IRB 2016-17 (Rev. April 25, 2016)

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

REG–108060–15, page 636.This document contains proposed regulations under section385 of the Internal Revenue Code (Code) that would authorizethe Commissioner to treat certain related party interests in acorporation as indebtedness in part and stock in part forfederal tax purposes, and establish threshold documentationrequirements that must be satisfied in order for certain relatedparty interests in a corporation to be treated as indebtedness forfederal tax purposes. The proposed regulations also would treatas stock certain related party interests that otherwise would betreated as indebtedness for federal tax purposes. The proposedregulations generally affect corporations that issue purportedindebtedness to related corporations or partnerships.

Rev. Proc. 2016–18, page 635.This revenue procedure provides an updated list of countrieswith which the IRS and Treasury have determined that it isappropriate to have an automatic exchange relationship withrespect to the bank deposit interest information collectedunder Sections 1.6049–4(b)(5) and 1.6049–8 of the IncomeTax Regulations. This revenue procedure is a March 2016supplement to Rev. Proc. 2014–64, 2014–53 I.R.B. 1022,which was last supplemented by Rev. Proc. 2015–50,2015–42 I.R.B 583 in September 2015.

EXEMPT ORGANIZATIONS

Announcement 2016–15, page 636.Revocation of IRC 501(c)(3) Organizations for failure to meetthe code section requirements. Contributions made to theorganizations by individual donors are no longer deductibleunder IRC 170(b)(1)(A).

Finding Lists begin on page ii.

Bulletin No. 2016–17April 25, 2016

The IRS MissionProvide America’s taxpayers top-quality service by helpingthem understand and meet their tax responsibilities and en-force the law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly.

It is the policy of the Service to publish in the Bulletin allsubstantive rulings necessary to promote a uniform applicationof the tax laws, including all rulings that supersede, revoke,modify, or amend any of those previously published in theBulletin. All published rulings apply retroactively unless other-wise indicated. Procedures relating solely to matters of internalmanagement are not published; however, statements of inter-nal practices and procedures that affect the rights and dutiesof taxpayers are published.

Revenue rulings represent the conclusions of the Service onthe application of the law to the pivotal facts stated in therevenue ruling. In those based on positions taken in rulings totaxpayers or technical advice to Service field offices, identify-ing details and information of a confidential nature are deletedto prevent unwarranted invasions of privacy and to comply withstatutory requirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautioned

against reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A, TaxConventions and Other Related Items, and Subpart B, Legisla-tion and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative index forthe matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

April 25, 2016 Bulletin No. 2016–17

Part III. Administrative, Procedural, and Miscellaneous26 CFR 1.6049.00–00: Returns Relating to Pay-ments of Interest(Also: 1.3406.07–00 Exceptions to Backup With-holding)

Rev. Proc. 2016–18

SECTION 1. PURPOSE

This revenue procedure supplements thelisting in Revenue Procedure 2014–64,2014–53 I.R.B. 1022, as previously sup-plemented by Rev. Proc. 2015–50,2015–42 I.R.B. 583, of the countries withwhich the Department of the Treasury(Treasury Department) and the InternalRevenue Service (IRS) have determinedthat it is appropriate to have an automaticexchange relationship with respect to theinformation collected under §§ 1.6049–4(b)(5) and 1.6049–8 of the Income TaxRegulations.

SECTION 2. BACKGROUND

Sections 1.6049–4(b)(5) and 1.6049–8(a),as revised by TD 9584, require the report-ing of certain deposit interest paid to non-resident alien individuals on or after Jan-uary 1, 2013. Rev. Proc. 2012–24,2012–20 I.R.B. 913, was published con-temporaneously with the publication ofTD 9584. Section 4 of that revenue pro-cedure identified the countries with whichthe Treasury Department and the IRS haddetermined that it was appropriate to havean automatic exchange relationship withrespect to the information collected under§§ 1.6049–4(b)(5) and 1.6049–8. Rev.Proc. 2012–24 was updated and super-seded by Rev. Proc. 2014–64, Section 4

of which contained an updated list ofcountries with which an automatic ex-change relationship had been determinedappropriate. Rev. Proc. 2014–64 was sup-plemented by Rev. Proc. 2015–50, whichadded 16 countries to that list. This reve-nue procedure further supplements Rev.Proc. 2014–64 by adding three countries(Azerbaijan, Jamaica, and the Slovak Re-public) to the list of countries in Section 4of Rev. Proc. 2014–64.

SECTION 3. SUPPLEMENT TOREV. PROC. 2014–64

Section 4 of Rev. Proc. 2014–64, assupplemented by Rev. Proc. 2015–50, isfurther supplemented to read as follows:

The following list identifies the coun-tries with which the automatic exchangeof the information collected under§§ 1.6049–4(b)(5) and 1.6049–8 hasbeen determined by the Treasury Depart-ment and the IRS to be appropriate:

AustraliaAzerbaijanBrazilCanadaCzech RepublicDenmarkEstoniaFinlandFranceGermanyGibraltarGuernseyHungaryIcelandIndiaIreland

Isle of ManItalyJamaicaJerseyLatviaLiechtensteinLithuaniaLuxembourgMaltaMauritiusMexicoNetherlandsNew ZealandNorwayPolandSlovak RepublicSloveniaSouth AfricaSpainSwedenUnited Kingdom

SECTION 4. EFFECT ON OTHERDOCUMENTS

Rev. Proc. 2014–64, as supplementedby Rev. Proc. 2015–50, is further supple-mented.

SECTION 5. DRAFTINGINFORMATION

The principal author of this revenueprocedure is Jackie Bennett Manasterli ofthe Office of Associate Chief Counsel (In-ternational). For further information re-garding this revenue procedure contactMs. Manasterli at (202) 317-5218 (not atoll-free number).

Bulletin No. 2016–17 April 25, 2016635

Part IV. Items of General InterestDeletions From CumulativeList of Organizations,Contributions to Which areDeductible Under Section170 of the Code

Announcement 2016–15

Table of Contents

The Internal Revenue Service has re-voked its determination that the organiza-tions listed below qualify as organizationsdescribed in sections 501(c)(3) and170(c)(2) of the Internal Revenue Code of1986.

Generally, the IRS will not disallowdeductions for contributions made to a

listed organization on or before the date ofannouncement in the Internal RevenueBulletin that an organization no longerqualifies. However, the IRS is not pre-cluded from disallowing a deduction forany contributions made after an organiza-tion ceases to qualify under section170(c)(2) if the organization has nottimely filed a suit for declaratory judg-ment under section 7428 and if the con-tributor (1) had knowledge of the revoca-tion of the ruling or determination letter,(2) was aware that such revocation wasimminent, or (3) was in part responsiblefor or was aware of the activities or omis-sions of the organization that broughtabout this revocation.

If on the other hand a suit for declara-tory judgment has been timely filed, con-

tributions from individuals and organiza-tions described in section 170(c)(2) thatare otherwise allowable will continue tobe deductible. Protection under section7428(c) would begin on April 25, 2016and would end on the date the court firstdetermines the organization is not de-scribed in section 170(c)(2) as more par-ticularly set for in section 7428(c)(1). Forindividual contributors, the maximum de-duction protected is $1,000, with a hus-band and wife treated as one contributor.This benefit is not extended to any indi-vidual, in whole or in part, for the acts oromissions of the organization that werethe basis for revocation.

NAME OF ORGANIZATION Effective Date of Revocation LOCATION

Cloverfield 180, Inc. January 1, 2013 Van Wert, Ohio

Texas Cave Conservancy January 1, 2012 Cedar Park, TX

Notice of ProposedRulemakingTreatment of CertainInterests in Corporations asStock or Indebtedness

REG–108060–15

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document containsproposed regulations under section 385 ofthe Internal Revenue Code (Code) thatwould authorize the Commissioner totreat certain related-party interests in acorporation as indebtedness in part andstock in part for federal tax purposes, andestablish threshold documentation re-quirements that must be satisfied in orderfor certain related-party interests in a cor-poration to be treated as indebtedness forfederal tax purposes. The proposed regu-lations also would treat as stock certainrelated-party interests that otherwisewould be treated as indebtedness for fed-

eral tax purposes. The proposed regula-tions generally affect corporations that is-sue purported indebtedness to relatedcorporations or partnerships.

DATES: Written or electronic commentsand requests for a public hearing must bereceived by July 7, 2016.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–108060–15), room5203, Internal Revenue Service, P.O. Box7604, Ben Franklin Station, Washington,DC 20044. Submissions may be hand-delivered Monday through Friday be-tween the hours of 8 a.m. and 4 p.m. toCC:PA:LPD:PR (REG–108060–15), Cou-rier’s Desk, Internal Revenue Service, 1111Constitution Avenue NW, Washington, DC20224 or sent electronically via the FederaleRulemaking Portal at http://www.regulations.gov (IRS REG–108060–15).

FOR FURTHER INFORMATIONCONTACT: Concerning the proposed reg-ulations under §§ 1.385–1 and 1.385–2, EricD. Brauer, (202) 317-5348; concerning theproposed regulations under §§ 1.385–3 and1.385–4, Raymond J. Stahl, (202) 317-

6938; concerning submissions of commentsor requests for a public hearing, ReginaJohnson, (202) 317-5177 (not toll-freenumbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in this notice of proposed rulemak-ing has been submitted to the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act of1995 (44 U.S.C. 3507(d)). Comments onthe collection of information should besent to the Office of Management andBudget, Attn: Desk Officer for the Depart-ment of the Treasury, Office of Informa-tion and Regulatory Affairs, Washington,DC 20503, with copies to the InternalRevenue Service, Attn: IRS ReportsClearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Commentson the collection of information should bereceived by June 7, 2016. Comments arespecifically requested concerning:

Whether the proposed collection of in-formation is necessary for the proper per-


formance of the functions of the IRS, in-cluding whether the information will havepractical utility;

The accuracy of the estimated burdenassociated with the proposed collection ofinformation;

How the quality, utility, and clarity ofthe information to be collected may beenhanced;

How the burden of complying with theproposed collection of information maybe minimized, including through the ap-plication of automated collection tech-niques or other forms of information tech-nology; and

Estimates of capital or start-up costs andcosts of operation, maintenance, and pur-chase of services to provide information.

The collection of information in thisproposed regulation is in § 1.385–2(b)(2).This collection of information is neces-sary to determine whether certain interestsbetween members of an expanded affili-ated group are to be treated as stock orindebtedness for federal tax purposes. Thelikely respondents are entities that are af-filiates of publicly traded entities or meetcertain thresholds on their financial state-ments.

Estimated total annual reporting bur-den: 735,000 hours.

Estimated average annual burden perrespondent: 35 hours.

Estimated number of respondents:21,000.

Estimated frequency of responses:Monthly.

An agency may not conduct or spon-sor, and a person is not required to re-spond to, a collection of information un-less it displays a valid control numberassigned by the Office of Managementand Budget.

Background

As described further in this preamble,courts historically have analyzed whetheran interest in a corporation should betreated as stock or indebtedness for fed-eral tax purposes by applying various setsof factors to the facts of a particular case.In 1969, Congress enacted section 385 toauthorize the Secretary of the Treasury(Secretary) to prescribe such regulationsas may be necessary or appropriate todetermine whether an interest in a corpo-ration is to be treated as stock or indebt-

edness for purposes of the Code. Becauseno regulations are currently in effect un-der section 385, the case law that devel-oped before the enactment of section 385has continued to evolve and to control thecharacterization of an interest in a corpo-ration as debt or equity.

I. Section 385 Statute and LegislativeHistory

A. Original Enactment of Section 385

Section 385(a), as originally enacted aspart of the Tax Reform Act of 1969 (Pub.L. No. 91–172, 83 Stat. 487), authorizesthe Secretary to prescribe such regulationsas may be necessary or appropriate todetermine whether an interest in a corpo-ration is treated as stock or indebtednessfor purposes of the Code.

Section 385(b) provides that the regu-lations prescribed under section 385 shallset forth factors that are to be taken intoaccount in determining in a particular fac-tual situation whether a debtor-creditorrelationship exists or a corporation-shareholder relationship exists. Under sec-tion 385(b), those factors may include,among other factors, the following: (1)whether there is a written unconditionalpromise to pay on demand or on a speci-fied date a sum certain in money in returnfor an adequate consideration in money ormoney’s worth, and to pay a fixed rate ofinterest; (2) whether there is subordinationto or preference over any indebtedness ofthe corporation; (3) the ratio of debt toequity of the corporation; (4) whetherthere is convertibility into the stock of thecorporation; and (5) the relationship be-tween holdings of stock in the corporationand holdings of the interest in question.

In enacting section 385(a) and (b),Congress authorized the Secretary to pre-scribe targeted rules to address particularfactual situations, stating:

In view of the uncertainties and dif-ficulties which the distinction be-tween debt and equity has producedin numerous situations . . . the com-mittee further believes that it wouldbe desirable to provide rules for dis-tinguishing debt from equity in thevariety of contexts in which thisproblem can arise. The differing cir-cumstances which characterize thesesituations, however, would make it

difficult for the committee to providecomprehensive and specific statutoryrules of universal and equal applica-bility. In view of this, the committeebelieves it is appropriate to specifi-cally authorize the Secretary of theTreasury to prescribe the appropriaterules for distinguishing debt from eq-uity in these different situations.

S. Rep. No. 91–552, at 138 (1969). Thelegislative history further explains thatregulations applicable to a particular fac-tual situation need not rely on the factorsset forth in section 385(b):

The provision also specifies certainfactors which may be taken into ac-count in these [regulatory] guide-lines. It is not intended that onlythese factors be included in theguidelines or that, with respect to aparticular situation, any of thesefactors must be included in theguidelines, or that any of the factorswhich are included by statute mustnecessarily be given any moreweight than other factors added byregulations.

Id. Accordingly, section 385(b) pro-vides the Secretary with discretion to es-tablish specific rules for determiningwhether an interest is treated as stock orindebtedness for federal tax purposes in aparticular factual situation.

B. 1989 and 1992 Amendments toSection 385

Congress amended section 385 in 1989and 1992. In 1989, the Omnibus BudgetReconciliation Act of 1989 (Pub. L. No.101–239, 103 Stat. 2106) amended sec-tion 385(a) to expressly authorize the Sec-retary to issue regulations under which aninterest in a corporation is to be treated asin part stock and in part indebtedness.This amendment also provides that anyregulations so issued may apply only withrespect to instruments issued after the dateon which the Secretary or the Secretary’sdelegate provides public guidance as tothe characterization of such instruments(whether by regulation, ruling, or other-wise). See Pub. L. No. 101–239, sec.7208(a)(2). The legislative history to the1989 amendment notes that, while “[t]hecharacterization of an investment in a cor-poration as debt or equity for Federal in-come tax purposes generally is deter-


mined by reference to numerous factors, .. . there has been a tendency by the courtsto characterize an instrument entirely asdebt or entirely as equity.” H.R. Rep. No.101–386, at 3165–66 (1989) (Conf. Rep.).

In 1992, Congress added section385(c) to the Code as part of the EnergyPolicy Act of 1992 (Pub. L. No. 102–486,106 Stat. 2776). Section 385(c)(1) pro-vides that the issuer’s characterization (asof the time of issuance) as to whether aninterest in a corporation is stock or indebt-edness shall be binding on such issuer andon all holders of such interest (but shallnot be binding on the Secretary). Section385(c)(2) provides that, except as pro-vided in regulations, section 385(c)(1)shall not apply to any holder of an interestif such holder on his return discloses thathe is treating such interest in a mannerinconsistent with the initial characteriza-tion of the issuer. Section 385(c)(3) autho-rizes the Secretary to require such infor-mation as the Secretary determines to benecessary to carry out the provisions ofsection 385(c), including the informationnecessary for the Secretary to determinehow the issuer characterized an interest asof the time of issuance.

Congress added section 385(c) in re-sponse to issuers and holders characteriz-ing a corporate instrument inconsistently.H.R. Rep. No. 102–716, at 3 (1992). Forexample, a corporate issuer may designatean instrument as indebtedness for federaltax purposes and deduct as interest theamounts paid on the instrument, while acorporate holder may treat the instrumentas stock for federal tax purposes and claima dividends received deduction with re-spect to the amounts paid on the instru-ment. See id.

II. Regulations

There are no regulations currently ineffect under section 385. On March 24,1980, the Department of the Treasury(Treasury Department) and the IRS pub-lished a notice of proposed rulemaking(LR–1661) in the Federal Register (45FR 18959) under section 385 relating tothe treatment of certain interests in corpo-rations as stock or indebtedness. Final reg-ulations (TD 7747) were published in theFederal Register (45 FR 86438) on De-cember 31, 1980. Subsequent revisions of

the final regulations were published in theFederal Register on May 4, 1981, Janu-ary 5, 1982, and July 2, 1982 (46 FR24945, 47 FR 147, and 47 FR 28915,respectively). The Treasury Departmentand the IRS published a notice of pro-posed withdrawal of TD 7747 in the Fed-eral Register on July 6, 1983 (48 FR31053), and in TD 7920, published in theFederal Register (48 FR 50711) on No-vember 3, 1983, the Treasury Departmentand the IRS withdrew TD 7747.

The Treasury Department and the IRShave not previously published any regula-tions regarding the 1989 amendment tosection 385(a), which authorizes the Sec-retary to issue regulations that treat aninterest in a corporation as indebtedness inpart or as stock in part. In addition, noregulations have been published with re-spect to the 1992 addition of section385(c) authorizing the Secretary to requireinformation related to an issuer’s initialcharacterization of an interest for federaltax purposes or to affect the ability of aholder to treat an interest inconsistent withthe initial treatment of the issuer.

III. Case Law

In the absence of regulations under sec-tion 385, the pre-1969 case law has con-tinued to evolve and control the charac-terization of an interest as debt or equityfor federal tax purposes. Under that caselaw, courts apply inconsistent sets of fac-tors to determine if an interest should betreated as stock or indebtedness, subject-ing substantially similar fact patterns todiffering analyses. The result has been abody of case law that perpetuates the “un-certainties and difficulties which the dis-tinction between debt and equity has pro-duced” and with which Congressexpressed concern when enacting section385. See S. Rep. No. 91–552, at 138. Forexample, in Fin Hay Realty Co. v. UnitedStates, 398 F.2d 694 (3d Cir. 1968), theU.S. Court of Appeals for the Third Cir-cuit identified sixteen factors relevant fordistinguishing between indebtedness andstock:

(1) the intent of the parties; (2) theidentity between creditors andshareholders; (3) the extent of par-ticipation in management by theholder of the instrument; (4) the

ability of the corporation to obtainfunds from outside sources; (5) the‘thinness’ of the capital structure inrelation to debt; (6) the risk in-volved; (7) the formal indicia of thearrangement; (8) the relative posi-tion of the obligees as to other cred-itors regarding the payment of inter-est and principal; (9) the votingpower of the holder of the instru-ment; (10) the provision of a fixedrate of interest; (11) a contingencyon the obligation to repay; (12) thesource of the interest payments; (13)the presence or absence of a fixedmaturity date; (14) a provision forredemption by the corporation; (15)a provision for redemption at theoption of the holder; and (16) thetiming of the advance with refer-ence to the organization of thecorporation.

Id. at 696. By contrast, in Estate ofMixon v. United States, 464 F.2d 394 (5thCir. 1972), the U.S. Court of Appeals forthe Fifth Circuit identified thirteen factorsthat are similar to, but not the same as,those used in Fin Hay to distinguish be-tween indebtedness and stock:

(1) the names given to the certifi-cates evidencing the indebtedness;(2) The presence or absence of afixed maturity date; (3) The sourceof payments; (4) The right to en-force payment of principal and in-terest; (5) participation in manage-ment flowing as a result; (6) thestatus of the contribution in relationto regular corporate creditors; (7)the intent of the parties; (8) ‘thin’ oradequate capitalization; (9) identityof interest between creditor andstockholder; (10) source of interestpayments; (11) the ability of thecorporation to obtain loans fromoutside lending institutions; (12) theextent to which the advance wasused to acquire capital assets; and(13) the failure of the debtor to re-pay on the due date or to seek apostponement.

Id. at 402. The weight given to thevarious factors in a particular case alsodiffers, and is highly dependent upon therelevant facts and circumstances. See, e.g.,J.S. Biritz Construction Co. v. Commis-sioner, 387 F.2d 451, 456–57 (8th Cir.1967) (stating that the factors “have vary-ing degrees of relevancy, depending onthe particular factual situation and are


generally not all applicable to any givencase”).

Under this facts-and-circumstancesanalysis, as developed in the case law, nosingle fact or circumstance is sufficient toestablish that an interest should be treatedas stock or indebtedness. See, e.g., JohnKelley Co. v. Commissioner, 326 U.S.521, 530 (1946) (“[N]o one characteristic. . . can be said to be decisive in thedetermination of whether the obligationsare risk investments in the corporations ordebts.”); Fin Hay, 398 F.2d at 697(“[N]either any single criterion nor anyseries of criteria can provide a conclusiveanswer in the kaleidoscopic circumstanceswhich individual cases present.”). It wasthis emphasis on particular taxpayer factsand circumstances, coupled with inconsis-tent analysis of the relevant factors bydifferent courts, that led Congress to del-egate to the Secretary the authority to pro-vide regulations under section 385 for dis-tinguishing debt from equity that coulddepart from the factors developed in caselaw or enumerated in the statute. See S.Rep. No. 91–552, at 138.

IV. Other Relevant Statutory Provisions

Section 701 provides that a partnershipas such shall not be subject to federalincome tax, but that persons carrying onbusiness as partners shall be liable forfederal income tax only in their separateor individual capacities.

Section 1502 provides that the Secre-tary shall prescribe such regulations as theSecretary deems necessary in order thatthe federal tax liability of any affiliatedgroup of corporations making a consoli-dated return and of each corporation in thegroup, both during and after the period ofaffiliation, may be returned, determined,computed, assessed, collected, and ad-justed, in such manner as clearly to reflectthe federal income tax liability and thevarious factors necessary for the determi-nation of such liability, and in order toprevent avoidance of such tax liability. Inprescribing such regulations, section 1502authorizes the Secretary to prescribe rulesthat are different from the provisions ofchapter 1 of subtitle A of the Code thatwould apply if such corporations filedseparate returns.

Section 7701(l) provides that the Sec-retary may prescribe regulations recharac-terizing any multiple-party financingtransaction as a transaction directlyamong any two or more of such partieswhere the Secretary determines that suchrecharacterization is appropriate to pre-vent avoidance of any tax imposed by theCode.

V. Earnings Stripping GuidanceDescribed in Notice 2014–52 and Notice2015–79

Notice 2014–52, 2014–42 IRB 712(Oct. 14, 2014), and Notice 2015–79,2015–49 IRB 775 (Dec. 7, 2015), de-scribed regulations that the Treasury De-partment and the IRS intend to issue withrespect to corporate inversions and relatedtransactions. Notice 2014–52 and Notice2015–79 also provided that the TreasuryDepartment and the IRS expect to issueadditional guidance to further limit thebenefits of post-inversion tax avoidancetransactions. The notices stated, in partic-ular, that the Treasury Department and theIRS are considering guidance to addressstrategies that avoid U.S. tax on U.S. op-erations by shifting or “stripping” U.S.-source earnings to lower-tax jurisdictions,including through intercompany debt.

VI. Purpose of the ProposedRegulations

These proposed regulations under sec-tion 385 address whether an interest in arelated corporation is treated as stock orindebtedness, or as in part stock or in partindebtedness, for purposes of the Code.While these proposed regulations are mo-tivated in part by the enhanced incentivesfor related parties to engage in transac-tions that result in excessive indebtednessin the cross-border context, federal in-come tax liability can also be reduced oreliminated with excessive indebtednessbetween domestic related parties. Thus,the proposed rules apply to purported in-debtedness issued to certain related par-ties, without regard to whether the partiesare domestic or foreign. Nonetheless, theTreasury Department and the IRS alsohave determined that the proposed regu-lations should not apply to issuances ofinterests and related transactions among

members of a consolidated group becausethe concerns addressed in the proposedregulations generally are not present whenthe issuer’s deduction for interest expenseand the holder’s corresponding interest in-come offset on the group’s consolidatedfederal income tax return.

Section A of this Part VI addressesbifurcation of interests that are indebted-ness in part but not in whole. Section B ofthis Part VI addresses documentation re-quirements for related-party indebtedness.Section C of this Part VI addresses distri-butions of debt instruments and similartransactions.

A. Interests that are Indebtedness inPart but Not in Whole

As previously noted, Congressamended section 385(a) in 1989 to autho-rize the issuance of regulations permittingan interest in a corporation to be treated asin part indebtedness and in part stock. Thelegislative history to the 1989 amendmentexplained that “there has been a tendencyby the courts to characterize an instrumententirely as debt or entirely as equity.”H.R. Rep. No. 101–386, at 562 (1989)(Conf. Rep.). No regulations have beenpromulgated under the amendment, how-ever, and this tendency by the courts hascontinued to the present day. Conse-quently, the Commissioner generally isrequired to treat an interest in a corpora-tion as either wholly indebtedness orwholly equity.

This all-or-nothing approach is partic-ularly problematic in cases where the factsand circumstances surrounding a pur-ported debt instrument provide onlyslightly more support for characterizationof the entire interest as indebtedness thanfor equity characterization, a situation thatis increasingly common in the related-party context. The Treasury Departmentand the IRS have determined that the all-or-nothing approach frequently fails to re-flect the economic substance of related-party interests that are in formindebtedness and gives rise to inappropri-ate federal tax consequences. Accord-ingly, the Treasury Department and theIRS have determined that the interests oftax administration would best be served ifthe Commissioner were able to departfrom the all-or-nothing approach where


appropriate to ensure that the provisionsof the Code are applied in a manner thatclearly reflects the income of related tax-payers. To that end, these proposed regu-lations would exercise the authoritygranted by section 385(a) to permit theCommissioner to treat a purported debtinstrument issued between related partiesas in part indebtedness and in part stockfor federal tax purposes. However, theproposed regulations would not permit is-suers and related holders to treat such aninstrument in a manner inconsistent withthe issuer’s initial characterization. Theproposed regulations described in PartIV.B.2 of the Explanation of Provisionssection of this preamble also rely in parton the authority granted under section385(a) to treat interests as in part indebt-edness and in part stock for federal taxpurposes.

The proposed rule applies with respectto parties that meet a lower 50-percentthreshold for relatedness than the thresh-old applicable with respect to other rulescontained in these proposed regulations.This is because, as noted in Part VI of theBackground section of this preamble, fed-eral income tax liability can be reduced oreliminated by the introduction of exces-sive indebtedness between related parties,and this can be accomplished without spe-cial cooperation among the related partiesand regardless of other transactions under-taken by the issuer or holder after issu-ance. In addition, a 50-percent relatednessthreshold is consistent with other provi-sions used in subchapter C of the Codeto identify a level of control or owner-ship that can warrant different federaltax consequences than those for less-related parties.

The proposed rule merely permits theCommissioner to treat a purported debtinstrument as in part indebtedness and inpart stock consistent with its substance.Moreover, the proposed regulationswould not affect the authority of the Com-missioner to disregard a purported debtinstrument as indebtedness or stock, totreat a purported debt instrument as in-debtedness or equity of another entity, orotherwise to treat a purported debt instru-ment in accordance with its substance.See, e.g., Plantation Patterns v. Commis-sioner, 462 F.2d 712 (5th Cir. 1972).

The Treasury Department and the IRSrecognize that authorizing the Commis-sioner to treat purported debt instrumentsissued among unrelated parties as indebt-edness in part and stock in part couldresult in unnecessary uncertainty in thecapital markets in the absence of detailedstandards for the exercise of that author-ity. Similarly, any exercise of this author-ity with respect to related-party intereststhat are denominated as other than indebt-edness would require more detailed guid-ance. Thus, the proposed rule does notapply in those contexts.

B. Related-Party Indebtedness

1. Background

Related-party indebtedness, like in-debtedness between unrelated persons,may be respected as indebtedness for fed-eral tax purposes, but only if there is intentto create a true debtor-creditor relation-ship that results in bona fide indebtedness.While still subject to the same multifactoranalysis used for characterizing interestsissued between third parties, “courts haveconsistently recognized that transactionalforms between related parties are suscep-tible of manipulation and, accordingly,warrant a more thorough and discerningexamination for tax characterization pur-poses.” PepsiCo Puerto Rico, Inc. v. Com-missioner, T.C. Memo 2012–269, at 51,citing United States v. Uneco, Inc., 532F.2d 1204, 1207 (8th Cir. 1976); CuyunaRealty Co. v. United States, 382 F.2d 298,301 (Ct. Cl. 1967) (stating that an advancebetween a parent corporation and a sub-sidiary or other affiliate under commoncontrol must be subject to particularscrutiny “because the control elementsuggests the opportunity to contrive afictional debt, an opportunity less pres-ent in an arms-length transaction be-tween strangers.”).

This scrutiny is warranted becausethere is typically less economic incentivefor a related-party lender to impose disci-pline on the legal documentation and eco-nomic analysis supporting the character-ization of an interest as indebtedness forfederal tax purposes. While a lender typ-ically carefully documents a loan to athird party borrower and decides whetherand how much to lend based on that doc-

umentation and objective financial crite-ria, a related-party lender, especially onethat directly or indirectly controls the bor-rower, may require only simple (or evenno) legal documentation and may forgoany economic analysis that would informthe lender of the amount that the borrowercould reasonably be expected to repay.

The absence of reasonable diligence byrelated-party lenders can have the effectof limiting the factual record that is avail-able for additional scrutiny and thoroughexamination. Nonetheless, courts do notalways require related parties to engage inreasonable financial analysis and legaldocumentation similar to that which busi-ness exigencies would incent third-partiesin connection with lending to unrelatedborrowers. See, e.g., C.M. Gooch LumberSales Co. v. Commissioner, 49 T.C. 649(1968) at 656 (noting that in the case ofrelated-party debt, “the absence of a writ-ten debt instrument, security, or provisionfor the payment of interest is not control-ling; formal evidences of indebtedness areat best clues to proof of the ultimatefact”); 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 ad-vancements to a corporation are madewithout requiring any evidence of indebt-edness . . . was not a controlling consid-eration . . .”).

Historically, the absence of clear guid-ance regarding the documentation and in-formation necessary to support debt char-acterization in the related-party contextdid not pose a significant obstacle, be-cause the transactions presented by casessuch as Mixon, Fin Hay, and their progenywere not factually complex. Typically, theearlier cases involved direct advances be-tween individual U.S. taxpayers and theirclosely held domestic corporations. Therelevant documentation was readily iden-tifiable, available on hand, and able to beanalyzed by the Commissioner in duecourse. Further, when the case law wasdeveloping, the dollar amounts at stakewere comparatively modest. In Fin Hay,the shareholder advances gave rise to atotal federal tax liability of $3,241; inMixon, the shareholder advances gave riseto 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 prac-tices, structures, and activities between re-lated parties have changed considerably.The Treasury Department and the IRS ac-knowledge that the size, activities, andfinancial complexity of corporations andtheir group structures have grown expo-nentially, and understand that thesegroups routinely include foreign entities,sometimes from multiple foreign jurisdic-tions, as well as federal tax-indifferentdomestic members. The scope and com-plexity of intragroup transactions hasgrown commensurately. Examples in-clude the transactions at issue in PepsiCoPuerto Rico, Inc. v. Commissioner and NAGeneral Partnership & Subsidiaries v.Commissioner, T.C. Memo 2012–172,both involving the global restructuring ofmultinational corporate groups.

As a result of these developments, it isincreasingly problematic that there is alack of guidance prescribing the informa-tion and documentation necessary to sup-port the characterization of a purporteddebt instrument as indebtedness in therelated-party context. The lack of suchguidance, combined with the sheer vol-ume of financial records taxpayers pro-duce in the ordinary course of business,makes it difficult to identify the docu-ments that will ultimately be required tosupport such a characterization, particu-larly with respect to whether a reasonableexpectation of repayment is present at thetime an interest is issued. The result canbe either the inadvertent omission of nec-essary documents from disclosure to theIRS or the provision of vast amounts ofirrelevant documents and material, suchthat forensic accounting expertise is re-quired to isolate and evaluate relevant in-formation. In either case, the ability of theCommissioner to administer the Code ef-ficiently with respect to related-party in-terests is impeded. In addition, the ab-sence of guidance makes it difficult forU.S. taxpayers to determine timely whatsteps they must take to ensure that essen-tial records are not only prepared, but alsomaintained in a manner that will facilitatetheir being made available upon request,particularly regarding transactions withrelated parties whose books and recordsare located in foreign jurisdictions.

Finally, the dollar amounts at stakehave often become increasingly signifi-

cant. For example, the federal tax liabilityat issue in PepsiCo was $363,056,012; thefederal tax liability at issue in NA GeneralPartnership was $188,000,000. As a re-sult, it has become increasingly importantto prescribe rules that identify the types ofdocumentation and information necessaryto support the characterization of arelated-party interest as indebtedness forfederal tax purposes.

2. Proposed Regulations AddressingDocumentation Requirements

To address these concerns, the Trea-sury Department and the IRS are propos-ing rules, under the authority granted insection 385(a) to prescribe regulations todetermine whether an interest in a corpo-ration is stock or indebtedness, that pre-scribe the nature of the documentation andinformation that must be prepared andmaintained for a purported debt instru-ment issued by a corporation to a relatedparty to be treated as indebtedness forfederal tax purposes. The proposed regu-lations are intended to impose disciplineon related parties by requiring timely doc-umentation and financial analysis that issimilar to the documentation and analysiscreated when indebtedness is issued tothird parties. This requirement also servesto help demonstrate whether there wasintent to create a true debtor-creditor re-lationship that results in bona fide indebt-edness and also to help ensure that thedocumentation necessary to perform ananalysis of a purported debt instrument isprepared and maintained. This approach isconsistent with the long-standing viewheld by courts that the taxpayer has theburden of substantiating its treatment ofan arrangement as indebtedness for fed-eral tax purposes. Hollenbeck v. Commis-sioner, 422 F.2d 2, 4 (9th Cir. 1970).

In general, the Treasury Departmentand the IRS have determined that timelypreparation of documentation and finan-cial analysis evidencing four essentialcharacteristics of indebtedness are a nec-essary factor in the characterization of acovered interest as indebtedness for fed-eral tax purposes. Those characteristicsare: a legally binding obligation to pay,creditors’ rights to enforce the obligation,a reasonable expectation of repayment atthe time the interest is created, and an

ongoing relationship during the life of theinterest consistent with arms-length rela-tionships between unrelated debtors andcreditors. These characteristics are drawnfrom the case law and are consistent withthe text of section 385(b)(1) and (5).While the proposed regulations do not in-tend to alter the general case law view ofthe importance of these essential charac-teristics of indebtedness, the proposedregulations do require a degree of disci-pline in the creation of necessary docu-mentation, and in the conduct of reason-able financial diligence indicative of a truedebtor-creditor relationship, that exceedswhat is required under current law. See,e.g., C.M. Gooch Lumber Sales Co., 49T.C. 649; Byerlite Corp., 286 F.2d 285.

The proposed regulations make clearthat the preparation and maintenance ofthis documentation and information arenot dispositive in establishing that a pur-ported debt instrument is indebtedness forfederal tax purposes. Rather, these re-quirements are necessary to the conduct ofthe multi-factor analysis used in theMixon and Fin Hay line of cases to deter-mine the nature of an interest as indebt-edness for federal tax purposes.

C. Certain Distributions of DebtInstruments and Similar Transactions

1. In General

The Treasury Department and the IRShave identified three types of transactionsbetween affiliates that raise significantpolicy concerns and that should be ad-dressed under the Secretary’s authority toprescribe rules for particular factual situ-ations: (1) distributions of debt instru-ments by corporations to their related cor-porate shareholders; (2) issuances of debtinstruments by corporations in exchangefor stock of an affiliate (including “hookstock” issued by their related corporateshareholders); and (3) certain issuances ofdebt instruments as consideration in anexchange pursuant to an internal asset re-organization. Similar policy concernsarise when a related-party debt instrumentis issued in a separate transaction to fund(1) a distribution of cash or other propertyto a related corporate shareholder; (2) anacquisition of affiliate stock from an affil-iate; or (3) certain acquisitions of property


from an affiliate pursuant to an internalasset reorganization. Accordingly, theproposed regulations treat related-partydebt instruments issued in any of the fore-going transactions as stock, subject to cer-tain exceptions.

Sections C.2 through C.5 of this PartVI describe in greater detail the purposesof the proposed regulations that apply tothese types of transactions. Part IV of theExplanation of Provisions section of thispreamble describes in detail the proposedregulations.

2. Debt Instrument Issued in aDistribution

In Kraft Foods Co. v. Commissioner,232 F.2d 118 (2d Cir. 1956), the U.S.Court of Appeals for Second Circuit ad-dressed a situation in which a domesticcorporate subsidiary issued indebtednessin the form of debentures to its sole share-holder, also a domestic corporation, inpayment of a dividend. The parent andsubsidiary were required to file separatereturns under the Code in effect during theyears at issue, and, before taking into ac-count the interest income and deductionson the distributed indebtedness, the parentcorporation had losses and the subsidiarywas profitable.

The court considered arguments by thegovernment that the parent-subsidiary re-lationship warranted additional scrutiny indetermining whether a debtor-creditor re-lationship was established in substance. Inparticular, the Commissioner argued that,because the issuer subsidiary was wholly-owned, “the sole stockholder [could] dealas it please[d] with the corporate entity itcontrol[led]” and, as a result, the transac-tion could have been a sham. Id. at 123.The Commissioner also argued that thedebentures should be treated as stock be-cause no new capital was introduced intothe subsidiary in connection with the is-suance of the debentures, see id. at 126–27, and because the taxpayer concededthat the issuance of the debentures in pay-ment of the dividend lacked a businesspurpose other than tax minimization. Seeid. at 127–28.

In holding for the taxpayer, the SecondCircuit determined that the debenturesshould be respected as indebtedness be-cause the debentures were unambiguously

denominated as debt, were issued by andto real taxable entities, and created reallegal rights and duties between the parties.See id. at 127–28. In a dissenting opinion,Chief Judge Clark supported “test[ing] thegenuineness of the intercorporate indebt-edness by objective standards” that woulddisregard indebtedness issued in this cir-cumstance, and warned that the majorityopinion would open “a large leak . . .operable merely by denominating an in-tercorporate allocation of surplus a debt”and would “[s]urely . . . stimulate imita-tors.” Id. at 129.

Other courts have not given the samelevel of deference to the form of a trans-action that the Second Circuit did in Kraftand have treated purported indebtednessas stock in similar circumstances. For ex-ample, some courts have closely scruti-nized situations in which indebtedness isowed in proportion to stock ownership todetermine whether a debtor-creditor rela-tionship exists in substance. See, e.g., Un-eco, Inc. v. United States, 532 F.2d 1204,1207 (8th Cir. 1976) (“Advances betweena parent corporation and a subsidiary orother affiliate are subject to particularscrutiny . . . .”); Arlington Park JockeyClub, Inc. v. Sauber, 262 F.2d 902, 906(7th Cir. 1959) (“It has been held that [acash advance made in proportion to stockownership] gives rise to a strong inferencethat the advances represent additional cap-ital investment and not loans.” (citingSchnitzer v. Commissioner, 13 T.C. 43,aff’d 183 F.2d 70 (9th Cir. 1950))). Con-sistent with those decisions, section385(b)(5) specifically authorizes the Sec-retary, in issuing regulations distinguish-ing between stock and indebtedness, totake into account “the relationship be-tween holdings of stock in the corporationand holdings of the interest in question.”

Courts also have given weight to thelack of new capital investment when aclosely-held corporation issues indebted-ness to a controlling shareholder but re-ceives no new investment in exchange.See, e.g., Talbot Mills v. Commissioner,146 F.2d 809 (1st Cir. 1944) (emphasizingthat a transaction involved no new invest-ment, did not affect proportionate owner-ship, and was motivated primarily by taxbenefits in holding that a closely-held cor-poration’s participating notes should betreated as stock when each stockholder

exchanged four-fifths of its existing stockfor notes with a face amount equal to thepar value of the stock surrendered), aff’dsub nom, John Kelley Co. v. Commis-sioner, 326 U.S. 521 (1946); Sayles Fin-ishing Plants, Inc. v. United States, 399F.2d 214 (Ct. Cl. 1968) (noting that a“lack of new money can be a significantfactor in holding a purported indebtednessto be a capital transaction, particularlywhen the facts otherwise show that thepurported indebtedness was merely a con-tinuation of the stock interests allegedlyconverted”).

In many contexts, a distribution of adebt instrument similar to the one at issuein Kraft lacks meaningful non-tax signif-icance, such that respecting the distributedinstrument as indebtedness for federal taxpurposes produces inappropriate results.For example, inverted groups and otherforeign-parented groups use these types oftransactions to create interest deductionsthat reduce U.S. source income withoutinvesting any new capital in the U.S. op-erations. In addition, U.S.-parentedgroups obtain distortive results by, for ex-ample, using these types of transactions tocreate interest deductions that reduce theearnings and profits of controlled foreigncorporations (CFCs) and to facilitate therepatriation of untaxed earnings withoutrecognizing dividend income. An exam-ple of the latter type of transaction couldinvolve the distribution of a note from afirst-tier CFC to its United States share-holder in a taxable year when the distrib-uting CFC has no earnings and profits(although lower-tier CFCs may) and theUnited States shareholder has basis in theCFC stock. In a later taxable year, whenthe distributing CFC had untaxed earningsand profits (such as by reason of interven-ing distributions from lower-tier CFCs),the CFC could use cash attributable to theearnings and profits to repay the noteowed to its United States shareholder. Thetaxpayer takes the position that the noteshould be respected as indebtedness and,therefore, that the repayment of the notedoes not result in any of the untaxed earn-ings and profits of the CFC being taxed asa dividend to the United States share-holder.

In light of these policy concerns, theproposed regulations treat a debt instru-ment issued in fact patterns similar to that


in Kraft as stock. The factors discussed inKraft and Talbot Mills, including theparent-subsidiary relationship, the factthat no new capital is introduced in con-nection with a distribution of debentures,and the typical lack of a substantial non-tax business purpose, support the conclu-sion that the issuance of a debt instrumentin a distribution is a transaction that fre-quently has minimal or nonexistent non-tax effects. Moreover, although the holderof a debt instrument has different legalrights than a holder of stock, the distinc-tion between those rights usually has lim-ited significance when the parties are re-lated. Subsidiaries often do not havesignificant amounts of debt financing fromunrelated lenders (other than trade pay-ables) and, to the extent they do, they mayminimize any potential impact of related-party debt on unrelated creditors, for ex-ample, by subordinating the related-partydebt instrument.

Thus, any non-tax effects of a distribu-tion of a debt instrument to an affiliate areoften minimized or eliminated, allowingthe related parties to obtain significantfederal tax benefits at little or no cost.Accordingly, based on these consider-ations, the Treasury Department and theIRS have determined that in fact patternssimilar to Kraft it is appropriate to treat adebt instrument as stock.

3. Debt Instrument Issued in Exchangefor Affiliate Stock

The Treasury Department and the IRShave determined that the issuance of arelated-party debt instrument to acquirestock of a related person is similar inmany respects to a distribution of a debtinstrument and implicates similar policyconsiderations. Recognizing the economicsimilarities between purchases of affiliatestock and distributions, Congress enactedsection 304 and its predecessors to pre-vent taxpayers from acquiring affiliatestock to convert what otherwise would bea taxable dividend into a sale or exchangetransaction. See S. Rep. No. 83–1622 at46 (1954) (noting that, under section 304,“where the effect of the sale [of related-party stock] is in reality the distribution ofa dividend, it will be taxed as such”).Similarly, if the proposed regulations ad-dressed only debt instruments issued in a

distribution, and not acquisitions of affil-iate stock that have the effect of a distri-bution, taxpayers would readily substitutethe latter transaction for the former inorder to produce the inappropriate tax re-sult that the proposed regulations are in-tended to prevent.

Like distributions of debt instruments,issuances of debt instruments to acquireaffiliate stock frequently have limitednon-tax significance, particularly in rela-tion to the significant federal tax benefitsthat are generated in the transaction. Suchtransactions do not change the ultimateownership of the affiliate, and introduceno new operating capital to either affiliate.While the change in the direct ownershipof the affiliate’s stock may have somenon-tax significance in certain circum-stances, such as the harmonization of agroup’s corporate structure following anacquisition, other purchases of affiliatestock, including purchases of “hookstock” from a parent in exchange for adebt instrument, typically possess almostno non-tax significance.

Accordingly, the proposed regulationsgenerally treat a debt instrument issued inexchange for affiliate stock as stock.

4. Debt Instrument Issued Pursuant toan Internal Asset Reorganization

The proposed regulations also addresscertain debt instruments issued by an ac-quiring corporation as consideration in anexchange pursuant to an internal asset re-organization. Internal asset reorganiza-tions can operate in a similar manner tosection 304 transactions as a device toconvert what otherwise would be a distri-bution into a sale or exchange transactionwithout having any meaningful non-taxeffect. Congress noted this similarity in1984 when it harmonized the control re-quirement for section 368(a)(1)(D) reor-ganizations with the control requirementin section 304. See Staff of Joint Comm.on Taxation, 98th Cong., General Expla-nation of the Revenue Provisions of theDeficit Reduction Act of 1984 193(Comm. Print 1984) (“The D reorganiza-tion provisions address the bail-out prob-lem in the context of a transfer of assetsby 1 corporation to another. Section 304deals with the problem in the context of a

transfer of stock by shareholders to a cor-poration they control.”).

Consider the following example: Aforeign parent corporation (Parent) ownsall of the stock of two U.S. subsidiaries,S1 and S2. In a transaction qualifying as areorganization described in section368(a)(1)(D), Parent transfers its stock inS1 to S2 in exchange for a note issued byS2, and S1 converts to a limited liabilitycompany. For federal tax purposes, S1 istreated as selling all of its assets to S2 inexchange for a debt instrument, and undersection 356, Parent is treated as receivingthe S2 debt instrument from S1 in a liq-uidating distribution with respect to Pa-rent’s S1 stock. This transaction has asimilar effect (and tax treatment) as a sec-tion 304 transaction in which S2 issues adebt instrument to Parent in exchange forS1 stock, with the only difference beingthat S2 acquired the assets of S1 instead ofthe S1 stock and that Parent received thedebt instrument as a result of the liquida-tion of S1.

This transaction introduces no newcapital into the P group, and does notaffect the ultimate ownership of the assetsheld by S1 or S2. Furthermore, S1 gener-ally would not be required to recognizeany built-in gain on the transfer of itsassets to S2. Although this transaction en-tails a transfer of assets from S1 to S2, thetax costs (if any) and the non-tax conse-quences that result from this type of trans-action among related parties are typicallyinsignificant relative to the federal taxbenefits obtained through the introductionof a related-party debt instrument. Ac-cordingly, the proposed regulations treat adebt instrument issued by an acquiringcorporation as consideration in an ex-change pursuant to an internal asset reor-ganization as stock, consistent with thetreatment of a debt instrument issued in adistribution or in exchange for affiliatestock.

5. Debt Instrument Issued with aPrincipal Purpose of Funding CertainDistributions and Acquisitions

The Treasury Department and the IRShave determined that the policy concernsimplicated by the transactions describedin Sections C.2 through C.4 of this Part VIare also present when a corporation issues


a debt instrument with a principal purposeof funding certain related-party transac-tions. Specifically, the proposed regula-tions treat a debt instrument issued forproperty, including cash, as stock whenthe debt instrument is issued to an affiliatewith a principal purpose of funding (1) adistribution of cash or other property to arelated corporate shareholder, (2) an ac-quisition of affiliate stock from an affili-ate, or (3) certain acquisitions of propertyfrom an affiliate pursuant to an internalasset reorganization.

Without these funding provisions, tax-payers that otherwise would have issued adebt instrument in a one-step transactiondescribed in Sections C.2 through C.4 ofthis Part VI would be able to use multi-step transactions to avoid the applicationof these proposed regulations whileachieving economically similar outcomes.For example, a wholly-owned subsidiarythat otherwise would have distributed adebt instrument to its parent corporationin a distribution could, absent these rules,borrow cash from its parent and later dis-tribute that cash to its parent in a transac-tion that is purported to be independentfrom the borrowing. Like the distributionof a note, this transaction, if respected,would result in an increase of related-party debt, but no new net investment inthe operations of the subsidiary. The par-ent corporation would have effectively re-shuffled its subsidiary’s capital structureto obtain more favorable federal tax treat-ment for the subsidiary without affectingits control over the subsidiary. The simi-larity between these transactions indicatesthat they should be subject to similar taxtreatment.

The Treasury Department and the IRSalso have determined that a debt instru-ment should be subject to these fundingrules regardless of whether the fundingaffiliate (the lender) is a party to thefunded transaction. Otherwise, a corpora-tion could, for example, borrow fundsfrom a sister corporation and immediatelydistribute those funds to the common par-ent corporation. Issuances of debt instru-ments to an affiliate in order to fund adistribution of property, an acquisition ofaffiliate stock, or an acquisition of an af-filiate’s assets in a reorganization oftenwould confer significant federal tax bene-fits without having a significant non-tax

impact, regardless of whether the lender isalso a party to the funded transaction.Accordingly, the proposed regulationstreat as stock a debt instrument issued toan affiliate to fund one of the specifiedtransactions regardless of whether thelender is a party to the funded transaction.

Explanation of Provisions

I. Overview

The proposed regulations provideguidance regarding substantiation of thetreatment of certain interests issued be-tween related parties as indebtedness forfederal tax purposes, the treatment of cer-tain interests in a corporation as in partindebtedness and in part stock, and thetreatment of distributions of debt instru-ments and similar transactions that fre-quently have only limited non-tax effects.More specifically, the proposed regula-tions are set forth in four sections. First,proposed § 1.385–1 prescribes definitionsand operating rules applicable to the regu-lations under section 385 generally, includ-ing a rule treating members of a consoli-dated group, as defined in § 1.1502–1(h), asone corporation. Proposed § 1.385–1(d)also provides that the Commissioner hasthe discretion to treat certain interests in acorporation for federal tax purposes asindebtedness in part and stock in part.Second, proposed § 1.385–2 addresses thedocumentation and information that tax-payers must prepare and maintain withinrequired timeframes to substantiate thetreatment of an interest issued betweenrelated parties as indebtedness for federaltax purposes. Such substantiation is nec-essary, but not sufficient, for a purporteddebt interest that is within the scope ofthese rules to be characterized as indebt-edness; general federal income tax princi-ples also apply in making such a determi-nation. Third, if the application ofproposed § 1.385–2 and general federalincome tax principles otherwise would re-sult in treating an interest issued to a re-lated party as indebtedness for federal taxpurposes, proposed § 1.385–3 providesadditional rules that may treat the interest,in whole or in part, as stock for federal taxpurposes if it is issued in a distribution orother transaction that is identified as fre-quently having only limited non-tax ef-fect, or is issued to fund such a transac-

tion. Finally, proposed § 1.385–4provides operating rules for applying pro-posed § 1.385–3 to interests that cease tobe between members of the same consol-idated group or interests that become in-terests between members of the same con-solidated group.

II. Generally Applicable Definitions andSpecial Rules

A. Definition of Expanded Group

As previously discussed, the concernsaddressed by the proposed regulationsarise with respect to interests issuedamong related parties. The scope of theproposed regulations is therefore gener-ally limited to purported indebtedness be-tween members of an expanded group.Proposed § 1.385–1, which sets forth def-initions generally applicable to the regu-lations proposed under section 385, de-fines the term expanded group byreference to the term affiliated group insection 1504(a). However, the proposedregulations broaden the definition in sev-eral ways. Unlike an affiliated group, anexpanded group includes foreign and tax-exempt corporations, as well as corpora-tions held indirectly, for example, throughpartnerships. Further, in determining re-latedness, the proposed regulations adoptthe attribution rules of section 304(c)(3).The proposed regulations also modify thedefinition of affiliated group to treat acorporation as a member of an expandedgroup if 80 percent of the vote or value isowned by expanded group members (in-stead of 80 percent of the vote and value, asgenerally required under section 1504(a)).

Through this definition of an expandedgroup, the application of the proposed reg-ulations is limited to transactions betweenhighly-related parties. Other rules, dis-cussed in Section III.A (limiting the appli-cation of proposed § 1.385–2 to large tax-payers) and Section IV.C ($50 millionthreshold exception for proposed § 1.385–3)of this Explanation of Provisions limit theapplication of the proposed regulations tolarge taxpayers.

B. Treatment of Deemed Exchanges

Proposed § 1.385–1 includes rules thatprescribe the effects under the Code gen-


erally of an exchange of purported indebt-edness for stock that is deemed to occurunder the proposed regulations. Underthose rules, on the date the indebtedness isrecharacterized as stock, the indebtednessis deemed to be exchanged, in whole or inpart, for stock with a value that is equal tothe holder’s adjusted basis in the portionof the indebtedness that is treated as eq-uity under the regulations, and the issuerof the indebtedness is deemed to retire thesame portion of the indebtedness for anamount equal to its adjusted issue price asof that date. This rule generally will pre-vent both the holder and issuer from real-izing gain or loss from the deemed ex-change other than foreign exchange gainor loss recognized by the issuer or theholder under section 988.

C. Treatment of Certain Instruments asin Part Indebtedness and as in PartStock

Proposed § 1.385–1 implements thestatutory authority under section 385(a) totreat an instrument as part indebtednessand part stock by authorizing the Com-missioner to treat certain instruments is-sued between related parties in this man-ner. Any such treatment will occur only inthe event that the substance of the instru-ment is regarded for federal tax purposesand the instrument has met the documen-tation and information requirements inproposed § 1.385–2 (described subse-quently in Section III), if applicable. Inaddition, the Commissioner is not re-quired to treat such an interest as indebt-edness in part and stock in part. For ex-ample, under the proposed regulations, ifan analysis of a related-party interest thatis documented as a $5 million debt instru-ment demonstrates that the issuer cannotreasonably be expected to repay morethan $3 million of the principal amount asof the issuance of the interest, the Com-missioner may treat the interest as partindebtedness ($3 million) and part stock($2 million). The type of stock (for exam-ple, common stock or preferred stock, sec-tion 306 stock, stock described in section1504(a)(4)) that the instrument will betreated as for federal tax purposes is de-termined by taking into account the termsof the instrument (for example, voting andconversion rights and rights relating to

dividends, redemption, liquidation, andother distributions).

The Treasury Department and the IRSbelieve that this approach will facilitatethe treatment of purported debt instru-ments issued between related parties in amanner that is more consistent with thesubstance of the underlying transaction.

Pursuant to section 385(c) and the reg-ulatory authority granted the Secretary un-der section 385(c)(2), the issuer of theinterest, the holder of the interest, and anyother person relying on the characteriza-tion of the interest as indebtedness forfederal tax purposes are all required totreat the interest consistent with the issu-er’s initial characterization. Thus, for ex-ample, a holder may not disclose on itsreturn under section 385(c)(2) that it istreating an EGI, as later defined in SectionIII.A of this Explanation of Provisions, asindebtedness in part or stock in part if theissuer of the EGI treats the EGI as indebt-edness. This approach eliminates cases inwhich members of the same expandedgroup take contrary positions as to thetreatment of an EGI as indebtedness,stock, or indebtedness in part and stock inpart.

The proposed regulations authorize thetreatment of an interest as indebtedness inpart and stock in part in the case of instru-ments issued in the form of debt betweenparties that are related, but at a lesserdegree of relatedness than that required toinclude them in an expanded group. Underthe proposed regulations, treatment as in-debtedness in part and stock in part canapply to purported indebtedness betweenmembers of modified expanded groups(which are defined in the same manner asexpanded groups, but adopting a50-percent ownership test and includingcertain partnerships and other persons).The 50-percent relatedness threshold con-tained in the definition of modified ex-panded group is consistent with other pro-visions used in subchapter C of the Codeto identify a level of control or ownershipthat can warrant different federal tax con-sequences than those of less-related par-ties. For example, a similar threshold ap-plies in determining whether (i) controlexists under section 304(c), (ii) attributionto and from corporations is applicable un-der section 318, (iii) persons are relatedunder section 267(b), which is incorpo-

rated into numerous provisions of theCode, (iv) a redemption is substantiallydisproportionate under section 302(b)(2),(v) a disqualified distribution has occurredunder section 355(d), (vi) a distribution issubject to section 355(e), and (vii) cor-porations are under common control forpurposes of section 334. The TreasuryDepartment and the IRS request com-ments on whether it would be helpful orappropriate to have this rule apply moregenerally.

D. Consolidated Groups

As described in Part VI of the Back-ground section of this preamble, many ofthe concerns regarding related-party in-debtedness are not present in the case ofindebtedness between members of a con-solidated group. Accordingly, the pro-posed regulations under section 385 donot apply to interests between members ofa consolidated group, although generalfederal tax principles continue to apply.Proposed § 1.385–1(e) achieves this resultby treating a consolidated group as onecorporation. See Section III.A and SectionIV.F of this Part for additional rules af-fecting consolidated groups.

III. Substantiation of Related-PartyIndebtedness: Proposed § 1.385–2

A. In General

Proposed § 1.385–2 reflects the impor-tance of contemporaneous documentationin identifying the rights, obligations, andintent of the parties to an instrument thatis purported to be indebtedness for federaltax purposes. Such documentation is par-ticularly important to the analysis of in-struments issued between related parties.In recognition of this importance, theTreasury Department and the IRS are ex-ercising authority granted under section385(a) to treat the timely preparation andmaintenance of such documentation asnecessary factors to be taken into accountin determining whether certain interestsare properly characterized as stock or in-debtedness. Accordingly, the proposedregulations first prescribe the nature of thedocumentation necessary to substantiatethe treatment of related-party instrumentsas indebtedness and, second, require that


such documentation be timely preparedand maintained. The proposed regulationsfurther provide that, if the specified doc-umentation is not provided to the Com-missioner upon request, the Commis-sioner will treat the preparation andmaintenance requirements as not satisfiedand will treat the instrument as stock forfederal tax purposes. The type of stock(for example, common stock or preferredstock, section 306 stock, stock describedin section 1504(a)(4)) that the instrumentwill be treated as for federal tax purposesis determined by taking into account theterms of the instrument (for example, vot-ing and conversion rights and rights relat-ing to dividends, redemption, liquidation,and other distributions).

Satisfaction of the requirements of theproposed regulations does not establishthat a related-party instrument is indebt-edness. Rather, satisfaction of the pro-posed regulations acts as a threshold testfor allowing the possibility of indebted-ness treatment after the determination ofan instrument’s character is made underfederal tax principles developed under ap-plicable case law. If the requirements ofthe proposed regulations are not satisfied,the purported indebtedness would be re-characterized as stock. In such a case, anyfederal tax benefit claimed by the taxpayerwith respect to the treatment of the inter-est as indebtedness will be disallowed.

Judicial doctrines that disregard trans-actions as having no substance continue tobe applicable and are not affected by theproposed regulations. Accordingly, pro-posed § 1.385–2 applies only to intereststhe substance of which is potentially re-garded as indebtedness for federal tax pur-poses. In addition, proposed § 1.385–2does not limit the ability of the IRS torequest information under any existing au-thorities, such as the rules under section7602.

As discussed previously, these pro-posed regulations apply only to purportedindebtedness issued among entities thatare highly related. Several provisions ofthe proposed regulations combine to ef-fect this limitation.

First, proposed § 1.385–2 providesrules only with respect to applicable in-struments, that is, interests issued in theform of debt. Thus, these proposed regu-lations do not apply to any interest or

arrangement that is not, in form, indebt-edness. The documentation and otherrules in proposed § 1.385–2(b) are tailoredto arrangements that in form are tradi-tional debt instruments and do not addressother arrangements that may be treated asindebtedness under general federal taxprinciples. The proposed regulations un-der § 1.385–2 reserve with respect to doc-umentation of interests that are not inform indebtedness. Because there are alarge number of ways to document thesearrangements, rules that provide sufficientinformation about these arrangements willneed to contain specific documentationand timing requirements depending on thetype of arrangement. Accordingly, theTreasury Department and the IRS requestcomments regarding the appropriate doc-umentation and timing requirements forthe various forms that these arrangementscan take.

Second, proposed § 1.385–2 only ap-plies to applicable interests that are issuedand held by members of an expandedgroup (expanded group instruments, orEGI). For purposes of § 1.385–2, con-trolled partnerships are treated as mem-bers of the expanded group, and the termcontrolled partnership is defined as anypartnership the capital or profits interest inwhich is 80-percent owned by members ofthe expanded group. Proposed § 1.385–2provides that, solely for purposes of§ 1.385–2, the term issuer means a personthat is obligated to satisfy any materialpayment obligations created under theterms of an EGI. For this purpose, a dis-regarded entity can be treated as the is-suer. A person can be an issuer if thatperson is expected to satisfy a materialobligation under an EGI, even if that per-son is not the primary obligor. A guaran-tor, however, is not an issuer unless theguarantor is treated as the primary obligorunder federal tax principles. See, e.g.,Plantation Patterns, Inc. v. Commis-sioner, 462 F.2d 712 (5th Cir. 1972).

Third, proposed § 1.385–2 is intendedto apply only to large taxpayer groups.Accordingly, an EGI is not subject to pro-posed § 1.385–2 unless the stock of anymember of the expanded group is publiclytraded, all or any portion of the expandedgroup’s financial results are reported onfinancial statements with total assets ex-ceeding $100 million, or the expanded

group’s financial results are reported onfinancial statements that reflect annual to-tal revenue that exceeds $50 million. Theproposed regulations provide guidance re-garding the financial statement or state-ments that are to be used for purposes ofdetermining the expanded group’s assetsand liabilities. In general, this determina-tion is made by reference to a financialstatement required to be filed with theSecurities and Exchange Commission, acertified audited financial statement that isaccompanied by the report of an indepen-dent certified public accountant (or in thecase of a foreign entity, by the report of asimilarly qualified independent profes-sional) that is used for certain purposes, ora financial statement (other than a tax re-turn) required to be provided to the fed-eral, state, or foreign government or anyfederal, state, or foreign agency. Becausethis list represents a set of financial state-ments created for other purposes for per-sons outside the expanded group, thesefinancial statements are expected to besufficiently reliable for this purpose. Inaddition, to prevent the use of stale finan-cial information, only applicable financialstatements prepared within the three yearsof the EGI becoming subject to the pro-posed regulations are relevant for deter-mining whether an EGI is subject to theproposed regulations under § 1.385–2.

B. Types of Documentation and OtherInformation Required

The core of proposed § 1.385–2 is theguidance regarding the nature of the doc-umentation and information that must beprepared and maintained to support thecharacterization of an EGI as indebted-ness for federal tax purposes. The regula-tions organize the requirement into fourcategories, each reflecting an essentialcharacteristic of indebtedness for federaltax purposes: a binding obligation to re-pay the funds advanced, creditor’s rightsto enforce the terms of the EGI, a reason-able expectation that the advanced fundscan be repaid, and actions evidencing agenuine debtor-creditor relationship. To-gether these categories represent a distil-lation of case law principles establishedfor determining that an instrument isgenuine indebtedness for federal taxpurposes.


The proposed regulations require thatthe prescribed documentation and infor-mation must be provided with respect toeach category. Failure to provide the doc-umentation and information upon requestby the Commissioner will result in theCommissioner treating the requirementsof this section as not satisfied. The fourcategories are more specifically describedin the following four paragraphs.

1. Binding Obligation to Repay. Thethreshold requirement for indebtedness isa binding legal obligation to repay thefunds advanced. The proposed regulationsrequire evidence of such obligation in theform of timely prepared written documen-tation executed by the parties.

2. Creditor’s Rights to Enforce Terms.The documents establishing the issuer’sobligation to repay must also establishthat the creditor/holder has the legal rightsof a creditor to enforce the terms of theEGI. The proposed regulations give exam-ples of such rights that creditor/holdertypically has, including the right to triggera default and the right to accelerate pay-ments. The proposed regulations also givean example of one right that a creditor/holder must have, which is a superior rightto shareholders to share in the assets of theissuer in the event that the issuer is dis-solved or liquidated.

3. Reasonable Expectation of Repay-ment. The proposed regulations also re-quire the taxpayer to provide timely pre-pared documentation evidencing areasonable expectation that the issuercould in fact repay the amount of a pur-ported loan. The proposed regulationsgive examples of such documentation, in-cluding cash flow projections, financialstatements, business forecasts, asset ap-praisals, determination of debt-to-equityand other relevant financial ratios of theissuer (compared to industry averages).Special rules are provided to address dis-regarded entities that issue an EGI.

4. Genuine Debtor-Creditor Relation-ship. Finally, the taxpayer asserting in-debtedness treatment must prepare andmaintain timely evidence of an ongoingdebtor-creditor relationship. This docu-mentation can take two forms. In the caseof an issuer that complied with the termsof the EGI, the documentation must in-clude timely prepared documentation ofany payments on which the taxpayer relies

to establish such treatment under generalfederal tax principles. Alternatively, if theissuer failed to comply with the terms of theEGI, either by failing to make required pay-ments or by otherwise suffering an event ofdefault under the terms of the EGI, the doc-umentation must include evidence of theholder’s reasonable exercise of the diligenceand judgment of a creditor. The proposedregulations give examples of such docu-mentation, including evidence of the hold-er’s efforts to enforce the terms of the EGI,as well as any efforts to renegotiate the EGI.

In general, the documentation must beprepared no later than 30 calendar daysafter the date of the relevant event, whichis generally the later of the date that theinstrument becomes an EGI or the datethat an expanded group member becomesan issuer with respect to an EGI. How-ever, in the case of documentation of thedebtor-creditor relationship, the regula-tions allow the documentation to be pre-pared up to 120 calendar days after thepayment or relevant event occurred. Thisextended period is intended to avoid inad-vertent failures to comply with the regu-lations that may be more likely in the caseof events that occur during the life of anEGI. If an applicable instrument is not anEGI when issued, no documentation isrequired under the proposed regulationsfor any date before the date the applicableinstrument becomes an EGI.

The proposed regulations provide spe-cial rules for determining the timeliness ofdocumentation preparation in the case ofcertain revolving credit agreements andsimilar arrangements and cash pooling ar-rangements, generally looking to the doc-uments pursuant to which the arrange-ments were established.

C. Maintenance Requirement

Under proposed § 1.385–2, the docu-mentation and information in the four cat-egories previously described must bemaintained for all taxable years that theEGI is outstanding and until the period oflimitations expires for any return with re-spect to which the federal tax treatment ofthe EGI is relevant. The proposed regula-tions do not otherwise specify where or inwhat manner such records must be kept.The Treasury Department and the IRS in-tend that taxpayers have flexibility to de-

termine the manner in which the require-ments of the proposed regulations aresatisfied.

D. Timing of Application of Rule

In general, proposed § 1.385–2 willapply to an applicable instrument at thetime it becomes an EGI and thereafter. Ifan EGI that was characterized as stockunder the rules of § 1.385–2 ceases to bean EGI, general federal tax principles willapply to determine its character at the timeit ceases to be an EGI; if, under generalfederal tax principles, it is treated as in-debtedness, the issuer is treated as issuinga new debt instrument to the holder inexchange for the EGI immediately beforethe transaction that causes the instrumentto cease to qualify as an EGI.

If an applicable instrument is an EGIwhen issued, determinations under pro-posed § 1.385–2 are generally effectivefrom the issuance date. If an applicableinstrument was not an EGI when issued,proposed § 1.385–2 applies, and any re-sulting determination is generally effec-tive, when the applicable instrument be-comes an EGI. However, if an EGIoriginally treated as debt is later recharac-terized as stock because the documenta-tion and information cease to evidence anongoing debtor-creditor relationship, therecharacterization will be effective as ofthe time that the facts and circumstancescease to evidence a debtor-creditorrelationship.

E. Consolidated Groups

Proposed § 1.385–1(e) provides thatmembers of a consolidated group aretreated as one corporation. Proposed§ 1.385–2(c)(4)(ii) further provides that ifan applicable instrument ceases to be anintercompany obligation and, as a result,becomes an EGI subject to the rules ofproposed § 1.385–2, the applicable instru-ment is treated as becoming an EGI im-mediately after it ceases to be an inter-company obligation.

F. Modifications to General Operationof Proposed § 1.385–2

The proposed regulation includes anumber of provisions that modify the gen-


eral rules of § 1.385–2 in order to provideflexibility in appropriate circumstances orto prevent abuse. First, the requirementsof proposed § 1.385–2 may be modified ifa taxpayer’s failure to comply with therequirements is attributable to reasonablecause. The principles of § 301.6724–1(relating to waivers of penalty if failuredue to reasonable cause) apply for pur-poses of determining whether reasonablecause exists in any particular case.

Second, to prevent abuse, proposed§ 1.385–2 prohibits the affirmative use ofthe rules in the proposed regulations tosupport a particular characterization of aninstrument. Thus, if a taxpayer fails tosatisfy the requirements of proposed§ 1.385–2 with a principal purpose ofreducing the federal tax liability of anymember of the expanded group, the rulesof the proposed regulations do not apply.

Third, if an applicable instrument thatis not an EGI is issued with a principalpurpose of avoiding the purposes of pro-posed § 1.385–2, the applicable instru-ment is treated as an EGI and will besubject to the provisions of the proposedregulations. Such a situation could occurif, for example, an applicable interest wasissued by an expanded group member to atrust held by members of the same ex-panded group.

G. Effective Date of Proposed § 1.385–2

The provisions of § 1.385–2 are pro-posed to be generally effective when theregulations are published as final regula-tions. Proposed § 1.385–2 would apply toany applicable instrument issued on orafter that date, as well as to any applicableinstrument treated as issued as a result of anentity classification election under§ 301.7701–3 made on or after the date theregulations are issued as final regulations.

IV. Certain Distributions of DebtInstruments and Similar Transactions

A. In General

Proposed §§ 1.385–3 and 1.385–4 pro-vide rules that treat as stock certain inter-ests that otherwise would be treated asindebtedness for federal income tax pur-poses. Proposed § 1.385–3 applies to debtinstruments that are within the meaning of

section 1275(a) and § 1.1275–1(d), as de-termined without regard to the applicationof proposed § 1.385–3. Section 1275(a)and § 1.1275–1(d) generally define a debtinstrument as any instrument or contrac-tual arrangement that constitutes indebt-edness under general principles of federalincome tax law. Thus, the term debt in-strument for purposes of proposed§§ 1.385–3 and 1.385–4 means an instru-ment that satisfies the requirements ofproposed §§ 1.385–1 and 1.385–2 and thatis indebtedness under general principles offederal income tax law. The Treasury De-partment and the IRS plan to amend§ 1.1275–1(d) to coordinate § 1.1275–1(d)with the regulations under section 385 whenthe proposed regulations are finalized.

Specifically, proposed § 1.385–3 treatsas stock certain debt instruments issued byone member of an expanded group to an-other member of the same group (ex-panded group debt instrument) in the cir-cumstances described in Section B of thisPart IV, unless an exception described inSection C of this Part IV applies. Detailedoperating rules regarding the recharacter-ization (including with respect to partner-ships) are discussed in Section D of thisPart IV. A rule to prevent taxpayers fromaffirmatively using proposed §§ 1.385–3and 1.385–4 is discussed in Section E ofthis Part IV. Section F of this Part IVdiscusses proposed § 1.385–4, which pro-vides special rules to address the treat-ment of consolidated groups. The effec-tive date of proposed §§ 1.385–3 and1.385–4 is discussed in Section G of thisPart IV.

To the extent proposed § 1.385–3 treatsan interest as stock, the interest is treatedas stock for all federal tax purposes. Con-sistent with the traditional case law debt-equity analysis, when a debt instrument istreated as stock under proposed§ 1.385–3, the terms of the debt instru-ment (for example, voting rights or con-version features) are taken into accountfor purposes of determining the type ofstock resulting from the recharacteriza-tion, including whether such stock is pre-ferred stock or common stock.

B. Debt Instruments Treated as Stock

Proposed § 1.385–3 provides threerules that treat an expanded group debt

instrument as stock: a general rule, a fund-ing rule, and an anti-abuse rule.

1. The General Rule

The general rule treats an expandedgroup debt instrument as stock to the ex-tent it is issued by a corporation to amember of the corporation’s expandedgroup (1) in a distribution; (2) in exchangefor expanded group stock, other than in anexempt exchange (as defined later in thisSection 1); or (3) in exchange for propertyin an asset reorganization, but only to theextent that, pursuant to the plan of reor-ganization, a shareholder that is a memberof the issuer’s expanded group immedi-ately before the reorganization receivesthe debt instrument with respect to itsstock in the transferor corporation. All ora portion of an issuance of a debt instru-ment may be described in more than oneprong of the general rule without chang-ing the result that follows from being de-scribed in a single prong.

For purposes of the first prong of thegeneral rule, the term distribution isbroadly defined as any distribution by acorporation to a member of the corpora-tion’s expanded group with respect to thedistributing corporation’s stock, regard-less of whether the distribution is treatedas a dividend within the meaning of sec-tion 316. Thus, a debt instrument issued inexchange for stock of the issuer of thedebt instrument (that is, in a redemptionunder corporate law) is a distribution thatis covered by the first prong of the generalrule and an acquisition of expanded groupstock covered by the second prong of thegeneral rule.

The second prong of the general rule –addressing debt instruments issued in ex-change for expanded group stock – ap-plies regardless of whether the expandedgroup stock is acquired from a share-holder of the issuer of the expanded groupstock, or directly from the issuer. For anillustration of this rule in a context wherestock is not formally issued because itwould be a “meaningless gesture,” seeExample 11 in § 1.385–3(g)(3) of the pro-posed regulations.

For purposes of the second prong of thegeneral rule, the term exempt exchangemeans an acquisition of expanded groupstock in which the transferor and trans-


feree of the stock are parties to a reorga-nization that is an asset reorganization,and either (i) section 361(a) or (b) appliesto the transferor of the expanded groupstock and the stock is not transferredby issuance; or (ii) section 1032 or§ 1.1032–2 applies to the transferor of theexpanded group stock and the stock isdistributed by the transferee pursuant tothe plan of reorganization. As a result, thesecond prong of the general rule generallydoes not apply to a debt instrument that isissued in exchange for expanded groupstock when section 361(a) or (b) applies tothe transferor of such stock. This limita-tion has the effect of causing exchanges ofexpanded group stock that are part of anasset reorganization to be covered only bythe third prong of the general rule, which,as discussed in the next paragraph, im-poses limitations on the application of thegeneral rule to exchanges that are part ofan asset reorganization.

The third prong of the general ruleapplies to asset reorganizations amongcorporations that are members of the sameexpanded group. An asset reorganizationis a reorganization within the meaning ofsection 368(a)(1)(A), (C), (D), (F), or (G).Specifically, the third prong of the generalrule applies to a debt instrument issued inexchange for property in an asset reorga-nization, but only to the extent that, pur-suant to the plan of reorganization, ashareholder that is a member of the issu-er’s expanded group immediately beforethe reorganization receives the debt in-strument with respect to its stock in thetransferor corporation. The second stepreceipt of the debt instrument by the ex-panded group shareholder could be in theform of a distribution of the debt instru-ment to shareholders of the distributingcorporation in a divisive asset reorganiza-tion, or in redemption of the shareholder’sstock in the transferor corporation in anacquisitive asset reorganization. Becausethe third prong of the general rule appliesonly to a debt instrument that is receivedby a shareholder with respect to its stockin the transferor corporation, that debt in-strument would, absent the application of§ 1.385–3, be treated as “other property”within the meaning of section 356.

The third prong of the general rule islimited to debt instruments distributed toshareholders pursuant to the reorganiza-

tion, and does not apply to debt instru-ments exchanged for securities or otherdebt interests because, in that latter case,the newly issued debt instrument is ex-changed for existing debt interests andthus no additional debt is incurred by theparties to the reorganization.

2. The Funding Rule

a. Funded Transactions

The funding rule treats as stock an ex-panded group debt instrument that is is-sued with a principal purpose of funding atransaction described in the general rule(principal purpose debt instrument). Spe-cifically, a principal purpose debt instru-ment is a debt instrument issued by acorporation (funded member) to anothermember of the funded member’s ex-panded group in exchange for propertywith a principal purpose of funding (1) adistribution of property by the fundedmember to a member of the funded mem-ber’s expanded group, other than a distri-bution of stock pursuant to an asset reor-ganization that is permitted to be receivedwithout the recognition of gain or incomeunder section 354(a)(1) or 355(a)(1) or,when section 356 applies, that is nottreated as “other property” or money de-scribed in section 356; (2) an acquisitionof expanded group stock, other than in anexempt exchange, by the funded memberfrom a member of the funded member’sexpanded group in exchange for propertyother than expanded group stock; or (3)the acquisition of property by the fundedmember in an asset reorganization butonly to the extent that, pursuant to the planof reorganization, a shareholder that is amember of the funded member’s ex-panded group immediately before the re-organization receives “other property” ormoney within the meaning of section 356with respect to its stock in the transferorcorporation.

Prongs (1) through (3) of the fundingrule are referred to in this Section 2 as“distributions or acquisitions.” Proposed§ 1.385–3(b)(3)(iii) provides that, if all ora portion of a distribution or acquisitionby a funded member is described in morethan one prong of the funding rule, thefunded member is treated as engaging inonly a single distribution or acquisition

for purposes of applying the funding rule.The funding rule addresses transactionsthat, when viewed together, present simi-lar policy concerns as the transactions thatare subject to the general rule.

The first prong of the funding rule –addressing a distribution by a fundedmember – excludes a distribution of stockpermitted to be received without the rec-ognition of gain under section 355(a)(1)when the distribution is pursuant to anasset reorganization (that is, a divisivereorganization qualifying under section368(a)(1)(D)), but does not exclude a dis-tribution of stock that is permitted to bereceived without the recognition of gainunder section 355(a)(1) when the transac-tion qualifies under section 355 withoutalso qualifying as a reorganization (that is,a distribution of the stock of a controlledcorporation without a related transfer ofproperty by the distributing corporation tothe controlled corporation pursuant to theplan of reorganization). The reason forthis distinction is that the controlled cor-poration in a divisive reorganization de-scribed in section 368(a)(1)(D) acquiresassets of the distributing corporation and,as described in Section B.2.b.v of this PartIV, is treated as a successor of the distrib-uting corporation (and the distributingcorporation is treated as a predecessor ofthe controlled corporation) for purposes ofthe funding rule. In contrast, when a dis-tribution transaction qualifies under sec-tion 355 without also qualifying as a re-organization, the controlled corporationdoes not acquire assets from the distribut-ing corporation as part of the transactionand the corporations are not treated aspredecessor and successor of each otherfor purposes of the funding rule. Consis-tent with this approach, proposed§ 1.385–3 does not treat a section 355distribution that is part of a divisive reor-ganization as a distribution for purposesof the funding rule because the distribut-ing corporation and the controlled corpo-ration are both parties to the reorganiza-tion and are both treated as fundedmembers to the extent of any prior debtinstrument issued by the distributing cor-poration. For a further illustration of thisrule, see Example 10 in § 1.385–3(g)(3) ofthe proposed regulations.


b. Determining Whether a DebtInstrument Is Issued with a PrincipalPurpose of Funding a Distribution orAcquisition

The determination as to whether a debtinstrument is issued with a principal pur-pose of funding a distribution or acquisi-tion is based on all of the facts and cir-cumstances. A debt instrument may betreated as issued with such a principalpurpose whether it is issued before or aftera distribution or acquisition.

i. Non-Rebuttable Presumption Duringthe 72-Month Period

Proposed § 1.385–3 also establishes anon-rebuttable presumption that certainexpanded group debt instruments are is-sued with a principal purpose of funding adistribution or acquisition by the fundedmember. Specifically, such a principalpurpose is deemed to exist if the expandedgroup debt instrument is issued by thefunded member during the period begin-ning 36 months before the funded membermakes a distribution or acquisition andending 36 months after the distribution oracquisition (the 72-month period). Thisper se rule does not create a safe harbor.Accordingly, a debt instrument issued out-side the 72-month period may be treatedas having a principal purpose of funding adistribution or acquisition, based on thefacts and circumstances.

The Treasury Department and the IRShave determined that this non-rebuttablepresumption is appropriate becausemoney is fungible and because it is diffi-cult for the IRS to establish the principalpurposes of internal transactions. In theabsence of a per se rule, taxpayers couldassert that free cash flow generated fromoperations funded any distributions andacquisitions, while any debt instrumentwas incurred to finance the capital needsof those operations. Because taxpayerswould be able to document the purposesof funding transactions accordingly, itwould be difficult for the IRS to establishthat any particular debt instrument wasincurred with a principal purpose of fund-ing a distribution or acquisition. The ex-ception discussed in Section C of this PartIV for distributions and acquisitions thatdo not exceed current year earnings andprofits would accommodate many ordi-

nary course distributions and acquisitions,providing significant flexibility to avoidthe application of this per se rule. TheTreasury Department and the IRS havedetermined that this exception, togetherwith the exception for a tainted debt in-strument that does not exceed $50 million,also discussed in Section C of this Part IV,appropriately balance between preventingtax-motivated transactions among mem-bers of an expanded group and accommo-dating ordinary course transactions.

ii. Exception to Non-RebuttablePresumption for Ordinary Course DebtInstruments

An exception to this per se rule appliesto ordinary course debt instruments. Pro-posed § 1.385–3(b)(3)(iv)(B)(2) definesan ordinary course debt instrument as adebt instrument that arises in the ordinarycourse of the issuer’s trade or business inconnection with the purchase of propertyor the receipt of services to the extent thatit reflects an obligation to pay an amountthat is currently deductible by the issuerunder section 162 or currently included inthe issuer’s cost of goods sold or inven-tory, provided that the amount of the ob-ligation outstanding at no time exceedsthe amount that would be ordinary andnecessary to carry on the trade or businessof the issuer if it was unrelated to thelender. This exception is intended to applyto debt instruments that arise in connec-tion with the purchase of property or thereceipt of services between members ofthe same expanded group in the ordinarycourse of the purchaser’s or recipient’strade or business, and is not intended toapply to intercompany financing or trea-sury center activities or to capital expen-ditures. An ordinary course debt instru-ment is not subject to the per se rule;however, it may be treated as having aprincipal purpose of funding a distributionor acquisition by the issuer, based on thefacts and circumstances.

iii. Ordering Rules

For purposes of applying the per serule, proposed § 1.385–3(b)(3)(iv)(B)(3)includes an ordering rule that providesthat, when two or more debt instrumentsmay be treated as potentially funding the

same acquisition or distribution, the debtinstruments are tested based on the orderin which they were issued. Thus, for ex-ample, if a company issues an expandedgroup debt instrument of $100x in each ofyears 1 and 2, and then makes a distributionof $150x in year 3, the distribution willresult in a recharacterization as of the date ofthe distribution of $100x of the year 1 debtinstrument and $50x of the year 2 debt in-strument. For a further illustration of thisrule, see Example 6 in § 1.385–3(g)(3) ofthe proposed regulations.

A second ordering rule in proposed§ 1.385–3(b)(3)(iv)(B)(4) provides that,when a debt instrument may be treated asfunding more than one distribution or ac-quisition, the earliest distribution or acqui-sition is treated as the first distribution oracquisition that was funded.

An exception to these ordering rulesapplies when an acquisition of expandedgroup stock by issuance ceases to qualifyfor the exception from the funding ruledescribed in Section C.3 of this Part IV. Inthat case, the acquisition of expandedgroup stock is treated as an acquisitionthat is subject to the funding rule on thedate that the acquisition actually occurred,but debt instruments issued, and other dis-tributions and acquisitions that occurred,prior to the date that the acquirer ceases toqualify for the exception are ordered with-out regard to the acquisition of expandedgroup stock that previously was exceptedfrom the funding rule.

iv. Transition Rule

For a rule preventing the funding rulefrom treating a debt instrument issued onor after April 4, 2016 from being treatedas funding a distribution or acquisitionthat occurred before April 4, 2016, seeSection G of this Part IV.

v. Predecessor and Successor Rules

Finally, the funding rule provides thatreferences in the funding rule to thefunded member include any predecessoror successor of such member. A predeces-sor is defined to include the distributor ortransferor corporation in a transaction de-scribed in section 381(a) in which a mem-ber of the expanded group is the acquiringcorporation, but also includes the trans-


feror corporation in a divisive reorganiza-tion described in section 368(a)(1)(D) or(G). The term predecessor does not in-clude, with respect to a controlled corpo-ration, a distributing corporation that dis-tributed the stock of the controlledcorporation pursuant to section 355(c).Similarly, a successor is defined to in-clude the acquiring corporation in a trans-action described in section 381(a) inwhich a member of the expanded group isthe distributor or transferor corporation,but also includes the acquiring corpora-tion in a divisive reorganization describedin section 368(a)(1)(D) or (G). The termsuccessor does not include, with respect toa distributing corporation, a controlledcorporation the stock of which was dis-tributed by the distributing corporationpursuant to section 355(c). In addition,Section C.3 of this Part IV, which setsforth an exception to the funding rule forcertain acquisitions of expanded groupstock by issuance, provides that thefunded member is treated as a predecessorof the issuer and the issuer is treated as asuccessor of the funded member to the ex-tent of the value of the acquired stock. Foran illustration of these rules, see Examples9, 10, and 12 in proposed § 1.385–3(g)(3).

3. The Anti-Abuse Rule

Proposed § 1.385–3(b)(4) also pro-vides that a debt instrument is treated asstock if it is issued with a principal pur-pose of avoiding the application of theproposed regulations. In addition, otherinterests that are not debt instruments forpurposes of proposed §§ 1.385–3 and1.385–4 (for example, contracts to whichsection 483 applies or nonperiodic swappayments) are treated as stock if issuedwith a principal purpose of avoiding theapplication of proposed §§ 1.385–3 or1.385–4.

Proposed § 1.385–3(b)(4) includes anon-exhaustive list of examples illustrat-ing situations where the anti-abuse rulemight apply. The anti-abuse rule may ap-ply, for example, if a debt instrument isissued to, and later acquired from, a per-son that is not a member of the issuer’sexpanded group with a principal purposeof avoiding the application of the pro-posed regulations. In that situation, factorsthat may be taken into account in deter-

mining the presence or absence of a prin-cipal purpose of avoiding the applicationof the proposed regulations include thetime period between the issuance of thedebt instrument to the non-member andthe acquisition of the debt instrument by amember of the issuer’s expanded group,and whether there was a significantchange in circumstances during that timeperiod. For example, a change of controlof the issuer group (for example, a cashacquisition of all of the stock of the ulti-mate parent company of the issuer) afterthe issuance and before the acquisition ofthe debt instrument that was not foresee-able when the debt instrument was issuedto the non-member could indicate that thedebt instrument was not issued with aprincipal purpose of avoiding the applica-tion of the proposed regulations. In con-trast, the issuance of a debt instrument toa non-member after discussions were un-derway regarding the change-of-controltransaction could indicate that the debtinstrument was issued with a principalpurpose of avoiding the application of theproposed regulations.

Other examples of when the anti-abuserule could apply include situations where,with a principal purpose of avoiding theapplication of proposed § 1.385–3: (i) adebt instrument is issued to a person thatis not a member of the issuer’s expandedgroup and that person later becomes amember of the issuer’s expanded group;(ii) a debt instrument is issued to an entitythat is not taxable as a corporation forfederal tax purposes (for example, a trustthat is beneficially owned by an expandedgroup member); or (iii) a member of theissuer’s expanded group is substituted as anew obligor or added as a co-obligor onan existing debt instrument. The anti-abuse rule also could apply to a debt in-strument that is issued or transferred inconnection with a reorganization or similartransaction with a principal purpose ofavoiding the application of the proposedregulations. For a further illustration of thisrule, see Example 18 in § 1.385–3(g)(3) ofthe proposed regulations.

4. Coordination Between General Ruleand Funding Rule

Proposed § 1.385–3(b)(5) includes arule to address a potential overlap be-

tween the general rule and the fundingrule. This coordination rule provides that,to the extent all or a portion of a debtinstrument issued in an asset reorganiza-tion is treated as stock under the thirdprong of the general rule (relating to adebt instrument issued for property in anasset reorganization), the distribution ofthe deemed stock to a shareholder in theasset reorganization is not also treated as adistribution or acquisition by the trans-feror corporation for purposes of the fund-ing rule. This coordination rule addressesa specific potential overlap situationwhere a debt instrument is distributed to ashareholder pursuant to an asset reorgani-zation and is characterized under the thirdprong of the general rule as an issuance ofstock. When the issuance of the debt in-strument is characterized under the gen-eral rule as an issuance of stock, the stockmay be treated as non-qualified preferredstock for purposes of section 356. Non-qualified preferred stock received by ashareholder in a distribution is itselftreated as “other property” for purposes ofsection 356. This overlap rule providesthat, if the shareholder is deemed to re-ceive nonqualified preferred stock in theasset reorganization, the distribution ofthe nonqualified preferred stock in the as-set reorganization is not treated as a dis-tribution or acquisition for purposes of thefunding rule. For an illustration of thisrule, see Example 8 in § 1.385–3(g)(3) ofthe proposed regulations.

C. Exceptions

Proposed § 1.385–3(c) provides threeexceptions from the application of pro-posed § 1.385–3(b) for transactions thatotherwise could result in a debt instrumentbeing treated as stock.

1. Exception for Current Year Earningsand Profits

As noted in Section B.2 of this Part IV,proposed § 1.385–3(c)(1) includes an ex-ception pursuant to which distributionsand acquisitions described in proposed§ 1.385–3(b)(2) (the general rule) or pro-posed § 1.385–3(b)(3)(ii) (the fundingrule) that do not exceed current year earn-ings and profits (as described in section316(a)(2)) of the distributing or acquiring


corporation are not treated as distributionsor acquisitions for purposes of the generalrule or the funding rule. For this purpose,distributions and acquisitions are attrib-uted to current year earnings and profits inthe order in which they occur.

2. Threshold Exception

A second exception provides that anexpanded group debt instrument will notbe treated as stock if, when the debt in-strument is issued, the aggregate issueprice of all expanded group debt instru-ments that otherwise would be treated asstock under the proposed regulations doesnot exceed $50 million (the threshold ex-ception). If the expanded group’s debt in-struments that otherwise would be treatedas stock later exceed $50 million, then allexpanded group debt instruments that, butfor the threshold exception, would havebeen treated as stock are treated as stock,rather than only the amount that exceeds$50 million. Thus, the threshold exceptionis not an exemption of the first $50 millionof expanded group debt instruments thatotherwise would be treated as stock underthe proposed regulations, but rather isonly intended to provide an exceptionfrom the application of proposed§ 1.385–3 for taxpayers that have not ex-ceeded the $50 million threshold. If the$50 million threshold subsequently is ex-ceeded, the timing of the recharacteriza-tion of the relevant debt instrument asstock depends on when the debt instru-ment was issued. If the debt instrumentceases to qualify for the threshold excep-tion after the taxable year of its issuance,the recharacterization is treated as occur-ring on the date that the threshold excep-tion ceases to apply. If, on the other hand,the debt instrument ceases to qualify forthe threshold exception during the sametaxable year that the debt instrument isissued, the debt instrument is treated asstock as of the day that the debt instru-ment is issued. Once the $50 millionthreshold is exceeded, the threshold ex-ception will not apply to any debt instru-ment issued by members of the expandedgroup for so long as any instrument thatpreviously was treated as indebtednesssolely because of the threshold excep-tion remains outstanding, in order toprevent the $50 million limitation from

refreshing after those instruments aretreated as stock.

The threshold exception is applied af-ter applying the exception for current yearearnings and profits. For an illustration ofthe interaction of the threshold exceptionand the exception for current year earn-ings and profits, see Example 17 in§ 1.385–3(g)(3) of the proposed regula-tions.

3. Exception for Funded Acquisitionsof Subsidiary Stock by Issuance

An acquisition of expanded groupstock will not be treated as an acquisitiondescribed in the second prong of the fund-ing rule if (i) the acquisition results from atransfer of property by a funded member(the transferor) to an issuer in exchangefor stock of the issuer, and (ii) for the36-month period following the issuance,the transferor holds, directly or indirectly,more than 50 percent of the total com-bined voting power of all classes of stockof the issuer entitled to vote and more than50 percent of the total value of the stockof the issuer. For purposes of this excep-tion, a transferor’s indirect stock owner-ship is determined by applying the princi-ples of section 958(a) without regard towhether an intermediate entity is foreignor domestic.

If the transferor ceases to meet theownership requirement at any time duringthe 36-month period, the acquisition ofexpanded group stock will no longer qual-ify for the exception and will be treated asan acquisition described in the secondprong of the funding rule. In this case, forpurposes of applying the per se rule, theacquisition may be treated as having beenfunded by a debt instrument issued duringthe 72-month period determined with re-spect to the date of the acquisition (ratherthan the date that the exception ceased toapply (the cessation date)), but, in the caseof a debt instrument issued prior to thecessation date, only to the extent that suchdebt instrument is treated as indebtednessas of the cessation date (that is, a debtinstrument not already treated as stock).

The proposed regulations treat an is-suer and a transferor as a successor andpredecessor, respectively, for purposes ofthe funding rule to the extent of the valueof the expanded group stock acquired

from the issuer. However, for purposes ofthe per se rule, the issuer and transferorare only treated as successor and prede-cessor, respectively, with respect to a debtinstrument issued by the transferor duringthe period beginning 36 months before therelevant issuance of expanded group stockand ending 36 months after such issuance.Proposed § 1.385–3(f)(11) further limitsthe effect of treating the issuer and trans-feror as successor and predecessor by pro-viding that a distribution made by the is-suer directly to the transferor is not treatedas a distribution made by the transferor forpurposes of applying the funding rule to adebt instrument of the transferor.

For an illustration of this exception, seeExample 12 in § 1.385–3(g)(3) of the pro-posed regulations.

D. Operating Rules

Proposed § 1.385–3(d) includes oper-ating rules for determining when a debtinstrument is treated as stock and for cer-tain deemed exchanges required under theproposed regulations.

1. Timing of Stock Treatment

a. Timing under the General Rule

A debt instrument treated as stock un-der the general rule is treated as stockfrom the time when the debt instrument isissued. In addition, and in contrast to thefunding rule, the treatment of a debt in-strument as stock pursuant to the generalrule may affect other aspects of the taxtreatment of the transaction in which thedebt instrument is issued. For example, adistribution of a debt instrument is treatedas a distribution of stock for all federal taxpurposes and, accordingly, is subject tosection 305. Similarly, a debt instrumentissued in exchange for expanded groupstock is treated as an acquisition of ex-panded group stock in exchange for stockof the issuing corporation. Because stockof the issuing corporation is not treated as“property” within the meaning of section317, such transactions would not, for ex-ample, be described in section 304(a)(1)or be subject to § 1.367(b)–10, both ofwhich only apply to certain acquisitions ofstock for property.


b. Timing under the Funding Rule

When the funding rule applies, a prin-cipal purpose debt instrument also istreated as stock from the time when thedebt instrument is issued, but only to theextent it is issued in the same or a subse-quent taxable year as the distribution oracquisition that the debt instrument istreated as funding. To the extent that aprincipal purpose debt instrument is is-sued in a taxable year preceding the tax-able year in which the distribution or ac-quisition that it is treated as fundingoccurs, the debt instrument is respected asindebtedness until the date such distribu-tion or acquisition occurs, at which time itis deemed to be exchanged (as describedin Section D.2 of this Part IV) for stock.For these purposes, the relevant taxableyear is the taxable year of the fundedmember. See Section C.3 of this Part IVfor a discussion of the timing rule when theexception for funded acquisitions of subsid-iary stock by issuance ceases to apply.

In contrast to transactions that are char-acterized under the general rule, when thefunding rule applies, the tax treatment ofthe distribution or acquisition that theprincipal purpose debt instrument istreated as funding is never recharacterizedunder the proposed regulations. Accord-ingly, in the case of a section 301 distri-bution that triggers the application of thefunding rule, section 301 will continue toapply to the distribution without regard tothe fact that the debt instrument that istreated as funding the distribution is re-characterized as stock. Similarly, the ap-plication of section 304 to a funded acqui-sition of expanded group stock would notbe affected by the fact that the debt instru-ment that is treated as funding the acqui-sition is recharacterized as stock under thefunding rule.

c. Transitional Timing Rule

For an additional timing rule address-ing certain debt instruments issued on orafter April 4, 2016 and before the date ofpublication in the Federal Register of theTreasury decision adopting proposed§ 1.385–3 as a final regulation, see sectionG of this Part IV.

2. Deemed Exchange

As described in Section D.1 of this PartIV, the funding rule can apply to treat adebt instrument as stock in a taxable yearthat is subsequent to the taxable year inwhich the debt instrument is issued. Inaddition, as described in Section C of thisPart IV, when the $50 million thresholdexception ceases to apply, all debt instru-ments of the expanded group issued in aprior taxable year that previously wastreated as indebtedness because of thethreshold exception is treated as stock onthe date that the threshold exceptionceases to apply. In those situations thedeemed exchange rule described in Sec-tion B of Part II applies. This deemedexchange rule does not apply when a debtinstrument that is treated as stock underproposed § 1.385–3 leaves the expandedgroup, as described in Section D.3 of thisPart IV.

3. Debt Instrument that Leaves theExpanded Group

When a debt instrument that is treatedas stock under proposed § 1.385–3 istransferred to a person that is not a mem-ber of the expanded group, or when theobligor with respect to such debt instru-ment ceases to be a member of the ex-panded group that includes the issuer, theinterest ceases to be treated as stock. Thisis because proposed § 1.385–3 generallyapplies only to a debt instrument that isheld by a member of an expanded group.For purposes of this rule, it should benoted that a debt instrument held by apartnership is considered held by its part-ners, as described in Section D.4 of thisPart IV.

The proposed regulations provide that,immediately before a debt instrument thatis treated as stock under proposed§ 1.385–3 ceases to be held by a memberof the expanded group, the expandedgroup issuer is deemed to issue a new debtinstrument to the expanded group holderin exchange for the debt instrument thatwas treated as stock. The proposed regu-lations provide that this deemed issuanceof the debt instrument is not itself subjectto the general rule.

When a debt instrument treated asstock pursuant to the funding rule ceases

to be treated as stock because it is nolonger an expanded group debt instru-ment, all other debt instruments of theissuer that are not currently treated asstock are re-tested to determine whetherother debt instruments are treated asfunding the distribution or acquisitionthat previously was treated as funded bythe debt instrument that ceases to betreated as stock pursuant to this rule. Foran illustration of this rule, see Example7 in § 1.385–3(g)(3) of the proposedregulations.

4. Treatment of Partnerships

To prevent avoidance of these rulesthrough the use of partnerships, proposed§ 1.385–3(d)(5) takes an aggregate ap-proach to controlled partnerships for pur-poses of the proposed regulations. Thelegislative history of subchapter K ofchapter 1 of the Code provides that, forpurposes of interpreting Code provisionsoutside of that subchapter, a partnershipmay be treated as either an entity separatefrom its partners or an aggregate of itspartners, depending on which character-ization is more appropriate to carry out thepurpose of the particular section underconsideration. H.R. Conf. Rep. No. 2543,83rd Cong. 2d. Sess. 59 (1954). Thus, forexample, when a member of an expandedgroup becomes a partner in a partnershipthat is a controlled partnership with re-spect to the expanded group, the memberis treated as acquiring its proportionateshare of the controlled partnership’s as-sets. In addition, each expanded grouppartner in a controlled partnership istreated as (i) issuing its proportionateshare of any debt instrument issued by thecontrolled partnership, (ii) acquiring itsproportionate share of any expandedgroup stock acquired by the controlledpartnership, and (iii) receiving its propor-tionate share of any “other property” re-ceived by the partnership in a transactiondescribed in section 356. For this purpose,a partner’s proportionate share is deter-mined in accordance with the partner’sshare of partnership profits. A partnershipis a controlled partnership if 80 percent ormore of the interests in the capital orprofits of the partnership are owned, di-rectly or indirectly, by one or more mem-bers of an expanded group. For this pur-


pose, indirect ownership of a partnershipinterest is determined based on the indi-rect ownership rules of section 304(c)(3).

If a debt instrument issued by a con-trolled partnership were to be recharacter-ized as equity in the controlled partner-ship, the resulting equity could give rise toguaranteed payments that may be deduct-ible or gross income allocations to part-ners that would reduce the taxable incomeof the other partners that did not receivesuch allocations. Therefore, under the au-thority of section 7701(l) to recharacterizemultiple-party financing transactions, pro-posed § 1.385–3(d)(5)(ii) provides that,when a debt instrument issued by a part-nership is recharacterized, in whole or inpart, under proposed § 1.385–3, the holderof the recharacterized debt instrument istreated as holding stock in the expandedgroup partner or partners rather than asholding a partnership interest in the con-trolled partnership. The partnership and itspartners must make appropriate conform-ing adjustments to reflect the expandedgroup partner’s treatment under the pro-posed regulations. Any such adjustmentsmust be consistent with the purposes ofthese proposed regulations and must bemade in a manner that avoids the creationof, or increase in, a disparity between thecontrolled partnership’s aggregate basis inits assets and the aggregate bases of thepartners’ respective interests in the part-nership. For an illustration of the rulesapplicable to controlled partnerships, seeExamples 13, 14, and 15 in § 1.385–3(g)(3) of the proposed regulations.

5. Notification of Inconsistent TreatmentWaived

Section 385(c)(1) provides that an is-suer’s characterization as of the time ofissuance of an interest as debt or stock isbinding on the issuer and on all holders ofthe interest. Section 385(c)(2) provides anexception to that rule if the holder dis-closes on its return that the holder is treat-ing such interest in a manner that is in-consistent with such characterization.Section 385(c)(3) provides that the Secre-tary is authorized to require such informa-tion as the Secretary determines to benecessary to carry out the provisions of sec-tion 385(c). Under proposed § 1.385–3, aholder may be required to treat an interest as

stock even though the issuer treated it asdebt when it was issued. For example, adebt instrument may first be treated as aprincipal purpose debt instrument in a yearthat follows the year in which the debt in-strument was issued. In that case, absent aregulatory provision to the contrary, theholder would be subject to the reportingrequirement described in section 385(c)(2).

The Treasury Department and the IRShave determined that the characterizationand reporting requirements in section385(c) were not intended to apply whenregulations under section 385 require aninterest to be recharacterized after the is-suer’s initial characterization of that inter-est. Accordingly, the proposed regulationsprovide that section 385(c)(1) does notapply to a debt instrument to the extentthat it is treated as stock under the pro-posed regulations.

6. Obligations of Disregarded Entities

Proposed § 1.385–3(d)(6) provides thata debt instrument issued by a disregardedentity that is treated as stock under pro-posed § 1.385–3 is treated as stock in thedisregarded entity’s owner rather than asan equity interest in the disregarded entity.Ordinarily, when a disregarded entity be-comes an entity with more than one equityowner, the disregarded entity converts to apartnership. See, e.g., § 301.7701–3(f)(2);Rev. Rul. 99–5, 1999–1 C.B. 434. Underthese circumstances, the Treasury Depart-ment and the IRS have determined thattreating a debt instrument issued by a dis-regarded entity that is treated as stockunder proposed § 1.385–3 as stock in itsowner, rather than as an equity interest inthe disregarded entity, is consistent with,and addresses similar policy concerns as,the rules applicable to a debt instrumentissued by a controlled partnership, whichare described in Section D.4 of this Part IV.

E. No Affirmative Use

Under proposed § 1.385–3(e), pro-posed §§ 1.385–3 and 1.385–4 do notapply to the extent a person enters into atransaction that otherwise would be sub-ject to the proposed regulations with aprincipal purpose of reducing its federaltax liability or the federal tax liability ofanother person by disregarding the treat-

ment of the debt instrument that wouldoccur without regard to the proposedregulations.

F. Treatment of Consolidated Groups

As noted previously, the Treasury De-partment and the IRS have determinedthat a debt instrument between membersof the same consolidated group does notraise the same federal tax concerns as adebt instrument between members of thesame expanded (but not consolidated)group. Accordingly, proposed § 1.385–4includes special rules, issued under theauthority of section 1502, for applying§ 1.385–3 to consolidated groups, includ-ing rules addressing the treatment of adebt instrument issued by one member ofa consolidated group to another memberof the same consolidated group (consoli-dated group debt instrument) and rulesregarding the treatment of a debt instru-ment when it ceases to be a consolidatedgroup debt instrument.

1. Consolidated Groups Treated as OneCorporation

For purposes of proposed § 1.385–3,all members of a consolidated group aretreated as one corporation. Accordingly,proposed § 1.385–3 does not apply to aconsolidated group debt instrument. Thus,for example, the proposed regulations donot treat as stock a debt instrument that isissued by one member of a consolidatedgroup to another member of the consoli-dated group in a distribution. The proposedregulations define a consolidated group inthe same manner as the consolidated returnregulations. See § 1.1502–1(h).

As a result of treating all members of aconsolidated group as one corporation forpurposes of applying proposed § 1.385–3,a debt instrument issued to or by onemember of a consolidated group generallyis treated as issued to or by all members ofthe same consolidated group. Thus, a debtinstrument issued by one consolidatedgroup member to a member of its ex-panded group that is not a member of itsconsolidated group may be treated underthe funding rule as funding a distributionor acquisition by another member of thatconsolidated group, even though thatother consolidated group member was not


the issuer and thus was not funded di-rectly. Similarly, a debt instrument issuedby one consolidated group member to an-other consolidated group member istreated as stock under the general rulewhen the debt instrument is distributed bythe holder to a member of the expandedgroup that is not a member of the sameconsolidated group, regardless of whetherthe issuer itself distributed the debt instru-ment. For an illustration of this rule, seeExample 1 in proposed § 1.385–4(d)(3).

2. Debt Instrument that Ceases to Be aConsolidated Group Debt Instrument butContinues to Be an Expanded GroupDebt Instrument

Proposed § 1.385–4 includes rules ad-dressing debt held or issued by a consol-idated group member that leaves a consol-idated group, but continues to be amember of the expanded group (such cor-poration, a departing member).

Generally, any consolidated group debtinstrument that is issued or held by thedeparting member and that is not treatedas stock solely by reason of the rule treat-ing all members of a consolidated groupas one corporation (exempt consolidatedgroup debt instrument) is deemed to beexchanged for stock immediately after thedeparting member leaves the group. Anyconsolidated group debt instrument issuedor held by a departing member that is notan exempt consolidated group debt instru-ment (non-exempt consolidated group debtinstrument) is treated as indebtedness unlessand until the non-exempt consolidatedgroup debt instrument is treated as a princi-pal purpose debt instrument under proposed§§ 1.385–3(b)(3)(ii) and 1.385–3(d)(1) as aresult of a distribution or acquisition de-scribed in proposed § 1.385–3(b)(3)(ii) thatoccurs after the departure. However, solelyfor purposes of applying the 72-month pe-riod under the per se funding rule, the debtinstrument is treated as having been issuedwhen it was first treated as a consolidatedgroup debt instrument.

When a member of a consolidatedgroup transfers a consolidated group debtinstrument to an expanded group memberthat is not a member of the consolidatedgroup, the debt instrument is treated asissued by the issuer of the debt instrument(which is treated as one corporation with

the transferor of the debt instrument) tothe transferee expanded group member onthe date of the transfer. For purposes ofproposed § 1.385–3, the consequences ofthe transfer are determined in a mannerthat is consistent with treating a consoli-dated group as one corporation. Thus, forexample, the sale of a consolidated groupdebt instrument to an expanded groupmember that is not a member of the con-solidated group is treated as an issuance ofthe debt instrument to the transferee ex-panded group member in exchange forproperty. To the extent the debt instru-ment is treated as stock upon beingtransferred, the debt instrument isdeemed to be exchanged for stock im-mediately after the debt instrument istransferred outside of the consolidatedgroup. For an illustration of this rule,see Examples 1 and 2 in § 1.385– 4(d)(3)of the proposed regulations.

G. Proposed Effective/Applicability Dateand Transition Rules

Sections 1.385–3 and 1.385–4 are pro-posed to apply to any debt instrumentissued on or after April 4, 2016 and to anydebt instrument issued before April 4,2016 as a result of an entity classificationelection made under § 301.7701–3 that isfiled on or after April 4, 2016. However,when §§ 1.385–3(b) and 1.385–3(d)(1)(i)through (d)(1)(v), or § 1.385–4 of theproposed regulations, otherwise wouldtreat a debt instrument as stock prior to thedate of publication in the Federal Regis-ter of the Treasury decision adopting thisrule as a final regulation, the debt instru-ment is treated as indebtedness until thedate that is 90 days after the date of pub-lication in the Federal Register of theTreasury decision adopting this rule as afinal regulation. To the extent that the debtinstrument described in the preceding sen-tence is held by a member of the issuer’sexpanded group on the date that is 90 daysafter the date of publication in the FederalRegister of the Treasury decision adopt-ing this rule as a final regulation, the debtinstrument is deemed to be exchanged forstock on the date that is 90 days after thedate of publication in the Federal Regis-ter of the Treasury decision adopting thisrule as a final regulation.

In addition, for purposes of determin-ing whether a debt instrument is a princi-pal purpose debt instrument described inproposed § 1.385–3(b)(3)(iv), a distribu-tion or acquisition described in proposed§ 1.385–3(b)(3)(ii) that occurs beforeApril 4, 2016, other than a distribution oracquisition that is treated as occurring be-fore April 4, 2016 as a result of an entityclassification election made under§ 301.7701–3 that is filed on or after April4, 2016, is not taken into account.

Statement of Availability of IRSDocuments

IRS Revenue Procedures, RevenueRulings notices, and other guidance citedin this document are published in the In-ternal Revenue Bulletin (or CumulativeBulletin) and are available from the Su-perintendent of Documents, U.S. Govern-ment Printing Office, Washington, DC20402, or by visiting the IRS website athttp://www.irs.gov.

Special Analyses

Executive Orders 13563 and 12866 di-rect agencies to assess costs and benefitsof available regulatory alternatives and, ifregulation is necessary, to select regula-tory approaches that maximize net bene-fits (including potential economic, envi-ronmental, public health and safetyeffects, distributive impacts, and equity).Executive Order 13563 emphasizes theimportance of quantifying both costs andbenefits, of reducing costs, of harmoniz-ing rules, and of promoting flexibility.This rule has been designated a “signifi-cant regulatory action” under section 3(f)of Executive Order 12866 and designatedas economically significant. Accordingly,the rule has been reviewed by the Officeof Management and Budget. A regulatoryassessment for this proposed rule is avail-able in the docket for this rulemaking onwww.regulations.gov.

Pursuant to the Regulatory FlexibilityAct (5 U.S.C. Chapter 6), it is herebycertified that the proposed regulations willnot have a significant economic impact ona substantial number of small entities. Ac-cordingly, an initial regulatory flexibilityanalysis is not required. The Commis-sioner and the courts historically have an-alyzed whether an interest in a corporation


should be treated as stock or indebtednessfor federal tax purposes by applying var-ious sets of factors to the facts of a par-ticular case. Proposed § 1.385–1 providesthat in connection with determiningwhether an interest in a corporationshould be treated as stock or indebtednessfor federal tax purposes, the Commis-sioner has the discretion to treat certaininterests in a corporation for federal taxpurposes as indebtedness in part and stockin part. Proposed § 1.385–1 does not re-quire taxpayers to take any additional ac-tions or to engage in any new proceduresor documentation. Because proposed§ 1.385–1 contains no such requirements,it does not have an effect on small entities.

To facilitate the federal tax analysis ofan interest in a corporation, taxpayers arerequired to substantiate their classificationof an interest as stock or indebtedness forfederal tax purposes. Proposed § 1.385–2provides documentation requirements tosubstantiate the treatment of certainrelated-party instruments as indebtedness.First, these rules apply only to debt instru-ments in form issued within expandedgroups of corporations and other entities.Second, proposed § 1.385–2 only appliesto expanded groups if the stock of a mem-ber of the expanded group is publiclytraded, or financial statements of the ex-panded group or its members show totalassets exceeding $100 million or annualtotal revenue exceeding $50 million. Be-cause the rules are limited to large ex-panded groups, they will not affect a sub-stantial number of small entities.

Proposed § 1.385–3 provides rules thattreat as stock certain interests in a corpo-ration that are held by a member of thecorporation’s expanded group and thatotherwise would be treated as indebted-ness for federal tax purposes. Proposed§ 1.385–4 provides rules regarding theapplication of proposed § 1.385–3 tomembers of a consolidated group. Pro-posed § 1.385–3 includes multiple excep-tions that limit its application. In particu-lar, the threshold exception provides thatan expanded group debt instrument willnot be treated as stock under proposed§ 1.385–3 if, when the debt instrument isissued, the aggregate issue price of allexpanded group debt instruments that oth-erwise would be treated as stock underproposed § 1.385–3 does not exceed $50

million. The threshold exception also gov-erns the application of proposed § 1.385–3rules to members of a consolidated groupdescribed in proposed § 1.385–4. Al-though it is possible that the classificationrules in proposed §§ 1.385–3 and 1.385–4could have an effect on small entities, thethreshold exception makes it unlikely thata substantial number of small entities willbe affected by proposed §§ 1.385–3 and1.385– 4. Pursuant to section 7805(f) ofthe Code, these regulations have beensubmitted to the Chief Counsel for Ad-vocacy of the Small Business Adminis-tration for comment on their impact onsmall business.

Comments and Public Hearing

Before the proposed regulations are ad-opted as final regulations, considerationwill be given to any written (a signedoriginal and eight copies) or electroniccomments that are submitted timely to theIRS. The Treasury Department and theIRS request comments on all aspects ofthe proposed rules, including commentson the clarity of the proposed rules andhow they can be made more administra-ble. In addition, comments are requestedon: (1) other instruments that should besubject to the proposed regulations, in-cluding other types of applicable instru-ments that are not indebtedness in formthat should be subject to proposed§ 1.385–2 and the documentation require-ments that should apply to such applicableinstruments; (2) whether special rules arewarranted for cash pools, cash sweeps,and similar arrangements for managingcash of an expanded group; (3) the ruleaddressing deemed exchanges of an EGIand a debt instrument; (4) the applicationof these rules to any entity with respect toa 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, andis not a CFC or a controlled foreign part-nership, but in a later year becomes one ofthe foregoing; (5) whether certain indebt-edness commonly used by investmentpartnerships, including indebtedness is-sued by certain “blocker” entities, impli-cate similar policy concerns as those mo-tivating the proposed regulations, suchthat the scope of the proposed regulationsshould be broadened; (6) whether guid-ance is needed under section 909 to the

extent a U.S. equity hybrid instrumentarises solely by reason of the applicationof proposed § 1.385–3; and (7) the treat-ment of controlled partnerships in pro-posed § 1.385–3 and the collateral conse-quences of the recharacterization and anycorresponding adjustments, including thetreatment of a partner’s proportionateshare of partnership assets or debt instru-ments, of treating a debt instrument issuedby a controlled partnership as stock in itsexpanded group partners, including a sit-uation in which a recharacterization re-sults in a partnership owning stock of anexpanded group partner. Specifically, theTreasury Department and the IRS requestcomments on how to apply proposed§ 1.385–3 when expanded group partnersmake distributions subject to the fundingrule with respect to some, but not all,partnership debt instruments; when one ormore, but not all, expanded group partnersmake a distribution subject to the fundingrule with respect to part or all of theirshare of the partnership debt instrument;and how to address such distributionswhen a controlled partnership has one ormore partners that are not expanded groupmembers. The Treasury Department andthe IRS also request comments onwhether the objective rules in proposed§ 1.385–3(d)(5) have the potential to bemanipulated, including by selectively lo-cating debt instruments in order to achieveresults that are contrary to the purposes ofthese regulations, and, if so, whether theanti-abuse rule in proposed § 1.385–3(b)(4) or the rule prohibiting the affirma-tive use of these rules by taxpayers inproposed § 1.385–3(e) are sufficient toaddress these concerns.

More generally, the Treasury Depart-ment and the IRS request comments onwhether additional guidance is necessaryregarding the manner by which issuersand holders notify the Secretary of theintended federal tax treatment of an inter-est in a corporation.

The Treasury Department and the IRSare aware that the issuance of preferredequity by a controlled partnership to anexpanded group member may give rise tosimilar concerns as debt instruments of acontrolled partnership issued to an ex-panded group member, and that controlledpartnerships may, in some cases, issuepreferred equity with a principal purpose


of avoiding the application of § 1.385–3of the proposed regulations. The TreasuryDepartment and the IRS are consideringrules that would treat preferred equity in acontrolled partnership as equity in the ex-panded group partners, based on the prin-ciples of the aggregate approach used inproposed § 1.385–3(d)(5). Comments arerequested regarding the recharacterizationof preferred equity in those circumstances.Until any such guidance is issued, the IRSintends to closely scrutinize, and maychallenge when the regulations becomeeffective, transactions in which a con-trolled partnership issues preferred equityto an expanded group member and, withinthe relevant 72-month period, one or moreexpanded group partners in the controlledpartnership engage in a transaction de-scribed in § 1.385–3(b)(3)(ii) of the pro-posed regulations.

Finally, regarding the request for com-ments on whether guidance is needed un-der section 909 when a U.S. equity hybridinstrument arises solely by reason of theapplication of § 1.385–3: the applicationof proposed § 1.385–3 may give rise to aU.S. equity hybrid instrument splitter ar-rangement under § 1.909–2(b)(3)(i) (forexample when indebtedness issued by oneCFC to another CFC is treated as equityunder proposed § 1.385–3). When thisoccurs, payments made pursuant to theinstrument generally would result in dis-tributions out of earnings and profits at-tributable pro rata to related income andother income, as described in §§ 1.909–3and 1.909–6(d). Given that these section385 regulations may give rise to a prolif-eration of U.S. hybrid equity instrumentsplitter arrangements, the Treasury De-partment and the IRS request commentson whether additional guidance is neededunder section 909, including to addressany uncertainty with respect to how U.S.hybrid equity instrument splitter ar-rangements are treated. All commentswill be available for public inspectionand copying at www.regulations.gov orupon request.

Drafting Information

The principal authors of these regula-tions are Eric D. Brauer of the Office ofAssociate Chief Counsel (Corporate) andRaymond J. Stahl of the Office of Asso-ciate Chief Counsel (International). How-

ever, other personnel from the TreasuryDepartment and the IRS participated intheir development.

* * * * *

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and record-keeping requirements.

Proposed Amendment to theRegulations

Accordingly, 26 CFR part 1 is pro-posed to be amended as follows:

PART I—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding entries innumerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.385–1 also issued under 26

U.S.C. 385.Section 1.385–2 also issued under 26

U.S.C. 385 and 26 U.S.C. 1502.Section 1.385–3 also issued under 26

U.S.C. 385, 26 U.S.C. 701, and 7701(l).Section 1.385–4 also issued under 26

U.S.C. 385 and 26 U.S.C. 1502.Par. 2. Section 1.385–1 is added to read

as follows:

§ 1.385–1 General provisions.

(a) Overview. This section providesdefinitions applicable to the regulationsunder section 385 and operating rules re-garding the treatment of certain direct andindirect interests in corporations as stockor indebtedness for federal tax purposes.Section 1.385–2 provides documentationand information requirements necessaryfor certain interests issued between mem-bers of an expanded group (as defined inparagraph (b)(3) of this section) to betreated as indebtedness for federal tax pur-poses. Section 1.385–3 provides rules thattreat as stock certain interests in a corpo-ration issued between members of an ex-panded group in connection with certainpurported distributions of debt instru-ments and similar transactions. Section1.385–4 provides special rules regardingthe transactions described in § 1.385–3 asthey relate to consolidated groups.

(b) Definitions. The definitions in thisparagraph (b) apply for purposes of theregulations under section 385. For addi-

tional definitions that apply for purposesof § 1.385–2, see § 1.385–2(a)(4). Foradditional definitions that apply for pur-poses of §§ 1.385–3 and 1.385–4, see§ 1.385–3(f).

(1) Controlled partnership. The termcontrolled partnership means a partner-ship with respect to which at least 80percent of the interests in partnership cap-ital or profits are owned, directly or indi-rectly, by one or more members of anexpanded group. For this purpose, indirectownership of a partnership interest is de-termined by applying the principles ofparagraph (b)(3)(ii) of this section.

(2) Disregarded entity. The term disre-garded entity means a business entity (asdefined in § 301.7701–2(a) of this chap-ter) that is disregarded as an entity sepa-rate from its owner for federal tax pur-poses under §§ 301.7701–1 through301.7701–3 of this chapter.

(3) Expanded group—(i) In general.The term expanded group means an affil-iated 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 indi-rectly” for “directly” in section1504(a)(1)(B)(i); and

(C) By substituting “or” for “and” insection 1504(a)(2)(A).

(ii) Indirect stock ownership. For pur-poses of this paragraph (b)(3), indirectstock ownership is determined by apply-ing the rules of section 304(c)(3).

(4) Modified controlled partnership.The term modified controlled partnershipmeans a partnership with respect to whichat least 50 percent of the interests in part-nership capital or profits are owned, di-rectly or indirectly, by one or more mem-bers of a modified expanded group. Forthis purpose, indirect ownership of a part-nership interest is determined by applyingthe principles of paragraph (b)(3)(ii) ofthis section.

(5) Modified expanded group. The termmodified expanded group means an ex-panded group, as defined in this section,determined by substituting “50” for “80”in sections 1504(a)(2)(A) and (B). If oneor more members of a modified expandedgroup own, directly or indirectly, 50 per-cent of the interests in partnership capitalor profits of a modified controlled partner-


ship, the modified controlled partnershipis treated as a member of the modifiedexpanded group. In addition, if a person(as defined in section 7701(a)(1)) istreated, under the rules of section 318, asowning at least 50 percent of the value ofthe stock of a modified expanded groupmember, the person is treated as a memberof the modified expanded group.

(c) Treatment of deemed exchange. If adebt instrument (as defined in § 1.385–3(f)(3)) or an EGI (as defined in § 1.385–2(a)(4)(ii)) is deemed to be exchanged, inwhole or in part, for stock pursuant to§ 1.385–2(c)(3)(ii), § 1.385–3(d)(1)(ii),§ 1.385–3(d)(1)(iii), § 1.385–3(d)(1)(iv),§ 1.385–3(d)(1)(v), § 1.385–3(h)(3), or§ 1.385–4(e)(3), the holder is treated ashaving realized an amount equal to theholder’s adjusted basis in that portion ofthe indebtedness or EGI as of the date ofthe deemed exchange (and as having basisin the stock deemed to be received equalto that amount), and the issuer is treated ashaving retired that portion of the debt in-strument or EGI for an amount equal to itsadjusted issue price as of the date of thedeemed exchange. In addition, neitherparty accounts for any accrued but unpaidqualified stated interest on the debt instru-ment or EGI or any foreign exchange gainor loss with respect to that accrued butunpaid qualified stated interest (if any) asof the deemed exchange. Notwithstandingthe first sentence of this paragraph (c), therules of § 1.988–2(b)(13) apply to requirethe holder and the issuer of a debt instru-ment or an EGI that is deemed to beexchanged in whole or in part for stockpursuant to § 1.385–2(c)(3)(ii), § 1.385–3(d)(1)(ii), § 1.385–3(d)(1)(iii), § 1.385–3(d)(1)(iv), § 1.385–3(d)(1)(v), § 1.385–3(h)(3), or § 1.385–4(e)(3) to recognizeany exchange gain or loss, other than anyexchange gain or loss with respect to ac-crued but unpaid qualified stated interestthat is not taken into account under thisparagraph (c) at the time of the deemedexchange. For purposes of this paragraph(c), in applying § 1.988–2(b)(13) the ex-change gain or loss under section 988 istreated as the total gain or loss on theexchange.

(d) Treatment as indebtedness inpart—(1) In general. The Commissionermay treat an EGI (as defined in § 1.385–2(a)(4)(ii) and described in paragraph

(d)(2) of this section) as in part indebted-ness and in part stock to the extent that ananalysis, as of the issuance of the EGI, ofthe relevant facts and circumstances con-cerning the EGI (taking into account anyapplication of § 1.385–2) under generalfederal tax principles results in a determi-nation that the EGI is properly treated forfederal tax purposes as indebtedness inpart and stock in part. For example, if theCommissioner’s analysis supports a rea-sonable expectation that, as of the issu-ance of the EGI, only a portion of theprincipal amount of an EGI will be repaidand the Commissioner determines that theEGI should be treated as indebtedness inpart and stock in part, the EGI may betreated as indebtedness in part and stockin part in accordance with such determi-nation, provided the requirements of§ 1.385–2, if applicable, are otherwisesatisfied and the application of federal taxprinciples supports this treatment. The is-suer of an EGI, the holder of an EGI, andany other person relying on the character-ization of an EGI as indebtedness for fed-eral tax purposes are required to treat theEGI consistent with the issuer’s initialcharacterization. Thus, for example, aholder may not disclose on its return un-der section 385(c)(2) that it is treating anEGI as indebtedness in part or stock inpart if the issuer of the EGI treats the EGIas indebtedness.

(2) EGI described in this paragraph(d)(2). An EGI is described in this para-graph (d)(2) if it is an applicable instru-ment (as defined in § 1.385–2(a)(4)(i)) anissuer of which is one member of a mod-ified expanded group and the holder ofwhich is another member of the samemodified expanded group.

(e) Treatment of consolidated groups.For purposes of the regulations under sec-tion 385, all members of a consolidatedgroup (as defined in § 1.1502–1(h)) aretreated as one corporation.

(f) Effective/applicability date. Thissection applies to any applicable instru-ment issued or deemed issued on or afterthe date these regulations are published asfinal regulations in the Federal Register,and to any applicable instrument treatedas indebtedness issued or deemed issuedbefore the date these regulations are is-sued as final regulations if and to theextent it was deemed issued as a result of

an entity classification election made un-der § 301.7701–3 of this chapter that isfiled on or after the date these regulationsare issued as final regulations in the Fed-eral Register. For purposes of §§ 1.385–3and 1.385–4, this section applies to anydebt instrument issued on or after April 4,2016 and to any debt instrument treated asissued before April 4, 2016 as a result ofan entity classification election made un-der § 301.7701–3 of this chapter that isfiled on or after April 4, 2016.

Par. 3. Section 1.385–2 is added to readas follows:

§ 1.385–2 Treatment of certain interestsbetween members of an expanded group.

(a) General—(1) Scope. This sectionprescribes threshold requirements thatmust be satisfied regarding the preparationand maintenance of documentation andinformation with respect to an expandedgroup instrument (an EGI, as defined inparagraph (a)(4)(ii) of this section). Thepurpose of preparing and maintaining thedocumentation and information requiredby this section is to enable an analysis tobe made whether an EGI is appropriatelytreated as stock or indebtedness for fed-eral tax purposes. Satisfying the require-ments of this section does not establishthat an interest is indebtedness; such sat-isfaction serves as a minimum standardthat enables this determination to be madeunder general federal tax principles. Therules of this section must be interpretedand applied in a manner that is consistentwith and reasonably carries out the pur-poses of this section. Moreover, nothingin this section prevents the Commissionerfrom asserting that the substance of atransaction involving an EGI (or the EGIitself) is different from the form of thetransaction (or the EGI) or disregardingthe transaction (or the EGI) or treating thetransaction (or the EGI) in accordancewith its substance for federal tax purposes.Such an assertion may be made based onthe documentation or information re-ceived pursuant to a request under thissection or a request for information undersection 7602. If, and only if, the require-ments of this section are satisfied, the de-termination of the federal tax treatment ofthe EGI is made based on an analysis ofthe documentation and information pre-


pared and maintained, other facts and cir-cumstances relating to the EGI, and gen-eral federal tax principles. If therequirements of this section are not satis-fied with respect to an EGI the substanceof which is regarded for federal tax pur-poses, the EGI will be treated as stock.This section does not otherwise affect theauthority of the Commissioner under sec-tion 7602 to request and obtain documen-tation and information regarding transac-tions and instruments that purport tocreate an interest in a corporation. If therequirements of this section are satisfiedor otherwise do not apply, see §§ 1.385–3and 1.385–4 for additional rules for de-termining whether and the extent to whichan interest otherwise treated as indebted-ness under general federal tax principles isrecharacterized as stock for federal taxpurposes.

(2) Application—(i) In general. Thissection applies to an EGI only if—

(A) The stock of any member of theexpanded group is traded on (or subject tothe rules of) an established financial marketwithin the meaning of § 1.1092(d)–1(b);

(B) On the date that an applicable in-strument first becomes an EGI, total assetsexceed $100 million on any applicablefinancial statement, or

(C) On the date that an applicable in-strument first becomes an EGI, annualtotal revenue exceeds $50 million on anyapplicable financial statement.

(ii) Non-U.S. dollar applicable finan-cial statements. If an applicable financialstatement is denominated in a currencyother than the U.S. dollar, the total assetsand annual total revenue are translatedinto U.S. dollars at the spot rate (as de-fined in § 1.988–1(d)) as of the date of theapplicable financial statement.

(3) Consistency rule. If an issuer char-acterizes an EGI as indebtedness, the EGIwill be respected as indebtedness only ifthe requirements of § 1.385–2(b) are metwith respect to the EGI. If the issuer of anEGI characterizes that EGI as indebted-ness, the issuer, the holder, and any otherperson relying on the characterization ofan EGI as indebtedness for federal taxpurposes is required to treat the EGI asindebtedness for all federal tax purposes.The Commissioner is not bound by theissuer’s characterization of an EGI.

(4) Definitions. The definitions in thisparagraph (a)(4) apply for purposes of thissection.

(i) Applicable instrument—(A) In gen-eral. The term applicable instrumentmeans any interest issued or deemed is-sued that is in form a debt instrument. Seeparagraph (a)(4)(i)(B) of this section forrules regarding an interest that is not inform a debt instrument.

(B) [Reserved](ii) Expanded group instrument. The

term expanded group instrument (EGI)means an applicable instrument an issuerof which is one member of an expandedgroup and the holder of which is anothermember of the same expanded group.

(iii) Issuer. Solely for purposes of thissection, the term issuer means a person(including a disregarded entity defined in§ 1.385–1(b)(2)) that is obligated to sat-isfy any material obligations created un-der the terms of an EGI. A person can bean issuer if that person is expected tosatisfy a material obligation under an EGI,even if that person is not the primaryobligor. A guarantor, however, is not anissuer unless the guarantor is expected tobe the primary obligor.

(iv) Applicable financial statement. Forpurposes of this section, the term applica-ble financial statement means a financialstatement, listed in paragraphs(a)(4)(iv)(A) through (C) of this section,that includes the assets, portion of theassets or annual total revenue of anymember of the expanded group and that isprepared as of any date within 3 yearsprior to the date the applicable instrumentat issue first becomes an EGI. A financialstatement that includes the assets or an-nual total revenue of a member of anexpanded group may be a separate com-pany financial statement of any memberof the expanded group or any consolidatedfinancial statement that includes the as-sets, portion of the assets, or annual totalrevenue of any member of the expandedgroup. A financial statement includes—

(A) A financial statement required tobe filed with the Securities and ExchangeCommission (the Form 10–K or the An-nual Report to Shareholders);

(B) A certified audited financial state-ment that is accompanied by the report ofan independent certified public accountant(or in the case of a foreign entity, by the

report of a similarly qualified independentprofessional) that is used for—

(1) Credit purposes;(2) Reporting to shareholders, partners,

or similar persons; or(3) Any other substantial non-tax pur-

pose; or(C) A financial statement (other than a

tax return) required to be provided to theFederal, state, or foreign government orany Federal, state, or foreign agency.

(b) Documentation and information re-quired to determine treatment—(1) Prep-aration and maintenance of documenta-tion and information—(i) In general.Except as otherwise provided in this sec-tion, an EGI is treated for federal taxpurposes as stock if the documentationand information described in paragraph(b)(2) of this section are not prepared, orthe maintenance requirements of para-graph (b)(4) of this section are not satis-fied. If the requirements of this section aresatisfied, general federal tax principles ap-ply to determine whether, or the extent towhich, the EGI is treated as indebtednessfor federal tax purposes. This determina-tion will take into account the documen-tation and information prepared, main-tained, and provided in accordance withthis section, as well as any additional factsand circumstances. This section applies toeach EGI separately, but the same docu-mentation and information may satisfy therequirements of this section for more thanone EGI.

(ii) Failure to provide documentationand information described in paragraph(b)(2) of this section. If a taxpayer char-acterizes an EGI as indebtedness and failsto provide the documentation and infor-mation described in paragraph (b)(2) ofthis section upon request by the Commis-sioner, the Commissioner will treat the re-quirements of this section as not satisfied.

(2) Documentation and other informa-tion required. This paragraph (b)(2) de-scribes the documentation and informa-tion that must be prepared and maintainedto satisfy the requirements of this section.In each case, the documentation must in-clude complete and (if relevant) executedcopies of all instruments, agreements andother documents evidencing the materialrights and obligations of the issuer and theholder relating to the EGI, and any asso-ciated rights and obligations of other par-


ties, such as guarantees and subordinationagreements. Additional documentationand information may be provided tosupplement, but not substitute for, thedocumentation and information requiredunder this section. The documentationand information must satisfy the follow-ing requirements:

(i) Unconditional obligation to pay asum certain. There must be written docu-mentation prepared by the time requiredin paragraph (b)(3) of this section estab-lishing that the issuer has entered into anunconditional and legally binding obliga-tion to pay a sum certain on demand or atone or more fixed dates.

(ii) Creditor’s rights. The written doc-umentation described in paragraph(b)(2)(i) of this section must establish thatthe holder has the rights of a creditor toenforce the obligation. The rights of acreditor typically include, but are not lim-ited to, the right to cause or trigger anevent of default or acceleration of the EGI(when the event of default or accelerationis not automatic) for non-payment of in-terest or principal when due under theterms of the EGI and the right to sue theissuer to enforce payment. The rights of acreditor must include a superior right toshareholders to share in the assets of theissuer in case of dissolution.

(iii) Reasonable expectation of abilityto repay EGI. There must be written doc-umentation prepared containing informa-tion establishing that, as of the date ofissuance of the applicable instrument andtaking into account all relevant circum-stances (including all other obligations in-curred by the issuer as of the date ofissuance of the applicable instrument orreasonably anticipated to be incurred afterthe date of issuance of the applicable in-strument), the issuer’s financial positionsupported a reasonable expectation thatthe issuer intended to, and would be ableto, meet its obligations pursuant to theterms of the applicable instrument. Forthis purpose, if a disregarded entity istreated as the issuer of an EGI, and theowner of the disregarded entity has lim-ited liability within the meaning of§ 301.7701–3(b)(2)(ii) of this chapter,only the assets and financial position ofthe disregarded entity are relevant for pur-poses of this paragraph (b)(2)(iii). If theowner of such a disregarded entity does

not have limited liability within the mean-ing of § 301.7701–3(b)(2)(ii), all of theassets and the financial position of thedisregarded entity and the owner are rel-evant for purposes of this paragraph(b)(2)(iii). The documentation may in-clude cash flow projections, financialstatements, business forecasts, asset ap-praisals, determination of debt-to-equityand other relevant financial ratios of theissuer in relation to industry averages, andother information regarding the sources offunds enabling the issuer to meet its obli-gations pursuant to the terms of the appli-cable instrument. If any member of anexpanded group relied on any report oranalysis prepared by a third party in ana-lyzing whether the issuer would be able tomeet its obligations pursuant to the termsof the EGI, the documentation must in-clude the report or analysis. If the reportor analysis is protected or privileged un-der law governing an inquiry or proceed-ing with respect to the EGI and the pro-tection or privilege is asserted, neither theexistence nor the contents of the report oranalysis is taken into account in determin-ing whether the requirements of this sec-tion are satisfied.

(iv) Actions evidencing debtor-creditorrelationship—(A) Payments of principaland interest. If an issuer made any pay-ment of interest or principal with respectto the EGI (whether in accordance withthe terms and conditions of the EGI orotherwise, including prepayments), andsuch payment is claimed to support thetreatment of the EGI as indebtedness un-der general federal tax principles, docu-mentation must include written evidenceof such payment that is prepared by thetime required in paragraph (b)(3) of thissection. Such evidence could include, forexample, a wire transfer record or a bankstatement reflecting the payment.

(B) Events of default and similarevents. If the issuer did not make a pay-ment of interest or principal that was dueand payable under the terms and condi-tions of the EGI, or if any other event ofdefault or similar event has occurred,there must be written documentation, pre-pared, by the time required in paragraph(b)(3) of this section, evidencing the hold-er’s reasonable exercise of the diligenceand judgment of a creditor. Such docu-mentation may include evidence of the

holder’s efforts to assert its rights underthe terms of the EGI, including the par-ties’ efforts to renegotiate the EGI or tomitigate the breach of an obligation underthe EGI, or any change in material termsand conditions of the EGI, such as matu-rity date, interest rate, or obligation to payinterest or principal, and any documenta-tion detailing the holder’s decision to re-frain from pursuing any actions to enforcepayment.

(v) Additional information with respectto an EGI evidenced by documentationthat does not in form reflect indebtedness.This paragraph (b)(1)(v) describes addi-tional information with respect to an EGIevidenced by documentation that does notin form reflect indebtedness.

(A)–(B) [Reserved](3) Timely preparation requirement—

(i) General rule. For purposes of this sec-tion, the documentation described in para-graphs (b)(2)(i), (ii) and (iii) of thissection will be treated as satisfying thetimely preparation requirement of thisparagraph (b)(3) if it is prepared no laterthan 30 calendar days after the relevantdate, as defined in paragraph (b)(3)(ii) ofthis section. The documentation describedin paragraph (b)(2)(iv) of this section willbe treated as satisfying the timely prepa-ration requirement of this paragraph (b)(3)if it is prepared no later than 120 calendardays after the relevant date, as defined inparagraph (b)(3)(ii) of this section, asapplicable.

(ii) Relevant date. Subject to the spe-cial rules in paragraph (b)(3)(iii) of thissection (relating to certain financial ar-rangements not evidenced by an instru-ment) and paragraph (c)(1) of this section(relating to modifications to certain re-quirements of this section), the relevantdate is as follows:

(A) For documentation and informa-tion described in paragraphs (b)(2)(i) and(b)(2)(ii) of this section (relating to issu-er’s unconditional obligation to repay andestablishment of holder’s creditor’srights), the relevant date is the date onwhich a member of the expanded groupbecomes an issuer of a new or existingEGI, without regard to any subsequentdeemed issuance of the EGI under§ 1.1001–3. In the case of an applicableinstrument that becomes an EGI subse-quent to issuance, including an intercom-


pany obligation, as defined in § 1.1502–13(g)(2)(ii), that ceases to be anintercompany obligation, the relevant dateis the day on which the applicable instru-ment becomes an EGI.

(B) For documentation and informa-tion described in paragraph (b)(2)(iii) ofthis section (relating to reasonable expec-tation of issuer’s repayment), the relevantdates are the dates on which a member ofthe expanded group becomes an issuerwith respect to an EGI and any later dateon which an issuance is deemed to occurunder § 1.1001–3 and any subsequent rel-evant date that occurs under the specialrules in paragraph (b)(3)(iii) of this sec-tion. In the case of an applicable instru-ment that becomes an EGI subsequent toissuance, the relevant date is the day onwhich the applicable instrument becomesan EGI and any relevant date after the datethat the applicable instrument becomes anEGI.

(C) For documentation and informa-tion described in paragraph (b)(2)(iv)(A)of this section (relating to payments ofprincipal and interest), each date on whicha payment of interest or principal is due,taking into account all additional time per-mitted under the terms of the EGI beforethere is (or holder can declare) an event ofdefault for nonpayment, is a relevant date.

(D) For documentation and informa-tion described in paragraph (b)(2)(iv)(B)of this section (relating to events of de-fault and similar events), each date onwhich an event of default, accelerationevent or similar event occurs under theterms of the EGI is a relevant date. Forexample, if the terms of the EGI requirethe issuer to maintain certain financial ra-tios, any date on which the issuer fails tomaintain the specified financial ratio (andsuch failure results in an event of defaultunder the terms of the EGI) is a relevantdate.

(E) In the case of an applicable instru-ment that becomes an EGI subsequent toissuance, no date before the applicableinstrument becomes an EGI is a relevantdate.

(iii) Special rules for determining rel-evant dates with respect to certain finan-cial arrangements. The relevant dateswith respect to the arrangements de-scribed in this paragraph (b)(3)(iii) in-clude the date of the execution of the legal

documents governing the EGI and thedate of any amendment to those docu-ments that provides for an increase in thepermitted maximum amount of principal.In addition —

(A) Revolving credit agreements andsimilar agreements. Notwithstandingparagraph (b)(2)(i) of this section, if anEGI is not evidenced by a separate note orother writing executed with respect to theinitial principal balance or any increase inprincipal balance (for example, an EGIdocumented as a revolving credit agree-ment or an omnibus agreement that gov-erns open account obligations), the EGIsatisfies the requirements of paragraph(b)(2)(i) of this section only if the materialdocumentation associated with the EGI,including all relevant enabling docu-ments, is prepared, maintained, and pro-vided in accordance with the requirementsof this section. Relevant enabling docu-ments may include board of directors’ res-olutions, credit agreements, omnibusagreements, security agreements, oragreements prepared in connection withthe execution of the legal documents gov-erning the EGI as well as any relevantdocumentation executed with respect toan initial principal balance or increase inthe principal balance of the EGI.

(B) Cash pooling arrangements. Not-withstanding paragraph (b)(2)(i) of thissection, if an EGI is issued pursuant to acash pooling arrangement or internalbanking service that involves accountsweeps, revolving cash advance facilities,overdraft set-off facilities, operational fa-cilities, or similar features, the EGI satis-fies the requirements of paragraph(b)(2)(i) of this section only if the materialdocumentation governing the ongoing op-erations of the cash pooling arrangementor internal banking service, including anyagreements with entities that are not mem-bers of the expanded group, is prepared,maintained, and provided in accordancewith the requirements of this section. Suchdocumentation must contain the relevantlegal rights and responsibilities of anymembers of the expanded group and anyentities that are not members of the ex-panded group in conducting the operationof the cash pooling arrangement or inter-nal banking service.

(4) Maintenance requirements. Thedocumentation and information described

in paragraph (b)(2) of this section must bemaintained for all taxable years that theEGI is outstanding and until the period oflimitations expires for any return with re-spect to which the treatment of the EGI isrelevant. See section 6001 (requirement tokeep books and records).

(c) Operating rules—(1) Reasonablecause exception. If the person character-izing an EGI as indebtedness for federaltax purposes establishes that a failure tosatisfy the requirements of this section isdue to reasonable cause, appropriate mod-ifications may be made to the require-ments of this section in determiningwhether the requirements of this sectionhave been satisfied. The principles of§ 301.6724–1 of this chapter apply ininterpreting whether reasonable cause ex-ists in any particular case.

(2) General application of section toapplicable instrument becoming or ceas-ing to be an EGI—(i) Applicable instru-ment becomes an EGI. If an applicableinstrument that is not an EGI when issuedsubsequently becomes an EGI, this sec-tion applies to the applicable instrumentimmediately after it becomes an EGI andthereafter.

(ii) EGI treated as stock ceases to bean EGI. When an EGI treated as stock dueto the application of this section ceases tobe an EGI, the applicable instrument ischaracterized at that time under generalfederal tax principles. If, under generalfederal tax principles, the applicable in-strument is treated as indebtedness, theissuer is treated as issuing a new instru-ment to the holder in exchange for theEGI immediately before the transactionthat causes the EGI treated as stock due tothe application of this section to cease tobe treated as an EGI. See § 1.385–1(c).

(3) Effective date for treatment of EGIas stock under this section—(i) In gen-eral. If an applicable instrument is an EGIwhen issued and is determined to be stock,in whole or in part, due to the applicationof this section, the applicable instrumentor relevant portion thereof is treated asstock from the date it was issued. How-ever, if an applicable instrument is is-sued prior to the time it becomes an EGIand is determined to be stock, at thetime it becomes an EGI due to the ap-plication of this section, it is treated asstock from the date it becomes an EGI.


See § 1.385–2(c)(4) regarding intercom-pany obligations (deemed issued imme-diately after ceasing to be an intercom-pany obligation for purposes of thissection and § 1.385–3).

(ii) EGI recharacterized as stock basedon behavior of issuer or holder after issu-ance. Notwithstanding paragraph (c)(3)(i)of this section, if an EGI initially treatedas indebtedness is recharacterized as stockas a result of failing to satisfy paragraph(b)(2)(iv) of this section (actions evidenc-ing debtor-creditor relationship), the EGIwill cease to be treated as indebtedness asof the time the facts and circumstancesregarding the behavior of the issuer or theholder with respect to the EGI cease toevidence a debtor-creditor relationship.For purposes of determining whether anEGI originally treated as indebtednessceases to be treated as indebtedness byreason of paragraph (b)(2)(iv) of this sec-tion, the rules of this section apply beforethe rules of § 1.1001–3, such that an EGIinitially treated as indebtedness may berecharacterized as stock regardless ofwhether the indebtedness is altered ormodified (as defined in § 1.1001–3(c))and, in determining whether indebtednessis recharacterized as stock, § 1.1001–3(f)(7)(ii)(A) does not apply.

(4) Applicable instruments issued andheld by members of consolidatedgroups—(i) Consolidated group treatedas one corporation. Section 1.385–1(e)provides that members of a consolidatedgroup are treated as one corporation.Thus, during the time that the issuer andthe holder of an applicable instrument aremembers of the same consolidated group,the applicable instrument is treated as notoutstanding for purposes of this section.As a result, this section does not apply toany applicable instrument that is an inter-company obligation as defined in§ 1.1502–13(g)(2)(ii).

(ii) Applicable instrument that ceasesto be an intercompany obligation. If anapplicable instrument ceases to be an in-tercompany obligation and, as a result,becomes an EGI, the applicable instru-ment is treated as becoming an EGI im-mediately after it ceases to be an inter-company obligation. This paragraph(c)(4)(i) does not affect the application ofthe rules under § 1.1502–13(g).

(5) Treatment of disregarded entities.If a disregarded entity is the issuer of anEGI and that EGI is treated as equityunder this section, the EGI is treated as anequity interest in the disregarded entityrather than stock in the disregarded enti-ty’s owner. See § 1.385–2(c)(6)(ii) forrules regarding the treatment of an EGIissued by a controlled partnership.

(6) Applicable instruments issued orheld by controlled partnerships—(i) Con-trolled partnerships included in expandedgroup. For purposes of this section, a con-trolled partnership (as defined in § 1.385–1(b)(1)) is treated as a member of an ex-panded group if one or more members ofthe expanded group own, directly or indi-rectly, 80 percent of the interests in part-nership capital or profits of the controlledpartnership.

(ii) Treatment of EGI issued by a con-trolled partnership that is recharacterizedunder this section. If an EGI that is issuedby a controlled partnership is recharacter-ized as stock under this section, the EGI istreated as an equity interest in the con-trolled partnership.

(d) No affirmative use. The rules of thissection do not apply if there is a failure tosatisfy the requirements of paragraph (b)of this section with a principal purpose ofreducing the federal tax liability of anymember or members of the expandedgroup of the issuer and holder of the EGIor any other person relying on the charac-terization of an EGI as indebtedness forfederal tax purposes.

(e) Anti-avoidance. If an applicable in-strument that is not an EGI is issued witha principal purpose of avoiding the pur-poses of this section, the applicable instru-ment is treated as an EGI subject to thissection.

(f) Effective/applicability date. Thissection applies to any applicable instru-ment issued or deemed issued on or afterthe date these regulations are published asfinal regulations in the Federal Register,and to any applicable instrument treatedas indebtedness issued or deemed issuedbefore the date these regulations are is-sued as final regulations if and to theextent it was deemed issued as a result ofan entity classification election made un-der § 301.7701–3 of this chapter that isfiled on or after the date these regulations

are issued as final regulations in the Fed-eral Register.

Par. 4. Section 1.385–3 is added to readas follows:

§ 1.385–3 Certain distributions of debtinstruments and similar transactions.

(a) Scope. This section provides rulesthat treat as stock certain interests in acorporation that are held by a member ofthe corporation’s expanded group and thatotherwise would be treated as indebted-ness for federal tax purposes. Paragraph(b) of this section sets forth situations inwhich a debt instrument is treated as stockunder this section. Paragraph (c) of thissection provides three exceptions to theapplication of paragraph (b) of this sec-tion. Paragraph (d) of this section providesoperating rules. Paragraph (e) of this sec-tion limits the affirmative use of this sec-tion. Paragraph (f) of this section providesdefinitions. Paragraph (g) of this sectionprovides examples illustrating the applica-tion of the rules of this section. Paragraph(h) of this section provides dates of appli-cability. For rules regarding the applica-tion of this section to members of a con-solidated group, see § 1.385–4.

(b) Debt instrument treated as stock—(1) Effect of characterization as stock. Tothe extent a debt instrument is treated asstock under paragraphs (b)(2), (3), or (4)of this section, it is treated as stock for allfederal tax purposes. Any interest, or por-tion thereof, that is not characterized asstock under this section is treated as stockor indebtedness under applicable federaltax law, without reference to this section.

(2) General rule. Except as provided inparagraphs (c) and (e) of this section andin § 1.385–4, a debt instrument is treatedas stock to the extent the debt instrumentis issued by a corporation to a member ofthe corporation’s expanded group as de-scribed in one or more of the followingparagraphs:

(i) In a distribution;(ii) In exchange for expanded group

stock, other than in an exempt exchange;or

(iii) In exchange for property in anasset reorganization, but only to the extentthat, pursuant to the plan of reorganiza-tion, a shareholder that is a member of theissuer’s expanded group immediately be-


fore the reorganization receives the debtinstrument with respect to its stock in thetransferor corporation.

(3) Funding rule—(i) In general. Ex-cept as provided in paragraphs (c) and (e)of this section and in § 1.385–4, a debtinstrument is treated as stock to the extentit is a principal purpose debt instrument.

(ii) Principal purpose debt instrument.For purposes of this paragraph (b)(3), adebt instrument is a principal purpose debtinstrument to the extent it is issued by acorporation (funded member) to a mem-ber of the funded member’s expandedgroup in exchange for property with aprincipal purpose of funding a distributionor acquisition described in one or more ofthe following paragraphs:

(A) A distribution of property by thefunded member to a member of thefunded member’s expanded group, otherthan a distribution of stock pursuant to anasset reorganization that is permitted to bereceived without the recognition of gainor income under section 354(a)(1) or355(a)(1) or, when section 356 applies,that is not treated as “other property” ormoney described in section 356;

(B) An acquisition of expanded groupstock, other than in an exempt exchange,by the funded member from a member ofthe funded member’s expanded group inexchange for property other than ex-panded group stock; or

(C) An acquisition of property by thefunded member in an asset reorganizationbut only to the extent that, pursuant to theplan of reorganization, a shareholder thatis a member of the funded member’s ex-panded group immediately before the re-organization receives “other property” ormoney within the meaning of section 356with respect to its stock in the transferorcorporation.

(iii) Transactions described in morethan one paragraph. Solely for purposesof this section, to the extent all or a por-tion of a distribution or acquisition by afunded member is described in more thanone of paragraphs (b)(3)(ii)(A) through(C) of this section, the funded member istreated as engaging in only a single distri-bution or acquisition described in para-graph (b)(3)(ii) of this section.

(iv) Principal purpose—(A) In gen-eral. Subject to paragraph (b)(3)(iv)(B)(1)of this section, whether a debt instrument

is issued with a principal purpose of fund-ing a distribution or acquisition describedin paragraph (b)(3)(ii) of this section isdetermined based on all the facts and cir-cumstances. A debt instrument may betreated as issued with a principal purposeof funding a distribution or acquisitiondescribed in paragraph (b)(3)(ii) of thissection regardless of whether it is issuedbefore or after such distribution or acqui-sition.

(B) Per se rule—(1) In general. Exceptas provided in paragraph (b)(3)(iv)(B)(2)of this section, a debt instrument is treatedas issued with a principal purpose of fund-ing a distribution or acquisition describedin paragraph (b)(3)(ii) of this section if itis issued by the funded member during theperiod beginning 36 months before thedate of the distribution or acquisition, andending 36 months after the date of thedistribution or acquisition (72-monthperiod).

(2) Ordinary course exception. Para-graph (b)(3)(iv)(B)(1) of this section doesnot apply to a debt instrument that arisesin the ordinary course of the issuer’s tradeor business in connection with the pur-chase of property or the receipt of servicesto the extent that it reflects an obligationto pay an amount that is currently deduct-ible by the issuer under section 162 orcurrently included in the issuer’s cost ofgoods sold or inventory, provided that theamount of the obligation outstanding at notime exceeds the amount that would beordinary and necessary to carry on thetrade or business of the issuer if it wasunrelated to the lender.

(3) Multiple interests. If, pursuant toparagraph (b)(3)(iv)(B) of this section,two or more debt instruments may betreated as a principal purpose debt instru-ment, the debt instruments are tested un-der paragraph (b)(3)(iv)(B) of this sectionbased on the order in which they wereissued, with the earliest issued debt instru-ment tested first. See paragraph (g)(3) ofthis section, Example 6, for an illustrationof this rule.

(4) Multiple distributions or acquisi-tions. Except as provided in paragraph(c)(3) of this section, if, pursuant to para-graph (b)(3)(iv)(B) of this section, a debtinstrument may be treated as fundingmore than one distribution or acquisitiondescribed in paragraph (b)(3)(ii) of this

section, the debt instrument is treated asfunding one or more distributions or ac-quisitions based on the order in which thedistributions or acquisitions occurred,with the earliest distribution or acquisitiontreated as the first distribution or acquisi-tion that was funded. See paragraph (g)(3)of this section, Example 9, for an illustra-tion of this rule.

(v) Predecessors and successors. Forpurposes of this paragraph (b)(3), refer-ences to the funded member include ref-erences to any predecessor or successor ofsuch member. See paragraph (g)(3) of thissection, Examples 9, 10, and 12, for illus-trations of this rule.

(vi) Treatment of funded transactions.When a debt instrument is treated as stockpursuant to paragraph (b)(3) of this sec-tion, the distribution or acquisition de-scribed in paragraph (b)(3)(ii) of this sec-tion that is treated as funded by such debtinstrument is not recharacterized as a re-sult of the treatment of the debt instrumentas stock.

(4) Anti-abuse rule. A debt instrumentis treated as stock if it is issued with aprincipal purpose of avoiding the applica-tion of this section or § 1.385–4. In addi-tion, an interest that is not a debt instru-ment for purposes of this section and§ 1.385–4 (for example, a contract towhich section 483 applies or a nonperi-odic swap payment) is treated as stock ifissued with a principal purpose of avoid-ing the application of this section or§ 1.385–4. This paragraph (b)(4) may ap-ply, for example, if a debt instrument isissued to, and later acquired from, a per-son that is not a member of the issuer’sexpanded group with a principal purposeof avoiding the application of this section.Additional examples of when this para-graph (b)(4) could apply include, withoutlimitation, situations where, with a princi-pal purpose of avoiding the application ofthis section, a debt instrument is issued toa person that is not a member of the issu-er’s expanded group, and such personlater becomes a member of the issuer’sexpanded group; a debt instrument is is-sued to an entity that is not taxable as acorporation for federal tax purposes; or amember of the issuer’s expanded group issubstituted as a new obligor or added as aco-obligor on an existing debt instrument.This paragraph (b)(4) also may apply to a


debt instrument that is issued or trans-ferred in connection with a reorganizationor similar transaction with a principal pur-pose of avoiding the application of thissection or § 1.385–4. See paragraph (g)(3)of this section, Example 18, for an illus-tration of this rule.

(5) Coordination between general ruleand funding rule. To the extent a debtinstrument is treated as stock under para-graph (b)(2)(iii) of this section, the distri-bution of the debt instrument (which istreated as a distribution of stock as a resultof the application of paragraph (b)(2)(iii)of this section) pursuant to the same reor-ganization that caused paragraph(b)(2)(iii) of this section to apply is notalso treated as a distribution or acquisitiondescribed in paragraph (b)(3)(ii) of thissection. See paragraph (g)(3) of this sec-tion, Example 8, for an illustration of thisrule.

(c) Exceptions—(1) Exception for cur-rent year earnings and profits. For pur-poses of applying paragraphs (b)(2) and(b)(3) of this section to a member of anexpanded group with respect to a taxableyear, the aggregate amount of any distri-butions or acquisitions that are describedin paragraphs (b)(2) or (b)(3)(ii) of thissection are reduced by an amount equal tothe member’s current year earnings andprofits described in section 316(a)(2). Thisreduction is applied to the transactionsdescribed in paragraphs (b)(2) and(b)(3)(ii) of this section based on the orderin which the distribution or acquisitionoccurs. See paragraph (g)(3) of this sec-tion, Example 17, for an illustration of thisrule.

(2) Threshold exception. A debt instru-ment is not treated as stock under thissection if, immediately after the debt in-strument is issued, the aggregate adjustedissue price of debt instruments held bymembers of the expanded group thatwould be subject to paragraph (b) of thissection but for the application of this para-graph (c)(2) does not exceed $50 million.Once this threshold is exceeded, this para-graph (c)(2) will not apply to any debtinstrument issued by members of the ex-panded group for so long as any debtinstrument that previously was treated asindebtedness solely because of this para-graph (c)(2) remains outstanding. For pur-poses of this rule, any debt instrument that

is not denominated in U.S. dollars is trans-lated into U.S. dollars at the spot rate (asdefined in § 1.988–1(d)) on the date thatthe debt instrument is issued. See para-graph (g)(3) of this section, Example 17,for an illustration of this rule. See para-graph (d)(1)(iii) of this section for rulesregarding the treatment of a debt instru-ment that ceases to qualify for the excep-tion provided in this paragraph (c)(2).

(3) Exception for funded acquisitionsof subsidiary stock by issuance. An acqui-sition of expanded group stock will not betreated as described in paragraph(b)(3)(ii)(B) of this section if the acquisi-tion results from a transfer of property bya funded member (the transferor) to anexpanded group member (the issuer) inexchange for stock of the issuer, providedthat, for the 36-month period immediatelyfollowing the issuance, the transferorholds, directly or indirectly, more than 50percent of the total combined votingpower of all classes of stock of the issuerentitled to vote and more than 50 percentof the total value of the stock of the issuer.If the transferor ceases to meet this own-ership requirement at any time during that36-month period, then on the date that theownership requirement ceases to be met(cessation date), this paragraph (c)(3)ceases to apply and the acquisition istreated as an acquisition described in para-graph (b)(3)(ii)(B) of this section. In thiscase, for purposes of applying the per serule, the acquisition may be treated ashaving been funded by any debt instru-ment issued during the 72-month perioddetermined with respect to the date of theacquisition (rather than with respect to thecessation date), but, in the case of a debtinstrument issued prior to the cessationdate, only to the extent that such debtinstrument is treated as indebtedness as ofthe cessation date (that is, a debt instru-ment not already treated as stock). Forpurposes of this paragraph (c)(3), a trans-feror’s indirect stock ownership is deter-mined by applying the principles of sec-tion 958(a) without regard to whether anintermediate entity is foreign or domestic.See paragraph (d)(1)(v) of this section forrules regarding the treatment of a debtinstrument that is treated as funding anacquisition to which this exception ceasesto apply.

(d) Operating rules—(1) Timing. Thisparagraph (d)(1) provides rules for deter-mining when a debt instrument is treatedas stock under paragraph (b) of this sec-tion. For special rules regarding the treat-ment of a deemed exchange of a debtinstrument that occurs pursuant to para-graphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), or(d)(1)(v), see § 1.385–1(c).

(i) General timing rule. Except as oth-erwise provided in this paragraph (d)(1),when paragraph (b) of this section appliesto treat a debt instrument as stock, the debtinstrument is treated as stock when thedebt instrument is issued. When paragraph(b)(3) of this section applies to treat a debtinstrument as stock when the debt instru-ment is issued, see also paragraph(b)(3)(vi) of this section.

(ii) Exception when a debt instrumentis treated as funding a distribution or ac-quisition that occurs in a subsequent tax-able year. When paragraph (b)(3)(iv)(B)of this section applies to treat a debt in-strument as funding a distribution or ac-quisition described in paragraph (b)(3)(ii)of this section that occurs in a taxable yearsubsequent to the taxable year in whichthe debt instrument is issued, the debtinstrument is deemed to be exchanged forstock when the distribution or acquisitiondescribed in paragraph (b)(3)(ii) of thissection occurs. See paragraph (g)(3) ofthis section, Example 9, for an illustrationof this rule.

(iii) Exception when a debt instrumentceases to qualify for the threshold excep-tion. A debt instrument that previouslywas treated as indebtedness pursuant tothe threshold exception set forth in para-graph (c)(2) of this section is deemed tobe exchanged for stock when the debtinstrument ceases to qualify for thethreshold exception. Notwithstanding thepreceding sentence, if the debt instrumentwas both issued and ceases to qualify forthe threshold exception during the sametaxable year, the general timing rule ofparagraph (d)(1)(i) of this section applies.See paragraph (g)(3) of this section, Ex-ample 17, for an illustration of this rule.

(iv) Exception when a debt instrumentis re-tested under paragraph (d)(2) of thissection. When paragraph (b)(3)(iv)(B) ofthis section applies to treat a debt instru-ment as funding a distribution or acquisi-tion described in paragraph (b)(3)(ii) of


this section as a result of a re-testing de-scribed in paragraph (d)(2) of this sectionthat occurs in a taxable year subsequent tothe taxable year in which the debt instru-ment is issued, the debt instrument isdeemed to be exchanged for stock on thedate of the re-testing. See paragraph (g)(3)of this section, Example 7, for an illustra-tion of this rule.

(v) Exception when a debt instrumentceases to qualify for the exception foracquisitions of subsidiary stock by issu-ance. When paragraph (b)(3)(iv)(B) andthe modified ordering rule in paragraph(c)(3) of this section apply to treat a debtinstrument as funding an acquisition ofexpanded group stock that previouslyqualified for the exception set forth inparagraph (c)(3) of this section, the debtinstrument is deemed to be exchanged forstock on the cessation date referred to inparagraph (c)(3) of this section if the debtinstrument was issued in a taxable yearpreceding the taxable year that includesthe cessation date. For all other debt in-struments that are treated as funding anacquisition of expanded group stock thatpreviously qualified for the exception setforth 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 stockthat leaves the expanded group. Subject toparagraph (b)(4) of this section, when theholder and issuer of a debt instrument thatis treated as stock under this section ceaseto be members of the same expandedgroup, either because the debt instrumentis transferred to a person that is not amember of the expanded group that in-cludes the issuer or because the holder orthe issuer cease to be members of thesame expanded group, the debt instrumentceases to be treated as stock under thissection. For this purpose, immediately be-fore the transaction that causes the holderand issuer of the debt instrument to ceaseto be members of the same expandedgroup, the issuer is deemed to issue a newdebt instrument to the holder in exchangefor the debt instrument that was treated asstock in a transaction that is disregardedfor purposes of paragraphs (b)(2) and(b)(3) of this section. For purposes ofparagraph (b)(3)(iv)(B) of this section,when this paragraph (d)(2) causes a debtinstrument that previously was treated as

stock pursuant to paragraph (b)(3) of thissection to cease to be treated as stock, allother debt instruments of the issuer thatare not currently treated as stock are re-tested to determine whether those otherdebt instruments are treated as funding thedistribution or acquisition that previouslywas treated as funded by the debt instru-ment that ceases to be treated as stockpursuant to this paragraph (d)(2). Seeparagraph (g)(3) of this section, Example7, for an illustration of this rule.

(3) Inapplicability of section 385(c)(1).Section 385(c)(1) does not apply withrespect to a debt instrument to the extentthat it is treated as stock under thissection.

(4) Taxable year. For purposes of thissection, the term taxable year refers to thetaxable year of the issuer of the debt in-strument.

(5) Treatment of partnerships—(i) Ap-plication of aggregate treatment. For pur-poses of this section, a controlled partner-ship is treated as an aggregate of itspartners. Thus, for example, when a cor-poration that is a member of an expandedgroup becomes a partner in a partnershipthat is a controlled partnership with respectto that expanded group, the corporation istreated as acquiring its proportionate shareof the controlled partnership’s assets. In ad-dition, each expanded group partner in acontrolled partnership is treated as issuingits proportionate share of any debt instru-ment issued by the controlled partnership.For this purpose, a partner’s proportionateshare is determined in accordance with thepartner’s share of partnership profits. Seeparagraph (g)(3) of this section, Example13, for an illustration of this rule.

(ii) Treatment of debt instruments is-sued by partnerships. To the extent thatthe application of the aggregate approachin paragraph (d)(5)(i) of this sectioncauses a debt instrument issued by a con-trolled partnership to be recharacterizedunder paragraph (b) of this section, thenthe holder of the recharacterized debt in-strument is treated as holding stock in theexpanded group partners. In addition, thepartnership and its partners must makeappropriate conforming adjustments to re-flect this treatment. Any such adjustmentsmust be consistent with the purposes ofthis section and must be made in a mannerthat avoids the creation of, or increase in,

a disparity between the controlled partner-ship’s aggregate basis in its assets and theaggregate bases of the partners’ respectiveinterests 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 entityis treated as stock under this section, suchdebt instrument is treated as stock in theentity’s owner rather than as an equityinterest in the entity.

(e) No affirmative use. The rules of thissection and § 1.385–4 do not apply to theextent a person enters into a transactionthat otherwise would be subject to theserules with a principal purpose of reducingthe federal tax liability of any member ofthe expanded group that includes the is-suer and the holder of the debt instrumentby disregarding the treatment of the debtinstrument that would occur withoutregard to this section.

(f) Definitions. The definitions in thisparagraph (f) apply for purposes of thissection and for purposes of § 1.385–4.

(1) Asset reorganization. The term assetreorganization means a reorganizationwithin the meaning of section 368(a)(1)(A),(C), (D), (F), or (G).

(2) Controlled partnership. The termcontrolled partnership has the meaningspecified in § 1.385–1(b)(1).

(3) Debt instrument. The term debt in-strument means an interest that would, butfor the application of this section, betreated as a debt instrument as defined insection 1275(a) and § 1.1275–1(d).

(4) Distribution. The term distributionmeans any distribution made by a corpo-ration with respect to its stock.

(5) Exempt exchange. The term exemptexchange means an acquisition of ex-panded group stock in which the trans-feror and transferee of the stock are par-ties to an asset reorganization, andeither—

(i) Section 361(a) or (b) applies to thetransferor of the expanded group stockand the stock is not transferred byissuance; or

(ii) Section 1032 or § 1.1032–2 ap-plies to the transferor of the expandedgroup stock and the stock is distributedby the transferee pursuant to the plan ofreorganization.


(6) Expanded group. The term ex-panded group has the meaning specifiedin § 1.385–1(b)(3).

(7) Expanded group partner. The termexpanded group partner means any per-son that is a partner in a controlled part-nership and that is a member of the ex-panded group whose members own,directly or indirectly, at least 80 percent ofthe interests in the controlled partner-ship’s capital or profits.

(8) Expanded group stock. The termexpanded group stock means, with respectto a member of an expanded group, stockof a member of the same expanded group.

(9) Predecessor—(i) In general. Theterm predecessor includes, with respect toa corporation, the distributor or transferorcorporation in a transaction described insection 381(a) in which the corporation isthe acquiring corporation. For purposes ofthe preceding sentence, the transferor cor-poration in a reorganization within themeaning of section 368(a)(1)(D) or (G) istreated as a transferor corporation in atransaction described in section 381(a)without regard to whether the reorganiza-tion meets the requirements of sections354(b)(1)(A) and (B). The term predeces-sor does not include, with respect to acontrolled corporation, a distributing cor-poration that distributed the stock of thecontrolled corporation pursuant to section355(c).

(ii) Special rules for funded acquisi-tions of subsidiary stock by issuance. Theterm predecessor also includes, with re-spect to an issuer that issues stock to atransferor in a transaction described inparagraph (c)(3) of this section, the trans-feror, but, for purposes of applying the perse rule in paragraph (b)(3)(iv)(B)(1) ofthis section, only with respect to a debtinstrument issued by the transferor duringthe 72-month period determined with re-spect to the transaction described in para-graph (c)(3) of this section, and only to theextent of the value of the expanded groupstock acquired from the issuer in the trans-action described in paragraph (c)(3) ofthis section.

(10) Property. The term property hasthe meaning specified in section 317(a).

(11) Successor—(i) In general. Theterm successor includes, with respect to acorporation, the acquiring corporation in atransaction described in section 381(a) in

which the corporation is the distributor ortransferor corporation. For purposes of thepreceding sentence, the acquiring corpo-ration in a reorganization within themeaning of section 368(a)(1)(D) or (G) istreated as an acquiring corporation in atransaction described in section 381(a)without regard to whether the reorganiza-tion meets the requirements of sections354(b)(1)(A) and (B). The term successordoes not include, with respect to a distrib-uting corporation, a controlled corpora-tion the stock of which was distributed bythe distributing corporation pursuant tosection 355(c).

(ii) Special rules for funded acquisi-tions of subsidiary stock by issuance. Theterm successor also includes, with respectto a transferor that transfers property to anissuer in exchange for stock of the issuerin a transaction described in paragraph(c)(3) of this section, the issuer, but, forpurposes of applying the per se rule inparagraph (b)(3)(iv)(B)(1) of this section,only with respect to a debt instrumentissued by the transferor during 72-monthperiod determined with respect to thetransaction described in paragraph (c)(3)of this section, and only to the extent ofthe value of the expanded group stockacquired from the issuer in the transactiondescribed in paragraph (c)(3) of this sec-tion. A distribution by an issuer describedin paragraph (c)(3) of this section directlyto the transferor is not taken into accountfor purposes of applying paragraph (b)(3)of this section to a debt instrument of thetransferor.

(g) Examples—(1) Assumed facts. Ex-cept as otherwise stated, the followingfacts are assumed for purposes of the ex-amples in paragraph (g)(3) of this section:

(i) FP is a foreign corporation thatowns 100 percent of the stock of USS1, adomestic corporation, 100 percent of thestock of USS2, a domestic corporation,and 100 percent of the stock of FS, aforeign corporation;

(ii) USS1 owns 100 percent of thestock of DS, a domestic corporation, andCFC, which is a controlled foreign corpo-ration within the meaning of section 957;

(iii) At the beginning of Year 1, FP isthe common parent of an expanded groupcomprised solely of FP, USS1, USS2, FS,DS, and CFC (the FP expanded group);

(iv) The FP expanded group has morethan $50 million of debt instruments de-scribed in paragraph (c)(2) of this sectionat all times;

(v) No issuer of a debt instrument hascurrent year earnings and profits describedin section 316(a)(2);

(vi) All notes are debt instruments de-scribed in paragraph (f)(3) of this section;

(vii) No notes are eligible for the ordi-nary course exception described in para-graph (b)(3)(iv)(B)(2) of this section;

(viii) Each entity has as its taxable yearthe calendar year;

(ix) PRS is a partnership for federalincome tax purposes;

(x) No corporation is a member of aconsolidated group, as defined in§ 1.1502–1(h);

(xi) No domestic corporation is aUnited States real property holding corpo-ration within the meaning of section897(c)(2); and

(xii) Each note is issued with adequatestated interest (as defined in section1274(c)(2)).

(2) No inference. Except as provided inthis section, it is assumed for purposes ofthe examples that the form of each trans-action is respected for federal tax pur-poses. No inference is intended, however,as to whether any particular note would berespected as indebtedness or as to whetherthe form of any particular transaction de-scribed in paragraph (g)(3) of this sectionwould be respected for federal tax pur-poses.

(3) Examples. The following examplesillustrate the rules of this section.

Example 1. Distribution of a debt instrument. (i)Facts. On Date A in Year 1, FS lends $100x to USS1in 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 instrumentthat is issued by USS1 to FP, a member of USS1’sexpanded 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) ofthis section, USS1 Note B is treated as stock when itis issued by USS1 to FP on Date B in Year 2.Accordingly, USS1 is treated as distributing USS1stock to its shareholder FP in a distribution that issubject to section 305. Because USS1 Note B istreated as stock for federal tax purposes when it isissued by USS1, USS1 Note B is not treated asproperty for purposes of paragraph (b)(3)(ii)(A) ofthis section because it is not property within themeaning specified in section 317(a). Accordingly,USS1 Note A is not treated as funding the distribu-


tion of USS1 Note B for purposes of paragraph(b)(3)(ii)(A) of this section.

Example 2. Debt instrument issued for expandedgroup stock that is exchanged for stock in a corpo-ration that is not a member of the same expandedgroup. (i) Facts. UST is a publicly traded domesticcorporation. On Date A in Year 1, USS1 issuesUSS1 Note to FP in exchange for FP stock. On DateB of Year 1, USS1 transfers the FP stock to UST’sshareholders, which are not members of the FP ex-panded group, in exchange for all of the stock ofUST.

(ii) Analysis. (A) Because USS1 and FP are bothmembers of the FP expanded group, USS1 Note istreated as stock when it is issued by USS1 to FP inexchange for FP stock on Date A in Year 1 underparagraphs (b)(2)(ii) and (d)(1)(i) of this section.This result applies even though, pursuant to the sameplan, USS1 transfers the FP stock to persons that arenot members of the FP expanded group. The ex-change of USS1 Note for FP stock is not an exemptexchange within the meaning of paragraph (f)(5) ofthis section.

(B) Because USS1 Note is treated as stock forfederal tax purposes when it is issued by USS1,pursuant to section § 1.367(b)–10(a)(3)(ii) (definingproperty for purposes of § 1.367(b)–10) there is nopotential application of § 1.367(b)–10(a) to USS1’sacquisition of the FP stock.

(C) Because paragraph (b)(2) of this sectiontreats USS1 Note as stock for federal tax purposeswhen it is issued by USS1, USS1 Note is not treatedas indebtedness for purposes of applying paragraph(b)(3) of this section.

Example 3. Issuance of a note in exchange forexpanded group stock. (i) Facts. On Date A in Year1, USS1 issues USS1 Note to FP in exchange for 40percent of the FS stock owned by FP.

(ii) Analysis. (A) Because USS1 and FP are bothmembers of the FP expanded group, USS1 Note istreated as stock when it is issued by USS1 to FP inexchange for FS stock on Date A in Year 1 underparagraphs (b)(2)(ii) and (d)(1)(i) of this section. Theexchange of USS1 Note for FS stock is not anexempt exchange within the meaning of paragraph(f)(5) of this section because USS1 and FP are notparties to a reorganization.

(B) Because USS1 Note is treated as stock forfederal tax purposes when it is issued by USS1,USS1 Note is not treated as property for purposes ofsection 304(a) because it is not property within themeaning specified in section 317(a). Therefore,USS1’s acquisition of FS stock from FP in exchangefor USS1 Note is not an acquisition described insection 304(a)(1).

(C) Because USS1 Note is treated as stock forfederal tax purposes when it is issued by USS1,USS1 Note is not treated as indebtedness for pur-poses of applying paragraph (b)(3) of this section.

Example 4. Funding occurs in same taxable yearas distribution. (i) Facts. On Date A in Year 1, FPlends $200x to CFC in exchange for CFC Note A.On Date B in Year 1, CFC distributes $400x of cashto USS1 in a distribution. CFC is not an expatriatedforeign subsidiary as defined in § 1.7874–12T(a)(9).

(ii) Analysis. Under paragraph (b)(3)(iv)(B) ofthis section, CFC Note A is treated as issued with aprincipal purpose of funding the distribution by CFC

to USS1 because CFC Note A is issued to a memberof the FP expanded group during the 72-month pe-riod determined with respect to CFC’s distribution toUSS1. Accordingly, under paragraphs (b)(3)(ii)(A)and (d)(1)(i) of this section, CFC Note A is treated asstock when it is issued by CFC to FP on Date A inYear 1.

Example 5. Additional funding. (i) Facts. Thefacts are the same as in Example 4, except that, inaddition, 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 inExample 4 with respect to CFC Note A. CFC Note Bis also issued to a member of the FP expanded groupduring the 72-month period determined with respectto CFC’s distribution to USS1. Under paragraph(b)(3)(iv)(B) of this section, CFC Note B is treatedas issued with a principal purpose of funding theremaining portion of CFC’s distribution to USS1,which is $200x. Accordingly, $200x of CFC Note Bis a principal purpose debt instrument that is treatedas stock under paragraph (b)(3)(ii)(A) of this section.Under paragraph (d)(1)(ii) of this section, $200x ofCFC Note B is deemed to be exchanged for stock onDate C in Year 2. The remaining $100x of CFC NoteB continues to be treated as indebtedness.

Example 6. Funding involving multiple interests.(i) Facts. On Date A in Year 1, FP lends $300x toUSS1 in exchange for USS1 Note A. On Date B inYear 2, USS1 distributes $300x of cash to FP. OnDate C in Year 3, FP lends another $300x to USS1in exchange for USS1 Note B.

(ii) Analysis. (A) Under paragraph(b)(3)(iv)(B)(3) of this section, USS1 Note A istested under paragraph (b)(3) of this section beforeUSS1 Note B is tested. USS1 Note A is issuedduring the 72-month period determined with respectto USS1’s $300x distribution to FP and, therefore, istreated as issued with a principal purpose of fundingthe distribution under paragraph (b)(3)(iv)(B)(1) ofthis section. Beginning on Date B in Year 2, USS1Note A is a principal purpose debt instrument that istreated 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 sec-tion, USS1 Note B is tested under paragraph (b)(3)of this section after USS1 Note A is tested. BecauseUSS1 Note A is treated as funding the entire $300xdistribution by USS1 to FP, USS1 Note B will con-tinue to be treated as indebtedness.

Example 7. Re-testing. (i) Facts. The facts are thesame as in Example 6, except that on Date D in Year4, FP sells USS1 Note A to Bank.

(ii) Analysis. (A) Under paragraph (d)(2) of thissection, USS1 Note A ceases to be treated as stockwhen FP sells USS1 Note A to Bank on Date D inYear 4. Immediately before FP sells USS1 Note A toBank, USS1 is deemed to issue a debt instrument toFP in exchange for USS1 Note A in a transactionthat is disregarded for purposes of paragraphs (b)(2)and (b)(3) of this section.

(B) Under paragraph (d)(2) of this section, afterUSS1 Note A is deemed exchanged, USS1’s otherdebt instruments that are not treated as stock as ofDate D in Year 4 (USS1 Note B) are re-tested forpurposes of paragraph (b)(3)(iv)(B) of this section todetermine whether other USS1 debt instruments aretreated as funding the $300x distribution by USS1 to

FP on Date B in Year 2. USS1 Note B was issued byUSS1 to FP within the 72-month period determinedwith respect to the $300x distribution. Under paragraph(b)(3)(iv)(B)(1) of this section, USS1 Note B is treatedas issued with a principal purpose of funding the $300xdistribution. Accordingly, USS1 Note B is a principalpurpose debt instrument under paragraph (b)(3)(ii)(A)of this section that is deemed to be exchanged for stockon Date D in Year 4, the re-testing date, under para-graph (d)(1)(iv) of this section. See § 1.385–1(c) forrules regarding the treatment of this deemed exchange.

Example 8. Distribution of expanded group stockand debt instrument in a reorganization that quali-fies under section 355. (i) Facts. On Date A in Year1, FP lends $200x to USS2 in exchange for USS2Note. In a transaction that is treated as independentfrom the transaction on Date A in Year 1, on Date Bin Year 2, USS2 transfers a portion of its assets toDS2, a newly-formed domestic corporation, in ex-change for all of the stock of DS2 and DS2 Note.Immediately afterwards, USS2 distributes all of theDS2 stock and the DS2 Note to FP with respect toFP’s USS2 stock in a transaction that qualifies undersection 355. USS2’s transfer of a portion of its assetsqualifies as a reorganization within the meaning ofsection 368(a)(1)(D). The DS2 stock has a value of$150x and DS2 Note has a value of $50x. The DS2stock is not non-qualified preferred stock as definedin section 351(g)(2). Absent the application of thissection, DS2 Note would be treated by FP as “otherproperty” within the meaning of section 356.

(ii) Analysis. (A) The contribution and distribu-tion transaction is a reorganization within the mean-ing of section 368(a)(1) involving a transfer ofUSS2’s property described in section 361(a). Thus,DS2 Note is a debt instrument that is issued by DS2to USS2, both members of the FP expanded group,pursuant to an asset reorganization (as defined inparagraph (f)(1) of this section), and received by FP,another FP expanded group member, with respect toFP’s USS2 stock. Accordingly, DS2 Note is treatedas stock when it is issued by DS2 to USS2 on DateB 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 itis issued, section 355(a)(1) rather than section 356may apply to FP on FP’s receipt of DS2 Note.Alternatively, depending on the terms of DS2 Noteand other factors, DS2 Note may be treated as non-qualified preferred stock that is not treated as stockpursuant to section 355(a)(3)(D). If DS2 Note istreated as non-qualified preferred stock, such stockwould continue to be treated by FP as “other prop-erty” for purposes of section 356 under section356(e). In that case, USS2’s distribution of DS2Note would be treated as “other property” describedin section 356, and thus the distribution of DS2 notepreliminarily would be described in paragraph(b)(3)(ii)(A) of this section. However, under para-graph (b)(5) of this section, because DS2 Note istreated as stock under paragraph (b)(2)(iii) of thissection, USS2’s distribution of DS2 Note to FPpursuant to the plan of reorganization is not alsotreated as a distribution or acquisition described inparagraph (b)(3)(ii) of this section that couldcause USS2 Note to be a principal purpose debtinstrument.


(C) USS2’s distribution of $150x of actual DS2stock is a distribution of stock pursuant to an assetreorganization that is permitted to be received by FPwithout recognition of gain under section355(a)(1). Accordingly, USS2’s distribution of theactual DS2 stock to FP is not a distribution ofproperty by USS2 for purposes of paragraph(b)(3)(ii)(A) of this section.

(D) USS2’s transfer of assets to DS2 in exchangefor DS2 stock is not an acquisition described inparagraph (b)(3)(ii)(B) of this section becauseUSS2’s acquisition of DS2 stock is an exempt ex-change. USS2’s acquisition of DS2 stock is an ex-empt exchange described in paragraph (f)(5)(ii) ofthis section because USS2 and DS2 are both partiesto a reorganization that is an asset reorganization,section 1032 applies to DS2, the transferor of theexpanded group stock, and the DS2 stock is distrib-uted by USS2, the transferee, pursuant to the plan ofreorganization. Because USS2 has not made a dis-tribution or acquisition that is treated as a distribu-tion or acquisition for purposes of paragraph(b)(3)(ii) of this section, USS2 Note is not a principalpurpose debt instrument.

Example 9. Funding a distribution by a succes-sor to funded member. (i) Facts. The facts are thesame as in Example 8, except that on Date C in Year3, DS2 distributes $200x of cash to FP and, subse-quently, on Date D in Year 3, USS2 distributes$100x of cash to FP.

(ii) Analysis. (A) DS2 is a successor with respectto USS2 under paragraph (f)(11)(i) of this sectionbecause DS2 is the acquiring corporation in a reor-ganization within the meaning of section368(a)(1)(D). USS2 is a predecessor with respect toDS2 under paragraph (f)(9)(i) of this section becauseUSS2 is the transferor corporation in a reorganiza-tion within the meaning of section 368(a)(1)(D).Accordingly, under paragraph (b)(3)(v) of this sec-tion, a distribution by DS2 is treated as a distributionby USS2. Under paragraph (b)(3)(iv)(B) of this sec-tion, USS2 Note is treated as issued with a principalpurpose of funding the distribution by DS2 to FPbecause USS2 Note was issued during the 72-monthperiod determined with respect to DS2’s $200x cashdistribution. Accordingly, USS2 Note is a principalpurpose debt instrument under paragraph(b)(3)(ii)(A) of this section that is deemed to beexchanged for stock on Date C in Year 3 underparagraph (d)(1)(ii) of this section. See § 1.385–1(c)for rules regarding the treatment of this deemedexchange.

(B) Because the entire amount of USS2 Note istreated 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 subsequentdistribution by USS2 on Date D in Year 3.

Example 10. Asset reorganization; section 354qualified 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 asa reorganization within the meaning of section368(a)(1)(D), USS2 transfers all of its assets toUSS1 in exchange for stock of USS1 and the as-sumption by USS1 of all of the liabilities of USS2,and USS2 distributes to FP, with respect to FP’sUSS2 stock, all of the USS1 stock that USS2 re-

ceived. FP does not recognize gain under section354(a)(1).

(ii) Analysis. (A) USS1 is a successor with re-spect to USS2 under paragraph (f)(11)(i) of thissection because USS1 is the acquiring corporation ina reorganization within the meaning of section368(a)(1)(D). For purposes of paragraph (b)(3) ofthis section, USS2 and its successor, USS1, arefunded members with respect to USS2 Note. Al-though USS2, a funded member, distributes property(USS1 stock) to its shareholder, FP, pursuant to thereorganization, the distribution of USS1 stock is notdescribed in paragraph (b)(3)(ii)(A) of this sectionbecause the property is permitted to be receivedwithout the recognition of gain under section354(a)(1). The distribution of USS1 stock is also notdescribed in paragraph (b)(3)(ii)(C) of this sectionbecause 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 isnot an acquisition described in paragraph(b)(3)(ii)(B) of this section because USS2’s acquisi-tion of USS1 stock is an exempt exchange. USS2’sacquisition of USS1 stock is an exempt exchangedescribed in paragraph (f)(5)(ii) of this section be-cause USS1 and USS2 are both parties to a reorga-nization, section 1032 applies to USS1, the trans-feror of the expanded group stock, and the USS1stock is distributed by USS2, the transferee, pursuantto the plan of reorganization.

(C) Because neither USS1 nor USS2 has made adistribution or acquisition described in paragraph(b)(3)(ii) of this section, USS2 Note is not a principalpurpose 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, FPissues FP stock and FP Note to USS1 as a contribu-tion to capital. USS1 does not formally issue addi-tional USS1 stock to FP in exchange for FP stockand FP Note, but is treated as issuing stock to FP inan exchange to which section 351 applies. Immedi-ately afterwards, USS1 transfers the FP stock and FPNote to DS2 in exchange for all of DS2’s assets, andDS2 distributes the FP stock and FP Note to USS2with respect to USS2’s DS2 stock in a liquidatingdistribution.

(ii) Analysis. FP Note is issued by FP to USS1 inexchange for stock of USS1 in an exchange that isnot an exempt exchange described in paragraph(f)(5) of this section. Under paragraph (b)(2)(ii) ofthis section, FP Note is treated as stock beginning onDate B in Year 1.

Example 12. Funded acquisition of subsidiarystock by issuance; successor.

(i) Facts. On Date A in Year 1, FS lends $100xto USS1 in exchange for USS1 Note. On Date B inYear 1, USS1 transfers property that has a value of$20x to CFC in exchange for additional CFC stockthat has a value of $20x. On Date C in Year 2, CFCdistributes $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 para-graph (c)(3) of this section, USS1 Note would betreated under paragraph (b)(3)(iv)(B) of this sectionas issued with a principal purpose of funding anacquisition of expanded group stock described in

paragraph (b)(3)(ii)(B) of this section because USS1Note is issued to a member of the FP expandedgroup during the 72-month period determined withrespect to USS1’s acquisition of CFC stock on DateB in Year 1. However, because USS1’s acquisitionof CFC stock results from a transfer of property fromUSS1 to CFC in exchange for CFC stock and im-mediately after the transaction USS1 holds 100 per-cent of the stock of CFC, the exception in paragraph(c)(3) of this section applies. Accordingly, USS1’sacquisition of CFC stock on Date B in Year 1 is nottreated as an acquisition of stock described in para-graph (b)(3)(ii)(B) of this section, and USS1 Note isnot treated as stock.

(B) CFC is a successor with respect to USS1under paragraph (f)(11)(ii) of this section. For pur-poses of paragraph (b)(3)(iv)(B)(1) of this sectionCFC is a successor only to the extent of the valueof the expanded group stock acquired from CFC inthe transaction described in paragraph (c)(3) ofthis section.

(C) Under paragraph (f)(11)(ii) of this section,CFC’s $20x cash distribution to USS1 on Date C inYear 2 is not taken into account for purposes ofapplying paragraph (b)(3) of this section to USS1Note.

(D) On Date D in Year 3, CFC continues to be asuccessor to USS1 for purposes of applying the perse rule in paragraph (b)(3)(iv)(B) of this section.Accordingly, USS1 Note is a principal purpose debtinstrument under paragraph (b)(3)(ii)(A) of this sec-tion that is deemed to be exchanged for stock onDate D in Year 3 under paragraph (d)(1)(ii) of thissection. See § 1.385–1(c) for rules regarding thetreatment of this deemed exchange.

Example 13. Distribution of a debt instrument topartnership. (i) Facts. CFC and FS are equal part-ners in PRS. PRS owns 100 percent of the stock ofX Corp, a domestic corporation. On Date A in Year1, X Corp issues X Note to PRS in a distribution.

(ii) Analysis. (A) Under § 1.385–1(b)(3), in de-termining whether X Corp is a member of the ex-panded group that includes CFC and FS, CFC andFS are each treated as holding 50 percent of the XCorp stock held by PRS. Accordingly, 100 percentof X Corp’s stock is treated as owned by CFC andFS under § 1.385–1(b)(3)(i)(B), and X Corp is amember of the FP expanded group.

(B) Together CFC and FS own 100 percent of theinterests in PRS capital and profits, such that PRS isa controlled partnership described in § 1.385–1(b)(1). Under paragraph (d)(5)(i) of this section,solely for purposes of this section, when X Corpissues X Note to PRS, proportionate shares of XNote are treated as issued to CFC and FS. Accord-ingly, for purposes of applying paragraph (b) of thissection, in Year 1, 50 percent of X Note is treated asissued to CFC in a distribution and the other 50percent of X Note is treated as issued to FS in adistribution. Therefore, under paragraphs (b)(2)(i)and (d)(1)(i) of this section, X Note is treated asstock beginning on Date A in Year 1. Under para-graph (d)(5)(i) of this section, CFC and FS aretreated as holding X Note solely for purposes ofthis section. For all other federal tax purposes, XNote is treated as stock in X Corp that is held byPRS, and X Corp is treated as distributing its stock


to its shareholder in a distribution that is subject tosection 305.

Example 14. Loan to partnership; same-year dis-tribution. (i) Facts. The facts are the same as inExample 13, except that X Corp does not distributeX Note to PRS; instead, on Date A in Year 1 FPlends $200x to PRS in exchange for PRS Note. OnDate B in Year 1, CFC distributes $100x to USS1and FS distributes $100x to FP. CFC is not anexpatriated foreign subsidiary as defined in§ 1.7874–12T(a)(9).

(ii) Analysis. (A) Under paragraph (d)(5)(i) ofthis section, solely for purposes of this section, CFCand FS are each treated as issuing $100x of PRSNote on Date A in Year 1, which represents theirproportionate shares of PRS Note. CFC’s and FS’sshares of PRS Note are each issued to FP, a memberof the same expanded group, during the 72-monthperiods determined with respect to the distributionsby CFC and FS. Under paragraph (b)(3)(iv)(B)(1) ofthis section, PRS Note is treated as issued with aprincipal purpose of funding the distributions byCFC and FS. Accordingly, under paragraphs(b)(3)(ii)(A) and (d)(1)(i) of this section, PRS Noteis a principal purpose debt instrument that is treatedas 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 ofstock to FP. Appropriate conforming adjustmentsmust be made to CFC’s and FS’s interests in PRS toreflect the deemed treatment of PRS Note as stockissued by CFC and FS, which must be done in amanner that avoids the creation of, or increase in, adisparity between PRS’s aggregate basis in its assetsand the aggregate bases of CFC’s and FS’s respec-tive interests in PRS. For example, reasonable andappropriate adjustments may occur when the follow-ing steps are deemed to occur on Date A in Year 1:

(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 inExample 14, except that CFC and FS do not makedistributions on Date B of Year 1; instead, CFCdistributes $100x to USS1 and FS distributes $100xto FP on Date C of Year 2.

(ii) Analysis. (A) As in Example 14, CFC’s andFS’s shares of PRS Note are each issued to FP, amember of the same expanded group, during the72-month periods determined with respect to thedistributions by CFC and FS. Under paragraph(b)(3)(iv)(B)(1) of this section, PRS Note is treatedas issued with a principal purpose of funding thedistributions by CFC and FS. Accordingly, PRSNote is a principal purpose debt instrument that istreated as stock under paragraph (b)(3)(i)(A) of thissection. 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 ofstock to FP. Appropriate conforming adjustmentsmust be made to CFC’s and FS’s interests in PRS toreflect the deemed treatment of PRS Note as stock

issued by CFC and FS, which must be done in amanner that avoids the creation of, or increase in, adisparity between PRS’s aggregate basis in its assetsand the aggregate bases of CFC’s and FS’s respec-tive interests in PRS. For example, reasonable andappropriate adjustments may occur when the follow-ing steps are deemed to occur on Date C in Year 2:

(1) CFC assumes liability with respect to $100xof PRS Note;

(2) FS assumes liability with respect to $100x ofPRS 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’sdebt instrument. (i) Facts. On Date A in Year 1, CFClends $100x to FS in exchange for FS Note. On DateB in Year 2, CFC distributes FS Note to USS1.

(ii) Analysis. Although CFC distributes FS Note,which is a debt instrument, to USS1, another mem-ber of CFC’s expanded group, paragraph (b)(2)(i) ofthis section does not apply because CFC is not theissuer of the FS Note.

Example 17. Threshold exception and currentyear earnings and profits exception. (i) Facts. BeforeDate A in Year 1, the members of FP’s expandedgroup hold no outstanding debt instruments that oth-erwise would be treated as stock under this section.On Date A in Year 1, CFC issues CFC Note, whichhas an issue price of $40 million, to USS1 in adistribution. On Date B in Year 2, USS1 issuesUSS1 Note, which has an issue price of $20 million,to FP in a distribution. On Date C in Year 3, FSdistributes $30 million in cash to FP. On Date D inYear 3, DS lends $30 million to FS in exchange forFS Note A. On Date E in Year 3, FS issues FS NoteB, which has an issue price of $19 million, to FP ina distribution. In Year 3, FS has $35 million inearnings and profits described in section 316(a)(2).

(ii) Analysis. (A) Because CFC does not haveearnings and profits described in section 316(a)(2) inYear 1, the exception in paragraph (c)(1) of thissection does not apply to CFC Note. Immediatelyafter CFC Note is issued to USS1 on Date A in Year1, the aggregate adjusted issue price of outstandingdebt instruments issued by members of FP’s ex-panded 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 inparagraph (c)(2) applies to the CFC Note.

(B) Because USS1 does not have earnings andprofits described in section 316(a)(2) in Year 2, theexception in paragraph (c)(1) of this section does notapply to USS1 Note. Immediately after USS1 Note isissued to FP on Date B in Year 2, the aggregateadjusted issue price of outstanding debt instrumentsissued by members of the FP expanded group thatwould be subject to paragraph (b) of this section butfor the application of paragraph (c)(2) of this sectionexceeds $50 million. Under paragraph (d)(1)(iii) ofthis section, CFC Note is deemed to be exchangedfor stock on Date B in Year 2, when debt instrumentsof the FP expanded group cease to qualify for thethreshold exception described in paragraph (c)(2) ofthis section. In addition, the threshold exception de-scribed in paragraph (c)(2) of this section does not

apply to USS1 Note because, immediately afterUSS1 Note is issued, the aggregate adjusted issueprice of outstanding debt instruments issued bymembers of the expanded group that would be sub-ject to paragraph (b) of this section but for theapplication paragraph (c)(2) of this section exceeds$50 million. Accordingly, USS1 Note is treated asstock when it is issued on Date B in Year 2.

(C) Under paragraph (c)(1) of this section, forpurposes of applying paragraphs (b)(2) and (b)(3) ofthis section to a member of an expanded group withrespect to Year 3, the aggregate amount of anydistributions or acquisitions by FS that are describedin paragraphs (b)(2) or (b)(3)(ii) of this section arereduced by an amount equal to FS’s current yearearnings and profits described in section 316(a)(2)for Year 3, which is $35 million. Thus, $35 millionof distributions or acquisitions by FS in Year 3 arenot taken into account for purposes of applying para-graphs (b)(2) and (b)(3) of this section. The reduc-tion is applied first against FS’s $30 million cashdistribution on Date C in Year 3 and second againstFS’s $19 million note distribution on Date E in Year3. Accordingly, under paragraph (c)(1) of this sec-tion, FS Note A is not treated as stock under para-graph (b)(3) of this section. In addition, under para-graph (c)(1) of this section a portion of FS Note Bequal to $5 million is not treated as stock underparagraph (b)(2) of this section.

(D) When FS Note B is issued in Year 3, CFCNote, which previously was treated as indebtednesssolely because of paragraph (c)(2) of this section,remains outstanding. Accordingly, the threshold ex-ception described in paragraph (c)(2) of this sectiondoes not apply to FS Note B. Accordingly, the re-maining amount of FS Note B equal to $14 millionafter 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 instrumentand issuance of a debt instrument with a principalpurpose of avoiding the purposes of this section. (i)Facts. On Date A in Year 1, USS1 issues USS1 NoteA, which has a value of $100x, to FP in a distribu-tion. On Date B in Year 1, with a principal purposeof avoiding the application of this section, FP sellsUSS1 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 instrumentthat is issued by USS1 to FP, a member of USS1’sexpanded group, in a distribution. Accordingly, un-der paragraphs (b)(2)(i) and (d)(1)(i) of this section,USS1 Note A is treated as stock when it is issued byUSS1 to FP on Date A in Year 1. Accordingly, USS1is treated as distributing USS1 stock to its share-holder FP. Because USS1 Note A is treated as stockof USS1, USS1 Note A is not property as specifiedin section 317(a) on Date A in Year 1. Under para-graph (d)(2) of this section, USS1 Note A ceases tobe treated as stock when FP sells USS1 Note A toBank on Date B in Year 1. Immediately before FPsells USS1 Note A to Bank, USS1 is deemed to issuea debt instrument to FP in exchange for USS1 NoteA in a transaction that is disregarded for purposes ofparagraphs (b)(2) and (b)(3) of this section. USS1Note B is not treated as stock under paragraph(b)(3)(ii)(A) of this section because the funded mem-ber, USS1, has not made a distribution of property.


However, because the transactions occurring on DateB of Year 1 were undertaken with a principal pur-pose of avoiding the purposes of this section, USS1Note B is treated as stock on Date B of Year 1 underparagraph (b)(4) of this section.

(h) Effective/applicability date andtransition rules—(1) In general. This sec-tion applies to any debt instrument issuedon or after April 4, 2016, and to any debtinstrument treated as issued before April4, 2016 as a result of an entity classifica-tion election made under § 301.7701–3 ofthis chapter that is filed on or after April 4,2016.

(2) Transition rule for distributions oracquisitions occurring before April 4,2016. For purposes of paragraph (b)(3)(iv)of this section, a distribution or acquisi-tion described in paragraph (b)(3)(ii) ofthis section that occurs before April 4,2016, other than a distribution or acquisi-tion that is treated as occurring beforeApril 4, 2016 as a result of an entityclassification election made under§ 301.7701–3 of this chapter that is filedon or after April 4, 2016, is not taken intoaccount.

(3) Transition rule for debt instrumentsthat would be treated as stock prior to thedate of publication in the Federal Regis-ter of the Treasury decision adopting thisrule as a final regulation. When para-graphs (b) and (d)(1)(i) through (v) of thissection otherwise would treat a debt in-strument as stock prior to the date of pub-lication in the Federal Register of theTreasury decision adopting this rule as afinal regulation, the debt instrument istreated as indebtedness until the date thatis 90 days after the date of publication inthe Federal Register of the Treasury de-cision adopting this rule as a final regula-tion. To the extent that the debt instrumentdescribed in the preceding sentence isheld by a member of the issuer’s ex-panded group on the date that is 90 daysafter the date of publication in the FederalRegister of the Treasury decision adopt-ing this rule as a final regulation, the debtinstrument is deemed to be exchanged forstock on the date that is 90 days after thedate of publication in the Federal Regis-ter of the Treasury decision adopting thisrule as a final regulation.

Par. 5. Section 1.385–4 is added toread as follows:

§ 1.385–4 Treatment of consolidatedgroups.

(a) Scope. Section 1.385–1(e) providesthat members of a consolidated group aretreated as one corporation for purposes ofthe regulations under section 385. Thissection provides rules for applying§ 1.385–3 to consolidated groups when aninterest ceases to be a consolidated groupdebt instrument or becomes a consoli-dated group debt instrument. For defini-tions applicable to this section, see§ 1.385–3(f).

(b) Debt instrument ceases to be a con-solidated group debt instrument but con-tinues to be an expanded group debt in-strument—(1) Member leaving the group.When a corporation ceases to be a mem-ber of the consolidated group but contin-ues to be a member of the expanded group(such corporation, a departing member), adebt instrument that is issued or held bythe departing member is treated as indebt-edness or stock pursuant to paragraphs(b)(1)(i) or (b)(1)(ii) of this section.

(i) Exempt consolidated group debt in-strument that ceases to be consolidatedgroup debt instrument. Any exempt con-solidated group debt instrument that isissued or held by the departing member isdeemed to be exchanged for stock imme-diately after the departing member leavesthe group. For these purposes, the termexempt consolidated group debt instru-ment means any debt instrument that wasnot treated as stock solely by reason of thedeparting member’s treatment under§ 1.385–1(e). See paragraph (d) of thissection, Example 3, for an illustration ofthis rule.

(ii) Non-exempt consolidated groupdebt instrument that ceases to be consol-idated group debt instrument—(A) Ingeneral. Any consolidated group debt in-strument issued or held by a departingmember that is not an exempt consoli-dated group debt instrument (non-exemptconsolidated group debt instrument) istreated as indebtedness unless and untilthe non-exempt consolidated group debtinstrument is treated as a principal pur-pose debt instrument under § 1.385–3(b)(3)(ii) and (d)(1) as a result of a dis-tribution or acquisition described in§ 1.385–3(b)(3)(ii) that occurs after thedeparture.

(B) Coordination with funding rule.Solely for purposes of applying the 72-month period under § 1.385–3(b)(3)(iv)(B) (the per se rule), a non-exempt consolidated group debtinstrument is treated as having been is-sued when it was first treated as a consol-idated group debt instrument. For all otherpurposes of applying § 1.385–3, includingfor purposes of applying § 1.385–3(d), anon-exempt consolidated group debt in-strument is treated as issued by the issuerof the debt instrument immediately afterthe departing member leaves the group.

(2) Consolidated group debt instru-ment that is transferred outside of theconsolidated group. Solely for purposesof § 1.385–3, when a member of a con-solidated group that holds a consolidatedgroup debt instrument transfers the debtinstrument to an expanded group memberthat is not a member of the consolidatedgroup, the debt instrument is treated asissued by the issuer of the debt instrument(which is treated as one corporation withthe transferor of the debt instrument pur-suant to § 1.385–1(e)) to the transfereeexpanded group member on the date ofthe transfer. For purposes of § 1.385–3,the consequences of such transfer are de-termined in a manner that is consistentwith treating a consolidated group as onecorporation. Thus, for example, the sale ofa consolidated group debt instrument to anexpanded group member that is not amember of the consolidated group will betreated as an issuance of the debt instru-ment to the transferee expanded groupmember in exchange for property. To theextent the debt instrument is treated asstock upon being transferred, the debt in-strument is deemed to be exchanged forstock immediately after the debt instru-ment is transferred outside of the consol-idated group. For examples illustratingthis rule, see paragraph (d) of this section,Examples 1 and 2.

(c) Debt instrument entering a consol-idated group. When a debt instrument thatis treated as stock under § 1.385–3 be-comes a consolidated group debt instru-ment, immediately before that debt instru-ment becomes a consolidated group debtinstrument, the issuer is treated as issuinga new debt instrument to the holder inexchange for the debt instrument that was


treated as stock in a transaction that isdisregarded for purposes of § 1.385–3(b).

(d) Examples—(1) Assumed facts. Ex-cept as otherwise stated, the followingfacts are assumed for purposes of the ex-amples in paragraph (d)(3) of this section:

(i) FP is a foreign corporation thatowns 100 percent of the stock of USS1, adomestic corporation, and 100 percent ofthe stock of FS, a foreign corporation;

(ii) USS1 owns 100 percent of thestock of DS1, a domestic corporation;

(iii) DS1 owns 100 percent of the stockof DS2, a domestic corporation;

(iv) At the beginning of Year 1, FP isthe common parent of an expanded groupcomprised solely of FP, USS1, FS, DS1,and DS2 (the FP expanded group);

(v) USS1, DS1, and DS2 are membersof a consolidated group of which USS1 isthe common parent (the USS1 consoli-dated group);

(vi) The FP expanded group has morethan $50 million of debt instruments de-scribed in § 1.385–3(c)(2) at all times;

(vii) No issuer of a debt instrument hascurrent year earnings and profits describedin section 316(a)(2);

(viii) All notes are debt instrumentsdescribed in § 1.385–3(f)(3) and thereforehave satisfied any requirements under§ 1.385–2, if applicable, and are respectedas debt instruments under general federaltax principles;

(ix) No notes are eligible for the ordi-nary course exception described in§ 1.385–3(b)(3)(iv)(B)(2);

(x) Each entity has as its taxable yearthe calendar year;

(xi) No domestic corporation is aUnited States real property holding corpo-ration within the meaning of section897(c)(2); and

(xii) Each note is issued with adequatestated interest (as defined in section1274(c)(2)).

(2) No inference. Except as provided inthis section, it is assumed for purposes ofthe examples that the form of each trans-action is respected for federal tax pur-poses. No inference is intended, however,as to whether any particular note would berespected as indebtedness or as to whetherthe form of any particular transaction de-scribed in paragraph (d)(3) of this sectionwould be respected for federal tax pur-poses.

(3) Examples. The following examplesillustrate the rules of this section.

Example 1. Distribution of consolidated groupdebt instrument. (i) Facts. On Date A in Year 1, DS1issues DS1 Note to USS1 in a distribution. On DateB in Year 2, USS1 distributes DS1 Note to FP.

(ii) Analysis. Under § 1.385–1(e), the USS1 con-solidated group is treated as one corporation forpurposes of § 1.385–3. Accordingly, when DS1 is-sues DS1 Note to USS1 in a distribution, DS1 is nottreated as issuing a debt instrument to another mem-ber of DS1’s expanded group in a distribution forpurposes of § 1.385–3, and DS1 Note is not treatedas stock under § 1.385–3. Under paragraph (b)(2) ofthis section, when USS1 distributes DS1 Note to FP,the USS1 consolidated group is treated as issuing adebt instrument to FP in a distribution. Accordingly,DS1 Note is treated as DS1 stock under § 1.385–3(b)(2)(i). For this purpose, DS1 Note is deemed tobe exchanged for stock immediately after DS1 Noteis transferred outside of the USS1 consolidatedgroup.

Example 2. Sale of consolidated group debt in-strument. (i) Facts. On Date A in Year 1, DS1 lends$200x to USS1 in exchange for USS1 Note. On DateB in Year 2, USS1 distributes $200x to FP. On DateC in Year 2, DS1 sells USS1 Note to FS for $200x.

(ii) Analysis. Under § 1.385–1(e), the USS1 con-solidated group is treated as one corporation forpurposes of § 1.385–3. Accordingly, when USS1issues USS1 Note to DS1 on Date A in Year 1, USS1is not treated as a funded member, and when USS1distributes $200x to FP on Date B in Year 2,§ 1.385–2(b)(3) does not apply. Under paragraph(b)(2) of this section, when DS1 sells USS1 Note toFS, the USS1 consolidated group is treated as issuingUSS1 Note to FS in exchange for $200x on Date Cin Year 2. Because USS1 Note was issued by theUSS1 consolidated group to FS within 36 months ofthe distribution by the USS1 consolidated group toFP, § 1.385–3(b)(3)(iv)(B)(1) treats USS1 Note asissued with a principal purpose of funding that dis-tribution. Accordingly, USS1 Note is a principalpurpose debt instrument that is treated as USS1 stockunder § 1.385–3(b)(3)(ii)(A). Under paragraph(b)(2) of this section, immediately after USS1 Noteis transferred outside of the USS1 consolidatedgroup, USS1 Note is deemed to be exchanged forstock.

Example 3. Treatment of exempt consolidatedgroup debt instrument when a consolidated groupmember leaves the consolidated group. (i) Facts. OnDate A in Year 1, DS1 issues DS1 Note A to USS1in a distribution. On Date B in Year 2, USS1 lends$100x to DS1 in exchange for DS1 Note B. On DateC in Year 4, FP purchases 25 percent of DS1’s stockfrom USS1, resulting in DS1 ceasing to be a memberof the USS1 consolidated group.

(ii) Analysis. (A) Under § 1.385–1(e), the USS1consolidated group is treated as one corporation forpurposes of § 1.385–3 until Date C in Year 4. Ac-cordingly, when DS1 issues DS1 Note to USS1 in adistribution on Date A in Year 1, DS1 is not treatedas issuing a debt instrument to a member of DS’sexpanded group in a distribution for purposes of§ 1.385–3(b)(2), and DS1 Note A is not treated asstock under § 1.385–3 on Date A in Year 1. DS1Note A is an exempt consolidated group debt instru-

ment because DS1 Note A is not treated as stock onDate A in Year 1 solely by reason of § 1.385–1(e).Under paragraph (b)(1)(i) of this section, immedi-ately 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 consolidatedgroup debt instrument because DS1 Note B, which isissued in exchange for cash, would not be treated asstock even absent the application of § 1.385–1(e)because there have been no transactions described in§ 1.385–3(b)(3)(ii) that would have been treated asfunded by DS1 Note B in the absence of the appli-cation of § 1.385–1(e). Accordingly, under para-graph (b)(1)(ii)(A) of this section, DS1 Note B is nottreated as stock when DS1 ceases to be a member ofthe USS1 consolidated group, provided there are nodistributions or acquisitions described in § 1.385–3(b)(3)(ii) by DS1 that occur later in Year 4 (afterDate C).

Example 4. Distribution after a funded consoli-dated 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 § 1.385–3(b)(3)(iv)(B)(1) does not apply to DS1 Note B andthe distribution on Date D in Year 6 because undersection (b)(1)(ii)(B) of this section, for purposes ofapplying § 1.385–3(b)(3)(iv)(B)(1), DS1 Note B istreated as issued on Date B in Year 2, which is morethan 36 months before Date D in Year 6.

Example 5. Treatment of non-exempt consoli-dated group debt instrument when a consolidatedgroup member leaves the group. (i) Facts. On DateA in Year 1, DS2 lends $100x to DS1 in exchangefor DS1 Note. On Date B in Year 1, DS1 distributes$100x of cash to USS1. On Date C in Year 1, FPpurchases 25 percent of DS2’s stock from DS1,resulting in DS2 ceasing to be a member of the USS1consolidated group.

(ii) Analysis. After DS2 ceases to be a member ofthe USS1 consolidated group, DS1 and USS1 con-tinue to be treated as one corporation under § 1.385–1(e), such that DS1’s distribution of cash to USS1 onDate B in Year 1 continues to be disregarded forpurposes of § 1.385–3. Accordingly, DS1 Note is anon-exempt consolidated group debt instrument be-cause DS1 Note, which is issued in exchange forcash, would not be treated as stock even absent theapplication of § 1.385–1(e) to DS2, because, takinginto account the continued application of § 1.385–1(e) to USS1 and DS1, DS1 Note does not fund anytransaction described in § 1.385–3(b)(3)(ii). Accord-ingly, under paragraph (b)(1)(ii)(A) of this section,DS1 Note is not treated as stock when it ceases to bea consolidated group debt instrument, provided thereare no distributions or acquisitions described in§ 1.385–3(b)(3)(ii) by DS1 that occur later in Year1 (after Date C).

(e) Effective/applicability date andtransition rules—(1) In general. This sec-tion applies to any debt instrument issuedon or after April 4, 2016, and to any debtinstrument treated as issued before April4, 2016 as a result of an entity classifica-tion election made under § 301.7701–3 of


this chapter that is filed on or after April 4,2016.

(2) Transition rule for distributions oracquisitions occurring before April 4,2016. For purposes of this section, a dis-tribution or acquisition described in§ 1.385–3(b)(3)(ii) that occurs before April4, 2016, other than a distribution or acqui-sition that is treated as occurring beforeApril 4, 2016 as a result of an entity classi-fication election made under § 301.7701–3of this chapter that is filed on or after April4, 2016, is not taken into account.

(3) Transition rule for debt instrumentsthat would be treated as stock prior to thedate of publication in the Federal Regis-

ter of the Treasury decision adopting thisrule as a final regulation. When this sec-tion otherwise would treat a debt instru-ment as stock prior to the date of publica-tion in the Federal Register of theTreasury decision adopting this rule as afinal regulation, the debt instrument istreated as indebtedness until the date thatis 90 days after the date of publication inthe Federal Register of the Treasury de-cision adopting this rule as a final regula-tion. To the extent that the debt instrumentdescribed in the preceding sentence isheld by a member of the issuer’s ex-panded group on the date that is 90 daysafter the date of publication in the Federal

Register of the Treasury decision adopt-ing this rule as a final regulation, the debtinstrument is deemed to be exchanged forstock on the date that is 90 days after thedate of publication in the Federal Regis-ter of the Treasury decision adopting thisrule as a final regulation.

John Dalrymple.Deputy Commissioner for

Services and Enforcement.

(Filed by the Office of the Federal Register on April 4, 2016,5:00 p.m., and published in the issue of the Federal Registerfor April 8, 2016, 80 F.R. 20912)


Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe theeffect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position isbeing extended to apply to a variation ofthe fact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds thatthe same principle also applies to B, theearlier ruling is amplified. (Compare withmodified, below).

Clarified is used in those instanceswhere the language in a prior ruling isbeing made clear because the languagehas caused, or may cause, some confu-sion. It is not used where a position in aprior ruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more thanrestate the substance and situation of apreviously published ruling (or rulings).Thus, the term is used to republish underthe 1986 Code and regulations the sameposition published under the 1939 Codeand regulations. The term is also usedwhen it is desired to republish in a singleruling a series of situations, names, etc.,that were previously published over a pe-riod of time in separate rulings. If the newruling does more than restate the sub-

stance of a prior ruling, a combination ofterms is used. For example, modified andsuperseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that isself contained. In this case, the previouslypublished ruling is first modified and then,as modified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further namesin subsequent rulings. After the originalruling has been supplemented severaltimes, a new ruling may be published thatincludes the list in the original ruling andthe additions, and supersedes all prior rul-ings in the series.

Suspended is used in rare situations toshow that the previous published rulingswill not be applied pending some futureaction such as the issuance of new oramended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in currentuse and formerly used will appear in ma-terial published in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.ER—Employer.

ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.PRS—Partnership.

PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D.—Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z—Corporation.

Bulletin No. 2016–17 April 25, 2016i

Numerical Finding List1

Bulletins 2016–1 through 2016–17

Announcements:

2016–1, 2016–3 I.R.B. 2832016-2, 2016-3 I.R.B. 2832016-3, 2016-4 I.R.B. 2942016-4, 2016-6 I.R.B. 3132016-5, 2016-8 I.R.B. 3562016-6, 2016-10 I.R.B. 4092016-7, 2016-8 I.R.B. 3562016-8, 2016-9 I.R.B. 3672016-9, 2016-9 I.R.B. 3672016-10, 2016-9 I.R.B. 3672016-11, 2016-10 I.R.B. 4112016-12, 2016-16 I.R.B. 5892016-13, 2016-13 I.R.B. 5142016-14, 2016-14 I.R.B. 5352016-15, 2016-17 I.R.B. 636

Notices:

2016-1, 2016-2 I.R.B. 2652016-2, 2016-2 I.R.B. 2652016-3, 2016-3 I.R.B. 2782016-4, 2016-3 I.R.B. 2792016-5, 2016-6 I.R.B. 3022016-6, 2016-4 I.R.B. 2872016-7, 2016-5 I.R.B. 2962016-8, 2016-6 I.R.B. 3042016-9, 2016-6 I.R.B. 3062016-10, 2016-6 I.R.B. 3072016-11, 2016-6 I.R.B. 3122016-12, 2016-6 I.R.B. 3122016-13, 2016-7 I.R.B. 3142016-14, 2016-7 I.R.B. 3152016-15, 2016-13 I.R.B. 4862016-16, 2016-7 I.R.B. 3182016-17, 2016-9 I.R.B. 3582016-18, 2016-9 I.R.B. 3592016-19, 2016-9 I.R.B. 3622016-20, 2016-9 I.R.B. 3622016-21, 2016-12 I.R.B. 4652016-22, 2016-13 I.R.B. 4882016-23, 2016-13 I.R.B. 4902016-24, 2016-13 I.R.B. 4922016-25, 2016-13 I.R.B. 4932016-26, 2016-14 I.R.B. 5332016-27, 2016-15 I.R.B. 5762016-28, 2016-15 I.R.B. 576

Proposed Regulations:

REG-103380-05, 2016-16 I.R.B. 614REG-118867-10, 2016-10 I.R.B. 411REG-147310-12, 2016-7 I.R.B. 336REG-150349-12, 2016-11 I.R.B. 440REG-138344-13, 2016-4 I.R.B. 294REG-123867-14, 2016-12 I.R.B. 484

Proposed Regulations:—Continued

REG-125761-14, 2016-7 I.R.B. 322REG-100861-15, 2016-8 I.R.B. 356REG-108060-15, 2016-17 I.R.B. 636REG-109822-15, 2016-14 I.R.B. 535REG-127923-15, 2016-12 I.R.B. 473REG-129067-15, 2016-10 I.R.B. 421REG-134122-15, 2016-7 I.R.B. 334REG-101701-16, 2016-9 I.R.B. 368

Revenue Procedures:

2016-1, 2016-1 I.R.B. 12016-2, 2016-1 I.R.B. 1022016-3, 2016-1 I.R.B. 1262016-4, 2016-1 I.R.B. 1422016-5, 2016-1 I.R.B. 1882016-6, 2016-1 I.R.B. 2002016-7, 2016-1 I.R.B. 2392016-8, 2016-1 I.R.B. 2432016-10, 2016-2 I.R.B. 2702016-11, 2016-2 I.R.B. 2742016-13, 2016-4 I.R.B. 2902016-14, 2016-9 I.R.B. 3652016-15, 2016-11 I.R.B. 4352016-16, 2016-10 I.R.B. 3942016-17, 2016-11 I.R.B. 4362016-18, 2016-17 I.R.B. 6352016-19, 2016-13 I.R.B. 4972016-20, 2016-13 I.R.B. 4992016-21, 2016-14 I.R.B. 5332016-22, 2016-15 I.R.B. 5772016-23, 2016-16 I.R.B. 581

Revenue Rulings:

2016-1, 2016-2 I.R.B. 2622016-2, 2016-4 I.R.B. 2842016-3, 2016-3 I.R.B. 2822016-4, 2016-6 I.R.B. 2992016-5, 2016-8 I.R.B. 3442016-6, 2016-14 I.R.B. 5192016-7, 2016-10 I.R.B. 3912016-8, 2016-11 I.R.B. 4262016-9, 2016-14 I.R.B. 5302016-10, 2016-15 I.R.B. 545

Treasury Decisions:

9745, 2016-2 I.R.B. 2569746, 2016-14 I.R.B. 5159748, 2016-8 I.R.B. 3479749, 2016-10 I.R.B. 3739750, 2016-10 I.R.B. 3749751, 2016-10 I.R.B. 3799752, 2016-10 I.R.B. 3859753, 2016-11 I.R.B. 4269754, 2016-11 I.R.B. 4329755, 2016-12 I.R.B. 442

Treasury Decisions:—Continued

9756, 2016-12 I.R.B. 4509757, 2016-12 I.R.B. 4629759, 2016-15 I.R.B. 5459760, 2016-15 I.R.B. 564

1A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2015–27 through 2015–52 is in Internal Revenue Bulletin2015–52, dated December 28, 2015.

April 25, 2016 Bulletin No. 2016–17ii

Finding List of Current Actions onPreviously Published Items1

Bulletins 2016–1 through 2016–17

Announcements:

2007-21Modified byAnn. 2016-1, 2016-3 I.R.B. 283

Notices:

2005-50Modified byNotice 2016-2, 2016-2 I.R.B. 265

2007-59Revoked byNotice 2016-16, 2016-7 I.R.B. 318

2013-54Supplemented byNotice 2016-17, 2016-9 I.R.B. 358

2014-79Superseded byNotice 2016-1, 2016-2 I.R.B. 265



Revenue Procedures:

1987-24Superseded byRev. Proc. 2016-22, 2016-15 I.R.B. 577



2014-64Supplemented byRev. Proc. 2016-18, 2016-17 I.R.B. 635



Revenue Procedures:—Continued







2015-19Amplified byRev. Proc. 2016-23, 2016-16 I.R.B. 581

2015-19Modified byRev. Proc. 2016-23, 2016-16 I.R.B. 581


2015-50Supplemented byRev. Proc. 2016-18, 2016-17 I.R.B. 635

2015-53Modified byRev. Proc. 2016-11, 2016-2 I.R.B. 274

Revenue Rulings:

2005-3Modified byRev. Rul. 2016-8, 2016-11 I.R.B. 426

2008-15Revoked byRev. Rul. 2016-3, 2016-3 I.R.B. 282

1A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2015–27 through 2015–52 is in Internal Revenue Bulletin2015–52, dated December 28, 2015.

Bulletin No. 2016–17 April 25, 2016iii

INTERNAL REVENUE BULLETINThe Introduction at the beginning of this issue describes the purpose and content of this publication. The weekly Internal Revenue

Bulletins are available at www.irs.gov/irb/.

We Welcome Comments About the Internal Revenue BulletinIf you have comments concerning the format or production of the Internal Revenue Bulletin or suggestions for improving it, we

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