[Federal Register Volume 59, Number 198 (Friday, October 14, 1994)] [Unknown Section] [Page 0] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 94-25403] [[Page Unknown]] [Federal Register: October 14, 1994] ----------------------------------------------------------------------- DEPARTMENT OF THE TREASURY 26 CFR Part 1 [INTL-0064-93] RIN 1545-AS40 Conduit Arrangements Regulations AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking and notice of public hearing. ----------------------------------------------------------------------- SUMMARY: This document contains proposed regulations relating to conduit financing arrangements issued under the authority granted by section 7701(l). The proposed regulations apply to persons engaging in multiple-party financing arrangements and are necessary in order to determine which of those arrangements should be recharacterized under section 7701(l). This document also provides notice of a public hearing on these proposed regulations. DATES: Written comments, requests to speak and outlines of topics to be discussed at the public hearing scheduled for December 16, 1994, must be received by December 13, 1994. ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0064-93), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (INTL-0064-93), Courier's Desk, Internal Revenue Service, 1111 Constitution Ave. NW, Washington, DC. The public hearing will be held in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. FOR FURTHER INFORMATION CONTACT: Concerning the regulations Richard L. Chewning, Ramon Camacho, or Elissa Shendalman (202) 622-3870, concerning submissions and the hearing, Christina Vasquez, (202) 622- 7782 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Paperwork Reduction Act The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h)). Comments on the collections of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224. The collections of information are in Secs. 1.881-4(c), 1.6038-2, 1.6038A-2, and 1.6038A-3. The information is required by the IRS so that a district director can determine whether a financing arrangement is subject to recharacterization under Sec. 1.881-3. The data will be used by the IRS and taxpayers to verify that the proper amount of tax is withheld. The likely respondents are withholding agents and foreign investors. Estimated total annual recordkeeping burden: 10,000 hours. Estimated average annual burden per taxpayer: 10 hours. Estimated number of recordkeepers: 1,000. Estimated total annual reporting burden: 3,000 hours. Estimated average burden per respondent: 3 hours. Estimated number of respondents: 1,000. Estimated frequency of responses: Annually. Background This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under Secs. 1.871-1, 1.881-0, 1.881-3, 1.881-4, 1.1441-3, 1.1441-7, 1.6038-2, 1.6038A-2, 1.6038A-3 and 1.7701(l)-1 that are issued under the authority granted by section 7701(l). Section 7701(l) was enacted as part of the Omnibus Budget Reconciliation Act of 1993 (Pub.L. 103-66). These proposed regulations provide guidance with regard to conduit financing arrangements. Explanation of Provisions Section 7701(l) authorizes the Secretary to ``prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title.'' Pursuant to this authority, these regulations provide rules that permit the district director to disregard, for purposes of sections 871, 881, 1441 and 1442, the participation of one or more persons in a conduit financing arrangement. Section 1.881-3 1. Definitions Section 1.881-3(a)(2) provides definitions of certain terms used throughout the regulations. A ``financing arrangement'' generally means two or more financing transactions pursuant to which one person (the financing entity) advances money or other property to another person (the intermediate entity) and the intermediate entity advances money or other property to a third person (the financed entity). The term also includes two or more financing transactions that achieve substantially the same result through any other series of steps (e.g., a loan from a foreign person to a U.S. person, followed by an assignment of the loan by the foreign person to another person in exchange for a note issued by the assignee). A ``financing transaction'' generally means any advance of money or other property in exchange for debt; any advance of money or other property in exchange for certain types of stock or a similar interest in a partnership or trust; any lease or license; any other advance of money or other property pursuant to which the transferee is obligated to repay or return a substantial portion of the money or other property advanced (or the equivalent in value); and any transaction by which a person becomes a party to an existing financing transaction. An advance of money or other property in exchange for stock will be considered a financing transaction only if the issuer or holder of the stock has rights, or there are arrangements in place, that are intended to ensure that payments on the instrument will be made as contemplated. Therefore, an exchange for common stock or ordinary perpetual preferred stock will not be included. However, an exchange for certain instruments, such as dividend-linked notes or other perpetual subordinated debt (which, though denominated as debt, are treated as equity under U.S. tax principles), will be included if those instruments provide for normal creditors' rights, such as the right, arising upon a default on a payment, to enforce the payment through a legal proceeding or to cause the liquidation of the issuer. The IRS solicits comments on the definition of a financing transaction. A ``conduit entity'' means an intermediate entity whose participation in a financing arrangement is disregarded pursuant to Sec. 1.881-3. The regulations also define the terms ``guarantee'' and ``related,'' which are discussed elsewhere in this preamble. The IRS and the Treasury recognize the potential overlap of these regulations with the proposed regulations governing securities lending issued under sections 861, 871, 881, 894 and 1441, published in the issue of the Federal Register for January 9, 1992, 57 F.R. 860. In connection with the finalization of the proposed regulations concerning securities lending and these regulations, guidance will be provided coordinating the two sets of regulations. 2. Authority of District Director Section 1.881-3(a)(3) authorizes the district director to treat an intermediate entity as a conduit entity if the financing arrangement satisfies the standard for conduit treatment set forth in Sec. 1.881- 3(a)(4). The district director's exercise of this authority will be subject to judicial review under an ``abuse of discretion'' standard. In applying the standard for conduit treatment, the district director has the authority to determine which financing transactions comprise the financing arrangement and which persons are parties to the financing arrangement. For example, if an intermediate entity borrows $100 from a related person and $100 from an unrelated person, and in turn lends $100 to a U.S. person, the district director may determine based on the facts, whether the financing arrangement is among the U.S. borrower, the intermediate entity and the related person or the U.S. borrower, the intermediate entity and the unrelated person. 3. Standard for Conduit Treatment Section 1.881-3(a)(4) provides the standard to be applied by the district director in determining whether an intermediate entity is disregarded for purposes of section 881. The standard depends upon the relationship of the parties in the financing arrangement. If the intermediate entity is related to the financing entity or the financed entity, the financing arrangement will be subject to recharacterization if two conditions are satisfied: (i) The participation of the intermediate entity in the financing arrangement reduces the tax imposed by section 881; and (ii) the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan, which is defined in Sec. 1.881-3(c)(1) as a plan one of the principal purposes of which is the avoidance of tax imposed by section 881. The definition of the term ``related'' contained in Sec. 1.881- 3(a)(2)(v), with certain exceptions, is consistent with the definition of related party (and the related attribution rules) in Sec. 1.6038A-1 (d) and (e). If the intermediate entity is unrelated to both the financing entity and the financed entity, the financing arrangement will be subject to recharacterization if the two conditions described above are satisfied and, in addition, the intermediate entity would not have participated in the financing arrangement on substantially the same terms but for the fact that the financing entity engaged in the financing transaction with the intermediate entity. Section 1.881-3(b) provides that, if the financing entity guarantees the liability of the financed entity to the intermediate entity, it will be presumed that the intermediate entity would not have participated in the financing arrangement on substantially the same terms but for the fact that the financing entity engaged in the financing transaction with the intermediate entity. A taxpayer may rebut this presumption by producing clear and convincing evidence to the contrary. Section 1.881-3(a)(2)(iv) defines a ``guarantee'' as any arrangement under which a person, directly or indirectly, assures, on a conditional or unconditional basis, the payment of another person's obligation with respect to a financing transaction. The regulations further provide that the term is to be interpreted in accordance with the definition of guarantee in section 163(j)(6)(D)(iii). Section 1.881-3(a)(4)(ii)(A) provides that the district director may apply principles consistent with the general recharacterization standard described above in cases involving multiple intermediate entities. Section 1.881-3(a)(4)(ii)(B) contains a special rule that applies if two (or more) financing transactions involving two (or more) related persons would form part of a financing arrangement but for the absence of a financing transaction between the related persons. In such a case, the district director may treat the related persons as a single intermediate entity if he or she determines based upon all the facts and circumstances that the avoidance of the application of Sec. 1.881-3 is one of the principal purposes for the structuring of the financing transactions. That paragraph also permits the district director to apply similar principles if a financing transaction exists between related persons, but one of the principal purposes for the existence of the financing transaction is to prevent the district director from treating the related persons as a single intermediate entity. 4. Determination of Existence of Tax Avoidance Plan Section 1.881-3(c) contains rules for determining whether the participation of the intermediate entity in the financing arrangement is pursuant to a plan one of the principal purposes of which is the avoidance of tax imposed by section 881 (tax avoidance plan). This determination is to be based upon all of the facts and circumstances. In this regard, the only relevant purposes are those pertaining to the participation of the intermediate entity in the financing arrangement, not those pertaining to the existence of the financing arrangement in general. Moreover, the fact that an intermediate entity is a resident of a country that has a treaty with the United States that significantly reduces the tax that otherwise would have been imposed under section 881 is not sufficient, by itself, to establish the existence of a tax avoidance plan. The application of these regulations only to an intermediate entity whose participation is pursuant to a plan ensures that these regulations apply only to transactions that are related to each other through the taxpayer's intention to secure, in an artificial manner, exemptions or reductions of withholding tax that would not otherwise be available given the economic substance of its transactions. Section 1.881-3(c)(2) lists several nonexclusive factors that are relevant to the determination of whether the intermediate entity's participation is pursuant to a tax avoidance plan. Avoidance of the tax imposed by section 881 may be one of the principal purposes for such a plan even though it is outweighed by other purposes (taken together or separately). Section 1.881-3(c)(3) provides that it shall be presumed that the participation of an intermediate entity (or entities) in a financing arrangement is not pursuant to a tax avoidance plan if the intermediate entity is related to the financing entity or the financed entity and the intermediate entity performs significant financing activities, as defined, with respect to the financing transactions forming part of the financing arrangement to which it is a party. The district director may rebut the presumption by establishing that the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan. The IRS solicits comments on the significant financing activity presumption. Section 1.881-3(c)(4) provides a set of special rules applicable in cases where the financing entity is unrelated to the intermediate entity (or entities) and the financed entity. Section 1.881-3(c)(4)(i) provides that, in such cases, if the intermediate entity (or, in the case of multiple intermediate entities, the intermediate entity that has engaged in a financing transaction with the financed entity) is actively engaged in a substantial trade or business (other than the business of making or managing investments, except pursuant to a banking, insurance, financing or similar trade or business, the income from which is earned predominantly in transactions with unrelated persons), it will be presumed that the participation of the intermediate entity in the financing arrangement is not pursuant to a tax avoidance plan. This presumption may be rebutted if the district director establishes that the participation of the intermediate entity in the financing arrangement is pursuant to such a plan. Section 1.881-3(c)(4)(ii) provides that, in any case where a financing entity is unrelated to the financed entity and the intermediate entity (or entities), the financing entity will not be liable for tax under section 881 pursuant to these regulations unless the financing entity knows or has reason to know that the financing arrangement is subject to recharacterization under Sec. 1.881-3(a)(3). Section 1.881-3(c)(4)(ii) does not relieve the section 881 liability for purposes of determining whether any person is liable for withholding tax pursuant to Sec. 1.1441-3(j) or whether any party to a financing arrangement is entitled to a refund of tax actually withheld by a withholding agent pursuant to section 1441. Accordingly, if the requirements of Sec. 1.881-3(a)(4) are satisfied, the financed entity is required to pay withholding tax without regard to the knowledge of the financing entity and no party to the financing arrangement is entitled to a refund (except to the extent the amount withheld exceeds the amount determined under section 881). A person is not considered to have reason to know that the financing arrangement is subject to recharacterization if the person knows of the financing transactions that comprise the financing arrangement but does not know or have reason to know of facts sufficient to establish that the intermediate entity's participation was pursuant to a tax avoidance plan. The IRS solicits comments on the treatment of unrelated financing entities. 5. Determination of Amount of Tax Liability Section 1.881-3(d) provides rules for determining the portion of each payment made by a financed entity that is recharacterized under Sec. 1.881-3(a)(3). The recharacterized portion is proportionate to a ratio of the principal amounts of the financing transactions that comprise the financing arrangement. This ratio measures the proportion of money or other property advanced by the financing entity to the intermediate entity that is considered to flow through to the financed entity. If a financing arrangement involves multiple conduit entities, the ratio is based upon a comparison of the smallest financing transaction between a conduit entity and a party other than the financed entity, and the financing transaction involving the financed entity. Thus, if pursuant to a financing arrangement, A lends $500 to B, B lends $300 to C, and C lends $350 to D, and B and C are conduit entities, the ratio equals $300/$350 (assuming at the time of the payment from the financed entity to the conduit entity the principal amounts have not changed). This rule does not apply, however, in a case where the district director treats related persons as a single intermediate entity under Sec. 1.881-3(a)(4)(ii)(B). Section 1.881-3(d)(1)(iii) provides that the principal amount of a financing transaction will be determined on the basis of all of the facts and circumstances. The principal amount generally will equal the amount of money, or the fair market value of other property (determined as of the time that the financing transaction is entered into), advanced in the financing transaction. In the case of a debt instrument or stock, the fair market value of the property advanced will be considered to equal the issue price unless the fair market value differs materially from the issue price. The principal amount of a financing transaction will be subject to adjustments, as appropriate. The IRS solicits comments on the definition of principal amount. Section 1.881-3(d)(2) provides that payments made by a financed entity pursuant to a financing arrangement that is recharacterized under Sec. 1.881-3(a)(3) are subject to tax at the rate applicable to payments made directly to the financing entity. Thus, the rate of tax will be affected by whether an income tax treaty is in existence between the United States and the country in which the financing entity is a resident. However, special withholding rules apply under Sec. 1.1441-3(j). 6. Interaction With Treaties These regulations are intended to provide anti-abuse rules that supplement, but do not conflict with, the limitation on benefits articles in U.S. income tax treaties. Treaty limitation on benefits articles commonly limit the tax benefits of the treaty to those residents of the other contracting state that have a substantial business nexus with, or otherwise have a significant business purpose for residing in, the other contracting state. These articles generally provide objective, bright-line rules for determining whether an entity has a sufficient nexus to the contracting state to be treated as a resident for treaty purposes. It has been recognized that contracting states may supplement these rules by transactionally-based domestic anti-abuse rules, including rules under which a particular transaction may be recast, in accordance with the substance of the transaction. These regulations, which reflect common law substance over form principles as applied to conduit financing arrangements, complement the limitation on benefits provisions of income tax treaties and are not precluded by the inclusion of such provisions, just as those provisions have not overridden the applicability of existing anti-conduit rulings such as Rev. Rul. 84-152, 1984-2 C.B. 381, Rev. Rul. 84-153, 1984-2 C.B. 383, and Rev. Rul. 87-89, 1987-1 C.B. 195. Accordingly, Sec. 1.881-3(d)(3) provides that a financing arrangement may be recharacterized under Sec. 1.881-3 regardless of whether the conduit entity is a resident of a country that has an income tax treaty with the United States. Thus, the treaty applicable to determine the amount of tax due under section 881, if any, will be based upon the substance of the financing arrangement. 7. Alternative Approach Not Adopted In formulating these regulations, the IRS and the Treasury considered several alternative standards for recharacterizing a financing arrangement. For example, consideration was given to a test that would measure the similarity of the cash flows of the financing transactions that comprise the financing arrangement, with respect to both the advance and repayment of funds. This test was rejected principally for the following reasons. First, the delineation of cash flows considered characteristic of a conduit arrangement would be inherently arbitrary. In a substantial number of cases, the application of the test would produce results that were either overinclusive or underinclusive. Second, such a test could be circumvented, particularly with respect to cash flows on repayment. Related parties have particular flexibility to structure the terms of their financing transactions to satisfy a bright-line test. Unrelated parties may have less flexibility. However, in either case, parties could alter the financial consequences of holding an asset or liability with particular cash flows through the use of derivative financial instruments. Although the regulations do not adopt a bright-line cash flow test, Sec. 1.881-3(c)(2) (i)(C) and (ii)(B) provides that the timing of the advances of money or other property to the intermediate entity and the financed entity pursuant to the financing arrangement is a factor relevant to whether the intermediate entity's participation is pursuant to a tax avoidance plan. The regulations do not set forth as a factor the similarity of the repayment terms of the financing transactions. This is because of concerns about the extent to which the similarity of repayment terms is a useful indication of a tax avoidance plan. The IRS solicits comments on this point. 8. Equity Investments The legislative history to section 7701(l) authorizes the issuance of regulations that apply to financing arrangements involving equity investments. These regulations, however, generally do not include investments in common stock (or investments in ordinary perpetual preferred stock) in the definition of financing transaction principally for the following reasons. First, because a corporation has no legal obligation to make distributions with respect to its common stock, inclusion of ordinary common stock in the definition of financing transaction could add significant uncertainty and complexity to the application of the regulations. Second, there are substantial questions about the extent to which common stock and ordinary perpetual preferred stock can be used in a conduit financing arrangement to avoid U.S. withholding tax. Nevertheless, the IRS and the Treasury remain concerned about the potential for abuse with respect to such equity investments and will monitor developments in this area. If the IRS and the Treasury determine that taxpayers are structuring conduit financing arrangements with such stock to avoid U.S. withholding tax, these regulations may be extended to cover such stock. 9. Guarantees The legislative history to section 7701(l) authorizes the issuance of regulations that apply to financing arrangements involving debt guarantees. These regulations, however, generally do not treat debt guarantees as a financing transaction as defined in Sec. 1.881- 3(a)(2)(ii). Nevertheless, the IRS and the Treasury remain concerned about the potential for abuse with respect to debt guarantees and will monitor developments in this area. If the IRS and the Treasury determine that taxpayers are structuring conduit financing arrangements with debt guarantees to avoid U.S. withholding tax, these regulations may be extended to cover debt guarantees. 10. Collateral Consequences of Recharacterization These regulations do not provide that a financing arrangement recharacterized for purposes of sections 871, 881, 1441 or 1442 is also recharacterized for purposes of other Code sections. The IRS and the Treasury are considering, however, the circumstances under which the recharacterization should be extended to other Code sections. The IRS solicits comments on this point. 11. Use of Regulations by Taxpayers Section 1.881-3(a)(3) provides that a taxpayer may not apply Sec. 1.881-3 to reduce its tax liability. However, a taxpayer may comply with the provisions of Sec. 1.881-3 in order to avoid the imposition of interest and penalties. Section 1.881-4 Section 1.881-4 provides rules for the furnishing of information and the maintenance of records concerning financing arrangements to which Sec. 1.881-3 applies. Section 1.881-4(b) provides that a financed entity that is a reporting corporation within the meaning of section 6038A(a) and the regulations under that section, or that is required to report pursuant to section 6038(a) and the regulations under that section, must comply with certain reporting requirements with respect to any financing transaction to which the financed entity is a party that it knows or has reason to know forms a part of a financing arrangement described in Sec. 1.881-3(a)(4) (determined without regard to the tax avoidance purpose rule of Sec. 1.881-3(a)(4)(i)(B)). This rule applies only if a person with respect to which the financed entity is required to report under sections 6038 or 6038A is a party to that financing arrangement. Section 1.881-4(c) provides that a financed entity or any other person subject to the general recordkeeping requirements of section 6001, or the recordkeeping requirements of Sec. 1.6038A-3, must keep the permanent books of account or records, as required by section 6001 or Sec. 1.6038A-3, that may be relevant to the determination of whether the financing arrangement is subject to recharacterization under Sec. 1.881-3. Section 1.1441-3(j) Section 1.1441-3(j) provides that a financed entity or other person required to withhold tax under section 1441 with respect to a financing arrangement subject to recharacterization under Sec. 1.871-1(b)(7) or 1.881-3(a)(3), is required to withhold in accordance with the recharacterization on the portion of each payment subject to recharacterization, as determined by Sec. 1.881-3(d). Section 1.1441-7 Section 1.1441-7(d) provides that a person is required to withhold tax under section 1441 in accordance with the recharacterization of a financing arrangement under Sec. 1.881-3(a)(3) if the person knows or has reason to know that the financing arrangement is subject to recharacterization under those sections and the person otherwise is a withholding agent with respect to the financing arrangement. The ``knows or has reason to know'' standard is the standard that generally applies to withholding agents presented with a claim for treaty benefits. See, e.g., Rev. Rul. 85-4, 1985-1 C.B. 294, 295; Rev. Rul. 76-224, 1976-1 C.B. 268, 269. A person is not considered to have reason to know that a financing arrangement is subject to recharacterization under Sec. 1.881-3(a)(3) if the person knows of the financing transactions that comprise the financing arrangement but does not know or have reason to know of facts sufficient to establish that the intermediate entity's participation was pursuant to a tax avoidance plan. The IRS solicits comments on the standard applicable to withholding agents. Proposed Effective Date Sections 1.881-3, 1.881-4, 1.1441-3(j) and 1.1441-7(d) are proposed to be effective for payments made after the date which is 30 days after publication of final regulations in the Federal Register. This regulation shall not apply with respect to interest payments made by United States corporations to Netherlands Antilles corporations in connection with debt obligations issued prior to October 15, 1984 (see Rev. Rul. 85-163, 1985-2 C.B. 349) and payments of interest covered by section 127(g)(3) of the Tax Reform Act of 1984. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Comments and Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. All comments will be available for public inspection and copying. A public hearing has been scheduled for Friday, December 16, 1994, at 10 a.m., in the Internal Revenue Service Auditorium, 7400 corridor. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15 minutes before the hearing starts. The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons that wish to present oral comments at the hearing must submit written comments and submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by December 13, 1994. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing. Drafting Information Several persons from the Office of Chief Counsel and the Treasury Department participated in developing these regulations. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Proposed Amendment to the Regulations Accordingly, 26 CFR part 1 is proposed to be amended as follows: PART 1--INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by removing the entry for Secs. 1.6038A-1 through 1.6038A-7 and adding entries in numerical order to read as follows: Authority: 26 U.S.C. 7805 * * * Section 1.871-1 also issued under 26 U.S.C. 7701(l). * * * Section 1.881-3 also issued under 26 U.S.C. 7701(l). * * * Section 1.881-4 also issued under 26 U.S.C. 7701(l). * * * Section 1.1441-3 also issued under 26 U.S.C. 7701(l). * * * Section 1.1441-7 also issued under 26 U.S.C. 7701(l). * * * Section 1.6038-2 also issued under 26 U.S.C. 7701(l). * * * Section 1.6038A-1 also issued under 26 U.S.C. 6038A. Section 1.6038A-2 also issued under 26 U.S.C. 6038A and 7701(l). Section 1.6038A-3 also issued under 26 U.S.C. 6038A and 7701(l). Section 1.6038A-4 also issued under 26 U.S.C. 6038A. Section 1.6038A-5 also issued under 26 U.S.C. 6038A. Section 1.6038A-6 also issued under 26 U.S.C. 6038A. Section 1.6038A-7 also issued under 26 U.S.C. 6038A. * * * Section 1.7701(l)-1 also issued under 26 U.S.C. 7701(l). * * * Par. 2. In Sec. 1.871-1, paragraph (b)(7) is added to read as follows: Sec. 1.871-1 Classification and manner of taxing alien individuals. * * * * * (b) * * * (7) Conduit financing arrangements. For rules regarding conduit financing arrangements, see Secs. 1.881-3 and 1.881-4. * * * * * Par. 3. Sections 1.881-0, 1.881-3 and 1.881-4 are added to read as follows: Sec. 1.881-0 Table of contents. This section lists the major headings for Secs. 1.881-1 through 1.881-4. Sec. 1.881-1 Manner of taxing foreign corporations. (a) Classes of foreign corporations. (b) Manner of taxing. (1) Foreign corporations not engaged in U.S. business. (2) Foreign corporations engaged in U.S. business. (c) Meaning of terms. (d) Rules applicable to foreign insurance companies. (1) Corporations qualifying under subchapter L. (2) Corporations not qualifying under subchapter L. (e) Other provisions applicable to foreign corporations. (1) Accumulated earnings tax. (2) Personal holding company tax. (3) Foreign personal holding companies. (4) Controlled foreign corporations. (i) Subpart F income and increase of earnings invested in U.S. property. (ii) Certain accumulations of earnings and profits. (5) Changes in tax rate. (6) Consolidated returns. (7) Adjustment of tax of certain foreign corporations. Sec. 1.881-2 Taxation of foreign corporations not engaged in U.S. business. (a) Imposition of tax. (b) Fixed or determinable annual or periodical income. (c) Other income and gains. (1) Items subject to tax. (2) Determination of amount of gain. (d) Credits against tax. (e) Effective date. Sec. 1.881-3 Conduit financing arrangements. (a) General rules and definitions. (1) Purpose and scope. (2) Definitions. (i) Financing arrangement. (ii) Financing transaction. (iii) Conduit entity. (iv) Guarantee. (v) Related. (vi) Tax avoidance plan. (3) Treatment of intermediate entity as conduit entity. (i) Authority of district director. (ii) Taxpayer's use of this section. (4) Standard for conduit treatment. (i) In general. (ii) Multiple intermediate entities. (A) In general. (B) Special rule for related persons. (b) Determination of whether intermediate entity would not have participated in financing arrangement on substantially same terms. (c) Determination of whether participation of intermediate entity is pursuant to a tax avoidance plan. (1) In general. (2) Factors taken into account in determining the presence or absence of a tax avoidance plan. (3) Presumption if significant financing activities performed by a related intermediate entity. (i) General rule. (ii) Requirements. (4) Special rules for cases where financing entity is unrelated to both intermediate entity and financed entity. (i) Presumption of no tax avoidance. (ii) Liability of financing entity. (d) Determination of amount of tax liability. (1) Amount of payment subject to recharacterization. (i) In general. (ii) Multiple conduit entities. (iii) Determination of principal amount. (2) Rate of tax. (3) Effect of income tax treaties. (4) Withholding tax due. (e) Coordination with sections 871, 884, 1441 and 1442. (f) Examples. (g) Effective date. Sec. 1.881-4 Reporting and recordkeeping requirements concerning conduit financing arrangements. (a) Scope. (b) Reporting requirements. (1) Persons required to report. (2) Reporting requirement. (3) Additional disclosure. (c) Recordkeeping requirements. (d) Application of sections 6038 and 6038A. (1) In general. (2) Duplication of reporting requirements. (e) Effective date. Sec. 1.881-3 Conduit financing arrangements. (a) General rules and definitions--(1) Purpose and scope. Pursuant to the authority of section 7701(l), this section provides rules that permit the district director to disregard, for purposes of section 881, the participation of one or more persons in a conduit financing arrangement. These rules also apply for purposes of sections 871, 1441, and 1442. See Sec. 1.881-4 for reporting and recordkeeping requirements concerning conduit financing arrangements. See Secs. 1.1441-3(j) and 1.1441-7(d) for withholding rules applicable to conduit financing arrangements. (2) Definitions. The following definitions apply to this section and to Secs. 1.881-4, 1.1441-3(j) and 1.1441-7(d). (i) Financing arrangement means two or more financing transactions pursuant to which one person (the financing entity) advances money or other property to another person (the intermediate entity) and the intermediate entity advances money or other property to a third person (the financed entity), and, if there is more than one intermediate entity, there is a chain of financing transactions linking each intermediate entity. For this purpose, a transfer of money or other property in satisfaction of a repayment obligation is not an advance of money or other property. The term financing arrangement also includes two or more financing transactions that achieve substantially the same result through any other series of steps. A financing arrangement exists only for the period during which all of the financing transactions are coexistent. See Example 1 of paragraph (f) of this section for an illustration of the term financing arrangement. (ii) Financing transaction means-- (A) Any advance of money or other property in exchange for debt; (B) Any advance of money or other property in exchange for stock (or a similar interest in a partnership or trust) if-- (1) As of the issue date, the holder has the right (or, as of the issue date, it is more likely than not that the holder will receive the right) to cause the issuer to redeem the stock, or will receive such a right upon the occurrence of a specified event and such event is more likely than not to occur, or, as of the issue date, it is more likely than not that the stock will be redeemed as a result of an issuer's right to redeem the stock (assuming for all purposes of this paragraph (a)(2)(ii)(B)(1) that the issuer will have the legally available funds to redeem the stock); (2) The holder possesses the right (or, as of the issue date, it is more likely than not that the holder will obtain the right) to cause, directly or indirectly, the issuer to make any payment (other than a payment described in paragraph (a)(2)(ii)(B)(1) of this section) with respect to the stock (assuming for this purpose that the issuer will have the legally available funds to make such a payment), including the right, arising upon a default on a payment (other than rights arising, in the ordinary course, between the date that a payment is declared and the date that a payment is made), to enforce the payment through a legal proceeding, cause the issuer to be liquidated, or elect a majority of the issuer's board of directors, but not including a right derived from ownership of a controlling interest in the issuer in cases where the control does not arise from a default or similar contingency under the instrument; or (3) Under circumstances similar to those described in paragraph (a)(2)(ii)(B)(1) or (2) of this section, the holder has the right to require a person related to the issuer (or any other person who is acting pursuant to a plan or arrangement with the issuer) to acquire the stock or make a payment with respect to the stock; (C) Any lease or license; (D) Any advance of money or other property not described in paragraph (a)(2)(ii)(A), (B) or (C) of this section (including an advance by any person to a trust described in sections 671 through 679) pursuant to which the transferee is obligated to repay or return a substantial portion of the money or other property advanced, or the equivalent in value. This paragraph (a)(2)(ii)(D) shall not apply to the posting of collateral unless the intermediate entity is permitted to reduce such collateral to cash (through a transfer, grant of a security interest or similar transaction) prior to default on the financing transaction secured by the collateral; and (E) Any transaction by which a person becomes a party to an existing financing transaction. (iii) Conduit entity means an intermediate entity whose participation in a financing arrangement is disregarded in whole or in part pursuant to this section. (iv) Guarantee means any arrangement under which a person, directly or indirectly, assures, on a conditional or unconditional basis, the payment of another person's obligation with respect to a financing transaction. The term shall be interpreted in accordance with the definition of the term in section 163(j)(6)(D)(iii). However, a guarantee that was neither in existence nor contemplated at the time the financing transaction between the intermediate entity and the financed entity was entered into is not a guarantee for these purposes. (v) Related means related within the meaning of sections 267(b) or 707(b)(1), or controlled within the meaning of section 482, and the regulations under those sections. For purposes of determining whether a person is related to another person, the constructive ownership rules of section 318 shall apply, and the attribution rules of section 267(c) also shall apply to the extent they attribute ownership to persons to whom section 318 does not attribute ownership. (vi) Tax avoidance plan is defined in paragraph (c)(1) of this section. (3) Treatment of intermediate entity as conduit entity--(i) Authority of district director. For purposes of section 881, the district director may determine that an intermediate entity is a conduit entity under the standard set forth in paragraph (a)(4) of this section. In applying that paragraph, the district director may determine the composition of the financing arrangement and the number of parties to the financing arrangement. (ii) Taxpayer's use of this section. A taxpayer may not apply this section to reduce the amount of its Federal income tax liability by disregarding the form of its financing transactions for Federal income tax purposes or by compelling the district director to do so. (4) Standard for conduit treatment--(i) In general. The district director, in his or her discretion, may treat an intermediate entity in a financing arrangement as a conduit entity if-- (A) The participation of the intermediate entity in the financing arrangement reduces the tax imposed by section 881; (B) The participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan; and (C) Either-- (1) The intermediate entity is related to the financing entity or the financed entity; or (2) The intermediate entity would not have participated in the financing arrangement on substantially the same terms but for the fact that the financing entity engaged in the financing transaction with the intermediate entity. (ii) Multiple intermediate entities--(A) In general. If a financing arrangement involves multiple intermediate entities, the district director may apply principles consistent with those of paragraph (a)(4)(i) of this section to the entire financing arrangement so as to treat two or more intermediate entities as conduit entities. For an illustration of this rule see Example 2 of paragraph (f) of this section. (B) Special rule for related persons. If two (or more) financing transactions involving two (or more) related persons would form part of a financing arrangement but for the absence of a financing transaction between the related persons, the district director may treat the related persons as a single intermediate entity if he or she determines that the avoidance of the application of this section is one of the principal purposes for the structuring of the financing transactions. This determination shall be based upon all of the facts and circumstances, including, without limitation, the factors set forth in paragraph (c)(2) of this section. The district director may apply similar principles if a financing transaction exists between related persons, but one of the principal purposes for the existence of the financing transaction is to prevent the district director from treating the related persons as a single intermediate entity. For examples illustrating the special rule of this paragraph, see Examples 3, 4 and 5 of paragraph (f) of this section. (b) Determination of whether intermediate entity would not have participated in financing arrangement on substantially same terms. The determination of whether an intermediate entity would not have participated in a financing arrangement on substantially the same terms but for the financing transaction between the financing entity and the intermediate entity shall be based upon all of the facts and circumstances. It shall be presumed that the intermediate entity would not have participated in the financing arrangement on substantially the same terms if the financing entity guarantees the liability of the financed entity to the intermediate entity under that financing transaction. A taxpayer may rebut this presumption by producing clear and convincing evidence to the contrary. (c) Determination of whether participation of intermediate entity is pursuant to a tax avoidance plan--(1) In general. A tax avoidance plan is a plan one of the principal purposes of which is the avoidance of tax imposed by section 881. The plan may be formal or informal, written or oral, and may involve any one or more of the parties to the financing arrangement. It may be inferred from the facts and circumstances, but must be in existence no later than the last date that any of the financing transactions comprising the financing arrangement are entered into. The determination of whether the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan shall be based upon all of the facts and circumstances relevant to the existence of a plan and to the purposes for the participation of the intermediate entity in the financing arrangement. (2) Factors taken into account in determining the presence or absence of a tax avoidance plan. Among the facts and circumstances taken into account in determining whether the participation of an intermediate entity in a financing arrangement is pursuant to a tax avoidance plan are-- (i) Whether the participation of the intermediate entity in the financing arrangement significantly reduces the tax that otherwise would have been imposed under section 881 (determined by comparing the rate of tax imposed on payments made by the financed entity to the intermediate entity with the rate that would have been imposed had the payments been made by the financed entity to the financing entity). However, the fact that an intermediate entity is a resident of a country that has a treaty with the United States that significantly reduces the tax that otherwise would have been imposed under section 881 is not sufficient, by itself, to establish the existence of a tax avoidance plan; (ii) Whether the intermediate entity would have been able to make the advance of the money or other property to the financed entity without the advance of money or other property to it by the financing entity; (iii) The length of the period of time that separates the advances of money or other property by the financing entity to the intermediate entity and by the intermediate entity to the financed entity. A short period of time is indicative of a tax avoidance plan while a long period of time is not; and (iv) If the intermediate entity is related to the financed entity, whether the two entities enter into a financing transaction to finance a trade or business actively engaged in by the financed entity that forms a part of, or is complementary to, a substantial trade or business actively engaged in by the intermediate entity (other than the business of making or managing investments, except pursuant to a banking, insurance, financing or similar trade or business the income from which is earned predominantly in transactions with unrelated persons). A financing transaction described in the preceding sentence is indicative that no tax avoidance plan exists. (3) Presumption if significant financing activities performed by a related intermediate entity-- (i) General rule. It shall be presumed that the participation of an intermediate entity (or entities) in a financing arrangement is not pursuant to a tax avoidance plan if the intermediate entity is related to either or both the financing entity or the financed entity, and the intermediate entity performs significant financing activities with respect to the financing transactions forming part of the financing arrangement to which it is a party. This presumption may be rebutted if the district director establishes that the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan. For illustrations of this presumption, see Examples 12, 13 and 14 of paragraph (f) of this section. (ii) Requirements. For purposes of this paragraph (c)(3), an intermediate entity performs significant financing activities with respect to such financing transactions if-- (A) Rents or royalties earned with respect to leases or licenses constituting such financing transactions are derived in the active conduct of a trade or business within the meaning of Sec. 1.954-2T(c) or (d), to be applied by substituting the term intermediate entity for the term controlled foreign corporation; or (B) Officers and employees of the intermediate entity, without the material participation of any officer or employee of a related person, other than participation in the approval of any guarantee of a financing transaction-- (1) Participate actively and materially in arranging the intermediate entity's participation in such financing transactions. This requirement shall not apply to a financing transaction that is the advance of property in exchange for a trade receivable that is ordinary and necessary to carrying on a substantial trade or business of either the financed entity or the financing entity if officers or employees of that entity participated actively and materially in arranging the financing transaction; and (2) Within the country in which the intermediate entity is organized (or, if different, within the country with respect to which the intermediate entity is claiming the benefits of a tax treaty)-- (i) Exercise management and oversight of (and actually carry out) the intermediate entity's strategic business decision-making process and of its day-to-day operations, which must consist of a substantial trade or business, or supervision, administration and financing of a substantial group of related persons; and (ii) Actively manage, on an ongoing basis, material business risks arising from such financing transactions as an integral part of the management of the intermediate entity's financial and capital requirements (including management of risks of currency and interest rate fluctuations) and management of the intermediate entity's short- term investments of working capital. (4) Special rules for cases where financing entity is unrelated to both intermediate entity and financed entity--(i) Presumption of no tax avoidance. It shall be presumed that the participation of an intermediate entity (or entities) in a financing arrangement is not pursuant to a tax avoidance plan if the financing entity is unrelated to the intermediate entity (or entities) and the financed entity, and the intermediate entity (or, in the case of multiple intermediate entities, the intermediate entity that has engaged in a financing transaction with the financing entity) is actively engaged in a substantial trade or business (other than the business of making or managing investments, except pursuant to a banking, insurance, financing or similar trade or business the income from which is earned predominantly in transactions with unrelated persons). This presumption may be rebutted if the district director establishes that the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan. For an illustration of this special rule see Example 15 of paragraph (f) of this section. (ii) Liability of financing entity--(A) In general. Notwithstanding that the district director may treat an intermediate entity in a financing arrangement as a conduit entity under paragraph (a)(4) of this section, a financing entity that is unrelated to the financed entity and the intermediate entity (or entities) shall not be liable for tax under section 881 pursuant to this section unless the financing entity knows or has reason to know that the financing arrangement is subject to recharacterization under paragraph (a)(3) of this section. This paragraph (c)(4)(ii) shall not apply, however, for purposes of determining whether any person is liable for withholding tax pursuant to Sec. 1.1441-3(j) or whether any party to a financing arrangement is entitled under sections 1461 to 1464 to a refund of tax actually withheld by a withholding agent pursuant to section 1441. Accordingly, if the conditions of paragraph (a)(4) of this section are satisfied, the financed entity shall be required to pay withholding tax without regard to the knowledge of the financing entity and no party to the financing arrangement shall be entitled to a refund except to the extent the amount withheld exceeds the amount determined under section 881 by recharacterizing the transaction and disregarding the conduit entity pursuant to paragraph (a)(4). (B) Know or have reason to know standard. The standard described in paragraph (c)(4)(ii)(A) shall be satisfied if the person knows or has reason to know those facts relevant to whether the financing arrangement satisfies the conditions set forth in paragraph (a)(4) of this section, including whether the participation of the intermediate entity in the financing arrangement is pursuant to a tax avoidance plan. A person shall not be considered to have reason to know that the financing arrangement is subject to recharacterization under paragraph (a)(3) of this section if the person knows of the financing transactions that comprise the financing arrangement but does not know or have reason to know of facts sufficient to establish that the participation of the intermediate entity in the financing arrangement was pursuant to such a plan. (d) Determination of amount of tax liability--(1) Amount of payment subject to recharacterization--(i) In general. If the district director treats an intermediate entity as a conduit entity pursuant to paragraph (a)(3) of this section, a portion of each payment made by the financed entity with respect to the financing transactions that comprise the financing arrangement shall be subject to recharacterization as a transaction directly between the financed entity and the financing entity. The recharacterized portion shall be the portion of the payment that is equal to the ratio (not to exceed 1:1) of the average principal amount of such financing transaction(s) between the conduit entity and the financing entity to the average principal amount of such financing transaction(s) between the financed entity and the conduit entity, for the period to which the payment made by the financed entity relates. The average may be computed using any method applied consistently that reflects with reasonable accuracy the amount outstanding for the period. For an illustration of the calculation of the amount of tax liability see Example 16 of paragraph (f) of this section. (ii) Multiple conduit entities. Except in the case of a financing arrangement described in paragraph (a)(4)(ii)(B) of this section, if a financing arrangement involves multiple intermediate entities that are treated as conduit entities, the ratio described in paragraph (d)(1)(i) of this section shall be based upon a comparison of the financing transaction between a conduit entity and a party other than the financed entity that has the lowest average principal amount, and the financing transaction involving the financed entity. (iii) Determination of principal amount. The principal amount of a financing transaction shall be determined on the basis of all of the facts and circumstances. The principal amount generally will equal the amount of money, or the fair market value of other property (determined as of the time that the financing transaction is entered into), advanced in the financing transaction. In the case of a debt instrument or stock, the fair market value of the property advanced will be considered to equal the issue price unless the fair market value differs materially from the issue price. The principal amount of a financing transaction shall be subject to adjustments, as appropriate. For example, in the case of an OID debt instrument that is repaid in installments and has an issue price equal to the fair market value of the property advanced, appropriate adjustments will be made for accruals of original issue discount and repayments of principal (including accrued original issue discount). (2) Rate of tax. If a financing arrangement is recharacterized under paragraph (a)(3) of this section, the payments by the financed entity described in section 881 shall be subject to tax at the rate that would have been applicable had payments been made directly to the financing entity. The applicable rate shall be determined by reference to the character of the financing transaction (e.g., loan or lease) between the intermediate entity and the financed entity. (3) Effect of income tax treaties. A financing arrangement shall be subject to recharacterization under this section regardless of whether a conduit entity is a resident of a country that has an income tax treaty with the United States. Accordingly, if the financing arrangement is recharacterized as a transaction directly between the financed entity and a person that is not entitled to claim the benefits of the income tax treaty, the treaty shall not operate to reduce the amount of tax due under section 881. (4) Withholding tax due. For withholding rules applicable to financing arrangements described in paragraph (a)(4) of this section, see Secs. 1.1441-3(j) and 1.1441-7(d). (e) Coordination with sections 871, 884, 1441 and 1442. For purposes of this section, any reference to tax imposed under section 881 includes, as the context may require, a reference to tax imposed under sections 871, 884(f)(1)(A), 1441, or 1442. (f) Examples. The following examples illustrate this section. For purposes of these examples, unless otherwise indicated, it is assumed that FP, a corporation organized in country X, owns all of the stock of FS, a corporation organized in country Y, and DS, a corporation organized in the United States. Country Y, but not country X, has an income tax treaty with the United States. The treaty exempts interest, rents and royalties paid by a resident of one state (the source state) to a resident of the other state from tax in the source state. Example 1. Financing arrangement. (i) On January 1, 1995, FP lends $1,000,000 to DS in exchange for a note issued by DS. On January 1, 1996, FP assigns the DS note to FS in exchange for a note issued by FS. After receiving notice of the assignment, DS remits payments due under its note to FS. (ii) FP's loan to DS and FP's assignment of the DS note to FS are financing transactions within the meaning of paragraph (a)(2)(ii) of this section, and the transactions together constitute a financing arrangement within the meaning of paragraph (a)(2)(i) of this section. Therefore, for purposes of section 881, the district director may treat FS as a conduit entity if the conditions of paragraph (a)(4)(i) of this section are satisfied. Example 2. Multiple conduits. (i) On January 1, 1995, FP deposits $1,000,000 with BK, a bank that is organized in country Y and is unrelated to FP and its subsidiaries. On January 1, 1996, at a time when the FP-BK deposit is still outstanding, BK lends $500,000 to BK2, a bank that is wholly- owned by BK and is organized in country Y. On the same date, BK2 lends $500,000 to FS. On July 1, 1996, FS lends $500,000 to DS. FP pledges its deposit to BK2 in support of FS' obligation to repay the BK2 loan. FS', BK's and BK2's participation in the financing arrangement is pursuant to a tax avoidance plan. (ii) Since there are multiple intermediate entities, under paragraph (a)(4)(ii)(A) of this section, principles consistent with those of paragraph (a)(4)(i) of this section apply to the entire financing arrangement for purposes of determining whether the requirements of paragraph (a)(4) of this section are satisfied. Since BK and BK2 are unrelated to FP, FS and DS, the conditions of paragraph (a)(4)(i)(C)(2) of this section must be satisfied with respect to the financing transactions between FP, BK, BK2 and FS. The conditions of that paragraph are presumed under paragraph (b) of this section to be satisfied because FP's pledge of an asset in support of FS' obligation to repay the BK2 loan is a guarantee within the meaning of paragraph (a)(2)(iv) of this section. Since BK and BK2 are related, it is not necessary that the conditions of paragraph (a)(4)(i)(C)(2) of this section be satisfied independently with respect to the financing transactions between FP, BK and BK2. In addition, the conditions of paragraphs (a)(4)(i)(A) and (B) of this section are satisfied because the participation of BK, BK2 and FS in the financing arrangement reduces the tax imposed by section 881, and FS', BK's and BK2's participation in the financing arrangement is pursuant to a tax avoidance plan. Accordingly, for purposes of section 881, the district director may treat FP as a financing entity and BK, BK2 and FS as conduit entities, and recharacterize the financing arrangement as a financing transaction directly between DS and FP. Example 3. Related persons treated as a single conduit entity. (i) On January 1, 1995, FP deposits $1,000,000 with BK, a bank that is organized in country X and is unrelated to FP and its subsidiaries. M, a corporation also organized in country X, is wholly-owned by the sole shareholder of BK but is not a bank within the meaning of section 881(c)(3)(A). On July 1, 1995, M lends $1,000,000 to DS in exchange for a note maturing on July 1, 2005. The note is in registered form within the meaning of section 881(c)(2)(B)(i) and DS has received from M the statement required by section 881(c)(2)(B)(ii). The conditions of paragraph (a)(4)(i) of this section would be satisfied with respect to the financing transactions between FP, BK, M and DS but for the absence of a financing transaction between BK and M. One of the principal purposes for the absence of a financing transaction between BK and M is the avoidance of the application of this section. (ii) Pursuant to paragraph (a)(4)(ii)(B) of this section, the district director may treat the financing transactions between FP, BK, M and DS as a financing arrangement for purposes of this section even though BK and M do not engage in a financing transaction. In such a case, BK and M would be considered a single intermediate entity for purposes of this section. Example 4. Related persons treated as a single conduit entity. (i) On January 1, 1995, FP lends $10,000,000 to FS in exchange for a 10-year note that pays interest annually at a rate of 8 percent per annum. On January 2, 1995, FS contributes $10,000,000 to FS2, a wholly-owned subsidiary of FS organized in country Y, in exchange for common stock of FS2. On January 1, 1996, FS2 lends $10,000,000 to DS in exchange for an 8-year note that pays interest annually at a rate of 10 percent per annum. (ii) FS is a holding company that has no significant assets other than the stock of FS2. Throughout the period that the FP-FS loan is outstanding, FS causes FS2 to make distributions to FS, most of which are used to make interest and principal payments on the FP- FS loan. Without the distributions from FS2, FS would not have had the funds with which to make payments on the FP-FS loan. (iii) The conditions of paragraph (a)(4)(i) of this section would be satisfied with respect to the financing transactions between FP, FS, FS2 and DS but for the absence of a financing transaction between FS and FS2. One of the principal purposes for the absence of a financing transaction between FS and FS2 is the avoidance of the application of this section. (iv) Pursuant to paragraph (a)(4)(ii)(B) of this section, the district director may treat the financing transactions between FP, FS, FS2 and DS as a financing arrangement for purposes of this section even though FS and FS2 do not engage in a financing transaction. In such a case, FS and FS2 would be considered a single intermediate entity for purposes of this section. Example 5. Related persons treated as a single conduit entity. Assume the same facts as in Example 4 except that FS contributes $9,900,000 and lends $100,000 to FS2. Pursuant to paragraph (a)(4)(ii)(B) of this section, the district director may treat the financing transactions between FP, FS, FS2 and DS as a financing arrangement for purposes of this section even though FS and FS2 engage in a financing transaction since from the facts and circumstances the district director may determine that one of the principal purposes for the existence of the financing transaction is to prevent the district director from treating the related persons as a single intermediate entity. In such a case, FS and FS2 would be considered a single intermediate entity for purposes of this section. Example 6. Reduction of tax. (i) On January 1, 1995, FP licenses to FS the rights to use a patent in the U.S. to manufacture product A. FS agrees to pay FP a fixed amount in royalties each year under the license. On January 1, 1996, FS sublicenses to DS the rights to use the patent in the U.S. Under the sublicense, DS agrees to pay FS royalties based upon the units of product A manufactured by DS each year. Although the formula for computing the amount of royalties paid by DS to FS differs from the formula for computing the amount of royalties paid by FS to FP, each represents an arm's length rate. The fair market value of the patent rights do not increase between January 1, 1995, and January 1, 1996. (ii) Under the country Y-U.S. income tax treaty, the royalties paid by DS to FS are exempt from U.S. withholding tax. However, pursuant to Secs. 1.881-2(b) and 1.1441-2(a), the parties withhold tax at a 30 percent rate on the royalties paid to FP because the royalties are paid in consideration for the privilege of using the patent in the United States, and therefore the royalties constitute income from U.S. sources under section 861(a)(4). (iii) Because the principal amount of the license between FS and DS is equal to or less than the principal amount of the license between FP and FS, the royalties paid by DS and FS represent an arm's length rate, and the rate of tax imposed on royalties paid by FS to FP is the same as the rate that would have been imposed on royalties paid by DS to FP, the participation of FS in the FP-FS-DS financing arrangement is not considered to reduce the tax imposed by section 881 within the meaning of paragraph (a)(4)(i)(A) of this section. Example 7. A principal purpose of plan. (i) On January 1, 1995, FS lends $10,000,000 to DS in exchange for a 10-year note that pays interest annually at a rate of 8 percent per annum. As was intended at the time of the loan from FS to DS, on July 1, 1995, FP makes an interest-free demand loan of $10,000,000 to FS. A principal purpose for FS' participation in the FP-FS-DS financing arrangement is that FS generally coordinates the financing for all of FP's subsidiaries (although FS does not engage in significant financing activities with respect to such financing transactions). However, another principal purpose for FS' participation is to allow the parties to benefit from the lower withholding tax rate provided under the treaty between country Y and the United States. (ii) The financing arrangement satisfies the tax avoidance purpose requirement of paragraph (a)(4)(i)(B) of this section since FS participated in the financing arrangement pursuant to a plan one of the principal purposes of which is to allow the parties to benefit from the country Y-U.S. treaty. Example 8. Reduction of tax. (i) FX is a wholly-owned subsidiary of FP and is a resident of country Y. FX owns all of the stock of FS1, which also is a resident of country Y. FS1 owns all of the stock of DX, a corporation organized in the United States. On January 1, 1995, FP contributes $10,000,000 to the capital of FX. On July 1, 1995, FX lends $10,000,000 to FS1. On January 1, 1996, FS1 lends $10,000,000 to DX. Under the terms of the country Y-U.S. income tax treaty, a country Y resident is not entitled to the reduced withholding rate on interest income provided by the treaty if the resident is entitled to, even if it does not claim, special tax benefits under country Y law. In order to qualify for the reduced withholding rate on the interest it receives from DX, FS1 does not claim the special tax benefits under country Y law. FX, however, obtains the special tax benefits under country Y law, which substantially reduces the rate of tax imposed on the interest it receives from FS1. Accordingly, if FX had made a loan directly to DX, payments of interest by DX to FX would have been subject to tax under section 881 at a 30 percent rate. (ii) Pursuant to paragraph (a)(3)(i) of this section, the district director may determine that the FX-FS1 loan and the FS1-DX loan comprise a financing arrangement. Pursuant to paragraph (c)(2)(i)(A) of this section, the significant reduction in tax resulting from the participation of FS1 in the financing arrangement is evidence that the participation of FS1 in the financing arrangement is pursuant to a tax avoidance plan. However, other facts relevant to the presence of such a plan must also be taken into account. Example 9. Time period between financing transactions. (i) On January 1, 1995, FP lends $10,000,000 to FS in exchange for a 10- year note that pays no interest annually. When the note matures, FS is obligated to pay $24,000,000 to FP. On January 1, 1996, FS lends $10,000,000 to DS in exchange for a 10-year note that pays interest annually at a rate of 10 percent per annum. (ii) Pursuant to paragraph (c)(2)(i)(C) of this section, the twelve-month period between the loan by FP to FS and the loan by FS to DS is evidence that the participation of FS in the financing arrangement is pursuant to a tax avoidance plan. However, other facts relevant to the presence of such a plan must also be taken into account. Example 10. Active conduct of a trade or business. (i) FP is a holding company. FS is actively engaged in country Y in the business of manufacturing and selling product A. DS manufactures product B, which is a principal component used by FS in the manufacture of product A. FS' business activity is substantial. On January 1, 1995, FP lends $100,000,000 to FS to finance FS' business operations. On January 1, 1996, FS lends $30,000,000 to DS to finance its manufacturing business. (ii) Pursuant to paragraph (c)(2)(ii)(C) of this section, the fact that FS makes a loan to DS in order to finance a business actively engaged in by DS that forms a part of, or is complementary to, a substantial business actively engaged in by FS is evidence that the participation of FS in the financing arrangement is not pursuant to a tax avoidance plan. However, other facts relevant to the presence of such a plan must also be taken into account. Example 11. Ordinary course deposits of working capital. (i) Over a period of years, FP has maintained a deposit with BK, a bank that is organized in country Y and is unrelated to FP and its subsidiaries. FP has placed funds in the bank account in order to maintain sufficient liquidity to meet its working capital needs. On January 1, 1995, BK lends $5,000,000 to DS. FP guarantees to BK that DS will satisfy its repayment obligation on the loan. Both prior to and after the loan is made, the balance in FP's bank account remains within a range appropriate to meet FP's working capital needs. (ii) The fact that FP has historically maintained an account with BK to meet its working capital needs and that, prior to and after BK's loan to DS, the balance within the account remains within a range appropriate to meet those business needs, is evidence that the participation of BK in the FP-BK-DS financing arrangement is not pursuant to a tax avoidance plan. However, other facts relevant to the presence of such a plan must also be taken into account. (iii) Assume the same facts, except that on January 1, 2000, FP's deposit with BK substantially exceeds FP's expected working capital needs. On January 2, 2000, BK lends additional funds to DS. FP would have lent the funds to DS directly but for the imposition of the withholding tax on payments made directly to FP by DS. (iv) The presence of funds substantially in excess of FP's working capital needs and FP's willingness to lend funds directly to DS is evidence that the participation of BK in the FP-BK-FS financing arrangement is pursuant to a tax avoidance plan. However, other facts relevant to the presence of such a plan must also be taken into account. (v) In either case, the taxpayer may establish, pursuant to paragraph (b) of this section, that BK would have made the loan to DS on substantially the same terms in the absence of FP's deposit with BK. Example 12. Presumption with respect to significant financing activities. (i) FS has 100 employees located in country Y who are responsible for coordinating the financing of all of the subsidiaries of FP, which are engaged in a substantial trade or business and are located in both country Y and country X. FS maintains a centralized cash management accounting system for FP and its subsidiaries in which it records all intercompany payables and receivables; these payables and receivables ultimately are reduced to a single balance either due from or owing to FS and each of FP's subsidiaries. FS is responsible for disbursing or receiving any cash payments required by transactions between its affiliates and unrelated parties. FS must borrow any cash necessary to meet those external obligations and invests any excess cash for the benefit of the FP group. FS enters into interest rate and foreign exchange contracts as necessary to manage the risks arising from mismatches in incoming and outgoing cash flows. At the request of DS, on January 1, 1995, FS pays a supplier $1,000,000 for materials delivered to DS and charges DS an open account receivable for this amount. On February 3, 1995, FS reverses the account receivable from DS to FS when DS delivers to FP goods with a value in excess of $1,000,000. (ii) The accounts payable from DS to FS and from FS to other subsidiaries of FP constitute financing transactions within the meaning of paragraph (a)(2)(ii) of this section, and the transactions together constitute a financing arrangement within the meaning of paragraph (a)(2)(i) of this section. FS performs significant financing activities with respect to the financing transactions even though FS did not actively and materially participate in arranging the financing transactions because the financing transactions consisted of advances of property in exchange for trade receivables that were ordinary and necessary to carry on the trades or businesses of DS and the other subsidiaries of FP. Accordingly, pursuant to paragraph (c)(3)(i) of this section, FS's participation in the financing arrangement is presumed not to be pursuant to a tax avoidance plan. Example 13. Active management of material business risks. (i) The facts are the same as in Example 12, except that, in addition to its short-term funding needs, DS needs long-term financing to fund an acquisition of another U.S. company; the acquisition is scheduled to close on January 15, 1995. FS has a revolving credit agreement with a syndicate of banks located in Country X. On January 14, 1995, FS borrows $10 billion for 10 years under the revolving credit agreement, paying yen LIBOR plus 50 basis points on a quarterly basis. FS enters into a currency swap with BK, an unrelated bank that is not a member of the syndicate, under which FS will pay BK 10 billion and will receive $100 million on January 15, 1994; these payments will be reversed on January 15, 2004. FS will pay BK U.S. dollar LIBOR plus 50 basis points on a notional principal amount of $100 million semiannually and will receive yen LIBOR plus 50 basis points on a notional principal amount of $10 billion quarterly. Upon the closing of the acquisition on January 15, 1995, DS borrows $100 million from FS for 10 years, paying U.S. dollar LIBOR plus 50 basis points semiannually. (ii) Although FS performs significant financing activities with respect to certain financing transactions to which it is a party, FS does not perform significant financing activities with respect to the financing transactions between FS and the syndicate of banks and between FS and DS because FS has eliminated all material business risks arising from those financing transactions through its currency swap with BK. Accordingly, the financing arrangement does not benefit from the presumption of paragraph (c)(3)(i) and the district director must determine whether the participation of FS in the financing arrangement is pursuant to a tax avoidance plan on the basis of all the facts and circumstances. Example 14. A principal purpose of plan. (i) The facts are the same as in Example 12, except that, on January 1, 1995, FP lends to FS 20,000,000 deutsche marks (worth $10,000,000) in exchange for a 10-year note that pays interest annually at a rate of 5 percent per annum. Also, on January 1, 1995, FS lends $10,000,000 to DS in exchange for a 10-year note that pays interest annually at a rate of 8 percent per annum. FS would not have had sufficient funds to make the loan to DS without the loan from FP. FS does not enter into any long-term hedging transaction with respect to these financing transactions, but manages its currency risk arising from the transactions on a daily, weekly or quarterly basis by entering into forward currency contracts. (ii) Because FS performs significant financing activities with respect to the financing transactions between FS, DS and FP, the participation of FS in the financing arrangement is presumed not to be pursuant to a tax avoidance plan. The district director may rebut this presumption by establishing that the participation of FS is pursuant to a tax avoidance plan, based on all the facts and circumstances. The mere fact that FS is a resident of country Y is not sufficient to establish the existence of a tax avoidance plan. However, the existence of a plan can be inferred from other factors in addition to the fact that FS is a resident of country Y. For example, the loans are made on the same day and FS would not have been able to make the loan to DS without the loan from FP. Example 15. Presumption with respect to unrelated financing entity. (i) FP is a corporation organized in country Y that is actively engaged in a substantial manufacturing business. On January 1, 1995, FP obtains a 20-year $100,000,000 loan from BK, a bank that is organized in country X and is unrelated to FP and its subsidiaries. On January 1, 1996, FP lends $10,000,000 to DS. (ii) Pursuant to paragraph (c)(4)(i) of this section, FP's participation in the financing arrangement with BK and DS is presumed not to be pursuant to a tax avoidance plan because BK is unrelated to both FP and DS, and FP is actively engaged in a substantial manufacturing business. Example 16. Calculation of amount of tax liability. (i) On January 1, 1996, FP makes two three-year installment loans of $250,000 each to FS that pay interest at a rate of 9 percent per annum. Payments on each loan are $7,950 per month. On the same date, FS lends $1,000,000 to DS in exchange for a two-year note that pays interest semi-annually at a rate of 10 percent per annum, beginning on June 30, 1996. The district director determines that the financing transactions between FP and FS, and FS and DS, are made pursuant to a financing arrangement involving FP, FS and DS, that satisfies the conditions of paragraph (a)(4) of this section. (ii) Assume that for the period of January 1, 1996 through June 30, 1996, the average principal amount of the financing transactions between FP and FS that comprise the financing arrangement is $469,319. Further, assume that for the period of July 1, 1996 through December 31, 1996, the average principal amount of the financing transactions between FP and FS is $393,632. The average principal amount of the financing transaction between FS and DS for the same periods is $1,000,000. (iii) Pursuant to paragraph (d)(1)(i) of this section, the portion of the $50,000 interest payment made by DS to FS on June 30, 1996, that is recharacterized as a payment to FP is $23,450 computed as follows: ($50,000 x $469,319/$1,000,000) = $23,450. The portion of the interest payment made on December 31, 1996 that is recharacterized as a payment to FP is $19,650, computed as follows: ($50,000 x $393,632/$1,000,000)=$19,650. (iv) Under Sec. 1.1441-3(j), DS is liable for withholding tax at a 30 percent rate on the portion of the $50,000 payment to FS that is recharacterized as a payment to FP, i.e., $7,035 with respect to the June 30, 1996 payment and $5,895 with respect to the December 31, 1996 payment. (g) Effective date. This section is effective for payments made after the date which is 30 days after publication of final regulations in the Federal Register. This section shall not apply with respect to interest payments made by United States corporations to Netherlands Antilles corporations in connection with debt obligations issued prior to October 15, 1984 and payments of interest covered by section 127(g)(3) of the Tax Reform Act of 1984. Sec. 1.881-4 Reporting and recordkeeping requirements concerning conduit financing arrangements. (a) Scope. This section provides rules for the furnishing of information and the maintenance of records concerning certain financing arrangements to which the provisions of Sec. 1.881-3 apply. This section also provides rules for coordinating the application of sections 6038 and 6038A with the application of this section. (b) Reporting requirements--(1) Persons required to report. A financed entity that is a reporting corporation within the meaning of section 6038A(a) and the regulations under that section, or that is required to report pursuant to section 6038(a) and the regulations under that section, shall be required to comply with the requirements of this paragraph (b) with respect to any financing transaction to which the financed entity is a party, that the financed entity knows or has reason to know forms a part of a financing arrangement described in Sec. 1.881-3(a)(4) (determined without regard to Sec. 1.881- 3(a)(4)(i)(B)). For purposes of this paragraph (b), a financed entity will be considered to know or have reason to know that the conditions of Sec. 1.881-3(a)(4)(i)(C)(2) are satisfied with respect to a financing arrangement if the financed entity knows or has reason to know that the financing entity has guaranteed the liability of the financed entity under the financing transaction. This paragraph (b) applies only if a person with respect to which the financed entity is required to report under sections 6038 or 6038A is a party to the financing arrangement. (2) Reporting requirement. A financed entity described in paragraph (b)(1) of this section shall be required to attach to the Form 5471 or 5472, whichever is applicable, for each year in which it is a party to a financing transaction described in paragraph (b)(1) of this section, a statement setting forth the following information (rendered in the English language and expressed in United States currency, with disclosure of applicable exchange rates) concerning each financing transaction-- (i) The character (e.g., loan, stock, lease, license) of the financing transaction; (ii) The name of the person that advanced money or other property to the financed entity in the financing transaction, and the name of the person (if different) to which the financed entity has made payments pursuant to the financing arrangement; (iii) The date and amount of each advance of money or other property to the financed entity; (iv) The amount of money or other property paid by the financed entity pursuant to the financing transaction, and the date on which each payment was made; (v) A description of any guarantee provided by the financing entity in connection with the financing arrangement; and (vi) With respect to each party to the financing arrangement that is related to the financed entity within the meaning of Sec. 1.881- 3(a)(2)(v)-- (A) The name, address, taxpayer identification number, if any, and country of residence of the related person; and (B) A description of the manner in which the financed entity and the person are related. (3) Additional disclosure. A financed entity may be required to disclose on its Federal income tax return, or on other forms (including Form 5471 or Form 5472, if otherwise applicable), information concerning its participation in a financing arrangement described in paragraph (b)(1) of this section, regardless of whether the financed entity is required to report pursuant to paragraph (b)(1) of this section. Information disclosed on the return or other forms need not also be reported pursuant to paragraph (b)(2) of this section. (c) Recordkeeping requirements. A financed entity or any other person subject to the general recordkeeping requirements of section 6001 must keep the permanent books of account or records, as required by section 6001, that may be relevant to whether that person is a party to a financing arrangement that is subject to recharacterization under Sec. 1.881-3. In addition, a financed entity that is a reporting corporation within the meaning of section 6038A(a) and the regulations under that section, and any other person that is subject to the recordkeeping requirements of Sec. 1.6038A-3, must comply with such recordkeeping requirements with respect to records that may be relevant to whether the financed entity is a party to a financing arrangement that is subject to recharacterization under Sec. 1.881-3. (d) Application of sections 6038 and 6038A--(1) In general. Any information that a financed entity is required to report pursuant to paragraph (b) of this section, or any records that any person is required to maintain pursuant to paragraph (c) of this section, shall be considered information that is required to be reported, or records that are required to be maintained, pursuant to sections 6038 or 6038A if such person is required to report information or maintain records concerning transactions between the financed entity and any other party to the financing arrangement under either section 6038 or section 6038A. Accordingly, the provisions of sections 6038 and 6038A (including, without limitation, the penalty provisions thereof), and the regulations under those sections, shall apply to any information required to be reported or records required to be maintained pursuant to this section. (2) Duplication of reporting requirements. Information that is required to be reported on Form 5471 by Sec. 1.6038-2(f) or on Form 5472 by Sec. 1.6038A-2(b) need not be duplicated on the statements required by paragraph (b)(2) of this section. Information that is required to be reported about a particular financing transaction on the statement required by paragraph (b)(2) of this section shall not be considered to duplicate information required to be reported in the aggregate on Form 5471 or Form 5472 about more than one financing transaction. (e) Effective date. This section is effective for tax years in which payments described in Sec. 1.881-3 are made. This section shall not apply with respect to interest payments made by United States corporations to Netherlands Antilles corporations in connection with debt obligations issued prior to October 15, 1984 and payments of interest covered by section 127(g)(3) of the Tax Reform Act of 1984. Par. 4. In Sec. 1.1441-3, paragraph (j) is added to read as follows: Sec. 1.1441-3 Exceptions and rules of special application. * * * * * (j) Conduit financing arrangements. A financed entity or other person required to withhold tax under section 1441 with respect to a financing arrangement subject to recharacterization under Sec. 1.871- 1(b)(7) or 1.881-3(a)(3), shall be required to withhold in accordance with the recharacterization on the portion of each payment subject to recharacterization, as determined by Sec. 1.881-3(c). If the financing entity is entitled to the benefit of a treaty that provides a reduced rate of tax on a payment of the type recharacterized, the financed entity may withhold tax at that reduced rate if the financing entity complies with the procedures, if any, prescribed in the relevant treaty, or in regulations under section 1441. See Sec. 1.1441-7(d) relating to withholding tax liability of the withholding agent in conduit financing arrangements subject to Sec. 1.881-3. This paragraph (j) is effective for payments made after the date which is 30 days after publication of final regulations in the Federal Register. This section shall not apply with respect to interest payments made by United States corporations to Netherlands Antilles corporations in connection with debt obligations issued prior to October 15, 1984 and payments of interest covered by section 127(g)(3) of the Tax Reform Act of 1984. Par. 5. In Sec. 1.1441-7, paragraph (d) is added to read as follows: Sec. 1.1441-7 General provisions relating to withholding agents. * * * * * (d) Conduit financing arrangements. A person shall be required to withhold tax under section 1441 in accordance with the recharacterization of a financing arrangement under Sec. 1.871-1(b)(7) or 1.881-3(a)(3) if the person knows or has reason to know that the financing arrangement is subject to recharacterization under those sections and the person otherwise is a withholding agent with respect to the financing arrangement. This standard shall be satisfied if the person knows or has reason to know those facts relevant to whether the financing arrangement satisfies the conditions set forth in Sec. 1.881- 3(a)(4), including whether the participation of the intermediate entity is pursuant to a tax avoidance plan. A person shall not be considered to have reason to know that the financing arrangement is subject to recharacterization under Sec. 1.871-1(b)(7) or 1.881-3(a)(3) if the person knows of the financing transactions that comprise the financing arrangement but does not know or have reason to know facts sufficient to establish that the participation of the intermediate entity in the financing arrangement was pursuant to such a plan. This paragraph is effective for payments made after the date which is 30 days after publication of final regulations in the Federal Register. This section shall not apply with respect to interest payments made by United States corporations to Netherlands Antilles corporations in connection with debt obligations issued prior to October 15, 1984 and payments of interest covered by section 127(g)(3) of the Tax Reform Act of 1984. Par. 6. In Sec. 1.6038-2, paragraph (f)(12) is added to read as follows: Sec. 1.6038-2 Reporting requirements for conduit financing arrangements. * * * * * (f) * * * (12) Conduit financing arrangements. See Sec. 1.881-4 for additional information that must be reported on (or attached to) Form 5471 relating to conduit financing arrangements. * * * * * Par. 7. In Sec. 1.6038A-2, paragraph (b)(9) is added to read as follows: Sec. 1.6038A-2 Requirement of return. * * * * * (b) * * * (9) See Sec. 1.881-4 for additional information that must be reported on (or attached to) Form 5472 relating to conduit financing arrangements. * * * * * Par. 8. In Sec. 1.6038A-3, paragraphs (b)(5) and (c)(2)(vii) are added to read as follows: Sec. 1.6038A-3 Record maintenance. * * * * * (b) * * * (5) Records relating to conduit financing arrangements. See Sec. 1.881-4 relating to conduit financing arrangements. (c) * * * (2) * * * (vii) Records relating to conduit financing arrangements. See Sec. 1.881-4 relating to conduit financing arrangements. * * * * * Par. 9. Section 1.7701(l)-1 is added to read as follows: Sec. 1.7701(l)-1 Conduit financing arrangements. (a) Scope. Section 7701(l) authorizes the issuance of regulations that recharacterize any multiple-party financing transaction as a transaction directly among any two or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by title 26 of the United States Code. (b) Regulations issued under authority of section 7701(l). The following regulations are issued under the authority of section 7701(l)-- (1) Sec. 1.871-1(b)(7); (2) Sec. 1.881-3; (3) Sec. 1.881-4; (4) Sec. 1.1441-3(j); (5) Sec. 1.1441-7(d); (6) Sec. 1.6038A-2(f)(12); (7) Sec. 1.6038A-2(b)(9); (8) Sec. 1.6038A-3(b)(5); and (9) Sec. 1.6038A-3(c)(2)(vii). Margaret Milner Richardson, Commissioner of Internal Revenue. [FR Doc. 94-25403 Filed 10-11-94; 8:48 am] BILLING CODE 4830-01-U