[Federal Register Volume 81, Number 68 (Friday, April 8, 2016)]
[Proposed Rules]
[Pages 20911-20943]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-07425]



[[Page 20911]]

Vol. 81

Friday,

No. 68

April 8, 2016

Part IV





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





Treatment of Certain Interests in Corporations as Stock or 
Indebtedness; Proposed Rule

Federal Register / Vol. 81 , No. 68 / Friday, April 8, 2016 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-108060-15]
RIN 1545-BN40


Treatment of Certain Interests in Corporations as Stock or 
Indebtedness

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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

DATES: Written or electronic comments and requests for a public hearing 
must be received by July 7, 2016.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-108060-15), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
108060-15), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC 20224 or sent electronically via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-108060-15).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
under Sec. Sec.  1.385-1 and 1.385-2, Eric D. Brauer, (202) 317-5348; 
concerning the proposed regulations under Sec. Sec.  1.385-3 and 1.385-
4, Raymond J. Stahl, (202) 317-6938; concerning submissions of comments 
or requests for a public hearing, Regina Johnson, (202) 317-5177 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget in 
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)). Comments on the collection of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by June 7, 2016. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec.  1.385-2(b)(2). This collection of information is necessary to 
determine whether certain interests between members of an expanded 
affiliated group are to be treated as stock or indebtedness for federal 
tax purposes. The likely respondents are entities that are affiliates 
of publicly traded entities or meet certain thresholds on their 
financial statements.
    Estimated total annual reporting burden: 735,000 hours.
    Estimated average annual burden per respondent: 35 hours.
    Estimated number of respondents: 21,000.
    Estimated frequency of responses: Monthly.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.

Background

    As described further in this preamble, courts historically have 
analyzed whether an interest in a corporation should be treated as 
stock or indebtedness for federal tax purposes by applying various sets 
of factors to the facts of a particular case. In 1969, Congress enacted 
section 385 to authorize the Secretary of the Treasury (Secretary) to 
prescribe such regulations as may be necessary or appropriate to 
determine whether an interest in a corporation is to be treated as 
stock or indebtedness for purposes of the Code. Because no regulations 
are currently in effect under section 385, the case law that developed 
before the enactment of section 385 has continued to evolve and to 
control the characterization of an interest in a corporation as debt or 
equity.

I. Section 385 Statute and Legislative History

A. Original Enactment of Section 385
    Section 385(a), as originally enacted as part of the Tax Reform Act 
of 1969 (Pub. L. 91-172, 83 Stat. 487), authorizes the Secretary to 
prescribe such regulations as may be necessary or appropriate to 
determine whether an interest in a corporation is treated as stock or 
indebtedness for purposes of the Code.
    Section 385(b) provides that the regulations prescribed under 
section 385 shall set forth factors that are to be taken into account 
in determining in a particular factual situation whether a debtor-
creditor relationship exists or a corporation-shareholder relationship 
exists. Under section 385(b), those factors may include, among other 
factors, the following: (1) Whether there is a written unconditional 
promise to pay on demand or on a specified date a sum certain in money 
in return for an adequate consideration in money or money's worth, and 
to pay a fixed rate of interest; (2) whether there is subordination to 
or preference over any indebtedness of the corporation; (3) the ratio 
of debt to equity of the corporation; (4) whether there is 
convertibility into the stock of the corporation; and (5) the 
relationship between holdings of stock in the corporation and holdings 
of the interest in question.
    In enacting section 385(a) and (b), Congress authorized the 
Secretary to prescribe targeted rules to address particular factual 
situations, stating:

    In view of the uncertainties and difficulties which the 
distinction between debt and equity has produced in numerous 
situations . . . the committee further believes that it would be 
desirable to provide rules for distinguishing debt from equity in 
the variety of contexts in which this problem can arise. The 
differing circumstances which characterize these situations, 
however, would

[[Page 20913]]

make it difficult for the committee to provide comprehensive and 
specific statutory rules of universal and equal applicability. In 
view of this, the committee believes it is appropriate to 
specifically authorize the Secretary of the Treasury to prescribe 
the appropriate rules for distinguishing debt from equity in these 
different situations.

S. Rep. No. 91-552, at 138 (1969). The legislative history further 
explains that regulations applicable to a particular factual situation 
need not rely on the factors set forth in section 385(b):

    The provision also specifies certain factors which may be taken 
into account in these [regulatory] guidelines. It is not intended 
that only these factors be included in the guidelines or that, with 
respect to a particular situation, any of these factors must be 
included in the guidelines, or that any of the factors which are 
included by statute must necessarily be given any more weight than 
other factors added by regulations.

Id. Accordingly, section 385(b) provides the Secretary with discretion 
to establish specific rules for determining whether an interest is 
treated as stock or indebtedness for federal tax purposes in a 
particular factual situation.
B. 1989 and 1992 Amendments to Section 385
    Congress amended section 385 in 1989 and 1992. In 1989, the Omnibus 
Budget Reconciliation Act of 1989 (Pub. L. 101-239, 103 Stat. 2106) 
amended section 385(a) to expressly authorize the Secretary to issue 
regulations under which an interest in a corporation is to be treated 
as in part stock and in part indebtedness. This amendment also provides 
that any regulations so issued may apply only with respect to 
instruments issued after the date on which the Secretary or the 
Secretary's delegate provides public guidance as to the 
characterization of such instruments (whether by regulation, ruling, or 
otherwise). See Public Law 101-239, sec. 7208(a)(2). The legislative 
history to the 1989 amendment notes that, while ``[t]he 
characterization of an investment in a corporation as debt or equity 
for Federal income tax purposes generally is determined by reference to 
numerous factors, . . . there has been a tendency by the courts to 
characterize an instrument entirely as debt or entirely as equity.'' 
H.R. Rep. No. 101-386, at 3165-66 (1989) (Conf. Rep.).
    In 1992, Congress added section 385(c) to the Code as part of the 
Energy Policy Act of 1992 (Pub. L. 102-486, 106 Stat. 2776). Section 
385(c)(1) provides that the issuer's characterization (as of the time 
of issuance) as to whether an interest in a corporation is stock or 
indebtedness shall be binding on such issuer and on all holders of such 
interest (but shall not be binding on the Secretary). Section 385(c)(2) 
provides that, except as provided in regulations, section 385(c)(1) 
shall not apply to any holder of an interest if such holder on his 
return discloses that he is treating such interest in a manner 
inconsistent with the initial characterization of the issuer. Section 
385(c)(3) authorizes the Secretary to require such information as the 
Secretary determines to be necessary to carry out the provisions of 
section 385(c), including the information necessary for the Secretary 
to determine how the issuer characterized an interest as of the time of 
issuance.
    Congress added section 385(c) in response to issuers and holders 
characterizing a corporate instrument inconsistently. H.R. Rep. No. 
102-716, at 3 (1992). For example, a corporate issuer may designate an 
instrument as indebtedness for federal tax purposes and deduct as 
interest the amounts paid on the instrument, while a corporate holder 
may treat the instrument as stock for federal tax purposes and claim a 
dividends received deduction with respect to the amounts paid on the 
instrument. See id.

II. Regulations

    There are no regulations currently in effect under section 385. On 
March 24, 1980, the Department of the Treasury (Treasury Department) 
and the IRS published a notice of proposed rulemaking (LR-1661) in the 
Federal Register (45 FR 18959) under section 385 relating to the 
treatment of certain interests in corporations as stock or 
indebtedness. Final regulations (TD 7747) were published in the Federal 
Register (45 FR 86438) on December 31, 1980. Subsequent revisions of 
the final regulations were published in the Federal Register on May 4, 
1981, January 5, 1982, and July 2, 1982 (46 FR 24945, 47 FR 147, and 47 
FR 28915, respectively). The Treasury Department and the IRS published 
a notice of proposed withdrawal of TD 7747 in the Federal Register on 
July 6, 1983 (48 FR 31053), and in TD 7920, published in the Federal 
Register (48 FR 50711) on November 3, 1983, the Treasury Department and 
the IRS withdrew TD 7747.
    The Treasury Department and the IRS have not previously published 
any regulations regarding the 1989 amendment to section 385(a), which 
authorizes the Secretary to issue regulations that treat an interest in 
a corporation as indebtedness in part or as stock in part. In addition, 
no regulations have been published with respect to the 1992 addition of 
section 385(c) authorizing the Secretary to require information related 
to an issuer's initial characterization of an interest for federal tax 
purposes or to affect the ability of a holder to treat an interest 
inconsistent with the initial treatment of the issuer.

III. Case Law

    In the absence of regulations under section 385, the pre-1969 case 
law has continued to evolve and control the characterization of an 
interest as debt or equity for federal tax purposes. Under that case 
law, courts apply inconsistent sets of factors to determine if an 
interest should be treated as stock or indebtedness, subjecting 
substantially similar fact patterns to differing analyses. The result 
has been a body of case law that perpetuates the ``uncertainties and 
difficulties which the distinction between debt and equity has 
produced'' and with which Congress expressed concern when enacting 
section 385. See S. Rep. No. 91-552, at 138. For example, in Fin Hay 
Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), the U.S. 
Court of Appeals for the Third Circuit identified sixteen factors 
relevant for distinguishing between indebtedness and stock:

    (1) the intent of the parties; (2) the identity between 
creditors and shareholders; (3) the extent of participation in 
management by the holder of the instrument; (4) the ability of the 
corporation to obtain funds from outside sources; (5) the `thinness' 
of the capital structure in relation to debt; (6) the risk involved; 
(7) the formal indicia of the arrangement; (8) the relative position 
of the obligees as to other creditors regarding the payment of 
interest and principal; (9) the voting power of the holder of the 
instrument; (10) the provision of a fixed rate of interest; (11) a 
contingency on the obligation to repay; (12) the source of the 
interest payments; (13) the presence or absence of a fixed maturity 
date; (14) a provision for redemption by the corporation; (15) a 
provision for redemption at the option of the holder; and (16) the 
timing of the advance with reference to the organization of the 
corporation.

Id. at 696. By contrast, in Estate of Mixon v. United States, 464 F.2d 
394 (5th Cir. 1972), the U.S. Court of Appeals for the Fifth Circuit 
identified thirteen factors that are similar to, but not the same as, 
those used in Fin Hay to distinguish between indebtedness and stock:

    (1) the names given to the certificates evidencing the 
indebtedness; (2) The presence or absence of a fixed maturity date; 
(3) The source of payments; (4) The right to enforce payment of 
principal and interest; (5) participation in management flowing as a 
result; (6) the status of the contribution in relation to regular 
corporate creditors; (7) the intent of the parties; (8) `thin' or 
adequate capitalization; (9) identity of interest between creditor 
and stockholder; (10) source of interest payments; (11) the ability 
of the

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corporation to obtain loans from outside lending institutions; (12) 
the extent to which the advance was used to acquire capital assets; 
and (13) the failure of the debtor to repay on the due date or to 
seek a postponement.

Id. at 402. The weight given to the various factors in a particular 
case also differs, and is highly dependent upon the relevant facts and 
circumstances. See, e.g., J.S. Biritz Construction Co. v. Commissioner, 
387 F.2d 451, 456-57 (8th Cir. 1967) (stating that the factors ``have 
varying degrees of relevancy, depending on the particular factual 
situation and are generally not all applicable to any given case'').
    Under this facts-and-circumstances analysis, as developed in the 
case law, no single fact or circumstance is sufficient to establish 
that an interest should be treated as stock or indebtedness. See, e.g., 
John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946) (``[N]o one 
characteristic . . . can be said to be decisive in the determination of 
whether the obligations are risk investments in the corporations or 
debts.''); Fin Hay, 398 F.2d at 697 (``[N]either any single criterion 
nor any series of criteria can provide a conclusive answer in the 
kaleidoscopic circumstances which individual cases present.''). It was 
this emphasis on particular taxpayer facts and circumstances, coupled 
with inconsistent analysis of the relevant factors by different courts, 
that led Congress to delegate to the Secretary the authority to provide 
regulations under section 385 for distinguishing debt from equity that 
could depart from the factors developed in case law or enumerated in 
the statute. See S. Rep. No. 91-552, at 138.

IV. Other Relevant Statutory Provisions

    Section 701 provides that a partnership as such shall not be 
subject to federal income tax, but that persons carrying on business as 
partners shall be liable for federal income tax only in their separate 
or individual capacities.
    Section 1502 provides that the Secretary shall prescribe such 
regulations as the Secretary deems necessary in order that the federal 
tax liability of any affiliated group of corporations making a 
consolidated return and of each corporation in the group, both during 
and after the period of affiliation, may be returned, determined, 
computed, assessed, collected, and adjusted, in such manner as clearly 
to reflect the federal income tax liability and the various factors 
necessary for the determination of such liability, and in order to 
prevent avoidance of such tax liability. In prescribing such 
regulations, section 1502 authorizes the Secretary to prescribe rules 
that are different from the provisions of chapter 1 of subtitle A of 
the Code that would apply if such corporations filed separate returns.
    Section 7701(l) provides that the Secretary may prescribe 
regulations recharacterizing any multiple-party financing transaction 
as a transaction directly among any two or more of such parties where 
the Secretary determines that such recharacterization is appropriate to 
prevent avoidance of any tax imposed by the Code.

V. Earnings Stripping Guidance Described in Notice 2014-52 and Notice 
2015-79

    Notice 2014-52, 2014-42 IRB 712 (Oct. 14, 2014), and Notice 2015-
79, 2015-49 IRB 775 (Dec. 7, 2015), described regulations that the 
Treasury Department and the IRS intend to issue with respect to 
corporate inversions and related transactions. Notice 2014-52 and 
Notice 2015-79 also provided that the Treasury Department and the IRS 
expect to issue additional guidance to further limit the benefits of 
post-inversion tax avoidance transactions. The notices stated, in 
particular, that the Treasury Department and the IRS are considering 
guidance to address strategies that avoid U.S. tax on U.S. operations 
by shifting or ``stripping'' U.S.-source earnings to lower-tax 
jurisdictions, including through intercompany debt.

VI. Purpose of the Proposed Regulations

    These proposed regulations under section 385 address whether an 
interest in a related corporation is treated as stock or indebtedness, 
or as in part stock or in part indebtedness, for purposes of the Code. 
While these proposed regulations are motivated in part by the enhanced 
incentives for related parties to engage in transactions that result in 
excessive indebtedness in the cross-border context, federal income tax 
liability can also be reduced or eliminated with excessive indebtedness 
between domestic related parties. Thus, the proposed rules apply to 
purported indebtedness issued to certain related parties, without 
regard to whether the parties are domestic or foreign. Nonetheless, the 
Treasury Department and the IRS also have determined that the proposed 
regulations should not apply to issuances of interests and related 
transactions among members of a consolidated group because the concerns 
addressed in the proposed regulations generally are not present when 
the issuer's deduction for interest expense and the holder's 
corresponding interest income offset on the group's consolidated 
federal income tax return.
    Section A of this Part VI addresses bifurcation of interests that 
are indebtedness in part but not in whole. Section B of this Part VI 
addresses documentation requirements for related-party indebtedness. 
Section C of this Part VI addresses distributions of debt instruments 
and similar transactions.
A. Interests That Are Indebtedness in Part but Not in Whole
    As previously noted, Congress amended section 385(a) in 1989 to 
authorize the issuance of regulations permitting an interest in a 
corporation to be treated as in part indebtedness and in part stock. 
The legislative history to the 1989 amendment explained that ``there 
has been a tendency by the courts to characterize an instrument 
entirely as debt or entirely as equity.'' H.R. Rep. No. 101-386, at 562 
(1989) (Conf. Rep.). No regulations have been promulgated under the 
amendment, however, and this tendency by the courts has continued to 
the present day. Consequently, the Commissioner generally is required 
to treat an interest in a corporation as either wholly indebtedness or 
wholly equity.
    This all-or-nothing approach is particularly problematic in cases 
where the facts and circumstances surrounding a purported debt 
instrument provide only slightly more support for characterization of 
the entire interest as indebtedness than for equity characterization, a 
situation that is increasingly common in the related-party context. The 
Treasury Department and the IRS have determined that the all-or-nothing 
approach frequently fails to reflect the economic substance of related-
party interests that are in form indebtedness and gives rise to 
inappropriate federal tax consequences. Accordingly, the Treasury 
Department and the IRS have determined that the interests of tax 
administration would best be served if the Commissioner were able to 
depart from the all-or-nothing approach where appropriate to ensure 
that the provisions of the Code are applied in a manner that clearly 
reflects the income of related taxpayers. To that end, these proposed 
regulations would exercise the authority granted by section 385(a) to 
permit the Commissioner to treat a purported debt instrument issued 
between related parties as in part indebtedness and in part stock for 
federal tax purposes. However, the proposed regulations would not 
permit issuers and related holders to treat such an instrument in a 
manner inconsistent with the issuer's initial characterization. The 
proposed regulations described in

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Part IV.B.2 of the Explanation of Provisions section of this preamble 
also rely in part on the authority granted under section 385(a) to 
treat interests as in part indebtedness and in part stock for federal 
tax purposes.
    The proposed rule applies with respect to parties that meet a lower 
50-percent threshold for relatedness than the threshold applicable with 
respect to other rules contained in these proposed regulations. This is 
because, as noted in Part VI of the Background section of this 
preamble, federal income tax liability can be reduced or eliminated by 
the introduction of excessive indebtedness between related parties, and 
this can be accomplished without special cooperation among the related 
parties and regardless of other transactions undertaken by the issuer 
or holder after issuance. In addition, a 50-percent relatedness 
threshold is consistent with other provisions used in subchapter C of 
the Code to identify a level of control or ownership that can warrant 
different federal tax consequences than those for less-related parties.
    The proposed rule merely permits the Commissioner to treat a 
purported debt instrument as in part indebtedness and in part stock 
consistent with its substance. Moreover, the proposed regulations would 
not affect the authority of the Commissioner to disregard a purported 
debt instrument as indebtedness or stock, to treat a purported debt 
instrument as indebtedness or equity of another entity, or otherwise to 
treat a purported debt instrument in accordance with its substance. 
See, e.g., Plantation Patterns v. Commissioner, 462 F.2d 712 (5th Cir. 
1972).
    The Treasury Department and the IRS recognize that authorizing the 
Commissioner to treat purported debt instruments issued among unrelated 
parties as indebtedness in part and stock in part could result in 
unnecessary uncertainty in the capital markets in the absence of 
detailed standards for the exercise of that authority. Similarly, any 
exercise of this authority with respect to related-party interests that 
are denominated as other than indebtedness would require more detailed 
guidance. Thus, the proposed rule does not apply in those contexts.
B. Related-Party Indebtedness
1. Background
    Related-party indebtedness, like indebtedness between unrelated 
persons, may be respected as indebtedness for federal tax purposes, but 
only if there is intent to create a true debtor-creditor relationship 
that results in bona fide indebtedness. While still subject to the same 
multifactor analysis used for characterizing interests issued between 
third parties, ``courts have consistently recognized that transactional 
forms between related parties are susceptible of manipulation and, 
accordingly, warrant a more thorough and discerning examination for tax 
characterization purposes.'' PepsiCo Puerto Rico, Inc. v. Commissioner, 
T.C. Memo 2012-269, at 51, citing United States v. Uneco, Inc., 532 
F.2d 1204, 1207 (8th Cir. 1976); Cuyuna Realty Co. v. United States, 
382 F.2d 298, 301 (Ct. Cl. 1967) (stating that an advance between a 
parent corporation and a subsidiary or other affiliate under common 
control must be subject to particular scrutiny ``because the control 
element suggests the opportunity to contrive a fictional debt, an 
opportunity less present in an arms-length transaction between 
strangers.'').
    This scrutiny is warranted because there is typically less economic 
incentive for a related-party lender to impose discipline on the legal 
documentation and economic analysis supporting the characterization of 
an interest as indebtedness for federal tax purposes. While a lender 
typically carefully documents a loan to a third party borrower and 
decides whether and how much to lend based on that documentation and 
objective financial criteria, a related-party lender, especially one 
that directly or indirectly controls the borrower, may require only 
simple (or even no) legal documentation and may forgo any economic 
analysis that would inform the lender of the amount that the borrower 
could reasonably be expected to repay.
    The absence of reasonable diligence by related-party lenders can 
have the effect of limiting the factual record that is available for 
additional scrutiny and thorough examination. Nonetheless, courts do 
not always require related parties to engage in reasonable financial 
analysis and legal documentation similar to that which business 
exigencies would incent third-parties in connection with lending to 
unrelated borrowers. See, e.g., C.M. Gooch Lumber Sales Co. v. 
Commissioner, 49 T.C. 649 (1968) at 656 (noting that in the case of 
related-party debt, ``the absence of a written debt instrument, 
security, or provision for the payment of interest is not controlling; 
formal evidences of indebtedness are at best clues to proof of the 
ultimate fact''); see also Byerlite Corp. v. Williams, 286 F.2d 285, 
290-91 (6th Cir. 1960), citing Ewing v. Commissioner, 5 T.C. Memo 908 
(1946) (``The fact that advancements to a corporation are made without 
requiring any evidence of indebtedness . . . was not a controlling 
consideration . . .'').
    Historically, the absence of clear guidance regarding the 
documentation and information necessary to support debt 
characterization in the related-party context did not pose a 
significant obstacle, because the transactions presented by cases such 
as Mixon, Fin Hay, and their progeny were not factually complex. 
Typically, the earlier cases involved direct advances between 
individual U.S. taxpayers and their closely held domestic corporations. 
The relevant documentation was readily identifiable, available on hand, 
and able to be analyzed by the Commissioner in due course. Further, 
when the case law was developing, the dollar amounts at stake were 
comparatively modest. In Fin Hay, the shareholder advances gave rise to 
a total federal tax liability of $3,241; in Mixon, the shareholder 
advances gave rise to a total federal tax liability of $126,964.
    Increasingly, this is no longer the case. Over time, the Treasury 
Department and the IRS have observed that business practices, 
structures, and activities between related parties have changed 
considerably. The Treasury Department and the IRS acknowledge that the 
size, activities, and financial complexity of corporations and their 
group structures have grown exponentially, and understand that these 
groups routinely include foreign entities, sometimes from multiple 
foreign jurisdictions, as well as federal tax-indifferent domestic 
members. The scope and complexity of intragroup transactions has grown 
commensurately. Examples include the transactions at issue in PepsiCo 
Puerto Rico, Inc. v. Commissioner and NA General Partnership & 
Subsidiaries v. Commissioner, T.C. Memo 2012-172, both involving the 
global restructuring of multinational corporate groups.
    As a result of these developments, it is increasingly problematic 
that there is a lack of guidance prescribing the information and 
documentation necessary to support the characterization of a purported 
debt instrument as indebtedness in the related-party context. The lack 
of such guidance, combined with the sheer volume of financial records 
taxpayers produce in the ordinary course of business, makes it 
difficult to identify the documents that will ultimately be required to 
support such a characterization, particularly with respect to whether a 
reasonable expectation of repayment is present at the time an interest 
is issued. The result can be either the inadvertent omission of 
necessary documents from disclosure

[[Page 20916]]

to the IRS or the provision of vast amounts of irrelevant documents and 
material, such that forensic accounting expertise is required to 
isolate and evaluate relevant information. In either case, the ability 
of the Commissioner to administer the Code efficiently with respect to 
related-party interests is impeded. In addition, the absence of 
guidance makes it difficult for U.S. taxpayers to determine timely what 
steps they must take to ensure that essential records are not only 
prepared, but also maintained in a manner that will facilitate their 
being made available upon request, particularly regarding transactions 
with related parties whose books and records are located in foreign 
jurisdictions.
    Finally, the dollar amounts at stake have often become increasingly 
significant. For example, the federal tax liability at issue in PepsiCo 
was $363,056,012; the federal tax liability at issue in NA General 
Partnership was $188,000,000. As a result, it has become increasingly 
important to prescribe rules that identify the types of documentation 
and information necessary to support the characterization of a related-
party interest as indebtedness for federal tax purposes.
2. Proposed Regulations Addressing Documentation Requirements
    To address these concerns, the Treasury Department and the IRS are 
proposing rules, under the authority granted in section 385(a) to 
prescribe regulations to determine whether an interest in a corporation 
is stock or indebtedness, that prescribe the nature of the 
documentation and information that must be prepared and maintained for 
a purported debt instrument issued by a corporation to a related party 
to be treated as indebtedness for federal tax purposes. The proposed 
regulations are intended to impose discipline on related parties by 
requiring timely documentation and financial analysis that is similar 
to the documentation and analysis created when indebtedness is issued 
to third parties. This requirement also serves to help demonstrate 
whether there was intent to create a true debtor-creditor relationship 
that results in bona fide indebtedness and also to help ensure that the 
documentation necessary to perform an analysis of a purported debt 
instrument is prepared and maintained. This approach is consistent with 
the long-standing view held by courts that the taxpayer has the burden 
of substantiating its treatment of an arrangement as indebtedness for 
federal tax purposes. Hollenbeck v. Commissioner, 422 F.2d 2, 4 (9th 
Cir. 1970).
    In general, the Treasury Department and the IRS have determined 
that timely preparation of documentation and financial analysis 
evidencing four essential characteristics of indebtedness are a 
necessary factor in the characterization of a covered interest as 
indebtedness for federal tax purposes. Those characteristics are: a 
legally binding obligation to pay, creditors' rights to enforce the 
obligation, a reasonable expectation of repayment at the time the 
interest is created, and an ongoing relationship during the life of the 
interest consistent with arms-length relationships between unrelated 
debtors and creditors. These characteristics are drawn from the case 
law and are consistent with the text of section 385(b)(1) and (5). 
While the proposed regulations do not intend to alter the general case 
law view of the importance of these essential characteristics of 
indebtedness, the proposed regulations do require a degree of 
discipline in the creation of necessary documentation, and in the 
conduct of reasonable financial diligence indicative of a true debtor-
creditor relationship, that exceeds what is required under current law. 
See, e.g., C.M. Gooch Lumber Sales Co., 49 T.C. 649; Byerlite Corp., 
286 F.2d 285.
    The proposed regulations make clear that the preparation and 
maintenance of this documentation and information are not dispositive 
in establishing that a purported debt instrument is indebtedness for 
federal tax purposes. Rather, these requirements are necessary to the 
conduct of the multi-factor analysis used in the Mixon and Fin Hay line 
of cases to determine the nature of an interest as indebtedness for 
federal tax purposes.
C. Certain Distributions of Debt Instruments and Similar Transactions
1. In General
    The Treasury Department and the IRS have identified three types of 
transactions between affiliates that raise significant policy concerns 
and that should be addressed under the Secretary's authority to 
prescribe rules for particular factual situations: (1) distributions of 
debt instruments by corporations to their related corporate 
shareholders; (2) issuances of debt instruments by corporations in 
exchange for stock of an affiliate (including ``hook stock'' issued by 
their related corporate shareholders); and (3) certain issuances of 
debt instruments as consideration in an exchange pursuant to an 
internal asset reorganization. Similar policy concerns arise when a 
related-party debt instrument is issued in a separate transaction to 
fund (1) a distribution of cash or other property to a related 
corporate shareholder; (2) an acquisition of affiliate stock from an 
affiliate; or (3) certain acquisitions of property from an affiliate 
pursuant to an internal asset reorganization. Accordingly, the proposed 
regulations treat related-party debt instruments issued in any of the 
foregoing transactions as stock, subject to certain exceptions.
    Sections C.2 through C.5 of this Part VI describe in greater detail 
the purposes of the proposed regulations that apply to these types of 
transactions. Part IV of the Explanation of Provisions section of this 
preamble describes in detail the proposed regulations.
2. Debt Instrument Issued in a Distribution
    In Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956), 
the U.S. Court of Appeals for Second Circuit addressed a situation in 
which a domestic corporate subsidiary issued indebtedness in the form 
of debentures to its sole shareholder, also a domestic corporation, in 
payment of a dividend. The parent and subsidiary were required to file 
separate returns under the Code in effect during the years at issue, 
and, before taking into account the interest income and deductions on 
the distributed indebtedness, the parent corporation had losses and the 
subsidiary was profitable.
    The court considered arguments by the government that the parent-
subsidiary relationship warranted additional scrutiny in determining 
whether a debtor-creditor relationship was established in substance. In 
particular, the Commissioner argued that, because the issuer subsidiary 
was wholly-owned, ``the sole stockholder [could] deal as it please[d] 
with the corporate entity it control[led]'' and, as a result, the 
transaction could have been a sham. Id. at 123. The Commissioner also 
argued that the debentures should be treated as stock because no new 
capital was introduced into the subsidiary in connection with the 
issuance of the debentures, see id. at 126-27, and because the taxpayer 
conceded that the issuance of the debentures in payment of the dividend 
lacked a business purpose other than tax minimization. See id. at 127-
28.
    In holding for the taxpayer, the Second Circuit determined that the 
debentures should be respected as indebtedness because the debentures 
were unambiguously denominated as debt, were issued by and to real 
taxable entities, and created real legal rights and duties between the 
parties. See id. at

[[Page 20917]]

127-28. In a dissenting opinion, Chief Judge Clark supported 
``test[ing] the genuineness of the intercorporate indebtedness by 
objective standards'' that would disregard indebtedness issued in this 
circumstance, and warned that the majority opinion would open ``a large 
leak . . . operable merely by denominating an intercorporate allocation 
of surplus a debt'' and would ``[s]urely . . . stimulate imitators.'' 
Id. at 129.
    Other courts have not given the same level of deference to the form 
of a transaction that the Second Circuit did in Kraft and have treated 
purported indebtedness as stock in similar circumstances. For example, 
some courts have closely scrutinized situations in which indebtedness 
is owed in proportion to stock ownership to determine whether a debtor-
creditor relationship exists in substance. See, e.g., Uneco, Inc. v. 
United States, 532 F.2d 1204, 1207 (8th Cir. 1976) (``Advances between 
a parent corporation and a subsidiary or other affiliate are subject to 
particular scrutiny . . . .''); Arlington Park Jockey Club, Inc. v. 
Sauber, 262 F.2d 902, 906 (7th Cir. 1959) (``It has been held that [a 
cash advance made in proportion to stock ownership] gives rise to a 
strong inference that the advances represent additional capital 
investment and not loans.'' (citing Schnitzer v. Commissioner, 13 T.C. 
43, aff'd 183 F.2d 70 (9th Cir. 1950))). Consistent with those 
decisions, section 385(b)(5) specifically authorizes the Secretary, in 
issuing regulations distinguishing between stock and indebtedness, to 
take into account ``the relationship between holdings of stock in the 
corporation and holdings of the interest in question.''
    Courts also have given weight to the lack of new capital investment 
when a closely-held corporation issues indebtedness to a controlling 
shareholder but receives no new investment in exchange. See, e.g., 
Talbot Mills v. Commissioner, 146 F.2d 809 (1st Cir. 1944) (emphasizing 
that a transaction involved no new investment, did not affect 
proportionate ownership, and was motivated primarily by tax benefits in 
holding that a closely-held corporation's participating notes should be 
treated as stock when each stockholder exchanged four-fifths of its 
existing stock for notes with a face amount equal to the par value of 
the stock surrendered), aff'd sub nom, John Kelley Co. v. Commissioner, 
326 U.S. 521 (1946); Sayles Finishing Plants, Inc. v. United States, 
399 F.2d 214 (Ct. Cl. 1968) (noting that a ``lack of new money can be a 
significant factor in holding a purported indebtedness to be a capital 
transaction, particularly when the facts otherwise show that the 
purported indebtedness was merely a continuation of the stock interests 
allegedly converted'').
    In many contexts, a distribution of a debt instrument similar to 
the one at issue in Kraft lacks meaningful non-tax significance, such 
that respecting the distributed instrument as indebtedness for federal 
tax purposes produces inappropriate results. For example, inverted 
groups and other foreign-parented groups use these types of 
transactions to create interest deductions that reduce U.S. source 
income without investing any new capital in the U.S. operations. In 
addition, U.S.-parented groups obtain distortive results by, for 
example, using these types of transactions to create interest 
deductions that reduce the earnings and profits of controlled foreign 
corporations (CFCs) and to facilitate the repatriation of untaxed 
earnings without recognizing dividend income. An example of the latter 
type of transaction could involve the distribution of a note from a 
first-tier CFC to its United States shareholder in a taxable year when 
the distributing CFC has no earnings and profits (although lower-tier 
CFCs may) and the United States shareholder has basis in the CFC stock. 
In a later taxable year, when the distributing CFC had untaxed earnings 
and profits (such as by reason of intervening distributions from lower-
tier CFCs), the CFC could use cash attributable to the earnings and 
profits to repay the note owed to its United States shareholder. The 
taxpayer takes the position that the note should be respected as 
indebtedness and, therefore, that the repayment of the note does not 
result in any of the untaxed earnings and profits of the CFC being 
taxed as a dividend to the United States shareholder.
    In light of these policy concerns, the proposed regulations treat a 
debt instrument issued in fact patterns similar to that in Kraft as 
stock. The factors discussed in Kraft and Talbot Mills, including the 
parent-subsidiary relationship, the fact that no new capital is 
introduced in connection with a distribution of debentures, and the 
typical lack of a substantial non-tax business purpose, support the 
conclusion that the issuance of a debt instrument in a distribution is 
a transaction that frequently has minimal or nonexistent non-tax 
effects. Moreover, although the holder of a debt instrument has 
different legal rights than a holder of stock, the distinction between 
those rights usually has limited significance when the parties are 
related. Subsidiaries often do not have significant amounts of debt 
financing from unrelated lenders (other than trade payables) and, to 
the extent they do, they may minimize any potential impact of related-
party debt on unrelated creditors, for example, by subordinating the 
related-party debt instrument.
    Thus, any non-tax effects of a distribution of a debt instrument to 
an affiliate are often minimized or eliminated, allowing the related 
parties to obtain significant federal tax benefits at little or no 
cost. Accordingly, based on these considerations, the Treasury 
Department and the IRS have determined that in fact patterns similar to 
Kraft it is appropriate to treat a debt instrument as stock.
3. Debt Instrument Issued in Exchange for Affiliate Stock
    The Treasury Department and the IRS have determined that the 
issuance of a related-party debt instrument to acquire stock of a 
related person is similar in many respects to a distribution of a debt 
instrument and implicates similar policy considerations. Recognizing 
the economic similarities between purchases of affiliate stock and 
distributions, Congress enacted section 304 and its predecessors to 
prevent taxpayers from acquiring affiliate stock to convert what 
otherwise would be a taxable dividend into a sale or exchange 
transaction. See S. Rep. No. 83-1622 at 46 (1954) (noting that, under 
section 304, ``where the effect of the sale [of related-party stock] is 
in reality the distribution of a dividend, it will be taxed as such''). 
Similarly, if the proposed regulations addressed only debt instruments 
issued in a distribution, and not acquisitions of affiliate stock that 
have the effect of a distribution, taxpayers would readily substitute 
the latter transaction for the former in order to produce the 
inappropriate tax result that the proposed regulations are intended to 
prevent.
    Like distributions of debt instruments, issuances of debt 
instruments to acquire affiliate stock frequently have limited non-tax 
significance, particularly in relation to the significant federal tax 
benefits that are generated in the transaction. Such transactions do 
not change the ultimate ownership of the affiliate, and introduce no 
new operating capital to either affiliate. While the change in the 
direct ownership of the affiliate's stock may have some non-tax 
significance in certain circumstances, such as the harmonization of a 
group's corporate structure following an acquisition, other

[[Page 20918]]

purchases of affiliate stock, including purchases of ``hook stock'' 
from a parent in exchange for a debt instrument, typically possess 
almost no non-tax significance.
    Accordingly, the proposed regulations generally treat a debt 
instrument issued in exchange for affiliate stock as stock.
4. Debt Instrument Issued Pursuant to an Internal Asset Reorganization
    The proposed regulations also address certain debt instruments 
issued by an acquiring corporation as consideration in an exchange 
pursuant to an internal asset reorganization. Internal asset 
reorganizations can operate in a similar manner to section 304 
transactions as a device to convert what otherwise would be a 
distribution into a sale or exchange transaction without having any 
meaningful non-tax effect. Congress noted this similarity in 1984 when 
it harmonized the control requirement for section 368(a)(1)(D) 
reorganizations with the control requirement in section 304. See Staff 
of Joint Comm. on Taxation, 98th Cong., General Explanation of the 
Revenue Provisions of the Deficit Reduction Act of 1984 193 (Comm. 
Print 1984) (``The D reorganization provisions address the bail-out 
problem in the context of a transfer of assets by 1 corporation to 
another. Section 304 deals with the problem in the context of a 
transfer of stock by shareholders to a corporation they control.'').
    Consider the following example: A foreign parent corporation 
(Parent) owns all of the stock of two U.S. subsidiaries, S1 and S2. In 
a transaction qualifying as a reorganization described in section 
368(a)(1)(D), Parent transfers its stock in S1 to S2 in exchange for a 
note issued by S2, and S1 converts to a limited liability company. For 
federal tax purposes, S1 is treated as selling all of its assets to S2 
in exchange for a debt instrument, and under section 356, Parent is 
treated as receiving the S2 debt instrument from S1 in a liquidating 
distribution with respect to Parent's S1 stock. This transaction has a 
similar effect (and tax treatment) as a section 304 transaction in 
which S2 issues a debt instrument to Parent in exchange for S1 stock, 
with the only difference being that S2 acquired the assets of S1 
instead of the S1 stock and that Parent received the debt instrument as 
a result of the liquidation of S1.
    This transaction introduces no new capital into the P group, and 
does not affect the ultimate ownership of the assets held by S1 or S2. 
Furthermore, S1 generally would not be required to recognize any built-
in gain on the transfer of its assets to S2. Although this transaction 
entails a transfer of assets from S1 to S2, the tax costs (if any) and 
the non-tax consequences that result from this type of transaction 
among related parties are typically insignificant relative to the 
federal tax benefits obtained through the introduction of a related-
party debt instrument. Accordingly, the proposed regulations treat a 
debt instrument issued by an acquiring corporation as consideration in 
an exchange pursuant to an internal asset reorganization as stock, 
consistent with the treatment of a debt instrument issued in a 
distribution or in exchange for affiliate stock.
5. Debt Instrument Issued With a Principal Purpose of Funding Certain 
Distributions and Acquisitions
    The Treasury Department and the IRS have determined that the policy 
concerns implicated by the transactions described in Sections C.2 
through C.4 of this Part VI are also present when a corporation issues 
a debt instrument with a principal purpose of funding certain related-
party transactions. Specifically, the proposed regulations treat a debt 
instrument issued for property, including cash, as stock when the debt 
instrument is issued to an affiliate with a principal purpose of 
funding (1) a distribution of cash or other property to a related 
corporate shareholder, (2) an acquisition of affiliate stock from an 
affiliate, or (3) certain acquisitions of property from an affiliate 
pursuant to an internal asset reorganization.
    Without these funding provisions, taxpayers that otherwise would 
have issued a debt instrument in a one-step transaction described in 
Sections C.2 through C.4 of this Part VI would be able to use multi-
step transactions to avoid the application of these proposed 
regulations while achieving economically similar outcomes. For example, 
a wholly-owned subsidiary that otherwise would have distributed a debt 
instrument to its parent corporation in a distribution could, absent 
these rules, borrow cash from its parent and later distribute that cash 
to its parent in a transaction that is purported to be independent from 
the borrowing. Like the distribution of a note, this transaction, if 
respected, would result in an increase of related-party debt, but no 
new net investment in the operations of the subsidiary. The parent 
corporation would have effectively reshuffled its subsidiary's capital 
structure to obtain more favorable federal tax treatment for the 
subsidiary without affecting its control over the subsidiary. The 
similarity between these transactions indicates that they should be 
subject to similar tax treatment.
    The Treasury Department and the IRS also have determined that a 
debt instrument should be subject to these funding rules regardless of 
whether the funding affiliate (the lender) is a party to the funded 
transaction. Otherwise, a corporation could, for example, borrow funds 
from a sister corporation and immediately distribute those funds to the 
common parent corporation. Issuances of debt instruments to an 
affiliate in order to fund a distribution of property, an acquisition 
of affiliate stock, or an acquisition of an affiliate's assets in a 
reorganization often would confer significant federal tax benefits 
without having a significant non-tax impact, regardless of whether the 
lender is also a party to the funded transaction. Accordingly, the 
proposed regulations treat as stock a debt instrument issued to an 
affiliate to fund one of the specified transactions regardless of 
whether the lender is a party to the funded transaction.

Explanation of Provisions

I. Overview

    The proposed regulations provide guidance regarding substantiation 
of the treatment of certain interests issued between related parties as 
indebtedness for federal tax purposes, the treatment of certain 
interests in a corporation as in part indebtedness and in part stock, 
and the treatment of distributions of debt instruments and similar 
transactions that frequently have only limited non-tax effects. More 
specifically, the proposed regulations are set forth in four sections. 
First, proposed Sec.  1.385-1 prescribes definitions and operating 
rules applicable to the regulations under section 385 generally, 
including a rule treating members of a consolidated group, as defined 
in Sec.  1.1502-1(h), as one corporation. Proposed Sec.  1.385-1(d) 
also provides that the Commissioner has the discretion to treat certain 
interests in a corporation for federal tax purposes as indebtedness in 
part and stock in part. Second, proposed Sec.  1.385-2 addresses the 
documentation and information that taxpayers must prepare and maintain 
within required timeframes to substantiate the treatment of an interest 
issued between related parties as indebtedness for federal tax 
purposes. Such substantiation is necessary, but not sufficient, for a 
purported debt interest that is within the scope of these rules to be 
characterized as indebtedness; general federal income tax principles 
also apply in making such a determination. Third, if the application of 
proposed Sec.  1.385-2 and

[[Page 20919]]

general federal income tax principles otherwise would result in 
treating an interest issued to a related party as indebtedness for 
federal tax purposes, proposed Sec.  1.385-3 provides additional rules 
that may treat the interest, in whole or in part, as stock for federal 
tax purposes if it is issued in a distribution or other transaction 
that is identified as frequently having only limited non-tax effect, or 
is issued to fund such a transaction. Finally, proposed Sec.  1.385-4 
provides operating rules for applying proposed Sec.  1.385-3 to 
interests that cease to be between members of the same consolidated 
group or interests that become interests between members of the same 
consolidated group.

II. Generally Applicable Definitions and Special Rules

A. Definition of Expanded Group
    As previously discussed, the concerns addressed by the proposed 
regulations arise with respect to interests issued among related 
parties. The scope of the proposed regulations is therefore generally 
limited to purported indebtedness between members of an expanded group. 
Proposed Sec.  1.385-1, which sets forth definitions generally 
applicable to the regulations proposed under section 385, defines the 
term expanded group by reference to the term affiliated group in 
section 1504(a). However, the proposed regulations broaden the 
definition in several ways. Unlike an affiliated group, an expanded 
group includes foreign and tax-exempt corporations, as well as 
corporations held indirectly, for example, through partnerships. 
Further, in determining relatedness, the proposed regulations adopt the 
attribution rules of section 304(c)(3). The proposed regulations also 
modify the definition of affiliated group to treat a corporation as a 
member of an expanded group if 80 percent of the vote or value is owned 
by expanded group members (instead of 80 percent of the vote and value, 
as generally required under section 1504(a)).
    Through this definition of an expanded group, the application of 
the proposed regulations is limited to transactions between highly-
related parties. Other rules, discussed in Section III.A (limiting the 
application of proposed Sec.  1.385-2 to large taxpayers) and Section 
IV.C ($50 million threshold exception for proposed Sec.  1.385-3) of 
this Explanation of Provisions limit the application of the proposed 
regulations to large taxpayers.
B. Treatment of Deemed Exchanges
    Proposed Sec.  1.385-1 includes rules that prescribe the effects 
under the Code generally of an exchange of purported indebtedness for 
stock that is deemed to occur under the proposed regulations. Under 
those rules, on the date the indebtedness is recharacterized as stock, 
the indebtedness is deemed to be exchanged, in whole or in part, for 
stock with a value that is equal to the holder's adjusted basis in the 
portion of the indebtedness that is treated as equity under the 
regulations, and the issuer of the indebtedness is deemed to retire the 
same portion of the indebtedness for an amount equal to its adjusted 
issue price as of that date. This rule generally will prevent both the 
holder and issuer from realizing gain or loss from the deemed exchange 
other than foreign exchange gain or loss recognized by the issuer or 
the holder under section 988.
C. Treatment of Certain Instruments as in Part Indebtedness and as in 
Part Stock
    Proposed Sec.  1.385-1 implements the statutory authority under 
section 385(a) to treat an instrument as part indebtedness and part 
stock by authorizing the Commissioner to treat certain instruments 
issued between related parties in this manner. Any such treatment will 
occur only in the event that the substance of the instrument is 
regarded for federal tax purposes and the instrument has met the 
documentation and information requirements in proposed Sec.  1.385-2 
(described subsequently in Section III), if applicable. In addition, 
the Commissioner is not required to treat such an interest as 
indebtedness in part and stock in part. For example, under the proposed 
regulations, if an analysis of a related-party interest that is 
documented as a $5 million debt instrument demonstrates that the issuer 
cannot reasonably be expected to repay more than $3 million of the 
principal amount as of the issuance of the interest, the Commissioner 
may treat the interest as part indebtedness ($3 million) and part stock 
($2 million). The type of stock (for example, common stock or preferred 
stock, section 306 stock, stock described in section 1504(a)(4)) that 
the instrument will be treated as for federal tax purposes is 
determined by taking into account the terms of the instrument (for 
example, voting and conversion rights and rights relating to dividends, 
redemption, liquidation, and other distributions).
    The Treasury Department and the IRS believe that this approach will 
facilitate the treatment of purported debt instruments issued between 
related parties in a manner that is more consistent with the substance 
of the underlying transaction.
    Pursuant to section 385(c) and the regulatory authority granted the 
Secretary under section 385(c)(2), the issuer of the interest, the 
holder of the interest, and any other person relying on the 
characterization of the interest as indebtedness for federal tax 
purposes are all required to treat the interest consistent with the 
issuer's initial characterization. Thus, for example, a holder may not 
disclose on its return under section 385(c)(2) that it is treating an 
EGI, as later defined in Section III.A of this Explanation of 
Provisions, as indebtedness in part or stock in part if the issuer of 
the EGI treats the EGI as indebtedness. This approach eliminates cases 
in which members of the same expanded group take contrary positions as 
to the treatment of an EGI as indebtedness, stock, or indebtedness in 
part and stock in part.
    The proposed regulations authorize the treatment of an interest as 
indebtedness in part and stock in part in the case of instruments 
issued in the form of debt between parties that are related, but at a 
lesser degree of relatedness than that required to include them in an 
expanded group. Under the proposed regulations, treatment as 
indebtedness in part and stock in part can apply to purported 
indebtedness between members of modified expanded groups (which are 
defined in the same manner as expanded groups, but adopting a 50-
percent ownership test and including certain partnerships and other 
persons). The 50-percent relatedness threshold contained in the 
definition of modified expanded group is consistent with other 
provisions used in subchapter C of the Code to identify a level of 
control or ownership that can warrant different federal tax 
consequences than those of less-related parties. For example, a similar 
threshold applies in determining whether (i) control exists under 
section 304(c), (ii) attribution to and from corporations is applicable 
under section 318, (iii) persons are related under section 267(b), 
which is incorporated into numerous provisions of the Code, (iv) a 
redemption is substantially disproportionate under section 302(b)(2), 
(v) a disqualified distribution has occurred under section 355(d), (vi) 
a distribution is subject to section 355(e), and (vii) corporations are 
under common control for purposes of section 334. The Treasury 
Department and the IRS request comments on whether it would be helpful 
or appropriate to have this rule apply more generally.
D. Consolidated Groups
    As described in Part VI of the Background section of this preamble,

[[Page 20920]]

many of the concerns regarding related-party indebtedness are not 
present in the case of indebtedness between members of a consolidated 
group. Accordingly, the proposed regulations under section 385 do not 
apply to interests between members of a consolidated group, although 
general federal tax principles continue to apply. Proposed Sec.  1.385-
1(e) achieves this result by treating a consolidated group as one 
corporation. See Section III.A and Section IV.F of this Part for 
additional rules affecting consolidated groups.

III. Substantiation of Related-Party Indebtedness: Proposed Sec.  
1.385-2

A. In General
    Proposed Sec.  1.385-2 reflects the importance of contemporaneous 
documentation in identifying the rights, obligations, and intent of the 
parties to an instrument that is purported to be indebtedness for 
federal tax purposes. Such documentation is particularly important to 
the analysis of instruments issued between related parties. In 
recognition of this importance, the Treasury Department and the IRS are 
exercising authority granted under section 385(a) to treat the timely 
preparation and maintenance of such documentation as necessary factors 
to be taken into account in determining whether certain interests are 
properly characterized as stock or indebtedness. Accordingly, the 
proposed regulations first prescribe the nature of the documentation 
necessary to substantiate the treatment of related-party instruments as 
indebtedness and, second, require that such documentation be timely 
prepared and maintained. The proposed regulations further provide that, 
if the specified documentation is not provided to the Commissioner upon 
request, the Commissioner will treat the preparation and maintenance 
requirements as not satisfied and will treat the instrument as stock 
for federal tax purposes. The type of stock (for example, common stock 
or preferred stock, section 306 stock, stock described in section 
1504(a)(4)) that the instrument will be treated as for federal tax 
purposes is determined by taking into account the terms of the 
instrument (for example, voting and conversion rights and rights 
relating to dividends, redemption, liquidation, and other 
distributions).
    Satisfaction of the requirements of the proposed regulations does 
not establish that a related-party instrument is indebtedness. Rather, 
satisfaction of the proposed regulations acts as a threshold test for 
allowing the possibility of indebtedness treatment after the 
determination of an instrument's character is made under federal tax 
principles developed under applicable case law. If the requirements of 
the proposed regulations are not satisfied, the purported indebtedness 
would be recharacterized as stock. In such a case, any federal tax 
benefit claimed by the taxpayer with respect to the treatment of the 
interest as indebtedness will be disallowed.
    Judicial doctrines that disregard transactions as having no 
substance continue to be applicable and are not affected by the 
proposed regulations. Accordingly, proposed Sec.  1.385-2 applies only 
to interests the substance of which is potentially regarded as 
indebtedness for federal tax purposes. In addition, proposed Sec.  
1.385-2 does not limit the ability of the IRS to request information 
under any existing authorities, such as the rules under section 7602.
    As discussed previously, these proposed regulations apply only to 
purported indebtedness issued among entities that are highly related. 
Several provisions of the proposed regulations combine to effect this 
limitation.
    First, proposed Sec.  1.385-2 provides rules only with respect to 
applicable instruments, that is, interests issued in the form of debt. 
Thus, these proposed regulations do not apply to any interest or 
arrangement that is not, in form, indebtedness. The documentation and 
other rules in proposed Sec.  1.385-2(b) are tailored to arrangements 
that in form are traditional debt instruments and do not address other 
arrangements that may be treated as indebtedness under general federal 
tax principles. The proposed regulations under Sec.  1.385-2 reserve 
with respect to documentation of interests that are not in form 
indebtedness. Because there are a large number of ways to document 
these arrangements, rules that provide sufficient information about 
these arrangements will need to contain specific documentation and 
timing requirements depending on the type of arrangement. Accordingly, 
the Treasury Department and the IRS request comments regarding the 
appropriate documentation and timing requirements for the various forms 
that these arrangements can take.
    Second, proposed Sec.  1.385-2 only applies to applicable interests 
that are issued and held by members of an expanded group (expanded 
group instruments, or EGI). For purposes of Sec.  1.385-2, controlled 
partnerships are treated as members of the expanded group, and the term 
controlled partnership is defined as any partnership the capital or 
profits interest in which is 80-percent owned by members of the 
expanded group. Proposed Sec.  1.385-2 provides that, solely for 
purposes of Sec.  1.385-2, the term issuer means a person that is 
obligated to satisfy any material payment obligations created under the 
terms of an EGI. For this purpose, a disregarded entity can be treated 
as the issuer. A person can be an issuer if that person is expected to 
satisfy a material obligation under an EGI, even if that person is not 
the primary obligor. A guarantor, however, is not an issuer unless the 
guarantor is treated as the primary obligor under federal tax 
principles. See, e.g., Plantation Patterns, Inc. v. Commissioner, 462 
F.2d 712 (5th Cir. 1972).
    Third, proposed Sec.  1.385-2 is intended to apply only to large 
taxpayer groups. Accordingly, an EGI is not subject to proposed Sec.  
1.385-2 unless the stock of any member of the expanded group is 
publicly traded, all or any portion of the expanded group's financial 
results are reported on financial statements with total assets 
exceeding $100 million, or the expanded group's financial results are 
reported on financial statements that reflect annual total revenue that 
exceeds $50 million. The proposed regulations provide guidance 
regarding the financial statement or statements that are to be used for 
purposes of determining the expanded group's assets and liabilities. In 
general, this determination is made by reference to a financial 
statement required to be filed with the Securities and Exchange 
Commission, a certified audited financial statement that is accompanied 
by the report of an independent certified public accountant (or in the 
case of a foreign entity, by the report of a similarly qualified 
independent professional) that is used for certain purposes, or a 
financial statement (other than a tax return) required to be provided 
to the federal, state, or foreign government or any federal, state, or 
foreign agency. Because this list represents a set of financial 
statements created for other purposes for persons outside the expanded 
group, these financial statements are expected to be sufficiently 
reliable for this purpose. In addition, to prevent the use of stale 
financial information, only applicable financial statements prepared 
within the three years of the EGI becoming subject to the proposed 
regulations are relevant for determining whether an EGI is subject to 
the proposed regulations under Sec.  1.385-2.
B. Types of Documentation and Other Information Required
    The core of proposed Sec.  1.385-2 is the guidance regarding the 
nature of the

[[Page 20921]]

documentation and information that must be prepared and maintained to 
support the characterization of an EGI as indebtedness for federal tax 
purposes. The regulations organize the requirement into four 
categories, each reflecting an essential characteristic of indebtedness 
for federal tax purposes: a binding obligation to repay the funds 
advanced, creditor's rights to enforce the terms of the EGI, a 
reasonable expectation that the advanced funds can be repaid, and 
actions evidencing a genuine debtor-creditor relationship. Together 
these categories represent a distillation of case law principles 
established for determining that an instrument is genuine indebtedness 
for federal tax purposes.
    The proposed regulations require that the prescribed documentation 
and information must be provided with respect to each category. Failure 
to provide the documentation and information upon request by the 
Commissioner will result in the Commissioner treating the requirements 
of this section as not satisfied. The four categories are more 
specifically described in the following four paragraphs.
    1. Binding Obligation to Repay. The threshold requirement for 
indebtedness is a binding legal obligation to repay the funds advanced. 
The proposed regulations require evidence of such obligation in the 
form of timely prepared written documentation executed by the parties.
    2. Creditor's Rights to Enforce Terms. The documents establishing 
the issuer's obligation to repay must also establish that the creditor/
holder has the legal rights of a creditor to enforce the terms of the 
EGI. The proposed regulations give examples of such rights that 
creditor/holder typically has, including the right to trigger a default 
and the right to accelerate payments. The proposed regulations also 
give an example of one right that a creditor/holder must have, which is 
a superior right to shareholders to share in the assets of the issuer 
in the event that the issuer is dissolved or liquidated.
    3. Reasonable Expectation of Repayment. The proposed regulations 
also require the taxpayer to provide timely prepared documentation 
evidencing a reasonable expectation that the issuer could in fact repay 
the amount of a purported loan. The proposed regulations give examples 
of such documentation, including cash flow projections, financial 
statements, business forecasts, asset appraisals, determination of 
debt-to-equity and other relevant financial ratios of the issuer 
(compared to industry averages). Special rules are provided to address 
disregarded entities that issue an EGI.
    4. Genuine Debtor-Creditor Relationship. Finally, the taxpayer 
asserting indebtedness treatment must prepare and maintain timely 
evidence of an ongoing debtor-creditor relationship. This documentation 
can take two forms. In the case of an issuer that complied with the 
terms of the EGI, the documentation must include timely prepared 
documentation of any payments on which the taxpayer relies to establish 
such treatment under general federal tax principles. Alternatively, if 
the issuer failed to comply with the terms of the EGI, either by 
failing to make required payments or by otherwise suffering an event of 
default under the terms of the EGI, the documentation must include 
evidence of the holder's reasonable exercise of the diligence and 
judgment of a creditor. The proposed regulations give examples of such 
documentation, including evidence of the holder's efforts to enforce 
the terms of the EGI, as well as any efforts to renegotiate the EGI.
    In general, the documentation must be prepared no later than 30 
calendar days after the date of the relevant event, which is generally 
the later of the date that the instrument becomes an EGI or the date 
that an expanded group member becomes an issuer with respect to an EGI. 
However, in the case of documentation of the debtor-creditor 
relationship, the regulations allow the documentation to be prepared up 
to 120 calendar days after the payment or relevant event occurred. This 
extended period is intended to avoid inadvertent failures to comply 
with the regulations that may be more likely in the case of events that 
occur during the life of an EGI. If an applicable instrument is not an 
EGI when issued, no documentation is required under the proposed 
regulations for any date before the date the applicable instrument 
becomes an EGI.
    The proposed regulations provide special rules for determining the 
timeliness of documentation preparation in the case of certain 
revolving credit agreements and similar arrangements and cash pooling 
arrangements, generally looking to the documents pursuant to which the 
arrangements were established.
C. Maintenance Requirement
    Under proposed Sec.  1.385-2, the documentation and information in 
the four categories previously described must be maintained for all 
taxable years that the EGI is outstanding and until the period of 
limitations expires for any return with respect to which the federal 
tax treatment of the EGI is relevant. The proposed regulations do not 
otherwise specify where or in what manner such records must be kept. 
The Treasury Department and the IRS intend that taxpayers have 
flexibility to determine the manner in which the requirements of the 
proposed regulations are satisfied.
D. Timing of Application of Rule
    In general, proposed Sec.  1.385-2 will apply to an applicable 
instrument at the time it becomes an EGI and thereafter. If an EGI that 
was characterized as stock under the rules of Sec.  1.385-2 ceases to 
be an EGI, general federal tax principles will apply to determine its 
character at the time it ceases to be an EGI; if, under general federal 
tax principles, it is treated as indebtedness, the issuer is treated as 
issuing a new debt instrument to the holder in exchange for the EGI 
immediately before the transaction that causes the instrument to cease 
to qualify as an EGI.
    If an applicable instrument is an EGI when issued, determinations 
under proposed Sec.  1.385-2 are generally effective from the issuance 
date. If an applicable instrument was not an EGI when issued, proposed 
Sec.  1.385-2 applies, and any resulting determination is generally 
effective, when the applicable instrument becomes an EGI. However, if 
an EGI originally treated as debt is later recharacterized as stock 
because the documentation and information cease to evidence an ongoing 
debtor-creditor relationship, the recharacterization will be effective 
as of the time that the facts and circumstances cease to evidence a 
debtor-creditor relationship.
E. Consolidated Groups
    Proposed Sec.  1.385-1(e) provides that members of a consolidated 
group are treated as one corporation. Proposed Sec.  1.385-2(c)(4)(ii) 
further provides that if an applicable instrument ceases to be an 
intercompany obligation and, as a result, becomes an EGI subject to the 
rules of proposed Sec.  1.385-2, the applicable instrument is treated 
as becoming an EGI immediately after it ceases to be an intercompany 
obligation.
F. Modifications to General Operation of Proposed Sec.  1.385-2
    The proposed regulation includes a number of provisions that modify 
the general rules of Sec.  1.385-2 in order to provide flexibility in 
appropriate circumstances or to prevent abuse. First, the requirements 
of proposed Sec.  1.385-2 may be modified if a taxpayer's failure to 
comply with the requirements is attributable to reasonable cause. The 
principles of Sec.  301.6724-1 (relating to

[[Page 20922]]

waivers of penalty if failure due to reasonable cause) apply for 
purposes of determining whether reasonable cause exists in any 
particular case.
    Second, to prevent abuse, proposed Sec.  1.385-2 prohibits the 
affirmative use of the rules in the proposed regulations to support a 
particular characterization of an instrument. Thus, if a taxpayer fails 
to satisfy the requirements of proposed Sec.  1.385-2 with a principal 
purpose of reducing the federal tax liability of any member of the 
expanded group, the rules of the proposed regulations do not apply.
    Third, if an applicable instrument that is not an EGI is issued 
with a principal purpose of avoiding the purposes of proposed Sec.  
1.385-2, the applicable instrument is treated as an EGI and will be 
subject to the provisions of the proposed regulations. Such a situation 
could occur if, for example, an applicable interest was issued by an 
expanded group member to a trust held by members of the same expanded 
group.
G. Effective Date of Proposed Sec.  1.385-2
    The provisions of Sec.  1.385-2 are proposed to be generally 
effective when the regulations are published as final regulations. 
Proposed Sec.  1.385-2 would apply to any applicable instrument issued 
on or after that date, as well as to any applicable instrument treated 
as issued as a result of an entity classification election under Sec.  
301.7701-3 made on or after the date the regulations are issued as 
final regulations.

IV. Certain Distributions of Debt Instruments and Similar Transactions

A. In General
    Proposed Sec. Sec.  1.385-3 and 1.385-4 provide rules that treat as 
stock certain interests that otherwise would be treated as indebtedness 
for federal income tax purposes. Proposed Sec.  1.385-3 applies to debt 
instruments that are within the meaning of section 1275(a) and Sec.  
1.1275-1(d), as determined without regard to the application of 
proposed Sec.  1.385-3. Section 1275(a) and Sec.  1.1275-1(d) generally 
define a debt instrument as any instrument or contractual arrangement 
that constitutes indebtedness under general principles of federal 
income tax law. Thus, the term debt instrument for purposes of proposed 
Sec. Sec.  1.385-3 and 1.385-4 means an instrument that satisfies the 
requirements of proposed Sec. Sec.  1.385-1 and 1.385-2 and that is 
indebtedness under general principles of federal income tax law. The 
Treasury Department and the IRS plan to amend Sec.  1.1275-1(d) to 
coordinate Sec.  1.1275-1(d) with the regulations under section 385 
when the proposed regulations are finalized.
    Specifically, proposed Sec.  1.385-3 treats as stock certain debt 
instruments issued by one member of an expanded group to another member 
of the same group (expanded group debt instrument) in the circumstances 
described in Section B of this Part IV, unless an exception described 
in Section C of this Part IV applies. Detailed operating rules 
regarding the recharacterization (including with respect to 
partnerships) are discussed in Section D of this Part IV. A rule to 
prevent taxpayers from affirmatively using proposed Sec. Sec.  1.385-3 
and 1.385-4 is discussed in Section E of this Part IV. Section F of 
this Part IV discusses proposed Sec.  1.385-4, which provides special 
rules to address the treatment of consolidated groups. The effective 
date of proposed Sec. Sec.  1.385-3 and 1.385-4 is discussed in Section 
G of this Part IV.
    To the extent proposed Sec.  1.385-3 treats an interest as stock, 
the interest is treated as stock for all federal tax purposes. 
Consistent with the traditional case law debt-equity analysis, when a 
debt instrument is treated as stock under proposed Sec.  1.385-3, the 
terms of the debt instrument (for example, voting rights or conversion 
features) are taken into account for purposes of determining the type 
of stock resulting from the recharacterization, including whether such 
stock is preferred stock or common stock.
B. Debt Instruments Treated as Stock
    Proposed Sec.  1.385-3 provides three rules that treat an expanded 
group debt instrument as stock: a general rule, a funding rule, and an 
anti-abuse rule.
1. The General Rule
    The general rule treats an expanded group debt instrument as stock 
to the extent it is issued by a corporation to a member of the 
corporation's expanded group (1) in a distribution; (2) in exchange for 
expanded group stock, other than in an exempt exchange (as defined 
later in this Section 1); or (3) in exchange for property in an asset 
reorganization, but only to the extent that, pursuant to the plan of 
reorganization, a shareholder that is a member of the issuer's expanded 
group immediately before the reorganization receives the debt 
instrument with respect to its stock in the transferor corporation. All 
or a portion of an issuance of a debt instrument may be described in 
more than one prong of the general rule without changing the result 
that follows from being described in a single prong.
    For purposes of the first prong of the general rule, the term 
distribution is broadly defined as any distribution by a corporation to 
a member of the corporation's expanded group with respect to the 
distributing corporation's stock, regardless of whether the 
distribution is treated as a dividend within the meaning of section 
316. Thus, a debt instrument issued in exchange for stock of the issuer 
of the debt instrument (that is, in a redemption under corporate law) 
is a distribution that is covered by the first prong of the general 
rule and an acquisition of expanded group stock covered by the second 
prong of the general rule.
    The second prong of the general rule--addressing debt instruments 
issued in exchange for expanded group stock--applies regardless of 
whether the expanded group stock is acquired from a shareholder of the 
issuer of the expanded group stock, or directly from the issuer. For an 
illustration of this rule in a context where stock is not formally 
issued because it would be a ``meaningless gesture,'' see Example 11 in 
Sec.  1.385-3(g)(3) of the proposed regulations.
    For purposes of the second prong of the general rule, the term 
exempt exchange means an acquisition of expanded group stock in which 
the transferor and transferee of the stock are parties to a 
reorganization that is an asset reorganization, and either (i) section 
361(a) or (b) applies to the transferor of the expanded group stock and 
the stock is not transferred by issuance; or (ii) section 1032 or Sec.  
1.1032-2 applies to the transferor of the expanded group stock and the 
stock is distributed by the transferee pursuant to the plan of 
reorganization. As a result, the second prong of the general rule 
generally does not apply to a debt instrument that is issued in 
exchange for expanded group stock when section 361(a) or (b) applies to 
the transferor of such stock. This limitation has the effect of causing 
exchanges of expanded group stock that are part of an asset 
reorganization to be covered only by the third prong of the general 
rule, which, as discussed in the next paragraph, imposes limitations on 
the application of the general rule to exchanges that are part of an 
asset reorganization.
    The third prong of the general rule applies to asset 
reorganizations among corporations that are members of the same 
expanded group. An asset reorganization is a reorganization within the 
meaning of section 368(a)(1)(A), (C), (D), (F), or (G). Specifically, 
the third prong of the

[[Page 20923]]

general rule applies to a debt instrument issued in exchange for 
property in an asset reorganization, but only to the extent that, 
pursuant to the plan of reorganization, a shareholder that is a member 
of the issuer's expanded group immediately before the reorganization 
receives the debt instrument with respect to its stock in the 
transferor corporation. The second step receipt of the debt instrument 
by the expanded group shareholder could be in the form of a 
distribution of the debt instrument to shareholders of the distributing 
corporation in a divisive asset reorganization, or in redemption of the 
shareholder's stock in the transferor corporation in an acquisitive 
asset reorganization. Because the third prong of the general rule 
applies only to a debt instrument that is received by a shareholder 
with respect to its stock in the transferor corporation, that debt 
instrument would, absent the application of Sec.  1.385-3, be treated 
as ``other property'' within the meaning of section 356.
    The third prong of the general rule is limited to debt instruments 
distributed to shareholders pursuant to the reorganization, and does 
not apply to debt instruments exchanged for securities or other debt 
interests because, in that latter case, the newly issued debt 
instrument is exchanged for existing debt interests and thus no 
additional debt is incurred by the parties to the reorganization.
2. The Funding Rule
a. Funded Transactions
    The funding rule treats as stock an expanded group debt instrument 
that is issued with a principal purpose of funding a transaction 
described in the general rule (principal purpose debt instrument). 
Specifically, a principal purpose debt instrument is a debt instrument 
issued by a corporation (funded member) to another member of the funded 
member's expanded group in exchange for property with a principal 
purpose of funding (1) a distribution of property by the funded member 
to a member of the funded member's expanded group, other than a 
distribution of stock pursuant to an asset reorganization that is 
permitted to be received without the recognition of gain or income 
under section 354(a)(1) or 355(a)(1) or, when section 356 applies, that 
is not treated as ``other property'' or money described in section 356; 
(2) an acquisition of expanded group stock, other than in an exempt 
exchange, by the funded member from a member of the funded member's 
expanded group in exchange for property other than expanded group 
stock; or (3) the acquisition of property by the funded member in an 
asset reorganization but only to the extent that, pursuant to the plan 
of reorganization, a shareholder that is a member of the funded 
member's expanded group immediately before the reorganization receives 
``other property'' or money within the meaning of section 356 with 
respect to its stock in the transferor corporation.
    Prongs (1) through (3) of the funding rule are referred to in this 
Section 2 as ``distributions or acquisitions.'' Proposed Sec.  1.385-
3(b)(3)(iii) provides that, if all or a portion of a distribution or 
acquisition by a funded member is described in more than one prong of 
the funding rule, the funded member is treated as engaging in only a 
single distribution or acquisition for purposes of applying the funding 
rule. The funding rule addresses transactions that, when viewed 
together, present similar policy concerns as the transactions that are 
subject to the general rule.
    The first prong of the funding rule--addressing a distribution by a 
funded member--excludes a distribution of stock permitted to be 
received without the recognition of gain under section 355(a)(1) when 
the distribution is pursuant to an asset reorganization (that is, a 
divisive reorganization qualifying under section 368(a)(1)(D)), but 
does not exclude a distribution of stock that is permitted to be 
received without the recognition of gain under section 355(a)(1) when 
the transaction qualifies under section 355 without also qualifying as 
a reorganization (that is, a distribution of the stock of a controlled 
corporation without a related transfer of property by the distributing 
corporation to the controlled corporation pursuant to the plan of 
reorganization). The reason for this distinction is that the controlled 
corporation in a divisive reorganization described in section 
368(a)(1)(D) acquires assets of the distributing corporation and, as 
described in Section B.2.b.v of this Part IV, is treated as a successor 
of the distributing corporation (and the distributing corporation is 
treated as a predecessor of the controlled corporation) for purposes of 
the funding rule. In contrast, when a distribution transaction 
qualifies under section 355 without also qualifying as a 
reorganization, the controlled corporation does not acquire assets from 
the distributing corporation as part of the transaction and the 
corporations are not treated as predecessor and successor of each other 
for purposes of the funding rule. Consistent with this approach, 
proposed Sec.  1.385-3 does not treat a section 355 distribution that 
is part of a divisive reorganization as a distribution for purposes of 
the funding rule because the distributing corporation and the 
controlled corporation are both parties to the reorganization and are 
both treated as funded members to the extent of any prior debt 
instrument issued by the distributing corporation. For a further 
illustration of this rule, see Example 10 in Sec.  1.385-3(g)(3) of the 
proposed regulations.
b. Determining Whether a Debt Instrument Is Issued With a Principal 
Purpose of Funding a Distribution or Acquisition
    The determination as to whether a debt instrument is issued with a 
principal purpose of funding a distribution or acquisition is based on 
all of the facts and circumstances. A debt instrument may be treated as 
issued with such a principal purpose whether it is issued before or 
after a distribution or acquisition.
i. Non-Rebuttable Presumption During the 72-Month Period
    Proposed Sec.  1.385-3 also establishes a non-rebuttable 
presumption that certain expanded group debt instruments are issued 
with a principal purpose of funding a distribution or acquisition by 
the funded member. Specifically, such a principal purpose is deemed to 
exist if the expanded group debt instrument is issued by the funded 
member during the period beginning 36 months before the funded member 
makes a distribution or acquisition and ending 36 months after the 
distribution or acquisition (the 72-month period). This per se rule 
does not create a safe harbor. Accordingly, a debt instrument issued 
outside the 72-month period may be treated as having a principal 
purpose of funding a distribution or acquisition, based on the facts 
and circumstances.
    The Treasury Department and the IRS have determined that this non-
rebuttable presumption is appropriate because money is fungible and 
because it is difficult for the IRS to establish the principal purposes 
of internal transactions. In the absence of a per se rule, taxpayers 
could assert that free cash flow generated from operations funded any 
distributions and acquisitions, while any debt instrument was incurred 
to finance the capital needs of those operations. Because taxpayers 
would be able to document the purposes of funding transactions 
accordingly, it would be difficult for the IRS to establish that any 
particular debt instrument was incurred with a principal purpose of 
funding a

[[Page 20924]]

distribution or acquisition. The exception discussed in Section C of 
this Part IV for distributions and acquisitions that do not exceed 
current year earnings and profits would accommodate many ordinary 
course distributions and acquisitions, providing significant 
flexibility to avoid the application of this per se rule. The Treasury 
Department and the IRS have determined that this exception, together 
with the exception for a tainted debt instrument that does not exceed 
$50 million, also discussed in Section C of this Part IV, appropriately 
balance between preventing tax-motivated transactions among members of 
an expanded group and accommodating ordinary course transactions.
ii. Exception to Non-Rebuttable Presumption for Ordinary Course Debt 
Instruments
    An exception to this per se rule applies to ordinary course debt 
instruments. Proposed Sec.  1.385-3(b)(3)(iv)(B)(2) defines an ordinary 
course debt instrument as a debt instrument that arises in the ordinary 
course of the issuer's trade or business in connection with the 
purchase of property or the receipt of services to the extent that it 
reflects an obligation to pay an amount that is currently deductible by 
the issuer under section 162 or currently included in the issuer's cost 
of goods sold or inventory, provided that the amount of the obligation 
outstanding at no time exceeds the amount that would be ordinary and 
necessary to carry on the trade or business of the issuer if it was 
unrelated to the lender. This exception is intended to apply to debt 
instruments that arise in connection with the purchase of property or 
the receipt of services between members of the same expanded group in 
the ordinary course of the purchaser's or recipient's trade or 
business, and is not intended to apply to intercompany financing or 
treasury center activities or to capital expenditures. An ordinary 
course debt instrument is not subject to the per se rule; however, it 
may be treated as having a principal purpose of funding a distribution 
or acquisition by the issuer, based on the facts and circumstances.
iii. Ordering Rules
    For purposes of applying the per se rule, proposed Sec.  1.385-
3(b)(3)(iv)(B)(3) includes an ordering rule that provides that, when 
two or more debt instruments may be treated as potentially funding the 
same acquisition or distribution, the debt instruments are tested based 
on the order in which they were issued. Thus, for example, if a company 
issues an expanded group debt instrument of $100x in each of years 1 
and 2, and then makes a distribution of $150x in year 3, the 
distribution will result in a recharacterization as of the date of the 
distribution of $100x of the year 1 debt instrument and $50x of the 
year 2 debt instrument. For a further illustration of this rule, see 
Example 6 in Sec.  1.385-3(g)(3) of the proposed regulations.
    A second ordering rule in proposed Sec.  1.385-3(b)(3)(iv)(B)(4) 
provides that, when a debt instrument may be treated as funding more 
than one distribution or acquisition, the earliest distribution or 
acquisition is treated as the first distribution or acquisition that 
was funded.
    An exception to these ordering rules applies when an acquisition of 
expanded group stock by issuance ceases to qualify for the exception 
from the funding rule described in Section C.3 of this Part IV. In that 
case, the acquisition of expanded group stock is treated as an 
acquisition that is subject to the funding rule on the date that the 
acquisition actually occurred, but debt instruments issued, and other 
distributions and acquisitions that occurred, prior to the date that 
the acquirer ceases to qualify for the exception are ordered without 
regard to the acquisition of expanded group stock that previously was 
excepted from the funding rule.
iv. Transition Rule
    For a rule preventing the funding rule from treating a debt 
instrument issued on or after April 4, 2016 from being treated as 
funding a distribution or acquisition that occurred before April 4, 
2016, see Section G of this Part IV.
v. Predecessor and Successor Rules
    Finally, the funding rule provides that references in the funding 
rule to the funded member include any predecessor or successor of such 
member. A predecessor is defined to include the distributor or 
transferor corporation in a transaction described in section 381(a) in 
which a member of the expanded group is the acquiring corporation, but 
also includes the transferor corporation in a divisive reorganization 
described in section 368(a)(1)(D) or (G). The term predecessor does not 
include, with respect to a controlled corporation, a distributing 
corporation that distributed the stock of the controlled corporation 
pursuant to section 355(c). Similarly, a successor is defined to 
include the acquiring corporation in a transaction described in section 
381(a) in which a member of the expanded group is the distributor or 
transferor corporation, but also includes the acquiring corporation in 
a divisive reorganization described in section 368(a)(1)(D) or (G). The 
term successor does not include, with respect to a distributing 
corporation, a controlled corporation the stock of which was 
distributed by the distributing corporation pursuant to section 355(c). 
In addition, Section C.3 of this Part IV, which sets forth an exception 
to the funding rule for certain acquisitions of expanded group stock by 
issuance, provides that the funded member is treated as a predecessor 
of the issuer and the issuer is treated as a successor of the funded 
member to the extent of the value of the acquired stock. For an 
illustration of these rules, see Examples 9, 10, and 12 in proposed 
Sec.  1.385-3(g)(3).
3. The Anti-Abuse Rule
    Proposed Sec.  1.385-3(b)(4) also provides that a debt instrument 
is treated as stock if it is issued with a principal purpose of 
avoiding the application of the proposed regulations. In addition, 
other interests that are not debt instruments for purposes of proposed 
Sec. Sec.  1.385-3 and 1.385-4 (for example, contracts to which section 
483 applies or nonperiodic swap payments) are treated as stock if 
issued with a principal purpose of avoiding the application of proposed 
Sec. Sec.  1.385-3 or 1.385-4.
    Proposed Sec.  1.385-3(b)(4) includes a non-exhaustive list of 
examples illustrating situations where the anti-abuse rule might apply. 
The anti-abuse rule may apply, for example, if a debt instrument is 
issued to, and later acquired from, a person that is not a member of 
the issuer's expanded group with a principal purpose of avoiding the 
application of the proposed regulations. In that situation, factors 
that may be taken into account in determining the presence or absence 
of a principal purpose of avoiding the application of the proposed 
regulations include the time period between the issuance of the debt 
instrument to the non-member and the acquisition of the debt instrument 
by a member of the issuer's expanded group, and whether there was a 
significant change in circumstances during that time period. For 
example, a change of control of the issuer group (for example, a cash 
acquisition of all of the stock of the ultimate parent company of the 
issuer) after the issuance and before the acquisition of the debt 
instrument that was not foreseeable when the debt instrument was issued 
to the non-member could indicate that the debt instrument was not 
issued with a principal purpose of avoiding the

[[Page 20925]]

application of the proposed regulations. In contrast, the issuance of a 
debt instrument to a non-member after discussions were underway 
regarding the change-of-control transaction could indicate that the 
debt instrument was issued with a principal purpose of avoiding the 
application of the proposed regulations.
    Other examples of when the anti-abuse rule could apply include 
situations where, with a principal purpose of avoiding the application 
of proposed Sec.  1.385-3: (i) A Debt instrument is issued to a person 
that is not a member of the issuer's expanded group and that person 
later becomes a member of the issuer's expanded group; (ii) a debt 
instrument is issued to an entity that is not taxable as a corporation 
for federal tax purposes (for example, a trust that is beneficially 
owned by an expanded group member); or (iii) a member of the issuer's 
expanded group is substituted as a new obligor or added as a co-obligor 
on an existing debt instrument. The anti-abuse rule also could apply to 
a debt instrument that is issued or transferred in connection with a 
reorganization or similar transaction with a principal purpose of 
avoiding the application of the proposed regulations. For a further 
illustration of this rule, see Example 18 in Sec.  1.385-3(g)(3) of the 
proposed regulations.
4. Coordination Between General Rule and Funding Rule
    Proposed Sec.  1.385-3(b)(5) includes a rule to address a potential 
overlap between the general rule and the funding rule. This 
coordination rule provides that, to the extent all or a portion of a 
debt instrument issued in an asset reorganization is treated as stock 
under the third prong of the general rule (relating to a debt 
instrument issued for property in an asset reorganization), the 
distribution of the deemed stock to a shareholder in the asset 
reorganization is not also treated as a distribution or acquisition by 
the transferor corporation for purposes of the funding rule. This 
coordination rule addresses a specific potential overlap situation 
where a debt instrument is distributed to a shareholder pursuant to an 
asset reorganization and is characterized under the third prong of the 
general rule as an issuance of stock. When the issuance of the debt 
instrument is characterized under the general rule as an issuance of 
stock, the stock may be treated as non-qualified preferred stock for 
purposes of section 356. Nonqualified preferred stock received by a 
shareholder in a distribution is itself treated as ``other property'' 
for purposes of section 356. This overlap rule provides that, if the 
shareholder is deemed to receive nonqualified preferred stock in the 
asset reorganization, the distribution of the nonqualified preferred 
stock in the asset reorganization is not treated as a distribution or 
acquisition for purposes of the funding rule. For an illustration of 
this rule, see Example 8 in Sec.  1.385-3(g)(3) of the proposed 
regulations.
C. Exceptions
    Proposed Sec.  1.385-3(c) provides three exceptions from the 
application of proposed Sec.  1.385-3(b) for transactions that 
otherwise could result in a debt instrument being treated as stock.
1. Exception for Current Year Earnings and Profits
    As noted in Section B.2 of this Part IV, proposed Sec.  1.385-
3(c)(1) includes an exception pursuant to which distributions and 
acquisitions described in proposed Sec.  1.385-3(b)(2) (the general 
rule) or proposed Sec.  1.385-3(b)(3)(ii) (the funding rule) that do 
not exceed current year earnings and profits (as described in section 
316(a)(2)) of the distributing or acquiring corporation are not treated 
as distributions or acquisitions for purposes of the general rule or 
the funding rule. For this purpose, distributions and acquisitions are 
attributed to current year earnings and profits in the order in which 
they occur.
2. Threshold Exception
    A second exception provides that an expanded group debt instrument 
will not be treated as stock if, when the debt instrument is issued, 
the aggregate issue price of all expanded group debt instruments that 
otherwise would be treated as stock under the proposed regulations does 
not exceed $50 million (the threshold exception). If the expanded 
group's debt instruments that otherwise would be treated as stock later 
exceed $50 million, then all expanded group debt instruments that, but 
for the threshold exception, would have been treated as stock are 
treated as stock, rather than only the amount that exceeds $50 million. 
Thus, the threshold exception is not an exemption of the first $50 
million of expanded group debt instruments that otherwise would be 
treated as stock under the proposed regulations, but rather is only 
intended to provide an exception from the application of proposed Sec.  
1.385-3 for taxpayers that have not exceeded the $50 million threshold. 
If the $50 million threshold subsequently is exceeded, the timing of 
the recharacterization of the relevant debt instrument as stock depends 
on when the debt instrument was issued. If the debt instrument ceases 
to qualify for the threshold exception after the taxable year of its 
issuance, the recharacterization is treated as occurring on the date 
that the threshold exception ceases to apply. If, on the other hand, 
the debt instrument ceases to qualify for the threshold exception 
during the same taxable year that the debt instrument is issued, the 
debt instrument is treated as stock as of the day that the debt 
instrument is issued. Once the $50 million threshold is exceeded, the 
threshold exception will not apply to any debt instrument issued by 
members of the expanded group for so long as any instrument that 
previously was treated as indebtedness solely because of the threshold 
exception remains outstanding, in order to prevent the $50 million 
limitation from refreshing after those instruments are treated as 
stock.
    The threshold exception is applied after applying the exception for 
current year earnings and profits. For an illustration of the 
interaction of the threshold exception and the exception for current 
year earnings and profits, see Example 17 in Sec.  1.385-3(g)(3) of the 
proposed regulations.
3. Exception for Funded Acquisitions of Subsidiary Stock by Issuance
    An acquisition of expanded group stock will not be treated as an 
acquisition described in the second prong of the funding rule if (i) 
the acquisition results from a transfer of property by a funded member 
(the transferor) to an issuer in exchange for stock of the issuer, and 
(ii) for the 36-month period following the issuance, the transferor 
holds, directly or indirectly, more than 50 percent of the total 
combined voting power of all classes of stock of the issuer entitled to 
vote and more than 50 percent of the total value of the stock of the 
issuer. For purposes of this exception, a transferor's indirect stock 
ownership is determined by applying the principles of section 958(a) 
without regard to whether an intermediate entity is foreign or 
domestic.
    If the transferor ceases to meet the ownership requirement at any 
time during the 36-month period, the acquisition of expanded group 
stock will no longer qualify for the exception and will be treated as 
an acquisition described in the second prong of the funding rule. In 
this case, for purposes of applying the per se rule, the acquisition 
may be treated as having been funded by a debt instrument issued during 
the 72-month period determined with respect to the date of the 
acquisition (rather than the date that

[[Page 20926]]

the exception ceased to apply (the cessation date)), but, in the case 
of a debt instrument issued prior to the cessation date, only to the 
extent that such debt instrument is treated as indebtedness as of the 
cessation date (that is, a debt instrument not already treated as 
stock).
    The proposed regulations treat an issuer and a transferor as a 
successor and predecessor, respectively, for purposes of the funding 
rule to the extent of the value of the expanded group stock acquired 
from the issuer. However, for purposes of the per se rule, the issuer 
and transferor are only treated as successor and predecessor, 
respectively, with respect to a debt instrument issued by the 
transferor during the period beginning 36 months before the relevant 
issuance of expanded group stock and ending 36 months after such 
issuance. Proposed Sec.  1.385-3(f)(11) further limits the effect of 
treating the issuer and transferor as successor and predecessor by 
providing that a distribution made by the issuer directly to the 
transferor is not treated as a distribution made by the transferor for 
purposes of applying the funding rule to a debt instrument of the 
transferor.
    For an illustration of this exception, see Example 12 in Sec.  
1.385-3(g)(3) of the proposed regulations.
D. Operating Rules
    Proposed Sec.  1.385-3(d) includes operating rules for determining 
when a debt instrument is treated as stock and for certain deemed 
exchanges required under the proposed regulations.
1. Timing of Stock Treatment
a. Timing Under the General Rule
    A debt instrument treated as stock under the general rule is 
treated as stock from the time when the debt instrument is issued. In 
addition, and in contrast to the funding rule, the treatment of a debt 
instrument as stock pursuant to the general rule may affect other 
aspects of the tax treatment of the transaction in which the debt 
instrument is issued. For example, a distribution of a debt instrument 
is treated as a distribution of stock for all federal tax purposes and, 
accordingly, is subject to section 305. Similarly, a debt instrument 
issued in exchange for expanded group stock is treated as an 
acquisition of expanded group stock in exchange for stock of the 
issuing corporation. Because stock of the issuing corporation is not 
treated as ``property'' within the meaning of section 317, such 
transactions would not, for example, be described in section 304(a)(1) 
or be subject to Sec.  1.367(b)-10, both of which only apply to certain 
acquisitions of stock for property.
b. Timing Under the Funding Rule
    When the funding rule applies, a principal purpose debt instrument 
also is treated as stock from the time when the debt instrument is 
issued, but only to the extent it is issued in the same or a subsequent 
taxable year as the distribution or acquisition that the debt 
instrument is treated as funding. To the extent that a principal 
purpose debt instrument is issued in a taxable year preceding the 
taxable year in which the distribution or acquisition that it is 
treated as funding occurs, the debt instrument is respected as 
indebtedness until the date such distribution or acquisition occurs, at 
which time it is deemed to be exchanged (as described in Section D.2 of 
this Part IV) for stock. For these purposes, the relevant taxable year 
is the taxable year of the funded member. See Section C.3 of this Part 
IV for a discussion of the timing rule when the exception for funded 
acquisitions of subsidiary stock by issuance ceases to apply.
    In contrast to transactions that are characterized under the 
general rule, when the funding rule applies, the tax treatment of the 
distribution or acquisition that the principal purpose debt instrument 
is treated as funding is never recharacterized under the proposed 
regulations. Accordingly, in the case of a section 301 distribution 
that triggers the application of the funding rule, section 301 will 
continue to apply to the distribution without regard to the fact that 
the debt instrument that is treated as funding the distribution is 
recharacterized as stock. Similarly, the application of section 304 to 
a funded acquisition of expanded group stock would not be affected by 
the fact that the debt instrument that is treated as funding the 
acquisition is recharacterized as stock under the funding rule.
c. Transitional Timing Rule
    For an additional timing rule addressing certain debt instruments 
issued on or after April 4, 2016 and before the date of publication in 
the Federal Register of the Treasury decision adopting proposed Sec.  
1.385-3 as a final regulation, see section G of this Part IV.
2. Deemed Exchange
    As described in Section D.1 of this Part IV, the funding rule can 
apply to treat a debt instrument as stock in a taxable year that is 
subsequent to the taxable year in which the debt instrument is issued. 
In addition, as described in Section C of this Part IV, when the $50 
million threshold exception ceases to apply, all debt instruments of 
the expanded group issued in a prior taxable year that previously was 
treated as indebtedness because of the threshold exception is treated 
as stock on the date that the threshold exception ceases to apply. In 
those situations the deemed exchange rule described in Section B of 
Part II applies. This deemed exchange rule does not apply when a debt 
instrument that is treated as stock under proposed Sec.  1.385-3 leaves 
the expanded group, as described in Section D.3 of this Part IV.
3. Debt Instrument That Leaves the Expanded Group
    When a debt instrument that is treated as stock under proposed 
Sec.  1.385-3 is transferred to a person that is not a member of the 
expanded group, or when the obligor with respect to such debt 
instrument ceases to be a member of the expanded group that includes 
the issuer, the interest ceases to be treated as stock. This is because 
proposed Sec.  1.385-3 generally applies only to a debt instrument that 
is held by a member of an expanded group. For purposes of this rule, it 
should be noted that a debt instrument held by a partnership is 
considered held by its partners, as described in Section D.4 of this 
Part IV.
    The proposed regulations provide that, immediately before a debt 
instrument that is treated as stock under proposed Sec.  1.385-3 ceases 
to be held by a member of the expanded group, the expanded group issuer 
is deemed to issue a new debt instrument to the expanded group holder 
in exchange for the debt instrument that was treated as stock. The 
proposed regulations provide that this deemed issuance of the debt 
instrument is not itself subject to the general rule.
    When a debt instrument treated as stock pursuant to the funding 
rule ceases to be treated as stock because it is no longer an expanded 
group debt instrument, all other debt instruments of the issuer that 
are not currently treated as stock are re-tested to determine whether 
other debt instruments are treated as funding the distribution or 
acquisition that previously was treated as funded by the debt 
instrument that ceases to be treated as stock pursuant to this rule. 
For an illustration of this rule, see Example 7 in Sec.  1.385-3(g)(3) 
of the proposed regulations.
4. Treatment of Partnerships
    To prevent avoidance of these rules through the use of 
partnerships, proposed Sec.  1.385-3(d)(5) takes an

[[Page 20927]]

aggregate approach to controlled partnerships for purposes of the 
proposed regulations. The legislative history of subchapter K of 
chapter 1 of the Code provides that, for purposes of interpreting Code 
provisions outside of that subchapter, a partnership may be treated as 
either an entity separate from its partners or an aggregate of its 
partners, depending on which characterization is more appropriate to 
carry out the purpose of the particular section under consideration. 
H.R. Conf. Rep. No. 2543, 83rd Cong. 2d. Sess. 59 (1954). Thus, for 
example, when a member of an expanded group becomes a partner in a 
partnership that is a controlled partnership with respect to the 
expanded group, the member is treated as acquiring its proportionate 
share of the controlled partnership's assets. In addition, each 
expanded group partner in a controlled partnership is treated as (i) 
issuing its proportionate share of any debt instrument issued by the 
controlled partnership, (ii) acquiring its proportionate share of any 
expanded group stock acquired by the controlled partnership, and (iii) 
receiving its proportionate share of any ``other property'' received by 
the partnership in a transaction described in section 356. For this 
purpose, a partner's proportionate share is determined in accordance 
with the partner's share of partnership profits. A partnership is a 
controlled partnership if 80 percent or more of the interests in the 
capital or profits of the partnership are owned, directly or 
indirectly, by one or more members of an expanded group. For this 
purpose, indirect ownership of a partnership interest is determined 
based on the indirect ownership rules of section 304(c)(3).
    If a debt instrument issued by a controlled partnership were to be 
recharacterized as equity in the controlled partnership, the resulting 
equity could give rise to guaranteed payments that may be deductible or 
gross income allocations to partners that would reduce the taxable 
income of the other partners that did not receive such allocations. 
Therefore, under the authority of section 7701(l) to recharacterize 
multiple-party financing transactions, proposed Sec.  1.385-3(d)(5)(ii) 
provides that, when a debt instrument issued by a partnership is 
recharacterized, in whole or in part, under proposed Sec.  1.385-3, the 
holder of the recharacterized debt instrument is treated as holding 
stock in the expanded group partner or partners rather than as holding 
a partnership interest in the controlled partnership. The partnership 
and its partners must make appropriate conforming adjustments to 
reflect the expanded group partner's treatment under the proposed 
regulations. Any such adjustments must be consistent with the purposes 
of these proposed regulations and must be made in a manner that avoids 
the creation of, or increase in, a disparity between the controlled 
partnership's aggregate basis in its assets and the aggregate bases of 
the partners' respective interests in the partnership. For an 
illustration of the rules applicable to controlled partnerships, see 
Examples 13, 14, and 15 in Sec.  1.385-3(g)(3) of the proposed 
regulations.
5. Notification of Inconsistent Treatment Waived
    Section 385(c)(1) provides that an issuer's characterization as of 
the time of issuance of an interest as debt or stock is binding on the 
issuer and on all holders of the interest. Section 385(c)(2) provides 
an exception to that rule if the holder discloses on its return that 
the holder is treating such interest in a manner that is inconsistent 
with such characterization. Section 385(c)(3) provides that the 
Secretary is authorized to require such information as the Secretary 
determines to be necessary to carry out the provisions of section 
385(c). Under proposed Sec.  1.385-3, a holder may be required to treat 
an interest as stock even though the issuer treated it as debt when it 
was issued. For example, a debt instrument may first be treated as a 
principal purpose debt instrument in a year that follows the year in 
which the debt instrument was issued. In that case, absent a regulatory 
provision to the contrary, the holder would be subject to the reporting 
requirement described in section 385(c)(2).
    The Treasury Department and the IRS have determined that the 
characterization and reporting requirements in section 385(c) were not 
intended to apply when regulations under section 385 require an 
interest to be recharacterized after the issuer's initial 
characterization of that interest. Accordingly, the proposed 
regulations provide that section 385(c)(1) does not apply to a debt 
instrument to the extent that it is treated as stock under the proposed 
regulations.
6. Obligations of Disregarded Entities
    Proposed Sec.  1.385-3(d)(6) provides that a debt instrument issued 
by a disregarded entity that is treated as stock under proposed Sec.  
1.385-3 is treated as stock in the disregarded entity's owner rather 
than as an equity interest in the disregarded entity. Ordinarily, when 
a disregarded entity becomes an entity with more than one equity owner, 
the disregarded entity converts to a partnership. See, e.g., Sec.  
301.7701-3(f)(2); Rev. Rul. 99-5, 1999-1 C.B. 434. Under these 
circumstances, the Treasury Department and the IRS have determined that 
treating a debt instrument issued by a disregarded entity that is 
treated as stock under proposed Sec.  1.385-3 as stock in its owner, 
rather than as an equity interest in the disregarded entity, is 
consistent with, and addresses similar policy concerns as, the rules 
applicable to a debt instrument issued by a controlled partnership, 
which are described in Section D.4 of this Part IV.
E. No Affirmative Use
    Under proposed Sec.  1.385-3(e), proposed Sec. Sec.  1.385-3 and 
1.385-4 do not apply to the extent a person enters into a transaction 
that otherwise would be subject to the proposed regulations with a 
principal purpose of reducing its federal tax liability or the federal 
tax liability of another person by disregarding the treatment of the 
debt instrument that would occur without regard to the proposed 
regulations.
F. Treatment of Consolidated Groups
    As noted previously, the Treasury Department and the IRS have 
determined that a debt instrument between members of the same 
consolidated group does not raise the same federal tax concerns as a 
debt instrument between members of the same expanded (but not 
consolidated) group. Accordingly, proposed Sec.  1.385-4 includes 
special rules, issued under the authority of section 1502, for applying 
Sec.  1.385-3 to consolidated groups, including rules addressing the 
treatment of a debt instrument issued by one member of a consolidated 
group to another member of the same consolidated group (consolidated 
group debt instrument) and rules regarding the treatment of a debt 
instrument when it ceases to be a consolidated group debt instrument.
1. Consolidated Groups Treated as One Corporation
    For purposes of proposed Sec.  1.385-3, all members of a 
consolidated group are treated as one corporation. Accordingly, 
proposed Sec.  1.385-3 does not apply to a consolidated group debt 
instrument. Thus, for example, the proposed regulations do not treat as 
stock a debt instrument that is issued by one member of a consolidated 
group to another member of the consolidated group in a distribution. 
The proposed regulations define a consolidated group

[[Page 20928]]

in the same manner as the consolidated return regulations. See Sec.  
1.1502-1(h).
    As a result of treating all members of a consolidated group as one 
corporation for purposes of applying proposed Sec.  1.385-3, a debt 
instrument issued to or by one member of a consolidated group generally 
is treated as issued to or by all members of the same consolidated 
group. Thus, a debt instrument issued by one consolidated group member 
to a member of its expanded group that is not a member of its 
consolidated group may be treated under the funding rule as funding a 
distribution or acquisition by another member of that consolidated 
group, even though that other consolidated group member was not the 
issuer and thus was not funded directly. Similarly, a debt instrument 
issued by one consolidated group member to another consolidated group 
member is treated as stock under the general rule when the debt 
instrument is distributed by the holder to a member of the expanded 
group that is not a member of the same consolidated group, regardless 
of whether the issuer itself distributed the debt instrument. For an 
illustration of this rule, see Example 1 in proposed Sec.  1.385-
4(d)(3).
2. Debt Instrument That Ceases To Be a Consolidated Group Debt 
Instrument but Continues To Be an Expanded Group Debt Instrument
    Proposed Sec.  1.385-4 includes rules addressing debt held or 
issued by a consolidated group member that leaves a consolidated group, 
but continues to be a member of the expanded group (such corporation, a 
departing member).
    Generally, any consolidated group debt instrument that is issued or 
held by the departing member and that is not treated as stock solely by 
reason of the rule treating all members of a consolidated group as one 
corporation (exempt consolidated group debt instrument) is deemed to be 
exchanged for stock immediately after the departing member leaves the 
group. Any consolidated group debt instrument issued or held by a 
departing member that is not an exempt consolidated group debt 
instrument (non-exempt consolidated group debt instrument) is treated 
as indebtedness unless and until the non-exempt consolidated group debt 
instrument is treated as a principal purpose debt instrument under 
proposed Sec. Sec.  1.385-3(b)(3)(ii) and 1.385-3(d)(1) as a result of 
a distribution or acquisition described in proposed Sec.  1.385-
3(b)(3)(ii) that occurs after the departure. However, solely for 
purposes of applying the 72-month period under the per se funding rule, 
the debt instrument is treated as having been issued when it was first 
treated as a consolidated group debt instrument.
    When a member of a consolidated group transfers a consolidated 
group debt instrument to an expanded group member that is not a member 
of the consolidated group, the debt instrument is treated as issued by 
the issuer of the debt instrument (which is treated as one corporation 
with the transferor of the debt instrument) to the transferee expanded 
group member on the date of the transfer. For purposes of proposed 
Sec.  1.385-3, the consequences of the transfer are determined in a 
manner that is consistent with treating a consolidated group as one 
corporation. Thus, for example, the sale of a consolidated group debt 
instrument to an expanded group member that is not a member of the 
consolidated group is treated as an issuance of the debt instrument to 
the transferee expanded group member in exchange for property. To the 
extent the debt instrument is treated as stock upon being transferred, 
the debt instrument is deemed to be exchanged for stock immediately 
after the debt instrument is transferred outside of the consolidated 
group. For an illustration of this rule, see Examples 1 and 2 in Sec.  
1.385-4(d)(3) of the proposed regulations.
G. Proposed Effective/Applicability Date and Transition Rules
    Sections 1.385-3 and 1.385-4 are proposed to apply to any debt 
instrument issued on or after April 4, 2016 and to any debt instrument 
issued before April 4, 2016 as a result of an entity classification 
election made under Sec.  301.7701-3 that is filed on or after April 4, 
2016. However, when Sec. Sec.  1.385-3(b) and 1.385-3(d)(1)(i) through 
(d)(1)(v), or Sec.  1.385-4 of the proposed regulations, otherwise 
would treat a debt instrument as stock prior to the date of publication 
in the Federal Register of the Treasury decision adopting this rule as 
a final regulation, the debt instrument is treated as indebtedness 
until the date that is 90 days after the date of publication in the 
Federal Register of the Treasury decision adopting this rule as a final 
regulation. To the extent that the debt instrument described in the 
preceding sentence is held by a member of the issuer's expanded group 
on the date that is 90 days after the date of publication in the 
Federal Register of the Treasury decision adopting this rule as a final 
regulation, the debt instrument is deemed to be exchanged for stock on 
the date that is 90 days after the date of publication in the Federal 
Register of the Treasury decision adopting this rule as a final 
regulation.
    In addition, for purposes of determining whether a debt instrument 
is a principal purpose debt instrument described in proposed Sec.  
1.385-3(b)(3)(iv), a distribution or acquisition described in proposed 
Sec.  1.385-3(b)(3)(ii) that occurs before April 4, 2016, other than a 
distribution or acquisition that is treated as occurring before April 
4, 2016 as a result of an entity classification election made under 
Sec.  301.7701-3 that is filed on or after April 4, 2016, is not taken 
into account.

Statement of Availability of IRS Documents

    IRS Revenue Procedures, Revenue Rulings notices, and other guidance 
cited in this document are published in the Internal Revenue Bulletin 
(or Cumulative Bulletin) and are available from the Superintendent of 
Documents, U.S. Government Printing Office, Washington, DC 20402, or by 
visiting the IRS Web site at http://www.irs.gov.

Special Analyses

    Executive Orders 13563 and 12866 direct agencies to assess costs 
and benefits of available regulatory alternatives and, if regulation is 
necessary, to select regulatory approaches that maximize net benefits 
(including potential economic, environmental, public health and safety 
effects, distributive impacts, and equity). Executive Order 13563 
emphasizes the importance of quantifying both costs and benefits, of 
reducing costs, of harmonizing rules, and of promoting flexibility. 
This rule has been designated a ``significant regulatory action'' under 
section 3(f) of Executive Order 12866 and designated as economically 
significant. Accordingly, the rule has been reviewed by the Office of 
Management and Budget. A regulatory assessment for this proposed rule 
is available in the docket for this rulemaking on www.regulations.gov.
    Pursuant to the Regulatory Flexibility Act (5 U.S.C. Chapter 6), it 
is hereby certified that the proposed regulations will not have a 
significant economic impact on a substantial number of small entities. 
Accordingly, an initial regulatory flexibility analysis is not 
required. The Commissioner and the courts historically have analyzed 
whether an interest in a corporation should be treated as stock or 
indebtedness for federal tax purposes by applying various sets of 
factors to the facts of a particular case. Proposed Sec.  1.385-1 
provides that in connection with determining whether an interest in a 
corporation should be treated as stock or indebtedness for federal tax 
purposes,

[[Page 20929]]

the Commissioner has the discretion to treat certain interests in a 
corporation for federal tax purposes as indebtedness in part and stock 
in part. Proposed Sec.  1.385-1 does not require taxpayers to take any 
additional actions or to engage in any new procedures or documentation. 
Because proposed Sec.  1.385-1 contains no such requirements, it does 
not have an effect on small entities.
    To facilitate the federal tax analysis of an interest in a 
corporation, taxpayers are required to substantiate their 
classification of an interest as stock or indebtedness for federal tax 
purposes. Proposed Sec.  1.385-2 provides documentation requirements to 
substantiate the treatment of certain related-party instruments as 
indebtedness. First, these rules apply only to debt instruments in form 
issued within expanded groups of corporations and other entities. 
Second, proposed Sec.  1.385-2 only applies to expanded groups if the 
stock of a member of the expanded group is publicly traded, or 
financial statements of the expanded group or its members show total 
assets exceeding $100 million or annual total revenue exceeding $50 
million. Because the rules are limited to large expanded groups, they 
will not affect a substantial number of small entities.
    Proposed Sec.  1.385-3 provides rules that treat as stock certain 
interests in a corporation that are held by a member of the 
corporation's expanded group and that otherwise would be treated as 
indebtedness for federal tax purposes. Proposed Sec.  1.385-4 provides 
rules regarding the application of proposed Sec.  1.385-3 to members of 
a consolidated group. Proposed Sec.  1.385-3 includes multiple 
exceptions that limit its application. In particular, the threshold 
exception provides that an expanded group debt instrument will not be 
treated as stock under proposed Sec.  1.385-3 if, when the debt 
instrument is issued, the aggregate issue price of all expanded group 
debt instruments that otherwise would be treated as stock under 
proposed Sec.  1.385-3 does not exceed $50 million. The threshold 
exception also governs the application of proposed Sec.  1.385-3 rules 
to members of a consolidated group described in proposed Sec.  1.385-4. 
Although it is possible that the classification rules in proposed 
Sec. Sec.  1.385-3 and 1.385-4 could have an effect on small entities, 
the threshold exception makes it unlikely that a substantial number of 
small entities will be affected by proposed Sec. Sec.  1.385-3 and 
1.385-4. Pursuant to section 7805(f) of the Code, these regulations 
have been submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on their impact on small business.

Comments and Public Hearing

    Before the proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
copies) or electronic comments that are submitted timely to the IRS. 
The Treasury Department and the IRS request comments on all aspects of 
the proposed rules, including comments on the clarity of the proposed 
rules and how they can be made more administrable. In addition, 
comments are requested on: (1) Other instruments that should be subject 
to the proposed regulations, including other types of applicable 
instruments that are not indebtedness in form that should be subject to 
proposed Sec.  1.385-2 and the documentation requirements that should 
apply to such applicable instruments; (2) whether special rules are 
warranted for cash pools, cash sweeps, and similar arrangements for 
managing cash of an expanded group; (3) the rule addressing deemed 
exchanges of an EGI and a debt instrument; (4) the application of these 
rules to any entity with respect to a year in which the entity is not a 
U.S. person (as defined in section 7701(a)(30)), is not required to 
file a U.S. tax return, and is not a CFC or a controlled foreign 
partnership, but in a later year becomes one of the foregoing; (5) 
whether certain indebtedness commonly used by investment partnerships, 
including indebtedness issued by certain ``blocker'' entities, 
implicate similar policy concerns as those motivating the proposed 
regulations, such that the scope of the proposed regulations should be 
broadened; (6) whether guidance is needed under section 909 to the 
extent a U.S. equity hybrid instrument arises solely by reason of the 
application of proposed Sec.  1.385-3; and (7) the treatment of 
controlled partnerships in proposed Sec.  1.385-3 and the collateral 
consequences of the recharacterization and any corresponding 
adjustments, including the treatment of a partner's proportionate share 
of partnership assets or debt instruments, of treating a debt 
instrument issued by a controlled partnership as stock in its expanded 
group partners, including a situation in which a recharacterization 
results in a partnership owning stock of an expanded group partner. 
Specifically, the Treasury Department and the IRS request comments on 
how to apply proposed Sec.  1.385-3 when expanded group partners make 
distributions subject to the funding rule with respect to some, but not 
all, partnership debt instruments; when one or more, but not all, 
expanded group partners make a distribution subject to the funding rule 
with respect to part or all of their share of the partnership debt 
instrument; and how to address such distributions when a controlled 
partnership has one or more partners that are not expanded group 
members. The Treasury Department and the IRS also request comments on 
whether the objective rules in proposed Sec.  1.385-3(d)(5) have the 
potential to be manipulated, including by selectively locating debt 
instruments in order to achieve results that are contrary to the 
purposes of these regulations, and, if so, whether the anti-abuse rule 
in proposed Sec.  1.385-3(b)(4) or the rule prohibiting the affirmative 
use of these rules by taxpayers in proposed Sec.  1.385-3(e) are 
sufficient to address these concerns.
    More generally, the Treasury Department and the IRS request 
comments on whether additional guidance is necessary regarding the 
manner by which issuers and holders notify the Secretary of the 
intended federal tax treatment of an interest in a corporation.
    The Treasury Department and the IRS are aware that the issuance of 
preferred equity by a controlled partnership to an expanded group 
member may give rise to similar concerns as debt instruments of a 
controlled partnership issued to an expanded group member, and that 
controlled partnerships may, in some cases, issue preferred equity with 
a principal purpose of avoiding the application of Sec.  1.385-3 of the 
proposed regulations. The Treasury Department and the IRS are 
considering rules that would treat preferred equity in a controlled 
partnership as equity in the expanded group partners, based on the 
principles of the aggregate approach used in proposed Sec.  1.385-
3(d)(5). Comments are requested regarding the recharacterization of 
preferred equity in those circumstances. Until any such guidance is 
issued, the IRS intends to closely scrutinize, and may challenge when 
the regulations become effective, transactions in which a controlled 
partnership issues preferred equity to an expanded group member and, 
within the relevant 72-month period, one or more expanded group 
partners in the controlled partnership engage in a transaction 
described in Sec.  1.385-3(b)(3)(ii) of the proposed regulations.
    Finally, regarding the request for comments on whether guidance is 
needed under section 909 when a U.S. equity hybrid instrument arises 
solely by reason of the application of Sec.  1.385-3: the application 
of proposed Sec.  1.385-

[[Page 20930]]

3 may give rise to a U.S. equity hybrid instrument splitter arrangement 
under Sec.  1.909-2(b)(3)(i) (for example when indebtedness issued by 
one CFC to another CFC is treated as equity under proposed Sec.  1.385-
3). When this occurs, payments made pursuant to the instrument 
generally would result in distributions out of earnings and profits 
attributable pro rata to related income and other income, as described 
in Sec. Sec.  1.909-3 and 1.909-6(d). Given that these section 385 
regulations may give rise to a proliferation of U.S. hybrid equity 
instrument splitter arrangements, the Treasury Department and the IRS 
request comments on whether additional guidance is needed under section 
909, including to address any uncertainty with respect to how U.S. 
hybrid equity instrument splitter arrangements are treated. All 
comments will be available for public inspection and copying at 
www.regulations.gov or upon request.

Drafting Information

    The principal authors of these regulations are Eric D. Brauer of 
the Office of Associate Chief Counsel (Corporate) and Raymond J. Stahl 
of the Office of Associate Chief Counsel (International). However, 
other personnel from the Treasury Department and the IRS participated 
in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART I--INCOME TAXES

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

    Authority:  26 U.S.C. 7805 * * *

0
Section 1.385-1 also issued under 26 U.S.C. 385.
0
Section 1.385-2 also issued under 26 U.S.C. 385 and 26 U.S.C. 1502.
0
Section 1.385-3 also issued under 26 U.S.C. 385, 26 U.S.C. 701, and 
7701(l).
0
Section 1.385-4 also issued under 26 U.S.C. 385 and 26 U.S.C. 1502.
0
Par. 2. Section 1.385-1 is added to read as follows:


Sec.  1.385-1  General provisions.

    (a) Overview. This section provides definitions applicable to the 
regulations under section 385 and operating rules regarding the 
treatment of certain direct and indirect interests in corporations as 
stock or indebtedness for federal tax purposes. Section 1.385-2 
provides documentation and information requirements necessary for 
certain interests issued between members of an expanded group (as 
defined in paragraph (b)(3) of this section) to be treated as 
indebtedness for federal tax purposes. Section 1.385-3 provides rules 
that treat as stock certain interests in a corporation issued between 
members of an expanded group in connection with certain purported 
distributions of debt instruments and similar transactions. Section 
1.385-4 provides special rules regarding the transactions described in 
Sec.  1.385-3 as they relate to consolidated groups.
    (b) Definitions. The definitions in this paragraph (b) apply for 
purposes of the regulations under section 385. For additional 
definitions that apply for purposes of Sec.  1.385-2, see Sec.  1.385-
2(a)(4). For additional definitions that apply for purposes of 
Sec. Sec.  1.385-3 and 1.385-4, see Sec.  1.385-3(f).
    (1) Controlled partnership. The term controlled partnership means a 
partnership with respect to which at least 80 percent of the interests 
in partnership capital or profits are owned, directly or indirectly, by 
one or more members of an expanded group. For this purpose, indirect 
ownership of a partnership interest is determined by applying the 
principles of paragraph (b)(3)(ii) of this section.
    (2) Disregarded entity. The term disregarded entity means a 
business entity (as defined in Sec.  301.7701-2(a) of this chapter) 
that is disregarded as an entity separate from its owner for federal 
tax purposes under Sec. Sec.  301.7701-1 through 301.7701-3 of this 
chapter.
    (3) Expanded group--(i) In general. The term expanded group means 
an affiliated group as defined in section 1504(a), determined:
    (A) Without regard to paragraphs (1) through (8) of section 
1504(b);
    (B) By substituting ``directly or indirectly'' for ``directly'' in 
section 1504(a)(1)(B)(i); and
    (C) By substituting ``or'' for ``and'' in section 1504(a)(2)(A).
    (ii) Indirect stock ownership. For purposes of this paragraph 
(b)(3), indirect stock ownership is determined by applying the rules of 
section 304(c)(3).
    (4) Modified controlled partnership. The term modified controlled 
partnership means a partnership with respect to which at least 50 
percent of the interests in partnership capital or profits are owned, 
directly or indirectly, by one or more members of a modified expanded 
group. For this purpose, indirect ownership of a partnership interest 
is determined by applying the principles of paragraph (b)(3)(ii) of 
this section.
    (5) Modified expanded group. The term modified expanded group means 
an expanded group, as defined in this section, determined by 
substituting ``50'' for ``80'' in sections 1504(a)(2)(A) and (B). If 
one or more members of a modified expanded group own, directly or 
indirectly, 50 percent of the interests in partnership capital or 
profits of a modified controlled partnership, the modified controlled 
partnership is treated as a member of the modified expanded group. In 
addition, if a person (as defined in section 7701(a)(1)) is treated, 
under the rules of section 318, as owning at least 50 percent of the 
value of the stock of a modified expanded group member, the person is 
treated as a member of the modified expanded group.
    (c) Treatment of deemed exchange. If a debt instrument (as defined 
in Sec.  1.385-3(f)(3)) or an EGI (as defined in Sec.  1.385-
2(a)(4)(ii)) is deemed to be exchanged, in whole or in part, for stock 
pursuant to Sec.  1.385-2(c)(3)(ii), Sec.  1.385-3(d)(1)(ii), Sec.  
1.385-3(d)(1)(iii), Sec.  1.385-3(d)(1)(iv), Sec.  1.385-3(d)(1)(v), 
Sec.  1.385-3(h)(3), or Sec.  1.385-4(e)(3), the holder is treated as 
having realized an amount equal to the holder's adjusted basis in that 
portion of the indebtedness or EGI as of the date of the deemed 
exchange (and as having basis in the stock deemed to be received equal 
to that amount), and the issuer is treated as having retired that 
portion of the debt instrument or EGI for an amount equal to its 
adjusted issue price as of the date of the deemed exchange. In 
addition, neither party accounts for any accrued but unpaid qualified 
stated interest on the debt instrument or EGI or any foreign exchange 
gain or loss with respect to that accrued but unpaid qualified stated 
interest (if any) as of the deemed exchange. Notwithstanding the first 
sentence of this paragraph (c), the rules of Sec.  1.988-2(b)(13) apply 
to require the holder and the issuer of a debt instrument or an EGI 
that is deemed to be exchanged in whole or in part for stock pursuant 
to Sec.  1.385-2(c)(3)(ii), Sec.  1.385-3(d)(1)(ii), Sec.  1.385-
3(d)(1)(iii), Sec.  1.385-3(d)(1)(iv), Sec.  1.385-3(d)(1)(v), Sec.  
1.385-3(h)(3), or Sec.  1.385-4(e)(3) to recognize any exchange gain or 
loss, other than any exchange gain or loss with respect to accrued but 
unpaid qualified stated interest that is not taken into account under 
this paragraph (c) at the time of the deemed exchange. For purposes of 
this paragraph (c), in applying Sec.  1.988-2(b)(13) the exchange

[[Page 20931]]

gain or loss under section 988 is treated as the total gain or loss on 
the exchange.
    (d) Treatment as indebtedness in part--(1) In general. The 
Commissioner may treat an EGI (as defined in Sec.  1.385-2(a)(4)(ii) 
and described in paragraph (d)(2) of this section) as in part 
indebtedness and in part stock to the extent that an analysis, as of 
the issuance of the EGI, of the relevant facts and circumstances 
concerning the EGI (taking into account any application of Sec.  1.385-
2) under general federal tax principles results in a determination that 
the EGI is properly treated for federal tax purposes as indebtedness in 
part and stock in part. For example, if the Commissioner's analysis 
supports a reasonable expectation that, as of the issuance of the EGI, 
only a portion of the principal amount of an EGI will be repaid and the 
Commissioner determines that the EGI should be treated as indebtedness 
in part and stock in part, the EGI may be treated as indebtedness in 
part and stock in part in accordance with such determination, provided 
the requirements of Sec.  1.385-2, if applicable, are otherwise 
satisfied and the application of federal tax principles supports this 
treatment. The issuer of an EGI, the holder of an EGI, and any other 
person relying on the characterization of an EGI as indebtedness for 
federal tax purposes are required to treat the EGI consistent with the 
issuer's initial characterization. Thus, for example, a holder may not 
disclose on its return under section 385(c)(2) that it is treating an 
EGI as indebtedness in part or stock in part if the issuer of the EGI 
treats the EGI as indebtedness.
    (2) EGI described in this paragraph (d)(2). An EGI is described in 
this paragraph (d)(2) if it is an applicable instrument (as defined in 
Sec.  1.385-2(a)(4)(i)) an issuer of which is one member of a modified 
expanded group and the holder of which is another member of the same 
modified expanded group.
    (e) Treatment of consolidated groups. For purposes of the 
regulations under section 385, all members of a consolidated group (as 
defined in Sec.  1.1502-1(h)) are treated as one corporation.
    (f) Effective/applicability date. This section applies to any 
applicable instrument issued or deemed issued on or after the date 
these regulations are published as final regulations in the Federal 
Register, and to any applicable instrument treated as indebtedness 
issued or deemed issued before the date these regulations are issued as 
final regulations if and to the extent it was deemed issued as a result 
of an entity classification election made under Sec.  301.7701-3 of 
this chapter that is filed on or after the date these regulations are 
issued as final regulations in the Federal Register. For purposes of 
Sec. Sec.  1.385-3 and 1.385-4, this section applies to any debt 
instrument issued on or after April 4, 2016, and to any debt instrument 
treated as issued before April 4, 2016 as a result of an entity 
classification election made under Sec.  301.7701-3 of this chapter 
that is filed on or after April 4, 2016.
0
Par. 3. Section 1.385-2 is added to read as follows:


Sec.  1.385-2  Treatment of certain interests between members of an 
expanded group.

    (a) General--(1) Scope. This section prescribes threshold 
requirements that must be satisfied regarding the preparation and 
maintenance of documentation and information with respect to an 
expanded group instrument (an EGI, as defined in paragraph (a)(4)(ii) 
of this section). The purpose of preparing and maintaining the 
documentation and information required by this section is to enable an 
analysis to be made whether an EGI is appropriately treated as stock or 
indebtedness for federal tax purposes. Satisfying the requirements of 
this section does not establish that an interest is indebtedness; such 
satisfaction serves as a minimum standard that enables this 
determination to be made under general federal tax principles. The 
rules of this section must be interpreted and applied in a manner that 
is consistent with and reasonably carries out the purposes of this 
section. Moreover, nothing in this section prevents the Commissioner 
from asserting that the substance of a transaction involving an EGI (or 
the EGI itself) is different from the form of the transaction (or the 
EGI) or disregarding the transaction (or the EGI) or treating the 
transaction (or the EGI) in accordance with its substance for federal 
tax purposes. Such an assertion may be made based on the documentation 
or information received pursuant to a request under this section or a 
request for information under section 7602. If, and only if, the 
requirements of this section are satisfied, the determination of the 
federal tax treatment of the EGI is made based on an analysis of the 
documentation and information prepared and maintained, other facts and 
circumstances relating to the EGI, and general federal tax principles. 
If the requirements of this section are not satisfied with respect to 
an EGI the substance of which is regarded for federal tax purposes, the 
EGI will be treated as stock. This section does not otherwise affect 
the authority of the Commissioner under section 7602 to request and 
obtain documentation and information regarding transactions and 
instruments that purport to create an interest in a corporation. If the 
requirements of this section are satisfied or otherwise do not apply, 
see Sec. Sec.  1.385-3 and 1.385-4 for additional rules for determining 
whether and the extent to which an interest otherwise treated as 
indebtedness under general federal tax principles is recharacterized as 
stock for federal tax purposes.
    (2) Application--(i) In general. This section applies to an EGI 
only if--
    (A) The stock of any member of the expanded group is traded on (or 
subject to the rules of) an established financial market within the 
meaning of Sec.  1.1092(d)-1(b);
    (B) On the date that an applicable instrument first becomes an EGI, 
total assets exceed $100 million on any applicable financial statement, 
or
    (C) On the date that an applicable instrument first becomes an EGI, 
annual total revenue exceeds $50 million on any applicable financial 
statement.
    (ii) Non-U.S. dollar applicable financial statements. If an 
applicable financial statement is denominated in a currency other than 
the U.S. dollar, the total assets and annual total revenue are 
translated into U.S. dollars at the spot rate (as defined in Sec.  
1.988-1(d)) as of the date of the applicable financial statement.
    (3) Consistency rule. If an issuer characterizes an EGI as 
indebtedness, the EGI will be respected as indebtedness only if the 
requirements of Sec.  1.385-2(b) are met with respect to the EGI. If 
the issuer of an EGI characterizes that EGI as indebtedness, the 
issuer, the holder, and any other person relying on the 
characterization of an EGI as indebtedness for federal tax purposes is 
required to treat the EGI as indebtedness for all federal tax purposes. 
The Commissioner is not bound by the issuer's characterization of an 
EGI.
    (4) Definitions. The definitions in this paragraph (a)(4) apply for 
purposes of this section.
    (i) Applicable instrument--(A) In general. The term applicable 
instrument means any interest issued or deemed issued that is in form a 
debt instrument. See paragraph (a)(4)(i)(B) of this section for rules 
regarding an interest that is not in form a debt instrument.
    (B) [Reserved]
    (ii) Expanded group instrument. The term expanded group instrument 
(EGI) means an applicable instrument an issuer of which is one member 
of an expanded group and the holder of

[[Page 20932]]

which is another member of the same expanded group.
    (iii) Issuer. Solely for purposes of this section, the term issuer 
means a person (including a disregarded entity defined in Sec.  1.385-
1(b)(2)) that is obligated to satisfy any material obligations created 
under the terms of an EGI. A person can be an issuer if that person is 
expected to satisfy a material obligation under an EGI, even if that 
person is not the primary obligor. A guarantor, however, is not an 
issuer unless the guarantor is expected to be the primary obligor.
    (iv) Applicable financial statement. For purposes of this section, 
the term applicable financial statement means a financial statement, 
listed in paragraphs (a)(4)(iv)(A) through (C) of this section, that 
includes the assets, portion of the assets or annual total revenue of 
any member of the expanded group and that is prepared as of any date 
within 3 years prior to the date the applicable instrument at issue 
first becomes an EGI. A financial statement that includes the assets or 
annual total revenue of a member of an expanded group may be a separate 
company financial statement of any member of the expanded group or any 
consolidated financial statement that includes the assets, portion of 
the assets, or annual total revenue of any member of the expanded 
group. A financial statement includes--
    (A) A financial statement required to be filed with the Securities 
and Exchange Commission (the Form 10-K or the Annual Report to 
Shareholders);
    (B) A certified audited financial statement that is accompanied by 
the report of an independent certified public accountant (or in the 
case of a foreign entity, by the report of a similarly qualified 
independent professional) that is used for--
    (1) Credit purposes;
    (2) Reporting to shareholders, partners, or similar persons; or
    (3) Any other substantial non-tax purpose; or
    (C) A financial statement (other than a tax return) required to be 
provided to the Federal, state, or foreign government or any Federal, 
state, or foreign agency.
    (b) Documentation and information required to determine treatment--
(1) Preparation and maintenance of documentation and information--(i) 
In general. Except as otherwise provided in this section, an EGI is 
treated for federal tax purposes as stock if the documentation and 
information described in paragraph (b)(2) of this section are not 
prepared, or the maintenance requirements of paragraph (b)(4) of this 
section are not satisfied. If the requirements of this section are 
satisfied, general federal tax principles apply to determine whether, 
or the extent to which, the EGI is treated as indebtedness for federal 
tax purposes. This determination will take into account the 
documentation and information prepared, maintained, and provided in 
accordance with this section, as well as any additional facts and 
circumstances. This section applies to each EGI separately, but the 
same documentation and information may satisfy the requirements of this 
section for more than one EGI.
    (ii) Failure to provide documentation and information described in 
paragraph (b)(2) of this section. If a taxpayer characterizes an EGI as 
indebtedness and fails to provide the documentation and information 
described in paragraph (b)(2) of this section upon request by the 
Commissioner, the Commissioner will treat the requirements of this 
section as not satisfied.
    (2) Documentation and other information required. This paragraph 
(b)(2) describes the documentation and information that must be 
prepared and maintained to satisfy the requirements of this section. In 
each case, the documentation must include complete and (if relevant) 
executed copies of all instruments, agreements and other documents 
evidencing the material rights and obligations of the issuer and the 
holder relating to the EGI, and any associated rights and obligations 
of other parties, such as guarantees and subordination agreements. 
Additional documentation and information may be provided to supplement, 
but not substitute for, the documentation and information required 
under this section. The documentation and information must satisfy the 
following requirements:
    (i) Unconditional obligation to pay a sum certain. There must be 
written documentation prepared by the time required in paragraph (b)(3) 
of this section establishing that the issuer has entered into an 
unconditional and legally binding obligation to pay a sum certain on 
demand or at one or more fixed dates.
    (ii) Creditor's rights. The written documentation described in 
paragraph (b)(2)(i) of this section must establish that the holder has 
the rights of a creditor to enforce the obligation. The rights of a 
creditor typically include, but are not limited to, the right to cause 
or trigger an event of default or acceleration of the EGI (when the 
event of default or acceleration is not automatic) for non-payment of 
interest or principal when due under the terms of the EGI and the right 
to sue the issuer to enforce payment. The rights of a creditor must 
include a superior right to shareholders to share in the assets of the 
issuer in case of dissolution.
    (iii) Reasonable expectation of ability to repay EGI. There must be 
written documentation prepared containing information establishing 
that, as of the date of issuance of the applicable instrument and 
taking into account all relevant circumstances (including all other 
obligations incurred by the issuer as of the date of issuance of the 
applicable instrument or reasonably anticipated to be incurred after 
the date of issuance of the applicable instrument), the issuer's 
financial position supported a reasonable expectation that the issuer 
intended to, and would be able to, meet its obligations pursuant to the 
terms of the applicable instrument. For this purpose, if a disregarded 
entity is treated as the issuer of an EGI, and the owner of the 
disregarded entity has limited liability within the meaning of Sec.  
301.7701-3(b)(2)(ii) of this chapter, only the assets and financial 
position of the disregarded entity are relevant for purposes of this 
paragraph (b)(2)(iii). If the owner of such a disregarded entity does 
not have limited liability within the meaning of Sec.  301.7701-
3(b)(2)(ii), all of the assets and the financial position of the 
disregarded entity and the owner are relevant for purposes of this 
paragraph (b)(2)(iii). The documentation may include cash flow 
projections, financial statements, business forecasts, asset 
appraisals, determination of debt-to-equity and other relevant 
financial ratios of the issuer in relation to industry averages, and 
other information regarding the sources of funds enabling the issuer to 
meet its obligations pursuant to the terms of the applicable 
instrument. If any member of an expanded group relied on any report or 
analysis prepared by a third party in analyzing whether the issuer 
would be able to meet its obligations pursuant to the terms of the EGI, 
the documentation must include the report or analysis. If the report or 
analysis is protected or privileged under law governing an inquiry or 
proceeding with respect to the EGI and the protection or privilege is 
asserted, neither the existence nor the contents of the report or 
analysis is taken into account in determining whether the requirements 
of this section are satisfied.
    (iv) Actions evidencing debtor-creditor relationship--(A) Payments 
of principal and interest. If an issuer made any payment of interest or 
principal with respect to the EGI (whether in accordance with the terms 
and conditions of the EGI or otherwise, including prepayments), and 
such payment is claimed to support the

[[Page 20933]]

treatment of the EGI as indebtedness under general federal tax 
principles, documentation must include written evidence of such payment 
that is prepared by the time required in paragraph (b)(3) of this 
section. Such evidence could include, for example, a wire transfer 
record or a bank statement reflecting the payment.
    (B) Events of default and similar events. If the issuer did not 
make a payment of interest or principal that was due and payable under 
the terms and conditions of the EGI, or if any other event of default 
or similar event has occurred, there must be written documentation, 
prepared, by the time required in paragraph (b)(3) of this section, 
evidencing the holder's reasonable exercise of the diligence and 
judgment of a creditor. Such documentation may include evidence of the 
holder's efforts to assert its rights under the terms of the EGI, 
including the parties' efforts to renegotiate the EGI or to mitigate 
the breach of an obligation under the EGI, or any change in material 
terms and conditions of the EGI, such as maturity date, interest rate, 
or obligation to pay interest or principal, and any documentation 
detailing the holder's decision to refrain from pursuing any actions to 
enforce payment.
    (v) Additional information with respect to an EGI evidenced by 
documentation that does not in form reflect indebtedness. This 
paragraph (b)(1)(v) describes additional information with respect to an 
EGI evidenced by documentation that does not in form reflect 
indebtedness.
    (A)-(B) [Reserved]
    (3) Timely preparation requirement--(i) General rule. For purposes 
of this section, the documentation described in paragraphs (b)(2)(i), 
(ii) and (iii) of this section will be treated as satisfying the timely 
preparation requirement of this paragraph (b)(3) if it is prepared no 
later than 30 calendar days after the relevant date, as defined in 
paragraph (b)(3)(ii) of this section. The documentation described in 
paragraph (b)(2)(iv) of this section will be treated as satisfying the 
timely preparation requirement of this paragraph (b)(3) if it is 
prepared no later than 120 calendar days after the relevant date, as 
defined in paragraph (b)(3)(ii) of this section, as applicable.
    (ii) Relevant date. Subject to the special rules in paragraph 
(b)(3)(iii) of this section (relating to certain financial arrangements 
not evidenced by an instrument) and paragraph (c)(1) of this section 
(relating to modifications to certain requirements of this section), 
the relevant date is as follows:
    (A) For documentation and information described in paragraphs 
(b)(2)(i) and (b)(2)(ii) of this section (relating to issuer's 
unconditional obligation to repay and establishment of holder's 
creditor's rights), the relevant date is the date on which a member of 
the expanded group becomes an issuer of a new or existing EGI, without 
regard to any subsequent deemed issuance of the EGI under Sec.  1.1001-
3. In the case of an applicable instrument that becomes an EGI 
subsequent to issuance, including an intercompany obligation, as 
defined in Sec.  1.1502-13(g)(2)(ii), that ceases to be an intercompany 
obligation, the relevant date is the day on which the applicable 
instrument becomes an EGI.
    (B) For documentation and information described in paragraph 
(b)(2)(iii) of this section (relating to reasonable expectation of 
issuer's repayment), the relevant dates are the dates on which a member 
of the expanded group becomes an issuer with respect to an EGI and any 
later date on which an issuance is deemed to occur under Sec.  1.1001-3 
and any subsequent relevant date that occurs under the special rules in 
paragraph (b)(3)(iii) of this section. In the case of an applicable 
instrument that becomes an EGI subsequent to issuance, the relevant 
date is the day on which the applicable instrument becomes an EGI and 
any relevant date after the date that the applicable instrument becomes 
an EGI.
    (C) For documentation and information described in paragraph 
(b)(2)(iv)(A) of this section (relating to payments of principal and 
interest), each date on which a payment of interest or principal is 
due, taking into account all additional time permitted under the terms 
of the EGI before there is (or holder can declare) an event of default 
for nonpayment, is a relevant date.
    (D) For documentation and information described in paragraph 
(b)(2)(iv)(B) of this section (relating to events of default and 
similar events), each date on which an event of default, acceleration 
event or similar event occurs under the terms of the EGI is a relevant 
date. For example, if the terms of the EGI require the issuer to 
maintain certain financial ratios, any date on which the issuer fails 
to maintain the specified financial ratio (and such failure results in 
an event of default under the terms of the EGI) is a relevant date.
    (E) In the case of an applicable instrument that becomes an EGI 
subsequent to issuance, no date before the applicable instrument 
becomes an EGI is a relevant date.
    (iii) Special rules for determining relevant dates with respect to 
certain financial arrangements. The relevant dates with respect to the 
arrangements described in this paragraph (b)(3)(iii) include the date 
of the execution of the legal documents governing the EGI and the date 
of any amendment to those documents that provides for an increase in 
the permitted maximum amount of principal. In addition--
    (A) Revolving credit agreements and similar agreements. 
Notwithstanding paragraph (b)(2)(i) of this section, if an EGI is not 
evidenced by a separate note or other writing executed with respect to 
the initial principal balance or any increase in principal balance (for 
example, an EGI documented as a revolving credit agreement or an 
omnibus agreement that governs open account obligations), the EGI 
satisfies the requirements of paragraph (b)(2)(i) of this section only 
if the material documentation associated with the EGI, including all 
relevant enabling documents, is prepared, maintained, and provided in 
accordance with the requirements of this section. Relevant enabling 
documents may include board of directors' resolutions, credit 
agreements, omnibus agreements, security agreements, or agreements 
prepared in connection with the execution of the legal documents 
governing the EGI as well as any relevant documentation executed with 
respect to an initial principal balance or increase in the principal 
balance of the EGI.
    (B) Cash pooling arrangements. Notwithstanding paragraph (b)(2)(i) 
of this section, if an EGI is issued pursuant to a cash pooling 
arrangement or internal banking service that involves account sweeps, 
revolving cash advance facilities, overdraft set-off facilities, 
operational facilities, or similar features, the EGI satisfies the 
requirements of paragraph (b)(2)(i) of this section only if the 
material documentation governing the ongoing operations of the cash 
pooling arrangement or internal banking service, including any 
agreements with entities that are not members of the expanded group, is 
prepared, maintained, and provided in accordance with the requirements 
of this section. Such documentation must contain the relevant legal 
rights and responsibilities of any members of the expanded group and 
any entities that are not members of the expanded group in conducting 
the operation of the cash pooling arrangement or internal banking 
service.
    (4) Maintenance requirements. The documentation and information 
described in paragraph (b)(2) of this section must be maintained for 
all taxable years that the EGI is outstanding and until the period of 
limitations

[[Page 20934]]

expires for any return with respect to which the treatment of the EGI 
is relevant. See section 6001 (requirement to keep books and records).
    (c) Operating rules--(1) Reasonable cause exception. If the person 
characterizing an EGI as indebtedness for federal tax purposes 
establishes that a failure to satisfy the requirements of this section 
is due to reasonable cause, appropriate modifications may be made to 
the requirements of this section in determining whether the 
requirements of this section have been satisfied. The principles of 
Sec.  301.6724-1 of this chapter apply in interpreting whether 
reasonable cause exists in any particular case.
    (2) General application of section to applicable instrument 
becoming or ceasing to be an EGI--(i) Applicable instrument becomes an 
EGI. If an applicable instrument that is not an EGI when issued 
subsequently becomes an EGI, this section applies to the applicable 
instrument immediately after it becomes an EGI and thereafter.
    (ii) EGI treated as stock ceases to be an EGI. When an EGI treated 
as stock due to the application of this section ceases to be an EGI, 
the applicable instrument is characterized at that time under general 
federal tax principles. If, under general federal tax principles, the 
applicable instrument is treated as indebtedness, the issuer is treated 
as issuing a new instrument to the holder in exchange for the EGI 
immediately before the transaction that causes the EGI treated as stock 
due to the application of this section to cease to be treated as an 
EGI. See Sec.  1.385-1(c).
    (3) Effective date for treatment of EGI as stock under this 
section--(i) In general. If an applicable instrument is an EGI when 
issued and is determined to be stock, in whole or in part, due to the 
application of this section, the applicable instrument or relevant 
portion thereof is treated as stock from the date it was issued. 
However, if an applicable instrument is issued prior to the time it 
becomes an EGI and is determined to be stock, at the time it becomes an 
EGI due to the application of this section, it is treated as stock from 
the date it becomes an EGI. See Sec.  1.385-2(c)(4) regarding 
intercompany obligations (deemed issued immediately after ceasing to be 
an intercompany obligation for purposes of this section and Sec.  
1.385-3).
    (ii) EGI recharacterized as stock based on behavior of issuer or 
holder after issuance. Notwithstanding paragraph (c)(3)(i) of this 
section, if an EGI initially treated as indebtedness is recharacterized 
as stock as a result of failing to satisfy paragraph (b)(2)(iv) of this 
section (actions evidencing debtor-creditor relationship), the EGI will 
cease to be treated as indebtedness as of the time the facts and 
circumstances regarding the behavior of the issuer or the holder with 
respect to the EGI cease to evidence a debtor-creditor relationship. 
For purposes of determining whether an EGI originally treated as 
indebtedness ceases to be treated as indebtedness by reason of 
paragraph (b)(2)(iv) of this section, the rules of this section apply 
before the rules of Sec.  1.1001-3, such that an EGI initially treated 
as indebtedness may be recharacterized as stock regardless of whether 
the indebtedness is altered or modified (as defined in Sec.  1.1001-
3(c)) and, in determining whether indebtedness is recharacterized as 
stock, Sec.  1.1001-3(f)(7)(ii)(A) does not apply.
    (4) Applicable instruments issued and held by members of 
consolidated groups--(i) Consolidated group treated as one corporation. 
Section 1.385-1(e) provides that members of a consolidated group are 
treated as one corporation. Thus, during the time that the issuer and 
the holder of an applicable instrument are members of the same 
consolidated group, the applicable instrument is treated as not 
outstanding for purposes of this section. As a result, this section 
does not apply to any applicable instrument that is an intercompany 
obligation as defined in Sec.  1.1502-13(g)(2)(ii).
    (ii) Applicable instrument that ceases to be an intercompany 
obligation. If an applicable instrument ceases to be an intercompany 
obligation and, as a result, becomes an EGI, the applicable instrument 
is treated as becoming an EGI immediately after it ceases to be an 
intercompany obligation. This paragraph (c)(4)(i) does not affect the 
application of the rules under Sec.  1.1502-13(g).
    (5) Treatment of disregarded entities. If a disregarded entity is 
the issuer of an EGI and that EGI is treated as equity under this 
section, the EGI is treated as an equity interest in the disregarded 
entity rather than stock in the disregarded entity's owner. See Sec.  
1.385-2(c)(6)(ii) for rules regarding the treatment of an EGI issued by 
a controlled partnership.
    (6) Applicable instruments issued or held by controlled 
partnerships--(i) Controlled partnerships included in expanded group. 
For purposes of this section, a controlled partnership (as defined in 
Sec.  1.385-1(b)(1)) is treated as a member of an expanded group if one 
or more members of the expanded group own, directly or indirectly, 80 
percent of the interests in partnership capital or profits of the 
controlled partnership.
    (ii) Treatment of EGI issued by a controlled partnership that is 
recharacterized under this section. If an EGI that is issued by a 
controlled partnership is recharacterized as stock under this section, 
the EGI is treated as an equity interest in the controlled partnership.
    (d) No affirmative use. The rules of this section do not apply if 
there is a failure to satisfy the requirements of paragraph (b) of this 
section with a principal purpose of reducing the federal tax liability 
of any member or members of the expanded group of the issuer and holder 
of the EGI or any other person relying on the characterization of an 
EGI as indebtedness for federal tax purposes.
    (e) Anti-avoidance. If an applicable instrument that is not an EGI 
is issued with a principal purpose of avoiding the purposes of this 
section, the applicable instrument is treated as an EGI subject to this 
section.
    (f) Effective/applicability date. This section applies to any 
applicable instrument issued or deemed issued on or after the date 
these regulations are published as final regulations in the Federal 
Register, and to any applicable instrument treated as indebtedness 
issued or deemed issued before the date these regulations are issued as 
final regulations if and to the extent it was deemed issued as a result 
of an entity classification election made under Sec.  301.7701-3 of 
this chapter that is filed on or after the date these regulations are 
issued as final regulations in the Federal Register.
0
Par. 4. Section 1.385-3 is added to read as follows:


Sec.  1.385-3  Certain distributions of debt instruments and similar 
transactions.

    (a) Scope. This section provides rules that treat as stock certain 
interests in a corporation that are held by a member of the 
corporation's expanded group and that otherwise would be treated as 
indebtedness for federal tax purposes. Paragraph (b) of this section 
sets forth situations in which a debt instrument is treated as stock 
under this section. Paragraph (c) of this section provides three 
exceptions to the application of paragraph (b) of this section. 
Paragraph (d) of this section provides operating rules. Paragraph (e) 
of this section limits the affirmative use of this section. Paragraph 
(f) of this section provides definitions. Paragraph (g) of this section 
provides examples illustrating the application of the rules of this 
section. Paragraph (h) of this section provides dates of applicability. 
For rules regarding the application of this section

[[Page 20935]]

to members of a consolidated group, see Sec.  1.385-4.
    (b) Debt instrument treated as stock--(1) Effect of 
characterization as stock. To the extent a debt instrument is treated 
as stock under paragraphs (b)(2), (3), or (4) of this section, it is 
treated as stock for all federal tax purposes. Any interest, or portion 
thereof, that is not characterized as stock under this section is 
treated as stock or indebtedness under applicable federal tax law, 
without reference to this section.
    (2) General rule. Except as provided in paragraphs (c) and (e) of 
this section and in Sec.  1.385-4, a debt instrument is treated as 
stock to the extent the debt instrument is issued by a corporation to a 
member of the corporation's expanded group as described in one or more 
of the following paragraphs:
    (i) In a distribution;
    (ii) In exchange for expanded group stock, other than in an exempt 
exchange; or
    (iii) In exchange for property in an asset reorganization, but only 
to the extent that, pursuant to the plan of reorganization, a 
shareholder that is a member of the issuer's expanded group immediately 
before the reorganization receives the debt instrument with respect to 
its stock in the transferor corporation.
    (3) Funding rule--(i) In general. Except as provided in paragraphs 
(c) and (e) of this section and in Sec.  1.385-4, a debt instrument is 
treated as stock to the extent it is a principal purpose debt 
instrument.
    (ii) Principal purpose debt instrument. For purposes of this 
paragraph (b)(3), a debt instrument is a principal purpose debt 
instrument to the extent it is issued by a corporation (funded member) 
to a member of the funded member's expanded group in exchange for 
property with a principal purpose of funding a distribution or 
acquisition described in one or more of the following paragraphs:
    (A) A distribution of property by the funded member to a member of 
the funded member's expanded group, other than a distribution of stock 
pursuant to an asset reorganization that is permitted to be received 
without the recognition of gain or income under section 354(a)(1) or 
355(a)(1) or, when section 356 applies, that is not treated as ``other 
property'' or money described in section 356;
    (B) An acquisition of expanded group stock, other than in an exempt 
exchange, by the funded member from a member of the funded member's 
expanded group in exchange for property other than expanded group 
stock; or
    (C) An acquisition of property by the funded member in an asset 
reorganization but only to the extent that, pursuant to the plan of 
reorganization, a shareholder that is a member of the funded member's 
expanded group immediately before the reorganization receives ``other 
property'' or money within the meaning of section 356 with respect to 
its stock in the transferor corporation.
    (iii) Transactions described in more than one paragraph. Solely for 
purposes of this section, to the extent all or a portion of a 
distribution or acquisition by a funded member is described in more 
than one of paragraphs (b)(3)(ii)(A) through (C) of this section, the 
funded member is treated as engaging in only a single distribution or 
acquisition described in paragraph (b)(3)(ii) of this section.
    (iv) Principal purpose--(A) In general. Subject to paragraph 
(b)(3)(iv)(B)(1) of this section, whether a debt instrument is issued 
with a principal purpose of funding a distribution or acquisition 
described in paragraph (b)(3)(ii) of this section is determined based 
on all the facts and circumstances. A debt instrument may be treated as 
issued with a principal purpose of funding a distribution or 
acquisition described in paragraph (b)(3)(ii) of this section 
regardless of whether it is issued before or after such distribution or 
acquisition.
    (B) Per se rule--(1) In general. Except as provided in paragraph 
(b)(3)(iv)(B)(2) of this section, a debt instrument is treated as 
issued with a principal purpose of funding a distribution or 
acquisition described in paragraph (b)(3)(ii) of this section if it is 
issued by the funded member during the period beginning 36 months 
before the date of the distribution or acquisition, and ending 36 
months after the date of the distribution or acquisition (72-month 
period).
    (2) Ordinary course exception. Paragraph (b)(3)(iv)(B)(1) of this 
section does not apply to a debt instrument that arises in the ordinary 
course of the issuer's trade or business in connection with the 
purchase of property or the receipt of services to the extent that it 
reflects an obligation to pay an amount that is currently deductible by 
the issuer under section 162 or currently included in the issuer's cost 
of goods sold or inventory, provided that the amount of the obligation 
outstanding at no time exceeds the amount that would be ordinary and 
necessary to carry on the trade or business of the issuer if it was 
unrelated to the lender.
    (3) Multiple interests. If, pursuant to paragraph (b)(3)(iv)(B) of 
this section, two or more debt instruments may be treated as a 
principal purpose debt instrument, the debt instruments are tested 
under paragraph (b)(3)(iv)(B) of this section based on the order in 
which they were issued, with the earliest issued debt instrument tested 
first. See paragraph (g)(3) of this section, Example 6, for an 
illustration of this rule.
    (4) Multiple distributions or acquisitions. Except as provided in 
paragraph (c)(3) of this section, if, pursuant to paragraph 
(b)(3)(iv)(B) of this section, a debt instrument may be treated as 
funding more than one distribution or acquisition described in 
paragraph (b)(3)(ii) of this section, the debt instrument is treated as 
funding one or more distributions or acquisitions based on the order in 
which the distributions or acquisitions occurred, with the earliest 
distribution or acquisition treated as the first distribution or 
acquisition that was funded. See paragraph (g)(3) of this section, 
Example 9, for an illustration of this rule.
    (v) Predecessors and successors. For purposes of this paragraph 
(b)(3), references to the funded member include references to any 
predecessor or successor of such member. See paragraph (g)(3) of this 
section, Examples 9, 10, and 12, for illustrations of this rule.
    (vi) Treatment of funded transactions. When a debt instrument is 
treated as stock pursuant to paragraph (b)(3) of this section, the 
distribution or acquisition described in paragraph (b)(3)(ii) of this 
section that is treated as funded by such debt instrument is not 
recharacterized as a result of the treatment of the debt instrument as 
stock.
    (4) Anti-abuse rule. A debt instrument is treated as stock if it is 
issued with a principal purpose of avoiding the application of this 
section or Sec.  1.385-4. In addition, an interest that is not a debt 
instrument for purposes of this section and Sec.  1.385-4 (for example, 
a contract to which section 483 applies or a nonperiodic swap payment) 
is treated as stock if issued with a principal purpose of avoiding the 
application of this section or Sec.  1.385-4. This paragraph (b)(4) may 
apply, for example, if a debt instrument is issued to, and later 
acquired from, a person that is not a member of the issuer's expanded 
group with a principal purpose of avoiding the application of this 
section. Additional examples of when this paragraph (b)(4) could apply 
include, without limitation, situations where, with a principal purpose 
of avoiding the application of this section, a debt instrument is 
issued to a person that is not a member of the issuer's expanded group, 
and such

[[Page 20936]]

person later becomes a member of the issuer's expanded group; a debt 
instrument is issued to an entity that is not taxable as a corporation 
for federal tax purposes; or a member of the issuer's expanded group is 
substituted as a new obligor or added as a co-obligor on an existing 
debt instrument. This paragraph (b)(4) also may apply to a debt 
instrument that is issued or transferred in connection with a 
reorganization or similar transaction with a principal purpose of 
avoiding the application of this section or Sec.  1.385-4. See 
paragraph (g)(3) of this section, Example 18, for an illustration of 
this rule.
    (5) Coordination between general rule and funding rule. To the 
extent a debt instrument is treated as stock under paragraph 
(b)(2)(iii) of this section, the distribution of the debt instrument 
(which is treated as a distribution of stock as a result of the 
application of paragraph (b)(2)(iii) of this section) pursuant to the 
same reorganization that caused paragraph (b)(2)(iii) of this section 
to apply is not also treated as a distribution or acquisition described 
in paragraph (b)(3)(ii) of this section. See paragraph (g)(3) of this 
section, Example 8, for an illustration of this rule.
    (c) Exceptions--(1) Exception for current year earnings and 
profits. For purposes of applying paragraphs (b)(2) and (b)(3) of this 
section to a member of an expanded group with respect to a taxable 
year, the aggregate amount of any distributions or acquisitions that 
are described in paragraphs (b)(2) or (b)(3)(ii) of this section are 
reduced by an amount equal to the member's current year earnings and 
profits described in section 316(a)(2). This reduction is applied to 
the transactions described in paragraphs (b)(2) and (b)(3)(ii) of this 
section based on the order in which the distribution or acquisition 
occurs. See paragraph (g)(3) of this section, Example 17, for an 
illustration of this rule.
    (2) Threshold exception. A debt instrument is not treated as stock 
under this section if, immediately after the debt instrument is issued, 
the aggregate adjusted issue price of debt instruments held by members 
of the expanded group that would be subject to paragraph (b) of this 
section but for the application of this paragraph (c)(2) does not 
exceed $50 million. Once this threshold is exceeded, this paragraph 
(c)(2) will not apply to any debt instrument issued by members of the 
expanded group for so long as any debt instrument that previously was 
treated as indebtedness solely because of this paragraph (c)(2) remains 
outstanding. For purposes of this rule, any debt instrument that is not 
denominated in U.S. dollars is translated into U.S. dollars at the spot 
rate (as defined in Sec.  1.988-1(d)) on the date that the debt 
instrument is issued. See paragraph (g)(3) of this section, Example 17, 
for an illustration of this rule. See paragraph (d)(1)(iii) of this 
section for rules regarding the treatment of a debt instrument that 
ceases to qualify for the exception provided in this paragraph (c)(2).
    (3) Exception for funded acquisitions of subsidiary stock by 
issuance. An acquisition of expanded group stock will not be treated as 
described in paragraph (b)(3)(ii)(B) of this section if the acquisition 
results from a transfer of property by a funded member (the transferor) 
to an expanded group member (the issuer) in exchange for stock of the 
issuer, provided that, for the 36-month period immediately following 
the issuance, the transferor holds, directly or indirectly, more than 
50 percent of the total combined voting power of all classes of stock 
of the issuer entitled to vote and more than 50 percent of the total 
value of the stock of the issuer. If the transferor ceases to meet this 
ownership requirement at any time during that 36-month period, then on 
the date that the ownership requirement ceases to be met (cessation 
date), this paragraph (c)(3) ceases to apply and the acquisition is 
treated as an acquisition described in paragraph (b)(3)(ii)(B) of this 
section. In this case, for purposes of applying the per se rule, the 
acquisition may be treated as having been funded by any debt instrument 
issued during the 72-month period determined with respect to the date 
of the acquisition (rather than with respect to the cessation date), 
but, in the case of a debt instrument issued prior to the cessation 
date, only to the extent that such debt instrument is treated as 
indebtedness as of the cessation date (that is, a debt instrument not 
already treated as stock). For purposes of this paragraph (c)(3), a 
transferor's indirect stock ownership is determined by applying the 
principles of section 958(a) without regard to whether an intermediate 
entity is foreign or domestic. See paragraph (d)(1)(v) of this section 
for rules regarding the treatment of a debt instrument that is treated 
as funding an acquisition to which this exception ceases to apply.
    (d) Operating rules--(1) Timing. This paragraph (d)(1) provides 
rules for determining when a debt instrument is treated as stock under 
paragraph (b) of this section. For special rules regarding the 
treatment of a deemed exchange of a debt instrument that occurs 
pursuant to paragraphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), or 
(d)(1)(v), see Sec.  1.385-1(c).
    (i) General timing rule. Except as otherwise provided in this 
paragraph (d)(1), when paragraph (b) of this section applies to treat a 
debt instrument as stock, the debt instrument is treated as stock when 
the debt instrument is issued. When paragraph (b)(3) of this section 
applies to treat a debt instrument as stock when the debt instrument is 
issued, see also paragraph (b)(3)(vi) of this section.
    (ii) Exception when a debt instrument is treated as funding a 
distribution or acquisition that occurs in a subsequent taxable year. 
When paragraph (b)(3)(iv)(B) of this section applies to treat a debt 
instrument as funding a distribution or acquisition described in 
paragraph (b)(3)(ii) of this section that occurs in a taxable year 
subsequent to the taxable year in which the debt instrument is issued, 
the debt instrument is deemed to be exchanged for stock when the 
distribution or acquisition described in paragraph (b)(3)(ii) of this 
section occurs. See paragraph (g)(3) of this section, Example 9, for an 
illustration of this rule.
    (iii) Exception when a debt instrument ceases to qualify for the 
threshold exception. A debt instrument that previously was treated as 
indebtedness pursuant to the threshold exception set forth in paragraph 
(c)(2) of this section is deemed to be exchanged for stock when the 
debt instrument ceases to qualify for the threshold exception. 
Notwithstanding the preceding sentence, if the debt instrument was both 
issued and ceases to qualify for the threshold exception during the 
same taxable year, the general timing rule of paragraph (d)(1)(i) of 
this section applies. See paragraph (g)(3) of this section, Example 17, 
for an illustration of this rule.
    (iv) Exception when a debt instrument is re-tested under paragraph 
(d)(2) of this section. When paragraph (b)(3)(iv)(B) of this section 
applies to treat a debt instrument as funding a distribution or 
acquisition described in paragraph (b)(3)(ii) of this section as a 
result of a re-testing described in paragraph (d)(2) of this section 
that occurs in a taxable year subsequent to the taxable year in which 
the debt instrument is issued, the debt instrument is deemed to be 
exchanged for stock on the date of the re-testing. See paragraph (g)(3) 
of this section, Example 7, for an illustration of this rule.
    (v) Exception when a debt instrument ceases to qualify for the 
exception for acquisitions of subsidiary stock by issuance. When 
paragraph (b)(3)(iv)(B) and the modified ordering rule in paragraph 
(c)(3) of this section apply to

[[Page 20937]]

treat a debt instrument as funding an acquisition of expanded group 
stock that previously qualified for the exception set forth in 
paragraph (c)(3) of this section, the debt instrument is deemed to be 
exchanged for stock on the cessation date referred to in paragraph 
(c)(3) of this section if the debt instrument was issued in a taxable 
year preceding the taxable year that includes the cessation date. For 
all other debt instruments that are treated as funding an acquisition 
of expanded group stock that previously qualified for the exception set 
forth in paragraph (c)(3) of this section, the general timing rule of 
paragraph (d)(1)(i) of this section applies.
    (2) Debt instrument treated as stock that leaves the expanded 
group. Subject to paragraph (b)(4) of this section, when the holder and 
issuer of a debt instrument that is treated as stock under this section 
cease to be members of the same expanded group, either because the debt 
instrument is transferred to a person that is not a member of the 
expanded group that includes the issuer or because the holder or the 
issuer cease to be members of the same expanded group, the debt 
instrument ceases to be treated as stock under this section. For this 
purpose, immediately before the transaction that causes the holder and 
issuer of the debt instrument to cease to be members of the same 
expanded group, the issuer is deemed to issue a new debt instrument to 
the holder in exchange for the debt instrument that was treated as 
stock in a transaction that is disregarded for purposes of paragraphs 
(b)(2) and (b)(3) of this section. For purposes of paragraph 
(b)(3)(iv)(B) of this section, when this paragraph (d)(2) causes a debt 
instrument that previously was treated as stock pursuant to paragraph 
(b)(3) of this section to cease to be treated as stock, all other debt 
instruments of the issuer that are not currently treated as stock are 
re-tested to determine whether those other debt instruments are treated 
as funding the distribution or acquisition that previously was treated 
as funded by the debt instrument that ceases to be treated as stock 
pursuant to this paragraph (d)(2). See paragraph (g)(3) of this 
section, Example 7, for an illustration of this rule.
    (3) Inapplicability of section 385(c)(1). Section 385(c)(1) does 
not apply with respect to a debt instrument to the extent that it is 
treated as stock under this section.
    (4) Taxable year. For purposes of this section, the term taxable 
year refers to the taxable year of the issuer of the debt instrument.
    (5) Treatment of partnerships--(i) Application of aggregate 
treatment. For purposes of this section, a controlled partnership is 
treated as an aggregate of its partners. Thus, for example, when a 
corporation that is a member of an expanded group becomes a partner in 
a partnership that is a controlled partnership with respect to that 
expanded group, the corporation is treated as acquiring its 
proportionate share of the controlled partnership's assets. In 
addition, each expanded group partner in a controlled partnership is 
treated as issuing its proportionate share of any debt instrument 
issued by the controlled partnership. For this purpose, a partner's 
proportionate share is determined in accordance with the partner's 
share of partnership profits. See paragraph (g)(3) of this section, 
Example 13, for an illustration of this rule.
    (ii) Treatment of debt instruments issued by partnerships. To the 
extent that the application of the aggregate approach in paragraph 
(d)(5)(i) of this section causes a debt instrument issued by a 
controlled partnership to be recharacterized under paragraph (b) of 
this section, then the holder of the recharacterized debt instrument is 
treated as holding stock in the expanded group partners. In addition, 
the partnership and its partners must make appropriate conforming 
adjustments to reflect this treatment. Any such adjustments must be 
consistent with the purposes of this section and must be made in a 
manner that avoids the creation of, or increase in, a disparity between 
the controlled partnership's aggregate basis in its assets and the 
aggregate bases of the partners' respective interests in the 
partnership. See paragraph (g)(3) of this section, Examples 14 and 15, 
for an illustration of this rule.
    (6) Treatment of disregarded entities. If a debt instrument of a 
disregarded entity is treated as stock under this section, such debt 
instrument is treated as stock in the entity's owner rather than as an 
equity interest in the entity.
    (e) No affirmative use. The rules of this section and Sec.  1.385-4 
do not apply to the extent a person enters into a transaction that 
otherwise would be subject to these rules with a principal purpose of 
reducing the federal tax liability of any member of the expanded group 
that includes the issuer and the holder of the debt instrument by 
disregarding the treatment of the debt instrument that would occur 
without regard to this section.
    (f) Definitions. The definitions in this paragraph (f) apply for 
purposes of this section and for purposes of Sec.  1.385-4.
    (1) Asset reorganization. The term asset reorganization means a 
reorganization within the meaning of section 368(a)(1)(A), (C), (D), 
(F), or (G).
    (2) Controlled partnership. The term controlled partnership has the 
meaning specified in Sec.  1.385-1(b)(1).
    (3) Debt instrument. The term debt instrument means an interest 
that would, but for the application of this section, be treated as a 
debt instrument as defined in section 1275(a) and Sec.  1.1275-1(d).
    (4) Distribution. The term distribution means any distribution made 
by a corporation with respect to its stock.
    (5) Exempt exchange. The term exempt exchange means an acquisition 
of expanded group stock in which the transferor and transferee of the 
stock are parties to an asset reorganization, and either--
    (i) Section 361(a) or (b) applies to the transferor of the expanded 
group stock and the stock is not transferred by issuance; or
    (ii) Section 1032 or Sec.  1.1032-2 applies to the transferor of 
the expanded group stock and the stock is distributed by the transferee 
pursuant to the plan of reorganization.
    (6) Expanded group. The term expanded group has the meaning 
specified in Sec.  1.385-1(b)(3).
    (7) Expanded group partner. The term expanded group partner means 
any person that is a partner in a controlled partnership and that is a 
member of the expanded group whose members own, directly or indirectly, 
at least 80 percent of the interests in the controlled partnership's 
capital or profits.
    (8) Expanded group stock. The term expanded group stock means, with 
respect to a member of an expanded group, stock of a member of the same 
expanded group.
    (9) Predecessor--(i) In general. The term predecessor includes, 
with respect to a corporation, the distributor or transferor 
corporation in a transaction described in section 381(a) in which the 
corporation is the acquiring corporation. For purposes of the preceding 
sentence, the transferor corporation in a reorganization within the 
meaning of section 368(a)(1)(D) or (G) is treated as a transferor 
corporation in a transaction described in section 381(a) without regard 
to whether the reorganization meets the requirements of sections 
354(b)(1)(A) and (B). The term predecessor does not include, with 
respect to a controlled corporation, a distributing corporation that 
distributed

[[Page 20938]]

the stock of the controlled corporation pursuant to section 355(c).
    (ii) Special rules for funded acquisitions of subsidiary stock by 
issuance. The term predecessor also includes, with respect to an issuer 
that issues stock to a transferor in a transaction described in 
paragraph (c)(3) of this section, the transferor, but, for purposes of 
applying the per se rule in paragraph (b)(3)(iv)(B)(1) of this section, 
only with respect to a debt instrument issued by the transferor during 
the 72-month period determined with respect to the transaction 
described in paragraph (c)(3) of this section, and only to the extent 
of the value of the expanded group stock acquired from the issuer in 
the transaction described in paragraph (c)(3) of this section.
    (10) Property. The term property has the meaning specified in 
section 317(a).
    (11) Successor--(i) In general. The term successor includes, with 
respect to a corporation, the acquiring corporation in a transaction 
described in section 381(a) in which the corporation is the distributor 
or transferor corporation. For purposes of the preceding sentence, the 
acquiring corporation in a reorganization within the meaning of section 
368(a)(1)(D) or (G) is treated as an acquiring corporation in a 
transaction described in section 381(a) without regard to whether the 
reorganization meets the requirements of sections 354(b)(1)(A) and (B). 
The term successor does not include, with respect to a distributing 
corporation, a controlled corporation the stock of which was 
distributed by the distributing corporation pursuant to section 355(c).
    (ii) Special rules for funded acquisitions of subsidiary stock by 
issuance. The term successor also includes, with respect to a 
transferor that transfers property to an issuer in exchange for stock 
of the issuer in a transaction described in paragraph (c)(3) of this 
section, the issuer, but, for purposes of applying the per se rule in 
paragraph (b)(3)(iv)(B)(1) of this section, only with respect to a debt 
instrument issued by the transferor during 72-month period determined 
with respect to the transaction described in paragraph (c)(3) of this 
section, and only to the extent of the value of the expanded group 
stock acquired from the issuer in the transaction described in 
paragraph (c)(3) of this section. A distribution by an issuer described 
in paragraph (c)(3) of this section directly to the transferor is not 
taken into account for purposes of applying paragraph (b)(3) of this 
section to a debt instrument of the transferor.
    (g) Examples--(1) Assumed facts. Except as otherwise stated, the 
following facts are assumed for purposes of the examples in paragraph 
(g)(3) of this section:
    (i) FP is a foreign corporation that owns 100 percent of the stock 
of USS1, a domestic corporation, 100 percent of the stock of USS2, a 
domestic corporation, and 100 percent of the stock of FS, a foreign 
corporation;
    (ii) USS1 owns 100 percent of the stock of DS, a domestic 
corporation, and CFC, which is a controlled foreign corporation within 
the meaning of section 957;
    (iii) At the beginning of Year 1, FP is the common parent of an 
expanded group comprised solely of FP, USS1, USS2, FS, DS, and CFC (the 
FP expanded group);
    (iv) The FP expanded group has more than $50 million of debt 
instruments described in paragraph (c)(2) of this section at all times;
    (v) No issuer of a debt instrument has current year earnings and 
profits described in section 316(a)(2);
    (vi) All notes are debt instruments described in paragraph (f)(3) 
of this section;
    (vii) No notes are eligible for the ordinary course exception 
described in paragraph (b)(3)(iv)(B)(2) of this section;
    (viii) Each entity has as its taxable year the calendar year;
    (ix) PRS is a partnership for federal income tax purposes;
    (x) No corporation is a member of a consolidated group, as defined 
in Sec.  1.1502-1(h);
    (xi) No domestic corporation is a United States real property 
holding corporation within the meaning of section 897(c)(2); and
    (xii) Each note is issued with adequate stated interest (as defined 
in section 1274(c)(2)).
    (2) No inference. Except as provided in this section, it is assumed 
for purposes of the examples that the form of each transaction is 
respected for federal tax purposes. No inference is intended, however, 
as to whether any particular note would be respected as indebtedness or 
as to whether the form of any particular transaction described in 
paragraph (g)(3) of this section would be respected for federal tax 
purposes.
    (3) Examples. The following examples illustrate the rules of this 
section.

    Example 1. Distribution of a debt instrument. (i) Facts. On Date 
A in Year 1, FS lends $100x to USS1 in exchange for USS1 Note A. On 
Date B in Year 2, USS1 issues USS1 Note B, which is has a value of 
$100x, to FP in a distribution.
    (ii) Analysis. USS1 Note B is a debt instrument that is issued 
by USS1 to FP, a member of USS1's expanded group, in a distribution. 
Accordingly, USS1 Note B is treated as stock under paragraph 
(b)(2)(i) of this section. Under paragraph (d)(1)(i) of this 
section, USS1 Note B is treated as stock when it is issued by USS1 
to FP on Date B in Year 2. Accordingly, USS1 is treated as 
distributing USS1 stock to its shareholder FP in a distribution that 
is subject to section 305. Because USS1 Note B is treated as stock 
for federal tax purposes when it is issued by USS1, USS1 Note B is 
not treated as property for purposes of paragraph (b)(3)(ii)(A) of 
this section because it is not property within the meaning specified 
in section 317(a). Accordingly, USS1 Note A is not treated as 
funding the distribution of USS1 Note B for purposes of paragraph 
(b)(3)(ii)(A) of this section.
    Example 2. Debt instrument issued for expanded group stock that 
is exchanged for stock in a corporation that is not a member of the 
same expanded group. (i) Facts. UST is a publicly traded domestic 
corporation. On Date A in Year 1, USS1 issues USS1 Note to FP in 
exchange for FP stock. On Date B of Year 1, USS1 transfers the FP 
stock to UST's shareholders, which are not members of the FP 
expanded group, in exchange for all of the stock of UST.
    (ii) Analysis. (A) Because USS1 and FP are both members of the 
FP expanded group, USS1 Note is treated as stock when it is issued 
by USS1 to FP in exchange for FP stock on Date A in Year 1 under 
paragraphs (b)(2)(ii) and (d)(1)(i) of this section. This result 
applies even though, pursuant to the same plan, USS1 transfers the 
FP stock to persons that are not members of the FP expanded group. 
The exchange of USS1 Note for FP stock is not an exempt exchange 
within the meaning of paragraph (f)(5) of this section.
    (B) Because USS1 Note is treated as stock for federal tax 
purposes when it is issued by USS1, pursuant to section Sec.  
1.367(b)-10(a)(3)(ii) (defining property for purposes of Sec.  
1.367(b)-10) there is no potential application of Sec.  1.367(b)-
10(a) to USS1's acquisition of the FP stock.
    (C) Because paragraph (b)(2) of this section treats USS1 Note as 
stock for federal tax purposes when it is issued by USS1, USS1 Note 
is not treated as indebtedness for purposes of applying paragraph 
(b)(3) of this section.
    Example 3. Issuance of a note in exchange for expanded group 
stock. (i) Facts. On Date A in Year 1, USS1 issues USS1 Note to FP 
in exchange for 40 percent of the FS stock owned by FP.
    (ii) Analysis. (A) Because USS1 and FP are both members of the 
FP expanded group, USS1 Note is treated as stock when it is issued 
by USS1 to FP in exchange for FS stock on Date A in Year 1 under 
paragraphs (b)(2)(ii) and (d)(1)(i) of this section. The exchange of 
USS1 Note for FS stock is not an exempt exchange within the meaning 
of paragraph (f)(5) of this section because USS1 and FP are not 
parties to a reorganization.
    (B) Because USS1 Note is treated as stock for federal tax 
purposes when it is issued by USS1, USS1 Note is not treated as 
property for purposes of section 304(a) because it is not property 
within the meaning specified in

[[Page 20939]]

section 317(a). Therefore, USS1's acquisition of FS stock from FP in 
exchange for USS1 Note is not an acquisition described in section 
304(a)(1).
    (C) Because USS1 Note is treated as stock for federal tax 
purposes when it is issued by USS1, USS1 Note is not treated as 
indebtedness for purposes of applying paragraph (b)(3) of this 
section.
    Example 4. Funding occurs in same taxable year as distribution. 
(i) Facts. On Date A in Year 1, FP lends $200x to CFC in exchange 
for CFC Note A. On Date B in Year 1, CFC distributes $400x of cash 
to USS1 in a distribution. CFC is not an expatriated foreign 
subsidiary as defined in Sec.  1.7874-12T(a)(9).
    (ii) Analysis. Under paragraph (b)(3)(iv)(B) of this section, 
CFC Note A is treated as issued with a principal purpose of funding 
the distribution by CFC to USS1 because CFC Note A is issued to a 
member of the FP expanded group during the 72-month period 
determined with respect to CFC's distribution to USS1. Accordingly, 
under paragraphs (b)(3)(ii)(A) and (d)(1)(i) of this section, CFC 
Note A is treated as stock when it is issued by CFC to FP on Date A 
in Year 1.
    Example 5. Additional funding. (i) Facts. The facts are the same 
as in Example 4, except that, in addition, on Date C in Year 2, FP 
lends an additional $300x to CFC in exchange for CFC Note B.
    (ii) Analysis. The analysis is the same as in Example 4 with 
respect to CFC Note A. CFC Note B is also issued to a member of the 
FP expanded group during the 72-month period determined with respect 
to CFC's distribution to USS1. Under paragraph (b)(3)(iv)(B) of this 
section, CFC Note B is treated as issued with a principal purpose of 
funding the remaining portion of CFC's distribution to USS1, which 
is $200x. Accordingly, $200x of CFC Note B is a principal purpose 
debt instrument that is treated as stock under paragraph 
(b)(3)(ii)(A) of this section. Under paragraph (d)(1)(ii) of this 
section, $200x of CFC Note B is deemed to be exchanged for stock on 
Date C in Year 2. The remaining $100x of CFC Note B continues to be 
treated as indebtedness.
    Example 6. Funding involving multiple interests. (i) Facts. On 
Date A in Year 1, FP lends $300x to USS1 in exchange for USS1 Note 
A. On Date B in Year 2, USS1 distributes $300x of cash to FP. On 
Date C in Year 3, FP lends another $300x to USS1 in exchange for 
USS1 Note B.
    (ii) Analysis. (A) Under paragraph (b)(3)(iv)(B)(3) of this 
section, USS1 Note A is tested under paragraph (b)(3) of this 
section before USS1 Note B is tested. USS1 Note A is issued during 
the 72-month period determined with respect to USS1's $300x 
distribution to FP and, therefore, is treated as issued with a 
principal purpose of funding the distribution under paragraph 
(b)(3)(iv)(B)(1) of this section. Beginning on Date B in Year 2, 
USS1 Note A is a principal purpose debt instrument that is treated 
as stock under paragraphs (b)(3)(ii)(A) and (d)(1)(ii) of this 
section.
    (B) Under paragraph (b)(3)(iv)(B)(3) of this section, USS1 Note 
B is tested under paragraph (b)(3) of this section after USS1 Note A 
is tested. Because USS1 Note A is treated as funding the entire 
$300x distribution by USS1 to FP, USS1 Note B will continue to be 
treated as indebtedness.
    Example 7. Re-testing. (i) Facts. The facts are the same as in 
Example 6, except that on Date D in Year 4, FP sells USS1 Note A to 
Bank.
    (ii) Analysis. (A) Under paragraph (d)(2) of this section, USS1 
Note A ceases to be treated as stock when FP sells USS1 Note A to 
Bank on Date D in Year 4. Immediately before FP sells USS1 Note A to 
Bank, USS1 is deemed to issue a debt instrument to FP in exchange 
for USS1 Note A in a transaction that is disregarded for purposes of 
paragraphs (b)(2) and (b)(3) of this section.
    (B) Under paragraph (d)(2) of this section, after USS1 Note A is 
deemed exchanged, USS1's other debt instruments that are not treated 
as stock as of Date D in Year 4 (USS1 Note B) are re-tested for 
purposes of paragraph (b)(3)(iv)(B) of this section to determine 
whether other USS1 debt instruments are treated as funding the $300x 
distribution by USS1 to FP on Date B in Year 2. USS1 Note B was 
issued by USS1 to FP within the 72-month period determined with 
respect to the $300x distribution. Under paragraph (b)(3)(iv)(B)(1) 
of this section, USS1 Note B is treated as issued with a principal 
purpose of funding the $300x distribution. Accordingly, USS1 Note B 
is a principal purpose debt instrument under paragraph (b)(3)(ii)(A) 
of this section that is deemed to be exchanged for stock on Date D 
in Year 4, the re-testing date, under paragraph (d)(1)(iv) of this 
section. See Sec.  1.385-1(c) for rules regarding the treatment of 
this deemed exchange.
    Example 8. Distribution of expanded group stock and debt 
instrument in a reorganization that qualifies under section 355. (i) 
Facts. On Date A in Year 1, FP lends $200x to USS2 in exchange for 
USS2 Note. In a transaction that is treated as independent from the 
transaction on Date A in Year 1, on Date B in Year 2, USS2 transfers 
a portion of its assets to DS2, a newly-formed domestic corporation, 
in exchange for all of the stock of DS2 and DS2 Note. Immediately 
afterwards, USS2 distributes all of the DS2 stock and the DS2 Note 
to FP with respect to FP's USS2 stock in a transaction that 
qualifies under section 355. USS2's transfer of a portion of its 
assets qualifies as a reorganization within the meaning of section 
368(a)(1)(D). The DS2 stock has a value of $150x and DS2 Note has a 
value of $50x. The DS2 stock is not non-qualified preferred stock as 
defined in section 351(g)(2). Absent the application of this 
section, DS2 Note would be treated by FP as ``other property'' 
within the meaning of section 356.
    (ii) Analysis. (A) The contribution and distribution transaction 
is a reorganization within the meaning of section 368(a)(1) 
involving a transfer of USS2's property described in section 361(a). 
Thus, DS2 Note is a debt instrument that is issued by DS2 to USS2, 
both members of the FP expanded group, pursuant to an asset 
reorganization (as defined in paragraph (f)(1) of this section), and 
received by FP, another FP expanded group member, with respect to 
FP's USS2 stock. Accordingly, DS2 Note is treated as stock when it 
is issued by DS2 to USS2 on Date B in Year 2 pursuant to paragraphs 
(b)(2)(iii) and (d)(1)(i) of this section.
    (B) Because DS2 Note is treated as stock when it is issued, 
section 355(a)(1) rather than section 356 may apply to FP on FP's 
receipt of DS2 Note. Alternatively, depending on the terms of DS2 
Note and other factors, DS2 Note may be treated as non-qualified 
preferred stock that is not treated as stock pursuant to section 
355(a)(3)(D). If DS2 Note is treated as non-qualified preferred 
stock, such stock would continue to be treated by FP as ``other 
property'' for purposes of section 356 under section 356(e). In that 
case, USS2's distribution of DS2 Note would be treated as ``other 
property'' described in section 356, and thus the distribution of 
DS2 note preliminarily would be described in paragraph (b)(3)(ii)(A) 
of this section. However, under paragraph (b)(5) of this section, 
because DS2 Note is treated as stock under paragraph (b)(2)(iii) of 
this section, USS2's distribution of DS2 Note to FP pursuant to the 
plan of reorganization is not also treated as a distribution or 
acquisition described in paragraph (b)(3)(ii) of this section that 
could cause USS2 Note to be a principal purpose debt instrument.
    (C) USS2's distribution of $150x of actual DS2 stock is a 
distribution of stock pursuant to an asset reorganization that is 
permitted to be received by FP without recognition of gain under 
section 355(a)(1). Accordingly, USS2's distribution of the actual 
DS2 stock to FP is not a distribution of property by USS2 for 
purposes of paragraph (b)(3)(ii)(A) of this section.
    (D) USS2's transfer of assets to DS2 in exchange for DS2 stock 
is not an acquisition described in paragraph (b)(3)(ii)(B) of this 
section because USS2's acquisition of DS2 stock is an exempt 
exchange. USS2's acquisition of DS2 stock is an exempt exchange 
described in paragraph (f)(5)(ii) of this section because USS2 and 
DS2 are both parties to a reorganization that is an asset 
reorganization, section 1032 applies to DS2, the transferor of the 
expanded group stock, and the DS2 stock is distributed by USS2, the 
transferee, pursuant to the plan of reorganization. Because USS2 has 
not made a distribution or acquisition that is treated as a 
distribution or acquisition for purposes of paragraph (b)(3)(ii) of 
this section, USS2 Note is not a principal purpose debt instrument.
    Example 9. Funding a distribution by a successor to funded 
member. (i) Facts. The facts are the same as in Example 8, except 
that on Date C in Year 3, DS2 distributes $200x of cash to FP and, 
subsequently, on Date D in Year 3, USS2 distributes $100x of cash to 
FP.
    (ii) Analysis. (A) DS2 is a successor with respect to USS2 under 
paragraph (f)(11)(i) of this section because DS2 is the acquiring 
corporation in a reorganization within the meaning of section 
368(a)(1)(D). USS2 is a predecessor with respect to DS2 under 
paragraph (f)(9)(i) of this section because USS2 is the transferor 
corporation in a reorganization within the meaning of section 
368(a)(1)(D). Accordingly, under paragraph (b)(3)(v) of this 
section, a distribution by DS2 is treated as a distribution by USS2. 
Under paragraph (b)(3)(iv)(B) of this section, USS2

[[Page 20940]]

Note is treated as issued with a principal purpose of funding the 
distribution by DS2 to FP because USS2 Note was issued during the 
72-month period determined with respect to DS2's $200x cash 
distribution. Accordingly, USS2 Note is a principal purpose debt 
instrument under paragraph (b)(3)(ii)(A) of this section that is 
deemed to be exchanged for stock on Date C in Year 3 under paragraph 
(d)(1)(ii) of this section. See Sec.  1.385-1(c) for rules regarding 
the treatment of this deemed exchange.
    (B) Because the entire amount of USS2 Note is treated as funding 
DS2's $200x distribution to FP, under paragraph (b)(3)(iv)(B)(4) of 
this section, USS2 Note is not treated as funding the subsequent 
distribution by USS2 on Date D in Year 3.
    Example 10. Asset reorganization; section 354 qualified 
property. (i) Facts. On Date A in Year 1, FS lends $100x to USS2 in 
exchange for USS2 Note. On Date B in Year 2, in a transaction that 
qualifies as a reorganization within the meaning of section 
368(a)(1)(D), USS2 transfers all of its assets to USS1 in exchange 
for stock of USS1 and the assumption by USS1 of all of the 
liabilities of USS2, and USS2 distributes to FP, with respect to 
FP's USS2 stock, all of the USS1 stock that USS2 received. FP does 
not recognize gain under section 354(a)(1).
    (ii) Analysis. (A) USS1 is a successor with respect to USS2 
under paragraph (f)(11)(i) of this section because USS1 is the 
acquiring corporation in a reorganization within the meaning of 
section 368(a)(1)(D). For purposes of paragraph (b)(3) of this 
section, USS2 and its successor, USS1, are funded members with 
respect to USS2 Note. Although USS2, a funded member, distributes 
property (USS1 stock) to its shareholder, FP, pursuant to the 
reorganization, the distribution of USS1 stock is not described in 
paragraph (b)(3)(ii)(A) of this section because the property is 
permitted to be received without the recognition of gain under 
section 354(a)(1). The distribution of USS1 stock is also not 
described in paragraph (b)(3)(ii)(C) of this section because FP does 
not receive the USS1 stock as ``other property'' within the meaning 
of section 356.
    (B) USS2's exchange of assets for USS1 stock is not an 
acquisition described in paragraph (b)(3)(ii)(B) of this section 
because USS2's acquisition of USS1 stock is an exempt exchange. 
USS2's acquisition of USS1 stock is an exempt exchange described in 
paragraph (f)(5)(ii) of this section because USS1 and USS2 are both 
parties to a reorganization, section 1032 applies to USS1, the 
transferor of the expanded group stock, and the USS1 stock is 
distributed by USS2, the transferee, pursuant to the plan of 
reorganization.
    (C) Because neither USS1 nor USS2 has made a distribution or 
acquisition described in paragraph (b)(3)(ii) of this section, USS2 
Note is not a principal purpose debt instrument.
    Example 11. Triangular reorganization. (i) Facts. USS2 owns 100 
percent of the stock of DS2, a domestic corporation. On Date B in 
Year 1, FP issues FP stock and FP Note to USS1 as a contribution to 
capital. USS1 does not formally issue additional USS1 stock to FP in 
exchange for FP stock and FP Note, but is treated as issuing stock 
to FP in an exchange to which section 351 applies. Immediately 
afterwards, USS1 transfers the FP stock and FP Note to DS2 in 
exchange for all of DS2's assets, and DS2 distributes the FP stock 
and FP Note to USS2 with respect to USS2's DS2 stock in a 
liquidating distribution.
    (ii) Analysis. FP Note is issued by FP to USS1 in exchange for 
stock of USS1 in an exchange that is not an exempt exchange 
described in paragraph (f)(5) of this section. Under paragraph 
(b)(2)(ii) of this section, FP Note is treated as stock beginning on 
Date B in Year 1.
    Example 12. Funded acquisition of subsidiary stock by issuance; 
successor.
    (i) Facts. On Date A in Year 1, FS lends $100x to USS1 in 
exchange for USS1 Note. On Date B in Year 1, USS1 transfers property 
that has a value of $20x to CFC in exchange for additional CFC stock 
that has a value of $20x. On Date C in Year 2, CFC distributes $20 
cash to USS1. On Date D in Year 3, CFC acquires stock of FS from FP 
in exchange for $50x cash.
    (ii) Analysis. (A) But for the exception in paragraph (c)(3) of 
this section, USS1 Note would be treated under paragraph 
(b)(3)(iv)(B) of this section as issued with a principal purpose of 
funding an acquisition of expanded group stock described in 
paragraph (b)(3)(ii)(B) of this section because USS1 Note is issued 
to a member of the FP expanded group during the 72-month period 
determined with respect to USS1's acquisition of CFC stock on Date B 
in Year 1. However, because USS1's acquisition of CFC stock results 
from a transfer of property from USS1 to CFC in exchange for CFC 
stock and immediately after the transaction USS1 holds 100 percent 
of the stock of CFC, the exception in paragraph (c)(3) of this 
section applies. Accordingly, USS1's acquisition of CFC stock on 
Date B in Year 1 is not treated as an acquisition of stock described 
in paragraph (b)(3)(ii)(B) of this section, and USS1 Note is not 
treated as stock.
    (B) CFC is a successor with respect to USS1 under paragraph 
(f)(11)(ii) of this section. For purposes of paragraph 
(b)(3)(iv)(B)(1) of this section CFC is a successor only to the 
extent of the value of the expanded group stock acquired from CFC in 
the transaction described in paragraph (c)(3) of this section.
    (C) Under paragraph (f)(11)(ii) of this section, CFC's $20x cash 
distribution to USS1 on Date C in Year 2 is not taken into account 
for purposes of applying paragraph (b)(3) of this section to USS1 
Note.
    (D) On Date D in Year 3, CFC continues to be a successor to USS1 
for purposes of applying the per se rule in paragraph (b)(3)(iv)(B) 
of this section. Accordingly, USS1 Note is a principal purpose debt 
instrument under paragraph (b)(3)(ii)(A) of this section that is 
deemed to be exchanged for stock on Date D in Year 3 under paragraph 
(d)(1)(ii) of this section. See Sec.  1.385-1(c) for rules regarding 
the treatment of this deemed exchange.
    Example 13. Distribution of a debt instrument to partnership. 
(i) Facts. CFC and FS are equal partners in PRS. PRS owns 100 
percent of the stock of X Corp, a domestic corporation. On Date A in 
Year 1, X Corp issues X Note to PRS in a distribution.
    (ii) Analysis. (A) Under Sec.  1.385-1(b)(3), in determining 
whether X Corp is a member of the expanded group that includes CFC 
and FS, CFC and FS are each treated as holding 50 percent of the X 
Corp stock held by PRS. Accordingly, 100 percent of X Corp's stock 
is treated as owned by CFC and FS under Sec.  1.385-1(b)(3)(i)(B), 
and X Corp is a member of the FP expanded group.
    (B) Together CFC and FS own 100 percent of the interests in PRS 
capital and profits, such that PRS is a controlled partnership 
described in Sec.  1.385-1(b)(1). Under paragraph (d)(5)(i) of this 
section, solely for purposes of this section, when X Corp issues X 
Note to PRS, proportionate shares of X Note are treated as issued to 
CFC and FS. Accordingly, for purposes of applying paragraph (b) of 
this section, in Year 1, 50 percent of X Note is treated as issued 
to CFC in a distribution and the other 50 percent of X Note is 
treated as issued to FS in a distribution. Therefore, under 
paragraphs (b)(2)(i) and (d)(1)(i) of this section, X Note is 
treated as stock beginning on Date A in Year 1. Under paragraph 
(d)(5)(i) of this section, CFC and FS are treated as holding X Note 
solely for purposes of this section. For all other federal tax 
purposes, X Note is treated as stock in X Corp that is held by PRS, 
and X Corp is treated as distributing its stock to its shareholder 
in a distribution that is subject to section 305.
    Example 14. Loan to partnership; same-year distribution. (i) 
Facts. The facts are the same as in Example 13, except that X Corp 
does not distribute X Note to PRS; instead, on Date A in Year 1 FP 
lends $200x to PRS in exchange for PRS Note. On Date B in Year 1, 
CFC distributes $100x to USS1 and FS distributes $100x to FP. CFC is 
not an expatriated foreign subsidiary as defined in Sec.  1.7874-
12T(a)(9).
    (ii) Analysis. (A) Under paragraph (d)(5)(i) of this section, 
solely for purposes of this section, CFC and FS are each treated as 
issuing $100x of PRS Note on Date A in Year 1, which represents 
their proportionate shares of PRS Note. CFC's and FS's shares of PRS 
Note are each issued to FP, a member of the same expanded group, 
during the 72-month periods determined with respect to the 
distributions by CFC and FS. Under paragraph (b)(3)(iv)(B)(1) of 
this section, PRS Note is treated as issued with a principal purpose 
of funding the distributions by CFC and FS. Accordingly, under 
paragraphs (b)(3)(ii)(A) and (d)(1)(i) of this section, PRS Note is 
a principal purpose debt instrument that is treated as stock when it 
is issued on Date A in Year 1.
    (B) Under paragraph (d)(5)(ii) of this section, CFC and FS are 
each treated as issuing $100x of stock to FP. Appropriate conforming 
adjustments must be made to CFC's and FS's interests in PRS to 
reflect the deemed treatment of PRS Note as stock issued by CFC and 
FS, which must be done in a manner that avoids the creation of, or 
increase in, a disparity between PRS's aggregate basis in its assets 
and the aggregate bases of CFC's and FS's respective interests in 
PRS. For example, reasonable and appropriate adjustments may occur 
when the following steps are deemed to occur on Date A in Year 1:

[[Page 20941]]

    (1) CFC issues stock to FP in exchange for $100x;
    (2) FS issues stock to FP in exchange for $100x;
    (3) CFC contributes $100x to PRS in exchange for a partnership 
interest in PRS; and
    (4) FS contributes $100x to PRS in exchange for a partnership 
interest in PRS.
    Example 15. Loan to partnership; distribution in later year. (i) 
Facts. The facts are the same as in Example 14, except that CFC and 
FS do not make distributions on Date B of Year 1; instead, CFC 
distributes $100x to USS1 and FS distributes $100x to FP on Date C 
of Year 2.
    (ii) Analysis. (A) As in Example 14, CFC's and FS's shares of 
PRS Note are each issued to FP, a member of the same expanded group, 
during the 72-month periods determined with respect to the 
distributions by CFC and FS. Under paragraph (b)(3)(iv)(B)(1) of 
this section, PRS Note is treated as issued with a principal purpose 
of funding the distributions by CFC and FS. Accordingly, PRS Note is 
a principal purpose debt instrument that is treated as stock under 
paragraph (b)(3)(i)(A) of this section. Under paragraph (d)(1)(ii) 
of this section, PRS Note is treated as stock on Date C in Year 2.
    (B) Under paragraph (d)(5)(ii) of this section, CFC and FS are 
each treated as issuing $100x of stock to FP. Appropriate conforming 
adjustments must be made to CFC's and FS's interests in PRS to 
reflect the deemed treatment of PRS Note as stock issued by CFC and 
FS, which must be done in a manner that avoids the creation of, or 
increase in, a disparity between PRS's aggregate basis in its assets 
and the aggregate bases of CFC's and FS's respective interests in 
PRS. For example, reasonable and appropriate adjustments may occur 
when the following steps are deemed to occur on Date C in Year 2:
    (1) CFC assumes liability with respect to $100x of PRS Note;
    (2) FS assumes liability with respect to $100x of PRS Note;
    (3) CFC issues stock to FP in satisfaction of the $100x of PRS 
Note assumed by CFC; and
    (4) FS issues stock to FP in satisfaction of the $100x of PRS 
Note assumed by FS.
    Example 16. Distribution of another member's debt instrument. 
(i) Facts. On Date A in Year 1, CFC lends $100x to FS in exchange 
for FS Note. On Date B in Year 2, CFC distributes FS Note to USS1.
    (ii) Analysis. Although CFC distributes FS Note, which is a debt 
instrument, to USS1, another member of CFC's expanded group, 
paragraph (b)(2)(i) of this section does not apply because CFC is 
not the issuer of the FS Note.
    Example 17. Threshold exception and current year earnings and 
profits exception. (i) Facts. Before Date A in Year 1, the members 
of FP's expanded group hold no outstanding debt instruments that 
otherwise would be treated as stock under this section. On Date A in 
Year 1, CFC issues CFC Note, which has an issue price of $40 
million, to USS1 in a distribution. On Date B in Year 2, USS1 issues 
USS1 Note, which has an issue price of $20 million, to FP in a 
distribution. On Date C in Year 3, FS distributes $30 million in 
cash to FP. On Date D in Year 3, DS lends $30 million to FS in 
exchange for FS Note A. On Date E in Year 3, FS issues FS Note B, 
which has an issue price of $19 million, to FP in a distribution. In 
Year 3, FS has $35 million in earnings and profits described in 
section 316(a)(2).
    (ii) Analysis. (A) Because CFC does not have earnings and 
profits described in section 316(a)(2) in Year 1, the exception in 
paragraph (c)(1) of this section does not apply to CFC Note. 
Immediately after CFC Note is issued to USS1 on Date A in Year 1, 
the aggregate adjusted issue price of outstanding debt instruments 
issued by members of FP's expanded group that would be subject to 
paragraph (b) of this section but for the application paragraph 
(c)(2) of this section does not exceed $50 million. Accordingly, the 
threshold exception described in paragraph (c)(2) applies to the CFC 
Note.
    (B) Because USS1 does not have earnings and profits described in 
section 316(a)(2) in Year 2, the exception in paragraph (c)(1) of 
this section does not apply to USS1 Note. Immediately after USS1 
Note is issued to FP on Date B in Year 2, the aggregate adjusted 
issue price of outstanding debt instruments issued by members of the 
FP expanded group that would be subject to paragraph (b) of this 
section but for the application of paragraph (c)(2) of this section 
exceeds $50 million. Under paragraph (d)(1)(iii) of this section, 
CFC Note is deemed to be exchanged for stock on Date B in Year 2, 
when debt instruments of the FP expanded group cease to qualify for 
the threshold exception described in paragraph (c)(2) of this 
section. In addition, the threshold exception described in paragraph 
(c)(2) of this section does not apply to USS1 Note because, 
immediately after USS1 Note is issued, the aggregate adjusted issue 
price of outstanding debt instruments issued by members of the 
expanded group that would be subject to paragraph (b) of this 
section but for the application paragraph (c)(2) of this section 
exceeds $50 million. Accordingly, USS1 Note is treated as stock when 
it is issued on Date B in Year 2.
    (C) Under paragraph (c)(1) of this section, for purposes of 
applying paragraphs (b)(2) and (b)(3) of this section to a member of 
an expanded group with respect to Year 3, the aggregate amount of 
any distributions or acquisitions by FS that are described in 
paragraphs (b)(2) or (b)(3)(ii) of this section are reduced by an 
amount equal to FS's current year earnings and profits described in 
section 316(a)(2) for Year 3, which is $35 million. Thus, $35 
million of distributions or acquisitions by FS in Year 3 are not 
taken into account for purposes of applying paragraphs (b)(2) and 
(b)(3) of this section. The reduction is applied first against FS's 
$30 million cash distribution on Date C in Year 3 and second against 
FS's $19 million note distribution on Date E in Year 3. Accordingly, 
under paragraph (c)(1) of this section, FS Note A is not treated as 
stock under paragraph (b)(3) of this section. In addition, under 
paragraph (c)(1) of this section a portion of FS Note B equal to $5 
million is not treated as stock under paragraph (b)(2) of this 
section.
    (D) When FS Note B is issued in Year 3, CFC Note, which 
previously was treated as indebtedness solely because of paragraph 
(c)(2) of this section, remains outstanding. Accordingly, the 
threshold exception described in paragraph (c)(2) of this section 
does not apply to FS Note B. Accordingly, the remaining amount of FS 
Note B equal to $14 million after applying the exception under 
paragraph (c)(1) of this section is treated as stock under paragraph 
(b)(2) of this section.
    Example 18. Distribution of a debt instrument and issuance of a 
debt instrument with a principal purpose of avoiding the purposes of 
this section. (i) Facts. On Date A in Year 1, USS1 issues USS1 Note 
A, which has a value of $100x, to FP in a distribution. On Date B in 
Year 1, with a principal purpose of avoiding the application of this 
section, FP sells USS1 Note A to Bank for $100x of cash and lends 
$100x to USS1 in exchange for USS1 Note B.
    (ii) Analysis. USS1 Note A is a debt instrument that is issued 
by USS1 to FP, a member of USS1's expanded group, in a distribution. 
Accordingly, under paragraphs (b)(2)(i) and (d)(1)(i) of this 
section, USS1 Note A is treated as stock when it is issued by USS1 
to FP on Date A in Year 1. Accordingly, USS1 is treated as 
distributing USS1 stock to its shareholder FP. Because USS1 Note A 
is treated as stock of USS1, USS1 Note A is not property as 
specified in section 317(a) on Date A in Year 1. Under paragraph 
(d)(2) of this section, USS1 Note A ceases to be treated as stock 
when FP sells USS1 Note A to Bank on Date B in Year 1. Immediately 
before FP sells USS1 Note A to Bank, USS1 is deemed to issue a debt 
instrument to FP in exchange for USS1 Note A in a transaction that 
is disregarded for purposes of paragraphs (b)(2) and (b)(3) of this 
section. USS1 Note B is not treated as stock under paragraph 
(b)(3)(ii)(A) of this section because the funded member, USS1, has 
not made a distribution of property. However, because the 
transactions occurring on Date B of Year 1 were undertaken with a 
principal purpose of avoiding the purposes of this section, USS1 
Note B is treated as stock on Date B of Year 1 under paragraph 
(b)(4) of this section.

    (h) Effective/applicability date and transition rules--(1) In 
general. This section applies to any debt instrument issued on or after 
April 4, 2016, and to any debt instrument treated as issued before 
April 4, 2016 as a result of an entity classification election made 
under Sec.  301.7701-3 of this chapter that is filed on or after April 
4, 2016.
    (2) Transition rule for distributions or acquisitions occurring 
before April 4, 2016. For purposes of paragraph (b)(3)(iv) of this 
section, a distribution or acquisition described in paragraph 
(b)(3)(ii) of this section that occurs before April 4, 2016, other than 
a distribution or acquisition that is treated as occurring before April 
4, 2016 as a result of an entity classification election made under 
Sec.  301.7701-3 of this chapter

[[Page 20942]]

that is filed on or after April 4, 2016, is not taken into account.
    (3) Transition rule for debt instruments that would be treated as 
stock prior to the date of publication in the Federal Register  of the 
Treasury decision adopting this rule as a final regulation. When 
paragraphs (b) and (d)(1)(i) through (v) of this section otherwise 
would treat a debt instrument as stock prior to the date of publication 
in the Federal Register of the Treasury decision adopting this rule as 
a final regulation, the debt instrument is treated as indebtedness 
until the date that is 90 days after the date of publication in the 
Federal Register of the Treasury decision adopting this rule as a final 
regulation. To the extent that the debt instrument described in the 
preceding sentence is held by a member of the issuer's expanded group 
on the date that is 90 days after the date of publication in the 
Federal Register of the Treasury decision adopting this rule as a final 
regulation, the debt instrument is deemed to be exchanged for stock on 
the date that is 90 days after the date of publication in the Federal 
Register of the Treasury decision adopting this rule as a final 
regulation.
0
Par. 5. Section 1.385-4 is added to read as follows:


Sec.  1.385-4  Treatment of consolidated groups.

    (a) Scope. Section 1.385-1(e) provides that members of a 
consolidated group are treated as one corporation for purposes of the 
regulations under section 385. This section provides rules for applying 
Sec.  1.385-3 to consolidated groups when an interest ceases to be a 
consolidated group debt instrument or becomes a consolidated group debt 
instrument. For definitions applicable to this section, see Sec.  
1.385-3(f).
    (b) Debt instrument ceases to be a consolidated group debt 
instrument but continues to be an expanded group debt instrument--(1) 
Member leaving the group. When a corporation ceases to be a member of 
the consolidated group but continues to be a member of the expanded 
group (such corporation, a departing member), a debt instrument that is 
issued or held by the departing member is treated as indebtedness or 
stock pursuant to paragraphs (b)(1)(i) or (b)(1)(ii) of this section.
    (i) Exempt consolidated group debt instrument that ceases to be 
consolidated group debt instrument. Any exempt consolidated group debt 
instrument that is issued or held by the departing member is deemed to 
be exchanged for stock immediately after the departing member leaves 
the group. For these purposes, the term exempt consolidated group debt 
instrument means any debt instrument that was not treated as stock 
solely by reason of the departing member's treatment under Sec.  1.385-
1(e). See paragraph (d) of this section, Example 3, for an illustration 
of this rule.
    (ii) Non-exempt consolidated group debt instrument that ceases to 
be consolidated group debt instrument--(A) In general. Any consolidated 
group debt instrument issued or held by a departing member that is not 
an exempt consolidated group debt instrument (non-exempt consolidated 
group debt instrument) is treated as indebtedness unless and until the 
non-exempt consolidated group debt instrument is treated as a principal 
purpose debt instrument under Sec.  1.385-3(b)(3)(ii) and (d)(1) as a 
result of a distribution or acquisition described in Sec.  1.385-
3(b)(3)(ii) that occurs after the departure.
    (B) Coordination with funding rule. Solely for purposes of applying 
the 72-month period under Sec.  1.385-3(b)(3)(iv)(B) (the per se rule), 
a non-exempt consolidated group debt instrument is treated as having 
been issued when it was first treated as a consolidated group debt 
instrument. For all other purposes of applying Sec.  1.385-3, including 
for purposes of applying Sec.  1.385-3(d), a non-exempt consolidated 
group debt instrument is treated as issued by the issuer of the debt 
instrument immediately after the departing member leaves the group.
    (2) Consolidated group debt instrument that is transferred outside 
of the consolidated group. Solely for purposes of Sec.  1.385-3, when a 
member of a consolidated group that holds a consolidated group debt 
instrument transfers the debt instrument to an expanded group member 
that is not a member of the consolidated group, the debt instrument is 
treated as issued by the issuer of the debt instrument (which is 
treated as one corporation with the transferor of the debt instrument 
pursuant to Sec.  1.385-1(e)) to the transferee expanded group member 
on the date of the transfer. For purposes of Sec.  1.385-3, the 
consequences of such transfer are determined in a manner that is 
consistent with treating a consolidated group as one corporation. Thus, 
for example, the sale of a consolidated group debt instrument to an 
expanded group member that is not a member of the consolidated group 
will be treated as an issuance of the debt instrument to the transferee 
expanded group member in exchange for property. To the extent the debt 
instrument is treated as stock upon being transferred, the debt 
instrument is deemed to be exchanged for stock immediately after the 
debt instrument is transferred outside of the consolidated group. For 
examples illustrating this rule, see paragraph (d) of this section, 
Examples 1 and 2.
    (c) Debt instrument entering a consolidated group. When a debt 
instrument that is treated as stock under Sec.  1.385-3 becomes a 
consolidated group debt instrument, immediately before that debt 
instrument becomes a consolidated group debt instrument, the issuer is 
treated as issuing a new debt instrument to the holder in exchange for 
the debt instrument that was treated as stock in a transaction that is 
disregarded for purposes of Sec.  1.385-3(b).
    (d) Examples--(1) Assumed facts. Except as otherwise stated, the 
following facts are assumed for purposes of the examples in paragraph 
(d)(3) of this section:
    (i) FP is a foreign corporation that owns 100 percent of the stock 
of USS1, a domestic corporation, and 100 percent of the stock of FS, a 
foreign corporation;
    (ii) USS1 owns 100 percent of the stock of DS1, a domestic 
corporation;
    (iii) DS1 owns 100 percent of the stock of DS2, a domestic 
corporation;
    (iv) At the beginning of Year 1, FP is the common parent of an 
expanded group comprised solely of FP, USS1, FS, DS1, and DS2 (the FP 
expanded group);
    (v) USS1, DS1, and DS2 are members of a consolidated group of which 
USS1 is the common parent (the USS1 consolidated group);
    (vi) The FP expanded group has more than $50 million of debt 
instruments described in Sec.  1.385-3(c)(2) at all times;
    (vii) No issuer of a debt instrument has current year earnings and 
profits described in section 316(a)(2);
    (viii) All notes are debt instruments described in Sec.  1.385-
3(f)(3) and therefore have satisfied any requirements under Sec.  
1.385-2, if applicable, and are respected as debt instruments under 
general federal tax principles;
    (ix) No notes are eligible for the ordinary course exception 
described in Sec.  1.385-3(b)(3)(iv)(B)(2);
    (x) Each entity has as its taxable year the calendar year;
    (xi) No domestic corporation is a United States real property 
holding corporation within the meaning of section 897(c)(2); and
    (xii) Each note is issued with adequate stated interest (as defined 
in section 1274(c)(2)).
    (2) No inference. Except as provided in this section, it is assumed 
for purposes of the examples that the form of each transaction is 
respected for federal tax purposes. No inference is

[[Page 20943]]

intended, however, as to whether any particular note would be respected 
as indebtedness or as to whether the form of any particular transaction 
described in paragraph (d)(3) of this section would be respected for 
federal tax purposes.
    (3) Examples. The following examples illustrate the rules of this 
section.

    Example 1. Distribution of consolidated group debt instrument. 
(i) Facts. On Date A in Year 1, DS1 issues DS1 Note to USS1 in a 
distribution. On Date B in Year 2, USS1 distributes DS1 Note to FP.
    (ii) Analysis. Under Sec.  1.385-1(e), the USS1 consolidated 
group is treated as one corporation for purposes of Sec.  1.385-3. 
Accordingly, when DS1 issues DS1 Note to USS1 in a distribution, DS1 
is not treated as issuing a debt instrument to another member of 
DS1's expanded group in a distribution for purposes of Sec.  1.385-
3, and DS1 Note is not treated as stock under Sec.  1.385-3. Under 
paragraph (b)(2) of this section, when USS1 distributes DS1 Note to 
FP, the USS1 consolidated group is treated as issuing a debt 
instrument to FP in a distribution. Accordingly, DS1 Note is treated 
as DS1 stock under Sec.  1.385-3(b)(2)(i). For this purpose, DS1 
Note is deemed to be exchanged for stock immediately after DS1 Note 
is transferred outside of the USS1 consolidated group.
    Example 2. Sale of consolidated group debt instrument. (i) 
Facts. On Date A in Year 1, DS1 lends $200x to USS1 in exchange for 
USS1 Note. On Date B in Year 2, USS1 distributes $200x to FP. On 
Date C in Year 2, DS1 sells USS1 Note to FS for $200x.
    (ii) Analysis. Under Sec.  1.385-1(e), the USS1 consolidated 
group is treated as one corporation for purposes of Sec.  1.385-3. 
Accordingly, when USS1 issues USS1 Note to DS1 on Date A in Year 1, 
USS1 is not treated as a funded member, and when USS1 distributes 
$200x to FP on Date B in Year 2, Sec.  1.385-2(b)(3) does not apply. 
Under paragraph (b)(2) of this section, when DS1 sells USS1 Note to 
FS, the USS1 consolidated group is treated as issuing USS1 Note to 
FS in exchange for $200x on Date C in Year 2. Because USS1 Note was 
issued by the USS1 consolidated group to FS within 36 months of the 
distribution by the USS1 consolidated group to FP, Sec.  1.385-
3(b)(3)(iv)(B)(1) treats USS1 Note as issued with a principal 
purpose of funding that distribution. Accordingly, USS1 Note is a 
principal purpose debt instrument that is treated as USS1 stock 
under Sec.  1.385-3(b)(3)(ii)(A). Under paragraph (b)(2) of this 
section, immediately after USS1 Note is transferred outside of the 
USS1 consolidated group, USS1 Note is deemed to be exchanged for 
stock.
    Example 3. Treatment of exempt consolidated group debt 
instrument when a consolidated group member leaves the consolidated 
group. (i) Facts. On Date A in Year 1, DS1 issues DS1 Note A to USS1 
in a distribution. On Date B in Year 2, USS1 lends $100x to DS1 in 
exchange for DS1 Note B. On Date C in Year 4, FP purchases 25 
percent of DS1's stock from USS1, resulting in DS1 ceasing to be a 
member of the USS1 consolidated group.
    (ii) Analysis. (A) Under Sec.  1.385-1(e), the USS1 consolidated 
group is treated as one corporation for purposes of Sec.  1.385-3 
until Date C in Year 4. Accordingly, when DS1 issues DS1 Note to 
USS1 in a distribution on Date A in Year 1, DS1 is not treated as 
issuing a debt instrument to a member of DS's expanded group in a 
distribution for purposes of Sec.  1.385-3(b)(2), and DS1 Note A is 
not treated as stock under Sec.  1.385-3 on Date A in Year 1. DS1 
Note A is an exempt consolidated group debt instrument because DS1 
Note A is not treated as stock on Date A in Year 1 solely by reason 
of Sec.  1.385-1(e). Under paragraph (b)(1)(i) of this section, 
immediately after DS1 leaves the USS1 consolidated group, DS1 Note A 
is deemed to be exchanged for stock.
    (B) DS1 Note B is a non-exempt consolidated group debt 
instrument because DS1 Note B, which is issued in exchange for cash, 
would not be treated as stock even absent the application of Sec.  
1.385-1(e) because there have been no transactions described in 
Sec.  1.385-3(b)(3)(ii) that would have been treated as funded by 
DS1 Note B in the absence of the application of Sec.  1.385-1(e). 
Accordingly, under paragraph (b)(1)(ii)(A) of this section, DS1 Note 
B is not treated as stock when DS1 ceases to be a member of the USS1 
consolidated group, provided there are no distributions or 
acquisitions described in Sec.  1.385-3(b)(3)(ii) by DS1 that occur 
later in Year 4 (after Date C).
    Example 4. Distribution after a funded consolidated group member 
leaves the consolidated group. (i) Facts. The facts are the same as 
in Example 3, except that on Date D in Year 6, DS1 distributes $100x 
pro rata to its shareholders ($75x to USS1 and $25x to FP).
    (ii) Analysis. The per se rule in Sec.  1.385-3(b)(3)(iv)(B)(1) 
does not apply to DS1 Note B and the distribution on Date D in Year 
6 because under section (b)(1)(ii)(B) of this section, for purposes 
of applying Sec.  1.385-3(b)(3)(iv)(B)(1), DS1 Note B is treated as 
issued on Date B in Year 2, which is more than 36 months before Date 
D in Year 6.
    Example 5. Treatment of non-exempt consolidated group debt 
instrument when a consolidated group member leaves the group. (i) 
Facts. On Date A in Year 1, DS2 lends $100x to DS1 in exchange for 
DS1 Note. On Date B in Year 1, DS1 distributes $100x of cash to 
USS1. On Date C in Year 1, FP purchases 25 percent of DS2's stock 
from DS1, resulting in DS2 ceasing to be a member of the USS1 
consolidated group.
    (ii) Analysis. After DS2 ceases to be a member of the USS1 
consolidated group, DS1 and USS1 continue to be treated as one 
corporation under Sec.  1.385-1(e), such that DS1's distribution of 
cash to USS1 on Date B in Year 1 continues to be disregarded for 
purposes of Sec.  1.385-3. Accordingly, DS1 Note is a non-exempt 
consolidated group debt instrument because DS1 Note, which is issued 
in exchange for cash, would not be treated as stock even absent the 
application of Sec.  1.385-1(e) to DS2, because, taking into account 
the continued application of Sec.  1.385-1(e) to USS1 and DS1, DS1 
Note does not fund any transaction described in Sec.  1.385-
3(b)(3)(ii). Accordingly, under paragraph (b)(1)(ii)(A) of this 
section, DS1 Note is not treated as stock when it ceases to be a 
consolidated group debt instrument, provided there are no 
distributions or acquisitions described in Sec.  1.385-3(b)(3)(ii) 
by DS1 that occur later in Year 1 (after Date C).

    (e) Effective/applicability date and transition rules--(1) In 
general. This section applies to any debt instrument issued on or after 
April 4, 2016, and to any debt instrument treated as issued before 
April 4, 2016 as a result of an entity classification election made 
under Sec.  301.7701-3 of this chapter that is filed on or after April 
4, 2016.
    (2) Transition rule for distributions or acquisitions occurring 
before April 4, 2016. For purposes of this section, a distribution or 
acquisition described in Sec.  1.385-3(b)(3)(ii) that occurs before 
April 4, 2016, other than a distribution or acquisition that is treated 
as occurring before April 4, 2016 as a result of an entity 
classification election made under Sec.  301.7701-3 of this chapter 
that is filed on or after April 4, 2016, is not taken into account.
    (3) Transition rule for debt instruments that would be treated as 
stock prior to the date of publication in the Federal Register of the 
Treasury decision adopting this rule as a final regulation. When this 
section otherwise would treat a debt instrument as stock prior to the 
date of publication in the Federal Register of the Treasury decision 
adopting this rule as a final regulation, the debt instrument is 
treated as indebtedness until the date that is 90 days after the date 
of publication in the Federal Register of the Treasury decision 
adopting this rule as a final regulation. To the extent that the debt 
instrument described in the preceding sentence is held by a member of 
the issuer's expanded group on the date that is 90 days after the date 
of publication in the Federal Register of the Treasury decision 
adopting this rule as a final regulation, the debt instrument is deemed 
to be exchanged for stock on the date that is 90 days after the date of 
publication in the Federal Register of the Treasury decision adopting 
this rule as a final regulation.

John Dalrymple.
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2016-07425 Filed 4-4-16; 5:00 pm]
BILLING CODE 4830-01-P