
results in a deductible interest payment of $100 by the entity with 
taxable income to the affiliate with a $100 net operating loss. As a 
result, both corporate entities will have zero taxable income for the 
year.
B. Affected Population
    This analysis begins by describing some basic facts about the size 
of the U.S. corporate business sector. These tax facts help to frame 
the discussion and suggest the magnitude of the section 385 
regulations' estimated effects. This analysis uses an expansive 
definition of the estimated affected population in order to minimize 
the risk that the analysis will not capture the effects on collateral 
groups.
1. Application to C Corporations
    The regulations are intended to apply primarily to large U.S. 
corporations taxable under subchapter C of chapter 1 of subtitle A of 
the Code (``C corporations'') that engage in substantial debt 
transactions, or purported debt transactions, between highly-related 
businesses. C corporations are businesses that are subject to the 
separate U.S. corporate income tax. In 2012, approximately 1.6 million 
C corporation tax returns were filed in the United States (tax filings 
for consolidated groups are counted as one return). The regulations 
specifically exempt other corporations which, while having the 
corporate form of organization, generally do not pay the separate 
corporate income tax. They are a form of ``pass-through'' organization, 
so called because the income generally is passed-through the business 
(without tax) to the businesses' owners, who pay tax on the income. 
These other corporations are much more numerous than are C 
corporations: They number roughly 4.2 million corporations and consist 
mainly of ``small business corporations'' taxable under subchapter S of 
chapter 1 of subtitle A of the Code (``S corporations''), regulated 
investment companies (RICs, commonly known as mutual funds), and real 
estate investment trusts (REITs). Because the income of pass-through 
businesses is aggregated on their owners' returns, there is little tax 
incentive to mischaracterize equity as debt for purposes of shifting 
income between

[[Page 72943]]

pass-through entities and their owners--deductions for interest paid 
would generally be offset by inclusions for interest received. 
Moreover, these pass-through entities typically are not members of 
large multinational or domestic affiliated groups, and so typically are 
not heavily engaged in the types of intra-group lending transactions 
with highly-related C corporations addressed by the regulations.
    In 2012, C corporations reported $63 trillion (74 percent of the 
total reported by all corporations) of total assets, $738 billion (91 
percent of the total) of interest deductions, $9.7 trillion (75 percent 
of the total) of total income, and $1 trillion (59 percent of the 
total) of net income, according to Treasury tabulations of tax return 
data. Given that only 27 percent of all corporate filings are for C 
corporations, these figures suggest that C corporations are larger than 
average for all corporations and account for a disproportionate 
fraction of business activity, relative to their number compared to all 
corporations. In 2012, C corporations paid $265 billion in income taxes 
after credits. Most C corporation activity is concentrated in a small 
fraction of very large firms. For instance, only about 1 percent of C 
corporation returns have assets in excess of $100 million and only 
about 0.6 percent have total income (a proxy for revenue) in excess of 
$50 million. However, returns of firms of this size account for about 
95 percent of total interest deductions and 85 percent of total income.
    The section 385 regulations do not apply to all C corporations. The 
concerns addressed by the regulations are not present in certain 
categories of related-party corporate transactions, for example among 
related corporations (whether ultimately U.S-parented or foreign-
parented) that file a consolidated U.S. income tax return. In addition, 
the Treasury Department and the IRS have determined that, with respect 
to certain smaller corporations, the benefits of applying the rules are 
outweighed by the compliance cost of applying the rules to such 
entities. Hence, the regulations narrow the number of firms affected 
substantially. As described in this description of the affected 
population, of 1.6 million C corporations, the Treasury Department 
estimates that only about 6,300 large C corporations will potentially 
be affected by the documentation requirements of the regulations. This 
is because only about 6,300 C corporations are part of expanded groups 
(which are defined by the regulations as section 1504(a) ``affiliated 
groups,'' but also include foreign corporations, tax-exempt 
corporations, and indirectly held corporations) that have sufficient 
assets (more than $100 million), revenue (more than $50 million), or 
are publicly traded. An even smaller number of corporations, about 
1,200, appear to report transactions consistent with those that are 
potentially subject to the general recharacterization rules of the 
regulation (Sec.  1.385-3), although limited data exists on the number 
of corporations that are covered by the regulations and engaged in 
transactions that are economically similar to the general rule 
transactions. Treasury estimates that even though these 1,200 
corporations comprise less than 0.1 percent of C corporations, they 
report approximately 11 percent of corporate interest deductions and 6 
percent of corporate net income on tax returns.
2. Documentation of Intercompany Loans and Compliance
    While there is variation across businesses, longer-term 
intercompany debt would typically be documented, in some form of 
agreement containing terms and rights, by corporations following good 
business practices. However, some information required by the 
regulations, such as a debt capacity analysis, may not typically be 
prepared in some cases. The regulations do not require a specific type 
of credit analysis or documentation be prepared in order to establish a 
debtor's creditworthiness and ability to repay, but merely impose a 
standard closer to commercial practice. To the extent that information 
supporting such analysis is already prepared in accordance with a 
company's normal business practice, complying with the regulations 
would have a relatively low compliance cost. However, where a business 
has not typically prepared and maintained written debt instruments, 
term sheets, cash flow, or debt capacity analyses for intercompany 
debt, compliance costs related to the regulations will be higher. While 
the level of documentation required is clearly evident in third-party 
lending, there is little available information on the extent to which 
related parties document their intercompany loans. Anecdotal evidence 
and comments received indicate that businesses vary in the extent to 
which related-party indebtedness is documented. Nevertheless, the 
Treasury Department does not have detailed and quantitative assessment 
of current documentation practices.
C. Description of the Regulations
1. In General
    The section 385 regulations have multiple parts. In general, the 
regulations describe factors to be used in assessing the nature of 
interests issued between highly-related corporations, how such factors 
may be demonstrated, and when the presence of certain factors will be 
dispositive. As proposed, the first part (proposed Sec.  1.385-1) 
allowed the IRS to bifurcate a single financial instrument between 
related parties into components of debt and equity, where appropriate. 
The final and temporary regulations, however, do not include the 
bifurcation rule as the Treasury Department and the IRS are continuing 
to study the potential issues raised by such a rule. Thus, the revenue 
and compliance-cost effects associated with the bifurcation rule of the 
proposed regulations are now excluded from this analysis.
    The second part of the regulations, Sec.  1.385-2, prescribes the 
nature of the documentation necessary to substantiate the tax treatment 
of related-party instruments as indebtedness, including documentation 
of factors analogous to those found in third-party loans. This 
generally means that taxpayers must be able to provide such things as: 
Evidence of an unconditional and binding obligation to make interest 
and principal payments on certain fixed dates; that the holder of the 
loan has the rights of a creditor, including superior rights to 
shareholders in the case of dissolution; a reasonable expectation of 
the borrower's ability to repay the loan; and evidence of conduct 
consistent with a debtor-creditor relationship. These documentation 
rules would apply to relevant intercompany debt issued by U.S. 
borrowers beginning in 2018 and would require that the taxpayer's 
documentation for a given tax year be prepared by the time the 
borrower's federal income tax return is filed.
    The third part of the regulations, Sec. Sec.  1.385-3 and 1.385-3T, 
provides rules that can recharacterize purported debt of U.S. issuers 
as equity if the interest is among highly-related parties and does not 
finance new investment. These rules are intended to address 
transactions that create significant U.S. federal tax benefits while 
lacking meaningful legal or economic significance. Subject to a variety 
of exceptions for more ordinary course transactions, the rules 
recharacterize a note that is distributed from a U.S. issuer to a 
parent corporation, or other highly-related entity, as equity. The 
rules also apply to the use of notes to fund acquisitions of related-
party stock and internal asset

[[Page 72944]]

reorganizations, as well as multi-step transactions that have an 
economically similar result. Any intra-group debt recharacterized as 
equity by the regulations eliminates the ability of the purported 
borrower to deduct interest from its taxable income.
    The fourth part of the regulations, Sec.  1.385-4T, includes 
special rules for applying Sec.  1.385-3 to consolidated groups, 
consistent with the general purpose of Sec.  1.385-3. References in the 
following discussion to ``Sec.  1.385-3'' include Sec. Sec.  1.385-3T 
and 1.385-4T. Section 1.385-3 applies only to debt issued after April 
4, 2016, the date the proposed regulations were published, and so 
grandfather intragroup debt issued before that date.
2. Limitations of Final and Temporary Regulations and Significant 
Modifications
    Taking into consideration the comments received on the proposed 
regulations, the Treasury Department and the IRS are modifying the 
regulations to address certain unintended impacts of the proposal. The 
final and temporary regulations also better target the entities and 
activities that lead to inappropriate interest deductions by limiting 
the type of businesses affected. In doing so, the final and temporary 
regulations significantly reduce compliance and administrative burden, 
while still placing effective limits on the transactions most 
responsible for inappropriately reducing U.S. tax revenue.
    Because tax-motived incentives to mischaracterize equity as debt 
depend on a taxpayer's situation, in certain circumstances the 
likelihood of mischaracterization or the consequences thereof are 
small. In these circumstances, exceptions to the general rules may 
reduce the compliance or administrative burden of the rules, increase 
the compliance benefit relative to associated costs, or avoid 
unintended costs. To this end, the final and temporary regulations 
limit the type and size of businesses affected and the types of 
transactions and activities to which they apply. In particular, Sec.  
1.385-2 only applies to related groups of corporations where the stock 
of at least one member is publicly traded or the group's financial 
results report assets exceeding $100 million or annual revenue 
exceeding $50 million. Because there is no general definition of a 
small business in tax law, these asset and revenue limits are designed 
to exceed the maximum receipts threshold used by the Small Business 
Administration in defining small businesses (U.S. Small Business 
Administration, Table of Small Business Size Standards, 2016). In 
addition, these thresholds exclude about 99 percent of C corporation 
taxpayers while retaining 85 percent of economic activity as measured 
by total income. Approximately 1.5 million out of 1.6 million C 
corporation tax filers are single entities and therefore have no 
affiliates with which to engage in tax arbitrage. The intent is to 
limit the regulations to large businesses with highly-related 
affiliates, which are responsible for most corporate activity.
    Furthermore, in response to public comments and analysis of the 
data related to the proposed regulations, the rules of Sec. Sec.  
1.385-2 and 1.385-3 have been significantly modified. In developing 
these modifications, the Treasury Department and the IRS considered a 
number of alternative approaches suggested by comments, as discussed 
previously in this preamble. The intended cumulative effect of these 
modifications is to focus the application of the regulations on large, 
complex corporate groups where the most opportunity for non-commercial, 
tax-motivated transactions of the type targeted by the regulations 
exists, while reducing, or eliminating, the burdens on other taxpayers. 
For example, large FCDCs (assets over $100 million and total income 
over $50 million) make up 3 percent of FCDCs but report 90 percent of 
FCDC interest deductions and 93 percent of FCDC total income. 
Similarly, the modifications are intended to exempt most ordinary 
course transactions from the application of the regulations. The most 
significant modifications include the following:
     S corporations, RICs, and REITs that are not controlled by 
corporate members of an expanded group are excluded from all aspects of 
the final and temporary regulations. See Part III.B.2.b of the Summary 
of Comments and Explanation of Revisions. The Treasury Department and 
the IRS have determined that an S corporation, RIC, or REIT that would 
otherwise be the parent of an expanded group is generally analogous to 
a non-controlled partnership. Under both the proposed and the final and 
temporary regulations, a non-controlled partnership that would, if it 
were a corporation, be the parent of an expanded group is excluded from 
the expanded group. S corporations, RICs, and REITs have similar flow-
through characteristics in that business income from these types of 
aggregate entities generally flows to and is aggregated on the business 
owners' returns. Moreover, S corporations and non-controlled RICs and 
REITs are generally not part of multinational groups and are unlikely 
to engage in the types of transactions targeted by the regulations 
because these types of entities have fewer incentives to 
mischaracterize equity as debt under the U.S. tax system, so their 
exclusion generally does not affect tax compliance benefits and 
eliminates compliance costs.
     The regulations reserve on the application to non-U.S. 
issuers (that is, foreign corporations that issue debt). See Part 
III.A.1 of the Summary of Comments and Explanation of Revisions. Non-
U.S. issuers have limited incentives to mischaracterize equity as debt 
under the U.S. tax system because non-U.S. debt does not generally 
affect U.S. corporate liability directly either because (i) the issuer 
is entirely foreign owned (and thus generally outside of the U.S. tax 
system if it lacks a U.S. presence) or, (ii) in the case of an issuer 
that is a CFC, its income is eligible for deferral. Applying the 
regulations to non-U.S. issuers would impact the operations of large, 
complex MNCs which may involve foreign-to-foreign lending or non-U.S. 
issuance, which would be burdensome to document and monitor for 
compliance, but there would be minimal revenue gains because the use of 
related party debt in these contexts generally does not result in U.S. 
tax benefits. In general, there is negligible tax revenue lost by this 
exclusion, while compliance costs are significantly reduced. 
Nevertheless, in certain cases there may be U.S. tax effects from 
mischaracterizing interests of non-U.S. issuers, although these effects 
are less direct and of a different nature. The regulations reserve on 
the application to foreign issuers as the Treasury Department and the 
IRS continue to consider how the burdens of complying in this context 
compare to the advantages of limiting potential abuses and how a better 
balance might be achieved.
     The final and temporary regulations generally exclude from 
the rules of Sec.  1.385-3 regulated financial services entities that 
are subject to certain levels of federal regulation and supervision, 
including insurance companies (other than captive insurers). See Parts 
IV.B.2.a and b, and V.G.1 and 2 of the Summary of Comments and 
Explanation of Revisions. Regulated financial service entities are 
subject to capital or leverage requirements which constrain the ability 
of such institutions to engage in the transactions that are addressed 
by the regulations. For example, such entities could be precluded from 
or required to issue related-party debt in certain cases. Such an 
exception is also generally consistent with international

[[Page 72945]]

accepted approaches on addressing interest stripping, which acknowledge 
the special circumstances presented by banks and insurance companies. 
See OECD BEPS Action Item 4 (Limiting Base Erosion Involving Interest 
Deductions and Other Financial Payments), ch. 10. Furthermore, 
compliance costs of including these entities in the regulations would 
likely have been significant compared to potential tax revenue gains 
from their inclusion. The documentation rules under Sec.  1.385-2 
exempt from some of the documentation requirements debt instruments 
issued by regulated financial service entities to the extent the debt 
instruments contain terms required by a regulator to satisfy regulatory 
requirements or require a regulator's approval before principal or 
interest is paid.
     The regulations under Sec.  1.385-3 provide various 
exceptions and exclusions that are intended to exempt certain 
transactions and certain common commercial lending practices from being 
subject to the rules in cases where compliance burdens or efficiency 
costs are likely to be elevated and potential improvements in tax 
compliance modest.
    [cir] Section 1.385-3 excludes cash pool borrowing and other short-
term debt, by excluding loans that are short term in form and 
substance. See Part V.D.8 of the Summary of Comments and Explanation of 
Revisions. The exception for short-term debt allows companies to 
efficiently transfer cash around an affiliated group in order to meet 
the day-to-day global cash needs of the business without resorting to 
third-party borrowing in order to avoid Sec.  1.385-3. These 
transactions tend to have low interest rates such that for a fixed 
amount of debt, the interest expense is limited. On the other hand, the 
costs of tracking these loans, which could occur with high frequency, 
for purposes of determining whether Sec.  1.385-3 applies may be 
significant. Therefore, tax compliance gains from their inclusion are 
likely to be small relative to the costs of compliance.
    [cir] When applying the Sec.  1.385-3 rules, an expanded earnings 
and profits (E&P) exception takes into account a corporation's E&P 
accumulated after April 4, 2016, as opposed to limiting distributions 
to the amount of E&P generated each year. See Part V.E.3.a of the 
Summary of Comments and Explanation of Revisions. The change ensures 
that companies are not incentivized to make distributions that use up 
their current E&P before it becomes unusable in the next taxable year. 
However, the accumulated E&P available to offset distributions or 
acquisitions resets to zero when there is a change in control of the 
issuer, due, for example, to the issuer being acquired by an unrelated 
party. The accumulated E&P available to offset distributions or 
acquisitions also resets to zero when there is a change of expanded 
group parent (including in an inversion). These limitations avoid 
creating incentives for companies (including inverted companies) to 
acquire or undertake transactions with companies rich in accumulated 
earnings to circumvent the regulations by relying on previously 
accumulated E&P. Therefore, this exception is of limited benefit to 
inverted corporations seeking to acquire new U.S. targets or to U.S. 
corporations themselves that undertake an inversion that results in a 
new foreign parent, which could otherwise represent a major source of 
tax revenue loss.
    [cir] The final and temporary regulations allow a taxpayer to 
reduce the amount of its distributions and acquisitions that otherwise 
could cause an equal amount of the taxpayer's debt to be 
recharacterized as equity by the amount of the contributions to the 
taxpayer's capital. This has the effect of treating distributions and 
acquisitions as funded by new equity contributions before related-party 
borrowings and ensuring that companies that have not seen a reduction 
in net equity are not subject to the rules. See Part V.E.3.b of the 
Summary of Comments and Explanation of Revisions.
    [cir] The final and temporary regulations expand access to the $50 
million indebtedness exception by removing the ``cliff effect'' of the 
threshold exception under the proposed regulations, so that all 
taxpayers can exclude the first $50 million of indebtedness that 
otherwise would be recharacterized. See Part V.E.4 of the Summary of 
Comments and Explanation of Revisions. Eliminating the $50 million 
cliff has little tax revenue effect but eliminates a potential economic 
distortion to the financing choices of corporations near the threshold.
     The regulations reduce and relax the documentation rules 
in various ways that reduce compliance burdens without compromising tax 
compliance.
    [cir] The documentation requirements in Sec.  1.385-2 do not apply 
until January 1, 2018. Delaying the documentation requirements 
marginally lowers the start-up costs related to complying with the 
regulations. The effect on revenue is expected to be negligible and the 
compliance costs slightly lower.
    [cir] The compliance period for documenting a loan has been 
extended from 30 days after issuance (or other relevant date) to 
instead be the date when the borrower's tax return is filed. Providing 
additional time for the recurring documentation requirements may lower 
the compliance burden while still providing documentation necessary for 
tax administration.
    [cir] The documentation rules have been eased so that a failure 
with respect to documentation of a particular instrument does not 
automatically result in recharacterization as equity where a group is 
otherwise substantially compliant with the rules. See Parts IV.A.2 and 
3 of the Summary of Comments and Explanation of Revisions. This relief 
is expected to have negligible tax revenue cost while potentially 
lowering compliance costs for companies and increasing costs for the 
IRS.
     The final and temporary regulations do not include a 
general rule that bifurcates (for tax purposes) a single financial 
instrument into debt and equity components. See Part III.D of the 
Summary of Comments and Explanation of Revisions. The general 
bifurcation rule in the proposed regulations was broadly applicable and 
not subject to the same threshold rules as most of the regulations' 
other provisions. The proposed rule is not being finalized due to 
concerns about a lack of specificity in application and corresponding 
unintended collateral consequences. For example, one concern was that 
this provision could have unintended and disqualifying effects on an 
entity's tax status, such as for an S Corporation or a REIT. The 
regulatory revenue effect was reduced by approximately 10 percent as a 
result of this change.
    The exceptions and exclusions summarized in this Regulatory Impact 
Assessment limit the compliance burden imposed by the final and 
temporary regulations at limited revenue cost. Hence, the final and 
temporary regulations narrowly target the transactions of greatest 
concern while still being administrable.
D. Assessment of the Regulations' Effects
    The documentation requirements for purported debt (Sec.  1.385-2) 
are likely to affect the largest number of corporations. As mentioned 
previously, in 2012 there were roughly 1.6 million U.S. C corporation 
tax returns filed (tax filings for consolidated groups are counted as 
one return). The Treasury Department and the IRS estimate that only 
6,300 (0.4 percent) of these taxpayers would be affected by the 
documentation rules, mainly because 95 percent of taxpayers do not have 
affiliated corporations, and the

[[Page 72946]]

regulations only affect transactions between affiliates.
    While only a small fraction of corporate taxpayers will be affected 
by Sec.  1.385-2, these 6,300 taxpayers tend to be the largest, with 65 
percent of total interest deductions, 53 percent of total income, 81 
percent of total income subject to tax, and 75 percent of total income 
tax after credits. Of these corporations, approximately one-third are 
FCDCs that report about 20 percent of the affected total income and 20 
percent of the affected interest deductions.
    A subset of these corporate taxpayers, including both domestic and 
foreign-controlled domestic corporations, are likely to be affected by 
Sec.  1.385-3. While it is difficult to measure the exact number of 
firms that are likely to be affected due to tax data limitations, 
Treasury estimates that of the 6,300 firms affected by Sec.  1.385-2, 
about 1,200 will be affected by Sec.  1.385-3. The number of firms 
affected is smaller because only transactions that exceed $50 million 
plus relevant E&P and capital contributions are affected, and because 
other exemptions in the final and temporary regulations limit the 
number of firms affected. The largest revenue effects are anticipated 
to arise from foreign-controlled domestic corporations.
    The regulations are intended to address scenarios that present the 
most potential for the creation of significant U.S. federal tax 
benefits without having meaningful non-tax significance because the 
obligations are between commonly-owned corporations and because the 
obligations do not finance new investment in the issuer. These 
situations most affect revenues due to tax arbitrage. That is, the 
regulations are tailored to reach only transactions between related 
parties (where the risk of such tax arbitrage is greatest), tax 
situations and transactions where incentives for mischaracterization of 
equity as debt are strongest, and only then when there is no new 
investment in the borrowing entity. In developing the regulations, care 
was taken to balance the goals of addressing the areas where 
mischaracterization of equity was likely to result in tax avoidance and 
to introduce economic distortions against the higher compliance costs 
placed on business.
    The likely effects of the rules in terms of their economic benefits 
and costs are discussed in the subsequent sections. The Treasury 
Department and the IRS used the best available studies, models, and 
data to estimate the effects of this rule. However, with regard to 
certain issues, relatively little relevant data and few rigorous 
studies are available.
1. Monetized Estimates of the Benefits and Costs
    The primary benefit of the regulations is an improvement in tax 
compliance, which is expected to increase tax revenue. In addition, 
there are likely to be modest efficiency benefits because differences 
in the tax treatment of competing corporations are reduced. The primary 
cost of the regulations is the change in compliance costs of 
businesses, particularly from the Sec.  1.385-2 documentation rules.
a. Revenue Effects Associated With Improved Compliance
    Because the regulations cover only new debt issuances occurring 
after April 4, 2016, and because the primary effect of the regulations 
is to limit the extent to which the transactions subject to the 
regulations can be used to achieve interest stripping, the revenue 
estimate is calculated primarily as a percentage reduction in the 
estimated growth in interest stripping relative to the baseline of 
current law absent these regulations. While the regulations are also 
likely to reduce tax avoidance by affiliated domestic corporations that 
do not file a consolidated return, those revenue effects are likely to 
be smaller and data limitations preclude an exact estimate of their 
magnitude. The estimated growth in interest stripping is the sum of 
estimates of the growth of interest stripping by existing FCDCs plus 
interest stripping by new FCDCs. Growth in interest stripping by 
existing FCDCs was calculated from the estimate of interest stripping 
by inverted corporations based on the Seida and Wempe and Bloomberg 
studies, inflated to 2016 dollars, and doubled to incorporate the 
amount of interest stripping by all other FCDCs, which are more 
numerous but where interest stripping is likely to be less intensive. 
The level of interest stripping is assumed to grow at a 5 percent rate 
annually.
    Interest stripping by new FCDCs was derived from the average 
interest stripping by firms in the Seida and Wempe (2004) subsample, 
discussed above, inflated to 2016 dollars. Based on inversion rates for 
the past 20 years, growth by three inversions of this average size per 
year was assumed. This assumed growth was doubled to account for 
interest stripping by new FCDCs not created by inversion.
    The assumed percentage reductions in interest stripping by existing 
FCDCs and by the creation of new FCDCs were in the mid-single digits, 
with the latter somewhat smaller than the former because interest 
stripping is not the sole reason for FCDC creation. The limitations and 
exclusions detailed above restrict the affected amounts of debt to a 
small fraction of total debt outstanding. The most important of these 
limitations and exclusions are the exception for short-term debt, the 
application of the regulations solely to related-party debt, the 
exclusion for most distributions separated by at least 36 months from 
debt issuance, and the E&P exception. Further, the grandfathering of 
existing interest stripping arrangements suggests that very little 
additional tax revenue will be paid in the short term, but that the 
growth rate of revenue will be high.
    While the regulations also apply to affiliated domestic 
corporations that do not file a consolidated return, there is no good 
information on the extent of interest stripping by such groups. The tax 
benefits of such interest stripping are likely of a smaller magnitude, 
because in the purely domestic context, both the interest deductions 
and the interest income are subject to the same U.S. tax system and 
hence interest stripping to reduce total U.S. tax liability in this 
context relies on asymmetric tax positions across the affiliated 
groups. As a result, the revenue estimate excludes tax revenue from 
purely domestic groups.
    Both Sec. Sec.  1.385-2 and 1.385-3 contribute to the revenue gain.
    The Sec.  1.385-2 rules requiring documentation of instruments to 
support debt characterization are consistent with best documentation 
practices under case law, but many taxpayers do not currently follow 
best documentation practices. Specifically, the existence of a written 
loan agreement and an evaluation of the creditworthiness of a borrower 
are factors used by courts in deciding whether an intercompany advance 
should be treated as debt or equity; however, under current law 
taxpayers are able to sustain debt treatment even in the absence of 
documentation. Elevating the importance of documentation will both aid 
in IRS audits (by requiring a taxpayer to show contemporaneous relevant 
documentation as to the parties' intent and their analysis of the 
borrower's ability to pay) and prevent taxpayers from characterizing 
intercompany debt with the aid of hindsight. Both effects will improve 
compliance and thus raise tax revenue.
    The revenue gain is also due to the Sec.  1.385-3 rules, which 
should limit the ability to mischaracterize equity as debt to 
facilitate interest stripping behaviors

[[Page 72947]]

to the extent not covered by the exclusions and limitations previously 
discussed. For example, under the regulations those taxpayers choosing 
to interest strip by borrowing from unrelated parties will have an 
incentive to minimize interest rates relative to what they pay to 
highly-related parties. Alternatively, taxpayers may choose to separate 
borrowings from distributions by more than 3 years, but there will be 
incentives to earn as much as possible on the funds in the interim, and 
such earnings offset interest deductions.
    Other significant limits on revenue gain from these rules include 
the availability of other means of earnings stripping, such as 
royalties and management fees, that can substitute for interest.
    Preliminary estimates of the regulatory revenue effect are $7.4 
billion over 10 years (or $600 million per year on an annualized 3 
percent discounted basis). There is not a single answer to the question 
of how much revenue is generated by each piece of the regulations. This 
is because interactions between the pieces make the allocated subtotals 
depend on the order in which the allocation is made. If one assumes 
that Sec.  1.385-2 is ``stacked first,'' then Sec.  1.385-2 accounts 
for approximately $1.5 billion of the total, and Sec.  1.385-3 accounts 
for the rest.
    Annual discounted total revenue effects ($ millions in 2016 
dollars) are shown below.

------------------------------------------------------------------------
                                          Fiscal years     Fiscal years
                                          2017 to 2026     2017 to 2026
     Annualized monetized transfer        (3% discount     (7% discount
                                          rate, 2016)      rate, 2016)
------------------------------------------------------------------------
Estimated change in annual tax                    $600             $461
 revenue--from firms to the Federal
 Government...........................
------------------------------------------------------------------------

    The regulations as originally proposed would have raised $10.1 
billion over 10 years (or $843 million on an annualized 3 percent 
discounted basis). Since then, modifications of the rules have lowered 
the revenue estimate by approximately 25 percent. The modifications 
that lowered the revenue estimate include: The short-term debt 
exception and the exclusion of the Sec.  1.385-1 rules allowing the 
bifurcation of instruments into debt and equity components from this 
analysis.
b. Compliance Burden
    Most of the compliance burden will stem from the rules requiring 
documentation of intra-group loans. Our analysis thus focuses on the 
compliance effects of the Sec.  1.385-2 documentation requirements.
    The Treasury Department and the IRS use the IRS business taxpayer 
burden model to estimate the additional compliance burden imposed on 
businesses by the regulations. These compliance costs are borne by 
businesses and are the primary costs imposed by this rule.
    The IRS business taxpayer burden model used to calculate this 
compliance cost estimate is a micro-simulation model created by the IRS 
to provide monetized estimates of compliance costs for the business 
income tax return population. The model is based on an econometric 
specification developed using linked compliance cost survey data and 
tax return data. This model accounts for time as well as out-of-pocket 
costs of businesses and controls for the substitution of time and money 
by monetizing time and reporting total compliance costs in dollars. 
Costs are differentiated based on the characteristics and size of the 
business. For more detailed information on this methodology, see 
``Taxpayer Compliance Costs for Corporations and Partnerships: A New 
Look''; Contos, Guyton, Langetieg, Lerman, Nelson; SOI Tax Stats--2012 
IRS-TPC Research Conference. https://www.irs.gov/pub/irs-soi/12rescontaxpaycompliance.pdf.
    Estimates of the change in compliance costs as a result of the 
regulations are produced using a process that compares results from a 
baseline scenario simulation (representing current law and practice) 
with an alternative scenario simulation (representing the effects of 
the regulations). The difference between the baseline and alternative 
simulation serves as the estimated compliance cost effect of the 
regulations.
    The estimates are likely to be somewhat overstated for two 
practical reasons. First, they do not allow for a decline in compliance 
costs over time as firms become more accustomed to documenting loans. 
Second, the analysis assumes that the documentation requirements apply 
immediately to all existing loans when the Sec.  1.385-2 apply 
prospectively to loans originated on or after January 1, 2018. While 
this is intended to provide an accurate estimate of the ongoing costs 
of documentation in the future, it will take several years for all of a 
company's intra-group loans to be covered by the regulations. Hence, 
the actual volume of loans requiring documentation and associated costs 
will initially be smaller. Thus, the compliance cost for any one of the 
first several years in which the regulations are in effect will be 
lower.
    Tax data were used to identify the (approximately) 6,300 businesses 
likely to be affected by Sec.  1.385-2 because they are estimated to 
have intercompany loans subject to the regulations. About 5,200 of 
these businesses have foreign affiliates, while the remaining firms 
have intercompany loans between U.S. affiliates.
    Compliance costs are unlikely to be the same on a per firm basis, 
since some firms are likely to engage in more transactions requiring 
documentation, and, conditional on current practice, some firms are 
going to have greater compliance costs per transaction. The tax data 
are used to estimate for each firm the number of transactions likely to 
require documentation (based on interest payments) and to place firms 
in categories that reflect differences in compliance cost per dollar of 
transaction.
    Estimates using the IRS model show a compliance cost increase of 
approximately $56 million or an average of $8,900 per firm in 2016 
dollars. In 2012, net income for these taxpayers was about $960 
billion, so the documentation requirements would reduce profits for 
these taxpayers by, on average, roughly 0.006 percent. Of course, the 
experience of each affected firm will vary.
    These estimates are higher than the $13 million estimate for the 
proposed regulations because of modifications in the regulations and 
adjustments to the methodology used to estimate the costs. The proposed 
regulations would have affected more businesses (21,000), but the 
modifications in response to comments significantly reduced the number 
affected (to 6,300). In and of itself, this would have significantly 
lowered the compliance cost. However, the initial estimate projected an 
average cost per business of $600, while the revised estimate projects 
an average cost per business of about $8,900. This change in the cost 
per business resulted in a higher overall compliance cost, all

[[Page 72948]]

else being constant. The initial estimate was based on assumptions and 
modeling approaches, including a lower-than-appropriate wage rate for 
accountants and attorneys working on the compliance issues, that were 
subsequently revised in light of comments received. The revised 
estimate is based on a more complete analysis by the IRS burden model.
    The burden estimate is lower than those suggested in some of the 
comments received on the proposed regulations. In part, this is because 
some comments assumed that none of the affected businesses have any 
documentation of affected loans, when other businesses, reported that 
they already maintain some or all of the information required. In 
addition, however, our estimate is lower because the final and 
temporary regulations have been modified in many ways in order to 
reduce the burden, in response to the comments received. For example, 
the final rules apply just to U.S. borrowers, while the proposed 
regulations also applied to borrowing between foreign affiliates. These 
foreign-to-foreign transactions are now outside the scope of the 
regulations, so that the numbers of businesses and transactions subject 
to the rule are reduced. This change reduces the compliance costs 
compared to those originally proposed.
    The $56 million estimate only reflects ongoing compliance costs. It 
does not reflect the initial startup costs and infrastructure 
investment. Initial startup costs and infrastructure investment are 
expected to result in additional costs in the first years that the 
section 385 regulations are in effect. IRS-supported research by 
Forrester in 2013 indicates these one-time start-up expenses are 
approximately four times the annual costs, or approximately $224 
million in 2016 dollars primarily over the initial years when the 
section 385 regulations go into effect. Most of these start-up costs 
are in 2017 even though the Sec.  1.385-2 regulations require 
documentation starting in 2018. The ongoing and start-up costs are 
reported on an annual average basis in the table on these costs. In 
addition, the analysis includes a sensitivity analysis in which the 
compliance costs are estimated for a 90 percent interval around our 
best estimate. First the distributional characteristics of critical 
parameters used to produce the estimate are evaluated. Then Monte Carlo 
simulations are used to vary the parameter values. Finally, alternative 
high and low estimates are computed based on parameter values at either 
end of the 90 percent range. These ongoing compliance cost estimates 
range from $29 million per year on an annualized basis in 2016 dollars 
to $60 million. Using the same factor of four to estimate one-time 
start-up expenses, these range from $15 million per year on an 
annualized basis in 2016 dollars to $27 million. These combined ongoing 
and start-up costs on an annual average basis for both the high and low 
estimates appear in the table summarizing these costs. Our sensitivity 
analysis indicates that even using the high compliance cost estimates, 
that tax revenues generated by the regulations would be 6 to 7 times as 
large as these costs.
    Annual discounted ongoing and start-up compliance costs ($ millions 
in 2016 dollars) are shown below.

------------------------------------------------------------------------
                                           Fiscal years    Fiscal years
    Compliance costs associated with       2017 to 2026    2017 to 2026
               addressing                  (3% discount    (7% discount
                                            rate, 2016)     rate, 2016)
------------------------------------------------------------------------
Central estimate........................             $70             $59
High estimate...........................              87              73
Low estimate............................              52              44
------------------------------------------------------------------------

2. Non-Monetized Effects
a. Increased Tax Compliance System Wide
    The U.S. tax system relies for its effectiveness on voluntary tax 
compliance. Voluntary compliance is eroded when there is a perception 
that some taxpayers are able to avoid paying their fair share of the 
tax burden. Tax strategies of large multinational corporations, such as 
interest stripping, have been widely reported in the press as 
inappropriate ways for these companies to avoid paying their fair share 
of taxes. By reducing the ability of such firms to strip earnings out 
of the U.S. through transactions with no meaningful economic or non-tax 
effect, and so raising their tax payments, the regulations are likely 
to increase the overall perceived legitimacy of the U.S. tax system, 
and hence promote voluntary compliance. This effect is not quantified.
b. Efficiency and Growth Effects
    By changing the treatment of certain transactions and activities, 
the regulations potentially affect economic efficiency and growth 
(output). While these changes may have multiple and, to some extent, 
offsetting effects, on net, they are likely to improve economic 
efficiency. For example, the regulations reduce the tax advantage 
foreign owners have over domestic owners of U.S. assets, and 
consequently reduce the propensity for foreign purchases and ownership 
of U.S. assets that are motivated by tax considerations rather than 
economic substance. While these effects are likely to be small, they 
are likely to enhance efficiency and growth. By reducing tax-motivated 
acquisitions or ownership structures, the regulations may encourage 
assets to be owned or managed by those most capable of putting the 
assets to their highest-valued use. In addition, the regulations reduce 
the tax benefit of inversions, which can have economic costs to the 
United States even if the actual management of a firm is not changed 
when the firm's ownership changes. And, it may help to put purely 
domestic U.S. firms on more even tax footing with their foreign-owned 
competitors operating in the United States. On the other hand, the 
regulations may slightly increase the effective tax rate and compliance 
costs on U.S. inbound investment. While the magnitude of this increase 
is small because of those provisions that exempt transactions financing 
new investment, to the extent that it reduces new capital investment in 
the U.S. its effects would be efficiency and growth reducing. On 
balance, the likely effect of the regulations is to improve the 
efficiency of the corporate tax system.
    The extent to which the regulations' changes in tax prices affect 
real U.S. economic activity depends on their size and on taxpayers' 
reaction to the changes. At the outset, it is important to realize that 
the change in tax prices associated with the regulations are likely to 
be small. The estimated total tax paid by the 1,200 taxpayers affected 
by the Sec.  1.385-3 rules was $13 billion in 2016 dollars. The 
annualized 3 percent discounted revenue effect is $600 million per year 
in 2016 dollars. Even assuming that all of the revenue comes from the 
Sec.  1.385-3 rules (which overstates the relevant revenue) implies

[[Page 72949]]

that the affected taxpayers would pay less than 5 percent (roughly 1 
percentage point) in additional tax, which is likely far less than 
their current tax advantage relative to domestic non-FCDCs 
corporations. (For example, Seida and Wempe find that the average 
reduction in effective tax rates of corporations in their inversion 
sample was 11.57 percentage points.) Furthermore, much evidence points 
to relatively small behavioral reactions to such tax changes. Many 
analysts have argued that even major changes in tax policy have no more 
than modest effects on the economy. For an idea of the range of 
results, see Congressional Research Service Report R42111, Tax Rates 
and Economic Growth, by Jane G. Gravelle and Donald J. Marples, 
January, 2015; Joint Committee on Taxation Staff, Macroeconomic 
Analysis of the ``Tax Reform Act of 2014'', JCX 22-14, February 26, 
2014; Robert Carroll, John Diamond, Craig Johnson, and James Mackie, A 
Summary of the Dynamic Analysis of the Tax Reform Options Prepared for 
the President's Advisory Panel on Federal Tax Reform, Office of Tax 
Analysis Paper Prepared for the American Enterprise Institute 
Conference on Tax Reform and Dynamic Analysis, May 25, 2006. It is 
unlikely, then, that a small tax increase on a small set of companies 
would have a measurable effect on major economic aggregates.
    Although the rules are designed to minimize any detrimental effect 
on U.S. investment, the regulations do to some extent make the U.S. a 
less attractive location for foreign investment. The effect is likely 
to be small, however because the rules exclude financing activities 
that are clearly associated with new investment in the U.S. For 
example, interest paid by a FCDC to a related party on new borrowing 
used to make a new investment in the U.S. would continue to be 
deductible. This is true, moreover, even if the new debt comes in the 
form of a ``dividend'' note paid out of E&P generated after the 
regulation's effective date. Such new debt finances new U.S. investment 
in the sense that the FCDC retains and invests in the United States 
cash earned on U.S. profits, rather than sending the cash to its 
foreign parent as a dividend.
    Furthermore, most inbound investment is via acquisition of existing 
U.S. companies rather than greenfield (new) investment in the U.S., and 
so changes the ownership of existing assets, without necessarily adding 
to the stock of capital employed in the U.S. Such acquisitions and 
cross-border mergers can make the U.S. economy stronger by encouraging 
foreign investment to flow into the United States and by enabling U.S. 
companies to invest overseas. But in an efficient market, these 
transactions should be driven by genuine business strategies and 
economic benefits, not simply by a desire to avoid U.S. taxes. One 
effect of the regulations is to reduce tax-motivated incentives for 
foreign ownership instead of domestic ownership of domestic companies 
and thus to improve economic efficiency. As Mihir A. Desai and James R. 
Hines, Jr. write, ``given the central importance of ownership to the 
nature of multinational firms, there is good reason to be particularly 
concerned about the potential for economic inefficiency due to 
distortions to ownership patterns.'' ``Evaluating International Tax 
Reform,'' National Tax Journal 56 No. 3 (September, 2003): 487-502. By 
reducing the tax advantage to foreign ownership, the regulations may 
help to promote a more efficient ownership structure, one guided more 
by economic fundamentals and less by tax benefits.
    Recently, apparently tax-motivated acquisitions of U.S. companies 
by foreign businesses have attracted much attention in the debate over 
inversions. Much of this debate has focused on the tax cost to the U.S. 
government, which can be substantial. But there could be other costs as 
well. For example, headquarters jobs may leave the United States. In 
addition, formerly U.S. headquartered companies may lose their U.S. 
focus and identity over time, which could reduce the incentive to keep 
production and research in the United States. Interest stripping is a 
primary tax benefit of inversions. By reducing the tax benefit of 
certain types of interest stripping, the regulations thus are likely to 
reduce, to some extent, the tax incentive for inversions. However, any 
reduction in inversion activity is likely to be modest because the tax 
change is small and leaves in place tax advantages for foreign 
ownership, e.g., through interest stripping not prohibited by the 
regulation.
    Finally, because FCDCs currently face lower effective tax rates 
than can be achieved by domestic U.S. firms, even when operating in 
domestic markets, they currently enjoy a competitive advantage in 
pricing, marketshare, and profitability. To the extent that this rule 
reduces this tax advantage, it levels the playing field relative to 
U.S. corporations, and thereby promotes efficient economic choices--
choices motivated by underlying economic fundamentals, rather than by 
tax differences.
c. Lower Tax Administrative Costs for the IRS
    The increased loan documentation required of large corporations 
will help the IRS to more effectively administer the tax laws by making 
it easier for the IRS to evaluate whether purported debt transactions 
are legitimate loans. This will lower the cost of auditing and 
evaluating the tax returns of companies engaged in these transactions. 
The lower administrative cost for the IRS offsets to some degree the 
higher compliance cost placed on corporations. It has not been 
possible, however, to quantify the cost savings.

II. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. Chapter 6), it 
is hereby certified that the final and temporary regulations will not 
have a significant economic impact on a substantial number of small 
entities. Accordingly, a 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. Section 1.385-1 does not require taxpayers 
to take any additional actions or to engage in any new procedures or 
documentation. Because 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 under existing law to substantiate 
their classification of an interest as stock or indebtedness for 
federal tax purposes. Section 1.385-2 provides minimum standards on 
documentation needed to substantiate the treatment of certain related-
party instruments as indebtedness, and provides rules on the weighting 
of particular factors in conducting such analysis. Section 1.385-2 will 
not have an impact on a substantial number of small entities for 
several reasons. First, the rules do not apply to S corporations or 
non-controlled pass-through entities. Second, the rules apply only to 
debt in form issued within expanded groups of corporations. Third, 
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 larger expanded groups, they will not affect a 
substantial number of small entities.

[[Page 72950]]

    Section 1.385-3 provides that 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 are 
treated as stock. Section 1.385-3T provides that for certain debt 
instruments issued by a controlled partnership, the holder is deemed to 
transfer all or a portion of the debt instrument to the partner or 
partners in the partnership in exchange for stock in the partner or 
partners. Section 1.385-4T provides rules regarding the application of 
Sec. Sec.  1.385-3 and 1.385-3T to members of a consolidated group. 
Sections 1.385-3 and 1.385-3T include multiple exceptions that limit 
their application. In particular, the threshold exception provides that 
the first $50 million of expanded group debt instruments that otherwise 
would be reclassified as stock or deemed to be transferred to a partner 
in a controlled partnership under Sec.  1.385-3 or Sec.  1.385-3T will 
not be reclassified or deemed transferred under Sec.  1.385-3 or Sec.  
1.385-3T. Although it is possible that the classification rules in 
Sec. Sec.  1.385-3, 1.385-3T, and 1.385-4T could have an effect on 
small entities, the threshold exception of the first $50 million of 
debt instruments otherwise subject to recharacterization or deemed 
transfer under Sec. Sec.  1.385-3, 1.385-3T, and 1.385-4T makes it 
unlikely that a substantial number of small entities will be affected 
by Sec. Sec.  1.385-3, 1.385-3T, and 1.385-4T.
    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 
were received requesting that the monetary thresholds contained in 
proposed Sec. Sec.  1.385-2, 1.385-3, and 1.385-4 be increased in order 
to mitigate the impact on small businesses. These comments are 
addressed in Parts IV.B.1.d and V.E.4 of the Summary of Comments and 
Explanation of Revisions. No comments were received concerning the 
economic impact on small entities from the Small Business 
Administration.

III. Congressional Review Act

    The Congressional Review Act, 5 U.S.C. 801 et seq., generally 
provides that before a rule may take effect, the agency promulgating 
the rule must submit a rule report, which includes a copy of the rule, 
to each House of the Congress and to the Comptroller General of the 
United States. A major rule cannot take effect until 60 days after it 
is published in the Federal Register. This action is a ``major rule'' 
as defined by 5 U.S.C. 804(2) and will become applicable more than 60 
days after publication (see Sec. Sec.  1.385-1(g), 1.385-2(i), 1.385-
3(j), 1.385-3T(k), 1.385-4T(g), and 1.752-2T(l)(4)).

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 (``Unfunded 
Mandates Act''), Public Law 104-4 (March 22, 1995), requires that an 
agency prepare a budgetary impact statement before promulgating a rule 
that may result in expenditure by state, local, and tribal governments, 
in the aggregate, or by the private sector, of $100 million or more in 
any one year. If a budgetary impact statement is required, section 205 
of the Unfunded Mandates Act also requires an agency to identify and 
consider a reasonable number of regulatory alternatives before 
promulgating a rule. See Part I of this Special Analyses for a 
discussion of the budgetary impact of this final rule.

Drafting Information

    The principal authors of these regulations are Austin M. Diamond-
Jones of the Office of Associate Chief Counsel (Corporate) and Joshua 
G. Rabon 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.385-1 also issued under 26 U.S.C. 385.
    Section 1.385-2 also issued under 26 U.S.C. 385, 6001, 6011, and 
7701(l).
    Section 1.385-3 also issued under 26 U.S.C. 385, 701, 1502, 
1504(a)(5)(A), and 7701(l).
    Section 1.385-3T also issued under 26 U.S.C. 385, 701, 
1504(a)(5)(A), and 7701(l).
    Section 1.385-4T also issued under 26 U.S.C. 385 and 1502.
* * * * *

0
Par. 2. Section 1.385-1 is added to read as follows:


Sec.  1.385-1  General provisions.

    (a) Overview of section 385 regulations. This section and 
Sec. Sec.  1.385-2 through 1.385-4T (collectively, the section 385 
regulations) provide rules under section 385 to determine the treatment 
of an interest in a corporation as stock or indebtedness (or as in part 
stock and in part indebtedness) in particular factual situations. 
Paragraph (b) of this section provides the general rule for determining 
the treatment of an interest based on provisions of the Internal 
Revenue Code and on common law, including the factors prescribed under 
common law. Paragraphs (c), (d), and (e) of this section provide 
definitions and rules of general application for purposes of the 
section 385 regulations. Section 1.385-2 provides additional guidance 
regarding the application of certain factors in determining the federal 
tax treatment of an interest in a corporation that is held by a member 
of the corporation's expanded group. Section 1.385-3 sets forth 
additional factors that, when present, control the determination of 
whether an interest in a corporation that is held by a member of the 
corporation's expanded group is treated (in whole or in part) as stock 
or indebtedness. Section 1.385-3T(f) provides rules on the treatment of 
debt instruments issued by certain partnerships. Section 1.385-4T 
provides rules regarding the application of the factors set forth in 
Sec.  1.385-3 and the rules in Sec.  1.385-3T to transactions described 
in those sections as they relate to consolidated groups.
    (b) General rule. Except as otherwise provided in the Internal 
Revenue Code and the regulations thereunder, including the section 385 
regulations, whether an interest in a corporation is treated for 
purposes of the Internal Revenue Code as stock or indebtedness (or as 
in part stock and in part indebtedness) is determined based on common 
law, including the factors prescribed under such common law.
    (c) Definitions. The definitions in this paragraph (c) apply for 
purposes of the section 385 regulations. For additional definitions 
that apply for purposes of their respective sections, see Sec. Sec.  
1.385-2(d), 1.385-3(g), and 1.385-4T(e).
    (1) Controlled partnership. The term controlled partnership means, 
with respect to an expanded group, 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 the 
expanded group. For purposes of identifying a controlled partnership, 
indirect ownership of a partnership interest is determined by applying 
the principles of paragraph

[[Page 72951]]

(c)(4)(iii) of this section. Such determination is separate from the 
determination of the status of a corporation as a member of an expanded 
group. An unincorporated organization described in Sec.  1.761-2 that 
elects to be excluded from all of subchapter K of chapter 1 of the 
Internal Revenue Code is not a controlled partnership.
    (2) Covered member. The term covered member means a member of an 
expanded group that is--
    (i) A domestic corporation; and
    (ii) [Reserved]
    (3) 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 
income tax purposes under Sec. Sec.  301.7701-1 through 301.7701-3 of 
this chapter.
    (4) Expanded group--(i) In general. The term expanded group means 
one or more chains of corporations (other than corporations described 
in section 1504(b)(8)) connected through stock ownership with a common 
parent corporation not described in section 1504(b)(6) or (b)(8) (an 
expanded group parent), but only if--
    (A) The expanded group parent owns directly or indirectly stock 
meeting the requirements of section 1504(a)(2) (modified by 
substituting ``or'' for ``and'' in section 1504(a)(2)(A)) in at least 
one of the other corporations; and
    (B) Stock meeting the requirements of section 1504(a)(2) (modified 
by substituting ``or'' for ``and'' in section 1504(a)(2)(A)) in each of 
the other corporations (except the expanded group parent) is owned 
directly or indirectly by one or more of the other corporations.
    (ii) Definition of stock. For purposes of paragraph (c)(4)(i) of 
this section, the term stock has the same meaning as ``stock'' in 
section 1504 (without regard to Sec.  1.1504-4) and all shares of stock 
within a single class are considered to have the same value. Thus, 
control premiums and minority and blockage discounts within a single 
class are not taken into account.
    (iii) Indirect stock ownership. For purposes of paragraph (c)(4)(i) 
of this section, indirect stock ownership is determined by applying the 
constructive ownership rules of section 318(a) with the following 
modifications:
    (A) Section 318(a)(1) and (a)(3) do not apply except as set forth 
in paragraph (c)(4)(v) of this section;
    (B) Section 318(a)(2)(C) applies by substituting ``5 percent'' for 
``50 percent;'' and
    (C) Section 318(a)(4) only applies to options (as defined in Sec.  
1.1504-4(d)) that are reasonably certain to be exercised as described 
in Sec.  1.1504-4(g).
    (iv) Member of an expanded group or expanded group member. The 
expanded group parent and each of the other corporations described in 
paragraphs (c)(4)(i)(A) and (c)(4)(i)(B) of this section is a member of 
an expanded group (also referred to as an expanded group member). For 
purposes of the section 385 regulations, a corporation is a member of 
an expanded group if it is described in this paragraph (c)(4)(iv) of 
this section immediately before the relevant time for determining 
membership (for example, immediately before the issuance of an EGI (as 
defined in Sec.  1.385-2(d)(3)) or a debt instrument (as defined in 
Sec.  1.385-3(g)(4)) or immediately before a distribution or 
acquisition that may be subject to Sec.  1.385-3(b)(2) or (3)).
    (v) Brother-sister groups with non-corporate owners. [Reserved]
    (vi) Special rule for indirect ownership through options for 
certain members of consolidated groups. In the case of an option of 
which a member of a consolidated group, other than the common parent, 
is the issuing corporation (as defined in Sec.  1.1504-4(c)(1)), 
section 318(a)(4) only applies (for purposes of applying paragraph 
(c)(4)(iii)(C) of this section) to the option if the option is treated 
as stock or as exercised under Sec.  1.1504-4(b) for purposes of 
determining whether a corporation is a member of an affiliated group.
    (vii) Examples. The following examples illustrate the rules of this 
paragraph (c)(4). Except as otherwise stated, for purposes of the 
examples in this paragraph (c)(4)(vii), all persons described are 
corporations that have a single class of stock outstanding and file 
separate federal tax returns and are not described in section 
1504(b)(6) or (b)(8). In addition, the stock of each publicly traded 
corporation is widely held such that no person directly or indirectly 
owns stock in the publicly traded corporation meeting the requirements 
of section 1504(a)(2) (as modified by this paragraph (c)(4)).

    Example 1. Two different expanded group parents. (i) Facts. P 
has two classes of common stock outstanding: Class A and Class B. X, 
a publicly traded corporation, directly owns all shares of P's Class 
A common stock, which is high-vote common stock representing 85% of 
the vote and 15% of the value of the stock of P. Y, a publicly 
traded corporation, directly owns all shares of P's Class B common 
stock, which is low-vote common stock representing 15% of the vote 
and 85% of the value of the stock of P. P directly owns 100% of the 
stock of S1.
    (ii) Analysis. X owns directly 85% of the vote of the stock of 
P, which is stock meeting the requirements of section 1504(a)(2) (as 
modified by paragraph (c)(4)(i)(A) of this section). Therefore, X is 
an expanded group parent described in paragraph (c)(4)(i) of this 
section with respect to P. Y owns 85% of the value of the stock of 
P, which is stock meeting the requirements of section 1504(a)(2) (as 
modified by paragraph (c)(4)(i)(A) of this section). Therefore, Y is 
also an expanded group parent described in paragraph (c)(4)(i) of 
this section with respect to P. P owns directly 100% of the voting 
power and value of the stock of S1, which is stock meeting the 
requirements of section 1504(a)(2) (as modified by paragraph 
(c)(4)(i)(B) of this section). Therefore, X, P, and S1 constitute an 
expanded group as defined in paragraph (c)(4)(i) of this section. 
Additionally, Y, P, and S1 constitute an expanded group as defined 
in paragraph (c)(4) of this section. X and Y are not members of the 
same expanded group under paragraph (c)(4) of this section because X 
does not directly or indirectly own any of the stock of Y and Y does 
not directly or indirectly own any of the stock of X, such that X 
and Y do not comprise a chain of corporations described in paragraph 
(c)(4)(i) of this section.
    Example 2. Inclusion of a REIT within an expanded group. (i) 
Facts. All of the stock of P is publicly traded. In addition to 
other assets representing 85% of the value of its total assets, P 
directly owns all of the stock of S1. S1 owns 99% of the stock of 
S2. The remaining 1% of the stock of S2 is owned by 100 unrelated 
individuals. In addition to other assets representing 85% of the 
value of its total assets, S2 owns all of the stock of S3. Both P 
and S2 are real estate investment trusts described in section 
1504(b)(6).
    (ii) Analysis. P directly owns 100% of the stock of S1. However, 
under paragraph (c)(4)(i) of this section, P cannot be the expanded 
group parent because P is a real estate investment trust described 
in section 1504(b)(6). Because no other corporation owns stock in P 
meeting the requirements described in paragraph (c)(4)(i) of this 
section, P is not an expanded group member. S1 directly owns 99% of 
the stock of S2, which is stock meeting the requirements of section 
1504(a)(2) (as modified by paragraph (c)(4)(i)(A) of this section). 
Although S2 is a corporation described in section 1504(b)(6), a 
corporation described in section 1504(b)(6) may be a member of an 
expanded group described under paragraph (c)(4)(i) of this section 
provided the corporation is not the expanded group parent. In this 
case, S1 is the expanded group parent. S2 directly owns 100% of the 
stock of S3, which is stock meeting the requirements of section 
1504(a)(2) (as modified by paragraph (c)(4)(i)(B) of this section). 
Therefore, S1, S2, and S3 constitute an expanded group as defined in 
paragraph (c)(4) of this section.
    Example 3. Attribution of hook stock. (i) Facts. P, a publicly 
traded corporation, directly owns 50% of the stock of S1. S1 
directly owns 100% of the stock of S2. S2 directly owns the 
remaining 50% of the stock of S1.
    (ii) Analysis. (A) P directly owns 50% of the stock of S1. Under 
paragraph (c)(4)(iii) of this section (which applies section 
318(a)(2)

[[Page 72952]]

with modifications), P constructively owns 50% of the stock of S2 
because P directly owns 50% of the stock of S1, which directly owns 
100% of S2. Under section 318(a)(5)(A), stock constructively owned 
by P by reason of the application of section 318(a)(2) is, for 
purposes of section 318(a)(2), considered as actually owned by P.
    (B) S2 directly owns 50% of the stock of S1. Thus, under 
paragraph (c)(4)(iii) of this section, P is treated as 
constructively owning an additional 25% of the stock of S1. For 
purposes of determining the expanded group, P's ownership must be 
recalculated treating the additional 25% of S1 stock as actually 
owned. Under the second application of section 318(a)(2)(C) as 
modified by paragraph (c)(4)(iii) of this section, P constructively 
owns an additional 12.5% of the stock of S1 as follows: 25% (P's new 
attributed ownership of S1) x 100% (S1's ownership of S2) x 50% 
(S2's ownership of S1) = 12.5%. After two iterations, P's ownership 
in S1 is 87.5% (50% direct ownership + 25% first order constructive 
ownership + 12.5% second order constructive ownership) and thus S1 
is a member of the expanded group that includes P and S2. Subsequent 
iterative calculations of P's ownership, treating constructive 
ownership as actual ownership, would demonstrate that P owns, 
directly and indirectly, 100% of the stock of S1. P, S1, and S2 
therefore constitute an expanded group as defined in paragraph 
(c)(4) of this section and P is the expanded group parent.
    Example 4. Attribution of hook stock when an intermediary has 
multiple owners. (i) Facts. The facts are the same as in Example 3, 
except that P directly owns only 25% of the stock of S1. X, a 
corporation unrelated to P, also directly owns 25% of the stock of 
S1.
    (ii) Analysis. (A) P and X each directly owns 25% of the stock 
of S1. Under paragraph (c)(4)(iii) of this section, P and X each 
constructively owns 25% of the stock of S2 because P and X each 
directly owns 25% of the stock of S1, which directly owns 100% of 
the stock of S2. Under section 318(a)(5)(A), stock constructively 
owned by P or X by reason of the application of section 318(a)(2) 
is, for purposes of section 318(a)(2), considered as actually owned 
by P or X, respectively.
    (B) S2 directly owns 50% of the stock of S1. Thus, under 
paragraph (c)(4)(iii) of this section, P and X each is treated as 
constructively owning an additional 12.5% of the stock of S1. Under 
a second application of section 318(a)(2)(C) as modified by 
paragraph (c)(4)(iii) of this section, P and X each constructively 
owns an additional 6.25% of the stock of S1 as follows: 12.5% (each 
of P's and X's new attributed ownership of S1) x 100% (S1's 
ownership of S2) x 50% (S2's ownership of S1) = 6.25%. After two 
iterations, each of P's and X's ownership in S1 is 43.75% (25% 
direct ownership + 12.5% first order constructive ownership + 6.25% 
second order constructive ownership). Subsequent iterative 
calculations of each of P's and X's ownership, treating constructive 
ownership as actual ownership, would demonstrate that P and X each 
owns, directly and indirectly, 50% of the stock of S1.
    (C) S1 and S2 constitute an expanded group as defined under 
paragraph (c)(4)(i) of this section because S1 directly owns 100% of 
the stock of S2. S1 is the expanded group parent of the expanded 
group and neither P nor X are a member of the expanded group that 
includes S1 and S2.

    (5) Regarded owner. The term regarded owner means a person (which 
cannot be a disregarded entity) that is the single owner (within the 
meaning of Sec.  301.7701-2(c)(2)(i) of this chapter) of a disregarded 
entity.
    (d) Treatment of deemed exchanges--(1) Debt instrument deemed to be 
exchanged for stock--(i) In general. If a debt instrument (as defined 
in Sec.  1.385-3(g)(4)) or an EGI (as defined in Sec.  1.385-2(d)(3)) 
is deemed to be exchanged under the section 385 regulations, in whole 
or in part, for stock, the holder is treated for all federal tax 
purposes as having realized an amount equal to the holder's adjusted 
basis in that portion of the debt instrument 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, except as provided in paragraph 
(d)(1)(iv)(B) of this section, the issuer is treated for all federal 
tax purposes 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. This paragraph (d)(1)(i) does not affect the rules that 
otherwise apply to the debt instrument or EGI prior to the date of the 
deemed exchange (for example, this paragraph (d)(1)(i) does not affect 
the issuer's deduction of accrued but unpaid qualified stated interest 
otherwise deductible prior to the date of the deemed exchange). 
Moreover, the stock issued in the deemed exchange is not treated as a 
payment of accrued but unpaid original issue discount or qualified 
stated interest on the debt instrument or EGI for federal tax purposes.
    (ii) Section 988. Notwithstanding the first sentence of paragraph 
(d)(1)(i) of this section, 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 under the section 385 regulations, in whole 
or in part, for stock 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 
paragraph (d)(1)(i) of this section at the time of the deemed exchange. 
For purposes of this paragraph (d)(1)(ii), in applying Sec.  1.988-
2(b)(13) the exchange gain or loss under section 988 is treated as the 
total gain or loss on the exchange.
    (iii) Section 108(e)(8). For purposes of section 108(e)(8), if the 
issuer of a debt instrument or EGI is treated as having retired all or 
a portion of the debt instrument or EGI in exchange for stock under 
paragraph (d)(1)(i) of this section, the stock is treated as having a 
fair market value equal to the adjusted issue price of that portion of 
the debt instrument or EGI as of the date of the deemed exchange.
    (iv) Issuer of stock deemed exchanged for debt. For purposes of 
applying paragraph (d)(1)(i) of this section--
    (A) A debt instrument that is issued by a disregarded entity is 
deemed to be exchanged for stock of the regarded owner under Sec. Sec.  
1.385-2(e)(4) and 1.385-3T(d)(4);
    (B) A debt instrument that is issued by a partnership that becomes 
a deemed transferred receivable, in whole or in part, is deemed to be 
exchanged by the holder for deemed partner stock under Sec.  1.385-
3T(f)(4) and the partnership is therefore not treated for any federal 
tax purpose as having retired any portion of the debt instrument; and
    (C) A debt instrument that is issued in any situation not described 
in paragraph (d)(1)(iv)(A) or (B) of this section is deemed to be 
exchanged for stock of the issuer of the debt instrument.
    (2) Stock deemed to be exchanged for newly-issued debt instrument--
(i) EGIs. If an EGI treated as stock under Sec.  1.385-2(e)(1) ceases 
to be an EGI and is deemed to be exchanged pursuant to Sec.  1.385-
2(e)(2), in whole or in part, for a newly-issued debt instrument, the 
issue price of the newly-issued debt instrument is determined under 
either section 1273(b)(4) or 1274, as applicable.
    (ii) Debt instruments recharacterized under Sec.  1.385-3. If a 
debt instrument treated as stock under Sec.  1.385-3(b) is deemed to be 
exchanged under Sec.  1.385-3(d)(2), in whole or in part, for a newly-
issued debt instrument, the issue price of the newly-issued debt 
instrument is determined under either section 1273(b)(4) or 1274, as 
applicable.
    (e) Indebtedness in part. [Reserved]
    (f) Applicability date. This section applies to taxable years 
ending on or after January 19, 2017.

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) In general--(1) Scope. This section provides rules for the 
preparation and maintenance of the documentation and information 
necessary for the

[[Page 72953]]

determination of whether certain instruments will be treated as 
indebtedness for federal tax purposes. It also prescribes presumptions 
and factors as well as the weighting of certain factors to be taken 
into account in the making of that determination. For definitions 
applicable to this section, including the terms ``applicable interest'' 
and ``expanded group interest'' (EGI), see paragraph (d) of this 
section.
    (2) Purpose. The rules in this section have two principal purposes. 
The first is to provide guidance regarding the documentation and other 
information that must be prepared, maintained, and provided to be used 
in the determination of whether an instrument subject to this section 
will be treated as indebtedness for federal tax purposes. The second is 
to establish certain operating rules, presumptions, and factors to be 
taken into account in the making of any such determination. Thus, 
compliance with this section does not establish that an interest is 
indebtedness; it serves only to satisfy the minimum documentation for 
the determination to be made under general federal tax principles.
    (3) Applicability of section. The application of this section is 
subject to the following limitations:
    (i) Covered member. An EGI is subject to this section only if it is 
issued by a covered member, as defined in Sec.  1.385-1(c)(2), or by a 
disregarded entity, as defined in Sec.  1.385-1(c)(3), that has a 
regarded owner that is a covered member.
    (ii) Threshold limitation--(A) In general. An EGI is subject to 
this section only if on the date that an applicable interest first 
becomes an EGI--
    (1) 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);
    (2) Total assets exceed $100 million on any applicable financial 
statement (as defined in paragraph (d)(1) of this section) or 
combination of applicable financial statements; or
    (3) Annual total revenue exceeds $50 million on any applicable 
financial statement or combination of applicable financial statements.
    (B) Non-U.S. dollar applicable financial statements. If an 
applicable financial statement is denominated in a currency other than 
the U.S. dollar, the amount of total assets is 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. The amount of annual total 
revenue is translated into U.S. dollars at the weighted average 
exchange rate (as defined in Sec.  1.989(b)-1) for the year for which 
the annual total revenue was calculated.
    (C) Integration and combination of multiple applicable financial 
statements--(1) In general. If there are multiple applicable financial 
statements that reflect the assets, portion of the assets, or annual 
total revenue of different members of the expanded group, the aggregate 
amount of total assets and annual total revenue must be used to 
determine whether the threshold limitation in paragraph (a)(3)(ii)(A) 
of this section applies. For this purpose, the use of the aggregate 
amount of total assets or annual total revenue in different applicable 
financial statements is required except to the extent that two or more 
applicable financial statements reflect the total assets and annual 
total revenue of a member of the expanded group.
    (2) Overlapping applicable financial statements. To the extent that 
two or more applicable financial statements reflect the total assets or 
annual total revenue of the same expanded group member, the applicable 
financial statement with the higher amount of total assets must be used 
for purposes of paragraph (a)(3)(ii) of this section.
    (3) Overlapping assets and revenue. If there are multiple 
applicable financial statements that reflect the assets, portion of the 
assets, or revenue of the same expanded group member, any duplication 
(by stock, consolidation, or otherwise) of that expanded group member's 
assets or revenue may be disregarded for purposes of paragraph 
(a)(3)(ii) of this section such that the total assets or annual total 
revenue of that expanded group member are only reflected once.
    (4) Coordination with other rules of law--(i) Substance of 
transaction controls. 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 treating the transaction (or the EGI) in accordance with its 
substance for federal tax purposes, which may involve disregarding the 
transaction (or the EGI).
    (ii) Commissioner's authority under section 7602 unaffected. 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.
    (iii) Covered debt instruments. If the requirements of this section 
are satisfied or otherwise do not apply, see Sec. Sec.  1.385-3 and 
1.385-4T 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.
    (5) Consistency rule--(i) In general. If an issuer (as defined in 
paragraph (d)(4) of this section) characterizes an EGI as indebtedness, 
the issuer and the holder are each required to treat the EGI as 
indebtedness for all federal tax purposes. For purposes of this 
paragraph (a)(5)(i), an issuer is considered to have characterized an 
EGI as indebtedness if the legal form of the EGI is debt, as described 
in paragraph (d)(2)(i)(A) of this section. An issuer is also considered 
to have characterized an EGI as indebtedness if the issuer claims any 
federal income tax benefit with respect to an EGI resulting from 
characterizing the EGI as indebtedness for federal tax purposes, such 
as by claiming an interest deduction under section 163 in respect of 
interest paid or accrued on the EGI on a federal income tax return (or, 
if the issuer is a member of a consolidated group, the issuer or the 
common parent of the consolidated group claims a federal income tax 
benefit by claiming such an interest deduction), or if the issuer 
reports the EGI as indebtedness or amounts paid or accrued on the EGI 
as interest on an applicable financial statement. Pursuant to section 
385(c)(1), the Commissioner is not bound by the issuer's 
characterization of an EGI.
    (ii) EGI characterized as stock. The consistency rule in paragraph 
(a)(5)(i) of this section and section 385(c)(1) does not apply with 
respect to an EGI to the extent that the EGI is treated as stock under 
this section or it has been determined that the EGI is treated as stock 
under applicable federal tax principles. In such case, the issuer and 
the holder are each required to treat the EGI as stock for all federal 
tax purposes.
    (b) Documentation rules and weighting of indebtedness factors--(1) 
General rule. Documentation and information evidencing the indebtedness 
factors set forth in paragraph (c) of this section must be prepared and 
maintained in accordance with the provisions of this section with 
respect to each EGI. If the documentation and information described in 
paragraph (c) of this section are prepared and maintained as required 
by this section, the determination of whether an EGI is properly 
treated as indebtedness (or otherwise) for federal tax purposes will be 
made under general federal tax principles. If the documentation and 
information described in paragraph (c) of this section are not prepared 
and

[[Page 72954]]

maintained in respect of an EGI in accordance with this section, and no 
exception listed in paragraph (b)(2) of this section applies, the EGI 
is treated as stock for all federal tax purposes. If a taxpayer 
characterizes an EGI as indebtedness but fails to provide the 
documentation and information described in paragraph (c)(2) of this 
section upon request by the Commissioner, the Commissioner will treat 
such documentation and information as not prepared or maintained.
    (2) Exceptions from per se treatment--(i) Rebuttable presumption 
rules--(A) General rule. If documentation and information evidencing 
the indebtedness factors set forth in paragraph (c) of this section are 
not prepared and maintained with respect to a particular EGI but a 
taxpayer demonstrates that with respect to an expanded group of which 
the issuer and holder of the EGI are members such expanded group is 
otherwise highly compliant with the documentation rules (as such 
compliance is described in paragraph (b)(2)(i)(B) of this section), the 
EGI is not automatically treated as stock but is presumed, subject to 
rebuttal, to be stock for federal tax purposes. A taxpayer can overcome 
the presumption that an EGI is stock if the taxpayer clearly 
establishes that there are sufficient common law factors present to 
treat the EGI as indebtedness, including that the issuer intended to 
create indebtedness when the EGI was issued.
    (B) High percentage of EGIs compliant with this section as evidence 
that the expanded group is highly compliant with the documentation 
rules. The rebuttable presumption in paragraph (b)(2)(i)(A) of this 
section applies if an expanded group of which the issuer and holder are 
members has a high percentage of EGIs compliant with paragraph (c) of 
this section. For this purpose, an expanded group is treated as having 
a high percentage of EGIs compliant with paragraph (c) of this section 
if during the calendar year in which an EGI does not meet the 
requirements of paragraph (c) of this section--
    (1) The average total adjusted issue price of all EGIs that are 
undocumented (as defined in paragraph (b)(2)(i)(B)(3) of this section) 
and outstanding as of the close of each calendar quarter is less than 
10 percent of the average amount of total adjusted issue price of all 
EGIs that are outstanding as of the close of each calendar quarter; or
    (2) If no EGI that is undocumented during the calendar year has an 
issue price in excess of--
    (i) $100,000,000, the average total number of EGIs that are 
undocumented and outstanding as of the close of each calendar quarter 
is less than 5 percent of the average total number of all EGIs that are 
outstanding as of the close of each calendar quarter; or
    (ii) $25,000,000, the average total number of EGIs that are 
undocumented and outstanding as of the close of each calendar quarter 
is less than 10 percent of the average total number of all EGIs that 
are outstanding as of the close of each calendar quarter.
    (3) Undocumented EGI. For purposes of paragraph (b)(2)(i)(B) of 
this section, an undocumented EGI is an EGI for which documentation has 
not been both prepared and maintained for one or more of the 
indebtedness factors in paragraph (c)(2) of this section by the time 
required under paragraph (c)(4) of this section.
    (4) Anti-stuffing rule. If a member of the expanded group increases 
the adjusted issue price of EGIs outstanding on a quarterly testing 
date with a principal purpose of satisfying the requirements of 
paragraph (b)(2)(i)(B)(1) of this section or increases the number of 
EGIs outstanding on a quarterly testing date with a principal purpose 
of satisfying the requirements of paragraph (b)(2)(ii)(B)(2) of this 
section, such increase will not be taken into account in calculating 
whether a taxpayer has met these requirements.
    (5) EGIs subject to this section. For purposes of determining 
whether the requirements of paragraph (b)(2)(i)(B)(1) or 
(b)(2)(i)(B)(2) of this section are met, only EGIs subject to the rules 
of this section are taken into account. Thus, for example, an EGI 
issued by an issuer other than a covered member is not taken into 
account.
    (C) Application of federal tax principles if presumption rebutted. 
If the presumption of stock treatment for federal tax purposes under 
paragraph (b)(2)(i)(A) of this section is rebutted, the determination 
of whether an EGI is properly treated as indebtedness (or otherwise) 
for federal tax purposes will be made under general federal tax 
principles. See paragraph (b)(3) of this section for the weighting of 
factors that must be made in this determination.
    (ii) Reasonable cause--(A) In general. To the extent a taxpayer 
establishes that there was reasonable cause for a failure to comply, in 
whole or in part, with the requirements of this section, such failure 
will not be taken into account in determining whether the requirements 
of this section have been satisfied, and the character of the EGI will 
be determined under general federal tax principles. The principles of 
Sec.  301.6724-1 of this chapter apply in interpreting whether 
reasonable cause exists in any particular case.
    (B) Requirement to document once reasonable cause established. If a 
taxpayer establishes that there was reasonable cause for a failure to 
comply, in whole or in part, with the requirements of this section, the 
documentation and information required under paragraph (c) of this 
section must be prepared within a reasonable time and maintained for 
the EGIs for which such reasonable cause was established.
    (iii) Taxpayer discovery and remedy of ministerial or non-material 
failure or error. If a taxpayer discovers and corrects a ministerial or 
non-material failure or error in complying with this section prior to 
the Commissioner's discovery of the failure or error, such failure or 
error will not be taken into account in determining whether the 
requirements of this section have been satisfied.
    (3) Weighting of indebtedness factors. In applying federal tax 
principles to the determination of whether an EGI is indebtedness or 
stock, the indebtedness factors in paragraph (c)(2) of this section are 
significant factors to be taken into account. Other relevant factors 
are taken into account in the determination as lesser factors, with the 
relative weighting of each lesser factor based on facts and 
circumstances.
    (c) Documentation and information to be prepared and maintained--
(1) In general--(i) Application. The indebtedness factors and the 
documentation and information that evidence each indebtedness factor 
are set forth in paragraph (c)(2) of this section. The requirement to 
prepare and maintain documentation and information with respect to each 
indebtedness factor applies to each EGI separately, but the same 
documentation and information may satisfy the requirements of this 
section for more than one EGI (see paragraph (c)(2)(iii)(B) of this 
section for rules relating to documentation that may be applicable to 
multiple EGIs issued by the same issuer for purposes of the 
indebtedness factor in paragraph (c)(2)(iii) of this section and 
paragraph (c)(3)(i) of this section for rules relating to certain 
master arrangements). Documentation must include complete copies of all 
instruments, agreements, subordination agreements, and other documents 
evidencing the material rights and obligations of the issuer and the 
holder relating to the EGI, and any associated

[[Page 72955]]

rights and obligations of other parties, such as guarantees. For 
documents that are executed, such copies must be copies of documents as 
executed. Additional documentation and information may be provided to 
supplement, but not substitute for, the documentation and information 
required under this section.
    (ii) Market standard safe harbor. Documentation of a kind 
customarily used in comparable third-party transactions treated as 
indebtedness for federal tax purposes may be used to satisfy the 
indebtedness factors in paragraphs (c)(2)(i) and (c)(2)(ii) of this 
section. Thus, for example, documentation of a kind that a taxpayer 
uses for trade payables with unrelated parties will generally satisfy 
the documentation requirements of this paragraph (c) for documenting 
trade payables with members of the expanded group.
    (iii) EGIs with terms required by certain regulators. 
Notwithstanding any other provision in this paragraph (c), an EGI that 
is described in this paragraph (c)(1)(iii) is treated as meeting the 
documentation and information requirements described in this paragraph 
(c), provided that documentation necessary to establish that the EGI is 
an instrument described in this paragraph (c)(1)(iii) is prepared and 
maintained in accordance with paragraph (b) of this section. An EGI 
described in this paragraph (c)(1)(iii) is--
    (A) An EGI issued by an excepted regulated financial company (as 
defined in Sec.  1.385-3(g)(3)(iv)) that contains terms required by a 
regulator of that company in order for the EGI to satisfy regulatory 
capital or similar rules that govern resolution or orderly liquidation 
of the excepted regulated financial company (including rules that 
require an excepted regulated financial company to issue EGIs in the 
form of Total Loss-Absorbing Capacity), provided that at the time of 
issuance it is expected that the EGI will be paid in accordance with 
its terms; and
    (B) An EGI issued by a regulated insurance company (as defined in 
Sec.  1.385-3(g)(3)(v)) that requires the issuer to receive approval or 
consent of an insurance regulatory authority prior to making payments 
of principal or interest on the EGI, provided that at the time of 
issuance it is expected that the EGI will be paid in accordance with 
its terms.
    (2) Indebtedness factors relating to documentation and information 
to be prepared and maintained in support of indebtedness. The 
indebtedness factors that must be documented to establish that an EGI 
is indebtedness for federal tax purposes, and the documentation and 
information that must be prepared and maintained with respect to each 
such factor, are described in paragraphs (c)(2)(i) through (c)(2)(iv) 
of this section.
    (i) Unconditional obligation to pay a sum certain. There must be 
written documentation establishing that the issuer has entered into an 
unconditional and legally binding obligation to pay a fixed or 
determinable sum certain on demand or at one or more fixed dates.
    (ii) Creditor's rights. There must be written documentation 
establishing 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 rights that are superior 
to the rights of shareholders (other than holders of interests treated 
as stock solely by reason of Sec.  1.385-3) to receive assets of the 
issuer in case of dissolution. An EGI that is a nonrecourse obligation 
has creditor's rights for this purpose if it provides sufficient 
remedies against a specified subset of the issuer's assets. For 
purposes of this paragraph (c)(2)(ii), creditor's rights may be 
provided either in the legal agreements that contain the terms of the 
EGI or under local law. If local law provides for creditor's rights 
under an EGI even if such rights are not specified in the legal 
agreements that contain the terms of the EGI, such creditor's rights do 
not need to be included in the EGI provided that written documentation 
for purposes of this paragraph (c)(2)(ii) contains a reference to the 
provisions of local law providing such rights.
    (iii) Reasonable expectation of ability to repay EGI--(A) In 
general. There must be written documentation containing information 
establishing that, as of the date of issuance of the applicable 
interest and taking into account all relevant circumstances (including 
all other obligations incurred by the issuer as of the date of issuance 
of the applicable interest or reasonably anticipated to be incurred 
after the date of issuance of the applicable interest), 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 interest. Documentation in respect of an EGI 
that is nonrecourse under its terms must include information on any 
cash and property that secures the EGI, including--
    (1) The fair market value of publicly traded property that is 
recourse property with respect to the EGI; and
    (2) An appraisal (if any) of recourse property that was prepared 
pursuant to the issuance of the EGI or within the three years preceding 
the issuance of the EGI. Thus, the documentation required by this 
paragraph (c)(2)(iii)(A) does not require that an appraisal be prepared 
for non-publicly traded property that secures nonrecourse debt, but 
does require that the documentation include any appraisal that was 
prepared for any purpose.
    (B) Documentation of ability to pay applicable to multiple EGIs 
issued by same issuer--(1) In general. Written documentation that 
applies to more than one EGI issued by a single issuer may be prepared 
on an annual basis to satisfy the requirements in paragraph 
(c)(2)(iii)(A) of this section (an annual credit analysis). An annual 
credit analysis can be used to support the reasonable expectation that 
the issuer has the ability to repay multiple EGIs, including a 
specified combined amount of indebtedness, provided any such EGIs are 
issued on any day within the 12-month period beginning on the date the 
analysis in the annual credit analysis is based on (an analysis date). 
An annual credit analysis must establish that, as of its analysis date 
and taking into account all relevant circumstances (including all other 
obligations incurred by the issuer as of such analysis date or 
reasonably anticipated to be incurred after such analysis date), the 
issuer's financial position supported a reasonable expectation that the 
issuer would be able to pay interest and principal in respect of the 
amount of indebtedness set forth in the annual credit analysis.
    (2) Material event of the issuer. If there is a material event (as 
defined in paragraph (d)(5) of this section) with respect to the issuer 
within the year beginning on the analysis date for written 
documentation described in paragraph (c)(2)(iii)(B)(1) of this section, 
such written documentation may not be used to satisfy the requirements 
in paragraph (c)(2)(iii)(A) of this section for EGIs with relevant 
dates (as described in paragraph (c)(4) of this section) on or after 
the date of the material event. However, an additional set of written 
documentation described in paragraph (c)(2)(iii)(B)(1) of this section 
may be prepared with an analysis date on or after the date of the 
material event of the issuer.
    (C) Third party reports or analysis. If any member of an expanded 
group

[[Page 72956]]

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.
    (D) EGI issued by disregarded entity. For purposes of this 
paragraph (c)(2)(iii), if a disregarded entity is 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 liabilities and the financial position of the disregarded 
entity are relevant for purposes of paragraph (c)(2)(iii)(A) of this 
section. If the owner of such a disregarded entity does not have 
limited liability within the meaning of Sec.  301.7701-3(b)(2)(ii) of 
this chapter (including by reason of a guarantee, keepwell, or other 
agreement), all of the assets and liabilities, and the financial 
position of the disregarded entity and the owner are relevant for 
purposes of paragraph (c)(2)(iii)(A) of this section.
    (E) Acceptable documentation. The documentation required under this 
paragraph (c)(2)(iii) 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 interest. For this purpose, such 
documentation may assume that the principal amount of an EGI may be 
satisfied with the proceeds of another borrowing by the issuer, 
provided that such assumption is reasonable. Documentation required 
under paragraph (c)(2) of this section may be prepared by employees of 
expanded group members, by agents of expanded group members or by third 
parties.
    (F) Third party financing terms. Documentation required under this 
paragraph (c)(2)(iii) may include evidence that a third party lender 
would have made a loan to the issuer with the same or substantially 
similar terms as the EGI.
    (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 
of the EGI or otherwise, including prepayments), and such payment is 
claimed to support the treatment of the EGI as indebtedness under 
federal tax principles, documentation must include written evidence of 
such payment. Such evidence could include, for example, a wire transfer 
record or a bank statement. Such evidence could also include a netting 
of payables or receivables between the issuer and holder, or payments 
of interest, evidenced by journal entries in a centralized cash 
management system or in the accounting system of the expanded group (or 
a subset of the members of the expanded group) reflecting the payment.
    (B) Events of default and similar events--(1) Enforcement of 
creditor's rights. If the issuer did not make a payment of interest or 
principal that was due and payable under the terms of the EGI, or if 
any other event of default or similar event has occurred, there must be 
written documentation evidencing the holder's reasonable exercise of 
the diligence and judgment of a creditor. Such documentation may 
include evidence of the holder's assertion of 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 of the EGI, such as maturity date, interest rate, or 
obligation to pay interest or principal.
    (2) Non-enforcement of creditor's rights. If the holder does not 
enforce its rights with respect to a payment of principal or interest, 
or with respect to an event of default or similar event, there must be 
documentation that supports the holder's decision to refrain from 
pursuing any actions to enforce payment as being consistent with the 
reasonable exercise of the diligence and judgment of a creditor. For 
example, if the issuer is unable to make a timely payment of principal 
or interest and the holder reasonably believes that the issuer's 
business or cash flow will improve such that the issuer will be able to 
comply with the terms of the EGI, the holder may be exercising the 
reasonable diligence and judgment of a creditor by granting an 
extension of time for the issuer to pay such interest or principal. 
However, if a holder fails to enforce its rights and there is no 
documentation explaining this failure, the holder will not be treated 
as exercising the reasonable due diligence and judgment of a creditor. 
See, however, Sec.  1.1001-3(c)(4)(ii) for rules regarding when a 
forbearance may be a modification of a debt instrument and therefore 
may result in an exchange subject to Sec.  1.1001-1(a).
    (3) Special documentation rules--(i) Agreements that cover multiple 
EGIs--(A) Revolving credit agreements, omnibus, umbrella, master, cash 
pool, and similar agreements--(1) In general. 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, a cash pool 
agreement, an omnibus or umbrella agreement that governs open account 
obligations or any other identified set of payables or receivables, or 
a master agreement that sets forth general terms of an EGI with an 
associated schedule or ticket that sets forth the specific terms of an 
EGI), the EGI is subject to the special rules of this paragraph 
(c)(3)(i)(A). A notional cash pool is subject to the rules of this 
paragraph (c)(3)(i) to the extent that the notional cash pool would be 
treated as an EGI issued directly between expanded group members.
    (2) Special rules with respect to paragraphs (c)(2)(i) and 
(c)(2)(ii) of this section regarding unconditional obligation to pay a 
sum certain and creditor's rights. An EGI subject to the special rules 
of paragraph (c)(3)(i)(A) of this section satisfies the requirements of 
paragraphs (c)(2)(i) and (c)(2)(ii) of this section only if the 
material documentation associated with the EGI, including all relevant 
enabling documents, is prepared and maintained 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.
    (3) Special rules under paragraph (c)(2)(iii) of this section 
regarding reasonable expectation of ability to repay--(i) In general. 
If an EGI is issued under an agreement described in paragraph 
(c)(3)(i)(A) of this section, written documentation must be prepared 
with respect to the date used for the analysis (an analysis date) and 
written documentation with a new analysis date must prepared at least 
annually to satisfy the requirements in paragraph (c)(2)(iii) of this 
section for EGIs issued under such an agreement on or after the most 
recent analysis date. Such written documentation satisfies the 
requirements in paragraph (c)(2)(iii)

[[Page 72957]]

of this section with respect to EGIs issued under such an agreement on 
any day within the year beginning on the analysis date of the annual 
credit analysis. Such written documentation must contain information 
establishing that, as of the analysis date of the annual credit 
analysis and taking into account all relevant circumstances (including 
all other obligations incurred by the issuer as of the analysis date of 
the written documentation or reasonably anticipated to be incurred 
after the analysis date of the written documentation), the issuer's 
financial position supported a reasonable expectation that the issuer 
would be able to pay interest and principal in respect of the maximum 
principal amount permitted under the terms of the revolving credit 
agreement, omnibus, umbrella, master, cash pool or similar agreement. 
Notwithstanding the foregoing, written documentation described in 
paragraph (c)(2)(iii)(B) of this section can be used to satisfy the 
requirements in paragraph (c)(2)(iii)(A) of this section with respect 
to such EGIs.
    (ii) Material event of the issuer. If there is a material event 
with respect to the issuer within the year beginning on the analysis 
date for the written documentation described in paragraph 
(c)(3)(i)(A)(3) of this section, such written documentation may not be 
used to satisfy the requirements in paragraph (c)(3)(i)(A)(3) of this 
section for EGIs with relevant dates (as described in paragraph (c)(4) 
of this section) on or after the date of the material event. However, 
an additional set of written documentation as described in paragraph 
(c)(3)(i)(A)(3) of this section may be prepared with an analysis date 
on the date of the material event of the issuer or if subsequent EGIs 
are issued, with respect to those issuances.
    (B) Additional requirements for cash pooling arrangements. 
Notwithstanding paragraphs (c)(2)(i) and (c)(2)(ii) of this section, 
and in addition to the requirements in paragraph (c)(3)(i)(A)(2) of 
this section, if an EGI is issued pursuant to a cash pooling 
arrangement (including a notional 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 paragraphs 
(c)(2)(i) and (c)(2)(ii) 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, are also prepared 
and maintained in accordance with the requirements of this section. 
Such documentation must contain the relevant legal rights and 
obligations 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.
    (ii) Debt not in form. [Reserved]
    (4) Timely preparation requirement--(i) General rule. Documentation 
and information required under this section must be timely prepared. 
For purposes of this section, documentation is treated as timely 
prepared if it is completed no later than the time for filing the 
issuer's federal income tax return (taking into account any applicable 
extensions) for the taxable year that includes the relevant date for 
such documentation or information, as specified in paragraph (c)(4)(ii) 
of this section.
    (ii) Relevant date. For purposes of this paragraph (c)(4), the term 
relevant date has the following meaning:
    (A) Issuer's obligation, creditor's rights. For documentation and 
information described in paragraphs (c)(2)(i) and (ii) of this section 
(relating to an issuer's unconditional obligation to repay and 
establishment of holder's creditor's rights), the relevant date is the 
date on which a covered member becomes an issuer of a new or existing 
EGI. A relevant date for such documentation and information does not 
include the date of any deemed issuance of the EGI resulting from as 
exchange under Sec.  1.1001-3 unless such deemed issuance relates to an 
alteration in the terms of the EGI reflected in an express written 
agreement or written amendment to the EGI. In the case of an applicable 
interest 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 interest becomes an EGI.
    (B) Reasonable expectation of payment--(1) In general. For 
documentation and information described in paragraph (c)(2)(iii) of 
this section (relating to reasonable expectation of issuer's 
repayment), each date on which a covered 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 date 
described in the special rules in paragraph (c)(4)(ii)(E) of this 
section, is a relevant date for that EGI. In the case of an applicable 
interest that becomes an EGI subsequent to issuance, the relevant date 
is the day on which the applicable interest becomes an EGI and any 
relevant date after the date that the applicable interest becomes an 
EGI.
    (2) Annual credit analysis--(i) With respect to documentation 
described in paragraph (c)(2)(iii)(B) of this section (documentation of 
ability to pay applicable to multiple EGIs issued by same issuer), the 
relevant date is the date used for the analysis in the annual credit 
analysis that is first prepared and the annual anniversary of such date 
unless a material event has occurred in respect of the issuer.
    (ii) Material event. With respect to the documentation described in 
paragraph (c)(2)(iii)(B) of this section, the date on which a material 
event has occurred in respect of an issuer is also a relevant date. If 
the precise date on which a material event occurred is uncertain, a 
taxpayer may choose a date on which the taxpayer reasonably believes 
that the material event occurred. If documentation described in 
paragraph (c)(2)(iii)(B) of this section is prepared with the relevant 
date of a material event, the next relevant date will be the annual 
anniversary of that relevant date (unless another material event occurs 
in respect of the issuer).
    (C) Subsequent actions--(1) Payment. For documentation and 
information described in paragraph (c)(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.
    (2) Default. For documentation and information described in 
paragraph (c)(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 a certain financial ratio, 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.
    (D) Applicable interest that becomes an EGI. In the case of an 
applicable interest that becomes an EGI subsequent to issuance, no date 
before the applicable interest becomes an EGI is a relevant date.
    (E) Revolving credit agreements, omnibus, umbrella, master, cash 
pool, and similar agreements--(1) Relevant dates for purposes of 
indebtedness factors in paragraphs (c)(2)(i) and (c)(2)(ii) of this 
section for overall arrangements. In the case of an

[[Page 72958]]

arrangement described in paragraph (c)(3)(i)(A) of this section for 
purposes of the indebtedness factors in paragraphs (c)(2)(i) and 
(c)(2)(ii) of this section, each of the following dates is a relevant 
date:
    (i) The date of the execution of the legal documents governing the 
overall arrangement.
    (ii) The date of any amendment to those documents that provides for 
an increase in the maximum amount of principal.
    (iii) The date of any amendment to those documents that permits an 
additional entity to borrow under the documents (but only with respect 
to EGIs issued by that entity).
    (2) Relevant dates for purposes of indebtedness factor in paragraph 
(c)(2)(iii) of this section for overall arrangements. The relevant 
dates with respect to the arrangements described in paragraph 
(c)(3)(i)(A) of this section for purposes of the indebtedness factor in 
paragraph (c)(2)(iii) of this section are--
    (i) Each anniversary of the date of execution of the legal 
documents during the life of the legal documents; and
    (ii) The date that a material event has occurred in respect of an 
issuer, unless the precise date on which a material event occurred is 
uncertain, in which case a taxpayer may use a date on which the 
taxpayer reasonably believes that the material event occurred.
    (3) Relevant dates for EGIs documented under an overall 
arrangement. A relevant date of an EGI under paragraphs (c)(4)(ii)(A) 
through (C) of this section is also a relevant date for each EGI 
documented under an overall arrangement described in paragraph 
(c)(2)(iii) of this section.
    (5) Maintenance requirements. The documentation and information 
described in paragraph (c) of this section must be maintained for all 
taxable years that the EGI is outstanding and until the period of 
limitations expires for any federal tax return with respect to which 
the treatment of the EGI is relevant. See section 6001 (requirement to 
keep books and records).
    (d) Definitions. For purposes of this section, the following 
definitions apply:
    (1) Applicable financial statement. The term applicable financial 
statement means a financial statement that is described in paragraphs 
(d)(1)(i) through (iii) 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 interest at issue first becomes an 
EGI. The financial statement may be a separate company financial 
statement of any member of the expanded group, if done in the ordinary 
course; otherwise, it is the 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--
    (i) A financial statement required to be filed with the Securities 
and Exchange Commission (the Form 10-K or the Annual Report to 
Shareholders);
    (ii) 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--
    (A) Credit purposes;
    (B) Reporting to shareholders, partners, or similar persons; or
    (C) Any other substantial non-tax purpose; or
    (iii) 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.
    (2) Applicable interest--(i) In general. Except to the extent 
provided in paragraph (d)(2)(ii) and (iii) of this section, the term 
applicable interest means--
    (A) Any interest that is issued or deemed issued in the legal form 
of a debt instrument, which therefore does not include, for example, a 
sale-repurchase agreement treated as indebtedness under federal tax 
principles; or
    (B) An intercompany payable and receivable documented as debt in a 
ledger, accounting system, open account intercompany debt ledger, trade 
payable, journal entry or similar arrangement if no written legal 
instrument or written legal arrangement governs the legal treatment of 
such payable and receivable.
    (ii) Certain intercompany obligations and statutory or regulatory 
debt instruments excluded. The term applicable interest does not 
include--
    (A) An intercompany obligation as defined in Sec.  1.1502-
13(g)(2)(ii) or an interest issued by a member of a consolidated group 
and held by another member of the same consolidated group, but only for 
the period during which both parties are members of the same 
consolidated group; for this purpose, a member includes any disregarded 
entity owned by a member;
    (B) Production payments treated as a loan under section 636(a) or 
(b);
    (C) A ``regular interest'' in a real estate mortgage investment 
conduit described in section 860G(a)(1);
    (D) A debt instrument that is deemed to arise under Sec.  1.482-
1(g)(3) (including adjustments made pursuant to Revenue Procedure 99-
32, 1999-2 C.B. 296); or
    (E) Any other instrument or interest that is specifically treated 
as indebtedness for federal tax purposes under a provision of the 
Internal Revenue Code or the regulations thereunder.
    (iii) Interests issued before January 1, 2018. The term applicable 
interest does not include any interest issued or deemed issued before 
January 1, 2018.
    (3) Expanded Group Interest (EGI). The term expanded group interest 
(EGI) means an applicable interest the issuer of which is a member of 
an expanded group (or a disregarded entity whose regarded owner is a 
member of an expanded group) and the holder of which is another member 
of the same expanded group, a disregarded entity whose regarded owner 
is another member of the same expanded group, or a controlled 
partnership (as defined in Sec.  1.385-1(c)(1)) with respect to the 
same expanded group.
    (4) Issuer. Solely for purposes of this section, the term issuer 
means a person (including a disregarded entity defined in Sec.  1.385-
1(c)(3)) 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. An 
issuer may include a person that, after the date that the EGI is 
issued, becomes obligated to satisfy a material obligation created 
under the terms of an EGI. For example, a person that becomes a co-
obligor on an EGI after the date of issuance of the EGI is an issuer of 
the EGI for purposes of this section if such person is expected to 
satisfy the obligations thereunder without indemnification.
    (5) Material event. The term material event means, with respect to 
an entity--
    (i) The entity comes under the jurisdiction of a court in a case 
under--
    (A) Title 11 of the United States Code (relating to bankruptcy); or
    (B) A receivership, foreclosure, or similar proceeding in a federal 
or state court;
    (ii) The entity becomes insolvent within the meaning of section 
108(d)(3);
    (iii) The entity materially changes its line of business;
    (iv) The entity sells, alienates, distributes, leases, or otherwise 
disposes of 50 percent or more of the total fair market value of its 
included assets; or

[[Page 72959]]

    (v) The entity consolidates or merges into another person and the 
person formed by or surviving such merger or consolidation does not 
assume liability for any of the entity's outstanding EGIs as of the 
time of the merger or consolidation.
    (6) Included assets. The term included assets means, with respect 
to an entity all assets other than--
    (i) Inventory sold in the ordinary course of business;
    (ii) Assets contributed to another entity in exchange for equity in 
such entity; and
    (iii) Investment assets such as portfolio stock investments to the 
extent that other investment assets or cash of equivalent value is 
substituted.
    (7) Regarded owner. For purposes of this section, the term regarded 
owner means a person (that is that is not a disregarded entity) that is 
the single owner (within the meaning of Sec.  301.7701-2(c)(2) of this 
chapter) of a disregarded entity.
    (e) Operating rules--(1) Applicable interest that becomes an EGI. 
If an applicable interest that is not an EGI becomes an EGI, this 
section applies to the applicable interest immediately after the 
applicable interest becomes an EGI and at all times thereafter during 
which the applicable interest remains an EGI.
    (2) EGI treated as stock ceases to be an EGI. If an EGI treated as 
stock due to the application of this section ceases to be an EGI, the 
character of the applicable interest is determined under general 
federal tax principles at the time that the applicable interest ceases 
to be an EGI. If the applicable interest is characterized as 
indebtedness under general federal tax principles, the issuer is 
treated for federal tax purposes as issuing a new debt instrument to 
the holder in exchange for the EGI immediately before the transaction 
that causes the EGI to cease to be treated as an EGI in a transaction 
that is disregarded for purposes of Sec.  1.385-3(b)(2) and (3). See 
Sec.  1.385-1(d).
    (3) Date of characterizations under this section--(i) In general. 
If an applicable interest that is an EGI when issued is determined to 
be stock due to the application of this section, the EGI is treated as 
stock from the date it was issued. However, if an applicable interest 
that is not an EGI when issued subsequently becomes an EGI and is then 
determined to be stock due to the application of this section, the EGI 
is treated as stock as of the date it becomes an EGI.
    (ii) Recharacterization of EGI based on behavior of issuer or 
holder after issuance. Notwithstanding paragraph (e)(3)(i) of this 
section, if an EGI initially treated as indebtedness is recharacterized 
as stock as a result of failing to satisfy paragraph (c)(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 (c)(2)(iv) of this section, the rules of this section apply 
before the rules of Sec.  1.1001-3. Thus, 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) Disregarded entities of regarded corporate owners. This 
paragraph (e)(4) applies to an EGI issued by a disregarded entity, the 
regarded owner of which is a covered member, if such EGI would, absent 
the application of this paragraph (e)(4), be treated as stock under 
this section. In this case, rather than the EGI being treated as stock, 
the covered member that is the regarded owner of the disregarded entity 
is deemed to issue its stock in the manner described in this paragraph 
(e)(4). If the EGI would have been recharacterized as stock from the 
date it was issued under paragraph (e)(3)(i) of this section, then the 
covered member is deemed to issue its stock to the actual holder to 
which the EGI was, in form, issued. If the EGI would have been 
recharacterized as stock at any other time, then the covered member is 
deemed to issue its stock to the holder of the EGI in exchange for the 
EGI. In each case, the covered member that is the regarded owner of the 
disregarded entity is treated as the holder of the EGI issued by the 
disregarded entity, and the actual holder is treated as the holder of 
the stock deemed to be issued by the regarded owner. Under federal tax 
principles, the EGI issued by the disregarded entity generally is 
disregarded. The stock deemed issued is deemed to have the same terms 
as the EGI issued by the disregarded entity, other than the identity of 
the issuer, and payments on the stock are determined by reference to 
payments made on the EGI issued by the disregarded entity.
    (f) Anti-avoidance. If an applicable interest that is not an EGI is 
issued with a principal purpose of avoiding the application of this 
section, the applicable interest is treated as an EGI subject to this 
section.
    (g) Affirmative use. [Reserved]
    (h) Example. The following example illustrates the rules of this 
section. Except as otherwise stated, the following facts are assumed 
for purposes of the example in this paragraph (h):
    (1) FP is a foreign corporation that owns 100% of the stock of 
USS1, a domestic corporation, and 100% of the stock of USS2, a domestic 
corporation.
    (2) USS1 and USS2 file separate federal income tax returns and have 
a calendar year taxable year.
    (3) USS1 and USS2 timely file their federal income tax returns on 
September 15 of the calendar year following each taxable year.
    (4) FP is traded on an established financial market within the 
meaning of Sec.  1.1092(d)-1(b).

    Example.  Application of paragraphs (c)(2)(iii) and (c)(4) of 
this section to an EGI-(i) Facts. USS1 issues an EGI (EGI A) to FP 
on Date A in Year 1. USS1 issues an EGI (EGI B) to USS2 on Date B in 
Year 1. Date B is after Date A. USS1 issues another EGI (EGI C) to 
FP on Date A in Year 2. USS1 prepares documentation sufficient to 
meet the requirements of paragraphs (c)(2)(i) and (ii) of this 
section on or before September 15 of Year 2. USS1, FP and USS2 also 
contemporaneously document the timely payment of interest by USS1 on 
EGI A and EGI B sufficient to meet the requirements of paragraph 
(c)(2)(iv) of this section. USS1 prepares documentation on Date C in 
Year 2, which is prior to September 15, to satisfy the requirements 
of paragraph (c)(2)(iii)(B) of this section (the credit analysis). 
The credit analysis concludes that as of Date B in Year 1, USS1 
would be able to pay interest and principal on an amount greater 
than the combined principal amounts of EGI A, EGI B and EGI C.
    (ii) Analysis. (A) P, USS1, and USS2 are members of an expanded 
group. Because FP is traded on an established financial market 
within the meaning of Sec.  1.1092(d)-1(b) and USS1 is a covered 
issuer, EGI A, EGI B, and EGI C are subject to the rules of this 
section.
    (B) The documentation evidencing USS1's obligation to pay a sum 
certain and the creditor's rights of the holders was prepared by 
September 15, Year 2, which is the time for filing USS1's federal 
income tax return (taking into account any applicable extensions) 
for the taxable year that includes the relevant date specified in 
paragraph (c)(4)(ii)(A) of this section. Thus, USS1 is treated as 
having timely documented its obligation to pay a sum certain and the 
creditor's rights of the holders of EGI A and EGI B for purposes of 
paragraph (c)(4)(i) of this section.
    (C) The credit analysis was prepared with a relevant date of 
Date B of Year 1. EGI A was issued prior to Date B in Year 1. Under 
paragraph (c)(4)(ii)(B) of this section, the date when USS1 became 
an issuer of EGI A (Date A of Year 1) is a relevant date for the

[[Page 72960]]

documentation and information described in paragraph (c)(2)(iii) of 
this section. As a result, EGI A does not satisfy the indebtedness 
factor in paragraph (c)(2)(iii) of this section (reasonable 
expectation of ability to repay EGI).
    (D) Similarly, under paragraph (c)(4)(ii)(B) of this section, 
the date when USS1 became an issuer of EGI B (Date B of Year 1) is a 
relevant date for the documentation and information described in 
paragraph (c)(2)(iii) of this section. The credit analysis was 
timely prepared under paragraph (c)(4)(i) of this section because it 
was prepared before the filing of the USS1 federal income tax return 
for Year 1. As a result, EGI B does satisfy the indebtedness factor 
in paragraph (c)(2)(iii) of this section (reasonable expectation of 
ability to repay EGI).
    (E) Finally, the date when USS1 became an issuer of EGI C (Date 
A of Year 2) is also a relevant date for the documentation and 
information described in paragraph (c)(2)(iii) of this section. 
Under paragraph (c)(2)(iii)(B) of this section, the credit analysis 
can be used to support the reasonable expectation that USS1 has the 
ability to repay multiple EGIs issued on any day within the 12-month 
period following the analysis date. Date A of Year 2 is within the 
12-month period following the analysis date. The credit analysis was 
timely prepared under paragraph (c)(4)(i) of this section because it 
was prepared before the filing of the USS1 federal income tax return 
for Year 2. As a result, EGI C does satisfy the indebtedness factor 
in paragraph (c)(2)(iii) of this section (reasonable expectation of 
ability to repay EGI).

    (i) Applicability date. This section applies to taxable years 
ending on or after January 19, 2017.


0
Par. 4. Section 1.385-3 is added to read as follows:


Sec.  1.385-3  Transactions in which debt proceeds are distributed or 
that have a similar effect.

    (a) Scope. This section sets forth factors that control the 
determination of whether an interest is treated as stock or 
indebtedness. Specifically, this section addresses the issuance of a 
covered debt instrument to a related person as part of a transaction or 
series of transactions that does not result in new investment in the 
operations of the issuer. Paragraph (b) of this section sets forth 
rules for determining when these factors are present, such that a 
covered debt instrument is treated as stock under this section. 
Paragraph (c) of this section provides exceptions to the application of 
paragraph (b) of this section. Paragraph (d) of this section provides 
operating rules. Paragraph (e) of this section reserves on the 
affirmative use of this section. Paragraph (f) of this section provides 
rules for the aggregate treatment of controlled partnerships. Paragraph 
(g) of this section provides definitions. Paragraph (h) of this section 
provides examples illustrating the application of the rules of this 
section. Paragraph (j) of this section provides dates of applicability. 
For rules regarding the application of this section to members of a 
consolidated group, see generally Sec.  1.385-4T.
    (b) Covered debt instrument treated as stock--(1) Effect of 
characterization as stock. Except as otherwise provided in paragraph 
(d)(7) of this section, to the extent a covered 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.
    (2) General rule. Except as otherwise provided in paragraphs (c) 
and (e) of this section, a covered debt instrument is treated as stock 
to the extent the covered debt instrument is issued by a covered member 
to a member of the covered member's expanded group in one or more of 
the following transactions:
    (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 in the transferor corporation that is a member of the 
issuer's expanded group immediately before the reorganization receives 
the covered debt instrument with respect to its stock in the transferor 
corporation.
    (3) Funding rule--(i) In general. Except as otherwise provided in 
paragraphs (c) and (e) of this section, a covered debt instrument that 
is not a qualified short-term debt instrument (as defined in paragraph 
(b)(3)(vii) of this section) is treated as stock to the extent that it 
is both issued by a covered member to a member of the covered member's 
expanded group in exchange for property and, pursuant to paragraph 
(b)(3)(iii) or (b)(3)(iv) of this section, treated as funding a 
distribution or acquisition described in one or more of paragraphs 
(b)(3)(i)(A) through (C) of this section. A covered member that makes a 
distribution or acquisition described in paragraphs (b)(3)(i)(A) 
through (C) is referred to as a ``funded member,'' regardless of when 
it issues a covered debt instrument in exchange for property.
    (A) A distribution of property by the funded member to a member of 
the funded member's expanded group, other than in an exempt 
distribution;
    (B) An acquisition of expanded group stock, other than 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 in the transferor corporation 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.
    (ii) Transactions described in more than one paragraph. For 
purposes of this section, to the extent that a distribution or 
acquisition by a funded member is described in more than one of 
paragraphs (b)(3)(i)(A) through (C) of this section, the funded member 
is treated as making only a single distribution or acquisition 
described in paragraph (b)(3)(i) of this section. In the case of an 
asset reorganization, to the extent an acquisition by the transferee 
corporation is described in paragraph (b)(3)(i)(C) of this section, a 
distribution or acquisition by the transferor corporation is not also 
described in paragraph (b)(3)(i)(A) through (C) of this section. For 
purposes of this paragraph (b)(3)(ii), whether a distribution or 
acquisition is described in paragraphs (b)(3)(i)(A) through (C) of this 
section is determined without regard to paragraph (c) of this section.
    (iii) Per se funding rule--(A) In general. A covered debt 
instrument is treated as funding a distribution or acquisition 
described in paragraphs (b)(3)(i)(A) through (C) of this section if the 
covered debt instrument is issued by a 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 
(per se period).
    (B) Multiple interests. If, pursuant to paragraph (b)(3)(iii)(A) of 
this section, two or more covered debt instruments may be treated as 
stock by reason of this paragraph (b)(3), the covered debt instruments 
are tested under paragraph (b)(3)(iii)(A) of this section based on the 
order in which they are issued, with the earliest issued covered debt 
instrument tested first. See paragraph (h)(3) of this section, Example 
6, for an illustration of this rule.
    (C) Multiple distributions or acquisitions. If, pursuant to 
paragraph (b)(3)(iii)(A) of this section, a covered debt instrument may 
be treated as funding more than one distribution or acquisition 
described in paragraphs (b)(3)(i)(A) through (C) of this section, the 
covered debt instrument is treated as funding one or more distributions 
or

[[Page 72961]]

acquisitions based on the order in which the distributions or 
acquisitions occur, with the earliest distribution or acquisition 
treated as the first distribution or acquisition that is funded. See 
paragraph (h)(3) of this section, Example 9, for an illustration of 
this rule.
    (D) Transactions that straddle different expanded groups--(1) In 
general. For purposes of paragraph (b)(3)(iii)(A) of this section, a 
covered debt instrument is not treated as issued by a funded member 
during the per se period with respect to a distribution or acquisition 
described in paragraphs (b)(3)(i)(A) through (C) of this section if all 
of the conditions described in paragraphs (b)(3)(iii)(D)(1)(i) through 
(iii) of this section are satisfied.
    (i) The distribution or acquisition occurs prior to the issuance of 
the covered debt instrument by the funded member or, if the funded 
member is treated as making the distribution or acquisition of a 
predecessor or a successor, the predecessor or successor is not a 
member of the expanded group of which the funded member is a member on 
the date on which the distribution or the acquisition occurs.
    (ii) The distribution or acquisition is made by the funded member 
when the funded member is a member of an expanded group that does not 
have an expanded group parent that is the funded member's expanded 
group parent when the covered debt instrument is issued. For purposes 
of the preceding sentence, a reference to an expanded group parent 
includes a reference to a predecessor or successor of the expanded 
group parent.
    (iii) On the date of the issuance of the covered debt instrument, 
the recipient member (as defined in paragraph (b)(3)(iii)(D)(2) of this 
section) is neither a member nor a controlled partnership of an 
expanded group of which the funded member is a member.
    (2) Recipient member. For purposes of this paragraph 
(b)(3)(iii)(D), the term recipient member means, with respect to a 
distribution or acquisition by a funded member described in paragraphs 
(b)(3)(i)(A) through (C) of this section, the expanded group member 
that receives a distribution of property, property in exchange for 
expanded group stock, or other property or money within the meaning of 
section 356 with respect to its stock in the transferor corporation. 
For purposes of this paragraph (b)(3)(iii)(D), a reference to the 
recipient member includes a predecessor or successor of the recipient 
member or one or more other entities that, in the aggregate, acquire 
substantially all of the property of the recipient member.
    (E) Modifications of a covered debt instrument--(1) In general. For 
purposes of paragraph (b)(3)(iii)(A) of this section, if a covered debt 
instrument is treated as exchanged for a modified covered debt 
instrument pursuant to Sec.  1.1001-3(b), the modified covered debt 
instrument is treated as issued on the original issue date of the 
covered debt instrument.
    (2) Effect of certain modifications. Notwithstanding paragraph 
(b)(3)(iii)(E)(1) of this section, if a covered debt instrument is 
treated as exchanged for a modified covered debt instrument pursuant to 
Sec.  1.1001-3(b) and the modification, or one of the modifications, 
that results in the deemed exchange includes the substitution of an 
obligor on the covered debt instrument, the addition or deletion of a 
co-obligor on the covered debt instrument, or the material deferral of 
scheduled payments due under the covered debt instrument, then the 
covered debt instrument is treated as issued on the date of the deemed 
exchange for purposes of paragraph (b)(3)(iii)(A) of this section.
    (3) Additional principal amount. For purposes of paragraph 
(b)(3)(iii)(A) of this section, if the principal amount of a covered 
debt instrument is increased, the portion of the covered debt 
instrument attributable to such increase is treated as issued on the 
date of such increase.
    (iv) Principal purpose rule. For purposes of this paragraph (b)(3), 
a covered debt instrument that is not issued by a funded member during 
the per se period with respect to a distribution or acquisition 
described in paragraphs (b)(3)(i)(A) through (C) of this section is 
treated as funding the distribution or acquisition to the extent that 
it is issued by a funded member with a principal purpose of funding a 
distribution or acquisition described in paragraphs (b)(3)(i)(A) 
through (C) of this section. Whether a covered debt instrument is 
issued with a principal purpose of funding a distribution or 
acquisition described in paragraphs (b)(3)(i)(A) through (C) of this 
section is determined based on all the facts and circumstances. A 
covered debt instrument may be treated as issued with a principal 
purpose of funding a distribution or acquisition described in 
paragraphs (b)(3)(i)(A) through (C) of this section regardless of 
whether it is issued before or after the distribution or acquisition.
    (v) Predecessors and successors--(A) In general. Subject to the 
limitations in paragraph (b)(3)(v)(B) of this section, for purposes of 
this paragraph (b)(3), references to a funded member include references 
to any predecessor or successor of such member. See paragraph (h)(3) of 
this section, Examples 9 and 10, for illustrations of this rule.
    (B) Limitations to the application of the per se funding rule. For 
purposes of paragraph (b)(3)(iii)(A) of this section, a covered debt 
instrument issued by a funded member that satisfies the condition 
described in paragraph (b)(3)(iii)(A) with respect to a distribution or 
acquisition described in paragraphs (b)(3)(i)(A) through (C) of this 
section made by a predecessor or successor of the funded member is not 
treated as issued during the per se period with respect to the 
distribution or acquisition unless the conditions described in 
paragraphs (b)(3)(v)(B)(1) and (2) of this section are satisfied:
    (1) The covered debt instrument is issued by the funded member 
during the period beginning 36 months before the date of the 
transaction in which the predecessor or successor becomes a predecessor 
or successor and ending 36 months after the date of the transaction.
    (2) The distribution or acquisition is made by the predecessor or 
successor during the period beginning 36 months before the date of the 
transaction in which the predecessor or successor becomes a predecessor 
or successor of the funded member and ending 36 months after the date 
of the transaction.
    (vi) Treatment of funded transactions. When a covered debt 
instrument is treated as stock pursuant to paragraph (b)(3) of this 
section, the distribution or acquisition described in paragraphs 
(b)(3)(i)(A) through (C) of this section that is treated as funded by 
such covered debt instrument is not recharacterized as a result of the 
treatment of the covered debt instrument as stock.
    (vii) Qualified short-term debt instrument. [Reserved]. For further 
guidance, see Sec.  1.385-3T(b)(3)(vii).
    (viii) Distributions or acquisitions occurring before April 5, 
2016. A distribution or acquisition that occurs before April 5, 2016, 
is not taken into account for purposes of applying this paragraph 
(b)(3).
    (4) Anti-abuse rule. If a member of an expanded group enters into a 
transaction with a principal purpose of avoiding the purposes of this 
section or Sec.  1.385-3T, an interest issued or held by that member or 
another member of the member's expanded group may, depending on the 
relevant facts and circumstances, be treated as stock. Paragraphs 
(b)(4)(i) and (ii) of this section include a non-exhaustive list of

[[Page 72962]]

transactions that could result in an interest being treated as stock 
under this paragraph (b)(4).
    (i) Interests. An interest is treated as stock if it is issued with 
a principal purpose of avoiding the purposes of this section or Sec.  
1.385-3T. Interests subject to this paragraph (b)(4)(i) may include:
    (A) An interest that is not a covered debt instrument for purposes 
of this section (for example, a contract to which section 483 applies 
that is not otherwise a covered debt instrument or a non-periodic swap 
payment that is not otherwise a covered debt instrument).
    (B) A covered debt instrument issued to a person that is not a 
member of the issuer's expanded group, if the covered debt instrument 
is later acquired by a member of the issuer's expanded group or such 
person later becomes a member of the issuer's expanded group.
    (C) A covered debt instrument issued to an entity that is not 
taxable as a corporation for federal tax purposes.
    (D) A covered debt instrument issued in connection with a 
reorganization or similar transaction.
    (E) A covered debt instrument issued as part of a plan or a series 
of transactions to expand the applicability of the transition rules 
described in Sec.  1.385-3(j)(2) or Sec.  1.385-3T(k)(2).
    (ii) Other transactions. A covered debt instrument is treated as 
stock if the funded member or any member of the expanded group engages 
in a transaction (including a distribution or acquisition) with a 
principal purpose of avoiding the purposes of this section or Sec.  
1.385-3T. Transactions subject to this paragraph (b)(4)(ii) may 
include:
    (A) A member of the issuer's expanded group is substituted as a new 
obligor or added as a co-obligor on an existing covered debt 
instrument.
    (B) A covered debt instrument is transferred in connection with a 
reorganization or similar transaction.
    (C) A covered debt instrument funds a distribution or acquisition 
where the distribution or acquisition is made by a member other than 
the funded member and the funded member acquires the assets of the 
other member in a transaction that does not make the other member a 
predecessor to the funded member.
    (D) Members of a consolidated group engage in transactions as part 
of a plan or a series of transactions through the use of the 
consolidated group rules set forth in Sec.  1.385-4T, including through 
the use of the departing member rules.
    (5) Coordination between general rule and funding rule in an asset 
reorganization. For purposes of this section, a distribution or 
acquisition described in paragraph (b)(2) of this section is not also 
described in paragraph (b)(3)(i) of this section. In the case of an 
asset reorganization, an acquisition described in paragraph (b)(2)(iii) 
of this section by the transferee corporation is not also a 
distribution or acquisition described in paragraph (b)(3)(i) of this 
section by the transferor corporation. For purposes of this paragraph 
(b)(5), whether a distribution or acquisition is described in 
paragraphs (b)(2)(i) through (iii) of this section is determined 
without regard to paragraph (c) of this section.
    (6) Non-duplication. Except as otherwise provided in paragraph 
(d)(2) of this section, to the extent a distribution or acquisition 
described in paragraphs (b)(3)(i)(A) through (C) of this section is 
treated as funded by a covered debt instrument under paragraph (b)(3) 
of this section, the distribution or acquisition is not treated as 
funded by another covered debt instrument and the covered debt 
instrument is not treated as funding another distribution or 
acquisition for purposes of paragraph (b)(3).
    (c) Exceptions--(1) In general. This paragraph (c) provides 
exceptions for purposes of applying paragraphs (b)(2) and (b)(3) of 
this section to a covered member. These exceptions are applied in the 
following order: First, paragraph (c)(2) of this section; second, 
paragraph (c)(3) of this section; and, third, paragraph (c)(4) of this 
section. The exceptions under Sec.  1.385-3(c)(2) and (c)(3) apply to 
distributions and acquisitions that are otherwise described in 
paragraph (b)(2) or (b)(3)(i) of this section after applying paragraphs 
(b)(3)(ii) and (b)(5) of this section. Except as otherwise provided, 
the exceptions are applied by taking into account the aggregate 
treatment of controlled partnerships described in Sec.  1.385-3T(f).
    (2) Exclusions for transactions otherwise described in paragraph 
(b)(2) or (b)(3)(i) of this section--(i) Exclusion for certain 
acquisitions of subsidiary stock--(A) In general. An acquisition of 
expanded group stock (including by issuance) is not treated as 
described in paragraph (b)(2)(ii) or (b)(3)(i)(B) of this section if, 
immediately after the acquisition, the covered member that acquires the 
expanded group stock (acquirer) controls the member of the expanded 
group from which the expanded group stock is acquired (seller), and the 
acquirer does not relinquish control of the seller pursuant to a plan 
that existed on the date of the acquisition, other than in a 
transaction in which the seller ceases to be a member of the expanded 
group of which the acquirer is a member. For purposes of the preceding 
sentence, an acquirer and seller do not cease to be members of the same 
expanded group by reason of a complete liquidation described in section 
331.
    (B) Control. For purposes of this paragraph (c)(2)(i) and paragraph 
(c)(3)(ii)(E) of this section, control of a corporation means the 
direct or indirect ownership of more than 50 percent of the total 
combined voting power of all classes of stock of the corporation 
entitled to vote and more than 50 percent of the total value of the 
stock of the corporation. For purposes of the preceding sentence, 
indirect ownership is determined by applying the principles of section 
958(a) without regard to whether an intermediate entity is foreign or 
domestic.
    (C) Rebuttable presumption. For purposes of paragraph (c)(2)(i)(A) 
of this section, the acquirer is presumed to have a plan to relinquish 
control of the seller on the date of the acquisition if the acquirer 
relinquishes control of the seller within the 36-month period following 
the date of the acquisition. The presumption created by the previous 
sentence may be rebutted by facts and circumstances clearly 
establishing that the loss of control was not contemplated on the date 
of the acquisition and that the avoidance of the purposes of this 
section or Sec.  1.385-3T was not a principal purpose for the 
subsequent loss of control.
    (ii) Exclusion for compensatory stock acquisitions. An acquisition 
of expanded group stock is not treated as described in paragraph 
(b)(2)(ii) or (b)(3)(i)(B) of this section if the expanded group stock 
is delivered to individuals that are employees, directors, or 
independent contractors in consideration for services rendered by such 
individuals to a member of the expanded group or a controlled 
partnership in which a member of the expanded group is an expanded 
group partner.
    (iii) Exclusion for distributions or acquisitions resulting from 
transfer pricing adjustments. A distribution or acquisition deemed to 
occur under Sec.  1.482-1(g) (including adjustments made pursuant to 
Revenue Procedure 99-32, 1999-2 C.B. 296) is not treated as described 
in paragraph (b)(3)(i)(A) or (B) of this section.
    (iv) Exclusion for acquisitions of expanded group stock by a dealer 
in securities. An acquisition of expanded group stock by a dealer in 
securities (within the meaning of section 475(c)(1)), or by an expanded 
group partner treated as acquiring expanded group stock pursuant to 
Sec.  1.385-3T(f)(2) if the relevant controlled partnership is

[[Page 72963]]

a dealer in securities, is not treated as described in paragraph 
(b)(2)(ii) or (b)(3)(i)(B) of this section to the extent the expanded 
group stock is acquired in the ordinary course of the dealer's business 
of dealing in securities. The preceding sentence applies solely to the 
extent that--
    (A) The dealer accounts for the stock as securities held primarily 
for sale to customers in the ordinary course of business;
    (B) The dealer disposes of the stock within a period of time that 
is consistent with the holding of the stock for sale to customers in 
the ordinary course of business, taking into account the terms of the 
stock and the conditions and practices prevailing in the markets for 
similar stock during the period in which it is held; and
    (C) The dealer does not sell or otherwise transfer the stock to a 
person in the same expanded group, other than in a sale to a dealer 
that in turn satisfies the requirements of paragraph (c)(2)(iv) of this 
section.
    (v) Exclusion for certain acquisitions of expanded group stock 
resulting from application of this section. The following deemed 
acquisitions are not treated as acquisitions of expanded group stock 
described in paragraph (b)(3)(i)(B) of this section, provided that they 
are not part of a plan or arrangement to prevent the application of 
paragraph (b)(3)(i) to a covered debt instrument:
    (A) An acquisition of a covered debt instrument that is treated as 
stock by means of paragraph (b)(3) of this section.
    (B) An acquisition of stock of a regarded owner that is deemed to 
be issued under Sec.  1.385-3T(d)(4).
    (C) An acquisition of deemed partner stock pursuant to a deemed 
transfer or a specified event described in Sec.  1.385-3T(f)(4) or (5).
    (3) Reductions for transactions described in paragraph (b)(2) or 
(b)(3)(i) of this section--(i) Reduction for expanded group earnings--
(A) In general. The aggregate amount of any distributions or 
acquisitions by a covered member described in paragraph (b)(2) or 
(b)(3)(i) of this section in a taxable year during the covered member's 
expanded group period is reduced by the covered member's expanded group 
earnings account (as defined in paragraph (c)(3)(i)(B) of this section) 
for the expanded group period as of the close of the taxable year. The 
reduction described in this paragraph (c)(3)(i)(A) applies to one or 
more distributions or acquisitions based on the order in which the 
distributions or acquisitions occur, regardless of whether any 
distribution or acquisition would be treated as funded by a covered 
debt instrument without regard to this paragraph (c)(3).
    (B) Expanded group earnings account. The term expanded group 
earnings account means, with respect to a covered member and an 
expanded group period (as defined in paragraph (c)(3)(i)(E) of this 
section) of the covered member, the excess, if any, of the covered 
member's expanded group earnings (as defined in paragraph (c)(3)(i)(C) 
of this section) for the expanded group period over the covered 
member's expanded group reductions (as defined in paragraph 
(c)(3)(i)(D) of this section) for the expanded group period.
    (C) Expanded group earnings--(1) In general. The term expanded 
group earnings means, with respect to a covered member and an expanded 
group period of the covered member, the earnings and profits 
accumulated by the covered member during the expanded group period, 
computed as of the close of the taxable year of the covered member, 
without regard to any distributions or acquisitions by the covered 
member described in paragraphs (b)(2) and (b)(3)(i) of this section. 
Notwithstanding the preceding sentence, the expanded group earnings of 
a covered member do not include earnings and profits accumulated by the 
covered member in any taxable year ending before April 5, 2016.
    (2) Special rule for change in expanded group within a taxable 
year. For purposes of calculating a covered member's expanded group 
earnings for a taxable year that is not wholly included in an expanded 
group period, the covered member's expanded group earnings are ratably 
allocated among the portion of the taxable year included in the 
expanded group period and the portion of the taxable year not included 
in the expanded group period. For purposes of the preceding sentence, 
the expanded group period is determined by excluding the day on which 
the covered member becomes a member of an expanded group with the same 
expanded group parent and including the day on which the covered member 
ceases to be a member of an expanded group with the same expanded group 
parent.
    (3) Look-thru rule for dividends--(i) In general. For purposes of 
paragraph (c)(3)(i)(C)(1) of this section, a dividend from a member of 
the same expanded group (distributing member) is not taken into account 
for purposes of calculating a covered member's expanded group earnings, 
except to the extent the dividend is attributable to earnings and 
profits accumulated by the distributing member in a taxable year ending 
after April 4, 2016, during its expanded group period (qualified 
earnings and profits). For purposes of the preceding sentence, a 
dividend received from a member (intermediate distributing member) is 
not taken into account for purposes of calculating the qualified 
earnings and profits of a distributing member (or another intermediate 
distributing member), except to the extent the dividend is attributable 
to qualified earnings and profits of the intermediate distributing 
member. A dividend from distributing member or an intermediate 
distributing member is considered to be attributable to qualified 
earnings and profits to the extent thereof. If a controlled partnership 
receives a dividend from a distributing member and a portion of the 
dividend is allocated (including through one or more partnerships) to a 
covered member, then, for purposes of this paragraph (c)(3)(i)(C)(3), 
the covered member is treated as receiving the dividend from the 
distributing member.
    (ii) Dividend. For purposes of paragraph (c)(3)(i)(C)(3)(i) of this 
section, the term dividend has the meaning specified in section 316, 
including the portion of gain recognized under section 1248 that is 
treated as a dividend and deemed dividends under section 367(b) and the 
regulations thereunder. In addition, the term dividend includes 
inclusions with respect to stock (for example, inclusions under 
sections 951(a) and 1293).
    (4) Effect of interest deductions. For purposes of calculating the 
expanded group earnings of a covered member for a taxable year, 
expanded group earnings are calculated without regard to the 
application of this section during the taxable year to a covered debt 
instrument issued by the covered member that was not treated as stock 
under paragraph (b) of this section as of the close of the preceding 
taxable year, or, if the covered member is an expanded group partner in 
a controlled partnership that is the issuer of a debt instrument, 
without regard to the application of Sec.  1.385-3T(f)(4)(i) during the 
taxable year with respect to the covered member's share of the debt 
instrument. To the extent that the application of this paragraph 
(c)(3)(i)(C)(4) reduces the expanded group earnings of the covered 
member for the taxable year, the expanded group earnings of the covered 
member are increased as of the beginning of the succeeding taxable year 
during the expanded group period.
    (D) Expanded group reductions. The term expanded group reductions 
means,

[[Page 72964]]

with respect to a covered member and an expanded group period of the 
covered member, the amounts by which acquisitions or distributions 
described in paragraph (b)(2) or (b)(3)(i) of this section were reduced 
by reason of paragraph (c)(3)(i)(A) of this section during the portion 
of the expanded group period preceding the taxable year.
    (E) Expanded group period--(1) In general. For purposes of this 
paragraph (c)(3)(i) and paragraph (c)(3)(ii) of this section, the term 
expanded group period means, with respect to a covered member, the 
period during which a covered member is a member of an expanded group 
with the same expanded group parent.
    (2) Mere change. For purposes of paragraph (c)(3)(i)(E)(1) of this 
section, an expanded group parent that is a resulting corporation 
(within the meaning of Sec.  1.368-2(m)(1)) in a reorganization 
described in section 368(a)(1)(F) is treated as the same expanded group 
parent as an expanded group parent that is a transferor corporation 
(within the meaning of Sec.  1.368-2(m)(1)) in the same reorganization, 
provided that either--
    (i) The transferor corporation is not a covered member; or
    (ii) Both the transferor corporation and the resulting corporation 
are covered members.
    (F) Special rules for certain corporate transactions--(1) Reduction 
for expanded group earnings in an asset reorganization. For purposes of 
applying paragraph (c)(3)(i) of this section, a distribution or 
acquisition described in paragraph (b)(2) or (b)(3)(i) of this section 
that occurs pursuant to a reorganization described in section 381(a)(2) 
is reduced solely by the expanded group earnings account of the 
acquiring member after taking into account the adjustment to its 
expanded group earnings account provided in paragraph 
(c)(3)(i)(F)(2)(ii) of this section.
    (2) Effect of certain corporate transactions on the calculation of 
expanded group earnings account--(i) In general. Section 381 and Sec.  
1.312-10 are not taken into account for purposes of calculating a 
covered member's expanded group earnings account for an expanded group 
period. The expanded group earnings account that a covered member 
succeeds to under paragraphs (c)(3)(i)(F)(2)(ii) through (iv) of this 
section is attributed to the covered member's expanded group period as 
of the close of the date of the distribution or transfer.
    (ii) Section 381 transactions. If a covered member (acquiring 
member) acquires the assets of another covered member (acquired member) 
in a transaction described in section 381(a), and, immediately before 
the transaction, both corporations are members of the same expanded 
group, then the acquiring member succeeds to the expanded group 
earnings account of the acquired member, if any, determined after 
application of paragraph (c)(3)(i) of this section with respect to the 
final taxable year of the acquired member.
    (iii) Section 1.312-10(a) transactions. If a covered member 
(transferor member) transfers property to another covered member 
(transferee member) in a transaction described in Sec.  1.312-10(a), 
the expanded group earnings account of the transferor member is 
allocated between the transferor member and the transferee member in 
the same proportion as the earnings and profits of the transferor 
member are allocated between the transferor member and the transferee 
member under Sec.  1.312-10(a).
    (iv) Section 1.312-10(b) transactions. If a covered member 
(distributing member) distributes the stock of another covered member 
(controlled member) in a transaction described in Sec.  1.312-10(b), 
the expanded group earnings account of the distributing member is 
decreased by the amount that the expanded group earnings account of the 
distributing member would have been decreased under paragraph 
(c)(3)(i)(F)(2)(iii) of this section if the distributing member had 
transferred the stock of the controlled member to a newly formed 
corporation in a transaction described in Sec.  1.312-10(a). If the 
amount of the decrease described in the preceding sentence exceeds the 
expanded group earnings account of the controlled member immediately 
before the transaction described in Sec.  1.312-10(b), then the 
expanded group earnings account of the controlled member after the 
transaction is equal to the amount of the decrease.
    (G) Overlapping expanded groups. A covered member that is a member 
of two expanded groups at the same time has a single expanded group 
earnings account with respect to a single expanded group period. In 
this case, the expanded group period is determined by reference to the 
shorter of the two periods during which the covered member is a member 
of an expanded group with the same expanded group parent.
    (ii) Reduction for qualified contributions--(A) In general. The 
amount of a distribution or acquisition by a covered member described 
in paragraph (b)(2) or (b)(3)(i) of this section is reduced by the 
aggregate fair market value of the stock issued by the covered member 
in one or more qualified contributions (as defined in paragraph 
(c)(3)(ii)(B) of this section) during the qualified period (as defined 
in paragraph (c)(3)(ii)(C) of this section), but only to the extent the 
qualified contribution or qualified contributions have not reduced 
another distribution or acquisition. The reduction described in this 
paragraph (c)(3)(ii)(A) applies to one or more distributions or 
acquisitions based on the order in which the distributions or 
acquisitions occur, regardless of whether any distribution or 
acquisition would be treated as funded by a covered debt instrument 
without regard to this paragraph (c)(3).
    (B) Qualified contribution. The term qualified contribution means, 
with respect to a covered member, except as provided in paragraph 
(c)(3)(ii)(E) of this section, a contribution of property, other than 
excluded property (defined in paragraph (c)(3)(ii)(D) of this section), 
to the covered member by a member of the covered member's expanded 
group (or by a controlled partnership of the expanded group) in 
exchange for stock.
    (C) Qualified period. The term qualified period means, with respect 
to a covered member, a qualified contribution, and a distribution or 
acquisition described in paragraph (b)(2) or (b)(3)(i) of this section, 
the period beginning on the later of the beginning of the periods 
described in paragraphs (c)(3)(ii)(C)(1) and (2) of this section, and 
ending on the earlier of the ending of the periods described in 
paragraphs (c)(3)(ii)(C)(1) and (2) of this section or the date 
described in paragraph (c)(3)(ii)(C)(3) of this section.
    (1) 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.
    (2) The covered member's expanded group period (as defined in 
paragraph (c)(3)(i)(E) of this section) that includes the distribution 
or acquisition.
    (3) The last day of the first taxable year that a covered debt 
instrument issued by the covered member would, absent the application 
of this paragraph (c)(3)(ii) with respect to the distribution or 
acquisition, be treated, in whole or in part, as stock under paragraph 
(b) of this section or, in the case of a covered debt instrument issued 
by a controlled partnership in which the covered member is an expanded 
group partner, the covered debt instrument would be treated, in whole 
or in part, as a specified portion.
    (D) Excluded property. The term excluded property means--
    (1) Expanded group stock;
    (2) Property acquired by the covered member in an asset 
reorganization from

[[Page 72965]]

a member of the expanded group of which the covered member is a member;
    (3) A covered debt instrument of any member of the same expanded 
group, including a covered debt instrument issued by the covered 
member;
    (4) Property acquired by the covered member in exchange for a 
covered debt instrument issued by the covered member that is 
recharacterized under paragraph (b)(3) of this section;
    (5) A debt instrument issued by a controlled partnership of the 
expanded group of which the covered member is a member, including the 
portion of such a debt instrument that is a deemed transferred 
receivable or a retained receivable; and
    (6) Any other property acquired by the covered member with a 
principal purpose to avoid the purposes of this section or Sec.  1.385-
3T, including a transaction involving an indirect transfer of property 
described in paragraphs (c)(3)(ii)(D)(1) through (5) of this section.
    (E) Excluded contributions--(1) Upstream contributions from certain 
subsidiaries. For purposes of paragraph (c)(3)(ii)(B) of this section, 
a contribution of property from a corporation (controlled member) that 
the covered member controls, within the meaning of paragraph 
(c)(2)(i)(B) of this section, is not a qualified contribution.
    (2) Contributions to a predecessor or successor. For purposes of 
paragraph (c)(3)(ii)(B) of this section, a contribution of property to 
a covered member from a corporation of which the covered member is a 
predecessor or successor, or from a corporation controlled by that 
corporation within the meaning of paragraph (c)(2)(i)(B) of this 
section, is not a qualified contribution.
    (3) Contributions that do not increase fair market value. A 
contribution of property to a covered member that is not described in 
paragraph (c)(3)(ii)(E)(1) or (2) of this section is not a qualified 
contribution to the extent that the contribution does not increase the 
aggregate fair market value of the outstanding stock of the covered 
member immediately after the transaction and taking into account all 
related transactions, other than distributions and acquisitions 
described in paragraphs (b)(2) and (b)(3)(i) of this section.
    (4) Contributions that become excluded contributions after the date 
of the contribution. If a contribution of property described in 
paragraph (c)(3)(ii)(E)(1) or (2) of this section occurs before the 
covered member acquires control of the controlled member described in 
paragraph (c)(3)(ii)(E)(1) or before the transaction in which the 
corporation described in paragraph (c)(3)(ii)(E)(2) becomes a 
predecessor or successor to the covered member, the contribution of 
property ceases to be a qualified contribution on the date that the 
covered member acquires control of the controlled member or on the date 
of the transaction in which the corporation becomes a predecessor or 
successor to the covered member (transaction date). If the contribution 
of property occurs within 36 months before the transaction date, the 
covered member is treated as making a distribution described in 
paragraph (b)(3)(i)(A) of this section on the transaction date equal to 
the amount by which any distribution or acquisition described in 
paragraph (b)(2) or (b)(3)(i) of this section was reduced under 
paragraph (c)(3)(ii)(A) of this section because the contribution of 
property was treated as a qualified contribution.
    (F) Special rules for certain corporate transactions--(1) Reduction 
for qualified contributions in an asset reorganization. For purposes of 
applying paragraph (c)(3)(ii)(A) of this section, a distribution or 
acquisition described in paragraph (b)(2) or (b)(3)(i) of this section 
that occurs pursuant to a reorganization described in section 381(a)(2) 
is reduced solely by the qualified contributions of the acquiring 
member after taking into account the adjustment to its qualified 
contributions provided in paragraph (c)(3)(ii)(F)(2) of this section.
    (2) Effect of certain corporate transactions on the calculation of 
qualified contributions--(i) In general. This paragraph 
(c)(3)(ii)(F)(2) provides rules for allocating or reducing the 
qualified contributions of a covered member as a result of certain 
corporation transactions. For purposes of paragraph (c)(3)(ii)(C)(1) of 
this section, a qualified contribution that a covered member succeeds 
to under paragraphs (c)(3)(ii)(F)(2)(ii) and (iii) of this section is 
treated as made to the covered member on the date on which the 
qualified contribution was made to the covered member that received the 
qualified contribution. For purposes of paragraph (c)(3)(ii)(C)(2) of 
this section, a qualified contribution that a covered member succeeds 
to under paragraphs (c)(3)(ii)(F)(2)(ii) and (iii) of this section is 
attributed to the covered member's expanded group period as of the 
close of the date of the distribution or transfer. For purposes of 
paragraph (c)(3)(ii)(C)(3) of this section, a qualified contribution a 
covered member succeeds to under paragraphs (c)(3)(ii)(F)(2)(ii) and 
(iii) of this section is treated as made to the covered member as of 
the close of the date of the distribution or transfer.
    (ii) Section 381 transactions. If a covered member (acquiring 
member) acquires the assets of another covered member (acquired member) 
in a transaction described in section 381(a), and, immediately before 
the transaction, both corporations are members of the same expanded 
group, the acquiring member succeeds to the qualified contributions of 
the acquired member, if any, adjusted for the application of paragraph 
(c)(3)(ii)(E)(4) of this section.
    (iii) Section 1.312-10(a) transactions. If a covered member 
(transferor member) transfers property to another covered member 
(transferee member) in a transaction described in Sec.  1.312-10(a), 
each qualified contribution of the transferor member is allocated 
between the transferor member and the transferee member in the same 
proportion as the earnings and profits of the transferor member are 
allocated between the transferor member and the transferee member under 
Sec.  1.312-10(a).
    (iv) Section 1.312-10(b) transactions. If a covered member 
(distributing member) distributes the stock of another covered member 
(controlled member) in a transaction described in Sec.  1.312-10(b), 
each qualified contribution of the distributing member is decreased by 
the amount that each qualified contribution of the distributing member 
would have been decreased under paragraph (c)(3)(ii)(F)(2)(iii) of this 
section if the distributing member had transferred the stock of the 
controlled member to a newly formed corporation in a transaction 
described in Sec.  1.312-10(a). No amount of the qualified 
contributions of the distributing member is allocated to the controlled 
member.
    (iii) Predecessors and successors. For purposes of this paragraph 
(c)(3), references to a covered member do not include references to any 
corporation of which the covered member is a predecessor or successor. 
Accordingly, a distribution or acquisition by a covered member 
described in paragraphs (b)(3)(i)(A) through (C) is reduced solely by 
the expanded group earnings account of the covered member (taking into 
account the application of paragraph (c)(3)(i)(F)(2) of this section) 
and the qualified contributions of the covered member (taking into 
account the application of paragraph (c)(3)(ii)(F)(2) of this section), 
notwithstanding that the distribution or acquisition is treated as made 
by a funded member of which the covered member is a predecessor or 
successor.
    (iv) Ordering rule. The exceptions described in this paragraph 
(c)(3) are

[[Page 72966]]

applied in the following order: First, paragraph (c)(3)(i) of this 
section; and, second, paragraph (c)(3)(ii) of this section.
    (4) Threshold exception. A covered debt instrument is not treated 
as stock under this section if, immediately after the covered debt 
instrument would be treated as stock under this section but for the 
application of this paragraph (c)(4), the aggregate adjusted issue 
price of covered debt instruments held by members of the issuer's 
expanded group that would be treated as stock under this section but 
for the application of this paragraph (c)(4) does not exceed $50 
million. To the extent a debt instrument issued by a controlled 
partnership would be treated as a specified portion (as defined in 
paragraph (g)(23) of this section) but for the application of this 
paragraph (c)(4), the debt instrument is treated as a covered debt 
instrument described in the preceding sentence for purposes of this 
paragraph (c)(4). To the extent that, immediately after a covered debt 
instrument would be treated as stock under this section but for the 
application of this paragraph (c)(4), the aggregate adjusted issue 
price of covered debt instruments held by members of the issuer's 
expanded group that would be treated as stock under this section but 
for the application of this paragraph (c)(4) exceeds $50 million, only 
the amount of the covered debt instrument in excess of $50 million is 
treated as stock under this section. For purposes of this rule, any 
covered 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 covered debt instrument is issued.
    (d) Operating rules--(1) Timing. This paragraph (d)(1) provides 
rules for determining when a covered debt instrument is treated as 
stock under paragraph (b) of this section. For special rules regarding 
the treatment of a deemed exchange of a covered debt instrument that 
occurs pursuant to paragraphs (d)(1)(ii), (d)(1)(iii), or (d)(1)(iv) of 
this section, see Sec.  1.385-1(d).
    (i) General timing rule. Except as otherwise provided in this 
paragraph (d)(1), when paragraph (b) of this section applies to treat a 
covered debt instrument as stock, the covered debt instrument is 
treated as stock when the covered debt instrument is issued. When 
paragraph (b)(3) of this section applies to treat a covered debt 
instrument as stock when the covered debt instrument is issued, see 
also paragraph (b)(3)(vi) of this section.
    (ii) Exception when a covered debt instrument is treated as funding 
a distribution or acquisition that occurs after the issuance of the 
covered debt instrument. When paragraph (b)(3)(iii) of this section 
applies to treat a covered debt instrument as funding a distribution or 
acquisition described in paragraph (b)(3)(i)(A) through (C) of this 
section that occurs after the covered debt instrument is issued, the 
covered debt instrument is deemed to be exchanged for stock on the date 
that the distribution or acquisition occurs. See paragraph (h)(3) of 
this section, Examples 4 and 9, for an illustration of this rule.
    (iii) Exception for certain predecessor and successor transactions. 
To the extent that a covered debt instrument would not be treated as 
stock but for the fact that a funded member is treated as the 
predecessor or successor of another expanded group member under 
paragraph (b)(3)(v) of this section, the covered debt instrument is 
deemed to be exchanged for stock on the later of the date that the 
funded member completes the transaction causing it to become a 
predecessor or successor of the other expanded group member or the date 
that the covered debt instrument would be treated as stock under 
paragraph (d)(1)(i) or (ii) of this section.
    (iv) Exception when a covered debt instrument is re-tested under 
paragraph (d)(2) of this section. When paragraph (b)(3)(iii) of this 
section applies to treat a covered debt instrument as funding a 
distribution or acquisition described in paragraphs (b)(3)(i)(A) 
through (C) of this section as a result of a re-testing described in 
paragraph (d)(2)(ii) of this section that occurs in a taxable year 
subsequent to the taxable year in which the covered debt instrument is 
issued, the covered debt instrument is deemed to be exchanged for stock 
on the later of the date of the re-testing or the date that the covered 
debt instrument would be treated as stock under paragraph (d)(1)(i) or 
(ii) of this section. See paragraph (h)(3) of this section, Example 7, 
for an illustration of this rule.
    (2) Covered debt instrument treated as stock that leaves the 
expanded group--(i) Events that cause a covered debt instrument to 
cease to be treated as stock. Subject to paragraph (b)(4) of this 
section, this paragraph (d)(2)(i) applies with respect to a covered 
debt instrument that is treated as stock under this section when the 
holder and issuer of a covered debt instrument cease to be members of 
the same expanded group, either because the covered 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 ceases to be a 
member of the same expanded group, or in the case of a holder that is a 
controlled partnership, when the holder ceases to be a controlled 
partnership with respect to the expanded group of which the issuer is a 
member, either because the partnership ceases to be a controlled 
partnership or because the issuer ceases to be a member of the same 
expanded group with respect to which the holder is a controlled 
partnership. In such a case, the covered 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 covered 
debt instrument to cease to be members of the same expanded group, or, 
if the holder is a controlled partnership, that causes the holder to 
cease to be a controlled partnership with respect to the expanded group 
of which the issuer is a member, the issuer is deemed to issue a new 
covered debt instrument to the holder in exchange for the covered 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.
    (ii) Re-testing of covered debt instruments and certain 
distributions and acquisitions--(A) General rule. For purposes of 
paragraph (b)(3)(iii) of this section, when paragraph (d)(2)(i) of this 
section or Sec.  1.385-4T(c)(2) causes a covered 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 covered debt 
instruments of the issuer that are not treated as stock on the date 
that the transaction occurs that causes paragraph (d)(2)(i) of this 
section to apply are re-tested to determine whether those other covered 
debt instruments are treated as funding the distribution or acquisition 
that previously was treated as funded by the covered debt instrument 
that ceases to be treated as stock pursuant to paragraph (d)(2)(i) of 
this section. In addition, a covered debt instrument that is issued 
after an application of paragraph (d)(2)(i) of this section and within 
the per se period may also be treated as funding that distribution or 
acquisition. See paragraph (h)(3) of this section, Example 7, for an 
illustration of this rule.
    (B) Re-testing upon a specified event with respect to a debt 
instrument issued by a controlled partnership. If, with respect to a 
covered member that is an expanded group partner and a debt instrument 
issued by the controlled partnership, there is reduction in the covered 
member's specified portion under Sec.  1.385-3T(f)(5)(i) by reason of a 
specified event, the covered member

[[Page 72967]]

must re-test its debt instruments as described in paragraph 
(d)(2)(ii)(A) of this section.
    (3) Inapplicability of section 385(c)(1). Section 385(c)(1) does 
not apply with respect to a covered debt instrument to the extent that 
it is treated as stock under this section.
    (4) Treatment of disregarded entities. [Reserved]. For further 
guidance, see Sec.  1.385-3T(d)(4).
    (5) Payments with respect to partially recharacterized covered debt 
instruments--(i) General rule. Except as otherwise provided in 
paragraph (d)(5)(ii) of this section, a payment with respect to an 
instrument that is partially recharacterized as stock is treated as 
made pro rata to the portion treated as stock and to the portion 
treated as indebtedness.
    (ii) Special rule for payments not required pursuant to the terms 
of the instrument. A payment with respect to an instrument that is 
partially recharacterized as stock and that is a payment that is not 
required to be made pursuant to the terms of the instrument (for 
example, a prepayment of principal) may be designated by the issuer and 
the holder as with respect to the portion treated as stock or to the 
portion treated as indebtedness, in whole or in part. In the absence of 
such designation, see paragraph (d)(5)(i) of this section.
    (6) Treatment of a general rule transaction to which an exception 
applies. To the extent a covered member would, absent the application 
of paragraph (c)(2) or (c)(3) of this section, be treated as making a 
distribution or acquisition described in paragraph (b)(2) of this 
section, then, solely for purposes of applying paragraph (b)(3) of this 
section, the covered member is treated as issuing the covered debt 
instrument issued in the distribution or acquisition to a member of the 
covered member's expanded group in exchange for property.
    (7) Treatment for purposes of section 1504(a)--(i) Debt instruments 
treated as stock. A covered debt instrument that is treated as stock 
under paragraph (b)(2), (3), or (4) of this section and that is not 
described in section 1504(a)(4) is not treated as stock for purposes of 
determining whether the issuer is a member of an affiliated group 
(within the meaning of section 1504(a)).
    (ii) Deemed partner stock and stock deemed issued by a regarded 
owner. If deemed partner stock or stock that is deemed issued by a 
regarded owner under Sec.  1.385-3T(d)(4) is not described in section 
1504(a)(4), then that stock is not treated as stock for purposes of 
determining whether the issuer of the stock is a member of an 
affiliated group (within the meaning of section 1504(a)).
    (e) No affirmative use. [Reserved]
    (f) Treatment of controlled partnerships. [Reserved]. For further 
guidance, see Sec.  1.385-3T(f).
    (g) Definitions. The definitions in this paragraph (g) apply for 
purposes of this section and Sec. Sec.  1.385-3T and 1.385-4T.
    (1) Asset reorganization. The term asset reorganization means a 
reorganization described in section 368(a)(1)(A), (C), (D), (F), or 
(G).
    (2) Consolidated group. The term consolidated group has the meaning 
specified in Sec.  1.1502-1(h).
    (3) Covered debt instrument--(i) In general. The term covered debt 
instrument means a debt instrument issued after April 4, 2016, that is 
not a qualified dealer debt instrument (as defined in paragraph 
(g)(3)(ii) of this section) or an excluded statutory or regulatory debt 
instrument (as defined in paragraph (g)(3)(iii) of this section), and 
that is issued by a covered member that is not an excepted regulated 
financial company (as defined in paragraph (g)(3)(iv) of this section) 
or a regulated insurance company (as defined in paragraph (g)(3)(v) of 
this section).
    (ii) For purposes of this paragraph (g)(3), the term qualified 
dealer debt instrument means a debt instrument that is issued to or 
acquired by an expanded group member that is a dealer in securities 
(within the meaning of section 475(c)(1)) in the ordinary course of the 
dealer's business of dealing in securities. The preceding sentence 
applies solely to the extent that--
    (A) The dealer accounts for the debt instruments as securities held 
primarily for sale to customers in the ordinary course of business;
    (B) The dealer disposes of the debt instruments (or the debt 
instruments mature) within a period of time that is consistent with the 
holding of the debt instruments for sale to customers in the ordinary 
course of business, taking into account the terms of the debt 
instruments and the conditions and practices prevailing in the markets 
for similar debt instruments during the period in which it is held; and
    (C) The dealer does not sell or otherwise transfer the debt 
instrument to a member of the dealer's expanded group unless that sale 
or transfer is to a dealer that satisfies the requirements of this 
paragraph (g)(3)(ii).
    (iii) For purposes of this paragraph (g)(3), the term excluded 
statutory or regulatory debt instrument means a debt instrument that is 
described in any of the following paragraphs:
    (A) Production payments treated as a loan under section 636(a) or 
(b).
    (B) A ``regular interest'' in a real estate mortgage investment 
conduit described in section 860G(a)(1).
    (C) A debt instrument that is deemed to arise under Sec.  1.482-
1(g)(3) (including adjustments made pursuant to Revenue Procedure 99-
32, 1999-2 C.B. 296).
    (D) A stripped bond or coupon described in section 1286, unless 
such instrument was issued with a principal purpose of avoiding the 
purposes of this section or Sec.  1.385-3T.
    (E) A lease treated as a loan under section 467.
    (iv) For purposes of this paragraph (g)(3), the term excepted 
regulated financial company means a covered member that is a regulated 
financial company (as defined in paragraph (g)(3)(iv)(A) of this 
section) or a member of a regulated financial group (as defined in 
paragraph (g)(3)(iv)(B) of this section).
    (A) Regulated financial company. For purposes of paragraph 
(g)(3)(iv), the term regulated financial company means--
    (1) A bank holding company, as defined in 12 U.S.C. 1841;
    (2) A covered savings and loan holding company, as defined in 12 
CFR 217.2;
    (3) A national bank;
    (4) A bank that is a member of the Federal Reserve System and is 
incorporated by special law of any State, or organized under the 
general laws of any State, or of the United States, including a Morris 
Plan bank, or other incorporated banking institution engaged in a 
similar business;
    (5) An insured depository institution, as defined in 12 U.S.C. 
1813(c)(2);
    (6) A nonbank financial company subject to a determination under 12 
U.S.C. 5323(a)(1) or (b)(1);
    (7) A U.S. intermediate holding company formed by a foreign banking 
organization in compliance with 12 CFR 252.153;
    (8) An Edge Act corporation organized under section 25A of the 
Federal Reserve Act (12 U.S.C. 611-631);
    (9) Corporations having an agreement or undertaking with the Board 
of Governors of the Federal Reserve System under section 25 of the 
Federal Reserve Act (12 U.S.C. 601-604a);
    (10) A supervised securities holding company, as defined in 12 
U.S.C. 1850a(a)(5);
    (11) A broker or dealer that is registered with the Securities and 
Exchange Commission under 15 U.S.C. 78o(b);
    (12) A futures commission merchant, as defined in 7 U.S.C. 1a(28);

[[Page 72968]]

    (13) A swap dealer, as defined in 7 U.S.C. 1a(49);
    (14) A security-based swap dealer, as defined in 15 U.S.C. 
78c(a)(71);
    (15) A Federal Home Loan Bank, as defined in 12 U.S.C. 1422(1)(A);
    (16) A Farm Credit System Institution chartered and subject to the 
provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.); or
    (17) A small business investment company, as defined in 15 U.S.C. 
662(3).
    (B) Regulated financial group--(1) General rule. For purposes of 
paragraph (g)(3)(iv) of this section, except as otherwise provided in 
paragraph (g)(3)(iv)(B)(2) of this section, the term regulated 
financial group means any expanded group of which a covered member that 
is a regulated financial company within the meaning of paragraphs 
(g)(3)(iv)(A)(1) through (10) of this section would be the expanded 
group parent if no person owned, directly or indirectly (as defined in 
Sec.  1.385-1(c)(4)(iii)), the regulated financial company.
    (2) Exception for certain non-financial entities. A corporation is 
not a member of a regulated financial group if it is held by a 
regulated financial company pursuant to 12 U.S.C. 1843(k)(1)(B), 12 
U.S.C. 1843(k)(4)(H), or 12 U.S.C. 1843(o).
    (v) For purposes of this paragraph (g)(3), the term regulated 
insurance company means a covered member that is--
    (A) Subject to tax under subchapter L of chapter 1 of the Internal 
Revenue Code;
    (B) Domiciled or organized under the laws of one of the 50 states 
or the District of Columbia (for purposes of paragraph (g)(3)(v) of 
this section, each being a ``state'');
    (C) Licensed, authorized, or regulated by one or more states to 
sell insurance, reinsurance, or annuity contracts to persons other than 
related persons (within the meaning of section 954(d)(3)) in such 
states, but in no case will a corporation satisfy the requirements of 
this paragraph (g)(3)(v)(C) if a principal purpose for obtaining such 
license, authorization, or regulation was to qualify the issuer as a 
regulated insurance company; and
    (D) Engaged in regular issuances of (or subject to ongoing 
liability with respect to) insurance, reinsurance, or annuity contracts 
with persons that are not related persons (within the meaning of 
section 954(d)(3)).
    (4) 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), 
provided that the interest is not recharacterized as stock under Sec.  
1.385-2.
    (5) Deemed holder. [Reserved]. For further guidance, see Sec.  
1.385-3T(g)(5).
    (6) Deemed partner stock. [Reserved]. For further guidance, see 
Sec.  1.385-3T(g)(6).
    (7) Deemed transfer. [Reserved]. For further guidance, see Sec.  
1.385-3T(g)(7).
    (8) Deemed transferred receivable. [Reserved]. For further 
guidance, see Sec.  1.385-3T(g)(8).
    (9) Distribution. The term distribution means any distribution made 
by a corporation with respect to its stock.
    (10) Exempt distribution. The term exempt distribution means 
either--
    (i) A distribution of stock that is permitted to be received 
without the recognition of gain or income under section 354(a)(1) or 
355(a)(1), or, if section 356 applies, that is not treated as other 
property or money described in section 356; or
    (ii) A distribution of property in a complete liquidation under 
section 336(a) or 337(a).
    (11) Exempt exchange. The term exempt exchange means an acquisition 
of expanded group stock in which either--
    (i) In a case in which the transferor and transferee of the 
expanded group stock are parties to an asset reorganization, either--
    (A) Section 361(a) or (b) applies to the transferor of the expanded 
group stock and the stock is not transferred by issuance; or
    (B) 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;
    (ii) The transferor of the expanded group stock is a shareholder 
that receives property in a complete liquidation to which section 331 
or 332 applies; or
    (iii) The transferor of the expanded group stock is an acquiring 
entity that is deemed to issue the stock in exchange for cash from an 
issuing corporation in a transaction described in Sec.  1.1032-3(b).
    (12) Expanded group partner. The term expanded group partner means, 
with respect to a controlled partnership of an expanded group, a member 
of the expanded group that is a partner (directly or indirectly through 
one or more partnerships).
    (13) 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.
    (14) Funded member. The term funded member has the meaning provided 
in paragraph (b)(3)(i) of this section.
    (15) Holder-in-form. [Reserved]. For further guidance, see Sec.  
1.385-3T(g)(15).
    (16) Issuance percentage. [Reserved]. For further guidance, see 
Sec.  1.385-3T(g)(16).
    (17) Liquidation value percentage. [Reserved]. For further 
guidance, see Sec.  1.385-3T(g)(17).
    (18) Member of a consolidated group. The term member of a 
consolidated group means a corporation described in Sec.  1.1502-1(b).
    (19) Per se period. The term per se period has the meaning provided 
in paragraph (b)(3)(iii)(A) of this section.
    (20) Predecessor--(i) In general. Except as otherwise provided in 
paragraph (g)(20)(ii) of this section, the term predecessor means, with 
respect to a corporation--
    (A) The distributor or transferor corporation in a transaction 
described in section 381(a) in which the corporation is the acquiring 
corporation; or
    (B) The distributing corporation in a distribution or exchange to 
which section 355 (or so much of section 356 that relates to section 
355) applies in which the corporation is a controlled corporation.
    (ii) Predecessor ceasing to be a member of the same expanded group 
as corporation. The term predecessor does not include the distributing 
corporation described in paragraph (g)(20)(i)(B) of this section from 
the date that the distributing corporation ceases to be a member of the 
expanded group of which the controlled corporation is a member.
    (iii) Multiple predecessors. A corporation may have more than one 
predecessor, including by reason of a predecessor of the corporation 
having a predecessor or successor. Accordingly, references to a 
corporation also include references to a predecessor or successor of a 
predecessor of the corporation.
    (21) Property. The term property has the meaning specified in 
section 317(a).
    (22) Retained receivable. [Reserved]. For further guidance, see 
Sec.  1.385-3T(g)(22).
    (23) Specified portion. [Reserved]. For further guidance, see Sec.  
1.385-3T(g)(23).
    (24) Successor--(i) In general. Except as otherwise provided in 
paragraph (g)(24)(iii) of this section, the term successor means, with 
respect to a corporation--
    (A) The acquiring corporation in a transaction described in section 
381(a) in which the corporation is the distributor or transferor 
corporation;
    (B) A controlled corporation in a distribution or exchange to which 
section 355 (or so much of section 356 that relates to section 355) 
applies in

[[Page 72969]]

which the corporation is the distributing corporation; or
    (C) Subject to the rules in paragraph (g)(24)(ii) of this section, 
a seller in an acquisition described in paragraph (c)(2)(i)(A) of this 
section in which the corporation is the acquirer.
    (ii) Special rules for certain acquisitions of subsidiary stock. 
The following rules apply with respect to a successor described in 
paragraph (g)(24)(i)(C) of this section:
    (A) The seller is a successor to the acquirer only to the extent of 
the value (adjusted as described in paragraph (g)(24)(ii)(C) of this 
section) of the expanded group stock acquired from the seller in 
exchange for property (other than expanded group stock) in the 
acquisition described in paragraph (c)(2)(i)(A) of this section.
    (B) A distribution or acquisition by the seller to or from the 
acquirer is not taken into account for purposes of applying paragraph 
(b)(3) of this section to a covered debt instrument of the acquirer.
    (C) To the extent that a covered debt instrument of the acquirer is 
treated as funding a distribution or acquisition by the seller 
described in paragraphs (b)(3)(i)(A) through (C) of this section, or 
would be treated but for the exceptions described in paragraphs 
(c)(3)(i) and (ii) of this section, the value of the expanded group 
stock described in paragraph (g)(24)(ii)(A) of this section is reduced 
by an amount equal to the distribution or acquisition for purposes of 
any further application of paragraph (g)(24)(ii)(A) of this section 
with respect to the acquirer and seller.
    (iii) Successor ceasing to be a member of the same expanded group 
as corporation. The term successor does not include a controlled 
corporation described in paragraph (g)(24)(i)(B) of this section with 
respect to a distributing corporation or a seller described in 
paragraph (g)(24)(i)(C) of this section with respect to an acquirer 
from the date that the controlled corporation or the seller ceases to 
be a member of the expanded group of which the controlled corporation 
or acquirer, respectively, is a member.
    (iv) Multiple successors. A corporation may have more than one 
successor, including by reason of a successor of the corporation having 
a predecessor or successor. Accordingly, references to a corporation 
also include references to a predecessor or successor of a successor of 
the corporation.
    (25) Taxable year. The term taxable year refers to the taxable year 
of the issuer of the covered debt instrument.
    (h) Examples--(1) Assumed facts. Except as otherwise stated, the 
following facts are assumed for purposes of the examples in paragraph 
(h)(3) of this section:
    (i) FP is a foreign corporation that owns 100% of the stock of 
USS1, a covered member, 100% of the stock of USS2, a covered member, 
and 100% of the stock of FS, a foreign corporation;
    (ii) USS1 owns 100% of the stock of DS, a covered member, 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 covered 
debt instruments described in paragraph (c)(4) of this section at all 
times;
    (v) No issuer of a covered debt instrument has a positive expanded 
group earnings account within the meaning of paragraph (c)(3)(i)(B) of 
this section or has received qualified contributions within the meaning 
of paragraph (c)(3)(ii) of this section;
    (vi) All notes are covered debt instruments (as defined in 
paragraph (g)(3) of this section) and are not qualified short-term debt 
instruments (as defined in paragraph (b)(3)(vii) of this section);
    (vii) Each entity has as its taxable year the calendar year;
    (viii) PRS is a partnership for federal income tax purposes;
    (ix) No corporation is a member of a consolidated group;
    (x) No domestic corporation is a United States real property 
holding corporation within the meaning of section 897(c)(2);
    (xi) Each note is issued with adequate stated interest (as defined 
in section 1274(c)(2)); and
    (xii) Each transaction occurs after January 19, 2017.
    (2) No inference. Except as otherwise provided in this section, it 
is assumed for purposes of the examples in paragraph (h)(3) of this 
section 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 an example in paragraph 
(h)(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 covered 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 covered debt instrument that is 
issued by USS1 to FP, a member of the expanded group of which USS1 
is a member, 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. Under paragraph (b)(5) 
of this section, because the distribution of USS1 Note B is 
described in paragraph (b)(2)(i) of this section, the distribution 
of USS1 Note B is not treated as a distribution of property 
described in paragraph (b)(3)(i)(A) of this section. Accordingly, 
USS1 Note A is not treated as funding the distribution of USS1 Note 
B for purposes of paragraph (b)(3)(i)(A) of this section.
    Example 2. Covered 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. Subsequently, 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 (g)(11) 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.
    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% 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 (g)(11) of this section.
    (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 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).

[[Page 72970]]

    Example 4. Funding occurs in same taxable year as distribution. 
(i) Facts. On Date A in Year 1, FP lends $200x to DS in exchange for 
DS Note A. On Date B in Year 1, DS distributes $400x of cash to USS1 
in a distribution.
    (ii) Analysis. Under paragraph (b)(3)(iii)(A) of this section, 
DS Note A is treated as funding the distribution by DS to USS1 
because DS Note A is issued to a member of the FP expanded group 
during the per se period with respect to DS's distribution to USS1. 
Accordingly, under paragraphs (b)(3)(i)(A) and (d)(1)(ii) of this 
section, DS Note A is treated as stock on Date B in Year 1.
    Example 5. Additional funding. (i) Facts. The facts are the same 
as in Example 4 of this paragraph (h)(3), except that, in addition, 
on Date C in Year 2, FP lends an additional $300x to DS in exchange 
for DS Note B.
    (ii) Analysis. The analysis is the same as in Example 4 of this 
paragraph (h)(3) with respect to DS Note A. DS Note B is also issued 
to a member of the FP expanded group during the per se period with 
respect to DS's distribution to USS1. Under paragraphs 
(b)(3)(iii)(A) and (b)(6) of this section, DS Note B is treated as 
funding only the remaining portion of DS's distribution to USS1, 
which is $200x. Accordingly, $200x of DS Note B is treated as stock 
under paragraph (b)(3)(i)(A) of this section. Under paragraph 
(d)(1)(i) of this section, $200x of DS Note B is treated as stock 
when it is issued by DS to FP on Date C in Year 2. The remaining 
$100x of DS 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)(iii)(B) 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 per se period with respect to USS1's $300x distribution to FP 
and, therefore, is treated as funding the distribution under 
paragraph (b)(3)(iii)(A) of this section. Beginning on Date B in 
Year 2, USS1 Note A is treated as stock under paragraphs 
(b)(3)(i)(A) and (d)(1)(ii) of this section.
    (B) Under paragraph (b)(3)(iii)(B) 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. See paragraph (b)(6) of this section.
    Example 7. Re-testing. (i) Facts. The facts are the same as in 
Example 6 of this paragraph (h)(3), except that on Date D in Year 4, 
FP sells USS1 Note A to Bank.
    (ii) Analysis. (A) Under paragraph (d)(2)(i) 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)(ii) of this section, after USS1 Note 
A is deemed exchanged for a new debt instrument, USS1's other 
covered 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)(iii) of this section to determine whether the 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 during the per se 
period. Accordingly, USS1 Note B is re-tested under paragraph 
(b)(3)(iii) of this section. Under paragraph (b)(3)(iii) of this 
section, USS1 Note B is treated as funding the distribution on Date 
C in Year 3 and, accordingly, is treated as stock under paragraph 
(b)(3)(i)(A) of this section. USS1 Note B 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(d) for rules regarding 
the treatment of this deemed exchange.
    Example 8. Distribution of expanded group stock and covered 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 to DS2 qualifies as a reorganization described in 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 described in section 368(a)(1)(D) involving a 
transfer of property by USS2 to DS2 in exchange for DS2 stock and 
DS2 Note. The transfer of property by USS2 to DS2 is a contribution 
of excluded property described in paragraph (c)(3)(ii)(D)(2) of this 
section and an excluded contribution described in paragraph 
(c)(3)(ii)(E)(2) of this section. Accordingly, USS2's contribution 
of property to DS2 is not a qualified contribution described in 
paragraph (c)(3)(ii)(B) of this section.
    (B) DS2 Note is a covered debt instrument that is issued by DS2 
to USS2, both members of the FP expanded group, in exchange for 
property of USS2 in an asset reorganization (as defined in paragraph 
(g)(1) of this section), and received by FP, another FP expanded 
group member immediately before the reorganization, as other 
property with respect to FP's USS2 stock. Accordingly, the 
transaction is described in paragraph (b)(2)(iii) of this section, 
and 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.
    (C) Because the issuance of DS2 Note by DS2 in exchange for the 
property of USS2 in an asset reorganization is described in 
paragraph (b)(2)(iii) of this section, the distribution and 
acquisition of DS2 Note by USS2 is not treated as a distribution or 
acquisition described in paragraph (b)(3)(i) of this section. 
Accordingly, USS2 Note is not treated as funding the distribution of 
DS2 Note for purposes of paragraph (b)(3)(i) of this section.
    (D) USS2's acquisition of DS2 stock is not an acquisition 
described in paragraph (b)(3)(i)(B) of this section because it is an 
exempt exchange (as defined in paragraph (g)(11) of this section). 
USS2's acquisition of DS2 stock is an exempt exchange 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 of the expanded group stock, pursuant to the plan of 
reorganization.
    (E) USS2's distribution of $150x of the DS2 stock is a 
distribution of stock that is permitted to be received by FP without 
recognition of gain under section 355(a)(1). Accordingly, USS2's 
distribution of the DS2 stock (other than the DS2 Note) to FP is an 
exempt distribution, and is not described in paragraph (b)(3)(i)(A) 
of this section.
    (F) Because USS2 has not made a distribution or acquisition that 
is described in paragraph (b)(3)(i)(A), (B), or (C) of this section, 
USS2 Note is not treated as stock.
    Example 9. Funding a distribution by a successor to funded 
member. (i) Facts. The facts are the same as in Example 8 of this 
paragraph (h)(3), 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) USS2 is a predecessor of DS2 under paragraph 
(g)(20)(i)(B) of this section and DS2 is a successor to USS2 under 
paragraph (g)(24)(i)(B) of this section because USS2 is the 
distributing corporation and DS2 is the controlled corporation in a 
distribution to which section 355 applies. Accordingly, under 
paragraph (b)(3)(v) of this section, a distribution by DS2 is 
treated as a distribution by USS2. Under paragraphs (b)(3)(iii)(A) 
and (b)(3)(v)(B) of this section, USS2 Note is treated as funding 
the distribution by DS2 to FP because USS2 Note was issued during 
the per se period with respect to DS2's $200x cash distribution, and 
because both the issuance of USS2 Note and the distribution by DS2 
occur during the per se period with respect to the section 355 
distribution. Accordingly, under paragraphs (b)(3)(i)(A) and 
(d)(1)(ii) of this section, USS2 Note is treated as stock beginning 
on Date C in Year 3. See Sec.  1.385-1(d) 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)(iii)(C) 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

[[Page 72971]]

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 
described in 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 
receives. FP does not recognize gain under section 354(a)(1).
    (ii) Analysis. (A) USS1 is a successor to USS2 under paragraph 
(g)(24)(i)(A) of this section. For purposes of paragraph (b)(3) of 
this section, USS2 and, under paragraph (b)(3)(v)(A) of this 
section, 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)(i)(A) of this section because the stock is distributed in an 
exempt distribution (as defined in paragraph (g)(10) of this 
section). In addition, neither USS1's acquisition of the assets of 
USS2 nor USS2's acquisition of USS1 stock is described in paragraph 
(b)(3)(i)(C) of this section because FP does not receive other 
property within the meaning of section 356 with respect to its stock 
in USS2.
    (B) USS2's acquisition of USS1 stock is not an acquisition 
described in paragraph (b)(3)(i)(B) of this section because it is an 
exempt exchange (as defined in paragraph (g)(11) of this section). 
USS2's acquisition of USS1 stock is an exempt exchange because USS1 
and USS2 are both parties to an asset reorganization, section 1032 
applies to USS1, the transferor of the USS1 stock, and the USS1 
stock is distributed by USS2, the transferee, pursuant to the plan 
of reorganization. Furthermore, USS2's acquisition of its own stock 
from FS is not an acquisition described in paragraph (b)(3)(i)(B) of 
this section because USS2 acquires its stock in exchange for USS1 
stock.
    (C) Because neither USS1 nor USS2 has made a distribution or 
acquisition described in paragraph (b)(3)(i)(A), (B), or (C) of this 
section, USS2 Note is not treated as stock under paragraph 
(b)(3)(iii)(A) of this section.
    Example 11. Distribution of a covered debt instrument and 
issuance of a covered 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 purposes 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 covered 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 FP. Because the distribution of USS1 Note 
A is described in paragraph (b)(2)(i) of this section, the 
distribution of USS1 Note A is not described in paragraph 
(b)(3)(i)(A) of this section under paragraph (b)(5) of this section. 
Under paragraph (d)(2)(i) 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)(i) of this section. USS1 Note B is not treated as stock 
under paragraph (b)(3)(i)(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.
    Example 12. [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 12.
    Example 13. [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 13.
    Example 14. [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 14.
    Example 15. [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 15.
    Example 16.  [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 16.
    Example 17.  [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 17.
    Example 18.  [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 18.
    Example 19.  [Reserved]. For further guidance, see Sec.  1.385-
3T(h)(3), Example 19.

    (i) [Reserved]
    (j) Applicability date and transition rules--(1) In general. This 
section applies to taxable years ending on or after January 19, 2017.
    (2) Transition rules--(i) Transition rule for covered debt 
instruments that would be treated as stock in taxable years ending 
before January 19, 2017. If paragraphs (b) and (d)(1) of this section, 
taking into account Sec. Sec.  1.385-1, 1.385-3T, and 1.385-4T, would 
have treated a covered debt instrument as stock in a taxable year 
ending before January 19, 2017 but for the application of paragraph 
(j)(1) of this section, to the extent that the covered debt instrument 
is held by a member of the expanded group of which the issuer is a 
member immediately after January 19, 2017, then the covered debt 
instrument is deemed to be exchanged for stock immediately after 
January 19, 2017.
    (ii) Transition rule for certain covered debt instruments treated 
as stock in taxable years ending on or after January 19, 2017. If 
paragraphs (b) and (d)(1) of this section, taking into account 
Sec. Sec.  1.385-1, 1.385-3T, and 1.385-4T, would treat a covered debt 
instrument as stock on or before January 19, 2017 but in a taxable year 
ending on or after January 19, 2017, that covered debt instrument is 
not treated as stock during the 90-day period after October 21, 2016. 
Instead, to the extent that the covered debt instrument is held by a 
member of the expanded group of which the issuer is a member 
immediately after January 19, 2017, the covered debt instrument is 
deemed to be exchanged for stock immediately after January 19, 2017.
    (iii) Transition funding rule. When a covered debt instrument would 
be recharacterized as stock after April 4, 2016, and on or before 
January 19, 2017 (the transition period), but that covered debt 
instrument is not recharacterized as stock on such date due to the 
application of paragraph (j)(1), (j)(2)(i), or (j)(2)(ii) of this 
section, any payments made with respect to such covered debt instrument 
(other than stated interest), including pursuant to a refinancing, 
after the date that the covered debt instrument would have been 
recharacterized as stock and through the remaining portion of the 
transition period are treated as distributions for purposes of applying 
paragraph (b)(3) of this section for taxable years ending on or after 
January 19, 2017. In addition, to the extent that the holder and the 
issuer of the covered debt instrument cease to be members of the same 
expanded group during the transition period, the distribution or 
acquisition that would have caused the covered debt instrument to be 
treated as stock is available to be treated as funded by other covered 
debt instruments of the issuer for purposes of paragraph (b)(3) of this 
section (to the extent provided in paragraph (b)(3)(iii) of this 
section). The prior sentence is applied in a manner that is consistent 
with the rules set forth in paragraph (d)(2) of this section.
    (iv) Coordination between the general rule and funding rule. When a 
covered debt instrument would be recharacterized as stock pursuant to 
paragraph (b)(2) of this section after April 4, 2016, and on or before 
January 19, 2017, but that covered debt instrument is not 
recharacterized as stock on such date due to the application of 
paragraph (j)(1), (j)(2)(i), or (j)(2)(ii) of this section, the 
issuance of such covered debt instrument is not treated as a 
distribution or acquisition described in Sec.  1.385-3(b)(3)(i), but 
only to the extent that the covered debt instrument is held by a member 
of the expanded group of which the issuer is a member immediately after 
January 19, 2017.
    (v) Option to apply proposed regulations. In lieu of applying 
Sec. Sec.  1.385-1, 1.385-3, 1.385-3T, and 1.385-4T, taxpayers may 
apply the provisions matching Sec. Sec.  1.385-1, 1.385-3, and 1.385-4 
from the Internal Revenue Bulletin (IRB) 2016-17 (https://www.irs.gov/pub/irs-irbs/irb16-17.pdf) to all debt instruments issued by

[[Page 72972]]

a particular issuer (and members of its expanded group that are covered 
members) after April 4, 2016, and before October 13, 2016, solely for 
purposes of determining whether a debt instrument is treated as stock, 
provided that those sections are consistently applied.

0
Par. 5. Section 1.385-3T is added to read as follows:


Sec.  1.385-3T  Certain distributions of debt instruments and similar 
transactions (temporary).

    (a) [Reserved]. For further guidance, see Sec.  1.385-3(a).
    (b)(1) through (b)(2). [Reserved]. For further guidance, see Sec.  
1.385-3(b)(1) through (b)(2).
    (b)(3)(i) through (vi). [Reserved]. For further guidance, see Sec.  
1.385-3(b)(3)(i) through (vi).
    (vii) Qualified short-term debt instrument. The term qualified 
short-term debt instrument means a covered debt instrument that is 
described in paragraph (b)(3)(vii)(A), (b)(3)(vii)(B), (b)(3)(vii)(C), 
or (b)(3)(vii)(D) of this section.
    (A) Short-term funding arrangement. A covered debt instrument is 
described in this paragraph (b)(3)(vii)(A) if the requirements of the 
specified current assets test described in paragraph (b)(3)(vii)(A)(1) 
of this section or the 270-day test described in paragraph 
(b)(3)(vii)(A)(2) of this section (the alternative tests) are 
satisfied, provided that an issuer may only claim the benefit of one of 
the alternative tests with respect to covered debt instruments issued 
by the issuer in the same taxable year.
    (1) Specified current assets test--(i) In general. The requirements 
of this paragraph (b)(3)(vii)(A)(1) are satisfied with respect to a 
covered debt instrument if the requirement of paragraph 
(b)(3)(vii)(A)(1)(ii) of this section is satisfied, but only to the 
extent the requirement of paragraph (b)(3)(vii)(A)(1)(iii) of this 
section is satisfied.
    (ii) Maximum interest rate. The rate of interest charged with 
respect to the covered debt instrument does not exceed an arm's length 
interest rate, as determined under section 482 and the regulations 
thereunder, that would be charged with respect to a comparable debt 
instrument of the issuer with a term that does not exceed the longer of 
90 days and the issuer's normal operating cycle.
    (iii) Maximum outstanding balance. The amount owed by the issuer 
under covered debt instruments issued to members of the issuer's 
expanded group that satisfy the requirements of paragraph 
(b)(3)(vii)(A)(1)(ii), (b)(3)(vii)(A)(2) (if the covered debt 
instrument was issued in a prior taxable year), (b)(3)(vii)(B), or 
(b)(3)(vii)(C) of this section immediately after the covered debt 
instrument is issued does not exceed the maximum of the amounts of 
specified current assets reasonably expected to be reflected, under 
applicable accounting principles, on the issuer's balance sheet as a 
result of transactions in the ordinary course of business during the 
subsequent 90-day period or the issuer's normal operating cycle, 
whichever is longer. For purposes of the preceding sentence, in the 
case of an issuer that is a qualified cash pool header, the amount owed 
by the issuer shall not take into account deposits described in 
paragraph (b)(3)(vii)(D) of this section. Additionally, the amount 
owned by any issuer shall be reduced by the amount of the issuer's 
deposits with a qualified cash pool header, but only to the extent of 
amounts borrowed from the same qualified cash pool header that satisfy 
the requirements of paragraph (b)(3)(vii)(A)(2) (if the covered debt 
instrument was issued in a prior taxable year) or (b)(3)(vii)(A)(1)(ii) 
of this section.
    (iv) Specified current assets. For purposes of paragraph 
(b)(3)(vii)(A)(1)(iii) of this section, the term specified current 
assets means assets that are reasonably expected to be realized in cash 
or sold (including by being incorporated into inventory that is sold) 
during the normal operating cycle of the issuer, other than cash, cash 
equivalents, and assets that are reflected on the books and records of 
a qualified cash pool header.
    (v) Normal operating cycle. For purposes of paragraph 
(b)(3)(vii)(A)(1) of this section, the term normal operating cycle 
means the issuer's normal operating cycle as determined under 
applicable accounting principles, except that if the issuer has no 
single clearly defined normal operating cycle, then the normal 
operating cycle is determined based on a reasonable analysis of the 
length of the operating cycles of the multiple businesses and their 
sizes relative to the overall size of the issuer.
    (vi) Applicable accounting principles. For purposes of paragraph 
(b)(3)(vii)(A)(1) of this section, the term applicable accounting 
principles means the financial accounting principles generally accepted 
in the United States, or an international financial accounting 
standard, that is applicable to the issuer in preparing its financial 
statements, computed on a consistent basis.
    (2) 270-day test--(i) In general. A covered debt instrument is 
described in this paragraph (b)(3)(vii)(A)(2) if the requirements of 
paragraphs (b)(3)(vii)(A)(2)(ii) through (b)(3)(vii)(A)(2)(iv) of this 
section are satisfied.
    (ii) Maximum term and interest rate. The covered debt instrument 
must have a term of 270 days or less or be an advance under a revolving 
credit agreement or similar arrangement and must bear a rate of 
interest that does not exceed an arm's length interest rate, as 
determined under section 482 and the regulations thereunder, that would 
be charged with respect to a comparable debt instrument of the issuer 
with a term that does not exceed 270 days.
    (iii) Lender-specific indebtedness limit. The issuer is a net 
borrower from the lender for no more than 270 days during the taxable 
year of the issuer, and in the case of a covered debt instrument 
outstanding during consecutive tax years, the issuer is a net borrower 
from the lender for no more than 270 consecutive days, in both cases 
taking into account only covered debt instruments that satisfy the 
requirement of paragraph (b)(3)(vii)(A)(2)(ii) of this section other 
than covered debt instruments described in paragraph (b)(3)(vii)(B) or 
(b)(3)(vii)(C) of this section.
    (iv) Overall indebtedness limit. The issuer is a net borrower under 
all covered debt instruments issued to members of the issuer's expanded 
group that satisfy the requirements of paragraphs (b)(3)(vii)(A)(2)(ii) 
and (iii) of this section, other than covered debt instruments 
described in paragraph (b)(3)(vii)(B) or (b)(3)(vii)(C) of this 
section, for no more than 270 days during the taxable year of the 
issuer, determined without regard to the identity of the lender under 
such covered debt instruments.
    (v) Inadvertent error. An issuer's failure to satisfy the 270-day 
test will be disregarded if the failure is reasonable in light of all 
the facts and circumstances and the failure is promptly cured upon 
discovery. A failure to satisfy the 270-day test will be considered 
reasonable if the taxpayer maintains due diligence procedures to 
prevent such failures, as evidenced by having written policies and 
operational procedures in place to monitor compliance with the 270-day 
test and management-level employees of the expanded group having 
undertaken reasonable efforts to establish, follow, and enforce such 
policies and procedures.
    (B) Ordinary course loans. A covered debt instrument is described 
in this paragraph (b)(3)(vii)(B) if the covered debt instrument is 
issued as consideration for the acquisition of property other than 
money in the

[[Page 72973]]

ordinary course of the issuer's trade or business, provided that the 
obligation is reasonably expected to be repaid within 120 days of 
issuance.
    (C) Interest-free loans. A covered debt instrument is described in 
this paragraph (b)(3)(vii)(C) if the instrument does not provide for 
stated interest or no interest is charged on the instrument, the 
instrument does not have original issue discount (as defined in section 
1273 and the regulations thereunder), interest is not imputed under 
section 483 or section 7872 and the regulations thereunder, and 
interest is not required to be charged under section 482 and the 
regulations thereunder.
    (D) Deposits with a qualified cash pool header--(1) In general. A 
covered debt instrument is described in this paragraph (b)(3)(vii)(D) 
if it is a demand deposit received by a qualified cash pool header 
described in paragraph (b)(3)(vii)(D)(2) of this section pursuant to a 
cash-management arrangement described in paragraph (b)(3)(vii)(D)(3) of 
this section. This paragraph (b)(3)(vii)(D) does not apply if a purpose 
for making the demand deposit is to facilitate the avoidance of the 
purposes of this section or Sec.  1.385-3 with respect to a qualified 
business unit (as defined in section 989(a) and the regulations 
thereunder) (QBU) that is not a qualified cash pool header.
    (2) Qualified cash pool header. The term qualified cash pool header 
means an expanded group member, controlled partnership, or QBU 
described in Sec.  1.989(a)-1(b)(2)(ii), that has as its principal 
purpose managing a cash-management arrangement for participating 
expanded group members, provided that the excess (if any) of funds on 
deposit with such expanded group member, controlled partnership, or QBU 
(header) over the outstanding balance of loans made by the header is 
maintained on the books and records of the header in the form of cash 
or cash equivalents, or invested through deposits with, or the 
acquisition of obligations or portfolio securities of, persons that do 
not have a relationship to the header (or, in the case of a header that 
is a QBU described in Sec.  1.989(a)-1(b)(2)(ii), its owner) described 
in section 267(b) or section 707(b).
    (3) Cash-management arrangement. The term cash-management 
arrangement means an arrangement the principal purpose of which is to 
manage cash for participating expanded group members. For purposes of 
the preceding sentence, managing cash means borrowing excess funds from 
participating expanded group members and lending funds to participating 
expanded group members, and may also include foreign exchange 
management, clearing payments, investing excess cash with an unrelated 
person, depositing excess cash with another qualified cash pool header, 
and settling intercompany accounts, for example through netting centers 
and pay-on-behalf-of programs.
    (b)(viii) [Reserved]. For further guidance, see Sec.  1.385-
3(b)(viii).
    (c) [Reserved]. For further guidance, see Sec.  1.385-3(c).
    (d)(1) through (d)(3) [Reserved]. For further guidance, see Sec.  
1.385-3(d)(1) through (d)(3).
    (4) Treatment of disregarded entities. This paragraph (d)(4) 
applies to the extent that a covered debt instrument issued by a 
disregarded entity, the regarded owner of which is a covered member, 
would, absent the application of this paragraph (d)(4), be treated as 
stock under Sec.  1.385-3. In this case, rather than the covered debt 
instrument being treated as stock to such extent (applicable portion), 
the covered member that is the regarded owner of the disregarded entity 
is deemed to issue its stock in the manner described in this paragraph 
(d)(4). If the applicable portion otherwise would have been treated as 
stock under Sec.  1.385-3(b)(2), then the covered member is deemed to 
issue its stock to the expanded group member to which the covered debt 
instrument was, in form, issued (or transferred) in the transaction 
described in Sec.  1.385-3(b)(2). If the applicable portion otherwise 
would have been treated as stock under Sec.  1.385-3(b)(3)(i), then the 
covered member is deemed to issue its stock to the holder of the 
covered debt instrument in exchange for a portion of the covered debt 
instrument equal to the applicable portion. In each case, the covered 
member that is the regarded owner of the disregarded entity is treated 
as the holder of the applicable portion of the debt instrument issued 
by the disregarded entity, and the actual holder is treated as the 
holder of the remaining portion of the covered debt instrument and the 
stock deemed to be issued by the regarded owner. Under federal tax 
principles, the applicable portion of the debt instrument issued by the 
disregarded entity generally is disregarded. This paragraph (d)(4) must 
be applied in a manner that is consistent with the principles of 
paragraph (f)(4) of this section. Thus, for example, stock deemed 
issued is deemed to have the same terms as the covered debt instrument 
issued by the disregarded entity, other than the identity of the 
issuer, and payments on the stock are determined by reference to 
payments made on the covered debt instrument issued by the disregarded 
entity. See Sec.  1.385-4T(b)(3) for additional rules that apply if the 
regarded owner of the disregarded entity is a member of a consolidated 
group. If the regarded owner of a disregarded entity is a controlled 
partnership, then paragraph (f) of this section applies as though the 
controlled partnership were the issuer in form of the debt instrument.
    (d)(5) through (d)(7). [Reserved]. For further guidance, see Sec.  
1.385-3(d)(5) through (d)(7).
    (e) [Reserved]. For further guidance, see Sec.  1.385-3(e).
    (f) Treatment of controlled partnerships--(1) In general. For 
purposes of this section and Sec. Sec.  1.385-3 and 1.385-4T, a 
controlled partnership is treated as an aggregate of its partners in 
the manner described in this paragraph (f). Paragraph (f)(2) of this 
section sets forth rules concerning the aggregate treatment when a 
controlled partnership acquires property from a member of the expanded 
group. Paragraph (f)(3) of this section sets forth rules concerning the 
aggregate treatment when a controlled partnership issues a debt 
instrument. Paragraph (f)(4) of this section deems a debt instrument 
issued by a controlled partnership to be held by an expanded group 
partner rather than the holder-in-form in certain cases. Paragraph 
(f)(5) of this section sets forth the rules concerning events that 
cause the deemed results described in paragraph (f)(4) of this section 
to cease. Paragraph (f)(6) of this section exempts certain issuances of 
a controlled partnership's debt to a partner and a partner's debt to a 
controlled partnership from the application of this section and Sec.  
1.385-3. For definitions applicable for this section, see paragraph (g) 
of this section and Sec.  1.385-3(g). For examples illustrating the 
application of this section, see paragraph (h) of this section.
    (2) Acquisitions of property by a controlled partnership--(i) 
Acquisitions of property when a member of the expanded group is a 
partner on the date of the acquisition--(A) Aggregate treatment. Except 
as otherwise provided in paragraphs (f)(2)(i)(C) and (f)(6) of this 
section, if a controlled partnership, with respect to an expanded 
group, acquires property from a member of the expanded group 
(transferor member), then, for purposes of this section and Sec.  
1.385-3, a member of the expanded group that is an expanded group 
partner on the date of the acquisition is treated as acquiring its 
share (as determined under paragraph (f)(2)(i)(B) of this section) of 
the property. The expanded group partner is treated as acquiring its 
share of the property from the transferor member in the manner (for 
example, in

[[Page 72974]]

a distribution, in an exchange for property, or in an issuance), and on 
the date on which, the property is actually acquired by the controlled 
partnership from the transferor member. Accordingly, this section and 
Sec.  1.385-3 apply to a member's acquisition of property described in 
this paragraph (f)(2)(i)(A) in the same manner as if the member 
actually acquired the property from the transferor member, unless 
explicitly provided otherwise.
    (B) Expanded group partner's share of property. For purposes of 
paragraph (f)(2)(i)(A) of this section, a partner's share of property 
acquired by a controlled partnership is determined in accordance with 
the partner's liquidation value percentage (as defined in paragraph 
(g)(17) of this section) with respect to the controlled partnership. 
The liquidation value percentage is determined on the date on which the 
controlled partnership acquires the property.
    (C) Exception if transferor member is an expanded group partner. If 
a transferor member is an expanded group partner in the controlled 
partnership, paragraph (f)(2)(i)(A) of this section does not apply to 
such partner.
    (ii) Acquisitions of expanded group stock when a member of the 
expanded group becomes a partner after the acquisition--(A) Aggregate 
treatment. Except as otherwise provided in paragraph (f)(2)(ii)(C) of 
this section, if a controlled partnership, with respect to an expanded 
group, owns expanded group stock, and a member of the expanded group 
becomes an expanded group partner in the controlled partnership, then, 
for purposes of this section and Sec.  1.385-3, the member is treated 
as acquiring its share (as determined under paragraph (f)(2)(ii)(B) of 
this section) of the expanded group stock owned by the controlled 
partnership. The member is treated as acquiring its share of the 
expanded group stock on the date on which the member becomes an 
expanded group partner. Furthermore, the member is treated as if it 
acquires its share of the expanded group stock from a member of the 
expanded group in exchange for property other than expanded group 
stock, regardless of the manner in which the partnership acquired the 
stock and in which the member acquires its partnership interest. 
Accordingly, this section and Sec.  1.385-3 apply to a member's 
acquisition of expanded group stock described in this paragraph 
(f)(2)(ii)(A) in the same manner as if the member actually acquired the 
stock from a member of the expanded group in exchange for property 
other than expanded group stock, unless explicitly provided otherwise.
    (B) Expanded group partner's share of expanded group stock. For 
purposes of paragraph (f)(2)(ii)(A) of this section, a partner's share 
of expanded group stock owned by a controlled partnership is determined 
in accordance with the partner's liquidation value percentage with 
respect to the controlled partnership. The liquidation value percentage 
is determined on the date on which a member of the expanded group 
becomes an expanded group partner in the controlled partnership.
    (C) Exception if an expanded group partner acquires its interest in 
a controlled partnership in exchange for expanded group stock. 
Paragraph (f)(2)(ii)(A) of this section does not apply to a member of 
an expanded group that acquires its interest in a controlled 
partnership either from another partner in exchange solely for expanded 
group stock or upon a partnership contribution to the controlled 
partnership comprised solely of expanded group stock.
    (3) Issuances of debt instruments by a controlled partnership to a 
member of an expanded group--(i) Aggregate treatment. If a controlled 
partnership, with respect to an expanded group, issues a debt 
instrument to a member of the expanded group, then, for purposes of 
this section and Sec.  1.385-3, a covered member that is an expanded 
group partner is treated as the issuer with respect to its share (as 
determined under paragraph (f)(3)(ii) of this section) of the debt 
instrument issued by the controlled partnership. This section and Sec.  
1.385-3 apply to the portion of the debt instrument treated as issued 
by the covered member as described in this paragraph (f)(3)(i) in the 
same manner as if the covered member actually issued the debt 
instrument to the holder-in-form, unless otherwise provided. See 
paragraph (f)(4) of this section, which deems a debt instrument issued 
by a controlled partnership to be held by an expanded group partner 
rather than the holder-in-form in certain cases.
    (ii) Expanded group partner's share of a debt instrument issued by 
a controlled partnership--(A) General rule. An expanded group partner's 
share of a debt instrument issued by a controlled partnership is 
determined on each date on which the partner makes a distribution or 
acquisition described in Sec.  1.385-3(b)(2) or (b)(3)(i) (testing 
date). An expanded group partner's share of a debt instrument issued by 
a controlled partnership to a member of the expanded group is 
determined in accordance with the partner's issuance percentage (as 
defined in paragraph (g)(16) of this section) on the testing date. A 
partner's share determined under this paragraph (f)(3)(ii)(A) is 
adjusted as described in paragraph (f)(3)(ii)(B) of this section.
    (B) Additional rules if there is a specified portion with respect 
to a debt instrument--(1) An expanded group partner's share (as 
determined under paragraph (f)(3)(ii)(A) of this section) of a debt 
instrument issued by a controlled partnership is reduced, but not below 
zero, by the sum of all of the specified portions (as defined in 
paragraph (g)(23) of this section), if any, with respect to the debt 
instrument that correspond to one or more deemed transferred 
receivables (as defined in paragraph (g)(8) of this section) that are 
deemed to be held by the partner.
    (2) If the aggregate of all of the expanded group partners' shares 
(as determined under paragraph (f)(3)(ii)(A) of this section and 
reduced under paragraph (f)(3)(ii)(B)(1) of this section) of the debt 
instrument exceeds the adjusted issue price of the debt, reduced by the 
sum of all of the specified portions with respect to the debt 
instrument that correspond to one or more deemed transferred 
receivables that are deemed to be held by one or more expanded group 
partners (excess amount), then each expanded group partner's share (as 
determined under paragraph (f)(3)(ii)(A) of this section and reduced 
under paragraph (f)(3)(ii)(B)(1) of this section) of the debt 
instrument is reduced. The amount of an expanded group partner's 
reduction is the excess amount multiplied by a fraction, the numerator 
of which is the partner's share, and the denominator of which is the 
aggregate of all of the expanded group partners' shares.
    (iii) Qualified short-term debt instrument. The determination of 
whether a debt instrument is a qualified short-term debt instrument for 
purposes of Sec.  1.385-3(b)(3)(vii) is made at the partnership-level 
without regard to paragraph (f)(3)(i) of this section.
    (4) Recharacterization when there is a specified portion with 
respect to a debt instrument issued by a controlled partnership--(i) 
General rule. A specified portion, with respect to a debt instrument 
issued by a controlled partnership and an expanded group partner, is 
not treated as stock under Sec.  1.385-3(b)(2) or (b)(3)(i). Except as 
otherwise provided in paragraphs (f)(4)(ii) and (f)(4)(iii) of this 
section, the holder-in-form (as defined in paragraph (g)(15) of this 
section) of the debt instrument is deemed to transfer a portion of the 
debt instrument (a deemed transferred receivable, as defined in 
paragraph (g)(8) of this

[[Page 72975]]

section) with a principal amount equal to the adjusted issue price of 
the specified portion to the expanded group partner in exchange for 
stock in the expanded group partner (deemed partner stock, as defined 
in paragraph (g)(6) of this section) with a fair market value equal to 
the principal amount of the deemed transferred receivable. Except as 
otherwise provided in paragraph (f)(4)(vi) of this section (concerning 
the treatment of a deemed transferred receivable for purposes of 
section 752) and paragraph (f)(5) of this section (concerning specified 
events subsequent to the deemed transfer), the deemed transfer 
described in this paragraph (f)(4)(i) is deemed to occur for all 
federal tax purposes.
    (ii) Expanded group partner is the holder-in-form of a debt 
instrument. If the specified portion described in paragraph (f)(4)(i) 
of this section is with respect to an expanded group partner that is 
the holder-in-form of the debt instrument, then paragraph (f)(4)(i) of 
this section will not apply with respect to that specified portion 
except that only the first sentence of paragraph (f)(4)(i) of this 
section is applicable.
    (iii) Expanded group partner is a consolidated group member. This 
paragraph (f)(4)(iii) applies when one or more expanded group partners 
is a member of a consolidated group that files (or is required to file) 
a consolidated U.S. federal income tax return. In this case, 
notwithstanding Sec.  1.385-4T(b)(1) (which generally treats members of 
a consolidated group as one corporation for purposes of this section 
and Sec.  1.385-3), the holder-in-form of the debt instrument issued by 
the controlled partnership is deemed to transfer the deemed transferred 
receivable or receivables to the expanded group partner or partners 
that are members of a consolidated group that make, or are treated as 
making under paragraph (f)(2) of this section, the regarded 
distributions or acquisitions (within the meaning of Sec.  1.385-
4T(e)(5)) described in Sec.  1.385-3(b)(2) or (b)(3)(i) in exchange for 
deemed partner stock in such partner or partners. To the extent those 
regarded distributions or acquisitions are made by a member of the 
consolidated group that is not an expanded group partner (excess 
amount), the holder-in-form is deemed to transfer a portion of the 
deemed transferred receivable or receivables to each member of the 
consolidated group that is an expanded group partner in exchange for 
deemed partner stock in the expanded group partner. The portion is the 
excess amount multiplied by a fraction, the numerator of which is the 
portion of the consolidated group's share (as determined under 
paragraph (f)(3)(ii) of this section) of the debt instrument issued by 
the controlled partnership that would have been the expanded group 
partner's share if the partner was not a member of a consolidated 
group, and the denominator of which is the consolidated group's share 
of the debt instrument issued by the controlled partnership.
    (iv) Rules regarding deemed transferred receivables and deemed 
partner stock--(A) Terms of deemed partner stock. Deemed partner stock 
has the same terms as the deemed transferred receivable with respect to 
the deemed transfer, other than the identity of the issuer.
    (B) Treatment of payments with respect to a debt instrument for 
which there is one or more deemed transferred receivables. When a 
payment is made with respect to a debt instrument issued by a 
controlled partnership for which there is one or more deemed 
transferred receivables, then, if the amount of the retained receivable 
(as defined in paragraph (g)(22) of this section) held by the holder-
in-form is zero and a single deemed holder is deemed to hold all of the 
deemed transferred receivables, the entire payment is allocated to the 
deemed transferred receivables held by the single deemed holder. If the 
amount of the retained receivable held by the holder-in-form is greater 
than zero or there are multiple deemed holders of deemed transferred 
receivables, or both, the payment is apportioned among the retained 
receivable, if any, and each deemed transferred receivable in 
proportion to the principal amount of all the receivables. The portion 
of a payment allocated or apportioned to a retained receivable or a 
deemed transferred receivable reduces the principal amount of, or 
accrued interest with respect to, as applicable depending on the 
payment, the retained receivable or deemed transferred receivable. When 
a payment allocated or apportioned to a deemed transferred receivable 
reduces the principal amount of the receivable, the expanded group 
partner that is the deemed holder with respect to the deemed 
transferred receivable is deemed to redeem the same amount of deemed 
partner stock, and the specified portion with respect to the debt 
instrument is reduced by the same amount. When a payment allocated or 
apportioned to a deemed transferred receivable reduces accrued interest 
with respect to the receivable, the expanded group partner that is the 
deemed holder with respect to the deemed transferred receivable is 
deemed to make a matching distribution in the same amount with respect 
to the deemed partner stock. The controlled partnership is treated as 
the paying agent with respect to the deemed partner stock.
    (v) Holder-in-form transfers debt instrument in a transaction that 
is not a specified event. If the holder-in-form transfers the debt 
instrument (which is disregarded for federal tax purposes) to a member 
of the expanded group or a controlled partnership (and therefore the 
transfer is not a specified event described in paragraph (f)(5)(iii)(F) 
of this section), then, for federal tax purposes, the holder-in-form is 
deemed to transfer the retained receivable and the deemed partner stock 
to the transferee.
    (vi) Allocation of deemed transferred receivable under section 752. 
A partnership liability that is a debt instrument with respect to which 
there is one or more deemed transferred receivables is allocated for 
purposes of section 752 without regard to any deemed transfer.
    (5) Specified events affecting ownership following a deemed 
transfer--(i) General rule. If a specified event (within the meaning of 
paragraph (f)(5)(iii) of this section) occurs with respect to a deemed 
transfer, then, immediately before the specified event, the expanded 
group partner that is both the issuer of the deemed partner stock and 
the deemed holder of the deemed transferred receivable is deemed to 
distribute the deemed transferred receivable (or portion thereof, as 
determined under paragraph (f)(5)(iv) of this section) to the holder-
in-form in redemption of the deemed partner stock (or portion thereof, 
as determined under paragraph (f)(5)(iv) of this section) deemed to be 
held by the holder-in-form. The deemed distribution is deemed to occur 
for all federal tax purposes, except that the distribution is 
disregarded for purposes of Sec.  1.385-3(b). Except when the deemed 
transferred receivable (or portion thereof, as determined under 
paragraph (f)(5)(iv) of this section) is deemed to be retransferred 
under paragraph (f)(5)(ii) of this section, the principal amount of the 
retained receivable held by the holder-in-form is increased by the 
principal amount of the deemed transferred receivable, the deemed 
transferred receivable ceases to exist for federal tax purposes, and 
the specified portion (or portion thereof) that corresponds to the 
deemed transferred receivable (or portion thereof) ceases to be treated 
as a specified portion for purposes of this section and Sec.  1.385-3.
    (ii) New deemed transfer when a specified event involves a 
transferee

[[Page 72976]]

that is a covered member that is an expanded group partner. If the 
specified event is described in paragraph (f)(5)(iii)(E) of this 
section, the holder-in-form of the debt instrument is deemed to 
retransfer the deemed transferred receivable (or portion thereof, as 
determined under paragraph (f)(5)(iv) of this section) that the holder-
in-form is deemed to have received pursuant to paragraph (f)(5)(i) of 
this section, to the transferee expanded group partner in exchange for 
deemed partner stock issued by the transferee expanded group partner 
with a fair market value equal to the principal amount of the deemed 
transferred receivable (or portion thereof) that is retransferred. For 
purposes of this section, this deemed transfer is treated in the same 
manner as a deemed transfer described in paragraph (f)(4)(i) of this 
section.
    (iii) Specified events. A specified event, with respect to a deemed 
transfer, occurs when, immediately after the transaction and taking 
into account all related transactions:
    (A) The controlled partnership that is the issuer of the debt 
instrument either ceases to be a controlled partnership or ceases to 
have an expanded group partner that is a covered member.
    (B) The holder-in-form is a member of the expanded group 
immediately before the transaction, and the holder-in-form and the 
deemed holder cease to be members of the same expanded group for the 
reasons described in Sec.  1.385-3(d)(2).
    (C) The holder-in-form is a controlled partnership immediately 
before the transaction, and the holder-in-form ceases to be a 
controlled partnership.
    (D) The expanded group partner that is both the issuer of deemed 
partner stock and the deemed holder transfers (directly or indirectly 
through one or more partnerships) all or a portion of its interest in 
the controlled partnership to a person that neither is a covered member 
nor a controlled partnership with an expanded group partner that is a 
covered member. If there is a transfer of only a portion of the 
interest, see paragraph (f)(5)(iv) of this section.
    (E) The expanded group partner that is both the issuer of deemed 
partner stock and the deemed holder transfers (directly or indirectly 
through one or more partnerships) all or a portion of its interest in 
the controlled partnership to a covered member or a controlled 
partnership with an expanded group partner that is a covered member. If 
there is a transfer of only a portion of the interest, see paragraph 
(f)(5)(iv) of this section.
    (F) The holder-in-form transfers the debt instrument (which is 
disregarded for federal tax purposes) to a person that is neither a 
member of the expanded group nor a controlled partnership. See 
paragraph (f)(4)(v) of this section if the holder-in-form transfers the 
debt instrument to a member of the expanded group or a controlled 
partnership.
    (iv) Specified event involving a transfer of only a portion of an 
interest in a controlled partnership. If, with respect to a specified 
event described in paragraph (f)(5)(iii)(D) or (E) of this section, an 
expanded group partner transfers only a portion of its interest in a 
controlled partnership, then, only a portion of the deemed transferred 
receivable that is deemed to be held by the expanded group partner is 
deemed to be distributed in redemption of an equal portion of the 
deemed partner stock. The portion of the deemed transferred receivable 
referred to in the preceding sentence is equal to the product of the 
entire principal amount of the deemed transferred receivable deemed to 
be held by the expanded group partner multiplied by a fraction, the 
numerator of which is the portion of the expanded group partner's 
capital account attributable to the interest that is transferred, and 
the denominator of which is the expanded group partner's capital 
account with respect to its entire interest, determined immediately 
before the specified event.
    (6) Issuance of a partnership's debt instrument to a partner and a 
partner's debt instrument to a partnership. If a controlled 
partnership, with respect to an expanded group, issues a debt 
instrument to an expanded group partner, or if a covered member that is 
an expanded group partner issues a covered debt instrument to a 
controlled partnership, and in each case, no partner deducts or 
receives an allocation of expense with respect to the debt instrument, 
then this section and 1.385-3 do not apply to the debt instrument.
    (g)(1) through (4) [Reserved]. For further guidance, see Sec.  
1.385-3(g)(1) through (4).
    (5) Deemed holder. The term deemed holder means, with respect to a 
deemed transfer, the expanded group partner that is deemed to hold a 
deemed transferred receivable by reason of the deemed transfer.
    (6) Deemed partner stock. The term deemed partner stock means, with 
respect to a deemed transfer, the stock deemed issued by an expanded 
group partner as described in paragraphs (f)(4)(i), (f)(4)(iii), and 
(f)(5)(ii) of this section. The amount of deemed partner stock is 
reduced as described in paragraphs (f)(4)(iv)(B) and (f)(5)(i) of this 
section.
    (7) Deemed transfer. The term deemed transfer means, with respect 
to a specified portion, the transfer described in paragraph (f)(4)(i), 
(f)(4)(iii), or (f)(5)(ii) of this section.
    (8) Deemed transferred receivable. The term deemed transferred 
receivable means, with respect to a deemed transfer, the portion of the 
debt instrument described in paragraph (f)(4)(i), (f)(4)(iii), or 
(f)(5)(ii) of this section. The deemed transferred receivable is 
reduced as described in paragraphs (f)(4)(iv)(B) and (f)(5)(i) of this 
section.
    (g)(9) through (14) [Reserved]. For further guidance, see Sec.  
1.385-3(g)(9) through (14).
    (15) Holder-in-form. The term holder-in-form means, with respect to 
a debt instrument issued by a controlled partnership, the person that, 
absent the application of paragraph (f)(4) of this section, would be 
the holder of the debt instrument for federal tax purposes. Therefore, 
the term holder-in-form does not include a deemed holder (as defined in 
paragraph (g)(5) of this section).
    (16) Issuance percentage. The term issuance percentage means, with 
respect to a controlled partnership and an expanded group partner, the 
ratio (expressed as a percentage) of the partner's reasonably 
anticipated distributive share of all the partnership's interest 
expense over a reasonable period, divided by all of the partnership's 
reasonably anticipated interest expense over that same period, taking 
into account any and all relevant facts and circumstances. The relevant 
facts and circumstances include, without limitation, the term of the 
debt instrument; whether the partnership anticipates issuing other debt 
instruments; and the partnership's anticipated section 704(b) income 
and expense, and the partners' respective anticipated allocation 
percentages, taking into account anticipated changes to those 
allocation percentages over time resulting, for example, from 
anticipated contributions, distributions, recapitalizations, or 
provisions in the controlled partnership agreement.
    (17) Liquidation value percentage. The term liquidation value 
percentage means, with respect to a controlled partnership and an 
expanded group partner, the ratio (expressed as a percentage) of the 
liquidation value of the expanded group partner's interest in the 
partnership divided by the aggregate liquidation value of all the 
partners' interests in the partnership. The liquidation value of an 
expanded group partner's interest in a controlled

[[Page 72977]]

partnership is the amount of cash the partner would receive with 
respect to the interest if the partnership (and any partnership through 
which the partner indirectly owns an interest in the controlled 
partnership) sold all of its property for an amount of cash equal to 
the fair market value of the property (taking into account section 
7701(g)), satisfied all of its liabilities (other than those described 
in Sec.  1.752-7), paid an unrelated third party to assume all of its 
Sec.  1.752-7 liabilities in a fully taxable transaction, and then the 
partnership (and any partnership through which the partner indirectly 
owns an interest in the controlled partnership) liquidated.
    (g)(18) through (g)(21) [Reserved]. For further guidance, see Sec.  
1.385-3(g)(18) through (g)(21).
    (22) Retained receivable. The term retained receivable means, with 
respect to a debt instrument issued by a controlled partnership, the 
portion of the debt instrument that is not transferred by the holder-
in-form pursuant to one or more deemed transfers. The retained 
receivable is adjusted for decreases described in paragraph 
(f)(4)(iv)(B) of this section and increases described in paragraph 
(f)(5)(i) of this section.
    (23) Specified portion. The term specified portion means, with 
respect to a debt instrument issued by a controlled partnership and a 
covered member that is an expanded group partner, the portion of the 
debt instrument that is treated under paragraph (f)(3)(i) of this 
section as issued on a testing date (within the meaning of paragraph 
(f)(3)(ii) of this section) by the covered member and that, absent the 
application of paragraph (f)(4)(i) of this section, would be treated as 
stock under Sec.  1.385-3(b)(2) or (b)(3)(i) on the testing date. A 
specified portion is reduced as described in paragraphs (f)(4)(iv)(B) 
and (5)(i) of this section.
    (g)(24) through (25) [Reserved]. For further guidance, see Sec.  
1.385-3(g)(24) through (25).
    (h) Introductory text through (h)(3), Example 11 [Reserved]. For 
further guidance, see Sec.  1.385-3(h) introductory text through 
(h)(3), Example 11.

    Example 12.  Distribution of a covered debt instrument to a 
controlled partnership. (i) Facts. CFC and FS are equal partners in 
PRS. PRS owns 100% of the stock in 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(c)(4), in determining 
whether X Corp is a member of the FP expanded group that includes 
CFC and FS, CFC and FS are each treated as owning 50% of the X Corp 
stock held by PRS. Accordingly, 100% of X Corp's stock is treated as 
owned by CFC and FS, and X Corp is a member of the FP expanded 
group.
    (B) Together CFC and FS own 100% of the interests in PRS capital 
and profits, such that PRS is a controlled partnership under Sec.  
1.385-1(c)(1). CFC and FS are both expanded group partners on the 
date on which PRS acquired X Note. Therefore, pursuant to paragraph 
(f)(2)(i)(A) of this section, each of CFC and FS is treated as 
acquiring its share of X Note in the same manner (in this case, by a 
distribution of X Note), and on the date on which, PRS acquired X 
Note. Likewise, X Corp is treated as issuing to each of CFC and FS 
its share of X Note. Under paragraph (f)(2)(i)(B) of this section, 
each of CFC's and FS's share of X Note, respectively, is determined 
in accordance with its liquidation value percentage determined on 
Date A in Year 1, the date X Corp distributed X Note to PRS. On Date 
A in Year 1, pursuant to paragraph (g)(17) of this section, each of 
CFC's and FS's liquidation value percentages is 50%. Accordingly, on 
Date A in Year 1, under paragraph (f)(2)(i)(A) of this section, for 
purposes of this section and Sec.  1.385-3, CFC and FS are each 
treated as acquiring 50% of X Note in a distribution.
    (C) Under Sec.  1.385-3(b)(2)(i) and (d)(1)(i), X Note is 
treated as stock on the date of issuance, which is Date A in Year 1. 
Under paragraph (f)(2)(i)(A) of this section, each of CFC and FS are 
treated as acquiring 50% of X Note in a distribution for purposes of 
this section and Sec.  1.385-3. Therefore, X Corp is treated as 
distributing its stock to PRS in a distribution described in section 
305.
    Example 13.  Loan to a controlled partnership; proportionate 
distributions by expanded group partners. (i) Facts. DS, USS2, and 
USP are partners in PRS. USP is a domestic corporation that is not a 
member of the FP expanded group. Each of DS and USS2 own 45% of the 
interests in PRS profits and capital, and USP owns 10% of the 
interests in PRS profits and capital. The PRS partnership agreement 
provides that all items of PRS income, gain, loss, deduction, and 
credit are allocated in accordance with the percentages in the 
preceding sentence. On Date A in Year 1, FP lends $200x to PRS in 
exchange for PRS Note. PRS uses all $200x in its business and does 
not distribute any money or other property to a partner. 
Subsequently, on Date B in Year 1, DS distributes $90x to USS1, USS2 
distributes $90x to FP, and USP distributes $20x to its shareholder. 
Each of DS's and USS2's issuance percentage is 45% on Date B in Year 
1, the date of the distributions and therefore a testing date under 
paragraph (f)(3)(ii)(A) of this section.
    (ii) Analysis. (A) DS and USS2 together own 90% of the interests 
in PRS profits and capital and therefore PRS is a controlled 
partnership under Sec.  1.385-1(c)(1). Under Sec.  1.385-1(c)(2), 
each of DS and USS2 is a covered member.
    (B) Under paragraph (f)(3)(i) of this section, each of DS and 
USS2 is treated as issuing its share of PRS Note, and under 
paragraph (f)(3)(ii)(A) of this section, DS's and USS2's share is 
each $90x (45% of $200x). USP is not an expanded group partner and 
therefore has no issuance percentage and is not treated as issuing 
any portion of PRS Note.
    (C) The $90x distributions made by DS to USS1 and by USS2 to FP 
are described in Sec.  1.385-3(b)(3)(i)(A). Under Sec.  1.385-
3(b)(3)(iii)(A), the portions of PRS Note treated as issued by each 
of DS and USS2 are treated as funding the distribution made by DS 
and USS2 because the distributions occurred within the per se period 
with respect to PRS Note. Under Sec.  1.385-3(b)(3)(i), the portions 
of PRS Note treated as issued by each of DS and USS2 would, absent 
the application of (f)(4)(i) of this section, be treated as stock of 
DS and USS2 on Date B in Year 1, the date of the distributions. See 
Sec.  1.385-3(d)(1)(ii). Under paragraph (g)(23) of this section, 
each of the $90x portions is a specified portion.
    (D) Under paragraph (f)(4)(i) of this section, the specified 
portions are not treated as stock under Sec.  1.385-3(b)(3)(i). 
Instead, FP is deemed to transfer a portion of PRS Note with a 
principal amount equal to $90x (the adjusted issue price of the 
specified portion with respect to DS) to DS in exchange for deemed 
partner stock in DS with a fair market value of $90x. Similarly, FP 
is deemed to transfer a portion of PRS Note with a principal amount 
equal to $90 (the adjusted issue price of the specified portion with 
respect to USS2) to USS2 in exchange for deemed partner stock in 
USS2 with a fair market value of $90x. The principal amount of the 
retained receivable held by FP is $20x ($200x--$90x--$90x).
    Example 14.  Loan to a controlled partnership; disproportionate 
distributions by expanded group partners. (i) Facts. The facts are 
the same as in Example 13 of this paragraph (h)(3), except that on 
Date B in Year 1, DS distributes $45x to USS1 and USS2 distributes 
$135x to FP.
    (ii) Analysis. (A) The analysis is the same as in paragraph 
(ii)(A) of Example 13 of this paragraph (h)(3).
    (B) The analysis is the same as in paragraph (ii)(B) of Example 
13 of this paragraph (h)(3).
    (C) The $45x and $135x distributions made by DS to USS1 and by 
USS2 to FP, respectively, are described in Sec.  1.385-
3(b)(3)(i)(A). Under Sec.  1.385-3(b)(3)(iii)(A), the portion of PRS 
Note treated as issued by DS is treated as funding the distribution 
made by DS because the distribution occurred within the per se 
period with respect to PRS Note, but under Sec.  1.385-3(b)(3)(i), 
only to the extent of DS's $45x distribution. USS2 is treated as 
issuing $90x of PRS Note, all of which is treated as funding $90x of 
USS2's $135x distribution under Sec.  1.385-3(b)(3)(iii)(A). Under 
Sec.  1.385-3(b)(3)(i), absent the application of (f)(4)(i) of this 
section, $45x of PRS Note would be treated as stock of DS and $90x 
of PRS Note would be treated as stock of USS2 on Date B in Year 1, 
the date of the distributions. See Sec.  1.385-3(d)(1)(ii). Under 
paragraph (g)(23) of this section, $45x of PRS Note is a specified 
portion with respect to DS and $90x of PRS Note is a specified 
portion with respect to USS2.
    (D) Under paragraph (f)(4)(i) of this section, the specified 
portions are not treated as stock under Sec.  1.385-3(b)(3)(i). 
Instead, FP is deemed to transfer a portion of PRS Note with a 
principal amount equal to $45x (the

[[Page 72978]]

adjusted issue price of the specified portion with respect to DS) to 
DS in exchange for stock of DS with a fair market value of $90x. 
Similarly, FP is deemed to transfer a portion of PRS Note with a 
principal amount equal to $90 (the adjusted issue price of the 
specified portion with respect to USS2) to USS2 in exchange for 
stock of USS2 with a fair market value of $90x. The principal amount 
of the retained receivable held by FP is $65x ($200x-$45x-$90x).
    Example 15.  Loan to partnership; distribution in later year. 
(i) Facts. The facts are the same as in Example 13 of this paragraph 
(h)(3), except that USS2 does not distribute $90x to FP until Date C 
in Year 2, which is less than 36 months after Date A in Year 1. No 
principal or interest payments are made or required until Year 3. On 
Date C in Year 2, DS's, USS2's, and USP's issuance percentages under 
paragraph (g)(16) of this section are unchanged at 45%, 45%, and 
10%, respectively.
    (ii) Analysis. (A) The analysis is the same as in paragraph 
(ii)(A) of Example 13 of this paragraph (h)(3).
    (B) The analysis is the same as in paragraph (ii)(B) of Example 
13 of this paragraph (h)(3).
    (C) With respect to the distribution made by DS, the analysis is 
the same as in paragraph (ii)(C) of Example 13 of this paragraph 
(h)(3).
    (D) With respect to the deemed transfer to DS, the analysis is 
the same as in paragraph (ii)(D) of Example 13 of this paragraph 
(h)(3). Accordingly, the amount of the retained receivable held by 
FP as of Date B in Year 1 is $110x ($200x-$90x).
    (E) Under paragraph (f)(3)(ii)(A) of this section, USS2's share 
of PRS Note is determined on Date C in Year 2. On Date C in Year 2, 
DS's, USS2's, and USP's respective shares of PRS Note under 
paragraph (f)(3)(ii)(A) of this section $90x, $90x, and $20x. 
However, because DS is treated as the issuer with respect to a $90x 
specified portion of PRS Note, DS's share of PRS Note is reduced by 
$90x to $0 under paragraph (f)(3)(ii)(B)(1) of this section. No 
reduction to either of USS2's or USP's share of PRS Note is required 
under paragraph (f)(3)(ii)(B)(2) of this section because the 
aggregate of DS's, USS2's, and USP's shares of PRS Note as reduced 
is $110x (DS has a $0 share, USS2 has a $90x share, and USP has a 
$20x share), which does not exceed $110x (the $200x adjusted issue 
price of PRS Note reduced by the $90x specified portion with respect 
to DS). Under paragraph (f)(3)(i) of this section, USS2 is treated 
as issuing its share of PRS Note.
    (F) The $90x distribution made by USS2 to FP is described in 
Sec.  1.385-3(b)(3)(i)(A). Under Sec.  1.385-3(b)(3)(iii)(A), the 
portion of PRS Note treated as issued by USS2 is treated as funding 
the distribution made by USS2, because the distribution occurred 
within the per se period with respect to PRS Note. Accordingly, the 
portion of PRS Note treated as issued by USS2 would, absent the 
application of paragraph (f)(4)(i) of this section, be treated as 
stock of USS2 under Sec.  1.385-3(b)(3)(i) on Date C in Year 2. See 
Sec.  1.385-3(d)(1)(ii). Under paragraph (g)(23) of this section, 
the $90x portion is a specified portion.
    (G) Under paragraph (f)(4)(i) of this section, the specified 
portion of PRS Note treated as issued by USS2 is not treated as 
stock under Sec.  1.385-3(b)(3)(i). Instead, on Date C in Year 2, FP 
is deemed to transfer a portion of PRS Note with a principal amount 
equal to $90x (the adjusted issue price of the specified portion 
with respect to USS2) to USS2 in exchange for stock in USS2 with a 
fair market value of $90x. The principal amount of the retained 
receivable held by FP is reduced from $110x to $20x.
    Example 16.  Loan to a controlled partnership; partnership 
ceases to be a controlled partnership. (i) Facts. The facts are the 
same as in Example 13 of this paragraph (h)(3), except that on Date 
C in Year 4, USS2 sells its entire interest in PRS to an unrelated 
person.
    (ii) Analysis. (A) On date C in Year 4, PRS ceases to be a 
controlled partnership with respect to the FP expanded group under 
Sec.  1.385-1(c)(1). This is the case because DS, the only remaining 
partner that is a member of the FP expanded group, only owns 45% of 
the total interest in PRS profits and capital. Because PRS ceases to 
be a controlled partnership, a specified event (within the meaning 
of paragraph (f)(5)(iii)(A) of this section) occurs with respect to 
the deemed transfers with respect to each of DS and USS2.
    (B) Under paragraph (f)(5)(i) of this section, on Date C in Year 
4, immediately before PRS ceases to be a controlled partnership, 
each of DS and USS2 is deemed to distribute its deemed transferred 
receivable to FP in redemption of FP's deemed partner stock in DS 
and USS2. The specified portion that corresponds to each of the 
deemed transferred receivables ceases to be treated as a specified 
portion. Furthermore, the deemed transferred receivables cease to 
exist, and the retained receivable held by FP increases from $20x to 
$200x.
    Example 17.  Transfer of an interest in a partnership to a 
covered member. (i) Facts. The facts are the same as in Example 13 
of this paragraph (h)(3), except that on Date C in Year 4, USS2 
sells its entire interest in PRS to USS1.
    (ii) Analysis. (A) After USS2 sells its interest in PRS to USS1, 
DS and USS1 together own 90% of the interests in PRS profits and 
capital and therefore PRS continues to be a controlled partnership 
under Sec.  1.385-1(c)(1). A specified event (within the meaning of 
paragraph (f)(5)(iii)(E) of this section) occurs as result of the 
sale only with respect to the deemed transfer with respect to USS2.
    (B) Under paragraph (f)(5)(i) of this section, on Date C in Year 
4, immediately before USS2 sells its entire interest in PRS to USS1, 
USS2 is deemed to distribute its deemed transferred receivable to FP 
in redemption of FP's deemed partner stock in USS2. Because the 
specified event is described in paragraph (f)(5)(iii)(E) of this 
section, under paragraph (f)(5)(ii) of this section, FP is deemed to 
retransfer the deemed transferred receivable deemed received from 
USS2 to USS1 in exchange for deemed partner stock in USS1 with a 
fair market value equal to the principal amount of the deemed 
transferred receivable that is retransferred to USS1.
    Example 18.  Loan to partnership and all partners are members of 
a consolidated group. (i) Facts. USS1 and DS are equal partners in 
PRS. USS1 and DS are members of a consolidated group, as defined in 
Sec.  1.1502-1(h). The PRS partnership agreement provides that all 
items of PRS income, gain, loss, deduction, and credit are allocated 
equally between USS1 and DS. On Date A in Year 1, FP lends $200x to 
PRS in exchange for PRS Note. PRS uses all $200x in its business and 
does not distribute any money or other property to any partner. On 
Date B in Year 1, DS distributes $200x to USS1, and USS1 distributes 
$200x to FP. If neither of USS1 or DS were a member of the 
consolidated group, each would have an issuance percentage under 
paragraph (g)(16) of this section, determined as of Date A in Year 
1, of 50%.
    (ii) Analysis. (A) Pursuant to Sec.  1.385-4T(b)(6), PRS is 
treated as a partnership for purposes of Sec.  1.385-3. Under Sec.  
1.385-4T(b)(1), DS and USS1 are treated as one corporation for 
purposes of this section and Sec.  1.385-3, and thus a single 
covered member under Sec.  1.385-1(c)(2). For purposes of this 
section, the single covered member owns 100% of the PRS profits and 
capital and therefore PRS is a controlled partnership under Sec.  
1.385-1(c)(1). Under paragraph (f)(3)(i) of this section, the single 
covered member is treated as issuing all $200x of PRS Note to FP, a 
member of the same expanded group as the single covered member. DS's 
distribution to USS1 is a disregarded distribution because it is a 
distribution between members of a consolidated group that is 
disregarded under the one-corporation rule of Sec.  1.385-4T(b)(1). 
However, under Sec.  1.385-3(b)(3)(iii)(A), PRS Note, treated as 
issued by the single covered member, is treated as funding the 
distribution by USS1 to FP, which is described in Sec.  1.385-
3(b)(3)(i)(A) and which is a regarded distribution. Accordingly, PRS 
Note, absent the application of (f)(4)(i) of this section, would be 
treated as stock under Sec.  1.385-3(b) on Date B in Year 1. Thus, 
pursuant to paragraph (g)(23) of this section, the entire PRS Note 
is a specified portion.
    (B) Under paragraphs (f)(4)(i) and (iii) of this section, the 
specified portion is not treated as stock and, instead, FP is deemed 
to transfer PRS Note with a principal amount equal to $200x to USS1 
in exchange for stock of USS1 with a fair market value of $200x. 
Under paragraph (f)(4)(iii) of this section, FP is deemed to 
transfer PRS Note to USS1 because only USS1 made a regarded 
distribution described in Sec.  1.385-3(b)(3)(i).
    Example 19.  (i) Facts. DS owns DRE, a disregarded entity within 
the meaning of Sec.  1.385-1(c)(3). On Date A in Year 1, FP lends 
$200x to DRE in exchange for DRE Note. Subsequently, on Date B in 
Year 1, DS distributes $100x of cash to USS1.
    (ii) Analysis. Under Sec.  1.385-3(b)(3)(iii)(A), $100x of DRE 
Note would be treated as funding the distribution by DS to USS1 
because DRE Note is issued to a member of the FP expanded group 
during the per se period with respect to DS's distribution0 to USS1. 
Accordingly, under Sec.  1.385-3(b)(3)(i)(A) and (d)(1)(ii), $100x 
of DRE Note would be treated as stock on Date B in Year

[[Page 72979]]

1. However, under paragraph (d)(4) of this section, DS, as the 
regarded owner, within the meaning of Sec.  1.385-1(c)(5), of DRE is 
deemed to issue its stock to FP in exchange for a portion of DRE 
Note equal to the $100x applicable portion (as defined in paragraph 
(d)(4) of this section). Thus, DS is treated as the holder of $100x 
of DRE Note, which is disregarded, and FP is treated as the holder 
of the remaining $100x of DRE Note. The $100x of stock deemed issued 
by DS to FP has the same terms as DRE Note, other than the issuer, 
and payments on the stock are determined by reference to payments on 
DRE Note.

    (i) through (j) [Reserved]
    (k) Applicability date--(1) In general. This section applies to 
taxable years ending on or after January 19, 2017.
    (2) Transition rules--(i) Transition rule for covered debt 
instruments issued by partnerships that would have had a specified 
portion in taxable years ending before January 19, 2017. If the 
application of paragraphs (f)(3) through (5) of this section and Sec.  
1.385-3 would have resulted in a covered debt instrument issued by a 
controlled partnership having a specified portion in a taxable year 
ending before January 19, 2017 but for the application of paragraph 
(k)(1) of this section and Sec.  1.385-3(j)(1), then, to the extent of 
the specified portion immediately after January 19, 2017, there is a 
deemed transfer immediately after January 19, 2017.
    (ii) Transition rule for certain covered debt instruments treated 
as having a specified portion in taxable years ending on or after 
January 19, 2017. If the application of paragraphs (f)(3) through (5) 
of this section and Sec.  1.385-3 would treat a covered debt instrument 
issued by a controlled partnership as having a specified portion that 
gives rise to a deemed transfer on or before January 19, 2017 but in a 
taxable year ending on or after January 19, 2017, that specified 
portion does not give rise to a deemed transfer during the 90-day 
period after October 21, 2016. Instead, to the extent of the specified 
portion immediately after January 19, 2017, there is a deemed 
transferred immediately after January 19, 2017.
    (iii) Transition funding rule. This paragraph (k)(2)(iii) applies 
if the application of paragraphs (f)(3) through (5) of this section and 
Sec.  1.385-3 would have resulted in a deemed transfer with respect to 
a specified portion of a debt instrument issued by a controlled 
partnership on a date after April 4, 2016, and on or before January 19, 
2017 (the transition period) but for the application of paragraph 
(k)(1), (k)(2)(i), or (k)(2)(ii) of this section and Sec.  1.385-3(j). 
In this case, any payments made with respect to the covered debt 
instrument (other than stated interest), including pursuant to a 
refinancing, a portion of which would be treated as made with respect 
to deemed partner stock if there would have been a deemed transfer, 
after the date that there would have been a deemed transfer and through 
the remaining portion of the transition period are treated as 
distributions for purposes of applying Sec.  1.385-3(b)(3) for taxable 
years ending on or after January 19, 2017. In addition, if an event 
occurs during the transition period that would have been a specified 
event with respect to the deemed transfer described in the preceding 
sentence but for the application of paragraph (k)(1) of this section 
and Sec.  1.385-3(j), the distribution or acquisition that would have 
resulted in the deemed transfer is available to be treated as funded by 
other covered debt instruments of the covered member for purposes of 
Sec.  1.385-3(b)(3) (to the extent provided in Sec.  1.385-
3(b)(3)(iii)). The prior sentence shall be applied in a manner that is 
consistent with the rules set forth in paragraph (f)(5) of this section 
and Sec.  1.385-3(d)(2)(ii).
    (iv) Coordination between the general rule and funding rule. This 
paragraph (k)(2)(iv) applies when a covered debt instrument issued by a 
controlled partnership in a transaction described in Sec.  1.385-
3(b)(2) would have resulted in a specified portion that gives rise to a 
deemed transfer on a date after April 4, 2016, and on or before January 
19, 2017, but there is not a deemed transfer on such date due to the 
application of paragraph (k)(1), (k)(2)(i), or (k)(2)(ii) of this 
section and Sec.  1.385-3(j). In this case, the issuance of such 
covered debt instrument is not treated as a distribution or acquisition 
described in Sec.  1.385-3(b)(3)(i), but only to the extent of the 
specified portion immediately after January 19, 2017.
    (v) Option to apply proposed regulations. See Sec.  1.385-
3(j)(2)(v).
    (l) Expiration date. This section expires on October 11, 2019.

0
Par. 6. Section 1.385-4T is added to read as follows:


Sec.  1.385-4T  Treatment of consolidated groups.

    (a) Scope. This section provides rules for applying Sec. Sec.  
1.385-3 and 1.385-3T to members of consolidated groups. Paragraph (b) 
of this section sets forth rules concerning the extent to which, solely 
for purposes of applying Sec. Sec.  1.385-3 and 1.385-3T, members of a 
consolidated group that file (or that are required to file) a 
consolidated U.S. federal income tax return are treated as one 
corporation. Paragraph (c) of this section sets forth rules concerning 
the treatment of a debt instrument that ceases to be, or becomes, a 
consolidated group debt instrument. Paragraph (d) of this section 
provides rules for applying the funding rule of Sec.  1.385-3(b)(3) to 
members that depart a consolidated group. For definitions applicable to 
this section, see paragraph (e) of this section and Sec. Sec.  1.385-
1(c) and 1.385-3(g). For examples illustrating the application of this 
section, see paragraph (f) of this section.
    (b) Treatment of consolidated groups--(1) Members treated as one 
corporation. For purposes of this section and Sec. Sec.  1.385-3 and 
1.385-3T, and except as otherwise provided in this section and Sec.  
1.385-3T, all members of a consolidated group (as defined in Sec.  
1.1502-1(h)) that file (or that are required to file) a consolidated 
U.S. federal income tax return are treated as one corporation. Thus, 
for example, when a member of a consolidated group issues a covered 
debt instrument that is not a consolidated group debt instrument, the 
consolidated group generally is treated as the issuer of the covered 
debt instrument for purposes of this section and Sec. Sec.  1.385-3 and 
1.385-3T. Also, for example, when one member of a consolidated group 
issues a covered debt instrument that is not a consolidated group debt 
instrument and therefore is treated as issued by the consolidated 
group, and another member of the consolidated group makes a 
distribution or acquisition described in Sec.  1.385-3(b)(3)(i)(A) 
through (C) with an expanded group member that is not a member of the 
consolidated group, Sec.  1.385-3(b)(3)(i) may treat the covered debt 
instrument as funding the distribution or acquisition made by the 
consolidated group. In addition, except as otherwise provided in this 
section, acquisitions and distributions described in Sec.  1.385-
3(b)(2) and (b)(3)(i) in which all parties to the transaction are 
members of the same consolidated group both before and after the 
transaction are disregarded for purposes of this section and Sec. Sec.  
1.385-3 and 1.385-3T.
    (2) One-corporation rule inapplicable to expanded group member 
determination. The one-corporation rule in paragraph (b)(1) of this 
section does not apply in determining the members of an expanded group. 
Notwithstanding the previous sentence, an expanded group does not exist 
for purposes of this section and Sec. Sec.  1.385-3 and 1.385-3T if it 
consists only of members of a single consolidated group.
    (3) Application of Sec.  1.385-3 to debt instruments issued by 
members of a consolidated group--(i) Debt instrument treated as stock 
of the issuing member

[[Page 72980]]

of a consolidated group. If a covered debt instrument treated as issued 
by a consolidated group under the one-corporation rule of paragraph 
(b)(1) of this section is treated as stock under Sec.  1.385-3 or Sec.  
1.385-3T, the covered debt instrument is treated as stock in the member 
of the consolidated group that would be the issuer of such debt 
instrument without regard to this section. But see Sec.  1.385-3(d)(7) 
(providing that a covered debt instrument that is treated as stock 
under Sec.  1.385-3(b)(2), (3), or (4) and that is not described in 
section 1504(a)(4) is not treated as stock for purposes of determining 
whether the issuer is a member of an affiliated group (within the 
meaning of section 1504(a)).
    (ii) Application of the covered debt instrument exclusions. For 
purposes of determining whether a debt instrument issued by a member of 
a consolidated group is a covered debt instrument, each test described 
in Sec.  1.385-3(g)(3) is applied on a separate member basis without 
regard to the one-corporation rule in paragraph (b)(1) of this section.
    (iii) Qualified short-term debt instrument. The determination of 
whether a member of a consolidated group has issued a qualified short-
term debt instrument for purposes of Sec.  1.385-3(b)(3)(vii) is made 
on a separate member basis without regard to the one-corporation rule 
in paragraph (b)(1) of this section.
    (4) Application of the reductions of Sec.  1.385-3(c)(3) to members 
of a consolidated group--(i) Application of the reduction for expanded 
group earnings--(A) In general. A consolidated group maintains one 
expanded group earnings account with respect to an expanded group 
period, and only the earnings and profits, determined in accordance 
with Sec.  1.1502-33 (without regard to the application of Sec.  
1.1502-33(b)(2), (e), and (f)), of the common parent (within the 
meaning of section 1504) of the consolidated group are considered in 
calculating the expanded group earnings for the expanded group period 
of the consolidated group. Accordingly, a regarded distribution or 
acquisition made by a member of a consolidated group is reduced to the 
extent of the expanded group earnings account of the consolidated 
group.
    (B) Effect of certain corporate transactions on the calculation of 
expanded group earnings--(1) Consolidation. A consolidated group 
succeeds to the expanded group earnings account of a joining member 
under the principles of Sec.  1.385-3(c)(3)(i)(F)(2)(ii).
    (2) Deconsolidation--(i) In general. Except as otherwise provided 
in paragraph (b)(4)(i)(B)(2)(ii) of this section, no amount of the 
expanded group earnings account of a consolidated group for an expanded 
group period, if any, is allocated to a departing member. Accordingly, 
immediately after leaving the consolidated group, the departing member 
has no expanded group earnings account with respect to its expanded 
group period.
    (ii) Allocation of expanded group earnings to a departing member in 
a distribution described in section 355. If a departing member leaves 
the consolidated group by reason of an exchange or distribution to 
which section 355 (or so much of section 356 that relates to section 
355) applies, the expanded group earnings account of the consolidated 
group is allocated between the consolidated group and the departing 
member in proportion to the earnings and profits of the consolidated 
group and the earnings and profits of the departing member immediately 
after the transaction.
    (ii) Application of the reduction for qualified contributions--(A) 
In general. For purposes of applying Sec.  1.385-3(c)(3)(ii)(A) to a 
consolidated group--
    (1) A qualified contribution to any member of a consolidated group 
that remains a member of the consolidated group immediately after the 
qualified contribution from a person other than a member of the same 
consolidated group is treated as made to the one corporation provided 
in paragraph (b)(1) of this section;
    (2) A qualified contribution that causes a member of a consolidated 
group to become a departing member of that consolidated group is 
treated as made to the departing member and not to the consolidated 
group of which the departing member was a member immediately prior to 
the qualified contribution; and
    (3) No contribution of property by a member of a consolidated group 
to any other member of the consolidated group is a qualified 
contribution.
    (B) Effect of certain corporate transactions on the calculation of 
qualified contributions--(1) Consolidation. A consolidated group 
succeeds to the qualified contributions of a joining member under the 
principles of Sec.  1.385-3(c)(3)(ii)(F)(2)(ii).
    (2) Deconsolidation--(i) In general. Except as otherwise provided 
in paragraph (b)(4)(ii)(B)(2)(ii) of this section, no amount of the 
qualified contributions of a consolidated group for an expanded group 
period, if any, is allocated to a departing member. Accordingly, 
immediately after leaving the consolidated group, the departing member 
has no qualified contributions with respect to its expanded group 
period.
    (ii) Allocation of qualified contributions to a departing member in 
a distribution described in section 355. If a departing member leaves 
the consolidated group by reason of an exchange or distribution to 
which section 355 (or so much of section 356 that relates to section 
355) applies, each qualified contribution of the consolidated group is 
allocated between the consolidated group and the departing member in 
proportion to the earnings and profits of the consolidated group and 
the earnings and profits of the departing member immediately after the 
transaction.
    (5) Order of operations. For purposes of this section and 
Sec. Sec.  1.385-3 and 1.385-3T, the consequences of a transaction 
involving one or more members of a consolidated group are determined as 
provided in paragraphs (b)(5)(i) and (ii) of this section.
    (i) First, determine the characterization of the transaction under 
federal tax law without regard to the one-corporation rule of paragraph 
(b)(1) of this section.
    (ii) Second, apply this section and Sec. Sec.  1.385-3 and 1.385-3T 
to the transaction as characterized to determine whether to treat a 
debt instrument as stock, treating the consolidated group as one 
corporation under paragraph (b)(1) of this section, unless otherwise 
provided.
    (6) Partnership owned by a consolidated group. For purposes of this 
section and Sec. Sec.  1.385-3 and Sec.  1.385-3T, and notwithstanding 
the one-corporation rule of paragraph (b)(1) of this section, a 
partnership that is wholly owned by members of a consolidated group is 
treated as a partnership. Thus, for example, if members of a 
consolidated group own all of the interests in a controlled partnership 
that issues a debt instrument to a member of the consolidated group, 
such debt instrument would be treated as a consolidated group debt 
instrument because, under Sec.  1.385-3T(f)(3)(i), for purposes of this 
section and Sec.  1.385-3, a consolidated group member that is an 
expanded group partner is treated as the issuer with respect to its 
share of the debt instrument issued by the partnership.
    (7) Predecessor and successor--(i) In general. Pursuant to 
paragraph (b)(5) of this section, the determination as to whether a 
member of an expanded group is a predecessor or successor of another 
member of the consolidated

[[Page 72981]]

group is made without regard to paragraph (b)(1) of this section. For 
purposes of Sec.  1.385-3(b)(3), if a consolidated group member is a 
predecessor or successor of a member of the same expanded group that is 
not a member of the same consolidated group, the consolidated group is 
treated as a predecessor or successor of the expanded group member (or 
the consolidated group of which that expanded group member is a 
member). Thus, for example, a departing member that departs a 
consolidated group in a distribution or exchange to which section 355 
applies is a successor to the consolidated group and the consolidated 
group is a predecessor of the departing member.
    (ii) Joining members. For purposes of Sec.  1.385-3(b)(3), the term 
predecessor also means, with respect to a consolidated group, a joining 
member and the term successor also means, with respect to a joining 
member, a consolidated group.
    (c) Consolidated group debt instruments--(1) Debt instrument ceases 
to be a consolidated group debt instrument but continues to be issued 
and held by expanded group members--(i) Consolidated group member 
leaves the consolidated group. For purposes of this section and 
Sec. Sec.  1.385-3 and 1.385-3T, when a debt instrument ceases to be a 
consolidated group debt instrument as a result of a transaction in 
which the member of the consolidated group that issued the instrument 
(the issuer) or the member of the consolidated group holding the 
instrument (the holder) ceases to be a member of the same consolidated 
group but both the issuer and the holder continue to be a member of the 
same expanded group, the issuer is treated as issuing a new debt 
instrument to the holder in exchange for property immediately after the 
debt instrument ceases to be a consolidated group debt instrument. To 
the extent the newly-issued debt instrument is a covered debt 
instrument that is treated as stock under Sec.  1.385-3(b)(3), the 
covered debt instrument is then immediately deemed to be exchanged for 
stock of the issuer. For rules regarding the treatment of the deemed 
exchange, see Sec.  1.385-1(d). For examples illustrating this rule, 
see paragraph (f) of this section, Examples 4 and 5.
    (ii) Consolidated group debt instrument that is transferred outside 
of the consolidated group. For purposes of this section and Sec. Sec.  
1.385-3 and 1.385-3T, 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 same consolidated 
group (transferee expanded group member), the debt instrument is 
treated as issued by the consolidated group to the transferee expanded 
group member immediately after the debt instrument ceases to be a 
consolidated group debt instrument. Thus, for example, for purposes of 
this section and Sec. Sec.  1.385-3 and 1.385-3T, the sale of a 
consolidated group debt instrument to a transferee expanded group 
member is treated as an issuance of the debt instrument by the 
consolidated group to the transferee expanded group member in exchange 
for property. To the extent the newly-issued debt instrument is a 
covered debt instrument that is treated as stock upon being 
transferred, the covered debt instrument is deemed to be exchanged for 
stock of the member of the consolidated group treated as the issuer of 
the debt instrument (determined under paragraph (b)(3)(i) of this 
section) immediately after the covered debt instrument is transferred 
outside of the consolidated group. For rules regarding the treatment of 
the deemed exchange, see Sec.  1.385-1(d). For examples illustrating 
this rule, see paragraph (f) of this section, Examples 2 and 3.
    (iii) Overlap transactions. If a debt instrument ceases to be a 
consolidated group debt instrument in a transaction to which both 
paragraphs (c)(1)(i) and (ii) of this section apply, then only the 
rules of paragraph (c)(1)(ii) of this section apply with respect to 
such debt instrument.
    (iv) Subgroup exception. A debt instrument is not treated as 
ceasing to be a consolidated group debt instrument for purposes of 
paragraphs (c)(1)(i) and (ii) of this section if both the issuer and 
the holder of the debt instrument are members of the same consolidated 
group immediately after the transaction described in paragraph 
(c)(1)(i) or (ii) of this section.
    (2) Covered debt instrument treated as stock becomes a consolidated 
group debt instrument. When a covered debt instrument that is treated 
as stock under Sec.  1.385-3 becomes a consolidated group debt 
instrument, then immediately after the covered debt instrument becomes 
a consolidated group debt instrument, the issuer is deemed to issue a 
new covered debt instrument to the holder in exchange for the covered 
debt instrument that was treated as stock. In addition, in a manner 
consistent with Sec.  1.385-3(d)(2)(ii)(A), when the covered debt 
instrument that previously was treated as stock becomes a consolidated 
group debt instrument, other covered debt instruments issued by the 
issuer of that instrument (including a consolidated group that includes 
the issuer) that are not treated as stock when the instrument becomes a 
consolidated group debt instrument are re-tested to determine whether 
those other covered debt instruments are treated as funding the 
regarded distribution or acquisition that previously was treated as 
funded by the instrument (unless such distribution or acquisition is 
disregarded under paragraph (b)(1) of this section). Further, also in a 
manner consistent with Sec.  1.385-3(d)(2)(ii)(A), a covered debt 
instrument that is issued by the issuer (including a consolidated group 
that includes the issuer) after the application of this paragraph and 
within the per se period may also be treated as funding that regarded 
distribution or acquisition.
    (3) No interaction with the intercompany obligation rules of Sec.  
1.1502-13(g). The rules of this section do not affect the application 
of the rules of Sec.  1.1502-13(g). Thus, any deemed satisfaction and 
reissuance of a debt instrument under Sec.  1.1502-13(g) and any deemed 
issuance and deemed exchange of a debt instrument under this paragraph 
(c) that arise as part of the same transaction or series of 
transactions are not integrated. Rather, each deemed satisfaction and 
reissuance under the rules of Sec.  1.1502-13(g), and each deemed 
issuance and exchange under the rules of this section, are respected as 
separate steps and treated as separate transactions.
    (d) Application of the funding rule of Sec.  1.385-3(b)(3) to 
members departing a consolidated group. This paragraph (d) provides 
rules for applying the funding rule of Sec.  1.385-3(b)(3) when a 
departing member ceases to be a member of a consolidated group, but 
only if the departing member and the consolidated group are members of 
the same expanded group immediately after the deconsolidation.
    (1) Continued application of the one-corporation rule. A 
disregarded distribution or acquisition by any member of the 
consolidated group continues to be disregarded when the departing 
member ceases to be a member of the consolidated group.
    (2) Continued recharacterization of a departing member's covered 
debt instrument as stock. A covered debt instrument of a departing 
member that is treated as stock of the departing member under Sec.  
1.385-3(b) continues to be treated as stock when the departing member 
ceases to be a member of the consolidated group.
    (3) Effect of issuances of covered debt instruments that are not 
consolidated group debt instruments on the departing member and the 
consolidated group. If

[[Page 72982]]

a departing member has issued a covered debt instrument (determined 
without regard to the one-corporation rule of paragraph (b)(1) of this 
section) that is not a consolidated group debt instrument and that is 
not treated as stock immediately before the departing member ceases to 
be a consolidated group member, then the departing member (and not the 
consolidated group) is treated as issuing the covered debt instrument 
on the date and in the manner the covered debt instrument was issued. 
If the departing member is not treated as the issuer of a covered debt 
instrument pursuant to the preceding sentence, then the consolidated 
group continues to be treated as issuing the covered debt instrument on 
the date and in the manner the covered debt instrument was issued.
    (4) Treatment of prior regarded distributions or acquisitions. This 
paragraph (d)(4) applies when a departing member ceases to be a 
consolidated group member in a transaction other than a distribution to 
which section 355 applies (or so much of section 356 as relates to 
section 355), and the consolidated group has made a regarded 
distribution or acquisition. In this case, to the extent the 
distribution or acquisition has not caused a covered debt instrument of 
the consolidated group to be treated as stock under Sec.  1.385-3(b) on 
or before the date the departing member leaves the consolidated group, 
then--
    (i) If the departing member made the regarded distribution or 
acquisition (determined without regard to the one-corporation rule of 
paragraph (b)(1) of this section), the departing member (and not the 
consolidated group) is treated as having made the regarded distribution 
or acquisition.
    (ii) If the departing member did not make the regarded distribution 
or acquisition (determined without regard to the one-corporation rule 
of paragraph (b)(1) of this section), then the consolidated group (and 
not the departing member) continues to be treated as having made the 
regarded distribution or acquisition.
    (e) Definitions. The definitions in this paragraph (e) apply for 
purposes of this section.
    (1) Consolidated group debt instrument. The term consolidated group 
debt instrument means a covered debt instrument issued by a member of a 
consolidated group and held by a member of the same consolidated group.
    (2) Departing member. The term departing member means a member of 
an expanded group that ceases to be a member of a consolidated group 
but continues to be a member of the same expanded group. In the case of 
multiple members leaving a consolidated group as a result of a single 
transaction that continue to be members of the same expanded group, if 
such members are treated as one corporation under paragraph (b)(1) of 
this section immediately after the transaction, that one corporation is 
a departing member with respect to the consolidated group.
    (3) Disregarded distribution or acquisition. The term disregarded 
distribution or acquisition means a distribution or acquisition 
described in Sec.  1.385-3(b)(2) or (b)(3)(i) between members of a 
consolidated group that is disregarded under the one-corporation rule 
of paragraph (b)(1) of this section.
    (4) Joining member. The term joining member means a member of an 
expanded group that becomes a member of a consolidated group and 
continues to be a member of the same expanded group. In the case of 
multiple members joining a consolidated group as a result of a single 
transaction that continue to be members of the same expanded group, if 
such members were treated as one corporation under paragraph (b)(1) of 
this section immediately before the transaction, that one corporation 
is a joining member with respect to the consolidated group.
    (5) Regarded distribution or acquisition. The term regarded 
distribution or acquisition means a distribution or acquisition 
described in Sec.  1.385-3(b)(2) or (b)(3)(i) that is not disregarded 
under the one-corporation rule of paragraph (b)(1) of this section.
    (f) Examples--(1) Assumed facts. Except as otherwise stated, the 
following facts are assumed for purposes of the examples in paragraph 
(f)(3) of this section:
    (i) FP is a foreign corporation that owns 100% of the stock of 
USS1, a covered member, and 100% of the stock of FS, a foreign 
corporation;
    (ii) USS1 owns 100% of the stock of DS1 and DS3, both covered 
members;
    (iii) DS1 owns 100% of the stock of DS2, a covered member;
    (iv) FS owns 100% of the stock of UST, a covered member;
    (v) At the beginning of Year 1, FP is the common parent of an 
expanded group comprised solely of FP, USS1, FS, DS1, DS2, DS3, and UST 
(the FP expanded group);
    (vi) USS1, DS1, DS2, and DS3 are members of a consolidated group of 
which USS1 is the common parent (the USS1 consolidated group);
    (vii) The FP expanded group has outstanding more than $50 million 
of debt instruments described in Sec.  1.385-3(c)(4) at all times;
    (viii) No issuer of a covered debt instrument has a positive 
expanded group earnings account, within the meaning of Sec.  1.385-
3(c)(3)(i)(B), or has received a qualified contribution, within the 
meaning of Sec.  1.385-3(c)(3)(ii)(B);
    (ix) All notes are covered debt instruments, within the meaning of 
Sec.  1.385-3(g)(3), and are not qualified short-term debt instruments, 
within the meaning of Sec.  1.385-3(b)(3)(vii);
    (x) All notes between members of a consolidated group are 
intercompany obligations within the meaning of Sec.  1.1502-
13(g)(2)(ii);
    (xi) Each entity has as its taxable year the calendar year;
    (xii) No domestic corporation is a United States real property 
holding corporation within the meaning of section 897(c)(2);
    (xiii) Each note is issued with adequate stated interest (as 
defined in section 1274(c)(2)); and
    (xiv) Each transaction occurs after January 19, 2017.
    (2) No inference. Except as otherwise provided in this section, it 
is assumed for purposes of the examples in paragraph (f)(3) of this 
section 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 an example in paragraph 
(f)(3) of this section would be respected for federal tax purposes.
    (3) Examples. The following examples illustrate the rules of this 
section.

    Example 1. Order of operations. (i) Facts. On Date A in Year 1, 
UST issues UST Note to USS1 in exchange for DS3 stock representing 
less than 20% of the value and voting power of DS3.
    (ii) Analysis. UST is acquiring the stock of DS3, the non-common 
parent member of a consolidated group. Pursuant to paragraph 
(b)(5)(i) of this section, the transaction is first analyzed without 
regard to the one-corporation rule of paragraph (b)(1) of this 
section, and therefore UST is treated as issuing a covered debt 
instrument in exchange for expanded group stock. The exchange of UST 
Note for DS3 stock is not an exempt exchange within the meaning of 
Sec.  1.385-3(g)(11) because UST and USS1 are not parties to an 
asset reorganization. Pursuant to paragraph (b)(5)(ii), Sec.  1.385-
3 (including Sec.  1.385-3(b)(2)(ii)) is then applied to the 
transaction, thereby treating UST Note as stock for federal tax 
purposes when it is issued by UST to USS1. The UST Note is not 
treated as property for purposes of section 304(a) because it is not 
property within the meaning specified in section 317(a). Therefore, 
UST's acquisition of DS3 stock from USS1 in exchange for UST Note is 
not an acquisition described in section 304(a)(1).
    Example 2. Distribution of consolidated group debt instrument. 
(i) Facts. On Date A

[[Page 72983]]

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 paragraph (b)(1) of this section, 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 on Date A in Year 1, 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(b)(2), and DS1 Note is 
not treated as stock under Sec.  1.385-3. When USS1 distributes DS1 
Note to FP, DS1 Note is deemed satisfied and reissued under Sec.  
1.1502-13(g)(3)(ii), immediately before DS1 Note ceases to be an 
intercompany obligation. Under paragraph (c)(1)(ii) of this section, 
when USS1 distributes DS1 Note to FP, the USS1 consolidated group is 
treated as issuing DS1 Note to FP in a distribution on Date B in 
Year 2. Accordingly, DS1 Note is treated as stock under Sec.  1.385-
3(b)(2)(i). Under paragraph (c)(1)(ii) of this section, DS1 Note is 
deemed to be exchanged for stock of the issuing member, DS1, 
immediately after DS1 Note is transferred outside of the USS1 
consolidated group. Under paragraph (c)(3) of this section, the 
deemed satisfaction and reissuance under Sec.  1.1502-13(g)(3)(ii) 
and the deemed issuance and exchange under paragraph (c)(1)(ii) of 
this section, are respected as separate steps and treated as 
separate transactions.
    Example 3.  Sale of consolidated group debt instrument. (i) 
Facts. On Date A in Year 1, DS1 lends $200x of cash to USS1 in 
exchange for USS1 Note. On Date B in Year 2, USS1 distributes $200x 
of cash to FP. Subsequently, on Date C in Year 2, DS1 sells USS1 
Note to FS for $200x.
    (ii) Analysis. Under paragraph (b)(1) of this section, the USS1 
consolidated group is treated as one corporation for purposes of 
Sec.  1.385-3. Accordingly, when USS1 issues USS1 Note to DS1 for 
property on Date A in Year 1, the USS1 consolidated group is not 
treated as a funded member, and when USS1 distributes $200x to FP on 
Date B in Year 2, that distribution is a transaction described in 
Sec.  1.385-3(b)(3)(i)(A), but does not cause USS1 Note to be 
recharacterized under Sec.  1.385-3(b)(3). When DS1 sells USS1 Note 
to FS, USS1 Note is deemed satisfied and reissued under Sec.  
1.1502-13(g)(3)(ii), immediately before USS1 Note ceases to be an 
intercompany obligation. Under paragraph (c)(1)(ii) of this section, 
when the USS1 Note is transferred to FS for $200x on Date C in Year 
2, the USS1 consolidated group is treated as issuing USS1 Note to FS 
in exchange for $200x on that date. Because USS1 Note is issued by 
the USS1 consolidated group to FS within the per se period as 
defined in Sec.  1.385-3(g)(19) with respect to the distribution by 
the USS1 consolidated group to FP, USS1 Note is treated as funding 
the distribution under Sec.  1.385-3(b)(3)(iii)(A) and, accordingly, 
is treated as stock under Sec.  1.385-3(b)(3). Under Sec.  1.385-
3(d)(1)(i) and paragraph (c)(1)(ii) of this section, USS1 Note is 
deemed to be exchanged for stock of the issuing member, USS1, 
immediately after USS1 Note is transferred outside of the USS1 
consolidated group. Under paragraph (c)(3) of this section, the 
deemed satisfaction and reissuance under Sec.  1.1502-13(g)(3)(ii) 
and the deemed issuance and exchange under paragraph (c)(1)(ii) of 
this section, are respected as separate steps and treated as 
separate transactions.
    Example 4.  Treatment of consolidated group debt instrument and 
departing member's regarded distribution or acquisition when the 
issuer of the instrument leaves the consolidated group. (i) Facts. 
The facts are the same as provided in paragraph (f)(1) of this 
section, except that USS1 and FS own 90% and 10% of the stock of 
DS1, respectively. On Date A in Year 1, DS1 distributes $80x of cash 
and newly-issued DS1 Note, which has a value of $10x, to USS1. Also 
on Date A in Year 1, DS1 distributes $10x of cash to FS. On Date B 
in Year 2, FS purchases all of USS1's stock in DS1 (90% of the stock 
of DS1), resulting in DS1 ceasing to be a member of the USS1 
consolidated group.
    (ii) Analysis. Under paragraph (b)(1) of this section, the USS1 
consolidated group is treated as one corporation for purposes of 
Sec.  1.385-3. Accordingly, DS1's distribution of $80x of cash to 
USS1 on Date A in Year 1 is a disregarded distribution or 
acquisition, and under paragraph (d)(1) of this section, continues 
to be a disregarded distribution or acquisition when DS1 ceases to 
be a member of the USS1 consolidated group. In addition, 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 DS1's 
expanded group in a distribution for purposes of Sec.  1.385-
3(b)(2)(i), and DS1 Note is not treated as stock under Sec.  1.385-
3(b)(2)(i). DS1's issuance of DS1 Note to USS1 is also a disregarded 
distribution or acquisition, and under paragraph (d)(1) of this 
section, continues to be a disregarded distribution or acquisition 
when DS1 ceases to be a member of the USS1 consolidated group. The 
distribution of $10x cash by DS1 to FS on Date A in Year 1 is a 
regarded distribution or acquisition. When FS purchases 90% of the 
stock of DS1's from USS1 on Date B in Year 2 and DS1 ceases to be a 
member of the USS1 consolidated group, DS1 Note is deemed satisfied 
and reissued under Sec.  1.1502-13(g)(3)(ii), immediately before DS1 
Note ceases to be an intercompany obligation. Under paragraph 
(c)(1)(i) of this section, for purposes of Sec.  1.385-3, DS1 is 
treated as satisfying the DS1 Note with cash equal to the note's 
fair market value, followed by DS1's issuance of a new note for the 
same amount of cash immediately after DS1 Note ceases to be a 
consolidated group debt instrument. Under paragraph (d)(4)(i) of 
this section, the departing member, DS1 (and not the USS1 
consolidated group) is treated as having distributed $10x to FS on 
Date A in Year 1 (a regarded distribution or acquisition) for 
purposes of applying Sec.  1.385-3(b)(3) after DS1 ceases to be a 
member of the USS1 consolidated group. Because DS1 Note is reissued 
by DS1 to USS1 within the per se period (as defined in Sec.  1.385-
3(g)(19)) with respect to DS1's regarded distribution to FS, DS1 
Note is treated as funding the distribution under Sec.  1.385-
3(b)(3)(iii)(A) and, accordingly, is treated as stock under Sec.  
1.385-3(b)(3). Under Sec.  1.385-3(d)(1)(i) and paragraph (c)(1)(i) 
of this section, DS1 Note is immediately deemed to be exchanged for 
stock of DS1 on Date B in Year 2. Under paragraph (c)(3) of this 
section, the deemed satisfaction and reissuance under Sec.  1.1502-
13(g)(3)(ii) and the deemed issuance and exchange under paragraph 
(c)(1)(i) of this section are respected as separate steps and 
treated as separate transactions. Under Sec.  1.385-3(d)(7)(i), 
after DS1 Note is treated as stock held by USS1, DS1 Note is not 
treated as stock for purposes of determining whether DS1 is a member 
of the USS1 consolidated group.
    Example 5.  Treatment of consolidated group debt instrument and 
consolidated group's regarded distribution or acquisition. (i) 
Facts. On Date A in Year 1, DS1 issues DS1 Note to USS1. On Date B 
in Year 2, USS1 distributes $100x of cash to FP. On Date C in Year 
3, USS1 sells all of its interest in DS1 to FS, resulting in DS1 
ceasing to be a member of the USS1 consolidated group.
    (ii) Analysis. Under paragraph (b)(1) of this section, 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 on Date A in Year 1, DS1 is not treated as issuing a 
debt instrument to a member of DS1's expanded group in a 
distribution for purposes of Sec.  1.385-3(b)(2)(i), and DS1 Note is 
not treated as stock under Sec.  1.385-3(b)(2)(i). DS1's issuance of 
DS1 Note to USS1 is also a disregarded distribution or acquisition, 
and under paragraph (d)(1) of this section, continues to be a 
disregarded distribution or acquisition when DS1 ceases to be a 
member of the USS1 consolidated group. The distribution of $100x 
cash by DS1 to USS1 on Date B in Year 2 is a regarded distribution 
or acquisition. When FS purchases all of the stock of DS1 from USS1 
on Date C in Year 3 and DS1 ceases to be a member of the USS1 
consolidated group, DS1 Note is deemed satisfied and reissued under 
Sec.  1.1502-13(g)(3)(ii), immediately before DS1 Note ceases to be 
an intercompany obligation. Under paragraph (c)(1)(i) of this 
section, for purposes of Sec.  1.385-3, DS1 is treated as satisfying 
DS1 Note with cash equal to the note's fair market value, followed 
by DS1's issuance of a new note for the same amount of cash 
immediately after DS1 Note ceases to be a consolidated group debt 
instrument. Under paragraph (d)(4)(ii) of this section, the USS1 
consolidated group (and not DS1) is treated as having distributed 
$100x to FP on Date B in Year 2 (a regarded distribution or 
acquisition) for purposes of applying Sec.  1.385-3(b)(3) after DS1 
ceases to be a member of the USS1 consolidated group. Because DS1 
has not engaged in a regarded distribution or acquisition that would 
have been treated as funded by the reissued DS1 Note, the reissued 
DS1 Note is not treated as stock.
    Example 6.  Treatment of departing member's issuance of a 
covered debt instrument. (i) Facts. On Date A in Year 1, FS lends 
$100x of cash to DS1 in exchange for DS1 Note. On Date B in Year 2, 
USS1 distributes $30x of cash to FP. On Date C in Year 2, USS1 sells 
all of its DS1 stock to FP, resulting in DS1 ceasing to be a member 
of the USS1 consolidated group.

[[Page 72984]]

    (ii) Analysis. Under paragraph (b)(1) of this section, the USS1 
consolidated group is treated as one corporation for purposes of 
Sec.  1.385-3. Accordingly, on Date A in Year 1, the USS1 
consolidated group is treated as issuing DS1 Note to FS, and on Date 
B in Year 2, the USS1 consolidated group is treated as distributing 
$30x of cash to FP. Because DS1 Note is issued by the USS1 
consolidated group to FS within the per se period as defined in 
Sec.  1.385-3(g)(19) with respect to the distribution by the 
USS1consoldiated group of $30x cash to FP, $30x of DS1 Note is 
treated as funding the distribution under Sec.  1.385-
3(b)(3)(iii)(A), and, accordingly, is treated as stock on Date B in 
Year 2 under Sec.  1.385-3(b)(3) and Sec.  1.385-3(d)(1)(ii). Under 
paragraph (d)(3) of this section, DS1 (and not the USS1 consolidated 
group) is treated as the issuer of the remaining portion of DS1 Note 
for purposes of applying Sec.  1.385-3(b)(3) after DS1 ceases to be 
a member of the USS1 consolidated group.

    (g) Applicability date. This section applies to taxable years 
ending on or after January 19, 2017.
    (h) Expiration date. This section expires on October 11, 2019.

0
Par. 7. Section 1.752-2 is amended by adding paragraphs (c)(3) and 
(l)(4) to read as follows:


Sec.  1.752-2  Partner's share of recourse liabilities.

* * * * *
    (c) * * *
    (3) [Reserved]. For further guidance, see Sec.  1.752-2T(c)(3).
* * * * *
    (l) * * *
    (4) [Reserved]. For further guidance, see Sec.  1.752-2T(l)(4).

0
Par. 8. Section 1.752-2T is amended by revising paragraphs (c)(3) and 
(m) and adding (l)(4) to read as follows:


Sec.  1.752-2T  Partner's share of recourse liabilities (temporary).

* * * * *
    (c) * * *
    (3) Allocation of debt deemed transferred to a partner pursuant to 
regulations under section 385. For a special rule regarding the 
allocation of a partnership liability that is a debt instrument with 
respect to which there is one or more deemed transferred receivables 
within the meaning of Sec.  1.385-3T(g)(8), see Sec.  1.385-
3T(f)(4)(vi).
* * * * *
    (l) * * *
    (4) Paragraph (c)(3) of this section applies on or after January 
19, 2017.
    (m) Expiration date--(1) Paragraphs (a) through (c)(2) and (d) 
through (l)(3) of this section expire on October 4, 2019.
    (2) Paragraphs (c)(3) and (l)(4) of this section expire on October 
11, 2019.

0
Par. 9. Section 1.1275-1 is amended by adding a sentence after the last 
sentence of paragraph (d) to read as follows:


Sec.  1.1275-1  Definitions.

* * * * *
    (d) * * * See Sec.  1.385-2 for rules to determine whether certain 
instruments are treated as stock for federal tax purposes and Sec.  
1.385-3 for rules that treat certain instruments that otherwise would 
be treated as indebtedness as stock for federal tax purposes.
* * * * *

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: October 11, 2016
Mark J. Mazur
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2016-25105 Filed 10-13-16; 5:00 pm]
 BILLING CODE 4830-01-P