Internal Revenue Bulletin 2016-45 (PDF rendition): IRS Notices

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# INTERNAL REVENUE BULLETIN

IRS

Bulletin No. 2016-45
November 7, 2016

## HIGHLIGHTS OF THIS ISSUE

These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.

## INCOME TAX

### REG-130314-16, page 718.

These proposed regulations correspond to temporary regula-
tions (published elsewhere in this edition of the Bulletin (TD
9790)) that treat as stock certain related-party interests that
otherwise would be treated as indebtedness for federal tax
purposes.

### Rev. Rul. 2016-26, page 538.

Federal rates; adjusted federal rates; adjusted federal long-
term rate and the long-term exempt rate. For purposes of
sections 382, 642, 1274, 1288, 7872, and other sections of
the Code, tables set forth the rates for November 2016.

### Rev. Proc. 2016-55, page 707.

This procedure provides the 2017 cost-of-living adjustments to
certain items due to inflation, as required by various provisions
of the Code and Service guidance.

### Notice 2016-63, page 683.

This notice provides rules interpreting the reasonable mortality
charge requirement contained in section 7702(c)(3)(B)(i) of the
Code. Notice 88-128 supplemented. Notice 2006-95 modi-
fied and superseded.

### T.D. 9790, page 540.

These regulations provide rules that establish threshold docu-
mentation requirements that ordinarily must be satisfied in
order for certain related-party interests in a corporation to be
treated as indebtedness for federal tax purposes, and treat as
stock certain related-party interests that otherwise would be
treated as indebtedness for federal tax purposes

## EMPLOYEE PLANS

Announcement 2016-39, page 720.

Announcement 2016-39 provides relief to victims of Hurri-
cane Matthew, which caused damage to parts of Florida, Geor-
gia, North Carolina and South Carolina. It permits easier ac-
cess to victims' funds held in workplace retirement plans and in
IRAs, for the period beginning October 4, 2016, (October 3,
2016, for Florida) and ending March 15, 2017. The relief
provided in the announcement is in addition to the relief already
provided by the IRS pursuant to News Release IR-2016-135.

## ESTATE TAX

Rev. Proc. 2016-55, page 707.

This procedure provides the 2017 cost-of-living adjustments to
certain items due to inflation, as required by various provisions
of the Code and Service guidance.

## EXCISE TAX

Rev. Proc. 2016-55, page 707.

This procedure provides the 2017 cost-of-living adjustments to
certain items due to inflation, as required by various provisions
of the Code and Service guidance.

(Continued on the next page)

## ADMINISTRATIVE

### Rev. Proc. 2016-54, page 685.

This procedure provides specifications for the private printing
of red-ink substitutes for the 2016 Forms W-2 and W-3. This
procedure will be produced as the next revision of Publication
1141. Rev. Proc. 2015-51 is superseded.

### Rev. Proc. 2016-55, page 707.

This procedure provides the 2017 cost-of-living adjustments to
certain items due to inflation, as required by various provisions
of the Code and Service guidance.

## The IRS Mission

Provide America's taxpayers top-quality service by helping
them understand and meet their tax responsibilities and en-
force the law with integrity and fairness to all.

## Introduction

The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly.

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

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

Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, 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 unless
the 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 of
the Internal Revenue Code of 1986.

### Part II .- Treaties and Tax Legislation.

This part is divided into two subparts as follows: Subpart A, Tax
Conventions 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 these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the 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 for
the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and are
published 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.

## Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 1274 .-
Determination of Issue
Price in the Case of
Certain Debt Instruments
Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482,
483, 642, 807, 846, 1288, 7520, 7872.)

## Rev. Rul. 2016-26

This revenue ruling provides various
prescribed rates for federal income tax
purposes for November 2016 (the current

month). Table 1 contains the short-term,
mid-term, and long-term applicable fed-
eral rates (AFR) for the current month for
purposes of section 1274(d) of the Internal
Revenue Code. Table 2 contains the short-
term, mid-term, and long-term adjusted
applicable federal rates (adjusted AFR)
for the current month for purposes of sec-
tion 1288(b). The rates in Table 2 have
been determined in accordance with
§ 1.1288-1. See T.D. 9763, 81 FR 24482
(April 26, 2016). Table 3 sets forth the
adjusted federal long-term rate and the
long-term tax-exempt rate described in

section 382(f). Table 4 contains the appro-
priate percentages for determining the
low-income housing credit described in
section 42(b)(1) for buildings placed in
service during the current month. How-
ever, under section 42(b)(2), the applica-
ble percentage for non-federally subsi-
dized new buildings placed in service
after July 30, 2008, shall not be less than
9%. Finally, Table 5 contains the federal
rate for determining the present value of
an annuity, an interest for life or for a term
of years, or a remainder or a reversionary
interest for purposes of section 7520.

REV. RUL. 2016-26 TABLE 1 Applicable Federal Rates (AFR) for November 2016 Period for Compounding Annual Semiannual Quarterly Monthly Short-term

AFR

.68%

110% AFR

.75%

120% AFR

.82%

130% AFR

.88%

Mid-term

AFR

1.33%

110% AFR

1.47%

1.46%

120% AFR

1.61%

1.60%

1.59%

130% AFR

1.74%

1.73%

1.72%

150% AFR

2.01%

2.00%

1.99%

175% AFR

2.34%

2.33%

2.32%

AFR

Long-term

2.07%

2.06%

2.05%

110% AFR

2.28%

2.27%

2.26%

120% AFR

2.49%

2.47%

2.46%

130% AFR

2.70%

2.68%

2.67%

REV. RUL. 2016-26 TABLE 2 Adjusted AFR for November 2016 Period for Compounding

Annual

Semiannual

Quarterly

Monthly

Short-term adjusted AFR

.51%

Mid-term adjusted AFR

.99%

Long-term adjusted AFR

1.54%

1.53%

# REV. RUL. 2016-26 TABLE 3 Rates Under Section 382 for November 2016

## Adjusted federal long-term rate for the current month

1.54%

Long-term tax-exempt rate for ownership changes during the current month
(the highest of the adjusted federal long-term rates for the current month and the prior two months.)

1.54%

# REV. RUL. 2016-26 TABLE 4 Appropriate Percentages Under Section 42(b)(1) for November 2016

Note: Under section 42(b)(2), the applicable percentage for non-federally subsidized new
buildings placed in service after July 30, 2008, shall not be less than 9%.

Appropriate percentage for the 70% present value low-income housing credit
Appropriate percentage for the 30% present value low-income housing credit

7.39%

3.17%

## REV. RUL. 2016-26 TABLE 5 Rate Under Section 7520 for November 2016

Applicable federal rate for determining the present value of an annuity, an interest
for life or a term of years, or a remainder or reversionary interest

1.6%

### Section 42 .- Low-Income Housing Credit

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

### Section 280G .- Golden Parachute Payments

Federal short-term, mid-term, and long-term
rates are set forth for the month of November 2016.
See Rev. Rul. 2016-26, page 538.

### Section 382 .- Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted applicable federal long-term rate is
set forth for the month of November 2016. See Rev.
Rul. 2016-26, page 538.

## Section 412 .- Minimum Funding Standards

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month

of November 2016. See Rev. Rul. 2016-26, page
538.

## Section 467 .- Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

## Section 468 .- Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month of
November 2016. See Rev. Rul. 2016-26, page 538.

## Section 482 .- Allocation of Income and Deductions Among Taxpayers

Federal short-term, mid-term, and long-term
rates are set forth for the month of November 2016.
See Rev. Rul. 2016-26, page 538.

## Section 483 .- Interest on Certain Deferred Payments

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

## Section 642 .- Special Rules for Credits and Deductions

Federal short-term, mid-term, and long-term
rates are set forth for the month of November 2016.
See Rev. Rul. 2016-26, page 538.

## Section 807 .- Rules for Certain Reserves

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

## Section 846 .- Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month

of November 2016. See Rev. Rul. 2016-26, page
538.

# Section 1288 .- Treatment of Original Issue Discount on Tax-Exempt Obligations

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

## Section 7520 .- Valuation Tables

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

## Section 7872 .- Treatment of Loans With Below- Market Interest Rates

The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of November 2016. See Rev. Rul. 2016-26, page
538.

26 CFR 1.385-1:General provisions; 26 CFR
1.385-2: Treatment of certain interests between
members of an expanded group; 26 CFR 1.385-3:
Transactions in which ....

### T.D. 9790

### DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

### Treatment of Certain Interests in Corporations as Stock or Indebtedness.

AGENCY: Internal Revenue Service (IRS),
Treasury.

ACTION: Final regulations and tempo-
rary regulations.

SUMMARY: This document contains fi-
nal and temporary regulations under sec-
tion 385 of the Internal Revenue Code
(Code) that establish threshold documen-

tation requirements that ordinarily must
be satisfied in order for certain related-
party interests in a corporation to be
treated as indebtedness for federal tax pur-
poses, and treat as stock certain related-
party interests that otherwise would be
treated as indebtedness for federal tax pur-
poses. The final and temporary regulations
generally affect corporations, including
those that are partners of certain partner-
ships, when those corporations or partner-
ships issue purported indebtedness to re-
lated corporations or partnerships.

DATES: Effective Date: These regula-
tions are effective on October 21, 2016.
Applicability Dates: For dates of appli-
cability, see §§ 1.385-1(f), 1.385-2(i),
1.385-3(j), 1.385-3T(k), 1.385-4T(g),
and 1.752-2T(1)(4).

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

#### SUPPLEMENTARY INFORMATION: Paperwork Reduction Act

The collection of information con-
tained in these regulations has been re-
viewed and approved by the Office of
Management and Budget under control
number 1545-2267. An agency may not
conduct or sponsor, and a person is not
required to respond to, a collection of
information unless the collection of infor-
mation displays a valid control number.

Books or records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial in the administration of any internal
revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.

##### Background

###### I. In General

On April 8, 2016, the Department of
the Treasury (Treasury Department) and
the IRS published proposed regulations
(REG-108060-15) under section 385 of
the Code (proposed regulations) in the
Federal Register (81 FR 20912) concern-
ing the treatment of certain interests in

corporations as stock or indebtedness. A
public hearing was held on July 14, 2016.
The Treasury Department and the IRS
also received numerous written comments
in response to the proposed regulations.
All comments are available at www.regu-
lations.gov or upon request. The com-
ments received in writing and at the public
hearing were carefully considered in de-
veloping the final and temporary regula-
tions. In addition, certain portions of the
proposed regulations that were substan-
tially revised based on comments received
are being issued as temporary regulations.
The text of the temporary regulations
serves as the text of the proposed regula-
tions set forth in the notice of proposed
rulemaking on this subject published in
the Proposed Rules section of this issue
of the Internal Revenue Bulletin. In ad-
dition, this Treasury decision reserves on
the application of certain portions of the
proposed regulations pending additional
study.

#### II. Summary of Section 385 and the Proposed Regulations

Section 385 authorizes the Secretary of
the Treasury to prescribe rules to deter-
mine whether an interest in a corporation
is treated for purposes of the Code as
stock or indebtedness (or as in part stock
and in part indebtedness) by setting forth
factors to be taken into account with re-
spect to particular factual situations. Un-
der this authority, the proposed regula-
tions provided specific factors that, when
present in the context of purported debt
instruments issued between highly-related
corporations, would be dispositive.

Specifically, proposed § 1.385-2 pro-
vided that the absence of timely prepa-
ration of documentation and financial
analysis evidencing four essential char-
acteristics of indebtedness would be a
dispositive factor requiring a purported
debt instrument to be treated as stock for
federal tax purposes. Because related
parties do not deal independently with
each other, it can be difficult for the IRS
to determine whether there was an intent
to create an actual debtor-creditor rela-
tionship in this context, particularly
when the parties do not document the
terms governing the arrangement or an-
alyze the creditworthiness of the bor-
rower contemporaneously with the loan,

each as unrelated parties would do. For
this reason, the proposed regulations
prescribed the nature of the documenta-
tion necessary to substantiate the treat-
ment of related-party instruments as in-
debtedness, including documentation to
establish an expectation of repayment
and a course of conduct that is generally
consistent with a debtor-creditor rela-
tionship. Proposed § 1.385-2 required
that such documentation be timely pre-
pared and maintained, and provided
that, if the specified documentation was
not provided to the Commissioner upon
request, the instrument would be treated
as stock for federal tax purposes.

Proposed § 1.385-3 identified an addi-
tional dispositive factor that indicates the
existence of a corporation-shareholder re-
lationship, rather than a debtor-creditor
relationship: the issuance of a purported
debt instrument to a controlling share-
holder in a distribution or in another trans-
action that achieves an economically
similar result. These purported debt in-
struments do not finance any new invest-
ment in the operations of the borrower and
therefore have the potential to create sig-
nificant federal tax benefits, including in-
terest deductions that erode the U.S. tax
base, without having meaningful non-tax
significance.

Proposed § 1.385-3 also included a
"funding rule" that treated as stock a pur-
ported debt instrument that is issued as
part of a series of transactions that
achieves a result similar to a distribution
of a debt instrument. Specifically, pro-
posed § 1.385-3 treated as stock a pur-
ported debt instrument that was issued in
exchange for property, including cash,
with a principal purpose of using the pro-
ceeds to fund a distribution to a control-
ling shareholder or another transaction
that achieves an economically similar re-
sult. Furthermore, the proposed regula-
tions included a "per se" application of the
funding rule that treated a purported debt
instrument as funding a distribution or
other transaction with a similar economic
effect if it was issued in exchange for
property (other than in the ordinary course
of purchasing goods or services from an
affiliate) during the period beginning 36
months before and ending 36 months after
the funded member made the distribution

or undertook the transaction with a similar
economic effect.

Proposed § 1.385-3 included excep-
tions that were intended to limit the scope
of the section to transactions undertaken
outside of the ordinary course of business
by large taxpayers with complex organiza-
tional structures. The proposed regulations
also included an anti-abuse provision to ad-
dress a purported debt instrument issued
with a principal purpose of avoiding the
application of the proposed regulations. Pro-
posed § 1.385-4 provided rules for applying
proposed § 1.385-3 in the context of con-
solidated groups.

Finally, proposed § 1.385-1(d) pro-
vided the Commissioner with the discretion
to treat certain interests in a corporation for
federal tax purposes as indebtedness in part
and stock in part (a "bifurcation rule").

### III. Overview of Significant Modifications to Minimize Burdens

In response to the proposed regula-
tions, the Treasury Department and the
IRS received numerous detailed and
thoughtful comments (including com-
ments provided at the public hearing)
suited to the highly technical nature of
certain of the proposed rules. The Trea-
sury Department and the IRS carefully
considered these comments. Many of the
comments expressed concern that the pro-
posed regulations would impose compli-
ance burdens and result in collateral con-
sequences that were not justified by the
stated policy objectives of the proposed
regulations. In response to the comments
received, the final and temporary regula-
tions substantially revise the proposed
regulations to achieve a better balance be-
tween minimizing the burdens imposed on
taxpayers and fulfilling the important pol-
icy objectives of the proposed regulations.
The remainder of this Part III summarizes
the most noteworthy modifications in-
cluded in the final and temporary regula-
tions, which are the following:

Changes to the overall scope of the
regulations:

· Exclusion of foreign issuers. The final
regulations reserve on all aspects of
their application to foreign issuers; as a
result, the final regulations do not ap-
ply to foreign issuers.

· Exclusion of S corporations and non-
controlled RICs and REITs. S corpo-
rations and non-controlled regulated
investment companies (RICs) and real
estate investment trusts (REITs) are
exempt from all aspects of the final
regulations.

· Removal of general bifurcation rule.
The final regulations do not include a
general bifurcation rule. The Treasury
Department and the IRS will continue
to study this issue.

Significant changes to the documenta-
tion requirements in § 1.385-2:

· Extension of period required for timely
preparation. The final regulations
eliminate the proposed regulations'
30-day timely preparation require-
ment, and instead treat documentation
and financial analysis as timely pre-
pared if it is prepared by the time that
the issuer's federal income tax return
is filed (taking into account all appli-
cable extensions).

· Rebuttable presumption based on
compliance with documentation re-
quirements. The final regulations pro-
vide that, if an expanded group is oth-
erwise generally compliant with the
documentation requirements, then a
rebuttable presumption, rather than per
se recharacterization as stock, applies
in the event of a documentation failure
with respect to a purported debt instru-
ment.

· Delayed implementation. The final
regulations apply only to debt instru-
ments issued on or after January 1,
2018.

Significant changes to the rules regard-
ing distributions of debt instruments and
similar transactions under § 1.385-3:

· Exclusion of debt instruments issued
by regulated financial groups and in-
surance entities. The final and tempo-
rary regulations do not apply to debt
instruments issued by certain specified
financial entities, financial groups, and
insurance companies that are subject
to a specified degree of regulatory
oversight regarding their capital struc-
ture.

· Treatment of cash management ar-
rangements and other short-term debt
instruments. The final and temporary
regulations generally exclude from the

scope of § 1.385-3 deposits pursuant
to a cash management arrangement as
well as certain advances that finance
short-term liquidity needs.

· Limiting certain "cascading" rechar-
acterizations. The final and temporary
regulations narrow the application of
the funding rule by preventing, in cer-
tain circumstances, the so-called "cas-
cading" consequence of recharacteriz-
ing a debt instrument as stock.

· Expanded earnings and profits excep-
tion. The final and temporary regula-
tions expand the earnings and profits
exception to include all the earnings
and profits of a corporation that were
accumulated while it was a member of
the same expanded group and after the
day that the proposed regulations were
issued.

· Expanded access to $50 million excep-
tion. The final and temporary regula-
tions remove the "cliff effect" of the
threshold exception under the pro-
posed regulations, so that all taxpayers
can exclude the first $50 million of
indebtedness that otherwise would be
recharacterized.

· Credit for certain capital contribu-
tions. The final and temporary regula-
tions provide an exception pursuant to
which certain contributions of prop-
erty are "netted" against distributions
and transactions with similar eco-
nomic effect.

· Exception for equity compensation.
The final and temporary regulations
provide an exception for the acquisi-
tion of stock delivered to employees,
directors, and independent contractors
as consideration for the provision of
services.

· Expansion of 90-day delay for rechar-
acterization. The 90-day delay pro-
vided in the proposed regulations for
debt instruments issued on or after
April 4, 2016, but prior to the publica-
tion of final regulations, is expanded
so that any debt instrument that is sub-
ject to recharacterization but that is
issued on or before January 19, 2017,
will not be recharacterized until imme-
diately after January 19, 2017.

The foregoing changes significantly re-
duce the number of taxpayers and transac-
tions affected by the final and temporary
regulations. As narrowed, many issuers are

entirely exempt from the application of
§§ 1.385-2 and 1.385-3. Moreover, with
respect to the large domestic issuers that are
subject to § 1.385-3, that section is substan-
tially revised to better focus on extraordi-
nary transactions that have the effect of in-
troducing related-party debt without
financing new investment in the operations
of the issuer. The final and temporary reg-
ulations thus apply in particular factual sit-
uations where there are elevated concerns
about related-party debt being used to create
significant federal tax benefits without hav-
ing meaningful non-tax effects.

### Summary of Comments and Explanation of Revisions

#### I. In General

The Treasury Department and the IRS
received numerous comments requesting
that various entities be excluded from the
scope of the proposed regulations. After
considering the comments received, the
Treasury Department and the IRS have
adopted several of these recommenda-
tions. As an alternative to excluding certain
entities from the scope of the regulations,
many comments also suggested adopting
special rules or narrower technical excep-
tions to provide relief for particular issues.
In many cases, adopting the broader com-
ment to exclude certain entities from the
scope of the final and temporary regulations
renders such alternative proposals moot. For
example, comments requested a rule provid-
ing that recharacterized debt of an S corpo-
ration will not be treated as a second class of
stock for purposes of section 1361(b)(1)(D).
This comment is moot because the final and
temporary regulations do not contain a gen-
eral bifurcation rule and provide that S cor-
porations are not treated as members of an
expanded group (as described in Part
III.B.2.b of the Summary of Comments and
Explanation of Revisions) and therefore are
not subject to the final and temporary regu-
lations. Although the Treasury Department
and the IRS considered all comments re-
ceived, this preamble generally does not dis-
cuss comments suggesting alternative ap-
proaches to the extent such comments are
rendered moot by adopting a broader com-
ment. Similarly, because the final and
temporary regulations do not contain the
general bifurcation rule of proposed
§ 1.385-1(d), this preamble does not discuss

that rule or the comments received with
respect to it.

Many comments requested that the
regulations include examples illustrating
the application of specific rules of the
proposed regulations to specific fact pat-
terns. Where appropriate to illustrate the
basic application of rules to common fact
patterns, the final and temporary regula-
tions provide the requested examples. In
some cases, the Treasury Department and
the IRS determined that a modification of
a rule rendered such request moot or that
a clarification of a rule was sufficient to
illustrate the point the requested example
would clarify. In other cases, the Treasury
Department and the IRS clarified the issue
through discussion in this preamble.

Numerous comments recommended
that the Treasury Department and the IRS
extend the deadline for receiving com-
ments. Many of those comments recom-
mended a 90-day extension. Other com-
ments recommended that the Treasury
Department and the IRS continue to so-
licit and consider taxpayer feedback out-
side of the comment period.

The Treasury Department and the IRS
declined to extend the standard 90-day
comment period because numerous de-
tailed and substantive comments were re-
ceived before the deadline. The proposed
regulations provided that written or elec-
tronic comments and requests for a public
hearing had to be received by July 7,
2016, which was 90 days after the publi-
cation of the notice of proposed regula-
tions in the Federal Register. A public
hearing was held on July 14, 2016. Six-
teen speakers or groups of speakers spoke
at the public hearing. Over 29,600 written
comments were received, of which 145
were unique and commented on specific
substantive aspects of the proposed regu-
lations. Of the written comments, 6 were
received after July 7, 2016, and all were
considered in drafting the final and tem-
porary regulations.

The final and temporary regulations re-
serve on several issues raised in com-
ments, and this preamble includes a new
request for comments regarding the type
of rules that should apply in those con-
texts. See Future Guidance and Request
for Comments. The Treasury Department
and the IRS believe that all remaining
issues raised in the comments are appro-

priately addressed in the changes de-
scribed in this preamble, and, in the time
since the comment period closed, have not
been made aware of any particular addi-
tional issues that would benefit from an
extended comment period.

In addition, because aspects of the final
and temporary regulations apply to debt
instruments issued after April 4, 2016, the
Treasury Department and the IRS deter-
mined that it is important for taxpayers
and for tax administration to issue the
final and temporary regulations expedi-
tiously after giving due consideration to
all comments received.

#### II. Comments Regarding Authority to Issue Regulations Under Section 385

#### A. Interpretation of authority under section 385

Various comments asserted that the
proposed regulations were an invalid ex-
ercise of regulatory authority under sec-
tion 385, including because the regula-
tions were motivated in part by the
concern over excessive interest deduc-
tions and that such purpose is not autho-
rized by section 385.

The Treasury Department and the IRS
have determined that the final and tempo-
rary regulations are a valid exercise of
authority under section 385. Section
385(a) vests the Secretary with authority
to promulgate such rules as may be
necessary or appropriate to determine
whether, for federal tax purposes, an in-
terest in a corporation is treated as stock
or indebtedness (or as in part stock and in
part indebtedness). The final and temporary
regulations exercise this authority consistent
with Congress's mandate by providing fac-
tors that determine whether a purported debt
interest is treated as stock, indebtedness, or
in part stock and in part indebtedness in
particular factual situations involving trans-
actions among highly-related corporations
(relatedness itself being a factor explicitly
enumerated in section 385(b)(5)). Section
385 does not limit the Treasury Department
and the IRS to issuing regulations only for
certain purposes.

Consistent with section 385(a), the
Treasury Department and the IRS have
concluded that the regulations are neces-
sary and appropriate. With respect to the

documentation rules in § 1.385-2, as Con-
gress observed when it enacted section
385, historically there has been consider-
able confusion regarding whether various
interests are debt or equity or some com-
bination of the two. See S. Rep. No. 91-
552, at 138 (1969). The Treasury Depart-
ment and the IRS have observed that this
uncertainty has been particularly acute in
the context of related-party debt instru-
ments. Section 1.385-2 of the final regu-
lations helps to resolve this uncertainty
with respect to the particular factual situ-
ation of transactions among highly-related
corporations by providing guidance on the
type of documentation that is required to
support debt classification. Focusing on
this particular factual situation is appro-
priate because such debt raises unique
concerns. Related parties do not have the
same commercial incentives as unrelated
parties to properly document their inter-
ests in one another, making it difficult to
determine whether there exists an actual
debtor-creditor relationship. In addition,
because debt, in contrast to equity, gives
rise to deductible interest payments, there
are often significant tax incentives to char-
acterize interests in a corporation as debt,
which may be far more important than the
practical commercial consequences of
such characterization. Accordingly, when
a controlling shareholder (or a party re-
lated to a controlling shareholder) invests
in a corporation, it is necessary and ap-
propriate to require the shareholder to
document that an analysis was undertaken
to establish an expectation of repayment
and that the parties' conduct throughout
the term of the loan is consistent with a
debtor-creditor relationship.

With respect to the rules described in
§§ 1.385-3, 1.385-3T, and 1.385-4T, a
distribution of a note or an issuance of a
purported debt instrument by a corpora-
tion to a controlling shareholder (or a per-
son related to a controlling shareholder)
followed by a distribution of the proceeds
to a controlling shareholder, either actu-
ally or in substance, raises additional,
unique concerns. These purported debt in-
struments have the potential to create sig-
nificant federal tax benefits, but lack
meaningful non-tax significance, includ-
ing because they do not finance new in-
vestment in the operations of the bor-
rower. In the context of highly-related

corporations, it is a necessary and appro-
priate exercise of the Secretary's rulemak-
ing authority to provide that when this
factor and the relatedness factor are pres-
ent, an interest is treated as equity rather
than indebtedness.

Various comments also asserted that
the regulations are inconsistent with the
Treasury Department and the IRS's statu-
tory authority under section 385 because
they fail to provide a rule of general ap-
plication and instead address only a par-
ticular set of instruments that raise certain
policy concerns.

The Treasury Department and the IRS
have concluded that these comments lack
merit. Section 385 does not require the
promulgation of rules of general applica-
bility. Nothing in section 385 requires the
Treasury Department and the IRS to pro-
vide a universal definition of debt and
equity that would apply to all possible
transactions. Instead, the statute autho-
rizes the Secretary to prescribe factors
"with respect to a particular factual situa-
tion," as opposed to all possible fact pat-
terns. The statute's legislative history re-
inforces the validity of this approach by
noting the difficulty of legislating "com-
prehensive and specific statutory rules of
universal and equal applicability" and the
desirability of addressing the characteriza-
tion of an interest as debt or equity across
"numerous [and] different situations." S.
Rep. No. 91-552, at 138.

The regulations follow this approach
by addressing the characterization of in-
terests in the particular factual situation of
transactions among highly-related corpo-
rations. This is a context in which there is
particular confusion regarding what is re-
quired in order to establish that a debtor-
creditor relationship exists. In addition, in
this context there are unique issues with
respect to the ability to claim significant
federal tax benefits through the creation of
indebtedness that often lacks meaningful
non-tax effects. The use of section 385's
regulatory authority to provide guidelines
for documentation is necessary and appro-
priate to provide greater certainty in de-
termining the nature of interests in a con-
text where there are often no third-party
checks. Further, the use of this authority
to identify determinative factors (the lack
of new capital along with relatedness) is
also necessary and appropriate to ensure

that the significant tax advantages that ac-
company debt (in particular, the signifi-
cant deductions that can be claimed) are
limited to circumstances in which there is
a financing of new investment.

Several comments asserted that regula-
tions promulgated under section 385 must
consist of a list of factors to be weighed
on a case-by-case basis, and that the pro-
posed regulations deviated from this re-
quirement by providing dispositive fac-
tors.

The Treasury Department and the IRS
have concluded that the authority under
section 385 does not include such a limi-
tation. Section 385(b) authorizes the Sec-
retary to "set forth factors which are to be
taken into account in determining with
respect to a particular factual situation"
whether an instrument is debt or equity.
The final and temporary regulations in-
clude two factors that are specifically
listed in section 385(b) (both of which are
critical factors traditionally relied on by
courts): the presence of a "written" prom-
ise to pay (section 385(b)(1)) and the re-
lationship between holdings of stock in
the corporation and holdings of the inter-
est in question (section 385(b)(5)). Two
other factors included in the regulations
have been cited in the case law: whether
debt finances new investment in the op-
erations of the borrower, and whether
the taxpayer can demonstrate that at the
time the advance was made the borrower
could reasonably be expected to repay
the loan. In the particular factual situa-
tion of loans between highly-related
corporations, a factual situation in
which the relatedness factor described
in section 385(b)(5) is amplified, the
final and temporary regulations appro-
priately elevate the importance of the
other factors listed above.

Section 385(b) does not require the
Secretary to set forth any particular fac-
tors (regulations "may include" certain
enumerated factors), nor does it prescribe
the weight to be given to any selected
factors, only that they "are to be taken into
account." Those decisions are left to the
discretion of the Secretary. See S. Rep.
No. 91-552, at 138 (1969) ("The provi-
sion also specifies certain factors which
may be taken into account in these [regu-
latory] guidelines. It is not intended that
only these factors be included in the

guidelines or that, with respect to a par-
ticular situation, any of these factors must
be included in the guidelines, or that any
of the factors which are included by stat-
ute must necessarily be given any more
weight than other factors added by regu-
lations."). As the legislative history makes
clear, the Treasury Department and the
IRS have the authority also to omit factors
in particular factual situations and instead
emphasize certain other factors. The fac-
tors identified and taken into account in
the regulations therefore fall within the
authority conveyed by section 385. In ad-
dition, the fact that the final and temporary
regulations provide for particular weight-
ing of these factors (including treating
certain factors as dispositive in a particu-
lar context) is consistent with the Secre-
tary's discretion to "set forth factors
which are to be taken into account."

Congress enacted section 385 to re-
solve the confusion created by the multi-
factor tests traditionally utilized by courts,
which produced inconsistent and unpre-
dictable results. See S. Rep. No. 91-552,
at 138 (1969). The congressional objec-
tive of providing clarity regarding the
characterization of instruments would be
undermined if the regulations authorized
by section 385 were required to replicate
the flawed multi-factor tests in the case
law that motivated the enactment of sec-
tion 385. Nothing in section 385 requires
a case-by-case approach. The statute does
not specify what level of generality is
required in respect of a "particular factual
situation," and the Treasury Department
and the IRS reasonably interpret this
phrase to include the subset of transac-
tions that take place among highly-related
corporations. Furthermore, as discussed
throughout this Part II.A, the legislative
history indicates that Congress intended to
grant the Secretary broad authority to pro-
vide different rules for distinguishing debt
from equity in different situations or con-
texts. See also S. Rep. No. 91-552, at 138
(discussing the need for debt/equity rules
given "the variety of contexts in which
this problem can arise").

To underscore the regulations' consis-
tency with the reference in section 385(b)
to factors that are to be taken into account
in particular factual situations, the final
and temporary regulations first provide in
§ 1.385-1(b) a general rule that effec-

tively implements the common law fac-
tors. Therefore, whether an interest is
classified as debt or equity ordinarily will
be determined based on common law,
including the factors prescribed under
common law. In the particular factual
situation of a purported debt instrument
issued between members of an expanded
group, § 1.385-2 provides a minimum
standard of documentation that must be
met in order for an instrument to be
treated as debt based on an application
of the common law factors and adjusts
the weighting of certain common law
factors, while § 1.385-3 elevates two
particular common law factors (the lack
of new investment in the operations of
the issuer and relatedness) into determi-
native factors. The regulations' enumer-
ation of these factors to determine the
characteristics of an instrument is en-
tirely consistent with the plain text of
section 385.

Finally, several comments asserted that
proposed § 1.385-3 set forth an inappro-
priate list of factors by exclusively con-
sidering circumstances outside the four
corners of the instrument, such as the
transaction in which the instrument is is-
sued and the use of the funds received in
exchange therefor, without regard to the
characteristics of the instrument itself.

The Treasury Department and the IRS
have concluded that the authority granted
by section 385 is plainly broader than
interpreted by the comments. As noted
above, section 385 authorizes the Secre-
tary to determine which factors must be
taken into account when determining the
nature of an interest in a particular factual
situation. Nothing in the statute requires
the Secretary to consider specific factors
or, conversely, to disregard other factors.
In any event, the factors set forth in the
regulations derive from common law
debt-equity analyses, which have, among
various considerations, often looked be-
yond the characteristics of the instrument.
For instance, Congress identified the re-
latedness of the parties to the transaction
as among the factors that "may" be set
forth under section 385, see section
385(b)(5) ("the relationship between hold-
ings of stock in the corporation and hold-
ings of the interest in question"), and this
factor has been relied upon by numerous
courts in similar factual situations. Like-

wise, the lack of new capital investment
created by an issuance of debt is also a
common law debt-equity factor. See, e.g.,
Talbot Mills v. Comm'r, 146 F.2d 809,
811 (1st Cir. 1944), aff'd sub nom, John
Kelley Co. v. Comm'r, 326 U.S. 521
(1946); Kraft Foods Co. v. Comm'r, 232
F.2d 118, 126-27 (2d Cir. 1956).

#### B. Consideration of costs

Various comments contended that the
Treasury Department and the IRS failed to
consider costs in the proposed regulations,
that the consideration given to the costs
imposed by the regulations was insuffi-
cient, or that the proposed regulations'
analysis did not accurately reflect the
costs of the proposed regulations. One
comment cited the Supreme Court's deci-
sion in Michigan v. EPA, 135 S. Ct. 2699
(2015), as imposing an obligation to con-
sider costs as part of establishing the ap-
propriateness of regulation, claiming that
the Treasury Department and the IRS
failed to meet this obligation in the pro-
posed regulations. Another comment as-
serted that the proposed regulations failed
to comply with Executive Order 12866's
instruction to assess the costs of regula-
tory action.

The Treasury Department and the IRS
disagree with these comments. The final
and temporary regulations are a necessary
and appropriate exercise of the Secre-
tary's authority based on the reasons de-
scribed in Section A of this Part II and the
analysis of the regulations' costs and ben-
efits. The Treasury Department and the
IRS do not agree with comments that the
holding of Michigan v. EPA compels con-
sideration of costs in every instance. In
any event, the Treasury Department and
the IRS analyzed the costs and benefits of
the proposed regulations in a regulatory
impact analysis. This regulatory impact
analysis was conducted consistent with
the proposed regulations' designation as a
"significant regulatory action" under Ex-
ecutive Order 12866. See https://www.
regulations.gov/document?D=IRS-2016-
0014-0001.

The Treasury Department and the IRS
received extensive comments regarding
the costs of the proposed regulations and
the regulatory impact analysis that accom-
panied the proposed regulations. The

Treasury Department and the IRS care-
fully considered those comments in revis-
ing the proposed rules to significantly re-
duce compliance burdens and in developing
the regulatory impact analysis of costs and
benefits that accompanies and supports the
final and temporary regulations. The regu-
latory impact analysis of the final and tem-
porary regulations is consistent with Exec-
utive Order 12866.

As explained in greater detail in Part I
of the Special Analyses, the Treasury De-
partment and the IRS estimate that the
aspects of the regulations that will apply
most broadly (§ 1.385-2) will impact only
6,300 of the roughly 1.6 million C corpo-
rations in the United States (0.4 percent).
The total start-up expenses for these af-
fected taxpayers is estimated to be $224
million in 2016 dollars, with ongoing an-
nual compliance costs estimated to be $56
million in 2016 dollars, or an average of
$8,900 per firm. By comparison, the reg-
ulations will significantly reduce the tax
revenue losses achieved by the avoidance
strategies that these regulations address.
Annualizing over the period from 2017 to
2026, the regulations are estimated to
yield tax revenue of between $461 million
per year (7% discount rate) or $600 mil-
lion per year (3% discount rate) in 2016
dollars. The analysis concludes that the
tax revenues generated from reduced tax
avoidance would be at least 6 to 7 times as
large as the compliance costs. The analy-
sis also explains the additional, non-
quantifiable benefits the regulations will
generate, such as increased tax compli-
ance system-wide, efficiency and growth
benefits, and lower tax administration
costs for the IRS. The analysis supports
the conclusion that the regulations are an
appropriate and effective exercise of the
Treasury Department and the IRS's au-
thority. The Office of Management and
Budget reviewed and approved the analy-
sis. The analysis and its conclusions rebut
the assertions in comments that the Trea-
sury Department and the IRS failed to
consider costs, did not adequately con-
sider costs, or did not accurately estimate
costs.

As set forth in this Part II.B, the Trea-
sury Department and the IRS disagree
with the comment that the proposed reg-
ulations failed to comply with Executive
Order 12866. Moreover, section 10 of Ex-

ecutive Order 12866 clearly states that the
Order "does not create any right or bene-
fit, substantive or procedural, enforceable
at law"; rather, the Order "is intended only
to improve the internal management of the
Federal Government."

##### III. Comments and Changes to § 1.385- 1 - General Provisions

###### A. General approach

####### 1. Regulations Limited to U.S. Borrowers

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

The Treasury Department and the IRS
have determined that the application of
the final and temporary regulations to in-
debtedness issued by foreign corporations
requires further study. Accordingly, the
final and temporary regulations apply only
to EGIs and debt instruments issued by
members of an expanded group that are
domestic corporations (including corpora-
tions treated as domestic corporations for
federal income tax purposes, such as pur-
suant to section 953(d), section 1504(d),
or section 7874(b)), and reserve on the

application to EGIs and debt instruments
issued by foreign corporations. The final
and temporary regulations achieve this re-
sult by creating a new term "covered
member," which is defined as a member
of an expanded group that is a domestic
corporation, and reserves on the inclusion
of foreign corporations.

One comment questioned how the
proposed regulations would apply to
U.S. branches of a foreign issuer. Al-
though it is possible to increase the debt
attributable to a U.S. branch through
issuances of debt by the foreign owner
to a related party, the various require-
ments on allocating liabilities between a
branch and its home office (whether un-
der the Code or a relevant bilateral tax
treaty) raise unique issues. This pream-
ble does not address those issues be-
cause the final and temporary regula-
tions reserve on their application to
foreign issuers, including with respect
to U.S. branches of foreign issuers.

####### 2. Treatment of Consolidated Groups as One Corporation

Proposed § 1.385-1(e) treated mem-
bers of a consolidated group as one cor-
poration for purposes of the regulations
under section 385.

As discussed in Part IV.B.1.b of this
Summary of Comments and Explanation
of Revisions, the final regulations do not
apply the rule in proposed § 1.385-1(e) to
§ 1.385-2. Instead § 1.385-2 provides that
an interest issued by a member of a con-
solidated group and held by another mem-
ber of the same consolidated group is not
within the scope of an applicable interest
as defined in § 1.385-2. As a result, such
an interest is not subject to the documen-
tation rules in § 1.385-2. Sections
1.385-3, 1.385-3T, and 1.385-4T con-
tinue to treat members of a consolidated
group as one corporation. Because the rule
described in proposed § 1.385-1(e) is now
only applicable for purposes of §§ 1.385-3
and 1.385-3T and relates to the treatment of
consolidated groups, the rule is moved to
§ 1.385-4T. See Part VI of this Summary of
Comments and Explanation of Revisions for
a discussion of the comments and revisions
to the rules regarding the application of
§§ 1.385-3 and 1.385-3T to consolidated
groups.

####### B. Definitions

######## 1. Controlled Partnership

One comment requested that the regu-
lations clarify that non-controlled partner-
ships are outside the scope of the regula-
tions. The Treasury Department and the
IRS have determined that proposed
§ 1.385-3 was sufficiently clear that the
partnership-specific provisions only ap-
plied to controlled partnerships and their
partners. Therefore, the regulations do not
contain clarifying language to that effect.
The application of §§ 1.385-3 and
1.385-3T to controlled partnerships is dis-
cussed further in Parts V.H.3 and 4 of this
Summary of Comments and Explanation
of Revisions.

####### a. Determining partners' interests in partnership capital or profits

The proposed regulations defined the
term controlled partnership as a partner-
ship with respect to which at least 80
percent of the interests in partnership cap-
ital or profits are owned, directly or indi-
rectly, by one or more members of an
expanded group.

A comment recommended the adop-
tion of rules for determining whether
members of an expanded group own 80
percent of the capital or profits interests
of a partnership. The determination of
whether a partner's share of partnership
profits or capital is above or below a
threshold is necessary to apply various
provisions of the Code or regulations.
In most cases, neither term is defined
with specificity. See, e.g., sections
163(j)(4)(B)(i) and (j)(6)(D)(ii)(II), 613A
(d)(3)(B), 707(b)(1) and (2), and 708(b)
(1)(B), as well as § 1.731-2(e)(4)(ii). The
Treasury Department and the IRS decline to
provide more specific rules regarding the
determination of profits or capital interests
in the context of identifying a controlled
partnership for purposes of the section 385
regulations.

The comment also specifically recom-
mended that, for purposes of measuring
partners' profits interests, consideration be
given to the use of a reasonable estimate of
the partners' aggregate profit shares over
time in order to prevent a partnership from
flipping in and out of controlled partnership

status (for example, when profit allocations
are based on distribution waterfalls, which
shift over time). This recommendation,
made in the context of identifying controlled
partnerships, echoed other comments re-
garding the determination of a partner's
share of profits for purposes of applying the
aggregate approach to partnerships under
proposed § 1.385-3. The Treasury Depart-
ment and the IRS recognize that a partner's
share of partnership profits may not always
be knowable with certainty, regardless of
the purpose for making such determination.
However, such determination must always
be made in a reasonable manner. In some
cases, that reasonable determination will re-
quire a partner or the partnership to make
estimates regarding a partnership's profit-
ability over some period of time.

The comment also recommended that
the definition of a controlled partnership
should not take percentages of capital in-
terests into account, but should instead
focus solely on a metric based on cumu-
lative shares of profits. The Treasury De-
partment and the IRS have determined
that such a limitation would be inappro-
priate because in certain circumstances a
partner's share of capital may be a good
metric for identifying control.

As an alternative, the comment recom-
mended that a shift in capital that is small
or transitory be disregarded for purposes
of the controlled partnership definition.
The Treasury Department and the IRS
have determined that such a rule would be
difficult to administer because it would
result in an additional deemed fiction -
that is, a partner's share of capital for this
purpose could be different from the part-
ner's actual share. The test for control
looks to shares of profits or capital, not
profits and capital, and because the thresh-
old is 80 percent, small or transitory shifts
in capital that would result in a partner-
ship becoming or ceasing to be a con-
trolled partnership should happen infre-
quently.

### b. Indirect ownership

A comment requested confirmation
that determining the status of a partner-
ship as a controlled partnership is a sepa-
rate and independent inquiry from deter-
mining the status of a corporation as an
expanded group member. The comment

suggested that it was unclear whether, in
applying the section 318(a) attribution
rules to determine "partnership interest"
ownership, such partnership interests are
then treated as actually owned for pur-
poses of then applying the section 318(a)
attribution rules to determine "stock"
ownership. The final regulations clarify
that determining the status of a partner-
ship as a controlled partnership is a sepa-
rate and independent inquiry from deter-
mining the status of a corporation as an
expanded group member.

### c. Unincorporated organizations

One comment requested that the regu-
lations not treat certain unincorporated or-
ganizations described in § 1.761-2 as con-
trolled partnerships. The final regulations
clarify that an unincorporated organiza-
tion described in § 1.761-2 that elects to
be excluded from all of subchapter K is
not a controlled partnership. Thus, the
Treasury Department and the IRS antici-
pate that such unincorporated organiza-
tions will apply the rules of section 385 in
a manner consistent with their pure aggre-
gate treatment.

#### d. Treatment as a publicly traded partnership

A comment expressed concern that a
debt instrument issued by a securitization
vehicle organized as a partnership that is
treated as stock in the expanded group part-
ner under the proposed regulations could be
treated as a partnership interest within the
meaning of § 1.7704-1(a)(2)(i)(B) because
a "partnership interest" for this purpose can
include certain derivative and other indirect
contract rights and interests with respect to a
partnership. The comment stated that many
securitization transactions require an un-
qualified opinion of tax counsel that the
entity is not a publicly traded partnership
treated as a corporation for federal income
tax purposes, and that the recharacterization
rules create uncertainty in this regard.

Section 1.385-2 of the final regulations
does not explicitly apply to a debt instru-
ment issued by a controlled partnership.
While such a debt instrument may be sub-
ject to the anti-avoidance rule in § 1.385-
2(f), the concern raised in the comment
would only arise under the final regula-

tions if the debt instrument is issued with
a principal purpose of avoiding the appli-
cation of § 1.385-2.

Similarly, § 1.385-3T(f)(4) provides
that a debt instrument issued by a con-
trolled partnership is not recharacterized
as stock. Instead, as described in more
detail in Part V.H.4 of this Summary of
Comments and Explanation of Revisions,
the holder of a debt instrument (holder-in-
form) all or a portion of which otherwise
would be treated as stock is deemed to
transfer such debt instrument to the part-
ner or partners in the controlled partner-
ship in exchange for stock in the partner
or partners. While the deemed partner
stock that the holder-in-form of the debt
instrument would receive in exchange for
the deemed transfer of all or a portion of
the debt instrument to the partner or part-
ners in the controlled partnership may be a
non-debt financial instrument or contract
the value of which is determined in whole
or in part by reference to the partnership
that issued the debt instrument pursuant to
§ 1.7704-1(a)(2), the qualified dealer debt
instrument exception in the final and tem-
porary regulations is expected to address
this issue. That exception applies to make
a debt instrument acquired by a dealer in
securities not a covered debt instrument,
and therefore, not subject to the rules that
could result in deemed partner stock.

### 2. Expanded Group

### a. General framework

The proposed regulations defined the
term expanded group by reference to the
term "affiliated group" in section 1504(a),
with several modifications. Section 1504
(a) defines an affiliated group for various
purposes under the Code, including for
purposes of defining an affiliated group of
corporations that are permitted to file a
consolidated return. Comments expressed
concern that the proposed regulations'
modifications to the definition in section
1504(a) for purposes of defining an ex-
panded group would treat certain corpora-
tions as members of the same expanded
group in situations where the corporations
are not "highly related," which would not
be consistent with the policy concerns that
the regulations are intended to address. In
particular, many comments described the

proposed regulations' adoption of the at-
tribution rules of sections 304(c)(3) and
318 in the definition of an expanded group
as overly broad. Comments also requested
that certain corporations not be included
in an expanded group because their spe-
cial federal tax status made their treatment
as an expanded group member less rele-
vant to the policy concerns of the pro-
posed regulations.

Many comments proposed changes to
the definition of an expanded group to
better align that definition with the regu-
lations' policy concerns, with the majority
of the comments recommending changes
that would retain section 1504 as the start-
ing point for the definition, including ad-
justments to the attribution rules of sec-
tions 304(c)(3) and 318. However, two
comments suggested that section 1563
would be a preferable starting point. Sec-
tion 1563 defines a "controlled group of
corporations" for various purposes under
the Code. One comment suggested that, to
the extent the regulations treat corpora-
tions that are commonly controlled by
non-corporate persons (for example, indi-
viduals, family members, or partnerships)
as an expanded group (brother-sister
groups), section 1563, with certain modi-
fications, would be a better starting point
than section 1504. Another comment as-
serted that the attribution rules in section
1563 would be more effective at including
in an expanded group only the most
highly-related entities. Other comments
recommended that brother-sister groups
should not be treated as a single expanded
group in any case.

As described in more detail in Sections
B.2.b through B.2.g of this Part III, the
final regulations continue to define the
term expanded group using concepts sim-
ilar to those used to define the term "af-
filiated group" in section 1504(a). How-
ever, changes have been made and new
examples added to address concerns ex-
pressed in comments regarding both the
asserted overbreadth with respect to the
types of corporations included in the pro-
posed definition of an expanded group and
with respect to the indirect ownership
rules under the proposed regulations.
Changes also have been made in response
to comments to clarify other situations in
which entities inadvertently were not
treated as members of an expanded group

under the proposed regulations but where
the policy goals of the regulations clearly
are implicated.

Additionally, the modifications that
were made to the section 1504-based def-
inition of an expanded group in response
to the majority of comments achieve the
same results that the two comments pro-
posing a section 1563 approach indicated
would be achieved through the use of a
section 1563 starting point. Accordingly,
the Treasury Department and the IRS de-
cline to adopt the recommendation to use
section 1563 concepts in defining an ex-
panded group. The Treasury Department
and the IRS have determined that the
modifications discussed in Sections B.2.a
through g of this Part III more precisely
define an expanded group to address those
situations in which highly-related corpo-
rations implicate the policy goals of the
regulations.

### b. Exclusion of certain entities

In defining an expanded group, the pro-
posed regulations included several modi-
fications to the definition of an affiliated
group under section 1504(a). Unlike an
affiliated group, an expanded group was
defined to include corporations that, under
section 1504(b), would not be included
within an affiliated group, including for-
eign corporations, tax-exempt corpora-
tions, S corporations, and RICs and RE-
ITs. In addition, indirect stock ownership
was taken into account for purposes of the
stock ownership requirement of section
1504(a)(1)(B)(i). Finally, the proposed
regulations also modified the definition of
affiliated group to treat a corporation as a
member of an expanded group if 80 per-
cent of the vote or value is owned by
expanded group members (a disjunctive
test) rather than 80 percent of the vote and
value (a conjunctive test), as required un-
der section 1504(a).

Numerous comments requested ex-
clusions from the definition of an ex-
panded group for entities described in
sections 1504(b)(6) (RICs and REITs)
and 1504(b)(8) (S corporations). Com-
ments noted that RICs, REITs, and S
corporations generally are not subject to
corporate level taxation either because
of the flow-through treatment accorded
under the Code (in the case of an S

corporation generally) or because of the
dividends paid deduction that can have a
similar effect (in the case of a RIC or
REIT). In that respect, comments as-
serted that RICs, REITs, and S corpora-
tions are similar to non-controlled
partnerships, which the proposed regu-
lations would not have included in an
expanded group. Comments also noted
that the recharacterization of an instru-
ment issued by an S corporation, REIT,
or RIC could jeopardize the entity's fed-
eral tax status. Consequently, comments
suggested that the regulations exclude S
corporations, REITs, and RICs from any
expanded group.

In response to these comments, the fi-
nal regulations exempt S corporations
from being expanded group members. The
final regulations also exempt RICs or
REITs from being expanded group mem-
bers unless the RIC or REIT is controlled
by members of the expanded group. The
Treasury Department and the IRS have
determined that an S corporation, RIC, or
REIT that otherwise would be the parent
of an expanded group is generally analo-
gous to a non-controlled partnership. Un-
der both the proposed and the final regu-
lations, a non-controlled partnership that
would, if it were a corporation, be the
parent of an expanded group is excluded
from the expanded group because, by def-
inition, the partnership is not a corporation
and only corporations can be members of
an expanded group. Consistent with the
partnership's status generally as an aggre-
gate of its owners, the partnership should
not be a member of the expanded group if
its partners would not be members. S cor-
porations, RICs, and REITs have similar
flow-through characteristics as partner-
ships and therefore also should not be
members of the expanded group, despite
otherwise being corporations that could
own stock of members of an expanded
group.

However, the final regulations continue
to treat a RIC or REIT that is controlled
by members of the expanded group as a
member of the expanded group. Similar to
a controlled partnership, a controlled RIC
or REIT should not be able to break affil-
iation with respect to an otherwise exist-
ing expanded group. Unlike partnerships,
RICs and REITs are corporations and in
certain limited cases are subject to federal

income tax at the entity level. Therefore,
the final regulations continue to treat con-
trolled RICs and REITs as members of an
expanded group, rather than as aggregates
of their owners. Because an S corporation
cannot be owned by persons other than
U.S. resident individuals, certain trusts,
and certain exempt organizations, an S
corporation cannot be controlled by mem-
bers of an expanded group in a manner
that implicates the policies underlying the
final and temporary regulations. S corpo-
rations are therefore excluded from the
definition of an expanded group member
for all purposes of the final and temporary
regulations.

Several comments specifically re-
quested exceptions for corporations ex-
empt from taxation under section 501 and
insurance companies subject to taxation
under section 801. The final regulations
do not adopt the recommendation to ex-
clude these corporations from the defini-
tion of an expanded group. Although gen-
erally exempt from taxation, section 501
corporations may still be subject to tax on
unrelated business income and therefore
still present concerns relating to related-
party indebtedness. In addition, while sec-
tion 501 corporations are themselves gen-
erally tax exempt, they may own taxable
C corporation subsidiaries. Even though S
corporations and non-controlled REITs
and RICs may also own taxable C corpo-
ration subsidiaries, in those situations in-
come of the S corporation, REIT, or RIC
is generally included in the income of
their owners, whereas unrelated business
taxable income of a corporation that is
exempt from taxation under section 501 is
not includible in another taxpayer's in-
come. With respect to insurance compa-
nies subject to taxation under section 801,
like other corporations, they may also use
related-party indebtedness to reduce their
taxable income. However, as discussed in
Part V.G.2 of this Summary of Comments
and Explanation of Revisions, the final
and temporary regulations exclude from
the application of § 1.385-3 debt instru-
ments issued by certain regulated insur-
ance companies, which generally include
insurance companies subject to taxation
under section 801.

Finally, one comment requested "spe-
cific evidence-based findings" justifying
the inclusion of any entity described in

section 1504(b) in an expanded group,
while another comment asserted that de-
fining a new category of related parties as
an expanded group, rather than relying on
a statutory definition such as an "affiliated
group," was an inappropriate use of the
regulatory process. Section 385 authorizes
regulations that affect the treatment of
certain interests in corporations as stock
or indebtedness. However, the regulations
limit their application to expanded group
members and are premised on a broad
definition of expanded group that gener-
ally applies to all types of corporations
that are closely related. In defining an
expanded group, the Treasury Department
and the IRS are not constrained to include
only "includible corporations" for pur-
poses of determining an affiliated group of
corporations under section 1504(a) or to
rely on other predefined groups. The ex-
clusion of specific types of corporations
under section 1504(b) is intended to en-
sure that only certain corporations are per-
mitted to benefit from consolidation for
U.S. federal income tax purposes. An ex-
clusion of a certain type of corporation
from the expanded group definition, on
the other hand, results from a determina-
tion by the Treasury Department and the
IRS that indebtedness between such entity
and its affiliates does not sufficiently im-
plicate the policy concerns of section 385
to subject the corporation to the final and
temporary regulations.

### c. Indirect stock ownership

To determine indirect stock ownership
for purposes of defining an expanded
group, the proposed regulations applied
the constructive ownership rules of sec-
tion 304(c)(3), which in turn applies
section 318(a) subject to certain modifica-
tions. This Part III.B.2.c discusses com-
ments related to indirect ownership and the
application of section 318(a).

#### i. Indirect ownership under section 1504(a)(1)(B)(ii)

For purposes of defining an expanded
group, proposed § 1.385-1(b)(3)(i)(B)
modified section 1504(a)(1)(B)(i) by pro-
viding that a common parent must own 80
percent of the vote or value of at least one
other includible corporation (without re-

gard to section 1504(b)) "directly or indi-
rectly" rather than "directly." The pro-
posed regulations did not include a similar
modification to section 1504(a)(1)(B)(ii)
(relating to the required ownership in in-
cludible corporations (without regard to
section 1504(b)) other than the common
parent); specifically, the regulations re-
quired that 80 percent of the vote or value
of each includible corporation be owned
"directly" by one or more includible cor-
porations other than the common parent.
Several comments recommended that, for
purposes of defining an expanded group,
section 1504(b)(1)(B)(ii) also be modified
by substituting "directly or indirectly" for
"directly."

In response to comments, the final reg-
ulations extend the "directly or indirectly"
language to both the common-parent test
of section 1504(a)(1)(B)(i) and the each-
includible-corporation test of section
1504(a)(1)(B)(ii). Accordingly, the indi-
rect ownership rules of section 318, as
modified by § 1.385-1(c)(4)(iii) (dis-
cussed in detail in Section B.2.c.ii of this
Part III) apply for purposes of both tests in
section 1504(a)(1)(B). However, to make
clear that the ownership tests of section
1504(a)(1)(B) apply to all corporations
that can be members of an expanded
group (as opposed to only includible cor-
porations within the meaning of section
1504(b)), the final regulations provide the
modified section 1504(a)(1)(B) tests in their
entirety rather than by cross-reference to
section 1504(a)(1)(B). Therefore, federal
tax principles that are applicable in deter-
mining whether a corporation is a member
of an affiliated group under section
1504(a)(1) and (a)(2) are generally applica-
ble in determining whether a corporation is
a member of an expanded group.

#### ii. Definition of indirect ownership

As noted in Section B.2.c of this Part
III, the proposed regulations cross refer-
enced the rules of section 304(c)(3),
which themselves cross reference section
318(a) (with certain modifications), to de-
fine indirect ownership. In order to clarify
how to determine indirect ownership for
purposes of determining an expanded
group, the final and temporary regulations
cross reference section 318 and the regula-
tions thereunder with modifications, rather

than cross reference section 304(c)(3). The
regulations under section 318(a) and, with
respect to certain options, the regulations
under section 1504, apply when determin-
ing a shareholder's indirect ownership for
purposes of the final regulations.

One comment suggested that the regu-
lations should indicate that indirect stock
ownership is determined by "applying the
constructive ownership rules of section
304(c)(3)," given that section 304(c)(3)
refers to constructive ownership rather
than indirect stock ownership. The final
regulations do not adopt this comment and
instead define indirect stock ownership by
reference to the "constructive ownership
rules" of section 318, with appropriate
modifications.

### iii. Stock owned through partnerships

Under section 318(a)(2)(A), stock
owned by a partnership is considered
owned "proportionately" by its partners.
Comments requested guidance on how
"proportionately" should be determined
under section 318(a)(2)(A) for purposes
of determining stock ownership under
the proposed regulations. Comments
noted that, in the partnership context,
determining the value of a partnership
interest is not always straightforward,
which makes it difficult to determine
partners' proportionate interests in a
partnership. To address these issues,
comments requested safe harbors, in-
cluding a safe harbor based on the liq-
uidation value of a partner's interest.

The final regulations do not provide
guidance on how "proportionately" should
be determined under section 318(a)(2)
(A) for purposes of determining stock
ownership. The proper interpretation of
"proportionately" in the context of section
318(a)(2)(A) is relevant to many provi-
sions. See sections 304(c)(3) (providing
constructive ownership rules for purposes
of determining control), 355(e)(4)(C)(ii)
(providing attribution rules applicable on a
distribution of stock and securities of a con-
trolled corporation), and 958(b) (regarding
constructive ownership of stock for many
international provisions). Thus, the Treasury
Department and the IRS have determined
that providing guidance on this issue is be-
yond the scope of these regulations because

these regulations do not require a different
application of section 318(a)(2)(A).

### iv. Hook equity

A comment requested guidance regard-
ing the application of the rules of section
318 to ownership structures involving
hook equity. The comment indicated that
the proposed regulations would increase
the circumstances under which hook eq-
uity arises, increasing the need for guid-
ance on the treatment of hook equity un-
der section 318 under current law.

The Treasury Department and the IRS
have concluded that the constructive own-
ership rules of section 318 already address
the effect of hook equity. In general, un-
der section 318(a)(2), the equity in the
entity owning the hook equity can be at-
tributed, in whole or in part, to the non-
hook equity holder. Under section
318(a)(5)(A), stock constructively owned
by a person by reason of section 318(a)(2)
is considered as actually owned by such
person. Section 318(a)(5)(A) permits a re-
cursive application of section 318(a)(2),
pursuant to which a non-hook equity
holder is treated as owning a percentage
of the hook equity owned. See Examples 3
and 4 of § 1.385-1(c)(4)(vii).

### v. Downward attribution and brother- sister groups

Comments recommended that, for
purposes of the expanded group defini-
tion, the "downward attribution" rule of
section 318(a)(3)(A) be modified to pre-
vent taxpayers that are not highly-
related from being treated as members
of the same expanded group. Under sec-
tion 318(a)(3)(A), all of the stock owned
by a partner is treated as owned by the
partnership, regardless of the partner's
ownership interest in the partnership.
Thus, for example, assume that USS1
owns a 1 percent interest in PRS, a
partnership. Further assume that USS1
wholly owns S1, which wholly owns S2.
PRS wholly owns S3. S1, S2, and S3 are
all corporations. Pursuant to section
318(a)(3)(A), PRS is treated as wholly
owning S1 and S2 (after application of
section 318(a)(2)(A)). Under section
318(a)(3)(C), S3 is treated as owning S1
and S2. As a result, S1, S2, and S3

would comprise an expanded group un-
der the proposed regulations despite
minimal common ownership between
S3 and the other corporations.

To address fact patterns similar to the
example above, comments recommended
that the section 318(a)(3)(A) downward
attribution rule apply only from partners
with a specific threshold ownership inter-
est in a partnership, such as partners that
own 50 percent or 80 percent of the
interests in a partnership. Other com-
ments suggested different solutions to
the same problem, including limiting
section 318(a)(3)(A) attribution to situ-

ations in which related parties owned
80 percent or more of the interests
in a partnership, or modifying section
318(a)(3)(A) attribution for these pur-
poses such that a partnership is treated
as owning only a proportionate amount
of any stock owned by a partner. As an
alternative, one comment recommended
that the regulations include an override
rule, pursuant to which two entities will
not be treated as members of the same
expanded group unless one of the enti-
ties has a direct or indirect ownership
interest of 80 percent or more in the
other entity, while applying proportion-
ality principles under this override rule.
One comment specifically requested that
the downward attribution rule of section
318(a)(3)(A) be limited for purposes of
applying the threshold rule of proposed
§ 1.385-3(c)(2).

Comments also requested similar lim-
its on downward attribution to entities
other than partnerships. Specifically,
comments recommended that section 318(a)
(3) in general should apply only when the
interest holder owns 80 percent or more of
the entity, or that section 318(a)(3)(C) be
modified to provide that the corporation is
attributed only a proportionate amount of
the stock owned by its shareholder. One
comment asserted, without explanation,
that an expanded group should be deter-
mined entirely without reference to sec-
tion 318(a)(3) or similar rules.

The principal consequence of requiring
downward attribution for purposes of de-
termining indirect ownership under the
proposed regulations is that an expanded
group included so-called "brother-sister"
groups of affiliated corporations that are
commonly controlled by non-corporate

owners. Similarly, the principal conse-
quence of applying section 318(a)(1) (in
connection with section 318(a)(3)), which
attributes stock owned by individual
members of a family, would also be the
treatment of brother-sister groups with
non-corporate owners as part of an ex-
panded group. The Treasury Department
and the IRS continue to study the issue of
brother-sister groups, including the impli-
cations of applying the final and tempo-
rary regulations to groups with identical
members but different expanded group
member corporate parents. As a result, the
final regulations reserve on the application
of section 318(a)(1) and (a)(3) for pur-
poses of determining indirect ownership
pending further study.

### vi. Option attribution

A comment requested that, for pur-
poses of determining an expanded group,
the option attribution rule of section
318(a)(4) should not apply. The comment
suggested that the anti-abuse rule should
instead expressly apply to the use of op-
tions to avoid the expanded group defini-
tion. The comment asserted that it would
not be appropriate, for example, to treat a
50-50 joint venture between unrelated
corporations as an expanded group mem-
ber of one or both corporations because of
the existence of buy-sell rights that are
common in many joint ventures.

The final regulations limit the applica-
tion of the option attribution rule of sec-
tion 318(a)(4) in two respects. First, the
rule only applies to options that are de-
scribed in § 1.1504-4(d), which can in-
clude: call or put options, warrants, con-
vertible obligations, redemption agree-
ments, or any instrument (other than
stock) that provides for the right to issue,
redeem, or transfer stock, and cash settle-
ment options, phantom stock, stock appre-
ciation rights, or any other similar inter-
ests. Second, the rule only applies to the
extent the options are reasonably certain
to be exercised based on all the facts and
circumstances as described in § 1.1504-
4(g). By limiting the application of the
option attribution rule in this manner, the
Treasury Department and the IRS intend
that ownership of stock will be attributed
to an option holder only in the limited

circumstances in which the option is anal-
ogous to actual stock ownership.

The final regulations also provide a
special rule for indirect ownership
through options for certain members of
consolidated groups. Under this special
rule, in applying section 318(a)(4) to an
option issued by a member of a consoli-
dated group (other than the common par-
ent of the consolidated group), section
318(a)(4) only applies to the option if the
option is treated as stock or as exercised
under § 1.1504-4(b) for purposes of de-
termining whether a corporation is a
member of an affiliated group. This rule is
intended to address cases where, because
of the reasonable anticipation requirement
of § 1.1504-4(b)(2)(i)(A), members of a
consolidated group could theoretically be
treated as members of different expanded
groups.

### vii. Knowledge of constructive ownership

A comment indicated that, under the
proposed regulations' attribution rules, it
would be difficult in certain cases to de-
termine whether entities are treated as
members of the same expanded group.
The comment requested that a person
should be treated as owning stock by rea-
son of attribution solely to the extent such
person has actual knowledge of a relation-
ship or should have reasonably known of
such relationship after due investigation.
The comment did not specify the relation-
ship with respect to which the proposed
knowledge qualifier would apply (for ex-
ample, whether the entities would need to
have actual knowledge of their status as
members of an expanded group, or if they
would only require actual knowledge of
the applicable relationship described in
section 318 (as modified by section
304(c)(3)).

The final regulations do not adopt a
knowledge qualifier with respect to the
application of the attribution rules. The
attribution rules in the final regulations are
similar to attribution rules that are appli-
cable under other Code sections, which
are based on objective metrics rather than
a subjective determination that would be
difficult for the IRS and taxpayers to ad-
minister. Furthermore, in the case of
highly-related groups, the requisite infor-

mation needed to determine constructive
ownership should be readily available to
group members. Therefore, the Treasury
Department and the IRS do not expect
there will be situations in which taxpayers
would be unable to determine constructive
ownership after reasonable investigation
and legal analysis.

#### d. Time for determining member status

Comments requested that the regula-
tions clarify when a corporation's status
as a member of an expanded group is
determined for purposes of § 1.385-3.
Several comments recommended that the
regulations adopt a "snapshot" approach,
under which a corporation's membership
in an expanded group is tested immedi-
ately before a transaction that is subject to
the regulations. In the alternative, one
comment suggested that, for purposes of
determining whether a corporation has be-
come a member of an expanded group at
the time of a distribution or acquisition, its
membership should be determined at the
close of the transaction or series of related
transactions that include the distribution
or acquisition. For example, assume FP, a
foreign corporation, owns a minority eq-
uity interest in USS1, a domestic corpo-
ration, with an unrelated party owning the
remainder of USS1's stock. USS1 issues a
note to FP to redeem FP's stock in USS1.
Pursuant to the same plan, FP purchases
100 percent of USS1's stock from the
unrelated party. If this comment were ad-
opted, FP and USS1 would be treated as
members of the same expanded group at
the time of the USS1 redemption because
at the close of a series of transactions, FP
and USS1 are members of the same ex-
panded group. Accordingly, the USS1
note would be subject to recharacteriza-
tion under § 1.385-3.

The Treasury Department and the IRS
have determined that a snapshot approach
to determining expanded group status is
more administrable and results in more
consistent outcomes than determining ex-
panded group membership after the trans-
action and a series of related transactions.
Accordingly, the final regulations provide
that the determination of whether a corpo-
ration is a member of an expanded group
at the time of a distribution or acquisition
described in § 1.385-3(b)(2) or (b)(3)(ii)

is made immediately before such distribu-
tion or acquisition.

e. Exceptions for certain stock holdings

i. Voting rights held by investment
advisors

A comment recommended that, for
purposes of the expanded group defini-
tion, any vote held by an investment ad-
visor, or an entity related to the invest-
ment advisor, should be ignored. The
comment indicated that private invest-
ment funds are typically structured so that
the fund's investment adviser, or a related
entity, owns the voting interests in the
investment fund (which may be taxable as
a corporation for federal income tax pur-
poses), while investors own non-voting
interests in the fund that represent most of
the fund's value. As a result, groups of
investment funds managed by the same
investment manager may be part of an
expanded group because a common in-
vestment adviser, or a related entity, con-
trols all of the voting interests in the invest-
ment funds. Furthermore, the comment
noted that because an investment advisor
generally owes separate duties to its invest-
ment funds, it does not enter into transac-
tions to shift tax obligations from one fund
to another, in contrast to a typical corporate
structure.

The final regulations do not adopt this
recommendation. The Treasury Depart-
ment and the IRS disagree that any fidu-
ciary duty owed by an investment advisor
to its funds places meaningful limits on
the ability for such funds to transact with
each other through loans. To the extent
that an investment advisor and its invest-
ment funds constitute an expanded group,
it does not follow that intercompany trans-
actions among such parties that give rise
to tax benefits for one or more of them
would be violative of fiduciary duties. In
addition, unlike certain companies subject
to regulation and oversight, see Part V.G.1
and 2 of this Summary of Comments and
Explanation of Revisions, these funds are
not subject to capital or leverage require-
ments that restrict their ability to issue
debt. Without such restrictions, invest-
ment advisors that control investment
funds may cause the funds to engage in

transactions otherwise subject to the final
and temporary regulations.

##### ii. Interests required to be held by law

A comment requested that, for pur-
poses of determining membership in an
expanded group, stock ownership should
be disregarded to the extent that the stock
is required to be held by law. The com-
ment offered as an example risk retention
rules applicable to asset-backed securities,
which generally require sponsors to retain
either five percent of the most subordinate
tranche of a securitization vehicle or to
retain a portion of each tranche of the
securitization vehicle's securities.

The Treasury Department and the IRS
decline to adopt this recommendation for
purposes of defining an expanded group
because the expanded group definition is
already limited to corporations with a high
degree of relatedness. However, as dis-
cussed in Part V.F.5 of this Summary of
Comments and Explanation of Revisions,
the final and temporary regulations adopt
certain recommended changes to limit the
application of § 1.385-3 in certain secu-
ritization transactions.

###### f. Investment blockers

The preamble to the proposed regula-
tions requested comments on whether cer-
tain debt instruments used by investment
partnerships, including indebtedness is-
sued by certain "blocker" entities, impli-
cate similar policy concerns as those mo-
tivating the proposed regulations, such
that the scope of the proposed regulations
should be broadened. Several comments
recommended that the scope of the pro-
posed regulations should not be broad-
ened to apply to such transactions (by, for
example, treating a partnership that owns
80 percent or greater of the stock of a
blocker corporation as an expanded group
member). The final and temporary regula-
tions do not adopt special rules for debt
instruments used by investment partner-
ships, including indebtedness issued by
certain "blocker" entities. The Treasury
Department and the IRS continue to study
these structures and these transactions in
the context of the section 385 regulations.

g. Overlapping expanded groups

One comment requested clarification
that, although a corporation may be a
member of multiple expanded groups, any
particular expanded group can have only
one common parent, such that having a
common expanded group member does
not cause overlapping expanded groups to
be treated as a single expanded group. For
example, the comment requested clarifi-
cation that if USS1, a domestic corpora-
tion, owned 80% of the value of X, a
corporation, and USS2, also a corporation,
owned 80% of the vote of X, USS1 and
USS2 would not be treated as members of
the same expanded group by virtue of
being common parents with respect to X.

The Treasury Department and the IRS
agree that, while a corporation can be a
member of more than one expanded group
(overlapping expanded groups), an ex-
panded group can have only a single com-
mon parent (an expanded group parent).
The final regulations add an example to
clarify that the expanded group parents of
overlapping expanded groups are not
themselves members of the same ex-
panded group. See § 1.385-1(c)(4)(vii)
Example 1.

#### C. Deemed exchange rule

Under the proposed regulations, the re-
characterization of an interest that was
treated as debt when issued and then later
characterized under the proposed regula-
tions as stock gave rise to a deemed ex-
change of that interest for stock. Com-
ments requested further guidance to
address the tax implications of the deemed
exchange of a debt instrument for stock
under the proposed regulations. Com-
ments requested clarification regarding
the extent to which gain or loss would be
recognized on the deemed exchange, as
well as the treatment of any gain or loss
recognized.

Comments also requested clarity on the
treatment of the deemed exchange when
an interest previously treated as stock un-
der the regulations ceases to be between
two members of an expanded group and,
as a result, is recharacterized as indebted-
ness. A number of comments requested
that the regulations minimize the collat-
eral consequences when an interest treated

as equity under the regulations leaves the
group, and urged that the consequences be
similar to those occurring when an interest
originally treated as debt is recharacter-
ized as stock. Of particular concern was
the treatment of accrued but unpaid inter-
est; comments asked for clarification of
the treatment of such amounts as part of
the redemption price, noting that such
treatment should be consistent with the
original issue discount rules. One com-
ment requested confirmation that the
deemed exchange that occurs when an
issuer or holder leaves the expanded
group should be treated as a section
302(a) redemption with sale or exchange
treatment.

In addition, comments requested fur-
ther guidance on the treatment of tax at-
tributes of an interest following the
deemed exchange, including clarification
of the treatment of foreign exchange gain
or loss on qualified stated interest (QSI)
and of the continued deductibility of QSI.
Comments asked that the regulations ad-
dress the various consequences of repay-
ment of indebtedness that is treated as
stock, including for example the effects on
the basis of the stock upon redemption.

Comments also requested that the reg-
ulations clarify that the deemed exchange
rule applies notwithstanding section
108(e)(8), which treats the satisfaction of
indebtedness with a payment of corporate
stock as a payment of an amount of
money equal to the fair market value of
the stock for purposes of determining the
income from discharge of indebtedness.

The final regulations address these
comments by adding a sentence to clarify
that the rule that excludes QSI from the
computation that takes place pursuant to
the exchange does not affect the rules that
otherwise apply to the debt instrument or
EGI before the date of the deemed ex-
change. Thus, for example, the regulations
do not affect the issuer's deduction of
unpaid QSI that accrued before the date of
the deemed exchange, provided that such
interest would otherwise be deductible.
The final regulations also clarify that the
rule that treats a holder as realizing an
amount equal to the holder's adjusted ba-
sis in a debt instrument or EGI that is
deemed to be exchanged for stock, as well
as the rule that treats an issuer as retiring
the debt instrument or EGI for an amount

equal to its adjusted issue price as of the
date of the deemed exchange, apply for all
federal tax purposes.

A new paragraph is added to the final
regulations to specifically provide that,
when an issuer of a debt instrument or an
EGI treated as a debt instrument is treated
as retiring all of or a portion of the debt
instrument or EGI in exchange for stock,
the stock is treated as having a fair market
value equal to the adjusted issue price of
the debt instrument or EGI as of the date
of the deemed exchange for purposes of
section 108(e)(8). This clarification also
responds to the treatment of foreign ex-
change gain or loss, which generally fol-
lows the realization rules on indebtedness.

The final regulations do not otherwise
change the rules in the proposed regula-
tions that address the treatment of a
deemed exchange. In particular, the regu-
lations treat a debt instrument recharacter-
ized as equity under § 1.385-3 that leaves
an expanded group as the issuance of a
new debt instrument rather than reinstat-
ing the original debt instrument. In the
case of an EGI recharacterized as equity
under § 1.385-2 that subsequently leaves
the expanded group, federal tax principles
apply to determine whether the interest is
treated as a debt instrument and, if so, a
new debt instrument is deemed exchanged
for the EGI before it leaves the expanded
group. Treating a debt instrument as
newly issued in this context matches the
treatment of an intercompany obligation
that leaves a consolidated group in
§ 1.1502-13(g)(3)(ii)(A). The final and
temporary regulations provide no addi-
tional rules because there are detailed
rules in sections 1273 and 1274 that de-
scribe how to determine issue price when
a debt instrument is issued for stock.

The final regulations include a rule that
coordinates § 1.385-1(d) with the modi-
fied approach in the temporary regulations
for controlled partnerships in § 1.385-
3T(f) and the modified approach in the
final and temporary regulations for disre-
garded entities in §§ 1.385-2(e)(4) and
1.385-3T(d)(4). The temporary regula-
tions addressing partnerships in § 1.385-
3T(f)(4) provide that a debt instrument
that is issued by a partnership that be-
comes a deemed transferred receivable, in
whole or in part, is deemed to be ex-
changed by the holder for deemed partner

stock. See Part V.H.4 of this Summary of
Comments and Explanation of Revisions.
The final and temporary regulations ad-
dressing disregarded entities in §§ 1.385-
2(e)(4) and 1.385-3T(d)(4) provide that
an EGI or debt instrument that is issued by
a disregarded entity is deemed to be ex-
changed for stock of the regarded owner.
See Parts IV.A.4 and V.H.5 of this Sum-
mary of Comments and Explanation of
Revisions.

#### D. Payments made on bifurcated instruments

Proposed § 1.385-1(d) contained a
general bifurcation rule that permitted the
Commissioner to treat certain debt instru-
ments as in part indebtedness and in part
stock (that is, to "bifurcate" the interest).
Bifurcation of an interest could occur if an
analysis of the relevant facts and circum-
stances under general federal tax princi-
ples resulted in a determination that the
interest should be bifurcated as of its is-
suance into part stock and part indebted-
ness for federal tax purposes.

The Treasury Department and the IRS
received many comments requesting addi-
tional guidance concerning how the por-
tion of a bifurcated interest treated as
stock would be determined, and how pay-
ments on such bifurcated interest would
be treated for federal tax purposes. As
noted in Part III of the Background, the
final regulations do not contain a general
bifurcation rule. The Treasury Department
and the IRS continue to study the com-
ments received. See the discussion regard-
ing the treatment of payments with respect
to debt instruments that are bifurcated
pursuant to § 1.385-3 in Part V.B.3 of this
Summary of Comments and Explanation
of Revisions.

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

#### A. In general

The Treasury Department and the IRS
received a significant number of com-
ments on the rules of proposed § 1.385-2
requiring preparation and maintenance of
certain documentation with respect to an
expanded group interest (EGI). As noted

in Part II of the Background, proposed
§ 1.385-2 prescribed the nature of the
minimum documentation necessary to
substantiate the presence of four factors
that are essential to the treatment of an
EGI as indebtedness for federal tax pur-
poses. The four factors are: (1) the issuer's
binding obligation to pay a sum certain;
(2) the holder's rights to enforce payment;
(3) a reasonable expectation of repay-
ment; and (4) a course of conduct that is
generally consistent with a debtor-creditor
relationship.

Comments received with respect to
proposed § 1.385-2 include the following:

· Comments regarding the necessity of
proposed § 1.385-2;

· Requests to extend the timely prepara-
tion periods;

· Requests to reconsider per se stock
treatment for an undocumented EGI;
and

· Requests that certain issuers or inter-
ests be exempted from proposed
§ 1.385-2 based on a lack of earnings-
stripping potential.

While a number of the comments re-
ceived were critical of proposed § 1.385-
2, the Treasury Department and the IRS
also received a number of comments that
supported the goals of the documentation
rules.

As noted in Part III of the Background
and discussed in the remainder of this Part
IV, the final regulations address many of
the concerns raised in comments by
adopting the following modifications:

· First, the final regulations narrow the
application of § 1.385-2 by excluding
an EGI issued by a foreign issuer or an
S corporation, and generally excluding
interests issued by REITs, RICs, and
controlled partnerships.

· Second, the final regulations replace
the proposed 30-day (and 120-day)
timely preparation requirements with a
requirement that documentation and
financial analysis be prepared by the
time that the issuer's federal income
tax return is filed (taking into account
all applicable extensions).

· Third, the final regulations provide a
rebuttable presumption to character-
ization as stock for EGIs that fail to
satisfy the documentation rules, pro-
vided the expanded group demon-

strates a high degree of compliance
with § 1.385-2. If an expanded group
does not demonstrate a high degree of
compliance with § 1.385-2, an EGI
for which the requirements of the doc-
umentation rules are not satisfied
would be treated as stock for federal
tax purposes.

· Fourth, the final regulations clarify the
application of the documentation rules
to certain interests issued by regulated
financial services entities and insur-
ance companies that are required by
regulators to include particular terms.

· Fifth, the final regulations clarify the
ability of expanded group members to
satisfy the documentation rules for
EGIs issued under revolving credit
agreements, cash pooling arrange-
ments, and similar arrangements by
establishing overall legal arrange-
ments (master agreements).

· Finally, § 1.385-2 applies only with
respect to an EGI that is issued on or
after January 1, 2018. The effect of
this change in combination with the
final regulations' new timely prepara-
tion requirements is that taxpayers will
have until the filing date of their tax-
able year that includes January 1,
2018, to complete the documentation
requirements under § 1.385-2.

This Part IV addresses these modifica-
tions and additional changes suggested by
comments that the Treasury Department
and the IRS have adopted or declined to
adopt in the final regulations.

##### 1. Necessity of Documentation Rules

Some of the comments perceived the
proposed documentation rules as beyond
what would be necessary to impose disci-
pline on related-party transactions, and
some perceived the recharacterization of
indebtedness as stock as a penalty dispro-
portionate to the concern addressed by the
proposed regulations. A number of com-
ments considered the proposed documen-
tation rules to be duplicative of existing
rules and regulations that place on taxpay-
ers both the burden of proof and the obli-
gation to keep appropriate books and re-
cords. As a result, many of those
comments urged the complete withdrawal
of proposed § 1.385-2.

Some comments suggested that the
regulatory approach of characterizing an
EGI as stock where adequate documenta-
tion is not prepared and maintained should
be abandoned in favor of seeking legisla-
tion that would provide authority to the
Treasury Department and the IRS to im-
pose a monetary fine in such cases. Some
comments noted that the documentation
rules are, to some extent, duplicative of
documentation requirements under sec-
tion 6662 (relating to the accuracy-related
penalty for underpayments) and suggested
the adoption of the principles of § 1.6662-
6(d)(2)(iii)(B) (providing documentation
rules for transfer pricing analysis pur-
poses) to give taxpayers more guidance on
the requirements of the regulations. Alter-
natively, some comments suggested relo-
cating the proposed documentation rules
under sections 6662 or 482. A number of
comments urged that, in any event, the
regulations should require only that a tax-
payer's position with respect to the char-
acterization of an interest as indebtedness
be reasonable based on the available facts
and circumstances instead of requiring
documentation of prescribed factors, re-
gardless of whether the IRS necessarily
agreed with the taxpayer's characteriza-
tion. Comments also suggested that the
documentation rules would need to be re-
vised in some manner, because the com-
ments asserted that such rules could not
override "substantial compliance" princi-
ples under common law.

However, in recognition of the policy
concerns stated by the Treasury Depart-
ment and the IRS, virtually all of these
comments also suggested modifications to
make the documentation rules of proposed
§ 1.385-2 more reasonable and adminis-
trable for both taxpayers and the IRS.
Provided certain modifications were made
to relax the burden of the documentation
rules, many comments stated that taxpay-
ers could comply with such modified
rules. A number of comments suggested
streamlining the documentation require-
ments, for example, by allowing (i) master
agreements to support multiple transac-
tions, (ii) balance sheets to evidence sol-
vency, and (iii) the advance preparation of
credit analysis of issuers. While many
comments recognized the value of the cer-
tainty that could come from increased
specificity and objective rules, many com-

ments were equally concerned that the
regulations be flexible regarding the
manner in which the documentation rules
apply.

The Treasury Department and the IRS
have determined that the documentation
rules of proposed § 1.385-2 further im-
portant tax administration purposes.
Moreover, the Treasury Department and
the IRS have determined that the presence
or absence of documentation evidencing
the four indebtedness factors is more than
a ministerial issue to be policed with a fine
or penalty. These factors are substantive
evidence of the intent to characterize an
EGI as indebtedness for federal tax pur-
poses. In addition, characterizing pur-
ported indebtedness as stock is not a pen-
alty for failing to meet a ministerial
requirement. Such characterization results
from a failure to evidence the intent of the
parties when the issuer characterizes the
EGI for federal tax purposes or from a
failure to act consistent with such charac-
terization during the life of the purported
indebtedness. As noted earlier in this Sec-
tion A, the Treasury Department and the
IRS have determined that many of the
concerns raised by comments can and
should be addressed by modifying the ap-
proach taken in proposed § 1.385-2 and,
as discussed in the remainder of this Sec-
tion A, that many of the modifications
suggested by comments would enhance
both the reasonableness and effectiveness
of the final regulations.

##### 2. Timely Preparation Requirement

Under proposed § 1.385-2, documen-
tation of an EGI issuer's binding obliga-
tion to pay a sum certain, the holder's
rights under the terms of the EGI to en-
force payment, and the reasonable expec-
tation of repayment under the terms of the
EGI generally would be required to be
prepared within 30 days of the "relevant
date" to which the documentation relates.
Documentation of actions evidencing a
debtor-creditor relationship would be re-
quired to be prepared within 120 days of
the "relevant date" to which the actions
relate.

Many comments raised concerns with
the proposed timeliness rules. Some com-
ments noted that the documentation rules
did not correspond to business practice,

were not reasonable, and would be impos-
sible to satisfy without an expense to tax-
payers far in excess of any benefit to be
achieved. Comments argued that there
was no administrative need for the docu-
mentation to be done in the timeframes
specified, as the documentation would not
be required until requested by the IRS in
audit.

The timely preparation requirements in
proposed § 1.385-2 were intended to ap-
proximate third-party practice with re-
spect to contemporaneous documentation
of relevant events demonstrating the cre-
ation of a debtor-creditor relationship. The
documentation rules relating to post-
issuance actions or inaction of issuers and
holders were intended to demonstrate that
the issuer and holder continued such a
relationship. Thus, the Treasury Depart-
ment and the IRS have determined that it
is not appropriate for taxpayers to prepare
documentation of the four indebtedness
factors only if the IRS requests such in-
formation during an audit. Documentation
prepared during an audit could not reason-
ably be viewed as contemporaneous evi-
dence of the intent of the taxpayers when
an EGI was issued.

After consideration of the comments,
however, the Treasury Department and
the IRS have determined that the objec-
tives of the proposed regulations can still
be achieved while allowing taxpayers
more time to satisfy the documentation
requirements. Many comments suggested
that a reasonable and appropriate time for
requiring compliance with the documen-
tation rules would be by the time that the
issuer's federal income tax return must be
filed (taking into account any extensions)
for the tax year of the relevant date. This
timeframe would also be consistent with
the framework of section 385(c), under
which an issuer and holder provide notice
to the Commissioner of their characteriza-
tion of an interest on their tax returns. The
Treasury Department and the IRS have
determined that documentation prepared
within such a timeframe could provide
reasonable evidence of the intent of the
issuer and the holder in connection with
the issuance of the EGI. Accordingly, the
final regulations adopt this comment for
all documentation required to be prepared
with respect to a relevant date for an EGI

that is subject to the documentation rules
(a covered EGI).

##### 3. Per Se Stock Treatment

Under proposed § 1.385-2, if the doc-
umentation rules for an EGI were not sat-
isfied, the EGI would be automatically
treated as stock for federal tax purposes.
The overwhelming response from com-
ments was that this aspect of the docu-
mentation rules was too harsh. As de-
scribed in Part V.B of this Summary of
Comments and Explanation of Revisions,
comments noted numerous and potentially
adverse consequences from characterizing
purported indebtedness as stock, includ-
ing purported indebtedness issued by for-
eign issuers.

Comments stated that, because of the
per se aspect of the documentation rules,
the penalty of recharacterization would
often be substantially disproportionate to
the failure to comply with the documen-
tation rules, as arguably minor instances
of noncompliance could trigger a rechar-
acterization of an interest as stock for fed-
eral tax purposes with potentially severe
consequences. Comments also raised con-
cerns that the per se aspect of the docu-
mentation rules would automatically treat
an interest as stock for federal tax pur-
poses without allowing for an alternative
characterization of a transaction, such as,
in substance, a distribution or contribution
of purported financing proceeds.

Comments offered various solutions to
address these concerns. A number of com-
ments urged that, before any conse-
quences attached, taxpayers be allowed to
cure any defect in their documentation.
Some comments urged that, instead of
characterization of purported indebted-
ness as stock for federal tax purposes, the
penalty for a failure to satisfy the docu-
mentation rules could be a denial of any
interest deduction under section 163; sim-
ilarly, other comments suggested allowing
taxpayers to make an election to forego
interest deductions under section 163 to
cure any documentation defect. Some
comments suggested that the bifurcation
rule in proposed § 1.385-1(d) could be
used to reach a more proportionate char-
acterization result.

Section 385(a) directs that regulations
promulgated under that section be appli-

cable for all purposes of the Code. Ac-
cordingly, the Treasury Department and
the IRS do not consider it appropriate to
limit the federal tax consequences of the
characterization of a covered EGI under
§ 1.385-2 to particular Code provisions,
such as section 163. Instead, as discussed
in Part V.B of this Summary of Comments
and Explanation of Revisions with respect
to §§ 1.385-3, 1.385-3T, and 1.385-4T,
the final regulations generally retain the
approach of the proposed regulations under
which related-party indebtedness treated as
stock by application of § 1.385-2 is stock
for all U.S. federal tax purposes, including
for purposes of applying section 1504(a) in
the context of § 1.385-2.

As discussed in Sections A.3.a through
c of this Part IV, the risk of per se stock
characterization as a result of a documen-
tation failure is substantially reduced un-
der the final regulations by the addition of
rebuttable presumption rules.

## a. Availability of rebuttable presumption

If the expanded group demonstrates a
high degree of compliance with the doc-
umentation rules, the final regulations pro-
vide a rebuttable presumption (rather than
a per se characterization) that a covered
EGI that is noncompliant with the require-
ments of § 1.385-2 is treated as stock for
federal tax purposes. To demonstrate a
high-degree of compliance with the doc-
umentation rules, a taxpayer must demon-
strate that one of two tests is met. Under
the first test, a taxpayer must demonstrate
that covered EGIs representing at least 90
percent of the aggregate adjusted issue
price of all covered EGIs within the ex-
panded group comply with § 1.385-2. Un-
der the second test, a taxpayer must dem-
onstrate either that (1) no covered EGI
with an issue price in excess of
$100,000,000 failed to comply with
§ 1.385-2 and less than 5 percent of the
covered EGIs outstanding failed to com-
ply with § 1.385-2 or (2) that no covered
EGI with an issue price in excess of
$25,000,000 failed to comply with
§ 1.385-2 and less than 10 percent of the
covered EGIs outstanding failed to com-
ply with § 1.385-2.

If eligible, an expanded group member
can rebut the presumption that a covered
EGI is stock with evidence that the issuer

intended to create indebtedness for federal
tax purposes and that there are sufficient
factors present to treat the covered EGI as
indebtedness for federal tax purposes.

Several comments suggested that the
final regulations include a de minimis rule
excepting interests under a certain
amount, specified as either a fixed dollar
amount or a percentage of assets. The
Treasury Department and the IRS are con-
cerned that this would provide a ready
method for circumventing the rules and so
decline to adopt this suggestion. However,
the rebuttable presumption rule contained
in the final regulations would operate to
mitigate these concerns. In particular, the
second test for demonstrating a high de-
gree of compliance with the documenta-
tion rules permits a simplified calculation
based only on the number of covered EGIs
that failed to comply with § 1.385-2. This
test reflects an understanding by the Trea-
sury Department and the IRS that simpli-
fied compliance rules are appropriate
where relatively smaller EGIs fail to com-
ply with § 1.385-2.

In cases where the rebuttable presump-
tion rule applies, the final regulations pro-
vide that in applying federal tax principles
to the determination of whether an EGI is
indebtedness or stock, the indebtedness
factors in the documentation rules are sig-
nificant factors to be taken into account.
The final regulations further provide that
other factors that are relevant are taken
into account in the determination as lesser
factors.

## b. Ministerial or non-material failure or errors

The final regulations adopt a rule in-
tended to safeguard against characterizing
a covered EGI as stock for federal tax
purposes if the failure to comply with the
documentation rules is attributable to a
minor error of a ministerial or non-
material nature, such as a clerical error. In
such a case, if a taxpayer discovers and
corrects the documentation failure or error
before discovery by the Commissioner,
the failure or error will not be taken into
account in determining whether the re-
quirements of the documentation rules
have been satisfied.

c. Reasonable cause exception

Proposed § 1.385-2 included an excep-
tion that would allow for "appropriate
modifications" to the documentation re-
quirements when a failure to satisfy the
requirements was due to reasonable cause
(the reasonable cause exception). Pro-
posed § 1.385-2 adopted the principles of
§ 301.6724-1 for purposes of determining
whether reasonable cause exists in any
particular case. These principles provide
that a reasonable cause exception will ap-
ply if there are significant mitigating fac-
tors with respect to the failure or if the
failure arose from events beyond the con-
trol of the members of the expanded
group. Moreover, these principles provide
that, in order for the reasonable cause ex-
ception to apply, the members of the ex-
panded group must act in a responsible
manner, both before and after the time that
the failure occurred. Thus, under proposed
§ 1.385-2, if the reasonable cause exception
did not apply, any failure to comply with the
documentation requirements would give
rise to a characterization as stock.

Comments viewed the exception as un-
necessarily narrow in scope and unclear in
application and effect. Some comments sug-
gested adding factors to be considered and
guidance about how modifications would be
made to the rules. Suggestions for a more
lenient standard included exceptions for
"good cause," "good faith," "reasonable be-
havior," "innocent error," "unintentional,"
"inadvertent," or "lacking willfulness."

The Treasury Department and the IRS
have determined that given the rebuttable
presumption rule and the ministerial error
rule adopted in the final regulations, the
scope of the reasonable cause exception is
appropriate. Accordingly, the final regula-
tions retain the reasonable cause exception,
including its incorporation of the principles
of § 301.6724-1 for guidance concerning its
application. In addition, the final regulations
provide that once a taxpayer establishes that
the reasonable cause exception applies to an
EGI, the taxpayer must prepare proper doc-
umentation in respect of the EGI.

### 4. Treatment of EGI issued by disregarded entities

Comments raised a number of ques-
tions and concerns regarding the charac-

terization of an interest issued by a disre-
garded entity under proposed § 1.385-2.
The concerns largely centered on the col-
lateral consequences of treating the inter-
est as equity in the issuing legal entity,
because in such a case the entity would
have at least two members and therefore
would be treated as a partnership under
§ 301.7701-2(c)(1) rather than as a disre-
garded entity under § 301.7701-2(c)(2).
This change in treatment could create the
potential for gain recognition and addi-
tional significant collateral issues.

The Treasury Department and the IRS
have determined that the analysis of
whether there is a reasonable expectation
of repayment of an interest must be made
with respect to the legal entity (whether
regarded or disregarded for federal tax
purposes) that issued the interest for non-
tax purposes, taking into account the ex-
tent to which other entities may have legal
liability for the obligations of the issuing
entity. In addition, documentation in re-
spect of the other indebtedness factors
must be prepared and maintained for the
legal entity (whether regarded or disre-
garded for federal tax purposes) that is-
sued the interest for non-tax purposes. To
avoid the effects that could occur if an
interest issued by a disregarded entity is
characterized as equity under the docu-
mentation rules, § 1.385-2 provides, un-
der the authority of section 7701(l), that,
in such cases, the regarded corporate
owner of the disregarded entity is deemed
to issue stock to the formal holder of the
interest in the disregarded entity (and, if
the recharacterization occurs later than the
issuance of the interest, in exchange for
that interest). The stock deemed issued is
deemed to have the same terms as the
interest issued by the disregarded entity,
other than the identity of the issuer, and
payments on the stock are determined by
reference to payments made on the inter-
est issued by the disregarded entity.

## 5. Exemption Based on Lack of Earnings-Stripping Potential

Some comments requested that the fi-
nal regulations exclude from the docu-
mentation rules several categories of
transactions believed not to raise earnings-
stripping concerns. For example, many
comments requested that transactions

done in the ordinary course of business be
exempt from the documentation rules.
These comments argued in part that the
sheer volume of such transactions would
render any documentation requirement
overly burdensome, especially given the
proposed 30-day time period for the
completion of such documentation and the
proposed consequence of failing to pre-
pare and maintain such documentation.
These comments also asserted that the na-
ture of ordinary course transactions makes
them an unlikely means of accomplishing
abuse and a poor candidate for ultimate
recharacterization as stock.

Some comments argued that this ratio-
nale would also support an exemption
from proposed § 1.385-2 for all interests
created under cash pooling and similar
arrangements. Other comments urged that
all trade payables and any debt that fi-
nanced working capital needs be excluded
from proposed § 1.385-2. A number of
these comments recognized the difficulty
of determining how such transactions
could be identified and suggested various
formulas. For example, some comments
suggested formulas based on an average
balance over a specified period or the av-
erage length of time outstanding. Other
suggested methods included formulas
based on the relationship of the underly-
ing transaction to the operation of the
business, such as financing inventory, ser-
vices, fixed assets, rent, or royalties.

In addition to comments based on the
nature of particular transactions, there
were requests to limit application of the
proposed documentation rules to the ex-
tent that the terms of a particular arrange-
ment do not present earnings-stripping
potential. Thus, for example, some com-
ments suggested exemptions be made for
purported indebtedness that is short term,
with a low rate of interest (or no interest),
or that is issued and held within the ex-
panded group for a limited period.

The Treasury Department and the IRS
considered these requests for exclusions
from the regulations under § 1.385-2, but
generally declined to adopt them, princi-
pally because the goal of the documenta-
tion rules is not solely to prevent earnings-
stripping. Rather, the documentation rules
are also intended to facilitate tax admin-
istration by imposing minimum documen-
tation standards for transactions between

highly related persons to determine the
federal tax treatment of covered EGIs.
Such minimum documentation standards
are warranted as related-party transactions
have historically raised concerns as to the
use of purported indebtedness and the lack
of proper documentation to verify the na-
ture of the interest purported to be indebt-
edness. Adopting the broad exceptions
urged by comments would undermine this
goal. In addition, it is unclear how to
administer an exemption from require-
ments to document ordinary course ar-
rangements because, if taxpayers do not
otherwise adequately document such ar-
rangements, it is unclear how to determine
whether they are, in fact, ordinary course
arrangements.

### B. Scope of covered EGIs

Many of the modifications suggested
by comments would reduce the number of
persons, types of entities, or transactions
that would be covered by the regulations
under § 1.385-2. Comments regarding the
scope of proposed § 1.385-2 as applied to
particular categories of issuers or transac-
tions not addressed elsewhere in this Sum-
mary of Comments and Explanation of
Revisions are addressed in this Section B.

#### 1. Scope of Issuers

Under proposed § 1.385-2, an issuer of
an interest included, solely for purposes of
the documentation rules, a person (includ-
ing a disregarded entity) that is obligated
to satisfy any material obligations created
under the terms of an EGI. Proposed
§ 1.385-2 also treated a person as an
issuer if such person was expected to sat-
isfy any material obligations created un-
der the terms of an EGI. Comments asked
for clarification regarding the circum-
stances under which someone other than
the person that is primarily liable under
the terms of an EGI (the primary obligor),
including a co-obligor, would be expected
to satisfy an obligation created under the
terms of the EGI.

Similar to the documentation rules in
proposed § 1.385-2, the final regulations
provide that the term issuer means any
person obligated to satisfy any material
obligations created under the terms of an
EGI, without regard to whether the person

is the primary obligor. The Treasury De-
partment and the IRS intend that the ques-
tion of whether a person other than the
primary obligor under the EGI is to be
treated as its issuer should be analyzed
under the principles of section 357(d),
which contains a similar analysis with re-
spect to liability assumptions. One com-
ment asked for clarification as to when an
obligor could be treated as an issuer for
this purpose. An issuer for this purpose
could include a guarantor of a primary
obligor's obligations created under the
terms of an EGI if the guarantor is ex-
pected to satisfy any of the material obli-
gations under that EGI. An issuer could
also include a person that assumes (as
determined under section 357(d)) any ma-
terial obligation under the EGI, even if
such assumption occurs after the date of
the issuance of the EGI.

#### a. Partnerships

Comments raised a number of con-
cerns with the application of proposed
§ 1.385-2 to controlled partnerships. Al-
though the four indebtedness factors at the
core of the documentation rules are im-
portant factors in determining the federal
tax treatment of purported indebtedness
issued by any entity, after consideration of
the issues raised by the comments, the
Treasury Department and the IRS have
determined that the documentation rules
should not generally apply to partnerships
under the final regulations. However, the
Treasury Department and the IRS remain
concerned that expanded group members
could use partnerships (or other non-
corporate entities) with a principal pur-
pose of avoiding the application of the
documentation rules. Accordingly, such
transactions remain subject to the final
regulations' anti-abuse rule.

In addition, because controlled partner-
ships are not treated as expanded group
members under the final regulations,
§ 1.385-2 provides that an EGI issued by
an expanded group member and held by a
controlled partnership with respect to the
same expanded group is a covered EGI.

## b. Consolidated groups

For purposes of proposed § 1.385-2,
members of a consolidated group were

generally treated as "one corporation" and
so interests issued between members of
the consolidated group were not subject to
the documentation rules. However, as
noted in Parts III.A.2 and VI.A of this
Summary of Comments and Explanation
of Revisions, the one-corporation ap-
proach gave rise to numerous questions
and concerns about both the implementa-
tion of the rule and the effect of this rule
on the application of other provisions of
the Code.

There were two reasons for excluding
indebtedness between members of a con-
solidated group from the application of
the documentation rule. The principal rea-
son was that the consolidated return reg-
ulations, specifically § 1.1502-13(g), al-
ready provide a comprehensive regime
governing substantially all obligations be-
tween members. This is not the case with
respect to indebtedness between consoli-
dated group members and nonmembers,
even if highly related. The second reason
was that, in the very few cases where such
obligations would not be subject to
§ 1.1502-13(g), the inapplicability of
§ 1.1502-13(g) would generally be of lim-
ited duration and, in the meantime, all
items of income, gain, deduction, and loss
attributable to the obligation would offset
on the consolidated federal income tax
return.

The Treasury Department and the IRS
have determined that the existing regula-
tions governing obligations between
members of a consolidated group are suf-
ficiently comprehensive to warrant the ex-
clusion of these obligations from the doc-
umentation rules. However, the Treasury
Department and the IRS have reconsid-
ered the use of the one-corporation ap-
proach with respect to § 1.385-2 and de-
termined that a simpler, more targeted
approach would be to exclude obliga-
tions between consolidated group mem-
bers from the category of instruments
subject to the documentation rules. This
approach, as provided in § 1.385-
2(d)(2)(ii)(A) of the final regulations,
retains the general exclusion for inter-
company obligations while eliminating
many of the questions and concerns
raised by comments, such as the ques-
tion of whether a particular member of a
consolidated group (or the consolidated

group as a whole) would be the issuer of
an EGI.

The final regulations do not, however,
adopt the suggestion to expand the excep-
tion to exclude other obligations, such as
obligations between affiliated corpora-
tions that are not includible corporations
under section 1504(b) (such as a REIT or
RIC) or that are prohibited from joining
the group under section 1504(c) (certain
insurance companies) and obligations be-
tween group members and controlled part-
nerships. In such cases, even though the
obligations may generate items that may
be reflected in a consolidated federal in-
come tax return, none of the obligations
generating the items are governed by the
consolidated return regulations.

The final regulations also do not adopt
the request to limit the consequences of
characterizing an EGI as stock under
§ 1.385-2, for example, by disregarding
such stock for purposes of determining
affiliation. The Treasury Department and
the IRS view the characterization of an
EGI as stock under § 1.385-2 as a deter-
mination that general federal tax princi-
ples would preclude a characterization of
the interest as indebtedness. Thus, the
Treasury Department and the IRS have
determined that it is appropriate to treat an
EGI characterized as stock pursuant to
§ 1.385-2 as stock for federal tax pur-
poses generally.

## c. Regulated entities

A number of comments were received
requesting exemptions from the documen-
tation rules for various regulated entities,
such as insurance companies, financial in-
stitutions, and securities brokers or deal-
ers. Comments stated that a rationale for
the proposed documentation rules, facili-
tating tax administration by imposing
minimal documentation standards for
transactions between highly-related per-
sons, is addressed by existing non-tax reg-
ulations and oversight already imposed on
these entities. The Treasury Department
and the IRS recognize that the various
requirements noted by comments, such as
the Basel III framework and increased
capitalization requirements, risk manage-
ment ratios, and liquidity requirements
that are applicable to certain regulated fi-
nancial entities, all afford increased assur-

ance regarding certain aspects of the doc-
umentation requirements, particularly
with respect to the creditworthiness of the
issuer.

Accepting the fact that non-tax regula-
tions may constrain the terms and condi-
tions of the obligations issued and held by
entities subject to those regulations does
not, however, change the fact that a deter-
mination of whether an EGI is character-
ized as stock or indebtedness for federal
tax purposes is made under federal tax
principles. This determination necessarily
involves the preparation of documentation
in respect of the four indebtedness factors.
In addition, a non-tax regulator may not
have the same interests as the Treasury
Department and the IRS. Such a non-tax
regulator may not constrain (and in some
cases may encourage) actions to lower
federal tax costs for the entities that it
regulates so that more assets may be avail-
able to the depositors in, or creditors of,
such entities.

Accordingly, the Treasury Department
and the IRS have determined that it is not
appropriate to exclude taxpayers from the
documentation rules on the grounds that
some of the documentation and informa-
tion required may also be required by and
provided to non-tax regulators. Indeed, to
the extent the final regulations require
documentation that is otherwise prepared
and maintained under requirements im-
posed by non-tax regulators, such as may
be required under regulations under 12
CFR Part 223 (Regulation W) issued by
the Board of Governors of the Federal
Reserve System, any additional burden
imposed by the final regulations is re-
duced.

## d. Expanded groups subject to § 1.385-2

Under proposed § 1.385-2, an EGI
would not be subject to the documentation
rules unless (i) the stock of any member of
the expanded group was publicly traded,
(ii) all or any portion of the expanded
group's financial results were reported on
financial statements with total assets ex-
ceeding $100 million, or (iii) the ex-
panded group's financial results were re-
ported on financial statements that reflect
annual total revenue exceeding $50 mil-
lion.

A number of comments suggested rais-
ing the asset and revenue thresholds, par-
ticularly for regulated businesses with
high asset levels relative to revenue, such
as banks, or for issuers with high amounts
of revenue but low profit margins, such as
construction companies. However, com-
ments did not suggest particular levels to
which the asset or revenue thresholds
should be raised. As a result of the mod-
ifications made to § 1.385-2 in the final
regulations, the Treasury Department and
the IRS have determined that the applica-
tion of the documentation rules will be
appropriately restricted to minimize bur-
den and therefore decline to adopt this
suggestion.

Accordingly, the final regulations con-
tinue to provide that an EGI is not subject
to the documentation rules unless one of
the following three conditions is present.
First, if the stock of any member of the
expanded group is publicly traded. Sec-
ond, if all or any portion of the expanded
group's financial results are reported on
financial statements with total assets ex-
ceeding $100 million. Or third, if the ex-
panded group's financial results are re-
ported on financial statements that reflect
annual total revenue that exceeds $50 mil-
lion.

## 2. Special Categories of EGIs

### a. Certain interests of regulated entities

Many of the comments submitted by or
on behalf of regulated entities requested
that, if a broad exception were not adopted
for regulated entities, certain arrange-
ments should be excluded from the docu-
mentation rules. As an example, several
comments requested an ordinary course
exception to the documentation rules ap-
plicable to all payments on insurance con-
tracts, funds-withheld arrangements in
connection with reinsurance, funds-
withheld reinsurance, and surplus notes.
Comments noted the need for further
guidance on the documentation that would
be required for many of these interests, as
they are typically executed by contract,
not loan documents. The Treasury Depart-
ment and the IRS do not agree that there is
a need for guidance with respect to rein-
surance or funds-withheld reinsurance,
because these arrangements are not debt

in form and are typically governed by the
terms of a reinsurance contract (and other
ancillary contracts). As such, they are not
covered EGIs under the final regulations.

Comments also suggested that the final
regulations create safe harbor exceptions
for instruments issued to satisfy regula-
tory capital requirements and regulatory
instruments issued in the legal form of
debt that contain required features that
could impair their characterization as
debt, such as instruments with loss-
absorbing capacity that are required by the
Federal Reserve Board. For example, if a
borrower's obligation to pay interest or
principal, or a holder's right to enforce
such payment, is conditioned upon the
issuer receiving regulatory approval, but
the instrument otherwise satisfies the un-
conditional obligation to pay a sum cer-
tain and creditor rights factors, comments
argued that the required regulatory ap-
proval should not prevent the interest
from being treated as debt. Similarly,
comments requested the final regulations
provide that, if regulatory approval delays
an action, such delay will not prevent an
issuer from satisfying the timeliness re-
quirement.

The Treasury Department and the IRS
agree that certain regulated entities may
be required in some cases to issue an
instrument that would be indebtedness un-
der federal tax principles but for certain
terms or conditions imposed by a regula-
tor. To address this situation, the final
regulations provide an exception from the
documentation requirements for certain
instruments issued by an excepted regu-
lated financial company or a regulated in-
surance company, as those terms are de-
fined in § 1.385-3(g). An EGI issued by
an excepted regulated financial company
is considered to meet the documentation
rules as long as it contains terms required
by a regulator of that issuer in order for
the EGI to satisfy regulatory capital or
similar rules that govern resolution or or-
derly liquidation. An EGI issued by a reg-
ulated insurance company issuer is con-
sidered to meet the documentation rules
even though the instrument requires the
issuer to receive approval or consent of an
insurance regulatory authority before
making payments of principal or interest
on the EGI. In both cases, the regulations
require that the parties expect at the time

of issuance that the EGI will be paid in
accordance with its terms and that the
parties prepare and maintain the docu-
mentation necessary to establish that the
instrument in question qualifies for the
exception.

The Treasury Department and the IRS
are aware that certain instruments re-
quired by regulators raise common law
debt-equity issues that extend beyond the
scope of these regulations. The scope and
the form of additional guidance to address
these instruments are under consideration.

### b. Certain interests characterized under the Code or other regulations

Several comments requested clarifica-
tion that instruments that are specifically
treated as indebtedness under the Code
and the regulations thereunder, such as
mineral production payments under sec-
tion 636, are not treated as applicable in-
struments, and accordingly not treated as
EGIs subject to proposed § 1.385-2. The
final regulations clarify that such instru-
ments are not subject to the documenta-
tion rules.

### c. Master agreements, revolving credit agreements, and cash pooling arrangements

Under proposed § 1.385-2, members
of an expanded group using revolving
credit agreements, cash pooling arrange-
ments, and similar arrangements under a
master agreement were generally required
to prepare and maintain documentation
for the master agreement as a whole
(rather than for each individual transac-
tion), but comments contained a number
of questions concerning the requirements
applicable to these master agreements.

Some comments requested that master
agreements be excluded altogether from
the documentation rules, excluded at least
for specific activities, or excluded if their
terms exceeded those given by third par-
ties. These comments argued that such
agreements were not likely vehicles for
earnings stripping. The Treasury Depart-
ment and the IRS decline to provide an
exemption for these master agreements
because if such an exemption were
granted, such master agreements could re-
place all other forms of indebtedness be-
tween highly-related parties, resulting in

avoidance of the documentation rules. In
addition, interests issued under these mas-
ter agreements must be characterized for
federal tax purposes, and there is no clear
justification for treating such interests as
exempt from the modified documentation
requirements in the final regulations based
on the fact that these interests are docu-
mented under a master agreement.

Many comments focused on solutions
for making the application of the docu-
mentation rules to master agreements sim-
pler, clearer, more workable for taxpayers,
and more administrable for the IRS. Com-
ments requested that the basic operation
of the rules governing master agreements
be clarified to provide certainty for tax-
payers that (i) a comprehensive agreement
such as a revolving credit agreement
could satisfy the documentation require-
ments and (ii) individual draws under the
revolving credit agreement would not be
treated as separate loans for purposes of
the documentation rules. Comments also
requested additional definitions and rules,
for example clarifying the interaction of
the documentation rules and § 1.1001-
3(f)(7) and the treatment of a cash pool
financing both ordinary course and capital
expenditures. The Treasury Department
and the IRS decline to provide special
rules under § 1.385-2 for the cash pool
financing of ordinary course and capital
expenditures. In general, the question of
whether an EGI is ordinary course or is
used for capital expenditures is not rele-
vant to the question of whether the EGI is
indebtedness for federal tax purposes. In
particular, this question is not relevant to
determine whether there is an uncondi-
tional obligation to pay a sum certain,
whether there are creditor's rights under
the EGI, whether the parties have a rea-
sonable expectation of repayment, or
whether the parties' actions are consistent
with a debtor-creditor relationship. As a
result, the final regulations provide that an
EGI issued under a cash pool arrangement
must meet the same documentation re-
quirements regardless of whether the EGI
funds ordinary course expenses or capital
expenditures.

The policy behind § 1.1001-3(f)(7) is
to encourage workouts when debtors have
difficulty repaying their obligations to
third-party creditors. In such a case, the
debtor (and any shareholders of the

debtor), have different economic interests
from the creditors, and any modifications
to a debt instrument are likely to mean-
ingfully maintain the rights of the credi-
tors. In the case of highly-related entities
that meet the definition of expanded
group, these different economic interests
are not present. As a result, the final reg-
ulations provide that the rules of
§ 1.385-2 apply before the rules of
§ 1.1001-3(f)(7). The final regulations
therefore require documentation as of cer-
tain deemed reissuances under § 1.1001-3
(even in cases where § 1.1001-3(f)(7)
would not require an analysis of whether a
modification resulted in an instrument be-
ing treated as an instrument that is not
indebtedness for federal income tax pur-
poses).

Many comments suggested that the
number of credit analyses required for
master agreements be limited. For exam-
ple, several comments asserted that the
time for testing the issuer's ability to re-
pay should be limited to the time of an
interest's issuance. Comments also sug-
gested that EGIs issued under master
agreements should require credit analysis
only upon the execution of the master
agreement and subsequently upon an in-
crease of the credit limit under the master
agreement, provided that the amount of
credit and term of the master agreement is
reasonable. Comments generally sug-
gested that the credit analysis be required
to be repeated on a specified schedule,
ranging from three to five years. The Trea-
sury Department and the IRS generally
agree with a specified schedule approach
for determining the required credit analy-
sis with respect to master agreements but
have concerns about potential changes in
an issuer's creditworthiness over longer
periods. Because such agreements among
members of an expanded group do not
generally contain covenants, financial in-
formation provision, and other protections
analogous to those in similar arrange-
ments among unrelated parties, it is nec-
essary to require a credit analysis under
these agreements more frequently than ev-
ery three to five years.

The Treasury Department and the IRS
have addressed these comments by clari-
fying in the final regulations that with
respect to EGIs governed by a master
agreement or similar arrangement, a sin-

gle credit analysis may be prepared and
used on an annual basis for all interests
issued by a covered member up to an
overall amount of indebtedness (including
interests that are not EGIs) set forth in the
annual credit analysis. The final regula-
tions make it clear that the first such an-
nual credit analysis should be performed
upon the execution of the documents re-
lated to the overall arrangement. The only
exception to this annual credit analysis
rule is when the issuer has undergone a
material change within the year intended
to be covered by the annual credit analy-
sis. In this case, the final regulations re-
quire a second credit analysis to be per-
formed with a relevant date on or after the
date of the material change. This require-
ment is consistent with commercial prac-
tice with respect to revolving credit agree-
ments, which typically contain covenants
requiring such terms.

Some comments requested clarification
of the treatment of notional cash pools,
noting that such arrangements are not doc-
umented as debt in form between ex-
panded group members. The final regula-
tions do not adopt this comment except to
clarify that a notional cash pool is gener-
ally subject to the same documentation
requirements as other cash pools when the
notional cash pool provider operates as an
intermediary. For example, a notional
cash pool in which the cash received by a
non-member cash pool provider from ex-
panded group members is required to
equal or exceed the amount loaned to ex-
panded group members will generally be
treated as a loan directly between ex-
panded group members, even though the
interests may be in form documented as
debt between an expanded group member
and a non-member facilitator. See, Rev.
Rul. 87-89 (1987-2 C.B. 195). Such ar-
rangements present the same issues as
other related-party instruments and ar-
rangements transacted under a master
agreement and should be subject to the
documentation rules. Because these ar-
rangements are administered by a non-
member, it is generally expected that most
of the documentation required under the
final regulations would already be pre-
pared, limiting the incremental burden of
the final regulations on these arrange-
ments.

Several comments also suggested lim-
iting the application of the documentation
rules to amounts in excess of average bal-
ances. The final regulations do not adopt
this approach because almost all provi-
sions of the Internal Revenue Code per-
taining to indebtedness and stock analyze
particular interests, not average or net bal-
ances. Thus, to apply the documentation
rules to average or net balances would not
adequately serve the purpose of determin-
ing whether a particular interest is prop-
erly treated as indebtedness or stock for
federal tax purposes.

Comments also noted that coming into
compliance following finalization of the
regulations would be facilitated by allow-
ing an extended time frame to document
these arrangements and by excluding bal-
ances outstanding on the effective date of
the final regulations. The final regulations
implement this comment. Only interests
issued or deemed issued on or after Janu-
ary 1, 2018, including EGIs issued on or
after January 1, 2018 under a master
agreement in place before January 1,
2018, will be subject to § 1.385-2.

#### C. Indebtedness factors generally

While many comments acknowledged
a need for documentation rules, there were
two overarching concerns with respect to
the form of such rules. First, comments
suggested that the requirements be made
as streamlined as possible. Second, com-
ments requested clarification of the in-
debtedness factors so that taxpayers could
have certainty about what information is
requested and what documentation will
satisfy the requirements of the regulations.

Some comments suggested that the
Treasury Department and the IRS publish
a form that taxpayers could use to report
new loans or payments, with sufficient
instructions to forestall debate over
whether adequate documentation is pro-
vided. Under such an approach, if the
form were properly completed with re-
spect to an interest, an audit would then
proceed to the merits of the debt-equity
determination for the interest. The Trea-
sury Department and the IRS have deter-
mined that the modifications made in the
final regulations address these concerns.
Other comments suggested providing for
a level of documentation scaled to the

principal amount of the loan, or that
would be reduced in the case of loan guar-
anteed by a solvent parent or affiliate. The
Treasury Department and the IRS do not
adopt this suggestion. Such an approach
would allow taxpayers to use numerous
smaller loans to avoid the full application
of the documentation rules.

Several comments suggested using a
"market standard safe harbor" that would
treat the documentation requirements as
satisfied by the documentation customar-
ily used in third-party transactions. The
final regulations adopt this comment and
provide that such documentation may be
used to satisfy the indebtedness factors
related to an unconditional obligation to
pay a sum certain and creditor's rights.

A number of comments also requested
guidance regarding the effect of a signif-
icant modification of an instrument under
section 1001 and under § 1.1001-3. The
consensus among comments was that the
final regulations should provide that when
there is a modification of an interest, as
long as such modification is not very sig-
nificant, no additional documentation
should be required. The Treasury Depart-
ment and the IRS have decided that a
deemed reissuance under § 1.1001-3 rep-
resents a case where the economic rights
and obligations of the issuer and holder
have changed in a meaningful way. As a
result, the final regulations provide that
the deemed reissuance of an EGI under
§ 1.1001-3 generally requires a new credit
analysis to be performed (unless an annual
credit analysis is in place at the time of the
deemed reissuance). However, the final
regulations do not require new documen-
tation in respect of the factors regarding
an unconditional obligation to pay a sum
certain or creditor's rights, as of such a
deemed reissuance, unless such deemed
reissuance relates to an alteration in the
terms of the EGI reflected under an ex-
press written agreement or written amend-
ment to the EGI.

Finally, comments noted that it was
unclear who was required to prepare and
maintain the documentation, and some of
these comments made suggestions as to
the persons that should be required to pre-
pare and maintain the documentation. Pro-
posed § 1.385-2 did not include any re-
quirement in this respect because the
taxpayer is in the best position to deter-

mine who should prepare and maintain its
documents; the IRS's interest in this re-
spect is limited to requiring that the proper
documentation be prepared and main-
tained and ensuring that the IRS may ob-
tain the documentation. In addition, if the
documentation rules contained specific re-
quirements as to the person or persons
required to prepare and maintain docu-
mentation, such requirements would im-
ply that an interest does not comply with
the documentation rules (even when ap-
propriate documentation was prepared
and maintained) merely because the
wrong member of the expanded group
prepared or maintained the documentation
for the interest. Such arguments would be
harmful to taxpayers and would not ad-
vance the policy goals of the documenta-
tion rules. Thus, proposed § 1.385-2 was
purposely silent on the question of who
must prepare and maintain documenta-
tion. The final regulations continue this
same approach.

#### 1. Unconditional Obligation to Pay a Sum Certain

Comments requested several clarifica-
tions regarding the requirement that there
be an unconditional obligation to pay a
sum certain. A number of comments
asked for clarification that an obligation
would not automatically fail because of a
contingency or because it was a nonre-
course obligation. Several comments also
requested a clarification that the sum need
only be an amount that is reasonably de-
terminable as opposed to a specified total
amount due on a single specified date. A
number of other comments also requested
confirmation that, if a borrower's binding
obligation to pay under an interest is sub-
ject to the condition of a regulatory ap-
proval before repayment, but otherwise
satisfies the requirement that there be an
unconditional obligation to pay a sum cer-
tain, the fact that regulatory approval is
required before repayment should not pre-
vent the interest from satisfying that re-
quirement. The Treasury Department and
the IRS generally agree with these com-
ments, and the final regulations provide
rules clarifying these points. The effect of
a contingency that may result in the re-
payment of less than an instrument's issue
price has not been addressed by the Trea-

sury Department or the IRS, and the doc-
umentation rules are not the appropriate
place for guidance in that area. The final
regulations provide that the documenta-
tion must establish that the issuer has an
unconditional and legally binding obliga-
tion to pay a fixed or determinable sum
certain on demand or at one or more fixed
dates, without elaborating on the amount
of the sum certain.

## 2. Creditor's Rights

Comments requested a number of clar-
ifications regarding the requirement that
the documents evidence the creditor's
right to enforce the obligation. The most
common concern raised by comments was
that the requirement be modified to recog-
nize that creditor's rights are often estab-
lished by law, and, in such cases, would
not necessarily be included in the loan
documentation. Comments requested that
the rules treat this requirement as estab-
lished in such cases, without regard to
whether the rights are reiterated in the
loan documents. In such cases, comments
requested that creditor's rights be re-
spected without requiring additional doc-
umentation.

The final regulations adopt this com-
ment with one modification. If creditor's
rights are created under local law without
being reflected in writing in a loan agree-
ment and no creditor's rights are written
as part of the documentation of an interest,
the documentation must refer to the law
that governs interpretation and enforce-
ment (for example, Delaware law or bank-
ruptcy law). This requirement verifies that
the issuer and holder did intend to create
creditor's rights and assists the IRS in
confirming that such creditor's rights ap-
ply to the holder of the interest.

Several comments requested clarifica-
tion that the fact that a note is nonrecourse
does not prevent the satisfaction of the
creditor's rights requirement. Further,
comments requested clarification that, if a
creditor only has rights to certain assets
under the terms of an interest, the refer-
ence to assets of the issuer means only
those assets, and such a limitation would
not result in the interest failing to satisfy
the creditor's rights indebtedness factor.
The final regulations clarify these points.

Finally, a number of comments sug-
gested that the final regulations remove
the proposed prohibition on subordination
to shareholders in the case of dissolution.
The principal concern of the comments
was that, if, for example, one EGI
(EGI#1) issued by an issuer were subor-
dinate to another EGI (EGI#2) issued by
the same issuer, and EGI#2 were rechar-
acterized as stock under the proposed
§ 1.385-3 regulations, EGI#1 would fail
this requirement because it would be sub-
ordinate to EGI#2 (which is treated as
stock for federal tax purposes). In such
case, EGI#1, because it is subordinate to
EGI#2, would be subordinate to share-
holders (the holders of EGI#2) in a disso-
lution of the issuer and would therefore
violate the proposed prohibition on subor-
dination to shareholders in the case of
dissolution. The Treasury Department and
the IRS have considered this comment
and determined that it would be appropri-
ate to disregard subordination if the re-
characterization occurred as a result of
§ 1.385-3 and the final regulations reflect
that decision. However, because a charac-
terization under the documentation rules
speaks to the substance of the interest
itself, including whether the interest prop-
erly could be indebtedness for federal tax
purposes under general federal tax princi-
ples, the Treasury Department and the IRS
do not agree that it is appropriate to dis-
regard a characterization caused by the
documentation rules of § 1.385-2 for this
purpose.

One comment asked for clarification
that equitable subordination imposed by a
court would not affect this determination.
The Treasury Department and the IRS are
not aware of a situation in which it would
be appropriate to disregard equitable sub-
ordination as a factor in determining
whether an interest is properly indebted-
ness or stock, and so the final regulations
do not adopt this comment.

Several comments noted that subordi-
nation to later issued, unrelated-party in-
debtedness is common and should not be a
negative factor. The Treasury Department
and the IRS do not expect this circum-
stance will cause a problem under the
regulations, as the unrelated-party indebt-
edness is not subject to recharacterization
under the final regulations and the docu-
mentation rules only require that an inter-

est be superior to the rights of sharehold-
ers, rather than debt holders.

## 3. Reasonable Expectation of Ability to Repay EGI

A number of comments requested clar-
ifications regarding the requirement that
there be a reasonable expectation of the
issuer's ability to repay its obligation.
Comments also requested that the final
regulations clarify that the expectation is
subjective and that the creditor should be
given reasonable latitude based on its
business judgment. In addition, comments
requested that the regulations should spec-
ify how frequently credit analysis is re-
quired. For example, some comments sug-
gested that an approach similar to that
taken for master agreements be adopted to
allow a single agreement and a single
credit analysis (done annually or at other
specified intervals) to document multiple
loans by expanded group members to a
particular member. Other comments re-
quested that the regulations should clarify
whether it is only necessary to retest credit
worthiness as often as is typical under
commercial practice, or whether an annual
analysis is sufficient. In response to these
comments, the final regulations assist in
implementing the documentation require-
ments for multiple EGIs issued by the
same issuer by making it clear that a sin-
gle credit analysis may be prepared on an
annual basis and used for all interests is-
sued by the issuer, up to an overall amount
of indebtedness set forth in the annual
credit analysis.

With respect to the time for measuring
an issuer's reasonable expectation of abil-
ity to repay an EGI, comments presumed
that the issue date of the interest would be
the appropriate date to measure. Although
comments also noted that there are ques-
tions as to when this measuring date
would arise. Comments also suggested
that the reasonable expectation of ability
to repay could be reevaluated if there is a
deemed reissuance of the interest under
the rules of section 1001, unless the par-
ties can show a third party would have
agreed to a modification.

The regulations retain the requirement
that documentation be prepared and main-
tained containing information establishing
that, as of the date of issuance of the EGI,

the issuer's financial position supported a
reasonable expectation that the issuer in-
tended to, and would be able to, meet its
obligations pursuant to the terms of the
EGI. The rules addressing the reasonable
expectation of repayment factor thus re-
tain the EGI's issuance date as the appro-
priate date for measuring the issuer's fi-
nancial position. Issuance dates are to be
determined under federal tax principles.

With respect to whether the issuer's
financial position supports a reasonable
expectation that the issuer intended to, and
would be able to meet its obligations pur-
suant to the terms of the obligation, com-
ments requested that the application of a
creditworthiness test of the issuer's finan-
cial position be excluded if the indebted-
ness is secured by specific property of the
issuer. In response to this concern, the
final regulations clarify that if the EGI is
nonrecourse to the issuer, then the docu-
mentation to support such indebtedness
must include the value of property avail-
able to support repayment of the nonre-
course EGI.

Comments suggested that the credit-
worthiness of the issuer could be deter-
mined by a confirmation of the creditwor-
thiness of the issuer by a third party or
internal staff of the issuer. They further
suggested that the regulations could pro-
vide safe harbors for creditworthiness us-
ing ratios such as a minimum debt-to-
equity or "EBIDTA"-to-interest ratios.
Comments also requested that the regula-
tions provide a list of documents that
would satisfy the reasonable expectation
requirement, which could include docu-
ments that would be sufficient (but not
necessary) to show that the obligation
could have been issued on the same terms
with a third party. The final regulations
clarify that documentation may include
cash flow projections and similar eco-
nomic analyses prepared by either the
members of the expanded group of the
issuer or third parties.

Comments also requested clarification
that refinancing would be an acceptable
method to repay an EGI and that a refi-
nancing does not adversely impact and
may be assumed as part of the credit anal-
ysis; in other words, if the issuer could
have issued the obligation to a third party
with the ability to refinance the obligation
on its maturity date, then the issuer would

satisfy this requirement. Moreover, com-
ments were of the view that in fact, a
borrower's ability to refinance obligations
when due should be a positive factor in a
credit analysis. The final regulations pro-
vide that the credit analysis may assume
that the principal amount of an EGI may
be satisfied with the proceeds of another
borrowing by the issuer to the extent that
such borrowing could occur on similar
terms with a third party.

Comments requested clarity as to
whose credit is being analyzed, specifi-
cally, whether it is only the "recipient"
of funds or, if the issuer is a member of
consolidated group, whether it is the
entire consolidated group. Because the
final regulations remove the one-
corporation rule for purposes of the doc-
umentation rules, the member that is the
issuer of an interest would be analyzed
for this purpose.

One comment requested that the regu-
lations clarify limits on privileged docu-
ments and provide specific limitations re-
garding the ability of the IRS to request,
review, and maintain such information.
The final regulations do not adopt this
comment. The IRS routinely reviews and
maintains confidential taxpayer informa-
tion as part of its tax administration func-
tion, and strong protections for confiden-
tial taxpayer information already exist.

### 4. Actions Evidencing Debtor-Creditor Relationship

Comments requested clarification that
certain types of payments such as
payments-in-kind, additions to principal,
and payments of interest could be evi-
denced by journal entries in centralized
cash management systems in which pay-
ables and receivables are managed. They
also noted that the journal entries could be
made with respect to the treasury center in
such cases. The Treasury Department and
the IRS agree that as long as a payment is
in fact made and a written record of the
payment is prepared and maintained, the
documentation rules should not require
that the payment be made or recorded in
any particular manner. However, the
Treasury Department and the IRS have
determined that there is no need to ex-
pressly note that payments-in-kind or ad-
ditions to principal should be included

because these actions generally would
take place and be recorded in as a part of
journal entries reflecting a payment of in-
terest. As a result, the final regulations
adopt these comments in respect of jour-
nal entries (other than with respect to
payments-in-kind or additions to princi-
pal).

Comments requested that the rules
make clear that the existence of creditors'
rights is more important than their exer-
cise. They urged a flexible approach that
included much deference to the judgment
of the creditor, suggesting a generous pe-
riod in which to act on default. Comments
noted that common law recognizes that
choosing not to enforce the terms of the
obligation may be completely consistent
with indebtedness treatment and does not
necessarily require an interest to be char-
acterized as stock. For example, if the
debtor's position deteriorates, if a default
could trigger other default events, or if
there are reasons to expect the debtor's
situation to improve, a creditor may be
well advised to choose forbearance. There
may also be legal constraints or obliga-
tions arising out of the relationship be-
tween an issuer and holder that are in an
expanded group that prevent or forestall
enforcement action, including fraudulent
conveyance laws.

Most comments, however, sought a
clear affirmation that this rule relates only
to the documentation required, not the
substantive evaluation of the creditor's ac-
tions. The Treasury Department and the
IRS agree that this rule addresses only the
requirement to document actions. How-
ever, the rules also require that an expla-
nation be documented for inaction by a
creditor upon failure of the issuer to com-
ply with the terms of purported indebted-
ness and that the explanation for such
inaction is an indebtedness factor. In the
context of highly-related parties, where
economic interests of the issuer and
holder are aligned, there is a greater need
for scrutiny where there is nonperfor-
mance and no assertion of creditor's
rights. The lack of an explanation for such
inaction may give rise to a substantive
determination that the parties did not in-
tend to create indebtedness in substance or
ceased to treat an interest as indebtedness.
Thus, the final regulations do not provide
any specific guidance that addresses the

comments related to the substantive eval-
uation of the actions the debtor or creditor
must take. The final regulations provide a
cross reference to § 1.1001-3(c)(4)(ii),
which provides rules regarding when a
forbearance may be a modification of a
debt instrument and therefore may result
in an exchange subject to § 1.1001-1(a).
As later discussed, such an exchange
could be a relevant date under the docu-
mentation rules.

## 5. Requests for Additional Guidance

Many comments requested more de-
tail about the type and extent of docu-
mentation that would be necessary in
order to satisfy the documentation rules,
often suggesting that examples and spe-
cific guidelines should be included in
the regulations. Comments expressed
concern that the lack of such guidelines
would cause administrative difficulties,
as agents would request, and taxpayers
would produce, unnecessary documen-
tation. As a result, time would be spent
unnecessarily on disputes over whether
the documentation rules were satisfied
instead of on the underlying substantive
determination of the character of the
interest at issue.

Comments suggested the issuance of
audit guidelines, the use of "fast track"
review by the IRS Office of Appeals, and
the admission of these issues relating to
the satisfaction of the documentation rules
into the pre-filing agreement program as
ways to facilitate administration for tax-
payers and the IRS alike. The IRS agrees
that these administrative procedures could
assist both taxpayers and the IRS in the
efficient resolution of cases. They are
available under generally applicable crite-
ria and procedures.

The Treasury Department and the IRS
have considered these comments and agree
that the purpose of the documentation rules
is not to prepare and maintain unnecessary
documentation. Rather, the purpose of the
documentation rules is to provide a taxpayer
with guidance regarding what broad catego-
ries of information are necessary to be doc-
umented to evidence the creation of a
debtor-creditor relationship, as well as to
facilitate tax administration.

D. Specific technical questions

### 1. Relevant Dates

Under proposed § 1.385-2, the rele-
vant date for purposes of documenting the
issuer's unconditional obligation to repay
and the creditor's right to repayment was
generally either the date that an expanded
group member issued an EGI or the date
that an instrument became an EGI. The
relevant date for purposes of documenting
the reasonable expectation of repayment
was generally either the date that an ex-
panded group member issued an EGI, the
date that an EGI was deemed reissued
under § 1.1001-3, or the date that an
instrument became an EGI. The relevant
date for purposes of documenting actions
evidencing a debtor-creditor relationship
was generally either the date that a pay-
ment was made or the date on which an
event of default occurred. Proposed
§ 1.385-2 provided that no date before the
applicable instrument becomes an EGI is
a relevant date.

Some comments suggested that the
"relevant date" be the same for the docu-
mentation requirements regarding the is-
suer's obligations, the holder's rights, or
the reasonable expectation of payment.
The Treasury Department and the IRS
have not adopted this suggestion because
these dates will not and should not always
match. For example, under a revolving
credit agreement individual draws would
typically be made at different times than
the requisite credit analysis of the bor-
rower. The Treasury Department and the
IRS have determined that the appropriate
times for retesting the reasonable expec-
tation of repayment and for documenting
other indebtedness factors may differ. For
example, if there is a material event af-
fecting the solvency or business of the
issuer, an updated analysis of the reason-
able expectation of repayment may be ap-
propriate, even where the legal documents
related to an interest have not been mod-
ified.

In addition, proposed § 1.385-2 pro-
vided that the relevant date with respect to
cash pools, master agreements, and simi-
lar arrangements included the date of the
execution of the legal documents govern-
ing the arrangement and the date of any
amendment to those documents that pro-

vides for an increase in the permitted
maximum amount of principal.

Comments suggested that relevant
dates for such arrangements should in-
clude only the dates that the arrangement
is put into place, new members are added,
or the maximum loan amount is increased.
The final regulations clarify that these
dates are generally the relevant dates for
these arrangements. However, as previ-
ously discussed, an annual credit analysis
(as well as a credit analysis as of a mate-
rial event of an issuer) must be performed
under these arrangements and, as a result,
the final regulations provide that relevant
dates for that credit analysis include the
anniversary of the credit analysis as well
as the date of any material event of the
issuer.

### 2. Maintenance Requirements

Proposed § 1.385-2 provided that re-
quired documentation must be maintained
for all taxable years that an EGI is out-
standing, until the period of limitations
expires for any federal tax return with
respect to which the treatment of the EGI
is relevant. Comments raised concerns
that this rule was burdensome and re-
quested that the final regulations include a
practical way to limit the length of time
that documentation must be maintained.
The Treasury Department and the IRS do
not adopt this request because they con-
sider it inappropriate to permit the de-
struction of documentation while such
documentation is relevant for federal tax
purposes because this would be inconsis-
tent with the requirements of section 6001
(requirement to keep books and records).

## 3. Period When § 1.385-2 Characterization is Given Effect

### a. Debt instrument becomes an EGI

Proposed § 1.385-2 provided that, in
the case of an interest that was an EGI
when issued, if the EGI is determined to
be stock as a result of the documentation
rules, the EGI is generally treated as stock
as of its issuance. The exception to this
general rule was if the failure to comply
with the documentation rules related to an
action evidencing a debtor-creditor rela-
tionship; in that case, the EGI would be

treated as stock as of the time that the
failure to comply occurs. However, if the
interest was not an EGI when issued but
later becomes an EGI that is determined to
be stock under the documentation rules,
the EGI is treated as stock from the date it
becomes an EGI.

Comments urged that the documenta-
tion rules apply only once an interest
becomes an EGI and that any character-
ization based on the application of rules
be limited to the treatment of the EGI
after it becomes an EGI. The Treasury
Department and the IRS intended that
the documentation rules would not gen-
erally apply to an interest until it be-
comes an EGI, and the final regulations
clarify this point.

Several comments also requested that
the rules not apply to any interest if, when
issued, either the issuer or holder was not
subject to federal tax, was a CFC, or was
a controlled foreign partnership. The final
regulations reserve on the treatment of
foreign issuers, and, other than potentially
under the anti-abuse rule, do not apply to
interests issued by a partnership. Accord-
ingly, the final regulations do not adopt
this comment.

Comments suggested clarifying the
treatment of an interest when its status
changes from an EGI to an intercompany
obligation subject to § 1.1502-13(g) and
when its status changes from an intercom-
pany obligation subject to § 1.1502-13(g)
to an EGI. Some comments requested that
in the case of an intercompany obligation
becoming an EGI, the regulations treat
the issue date as the date the interest
ceases to be an intercompany obligation.
Conversely, another comment urged that
if an interest becomes an EGI, it should
nevertheless be excluded from the reg-
ulations. The final regulations address
this comment by treating such an EGI
as subject to the documentation rules
when it becomes an EGI. This approach
is consistent with the approach in
§ 1.1502-13(g)(3)(ii), which treats such
an EGI as a new obligation for all fed-
eral income tax purposes.

Many comments urged that there was
no need to impose documentation require-
ments regarding the issuer's obligations,
the holder's rights, or the reasonable ex-
pectation of payment when a non-EGI be-
came an EGI because such documentation

would be done on issuance under common
commercial practices. As such, it arguably
would be adequate to police these require-
ments with an anti-abuse rule. Similarly,
some comments urged there be no such
documentation requirement when an ex-
panded group acquired an EGI from an-
other expanded group because the docu-
mentation rules would apply at the time
the EGI was issued.

Thus, under either suggestion, the only
documentation requirement that would
apply to such notes would be that relating
to evidence of a debtor-creditor relation-
ship. These comments also requested that,
if these suggestions were not adopted, the
regulations allow at least a year for tax-
payers to bring incoming EGIs into com-
pliance. The Treasury Department and the
IRS have determined that the documenta-
tion requirements are necessary for EGIs,
regardless of whether they are initially
issued within the expanded group or
whether they become EGIs after issuance.
The fact that such interests may have been
initially issued among less-related parties
does not change the requirement that the
interests must be characterized under fed-
eral tax principles as debt or equity, and
the indebtedness factors in the documen-
tation rules are important factors for the
debt-equity analysis of any interest. More-
over, once an interest becomes an EGI,
meaning that the issuer and holder are
highly related, the terms and conditions
may no longer be followed due to this
high degree of relatedness. Because of this
issue, it is necessary for such EGIs to be
subject to the rules in order to ensure that
the policy goals of the documentation
rules are achieved. Treating a loan differ-
ently once it becomes held by an entity
related to the issuer is not unique to these
rules. For purposes of testing for cancel-
lation of indebtedness income, section
108(e)(4) takes a similar approach by
treating a purchase of a note by a party
related to the issuer as in effect a repur-
chase of the note by the issuer. However,
the Treasury Department and the IRS
have relaxed the timely preparation re-
quirement so that the documentation of all
EGIs does not have to be prepared and
maintained until the time for filing the
issuer's federal income tax return (taking
into account all relevant extensions).

b. EGI treated as stock ceases to be an
EGI

Comments requested that, if an EGI
that was treated as stock under the docu-
mentation rules ceases to be treated as
stock when it ceases to be an EGI, the
recharacterization back to indebtedness is
deemed to occur immediately after the
interest ceases to be an EGI. The reason
offered was to avoid creating a noneco-
nomic dividend when the stock is deemed
exchanged for the note. The final regula-
tions do not adopt this comment. Under
the final regulations, if an EGI that was
treated as stock under the documentation
rules ceases to be treated as stock when it
ceases to be an EGI, the recharacterization
back to indebtedness is deemed to occur
immediately before the interest ceases to
be an EGI. This rule is intended to ensure
that the treatment of a third-party pur-
chaser of the EGI is not affected by the
final regulations, which are not intended
to affect issuances of notes among unre-
lated parties. If the rule suggested by the
comment were adopted, a third-party pur-
chaser would be treated as purchasing
stock that is immediately recharacterized
as indebtedness for federal tax purposes.
Such a rule would result in an issue price
of the new debt instrument determined
under section 1274, rather than section
1273, and might result in other collateral
consequences to the third party purchaser.

### 4. Applicable Financial Statements

Comments requested clarification on
the definition of the term applicable finan-
cial statement. For example, some com-
ments suggested that the regulations de-
fine the term to mean the most recent
regularly prepared financial statements,
provided that the statements were pre-
pared annually and that the taxpayer was
not aware of any material adverse decline
in the issuer's financial position. Other
comments asked for clarification on the
applicable financial statement that should
be used if more than one member of the
expanded group has a separate applicable
financial statement. Proposed § 1.385-2
referred to a combination of applicable
financial statements in such a case. The
final regulations clarify that, if there are
multiple separate applicable financial

statements that do not duplicate the assets
or income of expanded group members,
the applicable financial statements must
be combined to determine whether the
expanded group is under the threshold for
the application of the documentation
rules. The final regulations provide that in
the case of applicable financial statements
that reflect the total assets or annual total
revenue of the same expanded group
member, the applicable financial state-
ment with the greatest amount of total
assets is to be used. The final regulations
also provide rules that address the poten-
tial double counting of assets or revenue
when a combination of applicable finan-
cial statements is used. However, the final
regulations retain the rule that the set of
applicable financial statements are those
prepared in the past three years. This rule
eliminates the possibility that the most
recent applicable statement may not be
representative of the long-term asset and
revenue history of the expanded group.
The Treasury Department and the IRS
have determined that this history is an
appropriate measure of whether a group
should be subject to the documentation
rules. Because the expanded group defini-
tion and the consolidation rules for finan-
cial accounting rules differ, it will fre-
quently be the case that applicable
financial statements will provide informa-
tion about a set of corporations that does
not precisely match the set of corporations
in an expanded group. Applicable finan-
cial statements therefore provide an ap-
proximation of the assets and revenue of
the expanded group. Thus, even if the
most recent applicable financial statement
were below the threshold, it may not pro-
vide definitive information about the as-
sets and revenue of the expanded group.

One comment noted that, unless stock
and notes of expanded group members
were excluded from the computation of
assets and income, such amounts could be
duplicated in the calculation of total assets
or total annual revenue. The final regula-
tions exclude expanded group member
stock and notes, as well as any payments
with respect to such stock or notes to the
extent that those expanded group mem-
bers are consolidated for financial ac-
counting purposes in the applicable finan-
cial statements used to calculate whether
the asset or revenue thresholds are met.

### 5. Consistency Rule

Proposed § 1.385-2 provided that an
EGI would be respected as indebtedness
only if the documentation requirements
were satisfied. Further, if an issuer treated
an EGI as indebtedness, the issuer and all
other persons, except the Commissioner,
were required to treat the EGI as indebt-
edness for all federal tax purposes. Com-
ments requested clarification of this rule if
a taxpayer subsequently discovered that
an interest it treated as indebtedness
would be treated as stock under the doc-
umentation rules. The final regulations
adopt these comments with respect to the
consistency rule and clarify that only the
issuer and holder of an EGI are subject to
the consistency rule. Comments also
urged that taxpayers be permitted to treat
interests inconsistently with their classifi-
cation under the documentation rule once
an interest ceases to be subject to the rule,
provided such inconsistencies were dis-
closed on the taxpayers' returns. The final
regulations do not adopt this comment
because the final regulations, including
the consistency rule, would not apply to
an EGI for the period it were not an EGI.

### 6. No Affirmative Use Rule

Proposed § 1.385-2 included a rule
providing that the documentation rules
would not apply if a failure to comply
with the rules had as a principal purpose
reducing the federal tax liability of any
person. Comments urged that this rule be
removed, as they felt it caused significant
uncertainty that could lead to conflicts
with tax authorities. Comments also urged
that the rule be limited to failures of the
requirement to document actions evidenc-
ing a debtor-creditor relationship, inas-
much as taxpayers that intended an inter-
est to be treated as stock on issuance could
simply fashion the interest as stock or
nonqualified preferred stock at that time.

In response to comments, including
comments about the no affirmative use
rule creating unnecessary uncertainty, the
Treasury Department and the IRS reserve
on the application of the no affirmative
use rule in § 1.385-2 pending continued
study after the applicability date.

### 7. Anti-Abuse Rule

Under proposed § 1.385-2, if a debt
instrument not issued and held by mem-
bers of an expanded group was issued
with a principal purpose of avoiding the
documentation rules, the interest never-
theless would be subject to the documen-
tation rules. Comments suggested that this
broad anti-abuse rule be removed, or at
least narrowed, so that it would not apply
to loans between unrelated parties.

The Treasury Department and the IRS
decline to remove the rule as it serves an
important tax administration purpose.
Without such a rule, applicable instru-
ments not constituting EGIs could be is-
sued, for example, by a non-corporate en-
tity or a slightly less-related corporation to
circumvent the documentation rules. Fur-
ther, the Treasury Department and the IRS
decline to adopt the suggestion to limit the
rule to loans between related parties as
that would permit the use of accommoda-
tion parties to avoid the documentation
rules.

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

#### A. General approach of § 1.385-3

##### 1. Overview

The proposed regulations provided
that, to the extent a debt instrument is
treated as stock by reason of proposed
§ 1.385-3, the debt instrument would be
treated as stock for all federal tax pur-
poses.

Comments requested that proposed
§ 1.385-3 be withdrawn or thoroughly
reconsidered before being finalized. Other
comments recommended that proposed
§ 1.385-3 be withdrawn and replaced with
more limited rules, such as rules applica-
ble solely to inverted entities or foreign-
parented multinationals. Comments also
recommended withdrawal of portions of
the proposed regulations that would have
a significant impact on ordinary business
transactions. In some cases these com-
ments specified which provisions should
be withdrawn, such as the per se rule
described in proposed § 1.385-3(b)(3)
(iv)(B), while in other cases, the com-
ments did not specify which provisions

should be withdrawn. In addition, com-
ments suggested that the treatment of cer-
tain transactions (such as foreign-to-
foreign issuances or C corporation-to-C
corporation issuances) be excluded or re-
served in the final and temporary regula-
tions based on the U.S. tax status of the
issuer or holder of the instrument, or
based on whether the interest income from
the instrument is subject to federal income
tax.

As explained in this Part V.A, the Trea-
sury Department and the IRS decline to
adopt the alternative approaches sug-
gested by comments and have determined
that the general approach of proposed
§ 1.385-3, including the per se funding
rule, should be retained. However, based
on the comments received, the Treasury
Department and the IRS have determined
that it is appropriate to make significant
modifications to the scope of transactions
that must be considered in applying the
final and temporary regulations in order to
reduce the impact on ordinary business
transactions. These modifications are de-
scribed throughout this Part V.

The remainder of this Part V refers to
the "per se funding rule" to mean either
the rule described in proposed § 1.385-
3(b)(3)(iv)(B) or § 1.385-3(b)(3)(iii) of
the final regulations, or both, as the con-
text requires.

###### 2. U.S. Tax Status of Issuer or Holder

The final and temporary regulations do
not limit the application of § 1.385-3 to
inverted entities or foreign-parented mul-
tinationals. Any two highly-related do-
mestic corporations that compute federal
tax liability on a separate basis have sim-
ilar incentives to use purported debt to
create federal tax benefits without having
meaningful non-tax effects if one of the
domestic corporations has taxable income
and the other does not, for example due to
net operating loss carryovers. Moreover,
while an impetus for the regulations is the
ease with which related-party debt instru-
ments can be used to create significant
federal tax benefits, the final and tempo-
rary regulations are narrowly focused on
purported debt instruments that are issued
to a controlling corporate shareholder (or
person related thereto) and that do not
finance new investment in the operations

of the issuer. In developing regulations
under section 385, the Treasury Depart-
ment and the IRS have determined that,
when these factors are present, it is appro-
priate to treat the debt instrument as re-
flecting a corporation-shareholder rela-
tionship rather than a debtor-creditor
relationship across a broad range of cir-
cumstances.

Similarly, the final and temporary reg-
ulations do not adopt comments recom-
mending an exception from § 1.385-3 for
instruments for which the interest income
is subject to U.S. tax because it is: (i) paid
to a U.S. corporation, (ii) effectively con-
nected income of the lender, (iii) an
amount subject to withholding for U.S.
tax purposes, or (iv) subpart F income
(within the meaning of section 952(a)). As
explained in the preceding paragraph, the
Treasury Department and the IRS have
determined that, in the context of highly-
related corporations (where the related-
ness factor is also present), whether a pur-
ported debt instrument finances new
investment is an appropriate determina-
tive factor. Whether such factors are pres-
ent is not dependent on the federal income
tax treatment of payments on the instru-
ment. Moreover, in all of the situations
described in the comments in which an
amount of interest is "subject to" U.S. tax,
tax arbitrage opportunities would none-
theless arise if in fact the interest were not
subject to tax at the full U.S. corporate tax
rate and thus did not completely offset the
related interest deduction. Since the rules
apply only to payments between highly-
related parties, one would expect taxpay-
ers to seek to utilize related-party debt in
those circumstances, so that such a broad
exception would be inconsistent with the
underlying rationale for these rules. Fur-
ther, an exception based on the U.S. tax
consequences of payments with respect to
the instrument would require annual test-
ing of the effective tax rate with respect to
the payment and re-testing for any post-
issuance transfers of the debt instrument
to assess the tax status of each transferee
and the payments thereto. This require-
ment could result in instruments that
might otherwise be treated as equity pur-
suant to § 1.385-3 switching between debt
and equity classification from year to year,
depending on how the payment was taxed.
This generally would be inconsistent with

the purpose of section 385, which is to
characterize an instrument as debt or eq-
uity for all purposes of the Code, and
would be difficult for the IRS and taxpay-
ers to administer.

Comments also recommended that dis-
tributions that are subject to U.S. tax be
excluded from the general rule and fund-
ing rule. Comments asserted that such dis-
tributions do not facilitate earnings strip-
ping and therefore should not implicate
the concerns targeted under the proposed
regulations. For reasons similar to those
cited above for why the rules do not in-
clude an exception when interest is sub-
ject to U.S. tax, the Treasury Department
and the IRS decline to adopt these com-
ments. The final and temporary regula-
tions are intended to address debt instru-
ments that do not finance new investment
in the operations of the borrower. The
consequences of a distribution or acquisi-
tion to the recipient, whether the transac-
tion is taxed as a dividend (including as a
result of withholding tax), return of basis,
or gain, does not affect the determination
whether a close-in-time borrowing fi-
nanced new investment in the operations
of the borrower.

Thus, in general, the application of the
final and temporary regulations to a debt
instrument does not depend on the status
of the instrument's holder, except in the
case where the holder and issuer of the in-
strument are both members of the same
consolidated group. As discussed in the
preamble to the proposed regulations,
§ 1.385-3 does not apply to instruments
held by members of a consolidated group
because the concerns addressed in
§ 1.385-3 generally are not present when
the issuer's deduction for interest expense
and the holder's corresponding interest in-
come precisely offset on the consolidated
group's single consolidated federal in-
come tax return. Specifically, in addition
to being reported on a single federal in-
come tax return, the intercompany trans-
action rules of § 1.1502-13 operate to
ensure that the timing, character, and
other attributes of such items generally
match for federal income tax purposes.
For example, the ordinary character of a
borrowing member's repurchase premium
with respect to an intercompany obliga-
tion results in the lending member recog-
nizing as ordinary income what otherwise

would be treated as capital gain if the
members were taxed on a separate entity
basis.

However, as discussed in Part III.A.1
of this Summary of Comments and Expla-
nation of Revisions, and in response to
comments received, the final and tempo-
rary regulations reserve on their applica-
tion with respect to debt issued by foreign
issuers due to the potential complexity
and collateral consequences of applying
the regulations in this context where the
U.S. tax implications are less direct and of
a different nature. In addition, as dis-
cussed in Part III.B.2.b of this Summary
of Comments and Explanation of Revi-
sions, the final and temporary regulations
do not generally apply to S corporations
or non-controlled RICs and REITs. Even
though these entities are domestic corpo-
rations that can compute federal tax lia-
bility on a separate basis from their C
corporation subsidiaries, the general ap-
proach in the Code is to tax these entities
at the shareholder, rather than the corpo-
rate, level. Accordingly, they do not raise
the same type of concerns that underlie
the final and temporary regulations.

### 3. Entities with Disallowed or Minimal Interest Expense

Some comments requested an excep-
tion for U.S. issuers that are already
treated as paying disqualified interest un-
der section 163(j) (noting that United
States real property holding corporations
(USRPHCs) in particular are often subject
to such disallowance). Comments asserted
that this would mitigate the concerns
of the proposed regulations and proposed
that an issuer paying disqualified interest
be excluded from the scope of the regula-
tions because further base erosion through
related-party debt is not possible. Other
comments stated that the rules should not
apply to an entity with net interest income
or only a de minimis amount of net inter-
est expense.

The final and temporary regulations do
not adopt the suggestion to exclude issu-
ers with disqualified interest or issuers
with low or no net interest expense be-
cause, as explained in Section A.1 of this
Part V, the regulations are concerned
about debt instruments that do not finance
new investment, which does not depend

on whether the borrower is excessively
leveraged, has net interest income or ex-
pense, or is able to deduct its interest
expense. The final and temporary regula-
tions apply to distinguish debt from eq-
uity, whereas the rules under section
163(j) apply to all interest expense with-
out the need to attribute interest to partic-
ular debt instruments. In addition, the dis-
allowance under section 163(j) may vary
from year to year, so that even if it were
possible to trace interest limited under that
section to a particular instrument, whether
any particular instrument was so impacted
would change from year to year. As dis-
cussed in Section A.1 of this Part V, annual
retesting for purposes of an instrument's
characterization would be inconsistent with
the purpose of section 385 and would be
difficult to administer. For these reasons, the
Treasury Department and the IRS have de-
termined that it would not be practical or
administrable to create an exception under
the final and temporary regulations based on
whether interest has been disallowed under
section 163(j).

Furthermore, in the case of issuers with
low or no net interest expense, a number
of other exceptions provided in the final
and temporary regulations will achieve a
similar result for some entities. For exam-
ple, as described in Section G.1 of this
Part V, the final and temporary regulations
provide an exception for debt instruments
issued by certain regulated financial issu-
ers, for which interest income often off-
sets interest expense. In addition, the final
and temporary regulations expand the $50
million threshold exception in the manner
described in Section E.4 of this Part V so
that all taxpayers can exclude the first $50
million of indebtedness that otherwise
would be recharacterized under § 1.385-
3. Finally, in order to further reduce com-
pliance costs, the final and temporary reg-
ulations provide a broad exception to the
funding rule for short-term debt instru-
ments, as described in Section D.8 of this
Part V, which generally applies to all non-
interest bearing debt instruments as well
as many other debt instruments that are
short-term in form and substance. Similar
to a net interest expense limitation, these
new and expanded exceptions will, in
combination, have the effect of exempting
a number of entities with low net interest
expense and will reduce the burden of

complying with the final and temporary
regulations in cases where the U.S. tax
interest is limited. See also Section D.9 of
this Part V, which addresses a related
comment requesting that the final and
temporary regulations permit taxpayers to
net indebtedness "receivables" and "pay-
ables" for purposes of the funding rule.

### 4. Limiting Interest Deductibility without Reclassifying Interests

Comments also suggested addressing
the policy concerns underlying the regu-
lations by issuing guidance that more
closely conforms to concepts used in sec-
tion 163(j), which limits the deduction for
interest on certain indebtedness in a tax-
able year. Section 385 authority differs
fundamentally from section 163(j) be-
cause, rather than limiting interest deduc-
tions in a particular year, section 385 ad-
dresses the treatment of certain interests in
a corporation as stock or indebtedness.
While rules limiting interest deductions
from excessive related-party indebtedness
might address the broader policy concerns
described in this preamble and in the no-
tice of proposed rulemaking, Congress did
not delegate such authority under section
163(j) to the Secretary. Accordingly, the
final and temporary regulations are not
intended to resolve the tax preference for
using related-party debt to finance invest-
ment. Instead, the final and temporary reg-
ulations are more narrowly focused on the
question of whether purported debt instru-
ments issued to a controlling corporate
shareholder (or a person related thereto)
that do not finance new investment in the
operations of the issuer reflect a corporation-
shareholder relationship or a debtor-creditor
relationship for purposes of the Code. The
Treasury Department and the IRS have de-
termined that this question is appropriately
addressed under section 385 and, accord-
ingly, that it is appropriate to treat such debt
instruments generally as stock for federal
tax purposes.

### 5. Group Ratio Test

One comment suggested that the regu-
lations under § 1.385-3 include an excep-
tion to the extent the issuing member's net
indebtedness does not exceed its relative
share of the expanded group's third-party

indebtedness. The comment noted that
such a rule would be consistent with leg-
islative proposals made by the Treasury
Department to modify the interest expense
disallowance rules under section 163(j).

The Treasury Department and the IRS
decline to adopt this recommendation.
While reference to an expanded group's
third-party indebtedness could be part of a
comprehensive solution to address the tax
incentives to use related-party debt to cre-
ate excessive leverage, as discussed in this
Section A.1 of this Part V, the final and
temporary regulations are more narrowly
focused on purported debt instruments
that do not finance new investment. The
Treasury Department and the IRS have
determined that, when this factor, along
with the relatedness factor, is present, the
purported debt instrument should be
treated as stock without regard to whether
the issuer is over-leveraged, whether by
reference to the expanded group's third-
party indebtedness or some other ratio.
Furthermore, a member's relative share of
the expanded group's third-party indebt-
edness generally would fluctuate every
year as the group's income statement or
balance sheet changes. An exception that
varied based on such a ratio would there-
fore require that instruments that other-
wise might be treated as equity pursuant
to § 1.385-3 instead switch between debt
and equity classification from year to year,
depending on the group's ratio for that
year. As discussed in Section A.1 of this
Part V, annual retesting for purposes of an
instrument's characterization would be in-
consistent with the purpose of section 385,
and would be difficult for the IRS and
taxpayers to administer.

### 6. Multi-factor Analysis

Some comments suggested that the
regulations adopt a multi-factor debt-
equity analysis similar to that traditionally
undertaken by courts. The Treasury De-
partment and the IRS decline to adopt a
multi-factor approach to § 1.385-3. As
discussed in Part II.A of this Summary of
Comments and Explanation of Revisions,
section 385 authorizes the Secretary to
prescribe dispositive factors for determin-
ing the character of an instrument with
respect to particular factual situations.
Further, Congress enacted section 385 to

resolve the confusion created by the
multi-factor tests traditionally utilized by
courts, which produced inconsistent and
unpredictable results. See S. Rep. No. 91-
552, at 138 (1969). The Treasury Depart-
ment and the IRS have determined that it
is necessary and appropriate to provide a
clear rule regarding the characterization of
issuances of purported debt instruments
that do not finance new investment in the
operations of the issuer. In contrast, rec-
ommendations for a multi-factor approach
to address debt instruments that do not
finance new investment could result in
increased uncertainty for taxpayers, ad-
ministrative difficulties for the IRS, and
unpredictable case law.

### 7. Consistency with Base Erosion and Profit Shifting Outputs

Some comments claimed that the pro-
posed regulations were inconsistent with
the "best practice" recommendations that
were developed as part of the G20 and
Organisation for Economic Co-operation
and Development's (OECD) Base Erosion
and Profit Shifting (BEPS) project under
Action Item 4 (Limiting Base Erosion In-
volving Interest Deductions and Other Fi-
nancial Payments). The report from that
project recommended that countries adopt
limitations on interest deductions that in-
corporate general group ratio and fixed
ratio rules. The Treasury Department and
the IRS have concluded that the final and
temporary regulations are entirely consis-
tent with the final report for Action Item 4,
which recommends in paragraph 173 that,
in addition to the group ratio and fixed
ratio rules, countries consider introducing
domestic rules to address when "[a]n en-
tity makes a payment of interest on an
"artificial loan," where no new funding is
raised by the entity or its group." Consis-
tent with the Action Item 4 report, the
final and temporary regulations provide
targeted rules to address this concern.

Some comments also noted that the
recharacterization of debt instruments as
equity instruments under the proposed
regulations would result in a significant
increase in the number of hybrid instru-
ments, contrary to the United States' en-
dorsement of Action Item 2 (Neutralise
the effects of hybrid mismatch arrange-
ments) of the BEPS project, which recom-

mended rules for neutralizing the effects
of hybrid mismatch arrangements. The
comments also noted that foreign coun-
tries could apply the BEPS hybrid mis-
match rules to deny foreign interest de-
ductions with respect to debt instruments
issued by a foreign entity to a U.S. parent
that were treated as stock under the pro-
posed regulations, which could increase
the foreign tax credits claimed by the U.S.
parent.

The Treasury Department and the IRS
do not agree that the final and temporary
regulations are inconsistent with the goal
of Action Item 2, which is to neutralize
the tax effects of hybrid instruments that
otherwise would create income that is not
subject to tax in any jurisdiction, rather
than to establish an international consen-
sus on the treatment of particular instru-
ments as debt or equity. Furthermore, be-
cause the final and temporary regulations
reserve on their application to foreign is-
suers, hybrid instruments arising under the
final and temporary regulations should not
result in other jurisdictions applying the
hybrid mismatch rules described in Action
Item 2, which generally apply only to
instruments giving rise to a deduction in
the issuer's jurisdiction with no corre-
sponding inclusion in the lender's juris-
diction.

### B. Treatment as stock for purposes of the Code

### 1. In General

Comments requested clarification as to
the extent to which an interest treated as
stock under the proposed regulations is
treated as stock for all federal tax pur-
poses. The Treasury Department and the
IRS have determined that no further clar-
ification is needed on this point. Consis-
tent with the proposed regulations, the
final and temporary regulations generally
provide that an instrument treated as stock
under the final and temporary regulations
is treated as stock for all federal tax pur-
poses. However, as further discussed in
Section B.2 of this Part V, the final and
temporary regulations provide that a debt
instrument that is treated as stock under
§ 1.385-3 is not treated as stock for pur-
poses of section 1504(a).

Comments requested an alternative ap-
proach under which, to the extent a debt
instrument is treated as stock under the
regulations, equity treatment would apply
solely for purposes of disallowing interest
deductions under section 163, but the debt
instrument would not be treated as stock
for all other purposes of the Code. Other
comments recommended that the pro-
posed rules should not recharacterize a
debt instrument to the extent that a tax-
payer elects not to deduct interest other-
wise allowable under section 163 with
respect to a particular debt instrument.
The Treasury Department and the IRS
have not adopted these recommended ap-
proaches because, although section 385
authorizes the Secretary to prescribe rules
to determine whether an interest in a cor-
poration is treated as stock or indebted-
ness, neither section 385 nor section 163
authorizes a broad rule that disallows an
interest deduction under section 163 with
respect to an instrument that is otherwise
treated as indebtedness.

Comments also observed the potential
for uncertainty or adverse results under
the proposed regulations, particularly pro-
posed § 1.385-3, with respect to the fol-
lowing particular Code provisions and re-
quested additional guidance or relief. In
many cases, the recommended solution
was a limited exception from equity treat-
ment for a recharacterized instrument for
purposes of the particular Code provision.

· Section 246. Comments noted that
payments on a hybrid instrument (eq-
uity for federal income tax purposes,
but debt for non-tax purposes) that af-
fords the holder creditor rights may
not qualify for the dividends received
deduction under section 243. See sec-
tion 246(c); Rev. Rul. 94-28 (1994-1
C.B. 86) (concluding that the holding
period of such an instrument was re-
duced under section 246(c)(4)(A),
which reduces the holding period for
periods in which the taxpayer has an
option to sell, or is under a contractual
obligation to sell, the stock).

· Section 305. Comments requested
clarification regarding the application
of section 305 to a debt instrument
recharacterized as stock. For example,
a comment requested clarification re-
garding the application of section
305(c) to amounts that would repre-

sent accrued interest but for the rechar-
acterization, which could result in a
constructive distribution to the instru-
ment holder. A comment also recom-
mended that the final and temporary
regulations provide that an interest re-
classified as preferred stock should not
cause section 305(c) to apply as a re-
sult of any discount resulting from the
fact that the interest was issued with a
stated interest rate that is less than a
market rate for dividends on preferred
stock.

· Sections 336(e) and 338. A comment
requested clarification regarding the
qualification for, and results stemming
from, asset sales that are deemed to
occur when an election is made under
section 336(e) or section 338. The
comment posited a buyer making a
section 338(g) election with respect to
its purchase of a foreign target corpo-
ration, and certain of the foreign tar-
get's foreign subsidiaries, each of
which is either the holder or issuer of
an instrument that would have been
recharacterized under proposed § 1.385-
3. The comment posed a series of
questions, including whether the
"old" and "new" entities are re-
spected as unrelated or treated as
successors, and how the recharacter-
ized instruments affect calculations
required under section 338.

· Section 368. Comments expressed
concern that a debt instrument that is
recharacterized as stock would consti-
tute a discrete class of nonvoting stock
for purposes of determining control
under section 368(c), which could
cause a transaction to fail to satisfy the
control requirement of numerous non-
recognition provisions. See Rev. Rul.
59-259 (1959-2 C.B. 115) (holding
that control within the meaning of sec-
tion 368(c) requires ownership of 80
percent of the total number of shares
of each class of nonvoting stock). One
comment observed that a debt instru-
ment recharacterized as stock could
also affect whether the continuity of
interest requirement for reorganiza-
tions in § 1.368-1(e) is satisfied. Be-
cause continuity of interest is deter-
mined by reference to the value of the
proprietary interests of the target cor-
poration, a debt instrument that is

treated as target stock and that is re-
deemed for cash as part of the reorga-
nization would dilute the percentage of
acquirer stock in relation to total con-
sideration. See § 1.368-1(e)(1)(ii).

· Section 382. Comments observed that
the recharacterization of an instrument
could increase an existing sharehold-
er's ownership of a loss corporation or
result in the creation of a new share-
holder for purposes of section 382 test-
ing. In addition, a corresponding de-
crease in ownership could occur when
a recharacterized debt instrument is re-
tired. These transactions could cause
an owner shift or ownership change
within the meaning of section 382(g),
which could limit the ability of a loss
corporation (or loss group) to utilize
losses of the issuing entity.

· Section 1503. Comments observed
that recharacterized debt instruments
could be treated as applicable pre-
ferred stock for purposes of section
1503(f)(3)(D), which could result in a
member of a consolidated group los-
ing the ability to utilize the group's
losses or credits.

· Section 7701(l). Comments expressed
concern that an instrument that is
treated as stock could be subject to the
fast-pay stock rules of § 1.7701(1)-3,
and observed that transactions involv-
ing fast-pay stock are listed transac-
tions under Notice 2000-15 (2000-1
C.B. 826), thus imposing additional
reporting requirements and penalties
for noncompliance.

· Section 1.861-12T(f). One comment
questioned whether treating purported
indebtedness as stock would have
consequences under § 1.861-12T(f),
which provides that, for purposes of
apportioning expenses under an asset
method for purposes of section 904(d),
in the case of any asset in connection
with which interest expense accruing
at the end of the taxable year is capi-
talized, deferred, or disallowed, the ad-
justment or fair market value is re-
duced by the principal amount of the
indebtedness the interest on which is
so capitalized, deferred, or disallowed.

· Provisions relating to hedging trans-
actions. Comments expressed concern
that an interest treated as stock under
the final and temporary regulations

would be ineligible for purposes of
applying various hedging provisions in
the Code and regulations that apply to
debt instruments but not stock. See,
e.g., §§ 1.954-2(a)(4)(ii), 1.988-5,
and 1.1275-6.

Some comments suggested that the fi-
nal and temporary regulations exercise the
authority in section 351(g)(4) in order to
treat any debt instrument that is treated as
stock under the section 385 regulations as
not stock for purposes of the control test
in section 368(c) and other tests that are
based on the ownership of stock. Section
351(g)(4) provides that the Secretary may
prescribe such regulations as may be nec-
essary or appropriate to carry out the pur-
poses of section 351(g) and sections
354(a)(2)(C), 355(a)(3)(D), and 356(e), as
well as to prescribe regulations, consistent
with the treatment under those sections,
for the treatment of nonqualified preferred
stock under other provisions of the Code.
Some comments interpreted this authority
broadly to authorize the Secretary to treat
instruments treated as stock under section
385 as debt for all other purposes of the
Code when the context suggested that the
instruments were not being used to
achieve federal tax benefits.

The final and temporary regulations
retain the approach of the proposed reg-
ulations under which related-party in-
debtedness treated as stock by applica-
tion of § 1.385-3 is treated as stock for
all federal tax purposes, with one excep-
tion with respect to section 1504 that is
discussed in Section B.2 of this Part V.
As discussed in Section A of this Part V,
when a purported debt instrument issued
to a highly-related corporation does not
finance new investment in the opera-
tions of the issuer, the Treasury Depart-
ment and the IRS have determined that
it is appropriate to treat the purported
debt instrument as stock for all federal
tax purposes. Moreover, the issues de-
scribed in the comments listed in this
Section B.1 of this Part V generally do
not arise uniquely as a result of the
application of the final and temporary
regulations but, rather, arise whenever
purported debt instruments are charac-
terized as stock under applicable com-
mon law. Several of these issues relate
to longstanding uncertainties within
those particular provisions, which are

beyond the scope of the final and tem-
porary regulations.

In addition, the final and temporary
regulations provide new and broader ex-
ceptions than the proposed regulations, in-
cluding an expanded $50 million thresh-
old exception, the expanded group
earnings exception, and the new qualified
short-term debt exception. These excep-
tions are intended to accommodate ordi-
nary course loans and distributions with
the result that the final and temporary reg-
ulations focus on non-ordinary course
transactions. Taking these exceptions into
account, taxpayers generally will have the
ability to avoid issuing debt instruments
that will be treated as stock under
§ 1.385-3, and therefore to avoid the an-
cillary issues described in the comments
that are associated with recharacterization
as stock. Accordingly, the Treasury De-
partment and the IRS have determined
that the final and temporary regulations do
not need to provide additional guidance,
or additional exceptions, with respect to
the specific scenarios described above,
which also arise under the common law
when purported debt instruments are
treated as stock.

### 2. Limited Exception from Treatment as Stock: Section 1504(a)

Comments recommended that debt in-
struments treated as stock under the final
and temporary regulations be treated as
stock described in section 1504(a)(4),
which is not treated as stock for purposes
of the ownership requirements of section
1504(a). The recommended rule would
prevent the recharacterization of a cov-
ered debt instrument issued by a member
of a consolidated group under § 1.385-3
from causing deconsolidation of the mem-
ber.

Section 1504(a)(4) provides that, for
purposes of section 1504(a), the term
"stock" does not include certain preferred
stock commonly referred to as "plain va-
nilla preferred stock." Specifically, sec-
tion 1504(a)(4) provides that for purposes
of section 1504(a), the term "stock" does
not include any stock that meets four
technical requirements: (i) the stock is
not entitled to vote, (ii) the stock is
limited and preferred as to dividends
and does not participate in corporate

growth to any significant extent, (iii) the
stock has redemption and liquidation
rights that do not exceed the issue price
of the stock (except for a reasonable
redemption or liquidation premium),
and (iv) the stock is not convertible into
another class of stock.

Comments observed that, in many in-
stances, a debt instrument treated as stock
as a result of § 1.385-3 will qualify as
section 1504(a)(4) stock; in particular, be-
cause the terms of such instrument often
will be legally limited and preferred as to
payments and will not participate in cor-
porate growth to any significant extent.
However, comments observed that in
some circumstances a debt instrument
treated as stock under § 1.385-3 will not
qualify as section 1504(a)(4) stock be-
cause, for example, the instrument is
deemed reissued at a premium or discount
or is convertible into another class of
stock. Comments noted that section
1504(a)(5) provides that the Secretary
shall prescribe such regulations as may be
necessary or appropriate to carry out the
purposes of section 1504(a), including by
treating stock as not stock for purposes of
that subsection.

The final and temporary regulations
adopt the recommendation that debt in-
struments treated as stock under the final
and temporary regulations should be
treated as not stock for purposes of section
1504(a). This treatment is consistent with
the statutory policy of treating stock that
has certain legal features similar to debt as
not stock for purposes of section 1504(a).
The legislative history of section 1504(a)
(5) indicates that Congress intended for
the Secretary to use that authority to carry
out the purposes of section 1504(a), in-
cluding by treating certain stock that oth-
erwise could cause members of an affili-
ated group to disaffiliate, as not stock. See
H.R. Conf. Rep. No. 861, 98th Cong., 2d
Sess. 831, 834 (1984). Accordingly, pur-
suant to the authority under section
1504(a)(5)(A), the final and temporary
regulations provide that a debt instrument
that is treated as stock under § 1.385-3
and that would not otherwise be described
in section 1504(a)(4), is not treated as
stock for purposes of determining whether
a corporation is a member of an affiliated
group under section 1504(a).

3\. Allocation of Payments with respect
to Bifurcated Instruments

Comments requested guidance con-
cerning the allocation of payments to an
instrument that is partially recharacterized
as stock. For example, if USS borrows
$100x with, which is treated as funding a
distribution of $50x, and no exception ap-
plies, half of the debt instrument would be
treated as stock. If USS makes a $5x cou-
pon payment with respect to the purported
debt instrument, the proposed regulations
did not specify the manner in which the
payment would be allocated between the
portion of the instrument treated as stock
and the portion treated as debt.

Comments suggested the issuer should
be permitted to determine the allocation of
payments with respect to the portions of a
bifurcated instrument. Comments also
stated that, if an issuer fails to specifically
allocate the payment, the payment should
be allocated first to the debt portion of the
instrument because such an allocation
comports with general rules of corporate
law. Other comments noted the possibility
of allocating the payments on a pro rata
basis.

The final and temporary regulations
provide that a payment with respect to an
instrument partially recharacterized as
stock that is not required to be made pur-
suant to the terms of the instrument, for
example a prepayment of principal, may
be designated by the issuer as being with
respect to the portion recharacterized as
stock or to the portion that remains treated
as indebtedness. If no such designation is
made, the payment is treated as made pro
rata to the portion recharacterized as stock
and to the portion that remains treated as
indebtedness.

The Treasury Department and the IRS
decline to accept the recommendation to
provide similar optionality for payments
that are required to be made pursuant to
the terms of the agreement. In that situa-
tion, the Treasury Department and the IRS
are of the view that, because the instru-
ment will provide for payments with re-
spect to the entire instrument, it is appro-
priate to treat those payments as made pro
rata with respect to the portion recharac-
terized as stock and to the portion that
remains treated as indebtedness.

## 4. Repayments Treated as Distributions

Several comments recommended that
the final and temporary regulations in-
clude rules to address "cascading" rechar-
acterizations; that is, situations in which
the recharacterization of one covered debt
instrument could lead to deemed transac-
tions that result in the recharacterization
of one or more other covered debt instru-
ments in the same expanded group. Com-
ments generally addressed two different
scenarios. The first scenario involved pay-
ments made by the issuer with respect to
recharacterized instruments. Those pay-
ments would be treated as distributions on
stock for purposes of the funding rule,
which could result in one or more of the
issuer's other covered debt instruments
being treated as stock. Those transactions
are addressed in this Section B.4. The
second scenario involved the treatment of
the lending member with respect to acqui-
sitions of instruments treated as stock,
which could also result in the recharacter-
ization of covered debt instruments issued
by the lending member. This second sce-
nario is addressed in Section B.5 of this
Part V.

Regarding the first set of transactions,
comments noted that, under the proposed
regulations, a repayment of a debt instru-
ment recharacterized as stock is treated as
a distribution for purposes of the funding
rule, and as such may cause a recharacter-
ization of other debt instruments under the
funding rule. Comments requested that the
final and temporary regulations prevent
this by providing that repayments or dis-
tributions with respect to recharacterized
stock be disregarded for purposes of the
funding rule. For the reasons set forth
below, the final and temporary regulations
do not adopt this request.

Section 1.385-3(f)(4) of the proposed
regulations defined a distribution as any
distribution made by a corporation with
respect to its stock. Under the proposed
regulations, a debt instrument treated as
stock under § 1.385-3 was generally
treated as stock for all purposes of the
Code. As a result, a payment with respect
to a recharacterized debt instrument
was treated as a distribution for purposes
of the funding rule. Comments asserted
that the interaction of these rules resulted
in duplicative recasts. For example, as-

sume that a foreign parent corporation
(FP) wholly owns a U.S. subsidiary (S1).
FP lends $100x to S1 in exchange for
Note A (transaction 1), and within 36
months, S1 distributes $100x of cash to
FP (transaction 2), resulting in Note A
being recharacterized as stock under pro-
posed § 1.385-3(b)(3)(ii)(A). Then, S1 re-
pays the entire $100x principal amount of
Note A (transaction 3), which is treated as
a distribution, including for purposes of
the funding rule because Note A is treated
as stock. Next, within 36 months after
transaction 3, FP again lends $100x to S1
in exchange for Note B (transaction 4).
The proposed regulations would treat
Note B as funding the deemed distribution
in transaction 3. Therefore, as a result of
transaction 3 and transaction 4, Note B is
recharacterized as stock under proposed
§ 1.385-3(b)(3)(ii)(A).

Comments asserted that this result is
duplicative because both Note A and Note
B are treated as stock. The Treasury De-
partment and the IRS do not agree with
this assertion, and as a result the final and
temporary regulations do not provide for a
different result. In this series of four trans-
actions, on a net basis S1 has distributed
$100x to FP and has outstanding a $100x
loan from FP (Note B). If the final and
temporary regulations adopted the com-
ment and did not treat transaction 3 as
resulting in a distribution for purposes of
the funding rule, then Note B would not
be recharacterized as stock even though
the series of transactions results in a
funded distribution.

The Treasury Department and the IRS
decline to adopt this comment because the
funding rule could be circumvented if the
repayment of a note that is treated as stock
were not treated as a distribution. Apply-
ing the comment's requested change to
the facts above, the repayment of Note A
would redeem that particular instrument,
which could then be replaced with Note B
in transaction 4, putting the parties in an
economically similar position but avoid-
ing the application of § 1.385-3.

One comment did not dispute the suc-
cessive recharacterizations of Note A and
Note B for the funding rule, but argued
that the successive recasts nonetheless re-
sulted in duplicative income inclusions,
since each repayment would result in a
dividend to the extent of current and ac-

cumulated earnings and profits. The Trea-
sury Department and the IRS did not re-
vise the final and temporary regulations
for this comment because the potential for
multiple dividend inclusions is a conse-
quence of the subchapter C rules that treat
distributions with respect to stock (includ-
ing certain redemptions) as being made
first out of the corporation's current and
accumulated earnings and profits to the
extent thereof, rather than a result specific
to the application of § 1.385-3.

On the other hand, to prevent inappro-
priate duplication under the funding rule
in fact patterns like the preceding exam-
ple, § 1.385-3(b)(6) of the final regula-
tions clarifies that once a covered debt
instrument is recharacterized as stock un-
der the funding rule, the distribution or
acquisition that caused that recharacter-
ization cannot cause a recharacterization
of another covered debt instrument after
the first instrument is repaid. Thus, the
distribution in transaction 2 that caused
the recharacterization of Note A cannot
cause a recharacterization of another cov-
ered debt instrument. For a discussion of a
coordination rule that supersedes this non-
duplication rule during the transition pe-
riod while covered debt instruments that
otherwise would be recharacterized as
stock are not treated as stock, see Section
B.2 of Part VIII of this Summary of Com-
ments and Explanation of Revisions.

## 5. Iterative Recharacterizations

The second set of cascading transac-
tions addressed by comments involves a
type of iterative recharacterization. Spe-
cifically, comments noted that when a
debt instrument is recharacterized as stock
under the proposed regulations, the holder
of the instrument is treated as acquiring
stock of an expanded group member in-
stead of indebtedness. If that holder were
itself funded, the recharacterized instru-
ment could, in turn, cause a recharacter-
ization of the holder's own borrowing. For
example, assume that P is the parent of an
expanded group, and directly owns all of
the stock of S1 and S2. If P loaned $100x
to S1, S1 loaned $100x to S2, and S2
distributed $100x to P, S1's loan to S2
would be recharacterized as stock under
the funding rule, and S1's acquisition of
the S2 instrument would be treated as an

acquisition of S2 stock that would cause
S1's loan from P to be treated as stock
under the funding rule. Comments ex-
pressed concern that an initial recharacter-
ization could thus lead to a multitude of
recharacterized instruments throughout
the expanded group.

To address this concern, comments
recommended an exception to the funding
rule when, during the per se period de-
scribed in proposed § 1.385-3(b)(3)(iv)
(B), a funded member makes an advance
to a second expanded group member, and
that advance to the second expanded
group member is characterized as stock of
the second expanded group member under
§ 1.385-3. Comments stated that this se-
ries of transactions can occur frequently
when the first funded member makes and
receives advances frequently, particularly
in connection with cash pooling and cash
pool headers (as described in Section D.8
of this Part V), and thus could spread the
recharacterizations throughout the cash
pooling arrangement.

The Treasury Department and the IRS
expect that the changes adopted in the
final and temporary regulations limiting
the application of § 1.385-3 to domestic
issuers and providing a broad exception
for short-term indebtedness, including de-
posits with a qualified cash pool header,
should substantially address the concerns
regarding iterative recharacterizations of
covered debt instruments. Nonetheless, in
response to comments, the final and tem-
porary regulations include a limited ex-
ception to the funding rule for certain ac-
quisitions of expanded group stock that
result from the application of § 1.385-3,
which include not only covered debt in-
struments that are recharacterized as ex-
panded group stock under the funding
rule, but also acquisitions of stock of an
expanded group partner and a regarded
owner under the rules described in Sec-
tions H.4 and 5 of this Part V. If this new
exception applies, in the example above,
S1's loan to S2 would still be treated as
stock under the funding rule, but S1's
acquisition of the S2 instrument would not
be treated as an acquisition of S2 stock
that would cause S1's loan from P to be
treated as stock under the funding rule.

The Treasury Department and the IRS
intend for this exception to address the
concern raised in comments about unin-

tentional serial recharacterizations. There-
fore, this exception does not apply if the
acquisition of deemed stock by means of
the application of the funding rule is part
of a plan or arrangement to prevent the
application of the funding rule to a cov-
ered debt instrument.

## 6. Inadvertent Recharacterization

Comments noted that, in many in-
stances, a borrower could trigger the ap-
plication of the funding rule through sim-
ple inadvertence or genuine mistake (for
example, incorrectly estimating earnings
and profits despite reasonable effort). In
addition, a taxpayer that is unaware that a
debt instrument within the expanded
group is treated as stock under § 1.385-3
could engage in transactions that result in
unanticipated ancillary consequences.

One comment offered the following
example: FP wholly owns both FS and
USS1, and USS1 wholly owns both USS2
and USS3. In year 1, FS loans $10x to
USS2. Later in year 1, USS2 distributes
$10x to USS1 and, either through a simple
mistake or a good faith but erroneous be-
lief that an exception to recharacterization
applies, the expanded group fails to take
into account the treatment of the USS2
note as stock under § 1.385-3. Subse-
quently, in a transaction intended to qual-
ify under section 351, USS1 contributes
the stock of USS3 to USS2. Because FS
holds recharacterized stock in USS2,
USS1 fails to satisfy the section 368(c)
control requirement of section 351(a) and
is thus subject to tax on any unrealized
gain in the USS3 stock.

Comments also included examples in
which the inadvertent failure caused a ter-
mination of a consolidated group or of a
special tax status of the issuer (for exam-
ple, failure to qualify as a REIT). Com-
ments requested that an issuer be permit-
ted to cure the inadvertent recharacterization
within a reasonable period after becoming
aware of the correct treatment of the in-
strument under the final and temporary
regulations. One proposal suggested that
the issuer be permitted to eliminate the
debt by cancellation or repayment within
a specified time period, with such elimi-
nation presumably considered retroactive
to the issuance. A similar proposal re-
quested that an issuer be permitted to cure

an instrument recharacterized by the fund-
ing rule by making an equity contribution
sufficient to offset any reduction in net
equity, regardless of whether the rechar-
acterized instrument remains outstanding.
As discussed in Part IV.A.3.c of this Sum-
mary of Comments and Explanation of
Revisions, comments also suggested ex-
panding the scope of the reasonable cause
exception in proposed § 1.385-2(c)(1) to
apply to instruments recharacterized un-
der the documentation rules by adopting a
more lenient standard than those used in
§ 301.6724-1, that is, the presence of
significant mitigating factors with respect
to a failure or a failure arising from events
beyond the control of the members of the
expanded group.

The Treasury Department and the IRS
decline to adopt the recommendation to
provide a general remediation rule that
would allow certain taxpayers to mitigate
the ancillary consequences of issuing
stock beyond the specific and limited ex-
ceptions for certain iterative recharacter-
izations discussed in Section B.5 of this
Part V and certain qualified contributions
discussed in Section E.3.b of this Part V
because of concerns about administering
the regulations and concerns about pro-
viding taxpayers a right, but not an obli-
gation, to retroactively change the charac-
ter of a transaction. Moreover, the
Treasury Department and the IRS have
determined that the significant scope
changes to the final and temporary regu-
lations, including the narrowing of the
regulations to only apply to covered debt
instruments, the addition of several new
exceptions to § 1.385-3, the expansion of
existing exceptions to § 1.385-3, and the
explicit treatment of recharacterized stock
as not stock for purposes of section
1504(a) will reduce the instances of, and
mitigate the effects of, inadvertent rechar-
acterizations under the final and tempo-
rary regulations.

## 7. Hook Stock

One comment observed that the pro-
posed regulations would increase the in-
stances in which a debt instrument issued
by a corporation would be treated as stock
held by a direct or indirect subsidiary,
commonly referred to as hook stock. The
comment recommended that the regula-

tions provide rules to avoid the creation of
hook stock. The final and temporary reg-
ulations do not generally adopt this rec-
ommendation. The Treasury Department
and the IRS have determined that consid-
eration of whether a debt issuance fi-
nances new investment, in the context of
related parties, are appropriate determina-
tive factors with respect to debt-equity
characterization across a broad range of
circumstances. However, as discussed in
Section E.2.a of this Part V, the final and
temporary regulations expand the subsid-
iary stock issuance exception in proposed
§ 1.385-3(c)(3) into a new "subsidiary
stock acquisition exception" that excludes
from the general rule and funding rule
certain acquisitions of existing stock from
a majority-controlled subsidiary, which
eliminates one type of transaction that
otherwise would have the effect of creat-
ing hook stock. However, outside of the
specific exceptions discussed in Section E
of this Part V, the Treasury Department
and the IRS have determined that special
rules are not warranted when an issuer's
direct or indirect subsidiary holds an in-
terest that would be treated as stock under
the final and temporary regulations.

## 8. Income Tax Treaties

This section addresses comments re-
ceived related to concerns regarding the
impact of the proposed regulations on the
application of the income tax treaties to
which the United States is a party.

## a. Limitation on benefits (LOB) article

In order to qualify for treaty benefits on
U.S. source income, a resident of a treaty
partner must satisfy all of the require-
ments set forth in the applicable treaty,
including the requirement that the resident
satisfy the Limitation on Benefits" (LOB)
article, if any, of the applicable treaty.
Among other requirements, several LOB
tests require that the resident of the treaty
partner meet certain vote-and-value
thresholds for stock ownership by certain
qualified persons or equivalent beneficia-
ries. Some comments noted that, by re-
characterizing debt into non-voting stock,
the proposed regulations could cause a
foreign corporation that previously satis-
fied a stock ownership threshold to no

longer qualify for treaty benefits because
of a dilution of the value of its stock
owned by certain qualified persons or
equivalent beneficiaries.

The comments concerning LOB quali-
fication arise in the context of foreign
issuers claiming treaty benefits on U.S.
source income. Many of the comments
acknowledged that not applying the regu-
lations to foreign issuers would alleviate
these concerns. Accordingly, these com-
ments are addressed by the decision to
reserve on the application of the final and
temporary regulations to foreign issuers.

## b. Character of payments

Some comments noted that if the pro-
posed regulations applied to recharacter-
ize purported debt instruments as equity
for all purposes of the Code, it would
change the tax treatment of payments
made by U.S. issuers to foreign persons
that qualify for benefits under U.S. tax
treaties. Comments expressed concern
that purported payments of interest and
repayments of principal would be treated
as dividend payments, the taxation of
which would be governed by the divi-
dends article of U.S. tax treaties, which
generally result in withholding at a higher
rate (including a 15 percent rate in the
case of dividends paid to a beneficial
owner that does meet certain direct own-
ership thresholds) than withholding on in-
terest. Comments argued that the defini-
tion of "dividends" in U.S. tax treaties
should not encompass payments made un-
der instruments that are recharacterized as
equity under § 1.385-3.

The final and temporary regulations
generally treat purported debt instruments
as equity for all purposes of the Code,
which often will result in payments under
the instrument being treated as dividends,
including for purposes of applying U.S.
tax treaties. Treating the recharacterized
instrument as giving rise to dividends is
consistent with the manner in which U.S.
tax treaties generally define the term "div-
idends" as "[i]ncome from shares or other
rights, not being debt-claims, participating
in profits, as well as income that is subject
to the same taxation treatment as income
from shares under the laws of the Con-
tracting State of which the company mak-
ing the distribution is a resident." The

1996, 2006, and 2016 U.S. Model tax
treaties, as well as the OECD Model Tax
Convention, all contain similar language.
Because the treaty defines the term to in-
clude any "income that is subject to the
same taxation treatment as income from
shares," and because, under the final and
temporary regulations and other applica-
ble Code provisions, U.S. law generally
treats a payment with respect to an instru-
ment recharacterized as equity as a divi-
dend from shares for all purpose of the
Code, dividend treatment is consistent
with the terms of U.S. tax treaties. Fur-
ther, if the treaty does not define the term
dividends, the domestic law of the country
applying the treaty generally prevails, un-
less the context otherwise requires.

## c. Associated enterprises

Comments suggested that the proposed
regulations conflict with the arm's length
principle incorporated in Article 9 (Asso-
ciated Enterprises) of U.S. tax treaties be-
cause a result of recharacterizing debt into
equity is a denial of deductions for interest
payments even though those payments
were made on arm's length terms. Com-
ments raised similar concerns with respect
to section 482 and the arm's length prin-
ciple outside of the treaty context, assert-
ing that characterizing a purported debt
instrument as stock based on another
transaction occurring during the per se
period was inconsistent with the arm's
length principle. The Treasury Depart-
ment and the IRS have determined that
these comments mischaracterize the oper-
ation of Article 9 as well as section 482.
Although Article 9 governs the appropri-
ate arm's length terms (that is, pricing and
profit allocation) for transactions entered
into between associated enterprises, the
arm's length principle reflected in Article
9 and section 482 is not relevant for de-
lineating the transaction that is subject to
the arm's length principle. Thus, for ex-
ample, the arm's length principle may ap-
ply to determine the appropriate rate of
interest charged on a loan, but it would not
apply to the classification in the first in-
stance of whether an instrument is debt or
equity, which is a determination made un-
der the relevant domestic law of the juris-
diction that is applying the treaty. Under
federal income tax law, the characteriza-

tion of transactions, including determin-
ing debt versus equity, is not determined
by reference to the arm's length standard.
See § 1.482-2(a)(1) and (a)(3)(i). Further-
more, as discussed in Section B.8.b of this
Part V, an instrument recharacterized as
equity under § 1.385-3 will result in pay-
ments being treated as dividends, includ-
ing for purposes of U.S. tax treaties.
Therefore, the arm's length principle in-
corporated in Article 9 does not conflict
with the characterization of a purported
debt instrument of a U.S. issuer as equity
under § 1.385-3.

### d. Non-discrimination

Several comments asserted that the
proposed regulations implicate the non-
discrimination provisions of U.S. tax trea-
ties. These comments assert that the non-
discrimination article generally prevents
the United States from denying a deduc-
tion for interest paid to a resident of a
treaty partner where interest paid to a U.S.
resident under the same conditions would
be deductible.

The Treasury Department and the IRS
disagree that the final and temporary reg-
ulations raise discrimination concerns.
The regulations apply broadly to U.S. is-
suers and would recharacterize purported
debt instruments as equity under specified
conditions that apply equally regardless of
the residence of the payee. Although debt
issued by a member of a U.S. consolidated
group to another member of the group is
not subject to recharacterization under
these rules, the recharacterization does not
depend on whether the lender is a U.S. or
foreign person, but on whether the lender
files (or is required to file) a consolidated
return with the issuer. For example, debt
issued by a non-consolidated domestic
corporation to another non-consolidated
domestic corporation is subject to § 1.385-
3 to the same extent as debt issued to a
foreign corporation that is unable to con-
solidate with the domestic corporate is-
suer. The consolidation (or other similar)
rules of both the United States and other
treaty countries, which are generally lim-
ited to domestic affiliates, contain numer-
ous special rules that are generally under-
stood not to raise discrimination concerns.
See, e.g., paragraph 77 of Commentary on
Article 24 of the OECD Model Conven-

tion with Respect to Taxes on Income and
on Capital. Therefore, the final and tem-
porary regulations do not implicate the
non-discrimination provisions of Article
24 (Non-discrimination) of U.S. treaties.

# C. Exchange transactions that are subject to § 1.385-3(b)

## 1. Overview

The general rule under proposed
§ 1.385-3(b)(2) treated as stock any debt
instrument issued by a member of an ex-
panded group to another member of the
same expanded group in one of three
transactions: (i) in a distribution; (ii) in
exchange for the stock of a member of the
expanded group, other than pursuant to
certain identified exempt exchanges; and
(iii) in exchange for property in an inter-
nal asset reorganization, but only to the
extent that, pursuant to the plan of reor-
ganization, an expanded group share-
holder receives the debt instrument with
respect to its stock in the transferor cor-
poration. The funding rule under proposed
§ 1.385-3(b)(3) generally treated as stock
any debt instrument issued by a funded
member in exchange for property that was
treated as funding one of the three trans-
actions described in the general rule.

The distributions and acquisitions de-
scribed in the three prongs of the general
rule and funding rule are referred to in this
Part V as distributions and acquisitions,
unless otherwise indicated or the context
otherwise requires. Separately, unless oth-
erwise indicated or the context otherwise
requires, for purposes of this Part V, ac-
quisitions described in the second prong
of the general rule and funding rule are
referred to as "internal stock acquisi-
tions," and acquisitions described in the
third prong of the general rule and funding
rule are referred to as "internal asset reor-
ganizations."

The preamble to the proposed regula-
tions explained the policy concerns under-
lying the three transactions described in
proposed § 1.385-3(b)(2). In describing
concerns involving distributions of in-
debtedness, the preamble first noted that
courts have closely scrutinized situations
in which indebtedness is owed in propor-
tion to stock ownership to determine
whether a debtor-creditor relationship ex-

ists in substance. This is consistent with
the relatedness factor in section 385(b)(5).
The preamble also cited case law that has
given weight to the lack of new invest-
ment when a closely-held corporation is-
sues indebtedness to a controlling share-
holder but receives no new investment in
exchange. In addition, the preamble stated
that the distribution of indebtedness typi-
cally lacks a substantial non-tax business
purpose. With respect to debt instruments
issued for stock of a member of the ex-
panded group, the preamble noted that
these transactions are (i) similar in many
respects to distributions of indebtedness
and therefore implicate similar policy
concerns, (ii) could serve as a ready sub-
stitute for distributions of notes if not ad-
dressed, and (iii) frequently have limited
non-tax significance. Finally, with respect
to debt instruments issued in connection
with internal asset reorganizations, the
preamble explained that such transactions
can operate similar to internal stock ac-
quisitions as a device to convert what oth-
erwise would be a distribution into a sale
or exchange transaction without having
any meaningful non-tax effects.

Several comments requested that the
second and third prongs of the general
rule and funding rule be narrowed or elim-
inated. The comments stated that such
transactions are not economically or oth-
erwise similar to a distribution of a note
and thus should not be subject to the rules.
Comments distinguished a distribution of
debt, which reduces the value in corporate
solution, from a stock acquisition or asset
reorganization, which typically incorpo-
rates an exchange of value for value.
Other comments suggested replacing the
second and third prongs of the general
rule and funding rule with an anti-abuse
rule. In contrast, one comment suggested
that the general rule should be broadened
to include any transaction having a similar
effect to the transactions described in the
proposed regulations.

As explained in the remainder of this
Part V.C, after considering the comments,
the Treasury Department and the IRS,
with one exception described in Section
C.3.c of this Part V, continue to view the
transactions described in the second and
third prongs of proposed § 1.385-3(b)(2)
and (b)(3) as sufficiently economically
similar to distributions such that they

should be subject to the same rules and
should not be reduced to an anti-abuse
rule or excluded altogether. Accordingly,
the final and temporary regulations retain
the second and third prongs of proposed
§ 1.385-3(b)(2) and (3) with the modifi-
cations described in this Part V.C in re-
sponse to comments received.

## 2. Definitions of Distribution and Property

One comment recommended that the
final and temporary regulations specifi-
cally define the term distribution. The pro-
posed regulations defined the term distri-
bution as any distribution by a corporation
with respect to the distributing corpora-
tion's stock, and the final and temporary
regulations retain that definition.

A comment also recommended that the
final and temporary regulations clarify the
definition of the term property for pur-
poses of the funding rule in the context of
an exchange described in the second and
third prongs of the funding rule. Consis-
tent with the proposed regulations, the
final and temporary regulations define the
term property by reference to section
317(a). The comment asserts that it is not
clear how the statement in section 317(a)
that the term property does not include
stock of a distributing corporation should
be interpreted in the context of an ex-
change of property for stock or assets de-
scribed in the second and third prongs of
the funding rule. The Treasury Depart-
ment and the IRS have determined that
there is no need to clarify the term prop-
erty in this context. The second prong of
the funding rule applies to certain acqui-
sitions of expanded group stock by a cov-
ered member in exchange for property
other than expanded group stock (render-
ing moot the relevance of the reference in
section 317(a) to stock of the distributing
corporation). The third prong of the gen-
eral rule addresses acquisitions of certain
assets, and includes no specific require-
ment regarding property exchanged by the
acquirer.

The remainder of this Part V.C re-
sponds to comments regarding the scope
of the exchange transactions that are in-
cluded in the second and third prongs of
the general rule and funding rule.

## 3. Acquisitions of Expanded Group Stock

The second prongs of the general rule
and funding rule apply to certain acquisi-
tions of expanded group stock in ex-
change for a debt instrument or in ex-
change for property, respectively. These
rules apply both to acquisitions of ex-
panded group stock other than by issuance
(existing stock) and to acquisitions of ex-
panded group stock by issuance (newly-
issued stock).

## a. Acquisitions of existing stock in general

The Treasury Department and the IRS
continue to view a transfer of property
(including through the issuance of a debt
instrument) to a controlling shareholder
(or a person related to a controlling share-
holder) in exchange for existing expanded
group stock as having an economic effect
that is similar to a distribution. In general,
a distribution with respect to stock occurs
when there is a transfer of property from a
corporation to its shareholder in the share-
holder's capacity as such-that is, other
than in a value-for-value exchange. Al-
though an acquisition of existing ex-
panded group stock from a controlling
shareholder (or a person related to a con-
trolling shareholder) may, in form, be a
value-for-value exchange, it generally
does not change the ultimate ownership of
the corporation whose stock is acquired
(target). Furthermore, although neither the
corporation that acquires the stock (the
acquirer) nor the target experiences a
standalone reduction in its assets, the
combined capital of the acquirer and the
target is decreased by the value trans-
ferred to the selling shareholder (in other
words, by the value of the "sale" pro-
ceeds). Thus, similar to a distribution with
respect to stock, the transaction effects a
distribution of value from the acquirer to
the selling shareholder when the post-
transaction acquirer and target are consid-
ered together. As noted in the preamble to
the proposed regulations, viewing the ac-
quirer and target on a combined basis in
this context is consistent with the enact-
ment of section 304, which reflects Con-
gress's recognition that a purchase of af-
filiate stock generally has the effect of a

distribution with respect to stock. See S.
Rep. No. 83-1622 at 46 (1954).

For the foregoing reasons, and the rea-
sons discussed in the preamble to the pro-
posed regulations, the Treasury Depart-
ment and the IRS have determined that
acquisitions of existing expanded group
stock should continue to be included in
the general rule and funding rule. How-
ever, as discussed in Section C.3.c of this
Part V, in response to comments, the final
and temporary regulations provide a new
exception for certain acquisitions of exist-
ing expanded group stock by a member
from its majority-owned subsidiary.

## b. Acquisitions of newly-issued stock

The proposed regulations applied to two
categories of acquisitions of newly-issued
stock: (i) acquisitions of newly-issued stock
from a member that has direct or indirect
control of the acquiring member (hook
stock); and (ii) acquisitions of newly-issued
stock from a member that does not have
direct or indirect control of the acquiring
member (non-hook stock). While comments
generally acknowledged the similarity be-
tween acquisitions of newly-issued hook
stock and distributions, several comments
asserted that acquisitions of newly-issued
non-hook stock are not economically simi-
lar to a distribution and thus should be ex-
cluded from the second prongs of the gen-
eral rule and funding rule. One comment
recommended an exclusion for acquisitions
of affiliate stock by issuance as long as such
stock was acquired pursuant to arm's length
terms.

Under the proposed regulations, acqui-
sitions of newly-issued stock, whether
hook-stock or non-hook stock, were de-
scribed in the second prongs of the gen-
eral rule and funding rule. However,
solely for purposes of the funding rule, the
proposed regulations provided an excep-
tion for certain acquisitions of newly-
issued stock in a majority-owned subsid-
iary (subsidiary stock issuance exception),
whereby an acquisition of the stock in the
subsidiary was exempt from the funding
rule if, for the 36-month period immedi-
ately following the issuance, the acquirer
held, directly or indirectly, more than 50
percent of the total voting power and
value of the stock. For this purpose, indi-
rect ownership was determined applying

the principles of section 958(a) without
regard to whether an intermediate entity is
foreign or domestic.

Comments requested that the subsid-
iary stock issuance exception be expanded
to apply to any acquisition of newly-
issued non-hook stock, regardless of
whether the acquirer owned a majority
interest in the issuer following the acqui-
sition. Comments reasoned that an acqui-
sition of non-hook stock, unlike an
acquisition of hook stock or existing stock
described in section 304, is not economi-
cally similar to a distribution because (i)
the acquisition is not described in a divi-
dend provision of the Code, (ii) the ac-
quiring member's equity value is not re-
duced by reason of the acquisition, and
(iii) in contrast to transactions that are
described in section 304, the combined
value of the acquirer and the issuer is not
reduced by reason of the acquisition.

The final and temporary regulations do
not adopt this comment. As a result, the
second prongs of the general rule and
funding rule continue to apply to acquisi-
tions of newly-issued stock when the ac-
quirer owns, directly or indirectly, only a
minority interest in the issuer of the stock.
Such acquisitions are economically simi-
lar to a distribution in that the acquirer
diverts capital from its operations to an
affiliate controlled, directly or indirectly,
by the acquirer's ultimate shareholder in
exchange for a minority interest in the
affiliate. In the context of highly-related
corporations, holding a minority interest
in an affiliate generally lacks meaningful
non-tax consequences, and such an inter-
est could be structured for tax avoidance
purposes. Accordingly, the Treasury De-
partment and the IRS have determined
that, if such transactions were excluded
from the second prong of the funding rule,
they would become a ready substitute for
distributions as a way to use purported
debt instruments to produce significant
federal tax benefits without financing new
investment in the operations of the obli-
gor. That is, if the second prong did not
apply to such transactions, the purposes of
the final and temporary regulations could
be avoided by having the obligor divert
the proceeds of the purported financing to
the common parent through the transfer of
those proceeds to the common parent's
majority-owned subsidiary.

c. Acquisitions of existing stock from a
majority-owned subsidiary

Comments requested that the subsid-
iary stock issuance exception be extended
to apply to an expanded group member's
acquisition of existing stock in another
expanded group member from the acquir-
ing expanded group member's majority-
owned subsidiary. Thus, for example,
comments requested that an acquisition by
a first-tier wholly owned subsidiary (S1)
of the stock of a third-tier wholly owned
subsidiary (S3) from a second-tier wholly
owned subsidiary (S2) in exchange for
property be excluded from the second
prong of the funding rule.

The Treasury Department and the IRS
have determined that an acquisition of ex-
isting stock, like an acquisition of newly-
issued non-hook stock from a majority-
owned subsidiary, does not implicate the
same policy concerns as other transactions
described in the second prongs of the gen-
eral rule and funding rule when the ac-
quiring member owns more than 50 per-
cent of the stock in the selling member.
Specifically, an acquisition of existing
stock from a majority-owned subsidiary,
like an acquisition of newly-issued stock
from a majority-owned subsidiary, gener-
ally is not economically similar to a dis-
tribution because the consideration pro-
vided to the seller is indirectly controlled
by the acquirer through its majority inter-
est in the seller. In contrast, if the acquirer
does not, directly or indirectly, own more
than 50 percent of the seller after the
acquisition, the acquisition has the same
potential for making the sale proceeds
available to the common parent as when
funds are transferred in exchange for
newly-issued stock that is a minority in-
terest. Accordingly, the final and tempo-
rary regulations expand the subsidiary
stock issuance exception to include
acquisitions of existing stock from a
majority-owned subsidiary under the
same conditions applicable to acquisitions
of newly-issued non-hook stock from a
majority-owned subsidiary, and refer to
the expanded exception as the subsidiary
stock acquisition exception. The specific
requirements of the subsidiary stock ac-
quisition exception are discussed in Sec-
tion E.2.a of this Part V.

## d. Acquisitions of stock in exchange for a debt instrument

Comments recommended that the
subsidiary stock issuance exception be
expanded to cover acquisitions of the
stock of a controlled subsidiary de-
scribed in the general rule (for example,
when an expanded group member con-
tributes its note to a majority-owned
subsidiary for additional stock), based
on the view that a transaction described
in the general rule is economically sim-
ilar to a transaction described in the
funding rule and thus should receive
similar treatment under § 1.385-3. The
Treasury Department and the IRS agree
with this recommendation. In general,
the funding rule is designed to stop tax-
payers from achieving in multiple steps
what the general rule prohibits from be-
ing accomplished in one step. Accord-
ingly, the final and temporary regula-
tions provide that an acquisition of
expanded group stock (both existing
stock and newly issued stock) from a
majority-controlled subsidiary in ex-
change for the acquirer's note qualifies
for the exception on the same terms as a
funded acquisition.

## 4. Acquisitions of Expanded Group Assets Pursuant to a Reorganization

Comments also asserted that the trans-
actions described in the third prongs of the
general rule and funding rule are not ec-
onomically similar to a distribution and
therefore should not be subject to pro-
posed § 1.385-3. The preamble to the
proposed regulations stated that the third
prongs of the general rule and funding
rule were included because the issuance of
a debt instrument in an internal asset re-
organization is similar in many respects to
the issuance of a debt instrument to make
a distribution or to acquire expanded
group stock. For the same reasons de-
scribed in the preamble to the proposed
regulations, the Treasury Department and
the IRS continue to view the transfer of
"other property" in certain internal asset
reorganizations as having an economic ef-
fect that is similar to a distribution or an
internal stock acquisition. As discussed in
Section C.3.a of this Part V, a distribution
with respect to stock generally is a trans-

fer of value from a corporation to its
shareholder in its capacity as such and
therefore other than in a value-for-value
exchange. A corporation obtains a similar
result when, as part of an acquisitive asset
reorganization, the corporation (acquirer)
issues a debt instrument or transfers other
property in exchange for the assets of a
highly-related affiliate (target), which in
turn, distributes the debt instrument or
other property to the common shareholder
with respect to its target stock. In such a
transaction, the combined pre-acquisition
capital of the acquirer and the target is
decreased to the extent of the value of the
non-stock consideration received by the
common shareholder in exchange for its
target stock. Accordingly, similar to a dis-
tribution with respect to stock, the trans-
action effects a distribution of value from
the combined entity to the common share-
holder.

Congress acknowledged that an asset
reorganization between highly-related
parties can have the effect of distribut-
ing value to a common shareholder
when it provided in section 356(a)(2)
that "other property" received by the
common shareholder in exchange for its
target stock generally is treated as a
dividend to the extent of earnings and
profits. The premise of section 356(a)(2)
is that, when a shareholder exchanges its
stock in one controlled corporation for
property of equal value from another
controlled corporation, the property rep-
resents an extraction of value from the
combined entity consisting of the two
controlled corporations to the common
shareholder. For the same reason, the
Treasury Department and the IRS have

determined that an internal asset reorga-
nization in which a member of the ex-
panded group receives property de-
scribed in section 356 has an economic
effect that is similar to a distribution.
Thus, the final and temporary regula-
tions continue to include internal asset
reorganizations within the third prongs
of the general rule and funding rule.

Other comments recommended the
withdrawal of the third prongs of the gen-
eral rule and funding rule based on an
asserted inconsistency with the "boot-
within-gain" rule in section 356(a)(2). Un-
der section 356(a)(1), an exchanging
shareholder is required to recognize gain

equal to the lesser of the gain realized in
the exchange or the amount of money or
other property received by the share-
holder. If the exchange has the effect of a
distribution of a dividend, then section
356(a)(2) provides that all or part of the
gain recognized by the exchanging share-
holder is treated as a dividend to the ex-
tent of the shareholder's ratable share of
the corporation's earnings and profits. Un-
der the "boot-within-gain" rule, dividend
treatment under section 356(a)(2) is lim-
ited by the gain in the shareholder's stock
in the transferor corporation. Comments
asserted that, by converting a debt instru-
ment that would constitute other property
into stock, the third prong of the general
rule effectively achieves a result that the
Treasury Department and the IRS could
not otherwise accomplish under section
356(a)(2) because payments of interest
and principal made on the recharacterized
debt instrument generally would be char-
acterized as dividend income to the extent
of the earnings and profits of the issuing
corporation, without regard to the gain in
the shareholder's stock in the transferor
corporation. Accordingly, comments rec-
ommended that the Treasury Department
and the IRS withdraw the third prongs of
the general rule and funding rule. Alter-
natively, comments recommended that the
final and temporary regulations include a
coordination rule that would effectively
preserve the effect of section 356(a)(2),
without specifying how this rule would
operate.

The Treasury Department and the IRS
decline to adopt this recommendation.
Section 385 provides specific authority to
treat certain interests in a corporation as
stock, and this express grant of authority
extends to the treatment of such interests
as stock for all purposes of the Code. The
Treasury Department and the IRS have
exercised this grant of authority to treat a
debt instrument as stock when the debt
instrument does not finance new invest-
ment in the operations of the issuer. In
addition, as discussed in this Part V,
whether new investment has been fi-
nanced does not depend on whether the
amount transferred to the controlling
shareholder (or person related thereto) is
treated as a dividend, return of basis, or
gain.

# 5. Acquisitions of Expanded Group Assets Not Pursuant to a Reorganization

One comment questioned why the reg-
ulations apply to an acquisition of ex-
panded group stock or an acquisition of
business assets pursuant to an internal as-
set reorganization, but not to an acquisi-
tion of business assets not in connection
with a reorganization, including through
the acquisition of a disregarded entity.
The Treasury Department and the IRS
have determined that an acquisition of
business assets in a non-reorganization
transaction is not sufficiently similar to a
distribution to be covered by § 1.385-3. In
a non-reorganization transaction, the sell-
ing member continues as an entity sepa-
rate and distinct from the acquiring mem-
ber following the transaction, and the
common shareholder receives no property
with respect to its stock in either entity. As
a result, both on a standalone and com-
bined basis, the pre-equity value of the
entities does not decrease as a result of the
transaction. Moreover, the property trans-
ferred by the acquiring member to the
selling member is used to acquire assets
that augment the business of the acquiring
member. This is in contrast to property
transferred by an acquiring member to
acquire newly-issued non-hook stock in
exchange for a minority interest in an af-
filiate the ownership of which generally
lacks meaningful non-tax consequences.

One comment recommended that the
final and temporary regulations clarify the
treatment of the use of a note to acquire
stock in a disregarded LLC. Because eq-
uity in a disregarded LLC is disregarded,
the final and temporary regulations are not
revised to address this comment.

6\. Acquisitions of Existing Expanded
Group Stock or Expanded Group Assets
Pursuant to a Reorganization That Do
Not Result in Dividend Income

Comments recommended an exemp-
tion for an acquisition subject to section
304 or 356(a)(2) to the extent the transac-
tion results in sale or exchange treatment
(for example, due to insufficient earnings
and profits).

The Treasury Department and the IRS
decline to adopt this recommendation.
Under § 1.385-3, a purported debt instru-
ment that does not finance new investment

in the issuer is not respected as debt. An
issuance of a purported debt instrument
does not finance new investment of the
issuer to the extent a transaction has
the effect of distributing the proceeds of
the debt instrument to another member of
the expanded group. The amount of divi-
dend or gain recognized by an expanded
group member in the transaction in which
the instrument is issued or in a transaction
that has the effect of transferring the pro-
ceeds is not relevant for determining
whether the debt instrument financed new
investment or, instead, merely introduced
debt without having meaningful non-tax
effects.

## D. Funding rule

### 1. Lack of Identity between the Lender and a Recipient of the Proceeds of a Distribution or Acquisition

The funding rule under the proposed
regulations treated as stock a debt instru-
ment that was issued by a corporation
(funded member) to another member of
the funded member's expanded group in
exchange for property with a principal
purpose of funding a distribution or acqui-
sition described in the three prongs of the
funding rule. The proposed regulations in-
cluded a non-rebuttable presumption that
a principal purpose to fund such an acqui-
sition or distribution existed if the ex-
panded group debt instrument was issued
by the funded member during the period
beginning 36 months before the funded
member made the distribution or acquisi-
tion and ending 36 months after the dis-
tribution or acquisition.

Comments recommended several limi-
tations on the funding rule, including lim-
iting the funding rule to a rule that ad-
dresses only circular transactions that are
economically equivalent to transactions
subject to the general rule by requiring
that the lender be the recipient of the
proceeds of the distribution or acquisition.
Thus, for example, a comment indicated
that, if FP owned USP and FS, the funding
rule should apply when USP borrows
$100x from FP and distributes $100x to
FP, but should not apply when USP bor-
rows $100x from FS and distributes
$100x to FP, unless FP also transferred
funds to FS.

In the context of commonly-controlled
corporations, the Treasury Department
and the IRS have determined that there is
not a sufficient economic difference to
justify different treatment when the pro-
ceeds of a loan from one expanded group
member are used to fund a distribution to,
or acquisition from, that same member
versus another expanded group member.
First, and most significantly, in the exam-
ple described in the preceding paragraph,
a borrowing from FS and a distribution to
FP has the same economic effect with
respect to USP as a distribution by USP of
a debt instrument to FP. In both cases,
debt is added to USP without a commen-
surate increase in the amount of capital
invested in USP's operations.

Moreover, in the context of commonly-
controlled corporations, there is insuffi-
cient non-tax significance to the lack of
identity between the lender and the recip-
ient of the proceeds of the distribution or
acquisition to justify treating the two se-
ries of transactions differently. In this con-
text, there can be considerable flexibility
regarding the expanded group member
used to lend funds to another member,
since the lending member may itself be
funded by other members of the group.
Furthermore, an expanded group member
that receives the proceeds of a distribution
or economically similar transaction can
transfer those proceeds to other entities in
the group, for example, through distribu-
tions to a common controlling parent,
which in turn can re-transfer the funds.
Because of the ability to transfer funds
around a multinational group, the choice
of which entity will be a counterparty to a
borrowing or transaction that is economi-
cally similar to a distribution may not
have meaningful non-tax significance.
Comments also suggested that this flexi-
bility could be addressed through a second
set of rules that would consider the extent
to which the lender was itself funded by
another member of the group and the ex-
tent to which the proceeds of a distribu-
tion or other economically similar trans-
action were transferred to the lender.

After considering the comments, the
Treasury Department and the IRS decline
to adopt these recommendations. The bur-
den that would be required to essentially
replicate the per se funding rule with re-
spect to both the lender and the recipient

of the proceeds of the funded distribution
or acquisition in order to prevent such
transactions from being used to avoid the
purposes of the final and temporary regu-
lations would far outweigh any policy jus-
tification for treating the two types of
transactions differently, which, as ex-
plained in this Section D.1 of this Part V,
is not compelling.

2\. Per Se Application of the Funding
Rule

### a. Overview

Several comments noted that the per se
funding rule in the proposed regulations
would be overinclusive in certain fact pat-
terns and treat a purported debt instrument
as equity even though the taxpayer could
demonstrate as a factual matter that the
funding was used in the taxpayer's busi-
ness rather than to make a distribution or
acquisition. These comments recom-
mended that the regulations adopt a trac-
ing approach to connect a funding with a
distribution or acquisition by the funded
member, including by actual tracing or by
presumptions and other factors. Multiple
comments suggested eliminating the per
se funding rule entirely. Other comments
recommended that the per se funding rule
be altered or shortened. The range of sug-
gestions included:

· Eliminate the per se funding rule and
rely solely on a principal purpose test;

· Limit the per se funding rule to abu-
sive transactions, such as those that
lack a business purpose, or to ex-
pressly enumerated transactions;

· Replace the per se funding rule with a
"but-for" standard;

· Replace the per se funding rule with a
rule that would trace loan proceeds;

· Replace the per se funding rule with a
facts-and-circumstances test subject to
a rebuttable presumption (such as that
contained in the disguised sale rules in
§ 1.707-3(c)) or series of rebuttable
presumptions; and

· Retain the 36-month periods, but ap-
ply a rebuttable presumption in the
first and last 12 months.

In general, these comments suggested
that the final and temporary regulations
adopt a more subjective rule that would
take into account particular facts and cir-

cumstances and allow taxpayers to dem-
onstrate that an alternative source of cash
or other property funded the distribution
or acquisition and that the borrowed funds
were put to a different use, rather than an
objective rule based solely on whether a
related-party borrowing and a distribution
or acquisition both occur during a certain
time interval.

After considering these comments, the
Treasury Department and the IRS have
determined that it is appropriate to retain
the per se funding rule to determine
whether a debt instrument has funded a
distribution or acquisition that occurs dur-
ing the 36-month period before and after
the funding transaction (the per se period).
The final and temporary regulations reor-
ganize the funding rule as (i) a per se
funding rule addressing covered debt in-
struments issued by a funded member dur-
ing the per se period; and (ii) a second rule
that addresses a covered debt instrument
issued by a funded member outside of the
per se period with a principal purpose of
funding a distribution or acquisition, de-
termined based on all the facts and cir-
cumstances (principal purpose test). This
reorganization is intended to clarify the
purpose of the per se test and is not in-
tended to be a substantive change.

Section D.2.b of this Part V explains
why the Treasury Department and the IRS
have determined that retaining the per se
funding rule is justified. Section D.2.c of
this Part V discusses the stacking rules
that are necessitated by any approach
based on fungibility. Section D.2.d of this
Part V responds to comments regarding
the length of the per se period. Section
D.2.e of this Part V describes the principal
purpose test.

# b. Retention of per se funding rule

The general rule in § 1.385-3(b)(2)
addresses a distribution or acquisition in
which a purported debt instrument is is-
sued in the distribution or acquisition it-
self, for example, a distribution of indebt-
edness. In contrast, the funding rule in
§ 1.385-3(b)(3) addresses multi-step
transactions in which a related-party debt
instrument is issued for cash or property
to fund a distribution or acquisition. The
proposed regulations provided a principal
purpose test to determine whether the in-

debtedness funded the distribution or ac-
quisition in a multi-step transaction. How-
ever, the preamble to the proposed
regulations also observed that money is
fungible and that it is difficult for the IRS
to establish the principal purposes of in-
ternal transactions. In this regard, the pre-
amble cited the presence of intervening
events that can occur between the steps,
for example, other sources of cash such as
free cash flow generated from operations,
which could obscure the connection be-
tween the borrowing and the distribution
or acquisition. For this reason, the pro-
posed regulations included the per se
funding rule based on a 36-month
forward-and-back testing period.

The Treasury Department and the IRS
continue to be of the view that, because
money is fungible, an objective rule is an
appropriate way to attribute a distribution
or acquisition, in whole or in part, to a
funding. The preamble to the proposed
regulations emphasized the evidentiary
difficulties that the IRS would face if the
regulations relied exclusively on a
purpose-based rule. Some comments sug-
gested that a rebuttable presumption (such
as the one contained in § 1.707-3(c)) that
would require a taxpayer to overcome a
presumption arising upon specified events
by clearly establishing facts and circum-
stances to the contrary could address these
difficulties.

After considering these comments, the
Treasury Department and the IRS have
determined that, even with the benefit of a
rebuttable presumption, a purpose-based
rule that required tracing sources and uses
of funds would present significant admin-
istrative challenges for the IRS. In partic-
ular, taxpayers potentially could purport
to rebut the presumption by creating self-
serving contemporaneous documentation
that "earmarks" the proceeds of related-
party borrowings for particular purposes
and attributes distributions and acquisi-
tions to other sources of funds.

More fundamentally, however, be-
cause money is fungible, a taxpayer's par-
ticular purpose for a particular borrowing
is largely meaningless. This is particularly
true with respect to a large, active operat-
ing company (or group of operating com-
panies that file a consolidated return) with
multiple sources and uses of funds. Be-
cause of the fungibility of money, using

loan proceeds for one purpose frees up
funds from another source for another use.
For instance, funding a distribution or ac-
quisition with working capital could ne-
cessitate borrowing from a related party in
order to replenish depleted working capi-
tal. For this reason, the Treasury Depart-
ment and the IRS view tracing as having
limited economic significance in the con-
text of transactions involving indebted-
ness.

The concept of using mechanical rules
to account for the fungibility of money
from debt is well established: several pro-
visions of the Code and regulations relat-
ing to allocation of interest expense are
premised on the idea that, with certain
narrow exceptions, money is fungible and
therefore debt funding cannot be directly
traced to particular activities or assets. See
§ 1.861-9T(a) ("The method of allocation
and apportionment for interest . . . is based
on the approach that, in general, money is
fungible and that interest expense is attrib-
utable to all activities and property regard-
less of any specific purpose for incurring
an obligation on which interest is paid");
see also section 864(e)(2) (requiring allo-
cation and apportionment of interest ex-
pense on the basis of assets); § 1.882-5
(allocation of interest expense based on
assets for purposes of determining effec-
tively connected income); section 263A
(f)(2)(A)(ii) (allocating interest that is not
directly attributable to production expen-
ditures under avoided cost principles).
These provisions are based on the as-
sumption that, due to the fungibility of
money, a taxpayer's earmarking of the
proceeds of a borrowing for any particular
purpose is inconsequential for U.S. tax
purposes.

Accordingly, the Treasury Department
and the IRS have determined that it is
necessary and appropriate to treat a cov-
ered debt instrument as financing a distri-
bution or acquisition, regardless of
whether the issuer associates the proceeds
with a particular distribution or acquisi-
tion or with another use. As a result, the
final and temporary regulations do not
adopt recommendations to rely exclu-
sively on a purpose-based tracing rule,
including one based on a rebuttable pre-
sumption in favor of the IRS, an anti-
abuse rule, or other multi-factor approach.
In addition to the previously discussed

evidentiary and economic reasons, a trac-
ing, burden-shifting, or multi-factor ap-
proach would create significant uncer-
tainty for both the IRS and taxpayers in
ascertaining whether a borrowing should
be considered to have funded a distribu-
tion or acquisition.

In adopting a per se funding rule based
on the fungibility of money, the Treasury
Department and the IRS recognize that all
outstanding debt, regardless of how much
time has transpired between the issuance
and the distribution or acquisition, could
be treated as funding a distribution or ac-
quisition. This is the case for other
fungibility-based rules under the Code
and regulations, which typically apply to
all outstanding debt and do not depend on
when the debt was issued. See, e.g., sec-
tions 263A(f)(2)(A)(ii) and 864(e)(2).
Nevertheless, the Treasury Department
and the IRS have determined that it is
appropriate to limit the application of the
per se funding rule to testing distributions
or acquisitions made within a specified
period to the debt issuance. Using a fixed
per se period that is linked to the date of
the debt issuance should address the ma-
jority of cases where purported debt is
used to create federal tax benefits without
having meaningful non-tax effects, since
most such transactions seek to achieve
these benefits immediately upon debt is-
suance. Such a rule also provides certainty
so that taxpayers can determine the appro-
priate characterization of the debt instru-
ment within a fixed period after it is is-
sued, and need not redetermine their
liability for prior taxable years. See also
§ 1.385-3(d)(1)(ii) (treating a covered
debt instrument subject to the funding rule
due to a later distribution as a deemed
exchange on the date of the distribution
and not the issuance). Furthermore, the
retention of the principal purpose test, de-
scribed in Section D.2.e of this Part V,
ensures that the rules appropriately apply
to transactions occurring outside the per
se period that intentionally seek to cir-
cumvent the per se funding rule.

A comment also suggested that the fi-
nal and temporary regulations adopt a
"but-for" standard under which a distribu-
tion or acquisition would be treated as
funded by a purported debt instrument
only if the distribution or acquisition
would not have been made "but for" a

funding. This comment cited proposed
§ 1.956-4(c)(3) (REG-155164-09),
which used a similar formulation to ad-
dress whether a distribution by a foreign
partnership to a related U.S. partner is
connected to a funding of that partnership
by a related CFC for purposes of section
956. Specifically, proposed § 1.956-
4(c)(3) contains a special rule for deter-
mining a related partner's share of a for-
eign partnership's obligation when the
foreign partnership distributes the pro-
ceeds of the obligation to the related part-
ner and the partnership would not have
made the distribution "but for" a funding
of the partnership through an obligation
held or treated as held by a CFC.

The Treasury Department and the IRS
view a "but-for" standard in this context
as similar in effect to a subjective tracing
approach, in that a "but-for" test would
require an inquiry into what a taxpayer
would have chosen to do in the absence of
the funding. Therefore, a "but-for" test
contains the same shortcomings as a sub-
jective tracing rule and does not ade-
quately account for the fungibility of
money. Alternatively, a "but-for" test
could, in certain circumstances, function
like a taxpayer-favorable stacking rule
that would attribute a distribution or ac-
quisition to a related-party borrowing only
if there were no other sources of funding
for the transaction. Significantly, the "but-
for" approach in the proposed section 956
regulations operates only to increase the
amount that otherwise would be allocated
to a U.S. partner under the general aggre-
gate approach of the regulations. That is,
in the context of the proposed regulations
under section 956, the "but-for" test is an
anti-abuse backstop to a general rule that
otherwise takes into account the fungibil-
ity of money and allocates the liabilities of
a partnership pro rata based on the part-
ner's interests in the partnership. Because
the "but-for" test in the proposed section
956 regulations functions only as a back-
stop to a general rule that is based on the
fungibility of money, the Treasury De-
partment and the IRS considered the
taxpayer-favorable stacking assumption
implicit in the "but-for" test to be accept-
able in that context. In contrast, if the final
and temporary regulations under section
385 were to adopt a "but-for" test as the
operative rule in lieu of a per se funding

rule, a taxpayer could avoid the applica-
tion of § 1.385-3 entirely by demonstrat-
ing the presence of other sources of cash,
notwithstanding that the cash obtained
through a related-party borrowing facili-
tated a distribution or acquisition by al-
lowing those other sources of cash to sup-
port other uses.

## c. Stacking rules

Using a fungibility approach to attri-
bute distributions and acquisitions to cov-
ered debt instruments necessitates stack-
ing rules for attributing uses of funds to
sources of funds. Some comments as-
serted that the per se funding rule under
the proposed regulations represents an
anti-taxpayer stacking provision. One
comment suggested that, to the extent a
per se funding rule is appropriate due to
the fungibility of money, the per se fund-
ing rule necessarily should treat a distri-
bution or acquisition as funded pro rata by
all sources of free cash flow. For example,
if an entity generated $500x of free cash
flow from operating its business and bor-
rowed $100x from another member of the
entity's expanded group, and, during the
per se period the entity made a subsequent
distribution of $100x, the comment sug-
gested that only one-sixth of the $100x
should be treated as funded by the bor-
rowing. Other comments noted that the
proposed regulations included taxpayer-
unfavorable stacking because they always
treated a distribution or acquisition as
funded by a related-party borrowing with-
out regard to whether there were new con-
tributions to capital or third-party borrow-
ing during the per se period.

The final and temporary regulations
adopt several new and expanded excep-
tions described in Sections E, F, and G
of this Part V. These exceptions represent
taxpayer-favorable stacking rules that, in
the aggregate, significantly reduce the ex-
tent to which distributions and acquisi-
tions are attributed to related-party bor-
rowings. This exception-based approach
to stacking is significantly more adminis-
trable than a pro rata approach, which
would necessitate a constant recalculation
of the relative amounts of funding from
various sources.

In response to comments suggesting
that distributions and acquisitions should

be attributed first to free cash flow, or to
the cumulative earnings and profits of a
member, before being attributed to
related-party borrowings, the final and
temporary regulations treat distributions
and acquisitions as funded first from earn-
ings and profits accumulated during a cor-
poration's membership in an expanded
group. See Section E.3.a of this Part V
(which includes a discussion of why earn-
ings and profits are the better measure for
tax purposes). In response to comments
suggesting that distributions and acquisi-
tions should be attributed to new contrib-
uted capital received by a member before
its related-party borrowings, the final and
temporary regulations treat distributions
and acquisitions as funded next from cap-
ital contributions received from other
members of the expanded group within
the per se period but before the end of the
taxable year of the distribution or acqui-
sition. See Section E.3.b of this Part V. In
response to comments suggesting that cer-
tain borrowings should not be treated as
funding distributions and acquisitions, the
final and temporary regulations include a
broad exception from the funding rule for
short-term debt instruments, which effec-
tively are treated as financing the short-
term liquidity needs of the issuer rather
than distributions and acquisitions. See
Section D.8.c of this Part V. Accordingly,
after taking into account the various ex-
ceptions provided, the final and temporary
regulations generally (i) exclude certain
short-term debt instruments from funding
any distributions or acquisitions, (ii) ex-
clude certain distributions and acquisi-
tions from being funded by any type of
debt instrument, (iii) treat any remaining
distributions and acquisitions as funded
by new equity capital, and (iv) only then
treat any remaining distributions and ac-
quisitions as funded by any remaining re-
lated party borrowings.

Some comments suggested that the fi-
nal and temporary regulations should treat
any remaining distributions and acquisi-
tions as funded first by unrelated-party
debt, rather than funded first by covered
debt instruments. The Treasury Depart-
ment and the IRS decline to adopt this
recommendation. The Treasury Depart-
ment and the IRS have determined that it
is appropriate to treat any remaining dis-
tributions and acquisitions as funded first

by related-party debt, because the nature
of unrelated-party lending imposes a real
cost to the borrower through interest ex-
pense and other costs. This real cost from
unrelated-party borrowing can be justified
only if the issuer will use the borrowed
funds to achieve a return that is greater
than the interest expense and other costs
from the unrelated-party borrowing. On
the other hand, a borrowing among
highly-related parties, such as between
members of an expanded group, has no
net cost to the borrower and the lender.
Because the related-party borrower and
lender have a complete (or near complete)
identity of interests, the related-party bor-
rowing imposes no similar economic cost
on the borrower. Indeed, the pre-tax return
with respect to a related-party borrowing
can be zero, or even less than zero, and the
borrowing can still achieve a positive
after-tax return when the related party
lender's interest income is taxed at a
lower effective tax rate than the related-
party borrower's effective tax benefit
from interest deductions. This is true
whether the related-party lender is a U.S.
corporation or a foreign corporation. In
addition to interest and other costs, an
unrelated-party lender may impose re-
strictive covenants or other legal and con-
tractual restrictions that affect the borrow-
er's business, including restrictions on the
issuer's ability to distribute the proceeds
from the unrelated-party debt that a
related-party lender may not impose. For
these reasons, it is appropriate to treat any
remaining distributions and acquisitions
as funded first by related-party debt, be-
fore treating those remaining distributions
and acquisitions as funded by unrelated-
party debt.

## d. Retention of the 36-month testing periods

Several comments suggested that, if
the regulations continue to take a per se
approach, the testing period should be sig-
nificantly shortened. For example, com-
ments recommended testing periods of
24 months, 18 months, 12 months, or 6
months. After consideration of these com-
ments, the Treasury Department and the
IRS have determined that it continues to
be appropriate to use 36-month testing
periods.

As explained in Section D.2.b of this
Part V, the Treasury Department and the
IRS have determined that, because money
is fungible, an objective set of rules using
a fixed time period and various stacking
rules is the most administrable approach
to determine whether a debt instrument
funded a distribution or acquisition. The
Treasury Department and the IRS have
considered several factors in determining
that the 36-month testing periods in the
proposed regulations should be retained,
rather than adopting one of the recom-
mendations for a shorter period.

Many of the comments requesting a
shorter testing period were concerned pri-
marily about compliance burdens that
would be imposed if the per se funding
rule applied to ordinary course transac-
tions that occur with a high frequency.
These concerns are mitigated by the addi-
tion and expansion of numerous excep-
tions described in Sections D.8, E, F, and
G of this Part V, which substantially nar-
row the scope of the per se funding rule in
the final and temporary regulations. In
particular, as discussed in Section D.8 of
this Part V, short-term debt instruments
that finance short-term liquidity needs that
arise frequently in the ordinary course of
business are excluded from the scope of
the funding rule in the final and temporary
regulations. This change substantially re-
duces the compliance burden of applying
the per se funding rule during the 36-
month testing periods. In addition, as dis-
cussed in Section E.3 of this Part V, the
final and temporary regulations only take
into account distributions and acquisitions
that exceed increases to the issuer's equity
while the issuer was a member of the
same expanded group from: (i) earnings
and profits accumulated after the proposed
regulations were published and, (ii) cer-
tain contributions to capital that occurred
during the 36-month period preceding the
distribution or acquisition or during the
taxable year in which the distribution or
acquisition occurred. Thus, the funding
rule in the final and temporary regulations
is focused on non-ordinary course covered
debt instruments and extraordinary distri-
butions and acquisitions.

Taking into account the implications of
the narrower scope of § 1.385-3 with re-
spect to the issues raised by comments
regarding the 36-month testing periods,

the Treasury Department and the IRS
have determined that it is appropriate to
continue to attribute distributions and ac-
quisitions that exceed the relevant earn-
ings and profits and capital contributions
to non-ordinary course related-party bor-
rowings that were made 36 months before
or after the distribution or acquisition and
that remain outstanding at the time of the
distribution or acquisition. The Treasury
Department and the IRS have determined
that 36 months is a reasonable testing pe-
riod that appropriately balances the need
for an administrable rule and the fact that
transactions involving indebtedness are
inextricably linked due to the fungibility
of money. Furthermore, the Treasury De-
partment and the IRS are concerned that,
if a shorter testing period was used, such
as a 24-month forward-and-backward
testing period, taxpayers could find it
worthwhile to engage in funding transac-
tions by waiting 24 months after the issu-
ance of debt before conducting the second
transaction, and that the principal purpose
test described in Section D.2.e of this Part
V, which is more difficult for the IRS to
administer, would not be a sufficient de-
terrent in this circumstance.

The use of a 36-month testing period
for this purpose is consistent with, and in
some cases shorter than, other testing pe-
riods that the IRS has experience admin-
istering in which facts and circumstances
potentially observable by the IRS provide
an inadequate basis to establish the rela-
tionship between two events or transac-
tions. See, e.g., section 172(b)(1)(D) and
(g)(2) (treating certain interest deductions
from indebtedness in the year of a corpo-
rate equity reduction transaction (CERT)
and the following two tax years as per se
attributable to the CERT, in lieu of tracing
interest to specific transactions); section
302(c)(2)(A)(ii) (10-year period for deter-
mining whether shareholder has termi-
nated their interest for purposes of apply-
ing section 302(a) to a redemption);
section 2035(a) (treating gifts made three
years before the decedent's death as in-
cluded in the decedent's gross estate);
§ 1.1001-3(f)(3) (disregarding modifica-
tions occurring more than five-years apart
when determining if multiple modifica-
tions are significant); see also § 1.7874-
8T(g)(4) (36-month look-back period for

determining when to account for prior ac-
quisitions).

Although some comments asserted that
the per se funding rule should be modeled
on the two-year presumption rule in
§ 1.707-3(c), the Treasury Department
and the IRS have determined that the dis-
guised sale rules under § 1.707-3(c) ad-
dress a different policy in the context of
transactions between a partner and part-
nership (regardless of the level of owner-
ship), whereas the final and temporary
regulations address transactions between
highly-related corporations. In this case,
the Treasury Department and the IRS
have determined that a 36-month testing
period is more appropriate, taking into
account in particular the tax consequences
associated with corporate indebtedness
and the high degree of relatedness of the
parties.

For these reasons, the final and tempo-
rary regulations retain a 36-month testing
period as the per se period.

# e. Principal purpose test

Because of the mechanical nature of
the per se funding rule, the Treasury De-
partment and the IRS are concerned that
taxpayers may seek to intentionally cir-
cumvent the rule to achieve economically
similar results even though the funding
occurs outside of the per se period. There-
fore, the final and temporary regulations
provide that a covered debt instrument
that is not issued during the per se period
is treated as funding a distribution or ac-
quisition to the extent it is issued by a
funded member with a principal purpose
of funding the distribution or acquisition.
This determination is made based on all of
the relevant facts and circumstances.

# 3. Predecessors and Successors

Under the proposed regulations, refer-
ences to a funded member included a ref-
erence to any predecessor or successor of
such member. The proposed regulations
defined the terms predecessor and succes-
sor to "include" certain persons, without
specifically stating whether other persons
could be treated as predecessors or suc-
cessors in certain instances. Comments re-
quested additional clarity concerning the
scope of the definition of predecessor and

successor through an exclusive enumera-
tion of entities that may be considered
predecessors or successors.

In response to comments, the final and
temporary regulations replace "include"
with "means" in the definitions of prede-
cessor and successor, thereby limiting the
transactions that create predecessor or
successor status to those explicitly pro-
vided.

Comments recommended that a funded
member be treated as making a distribu-
tion or acquisition that is made by a pre-
decessor or successor only to the extent
that the transaction creating the predecessor-
successor relationship occurs during the
per se period determined with respect to
the distribution or acquisition. For exam-
ple, assume USS1 makes a distribution of
$10x to an expanded group member in
year 1. USS2, also an expanded group
member that is not consolidated with
USS1, borrows $10x from an expanded
group member in year 2. In year 10, USS1
merges into USS2 in an asset reorganiza-
tion. Comments suggested that the pro-
posed regulations arguably would treat
USS2's year 2 note as stock because
USS1 is a predecessor to USS2, and the
year 2 funding occurred within the 72-
month period determined with respect to
the year 1 distribution. One comment sug-
gested that the predecessor or successor
rule only apply in this context if there was
a principal purpose to avoid the regula-
tions.

In response to comments, the final and
temporary regulations provide that, for
purposes of the per se funding rule, a
covered debt instrument that is otherwise
issued by a funded member within the per
se period of a distribution or acquisition
made by a predecessor or successor is not
treated as issued during the per se period
with respect to the distribution or acquisi-
tion unless both (i) the covered debt in-
strument is issued by the funded member
during the period beginning 36 months
before the date of the transaction in which
the predecessor or successor becomes a
predecessor or successor and ending 36
months after the date of the transaction,
and (ii) the distribution or acquisition is
made by the predecessor or successor dur-
ing the same 72-month period. If the fund-
ing and the distribution or acquisition do
not both occur during the 72-month period

with respect to the transaction that created
the predecessor-successor relationship,
the covered debt instrument is not treated
as funding the distribution or acquisition
under the per se funding rule. In that case,
however, the principal purpose test may
still apply to treat the covered debt instru-
ment as funding the distribution or acqui-
sition.

Comments questioned the application
of the predecessor and successor rules
when a funded member and either its pre-
decessor or successor are members of dif-
ferent expanded groups. One comment
recommended that a funded member be
treated as making a distribution or acqui-
sition made by a predecessor or successor
only to the extent that the distribution or
acquisition was to a member of the same
expanded group as the funded member.
Similarly, comments requested that the
regulations clarify that a corporation
ceases to be a predecessor or successor to
a funded member when the corporation
and the funded member cease to be mem-
bers of the same expanded group.

In response to comments, the final and
temporary regulations provide that the
distributing corporation and controlled
corporation in a distribution that qualifies
under section 355 cease to have a prede-
cessor and successor relationship as of the
date that the corporations cease to be
members of the same expanded group.
Similarly, a seller in a transaction to
which the subsidiary stock acquisition ex-
ception applies ceases to be a successor of
the acquirer as of the date that the corpo-
rations cease to be members of the same
expanded group. See Section E.2.a of this
Part V for the new terminology. However,
any distribution or acquisition made by a
predecessor or successor of a corporation
up to the date that the predecessor or
successor relationship is terminated may
be treated as funded by a debt instrument
issued by the corporation after that date.

Comments requested that the terms
predecessor and successor not include the
distributing or controlled corporation in a
divisive reorganization described in sec-
tion 368(a)(1)(D) undertaken pursuant to
a distribution under section 355, regard-
less of whether distributing and controlled
remain members of the same expanded
group. The comments asserted that the
requirements of section 355 provide suf-

ficient safeguards to protect the concerns
underlying the proposed regulations (spe-
cifically, that a taxpayer would undertake
a divisive reorganization with a principal
purpose of avoiding the regulations), such
that it is not necessary to treat the distrib-
uting and controlled corporations as pre-
decessors and successors. For example,
the active trade or business requirement
and business purpose requirement of sec-
tion 355 limit the ability for taxpayers to
engage in tax-motivated transactions, al-
though comments did acknowledge that
these restrictions could be overcome in
some circumstances.

The final and temporary regulations do
not adopt this recommendation because
the Treasury Department and the IRS con-
tinue to be concerned about the ability of
taxpayers to issue indebtedness that does
not fund new investment in connection
with a reorganization that qualifies under
sections 355 and 368(a)(1)(D). As dis-
cussed in Section D.6 of this Part V, the
Treasury Department and the IRS have
determined that distributions that qualify
for nonrecognition under section 355,
whether or not preceded by a reorganiza-
tion, should not be subject to the funding
rule because the requirements of that pro-
vision-in particular, the active trade or
business requirement and the device lim-
itation-indicate that the stock of a con-
trolled corporation is likely not fungible
property. However, these safeguards do
not adequately limit the amount of liquid
assets that the distributing corporation can
transfer to the controlled corporation pur-
suant to the plan of reorganization or be-
fore the spin is contemplated in the case of
straight section 355 distributions. More-
over, section 355 includes no prohibition
against a post-spin distribution by the con-
trolled corporation to its common share-
holder with the distributing corporation.
As a result, the proceeds of a borrowing
by the distributing corporation can easily
be transferred to a controlled corporation,
which proceeds can then be distributed by
the controlled corporation or used in a
transaction with similar economic effect.

One comment suggested that the pre-
decessor and successor rules limit the ex-
tent to which multiple corporations may
be treated as successors with respect to the
same debt instrument issued by a funded
member. The comment proposed that, in

the event that a funded member has mul-
tiple successors (for example, by reason of
multiple transfers of property to which the
subsidiary stock acquisition exception de-
scribed in Section E.2.a of this Part V
applies), the successors, collectively,
should only be successors up to the aggre-
gate amount of debt instruments of the
funded member outstanding at the time of
the transactions that created the successor
relationships. The comment further sug-
gested that, if the recommendation were
accepted, an ordering rule may be appro-
priate to treat multiple successors as suc-
cessors to the funded member based on a
"first in time" principle.

The final and temporary regulations do
not adopt the recommendation, because
the Treasury Department and the IRS
have determined that limiting the extent to
which one or more corporations are suc-
cessors to a funded member based on the
member's outstanding related-party debt
is inconsistent with the funding rule out-
side the predecessor-successor context. As
discussed in Section D.2 of this Part V,
under either test of the funding rule - the
per se funding rule or the principal pur-
pose test-a covered debt instrument can
be treated as funding a distribution or ac-
quisition notwithstanding that the instru-
ment is issued subsequent to the distribu-
tion or acquisition. In contrast, limiting
successor status to the funded member's
debt outstanding at the time of the trans-
action that creates the successor relation-
ship would preclude a later issued covered
debt instrument from being treated as
funding a distribution or acquisition that
precedes it. For instance, if a funded
member, at a time that it has no covered
debt instrument outstanding, transfers
property to a subsidiary in a transaction
described in the subsidiary stock acquisi-
tion exception, under the proposed limita-
tion the subsidiary would not be a succes-
sor to the funded member, and thus any
distribution or acquisition by the subsid-
iary would not be treated as funding a
covered debt instrument of the funded
member issued thereafter but within the
per se period. On the other hand, if, in-
stead of transferring property to the sub-
sidiary, the funded member made a distri-
bution or acquisition itself, a subsequent
issuance by the funded member of a cov-
ered debt instrument within the per se

period would be treated as funding the
distribution or acquisition under the per se
funding rule. The Treasury Department
and the IRS have determined that a distri-
bution or acquisition by a predecessor or
successor of a funded member should not
be treated more favorably than a distribu-
tion or acquisition by the funded member
itself. Furthermore, because the final and
temporary regulations do not adopt the
recommendation, no ordering rule is nec-
essary for purposes of determining prede-
cessor or successor status in the context of
multiple predecessors or successors.

Comments also requested clarification
regarding the interaction of the predeces-
sor and successor rules and the multiple
instrument rule, which provides that when
two or more covered debt instruments
may be treated as stock under the per se
funding rule, the covered debt instruments
are tested based on the order in which they
were issued, with the earliest issued cov-
ered debt instrument tested first. Specifi-
cally, comments raised the concern that,
under one interpretation of the proposed
regulations, a distribution or acquisition
that is treated as funded by a covered debt
instrument of a covered member could be
re-tested and treated as funded by an
earlier-in-time debt instrument of another
member if and when the first covered
member acquires the other member in a
reorganization.

To address the foregoing concerns, the
final and temporary regulations provide
that, except as provided in § 1.385-
3(d)(2) (regarding covered debt instru-
ments treated as stock that leave the ex-
panded group), to the extent a distribution
or acquisition is treated as funded by a
covered debt instrument, the distribution
or acquisition may not be treated as
funded by another covered debt instru-
ment and the covered debt instrument may

not be treated as funding another distribu-
tion or acquisition. This non-duplication
rule clarifies that a distribution or acqui-
sition that is treated as funded by a cov-
ered debt instrument that is treated as
stock by reason of § 1.385-3(b) is not
re-tested under the multiple instrument
rule because of the existence of an earlier-
in-time covered debt instrument of the
corporation's predecessor or successor,
when the transaction that created the
predecessor-successor relationship occurs

after the first-mentioned covered debt in-
strument was already treated as stock.

## 4. Straddling Expanded Groups

Multiple comments recommended
that the final and temporary regulations
provide an exception for when a funded
member is funded within the per se pe-
riod with respect to a distribution or
acquisition, but the funding and the dis-
tribution occur in different expanded
groups. For example, P1 and S are mem-
bers of the P1 expanded group. P1 owns
all the stock of S, which distributes
$100x to P1 in year 1. In year 2, P1 sells
all the stock of S to unrelated P2, a
member of the P2 expanded group. In
year 3, P2 loans $100x to S. The com-
ments asserted that the borrowing and
distribution by S do not implicate the
policy concerns addressed by the fund-
ing rule because of the intervening
change in its expanded group. More-
over, comments asserted that it would
be difficult for P2 to determine the treat-
ment of its loan to S as debt or equity
without substantial due diligence with
respect to the distribution history of S.

The final and temporary regulations
adopt the recommendation by providing
an exception to the per se funding rule,
which generally applies when (i) a cov-
ered member makes a distribution or
acquisition that occurs before the cov-
ered member is funded; (ii) the distribu-
tion or acquisition occurs when the cov-
ered member's expanded group parent is
different than the expanded group parent
when the covered member is funded;
and (iii) the covered member and the
counterparty to the distribution or acqui-
sition (the "recipient member") are not
members of the same expanded group
on the date the covered member is
funded. For this purpose, a recipient
member includes a predecessor or suc-
cessor or one or more other entities that,
in the aggregate, acquire substantially
all of the property of the recipient mem-
ber. If the requirements of this exception
are satisfied, the covered debt instru-
ment is not treated as issued within the
per se period with respect to the earlier
distribution. However, the principal pur-
pose test may still apply so that, if the
debt instrument is actually issued with a

principal purpose of funding the distri-
bution or acquisition, the debt instru-
ment would be treated as stock under the
funding rule.

Comments also addressed a similar
scenario in which the covered member
and the recipient member are members of
one expanded group (prior expanded
group) at the time of the distribution or
acquisition and both parties join a differ-
ent expanded group (subsequent expanded
group) before the covered member is
funded by either the recipient member or
another member of the subsequent ex-
panded group. Some of the comments rec-
ommended that the funding rule, or at
least the per se rule, not apply in this
situation because the borrowing from the
subsequent expanded group cannot have
funded the distribution or acquisition that
occurred in the prior expanded group.
Comments also recommended a similar
exception to the funding rule when the
steps are reversed, such that the covered
member issues a covered debt instrument
to another member of the prior expanded
group, and the distribution or acquisition
occurs in the subsequent expanded group
that includes both the funding and funded
members.

The final and temporary regulations do
not adopt these recommendations. The
Treasury Department and IRS expect that
any burden on taxpayers to determine the
history of loans originated in the prior
expanded group would not be as signifi-
cant as any burden to determine the dis-
tribution and acquisition history in a prior
expanded group (that is, when the distri-
bution or acquisition occurs in the prior
expanded group, and the funding occurs in
the subsequent expanded group). The
Treasury Department and the IRS have
determined that, when the distribution or
acquisition occurs in the same expanded
group that includes the funding and
funded members, it is appropriate to apply
the per se funding rule to the distribution
or acquisition. Finally, the Treasury De-
partment and the IRS are concerned that
an exception for this type of transaction
could lead to transactions in which tax-
payers transfer subsidiaries between dif-
ferent expanded groups to accomplish
what they could not accomplish absent
such transactions.

5\. Transactions Described in More than
One Paragraph

Proposed § 1.385-3(b)(3)(iii) provided
that if all or a portion of a distribution or
acquisition by a funded member is de-
scribed in more than one prong of the
funding rule, the funded member is treated
as engaging in only a single distribution or
acquisition for purposes of applying the
funding rule. One comment questioned
the application of this rule to a payment of
boot in a reorganization where both the
acquiring corporation and the target cor-
poration in the reorganization have out-
standing covered debt instruments.

In response to this comment, § 1.385-
3(b)(3)(ii) clarifies that, in the case of an
internal asset reorganization, to the extent
an acquisition by the transferee corpora-
tion is described in the third prong of the
funding rule, a distribution or acquisition
by the transferor corporation is not also
described in the funding rule. Accord-
ingly, in the case of a reorganization in
which both the transferor corporation and
the transferee corporation have outstand-
ing covered debt instruments, the reorga-
nization is treated as a single transaction
and a payment of boot in the reorganiza-
tion is treated as a single acquisition by
the transferee corporation for purposes of
the funding rule. See Sections E.3.a.iv (re-
garding the application of reductions to
certain internal asset reorganizations) and
E.6.b (regarding the general coordination
rule applicable to internal asset reorgani-
zations) of this Part V.

## 6. Certain Nontaxable Distributions

Comments recommended that the
funding rule not apply to liquidating dis-
tributions described in section 332. Com-
ments further recommended that the final
and temporary regulations treat the 80-
percent distributee in a section 332 liqui-
dation as a successor to the liquidating
corporation. Comments requested, in the
alternative, that if a section 332 distribu-
tion is treated as a distribution for pur-
poses of the funding rule, the final and
temporary regulations should clarify
whether any resulting recharacterized in-
struments are taken into account in deter-
mining whether the liquidation satisfies

the 80-percent ownership test under sec-
tion 332.

One comment recommended that, if an
expanded group member distributes assets
in a section 331 liquidation to a share-
holder that assumes a liability of the liq-
uidated corporation, the liquidated corpo-
ration should not be treated as making a
distribution for purposes of the funding
rule to the extent of the assumed liabili-
ties. The comment reasoned that, in sub-
stance, the shareholder purchased assets
from the liquidating corporation. Conse-
quently, the comment concluded that a
distribution should be treated as occurring
under these circumstances only to the ex-
tent the value of the distributed assets
exceeds the amount of liabilities assumed.

In response to the comments, the final
and temporary regulations include an ex-
ception to the funding rule for a distribu-
tion in complete liquidation of a funded
member pursuant to a plan of liquidation.
This exception does not distinguish be-
tween a liquidation that qualifies under
section 332 and a liquidation that occurs
under section 331. In the case of a liqui-
dation that qualifies under section 332, the
acquiring corporation is treated as a suc-
cessor to the liquidated corporation for
purposes of the funding rule.

Comments also requested an exclusion
from the funding rule for distributions of
stock under section 355 not preceded by a
reorganization described in section 368(a)
(1)(D) (a straight 355 distribution). The
comment noted that in a straight 355 dis-
tribution, in contrast to a distribution of a
debt instrument or a distribution of cash,
the distribution of a controlled corporation
must be motivated by one or more non-
U.S. tax business purposes and both the
distributing and controlled corporations
must own historic, illiquid business assets.
Moreover, the comment noted that the
distributing corporation in a straight 355
distribution cannot have contributed bor-
rowed funds to the controlled corporation;
otherwise, the distribution would also
qualify as a reorganization and be subject
to a different rule that generally only
treated the amount of boot or other prop-
erty received in a distribution that quali-
fies under sections 355 and 368(a)(1)(D)
as a distribution or acquisition for pur-
poses of § 1.385-3(b).

In response to comments, the final and
temporary regulations provide an excep-
tion to the funding rule for a straight sec-
tion 355 distribution. As discussed in
Section D.2.a of this Part V, the per se
approach is retained by the final and tem-
porary regulations due, in large part, to the
fungibility of money and thus the diffi-
culty of tracing the proceeds of a borrow-
ing to a distribution. The Treasury Depart-
ment and the IRS have concluded that,
due to the heightened requirements for
qualification under section 355 (for exam-
ple, device limitation, business purpose
requirement, and active trade or business
requirement), the stock of a controlled
corporation should not be viewed as fun-
gible property. Furthermore, the Treasury
Department and the IRS have determined
that section 355 distributions should be
subject to the same treatment under the
final and temporary regulations as section
355 distributions that are preceded by a
reorganization under section 368(a)(1)
(D), because a distribution of stock de-
scribed in section 355 has the same eco-
nomic effect whether or not preceded by a
reorganization. In that regard, the final
and temporary regulations provide that a
distributing corporation and a controlled
corporation in a section 355, whether or
not in connection with a reorganization
described in section 368(a)(1)(D), are pre-
decessor and successor to each other for
purposes of the funding rule.

One comment requested that distribu-
tions described in section 305(a) (stock
distributed with respect to stock not in-
cluded in gross income) be excluded from
the funding rule because the shareholders
do not realize income and the distributing
corporation's net worth does not decrease.
The final and temporary regulations do
not directly address transactions to which
section 305(a) applies because a distribu-
tion of the stock of a corporation made by
such corporation is not a distribution of
property as defined for purposes of
§ 1.385-3, and thus is not addressed by
the funding rule.

## 7. Secondary Purchases

One comment requested confirmation
that an expanded group member's second-
ary purchase of a debt instrument issued
by a member of its expanded group is not

an issuance of a debt instrument described
in the funding rule. The comment further
recommended that the deemed issuance of
a debt instrument from one expanded
group member to another expanded group
member under § 1.108-2(g) should be
disregarded for purposes of the funding
rule. The Treasury Department and the
IRS have determined that no further clar-
ification is necessary in this area. Consis-
tent with the proposed regulations,
§ 1.385-3(b)(3) of the final regulations
provides that the funding rule applies to a
covered debt instrument issued by a cov-
ered member to a member of an expanded
group, and thus the funding rule generally
does not apply to secondary market pur-
chases. However, to the extent that any
other Code section or regulation deems a
debt instrument to be issued by a covered
member to a member of its expanded
group, that issuance could, absent an ex-
ception, be an issuance described in
§ 1.385-3(b)(3).

## 8. Ordinary Course Exception, Cash Pooling, and Short-Term Instruments

### a. Proposed regulations and general approach

The proposed regulations provided that
an ordinary course debt instrument is not
subject to the per se funding rule. Pro-
posed § 1.385-3(b)(3)(iv)(B)(2) defined
an ordinary course debt instrument as a
debt instrument that arises in the ordinary
course of the issuer's trade or business in
connection with the purchase of property
or the receipt of services, but only to the
extent that it reflects an obligation to pay
an amount that is currently deductible by
the issuer under section 162 or currently
included in the issuer's cost of goods sold
or inventory, and provided that the
amount of the obligation outstanding at no
time exceeds the amount that would be
ordinary and necessary to carry on the
trade or business of the issuer if it was
unrelated to the lender.

Proposed §§ 1.385-3 and 1.385-4 did
not include special rules for debt instru-
ments that are issued in the ordinary
course of managing the cash of an ex-
panded group. However, the preamble to
the proposed regulations requested com-
ments on the special rules that might be

needed with respect to cash pools, cash
sweeps, and similar arrangements for
managing the cash of an expanded group.

The comments regarding the ordinary
course exception and the need for an
exception to address common cash-
management techniques overlap consider-
ably. Accordingly, Section D.8 of this Part
V addresses both topics. In general, com-
ments indicated that it would be burden-
some to apply the per se funding rule to
any frequently recurring transactions, in-
cluding both ordinary course business
transactions between affiliates that in-
volve a short-term extension of credit as
well as debt instruments that arise in the
context of companies that participate in
arrangements with other expanded group
members that are intended to optimize, on
a daily basis, the amount of working cap-
ital required by the group. Comments also
observed that the risk that such extensions
of credit would be used for tax-motivated
purposes, such as funding a distribution, is
very low and does not justify the burdens
that would be imposed if companies had to
track these transactions and deal with the
complexity that would follow if such routine
extensions of credit were recharacterized
into equity. Far less uniform were the rec-
ommendations for how to address the con-
cerns expressed in the comments.

As described in Section D.8.c of this
Part V, the Treasury Department and the
IRS have determined that the ordinary
course exception should be an element of
a broader exception that also covers cer-
tain other short-term loans, including debt
instruments that arise in the context of a
cash-management arrangement. In many
cases the types of transactions covered by
the ordinary course exception are in sub-
stance similar to the transactions that are
facilitated by the short-term liquidity that
is extended under a cash-management ar-
rangement. For example, an expanded
group member may purchase inventory
from an affiliate in exchange for a trade
payable or using cash obtained by an ex-
tension of credit from a third group mem-
ber. The Treasury Department and the IRS
have determined that it is not appropriate
to create a tax preference for either form
of the transaction. Accordingly, the tem-
porary regulations adopt a broad excep-
tion from the funding rule for qualified
short-term debt instruments that is in-

tended to address the comments' concerns
regarding the ordinary course exception as
well as the broader need for an exception
to facilitate short-term cash management
arrangements.

## b. Overview of comments received

### i. Expansion of exception to additional instruments

Numerous comments requested that
the ordinary course exception be ex-
panded to apply to a wider range of debt
instruments. These comments ranged
from narrow requests to expand the list of
items that might be acquired in the ordi-
nary course of a taxpayer's business from
another group member to broad requests
for an exception that covers any short-
term loan, including for cash.

Some comments questioned the re-
quirement for a debt instrument to be is-
sued for goods and services in order to
qualify for the ordinary course exception,
stating that the ordinary course exception
otherwise would not cover many regular
business expenses, including some ex-
penses deductible as trade or business ex-
penses under section 162. Comments spe-
cifically noted that the ordinary course
exception would not apply to instruments
issued as payment for a rent or royalty due
to a related party for the use of assets
(including intangible assets) used in a
trade or business because such payments
are not in exchange for goods or services.
Other comments recommended that the
ordinary course exception apply to trans-
actions involving expenses that are cur-
rently deductible or creditable under other
sections of the Code, including payments
(or loans to finance payments) of expenses
creditable or deductible under section 41
(allowing a credit for increasing research
activities), section 164 (allowing a deduc-
tion for state and local taxes), and section
174 (allowing a deduction for certain re-
search and development expenses). Sepa-
rately, comments requested that transac-
tions involving expenses that are deferred
or disallowed under a provision of the
Code (for example, section 267) should
nonetheless qualify for the ordinary
course exception.

Comments also recommended that the
ordinary course exception apply to trans-

actions involving expenses that are re-
quired to be capitalized or amortized.
Along these lines, comments recom-
mended that loans issued in exchange for
certain business property, such as operat-
ing assets or tangible personal property
used in a trade or business, be treated as
ordinary course debt instruments.

## ii. Facts and circumstances

Comments suggested that the ordinary
course exception should apply broadly un-
der a facts-and-circumstances test. Under
one articulation of a facts-and-
circumstances test proposed in a com-
ment, the ordinary course exception
would apply to any debt instrument issued
for services or property in the conduct of
normal business activities on appropriate
terms unless the facts establish a principal
purpose of funding a general rule transac-
tion. The comment noted several instances
in which such a test would apply more
broadly than the test in the proposed rule,
including certain issuances by securitiza-
tion vehicles and dealers and issuances
and modifications of intercompany debt
by a distressed corporation in connection
with an agreement with third-party credi-
tors.

## iii. De minimis loans

Comments recommended that the ordi-
nary course exception apply to all loans
under a de minimis threshold. Suggestions
for a de minimis threshold included $1
million per obligation or $5 million per
entity.

## iv. Working capital loans

Numerous comments suggested an or-
dinary course exception or other safe har-
bor that would apply based on a determin-
able financial metric, such as current
assets, current assets less cash and cash
equivalents, annual expenses, or annual
cost of goods sold. Representative exam-
ples of this approach include: an excep-
tion for aggregate loans below 150 per-
cent of the closing balance of current
assets of the borrower as of its most recent
financial statements; an exception for ag-
gregate loans less than annual expenses;
an exception for aggregate loans less than

certain annual expenses related to ordi-
nary course transactions, such as payroll
and cost of goods sold; an exception for
loans up to a certain percentage of the
book value of gross assets; and an excep-
tion for any debt instrument with a prin-
cipal amount less than the average princi-
pal amount of all expanded group debt
instruments issued by expanded group
members (including the borrower) in the
prior 36 months, increased by a specific
percentage to account for growth. One
comment noted in particular that any safe
harbor should not apply to the extent the
borrower held unrestricted cash or cash
equivalents available to pay for the goods
or services. A comment also noted that the
measurement of any specific financial
metric used as the basis of an exception
(for example, current assets) could be de-
termined over a period, such as a trailing
three-year average (or other period). An-
other comment noted that an exception
based on a financial metric that is fixed in
time may not work well because (i) if the
metric is based on a specific balance sheet
date, that date may not be representative
of the working capital requirements at
other times, such as during a peak season,
and (ii) if the metric is based on the time
of issuance of the debt instrument and that
date is not a balance sheet date, it may not
be knowable.

Other comments recommended that all
short-term debt instruments and all non-
interest bearing debt instruments should
qualify for an exception.

## v. Net interest expense

A comment requested an exception for
cash pooling arrangements that do not
give rise to net interest expense in the
United States, determined on a taxable
year basis. For a discussion of comments
regarding exceptions based on net interest
generally, see Section A of this Part V.

## vi. Cash pooling arrangements

Comments noted that the preamble to
the proposed regulations explicitly stated
that the ordinary course exception "is not
intended to apply to intercompany financ-
ing or treasury center activities." Several
comments requested reconsideration of
this restriction because businesses often

use a treasury center or other cash-
management arrangement (such as a cash
pool) to finance ordinary course transac-
tions of group members, as well as for
intercompany netting programs, central-
ized payment systems, foreign currency
hedging, and bridge financing. Accord-
ingly, comments requested that financing
of routine transactions qualify for the or-
dinary course exception, regardless of
whether such financing is provided by a
treasury center or other cash-management
arrangement. Comments also requested
that debt instruments issued in connection
with netting, clearing-house, and billing
center arrangements be treated as ordinary
course debt instruments whether or not
conducted through a treasury center.

The comments suggested defining a
new entity such as a treasury center or
qualified cash pool and treating loans to
and from the entity as ordinary course
debt instruments. Some comments sug-
gested defining a treasury center by refer-
ence to § 1.1471-5(e)(5)(i)(D), which
generally applies to an entity that manages
working capital solely for members of its
expanded affiliated group (as defined in
section 1471(e)(2) and the regulations
thereunder). An alternative proposal de-
fined a qualified cash pool as any entity
with a principal purpose of managing the
funding and liquidity for members of the
expanded group. However, some com-
ments recommending such an approach
acknowledged that some companies pro-
vide long-term financing for non-ordinary
course transactions through an internal
treasury center, and thus noted that loans
to and from the qualified entity could be
subject to reasonable restrictions on dura-
tion.

Comments also expressed concern that
recharacterization of a debt instrument in
the context of a cash-management ar-
rangement could result in a multitude of
cascading recharacterizations, particularly
in situations where a cash pool header
makes and receives a substantial number
of loans. Comments indicated that cash
pools typically process many transactions
in a single business day, with one com-
ment stating that the company's cash pool
processed over a million transactions in a
year. For a summary of comments con-
cerning iterative effects (including com-
ments raising similar concerns outside the

context of cash pool) and the final and
temporary regulation's approach to miti-
gate those effects, see Section B.5 of this
Part V.

The comments suggesting relief by ref-
erence to a cash pool header, treasury
center, or similar entity (including an un-
related entity, such as a third party bank
facilitating a notional cash pool) also re-
quested that the exception provide that
instruments issued by and to such entity
be respected and not subject to recharac-
terization under the anti-conduit rules of
§ 1.881-3 or similar doctrines.

### c. Short-term debt instruments

In order to facilitate non-tax motivated
cash management techniques, such as
cash pooling or revolving credit arrange-
ments, as well as ordinary course short-
term lending outside a formal cash-
management arrangement, the temporary
regulations adopt an exception from the
funding rule for qualified short-term debt
instruments. The temporary regulations
do not adopt a general exemption for all
loans issued as part of a cash-management
arrangement because, as comments ac-
knowledged, such arrangements can pro-
vide long-term financing to expanded
group members.

Under the temporary regulations, a
covered debt instrument is treated as a
qualified short-term debt instrument, and
consequently is excluded from the scope
of the funding rule, if the covered debt
instrument is a short-term funding ar-
rangement that meets one of two alterna-
tive tests (the specified current assets test
or the 270-day test), or is an ordinary
course loan, an interest-free loan, or a
deposit with a qualified cash pool header.
The Treasury Department and the IRS ex-
pect that the exception for qualified short-
term debt instruments generally will pre-
vent the treatment as stock of short-term
debt instruments issued in the ordinary
course of an expanded group's business,
including covered debt instruments aris-
ing from financing provided by a cash
pool header pursuant to a cash-
management arrangement. Furthermore,
these tests generally rely on mechanical
rules that will provide taxpayers with
more certainty, and be more administrable
for the IRS, as compared to a facts-and-

circumstances approach that was sug-
gested by some comments.

# i. Short-term funding arrangement

A covered debt instrument that satisfies
one of two alternative tests - the speci-
fied current assets test or the 270-day test
\- constitutes a qualified short-term debt
instrument. These alternative tests are in-
tended to exclude covered debt instru-
ments issued as part of arrangements, in-
cluding cash pooling arrangements, to
meet short-term funding needs that arise
in the ordinary course of the issuer's busi-
ness. An issuer may only claim the benefit
of one of the alternative tests with respect
to covered debt instruments issued by the
issuer in the same taxable year.

To satisfy the specified current assets
test, two requirements must be satisfied.
First, the rate of interest charged with
respect to the covered debt instrument
must be less than or equal to an arm's
length interest rate, as determined under
section 482 and the regulations thereun-
der, that would be charged with respect to
a comparable debt instrument of the issuer
with a term that does not exceed the lon-
ger of 90 days and the issuer's normal
operating cycle.

Second, a covered debt instrument is
treated as satisfying the specified current
assets test only to the extent that, imme-
diately after the covered debt instrument
is issued, the issuer's outstanding balance
under covered debt instruments issued to
members of the issuer's expanded group
that satisfy any of (i) the interest rate
requirement of the specified current assets
test, (ii) the 270-day test (in the case of a
covered debt instrument that was issued in
a prior taxable year in which the issuer
claimed the benefit of the 270-day test),
(iii) the ordinary course loan exception, or
(iv) the interest-free loan exception, does
not exceed the amount expected to be
necessary to finance short-term financing
needs during the course of the issuer's
normal operating cycle. For purposes of
determining an issuer's outstanding bal-
ance, in the case of an issuer that is a
qualified cash pool header, the amount
owed does not take into account the qual-
ified cash pool header's deposits payables.
(These debt instruments are eligible for a
separate exception described in Section

D.8.c.iv of this Part V.) Additionally, the
amount owed by any other issuer is re-
duced by the issuer's deposits receivables
from a qualified cash pool header, but
only to the extent of amounts owed to the
same qualified cash pool header that sat-
isfy the interest rate requirement of the
specified current assets test or that satisfy
the requirements of the 270-day test (if the
covered debt instrument was issued in a
prior taxable year).

The issuer's amount of short-term fi-
nancing needs is determined by reference
to the maximum of the amounts of spec-
ified current assets reasonably expected to
be reflected, under applicable financial ac-
counting principles, on the issuer's bal-
ance sheet as a result of transactions in the
ordinary course of business during the
subsequent 90-day period or the issuer's
normal operating cycle, whichever is lon-
ger. For this purpose, specified current
assets means assets that are reasonably
expected to be realized in cash or sold
(including by being incorporated into in-
ventory that is sold) during the normal
operating cycle of the issuer, but does not
include cash, cash equivalents, or assets
that are reflected on the books and records
of a qualified cash pool header. Thus, for
example, the specified current assets test
allows a covered debt instrument that is
used to finance variable operating costs
and that is expected to be repaid from
sales during the course of a normal oper-
ating cycle to be considered a qualified
short-term debt instrument. Consistent
with the exclusion of a qualified cash pool
header's deposits payables from consider-
ation under the specified current assets
test, specified current assets do not include
assets that are reflected on the books and
records of a qualified cash pool header.

The applicable accounting principles to
be applied for purposes of the specified
current assets test, including for purposes
of determining specified current assets
reasonably expected to be reflected on the
issuer's balance sheet, are financial ac-
counting principles generally accepted in
the United States (GAAP), or an interna-
tional financial accounting standard, that
is applicable to the issuer in preparing its
financial statements, computed on a con-
sistent basis. The reference to a normal
operating cycle also is intended to be in-
terpreted consistent with the meaning of

that term under applicable accounting
principles. Under GAAP, the normal op-
erating cycle is the average period be-
tween the commitment of cash to acquire
economic resources to be resold or used in
production and the final realization of
cash from the sale of products or services
that are, or are made from, the acquired
resources. For example, in the course of a
normal operating cycle, a retail firm
would commit cash to buy inventory, con-
vert the inventory into accounts receiv-
able, and convert the accounts receivable
into cash. However, if the issuer has no
single clearly defined normal operating
cycle, then the issuer's normal operating
cycle is determined based on a reasonable
analysis of the length of the operating
cycles of the multiple businesses and their
sizes relative to the overall size of the
issuer.

The reference to a financial accounting-
based concept of current assets in the spec-
ified current assets test is consistent with
comments that recommended an exception
or safe harbor based on a determinable fi-
nancial metric. The Treasury Department
and the IRS have determined that, among
the many potential metrics recommended in
comments, the approach in the current as-
sets test most appropriately achieves the
goal of providing an administrable excep-
tion for variable funding needs during the
course of a normal operating cycle. The
reference to the amounts of specified current
assets that are "reasonably expected" to be
reflected on the balance sheet is intended to
address concerns expressed by comments
that any metric based on an amount reported
on a prior balance sheet should be increased,
for example, to 150 percent of such reported
amount, in order to account for growth and
seasonal needs that may not be reflected on
the balance sheet date. The reference to the
maximum of these amounts is intended to
refer to the day on which the issuer is rea-
sonably expected to hold the highest level of
specified current assets during the desig-
nated period. Such reference is not intended
to suggest the upper bound of the range of
assets that might reasonably be expected to
be held on any particular day. The reference
to specified current assets in the ordinary
course of business is intended to exclude
extraordinary transactions that could affect
the short-term balance sheet.

As an alternative to the specified cur-
rent assets test, a covered debt instrument
may also constitute a qualified short-term
debt instrument by satisfying the 270-day
test. The 270-day test generally provides
taxpayers an opportunity to qualify for the
short-term debt instrument exception
when the specified current assets test pro-
vides limited relief due to circumstances
unique to the issuer, such as when an
issuer has a relatively small amount of
current assets and comparatively large
temporary borrowing needs. The 270-day
test reflects consideration of comments
that requested, for example, an exception
for loans of up to 180 days or an exception
based on the issuer's number of days of
net indebtedness during the year.

For a covered debt instrument to sat-
isfy the 270-day test, three conditions
must be met. First, the covered debt in-
strument must have a term of 270 days or
less or be an advance under a revolving
credit agreement or similar arrangement,
and must bear a rate of interest that is less
than or equal to an arm's length interest
rate, as determined under section 482 and
the regulations thereunder, that would be
charged with respect to a comparable debt
instrument of the issuer with a term that
does not exceed 270 days. Second, the
issuer must be a net borrower from the
lender for no more than 270 days during
the taxable year of the issuer, and in the
case of a covered debt instrument out-
standing during consecutive taxable years,
the issuer may be a net borrower from the
lender for no more than 270 consecutive
days. In determining whether the issuer is
a net borrower from a particular lender for
this purpose, only covered debt instru-
ments that satisfy the term and interest
rate requirement and that are not ordinary-
course loans (described in Section D.8.c.ii
of this Part V) or interest-free loans (de-
scribed in Section D.8.c.iii of this Part V)
are taken into account. A covered debt
instrument with respect to which an issuer
claimed the benefit of the specified current
assets test in a prior year could meet these
conditions and be taken into account for
this purpose as a borrowing. Third, a cov-
ered debt instrument will only satisfy the
270-day test if the issuer is a net borrower
under all covered debt instruments issued
to any lender that is a member of the
issuer's expanded group that otherwise

would satisfy the 270-day test, other than
ordinary course loans and interest-free
loans, for 270 or fewer days during a
taxable year.

The temporary regulations provide that
an issuer's failure to satisfy the 270-day
test will be disregarded if the taxpayer
maintains due diligence procedures to pre-
vent such failures, as evidenced by having
written policies and operational proce-
dures in place to monitor compliance with
the 270-day test and management-level
employees of the expanded group having
undertaken reasonable efforts to establish,
follow, and enforce such policies and pro-
cedures.

## ii. Ordinary course loans

The temporary regulations generally
broaden the ordinary course exception in
the proposed regulations to provide that a
covered debt instrument constitutes a
qualified short-term debt instrument be-
cause it is an ordinary course loan if it is
issued as consideration for the acquisition
of property other than money, in the ordi-
nary course of the issuer's trade or busi-
ness. In contrast to the proposed regula-
tions, the temporary regulations provide
that, to constitute an ordinary course loan,
an obligation must be reasonably expected
to be repaid within 120 days of issuance.
The Treasury Department and the IRS
have determined that, based on comments
received, this term limitation, in conjunc-
tion with the addition of the new alterna-
tives for satisfying the qualified short-
term debt instrument exception, will
accommodate common business practice
with respect to trade payables while pro-
viding both the IRS and taxpayers with
increased certainty.

In response to comments received on
the ordinary course exception, the ordi-
nary course loan element of the exception
for qualified short-term debt instruments
is broadened so as to no longer be limited
to payables with respect to expenses that
are currently deductible by the issuer un-
der section 162 or currently includible in
the issuer's cost of goods sold or inven-
tory. Although comments requested an ex-
pansion to cover debt instruments issued
for rents or royalties, such debt instru-
ments are already outside the scope of the
funding rule because the funding rule ap-

plies solely to debt instruments issued in
exchange for property. For this reason, the
ordinary course exception in the tempo-
rary regulations also does not apply to a
debt instrument issued in connection with
the receipt of services.

## iii. Interest-free loans

In response to comments recommend-
ing that all non-interest bearing debt in-
struments should qualify for an exception,
the temporary regulations provide that a
covered debt instrument constitutes a
qualified short-term debt instrument if the
instrument does not provide for stated in-
terest or no interest is charged on the
instrument, the instrument does not have
original issue discount (as defined in sec-
tion 1273 and the regulations thereunder),
interest is not imputed under section 483
or section 7872 and the regulations there-
under, and interest is not required to be
charged under section 482 and the regu-
lations thereunder. See, e.g., § 1.482-
2(a)(1)(iii) (providing that interest is not
required to be charged with respect to an
intercompany trade receivable in certain
circumstances).

## iv. Deposits with a qualified cash pool header

Covered members making deposits
with a qualified cash pool header pursuant
to a cash-management arrangement may
maintain net deposits with the qualified
cash pool header under circumstances that
otherwise would not allow the qualified
cash pool header (which is an issuer of
covered debt instruments in connection
with its deposits payable) to qualify for
the qualified short-term debt instrument
exception with respect to the deposit, for
instance due to the length of time the
deposits are maintained with the cash
pool. In response to comments requesting
a specific exception for cash pool headers,
the temporary regulations provide that a
covered debt instrument is a qualified
short-term debt instrument if it is a deposit
payable by a qualified cash pool header
and certain other conditions are met. In
particular, the covered debt instrument
must be a demand deposit received by a
qualified cash pool header pursuant to a
cash-management arrangement. Addition-

ally, the deposit must not have a purpose
of facilitating the avoidance of the pur-
poses of § 1.385-3 or § 1.385-3T with
respect to a qualified business unit (as
defined in section 989(a) and the regula-
tions thereunder) (QBU) that is not a qual-
ified cash pool header.

A qualified cash pool header is defined
in the temporary regulations as a member
of an expanded group, controlled partner-
ship, or QBU described in § 1.989(a)-
1(b)(2)(ii) that is owned by an expanded
group member, that has as its principal
purpose managing a cash-management ar-
rangement for participating expanded
group members, provided that an amount
equal to the excess (if any) of funds on
deposit with the expanded group member,
controlled partnership, or QBU (header)
over the outstanding balance of loans
made by the header (that is, the amount of
deposits it receives from participating
members minus the amounts it lends to
participating members) is maintained on
the books and records of the cash pool
header in the form of cash or cash equiv-
alents or invested through deposits with,
or acquisition of obligations or portfolio
securities of, persons who are not related

to the header (or in the case of a header
that is a QBU described in § 1.989(a)-
1(b)(2)(ii), the QBU's owner) within the
meaning of section 267(b) or section
707(b). The Treasury Department and the
IRS expect that the qualified cash pool
header's expenses of operating the cash-
management arrangement (for example,
hedging costs) will be paid out of its gross
earnings on its cash management activi-
ties rather than from funds on deposit.

A cash-management arrangement is
defined as an arrangement the principal
purpose of which is to manage cash for
participating expanded group members.
Based on comments received, the regula-
tions provide that managing cash includes
borrowing excess funds from participating
expanded group members and lending
such funds to other participating expanded
group members, foreign exchange man-
agement, clearing payments, investing ex-
cess cash with an unrelated person, depos-
iting excess cash with another qualified
cash pool header, and settling intercom-
pany accounts, for example through net-
ting centers and pay-on-behalf-of pro-
grams.

# d. Other potential exceptions

## i. General rule exception

Comments recommended that the ordi-
nary course exception apply to the fund-
ing rule generally rather than applying
solely for purposes of the per se funding
rule. A few comments recommended that
the ordinary course exception apply to
both the general rule and funding rule.

The Treasury Department and the IRS
have determined that it is appropriate for
the exception applicable to qualified
short-term debt instruments, including
debt instruments issued to acquire prop-
erty in the ordinary course of a trade or
business, to apply to all aspects of the
funding rule because it is relatively un-
likely that short-term financing would be
used to fund a distribution or acquisition.
Moreover, in the event that such short-
term financing was issued with a principal
purpose of avoiding the purposes of
§ 1.385-3 or § 1.385-3T, the anti-abuse
rule at § 1.385-3(b)(4) may apply.

The Treasury Department and the IRS
are not persuaded, however, that the trans-
actions described in the general rule occur
in the ordinary course of business. Ac-
cordingly, the suggestion to extend the
ordinary course exception to general rule
transactions is not accepted. However,
certain specific exceptions to the general
rule are provided for particular ordinary
course transactions that were identified in
the comments. See, for example, the ex-
ception discussed in Section E.2.b of this
Part V for purchases of affiliate stock for
purposes of paying stock-based compen-
sation to employees, directors, and inde-
pendent contractors in the ordinary course
of business.

## ii. De minimis loans

The final and temporary regulations do
not adopt the recommendation to exempt
de minimis loans. The Treasury Depart-
ment and the IRS have determined that the
threshold exception that applies to the first
$50 million of aggregate issue price of
covered debt instruments held by mem-
bers of the expanded group that otherwise
would be treated as stock under § 1.385-3
is an appropriate de minimis rule that will
apply in addition to the exception for

short-term debt instruments described in
Section D.8.c of this Part V.

## iii. Notional pooling or similar arrangements

The temporary regulations do not spe-
cifically address the treatment of loans
made through a notional cash pool or a
similar arrangement including, for exam-
ple, whether such loans would be treated
for federal tax purposes as being made
between expanded group members under
conduit principles or other rules or doc-
trines. As noted in Part IV.B.2.c of this
Summary of Comments and Explanation
of Revisions, however, in some circum-
stances a notional cash pool may be
treated as a loan directly between ex-
panded group members applying federal
tax principles. To the extent that notional
pooling or similar arrangements give rise
to loans between expanded group mem-
bers for federal tax purposes, the final and
temporary regulations, including the qual-
ified short-term debt instrument excep-
tion, would apply to such loans in the
same manner that they apply to loans
made in form between expanded group
members.

## 9. Exceptions to Allow Netting Against Other Receivables

Comments recommended that the
amount of a member's debt instruments
subject to the funding rule be limited to
the excess of its related-party loan pay-
ables over its related-party loan receiv-
ables. Comments asserted that, in partic-
ular, such a rule would mitigate the impact
of the final and temporary regulations on a
cash pool header that receives deposits
from, and makes advances to, participants
in a cash pool arrangement, in particular
with respect to the potential iterative con-
sequences, which are discussed in detail in
Section B.5 of this Part V. More broadly,
this recommendation equates to a request
for an exception from the funding rule for
an amount of loans payable up to the
amount of related-party loan receivables
held by a funded member.

The temporary regulations, in effect,
implement this recommendation with re-
spect to short-term intercompany receiv-
ables and payables to varying degrees in

the context of the funding rule. As dis-
cussed in Section D.8 of this Part V, the
temporary regulations include an excep-
tion for qualified short-term debt instru-
ments that allows taxpayers to disregard
such qualified short-term debt instruments
when applying the funding rule. In addi-
tion to special rules treating ordinary
course loans and interest-free loans as
qualified short-term debt instruments, a
debt instrument that is part of a short-term
funding arrangement is considered a qual-
ified short-term debt instrument if it satis-
fies one of two mutually exclusive tests:
the specified current assets test or the 270-
day test. Both of the alternative tests, in
effect, allow some netting of short-term
receivables and payables. Significantly,
the specified current assets test provides
an exception for short-term borrowing up
to a limit determined by reference to spec-
ified current assets, effectively permitting
netting of short-term borrowing against
short-term assets, including accounts re-
ceivables. Additionally, that limit, applied
to short-term loans from a qualified cash
pool header, is increased by certain depos-
its the borrower has made to the qualified
cash pool header, which effectively per-
mits the borrower to net amounts on de-
posit with the qualified cash pool header
against borrowings from the qualified
cash pool header.

Additionally, with respect to a quali-
fied cash pool header, the temporary reg-
ulations treat an amount that is on deposit
with the cash pool header, which may
persist for a longer term, as a qualified
short-term debt instrument. A qualified
cash pool header, in effect, is permitted to
net its long- and short-term receivables
arising from its lending activities pursuant
to a cash management arrangement
against those deposit payables.

However, the Treasury Department
and the IRS decline to adopt a more gen-
eral netting rule. The exceptions described
above for qualified short-term debt instru-
ments operate by excluding altogether
from the funding rule an amount of short-
term loans based on circumstances that
exist at the time the loan is issued. This
approach is administrable and reaches ap-
propriate results in the context of short-
term debt instruments. Administering a
rule based on netting outside of this con-
text would be difficult because of the po-

tential variations in loans (including dif-
ferent terms, currencies, or interest rates)
and could result in a covered debt instru-
ment switching between debt and equity
on an ongoing basis, depending on the
terms of other loans.

### E. Exceptions from § 1.385-3 for certain distributions and acquisitions and the threshold exception

The proposed regulations included
three exceptions to the application of the
general rule and funding rule - the earn-
ings and profits exception, the subsidiary
stock issuance exception, and the $50 mil-
lion threshold exception. Numerous com-
ments were received regarding these ex-
ceptions, and many recommendations
were made to further narrow the scope of
the proposed regulations.

### 1. Overview of the Exceptions under the Final and Temporary Regulations

The final and temporary regulations in-
clude two categories of exceptions that
relate to distributions and acquisitions: (i)
exclusions described in § 1.385-3(c)(2),
which include the subsidiary stock acqui-
sition exception (the subsidiary stock is-
suance exception in the proposed regula-
tions), the compensatory stock acquisition
exception, and the exception to address
the potential iterative application of the
funding rule; and (ii) reductions described
in § 1.385-3(c)(3), which are the ex-
panded group earnings reduction and the
qualified contribution reduction. The ex-
ceptions under § 1.385-3(c)(2) and (c)(3)
apply to distributions and acquisitions that
are otherwise described in the general rule
or funding rule after applying the coordi-
nation rules in § 1.385-3(b). Except as
otherwise provided, the exceptions are ap-
plied by taking into account the aggregate
treatment of controlled partnerships de-
scribed in § 1.385-3T(f).

An exception under § 1.385-3(c)(2)
excludes a distribution or acquisition from
the application of the general rule and
funding rule. The Treasury Department
and the IRS have determined that, based
on comments received, the policy for in-
cluding the second and third prongs of the
general rule and funding rule does not

apply to the transactions identified in
§ 1.385-3(c)(2).

An exception under § 1.385-3(c)(3) re-
duces the amount of a distribution or ac-
quisition that can be treated as funded by
a covered debt instrument under the gen-
eral rule and funding rule. In contrast to an
exclusion, each reduction is determined
by reference to an attribute of a member-
expanded group earnings and qualified
contributions-rather than to a particular
category of transactions, and thus is avail-
able to reduce the amount of any distribu-
tion or acquisition by the member. The
Treasury Department and the IRS have
determined that a member's distributions
and acquisitions, to the extent of its ex-
panded group earnings and qualified con-
tributions, should be treated as funded by
its new equity capital rather than by the
proceeds of a related-party borrowing for
purposes of the general rule and funding
rule. To the extent the amount of a distri-
bution or acquisition is reduced, the
amount by which one or more covered
debt instruments can be recharacterized as
stock under the general rule or funding
rule by reason of the distribution or acqui-
sition is also reduced.

The exclusions and reductions of
§ 1.385-3(c)(2) and (3) operate indepen-
dently of any exclusion with respect to the
definition of covered debt instrument de-
scribed in § 1.385-3(g)(3) as well as the
exclusion of qualified short-term debt in-
struments from the funding rule. There-
fore, to the extent an exception applies to
a distribution or acquisition, either (i) the
distribution or acquisition is treated as not
described in the general rule or funding
rule (in the case of an exclusion) or (ii) the
amount of the distribution or acquisition
subject to the general rule or funding rule
is reduced (in the case of a reduction).
However, the application of an exception
in § 1.385-3(c)(2) or (3) with respect to a
distribution or acquisition does not affect
whether any covered debt instrument, in-
cluding one issued in the distribution or
acquisition itself, can be treated as fund-
ing another distribution or acquisition un-
der the funding rule. Thus, to the extent a
covered debt instrument is not treated as
stock by reason of the application of an
exception to a distribution or acquisition,
the covered debt instrument remains
available to be treated as funding another

distribution or acquisition. See Section
E.6 of this Part V for the treatment under
the funding rule of debt instruments that
are issued in a distribution or acquisition
that, absent an exclusion or reduction un-
der § 1.385-3(c)(2) or (3), would be sub-
ject to the general rule.

An exception under § 1.385-3(c)(2)
applies to distributions or acquisitions be-
fore an exception under § 1.385-3(c)(3).
A distribution or acquisition to which an
exclusion applies is not treated as de-
scribed in the general rule or funding rule,
whereas a reduction applies to reduce the
amount of a distribution or acquisition
described in the general rule or funding
rule. To the extent an exclusion exempts a
distribution or acquisition from the gen-
eral rule or funding rule, no amount of the
expanded group earnings or qualified con-
tributions of a covered member are used.

A third type of exception, the $50 mil-
lion threshold exception described in
§ 1.385-3(c)(4), applies to covered debt
instruments that otherwise would be
treated as stock under § 1.385-3(b) be-
cause they are treated as funding one or
more distributions or acquisitions, after
taking into account the exclusions and re-
ductions. The threshold exception over-
rides the general consequences of
§ 1.385-3(b) for the first $50 million of
debt instruments that otherwise would be
treated as stock under the general rule and
funding rule. A distribution or acquisition
treated as funded by a covered debt instru-
ment under § 1.385-3(b) is still treated as
funded by a covered debt instrument not-
withstanding the application of the thresh-
old exception. As a result, the distribution
or acquisition cannot be "matched" with
another covered debt instrument to cause
additional recharacterizations under the
funding rule.

# 2. Exclusions under the Final and Temporary Regulations

a. Exclusion for certain acquisitions of
subsidiary stock

i. Overview

Proposed § 1.385-3(c)(3) provided an
exception, the subsidiary stock issuance
exception, to the second prong of the
funding rule. The subsidiary stock issu-
ance exception applied to an acquisition

of stock of an expanded group member
(the issuer) by a funded member (the
transferor), provided that, for the 36-
month period immediately following the
issuance, the transferor held, directly or
indirectly, more than 50 percent of the
total combined voting power of all classes
of stock of the issuer entitled to vote and
more than 50 percent of the total value of
the stock of the issuer. For this purpose,
indirect ownership was determined by ap-
plying the principles of section 958(a)
without regard to whether an intermediate
entity is foreign or domestic. If the trans-
feror ceased to meet the ownership re-
quirement at any time during the 36-
month period, then on the date that the
ownership requirement ceased to be met
(cessation date), the exception ceased to
apply and the acquisition of expanded
group stock was subject to the funding
rule. The proposed regulations also pro-
vided that, if the exception applied to an
issuance, the transferor and the issuer
would be treated as predecessor and suc-
cessor but only with respect to any debt
instrument issued during the per se period
with respect to the issuance and only to
the extent of the fair market value of the
stock issued in the transaction.

## ii. New terminology

As discussed in Section C.3.c of this
Part V, the final and temporary regulations
expand the subsidiary stock issuance ex-
ception to include acquisitions of existing
stock of an expanded group member from
a majority-owned subsidiary (for exam-
ple, acquisitions of existing stock of a
second-tier subsidiary from a majority-
owned first tier subsidiary of the acquiring
expanded group member) under the same
conditions applicable to acquisitions of
newly-issued stock. To reflect these
changes, in the final and temporary regu-
lations: the "subsidiary stock issuance ex-
ception" is renamed "subsidiary stock ac-
quisition exception"; the "transferor" is
renamed "acquirer"; and the "issuer" is
renamed "seller." For the remainder of
this Part, the terminology of the proposed
regulations is used to describe the rules of
the proposed regulations, and comments
thereon. The terminology of the final and
temporary regulations is used in responses
to the comments, as well as to describe the

provisions of the final and temporary reg-
ulations.

## iii. Holding period requirement

Comments asserted that the 36-month
holding period requirement for the subsid-
iary stock issuance exception would un-
necessarily restrict post-issuance restruc-
turing unrelated to, and unanticipated at
the time of, the issuance. For this reason,
comments recommended that the regula-
tions adopt a control requirement that in-
corporates the principles of section 351,
under which the holding period require-
ment would be satisfied if the transferor
controlled the issuer immediately after the
issuance and all transactions occurring
pursuant to the same plan as the issuance.
Comments asserted that, if this recom-
mendation were adopted, the regulations
could retain the 36-month holding period
as a safe harbor.

The Treasury Department and the IRS
agree that transactions motivated by busi-
ness exigencies that are unforeseen at the
time of the acquisition should not gener-
ally result in the inapplicability of the
subsidiary stock acquisition exception
with respect to the acquisition. Therefore,
the final and temporary regulations pro-
vide that the exception applies if the ac-
quirer controls the seller immediately fol-
lowing the acquisition and does not
relinquish control of the seller pursuant to
a plan that existed at the time of the ac-
quisition. For this purpose, the acquirer is
presumed to have had a plan to relinquish
control of the seller at the time of the
acquisition if the transferor relinquishes
control of the seller within the 36-month
period following the acquisition. This pre-
sumption may be rebutted by facts and
circumstances that clearly establish that
the loss of control was not contemplated
at the time of the acquisition and that
avoiding the purposes of § 1.385-3 or
§ 1.385-3T was not a principal purpose
for the subsequent loss of control.

In contrast to the proposed regulations,
the final and temporary regulations do not
provide that the subsidiary stock acquisi-
tion exception ceases to apply upon the
cessation date. Instead, if the acquirer
loses control of the seller within the 36-
month period following the acquisition
pursuant to a plan that existed at the time

of the acquisition, the subsidiary stock
acquisition exception would be treated as
never having applied to the expanded
group stock acquisition.

## iv. Cessation of expanded group relationship

Comments requested clarification on
the application of the subsidiary stock is-
suance exception if the transferor and is-
suer cease to be members of the same
expanded group before the end of the 36-
month holding period. Comments recom-
mended that the subsidiary stock issuance
exception continue to exempt an issuance
if the transferor and issuer cease to be
members of the same expanded group in
the same transaction in which the trans-
feror's ownership in the issuer is reduced
to be at or below 50 percent. Comments
also recommended that, if the transferor
and issuer cease to be members of the
same expanded group, the predecessor
and successor status of the transferor and
issuer should also cease for purposes of
applying the per se funding rule.

As discussed in Section E.2.a.iii of this
Part V, the final and temporary regulations
eliminate the fixed holding period require-
ment of the proposed regulations. How-
ever, the issue could still arise if the loss
of control and the cessation of common
expanded group membership occur pursu-
ant to a plan that existed at the time of the
acquisition. For example, assume P bor-
rows from a member of the same ex-
panded group, and then, within 36 months
of the funding, contributes property to S in
exchange for S stock with the intent of
selling 100 percent of the stock of S to an
unrelated person. In this example, P loses
control of S pursuant to a plan that existed
at the time of the acquisition of S stock,
but that loss of control occurs in the same
transaction that causes P and S to cease to
be members of the same expanded group.

The Treasury Department and the IRS
have determined that a transaction that
results simultaneously in a loss of control
and a disaffiliation of the seller and ac-
quirer does not achieve a result that is
economically similar to a distribution be-
cause in that situation no property is made
available, directly or indirectly, to a com-
mon shareholder of the seller and the ac-
quirer. Accordingly, the final and tempo-

rary regulations provide that a transaction
that results in a loss of control is disre-
garded for purposes of applying the sub-
sidiary stock acquisition exception if the
transaction also results in the acquirer and
the seller ceasing to be members of the
same expanded group. For purposes of the
preceding sentence, an acquirer and seller
do not cease to be members of the same
expanded group by reason of a complete
liquidation described in section 331. Fur-
ther, as discussed in Section D.3 of this
Part V, the final and temporary regulations
provide that the seller ceases to be a suc-
cessor to the acquirer upon the date the
seller ceases to be a member of the same
expanded group as acquirer.

## v. Indirect ownership

One comment requested that the indi-
rect ownership rules used for the subsid-
iary stock issuance exception be con-
formed to the indirect ownership rules
used for other purposes of the section 385
regulations, such as the modified section
318 constructive ownership rules in
§ 1.385-1(c)(4) used to determine the
composition of an expanded group. The
final and temporary regulations retain the
indirect ownership rules of section 958(a)
as the proper measure of ownership for
purposes of the subsidiary stock acquisi-
tion exception because the Treasury De-
partment and the IRS have determined
that the constructive ownership rules
found in other provisions of the Code
would not properly differentiate an acqui-
sition of expanded group stock that does
not have an economic effect similar to that
of a distribution from one that does. As
discussed in Section C.3.c of this Part V,
the subsidiary stock acquisition exception
is predicated on the view that the acquisi-
tion of newly-issued stock of a controlled
direct or indirect subsidiary is not eco-
nomically similar to a distribution because
the property transferred in exchange for
the stock remains indirectly controlled
by the acquirer and, likewise, the transac-
tion does not have the effect of making the
property available to the ultimate common
shareholder (that is, the property is not
transferred "out from under" the acquirer).
In this regard, constructive ownership (for
instance, under section 318) is appropriate
for determining whether a common share-

holder controls each of two or more cor-
porations, but is inappropriate for the lim-
ited purpose of determining whether stock
or assets are indirectly owned by one of
those corporations. Therefore, to effectu-
ate the policy of the exception, indirect
ownership for purposes of the subsidiary
stock acquisition exception continues to
be limited to indirect ownership within the
meaning of section 958(a).

### vi. Tiered transfers

One comment requested that the regu-
lations clarify the impact of certain trans-
actions occurring after a funded member's
transfer of property to a controlled subsid-
iary. For instance, assume that S1 contrib-
uted property to S2, its wholly-owned
subsidiary, in exchange for S2 stock, and
S2 subsequently contributed property to
S3, its wholly-owned subsidiary, in ex-
change for S3 stock. The comment re-
quested that the regulations clarify that
S2's acquisition of S3 stock is not an
acquisition of expanded group stock that
affects the application of the subsidiary
stock issuance exception to S1's initial
transfer to S2.

The Treasury Department and the IRS
have determined that the proposed regu-
lations already properly provided for this
result. As a result of an issuance described
in the subsidiary stock issuance exception,
the issuer (S2) becomes a successor to the
transferor (S1) to the extent of the value
of the expanded group stock acquired
from the issuer, but only with respect to a
debt instrument of the issuer issued during
the per se period determined with respect
to the issuance. If the issuer (S2) engages
in another transaction described in the
subsidiary stock issuance exception as a
transferor, the acquisition of the stock of
the expanded group member (the second
issuer) would also not constitute an acqui-
sition of expanded group stock by reason
of the exception. Therefore, under a sec-
ond application of the subsidiary stock
issuance exception, the acquisition of the
stock of S3 by the issuer (S2), a successor
to the transferor (S1), is not treated as
described in the second prong of the fund-
ing rule and thus cannot be treated as
funded by a covered debt instrument is-
sued by the transferor (S1). After the sec-
ond issuance, the second issuer (S3) is a

successor to both the first transferor (S1)
and the first issuer (S2), which remains a
successor to the first transferor (S1). The
final and temporary regulations change
the terminology, but do not change the
result of the proposed regulations in this
regard.

b. Exclusion for certain other
acquisitions of expanded group stock,
including in connection with employee
stock compensation, and other
recommendations for exceptions for
acquisitions described in § 1.1032-3

Comments requested an exception
from the funding rule for all transactions
described in § 1.1032-3. Section 1.1032-
3 generally applies to an acquisition by a
corporation (acquiring entity) of the stock
of its controlling parent (issuing corpora-
tion) for use as consideration to acquire
money or other property (including com-
pensation for services). Section 1.1032-
3(b) addresses the transaction in the con-
text of an acquiring entity that either does
not make actual payment for the stock of
the issuing corporation (§ 1.1032-3(b)(1))
or makes actual payment for the stock of
the issuing corporation, but that actual
payment is less than the fair market value
of the issuing corporation stock that is
acquired (§ 1.1032-3(b)(2)). In either
case, to the extent the fair market value of
the stock of the issuing corporation ex-
ceeds the value of the consideration pro-
vided by the acquiring entity, § 1.1032-
3(b) deems a contribution of cash to the
acquiring entity by the issuing corporation
followed by a deemed purchase of stock
of the issuing corporation by the acquiring
entity. The majority of the comments on
this issue recommended an exception
from the funding rule to the extent that a
purchase of expanded group stock was
deemed to occur solely by reason of
§ 1.1032-3(b).

The final and temporary regulations
provide relief for purchases of expanded
group stock that are deemed to occur un-
der § 1.1032-3(b) by adopting a separate
recommendation to reduce the amount of
distributions or acquisitions described in
the general rule or funding rule by quali-
fied contributions. As described in Section
E.3.b of this Part V, qualified contribu-
tions include a deemed cash contribution
under § 1.1032-3(b). Accordingly, after

taking into account the new exception for
qualified contributions, a deemed transac-
tion under § 1.1032-3(b), regardless of
how the acquiring corporation uses the
stock of the issuing corporation, should
not result in a "net" acquisition of ex-
panded group stock for purposes of the
funding rule. Therefore, the request for a
specific exclusion for a deemed acquisi-
tion of expanded group stock under
§ 1.1032-3 is rendered moot by the new
exception for qualified contributions.

Some comments also recommended an
exception to the extent that the acquiring
entity makes an actual payment for the
stock of the issuing corporation that is
conveyed to a person as consideration for
services or an acquisition of assets. That
actual payment could be in the form of
cash, which could implicate the funding
rule, or an issuance of a debt instrument,
which could implicate the general rule.
Several comments, however, specifically
addressed this situation in the context of
an acquisition of parent stock that will be
transferred to an employee, director, or
independent contractor for the perfor-
mance of services. Comments asserted
that the acquisition of newly-issued stock
of a publicly-traded parent to compensate
employees, whether in exchange for ac-
tual or deemed consideration, does not
implicate the policy concerns of the pro-
posed regulations because such transac-
tions occur in the ordinary course of the
group's business and for meaningful non-
tax reasons (for example, reduced cost as
compared to acquiring the shares from the
public). One comment recommended an
exception for the acquisition of the stock
of an expanded group parent by another
member of the group that is a dealer in
securities (within the meaning of section
475(c)(1)) in the ordinary course of the
dealer's business as a dealer in securities.
A comment suggested that if the Treasury
Department and the IRS are concerned
about parent stock that is purchased for
use in a transaction that resembles a reor-
ganization, the exception could be limited
to stock that is transferred to a person in
connection with such person's perfor-
mance of services as an employee, direc-
tor, or independent contractor, or to a per-
son as consideration for the acquisition of
assets that will be used by the issuer in the
issuer's trade or business.

As discussed in Section C.3.a of this
Part V, by itself, an acquisition of ex-
panded group stock by issuance in ex-
change for cash or a debt instrument has
an economic effect that is similar to a
distribution of the cash or note used to
acquire the stock from the controlling par-
ent. The Treasury Department and the IRS
acknowledge that these concerns could be
mitigated in certain circumstances, for ex-
ample, when parent stock is conveyed to
an unrelated person as consideration for
services provided to a subsidiary or as
consideration for an acquisition of assets
for use in the ordinary course of a subsid-
iary's business. However, the Treasury
Department and the IRS also are con-
cerned that there has been significant
abuse involving purchases of parent stock
for use as consideration in other transac-
tions, particularly in the context of acqui-
sitions of control of another corporation or
of substantially all of the assets of another
corporation. This is the case regardless of
whether the acquisition is of the stock or
assets of a corporation and whether the
counter-party is a related or unrelated per-
son. See, e.g., Notice 2006-85, 2006-2
C.B. 677; Notice 2007-48, 2007-1 C.B.
1428; § 1.367(b)-10.

Accordingly, the Treasury Department
and the IRS have determined that, in re-
sponse to comments, it is appropriate to
provide an exception from the general rule
and funding rule for acquisitions of ex-
panded group stock in the two situations
where comments have pointed out that it
is common business practice to acquire
controlling parent stock for use as cur-
rency in another transaction. Specifically,
the final and temporary regulations pro-
vide an exclusion from the second prong
of the general rule and funding rule to the
extent the acquired expanded group stock
is delivered to individuals in consideration
for services rendered as an employee, a
director, or an independent contractor.
This exclusion applies to an acquisition of
expanded group stock regardless of
whether the acquisition is in exchange for
actual property or deemed property under
§ 1.1032-3(b). To the extent parent stock
is received in exchange for no consider-
ation, the deemed contribution of cash
used to purchase the stock under
§ 1.1032-3(b) may also constitute a qual-
ified contribution as described in Section

E.3.b of this Part V. The second situation,
involving acquisitions by dealers in secu-
rities, is discussed in Section E.2.d of this
Part V.

The Treasury Department and the IRS
decline to adopt the recommendation for a
broader exception that would apply when-
ever the acquiring member uses the ac-
quired stock as currency in a subsequent
acquisition because the Treasury Depart-
ment and the IRS remain concerned about
the potential for abuse outside of the sce-
narios identified in comments where the
use of parent stock is common business
practice. See § 1.385-3(h)(3) Example 2.
Furthermore, taxpayers that wish to use
parent stock as currency for other pur-
poses have the flexibility to structure the
transaction in ways that do not implicate
the final and temporary regulations. For
instance, the parent can provide the stock
to its subsidiary in exchange for no con-
sideration or, in the alternative, the parent
can acquire the asset with its own stock
and transfer the asset to the subsidiary.

c. Exclusion for distributions and
acquisitions resulting from the
application of section 482

Comments requested that the regula-
tions disregard distributions and contribu-
tions deemed to occur by virtue of other
provisions of the Code or regulations, in-
cluding distributions deemed to occur un-
der § 1.482-1(g)(3) and adjustments made
pursuant to Revenue Procedure 99-32,
1999-2 C.B. 296, and debt instruments
and contributions deemed to occur under
section 367(d). In response to these com-
ments, the final and temporary regulations
provide an exception from the funding
rule for distributions and acquisitions
deemed to occur as a result of transfer
pricing adjustments under section 482.
The Treasury Department and the IRS de-
cline to include an exception for transac-
tions deemed to occur under section
367(d) in the final and temporary regula-
tions because the regulations are limited
to U.S. borrowers.

d. Exclusions for acquisitions of
expanded group stock by a dealer in
securities

One comment recommended that the
regulations provide an exception for stock

issued by a member of an expanded group
and subsequently acquired by a member
of the same expanded group that is a
dealer in securities (within the meaning of
section 475(c)(1)) in the ordinary course
of the dealer's business as a dealer in
securities, provided that the dealer satis-
fies certain criteria in acquiring and hold-
ing the stock.

In response to the comments, the final
and temporary regulations provide an ex-
ception for the acquisition of expanded
group stock by a dealer in securities. Un-
der § 1.385-3(c)(2)(iv), the acquisition of
expanded group stock by a dealer in se-
curities (within the meaning of section
475(c)(1)) is not treated as described in
the general rule or funding rule to the
extent the expanded group stock is ac-
quired in the ordinary course of the deal-
er's business of dealing in securities. This
exception applies solely to the extent that
(i) the dealer accounts for the stock as
securities held primarily for sale to cus-
tomers in the ordinary course of business,
(ii) the dealer disposes of the stock within
a period that is consistent with the holding
of the stock for sale to customers in the
ordinary course of business, taking into
account the terms of the stock and the
conditions and practices prevailing in the
markets for similar stock during the pe-
riod in which it is held, and (iii) the dealer
does not sell or otherwise transfer the
stock to a person in the same expanded
group, other than in a sale to a dealer that
in turn satisfies the requirements of
§ 1.385-3(c)(2)(iv).

#### e. Exclusions for certain acquisitions of affiliate stock resulting from the application of the funding rule

The final and temporary regulations in-
clude an exception for iterative recharac-
terizations discussed in Section B.5 of this
Part V.

### 3. Reductions under the Final and Temporary Regulations

#### a. Reduction for expanded group earnings and profits

Proposed § 1.385-3(c)(1) provided that
the aggregate amount of distributions and
acquisitions described in the general rule
and funding rule for a taxable year was

reduced to the extent of the current year
earnings and profits (as described in sec-
tion 316(a)(2)) (the earnings and profits
exception). The reduction under the earn-
ings and profits exception was applied to
each distribution and acquisition based on
the order in which the distribution or ac-
quisition occurred. The preamble to the
proposed regulations explained that the
earnings and profits exception was in-
tended to accommodate ordinary course
distributions and acquisitions and to pro-
vide taxpayers significant flexibility to
avoid the application of the per se funding
rule.

##### i. Earnings period

Comments requested that the earnings
and profits exception be expanded to in-
clude earnings and profits accumulated by
a member in one or more taxable years
preceding the current year. Comments
noted that earnings and profits for the cur-
rent year may be difficult or impossible to
compute by the close of the year. More-
over, under certain circumstances, a mem-
ber may not be permitted under local law
to distribute earnings and profits for the
year (for example, due to a lack of distrib-
utable reserves). Comments also asserted
that, by taking into account only earnings
and profits for the current year, the excep-
tion would inappropriately incentivize
taxpayers to "use or lose" their earnings
and profits through annual distributions.
Also, comments noted that the current
earnings and profits of a company do not
necessarily represent a company's ability
to pay ordinary course dividends, due to
factors such as how earnings and profits
are calculated and the amount of cash
available from operations, and suggested
that a longer period for the exception
would mitigate the impact of these factors.

Recommendations varied regarding the
period for which earnings and profits
should be taken into account for purposes
of the exception, ranging from the current
year and the immediately preceding year
to the current year and all prior years. In
addition, some comments requested a
grace period (for example, 75 days) after
the close of the taxable year to make dis-
tributions or acquisitions that would relate
back to the earning and profits with re-
spect to the previous year. Some com-

ments requested that the earnings and
profits exception include earnings and
profits accumulated before the release of
the notice of proposed rulemaking on
April 4, 2016. Others stated that earnings
and profits for purposes of this exception
should include only those accumulated in
taxable years ending after that date. One
comment recommended that the earnings
and profits exception include all undistrib-
uted earnings and profits of a corporation
accumulated since April 4, 2016, but lim-
ited to the period in which such corpora-
tion was a member of the expanded group
of which it is a member at the time of a
distribution or acquisition. Comments
also requested that, if a cumulative mea-
sure of earnings and profits is adopted,
any years in which a member had a deficit
be disregarded, or, in the alternative, a
member be permitted to distribute
amounts at least equal to distributions
from other members that themselves qual-
ify for the earnings and profits exception,
notwithstanding that the member has an
accumulated deficit. In addition, com-
ments requested that the earnings and
profits exception include previously taxed
income, and that, regardless of the period
adopted, all previously taxed income be
permitted to be distributed without impli-
cations under § 1.385-3, including previ-
ously taxed income accumulated before
April 4, 2016. One comment suggested
that the earnings and profits exception be
eliminated, noting that only the threshold
exception is needed.

The final and temporary regulations
adopt the recommendation to take into
account all earnings and profits accumu-
lated by a corporation during its member-
ship in an expanded group in computing
the earnings and profits exception, pro-
vided that the earnings and profits were
accumulated in taxable years ending after
April 4, 2016 (the expanded group earn-
ings reduction). The expanded group earn-
ings reduction significantly expands the
exception provided in the proposed regu-
lations, but also appropriately limits the
reduction to earnings and profits attribut-
able to the period of a corporation's mem-
bership in a particular expanded group.
The Treasury Department and the IRS de-
cline to adopt a cumulative or fixed period
approach that is not limited upon a
change-of-control because either ap-

proach would create incentives for acqui-
sitions of earnings-rich corporations for
the purposes of avoiding these regulations
by having such corporations use related-
party debt to finance extraordinary distri-
butions rather than new investment. More-
over, an approach that takes into account
earnings and profits over a fixed period,
regardless of its duration, implicates the
same "use or lose" concern identified with
respect to the exception in the proposed
regulations, albeit delayed until the final
year of the period. The Treasury Depart-
ment and the IRS have determined that the
expanded group earnings reduction appro-
priately balances concerns regarding the
usefulness and administrability of the re-
duction with the purpose of providing an
exception only for ordinary course distri-
butions.

To effectuate this purpose, the final and
temporary regulations provide that the ag-
gregate amount of a covered member's
distributions or acquisitions described in
the general rule or funding rule in a tax-
able year during an expanded group pe-
riod are reduced by the member's ex-
panded group earnings account for the
expanded group period. The expanded
group period is the period during which
the covered member is a member of an
expanded group with the same expanded
group parent. The expanded group earn-
ings account with respect to an expanded
group period is the excess, if any, of the
covered member's expanded group earn-
ings during the period over the covered
member's expanded group reductions dur-
ing the period. The reduction for ex-
panded group earnings applies to one or
more distributions or acquisitions based
on the order in which the distributions or
acquisitions occur. The reduction occurs
regardless of whether any distribution or
acquisition would be treated as funded by
a covered debt instrument without regard
to the exception. The expanded group
earnings reduction is applied to distribu-
tions and acquisitions by a covered mem-
ber described in the general rule and fund-
ing rule before the reduction for qualified
contributions discussed in Section E.3.b
of this Part V.

Expanded group earnings are generally
the earnings and profits accumulated by
the covered member during the expanded
group period computed as of the close of

the taxable year without regard to any
distributions or acquisitions by the cov-
ered member described in §§ 1.385-
3(b)(2) and (b)(3)(i). Thus, for example, if
a covered member distributes property to
a member of the member's expanded
group, the covered member's expanded
group earnings are not decreased by the
amount of the property because the distri-
bution is described in the funding rule,
even assuming the distribution reduces the
covered member's accumulated earnings
and profits under section 312(a). How-
ever, if, for example, a covered member
distributes property to a shareholder that
is not a member of the member's ex-
panded group, so that the transaction is
not described in the funding rule, the dis-
tribution generally decreases the covered
member's expanded group earnings to the
extent that the accumulated earnings and
profits are decreased under section 312(a).

Expanded group reductions are the
amounts by which acquisitions or distri-
butions described in the general rule or
funding rule were reduced by reason of
the expanded group earnings reduction
during the portion of the expanded group
period preceding the taxable year. As dis-
cussed in the preceding paragraph, a dis-
tribution or acquisition described in the
general rule or funding rule does not re-
duce a covered member's expanded group
earnings. However, the same distribution
or acquisition, to the extent the amount of
the distribution or acquisition is reduced
under the expanded group earnings reduc-
tion in the taxable year, increases the cov-
ered member's expanded group reduc-
tions for the succeeding year, and thereby
decreases the covered member's ex-
panded group earnings account on a go-
forward basis.

The Treasury Department and the IRS
decline to adopt the recommendation to
extend the earnings and profits reduction
to take into account earnings and profits
accumulated before the release of the no-
tice of proposed rulemaking. The pro-
posed regulations included only current
year earnings and profits for the earnings
and profits exception. Accordingly, the
earnings and profits taken into account
under the proposed regulations were lim-
ited to those accumulated in a taxable year
ending on or after April 4, 2016. The
expanded group earnings reduction pro-

vides taxpayers with significantly more
flexibility than the proposed regulations to
avoid the application of § 1.385-3 with
respect to ordinary course distributions
and acquisitions. Moreover, the Treasury
Department and the IRS are concerned
that allowing a corporation to distribute
all of its historic earnings and profits
would facilitate related-party borrowing
to fund extraordinary distributions and ac-
quisitions. Although allowing a corpora-
tion to accumulate, and later distribute,
earnings and profits for taxable years end-
ing after April 4, 2016, could also facili-
tate extraordinary distributions, the Trea-
sury Department and the IRS have
concluded that, on balance, it is preferable
to avoid the incentives that would follow
from creating a "use or lose" attribute.
These incentives are not applicable with
respect to taxable years ending before
April 4, 2016. For similar reasons, divi-
dends from other expanded group mem-
bers are not taken into account in calcu-
lating expanded group earnings of a
covered member unless attributable to
earnings and profits accumulated in a tax-
able year of the distributing member end-
ing after April 4, 2016 and during its
expanded group period. For this purpose,
dividends include deemed inclusions with
respect to stock, including inclusions un-
der sections 951(a) and 1293.

The final and temporary regulations do
not adopt the recommendation to disre-
gard a deficit in any taxable year in cal-
culating a member's expanded group
earnings. The Treasury Department and
the IRS have determined that, by expand-
ing the reduction with respect to a corpo-
ration to include all earnings and profits
accumulated while the corporation was a
member of the same expanded group, the
expanded group earnings account appro-
priately reflects the amount of a corpora-
tion's new equity capital generated from
earnings that is available to fund ordinary
course distributions. Moreover, incorpo-
rating a "nimble dividend" concept into
the expanded group earnings reduction
would convert current year earnings and
profits into a "use or lose" attribute if the
covered member has an overall accumu-
lated deficit, which is contrary to the pol-
icy of expanding the exception to include
all earnings accumulated during an ex-
panded group period.

The final and temporary regulations
also do not adopt the recommendation to
attribute to the prior year distributions and
acquisitions that occur during a grace pe-
riod following the close of that taxable
year. The Treasury Department and the
IRS have determined that a grace period is
unnecessary because the cumulative ap-
proach of the expanded group earnings
reduction significantly relieves the burden
of computing the earnings and profits for
the particular year of a distribution or ac-
quisition.

Because the final and temporary regu-
lations do not apply to foreign issuers
(including CFC issuers), the regulations
no longer implicate the concerns regard-
ing distributions of previously taxed in-
come.

##### ii. Ordering rule

The proposed regulations provided that
the earnings and profits exception applied
to distributions or acquisitions in chrono-
logical order. Comments asserted that this
ordering rule would place an undue pre-
mium on the sequence of distributions.
For example, assume that P owns all the
stock of S. In Year 1, S makes distribu-
tions to P consisting of (i) $50x cash (the
funding rule distribution) and (ii) an S
note with a $50x principal amount (the
general rule distribution). S makes no
other distributions or acquisitions during
Year 1 and has not been funded by a debt
instrument that is outstanding during Year
1\. Under the proposed regulations, if S has
$50x of earnings and profits for Year 1,
whether the S note issued in the general
rule distribution is recharacterized as
stock would depend on the sequence of
the distributions. If the funding rule dis-
tribution occurred first, the earnings and
profits exception would reduce the
amount of that distribution; however, be-
cause S has no debt instruments outstand-
ing that can be treated as funding the
distribution, the exception would provide
no immediate benefit to S and P. Further,
because the funding rule distribution
would exhaust the earnings and profits of
S for the taxable year, the earnings and
profits exception would not reduce any
amount of the general rule distribution,
with the result that the S note would be
immediately recharacterized as stock un-

der the general rule. On the other hand, if
the general rule distribution occurred first,
the amount of the general rule distribution
would be reduced by the earnings and
profits exception, which would immedi-
ately benefit S and P. In that case, because
S has no debt instruments outstanding, the
funding rule distribution would not cause
the recharacterization of any debt instru-
ment in the taxable year of the distribution
even though no amount of the funding
rule distribution would be reduced by the
earnings and profits exception.

To address this concern, comments
recommended that, if the aggregate
amount of distributions or acquisitions by
a member in a taxable year exceeds the
amount of a member's earnings and prof-
its, the earnings and profits exception
should apply to reduce either a general
rule transaction or a funding rule transac-
tion that was preceded by a funding within
the per se period, before being applied to
reduce a funding rule transaction that is
not preceded by a funding, regardless of
the sequence of the transactions. In the
alternative, comments recommended that
the regulations provide taxpayers an elec-
tion to determine the distributions or ac-
quisitions to which the earnings and prof-
its exception would apply.

The Treasury Department and the IRS
agree that, in the absence of compelling
administrability or policy reasons to the
contrary, the sequencing of transactions
between expanded group members within
the same taxable year should not generally
control the consequences of debt issu-
ances. However, the Treasury Department
and the IRS do not adopt either recom-
mendation to address the significance of
sequencing under the proposed regula-
tions because, as discussed in Section E.6
of this Part V, the final and temporary
regulations treat a covered member that
issues a covered debt instrument in a dis-
tribution or acquisition as a funded mem-
ber if that distribution or acquisition sat-
isfies an exception described in § 1.385-
3(c)(2) and (3), including the expanded
group earnings reduction (the funded
member rule). The funded member rule
harmonizes the application of the ex-
panded group earnings reduction with re-
spect to general rule and funding rule
transactions, thus substantially eliminat-
ing the importance of the sequence of the

two types of transactions within a taxable
year. Accordingly, the final and temporary
regulations retain the "first-in-time" or-
dering rule of the proposed regulations for
the expanded group earnings reduction. A
similar ordering rule applies for purposes
of the qualified contribution reduction de-
scribed in Section E.3.b of this Part V.

#### iii. Alternate metrics

Comments recommended that metrics
other than earnings and profits be used as
the basis for a taxpayer-favorable stacking
rule. Suggestions included free cash flow
from operations, as determined under
GAAP; earnings before interest, taxes, de-
preciation and amortization (EBITDA);
adjusted taxable income described in sec-
tion 163(j)(6)(A); and other financial met-
rics under International Financial Report-
ing Standards (IFRS) or foreign country
statutory accounting requirements. The
Treasury Department and the IRS decline
to adopt an alternate metric, and the final
and temporary regulations retain earnings
and profits as the basis for determining the
amount of a distribution or acquisition
treated as not funded by a covered debt
instrument. The expanded group earnings
reduction is intended to permit a member
to make ordinary course distributions of
its business earnings. In this regard, and
most significantly, Congress established
earnings and profits as the appropriate
measure for federal tax purposes of
whether a distribution represents a pay-
ment of the corporation's earnings or is a
return of a shareholder's investment. In
addition, using a metric such as adjusted
taxable income described in section
163(j)(6)(A) or EBITDA would, over
time, significantly overstate the ability of
many members to make ordinary course
distributions because such computations
include no reduction for capital invest-
ment, interest, or taxes. Moreover, U.S.
issuers are already familiar with, and re-
quired to compute, earnings and profits for
general federal tax purposes, and estab-
lishing a requirement to use an alternate
metric would add administrative complex-
ity and compliance burden. For the fore-
going reasons, the final and temporary
regulations retain earnings and profits as
the starting point for the expanded group
earnings reduction.

Comments recommended an exception
for ordinary course distributions based on
the distribution history of the member. An
exception for ordinary course distribu-
tions based on a distribution history would
require an annual or other periodic aver-
aging of distributions by a member. Be-
cause the Treasury Department and the
IRS have determined that the cumulative
approach to determining the expanded
group earnings reduction is both more
taxpayer-favorable and easier to adminis-
ter than an approach based on distribution
history, the final and temporary regula-
tions reject this recommendation.

#### iv. Predecessors and successors

Comments requested clarification re-
garding the application of the earnings
and profits exception to predecessors and
successors. Specifically, comments ques-
tioned whether a funding rule distribution
or acquisition by a predecessor or succes-
sor with no earnings and profits nonethe-
less qualifies for the earnings and profits
exception when the member with respect
to which it is a predecessor or successor
has earnings and profits.

In response to comments, the final and
temporary regulations provide that, for
purposes of applying the expanded group
earnings reduction, as well as the qualified
contribution reduction discussed in Sec-
tion E.3.b of this Part V, with respect to a
distribution or acquisition, references to a
covered member do not include references
to any corporation to which the covered
member is a predecessor or successor. Ac-
cordingly, a distribution or acquisition by
a predecessor or successor that is other-
wise attributed to a funded member is
reduced solely to the extent of the ex-
panded group earnings and qualified con-
tributions of the predecessor or successor
that actually made the distribution or ac-
quisition. The as-reduced amount of the
distribution or acquisition is then attrib-
uted to the funded member, whose attri-
butes are not available to further reduce
the amount of the distribution or acquisi-
tion that may be treated as funded by a
debt instrument of the funded member.
The Treasury Department and the IRS
have determined that sourcing distribu-
tions and acquisitions solely out of the
relevant attributes of the distributing or

acquiring member is more administrable
and more consistent with the purpose of
the reductions to permit ordinary course
transactions not in excess of a member's
new equity capital than an alternative ap-
proach such as calculating reductions by
reference to the attributes of the other
corporation in the predecessor-successor
relationship or aggregating the attributes
of both corporations.

In lieu of incorporating predecessor-
successor concepts, the final and tempo-
rary regulations provide that a member
that acquires the assets of another member
in a complete liquidation described in sec-
tion 332 or in a reorganization described
in section 368 (whether acquisitive or di-
visive) succeeds to some or all of the
acquired member's expanded group earn-
ings account. Similar provisions apply
with respect to the qualified contribution
reduction described in Section E.3.b of
this Part V. This rule appropriately takes
into account the enlarged dividend-paying
capacity of a member that acquires the
assets of another member pursuant to cer-
tain non-recognition transactions, and en-
sures that the expanded group earnings of
a member are preserved and available for
use after a reorganization, liquidation, or
spin-off. Thus, while for purposes of ap-
plying the expanded group earnings re-
duction a reference to a member does not
include a reference to a corporation to
which the member is a predecessor or
successor, the expanded group earnings
account of a member may be determined,
in whole or in part, by reference to the
expanded group earnings account of a pre-
decessor.

As discussed in Section D.5 of this Part
V, the final and temporary regulations
provide that a reorganization with boot, to
the extent described in more than one
prong of the funding rule, is treated as a
single distribution or acquisition for pur-
poses of the funding rule. The final and
temporary regulations also provide that,
for purposes of applying the expanded
group earnings reduction, a distribution or
acquisition that occurs pursuant to an in-
ternal asset reorganization is reduced by
the expanded group earnings account of
the acquiring member, after taking into
account the expanded group earnings ac-
count it inherits form the target member.
A similar provision applies to the quali-

fied contribution reduction described in
Section E.3.b of this Part V.

v. Additional recommendations to make
the exception more administrable

Comments requested various safe har-
bors pursuant to which a taxpayer's deter-
mination of its earnings and profits would
be respected if determined in good faith.
One comment requested that the earnings
and profits reflected on a timely filed tax
return for an applicable taxable year be
conclusively treated as the earnings and
profits for such year, and any adjustments
to earnings and profits for such year that
arise out of an audit adjustment or
amended tax return not be taken into ac-
count. A similar comment recommended
that a taxpayer's determination of its earn-
ings and profits be respected for purposes
of applying the regulations, notwithstand-
ing audit adjustments by the IRS, unless
the determination was based upon a posi-
tion for which accuracy-related penalties
could be imposed under section 6662.
Comments also requested that the excep-
tion apply with respect to distributions or
acquisitions that do not exceed earnings
and profits by more than a de minimis
amount.

The final and temporary regulations do
not adopt these suggestions. The Treasury
Department and the IRS have determined
that the expanded group earnings reduc-
tion in the final and temporary regulations
provides taxpayers with far more latitude
than under the proposed regulations to
make ordinary course distributions while
eliminating incentives to distribute earn-
ings and profits in a particular year or
every year. Because earnings and profits
under the revised exception is not a "use
or lose" attribute, taxpayers will be able to
take a conservative approach to making
distributions in any particular year. Ac-
cordingly, the Treasury Department and
the IRS have determined that additional
safeguards against taxpayer error are not
warranted.

# b. Reduction for qualified contributions

Numerous comments recommended
that capital contributions to a member be
netted against distributions or acquisitions
by the member for purposes of applying

proposed § 1.385-3(b)(2) and (b)(3)(ii)
reasoning that, to the extent of capital
contributions, a distribution does not re-
duce a member's net equity. For this pur-
pose, some comments recommended a
broad definition of a capital contribution
to include any transfer of property in
deemed or actual exchange for stock un-
der section 1032, while other comments
suggested that transfers of expanded
group stock or a transfer of the assets of a
member pursuant to an internal reorgani-
zation not be taken into account for pur-
poses of the netting rule. Comments also
differed on the period for which capital
contributions should be taken into ac-
count. Some comments suggested that
contributions for the entire per se period
should be taken into account, even with
respect to debt instruments that had al-
ready been recharacterized under
§ 1.385-3. One comment suggested tak-
ing into account contributions that occur
after a debt instrument otherwise would
be recharacterized but only to the extent
that, as of that time, there was a plan to
make the subsequent contributions during
the remainder of the per se period. Other
comments suggested narrower ap-
proaches, such as taking into account only
the contributions made until the close of
the taxable year in which the recharacter-
ization otherwise would occur, or only
those made in the per se period preceding
the potential recharacterization. Some
comments recommended that contribu-
tions from any member of the expanded
group should be permitted to net against
distributions or acquisitions made by an-
other member, while other comments sug-
gested a member-by-member approach to
netting.

As discussed in Sections D.2.c and
E.3.a.i of this Part V, the Treasury Depart-
ment and the IRS have determined that it
is appropriate to treat distributions or ac-
quisitions as funded by new equity before
related-party borrowings. Accordingly,
the final and temporary regulations pro-
vide that a distribution or acquisition is
reduced by the aggregate fair market
value of the stock issued by the covered
member in one or more qualified contri-
butions (the qualified contribution reduc-
tion). A qualified contribution is a contri-
bution of property (other than excluded
property) to the covered member by any

member of the covered member's ex-
panded group in exchange for stock of the
covered member during the qualified pe-
riod. The qualified period generally
means, with respect to a distribution or
acquisition, the period beginning 36
months before the date of the distribution
or acquisition, and ending 36 months after
the date of the distribution or acquisition,
subject to two limitations. First, the qual-
ified period in no event ends later than the
last day of the first taxable year that a
covered debt instrument of the covered
member would, absent the application of
the qualified contribution reduction, be
treated as stock or, if the covered member
is an expanded group partner in a con-
trolled partnership that is the issuer of the
debt instrument, as a specified portion.
Second, the qualified period is further lim-
ited to only include the covered member's
expanded group period that includes the
date of the distribution or acquisition.

Excluded property (that is, property the
contribution of which does not give rise to
a qualified contribution) includes ex-
panded group stock and property acquired
by a covered member in an internal asset
reorganization. The Treasury Department
and the IRS have determined that the ac-
quisition of such assets in exchange for
stock of a covered member should not be
taken into account as increasing capital of
the covered member that is available to
make distributions for reasons similar to
those discussed in Sections C.3 and C.4 of
this Part V. In fact, if a covered member
were given "credit" for contributions of
expanded group stock, for example, the
covered member could do in two steps
(capital contribution of expanded group
stock to the covered member followed by
a distribution of a debt instrument by the
covered member) what the general rule
would not permit it to do in one step (a
covered member's purchase of that ex-
panded group stock in exchange for a debt
instrument).

Excluded property also includes a cov-
ered debt instrument issued by a member
of the covered member's expanded group,
property acquired by a covered member in
exchange for a covered debt instrument
issued by the covered member that is re-
characterized under the funding rule, and
a debt instrument issued by a controlled
partnership of the expanded group of

which a covered member is a member.
The final and temporary regulations ex-
clude covered debt instruments and debt
instruments issued by a controlled part-
nership because the Treasury Department
and the IRS are concerned that taxpayers
could use such property to create non-
economic qualified contributions before
such indebtedness is treated as stock un-
der § 1.385-3 or § 1.385-3T. Further, the
final and temporary regulations exclude
property acquired by a covered member in
exchange for its own covered debt instru-
ment that is treated as stock under the
funding rule. This category of excluded
property addresses the potential circular-
ity of treating a contribution of property in
exchange for a covered debt instrument
that is treated as stock under the funding
rule as a qualified contribution, which
could reduce the amount of the distribu-
tion that caused the covered debt instru-
ment to be treated as stock.

The final and temporary regulations
also provide that qualified contributions
do not include certain contributions to a
covered member that do not have the ef-
fect of increasing the capital of the cov-
ered member that is available to make
distributions (excluded contributions).
The contributions that are entirely disre-
garded are contributions (i) from a mem-
ber (controlled member) that the covered
member controls ("upstream" transfers),
and (ii) from a corporation of which the
covered member is a predecessor or suc-
cessor or from a corporation controlled by
that corporation. For purposes of the pre-
ceding sentence, control of a corporation
means the direct or indirect ownership of
more than 50 percent of the total com-
bined voting power and more than 50 per-
cent of the total value of the stock of a
corporation applying the principles of sec-
tion 958(a) without regard to whether an
intermediate entity is foreign or domestic.
If a contribution of property occurs before
the covered member acquires control of
the controlled member or before the trans-
action in which the corporation becomes a
predecessor or successor to the covered
member (transaction date), the contribu-
tion of property ceases to be a qualified
contribution on the transaction date. If the
contribution of property occurs within 36
months before the transaction date, the
covered member is treated as making a

distribution described in the funding rule
on the transaction date equal to the
amount by which any distribution or ac-
quisition was reduced because the contri-
bution of property was treated as a quali-
fied contribution.

The final and temporary regulations
also provide, more generally, that a con-
tribution of property to a covered member
is not a qualified contribution to the extent
that the contribution does not increase the
aggregate fair market value of the out-
standing stock of the covered member im-
mediately after the transaction and taking
into account all related transactions, other
than distributions and acquisitions de-
scribed in the general rule and funding
rule. Thus, for instance, a contribution to a
covered member from a member in which
the covered member owns an interest that
represents less than 50 percent of the total
combined voting power or value does not
constitute a qualified contribution to the
extent that the contribution does not in-
crease the value of the covered member.

The final and temporary regulations
generally take into account only contribu-
tions made during the per se period before
the time that a debt instrument would be
treated as stock. The Treasury Department
and the IRS have determined that taking
into account contributions after the tax-
able year in which a distribution or acqui-
sition caused the recharacterization of a
debt instrument would unduly increase the
incidence of instruments switching be-
tween debt and equity treatment, leading
to additional complexity and uncertainty
for both the IRS and the taxpayer. How-
ever, in response to comments, the final
and temporary regulations take into ac-
count contributions after a debt instrument
would be treated as stock if the contribu-
tion occurs before the end of the taxable
year in which such treatment begins. This
rule allows taxpayers some ability to self-
help for inadvertent distributions and ac-
quisitions without implicating the same
degree of uncertainty and administrability
concerns that would occur if contributions
in a subsequent taxable year were taken
into account.

The Treasury Department and the IRS
are concerned, however, that taxpayers
could use capital contributions to frustrate
the purposes of the final and temporary
regulations. For example, a calendar-year

taxpayer could take the position that a
distribution of a note on January 1, pur-
suant to a plan to "undo" the recharacter-
ization of the note that otherwise would
apply by making a capital contribution on
December 31, gives rise to interest deduc-
tions without funding new investment
during the 364-day period preceding the
contribution. Accordingly, the final and
temporary regulations provide that prop-
erty contributed to a covered member with
a principal purpose of avoiding the pur-
poses of § 1.385-3 or § 1.385-3T is ex-
cluded property, and thus does not give
rise to a qualified contribution. As a result,
in the example, the contribution on De-
cember 31 would not reduce the January 1
distribution or any subsequent distribu-
tion. This express limitation (as well as
other targeted anti-abuse provisions, such
as the limitation to the special exception
to iterative recharacterization described in
Section B.5 of this Part V) should not be
interpreted to create a negative inference
that the anti-abuse provision in § 1.385-
3(b)(4) would not also have addressed
such a transaction.

## 4. Threshold Exception

Proposed § 1.385-3(c)(2) provided that
an expanded group debt instrument would
not be treated as stock if, when the debt
instrument is issued, the aggregate issue
price of all expanded group debt instru-
ments that otherwise would be treated as
stock under the proposed regulations does
not exceed $50 million (the threshold ex-
ception). The proposed regulations also
provided that if the expanded group's debt
instruments that otherwise would be
treated as stock later exceed $50 million,
then all expanded group debt instruments
that, but for the threshold exception,
would have been treated as stock were
treated as stock, rather than only the
amount that exceeds $50 million. Thus,
the threshold exception in the proposed
regulations was not an exemption of the
first $50 million of expanded group debt
instruments that otherwise would be
treated as stock, but rather only provided
an exception from the application of pro-
posed § 1.385-3 for taxpayers that have
not exceeded the $50 million threshold.

Comments suggested that the $50 mil-
lion limitation should be increased, with

the highest specific recommended thresh-
old being $250 million. Comments also
suggested that the threshold be based on a
percentage of the issuer's or expanded
group's assets, income, or another rele-
vant financial metric. One comment rec-
ommended that the threshold exception be
determined by reference to the amount by
which the issuer's interest expense ex-
ceeds interest income. Comments also
suggested that the threshold exception
should be applied separately with respect
to each specific issuer (or a subset of an
expanded group) or specific instrument,
which would effectively increase the $50
million limitation.

The final and temporary regulations do
not increase the amount of the threshold
exception, or alter the basis for determin-
ing the exception except to include certain
debt instruments issued by a controlled
partnership that otherwise would be sub-
ject to the treatment described in Section
H.4 of this Part V in the determination of
whether the limitation has been surpassed.
The scope revisions (discussed in Part III
of the Background), the addition and ex-
pansion of exceptions for distributions
and acquisitions otherwise described in
§ 1.385-3(b)(2) and (3) (discussed in Sec-
tion E of this Part V), and the addition and
expansion of exceptions for debt instru-
ments otherwise subject to this section
(discussed in Sections D.8 and F of this
Part V) substantially reduce the number of
instruments subject to recharacterization.
These revisions are expected to limit the
application of the rules to non-ordinary
course transactions so that taxpayers will
have the flexibility to avoid their applica-
tion. Additionally, the final and temporary
regulations do not adopt the recommenda-
tion to vary the threshold based on the size
of the expanded group. The regulations
are intended to address the use of related-
party indebtedness that does not finance
new investment. The comments do not
establish, and the Treasury Department
and the IRS have not ascertained, a policy
justification for permitting larger ex-
panded groups to issue more indebtedness
that does not finance new investment, be-
yond the scaling that necessarily follows
from the expanded group earnings reduc-
tion. Furthermore, the assets, income, and
other financial attributes of an expanded
group fluctuate, making it difficult for

both taxpayers and the IRS to administer
such a percentage-based threshold excep-
tion. Accordingly, the final and temporary
regulations retain the $50 million thresh-
old.

Additionally, comments suggested
eliminating the so-called cliff effect by
only recharacterizing instruments in ex-
cess of the threshold. Alternatively, com-
ments suggested that the cliff effect apply
at a second, higher threshold. In response
to these comments, the final and tempo-
rary regulations eliminate the rule provid-
ing that the exception will not apply to
any debt instruments once the $50 million
threshold is exceeded. The final and tem-
porary regulations instead provide that, to
the extent that the $50 million threshold is
exceeded immediately after a debt instru-
ment would be treated as stock under
§ 1.385-3(b), only the amount of the debt
instrument in excess of $50 million is
treated as stock.

Comments also suggested revisions to
the operation of the threshold exception.
First, comments requested that an ex-
panded group that exceeds the $50 million
threshold due to reasonable cause be
given a grace period (such as 90 days) to
reduce the amount of outstanding debt
instruments below the $50 million thresh-
old. Second, comments recommended the
use of an average quarterly amount out-
standing to compute whether the $50 mil-
lion threshold is exceeded. The final and
temporary regulations do not adopt either
of these recommendations. In light of the
elimination of the cliff effect, the Treasury
Department and the IRS have determined
that neither a complex computation nor a
special remediation rule is required or ap-
propriate for the threshold exception. See
Part B.6 of this Part V regarding the de-
cision not to adopt a general remediation
rule.

## 5. Requests for New Exceptions Not Adopted in the Final and Temporary Regulations

### a. Post-acquisition and pre-divestiture restructuring

Comments requested an exception for
debt instruments issued in connection
with the post-merger integration of a pre-
viously unrelated target. Comments high-

lighted that a purchaser can generally fund
an acquisition of an unrelated target com-
pany entirely with related-party indebted-
ness without implicating the regulations,
but that the realignment of such acquisi-
tion indebtedness as part of the post-
merger integration of the newly acquired
entity, including its subsidiaries, impli-
cates § 1.385-3. Moreover, comments as-
serted that transfers of stock and assets in
exchange for debt are often the most prac-
tical method of realigning the stock and
assets of a newly-acquired member for
non-U.S. tax business reasons. Further,
while the purchaser (or its subsidiaries)
could acquire each target entity separately
in fully debt-funded transactions that
would not implicate § 1.385-3, comments
asserted that such a transaction structure
may be impractical due to regulatory or
financing restrictions or the inability to
negotiate such a transaction with an unre-
lated seller.

For the foregoing reasons, comments
recommended that the regulations exempt
debt instruments issued in exchange for
expanded group stock pursuant to the in-
tegration of a newly-acquired member and
its subsidiaries. Some comments sug-
gested that an exception should apply to
acquisitions from a member within one
year of the member's acquisition from an
unrelated person. One comment suggested
that an exception should apply to acquisi-
tions of newly-acquired members for 36
months after the acquisition. Another
comment recommended an exception that
would be limited to debt instruments is-
sued by a member in exchange for the
stock or assets of the new member with a
principal amount equal to the amount of
cash, notes, or rights to future payments
received by the unrelated seller from
members of the expanded group in the
earlier acquisition.

Comments also recommended an ex-
ception for related-party indebtedness is-
sued to acquire expanded group stock in
connection with a plan to divest the ac-
quiring member to unrelated persons. One
comment suggested an exception for in-
debtedness issued by the departing mem-
ber within 36 months of its divestiture,
while other comments recommended an
exception for any acquisitions of ex-
panded group stock that occur pursuant to
an integrated plan to dispose of the depart-

ing member. Another comment suggested
that an acquisition of expanded group
stock should not be described in the gen-
eral rule or funding rule if the acquisition
is part of a plan in which the acquirer,
seller, and target cease to be members of
the same expanded group.

The final and temporary regulations do
not adopt an exception for debt instru-
ments issued in connection with post-
acquisition or pre-disposition restructur-
ing. Such an exception would facilitate the
use of related-party indebtedness to create
significant federal tax benefits without fi-
nancing new investment in the issuer. The
incentives to create new related-party debt
that does not finance new investment can
be just as pronounced, if not more pro-
nounced, in connection with post-
acquisition restructuring or in preparation
for a planned divestiture, since the new
expanded group parent may have a differ-
ent tax status that will allow the newly-
configured group to use related-party debt
to achieve significant federal tax benefits
that were not possible before the acquisi-
tion or divestiture.

Moreover, the Treasury Department
and the IRS do not view the close prox-
imity of a third-party transaction as a basis
for providing a special exception for the
use of related-party debt in a transaction
that does not finance new investment in
the issuer. When an expanded group
member acquires stock or assets from an
unrelated third-party in exchange for cash
or property, that acquisition is not de-
scribed in the general rule or funding rule,
even if the cash or property consideration
is fully debt-funded by a related-party
borrowing, because the acquisition from
the unrelated third-party represents new
investment in the issuer of the debt. The
comments effectively recommend that, in
the case of a recent acquisition, the final
and temporary regulations extend this
concept further to provide that subsequent
transactions involving the recently-
acquired members be provided a special
exception. When those recently-acquired
members issue related-party indebtedness
to fund an internal stock acquisition or
internal asset reorganization, the concerns
set forth in Section C of this Part V about
related-party debt that does not finance
new investment in the issuer apply in a
similar manner as in the case of transac-

tions among old and cold expanded group
members. Moreover, the Treasury Depart-
ment and the IRS do not agree that be-
cause a transaction with a recently-
acquired expanded group member could
have been effectuated, hypothetically,
with the unrelated third-party seller, the
regulations should provide a special ex-
ception on the basis of this hypothetical
transaction.

Similar concerns apply in the case of
pre-divestiture planning. As for post-
acquisition restructuring, the Treasury De-
partment and the IRS do not view the
close proximity to a subsequent third-
party transaction as a basis for providing a
special exception for related-party debt
that does not finance new investment in
the issuer.

Comments addressing pre-divestiture
planning also observed that when a debt
instrument is recharacterized close-in-
time to the divestiture transaction with the
unrelated third-party, the recharacterized
debt instrument may be repaid immedi-
ately before the divestiture, which, as de-
scribed in Part B.4 of this Section V, may
result in a taxable sale or exchange. The
Treasury Department and the IRS do not
view the short duration of these instru-
ments as changing the analysis in the pre-
ceding paragraph; however, as discussed
in Part D.8 of this Section V, the tempo-
rary regulations adopt a broad exception
to the funding rule for qualified short-term
debt instruments that may overlap signif-
icantly with the types of short-duration
debt instruments issued in anticipation of
a divestiture transaction that are addressed
in comments. As a result, the final and
temporary regulations provide greater
flexibility for issuances of debt instru-
ments that are short term in form and in
substance.

Comments requested other exceptions
for certain restructuring transactions that
are not undertaken in connection with a
third-party transaction. One comment re-
quested a same-country exception, which
would apply to dispositions of stock or
assets between expanded group members
incorporated in the same country. The
same comment requested an exception for
internal stock acquisitions resulting in the
acquired member joining the acquiring
member's consolidated group or internal
asset reorganizations in which the ac-

quired member's assets are used by the
acquirer in its business. A comment also
requested that an internal asset reorgani-
zation be excepted if the taxpayer can
demonstrate a business purpose for the
reorganization.

The Treasury Department and the IRS
decline to accept a broad exception for
entity restructuring, because, as discussed
in Sections C.3 and C.4 of this Part V, an
internal stock acquisition and an internal
asset reorganization with "other property"
has an effect that is economically similar
to a distribution regardless of whether the
transaction is also supported by a non-
U.S. tax business purpose. Moreover, the
regulations do not generally prohibit a
taxpayer from restructuring its operations;
they only deny the undue federal tax ben-
efit from the use of indebtedness in the
restructuring to the extent it does not fi-
nance new investment.

### b. Distributions of non-cash assets

Comments recommended that distribu-
tions of "old-and-cold," non-financial as-
sets be excluded from the funding rule
because such assets are not fungible and
thus should not be treated as funded by a
related-party borrowing. A comment sug-
gested that the anti-abuse rule could ade-
quately police distributions of property
acquired with a principal purpose to avoid
the regulations or acquired within a cer-
tain period before the distribution. For
similar reasons, one comment recom-
mended that the purchase of operating as-
sets for a note should not be treated as a
funding that can be matched with a distri-
bution or acquisition.

The Treasury Department and the IRS
decline to adopt this recommendation be-
cause a distribution of old-and-cold non-
financial assets presents similar policy
concerns to those described in Section D.2
of this Part V concerning other distribu-
tions of cash and property by a funded
member. As discussed in Section D.6 of
this Part V, the final and temporary regu-
lations exclude all distributions described
in section 355, whether or not preceded by
an asset reorganization, from the scope of
the funding rule because the strict require-
ments of section 355 indicate that the
stock of a controlled corporation is not
fungible. There are no such safeguards

with respect to taxable distributions of
operating assets, which may be acquired
by the distributing member with cash the
day before the distribution and converted
into cash by the recipient member the day
after. Moreover, an acquisition of operat-
ing assets in exchange for a debt instru-
ment is like any other debt-financed pur-
chase, which frees up the cash that
otherwise would be used in the acquisition
for other uses by the issuer. For these
reasons, the Treasury Department and the
IRS have determined that transfers of old-
and-cold operating assets should not be
excepted from the funding rule, except in
the narrow circumstance that the distribu-
tion qualifies for nonrecognition under
section 355.

6\. Application of the Funding Rule to
Instruments Issued in General Rule
Transactions that Qualify for an
Exception

a. Treatment of the issuer of a covered
debt instrument in a general rule
transaction that satisfies an exception as
a funded member

Comments expressed concern that a
debt instrument issued in an internal stock
acquisition or an internal asset reorgani-
zation that would be recharacterized under
the general rule but for the application of
the earnings and profits exception may
nonetheless be recharacterized under the
funding rule. Comments noted that a debt
instrument issued in one of these transac-
tions is, in fact, issued in exchange for
property (namely, stock or assets). There-
fore, absent a special rule that prevents the
debt from being re-tested, the member that
engages in the transaction has been
funded and the debt instrument may be
recharacterized if the member has made,
or does make, another distribution or ac-
quisition described in the funding rule
during the per se period. Comments sug-
gested that testing the same debt instru-
ment under both the general rule and
funding rule amounts to "double jeop-
ardy" and recommended that the regula-
tions provide that, if the earnings and
profits exception applies to reduce the
amount of a transaction described in the
second or third prong of the general rule,
the issuing member should not be treated
as a funded member for purposes of re-

testing the instrument under the funding
rule.

The final and temporary regulations do
not adopt this recommendation and in-
stead provide that a member that issues a
debt instrument in a general rule transac-
tion that satisfies an exception under
§ 1.385-3(c)(2) or (3) is treated as a
funded member with respect to the debt
instrument for purposes of re-testing the
instrument under the funding rule (the
funded member rule). The Treasury De-
partment and the IRS have determined
that the so-called "double jeopardy" high-
lighted by comments, in fact, harmonizes
the treatment of general rule acquisitions
with funding rule acquisitions, and its
elimination would create an undue prefer-
ence in § 1.385-3 for general rule acqui-
sitions over funding rule acquisitions.
Moreover, the distribution of a debt in-
strument that qualifies for an exception
implicates the same policy concerns, and
thus the funded member rule applies to
transactions described in all three prongs
of the general rule.

As discussed in the preamble to the
proposed regulations, a funding rule trans-
action achieves an economically similar
outcome as a general rule transaction. In
this regard, both a general rule and a fund-
ing rule transaction effect a distribution of
the proceeds of a borrowing, except that
the latter does in multiple steps what the
former accomplishes in one. Therefore, to
achieve symmetry between the two types
of economically similar transactions, an
exception that would exclude or reduce a
distribution or acquisition described in the
funding rule should only exclude or re-
duce the distributive or acquisitive ele-
ment of a transaction described in the gen-
eral rule.

To illustrate, if S issues a note in ex-
change for property from P and, during
the per se period, acquires the stock of T
from P, and the acquisition satisfies an
exception in § 1.385-3(c)(2) or (3), the S
note is not treated as stock by reason of
the T stock acquisition. However, because
the S note is treated as not having funded
the T stock acquisition, the S note may
still be treated as funding another distri-
bution or acquisition that occurs within
the per se period. If, however, S acquires
the T stock directly from P in exchange
for its own note and the acquisition satis-

fies an exception in § 1.385-3(c)(2) or (3),
under the recommendation for eliminating
"double jeopardy," the S note would not
be treated as stock by reason of the T
stock acquisition and, moreover, the S
note would not be subject to potential
recharacterization under the funding rule
if there is another distribution or acquisi-
tion during the per se period. Accordingly,
under the recommendation, an exception
intended solely to exclude or reduce a
distribution or acquisition would effec-
tively negate both the distributive element
and the funding element of the transac-
tion. Moreover, this recommendation
would create divergent consequences as
between transactions with the same eco-
nomic effect - after both variations of
the transaction, S has acquired the T stock
and P holds an S note. To conform the
application of the exceptions in § 1.385-
3(c)(2) and (3) as between the S funding
rule acquisition and the S general rule
acquisition, the exceptions should apply
solely to exclude or reduce the distributive
aspect of the S general rule acquisition.

For the foregoing reasons, the final and
temporary regulations provide that, to the
extent an exception applies to exclude or
reduce the amount of a distribution or
acquisition described in the general rule,
the debt instrument issued in the transac-
tion is treated as issued by a member in
exchange for property solely for purposes
of applying the funding rule to the debt
instrument and the member. The funded
member rule addresses the sequencing
concern with respect to the expanded
group earnings reduction discussed in
Section E.3.a.ii of this Part V. In the ex-
ample provided in that section, S distrib-
utes $50x cash and a note with a $50x
principal amount in a taxable year in
which S has expanded group earnings of
$50x. Under the funded member rule, if
the general rule distribution is reduced by
$50x under the expanded group earnings
reduction, S is treated as having been
funded by the issuance of the $50x note.
As a result, the ordering of the distribu-
tions does not materially affect the conse-
quences of the transactions under the final
and temporary regulations - either (1) the
funding rule distribution occurs first, the
amount of the cash distribution is reduced
by $50x, and the S note is recharacterized
as stock under the general rule, or (2) the

general rule distribution occurs first, the
amount of the note distribution is reduced
by $50x, S is treated as having been
funded by the note, and the S note is
recharacterized as stock under the funding
rule by reason of the cash distribution. In
either sequence of events, the S note is
recharacterized as stock, whether by rea-
son of the general rule or the funding rule.

b. Treatment under the funding rule of a
covered debt instrument issued in a
general rule transaction that satisfies an
exception

The proposed regulations provided
that, to the extent a debt instrument issued
in an internal asset reorganization is
treated as stock under the general rule, the
distribution of the debt instrument pursu-
ant to the same reorganization is not also
treated as a distribution or acquisition de-
scribed in the funding rule (the "general
coordination rule"). One comment re-
quested that the general coordination rule
be expanded to provide that any transac-
tion described in the general rule, regard-
less of whether such transaction results in
the debt instrument being treated as stock,
is not also treated as a distribution or
acquisition described in the funding rule.
The comment questioned, for example,
whether the distribution of a covered debt
instrument could be treated as a distribu-
tion of property for purposes of the fund-
ing rule if the debt instrument were not
treated as stock by reason of the threshold
exception of § 1.385-3(c)(4). The issue
could also be implicated if the amount of
a general rule acquisition in an internal
asset reorganization is reduced by reason
of an exception described in § 1.385-
3(c)(3). To the extent that the amount of
the acquisition is reduced by reason of an
exception (for example, the expanded
group earnings reduction), the covered
debt instrument issued by the transferee
corporation would be respected as indebt-
edness, and thus the distribution of the
covered debt instrument by the transferor
corporation to its shareholder pursuant to
the plan of reorganization would be
treated as a distribution of property de-
scribed in the funding rule. Accordingly,
absent an expansion of the general coor-
dination rule, a single transaction with an
economic effect similar to a distribution

would be treated as two transactions sub-
ject to the general rule and funding rule.

The Treasury Department and the IRS
adopt the recommendation to expand the
general coordination rule to apply to all
general rule transactions, regardless of
whether the covered debt instrument is-
sued in the transaction is treated as stock
under the general rule. Accordingly, the
final and temporary regulations provide
that a distribution or acquisition described
in the general rule is not also described in
the funding rule. Moreover, the final and
temporary regulations also provide that an
acquisition in an internal asset reorganiza-
tion described in the general rule by the
transferee corporation is not also a distri-
bution or acquisition described in the
funding rule by the transferor corporation.
For purposes of the general coordination
rule, whether a distribution or acquisition
is described in the general rule is deter-
mined without regard the exceptions of
§ 1.385-3(c). Thus, in an internal asset
reorganization to which an exception ap-
plies, the distribution of a respected debt
instrument by the transferor corporation is
not also tested as a distribution or acqui-
sition described in the funding rule.

For a discussion of the general coordi-
nation rule applicable during the transition
period, see Part VIII.B.2 of this Summary
of Comments and Explanation of Revi-
sions.

F. Exceptions from § 1.385-3 for certain
debt instruments

The final and temporary regulations
limit the application of the general rule
and funding rule by excluding certain debt
instruments described in this Section F of
this Part V from the definition of covered
debt instruments. This Section F of this
Part V also discusses other requests for
exceptions that were not adopted.

#### 1. Qualified Dealer Debt Instrument

Comments recommended that the reg-
ulations provide an exception for debt in-
struments acquired and held by a dealer in
securities (within the meaning of section
475(c)(1)) in the ordinary course of its
business as a dealer in securities. Simi-
larly, comments recommended that the
regulations provide an exception for debt

instruments that would be excluded from
being investments in U.S. property if en-
tered into between a controlled foreign
corporation and a United States share-
holder under section 956(c)(2)(K), which
covers securities acquired and held by a
dealer in securities in the ordinary course
of its business.

In response to these comments, the reg-
ulations provide an exception for the ac-
quisition of debt instruments by a dealer
in securities. Under § 1.385-3(g)(3)(i), a
"qualified dealer debt instrument" is ex-
cluded from the definition of a covered
debt instrument. A qualified dealer debt
instrument is defined in § 1.385-
3(g)(3)(ii) to mean a debt instrument is-
sued to or acquired by an expanded group
member that is a dealer in securities
(within the meaning of section 475(c)(1))
in the ordinary course of the dealer's busi-
ness of dealing in securities. This excep-
tion applies solely to the extent that (i) the
dealer accounts for the debt instruments as
securities held primarily for sale to cus-
tomers in the ordinary course of business,
(ii) the dealer disposes of the debt instru-
ments (or the debt instruments mature)
within a period of time that is consistent
with the holding of the debt instruments
for sale to customers in the ordinary
course of business, taking into account the
terms of the debt instruments and the con-
ditions and practices prevailing in the
markets for similar debt instruments dur-
ing the period in which they are held, and
(iii) the dealer does not sell or otherwise
transfer the debt instruments to a person in
the same expanded group, other than to a
dealer that satisfies the requirements of
the exception for qualified dealer debt in-
struments.

### 2. Instruments That Are Not In Form Debt

Proposed §§ 1.385-3 and 1.385-4 ap-
plied to any interest that would, but for
those sections, be treated as a debt instru-
ment as defined in section 1275(a) and
§ 1.1275-1(d). Consequently, the pro-
posed regulations applied not only to debt
in form, but also to any instrument or
contractual arrangement that constitutes
indebtedness under general principles of
federal income tax law. One comment rec-
ommended that the funding rule apply

solely to instruments that are, in form,
debt instruments. The Treasury Depart-
ment and the IRS decline to accept this
recommendation because this would fail
to take into account the substance of an
arrangement that is otherwise treated as a
debt instrument for federal tax purposes
and create an inappropriate preference for
debt instruments that are not in-form debt.

Comments also noted that, in certain
cases, instruments (or deemed instru-
ments) that are expressly treated as debt
under other provisions of the Code and
regulations should not be subject to re-
characterization. The comments cited
leases treated as loans under section 467;
receivables and payables resulting from
correlative adjustments under section 482;
production payments under section 636;
coupon stripping transactions under sec-
tion 1286; and debt (or instruments treated
as debt) described in section 856(m)(2),
860G(a)(1), or 1361(c)(5). Similarly,
comments requested that the regulations
disregard debt instruments deemed to oc-
cur under section 367(d).

The final and temporary regulations
exclude from the definition of covered
debt instruments: production payments
under section 636; REMIC regular inter-
ests (as defined in section 860G(a)(1));
instruments described in section 1286 (re-
lating to coupon stripping transactions)
unless such an instrument is issued with a
principal purpose of avoiding the pur-
poses of § 1.385-3 or § 1.385-3T; and
leases treated as loans under section 467.
The final and temporary regulations also
provide an exception for debt instruments
deemed to arise as a result of transfer
pricing adjustments under section 482.
The Treasury Department and the IRS de-
cline to include an exception for payables
deemed to occur under section 367(d) in
the final and temporary regulations be-
cause the final and temporary regulations
are limited to U.S. borrowers.

The final and temporary regulations do
not provide an exception for debt de-
scribed in section 1361(c)(5) because S
corporations are not included in the defi-
nition of an expanded group in the final
and temporary regulations. The final and
temporary regulations also do not provide
an exception for debt described in section
856(m)(2), which addresses certain non-
contingent non-convertible debt securities

held by a REIT that are not taken into
account for one of the asset tests for qual-
ified REIT status. The final and temporary
regulations do not adopt this exception
because the final and temporary regula-
tions apply only to REITs that are con-
trolled by expanded group members, and
not parent-REITs. In this context, debt
instruments described in section 856(m)
(2) that are issued to other expanded
group members may present similar pol-
icy concerns as those presented by other
expanded group debt instruments.

One comment suggested that the fund-
ing rule should not apply to a deemed loan
arising from a nonperiodic payment aris-
ing with respect to a notional principal
contract. The comment noted that multi-
national enterprises frequently use inter-
company swaps to allocate and manage
interest rate and foreign currency risk. In
some situations, one member of an ex-
panded group may make a nonperiodic
payment to another member of the ex-
panded group that might be characterized
as a loan under § 1.446-3T(g)(4). The
comment asserts that it is unnecessary to
apply the funding rule to deemed loans
such as those that arise from a nonperiodic
payment on a notional principal contract
to achieve the policy goals of the pro-
posed regulations.

The Treasury Department and the IRS
decline to accept this recommendation,
because it would not take into account the
substance of an arrangement that is other-
wise treated as a debt instrument for fed-
eral tax purposes. Moreover, the regula-
tions referred to in the comment are not
currently in effect, and are not scheduled
to take effect until after final and tempo-
rary regulations are issued. The regula-
tions under § 1.446-3T(g)(4) have been
the subject of extensive comment and are
under active consideration. The Treasury
Department and the IRS will consider
whether it is necessary to coordinate the
nonperiodic payment rules on swaps with
section 385 when finalizing the regula-
tions on notional principal contracts.

### 3. Significant Modifications and Refinancing

Comments suggested that a significant
modification within the meaning of
§ 1.1001-3 should not implicate the fund-

ing rule because the debt instrument
deemed issued as a result of such a mod-
ification should be treated as having been
issued to retire the existing instrument in-
stead of generating new proceeds that
could fund distributions or acquisitions
subject to § 1.385-3. However, one com-
ment acknowledged that such an excep-
tion may be inappropriate in cases where
the significant modification extends the
term of the instrument. The comment
stated that, in such a case, the modified
debt could be viewed as essentially fi-
nancing activities of the borrower for the
extended term. Other comments recom-
mended that a similar exception apply to
an actual refinancing whereby a new debt
instrument is issued and the proceeds are
used to repay an old debt instrument.
Comments recommended that the borrow-
ing to refinance an existing debt instru-
ment be considered used for the same
purpose as the refinanced debt, and
thereby be subject to the funding rule to
the same extent as the refinanced debt
instrument.

In response to comments, the final and
temporary regulations provide that if a
covered debt instrument is treated as ex-
changed for a modified covered debt in-
strument pursuant to § 1.1001-3(b), the
modified covered debt instrument is
treated as issued on the original issue date
of the covered debt instrument. This spe-
cial rule is limited to situations in which
the modification, or one of the modifica-
tions, that results in the exchange (or
deemed exchange) does not include (i) the
substitution of an obligor on the covered
debt instrument, (ii) the addition or dele-
tion of a co-obligor on the covered debt
instrument, or (iii) the material deferral of
scheduled payments due under the cov-
ered debt instrument The special rule ex-
cludes a change in obligor or addition of
an obligor that results in a deemed ex-
change because the Treasury Department
and the IRS are concerned about such
modifications circumventing the funding
rule generally. The special rule excludes a
material deferral of scheduled payments
that results in a deemed exchange because
the Treasury Department and the IRS are
concerned about such extensions circum-
venting the per se period though contin-
ued extensions of maturity.

The final and temporary regulations
also clarify that if the principal amount of
a covered debt instrument is increased, the
portion of the covered debt instrument
attributable to such increase is treated as
issued on the date of such increase.

The final and temporary regulations do
not extend the special rule for modifica-
tions of debt instruments to an actual re-
financing outside of the context of a mod-
ification described in § 1.1001-3(a). For
example, the rule would not apply to a
refinancing of a debt instrument held by
one expanded group member through the
issuance of a new debt instrument to an-
other expanded group member. The Trea-
sury Department and the IRS have deter-
mined that it is appropriate to provide this
special rule in the context of a deemed
exchange for tax purposes that may not be
treated as an exchange for legal, account-
ing or other relevant purposes. By con-
trast, in a transaction that is in form a
refinancing that involves an exchange for
tax purposes without regard to the appli-
cation of § 1.1001-3(b), the Treasury De-
partment and the IRS decline to provide a
special rule. Furthermore, the Treasury
Department and the IRS are concerned
that the limitations to this special rule that
would be necessary to prevent abuse
would be difficult to administer in the
context of an actual refinancing.

### 4. Insurance and Reinsurance Arrangements

Comments asserted that the regulations
should not apply to insurance or reinsur-
ance transactions entered into in the ordi-
nary course of an insurer's or reinsurer's
trade or business. Several comments fur-
ther noted that the regulations should not
apply to reinsurance arrangements where
funds otherwise due to the reinsurance
company are withheld by the insurance
company ceding risk to a reinsurance
company.

The final and temporary regulations
only apply to interests that would, but for
the application of § 1.385-3, be treated as
debt instruments as defined in section
1275(a) and § 1.1275-1(d). As a result,
insurance and reinsurance contracts gen-
erally would not be subject to § 1.385-3
because such contracts are not ordinarily
treated as debt instruments as defined in
section 1275(a) and § 1.1275-1(d). To the

extent that an arrangement entered into in
connection with an insurance or reinsur-
ance contract would be treated as a debt
instrument, as defined in section 1275(a)
and § 1.1275-1(d), that arrangement is a
debt instrument for federal income tax
purposes. As a result, the Treasury De-
partment and the IRS have determined
that such a debt instrument should not be
treated differently than any other interest
subject to § 1.385-3. However, as dis-
cussed in Section G.2 of this Part V, the
final and temporary regulations exclude
debt instruments issued by regulated in-
surance companies.

### 5. Securitization Transactions

One comment requested an exception
for instruments issued pursuant to certain
securitization transactions. The comment
stated that in a common securitization
transaction, an operating entity transfers
income producing assets, such as receiv-
ables or loans, to a special purpose vehicle
(SPV). The SPV then re-transfers the as-
sets to a bankruptcy-remote entity that is
typically disregarded for federal tax pur-
poses in exchange for tranches of instru-
ments that the SPV sells, usually to unre-
lated parties and often utilizing an
underwriter or broker. The SPV fre-
quently hires a servicing agent to collect
on the income producing assets and chan-
nel the payments to the appropriate class
of securities. The funding rule is impli-
cated when an expanded group member
acquires securities of the SPV (or instru-
ments of the disregarded entity treated as
instruments of the SPV for federal tax
purposes). This may occur in the normal
course of the expanded group member's
investment in portfolio securities. It may
also occur when the expanded group
member acquires the securities because
the SPV cannot place them all with unre-
lated parties at the time of issuance. The
comment stated that the rule is particu-
larly problematic when the SPV is a mem-
ber of a consolidated group that is itself
the subsidiary of a foreign parent, and an
expanded group member that is not a
member of the consolidated group ac-
quires the securities. In this case, a distri-
bution by the common parent could be
considered funded by the SPV's issuance
of debt instruments acquired by related

parties. The comment requested an ex-
emption for such transactions because
they are motivated by non-tax consider-
ations and do not present the policy con-
cerns underlying the proposed regula-
tions.

The proposed regulations do not adopt
an exception for all securitization transac-
tions. The Treasury Department and the
IRS have determined that related party
debt issued as part of a securitization
transaction presents the same general pol-
icy concerns as related-party debt issued
in other contexts. This is because the pro-
ceeds from the sale of debt issued as part
of a securitization transaction generally
may be used to fund a distribution or
acquisition. However, the final and tem-
porary regulations adopt a number of ex-
ceptions for non-tax motivated transac-
tions that provide relief to the transaction
described in the comment. First, the final
and temporary regulations adopt an ex-
ception for qualified dealer debt instru-
ments acquired in the ordinary course of
the dealer's business that are subsequently
disposed of outside the expanded group.
See Section F.1 of this Part V. Second, the
final and temporary regulations do not ap-
ply to instruments issued by a foreign
SPV. See Part III.A.1 of this Summary of
Comments and Explanation of Revisions.
Finally, the regulations continue to treat a
consolidated group as a single corpora-
tion, such that the SPV will only be con-
sidered funded to the extent the securities
are acquired by an expanded group mem-
ber that is not part of the issuer's consol-
idated group. See Part III.A.2 of this Sum-
mary of Comments and Explanation of
Revisions. To the extent such a funding
occurs, the elimination of the cliff effect
in the threshold exception also provides
relief. See Section E.4 of this Part V.
Accordingly, the final and temporary reg-
ulations do not provide special rules for
the treatment of instruments issued as part
of a securitization transaction, but do pro-
vide numerous new exceptions that will
exclude many of these transactions.

### 6. Principal Motive of Tax Avoidance

One comment recommended that pro-
posed § 1.385-3 be limited to debt issu-
ances that have a principal motivation of
tax avoidance. The comment does not

elaborate on what type of transaction
would constitute tax "avoidance."

As discussed in Section A.1 of this Part
V, the Treasury Department and the IRS
have decided that consideration of
whether a debt instrument issued to a
member of the issuer's expanded group
finances new investment is an appropriate
determinative factor for whether a
corporation-shareholder or debtor-creditor
relationship exists. Such factor may exist
regardless of whether a taxpayer is moti-
vated principally by tax avoidance. Al-
though the final and temporary regulations
retain a principal purpose test as part of
the funding rule, this test looks to whether
the taxpayer intended for the debt issu-
ance to fund a distribution or acquisition,
rather than whether such transaction
avoided tax. See Section D.2.e of this
Part V.

G. Exceptions from § 1.385-3 for debt
instruments issued by certain issuers

The final and temporary regulations
limit the application of the general rule
and funding rule by excluding debt instru-
ments issued by excepted regulated finan-
cial companies and regulated insurance
companies from the definition of covered
debt instruments.

#### 1. Regulated Financial Groups

Several comments requested that the
proposed regulations be revised to ex-
clude debt instruments issued by certain
types of regulated financial institutions.
Comments reasoned that financial institu-
tions, whose core business is financial in-
termediation (such as the transmission of
funds between lenders and borrowers),
rely on intercompany loans to efficiently
transfer funds among their affiliates, and
therefore would be disproportionately af-
fected by the proposed regulations. These
comments also asserted that the supervi-
sion and regulation to which regulated
financial institutions are subject signifi-
cantly restricts their ability to engage in
the types of transactions the proposed reg-
ulations are intended to address. Further-
more, the comments noted that certain
regulatory and supervisory requirements
mandate the issuance of intercompany
debt and that it would be particularly bur-

densome for such debt to be subject to the
proposed regulations. Comments in par-
ticular sought exceptions from the regula-
tions for transactions that U.S. subsidiar-
ies of foreign banks undertake to comply
with the requirement adopted by the
Board of Governors of the Federal Re-
serve System (Federal Reserve) that cer-
tain foreign banks reorganize their U.S.
subsidiaries under a U.S. intermediate
holding company. Comments also re-
ferred to the rules proposed by the Federal
Reserve that would require U.S. subsid-
iaries of certain foreign banks to issue
intercompany debt that could be used to
facilitate a recapitalization of such subsid-
iaries in the event their intermediate hold-
ing company is in default or in danger of
default. Comments recommended exclud-
ing companies described in, for example,
section 954(h) or 904(d)(2)(C), or by ref-
erence to other provisions of U.S. law that
describe financial entities subject to cer-
tain forms of federal regulation. Com-
ments also recommended excluding cer-
tain transactions typically used to fund
financial institutions subject to regulation,
such as transactions of the type that are
described in section 956(c)(2)(I) and (J).

In response to these comments, the fi-
nal and temporary regulations provide an
exception to the definition of covered debt
instrument in § 1.385-3(g)(3) for covered
debt instruments that are issued by an
excepted regulated financial company. An
excepted regulated financial company is
defined in § 1.385-3(g)(3)(iv) to mean a
covered member that is a regulated finan-
cial company or a member of a regulated
financial group.

A regulated financial company is de-
fined in § 1.385-3(g)(3)(iv)(A) by refer-
ence to certain types of financial institu-
tions that are subject to specific regulatory
capital or leverage requirements. The def-
inition of regulated financial company is
comprised of: bank holding companies;
certain savings and loan holding compa-
nies; insured depository institutions and
any other national banks or state banks
that are members of the Federal Reserve
System; nonbank financial companies
subject to a determination by the Financial
Stability Oversight Council; certain U.S.
intermediate holding companies formed
by foreign banking organizations; Edge
Act and agreement corporations; super-

vised securities holding companies; regis-
tered broker-dealers; futures commission
merchants; swap dealers; security-based
swap dealers; Federal Home Loan Banks;
Farm Credit System institutions; and
small business investment companies.
The final and temporary regulations in-
clude exceptions for swap dealers and
security-based swap dealers in anticipa-
tion of the adoption of final rules that
would apply capital requirements to such
entities.

The Treasury Department and the IRS
recognize that other types of companies
are subject to various levels of regulation
and supervision, including regulation de-
signed to ensure the financial soundness
of the company. However, the Treasury
Department and the IRS have tailored the
exception to regulated institutions that are
subject to capital or leverage requirements
because such requirements most directly
constrain the ability of such institutions to
engage in the transactions that are in-
tended to be addressed by the final and
temporary regulations. Although the spe-
cific requirements vary across the regula-
tory regimes identified in § 1.385-3(g)(3)
(iv)(A), in each case the regulatory regime
imposes capital or leverage requirements
that have the effect of limiting the extent
to which a regulated company can in-
crease the amount of its debt. In contrast,
institutions that are not subject to entity-
specific capital or leverage requirements,
such as certain types of savings and loan
holding companies, are not eligible for the
exception. Furthermore, the exception is
tailored to focus on financial institutions
that are financial intermediaries whose
business activities require the efficient
transfer of money among affiliates.

In addition, certain financial institu-
tions that are included in the definition of
regulated financial company (specifically,
those listed in § 1.385-3(g)(3)(iv)(A)(1)
through (10)) are subject to consolidated
supervision with respect to the entire
group, including consolidated capital or
leverage requirements and supervision of
all material subsidiaries. This degree of
regulation and supervision generally
places meaningful limits on the ability of
subsidiaries to issue debt. The final and
temporary regulations therefore also ex-
clude from the definition of covered debt
instrument debt instruments issued by any

subsidiary of a regulated financial com-
pany that is listed in § 1.385-3(g)(3)
(iv)(A)(1) through (10), which includes
bank holding companies and certain other
types of banking organizations. With re-
spect to these regulated financial compa-
nies, § 1.385-3(g)(3)(iv)(B) defines a reg-
ulated financial group to include the
subsidiaries of the regulated financial
company that would constitute members
of an expanded group that had as its ex-
panded group parent the regulated finan-
cial company. Therefore, if a regulated
financial company is the expanded group
parent of an expanded group, the entire
expanded group constitutes a regulated fi-
nancial group. On the other hand, if a
regulated financial company is a non-
parent member of an expanded group,
then only the direct and indirect subsid-
iaries of such regulated financial company
that are expanded group members consti-
tute the regulated financial group.

However, the Treasury Department
and the IRS also have determined that
certain subsidiaries of a bank holding
company or savings and loan company
that engage in a non-financial business
should not be treated as part of a regulated
financial group. Specifically, under § 1.385-
3(g)(3)(iv)(B)(2), subsidiaries of a bank
holding company or savings and loan
holding company that are held pursuant to
the complementary activities authority,
merchant banking authority, or grandfa-
thered commodities activities authority
provided by sections 4(k)(1)(B), 4(k)(4)
(H), and 4(o) of the Bank Holding Com-
pany Act, respectively, are not treated as
part of the bank holding company's or
savings and loan holding company's reg-
ulated financial group. Such subsidiaries
are engaged in non-financial businesses
and have the same incentives as non-
financial companies that are not subsidiar-
ies of bank holding companies or savings
and loan holding companies to use
related-party debt to generate significant
federal tax benefits without having mean-
ingful non-tax effects, and generally do
not face significant regulatory restrictions
on doing so. Therefore, it is appropriate to
treat such non-financial subsidiaries com-
parably to non-financial companies that
are not subsidiaries of bank holding com-
panies or savings and loan holding com-
panies.

The final and temporary regulations do
not provide a separate exception for debt
issued to an excepted regulated financial
company because entities included within
the definition of an excepted regulated
financial company generally are not sub-
ject to regulatory limits on their ability to
lend. In any case, debt instruments issued
by one member of a regulated financial
group to another member of the group are
excluded from the definition of covered
debt instrument under the final and tem-
porary regulations by virtue of being is-
sued by an excepted regulated financial
company.

#### 2. Regulated Insurance Companies

For reasons similar to those discussed
in the immediately preceding section, the
Treasury Department and the IRS have
determined that debt instruments issued
by insurance companies that are subject to
risk-based capital requirements under
state law should be excluded from the
definition of covered debt instrument. The
Treasury Department and the IRS have
determined that, similar to regulated fi-
nancial companies, regulated insurance
companies are subject to risk-based capi-
tal requirements and other regulation that
mitigates the risk that they would engage
in the types of transactions addressed by
the final and temporary regulations.

Therefore, the final and temporary reg-
ulations provide that a covered debt in-
strument does not include a debt instru-
ment issued by a regulated insurance
company. Section 1.385-3(g)(3)(v) de-
fines a regulated insurance company as a
covered member that is: (i) subject to tax
under subchapter L of chapter 1 of the
Code; (ii) domiciled or organized under
the laws of a state or the District of Co-
lumbia; (iii) licensed, authorized, or reg-
ulated by one or more states or the District
of Columbia to sell insurance, reinsur-
ance, or annuity contracts to persons other
than related persons (within the meaning
of section 954(d)(3)); and (iv) engaged in
regular issuances of (or subject to ongoing
liability with respect to) insurance, rein-
surance, or annuity contracts with persons
that are not related persons (within the
meaning of section 954(d)(3)). In order to
prevent a company from inappropriately
qualifying as a regulated insurance com-

pany, the final and temporary regulations
also provide that in no case will a corpo-
ration satisfy the licensing, authorization,
or regulation requirements if a principal
purpose for obtaining such license, autho-
rization, or regulation was to qualify as a
"regulated insurance company" under the
final and temporary regulations.

The last prong of the definition of "reg-
ulated insurance company" has the effect
of not including within the exclusion cer-
tain captive insurance and reinsurance
captive companies. Covered debt instru-
ments issued by such companies are not
excluded under the final and temporary
regulations because captive insurers are
not subject to risk-based capital require-
ments and are otherwise not subject to
regulation and oversight to the same de-
gree as other insurance and reinsurance
companies.

The Treasury Department and the IRS
have not extended the regulated insurance
company exception to other members of
an insurance company's group that are not
themselves regulated insurance compa-
nies. State insurance regulators only exer-
cise direct authority over regulated insur-
ance companies; such direct authority
does not extend to other non-insurance
entities within the group. Subsidiaries of
insurance companies that are not them-
selves insurance companies are only sub-
ject to regulation indirectly through super-
vision of the affiliated insurance
companies. Among other things, in con-
trast to a regulated financial group, such
non-insurance subsidiaries and affiliates
are generally not subject to consolidated
capital requirements.

#### 3. Instruments Issued In Connection with Certain Real Estate Investments and Other Capital Investment

Comments expressed concern that a
debt instrument that is treated as stock
would not be treated as an interest "solely
as a creditor" for purposes of determining
whether the holder has an interest in a
United States real property holding corpo-
ration (USRPHC) for purposes of sections
897 and 1445. Generally, a foreign corpo-
ration that disposes of stock of a domestic
corporation is not subject to U.S. income
tax on the gain realized upon the sale.
However, section 897(a) treats gains from

the disposition of a United States real
property interest (USRPI), which includes
an interest in a USRPHC, as income that
is effectively connected with a U.S. trade
or business that is subject to tax under
section 882(a)(1). A USRPHC is defined
in section 897(c)(2) as any corporation
more than 50 percent of the fair market
value of the business and real estate assets
of which are USRPIs. Under section
897(c)(1)(A), an interest solely as a cred-
itor in a domestic corporation does not
constitute a USRPI. Under § 1.897-
1(d)(3)(i)(A), stock of a corporation is not
an interest solely as a creditor.

Comments requested that an instru-
ment treated as stock under the proposed
regulations nonetheless be considered to
be an interest solely as a creditor for pur-
poses of section 897(c)(1)(A). Alterna-
tively, comments requested relief for a
good faith failure to report and withhold
under section 1445 with respect to a re-
characterized instrument no longer con-
sidered to be an interest solely as a cred-
itor. Comments also suggested that the
proposed regulations would impact vari-
ous ownership-based tests under section
897 (including whether a corporation con-
stitutes a USRPHC and the application of
certain exceptions to section 897) and lead
to unexpected tax consequences. In par-
ticular, comments asserted that the pro-
posed regulations could affect the appli-
cation of the "look-through" rule in
section 897(c)(5), which could ultimately
affect the treatment of unrelated persons
with no control or knowledge of the re-
characterized instruments.

As discussed in Section B.1 of this Part
V, the Treasury Department and the IRS
have determined that an interest deter-
mined to be stock under the final and
temporary regulations generally should be
treated as stock for all federal tax pur-
poses. Accordingly, the final and tempo-
rary regulations do not provide a special
exception for purposes of section 897. The
regulations are concerned with the use of
related-party indebtedness issued to an ex-
panded group member that does not fi-
nance new investment in the operations of
the issuer. These concerns are no less im-
plicated in the case of debt issued by a
domestic corporation investing in U.S.
real estate that may be treated as a

USRPHC as compared to any other do-
mestic corporation.

With respect to the application of the
various ownership-based tests under sec-
tion 897, including the look-through rule
in section 897(c)(5), to the extent any
uncertainties exist, they do not arise
uniquely as a result of the final and tem-
porary regulations. Instead, such uncer-
tainties would arise whenever purported
debt instruments are characterized as
stock under applicable common law. Sec-
tion B.1 of this Part V illustrates other
areas in which recharacterization, whether
under the common law or under the final
and temporary regulations, can impact the
application of other Code provisions.

The final and temporary regulations
also do not adopt a special rule for pur-
poses of withholding under section 1445
because § 1.1445-1(e) provides rules of
general application for the failure to with-
hold under section 1445, and the applica-
tion of the final and temporary regulations
does not present unique issues in this re-
gard. The concerns raised in comments
related to transfers of USRPIs among
members of an expanded group, which
are, by definition, highly-related parties
that should be able to determine whether a
particular instrument has been recharac-
terized under the final and temporary reg-
ulations. Furthermore, any liability of the
transferee will be potentially mitigated by
§ 1.1445-1(e)(3), which provides that the
transferee is relieved of liability to the
extent the transferor satisfies its tax liabil-
ity with respect to the transfer. If the in-
strument is sold outside the group, the
disposition will not subject an unrelated
person to liability under section 1445 (as-
suming the interest is an interest solely as
a creditor in the hands of the unrelated
person) because the deemed exchange de-
scribed in § 1.385-3(d)(2) occurs imme-
diately before the instrument leaves the
group.

A comment also requested an excep-
tion for qualified foreign pension funds
described in section 897(l)(2), which gen-
erally allows such funds to invest in U.S.
real estate without being subject to section
897. The comment reasoned that the effect
of the regulations on interest deductibility
could decrease the after-tax returns such
funds receive on investments in U.S. in-
frastructure investments, resulting in de-

creased investment. Other comments cited
similar concerns, with one comment rec-
ommending an exception for a newly de-
fined infrastructure asset holding company
and another comment recommending an ex-
emption for debt tied to U.S. capital ex-
penditure investment more broadly. The
Treasury Department and the IRS decline
to adopt these recommendations because
the regulations are concerned in general
about the creation of indebtedness that
does not finance new investment, without
regard to the identity of the ultimate ben-
eficial owners of the expanded group, and
without regard to the nature of a taxpay-
er's business.

### H. Operating rules

### 1. Timing Rules

The proposed regulations provided that
when a debt instrument is treated as stock
under the funding rule, the debt instru-
ment is treated as stock from the time the
debt instrument is issued, but only to the
extent it is issued in the same or a subse-
quent taxable year as the distribution or
acquisition that the debt instrument is
treated as funding. Comments recom-
mended that this rule be modified such
that a debt instrument cannot be treated as
stock before the occurrence of the trans-
action that the debt instrument is treated
as funding. Comments noted that the col-
lateral consequences described in Section
B.1 of this Part V (including the implica-
tions under section 368(c)) would be par-
ticularly burdensome in this context. Sim-
ilarly, comments requested clarification
that the timing rule did not cause a debt
instrument that was repaid before the oc-
currence of a distribution or acquisition to
be treated as funding that distribution or
acquisition.

The final and temporary regulations
eliminate the timing rule under which a
covered debt instrument that is treated as
funding a distribution or acquisition that
occurs later in the same year is treated as
stock when the covered debt instrument is
issued. As a result, when a covered debt
instrument is treated as funding a distri-
bution or acquisition that occurs later in
the same year, or in a subsequent year, the
covered debt instrument is recharacterized
on the date of the later distribution or

acquisition. Thus, when a covered debt
instrument is repaid before a distribution
or acquisition that the debt instrument
might otherwise be treated as funding, the
covered debt instrument is not recharac-
terized.

### 2. Covered Debt Instrument Treated as Stock that Leaves the Expanded Group

In general, under proposed § 1.385-
3(d)(2), if a debt instrument treated as
stock leaves the expanded group, either
because the instrument is transferred out-
side the expanded group or because the
holder leaves the expanded group, the is-
suer is deemed to issue a new debt instru-
ment to the holder in exchange for the
debt instrument that was treated as stock,
in a transaction that is disregarded for
purposes of applying the general rule and
funding rule. Comments recommended
that, when the instrument is transferred
outside the group, rules similar to the
deemed exchange rules of proposed
§ 1.385-1(c) apply to the instrument
treated as stock that is converted to debt
upon sale outside the expanded group.
Another comment suggested that the ex-
panded group member disposing of the
instrument be treated as selling stock un-
der section 1001 and the acquirer treated
as purchasing debt at an issue price deter-
mined as if the debt were respected as
debt since issuance (that is, adjusting the
actual purchase price to account for any
accrued interest). Finally, a comment also
requested a clarification that any stated
interest that had accrued between the last
payment date and the date of the deemed
exchange should be considered a portion
of the redemption price. As discussed in
Part III.C of this Summary of Comments
and Explanation of Revisions, the final
and temporary regulations do not adopt
these recommendations because there are
detailed rules in sections 1273 and 1274
that describe how to determine issue price
when a debt instrument is issued for stock.
Moreover, the Treasury Department and
the IRS are of the view that in the situa-
tion where a debt instrument treated as
stock leaves the expanded group, treating
that instrument as newly issued more ap-
propriately reflects the characterization of
the transaction in the final and temporary
regulations.

A comment also suggested removing
the re-testing rule in the proposed regula-
tions that required an issuer to re-test all
outstanding debt instruments after a debt
instrument treated as stock leaves the ex-
panded group. The final and temporary
regulations do not adopt this recommen-
dation. The re-testing rule addresses a
concern similar to that discussed in Sec-
tion B.4 of this Part V, regarding when a
debt instrument that is treated as stock is
repaid in a transaction that is treated as a
distribution for purposes of § 1.385-3. In
the context of a repayment of the rechar-
acterized debt instrument, the Treasury
Department and the IRS are concerned
that, unless the repayment is treated as a
distribution for purposes of the funding
rule, the repayment could result in an in-
appropriate removal of a distribution or
acquisition described in the general rule or
funding rule from the funding rule. In the
context of a transfer of the instrument
outside of the expanded group, there is no
repayment of the recharacterized debt in-
strument that would be treated as a distri-
bution for purposes of the funding rule
(although the recharacterized debt instru-
ment is deemed redeemed when trans-
ferred outside the expanded group, pro-
posed § 1.385-3(d)(2) disregarded that
redemption for purposes of the funding
rule). Nonetheless, there is a similar con-
cern about an inappropriate removal of the
underlying distribution or acquisition
from the funding rule. Thus, the proposed
regulations provided that, after a transfer
of the instrument outside of the expanded
group, the underlying distribution or ac-
quisition that caused the disposed debt
instrument to be treated as stock is re-
tested against other debt instruments not
already recharacterized as stock. See pro-
posed § 1.385-3((g)(3) Example 7. The
final and temporary regulations clarify
that this rule also applies to recharacterize
later issued covered debt instruments that
are within the per se period. Thus, this
final rule provides that when a covered
debt instrument treated as stock is trans-
ferred outside of the expanded group, the
underlying distribution or acquisition that
caused the disposed debt instrument to be
treated as stock can cause any other cov-
ered debt instrument issued during the per
se period to be treated as stock. The final
and temporary regulations also apply this

operating rule when a covered debt instru-
ment treated as stock becomes a consoli-
dated group debt instrument under
§ 1.385-4T(c)(2).

Another comment suggested that the
re-testing rule should be limited to debt
instruments issued in the 36 months be-
fore the re-testing date because the re-
testing rule could apply to a debt instru-
ment issued many years before the
disposition of the debt instrument treated
as stock. The final and temporary regula-
tions adopt this recommendation because
it is consistent with the per se application
of the funding rule as described in Section
D.2 of this Part V.

The Treasury Department and the IRS
considered an alternative approach that
would more closely harmonize the rules
for repayments and dispositions of debt
instruments treated as stock by accepting
the comment to eliminate the re-testing
rule in § 1.385-3(d)(2) when the instru-
ment is transferred outside of the group
and making a corresponding change to the
funding rule to prevent inappropriate re-
moval of a distribution or acquisition de-
scribed in the general rule or funding rule.
This alternative approach would require
deeming a separate distribution that is
subject to the funding rule. The Treasury
Department and the IRS decline to make
those changes because the net effect
would extend the per se period.

### 3. Aggregate Treatment of Partnerships

### a. Overview

The legislative history of subchapter K
of chapter 1 of the Code (subchapter K)
provides that, for purposes of interpreting
Code provisions outside of that subchap-
ter, a partnership may be treated as either
an entity separate from its partners or an
aggregate of its partners, depending on
which characterization is more appropri-
ate to carry out the purpose of the partic-
ular section under consideration. H.R.
Conf. Rep. No. 2543, 83rd Cong. 2d. Sess.
59 (1954). To prevent the avoidance of the
application of the regulations through the
use of partnerships, the proposed regula-
tions adopted an aggregate approach to
controlled partnerships.

The proposed regulations provided
that, for example, when a corporate mem-

ber of an expanded group becomes a part-
ner (an expanded group partner) in a part-
nership that is a controlled partnership
with respect to the expanded group, the
expanded group partner is treated as ac-
quiring its proportionate share of the con-
trolled partnership's assets and issuing its
proportionate share of any debt instru-
ments issued by the controlled partner-
ship. For these purposes, the proposed
regulations determined a partner's propor-
tionate share in accordance with the part-
ner's share of partnership profits.

This aggregate treatment also applied
to the recharacterization under proposed
§ 1.385-3 of a debt instrument issued by a
controlled partnership. Therefore, pro-
posed § 1.385-3 provided that the holder
of a recharacterized debt instrument is-
sued by a controlled partnership would be
treated as holding stock in the expanded
group partners rather than as holding an
interest in the controlled partnership. The
proposed regulations also required the
partnership and its partners to make ap-
propriate conforming adjustments to re-
flect this treatment. Comments raised con-
cerns that neither section 385 nor the
legislative history to section 385 suggests
that Congress authorized regulations to
determine the status of debt issued by a
non-corporate entity and requested that
any future regulations only apply to debt
issued by corporations. Additionally, as
described in Section H.4 of this Part V,
comments expressed concern regarding
the collateral consequences of treating a
partnership instrument as stock of the ex-
panded group partners under proposed
§ 1.385-3.

After considering the comments, the
Treasury Department and the IRS have
determined that it is necessary and appro-
priate to adopt an aggregate approach to a
controlled partnership in order to prevent
the avoidance of the purposes of the final
and temporary regulations through the use
of a partnership. Thus, consistent with the
longstanding practice of the Treasury De-
partment and the IRS to apply aggregate
treatment to partnerships and their part-
ners when appropriate, and in accordance
with the legislative history of subchapter
K, the final and temporary regulations
generally treat a controlled partnership as
an aggregate of its partners in the manner
described in the temporary regulations.

However, in response to comments, the
final and temporary regulations do not re-
characterize debt issued by a partnership
as equity under section 385. Instead, pur-
suant to the authority granted under sec-
tion 7701(l) to recharacterize certain
multi-party financing transactions, the
temporary regulations deem the holder of
a debt instrument issued by a partnership
that otherwise would be subject to rechar-
acterization (based on an application of
the factors in § 1.385-3 to the expanded
group partners under the aggregate ap-
proach) as having transferred the debt in-
strument to the expanded group partner or
partners in exchange for stock in the ex-
panded group partner or partners.

Sections H.3.b through d of this Part V,
discuss the application of the aggregate
approach to a controlled partnership for
purposes of applying the rules in
§ 1.385-3, both for purposes of determin-
ing when a debt instrument issued by an
expanded group partner is treated as eq-
uity, as well as when a debt instrument
issued by the controlled partnership that
otherwise would be treated as equity un-
der the aggregate approach should be sub-
ject to the deemed transfer. Specifically,
Section H.3.b of this Part V discusses the
aggregate approach to controlled partner-
ships generally; Section H.3.c of this Part
V describes the extent to which an ex-
panded group partner is treated as acquir-
ing a controlled partnership's property for
purposes of applying the rules in
§ 1.385-3; and Section H.3.d of this Part
V describes the rules for identifying the
portion of a debt instrument issued by a
controlled partnership that an expanded
group partner is treated as issuing for pur-
poses of applying the rules in § 1.385-3.
Section H.4 of this Part V explains that a
debt instrument issued by a controlled
partnership that otherwise would be
treated, in whole or in part, as stock under
§ 1.385-3 is instead deemed to be trans-
ferred, in whole or in part, by the holder to
the expanded group partner or partners.

### b. Determining proportionate share generally

Comments raised concerns regarding
the proposed regulations' requirement to
determine a partner's proportionate share
based on the "partner's share of partner-

ship profits," which applied equally to the
determination of a partner's share of con-
trolled partnership assets and the determi-
nation of a partner's share of a debt instru-
ment issued by a controlled partnership.
Comments requested clarity regarding the
method for determining a partner's share
of partnership profits, and asserted that the
determination could be made in a number
of different ways. In the context of a debt
instrument issued by a controlled partner-
ship, comments noted that determining a
partner's proportionate share in accor-
dance with its share of partnership profits
may be inappropriate in certain cases,
such as if a controlled partnership distrib-
utes borrowed funds on a non-pro rata
basis to its partners, or if a minority part-
ner guarantees a debt. Comments further
asserted that, regardless of how a partner's
"proportionate share" is determined, that
share may fluctuate and rules should spec-
ify when the partner's proportionate share
is determined.

The temporary regulations continue to
provide that, for purposes of applying the
factors in § 1.385-3 (as well as the rules
of § 1.385-3T), an expanded group part-
ner is treated as acquiring its share of
property owned by a controlled partner-
ship and as issuing its share of a debt
instrument issued by a controlled partner-
ship. Specifically, § 1.385-3T(f)(2) pro-
vides rules for acquisitions of property by
a controlled partnership, and § 1.385-
3T(f)(3) provides rules addressing the
treatment of a debt instrument issued by a
controlled partnership. Both sets of rules
rely on a determination of a partner's
"share" of the controlled partnership's
property or indebtedness. However, and
as described in more detail in Section
H.3.c and d of this Part V, "share" is
defined differently for each purpose and,
in response to comments, is no longer
defined by reference to a partner's share
of profits.

When an expanded group partner is
treated as acquiring a share of property
owned by a controlled partnership or as
issuing a share of a debt instrument issued
by a controlled partnership, except as de-
scribed in Section H.4 of this Part V, all
parties apply the rules of § 1.385-3 as
though the expanded group partner ac-
quired the property or issued the debt in-
strument.

c. Partner's proportionate share of
controlled partnership property

A member of an expanded group that is
an expanded group partner on the date a
controlled partnership acquires property
(including expanded group stock, a debt
instrument, or any other property) from
another expanded group member is
treated as acquiring its share of that prop-
erty under § 1.385-3T(f)(2)(i)(A). The
covered member is treated as acquiring its
share of the property from the transferor
member in the manner (for example, in an
exchange for property or an issuance), and
on the date on which, the property is ac-
tually acquired by the controlled partner-
ship from the transferor member. Thus,
for example, if the controlled partnership
acquires expanded group stock in ex-
change for property other than other ex-
panded group stock, an expanded group
partner is treated as making an acquisition
described in § 1.385-3(b)(3)(i)(B) (fund-
ing rule) to the extent of its share of the
expanded group stock. Likewise, if a con-
trolled partnership acquires a debt instru-
ment issued by a covered member in a
distribution by that covered member or
a covered member distributes property to
a controlled partnership, the covered
member is treated as making a distribution
described in § 1.385-3(b)(2)(i) (general
rule) or 1.385-3(b)(3)(i)(A) (funding rule)
to the extent of any expanded group part-
ner's share of the distributed property.

Section 1.385-3T(f)(2)(i)(C) provides
that, if an expanded group partner trans-
fers expanded group stock to the con-
trolled partnership, the member is not
treated as reacquiring (by reason of its
interest in the controlled partnership) any
of the expanded group stock it transferred.
Thus, an expanded group partner will not
be treated as acquiring expanded group
stock that it already owned by reason of
transferring that expanded group stock to
a controlled partnership.

Expanded group stock is the only kind
of property a member of an expanded
group is treated as acquiring if it becomes
an expanded group partner after the con-
trolled partnership acquired the property.
Under § 1.385-3T(f)(2)(ii)(A), a member
of an expanded group that becomes an
expanded group partner when the con-
trolled partnership already owns expanded

group stock generally is treated, on the
date the member becomes an expanded
group partner, as acquiring its share of the
expanded group stock owned by the con-
trolled partnership from an expanded
group member in exchange for property
other than expanded group stock. Thus,
subject to an exception described in this
paragraph, the member is treated as mak-
ing an acquisition described in § 1.385-
3(b)(3)(i)(B) (funding rule) to the extent
of its share of the expanded group stock
owned by the controlled partnership, re-
gardless of how the controlled partnership
acquired that expanded group stock. This
approach avoids the complexity of at-
tempting to trace the acquisition of ex-
panded group stock to certain transferors
for certain consideration depending on
whether the partnership interest was ac-
quired by contribution or transfer. Section
1.385-3T(f)(2)(ii)(C) provides an excep-
tion to this general rule whereby a mem-
ber of an expanded group that acquires an
interest in a controlled partnership, either
from another partner in exchange solely
for expanded group stock or upon a con-
tribution to the controlled partnership
comprised solely of expanded group
stock, is not treated as acquiring expanded
group stock owned by the controlled part-
nership, so that § 1.385-3(b)(3)(i)(B) will
not apply.

In response to comments regarding the
use of a "partner's share of partnership
profits" to identify a partner's share of
property, the temporary regulations pro-
vide that a partner's share of property
acquired by a controlled partnership, in-
cluding expanded group stock acquired by
a controlled partnership before the mem-
ber of the expanded group became an ex-
panded group partner, is determined in
accordance with the partner's liquidation
value percentage. Pursuant to § 1.385-
3T(g)(17), a partner's liquidation value
percentage in a controlled partnership
(which can include a partnership that is
owned indirectly through one or more
partnerships) is the ratio (expressed as a
percentage) of the liquidation value of the
expanded group partner's interest in the
partnership divided by the aggregate liq-
uidation value of all the partners' interests
in the partnership. The liquidation value
of an expanded group partner's interest in
a partnership is the amount of cash the

partner would receive with respect to the
interest if the partnership sold all of its
property for an amount of cash equal to
the fair market value of the property (tak-
ing into account section 7701(g)), satisfied
all of its liabilities (other than those de-
scribed in § 1.752-7), paid an unrelated
third party to assume all of its § 1.752-7
liabilities in a fully taxable transaction,
and then the partnership (and any partner-
ship through which the partner indirectly
owns an interest in the controlled partner-
ship) liquidated.

The Treasury Department and the IRS
also agree with comments that the regula-
tions should set forth a specific time for
determining a partner's share of property
owned by a controlled partnership. There-
fore, if an expanded group member is an
expanded group partner on the date the
controlled partnership acquires property,
then, under § 1.385-3T(f)(2)(i)(B), the
liquidation value percentage is determined
on the date the controlled partnership ac-
quires the property. Otherwise, under
§ 1.385-3T(f)(2)(ii)(B), liquidation value
percentage is determined on the date the
expanded group member becomes an ex-
panded group partner in the controlled
partnership.

The Treasury Department and the IRS
determined that using liquidation value per-
centage in this context, as opposed to the
test based on capital and profits that is used
for purposes of identifying a controlled part-
nership, is appropriate because the two tests
are being used for different purposes. On the
one hand, the determination of whether a
partnership is a controlled partnership is a
threshold-based control determination.
Thus, while there may be uncertainty as to
ownership percentages at the margins, that
uncertainty is outweighed by the appropri-
ateness of using a partner's share of profits
as one proxy for control. On the other hand,
in identifying a partner's share of a con-
trolled partnership's property, the precision
afforded by using liquidation value percent-
age is appropriate because the test is in-
tended to arrive at a specific amount of the
property the partner is treated as acquiring.

### d. Partner's proportionate share of controlled partnership indebtedness

# Comments recommended alternative approaches to determining a partner's pro-

portionate share of a debt instrument is-
sued by a controlled partnership, including
determining the partner's proportionate
share by applying principles under section
752, by reference to the partners' capital
accounts, or by reference to a partner's
liquidation value percentage as defined in
proposed § 1.752-3(a)(3) (relating to the
determination of a partner's share of non-
recourse liabilities). Alternatively, com-
ments suggested providing such methods
as safe harbors. One comment suggested
that the regulations adopt a rule similar to
the tracing rule in § 1.707-5(b)(2)(i) (relat-
ing to debt-financed distributions) for deter-
mining a partner's share of a partnership
liability.

The Treasury Department and the IRS
have determined that an approach based
on a partner's anticipated allocations of
the partnership's interest expense is better
tailored to the purposes of the temporary
regulations. Like the proposed regula-
tions, § 1.385-3T(f)(3)(i) provides that,
for purposes of applying §§ 1.385-3 and
1.385-3T, an expanded group partner is
treated as the issuer with respect to its
share of a debt instrument issued by a
controlled partnership. Thus, for example,
the determination of whether a debt in-
strument is a covered debt instrument is
made at the partner level. Section 1.385-
3T(f)(3)(ii)(A) provides that an expanded
group partner's share of a covered debt
instrument is determined in accordance
with the partner's issuance percentage. A
partner's issuance percentage is defined in
§ 1.385-3T(g)(16) as the ratio (expressed
as a percentage) of the partner's reason-
ably anticipated distributive share of all
the partnership's interest expense over a
reasonable period, divided by all of the
partnership's reasonably anticipated inter-
est expense over that same period, taking
into account all the relevant facts and cir-
cumstances. This approach is premised, in
part, on the fungible nature of interest
expense. The Treasury Department and
the IRS have determined that this rule
should, in most cases over time, appropri-
ately match the interest income that an
expanded group partner will be deemed to
receive under the rules described in Sec-
tion H.4 of this Part V with respect to the
portion of a debt instrument issued by a
partnership that otherwise would be
treated as stock under an aggregate appli-

cation of § 1.385-3, with a partner's allo-
cations of partnership interest expense.

The Treasury Department and the IRS
also agree with comments that the tempo-
rary regulations should set forth the spe-
cific time for determining a partner's
share of a debt instrument issued by a
controlled partnership. Accordingly,
§ 1.385-3T(f)(3)(ii)(A) provides that an
expanded group partner's share of a debt
instrument is determined on each date on
which the partner makes a distribution or
acquisition described in § 1.385-3(b)(2)
or 1.385-3(b)(3)(i). Given that a partner's
issuance percentage is a forward-looking
facts and circumstances determination and
that it may need to be determined on dif-
ferent dates, a partner's issuance percent-
age may be different from one date to
another depending on whether the facts
and circumstances have changed between
determinations.

The exception to the funding rule for
qualified short-term debt instruments is
applied at the partnership level by treating
the partnership as the issuer of the rele-
vant debt instruments. This is an excep-
tion to the general rule that, for purposes
of applying §§ 1.385-3 and 1.385-3T, an
expanded group partner is treated as issu-
ing its share of a debt instrument issued by
a controlled partnership to a member of
the expanded group. Thus, for example, in
applying the specified current assets test,
one looks to the amount of specified cur-
rent assets reasonably expected to be re-
flected on the partnership's balance sheet
as a result of transactions in the ordinary
course of the partnership's business.

## 4. Treatment of Recharacterized Partnership Instrument

## a. Comments on recharacterization approach of proposed regulations

Comments requested clarification re-
garding the treatment of a partnership in-
strument recharacterized as stock of the
expanded group partners under proposed
§ 1.385-3. A number of comments
pointed out a variety of seemingly unin-
tended consequences of the approach
taken in the proposed regulations. Those
consequences arose under, among other
provisions, § 1.337(d)-3T; sections 707,
752, and the regulations thereunder; the

fractions rule under section 514(c)(9)(E);
rules regarding tax credits; and rules re-
garding the capitalization of interest ex-
pense into cost of goods sold.

Some comments noted that the ap-
proach in the proposed regulations could
lead to collateral consequences for non-
expanded group partners in a controlled
partnership. Comments requested clarity
regarding the "appropriate conforming ad-
justments" required to reflect the rechar-
acterization of debt issued by a partner-
ship and further noted that the relationship
between the partnership and the expanded
group partners deemed to issue stock to
the funding member could affect alloca-
tions of partnership items of income, gain,
loss, deduction, and credit among part-
ners, which could have economic conse-
quences. Comments also asked whether
the terms of additional partnership inter-
ests issued under the proposed regula-
tions' recharacterization rule would be
identical to the terms of the recharacter-
ized indebtedness. One comment re-
quested that the proposed regulations be
revised to permit partnerships to adjust the
basis of partnership property without re-
gard to the rules of § 1.754-1(b) (relating
to the time for making a section 754 elec-
tion to adjust basis of partnership prop-
erty) when gain is recognized as a result
of the section 385 regulations. A com-
ment requested clarification of the tax
consequences when a partnership pays
interest and principal on purported debt
that has been recharacterized as stock.
Finally, comments asserted that the eq-
uity interest in the partnership that a
partner necessarily would receive as a
result of the "appropriate adjustments"
upon a recharacterization of a partner-
ship's debt instrument could be viewed
as an interest that gives rise to guaran-
teed payments, which would result in
the partnership allocating deductions to
its partners.

Several similar comments suggested an
alternative approach to the recharacteriza-
tion of a partnership's debt instrument.
Those comments all essentially suggested
that the proposed regulations be revised to
provide that, upon an event that otherwise
would result in the partnership's debt in-
strument being treated as equity, in lieu of
recharacterizing the debt instrument, the
expanded group member that holds the

debt instrument be deemed to contribute
its receivable to the expanded group part-
ner or partners that made, or were treated
as making under the aggregate approach,
the distribution or acquisition that gave
rise to the potential recharacterization of
the debt instrument (deemed conduit ap-
proach). The comments asserted that this
deemed conduit approach would result in
interest income from the receivable offset-
ting the interest deductions from the part-
nership's debt obligation that would be
allocated to the expanded group partner or
partners that made (or were treated as
making) the distribution or acquisition
that otherwise would give rise to the re-
characterization of the debt instrument.
Additionally, the comments asserted that,
because this deemed conduit approach
would not require the "appropriate con-
forming adjustments" required by the pro-
posed regulations, the deemed conduit ap-
proach would mitigate nearly all of the
collateral consequences previously de-
scribed regarding the proposed regula-
tions.

In response to these comments, the
temporary regulations adopt the deemed
conduit approach. The Treasury Depart-
ment and the IRS agree with comments
that this approach should alleviate nearly
all of the collateral consequences the com-
ments identified. The Treasury Depart-
ment and the IRS also agree with
comments that this approach should ef-
fectively match interest income with in-
terest expense where appropriate, thus
addressing the policy concerns set forth
in the proposed regulations and in this
preamble. Moreover, section 7701(l)
provides ample authority for the deemed
conduit approach. The adoption of the
deemed conduit approach renders many
of the other comments received with
respect to the application of the pro-
posed regulations to partnerships moot.

## b. General framework for deemed conduit approach

The first step in applying the deemed
conduit approach is to determine the por-
tion of a debt instrument that is treated as
issued by an expanded group partner and
that otherwise would be treated as stock
under the aggregate approach to applying
§ 1.385-3(b) (specified portion). Section

1.385-3T(f)(4)(i) then provides that, in-
stead of treating the specified portion as
stock, the holder-in-form of the debt in-
strument is deemed to transfer a portion of
the debt instrument (deemed transferred
receivable) with a principal amount equal
to the adjusted issue price of the specified
portion to the expanded group partner
(deemed holder) in exchange for stock in
the expanded group partner (deemed part-
ner stock). This transaction is called a
"deemed transfer." Any portion of a debt
instrument issued by a controlled partner-
ship that is not deemed transferred is a
"retained receivable" in the hands of the
holder. Because the holder-in-form of
the debt instrument is deemed to transfer
the deemed transferred receivable, if a
specified portion is created at a time when
another specified portion exists, only all or
a portion of the retained receivable is
deemed to be transferred to the deemed
holder. This rule prevents a later distribu-
tion or acquisition described in § 1.385-
3(b)(2) or 1.385-3(b)(3)(i) from causing a
deemed transferred receivable that was
previously deemed to be transferred to an
expanded group partner from being
deemed to be transferred again when there
is a new specified portion with respect to
a covered debt instrument. The deemed
transfer is treated as occurring for all fed-
eral tax purposes, although there are spe-
cial rules under § 1.385-3(d)(7) for pur-
poses of section 1504(a) (determining
whether a corporation is a member of an
affiliated group) and under § 1.385-
3T(f)(4)(vi) for purposes of section 752
(allocating partnership liabilities). The
special rules regarding section 752 are
described in more detail in Section H.4.c
of this Part V.

An expanded group partner that is
treated as issuing part of a covered debt
instrument issued by a controlled partner-
ship can have a specified portion because
it actually makes a distribution or acqui-
sition described in § 1.385-3(b)(2) or
1.385-3(b)(3)(i), or is treated under the
aggregate approach as acquiring expanded
group stock the controlled partnership
owns or acquires.

Defining an expanded group partner's
specified portion by reference to the por-
tion of the expanded group partner's share
of a covered debt instrument that would
be treated as stock under § 1.385-3(b)

ensures that the principal amount of the
deemed transferred receivable will never
exceed the lesser of (i) the expanded
group partner's share of a covered debt
instrument, and (ii) the amount of the dis-
tribution or acquisition described in
§ 1.385-3(b)(2) or 1.385-3(b)(3)(i) the
expanded group partner made or was
treated as making.

The Treasury Department and the IRS
agree with comments that the terms of
stock deemed to exist as a result of section
385 applying to a debt instrument issued
by a partnership along with the conse-
quences of payments with respect to such
an instrument should be clear. Section
1.385-3T(f)(4)(iv)(A) provides that the
deemed partner stock generally has the
same terms as the deemed transferred re-
ceivable. Section 1.385-3T(f)(4)(iv)(B)
provides that when a payment is made
with respect to a debt instrument issued by
a controlled partnership for which there is
one or more deemed transferred receiv-
ables, then, if there is no retained receiv-
able held by the holder of the debt instru-
ment and a single deemed holder is
deemed to hold all of the deemed trans-
ferred receivables, the entire payment is
allocated to the deemed transferred re-
ceivables held by the single deemed
holder. Otherwise, if there is a retained
receivable held by the holder of the debt
instrument or there are multiple deemed
holders of deemed transferred receivables,
or both, the payment is apportioned
among the retained receivable, if any, and
each deemed transferred receivable in
proportion to the principal amount of all
the receivables. The portion of a payment
allocated or apportioned to a retained re-
ceivable or a deemed transferred receiv-
able reduces the principal amount of, or
accrued interest with respect to, such item
as applicable under general federal tax
principles depending on the payment.
When a payment allocated or apportioned
to a deemed transferred receivable re-
duces the principal amount of the receiv-
able, the expanded group partner that is
the deemed holder with respect to the
deemed transferred receivable is deemed
to redeem the same amount of the deemed
partner stock, and the specified portion
with respect to the debt instrument is re-
duced by the same amount. When a pay-
ment allocated or apportioned to a deemed

transferred receivable reduces accrued in-
terest with respect to the receivable, the
expanded group partner that is the deemed
holder with respect to the deemed trans-
ferred receivable is deemed to make a
matching distribution in the same amount
with respect to the deemed partner stock.
The controlled partnership is treated as the
paying agent with respect to the deemed
partner stock.

It would be necessary to determine an
expanded group partner's share of a debt
instrument after a deemed transfer if there
is a retained receivable and the expanded
group partner makes or is treated as mak-
ing a distribution or acquisition described
in § 1.385-3(b)(2) or 1.385-3(b)(3)(i). In
that case, under § 1.385-3T(f)(3)(ii)(B)
(1), the expanded group partner's share of
a debt instrument (determined as of the
time of the subsequent distribution or ac-
quisition) is reduced, but not below zero,
by the sum of all of the specified portions,
if any, with respect to the debt instrument
that correspond to one or more deemed
transferred receivables that are deemed to
be held by the partner. That is, the cre-
ation of a deemed transferred receivable
does not change the total amount of a debt
instrument for which expanded group
partners must be assigned shares, but it
does reduce a particular partner's share of
the debt instrument that can result in a
subsequent deemed transferred receivable
to that partner. If an expanded group part-
ner's issuance percentage on the later test-
ing date is lower than it was on the orig-
inal testing date, it is possible that the
expanded group partner's share of the
covered debt instrument cannot be re-
duced by the entire amount of the ex-
panded group partner's specified portion
without reducing that expanded group
partner's share below zero. In that case,
under § 1.385-3T(f)(3)(ii)(B)(2), the
other partners' shares of the covered debt
instrument are reduced proportionately.
Reducing a partner's share of a debt in-
strument for this purpose does not affect
the amount of any specified portion with
respect to that partner with respect to prior
deemed transfers or any deemed trans-
ferred receivable previously deemed
transferred. Under these rules, it is impos-
sible for the partners' aggregate shares of
a covered debt instrument to exceed the
adjusted issue price of the covered debt

instrument reduced by any specified por-
tions of that debt instrument, and there-
fore, the maximum principal amount of all
deemed transferred receivables with re-
spect to a covered debt instrument will
never exceed the adjusted issue price of
the covered debt instrument.

## c. Special rules

In response to comments regarding the
treatment of debt instruments actually
held by an expanded group partner,
§ 1.385-3T(f)(4)(ii) provides that, if a
specified portion is with respect to an ex-
panded group partner that is the holder-in-
form of a debt instrument, then the
deemed transfer described in Section
H.4.b of this Part V does not occur with
respect to that partner and that debt instru-
ment is not treated as stock. Similarly,
§ 1.385-3T(f)(6) provides more broadly
that as long as no partner deducts or re-
ceives an allocation of expense with re-
spect to the debt instrument, a debt instru-
ment issued by an expanded group partner
to a controlled partnership and a debt in-
strument issued by a controlled partner-
ship to an expanded group partner are not
subject to the rules in § 1.385-3T(f).

Section 1.385-3T(f)(5) provides rules
for events that could affect the ownership
of a deemed transferred receivable. These
events are called "specified events." Un-
der § 1.385-3T(f)(5)(iii), a specified event
includes the following: (A) the controlled
partnership that is the issuer of the debt
instrument either ceases to be a controlled
partnership or ceases to have an expanded
group partner that is a covered member;
(B) the holder-in-form is a member of the
expanded group immediately before the
transaction, and the holder-in-form and
the deemed holder cease to be members of
the same expanded group for the reasons
described in § 1.385-3(d)(2); (C) the
holder-in-form is a controlled partnership
immediately before the transaction, and
the holder-in-form ceases to be a con-
trolled partnership; (D) the expanded
group partner that is both the issuer of
deemed partner stock and the deemed
holder transfers (directly or indirectly
through one or more partnerships) all or a
portion of its interest in the controlled
partnership to a person that neither is a
covered member nor a controlled partner-

ship with an expanded group partner that
is a covered member; (E) the expanded
group partner that is both the issuer of
deemed partner stock and the deemed
holder transfers (directly or indirectly
through one or more partnerships) all or a
portion of its interest in the controlled
partnership to a covered member or a con-
trolled partnership with an expanded
group partner that is a covered member;
(F) the holder-in-form transfers the debt
instrument (which is disregarded for fed-
eral tax purposes) to a person that is nei-
ther a member of the expanded group nor
a controlled partnership.

Under § 1.385-3T(f)(5)(i), in the case
of any specified event, immediately before
the specified event, the expanded group
partner that was deemed to issue the
deemed partner stock is deemed to distrib-
ute the deemed transferred receivable to
the holder of the deemed partner stock in
redemption of the deemed partner stock. If
the specified event is that the expanded
group partner transfers all or a portion of
its partnership interest to a covered mem-
ber or a controlled partnership with an
expanded group partner that is a covered
member, then under § 1.385-3T(f)(5)(ii),
the holder of the deemed partner stock is
deemed to retransfer the deemed trans-
ferred receivable to the transferee ex-
panded group partner. In all cases, the
redemption of the deemed partner stock is
disregarded for purposes of testing
whether there has been a funded distribu-
tion or acquisition. However, under
§ 1.385-3(d)(2), all other debt instruments
of the expanded group partner that are not
currently treated as stock are re-tested to
determine whether those other debt instru-
ments are treated as funding the distribu-
tion or acquisition that previously resulted
in the deemed transfer.

Under § 1.385-3T(f)(4)(v), a transfer
of the debt instrument, which after a
deemed transfer is disregarded for federal
tax purposes in whole or in part, to a
member of the expanded group or to a
controlled partnership is not a specified
event. Such transfers are excluded from
the definition of specified event because
all specified events result in deemed part-
ner stock being redeemed for the deemed
transferred receivable, which is unneces-
sary when the debt instrument (as opposed
to an interest in the controlled partnership)

is transferred to a member of the ex-
panded group or a controlled partnership.
It is consistent with the rules contained in
§ 1.385-3T(f) that an expanded group
partner continue to own a deemed trans-
ferred receivable after the transfer of the
debt instrument to a member of the ex-
panded group or a controlled partnership.
Therefore, upon such a transfer, the
deemed partner stock is not redeemed for
the deemed transferred receivable and in-
stead the holder is deemed to transfer the
retained receivable and the deemed part-
ner stock to the transferee.

Finally, § 1.385-3T(f)(4)(iii) provides
specificity on who is deemed to receive a
receivable if one or more expanded group
partners are a member of a consolidated
group. That section generally provides
that the holder of a debt instrument is
deemed to transfer the deemed transferred
receivable or receivables to the expanded
group partner or partners that are mem-
bers of a consolidated group that make, or
are treated as making (under § 1.385-
3T(f)(2)) the regarded distributions or ac-
quisitions (within the meaning of § 1.385-
4T(e)(5)) described in § 1.385-3(b)(2) or
(b)(3)(i) in exchange for deemed partner
stock in such partner or partners. To the
extent those distributions or acquisitions
are made by a member of the consolidated
group that is not an expanded group part-
ner, the holder-in-form is treated as trans-
ferring a portion of the deemed transfer
receivable to each member of the consol-
idated group that is an expanded group
partner ratably as described in § 1.385-
3T(f)(4)(iii).

## d. Remaining collateral consequences

Comments raised certain additional
consequences that the deemed conduit ap-
proach does not mitigate.

Comments noted that the proposed reg-
ulations could have reduced the debt a
partnership was treated as issuing, and
therefore reduced a partner's share of
partnership liabilities under section 752.
This reduction would be considered a dis-
tribution of money to the partner, which
could be in excess of the partner's ad-
justed tax basis in its partnership interest
and thereby result in gain recognition un-
der section 731(a). The deemed conduit
approach does not reduce the debt a part-

nership is treated as issuing, but does
cause one or more partners to be deemed
to be the holder of the debt. Causing a
partner to be the holder of partnership
debt, absent a special rule, could result in
the liability being reallocated among the
partners under § 1.752-2(c)(1). Under
§ 1.752-2(a), a partner's share of a re-
course partnership liability equals the por-
tion of that liability, if any, for which the
partner or a related person bears the eco-
nomic risk of loss. Section 1.752-2(c)(1)
generally provides that a partner bears the
economic risk of loss for a partnership
liability to the extent that the partner
makes a nonrecourse loan to the partner-
ship. If the partner who is deemed to own
a deemed transferred receivable was not
previously allocated all of the partnership
liability represented by the deemed trans-
ferred receivable, the creation of a deemed
transferred receivable can result in a real-
location of the partnership liability. This
reallocation of the partnership liability
raises a concern similar to that raised re-
garding the proposed regulations, but it is
not the result of debt being treated as
equity. This consequence only results
from the application of these temporary
regulations. For that reason, § 1.385-
3T(f)(4)(vi) provides that a partnership li-
ability that is a debt instrument with re-
spect to which there is one or more
deemed transferred receivables is allo-
cated for purposes of section 752 without
regard to any deemed transfer. Section
1.752-2(c)(3) contains a cross-reference
to this rule.

Comments also noted that the proposed
regulations could have resulted in partners
recognizing gain under § 1.337(d)-3T.
Generally, the proposed regulations could
cause a corporate partner to recognize
gain when a transaction has the effect of
the corporate partner acquiring or increas-
ing an interest in its own stock in ex-
change for appreciated property. For this
purpose, stock of a corporate partner in-
cludes stock of a corporation that controls
the corporate partner within the meaning
of section 304(c), except that section
318(a)(1) and (3) shall not apply. The final
and temporary regulations do not provide
an exception to the application of
§ 1.337(d)-3T where a debt instrument
held by a partnership is recharacterized as
stock because the Treasury Department

and the IRS do not agree that an instru-
ment recharacterized under the final and
temporary regulations should be treated
differently for purposes of section 337(d)
than an instrument recharacterized under
common law. Likewise, neither the final
nor the temporary regulations provide an
exception where debt issued by a subsid-
iary of a partnership results in that subsid-
iary controlling a corporate partner be-
cause Treasury and the IRS have
determined that such an event that would
result in gain recognition under
§ 1.337(d)-3T is not likely to occur often.

Finally, comments asked about the in-
teraction of the regulations with future
partnership audit procedures under section
1101 of the Bipartisan Budget Act of
2015, Public Law 114-74. Because the
regulations under this new partnership au-
dit regime are under development, it is not
possible to address this comment at this
time.

## 5. Disregarded Entities

Comments requested that the treatment
of debt instruments and EGIs issued by
disregarded entities under proposed
§§ 1.385-2 and 1.385-3 be conformed. As
noted in Part IV.A.4 of this Summary of
Comments and Explanation of Revisions,
the final and temporary regulations mod-
ify the rules in § 1.385-2 to generally
conform those rules to the treatment of a
debt instrument issued by a disregarded
entity under the temporary § 1.385-3 reg-
ulations.

Proposed § 1.385-3(d)(6) provided
that if a debt instrument of a disregarded
entity was treated as stock under proposed
§ 1.385-3, the debt instrument would be
treated as stock in the entity's owner
rather than as an equity interest in the
entity. Comments requested clarity re-
garding the mechanical recharacterization
of an interest in a disregarded entity, par-
ticularly if the disregarded entity is owned
by a partnership. Consistent with the pro-
posed regulations, the temporary regula-
tions generally provide that a covered debt
instrument issued by a disregarded entity
will not be treated as an equity interest in
the entity. The final and temporary regu-
lations also provide that, to the extent that
a covered debt instrument issued by a
disregarded entity would be treated as

stock under the final and temporary regu-
lations, then, rather than treat the covered
debt instrument as stock, the covered
member that is the regarded owner of the
disregarded entity is deemed to issue its
stock. For purposes of the final and tem-
porary regulations, if the covered debt in-
strument otherwise would have been
treated as stock under the general rule,
then the covered member is deemed to
issue its stock to the expanded group
member to which the covered debt instru-
ment was, in form, issued (or transferred)
in the relevant general rule transaction. If
the covered debt instrument otherwise
would have been treated as stock under
the funding rule, then the covered member
is deemed to issue its stock to the holder
of the covered debt instrument in ex-
change for the covered debt instrument. In
each case, the covered member that is the
regarded owner of the disregarded entity
is treated as the owner of a debt instru-
ment issued by the disregarded entity.

This rule must be applied in a manner
that is consistent with the principles of
§ 1.385-3T(f)(4). Thus, for example,
stock deemed issued by the covered mem-
ber that is the regarded owner of the dis-
regarded entity is deemed to have the
same terms as the covered debt instrument
issued by the disregarded entity, other
than the identity of the issuer, and pay-
ments on the stock are determined by ref-
erence to payments made on the debt in-
strument issued by the disregarded entity.
Under the rules in § 1.385-3T(d)(4), if the
regarded owner of a disregarded entity is a
controlled partnership, then § 1.385-3T(f)
applies as though the controlled partner-
ship were the issuer in form of the debt
instrument. Thus, a debt instrument issued
by a disregarded entity owned by a con-
trolled partnership will generally not be,
for purposes of the final and temporary
regulations, treated as issued by the disre-
garded entity or the controlled partner-
ship, and any recharacterization of a cov-
ered debt instrument as stock required by
the final and temporary regulations will
happen at the partner level.

## 6. Withholding under Section 1441

One comment requested that a paying
agent that does not have actual knowledge
that a purported debt instrument is treated

as stock be exempt from liability under
section 1441 for a failure to withhold on a
distribution with respect to the recharac-
terized stock. The final and temporary reg-
ulations do not address this concern be-
cause the determination of whether a
payment is subject to withholding requires
a withholding agent to make a number of
factual determinations. These determina-
tions are not limited to whether an instru-
ment is debt or equity. The uncertainties
that may arise in making those determina-
tions are generally addressed in
§§ 1.1441-2, 1.1441-3, and 1.1441-7. Ac-
cordingly, the final and temporary regula-
tions do not adopt additional exemptions
from liability under chapter 3 for covered
debt instruments.

### I. Anti-abuse and affirmative use

#### 1. Anti-Abuse Rule

#### a. In general

Comments recommended that the anti-
abuse rule in proposed § 1.385-3(b)(4) be
narrowed to apply to transactions only if a
principal purpose of the transaction is the
avoidance of the purposes of the regula-
tions (rather than the avoidance of the
"application" of the regulations). The final
and temporary regulations adopt the rec-
ommendation and provide that the anti-
abuse rule in § 1.385-3(b)(4) applies if a
member of an expanded group enters into
a transaction with a principal purpose of
avoiding the purposes of § 1.385-3 or
§ 1.385-3T.

Comments recommended that the anti-
abuse rule be narrowed to apply only if
"the" principal purpose (rather than "a"
principal purpose) is the avoidance of the
purposes of the regulations. This recom-
mendation is not adopted because the
Treasury Department and the IRS have
determined that the anti-abuse rule should
apply when a principal purpose of a trans-
action is to avoid the purposes of
§ 1.385-3 or § 1.385-3T, even if a tax-
payer can establish that it also had other
principal purposes for the transaction. In
particular, it is often difficult for the IRS
to establish that any one purpose was
more or less motivating than another. The
requirement that the purpose be a "princi-
pal" purpose serves as a sufficient limita-

tion such that the rule should only apply in
appropriate cases. In addition, the use of
"a" principal purpose as part of an anti-
abuse rule is standard administrative prac-
tice and is consistent with other recent
regulations. See §§ 1.304-4(b); 1.956-
1T(b)(4).

Comments also suggested that, if the
anti-abuse rule applies, it should result in
the instrument being subject to the regu-
lations, rather than in the instrument au-
tomatically being recharacterized as stock.
The Treasury Department and the IRS de-
cline to accept this recommendation be-
cause of the administrative complexity
that would be involved in applying the
general rule and funding rule to transac-
tions that are, in form, not subject to these
rules due to structuring undertaken by the
taxpayer to intentionally avoid their appli-
cation.

Comments also requested that the anti-
abuse rule be clarified in several respects
to provide increased certainty, and that
examples be provided of the types of
transactions that are considered abusive.
In addition, comments requested various
specific exclusions from the anti-abuse
rule. The Treasury Department and the
IRS decline to provide new limitations on
the anti-abuse rule. While it is intended
that the anti-abuse rule will be applicable
in cases of avoidance transactions, as op-
posed to routine transactions that happen
to achieve a particular result, the anti-
abuse rule must retain the flexibility to
address transactions that circumvent the
purposes of the final and temporary regu-
lations in ways that were unexpected
when the regulations were issued.

The proposed regulations contained a
non-exhaustive list of the types of trans-
actions that could implicate the anti-abuse
rule, and the preamble to the proposed
regulations described other transactions
that could be relevant. The final and tem-
porary regulations include the same trans-
actions listed in the proposed regulations
that could implicate the anti-abuse rule
and add additional transactions with
which the Treasury Department and the
IRS are concerned. The final and tempo-
rary regulations also reorganize the anti-
abuse rule to clarify that the principal pur-
pose element is relevant both to issuances
of a debt instrument as well as other trans-
actions (including distributions or acqui-

sitions); examples of both are provided.
The examples listed in § 1.385-3(b)(4)(i)
and (ii) are illustrative and do not consti-
tute a mutually exclusive list of the types
of transactions that could implicate the
anti-abuse rule.

## b. Requested clarifications to and exclusions from the anti-abuse rule

## i. Debt between unrelated parties

Comments specifically requested clari-
fication that the anti-abuse rule would not
apply to bona fide debt between unrelated
parties (provided that neither party is act-
ing as a conduit or agent for a related
party) while the loan is held by the unre-
lated party. In addition, comments re-
quested clarification that guaranteed loans
are not subject to the anti-abuse rule. In
particular, one comment suggested that
the proposed regulations could apply to a
decision by a subsidiary to borrow di-
rectly from an unrelated bank with a par-
ent guarantee rather than cause the parent
to borrow from the unrelated bank and
on-lend to the subsidiary. The final and
temporary regulations do not adopt these
recommendations. The Treasury Depart-
ment and the IRS have determined that, in
light of the revision to apply § 1.385-
3(b)(4) only when a principal purpose of a
transaction is to avoid the "purposes" of
the regulations (rather than avoiding the
"application" of the regulations), it would
not be appropriate to provide a complete
exception for loans with unrelated parties
or related-party guarantees. There already
is sufficient clarity under the regulations
that, absent other facts and circumstances,
borrowing funds from an unrelated lender
including with a related-party guarantee
would not avoid the purposes of § 1.385-3
or § 1.385-3T, which are intended to ap-
ply in the particular factual circumstance
of loans between highly-related corpora-
tions.

In addition, the Treasury Department
and the IRS remain concerned about
transactions with non-expanded group
members that are structured to avoid the
purposes of § 1.385-3 or § 1.385-3T,
such as a transaction where the lender is a
not a member of the expanded group, but
only on a temporary basis. As in the pro-
posed regulations, § 1.385-3(b)(4) in-

cludes two examples of this situation. In
one example, a covered debt instrument is
issued to, and later acquired from, a per-
son that is not a member of the issuer's
expanded group with a principal purpose
of avoiding the purposes of § 1.385-3. In
the second example, with a principal pur-
pose of avoiding the purposes of
§ 1.385-3, a covered debt instrument is
issued to a person that is not a member of
the issuer's expanded group, and such per-
son later becomes a member of the issu-
er's expanded group.

## ii. Transactions that meet existing exceptions

Comments requested that the anti-
abuse rule not apply to a transaction that
satisfies a specific exception to either the
general rule or funding rule. For example,
the comments questioned the application
of the anti-abuse rule when a taxpayer
issues multiple debt instruments in multi-
ple years, each debt instrument would, but
for the E&P exception, be treated as stock,
and some of the debt instruments would
not have benefitted from the E&P excep-
tion if they had been issued during the first
year. The comments asserted that none of
the debt instruments in that example
should be treated as stock under the anti-
abuse rule (for example, by being treated
as being issued all at once in the first year
of the period). The Treasury Department
and the IRS agree that in that example, the
anti-abuse rule generally would not be
implicated, because no purpose of the reg-
ulations has been avoided. As discussed in
Section I.1.a of this Part V, the final and
temporary regulations provide that the
anti-abuse rule applies to transactions
with a principal purpose of avoiding the
"purposes" of §§ 1.385-3 or 1.385-3T,
rather than applying to transactions with a
principal purpose of avoiding the "appli-
cation" of §§ 1.385-3 or 1.385-3T.

However, the Treasury Department
and the IRS decline to provide that the
anti-abuse rule cannot apply to transac-
tions that meet a specific exception to
either the general rule or funding rule. The
Treasury Department and the IRS remain
concerned about structured transactions
that satisfy the technical requirements for
exceptions or exclusions but avoid the
purposes of the final and temporary regu-

lations. Those structured transactions may
technically qualify for a specific excep-
tion, but would nonetheless be subject to
the anti-abuse rule. Accordingly, the Trea-
sury Department and the IRS decline to
adopt the specific recommendation.

Because the final and temporary regu-
lations significantly expand the exceptions
and reductions in § 1.385-3(c) that are
discussed in Section E of this Part V, and
because of other changes addressed in
§ 1.385-4T that are discussed in Part VI
of this Summary of Comments and Expla-
nation of Revisions, the final and temporary
regulations also clarify that the anti-abuse
rule explicitly addresses distributions or ac-
quisitions that occur with a principal pur-
pose of avoiding the purposes of § 1.385-3
or § 1.385-3T, as well as other transactions
that are undertaken with a principal purpose
of avoiding the purposes of § 1.385-3 or
§ 1.385-3T.

## iii. Interests that are not debt instruments

Comments requested additional guid-
ance concerning the application of the
anti-abuse rule to interests that are not
debt instruments, with specific requests
for clarity concerning preferred partner-
ship interests. As discussed in Section F.2
of this Part V, the Treasury Department
and the IRS decline to adopt a recommen-
dation to limit the funding rule to instru-
ments that are, in form, debt instruments
and also decline to adopt a recommenda-
tion to exclude from the funding rule a
deemed loan arising from a nonperiodic
payment with respect to a notional princi-
pal contract. The Treasury Department
and the IRS similarly decline to narrow
the application of the anti-abuse rule in
these contexts.

The Treasury Department and the IRS
continue to study whether it is appropriate
to subject preferred equity in a controlled
partnership to the rules that would apply
to a debt instrument issued by a controlled
partnership. As described in the preamble
to the proposed regulations, the IRS in-
tends to closely scrutinize, and may chal-
lenge under the anti-abuse rule, transac-
tions in which a controlled partnership
issues preferred equity to an expanded
group member and the rules of § 1.385-
3T(f) would have applied had the pre-

ferred equity been denominated as a debt
instrument issued by the partnership.

## 2. Affirmative Use

The proposed regulations provided that
the rules of proposed §§ 1.385-3 and
§ 1.385-4 do not apply to the extent a
person enters into a transaction that oth-
erwise would be subject to proposed
§ 1.385-3 with a principal purpose of
reducing the federal tax liability of any
member of the expanded group that in-
cludes the issuer and the holder of the debt
instrument by disregarding the treatment
of the debt instrument that would occur
without regard to § 1.385-3.

Comments suggested eliminating the
prohibition on affirmative use as contra-
dictory to the objective factor-based anal-
ysis of the proposed regulations and
creating unnecessary uncertainty for tax-
payers that could lead to controversy with
tax authorities. Comments expressed con-
cern that determining whether a transac-
tion was entered into with a principal pur-
pose of reducing U.S. tax presented
additional administrative difficulties, par-
ticularly if the expected tax benefits are
realized at a future date, accrue to a re-
lated taxpayer, or are subject to a material
contingency. Furthermore, a taxpayer
could often issue preferred stock (or an-
other form of equity) in instances where
such treatment is preferable rather than
relying on recharacterization. One com-
ment asked how the rule concerning affir-
mative use should interact with common
law and for clarification as to what is
meant by a reduction in U.S. federal in-
come tax liability.

In response to comments, including
comments about the no affirmative use
rule creating unnecessary uncertainty, the
Treasury Department and the IRS reserve
on the application of the no affirmative
use rule in § 1.385-3 pending continued
study after the applicability date.

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

### A. Treatment of consolidated groups as one corporation

To prevent application of the proposed
regulations under section 385 to interests

between members of a consolidated
group, proposed § 1.385-1(e) provided
that a consolidated group (as defined in
§ 1.1502-1(h)) is treated as one corpora-
tion (the one-corporation rule). Several
comments were received requesting ex-
pansions, clarifications, or modifications
of this rule, as described in this Part VI.

### 1. Expansion of the One-Corporation Rule

Several comments suggested that all
domestic corporations under some degree
of common control should be treated as
one corporation under the regulations. For
example, comments suggested that a
group of domestic entities meeting the
ownership requirements of section 1504
(a)(2) connected through common owner-
ship by a domestic corporation (treating a
controlled partnership as an aggregate of
its partners or as a corporation for this
purpose) should be treated as one corpo-
ration. Other comments suggested that all
members of a "super affiliated group," as
defined in proposed § 1.163(j)-5(a)(3),
should be treated as one corporation. Oth-
ers suggested that multiple consolidated
groups that are commonly controlled
should be treated as one corporation, with-
out specifying the necessary degree of
common control.

Comments also suggested that certain
entities that would not be treated as mem-
bers of a consolidated group should be
treated as consolidated group members for
purposes of the one-corporation rule. For
example, comments suggested that the
one-corporation rule should apply to affil-
iated groups determined without regard to
section 1504(b)(2) and (c) (preventing
certain life insurance companies from
joining an affiliated group) or section
1504(b)(6) (preventing RICs and REITs
from joining an affiliated group).

As discussed in Part V.A.2 of this
Summary of Comments and Explanation
of Revisions, the proposed regulations did
not apply to indebtedness issued by a cor-
poration to members of its consolidated
group while the indebtedness was held in
such group because the policy concerns
addressed in the proposed regulations
generally are not present when the issuer's
deduction for interest expense and the
holder's corresponding inclusion of inter-

est income offset on the group's consoli-
dated federal income tax return. For the
reasons described in Part V.A.2 of this
this Summary of Comments and Explana-
tion of Revisions, the Treasury Depart-
ment and the IRS continue to view the
filing of a single federal income tax return
as the appropriate basis for excluding
transactions among consolidated group
members, and decline to extend the treat-
ment afforded to consolidated groups to
expanded group members that file sepa-
rate federal income tax returns. In addi-
tion, modifications made in the final and
temporary regulations significantly re-
duce, and in certain cases eliminate, the
application of the regulations to life insur-
ance companies and non-controlled RICs
and REITs.

## 2. Clarification of the One-Corporation Rule

## a. Scope

Comments generally supported the
principle-based one-corporation rule of
the proposed regulations while recom-
mending certain specific clarifications and
exceptions, each of which is described in
this preamble. One comment requested
guidance regarding the interaction of the
one-corporation rule with other provisions
of the Code, recommending that the reg-
ulations provide an order of operations as
follows: First, apply the provisions of the
Code and the regulations thereunder,
treating the members of a consolidated
group as separate entities for purposes of
applying the rules; second, apply the sec-
tion 385 regulations to the transaction as it
is characterized under other provisions of
the Code and the regulations thereunder,
giving effect to the one-corporation rule.
For example, assume that FP owns USP1
and USP2, each of which is the common
parent of a different consolidated group.
USP1, which owns USS1 and several
other subsidiaries, sells USS1 to USP2 for
a note. The comment recommended that
USP1 be treated as transferring USS1
stock, but noted that the transaction could
instead be treated as the sale of a branch
comprised of USS1's assets and liabilities
under the one-corporation rule.

The temporary regulations adopt this
recommendation. Under the order of op-

erations rule of § 1.385-4T(b)(5), a trans-
action involving one or more members of
a consolidated group is first characterized
under federal tax law without regard to the
one-corporation rule, and then §§ 1.385-3
and 1.385-4T apply to the transaction as
characterized to determine whether the
debt instrument is treated as stock, treat-
ing the consolidated group as one corpo-
ration, unless otherwise provided. Apply-
ing this rule to the example above, USP2's
acquisition of USS1 is respected as an
acquisition of the stock of USS1 in ex-
change for a note of USP2. Therefore,
absent an exception, the note issued by
USP2 is treated as stock under § 1.385-
3(b).

Another comment stated that the scope
of the one-corporation rule is unclear, and
recommended that certain items be clearly
included or excluded from the one-
corporation rule and that a principle-based
rule be used to address the items not ex-
pressly included or excluded. For exam-
ple, the comment noted that, for purposes
of determining the treatment of an interest
that ceases to be a consolidated group debt
instrument, proposed § 1.385-4(b)(1)(ii)
(B) respected the existence of the consol-
idated group debt instrument solely for
purposes of determining the per se period
under proposed § 1.385-3(b)(3)(iv)(B).
As discussed in more detail in Section B.2
of this Part VI, the temporary regulations
address the concern raised in this com-
ment by providing that when a departing
member ceases to be a member of a con-
solidated group, but remains a member of
the expanded group, the departing mem-
ber's history of transactions with other
consolidated group members remains dis-
regarded. For this purpose, a departing
member is a member of an expanded
group that ceases to be a member of its
original consolidated group but continues
to be a member of the same expanded
group.

## b. Wholly-owned partnerships

Comments requested clarification of
the treatment of loans between a consoli-
dated group member and a partnership
that is wholly owned by members of the
consolidated group. Specifically, com-
ments requested clarification that any such
loan would be treated as a loan from one

consolidated group member to another
consolidated group member, which gener-
ally would be treated as a debt instrument
issued and held by members of the same
consolidated group (a consolidated group
debt instrument), so that the loan would
not be subject to proposed §§ 1.385-3 and
1.385-4. By contrast, other comments
recommended that the regulations not ap-
ply to such a debt instrument because the
one-corporation rule suggests that a part-
nership wholly owned by members of a
consolidated group should be disregarded
as a separate entity for purposes of pro-
posed §§ 1.385-3 and 1.385-4.

The temporary regulations clarify that
a partnership all of the partners of which
are members of the same consolidated
group is treated as a partnership for pur-
poses of §§ 1.385-3, 1.385-3T, and
1.385-4T. However, § 1.385-3T treats a
partner in a controlled partnership as issu-
ing its share of a debt instrument issued by
the controlled partnership and holding its
share of a debt instrument held by the
controlled partnership. Accordingly, un-
der the one-corporation rule, a covered
debt instrument between a consolidated
group member and a controlled partner-
ship that is wholly owned by members of
the consolidated group is treated as a con-
solidated group debt instrument.

## c. Identity of issuer

Comments recommended that the reg-
ulations provide that a debt instrument
issued by a member of a consolidated
group, if characterized as stock under the
regulations, is stock in the particular
member that issued the debt instrument.
Comments noted that this result was dem-
onstrated by examples in the proposed
regulations, but requested that an opera-
tive rule in the regulations confirm the
outcome demonstrated by the examples.
Other comments questioned whether this
was the appropriate outcome, and indi-
cated that in certain cases, the common
parent of a consolidated group should be
treated as the issuer when a debt instru-
ment issued by another member of its
consolidated group is treated as stock un-
der the regulations. However, one com-
ment noted that treating a debt instrument
issued by one member as having been
issued by another member (such as the

common parent) may be inappropriate in
certain cases, including when the issuer of
the instrument has a minority shareholder
that is not a member of the consolidated
group.

In response to these comments, the
temporary regulations provide that a debt
instrument issued by a member of a con-
solidated group, if treated as stock under
the regulations, is treated as stock in the
particular member that is treated as the
issuer of the debt instrument under gen-
eral tax principles.

## d. Interaction with the funding rule

One comment requested confirmation
that an effect of the one-corporation rule
is that, under the funding rule, a debt
instrument issued by one member of a
consolidated group to a member of its
expanded group that is not a member of
the same consolidated group could be
treated as funding a transaction described
in proposed § 1.385-3(b)(3) undertaken
by a different member of the same con-
solidated group, such that the debt instru-
ment would be treated as stock. The tem-
porary regulations confirm this result in
§ 1.385-4T(b)(1).

Another comment recommended an
exception from the one-corporation rule
which would reverse this outcome when
the issuer of the debt instrument can dem-
onstrate that the proceeds obtained in con-
nection with the issuance of the debt in-
strument can be shown to have not
directly funded the other consolidated
group member's transaction. The tempo-
rary regulations do not adopt this recom-
mendation, which is essentially a tracing
approach, for the reasons described in
Section V.D.2 of this Summary of Com-
ments and Explanation of Revisions.

Multiple comments were received re-
garding the application of the funding rule
when a corporation joins a consolidated
group. One comment stated that when an
expanded group member engages in a
transaction described in proposed § 1.385-
3(b)(3)(ii) and subsequently joins a con-
solidated group (while remaining a mem-
ber of the same expanded group), it is
appropriate to treat the consolidated group
as having engaged in the transaction. For
example, assume that FP, USS1, and
USS2 are members of the same expanded

group, and that USS1 is the common par-
ent of a consolidated group that, in Year 1,
does not include USS2. If USS2 makes a
distribution to FP in Year 1, and joins
USS1's consolidated group in Year 2, the
USS1 consolidated group would be
treated as having made USS2's Year 1
distribution. The temporary regulations
adopt this recommendation by providing
that, when a member of an expanded
group becomes a member of a consoli-
dated group and continues to be a member
of the same expanded group (a joining
member), the joining member and the
consolidated group that it joins are a pre-
decessor and successor (respectively) for
purposes of § 1.385-3(b)(3).

## e. Interaction with the reduction for expanded group earnings

Comments recommended that the reg-
ulations clarify how to apply the current
year earnings and profits exception for a
consolidated group treated as one corpo-
ration. Generally, comments questioned
whether the one corporation's current year
earnings and profits is based on § 1.1502-
33, or whether it should instead be recal-
culated as though each member of the
consolidated group other than the com-
mon parent were a branch. For example,
under the latter approach, current year
earnings and profits would not include
worthless stock loss deductions with re-
spect to stock of a consolidated group
member, and certain stock acquisitions
would be treated as asset acquisitions,
which could produce a step-up or step-
down in the basis of depreciable or amor-
tizable assets.

As discussed in Section V.E.3.a of this
Summary of Comments and Explanation
of Revisions, the earnings and profits ex-
ception has been modified in the final and
temporary regulations. With respect to the
expanded group earnings account, the
temporary regulations provide that a con-
solidated group has one account and only
the earnings and profits, determined in
accordance with § 1.1502-33 (without re-
gard to the application of § 1.1502-
33(b)(2), (e), and (f)), of the common
parent (within the meaning of section
1504) of the consolidated group are con-
sidered in calculating the expanded group
earnings for the expanded group period of

a consolidated group. The Treasury De-
partment and the IRS have determined
that a methodology based on modified
§ 1.1502-33 principles is the simplest to
administer and most accurately reflects
the treatment of all members of a consol-
idated group as one corporation for pur-
poses of the final and temporary regula-
tions.

The temporary regulations provide
rules for determining when, and to what
extent, a consolidated group (treated as
one corporation) or a departing member
succeeds to all or some of the expanded
group earnings account of a joining mem-
ber or a consolidated group, respectively.
In this regard, a consolidated group suc-
ceeds to the expanded group earnings ac-
count of a joining member. In addition, if
a departing member (including departing
members that immediately after leaving a
consolidated group themselves comprise
another consolidated group treated as one
corporation) leaves a consolidated group
in a distribution under section 355, the
expanded group earnings account of the
consolidated group is allocated between
the consolidated group and the departing
member in proportion to the earnings and
profits of the consolidated group and the
earnings and profits of the departing mem-
ber immediately after the transaction.
However, no amount of the expanded
group earnings account of a consolidated
group is allocated to a departing member
that leaves the consolidated group in a
transaction other than a distribution to
which section 355 applies. The temporary
regulations provide similar rules with re-
spect to the reduction for qualified contri-
butions, discussed in Section A.2.f of this
Part VI.

Comments also questioned whether the
issuer's earnings and profits or the consol-
idated group's earnings and profits should
be used when an issuer makes a distribu-
tion to a minority shareholder that is not a
member of the consolidated group but is a
member of the expanded group. Providing
each member of a consolidated group ac-
cess to the consolidated group's earnings
account with respect to a distribution or
acquisition made by such member to or
from another member of the expanded
group is consistent with the premise of
treating all members of a consolidated
group as one corporation. Accordingly,

the temporary regulations provide that a
distribution or acquisition that a member
of a consolidated group makes to or from
another member of the same expanded
group that is not a member of the same
consolidated group is reduced to the ex-
tent of the expanded group earnings ac-
count of the consolidated group.

f. Interaction with reduction for qualified
contributions

As discussed in Part V.E.3.b of this
Summary of Comments and Explanation
of Revisions, the final and temporary reg-
ulations provide that an expanded group
member's distributions and acquisitions
are reduced by qualified contributions for
purposes of applying the general rule and
funding rule. The temporary regulations
provide that, for purposes of applying the
qualified contribution reduction to distri-
butions or acquisitions by a consolidated
group, qualified contributions to any
member that remains consolidated imme-
diately after the contribution are treated as
made to the consolidated group, a quali-
fied contribution that causes a deconsoli-
dation of a member is treated as made to
the departing member and not to the con-
solidated group, and no contribution of
property by a member of a consolidated
group to any other member of the consol-
idated group is treated as a qualified con-
tribution.

## g. Interaction with other specific provisions in § 1.385-3

The temporary regulations provide that
the determination of whether a debt in-
strument issued by a member of a consol-
idated group is a covered debt instrument
is made on a separate member basis with-
out regard to the one-corporation rule. The
Treasury Department and the IRS have
determined that separate-member treat-
ment is appropriate for making this deter-
mination because the exceptions to cov-
ered debt instrument status are tailored to
specific entity-level attributes of the is-
suer. For example, because status as an
excepted regulated financial company is
determined on an issuer-by-issuer basis,
the Treasury Department and the IRS
have determined that it would not be ap-
propriate to extend that special status to

other members of a consolidated group
that do not meet the specific requirements
for the exception.

Similarly, the determination of whether
a member of a consolidated group has
issued a qualified short-term debt instru-
ment for purposes of § 1.385-3(b)(3)(vii)
is made on a separate member basis. The
policy justifications for the specific tests
set forth in that exception, in particular
the specified current asset test, are more
suited to a separate member analysis. De-
spite the general use of a separate member
approach to applying the qualified short-
term debt instrument tests, § 1.385-
3(b)(4)(ii)(D) specifically references situ-
ations in which a member of an expanded
group enters into a transaction with a prin-
cipal purpose of avoiding the purposes of
§ 1.385-3 or § 1.385-3T, including as part
of a plan or a series of transactions
through the use of the consolidated group
rules set forth in § 1.385-4T. That rule
could apply, for example, to transactions
in which two different members of the
same consolidated group engage in "alter-
nating" loans from a lender that is not a
member of the consolidated group with a
principal purpose of avoiding the pur-
poses of the limitations in the 270-day test
in § 1.385-3(b)(3)(vii)(A)(2) by also en-
gaging in other intra-consolidated group
transactions that otherwise would be dis-
regarded under the one-corporation rule.

## 3. State and Local Tax Comments

Comments noted that the regulations
add complexity to state and local tax sys-
tems and may result in additional state tax
costs and compliance burdens for taxpay-
ers. In particular, a comment noted that, if
a state applies the one-corporation rule
based on the composition of the state fil-
ing group rather than the federal consoli-
dated group, transactions could be subject
to the regulations for state income tax
purposes even when the transactions are
not subject to the regulations for federal
income tax purposes. The comment sug-
gested that this concern could be miti-
gated in states that adhere to the literal
language of the section 385 regulations by
modifying proposed § 1.385-1(e) to pro-
vide that "all members of a consolidated
group (as defined in § 1.1502-1(h)) that
file (or that are required to file) consoli-

dated U.S. federal income tax returns are
treated as one corporation." The tempo-
rary regulations adopt this recommenda-
tion.

## 4. Newly-Acquired Life Insurance Subsidiaries

Several comments noted the one-
corporation rule in proposed § 1.385-1(e)
would not apply in cases where section
1504(c)(2) prohibits inclusion of newly-
acquired life insurance subsidiaries in a
consolidated group. These comments
asked that the regulations treat such
newly-acquired life insurance companies
as part of a consolidated group even when
section 1504(c)(2) would not.

The one-corporation rule is intended
only to treat members of a consolidated
group that file a single federal income tax
return as a single taxpayer because items
of income and expense with respect to
debt instruments between such members
are included and offset each other on the
consolidated group's single federal in-
come tax return. To the extent that section
1504(c)(2) prohibits recently-acquired life
insurance companies from joining a con-
solidated group, the items of income and
expense of the companies and the consol-
idated group are not included in a single
federal income tax return. In this context,
a consolidated group and its recently-
acquired life insurance subsidiaries are
not materially different from two separate
consolidated groups are part of the same
expanded group. Transactions between
two separate consolidated groups that are
part of the same expanded group are sub-
ject to §§ 1.385-3 and 1.385-4T. As a
result, the Treasury Department and the
IRS decline to include a special rule re-
lated to section 1504(c)(2) in the tempo-
rary regulations. However, as discussed in
Part V.G.2 of this Summary of Comments
and Explanation of Revisions, the final
and temporary regulations exclude debt
instruments issued by regulated insurance
companies.

B. Debt instruments that cease to be
among consolidated group members and
remain among expanded group members

The proposed regulations provided two
rules governing the treatment of a consol-

idated group debt instrument that ceased
to be a consolidated group debt instru-
ment, but continued to be issued and held
by members of the same expanded group.
One set of rules (the departing instrument
rules) addressed situations in which a
member of a consolidated group transfers
a consolidated group debt instrument to an
expanded group member that is not a
member of the consolidated group. The
other set of rules (the departing member
rules) addressed debt held or issued by a
consolidated group member that leaves
a consolidated group but continues to be a
member of the expanded group (such cor-
poration, a departing member). Several
comments were received regarding the
operation of these rules.

### 1. Departing Instrument Rules

Under the departing instrument rules,
when a member of a consolidated group
that held a consolidated group debt instru-
ment transferred the consolidated group
debt instrument to an expanded group
member that was not a member of the
consolidated group, the debt instrument
was treated as issued by the issuer of the
debt instrument (which is treated as one
corporation with the transferor of the debt
instrument) to the transferee expanded
group member on the date of the transfer.
For purposes of proposed § 1.385-3, the
consequences of the transfer were deter-
mined in a manner that was consistent
with treating a consolidated group as one
corporation. To the extent the debt instru-
ment was treated as stock upon being
transferred, the debt instrument was
deemed to be exchanged for stock imme-
diately after the debt instrument was
transferred outside of the consolidated
group.

Comments recommended that when a
consolidated group member distributes a
debt instrument issued by another member
of its consolidated group to a nonconsoli-
dated expanded group member in a distri-
bution, the distribution should not be tax-
able as an exchange, but should instead be
taxable in the same manner as a distribu-
tion by a consolidated group member of
its own debt instrument to a nonconsoli-
dated member of its expanded group,
which would generally be treated as a
distribution subject to section 305. The

temporary regulations do not adopt this
comment because the comment implicitly
suggests that the regulations apply the
one-corporation rule for all federal tax
purposes, rather than as a rule for applying
§§ 1.385-3, 1.385-3T, and 1.385-4T in
the consolidated return context.

### 2. Departing Member Rules

#### a. Harmonization with the departing instrument rule

Comments recommended harmonizing
the departing member rules with the de-
parting instrument rules. For example, one
comment recommended that, when a de-
parting member of a consolidated group is
the holder or the issuer of a debt instru-
ment issued or held by another member of
the consolidated group, and the departing
member remains in the same expanded
group after leaving the consolidated
group, then the debt instrument generally
should be treated for purposes of
§ 1.385-3 as being reissued immediately
following the member's departure from
the consolidated group (consistent with
the departing instrument rule). This would
have the effect of harmonizing the depart-
ing member rules with the departing in-
strument rules because the departing in-
strument rules provide that when a
member of a consolidated group that held
a consolidated group debt instrument
transfers the instrument to an expanded
group member that is not a member of the
consolidated group, the instrument is
treated as newly issued by the issuer to the
transferee. The comment suggested that, if
the debt instrument was issued by or to the
departing member of the consolidated
group as part of a plan that included the
member's departure from the consolidated
group, then the debt should be recast as
stock when the member departs from the
consolidated group if it would have pre-
viously been recast as stock absent the
one-corporation rule. However, the com-
ment also suggested that absent a plan that
included the member's departure from the
consolidated group and the issuance of the
debt instrument, the debt instrument
should be treated as reissued immediately
after the member's departure from the
consolidated group. As discussed in more
detail in Section B.2.b of this Part VI, the

temporary regulations generally adopt this
approach by eliminating the classification
of a departing member's debt instruments
that were previously consolidated group
debt instruments as either exempt consol-
idated group debt instruments or non-
exempt consolidated group debt instru-
ments after departure. Instead, the
temporary regulations treat those debt in-
struments as reissued, and thus generally
do not require separate tracking of intra-
consolidated group transactions, unless
the anti-abuse rule in § 1.385-3(b)(4) ap-
plies.

Another comment noted that, if the de-
parting member rule and the departing
instrument rule are not harmonized, there
could be situations in which both rules
appear to apply. For example, a consol-
idated group member that holds a con-
solidated group debt instrument and un-
dergoes an outbound reorganization
described in section 368(a)(1)(F) may
be viewed as both transferring the con-
solidated group debt instrument and
ceasing to be a member of the consoli-
dated group. The temporary regulations
add an overlap rule to provide that, if
both the departing member rules and the
departing instrument rules could apply
to the same transaction, the departing
instrument rules, rather than the depart-
ing member rules, apply.

## b. Operation of departing member rules

The proposed regulations generally
provided that any consolidated group debt
instrument that is issued or held by the
departing member and that was not treated
as stock solely by reason of the one-
corporation rule (an exempt consolidated
group debt instrument, under the nomen-
clature of the proposed regulations) was
deemed to be exchanged for stock imme-
diately after the departing member leaves
the consolidated group. The proposed reg-
ulations also generally provided that any
consolidated group debt instrument issued
or held by a departing member that is not
an exempt consolidated group debt instru-
ment (a non-exempt consolidated group
debt instrument, under the nomenclature
of the proposed regulations) continued to
be treated as indebtedness after the depar-
ture, unless and until the non-exempt con-
solidated group debt instrument was

treated as stock under the funding rule as
a result of a later distribution or acquisi-
tion. However, the proposed regulations
also provided that, solely for purposes of
applying the per se rule, the debt instru-
ment was treated as having been issued
when it was first treated as a consolidated
group debt instrument, and not when the
departing member departed from the con-
solidated group.

Several comments addressed the oper-
ation of the departing member rules. Com-
ments requested clarification as to how the
current year earnings and profits excep-
tion described in proposed § 1.385-
3(c)(1) applied for purposes of determin-
ing whether a consolidated group debt
instrument is an exempt consolidated
group debt instrument or a non-exempt
consolidated group debt instrument. Spe-
cifically, the comments noted that, in or-
der to analyze whether a consolidated
group debt instrument would or would not
have been recharacterized under proposed
§ 1.385-3(b)(3) but for the one-corpora-
tion rule, the issuer would need to analyze
the availability of the various exceptions
in proposed § 1.385-3(c), including the
current year earnings and profits excep-
tion in the proposed regulations. For pur-
poses of applying the earnings and profits
exception, comments questioned whether
the determination should be made by ref-
erence to the specific issuer's earnings and
profits (without regard to the one-
corporation rule) or whether some other
measure, such as the issuer's earnings and
profits plus the earnings and profits of
lower-tier group members should be used.
Further, one comment questioned whether
adjustments to an issuer's earnings and
profits should be made based on adjust-
ments to the earnings and profits of lower-
tier consolidated group members if all ex-
empt consolidated group debt instruments
were treated as stock rather than debt.

Comments also suggested that the spe-
cial timing rule for non-exempt consoli-
dated group debt instruments be elimi-
nated. Specifically, comments noted that,
because the proposed rule for non-exempt
consolidated group debt instruments did
not turn off the deemed satisfaction and
reissuance rules of § 1.1502-13(g), the
deemed reissuance rule in § 1.1502-13(g)
could conflict with the special timing rule,
and, as a result, start a new time period for

the per se rule. See proposed § 1.385-
4(d)(3), Example 4. Comments recom-
mended that the example be revised to
take the deemed satisfaction and reissu-
ance rules into account, and by implica-
tion, eliminate the special timing rule for
non-exempt consolidated group debt in-
struments. Other comments questioned
whether the interaction of the special tim-
ing rule for non-exempt consolidated
group debt instruments and the ordering
rule in proposed § 1.385-3(b)(3)(iv)
(B)(3) (multiple interests) could lead to
inappropriate results.

Other comments more directly recom-
mended that the regulations disregard any
history of transactions that occurred solely
between consolidated group members be-
fore a departure. This approach would
also render moot the concept of a non-
exempt consolidated group debt instru-
ment and an exempt consolidated group
debt instrument. One comment noted that
requiring tracking of consolidated group
history is contrary to the notion of ex-
cluding debt instruments issued by
members of a consolidated group from
the scope of proposed § 1.385-3, be-
cause the consolidated group would still
have to monitor and analyze the history
of intra-consolidated group transactions
in the event there was a departing mem-
ber.

Along similar lines, other comments
recommended that the regulations provide
that unfunded distribution and acquisition
transactions that occurred solely within a
consolidated group be disregarded for all
purposes of proposed §§ 1.385-3 and
1.385-4, so that the history of such intra-
consolidated group distribution and acqui-
sition transactions would not follow a
member that leaves the consolidated
group. For example, assume that in Year
1, DS1 makes a $100x distribution to
USS1, the common parent of a consoli-
dated group of which DS1 is a member. In
Year 2, DS1 ceases to be a member of the
USS1 consolidated group, but remains a
member of the same expanded group as
USS1. Immediately afterwards, DS1 bor-
rows $100x from a member of the ex-
panded group that is not a member of the
USS1 consolidated group. The comments
recommended that, for purposes of apply-
ing the funding rule in this context, DS1's

distribution to USS1 in Year 1 should be
disregarded.

Comments also requested clarification
of the application of the funding rule to a
departing member in situations in which
one member of a consolidated group
makes a distribution or acquisition to or
from another member of the same ex-
panded group that is not a member of the
same consolidated group (a regarded dis-
tribution or acquisition), and subse-
quently, another member of the consoli-
dated group departs the consolidated
group but remains a member of the ex-
panded group. One comment indicated
that the departing member should not be
treated as having made the regarded dis-
tribution or acquisition for purposes of the
funding rule, and by implication, the con-
solidated group should continue to be
treated as having made the regarded dis-
tribution or acquisition for purposes of the
funding rule. Other comments indicated
that, in order to prevent duplication, the
departing member should be allocated a
portion of each regarded distribution or
acquisition for purposes of the funding
rule.

Another comment sought clarification
when a member of a consolidated group is
funded through a borrowing from an ex-
panded group member that is not a mem-
ber of the same consolidated group, and
therefore the entire consolidated group is
treated as a funded member for purposes
of proposed § 1.385-3(b)(3), and a differ-
ent member of the consolidated group
subsequently leaves the consolidated
group. The comment specifically asked
whether that departing member is still
treated as a funded member after depar-
ture.

The temporary regulations generally
adopt the recommendations described
above. Specifically, the temporary regula-
tions provide that if a consolidated group
debt instrument ceases to be treated as
such because the issuer and holder are no
longer members of the same consolidated
group but remain members of the same
expanded group, then the issuer is treated
as issuing a new debt instrument to the
holder in exchange for property immedi-
ately after the debt instrument ceases to be
a consolidated group debt instrument. Ab-
sent application of the anti-abuse rule in
§ 1.385-3(b)(4), the departing member's

history of prior transactions with other
consolidated group members, which were
disregarded under the one-corporation
rule for purposes of applying § 1.385-
3(b)(3), remain disregarded when the de-
parting member ceases to be a member of
the consolidated group. By giving greater
effect to the one-corporation rule, the tem-
porary regulations reduce the need to
monitor transactions solely among consol-
idated group members and make the ad-
ditional exceptions set forth in § 1.385-
3(c) more administrable, particularly the
exceptions for expanded group earnings
and qualified contributions.

The temporary regulations also clarify
the designation of funded status when a
member leaves a consolidated group but
remains in the expanded group. When a
consolidated group member is funded
through a borrowing from an expanded
group member that is not a member of the
same consolidated group, and that consol-
idated group member later departs the
consolidated group, the departing member
continues to be treated as funded by the
borrowing, and the consolidated group
from which the departing member departs
ceases to be treated as funded by the bor-
rowing. If instead a non-departing mem-
ber had been funded by the borrowing, the
temporary regulations provide that the
consolidated group from which the de-
parting member departs continues to be
treated as funded by the borrowing, and
the departing member ceases to be treated
as funded by the borrowing when it leaves
the consolidated group.

Similarly, the temporary regulations
also clarify the treatment of consolidated
groups in situations when a departing
member has made a regarded distribution
or acquisition that has not yet caused a
recharacterization of a debt instrument un-
der the general rule or funding rule. The
temporary regulations provide that, in
such a situation, if the departing member
departs the consolidated group in a trans-
action other than a section 355 distribu-
tion, the departing member continues to
be treated as having made the regarded
distribution or acquisition, and the consol-
idated group from which the departing
member departs ceases to be treated as
having made the regarded distribution or
acquisition.

For purposes of applying the funding
rule when a departing member ceases to
be a member of a consolidated group by
reason of a section 355 distribution, the
temporary regulations clarify that a de-
parting member is a successor to the con-
solidated group and the consolidated
group is a predecessor to the departing
member. Specifically, based on the order
of operations rule of § 1.385-4T(b)(5),
the temporary regulations provide that the
determination as to whether an expanded
group member that is not a member of a
consolidated group is a predecessor or
successor of another expanded group
member that is a member of a consoli-
dated group is made without regard to the
one-corporation rule. Similarly, the deter-
mination as to whether a an expanded
group member that also is a member of a
consolidated group is a predecessor or
successor to another expanded group
member that is not a member the consol-
idated group is made without regard to the
one-corporation rule. The temporary reg-
ulations further provide that, for purposes
of the funding rule, if a consolidated
group member is a predecessor or succes-
sor of a member of the expanded group
that is not a member of the same consol-
idated group, the consolidated group is
treated as a predecessor or successor of
the expanded group member (or the con-
solidated group of which that expanded
group member is a member). Thus, a de-
parting member that is a successor to a
member of the consolidated group of
which it ceases to be a member is treated
as a successor to the consolidated group,
and the consolidated group is treated as a
predecessor to the departing member. Ac-
cordingly, any regarded distribution or ac-
quisition by the consolidated group before
the departing member ceases to a be a
member of the consolidated group may be
treated as made by either the departing
member or the consolidated group, de-
pending on the application of the multiple
interest rule of § 1.385-3(b)(3)(B).

In connection with these and other
changes in § 1.385-4T, the final and tem-
porary regulations add to the anti-abuse
rule in § 1.385-3(b)(4) a specific refer-
ence to § 1.385-4T, as well as specific
examples where an expanded group mem-
ber engages in a transaction with a prin-
cipal purpose of avoiding the purposes of

§ 1.385-3, 1.385-3T, or 1.385-4T
through the use of a departing member.
The anti-abuse rule may apply, for exam-
ple, if a covered debt instrument is issued
by a member of a consolidated group
(USP) to an expanded group member, and
pursuant to a plan with a principal purpose
of avoiding the purposes of § 1.385-3,
1.385-3T, or 1.385-4T, the following
transactions occur: (i) the proceeds of the
borrowing are contributed by USP to its
subsidiary (US1), also a member of the
same consolidated group, (ii) US1 decon-
solidates by USP transferring all of its
US1 stock to another expanded group
member that is not a member of the same
consolidated group, and (iii) US1 makes a
distribution to its shareholder.

Finally, the temporary regulations clar-
ify that if an interest in a consolidated
group member has previously been char-
acterized as stock under § 1.385-3, that
interest continues to be treated as stock in
the member after the member departs the
consolidated group but remains in the ex-
panded group.

## c. Subgroups leaving the consolidated group

Comments questioned whether the de-
parting member rule should apply when
an issuer and holder simultaneously de-
part the same consolidated group (the old
consolidated group) and then simultane-
ously join another consolidated group (the
new consolidated group), and both the old
and new consolidated groups are in the
same expanded group. Comments recom-
mended that, under these circumstances,
the concerns addressed in the proposed
regulations generally are not present be-
cause the issuer's deduction for interest
expense and the holder's corresponding
interest income continue to offset on the
new consolidated group's consolidated
federal income tax return. Accordingly,
comments recommended the provision of
a "subgroup exception" under which pro-
posed § 1.385-4(b)(1)(ii)(B) would not
apply where the issuer and holder together
depart one consolidated group and to-
gether join another consolidated group
within the same expanded group. In re-
sponse to these comments, the temporary
regulations adopt a subgroup rule when
both the issuer and the holder of a consol-

idated group debt instrument cease to be
members of a consolidated group, but the
issuer and the holder both become mem-
bers of another consolidated group that is
in the same expanded group immediately
after the transaction. When this exception
applies, the debt instrument between sub-
group members remains a consolidated
group debt instrument rather than a debt
instrument that is treated as issued under
§ 1.385-4T(c)(1)(ii) or deemed reissued
under § 1.385-4T(c)(1)(i).

## 3. Debt Instrument Entering a Consolidated Group

One comment noted that the deemed
exchange that occurred pursuant to pro-
posed § 1.385-4(c) could be treated as a
divided equivalent redemption described
in section 302(d). The comment recom-
mended that, to prevent some of the
ancillary consequences of such treat-
ment (for example, withholding tax lia-
bility), the deemed exchange should oc-
cur only after the debt instrument
becomes a consolidated group debt in-
strument. The Treasury Department and
the IRS generally adopt this recommen-
dation. The final and temporary regula-
tions provide that, if a covered debt in-
strument that is treated as stock under
§ 1.385-3 becomes a consolidated group
debt instrument, then immediately after
the covered debt instrument becomes a
consolidated group debt instrument, the
issuer is deemed to issue a new covered
debt instrument to the holder in ex-
change for the covered debt instrument
that was treated as stock. In addition, the
final and temporary regulations provide
that when the covered debt instrument
that previously was treated as stock be-
comes a consolidated group debt instru-
ment, the underlying distribution or ac-
quisition that caused the covered debt
instrument to be treated as stock is re-
tested against other covered debt instru-
ments issued by the consolidated group
following principles set forth in § 1.385-
3(d)(2)(ii)(A). For further discussion of
the re-testing principles in § 1.385-
3(d)(2)(ii)(A), see Part V.H.2 of this Sum-
mary of Comments and Explanation of
Revisions.

4\. Other Comments Regarding Proposed
§ 1.385-4

## a. Respecting deemed exchanges

Comments noted that § 1.1502-13(g)(3)
creates a deemed satisfaction and reissuance
of an obligation that ceases to be an inter-
company obligation, and does so immedi-
ately before such cessation, while § 1.1502-
13(g)(5) generally creates a deemed
satisfaction and reissuance of an obligation
that becomes an intercompany obligation,
and does so immediately after the obligation
enters the consolidated group. The consoli-
dated return regulations explicitly provide,
in each case, that the deemed satisfaction
and reissuance are treated as transactions
separate and apart from the transaction giv-
ing rise to the deemed satisfaction and reis-
suance. The comments noted that, absent
similar rules to address the deemed ex-
changes occurring under proposed § 1.385-
4 (including deemed exchanges occurring
when a debt instrument becomes or ceases
to be a consolidated group debt instrument,
as well as deemed exchanges occurring un-
der the transition rule described in proposed
§ 1.385-4(e)(3)), it is possible that those
exchanges could be viewed under general
tax principles as transitory and thus be dis-
regarded in certain cases. Comments recom-
mended that the regulations expressly pro-
vide that any deemed issuances,
satisfactions, or exchanges arising under
§ 1.1502-13(g) and proposed § 1.385-4(b)
or 1.385-4(e)(3) as part of the same trans-
action or series of transactions be respected
as steps that are separate and apart from one
another, similar to the rules currently artic-
ulated under §§ 1.1502-13(g)(3)(ii)(B) and
1.1502-13(g)(5)(ii)(B). The temporary reg-
ulations adopt this recommendation in
§ 1.385-4T(c)(3).

## b. Terminology

The preamble to the proposed regula-
tions described a debt instrument issued
by one member of a consolidated group to
another member of the same consolidated
group as a "consolidated group debt in-
strument." The same term was used in the
text of the proposed regulations, but the
term was not defined. One comment rec-
ommended that the regulations define the
term consolidated group debt instrument.

The temporary regulations adopt this rec-
ommendation.

Another comment recommended that
proposed § 1.385-4 should employ termi-
nology and concepts that are consistent
with those utilized throughout the consol-
idated return regulations. The comment
noted that, consistent with the one-
corporation rule, the examples in pro-
posed § 1.385-4 refer to a consolidated
group as the issuer of a debt instrument,
whereas the consolidated return regula-
tions would refer to a particular member
of the consolidated group as an issuer.
Consistent with the one corporation rule
in §§ 1.385-3 and 1.385-4T, the final and
temporary regulations continue to refer to
a consolidated group as the issuer of a
debt instrument.

## VII. Other Comments

### A. Coordination with § 1.368-2(m)(3)

One comment recommended that the
regulations clarify their interaction with
§ 1.368-2(m)(3)(iii), which provides that
a transaction may qualify as a reorganiza-
tion described in section 368(a)(1)(F) (an
F reorganization) even though a holder of
stock in the transferor corporation re-
ceives a distribution of money or other
property from either the transferor corpo-
ration or the resulting corporation (includ-
ing in exchange for shares of stock in the
transferor corporation). The regulations
provide that the receipt of such a distribu-
tion is treated as an unrelated, separate
transaction from the reorganization,
whether or not connected in a formal
sense. Thus, for example, assume that FP
owns USS1, USS1 forms USS2, USS1
merges into USS2, and FP receives USS2
stock and a USS2 debt instrument in ex-
change for its USS1 stock. Further assume
that the merger would be treated as an F
reorganization and that, under § 1.368-
2(m)(3)(iii), USS2's distribution of a debt
instrument would be treated as a separate
and independent transaction to which sec-
tion 301 applies.

The comment stated that the proposed
regulations' interaction with § 1.368-
2(m)(3)(iii) presented a circularity issue.
Specifically, the comment stated that a
distribution treated as a separate and in-
dependent transaction, such as USS2's

distribution of its debt instrument, would
result in the USS2 debt instrument being
treated as stock, such that § 1.368-
2(m)(3)(iii) would no longer apply. The
comment further stated that if § 1.368-
2(m)(3)(iii) did not apply, no separate and
independent distribution would be treated
as occurring, such that the general rule of
proposed § 1.385-3(b)(2)(i) would not ap-
ply. To address this, the comment recom-
mended that a coordinating rule be added
to clarify the application of the section
385 regulations to the issuance of a debt
instrument under this and similar circum-
stances.

The Treasury Department and the IRS
decline to adopt the recommendation, be-
cause it is not correct that this fact pattern
presents a circularity problem. Pursuant to
§ 1.368-2(m)(3)(ii) and (iii), if a distribu-
tion of money or other property occurs at
the same time as the transactions other-
wise qualifying as an F reorganization, the
distribution does not prevent the transac-
tions from so qualifying. Pursuant to
§ 1.368-2(m)(3)(iii), the distribution is
treated as a separate and unrelated trans-
action from the F reorganization and is
subject to section 301. Thus, the receipt
by FP of the USS2 debt instrument in the
merger would constitute a section 301 dis-
tribution of the instrument, which would
be treated as stock of USS2 under the
general rule.

### B. Proposed section 358 regulations

One comment noted that under pro-
posed § 1.358-2, a 100-percent share-
holder in a corporation may be treated as
holding multiple blocks of stock with dif-
ferent adjusted tax bases. The comment
noted that the proposed regulations, which
would treat purported indebtedness as
stock, would increase the number of in-
stances in which a shareholder has multi-
ple blocks of stock with different adjusted
tax bases. The Treasury Department and
the IRS decline to address comments re-
garding proposed regulations under sec-
tion 358, which are beyond the scope of
the final and temporary regulations. The
final and temporary regulations do, how-
ever, retain the proposed regulations' ap-
proach to treating an EGI or a debt instru-
ment as stock under certain circumstances.
On the date the indebtedness is recharac-

terized as stock, the indebtedness is
deemed to be exchanged, in whole or in
part, for stock with a value that is equal to
the holder's adjusted basis in the portion
of the indebtedness that is treated as eq-
uity under the regulations, and the issuer
of the indebtedness is deemed to retire the
same portion of the indebtedness for an
amount equal to its adjusted issue price as
of that date. Although this rule may result
in indebtedness that is treated as stock
having a different basis than other shares
of stock held by a shareholder, many com-
ments expressed support for this rule
given that it generally will prevent both
the holder and issuer from realizing gain
or loss from the deemed exchange other
than foreign exchange gain or loss recog-
nized by the issuer or holder under section
988.

## C. Certain additional guidance

### 1. Hook Equity

Ordinarily, the IRS will not issue a
ruling or determination letter regarding
the treatment or effects of "hook equity,"
including as a result of its issuance, own-
ership, or redemption. For this purpose,
"hook equity" means an ownership inter-
est in a business entity (such as stock in a
corporation) that is held by another busi-
ness entity in which at least 50 percent of
the interests (by vote or value) in such
latter entity are held directly or indirectly
by the former entity. However, if an entity
directly or indirectly owns all of the eq-
uity interests in another entity, the equity
interests in the latter entity are not hook
equity. See Rev. Proc. 2016-3, section
4.02(11), 2016-1 I.R.B. 126. One com-
ment, noting that the proposed regulations
could result in certain debt instruments
being treated as stock that would qualify
as hook equity, recommended that the IRS
repeal its policy on the issuance of rulings
or determination letters regarding the
treatment or effects of hook equity. The
Treasury Department and the IRS decline
to address this recommendation, which is
beyond the scope of the final and tempo-
rary regulations. The recommendation
will be considered, as appropriate, in con-
nection with future guidance.

### 2. Examination Guidance

One comment recommended that the
IRS should issue guidance to examiners
concerning the interpretation and practical
application of the regulations. The Trea-
sury Department and the IRS decline to
address this comment, which is beyond
the scope of the final and temporary reg-
ulations.

## VIII. Applicability Dates

## A. Applicability dates of the proposed regulations

Proposed §§ 1.385-1 and 1.385-2
were proposed to apply to any applicable
instrument issued or deemed issued on or
after the date that the proposed regulations
were published as final regulations and to
any applicable instrument issued or
deemed issued as a result of an entity
classification election made under
§ 301.7701-3 that is filed on or after that
date. For purposes of applying proposed
§§ 1.385-3 and 1.385-4, the provisions of
proposed § 1.385-1 were proposed to be
applicable in accordance with the pro-
posed applicability dates of proposed
§§ 1.385-3 and 1.385-4.

Proposed §§ 1.385-3 and 1.385-4
were proposed to be applicable on the date
of publication in the Federal Register of
the Treasury decision adopting these rules
as final regulations. Proposed §§ 1.385-3
and 1.385-4 were proposed to apply to
any debt instrument issued on or after
April 4, 2016, and to any debt instrument
issued before April 4, 2016, as a result of
an entity classification election made un-
der § 301.7701-3 that is filed on or after
that date. However, the proposed regula-
tions also provided that, if a debt instru-
ment otherwise would be treated as stock
before publication of the final regulations,
the debt instrument would be treated as
indebtedness until the date that is 90 days
after publication of the final regulations,
and would only be recharacterized on that
date to the extent that the debt instrument
was held by expanded group members on
that date (the proposed transition period).
This transition rule in the proposed regu-
lations did not apply to debt instruments
issued on or after publication of the final
regulations.

The proposed regulations also pro-
vided that, for purposes of determining
whether a debt instrument is described in
proposed § 1.385-3(b)(3)(iv) (the per se
funding rule), a distribution or acquisition
that occurred before April 4, 2016, other
than a distribution or acquisition that is
treated as occurring before April 4, 2016,
as a result of an entity classification elec-
tion made under § 301.7701-3 that is filed
on or after April 4, 2016, is not taken into
account.

## B. Applicability dates of the final and temporary regulations

### 1. In General

The final and temporary regulations
apply to taxable years ending on or after
January 19, 2017. As described in Part
IV.B.2.b of this Summary of Comments
and Explanation of Revisions, the final
regulations under § 1.385-2 delay the im-
plementation period described in pro-
posed § 1.385-2 such that § 1.385-2 does
not apply to interests issued or deemed
issued before January 1, 2018. Sections
1.385-3 and 1.385-3T grandfather debt
instruments issued before April 5, 2016
(rather than before April 4, 2016, as was
provided in the proposed regulations). The
final and temporary regulations do not in-
clude the special rule in proposed
§ 1.385-3(h)(1) relating to entity classifi-
cation elections filed on or after April 4,
2016. The final and temporary regulations
in § 1.385-3(b)(3)(viii) also grandfather
distributions and acquisitions occurring
before April 5, 2016, for purposes of ap-
plying the funding rule.

### 2. Transition Rules

The final regulations under § 1.385-3
lengthen the proposed transition period by
providing that any covered debt instru-
ment that would be treated as stock by
reason of the application of the final and
temporary regulations on or before Janu-
ary 19, 2017 (the final transition period) is
not treated as stock during that 90-day
period, but rather the covered debt instru-
ment is deemed to be exchanged for stock
immediately after January 19, 2017, but
only to the extent that the covered debt
instrument is held by a member of the

issuer's expanded group immediately af-
ter January 19, 2017 (final transition pe-
riod rule). Thus, the final transition period
rule addresses both covered debt instru-
ments that would have been recharacter-
ized before the final and temporary regu-
lations become applicable (that is, because
the recharacterization would have oc-
curred during a taxable year ending before
January 19, 2017, as well as other covered
debt instruments that would be treated as
stock on or before January 19, 2017. The
Treasury Department and the IRS ex-
tended the final transition period, as com-
pared to the proposed regulations, in re-
sponse to comments that requested
additional time for taxpayers to adjust
their conduct to take into account the final
and temporary regulations.

Generally, under the final transition pe-
riod rule, any issuance of a covered debt
instrument during the final transition pe-
riod that would be treated as stock under
§ 1.385-3(b)(2) upon issuance but for the
final transition period rule is treated as an
issuance of indebtedness, and not an issu-
ance of stock. The final transition period
rule also clarifies that §§ 1.385-1, 1.385-
3T, and 1.385-4T are taken into account
in applying § 1.385-3 during the final
transition period.

The Treasury Department and the IRS
are concerned that, under the final transi-
tion period rule, a taxpayer could avoid
the purposes of the final and temporary
regulations by, during the transition pe-
riod, distributing a covered debt instru-
ment that otherwise would be treated as
stock under the general rule, and then
issuing a second debt instrument to retire
the first instrument (either in a direct re-
financing or indirectly by using the pro-
ceeds from the second debt instrument)
before the end of the transition period. If
this were permitted to occur, a taxpayer
could issue substantial related-party debt
that does not finance new investment after
having received notice of these final and
temporary regulations, contrary to the pur-
poses of the applicability dates and lim-
ited grandfather rules provided in the pro-
posed regulations and in these final and
temporary regulations. Accordingly, the
final and temporary regulations also add a
transition funding rule. This transition
funding rule provides that on or after the
date on which a covered debt instrument

would be treated as stock but for the ap-
plicability date of § 1.385-3 or the final
transition period rule, any payment made
with respect to such covered debt instru-
ment (other than stated interest), including
pursuant to a refinancing, is treated as a
distribution for purposes of the funding
rule. This transition funding rule is in-
tended to provide for the orderly operation
of the funding rule, taking into account the
combination of the applicability date of
§ 1.385-3, the final transition period rule,
and § 1.385-3(b)(6).

Section 1.385-3(b)(6) is a non-dupli-
cation rule that provides that, once a cov-
ered debt instrument is recharacterized as
stock, the distribution or acquisition that
caused that recharacterization cannot
cause a recharacterization of another cov-
ered debt instrument even after the first
instrument is repaid. The non-duplication
rule in § 1.385-3(b)(6) is premised on the
fact that the funding rule already treats the
repayment of an instrument that is treated
as stock as its own distribution for pur-
poses of the funding rule. The rule in
§ 1.385-3(b)(6) prevents the funding rule
from applying on a duplicative basis - to
the repayment of the recharacterized in-
strument, and to the actual distribution or
acquisition that caused the recharacteriza-
tion. See Part V.B.4 of this Summary of
Comments and Explanation of Revisions.
The transition funding rule supersedes
that non-duplication rule during the final
transition period while the covered debt
instrument that otherwise would be
treated as stock continues to be treated as
indebtedness. The transition funding rule
treats payments with respect to the instru-
ment as distributions for purposes of the
funding rule, which is necessary because
repayments during the final transition pe-
riod are not otherwise treated as distribu-
tions.

Consistent with this transition funding
rule, the final and temporary regulations
also provide that a covered debt instru-
ment that is issued in a general rule trans-
action during the transition period is not
treated as a transaction described in
§ 1.385-3(b)(3)(i) if, and to the extent
that, the covered debt instrument is held
by a member of the issuer's expanded
group immediately after the transition pe-
riod. In such a case, the covered debt
instrument would be deemed to be ex-

changed for stock immediately after the
transition period, and no other covered
debt instrument would be treated as fund-
ing the issuance during the transition pe-
riod. This change addresses a comment
concerning the interaction of the general
rule and funding rule during the transition
period.

Covered debt instruments that other-
wise would not be recharacterized for fed-
eral income tax purposes during the final
transition period (due, for example, to the
fact that the covered debt instrument was
not treated as funding a distribution or
acquisition that also occurred during the
final transition period) remain subject to
the funding rule after the final transition
period. Finally, the final regulations clar-
ify in § 1.385-3(b)(4) that the anti-abuse
rule in § 1.385-3(b)(4) may apply if a
covered debt instrument is issued as part
of a plan or series of transactions with a
principal purpose to expand the applica-
bility of the transition rules described in
§ 1.385-3(j)(2) or § 1.385-3T(k)(2).

The following example illustrates these
transition rules: Assume FP, a foreign cor-
poration, wholly owns USS, a domestic
corporation. Both FP and USS use a cal-
endar year as their taxable year. No ex-
ceptions described in § 1.385-3(c) apply.
Assume that on June 1, 2016, USS dis-
tributes a $100x covered debt instrument
(Note 1) to FP. On January 1, 2017, USS
distributes a $200x covered debt instru-
ment (Note 2) to FP. On January 2, 2017,
USS makes a $100x repayment to retire
Note 1.

For USS and FP, the first taxable year
to which the final and temporary regula-
tions apply is the taxable year ending De-
cember 31, 2017. Section 1.385-3 does
not apply to the issuance of Note 1 be-
cause Note 1 is not issued in a taxable
year ending on or after January 19, 2017.
Section 1.385-3 does apply to the issu-
ance of Note 2, because Note 2 is issued in
a taxable year ending on or after January
19, 2017.

However, the final transition period
rule applies to Note 2 because Note 2
otherwise would be treated as stock on or
before January 19, 2017. Accordingly,
Note 2 is not treated as stock until imme-
diately after January 19, 2017; and to the
extent that Note 2 is held by a member of
USS's expanded group immediately after

January 19, 2017, Note 2 is deemed to be
exchanged for stock immediately after
January 19, 2017.

The final transition period rule also ap-
plies to Note 1 because § 1.385-3(b) and
(d)(1) would have treated Note 1 as stock
in a taxable year ending before January
19, 2017 but for the fact that USS's tax-
able year ending December 31, 2016, is
not a taxable year described in § 1.385-
3(j)(1). However, because Note 1 was re-
paid on January 2, 2017, Note 1 is not
held by a member of USS's expanded
group immediately after January 19, 2017
and, as a result, Note 1 will not be rechar-
acterized as stock. Because Note 1 would
be recharacterized as stock during the fi-
nal transition period, but Note 1 was not
recharacterized as stock because it was
not outstanding immediately after the final
transition period, the transition funding
rule applies to treat the payment with re-
spect to Note 1 on January 2, 2017, as a
distribution for purposes of applying
§ 1.385-3(b)(3) to USS's taxable year
ending on December 31, 2017, and on-
ward.

The temporary regulations provide
similar transition rules for transactions
covered by §§ 1.385-3T(f)(3) through (5).

## C. Retroactivity

The Treasury Department and the IRS
received various comments regarding the
applicability date of the rules in proposed
§§ 1.385-3 and 1.385-4. Comments as-
serted that applying proposed §§ 1.385-3
and 1.385-4 to instruments issued on or
after the date of the notice of proposed
rulemaking but before the adoption of fi-
nal or temporary regulations would be im-
permissibly retroactive under the relevant
statutory authorities.

While the Treasury Department and
the IRS disagree with these comments, the
applicability dates of the final and tempo-
rary regulations have been revised. The
comments regarding retroactivity con-
tinue to be inapposite. The final and tem-
porary regulations under §§ 1.385-3,
1.385-3T, and 1.385-4T apply only to
taxable years ending on or after 90 days
after the publication of the final and tem-
porary regulations (that is, January 19,
2017). Accordingly, the final and tempo-
rary regulations do not require taxpayers

to redetermine their federal income tax
liability for any taxable year ending be-
fore January 19, 2017.

Furthermore, as described in Section B
of this Part VIII, debt instruments issued
on or before April 4, 2016, are never
subject to §§ 1.385-3 or 1.385-3T, even if
they remain outstanding during taxable
years to which the final and temporary
regulations apply. Further, any covered
debt instrument issued after April 4, 2016,
and on or before January 19, 2017, will
not be recharacterized until immediately
after January 19, 2017. Any recharacteriza-
tion under the final and temporary regula-
tions will change an instrument's federal tax
characterization only prospectively.

The applicability dates governing these
regulations are not retroactive. Regula-
tions are retroactive if they "impair rights
a party possessed when [that party] acted,
increase a party's liability for past con-
duct, or impose new duties with respect to
transactions already completed." Land-
graf v. USI Film Prods., 511 U.S. 244,
280 (1994) (explaining retroactivity). The
regulations do not impair rights or in-
crease a party's tax liability with respect
to a purported debt instrument until at
least 90 days after the date of publication
of the final and temporary regulations.
Regardless of when an instrument is is-
sued, beginning on the publication date of
the final and temporary regulations, af-
fected parties are on notice that such in-
strument could be subject to the rules de-
scribed in the final and temporary
regulations, and those instruments will
only be prospectively recast as equity
(that is, beginning 90 days after publica-
tion of the final and temporary regula-
tions).

Additionally, even if the final and tem-
porary regulations were retroactive, the
Treasury Department and the IRS have
statutory authority to issue retroactive
rules. Regulations which relate to statu-
tory provisions enacted before July 30,
1996-such as section 385-are subject
to the pre-1996 version of section
7805(b). That provision provides express
retroactive rulemaking authority by stat-
ing that the Secretary may prescribe the
extent, if any, to which any ruling or reg-
ulation shall be applied without retroac-
tive effect. Section 7805(b) (1995). There-
fore, although the final and temporary

regulations are not retroactive, section
7805(b) in any event provides the neces-
sary statutory authority to issue regula-
tions with retroactive effect.

Comments also stated that the Treasury
Department and the IRS failed to comply
with the Administrative Procedure Act
(APA) notice-and-comment and delayed-
applicability-date provisions by purport-
edly making proposed §§ 1.385-3 and
1.385-4 effective as of April 4, 2016. One
comment stated that the APA's require-
ment of a delayed-applicability date in 5
U.S.C. 553(d) overrides the authority pro-
vided by section 7805(b). This comment
pointed to the provision in the APA that a
subsequent statute may not be held to su-
persede or modify the APA's rulemaking
requirements except to the extent that it
does so expressly. 5 U.S.C. 559.

These comments are inapposite be-
cause the final and temporary regulations
comply with the requirement of a 30-day
delayed-applicability date in 5 U.S.C.
553(d). The final and temporary regula-
tions apply only to taxable years that end
on or after 90 days after publication of the
final and temporary regulations, and only
begin to recharacterize instruments as eq-
uity immediately after 90 days after pub-
lication of the final and temporary regula-
tions. Furthermore, section 7805(b),
which permits regulations to have retroac-
tive effect, controls in these circumstances
because the more specific statute has pre-
cedence over the general notice statute in
section 553(d) of the APA. See, e.g., Red-
house v. Commissioner, 728 F.2d 1249,
1253 (9th Cir. 1984); Wing v. Commis-
sioner, 81 T.C. 17, 28-30 & n.17 (1983).
Finally, the statutory authority contained
in section 7805(b) predates the APA, so it
is not a subsequent statute that is governed
by section 559 of the APA.

Comments also identified a restriction
on Congress's authorization in section
385(a) to promulgate regulations deter-
mining whether an instrument is "in part
stock and in part indebtedness." See Om-
nibus Budget Reconciliation Act, Pub.L.
101-239, § 7208(a)(2) (requiring that
such authority "shall only apply with re-
spect to instruments issued after the date
on which" the Secretary "provides public
guidance as to the characterization of such
instruments whether by regulation, ruling,
or otherwise"). As explained in Part III.D

of this Summary of Comments and Expla-
nation of Revisions, the Treasury Depart-
ment and the IRS have decided at this
time not to adopt a general bifurcation
rule pending further study. Furthermore,
to the extent that § 1.385-3 results in a
partial recharacterization of a purported
debt instrument after January 19, 2017,
the final and temporary regulations only
apply to instruments issued after April 4,
2016, which is the date on which the pro-
posed regulations were filed for public
inspection with the Federal Register. Ac-
cordingly, the final and temporary regula-
tions do not apply to debt instruments
issued on or before the date (April 4,
2016) that the Treasury Department and
the IRS provided public guidance regard-
ing recharacterization. Therefore, the final
and temporary regulations comply with
the restriction regarding section 385(a) in
the Omnibus Budget Reconciliation Act.

Some comments questioned the fair-
ness of applying the proposed regulations
to instruments issued before the publica-
tion date of final or temporary regulations,
in light of the broad scope of the proposed
rules and the complex subject matter at
issue. The Treasury Department and the
IRS have concluded that the final and tem-
porary regulations adequately address
these concerns. As is explained through-
out this preamble, the scope of the final
and temporary regulations is significantly
narrower than the proposed regulations.
For instance, the final and temporary reg-
ulations reserve on their application to
foreign issuers and include many new ex-
ceptions, including a broad exception for
short-term debt instruments, among oth-
ers. Moreover, the final and temporary
regulations provide that covered debt in-
struments (which excludes instruments is-
sued on or before April 4, 2016) issued on
or before 90 days after publication of the
final and temporary regulations will con-
tinue to be treated for federal tax purposes
as debt instruments until immediately af-
ter 90 days after the date of publication of
the final and temporary regulations. To the
extent such instruments are retired on or
before 90 days after the date of publica-
tion of the final and temporary regula-
tions, they will not be affected by the
regulations.

Finally, a comment observed that if the
future regulations made significant

changes to the proposed regulations, such
that debt instruments that were not subject
to the proposed rules would become sub-
ject to recharacterization under the final
rules, this would create an impermissible
retroactive effect that is not addressed by
the proposed transition rule.

In general, the final and temporary reg-
ulations do not adopt rules that would
recharacterize debt instruments that would
not have been recharacterized under the
proposed regulations. However, to the ex-
tent a taxpayer prefers applying the pro-
posed regulations to debt instruments is-
sued after April 4, 2016, but before the
filing date of the final and temporary reg-
ulations, the final and temporary regula-
tions allow the taxpayer to apply
§§ 1.385-1, 1.385-3, and 1.385-4 of the
proposed regulations subject to certain
consistency requirements. In particular,
§ 1.385-3(j)(2)(v) provides that an issuer
and all members of the issuer's expanded
group that are covered members may
choose to consistently apply those sec-
tions of the proposed regulations to all
debt instruments issued after April 4,
2016, and before October 13, 2016, solely
for purposes of determining whether a
debt instrument will be treated as stock.
Taxpayers choosing to apply the proposed
regulations must apply them consistently
(including applying the partnership provi-
sion in proposed § 1.385-3(d)(5) in lieu of
the temporary regulations) and cannot se-
lectively choose which particular provi-
sions to apply.

Furthermore, because no instrument is-
sued before the publication date of the fi-
nal and temporary regulations will be
treated as equity until 90 days after the
publication date, taxpayers have ample
notice as to the effect the final regulations
will have on such instruments.

## D. Delayed applicability date and transition rules

Numerous comments requested that
the final and temporary regulations' appli-
cability date be delayed, with some com-
ments requesting a delay of several years
after the proposed regulations are final-
ized. Comments also requested that the
final and temporary regulations apply
solely to debt instruments issued on or
after such delayed applicability date.

Other comments suggested different ap-
plicability dates based on certain charac-
teristics of the issuer (for example, earlier
applicability dates for inverted corpora-
tions) or the situation in which an instru-
ment is issued (for example, cash pooling
arrangements, refinancings, and certain
deemed issuances of debt instruments).
Other comments discussed each section of
the proposed regulations and suggested
applicability dates appropriate for each
section. For example, many comments
were concerned that taxpayers would need
time to design and implement systems
necessary to comply with proposed
§ 1.385-2 and requested the applicability
date of the documentation rules be de-
layed from a few months to two years,
with the vast majority asking for a one
year delay after finalization. Comments
also requested that the documentation
rules not apply to interests outstanding on,
or to interests negotiated before, the ap-
plicability date of the final and temporary
regulations. A comment questioned
whether, for purposes of applying the pro-
posed regulations before the date on
which the final and temporary regulations
are issued, the issuance of a debt instru-
ment that would be treated as stock under
the proposed regulations should be treated
as an issuance of a debt instrument or an
issuance of stock. Similarly, a comment
recommended clarification of the treat-
ment of a repayment of such a debt instru-
ment before the date on which the interest
would be treated as stock under the pro-
posed regulations.

After considering the comments, the
final and temporary regulations adopt the
changes to applicability dates, grandfather
rules, and expanded transition rules de-
scribed in Section B of this Part VIII.
However, the Treasury Department and
the IRS do not adopt the recommenda-
tions to exempt covered debt instruments
issued on or after April 5, 2016, and be-
fore October 21, 2016 for purposes of the
regulations, or to exempt from those rules
covered debt instruments issued for some
period thereafter. The Treasury Depart-
ment and the IRS have determined that the
significant modifications made to scope of
the proposed regulations, coupled with the
expansion and addition of numerous ex-
ceptions, adequately address the compli-
ance burdens raised by the comments with

respect to the regulations. For example,
many of the comments that requested a
delayed applicability date cited compli-
ance difficulties faced by CFC issuers and
issues associated with cash pooling ar-
rangements. The final and temporary reg-
ulations reserve on the application to debt
instruments issued by CFCs, and include
broad exceptions to mitigate the compli-
ance burden for taxpayers that participate
in cash pooling arrangements.

Moreover, in developing the applica-
bility dates and grandfathering rules for
the proposed regulations, the Treasury
Department and the IRS balanced compli-
ance burdens with the need to prevent
taxpayers from using any delay in imple-
mentation to maximize their related-party
debt. If the proposed transition rules had
simply exempted covered debt instru-
ments issued after April 4, 2016, taxpay-
ers would have had significant incentiv-
izes to issue related-party debt that did not
finance new investment in advance of the
regulations' finalization. Accordingly, the
Treasury Department and the IRS have
determined that the applicability dates and
transition rules provided in §§ 1.385-3,
1.385-3T, and 1.385-4T are necessary
and appropriate.

## Future Guidance and Request for Comments

As described in this Summary of Com-
ments and Explanation of Revisions, sev-
eral aspects of the final and temporary
regulations are reserved pending further
study. The Treasury Department and the
IRS request comments on all of the re-
served issues, including in particular: (i)
the application of the final and temporary
regulations to foreign issuers; (ii) the ap-
plication of §§ 1.385-3 and 1.385-3T to
U.S. branches of foreign issuers, in the
absence of more comprehensive guidance
regarding the application of §§ 1.385-3
and 1.385-3T with respect to foreign is-
suers; (iii) the expanded group treatment
of brother-sister groups with common
non-corporate owners, including how to
apply the exceptions in § 1.385-3(c) to
such groups; (iv) the application of
§ 1.385-2 to debt not in form, and (v)
rules prohibiting the affirmative use of
§§ 1.385-2 and 1.385-3. The Treasury
Department and the IRS also request com-
ments on the general bifurcation rule of

proposed § 1.385-1(d). Any subsequently
issued guidance addressing these issues
will not apply to interests issued before
the date of such guidance.

The Treasury Department and the IRS
also request comments on all aspects of
the temporary regulations. In addition, re-
garding the exception for qualified short-
term debt instruments, the Treasury De-
partment and the IRS request comments
on the specified current assets test and
whether the maximum outstanding bal-
ance described in § 1.385-3T(b)(3)(vii)
(A)(1)(iii) should be limited by reference
to variances in expected working capital
needs over some period of time, rather
than by reference to the total amount of
specified current assets reasonably ex-
pected to be reflected on the issuer's bal-
ance sheet during the specified period of
time.

The Treasury Department and the IRS
also are concerned that under certain cir-
cumstances, such as a high-interest rate
environment, an interest rate that falls
within the safe haven interest rate range
under § 1.482-2(a)(2)(iii)(B), and thus is
deemed to be an arm's length interest rate,
may allow deduction of interest expense
substantially in excess of the amount that
would be determined to be an arm's
length interest rate in the absence of
§ 1.482-2(a)(2)(iii)(B). Specifically, the
Treasury Department and the IRS are con-
sidering whether there is a more appropri-
ate way to allow for a risk premium in the
safe haven rate than by using a fixed per-
centage of the applicable federal rate. The
Treasury Department and the IRS are con-
sidering a separate project to address this
issue and request comments on how the
safe haven rate of § 1.482-2(a)(2)(iii)(B)
might be modified to address these con-
cerns.

Finally, the Treasury Department and
the IRS request comments on possible fu-
ture guidance to address debt instruments
issued by a member of an expanded group
to an unrelated third party when the obli-
gation is guaranteed by another member
of the expanded group.

## Statement of Availability of IRS Documents

IRS Revenue Procedures, Revenue
Rulings, notices, and other guidance cited
in this document are published in the In-

ternal Revenue Bulletin (or Cumulative
Bulletin) and are available from the Su-
perintendent of Documents, U.S. Govern-
ment Publishing Office, Washington, DC
20402, or by visiting the IRS Web site at
http://www.irs.gov.

## Special Analyses

### I. Regulatory Planning and Review

Executive Orders 13563 and 12866 di-
rect agencies to assess costs and benefits
of available regulatory alternatives and, if
regulation is necessary, to select regula-
tory approaches that maximize net bene-
fits (including potential economic, envi-
ronmental, public health and safety
effects, distributive impacts, and equity).
Executive Order 13563 emphasizes the
importance of quantifying both costs and
benefits, of reducing costs, of 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 designated
as economically significant. Accordingly,
the rule has been reviewed by the Office
of Management and Budget. A regulatory
assessment for this final rule is provided
below.

## A. The need for the regulatory action

### 1. In General

Corporations can raise money using a
wide variety of financial instruments. But
for income tax purposes, what matters is
whether the firms borrow (issue debt) or
sell ownership interests in the corporation
(issue equity). Under U.S. tax rules, inter-
est (the return paid on debt) is deductible
in determining taxable income while div-
idends (the return paid on equity) are not.
This implies that corporations can reduce
their U.S. federal income tax liability by
financing their activities with debt instru-
ments rather than with equity. And this
provides a strong incentive to characterize
financial instruments issued as "debt"
even when they have some of the proper-
ties of equity instruments. In most circum-
stances, however, the ability to employ
debt instead of equity, and thereby reduce
income taxes paid, is limited by economic
forces and legal constraints. In the mar-
ketplace, the cost of debt (that is, the

interest rate charged) and the willingness
of lenders to supply credit are generally
dependent on a borrower's creditworthi-
ness and the terms of repayment to which
the parties agree. It is also generally ac-
cepted that independent parties to a lend-
ing transaction will act in their own best
interests in terms of honoring the terms of
a debt and in enforcing creditor's rights.
Therefore, in these circumstances where
unrelated parties engage in the financial
transactions, an individual corporation's
choice to employ either debt or equity,
and its assessment of the amount of debt it
can take on, are decisions that are deter-
mined, and limited, by market forces. In
this context, the ability of individual cor-
porations to reduce U.S. federal income
tax liability by financing their operations
with debt issued to unrelated parties rather
than equity is to a degree naturally lim-
ited.

When the checks and balances of the
market are removed, as they are when
related corporations transact, there are of-
ten few practical economic or legal forces
that constrain the choice between employ-
ing debt or equity. Related corporations
can essentially act as a unit that, in effect,
borrows and lends to itself without being
subject to the forces that otherwise place
limits on the cost and amount of indebt-
edness. In the context of highly-related
parties, for example a parent corporation
and its wholly-owned subsidiary, factors
such as creditworthiness, ability to repay,
and sufficiency of collateral may not be
relevant if a decision to finance has oth-
erwise been made. In these circumstances,
the financing choice thus can be deter-
mined solely on the basis of income tax
considerations, which often favor debt.

The absence of market forces operating
among related corporations can, in addi-
tion to influencing internal financing de-
cisions, create incentives for corporations
that do not require financing to incur debt
solely for tax-related reasons. Related cor-
porations can engage in tax arbitrage,
among other ways, by causing profitable
corporations (facing a relatively high mar-
ginal tax rate) to incur debt (and pay in-
terest) to corporations with losses (facing
a relatively low or zero marginal tax rate),
or by causing corporations in high tax rate
jurisdictions to incur debt and pay interest
to corporations in low tax rate jurisdic-

tions. In addition, because intra-group
debt will often have no legal or economic
consequences outside of the related-party
group of corporations, related corpora-
tions can use intra-group debt to increase
the total amount of their obligations la-
beled as debt well beyond the amount of
the external, third-party indebtedness of
the group. While such tax arbitrage oppor-
tunities have been a longstanding prob-
lem, their associated economic and reve-
nue costs appear to have increased in
recent years.

From a U.S. tax perspective, subject to
general tax principles and certain limited
statutory constraints, corporations are
generally free to structure their financial
arrangements, even intra-group instru-
ments, as debt or equity. However, the
unique nature of related-party debt pres-
ents a number of issues that the section
385 regulations are intended to address.
At a basic level, the section 385 regula-
tions require highly-related parties (mean-
ing generally those that meet an 80
percent common ownership test) to dem-
onstrate that purported debt issued among
them is properly characterized as debt for
U.S. federal tax purposes, and thus that
they are entitled to the interest deductions
associated with such debt. An 80 percent
common ownership threshold is often
used under the tax Code and tax regula-
tions to identify highly-related corpora-
tions, for example, to determine eligibility
to file a consolidated federal income tax
return or claim a deduction offsetting div-
idends received from subsidiaries. As
noted, there are generally no external
forces that constrain related-party debt
and, as a consequence, the parties to a
financing may attempt to characterize a
transaction as tax-favored debt when it is
more properly viewed in substance as eq-
uity. The section 385 regulations provide
factors that are required to be used in
evaluating the nature of an instrument
among highly-related parties as debt or
equity.

The section 385 regulations require re-
lated parties to document their intention to
create debt and that their continuing be-
havior is consistent with such character-
ization. With respect to unrelated parties,
the establishment of a creditor-debtor re-
lationship generally involves such docu-
mentation. In the context of related par-

ties, that is not always the case, even
though it is a factor indicative of debt
under existing common law tax principles.
The absence of such documentation can
be particularly problematic, for example,
when the IRS attempts to assess the ap-
propriateness of tax deductions for inter-
est attributable to related-party debt. The
section 385 regulations provide minimum
standards, in line with what would be ex-
pected of unrelated parties, that related
parties must observe in order for their
debtor-creditor relationships to be re-
spected as such for income tax purposes.

In addition, the section 385 regulations
recharacterize purported debt as equity
when certain prescribed factors demon-
strate that the interest reflects a corporation-
shareholder relationship rather than a
debtor-creditor relationship. An unrelated
party would not agree to owe a "creditor"
a principal amount without receiving loan
proceeds or some other property of value
in return. However, as discussed, related
parties are not so constrained, and an un-
funded promise among such parties to pay
some amount in the future may have little
economic effect or legal implication.
Nonetheless, that promise to pay, if re-
spected, could have significant conse-
quences for income tax purposes. If the
interest paid on an unfunded note (a debt
instrument) to a parent corporation from a
U.S. subsidiary was taxed at a lower rate
than the marginal tax rate faced by the
subsidiary or was untaxed at the parent
corporation level, then the parent-
subsidiary group would have achieved a
reduction of its overall tax burden with-
out meaningfully changing its overall
legal or economic profile. In character-
izing an instrument as debt or equity, the
section 385 regulations consider as fac-
tors the relatedness of corporations and
whether or not the instrument funded
new investment in the issuer. If an in-
strument among highly-related parties
does not finance new investment, the
section 385 regulations treat the instru-
ment as representing a corporation-
shareholder relationship.

The section 385 regulations are in-
tended to apply to related-party transac-
tions undertaken by large corporate tax-
payers that are responsible for a majority
of corporate business activity and that
have organizational structures that include

subsidiaries or affiliated groups. These
businesses represent about 0.1 percent of
all corporations (tax filings for consoli-
dated groups are counted as one return)
but are responsible for about 65 percent of
all corporate interest deductions and 54
percent of corporate net income. It is for
this group of corporations that the oppor-
tunity to engage in intercompany transac-
tions, the scale of the business activity,
and the potential gains from tax arbitrage
create the most potential for mischaracter-
ization of equity as debt.

### 2. Application

Information and tax data on intercom-
pany transactions within a single multina-
tional firm is generally not reported to the
IRS, making it harder to compile than
similar information for unrelated parties.
Nonetheless, examples of how the mis-
characterization of equity as debt can fa-
cilitate tax arbitrage are readily available.
One clear example can be found in the
case of foreign-parented corporations that
create debt to use interest deductions to
shift income out of the U.S. tax base (so-
called "interest stripping"). These corpo-
rations are referred to in this discussion as
foreign controlled domestic corporations
(or FCDCs) because they are owned/con-
trolled by non-U.S. companies and they
operate in the United States. When these
companies pay interest to affiliated com-
panies outside the United States, the pay-
ments reduce taxes on income generated
in the United States. This is an advantage
to the group as a whole if it lowers the
total amount of tax paid worldwide, which
will happen to the extent that the U.S. tax
rate exceeds the foreign tax rate that ap-
plies to the interest income. In a purely
domestic context (a U.S. owned domestic
corporation lending to another affiliated
U.S. owned domestic corporation), such
arbitrage possibilities also exist, for exam-
ple, if the borrower has net positive in-
come but the lender has a net operating
loss.

One common strategy for creating in-
tercompany debt between related entities
is distributing debt instruments. In a pro-
totypical transaction of this type, a U.S.
business distributes to its foreign parent a
note. The U.S. subsidiary receives nothing
in exchange for the note (in particular, it

receives no cash from the parent). The
parent can then keep the note, or transfer
it to an affiliate in a low tax jurisdiction.
The U.S. subsidiary then deducts interest
on the note, which reduces U.S. income
tax liability.

Such a transaction has little, if any, real
economic or financial consequence aside
from the tax benefit. There are no loan
proceeds for the U.S. subsidiary to invest,
so there is no new U.S. income generated
that could offset the tax deduction for
interest paid to the foreign parent. In ad-
dition, the companies can set a high inter-
est rate on the loan (as long as they can
defend the rate under tax rules as an arm's
length rate; the more leveraged the firm,
the higher the rate that can be justified), in
order to maximize the amount of income
that is stripped out of the U.S. tax system.
Because the income and deduction offset
each other on the multinational compa-
ny's financial statements, there are no
practical impediments to charging a high
rate (apart from tax audit risk related to
the appropriateness of the interest deduc-
tion). Importantly, the note does not lead
to an increase in investment in the United
States.

Other transactions can produce a simi-
lar tax result. For instance, the parent
company could lend a sum to the subsid-
iary, but have the subsidiary return the
amount borrowed to the parent through
another transaction, such as a dividend of
the sum lent or a purchase of the parent's
own stock. When the borrowing and the
related transaction to return funds to the
lender are considered in their totality, this
transaction has the same practical tax and
economic effect as distributing a note.

The ability of related parties to create
intercompany debt generates undesirable
tax incentives in certain contexts. For ex-
ample, the ability of a foreign parent cor-
poration to reduce U.S. tax liability by
causing a U.S. business to distribute notes
to the foreign parent gives an advantage to
foreign-owned U.S. businesses over U.S .-
owned multinational businesses. U.S.
multinational corporations (MNCs) gener-
ally cannot use related-party debt to strip
earnings out of the United States, because
interest paid from the U.S. parent and U.S.
subsidiaries to their foreign subsidiaries is
taxed when received under the subpart F
rules, the U.S. controlled foreign corpora-

tion (CFC) regime that taxes currently
passive and other mobile income earned
outside the United States. (Interest paid
from one U.S. subsidiary to another in a
consolidated group would do nothing to
reduce federal income taxes, because the
recipient's tax inclusion would offset the
payer's tax deduction in the same federal
income tax return.)

Moreover, the advantage FCDCs gain
over U.S. MNCs from mischaracterizing
equity as debt is economically significant,
because existing limits on tax deductions
from interest stripping, which generally
impact FCDCs, are ineffective in limiting
tax arbitrage opportunities. Under current
law, the two potential limits on the
amount of FCDC debt are a statutory limit
on related-party interest deductions (under
section 163(j) of the Code) and a general
limit based on case law distinguishing
debt from equity. The statutory limit (sec-
tion 163(j)) restricts deductions for inter-
est paid to related parties or guaranteed by
related parties to the extent that net inter-
est deductions (interest paid less interest
received) exceed 50 percent of adjusted
taxable income (which is an expanded
measure of income: income measured
without regard to deductions such as net
interest, depreciation, amortization, deple-
tion, net operating losses). This deduction
limit applies whenever the firm's debt-
equity ratio exceeds 1.5:1. Data from IRS
Form 8926 "Disqualified Corporate Inter-
est Expense Disallowed Under Section
163(j) and Related Information" shows
that 50 percent of adjusted taxable income
is roughly 100 percent of taxable income
before net interest, which means that firms
can on average strip all of their income
out of the United States using interest
deductions before the limit is reached.
Case law, moreover, supports a wide va-
riety of debt-equity ratios as acceptable
for purposes of supporting debt character-
ization. Even when debt-equity ratios are
considered in the case law, they are con-
sidered on a facts-and-circumstances basis
and as one of many factors used to distin-
guish debt from equity by the courts. Fi-
nally, as discussed previously, because in-
tercompany debt does not affect the
multinational firm's external capital struc-
ture, the amount of intercompany debt and
the interest rate applied are not subject to
the constraints that the market would im-

pose on third-party loans. Because these
limitations are not binding, the tax advan-
tages from mischaracterizing equity as
debt are large and unchecked.

While interest stripping has been a
longstanding problem for the U.S. tax sys-
tem, the associated economic and revenue
costs appear to have increased over the
past several years. For example, data gath-
ered by Bloomberg (http://www.bloomberg.
com/graphics/infographics/tax-runaways-
tracking-inversions.html) shows the pace of
corporate inversions, which are reorganiza-
tions whereby U.S. MNCs become FCDCs,
has increased over the past several years.
One of the principal tax advantages obtained
in an inversion is the ability to use interest
deductions to reduce U.S. taxes by stripping
income out of the United States. While in-
versions are a particularly visible example
of how related-party debt can be used for tax
avoidance purposes, other FCDCs have
similar incentives and opportunities to use
related-party debt to engage in interest strip-
ping.

The evidence suggests that FCDCs en-
gage in substantial interest stripping. The
best evidence for interest stripping by
FCDCs is presented in Jim Seida and
William Wempe, "Effective Tax Rate
Changes and Earnings Stripping Follow-
ing Corporate Inversion," National Tax
Journal, December 2004. In this paper,
the authors found that the worldwide ef-
fective tax rates of inverted companies fell
drastically after the inversion and that the
reduction in tax was due to interest strip-
ping. For a subsample of firms where ad-
ditional information was available, the au-
thors concluded that the mechanism for
interest stripping was intercompany debt.
In particular, Seida and Wempe estimate
that the inverted companies selected in
their subsample for detailed analysis in-
creased U.S. interest deductions by about
$1 billion per year on average in 2002 and
2003, or about $350 million in tax savings
at 35 percent. Seida and Wempe did not
report tax savings from their broader
group of companies (of which there were
12), only reductions in tax rates.

More recently, Zachary Mider, “Un-
patrioticTax Loophole' Targeted by
Obama to Cost U.S. $2 billion in 2015,"
Bloomberg BNA Daily Tax Report, De-
cember 2, 2014, reports a Bloomberg up-
date of Seida and Wempe's broader anal-

ysis, which expands the number of
inverted companies from 12 to 15 and
finds tax savings of between $2.8 billion
and $5.7 billion in 2015, depending on
whether cash taxes paid or accounting tax
expense is used.

These analyses looked at only a small
subset of the companies that have in-
verted. There have been at least 60 inver-
sions by public corporations since 1982.
In addition there have been many take-
overs of U.S. companies by previously-
inverted companies, which are equivalent
in result. From companies associated with
inversions, it is therefore likely that the
U.S. Treasury loses tens of billions of
dollars per year in corporate tax revenue
due to interest stripping.

Additional revenue losses come from
FCDCs that have operated in the United
States for many years or were not other-
wise involved in transactions classified as
inversions. Studies of interest stripping by
FCDCs more generally have not been as
conclusive as the studies of inversions. In
part, this is because the level of detail in
financial reports that is available for
FCDCs generally is lower than for in-
verted companies. Nonetheless, it is likely
that, given the advantage FCDCs have
over U.S. MNCs in their ability to strip
earnings using interest deductions, con-
siderable additional interest stripping is
attributable to FCDCs not associated with
inversions. As one indication of this pos-
sibility, the most recent (2012) available
data from corporate tax Form 1120 shows
that FCDCs have a nearly 50 percent
higher ratio of net interest deductions rel-
ative to earnings before net interest and
taxes (EBIT) than do U.S. MNCs.

While most of the concern about inter-
est stripping is focused on interest pay-
ments made to parties outside the United
States, similar transactions sometimes oc-
cur between U.S. companies. The scope
for a tax advantage from such intercom-
pany lending is limited because, in many
cases, one company's deduction of an in-
terest payment would be offset by the
other company's inclusion of interest in-
come. However, when the companies do
not file a consolidated tax return, but
nonetheless are members of an affiliated
group, there can be tax benefits to inter-
company lending. For example, if an af-
filiated group includes two U.S. corpora-

tions that do not file a consolidated return,
and one corporation has $100 of taxable
income and the other has $100 of net
operating losses carried over from prior
years, the corporation with taxable income
pays federal income tax and the one with
losses does not, nor does it get a tax re-
fund. Collectively, the $100 of income is
taxed. However, the overall federal in-
come tax liability of the affiliated group
can be reduced using an intercompany
loan that results in a deductible interest
payment of $100 by the entity with tax-
able income to the affiliate with a $100 net
operating loss. As a result, both corporate
entities will have zero taxable income for
the year.

## B. Affected population

This analysis begins by describing
some basic facts about the size of the U.S.
corporate business sector. These tax facts
help to frame the discussion and suggest
the magnitude of the section 385 regula-
tions' estimated effects. This analysis uses
an expansive definition of the estimated
affected population in order to minimize
the risk that the analysis will not capture
the effects on collateral groups.

### 1. Application to C Corporations

The regulations are intended to apply
primarily to large U.S. corporations tax-
able under subchapter C of chapter 1 of
subtitle A of the Code ("C corporations")
that engage in substantial debt transac-
tions, or purported debt transactions, be-
tween highly-related businesses. C corpo-
rations are businesses that are subject to
the separate U.S. corporate income tax. In
2012, approximately 1.6 million C corpo-
ration tax returns were filed in the United
States (tax filings for consolidated groups
are counted as one return). The regula-
tions specifically exempt other corpora-
tions which, while having the corporate
form of organization, generally do not pay
the separate corporate income tax. They
are a form of "pass-through" organization,
so called because the income generally is
passed-through the business (without tax)
to the businesses' owners, who pay tax on
the income. These other corporations are
much more numerous than are C corpora-
tions: they number roughly 4.2 million

corporations and consist mainly of "small
business corporations" taxable under sub-
chapter S of chapter 1 of subtitle A of the
Code ("S corporations"), regulated invest-
ment companies (RICs, commonly known
as mutual funds), and real estate invest-
ment trusts (REITs). Because the income
of pass-through businesses is aggregated
on their owners' returns, there is little tax
incentive to mischaracterize equity as debt
for purposes of shifting income between
pass-through entities and their owners -
deductions for interest paid would gener-
ally be offset by inclusions for interest
received. Moreover, these pass-through
entities typically are not members of large
multinational or domestic affiliated
groups, and so typically are not heavily
engaged in the types of intra-group lend-
ing transactions with highly-related C cor-
porations addressed by the regulations.

In 2012, C corporations reported $63
trillion (74 percent of the total reported by
all corporations) of total assets, $738 bil-
lion (91 percent of the total) of interest
deductions, $9.7 trillion (75 percent of the
total) of total income, and $1 trillion (59
percent of the total) of net income, accord-
ing to Treasury tabulations of tax return
data. Given that only 27 percent of all
corporate filings are for C corporations,
these figures suggest that C corporations
are larger than average for all corporations
and account for a disproportionate frac-
tion of business activity, relative to their
number compared to all corporations. In
2012, C corporations paid $265 billion in
income taxes after credits. Most C corpo-
ration activity is concentrated in a small
fraction of very large firms. For instance,
only about 1 percent of C corporation
returns have assets in excess of $100 mil-
lion and only about 0.6 percent have total
income (a proxy for revenue) in excess of
$50 million. However, returns of firms
of this size account for about 95 percent of
total interest deductions and 85 percent of
total income.

The section 385 regulations do not ap-
ply to all C corporations. The concerns
addressed by the regulations are not pres-
ent in certain categories of related-party
corporate transactions, for example
among related corporations (whether ulti-
mately U.S-parented or foreign-parented)
that file a consolidated U.S. income tax
return. In addition, the Treasury Depart-

ment and the IRS have determined that,
with respect to certain smaller corpora-
tions, the benefits of applying the rules are
outweighed by the compliance cost of ap-
plying the rules to such entities. Hence,
the regulations narrow the number of
firms affected substantially. As described
in this description of the affected popula-
tion, of 1.6 million C corporations, the
Treasury Department estimates that only
about 6,300 large C corporations will po-
tentially be affected by the documentation
requirements of the regulations. This is
because only about 6,300 C corporations
are part of expanded groups (which are
defined by the regulations as section
1504(a) "affiliated groups," but also in-
clude foreign corporations, tax-exempt
corporations, and indirectly held corpora-
tions) that have sufficient assets (more
than $100 million), revenue (more than
$50 million), or are publicly traded. An
even smaller number of corporations,
about 1,200, appear to report transactions
consistent with those that are potentially
subject to the general recharacterization
rules of the regulation (§ 1.385-3), al-
though limited data exists on the number
of corporations that are covered by the
regulations and engaged in transactions
that are economically similar to the gen-
eral rule transactions. Treasury estimates
that even though these 1,200 corporations
comprise less than 0.1 percent of C cor-
porations, they report approximately 11
percent of corporate interest deductions
and 6 percent of corporate net income on
tax returns.

### 2. Documentation of Intercompany Loans and Compliance

While there is variation across busi-
nesses, longer-term intercompany debt
would typically be documented, in some
form of agreement containing terms and
rights, by corporations following good
business practices. However, some infor-
mation required by the regulations, such
as a debt capacity analysis, may not typi-
cally be prepared in some cases. The reg-
ulations do not require a specific type of
credit analysis or documentation be pre-
pared in order to establish a debtor's cred-
itworthiness and ability to repay, but
merely impose a standard closer to com-
mercial practice. To the extent that infor-

mation supporting such analysis is already
prepared in accordance with a company's
normal business practice, complying with
the regulations would have a relatively
low compliance cost. However, where a
business has not typically prepared and
maintained written debt instruments, term
sheets, cash flow, or debt capacity analy-
ses for intercompany debt, compliance
costs related to the regulations will be
higher. While the level of documentation
required is clearly evident in third-party
lending, there is little available informa-
tion on the extent to which related parties
document their intercompany loans. An-
ecdotal evidence and comments received
indicate that businesses vary in the extent
to which related-party indebtedness is
documented. Nevertheless, the Treasury
Department does not have detailed and
quantitative assessment of current docu-
mentation practices.

## C. Description of the regulations

### 1. In General

The section 385 regulations have mul-
tiple parts. In general, the regulations de-
scribe factors to be used in assessing the
nature of interests issued between highly-
related corporations, how such factors
may be demonstrated, and when the pres-
ence of certain factors will be dispositive.
As proposed, the first part (proposed
§ 1.385-1) allowed the IRS to bifurcate a
single financial instrument between re-
lated parties into components of debt and
equity, where appropriate. The final and
temporary regulations, however, do not
include the bifurcation rule as the Trea-
sury Department and the IRS are continu-
ing to study the potential issues raised by
such a rule. Thus, the revenue and
compliance-cost effects associated with
the bifurcation rule of the proposed regu-
lations are now excluded from this analy-
sis.

The second part of the regulations,
§ 1.385-2, prescribes the nature of the
documentation necessary to substantiate
the tax treatment of related-party instru-
ments as indebtedness, including docu-
mentation of factors analogous to those
found in third-party loans. This generally
means that taxpayers must be able to pro-
vide such things as: evidence of an uncon-

ditional and binding obligation to make
interest and principal payments on certain
fixed dates; that the holder of the loan has
the rights of a creditor, including superior
rights to shareholders in the case of dis-
solution; a reasonable expectation of the
borrower's ability to repay the loan; and
evidence of conduct consistent with a
debtor-creditor relationship. These docu-
mentation rules would apply to relevant
intercompany debt issued by U.S. borrow-
ers beginning in 2018 and would require
that the taxpayer's documentation for a
given tax year be prepared by the time the
borrower's federal income tax return is
filed.

The third part of the regulations,
§§ 1.385-3 and 1.385-3T, provides rules
that can recharacterize purported debt of
U.S. issuers as equity if the interest is
among highly-related parties and does not
finance new investment. These rules are
intended to address transactions that cre-
ate significant U.S. federal tax benefits
while lacking meaningful legal or eco-
nomic significance. Subject to a variety of
exceptions for more ordinary course trans-
actions, the rules recharacterize a note that
is distributed from a U.S. issuer to a par-
ent corporation, or other highly-related
entity, as equity. The rules also apply to
the use of notes to fund acquisitions of
related-party stock and internal asset reor-
ganizations, as well as multi-step transac-
tions that have an economically similar
result. Any intra-group debt recharacter-
ized as equity by the regulations elimi-
nates the ability of the purported borrower
to deduct interest from its taxable income.

The fourth part of the regulations,
§ 1.385-4T, includes special rules for ap-
plying § 1.385-3 to consolidated groups,
consistent with the general purpose of
§ 1.385-3. References in the following dis-
cussion to "§ 1.385-3" include §§ 1.385-3T
and 1.385-4T. Section 1.385-3 applies only
to debt issued after April 4, 2016, the date
the proposed regulations were published,
and so grandfather intragroup debt issued
before that date.

2\. Limitations of Final and Temporary
Regulations and Significant
Modifications

Taking into consideration the com-
ments received on the proposed regula-

tions, the Treasury Department and the
IRS are modifying the regulations to ad-
dress certain unintended impacts of the
proposal. The final and temporary regula-
tions also better target the entities and
activities that lead to inappropriate inter-
est deductions by limiting the type of
businesses affected. In doing so, the final
and temporary regulations significantly
reduce compliance and administrative
burden, while still placing effective limits
on the transactions most responsible for
inappropriately reducing U.S. tax reve-
nue.

Because tax-motived incentives to mis-
characterize equity as debt depend on a
taxpayer's situation, in certain circum-
stances the likelihood of mischaracteriza-
tion or the consequences thereof are small.
In these circumstances, exceptions to the
general rules may reduce the compliance
or administrative burden of the rules, in-
crease the compliance benefit relative to
associated costs, or avoid unintended
costs. To this end, the final and temporary
regulations limit the type and size of busi-
nesses affected and the types of transac-
tions and activities to which they apply. In
particular, § 1.385-2 only applies to re-
lated groups of corporations where the
stock of at least one member is publicly
traded or the group's financial results re-
port assets exceeding $100 million or an-
nual revenue exceeding $50 million. Be-
cause there is no general definition of a
small business in tax law, these asset and
revenue limits are designed to exceed the
maximum receipts threshold used by the
Small Business Administration in defining
small businesses (U.S. Small Business
Administration, Table of Small Business
Size Standards, 2016). In addition, these
thresholds exclude about 99 percent of C
corporation taxpayers while retaining 85
percent of economic activity as measured
by total income. Approximately 1.5 mil-
lion out of 1.6 million C corporation tax
filers are single entities and therefore have
no affiliates with which to engage in tax
arbitrage. The intent is to limit the regu-
lations to large businesses with highly-
related affiliates, which are responsible for
most corporate activity.

Furthermore, in response to public
comments and analysis of the data related
to the proposed regulations, the rules of
§§ 1.385-2 and 1.385-3 have been signif-

icantly modified. In developing these
modifications, the Treasury Department
and the IRS considered a number of alter-
native approaches suggested by com-
ments, as discussed previously in this pre-
amble. The intended cumulative effect of
these modifications is to focus the appli-
cation of the regulations on large, com-
plex corporate groups where the most
opportunity for non-commercial, tax-
motivated transactions of the type targeted
by the regulations exists, while reducing,
or eliminating, the burdens on other tax-
payers. For example, large FCDCs (assets
over $100 million and total income over
$50 million) make up 3 percent of FCDCs
but report 90 percent of FCDC interest
deductions and 93 percent of FCDC total
income. Similarly, the modifications are
intended to exempt most ordinary course
transactions from the application of the
regulations. The most significant modifi-
cations include the following:

· S corporations, RICs, and REITs that
are not controlled by corporate mem-
bers of an expanded group are ex-
cluded from all aspects of the final and
temporary regulations. See Part
III.B.2.b of the Summary of Com-
ments and Explanation of Revisions.
The Treasury Department and the IRS
have determined that an S corporation,
RIC, or REIT that would otherwise be
the parent of an expanded group is
generally analogous to a non-
controlled partnership. Under both the
proposed and the final and temporary
regulations, a non-controlled partner-
ship that would, if it were a corpora-
tion, be the parent of an expanded
group is excluded from the expanded
group. S corporations, RICs, and
REITs have similar flow-through char-
acteristics in that business income
from these types of aggregate entities
generally flows to and is aggregated on
the business owners' returns. More-
over, S corporations and non-
controlled RICs and REITs are gener-
ally not part of multinational groups
and are unlikely to engage in the types
of transactions targeted by the regula-
tions because these types of entities
have fewer incentives to mischaracter-
ize equity as debt under the U.S. tax
system, so their exclusion generally

does not affect tax compliance benefits
and eliminates compliance costs.

· The regulations reserve on the appli-
cation to non-U.S. issuers (that is, for-
eign corporations that issue debt). See
Part III.A.1 of the Summary of Com-
ments and Explanation of Revisions.
Non-U.S. issuers have limited incen-
tives to mischaracterize equity as debt
under the U.S. tax system because
non-U.S. debt does not generally af-
fect U.S. corporate liability directly ei-
ther because (i) the issuer is entirely
foreign owned (and thus generally out-
side of the U.S. tax system if it lacks a
U.S. presence) or, (ii) in the case of an
issuer that is a CFC, its income is
eligible for deferral. Applying the reg-
ulations to non-U.S. issuers would im-
pact the operations of large, complex
MNCs which may involve foreign-to-
foreign lending or non-U.S. issuance,
which would be burdensome to docu-
ment and monitor for compliance, but
there would be minimal revenue gains
because the use of related party debt in
these contexts generally does not re-
sult in U.S. tax benefits. In general,
there is negligible tax revenue lost by
this exclusion, while compliance costs
are significantly reduced. Neverthe-
less, in certain cases there may be U.S.
tax effects from mischaracterizing in-
terests of non-U.S. issuers, although
these effects are less direct and of a
different nature. The regulations re-
serve on the application to foreign is-
suers as the Treasury Department and
the IRS continue to consider how the
burdens of complying in this context
compare to the advantages of limiting
potential abuses and how a better bal-
ance might be achieved.

· The final and temporary regulations
generally exclude from the rules of
§ 1.385-3 regulated financial services
entities that are subject to certain lev-
els of federal regulation and supervi-
sion, including insurance companies
(other than captive insurers). See Parts
IV.B.2.a and b, and V.G.1 and 2 of the
Summary of Comments and Explana-
tion of Revisions. Regulated financial
service entities are subject to capital or
leverage requirements which constrain
the ability of such institutions to en-
gage in the transactions that are ad-

dressed by the regulations. For exam-
ple, such entities could be precluded
from or required to issue related-party
debt in certain cases. Such an excep-
tion is also generally consistent with
international accepted approaches on
addressing interest stripping, which
acknowledge the special circum-
stances presented by banks and insur-
ance companies. See OECD BEPS
Action Item 4 (Limiting Base Erosion
Involving Interest Deductions and
Other Financial Payments), ch. 10.
Furthermore, compliance costs of in-
cluding these entities in the regulations
would likely have been significant
compared to potential tax revenue
gains from their inclusion. The docu-
mentation rules under § 1.385-2 ex-
empt from some of the documentation
requirements debt instruments issued
by regulated financial service entities
to the extent the debt instruments con-
tain terms required by a regulator to
satisfy regulatory requirements or re-
quire a regulator's approval before
principal or interest is paid.

· The regulations under § 1.385-3 pro-
vide various exceptions and exclusions
that are intended to exempt certain
transactions and certain common com-
mercial lending practices from being
subject to the rules in cases where
compliance burdens or efficiency costs
are likely to be elevated and potential
improvements in tax compliance mod-
est.

· Section 1.385-3 excludes cash
pool borrowing and other short-
term debt, by excluding loans that
are short term in form and sub-
stance. See Part V.D.8 of the Sum-
mary of Comments and Explana-
tion of Revisions. The exception
for short-term debt allows compa-
nies to efficiently transfer cash
around an affiliated group in order
to meet the day-to-day global cash
needs of the business without re-
sorting to third-party borrowing in
order to avoid § 1.385-3. These
transactions tend to have low in-
terest rates such that for a fixed
amount of debt, the interest ex-
pense is limited. On the other
hand, the costs of tracking these
loans, which could occur with high

frequency, for purposes of deter-
mining whether § 1.385-3 applies
may be significant. Therefore, tax
compliance gains from their inclu-
sion are likely to be small relative
to the costs of compliance.

· When applying the § 1.385-3
rules, an expanded earnings and
profits (E&P) exception takes into
account a corporation's E&P accu-
mulated after April 4, 2016, as op-
posed to limiting distributions to
the amount of E&P generated each
year. See Part V.E.3.a of the Sum-
mary of Comments and Explana-
tion of Revisions. The change en-
sures that companies are not
incentivized to make distributions
that use up their current E&P be-
fore it becomes unusable in the
next taxable year. However, the
accumulated E&P available to off-
set distributions or acquisitions re-
sets to zero when there is a change
in control of the issuer, due, for
example, to the issuer being ac-
quired by an unrelated party. The
accumulated E&P available to off-
set distributions or acquisitions
also resets to zero when there is a
change of expanded group parent
(including in an inversion). These
limitations avoid creating incen-
tives for companies (including in-
verted companies) to acquire or
undertake transactions with com-
panies rich in accumulated earn-
ings to circumvent the regulations
by relying on previously accumu-
lated E&P. Therefore, this excep-
tion is of limited benefit to in-
verted corporations seeking to
acquire new U.S. targets or to U.S.
corporations themselves that un-
dertake an inversion that results in
a new foreign parent, which could
otherwise represent a major source
of tax revenue loss.

· The final and temporary regula-
tions allow a taxpayer to reduce
the amount of its distributions and
acquisitions that otherwise could
cause an equal amount of the tax-
payer's debt to be recharacterized
as equity by the amount of the
contributions to the taxpayer's
capital. This has the effect of treat-

ing distributions and acquisitions
as funded by new equity contribu-
tions before related-party borrow-
ings and ensuring that companies
that have not seen a reduction in
net equity are not subject to the
rules. See Part V.E.3.b of the Sum-
mary of Comments and Explana-
tion of Revisions.

· The final and temporary regula-
tions expand access to the $50 mil-
lion indebtedness exception by re-
moving the "cliff effect" of the
threshold exception under the pro-
posed regulations, so that all tax-
payers can exclude the first $50
million of indebtedness that other-
wise would be recharacterized. See
Part V.E.4 of the Summary of
Comments and Explanation of Re-
visions. Eliminating the $50 mil-
lion cliff has little tax revenue ef-
fect but eliminates a potential
economic distortion to the financ-
ing choices of corporations near
the threshold.

· The regulations reduce and relax
the documentation rules in various
ways that reduce compliance bur-
dens without compromising tax
compliance.

· The documentation requirements
in § 1.385-2 do not apply until
January 1, 2018. Delaying the doc-
umentation requirements margin-
ally lowers the start-up costs re-
lated to complying with the
regulations. The effect on revenue
is expected to be negligible and the
compliance costs slightly lower.

· The compliance period for docu-
menting a loan has been extended
from 30 days after issuance (or
other relevant date) to instead be
the date when the borrower's tax
return is filed. Providing additional
time for the recurring documenta-
tion requirements may lower the
compliance burden while still pro-
viding documentation necessary
for tax administration.

· The documentation rules have
been eased so that a failure with
respect to documentation of a par-
ticular instrument does not auto-
matically result in recharacteriza-
tion as equity where a group is

otherwise substantially compliant
with the rules. See Parts IV.A.2
and 3 of the Summary of Com-
ments and Explanation of Revi-
sions. This relief is expected to
have negligible tax revenue cost
while potentially lowering compli-
ance costs for companies and in-
creasing costs for the IRS.

· The final and temporary regula-
tions do not include a general rule
that bifurcates (for tax purposes) a
single financial instrument into
debt and equity components. See
Part III.D of the Summary of
Comments and Explanation of Re-
visions. The general bifurcation
rule in the proposed regulations
was broadly applicable and not
subject to the same threshold rules
as most of the regulations' other
provisions. The proposed rule is
not being finalized due to con-
cerns about a lack of specificity in
application and corresponding un-
intended collateral consequences.
For example, one concern was
that this provision could have un-
intended and disqualifying effects
on an entity's tax status, such as
for an S Corporation or a REIT.
The regulatory revenue effect was
reduced by approximately 10 per-
cent as a result of this change.

The exceptions and exclusions summa-
rized in this Regulatory Impact Assess-
ment limit the compliance burden im-
posed by the final and temporary
regulations at limited revenue cost.
Hence, the final and temporary regulations
narrowly target the transactions of great-
est concern while still being administra-
ble.

## D. Assessment of the regulations' effects

The documentation requirements for
purported debt (§ 1.385-2) are likely to
affect the largest number of corporations.
As mentioned previously, in 2012 there
were roughly 1.6 million U.S. C corpora-
tion tax returns filed (tax filings for con-
solidated groups are counted as one re-
turn). The Treasury Department and the
IRS estimate that only 6,300 (0.4 percent)
of these taxpayers would be affected by
the documentation rules, mainly because

95 percent of taxpayers do not have affil-
iated corporations, and the regulations
only affect transactions between affiliates.

While only a small fraction of corpo-
rate taxpayers will be affected by
§ 1.385-2, these 6,300 taxpayers tend to
be the largest, with 65 percent of total
interest deductions, 53 percent of total
income, 81 percent of total income subject
to tax, and 75 percent of total income tax
after credits. Of these corporations, ap-
proximately one-third are FCDCs that re-
port about 20 percent of the affected total
income and 20 percent of the affected
interest deductions.

A subset of these corporate taxpayers,
including both domestic and foreign-
controlled domestic corporations, are
likely to be affected by § 1.385-3. While
it is difficult to measure the exact number
of firms that are likely to be affected due
to tax data limitations, Treasury estimates
that of the 6,300 firms affected by
§ 1.385-2, about 1,200 will be affected by
§ 1.385-3. The number of firms affected
is smaller because only transactions that
exceed $50 million plus relevant E&P and
capital contributions are affected, and be-
cause other exemptions in the final and
temporary regulations limit the number of
firms affected. The largest revenue effects
are anticipated to arise from foreign-
controlled domestic corporations.

The regulations are intended to address
scenarios that present the most potential
for the creation of significant U.S. federal
tax benefits without having meaningful
non-tax significance because the obliga-
tions are between commonly-owned cor-
porations and because the obligations do
not finance new investment in the issuer.
These situations most affect revenues due
to tax arbitrage. That is, the regulations
are tailored to reach only transactions be-
tween related parties (where the risk of
such tax arbitrage is greatest), tax situa-
tions and transactions where incentives
for mischaracterization of equity as debt
are strongest, and only then when there is
no new investment in the borrowing en-
tity. In developing the regulations, care
was taken to balance the goals of address-
ing the areas where mischaracterization of
equity was likely to result in tax avoid-
ance and to introduce economic distor-
tions against the higher compliance costs
placed on business.

The likely effects of the rules in terms
of their economic benefits and costs are
discussed in the subsequent sections. The
Treasury Department and the IRS used the
best available studies, models, and data to
estimate the effects of this rule. However,
with regard to certain issues, relatively
little relevant data and few rigorous stud-
ies are available.

### 1. Monetized Estimates of the Benefits and Costs

The primary benefit of the regulations
is an improvement in tax compliance,
which is expected to increase tax revenue.
In addition, there are likely to be modest
efficiency benefits because differences in
the tax treatment of competing corpora-
tions are reduced. The primary cost of the
regulations is the change in compliance
costs of businesses, particularly from the
§ 1.385-2 documentation rules.

## a. Revenue effects associated with improved compliance

Because the regulations cover only
new debt issuances occurring after April
4, 2016, and because the primary effect of
the regulations is to limit the extent to
which the transactions subject to the reg-
ulations can be used to achieve interest
stripping, the revenue estimate is calcu-
lated primarily as a percentage reduction
in the estimated growth in interest strip-
ping relative to the baseline of current law
absent these regulations. While the regu-
lations are also likely to reduce tax avoid-
ance by affiliated domestic corporations
that do not file a consolidated return, those
revenue effects are likely to be smaller
and data limitations preclude an exact es-
timate of their magnitude. The estimated
growth in interest stripping is the sum of
estimates of the growth of interest strip-
ping by existing FCDCs plus interest
stripping by new FCDCs. Growth in in-
terest stripping by existing FCDCs was
calculated from the estimate of interest
stripping by inverted corporations based
on the Seida and Wempe and Bloomberg
studies, inflated to 2016 dollars, and dou-
bled to incorporate the amount of interest
stripping by all other FCDCs, which are
more numerous but where interest strip-
ping is likely to be less intensive. The

level of interest stripping is assumed to
grow at a 5 percent rate annually.

Interest stripping by new FCDCs was
derived from the average interest stripping
by firms in the Seida and Wempe (2004)
subsample, discussed above, inflated to
2016 dollars. Based on inversion rates for
the past 20 years, growth by three inver-
sions of this average size per year was
assumed. This assumed growth was dou-
bled to account for interest stripping by
new FCDCs not created by inversion.

The assumed percentage reductions in
interest stripping by existing FCDCs and
by the creation of new FCDCs were in the
mid-single digits, with the latter some-
what smaller than the former because in-
terest stripping is not the sole reason for
FCDC creation. The limitations and ex-
clusions detailed above restrict the af-
fected amounts of debt to a small fraction
of total debt outstanding. The most impor-
tant of these limitations and exclusions are
the exception for short-term debt, the appli-
cation of the regulations solely to related-
party debt, the exclusion for most distribu-
tions separated by at least 36 months from
debt issuance, and the E&P exception. Fur-
ther, the grandfathering of existing interest
stripping arrangements suggests that very
little additional tax revenue will be paid in
the short term, but that the growth rate of
revenue will be high.

While the regulations also apply to af-
filiated domestic corporations that do not
file a consolidated return, there is no good
information on the extent of interest strip-
ping by such groups. The tax benefits of

such interest stripping are likely of a
smaller magnitude, because in the purely
domestic context, both the interest deduc-
tions and the interest income are subject to
the same U.S. tax system and hence inter-
est stripping to reduce total U.S. tax lia-
bility in this context relies on asymmetric
tax positions across the affiliated groups.
As a result, the revenue estimate excludes
tax revenue from purely domestic groups.

Both §§ 1.385-2 and 1.385-3 contrib-
ute to the revenue gain.

The § 1.385-2 rules requiring docu-
mentation of instruments to support debt
characterization are consistent with best
documentation practices under case law,
but many taxpayers do not currently fol-
low best documentation practices. Specif-
ically, the existence of a written loan
agreement and an evaluation of the cred-
itworthiness of a borrower are factors
used by courts in deciding whether an
intercompany advance should be treated
as debt or equity; however, under current
law taxpayers are able to sustain debt treat-
ment even in the absence of documentation.
Elevating the importance of documentation
will both aid in IRS audits (by requiring a
taxpayer to show contemporaneous relevant
documentation as to the parties' intent and
their analysis of the borrower's ability to
pay) and prevent taxpayers from character-
izing intercompany debt with the aid of
hindsight. Both effects will improve com-
pliance and thus raise tax revenue.

The revenue gain is also due to the
§ 1.385-3 rules, which should limit the
ability to mischaracterize equity as debt to

facilitate interest stripping behaviors to
the extent not covered by the exclusions
and limitations previously discussed. For
example, under the regulations those tax-
payers choosing to interest strip by bor-
rowing from unrelated parties will have an
incentive to minimize interest rates rela-
tive to what they pay to highly-related
parties. Alternatively, taxpayers may
choose to separate borrowings from dis-
tributions by more than 3 years, but there
will be incentives to earn as much as
possible on the funds in the interim, and
such earnings offset interest deductions.

Other significant limits on revenue
gain from these rules include the avail-
ability of other means of earnings strip-
ping, such as royalties and management
fees, that can substitute for interest.

Preliminary estimates of the regulatory
revenue effect are $7.4 billion over 10
years (or $600 million per year on an
annualized 3 percent discounted basis).
There is not a single answer to the ques-
tion of how much revenue is generated by
each piece of the regulations. This is be-
cause interactions between the pieces
make the allocated subtotals depend on
the order in which the allocation is made.
If one assumes that § 1.385-2 is "stacked
first," then § 1.385-2 accounts for approx-
imately $1.5 billion of the total, and
§ 1.385-3 accounts for the rest.

Annual discounted total revenue ef-
fects ($ millions in 2016 dollars) are
shown below.

Annualized Monetized Transfer

Fiscal Years 2017 to 2026 (3% Discount Rate, 2016)

Fiscal Years 2017 to 2026 (7% Discount Rate. 2016)

Estimated change in annual tax revenue - from firms to the Federal Government

$600

$461

The regulations as originally proposed
would have raised $10.1 billion over 10
years (or $843 million on an annualized 3
percent discounted basis). Since then,
modifications of the rules have lowered
the revenue estimate by approximately 25
percent. The modifications that lowered
the revenue estimate include: the short-
term debt exception and the exclusion of
the § 1.385-1 rules allowing the bifurca-
tion of instruments into debt and equity
components from this analysis.

## b. Compliance burden

Most of the compliance burden will
stem from the rules requiring documenta-
tion of intra-group loans. Our analysis
thus focuses on the compliance effects of
the § 1.385-2 documentation require-
ments.

The Treasury Department and the IRS
use the IRS business taxpayer burden
model to estimate the additional compli-
ance burden imposed on businesses by the

regulations. These compliance costs are
borne by businesses and are the primary
costs imposed by this rule.

The IRS business taxpayer burden
model used to calculate this compliance
cost estimate is a micro-simulation model
created by the IRS to provide monetized
estimates of compliance costs for the busi-
ness income tax return population. The
model is based on an econometric speci-
fication developed using linked compli-
ance cost survey data and tax return data.

This model accounts for time as well as
out-of-pocket costs of businesses and con-
trols for the substitution of time and
money by monetizing time and reporting
total compliance costs in dollars. Costs are
differentiated based on the characteristics
and size of the business. For more detailed
information on this methodology, see
"Taxpayer Compliance Costs for Corpo-
rations and Partnerships: A New Look";
Contos, Guyton, Langetieg, Lerman, Nel-
son; SOI Tax Stats - 2012 IRS-TPC Re-
search Conference. https://www.irs.gov/
pub/irs-soi/12rescontaxpaycompliance.
pdf.

Estimates of the change in compliance
costs as a result of the regulations are
produced using a process that compares
results from a baseline scenario simula-
tion (representing current law and prac-
tice) with an alternative scenario simula-
tion (representing the effects of the
regulations). The difference between the
baseline and alternative simulation serves
as the estimated compliance cost effect of
the regulations.

The estimates are likely to be some-
what overstated for two practical reasons.
First, they do not allow for a decline in
compliance costs over time as firms be-
come more accustomed to documenting
loans. Second, the analysis assumes that
the documentation requirements apply im-
mediately to all existing loans when the
§ 1.385-2 apply prospectively to loans
originated on or after January 1, 2018.
While this is intended to provide an accu-
rate estimate of the ongoing costs of
documentation in the future, it will take
several years for all of a company's intra-
group loans to be covered by the regula-
tions. Hence, the actual volume of loans
requiring documentation and associated
costs will initially be smaller. Thus, the
compliance cost for any one of the first
several years in which the regulations are
in effect will be lower.

Tax data were used to identify the (ap-
proximately) 6,300 businesses likely to be
affected by § 1.385-2 because they are
estimated to have intercompany loans
subject to the regulations. About 5,200 of
these businesses have foreign affiliates,
while the remaining firms have intercom-
pany loans between U.S. affiliates.

Compliance costs are unlikely to be the
same on a per firm basis, since some firms

are likely to engage in more transactions
requiring documentation, and, conditional
on current practice, some firms are going
to have greater compliance costs per
transaction. The tax data are used to esti-
mate for each firm the number of transac-
tions likely to require documentation
(based on interest payments) and to place
firms in categories that reflect differences
in compliance cost per dollar of transac-
tion.

Estimates using the IRS model show a
compliance cost increase of approxi-
mately $56 million or an average of
$8,900 per firm in 2016 dollars. In 2012,
net income for these taxpayers was about
$960 billion, so the documentation re-
quirements would reduce profits for these
taxpayers by, on average, roughly 0.006
percent. Of course, the experience of each
affected firm will vary.

These estimates are higher than the $13
million estimate for the proposed regula-
tions because of modifications in the reg-
ulations and adjustments to the methodol-
ogy used to estimate the costs. The
proposed regulations would have affected
more businesses (21,000), but the modifi-
cations in response to comments signifi-
cantly reduced the number affected (to
6,300). In and of itself, this would have
significantly lowered the compliance cost.
However, the initial estimate projected an
average cost per business of $600, while
the revised estimate projects an average
cost per business of about $8,900. This
change in the cost per business resulted in
a higher overall compliance cost, all else
being constant. The initial estimate was
based on assumptions and modeling
approaches, including a lower-than-
appropriate wage rate for accountants and
attorneys working on the compliance is-
sues, that were subsequently revised in
light of comments received. The revised
estimate is based on a more complete
analysis by the IRS burden model.

The burden estimate is lower than
those suggested in some of the comments
received on the proposed regulations. In
part, this is because some comments as-
sumed that none of the affected businesses
have any documentation of affected loans,
when other businesses, reported that they
already maintain some or all of the infor-
mation required. In addition, however, our
estimate is lower because the final and

temporary regulations have been modified
in many ways in order to reduce the bur-
den, in response to the comments re-
ceived. For example, the final rules apply
just to U.S. borrowers, while the proposed
regulations also applied to borrowing be-
tween foreign affiliates. These foreign-to-
foreign transactions are now outside the
scope of the regulations, so that the num-
bers of businesses and transactions subject
to the rule are reduced. This change re-
duces the compliance costs compared to
those originally proposed.

The $56 million estimate only reflects
ongoing compliance costs. It does not re-
flect the initial startup costs and infra-
structure investment. Initial startup costs
and infrastructure investment are expected
to result in additional costs in the first
years that the section 385 regulations are
in effect. IRS-supported research by For-
rester in 2013 indicates these one-time
start-up expenses are approximately four
times the annual costs, or approximately
$224 million in 2016 dollars primarily
over the initial years when the section 385
regulations go into effect. Most of these
start-up costs are in 2017 even though the
§ 1.385-2 regulations require documenta-
tion starting in 2018. The ongoing and
start-up costs are reported on an annual
average basis in the table on these costs.
In addition, the analysis includes a sensi-
tivity analysis in which the compliance
costs are estimated for a 90 percent inter-
val around our best estimate. First the
distributional characteristics of critical pa-
rameters used to produce the estimate are
evaluated. Then Monte Carlo simulations
are used to vary the parameter values.
Finally, alternative high and low estimates
are computed based on parameter values
at either end of the 90 percent range.
These ongoing compliance cost estimates
range from $29 million per year on an
annualized basis in 2016 dollars to $60
million. Using the same factor of four to
estimate one-time start-up expenses, these
range from $15 million per year on an
annualized basis in 2016 dollars to $27
million. These combined ongoing and
start-up costs on an annual average basis
for both the high and low estimates appear
in the table summarizing these costs. Our
sensitivity analysis indicates that even us-
ing the high compliance cost estimates,
that tax revenues generated by the regula-

tions would be 6 to 7 times as large as
these costs.

Annual discounted ongoing and
start-up compliance costs ($ millions in
2016 dollars) are shown below.

Compliance costs associated with addressing

Fiscal Years 2017 to 2026 (3% Discount Rate, 2016)

Fiscal Years 2017 to 2026 (7% Discount Rate, 2016)

Central estimate

$70

$59

High estimate

$87

$73

Low estimate

$52

$44

### 2. Non-Monetized Effects

## a. Increased Tax Compliance System Wide

The U.S. tax system relies for its effec-
tiveness on voluntary tax compliance.
Voluntary compliance is eroded when
there is a perception that some taxpayers
are able to avoid paying their fair share of
the tax burden. Tax strategies of large
multinational corporations, such as inter-
est stripping, have been widely reported in
the press as inappropriate ways for these
companies to avoid paying their fair share
of taxes. By reducing the ability of such
firms to strip earnings out of the U.S.
through transactions with no meaningful
economic or non-tax effect, and so raising
their tax payments, the regulations are
likely to increase the overall perceived
legitimacy of the U.S. tax system, and
hence promote voluntary compliance.
This effect is not quantified.

## b. Efficiency and growth effects

By changing the treatment of certain
transactions and activities, the regulations
potentially affect economic efficiency and
growth (output). While these changes may
have multiple and, to some extent, offset-
ting effects, on net, they are likely to
improve economic efficiency. For exam-
ple, the regulations reduce the tax advan-
tage foreign owners have over domestic
owners of U.S. assets, and consequently
reduce the propensity for foreign pur-
chases and ownership of U.S. assets that
are motivated by tax considerations rather
than economic substance. While these ef-
fects are likely to be small, they are likely
to enhance efficiency and growth. By re-
ducing tax-motivated acquisitions or own-
ership structures, the regulations may en-
courage assets to be owned or managed by

those most capable of putting the assets to
their highest-valued use. In addition, the
regulations reduce the tax benefit of inver-
sions, which can have economic costs to
the United States even if the actual man-
agement of a firm is not changed when the
firm's ownership changes. And, it may
help to put purely domestic U.S. firms on
more even tax footing with their foreign-
owned competitors operating in the
United States. On the other hand, the reg-
ulations may slightly increase the effec-
tive tax rate and compliance costs on U.S.
inbound investment. While the magnitude
of this increase is small because of those
provisions that exempt transactions fi-
nancing new investment, to the extent that
it reduces new capital investment in the
U.S. its effects would be efficiency and
growth reducing. On balance, the likely
effect of the regulations is to improve the
efficiency of the corporate tax system.

The extent to which the regulations'
changes in tax prices affect real U.S. eco-
nomic activity depends on their size and
on taxpayers' reaction to the changes. At
the outset, it is important to realize that the
change in tax prices associated with
the regulations are likely to be small. The
estimated total tax paid by the 1,200 tax-
payers affected by the § 1.385-3 rules was
$13 billion in 2016 dollars. The annual-
ized 3 percent discounted revenue effect is
$600 million per year in 2016 dollars.
Even assuming that all of the revenue
comes from the § 1.385-3 rules (which
overstates the relevant revenue) implies
that the affected taxpayers would pay less
than 5 percent (roughly 1 percentage
point) in additional tax, which is likely far
less than their current tax advantage rela-
tive to domestic non-FCDCs corporations.
(For example, Seida and Wempe find that
the average reduction in effective tax rates
of corporations in their inversion sample
was 11.57 percentage points.) Further-

more, much evidence points to relatively
small behavioral reactions to such tax
changes. Many analysts have argued that
even major changes in tax policy have no
more than modest effects on the economy.
For an idea of the range of results, see
Congressional Research Service Report
R42111, Tax Rates and Economic
Growth, by Jane G. Gravelle and Donald
J. Marples, January, 2015; Joint Commit-
tee on Taxation Staff, Macroeconomic
Analysis of the "Tax Reform Act of 2014",
JCX 22-14, February 26, 2014; Robert
Carroll, John Diamond, Craig Johnson,
and James Mackie, A Summary of the
Dynamic Analysis of the Tax Reform Op-
tions Prepared for the President's Advi-
sory Panel on Federal Tax Reform, Office
of Tax Analysis Paper Prepared for the
American Enterprise Institute Conference
on Tax Reform and Dynamic Analysis,
May 25, 2006. It is unlikely, then, that a
small tax increase on a small set of com-
panies would have a measurable effect on
major economic aggregates.

Although the rules are designed to
minimize any detrimental effect on U.S.
investment, the regulations do to some
extent make the U.S. a less attractive lo-
cation for foreign investment. The effect
is likely to be small, however because the
rules exclude financing activities that are
clearly associated with new investment in
the U.S. For example, interest paid by a
FCDC to a related party on new borrow-
ing used to make a new investment in the
U.S. would continue to be deductible.
This is true, moreover, even if the new
debt comes in the form of a "dividend"
note paid out of E&P generated after the
regulation's effective date. Such new debt
finances new U.S. investment in the sense
that the FCDC retains and invests in the
United States cash earned on U.S. profits,
rather than sending the cash to its foreign
parent as a dividend.

Furthermore, most inbound investment
is via acquisition of existing U.S. compa-
nies rather than greenfield (new) invest-
ment in the U.S., and so changes the
ownership of existing assets, without nec-
essarily adding to the stock of capital em-
ployed in the U.S. Such acquisitions and
cross-border mergers can make the U.S.
economy stronger by encouraging foreign
investment to flow into the United States
and by enabling U.S. companies to invest
overseas. But in an efficient market, these
transactions should be driven by genuine
business strategies and economic benefits,
not simply by a desire to avoid U.S. taxes.
One effect of the regulations is to reduce
tax-motivated incentives for foreign own-
ership instead of domestic ownership of
domestic companies and thus to improve
economic efficiency. As Mihir A. Desai
and James R. Hines, Jr. write, "given the
central importance of ownership to the
nature of multinational firms, there is
good reason to be particularly concerned
about the potential for economic ineffi-
ciency due to distortions to ownership pat-
terns." "Evaluating International Tax Re-
form," National Tax Journal 56 No. 3
(September, 2003): 487-502. By reducing
the tax advantage to foreign ownership,
the regulations may help to promote a
more efficient ownership structure, one
guided more by economic fundamentals
and less by tax benefits.

Recently, apparently tax-motivated ac-
quisitions of U.S. companies by foreign
businesses have attracted much attention
in the debate over inversions. Much of this
debate has focused on the tax cost to the
U.S. government, which can be substan-
tial. But there could be other costs as well.
For example, headquarters jobs may leave
the United States. In addition, formerly
U.S. headquartered companies may lose
their U.S. focus and identity over time,
which could reduce the incentive to keep
production and research in the United
States. Interest stripping is a primary tax
benefit of inversions. By reducing the tax
benefit of certain types of interest strip-
ping, the regulations thus are likely to
reduce, to some extent, the tax incentive
for inversions. However, any reduction in
inversion activity is likely to be modest
because the tax change is small and leaves
in place tax advantages for foreign own-

ership, e.g., through interest stripping not
prohibited by the regulation.

Finally, because FCDCs currently face
lower effective tax rates than can be
achieved by domestic U.S. firms, even
when operating in domestic markets, they
currently enjoy a competitive advantage
in pricing, marketshare, and profitability.
To the extent that this rule reduces this tax
advantage, it levels the playing field rela-
tive to U.S. corporations, and thereby pro-
motes efficient economic choices -
choices motivated by underlying eco-
nomic fundamentals, rather than by tax
differences.

## c. Lower Tax Administrative Costs for the IRS.

The increased loan documentation re-
quired of large corporations will help the
IRS to more effectively administer the tax
laws by making it easier for the IRS to
evaluate whether purported debt transac-
tions are legitimate loans. This will lower
the cost of auditing and evaluating the tax
returns of companies engaged in these
transactions. The lower administrative
cost for the IRS offsets to some degree the
higher compliance cost placed on corpo-
rations. It has not been possible, however,
to quantify the cost savings.

### II. Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility
Act (5 U.S.C. Chapter 6), it is hereby
certified that the final and temporary reg-
ulations will not have a significant eco-
nomic impact on a substantial number of
small entities. Accordingly, a regulatory
flexibility analysis is not required.

The Commissioner and the courts his-
torically have analyzed whether an inter-
est in a corporation should be treated as
stock or indebtedness for federal tax pur-
poses by applying various sets of factors
to the facts of a particular case. Section
1.385-1 does not require taxpayers to take
any additional actions or to engage in any
new procedures or documentation. Be-
cause § 1.385-1 contains no such require-
ments, it does not have an effect on small
entities.

To facilitate the federal tax analysis of
an interest in a corporation, taxpayers are
required under existing law to substantiate

their classification of an interest as stock
or indebtedness for federal tax purposes.
Section 1.385-2 provides minimum stan-
dards on documentation needed to sub-
stantiate the treatment of certain related-
party instruments as indebtedness, and
provides rules on the weighting of partic-
ular factors in conducting such analysis.
Section 1.385-2 will not have an impact
on a substantial number of small entities
for several reasons. First, the rules do not
apply to S corporations or non-controlled
pass-through entities. Second, the rules
apply only to debt in form issued within
expanded groups of corporations. Third,
§ 1.385-2 only applies to expanded
groups if the stock of a member of the
expanded group is publicly traded, or fi-
nancial statements of the expanded group
or its members show total assets exceed-
ing $100 million or annual total revenue
exceeding $50 million. Because the rules
are limited to larger expanded groups,
they will not affect a substantial number
of small entities.

Section 1.385-3 provides that certain
interests in a corporation that are held by
a member of the corporation's expanded
group and that otherwise would be treated
as indebtedness for federal tax purposes
are treated as stock. Section 1.385-3T
provides that for certain debt instruments
issued by a controlled partnership, the
holder is deemed to transfer all or a por-
tion of the debt instrument to the partner
or partners in the partnership in exchange
for stock in the partner or partners. Sec-
tion 1.385-4T provides rules regarding
the application of §§ 1.385-3 and
1.385-3T to members of a consolidated
group. Sections 1.385-3 and 1.385-3T in-
clude multiple exceptions that limit their
application. In particular, the threshold
exception provides that the first $50 mil-
lion of expanded group debt instruments
that otherwise would be reclassified as
stock or deemed to be transferred to a
partner in a controlled partnership under
§ 1.385-3 or § 1.385-3T will not be re-
classified or deemed transferred under
§ 1.385-3 or § 1.385-3T. Although it is
possible that the classification rules in
§§ 1.385-3, 1.385-3T, and 1.385-4T
could have an effect on small entities, the
threshold exception of the first $50 mil-
lion of debt instruments otherwise subject
to recharacterization or deemed transfer

under §§ 1.385-3, 1.385-3T, and
1.385-4T makes it unlikely that a sub-
stantial number of small entities will be
affected by §§ 1.385-3, 1.385-3T, and
1.385-4T.

Pursuant to section 7805(f) of the
Code, these regulations have been submit-
ted to the Chief Counsel for Advocacy of
the Small Business Administration for
comment on their impact on small busi-
ness. Comments were received requesting
that the monetary thresholds contained in
proposed §§ 1.385-2, 1.385-3, and
1.385-4 be increased in order to mitigate
the impact on small businesses. These
comments are addressed in Parts IV.B.1.d
and V.E.4 of the Summary of Comments
and Explanation of Revisions. No com-
ments were received concerning the eco-
nomic impact on small entities from the
Small Business Administration.

## III. Congressional Review Act

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

## IV. Unfunded Mandates Reform Act

Section 202 of the Unfunded Mandates
Reform Act of 1995 ("Unfunded Man-
dates Act"), Public Law 104-4 (March
22, 1995), requires that an agency prepare
a budgetary impact statement before pro-
mulgating a rule that may result in expen-
diture by state, local, and tribal govern-
ments, in the aggregate, or by the private
sector, of $100 million or more in any one
year. If a budgetary impact statement is
required, section 205 of the Unfunded
Mandates Act also requires an agency to
identify and consider a reasonable number
of regulatory alternatives before promul-
gating a rule. See Part I of this Special

Analyses for a discussion of the budgetary
impact of this final rule.

## Drafting Information

The principal authors of these regula-
tions are Austin M. Diamond-Jones of the
Office of Associate Chief Counsel (Cor-
porate) and Joshua G. Rabon of the Office
of Associate Chief Counsel (Interna-
tional). However, other personnel from
the Treasury Department and the IRS par-
ticipated in their development.

* * * * *

## Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is
amended as follows:

### PART 1-INCOME TAXES

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

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

Section 1.385-1 also issued under 26
U.S.C. 385.

Section 1.385-2 also issued under 26
U.S.C. 385, 6001, 6011, and 7701(l).

Section 1.385-3 also issued under 26
U.S.C. 385, 701, 1502, 1504(a)(5)(A), and
7701(l).

Section 1.385-3T also issued under 26
U.S.C. 385, 701, 1504(a)(5)(A), and
7701(l).

Section 1.385-4T also issued under 26
U.S.C. 385 and 1502.

* * * * *

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

§ 1.385-1 General provisions.

(a) Overview of section 385 regula-
tions. This section and §§ 1.385-2
through 1.385-4T (collectively, the sec-
tion 385 regulations) provide rules under
section 385 to determine the treatment of
an interest in a corporation as stock or
indebtedness (or as in part stock and in
part indebtedness) in particular factual sit-
uations. Paragraph (b) of this section pro-
vides the general rule for determining the
treatment of an interest based on provi-
sions of the Internal Revenue Code and on
common law, including the factors pre-
scribed under common law. Paragraphs

(c), (d), and (e) of this section provide
definitions and rules of general applica-
tion for purposes of the section 385 regu-
lations. Section 1.385-2 provides addi-
tional guidance regarding the application
of certain factors in determining the fed-
eral tax treatment of an interest in a cor-
poration that is held by a member of the
corporation's expanded group. Section
1.385-3 sets forth additional factors that,
when present, control the determination of
whether an interest in a corporation that is
held by a member of the corporation's
expanded group is treated (in whole or in
part) as stock or indebtedness. Section
1.385-3T(f) provides rules on the treat-
ment of debt instruments issued by certain
partnerships. Section 1.385-4T provides
rules regarding the application of the fac-
tors set forth in § 1.385-3 and the rules in
§ 1.385-3T to transactions described in
those sections as they relate to consoli-
dated groups.

(b) General rule. Except as otherwise
provided in the Internal Revenue Code
and the regulations thereunder, including
the section 385 regulations, whether an
interest in a corporation is treated for pur-
poses of the Internal Revenue Code as
stock or indebtedness (or as in part stock
and in part indebtedness) is determined
based on common law, including the fac-
tors prescribed under such common law.

(c) Definitions. The definitions in this
paragraph (c) apply for purposes of the
section 385 regulations. For additional
definitions that apply for purposes of their
respective sections, see §§ 1.385-2(d),
1.385-3(g), and 1.385-4T(e).

(1) Controlled partnership. The term
controlled partnership means, with respect
to an expanded group, a partnership with
respect to which at least 80 percent of the
interests in partnership capital or profits
are owned, directly or indirectly, by one
or more members of the expanded group.
For purposes of identifying a controlled
partnership, indirect ownership of a part-
nership interest is determined by applying
the principles of paragraph (c)(4)(iii) of
this section. Such determination is sepa-
rate from the determination of the status
of a corporation as a member of an ex-
panded group. An unincorporated organi-
zation described in § 1.761-2 that elects to
be excluded from all of subchapter K of

chapter 1 of the Internal Revenue Code is
not a controlled partnership.

(2) Covered member. The term covered
member means a member of an expanded
group that is-

(i) A domestic corporation; and

(ii) [Reserved]

(3) Disregarded entity. The term disre-
garded entity means a business entity (as
defined in § 301.7701-2(a) of this chap-
ter) that is disregarded as an entity sepa-
rate from its owner for federal income tax
purposes under §§ 301.7701-1 through
301.7701-3 of this chapter.

(4) Expanded group-(i) In general.
The term expanded group means one or
more chains of corporations (other than
corporations described in section 1504(b)
(8)) connected through stock ownership
with a common parent corporation not
described in section 1504(b)(6) or (b)(8)
(an expanded group parent), but only if-

(A) The expanded group parent owns
directly or indirectly stock meeting the
requirements of section 1504(a)(2) (mod-
ified by substituting "or" for "and" in sec-
tion 1504(a)(2)(A)) in at least one of the
other corporations; and

(B) Stock meeting the requirements of
section 1504(a)(2) (modified by substitut-
ing "or" for "and" in section 1504(a)(2)
(A)) in each of the other corporations (ex-
cept the expanded group parent) is owned
directly or indirectly by one or more of the
other corporations.

(ii) Definition of stock. For purposes of
paragraph (c)(4)(i) of this section, the
term stock has the same meaning as
"stock" in section 1504 (without regard to
§ 1.1504-4) and all shares of stock within
a single class are considered to have the
same value. Thus, control premiums and
minority and blockage discounts within a
single class are not taken into account.

(iii) Indirect stock ownership. For pur-
poses of paragraph (c)(4)(i) of this sec-
tion, indirect stock ownership is deter-
mined by applying the constructive
ownership rules of section 318(a) with the
following modifications:

(A) Section 318(a)(1) and (a)(3) do not
apply except as set forth in paragraph
(c)(4)(v) of this section;

(B) Section 318(a)(2)(C) applies by
substituting "5 percent" for "50 percent;"
and

(C) Section 318(a)(4) only applies to
options (as defined in § 1.1504-4(d)) that
are reasonably certain to be exercised as
described in § 1.1504-4(g).

(iv) Member of an expanded group or
expanded group member. The expanded
group parent and each of the other corpo-
rations described in paragraphs (c)(4)(i)
(A) and (c)(4)(i)(B) of this section is a
member of an expanded group (also re-
ferred to as an expanded group member).
For purposes of the section 385 regula-
tions, a corporation is a member of an
expanded group if it is described in this
paragraph (c)(4)(iv) of this section imme-
diately before the relevant time for deter-
mining membership (for example, imme-
diately before the issuance of an EGI (as
defined in § 1.385-2(d)(3)) or a debt in-
strument (as defined in § 1.385-3(g)(4))
or immediately before a distribution or
acquisition that may be subject to
§ 1.385-3(b)(2) or (3)).

(v) Brother-sister groups with non-
corporate owners. [Reserved]

(vi) Special rule for indirect ownership
through options for certain members of
consolidated groups. In the case of an
option of which a member of a consoli-
dated group, other than the common par-
ent, is the issuing corporation (as defined
in § 1.1504-4(c)(1)), section 318(a)(4)
only applies (for purposes of applying
paragraph (c)(4)(iii)(C) of this section) to
the option if the option is treated as stock
or as exercised under § 1.1504-4(b) for
purposes of determining whether a corpo-
ration is a member of an affiliated group.

(vii) Examples. The following exam-
ples illustrate the rules of this paragraph
(c)(4). Except as otherwise stated, for pur-
poses of the examples in this paragraph
(c)(4)(vii), all persons described are cor-
porations that have a single class of stock
outstanding and file separate federal tax
returns and are not described in section
1504(b)(6) or (b)(8). In addition, the stock
of each publicly traded corporation is
widely held such that no person directly or
indirectly owns stock in the publicly
traded corporation meeting the require-
ments of section 1504(a)(2) (as modified
by this paragraph (c)(4)).

Example 1. Two different expanded group par-
ents. (i) Facts. P has two classes of common stock
outstanding: Class A and Class B. X, a publicly
traded corporation, directly owns all shares of P's
Class A common stock, which is high-vote common

stock representing 85% of the vote and 15% of the
value of the stock of P. Y, a publicly traded corpo-
ration, directly owns all shares of P's Class B com-
mon stock, which is low-vote common stock repre-
senting 15% of the vote and 85% of the value of the
stock of P. P directly owns 100% of the stock of S1.

(ii) Analysis. X owns directly 85% of the vote of
the stock of P, which is stock meeting the require-
ments of section 1504(a)(2) (as modified by para-
graph (c)(4)(i)(A) of this section). Therefore, X is an
expanded group parent described in paragraph
(c)(4)(i) of this section with respect to P. Y owns
85% of the value of the stock of P, which is stock
meeting the requirements of section 1504(a)(2) (as
modified by paragraph (c)(4)(i)(A) of this section).
Therefore, Y is also an expanded group parent de-
scribed in paragraph (c)(4)(i) of this section with
respect to P. P owns directly 100% of the voting
power and value of the stock of S1, which is stock
meeting the requirements of section 1504(a)(2) (as
modified by paragraph (c)(4)(i)(B) of this section).
Therefore, X, P, and S1 constitute an expanded
group as defined in paragraph (c)(4)(i) of this sec-
tion. Additionally, Y, P, and S1 constitute an ex-
panded group as defined in paragraph (c)(4) of this
section. X and Y are not members of the same
expanded group under paragraph (c)(4) of this sec-
tion because X does not directly or indirectly own
any of the stock of Y and Y does not directly or
indirectly own any of the stock of X, such that X and
Y do not comprise a chain of corporations described
in paragraph (c)(4)(i) of this section.

Example 2. Inclusion of a REIT within an ex-
panded group. (i) Facts. All of the stock of P is
publicly traded. In addition to other assets represent-
ing 85% of the value of its total assets, P directly
owns all of the stock of S1. S1 owns 99% of the
stock of S2. The remaining 1% of the stock of S2 is
owned by 100 unrelated individuals. In addition to
other assets representing 85% of the value of its total
assets, S2 owns all of the stock of S3. Both P and S2
are real estate investment trusts described in section
1504(b)(6).

(ii) Analysis. P directly owns 100% of the stock
of S1. However, under paragraph (c)(4)(i) of this
section, P cannot be the expanded group parent be-
cause P is a real estate investment trust described in
section 1504(b)(6). Because no other corporation
owns stock in P meeting the requirements described
in paragraph (c)(4)(i) of this section, P is not an
expanded group member. S1 directly owns 99% of
the stock of S2, which is stock meeting the require-
ments of section 1504(a)(2) (as modified by para-
graph (c)(4)(i)(A) of this section). Although S2 is a
corporation described in section 1504(b)(6), a cor-
poration described in section 1504(b)(6) may be a
member of an expanded group described under para-
graph (c)(4)(i) of this section provided the corpora-
tion is not the expanded group parent. In this case,
S1 is the expanded group parent. S2 directly owns
100% of the stock of S3, which is stock meeting the
requirements of section 1504(a)(2) (as modified by
paragraph (c)(4)(i)(B) of this section). Therefore, S1,
S2, and S3 constitute an expanded group as defined
in paragraph (c)(4) of this section.

Example 3. Attribution of hook stock. (i) Facts.
P, a publicly traded corporation, directly owns 50%
of the stock of S1. S1 directly owns 100% of the

stock of S2. S2 directly owns the remaining 50% of
the stock of S1.

(ii) Analysis. (A) P directly owns 50% of the
stock of S1. Under paragraph (c)(4)(iii) of this sec-
tion (which applies section 318(a)(2) with modifica-
tions), P constructively owns 50% of the stock of S2
because P directly owns 50% of the stock of S1,
which directly owns 100% of S2. Under section
318(a)(5)(A), stock constructively owned by P by
reason of the application of section 318(a)(2) is, for
purposes of section 318(a)(2), considered as actually
owned by P.

(B) S2 directly owns 50% of the stock of S1.
Thus, under paragraph (c)(4)(iii) of this section, P is
treated as constructively owning an additional 25%
of the stock of S1. For purposes of determining the
expanded group, P's ownership must be recalculated
treating the additional 25% of S1 stock as actually
owned. Under the second application of section
318(a)(2)(C) as modified by paragraph (c)(4)(iii) of
this section, P constructively owns an additional
12.5% of the stock of S1 as follows: 25% (P's new
attributed ownership of S1) x 100% (S1's ownership
of S2) x 50% (S2's ownership of S1) = 12.5%. After
two iterations, P's ownership in S1 is 87.5% (50%
direct ownership + 25% first order constructive
ownership + 12.5% second order constructive own-
ership) and thus S1 is a member of the expanded
group that includes P and S2. Subsequent iterative
calculations of P's ownership, treating constructive
ownership as actual ownership, would demonstrate
that P owns, directly and indirectly, 100% of the
stock of S1. P, S1, and S2 therefore constitute an
expanded group as defined in paragraph (c)(4) of this
section and P is the expanded group parent.

Example 4. Attribution of hook stock when an
intermediary has multiple owners. (i) Facts. The
facts are the same as in Example 3, except that P
directly owns only 25% of the stock of S1. X, a
corporation unrelated to P, also directly owns 25% of
the stock of S1.

(ii) Analysis. (A) P and X each directly owns
25% of the stock of S1. Under paragraph (c)(4)(iii)
of this section, P and X each constructively owns
25% of the stock of S2 because P and X each directly
owns 25% of the stock of S1, which directly owns
100% of the stock of S2. Under section
318(a)(5)(A), stock constructively owned by P or X
by reason of the application of section 318(a)(2) is,
for purposes of section 318(a)(2), considered as ac-
tually owned by P or X, respectively.

(B) S2 directly owns 50% of the stock of S1.
Thus, under paragraph (c)(4)(iii) of this section, P
and X each is treated as constructively owning an
additional 12.5% of the stock of S1. Under a second
application of section 318(a)(2)(C) as modified by
paragraph (c)(4)(iii) of this section, P and X each
constructively owns an additional 6.25% of the stock
of S1 as follows: 12.5% (each of P's and X's new
attributed ownership of S1) x 100% (S1's ownership
of S2) x 50% (S2's ownership of S1) = 6.25%. After
two iterations, each of P's and X's ownership in S1
is 43.75% (25% direct ownership + 12.5% first
order constructive ownership + 6.25% second order
constructive ownership). Subsequent iterative calcu-
lations of each of P's and X's ownership, treating
constructive ownership as actual ownership, would

demonstrate that P and X each owns, directly and
indirectly, 50% of the stock of S1.

(C) S1 and S2 constitute an expanded group as
defined under paragraph (c)(4)(i) of this section be-
cause S1 directly owns 100% of the stock of S2. S1
is the expanded group parent of the expanded group
and neither P nor X are a member of the expanded
group that includes S1 and S2.

(5) Regarded owner. The term re-
garded owner means a person (which can-
not be a disregarded entity) that is the
single owner (within the meaning of
§ 301.7701-2(c)(2)(i) of this chapter) of a
disregarded entity.

(d) Treatment of deemed exchanges-
(1) Debt instrument deemed to be ex-
changed for stock-(i) In general. If a
debt instrument (as defined in § 1.385-
3(g)(4)) or an EGI (as defined in § 1.385-
2(d)(3)) is deemed to be exchanged under
the section 385 regulations, in whole or in
part, for stock, the holder is treated for all
federal tax purposes as having realized an
amount equal to the holder's adjusted ba-
sis in that portion of the debt instrument or
EGI as of the date of the deemed ex-
change (and as having basis in the stock
deemed to be received equal to that
amount), and, except as provided in para-
graph (d)(1)(iv)(B) of this section, the is-
suer is treated for all federal tax purposes
as having retired that portion of the debt
instrument or EGI for an amount equal to
its adjusted issue price as of the date of the
deemed exchange. In addition, neither
party accounts for any accrued but unpaid
qualified stated interest on the debt instru-
ment or EGI or any foreign exchange gain
or loss with respect to that accrued but
unpaid qualified stated interest (if any) as
of the deemed exchange. This paragraph
(d)(1)(i) does not affect the rules that oth-
erwise apply to the debt instrument or EGI
prior to the date of the deemed exchange
(for example, this paragraph (d)(1)(i) does
not affect the issuer's deduction of ac-
crued but unpaid qualified stated interest
otherwise deductible prior to the date of
the deemed exchange). Moreover, the
stock issued in the deemed exchange is
not treated as a payment of accrued but
unpaid original issue discount or qualified
stated interest on the debt instrument or
EGI for federal tax purposes.

(ii) Section 988. Notwithstanding the
first sentence of paragraph (d)(1)(i) of this
section, the rules of § 1.988-2(b)(13) ap-
ply to require the holder and the issuer of

a debt instrument or an EGI that is
deemed to be exchanged under the section
385 regulations, in whole or in part, for
stock to recognize any exchange gain or
loss, other than any exchange gain or loss
with respect to accrued but unpaid quali-
fied stated interest that is not taken into
account under paragraph (d)(1)(i) of this
section at the time of the deemed ex-
change. For purposes of this paragraph
(d)(1)(ii), in applying § 1.988-2(b)(13)
the exchange gain or loss under section
988 is treated as the total gain or loss on
the exchange.

(iii) Section 108(e)(8). For purposes of
section 108(e)(8), if the issuer of a debt
instrument or EGI is treated as having
retired all or a portion of the debt instru-
ment or EGI in exchange for stock under
paragraph (d)(1)(i) of this section, the
stock is treated as having a fair market
value equal to the adjusted issue price of
that portion of the debt instrument or EGI
as of the date of the deemed exchange.

(iv) Issuer of stock deemed exchanged
for debt. For purposes of applying para-
graph (d)(1)(i) of this section-

(A) A debt instrument that is issued by
a disregarded entity is deemed to be ex-
changed for stock of the regarded owner
under §§ 1.385-2(e)(4) and 1.385-
3T(d)(4);

(B) A debt instrument that is issued by
a partnership that becomes a deemed
transferred receivable, in whole or in part,
is deemed to be exchanged by the holder
for deemed partner stock under § 1.385-
3T(f)(4) and the partnership is therefore
not treated for any federal tax purpose as
having retired any portion of the debt in-
strument; and

(C) A debt instrument that is issued in
any situation not described in paragraph
(d)(1)(iv)(A) or (B) of this section is
deemed to be exchanged for stock of the
issuer of the debt instrument.

(2) Stock deemed to be exchanged for
newly-issued debt instrument-(i) EGIs.
If an EGI treated as stock under § 1.385-
2(e)(1) ceases to be an EGI and is deemed
to be exchanged pursuant to § 1.385-
2(e)(2), in whole or in part, for a newly-
issued debt instrument, the issue price of
the newly-issued debt instrument is deter-
mined under either section 1273(b)(4) or
1274, as applicable.

(ii) Debt instruments recharacterized
under § 1.385-3. If a debt instrument
treated as stock under § 1.385-3(b) is
deemed to be exchanged under § 1.385-
3(d)(2), in whole or in part, for a newly-
issued debt instrument, the issue price of
the newly-issued debt instrument is deter-
mined under either section 1273(b)(4) or
1274, as applicable.

(e) Indebtedness in part. [Reserved]

(f) Applicability date. This section ap-
plies to taxable years ending on or after
January 19, 2017.

Par. 3. Section 1.385-2 is added to read
as follows:

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

(a) In general-(1) Scope. This section
provides rules for the preparation and
maintenance of the documentation and in-
formation necessary for the determination
of whether certain instruments will be
treated as indebtedness for federal tax pur-
poses. It also prescribes presumptions and
factors as well as the weighting of certain
factors to be taken into account in the
making of that determination. For defini-
tions applicable to this section, including
the terms "applicable interest" and "ex-
panded group interest" (EGI), see para-
graph (d) of this section.

(2) Purpose. The rules in this section
have two principal purposes. The first is to
provide guidance regarding the documen-
tation and other information that must be
prepared, maintained, and provided to be
used in the determination of whether an
instrument subject to this section will be
treated as indebtedness for federal tax pur-
poses. The second is to establish certain
operating rules, presumptions, and factors
to be taken into account in the making of
any such determination. Thus, compliance
with this section does not establish that an
interest is indebtedness; it serves only to
satisfy the minimum documentation for
the determination to be made under gen-
eral federal tax principles.

(3) Applicability of section. The appli-
cation of this section is subject to the
following limitations:

(i) Covered member. An EGI is subject
to this section only if it is issued by a
covered member, as defined in § 1.385-
1(c)(2), or by a disregarded entity, as de-

fined in § 1.385-1(c)(3), that has a re-
garded owner that is a covered member.

(ii) Threshold limitation-(A) In gen-
eral. An EGI is subject to this section only
if on the date that an applicable interest
first becomes an EGI-

(1) The stock of any member of the
expanded group is traded on (or subject to
the rules of) an established financial mar-
ket within the meaning of § 1.1092(d)-
1(b);

(2) Total assets exceed $100 million on
any applicable financial statement (as de-
fined in paragraph (d)(1) of this section)
or combination of applicable financial
statements; or

(3) Annual total revenue exceeds $50
million on any applicable financial state-
ment or combination of applicable finan-
cial statements.

(B) Non-U.S. dollar applicable finan-
cial statements. If an applicable financial
statement is denominated in a currency
other than the U.S. dollar, the amount of
total assets is translated into U.S. dollars
at the spot rate (as defined in § 1.988-
1(d)) as of the date of the applicable fi-
nancial statement. The amount of annual
total revenue is translated into U.S. dollars
at the weighted average exchange rate (as
defined in § 1.989(b)-1) for the year for
which the annual total revenue was calcu-
lated.

(C) Integration and combination of
multiple applicable financial statements-
(1) In general. If there are multiple appli-
cable financial statements that reflect the
assets, portion of the assets, or annual
total revenue of different members of the
expanded group, the aggregate amount of
total assets and annual total revenue must
be used to determine whether the thresh-
old limitation in paragraph (a)(3)(ii)(A) of
this section applies. For this purpose, the
use of the aggregate amount of total assets
or annual total revenue in different appli-
cable financial statements is required ex-
cept to the extent that two or more appli-
cable financial statements reflect the total
assets and annual total revenue of a mem-
ber of the expanded group.

(2) Overlapping applicable financial
statements. To the extent that two or more
applicable financial statements reflect the
total assets or annual total revenue of the
same expanded group member, the appli-
cable financial statement with the higher

amount of total assets must be used for
purposes of paragraph (a)(3)(ii) of this
section.

(3) Overlapping assets and revenue. If
there are multiple applicable financial
statements that reflect the assets, portion
of the assets, or revenue of the same ex-
panded group member, any duplication
(by stock, consolidation, or otherwise) of
that expanded group member's assets or
revenue may be disregarded for purposes
of paragraph (a)(3)(ii) of this section such
that the total assets or annual total revenue
of that expanded group member are only
reflected once.

(4) Coordination with other rules of
law-(i) Substance of transaction con-
trols. Nothing in this section prevents the
Commissioner from asserting that the sub-
stance of a transaction involving an EGI
(or the EGI itself) is different from the
form of the transaction (or the EGI) or
treating the transaction (or the EGI) in
accordance with its substance for federal
tax purposes, which may involve disre-
garding the transaction (or the EGI).

(ii) Commissioner's authority under
section 7602 unaffected. This section does
not otherwise affect the authority of the
Commissioner under section 7602 to re-
quest and obtain documentation and infor-
mation regarding transactions and instru-
ments that purport to create an interest in
a corporation.

(iii) Covered debt instruments. If the
requirements of this section are satisfied
or otherwise do not apply, see §§ 1.385-3
and 1.385-4T for additional rules for de-
termining whether and the extent to which
an interest otherwise treated as indebted-
ness under general federal tax principles is
recharacterized as stock for federal tax
purposes.

(5) Consistency rule-(i) In general. If
an issuer (as defined in paragraph (d)(4) of
this section) characterizes an EGI as in-
debtedness, the issuer and the holder are
each required to treat the EGI as indebt-
edness for all federal tax purposes. For
purposes of this paragraph (a)(5)(i), an
issuer is considered to have characterized
an EGI as indebtedness if the legal form
of the EGI is debt, as described in para-
graph (d)(2)(i)(A) of this section. An is-
suer is also considered to have character-
ized an EGI as indebtedness if the issuer
claims any federal income tax benefit with

respect to an EGI resulting from charac-
terizing the EGI as indebtedness for fed-
eral tax purposes, such as by claiming an
interest deduction under section 163 in
respect of interest paid or accrued on the
EGI on a federal income tax return (or, if
the issuer is a member of a consolidated
group, the issuer or the common parent of
the consolidated group claims a federal
income tax benefit by claiming such an
interest deduction), or if the issuer reports
the EGI as indebtedness or amounts paid
or accrued on the EGI as interest on an
applicable financial statement. Pursuant to
section 385(c)(1), the Commissioner is
not bound by the issuer's characterization
of an EGI.

(ii) EGI characterized as stock. The
consistency rule in paragraph (a)(5)(i) of
this section and section 385(c)(1) does not
apply with respect to an EGI to the extent
that the EGI is treated as stock under this
section or it has been determined that the
EGI is treated as stock under applicable
federal tax principles. In such case, the
issuer and the holder are each required to
treat the EGI as stock for all federal tax
purposes.

(b) Documentation rules and weighting
of indebtedness factors-(1) General
rule. Documentation and information ev-
idencing the indebtedness factors set forth
in paragraph (c) of this section must be
prepared and maintained in accordance
with the provisions of this section with
respect to each EGI. If the documentation
and information described in paragraph
(c) of this section are prepared and main-
tained as required by this section, the de-
termination of whether an EGI is properly
treated as indebtedness (or otherwise) for
federal tax purposes will be made under
general federal tax principles. If the doc-
umentation and information described in
paragraph (c) of this section are not pre-
pared and maintained in respect of an EGI
in accordance with this section, and no
exception listed in paragraph (b)(2) of this
section applies, the EGI is treated as stock
for all federal tax purposes. If a taxpayer
characterizes an EGI as indebtedness but
fails to provide the documentation and
information described in paragraph (c)(2)
of this section upon request by the Com-
missioner, the Commissioner will treat
such documentation and information as
not prepared or maintained.

(2) Exceptions from per se treatment-
(i) Rebuttable presumption rules-(A)
General rule. If documentation and infor-
mation evidencing the indebtedness fac-
tors set forth in paragraph (c) of this sec-
tion are not prepared and maintained with
respect to a particular EGI but a taxpayer
demonstrates that with respect to an ex-
panded group of which the issuer and
holder of the EGI are members such ex-
panded group is otherwise highly compli-
ant with the documentation rules (as such
compliance is described in paragraph
(b)(2)(i)(B) of this section), the EGI is not
automatically treated as stock but is pre-
sumed, subject to rebuttal, to be stock for
federal tax purposes. A taxpayer can over-
come the presumption that an EGI is stock
if the taxpayer clearly establishes that
there are sufficient common law factors
present to treat the EGI as indebtedness,
including that the issuer intended to create
indebtedness when the EGI was issued.

(B) High percentage of EGIs compli-
ant with this section as evidence that the
expanded group is highly compliant with
the documentation rules. The rebuttable
presumption in paragraph (b)(2)(i)(A) of
this section applies if an expanded group
of which the issuer and holder are mem-
bers has a high percentage of EGIs com-
pliant with paragraph (c) of this section.
For this purpose, an expanded group is
treated as having a high percentage of
EGIs compliant with paragraph (c) of this
section if during the calendar year in
which an EGI does not meet the require-
ments of paragraph (c) of this section-

(1) The average total adjusted issue
price of all EGIs that are undocumented
(as defined in paragraph (b)(2)(i)(B)(3) of
this section) and outstanding as of the
close of each calendar quarter is less than
10 percent of the average amount of total
adjusted issue price of all EGIs that are
outstanding as of the close of each calen-
dar quarter; or

(2) If no EGI that is undocumented
during the calendar year has an issue price
in excess of-

(i) $100,000,000, the average total
number of EGIs that are undocumented
and outstanding as of the close of each
calendar quarter is less than 5 percent of
the average total number of all EGIs that
are outstanding as of the close of each
calendar quarter; or

(ii) $25,000,000, the average total
number of EGIs that are undocumented
and outstanding as of the close of each
calendar quarter is less than 10 percent of
the average total number of all EGIs that
are outstanding as of the close of each
calendar quarter.

(3) Undocumented EGI. For purposes
of paragraph (b)(2)(i)(B) of this section,
an undocumented EGI is an EGI for
which documentation has not been both
prepared and maintained for one or more
of the indebtedness factors in paragraph
(c)(2) of this section by the time required
under paragraph (c)(4) of this section.

(4) Anti-stuffing rule. If a member of
the expanded group increases the adjusted
issue price of EGIs outstanding on a quar-
terly testing date with a principal purpose
of satisfying the requirements of para-
graph (b)(2)(i)(B)(1) of this section or in-
creases the number of EGIs outstanding
on a quarterly testing date with a principal
purpose of satisfying the requirements of
paragraph (b)(2)(ii)(B)(2) of this section,
such increase will not be taken into ac-
count in calculating whether a taxpayer
has met these requirements.

(5) EGIs subject to this section. For
purposes of determining whether the re-
quirements of paragraph (b)(2)(i)(B)(1) or
(b)(2)(i)(B)(2) of this section are met,
only EGIs subject to the rules of this sec-
tion are taken into account. Thus, for ex-
ample, an EGI issued by an issuer other
than a covered member is not taken into
account.

(C) Application of federal tax princi-
ples if presumption rebutted. If the pre-
sumption of stock treatment for federal
tax purposes under paragraph (b)(2)(i)(A)
of this section is rebutted, the determina-
tion of whether an EGI is properly treated
as indebtedness (or otherwise) for federal
tax purposes will be made under general
federal tax principles. See paragraph
(b)(3) of this section for the weighting of
factors that must be made in this determi-
nation.

(ii) Reasonable cause-(A) In general.
To the extent a taxpayer establishes that
there was reasonable cause for a failure to
comply, in whole or in part, with the re-
quirements of this section, such failure
will not be taken into account in determin-
ing whether the requirements of this sec-
tion have been satisfied, and the character

of the EGI will be determined under gen-
eral federal tax principles. The principles
of § 301.6724-1 of this chapter apply in
interpreting whether reasonable cause ex-
ists in any particular case.

(B) Requirement to document once
reasonable cause established. If a tax-
payer establishes that there was reason-
able cause for a failure to comply, in
whole or in part, with the requirements of
this section, the documentation and infor-
mation required under paragraph (c) of
this section must be prepared within a
reasonable time and maintained for the
EGIs for which such reasonable cause was
established.

(iii) Taxpayer discovery and remedy of
ministerial or non-material failure or er-
ror. If a taxpayer discovers and corrects a
ministerial or non-material failure or error
in complying with this section prior to the
Commissioner's discovery of the failure
or error, such failure or error will not be
taken into account in determining whether
the requirements of this section have been
satisfied.

(3) Weighting of indebtedness factors.
In applying federal tax principles to the
determination of whether an EGI is in-
debtedness or stock, the indebtedness fac-
tors in paragraph (c)(2) of this section are
significant factors to be taken into ac-
count. Other relevant factors are taken
into account in the determination as lesser
factors, with the relative weighting of
each lesser factor based on facts and cir-
cumstances.

(c) Documentation and information to
be prepared and maintained-(1) In gen-
eral-(i) Application. The indebtedness
factors and the documentation and infor-
mation that evidence each indebtedness
factor are set forth in paragraph (c)(2) of
this section. The requirement to prepare
and maintain documentation and informa-
tion with respect to each indebtedness fac-
tor applies to each EGI separately, but the
same documentation and information may
satisfy the requirements of this section for
more than one EGI (see paragraph
(c)(2)(iii)(B) of this section for rules re-
lating to documentation that may be ap-
plicable to multiple EGIs issued by the
same issuer for purposes of the indebted-
ness factor in paragraph (c)(2)(iii) of this
section and paragraph (c)(3)(i) of this sec-
tion for rules relating to certain master

arrangements). Documentation must in-
clude complete copies of all instruments,
agreements, subordination agreements,
and other documents evidencing the ma-
terial rights and obligations of the issuer
and the holder relating to the EGI, and any
associated rights and obligations of other
parties, such as guarantees. For docu-
ments that are executed, such copies must
be copies of documents as executed. Ad-
ditional documentation and information
may be provided to supplement, but not
substitute for, the documentation and in-
formation required under this section.

(ii) Market standard safe harbor. Doc-
umentation of a kind customarily used in
comparable third-party transactions
treated as indebtedness for federal tax pur-
poses may be used to satisfy the indebt-
edness factors in paragraphs (c)(2)(i) and
(c)(2)(ii) of this section. Thus, for exam-
ple, documentation of a kind that a tax-
payer uses for trade payables with unre-
lated parties will generally satisfy the
documentation requirements of this para-
graph (c) for documenting trade payables
with members of the expanded group.

(iii) EGIs with terms required by cer-
tain regulators. Notwithstanding any
other provision in this paragraph (c), an
EGI that is described in this paragraph
(c)(1)(iii) is treated as meeting the docu-
mentation and information requirements
described in this paragraph (c), provided
that documentation necessary to establish
that the EGI is an instrument described in
this paragraph (c)(1)(iii) is prepared and
maintained in accordance with paragraph
(b) of this section. An EGI described in
this paragraph (c)(1)(iii) is-

(A) An EGI issued by an excepted reg-
ulated financial company (as defined in
§ 1.385-3(g)(3)(iv)) that contains terms
required by a regulator of that company in
order for the EGI to satisfy regulatory
capital or similar rules that govern resolu-
tion or orderly liquidation of the excepted
regulated financial company (including
rules that require an excepted regulated
financial company to issue EGIs in the
form of Total Loss-Absorbing Capacity),
provided that at the time of issuance it is
expected that the EGI will be paid in
accordance with its terms; and

(B) An EGI issued by a regulated in-
surance company (as defined in § 1.385-
3(g)(3)(v)) that requires the issuer to re-

ceive approval or consent of an insurance
regulatory authority prior to making pay-
ments of principal or interest on the EGI,
provided that at the time of issuance it is
expected that the EGI will be paid in
accordance with its terms.

(2) Indebtedness factors relating to
documentation and information to be pre-
pared and maintained in support of in-
debtedness. The indebtedness factors that
must be documented to establish that an
EGI is indebtedness for federal tax pur-
poses, and the documentation and infor-
mation that must be prepared and main-
tained with respect to each such factor, are
described in paragraphs (c)(2)(i) through
(c)(2)(iv) of this section.

(i) Unconditional obligation to pay a
sum certain. There must be written docu-
mentation establishing that the issuer has
entered into an unconditional and legally
binding obligation to pay a fixed or deter-
minable sum certain on demand or at one
or more fixed dates.

(ii) Creditor's rights. There must be
written documentation establishing that
the holder has the rights of a creditor to
enforce the obligation. The rights of a
creditor typically include, but are not lim-
ited to, the right to cause or trigger an
event of default or acceleration of the EGI
(when the event of default or acceleration
is not automatic) for non-payment of in-
terest or principal when due under the
terms of the EGI and the right to sue the
issuer to enforce payment. The rights of a
creditor must include rights that are supe-
rior to the rights of shareholders (other
than holders of interests treated as stock
solely by reason of § 1.385-3) to receive
assets of the issuer in case of dissolution.
An EGI that is a nonrecourse obligation
has creditor's rights for this purpose if it
provides sufficient remedies against a
specified subset of the issuer's assets. For
purposes of this paragraph (c)(2)(ii), cred-
itor's rights may be provided either in the
legal agreements that contain the terms of
the EGI or under local law. If local law
provides for creditor's rights under an
EGI even if such rights are not specified in
the legal agreements that contain the
terms of the EGI, such creditor's rights do
not need to be included in the EGI pro-
vided that written documentation for pur-
poses of this paragraph (c)(2)(ii) contains

a reference to the provisions of local law
providing such rights.

(iii) Reasonable expectation of ability
to repay EGI-(A) In general. There must
be written documentation containing in-
formation establishing that, as of the date
of issuance of the applicable interest and
taking into account all relevant circum-
stances (including all other obligations in-
curred by the issuer as of the date of
issuance of the applicable interest or rea-
sonably anticipated to be incurred after
the date of issuance of the applicable in-
terest), the issuer's financial position sup-
ported a reasonable expectation that the
issuer intended to, and would be able to,
meet its obligations pursuant to the terms
of the applicable interest. Documentation
in respect of an EGI that is nonrecourse
under its terms must include information
on any cash and property that secures the
EGI, including-

(1) The fair market value of publicly
traded property that is recourse property
with respect to the EGI; and

(2) An appraisal (if any) of recourse
property that was prepared pursuant to the
issuance of the EGI or within the three
years preceding the issuance of the EGI.
Thus, the documentation required by this
paragraph (c)(2)(iii)(A) does not require
that an appraisal be prepared for non-
publicly traded property that secures non-
recourse debt, but does require that the
documentation include any appraisal that
was prepared for any purpose.

(B) Documentation of ability to pay
applicable to multiple EGIs issued by
same issuer-(1) In general. Written doc-
umentation that applies to more than one
EGI issued by a single issuer may be
prepared on an annual basis to satisfy the
requirements in paragraph (c)(2)(iii)(A) of
this section (an annual credit analysis). An
annual credit analysis can be used to sup-
port the reasonable expectation that the
issuer has the ability to repay multiple
EGIs, including a specified combined
amount of indebtedness, provided any
such EGIs are issued on any day within
the 12-month period beginning on the date
the analysis in the annual credit analysis is
based on (an analysis date). An annual
credit analysis must establish that, as of its
analysis date and taking into account all
relevant circumstances (including all
other obligations incurred by the issuer as

of such analysis date or reasonably antic-
ipated to be incurred after such analysis
date), the issuer's financial position sup-
ported a reasonable expectation that the
issuer would be able to pay interest and
principal in respect of the amount of in-
debtedness set forth in the annual credit
analysis.

(2) Material event of the issuer. If there
is a material event (as defined in para-
graph (d)(5) of this section) with respect
to the issuer within the year beginning on
the analysis date for written documenta-
tion described in paragraph (c)(2)(iii)
(B)(1) of this section, such written docu-
mentation may not be used to satisfy the
requirements in paragraph (c)(2)(iii)(A) of
this section for EGIs with relevant dates
(as described in paragraph (c)(4) of this
section) on or after the date of the material
event. However, an additional set of writ-
ten documentation described in paragraph
(c)(2)(iii)(B)(1) of this section may be
prepared with an analysis date on or after
the date of the material event of the issuer.

(C) Third party reports or analysis. If
any member of an expanded group relied
on any report or analysis prepared by a
third party in analyzing whether the issuer
would be able to meet its obligations pur-
suant to the terms of the EGI, the docu-
mentation must include the report or anal-
ysis. If the report or analysis is protected
or privileged under law governing an in-
quiry or proceeding with respect to the
EGI and the protection or privilege is as-
serted, neither the existence nor the con-
tents of the report or analysis is taken into
account in determining whether the re-
quirements of this section are satisfied.

(D) EGI issued by disregarded entity.
For purposes of this paragraph (c)(2)(iii),
if a disregarded entity is the issuer of an
EGI, and the owner of the disregarded
entity has limited liability within the
meaning of § 301.7701-3(b)(2)(ii) of this
chapter, only the assets and liabilities and
the financial position of the disregarded
entity are relevant for purposes of para-
graph (c)(2)(iii)(A) of this section. If the
owner of such a disregarded entity does
not have limited liability within the mean-
ing of § 301.7701-3(b)(2)(ii) of this chap-
ter (including by reason of a guarantee,
keepwell, or other agreement), all of the
assets and liabilities, and the financial po-
sition of the disregarded entity and the

owner are relevant for purposes of para-
graph (c)(2)(iii)(A) of this section.

(E) Acceptable documentation. The
documentation required under this para-
graph (c)(2)(iii) may include cash flow
projections, financial statements, business
forecasts, asset appraisals, determination
of debt-to-equity and other relevant finan-
cial ratios of the issuer in relation to in-
dustry averages, and other information re-
garding the sources of funds enabling the
issuer to meet its obligations pursuant to
the terms of the applicable interest. For
this purpose, such documentation may as-
sume that the principal amount of an EGI
may be satisfied with the proceeds of an-
other borrowing by the issuer, provided
that such assumption is reasonable. Doc-
umentation required under paragraph
(c)(2) of this section may be prepared by
employees of expanded group members,
by agents of expanded group members or
by third parties.

(F) Third party financing terms. Docu-
mentation required under this paragraph
(c)(2)(iii) may include evidence that a
third party lender would have made a loan
to the issuer with the same or substantially
similar terms as the EGI.

(iv) Actions evidencing debtor-creditor
relationship-(A) Payments of principal
and interest. If an issuer made any pay-
ment of interest or principal with respect
to the EGI (whether in accordance with
the terms of the EGI or otherwise, includ-
ing prepayments), and such payment is
claimed to support the treatment of the
EGI as indebtedness under federal tax
principles, documentation must include
written evidence of such payment. Such
evidence could include, for example, a
wire transfer record or a bank statement.
Such evidence could also include a netting
of payables or receivables between the
issuer and holder, or payments of interest,
evidenced by journal entries in a central-
ized cash management system or in the
accounting system of the expanded group
(or a subset of the members of the ex-
panded group) reflecting the payment.

(B) Events of default and similar
events-(1) Enforcement of creditor's
rights. If the issuer did not make a pay-
ment of interest or principal that was due
and payable under the terms of the EGI, or
if any other event of default or similar
event has occurred, there must be written

documentation evidencing the holder's
reasonable exercise of the diligence and
judgment of a creditor. Such documenta-
tion may include evidence of the holder's
assertion of its rights under the terms of
the EGI, including the parties' efforts to
renegotiate the EGI or to mitigate the
breach of an obligation under the EGI, or
any change in material terms of the EGI,
such as maturity date, interest rate, or ob-
ligation to pay interest or principal.

(2) Non-enforcement of creditor's
rights. If the holder does not enforce its
rights with respect to a payment of prin-
cipal or interest, or with respect to an
event of default or similar event, there
must be documentation that supports the
holder's decision to refrain from pursuing
any actions to enforce payment as being
consistent with the reasonable exercise of
the diligence and judgment of a creditor.
For example, if the issuer is unable to
make a timely payment of principal or
interest and the holder reasonably believes
that the issuer's business or cash flow will
improve such that the issuer will be able
to comply with the terms of the EGI, the
holder may be exercising the reasonable
diligence and judgment of a creditor by
granting an extension of time for the is-
suer to pay such interest or principal.
However, if a holder fails to enforce its
rights and there is no documentation ex-
plaining this failure, the holder will not be
treated as exercising the reasonable due
diligence and judgment of a creditor. See,
however, § 1.1001-3(c)(4)(ii) for rules re-
garding when a forbearance may be a
modification of a debt instrument and
therefore may result in an exchange sub-
ject to § 1.1001-1(a).

(3) Special documentation rules-(i)
Agreements that cover multiple EGIs-
(A) Revolving credit agreements, omni-
bus, umbrella, master, cash pool, and sim-
ilar agreements-(1) In general. If an
EGI is not evidenced by a separate note or
other writing executed with respect to the
initial principal balance or any increase in
principal balance (for example, an EGI
documented as a revolving credit agree-
ment, a cash pool agreement, an omnibus
or umbrella agreement that governs open
account obligations or any other identified
set of payables or receivables, or a master
agreement that sets forth general terms of
an EGI with an associated schedule or

ticket that sets forth the specific terms of
an EGI), the EGI is subject to the special
rules of this paragraph (c)(3)(i)(A). A no-
tional cash pool is subject to the rules of
this paragraph (c)(3)(i) to the extent that
the notional cash pool would be treated as
an EGI issued directly between expanded
group members.

(2) Special rules with respect to para-
graphs (c)(2)(i) and (c)(2)(ii) of this sec-
tion regarding unconditional obligation to
pay a sum certain and creditor's rights.
An EGI subject to the special rules of
paragraph (c)(3)(i)(A) of this section sat-
isfies the requirements of paragraphs
(c)(2)(i) and (c)(2)(ii) of this section only
if the material documentation associated
with the EGI, including all relevant en-
abling documents, is prepared and main-
tained in accordance with the require-
ments of this section. Relevant enabling
documents may include board of direc-
tors' resolutions, credit agreements, omni-
bus agreements, security agreements, or
agreements prepared in connection with
the execution of the legal documents gov-
erning the EGI as well as any relevant
documentation executed with respect to
an initial principal balance or increase in
the principal balance of the EGI.

(3) Special rules under paragraph
(c)(2)(iii) of this section regarding rea-
sonable expectation of ability to repay-
(i) In general. If an EGI is issued under
an agreement described in paragraph (c)
(3)(i)(A) of this section, written documen-
tation must be prepared with respect to the
date used for the analysis (an analysis
date) and written documentation with a
new analysis date must prepared at least
annually to satisfy the requirements in
paragraph (c)(2)(iii) of this section for
EGIs issued under such an agreement on
or after the most recent analysis date.
Such written documentation satisfies the
requirements in paragraph (c)(2)(iii) of
this section with respect to EGIs issued
under such an agreement on any day
within the year beginning on the analysis
date of the annual credit analysis. Such
written documentation must contain infor-
mation establishing that, as of the analysis
date of the annual credit analysis and tak-
ing into account all relevant circum-
stances (including all other obligations in-
curred by the issuer as of the analysis date
of the written documentation or reason-

ably anticipated to be incurred after the
analysis date of the written documenta-
tion), the issuer's financial position sup-
ported a reasonable expectation that the
issuer would be able to pay interest and
principal in respect of the maximum prin-
cipal amount permitted under the terms of
the revolving credit agreement, omnibus,
umbrella, master, cash pool or similar
agreement. Notwithstanding the forego-
ing, written documentation described in
paragraph (c)(2)(iii)(B) of this section can
be used to satisfy the requirements in
paragraph (c)(2)(iii)(A) of this section
with respect to such EGIs.

(ii) Material event of the issuer. If there
is a material event with respect to the
issuer within the year beginning on the
analysis date for the written documenta-
tion described in paragraph (c)(3)(i)(A)(3)
of this section, such written documenta-
tion may not be used to satisfy the require-
ments in paragraph (c)(3)(i)(A)(3) of this
section for EGIs with relevant dates (as
described in paragraph (c)(4) of this sec-
tion) on or after the date of the material
event. However, an additional set of writ-
ten documentation as described in para-
graph (c)(3)(i)(A)(3) of this section may
be prepared with an analysis date on the
date of the material event of the issuer or
if subsequent EGIs are issued, with re-
spect to those issuances.

(B) Additional requirements for cash
pooling arrangements. Notwithstanding
paragraphs (c)(2)(i) and (c)(2)(ii) of this
section, and in addition to the require-
ments in paragraph (c)(3)(i)(A)(2) of this
section, if an EGI is issued pursuant to a
cash pooling arrangement (including a no-
tional cash pooling arrangement) or inter-
nal banking service that involves account
sweeps, revolving cash advance facilities,
overdraft set-off facilities, operational fa-
cilities, or similar features, the EGI satis-
fies the requirements of paragraphs
(c)(2)(i) and (c)(2)(ii) of this section only
if the material documentation governing
the ongoing operations of the cash pooling
arrangement or internal banking service,
including any agreements with entities
that are not members of the expanded
group, are also prepared and maintained in
accordance with the requirements of this
section. Such documentation must contain
the relevant legal rights and obligations of
any members of the expanded group and

any entities that are not members of the
expanded group in conducting the opera-
tion of the cash pooling arrangement or
internal banking service.

(ii) Debt not in form. [Reserved]

(4) Timely preparation requirement-
(i) General rule. Documentation and in-
formation required under this section must
be timely prepared. For purposes of this
section, documentation is treated as timely
prepared if it is completed no later than
the time for filing the issuer's federal in-
come tax return (taking into account any
applicable extensions) for the taxable year
that includes the relevant date for such
documentation or information, as speci-
fied in paragraph (c)(4)(ii) of this section.

(ii) Relevant date. For purposes of this
paragraph (c)(4), the term relevant date
has the following meaning:

(A) Issuer's obligation, creditor's
rights. For documentation and informa-
tion described in paragraphs (c)(2)(i) and
(ii) of this section (relating to an issuer's
unconditional obligation to repay and es-
tablishment of holder's creditor's rights),
the relevant date is the date on which a
covered member becomes an issuer of a
new or existing EGI. A relevant date for
such documentation and information does
not include the date of any deemed issu-
ance of the EGI resulting from as ex-
change under § 1.1001-3 unless such
deemed issuance relates to an alteration in
the terms of the EGI reflected in an ex-
press written agreement or written amend-
ment to the EGI. In the case of an appli-
cable interest that becomes an EGI
subsequent to issuance, including an in-
tercompany obligation, as defined in
§ 1.1502-13(g)(2)(ii), that ceases to be an
intercompany obligation, the relevant date
is the day on which the applicable interest
becomes an EGI.

(B) Reasonable expectation of pay-
ment-(1) In general. For documentation
and information described in paragraph
(c)(2)(iii) of this section (relating to rea-
sonable expectation of issuer's repay-
ment), each date on which a covered
member of the expanded group becomes
an issuer with respect to an EGI and any
later date on which an issuance is deemed
to occur under § 1.1001-3, and any date
described in the special rules in paragraph
(c)(4)(ii)(E) of this section, is a relevant
date for that EGI. In the case of an appli-

cable interest that becomes an EGI subse-
quent to issuance, the relevant date is the
day on which the applicable interest be-
comes an EGI and any relevant date after
the date that the applicable interest be-
comes an EGI.

(2) Annual credit analysis-(i) With
respect to documentation described in
paragraph (c)(2)(iii)(B) of this section
(documentation of ability to pay applica-
ble to multiple EGIs issued by same is-
suer), the relevant date is the date used for
the analysis in the annual credit analysis
that is first prepared and the annual anni-
versary of such date unless a material
event has occurred in respect of the issuer.

(ii) Material event. With respect to the
documentation described in paragraph
(c)(2)(iii)(B) of this section, the date on
which a material event has occurred in
respect of an issuer is also a relevant date.
If the precise date on which a material
event occurred is uncertain, a taxpayer
may choose a date on which the taxpayer
reasonably believes that the material event
occurred. If documentation described in
paragraph (c)(2)(iii)(B) of this section is
prepared with the relevant date of a ma-
terial event, the next relevant date will be
the annual anniversary of that relevant
date (unless another material event occurs
in respect of the issuer).

(C) Subsequent actions-(1) Payment.
For documentation and information de-
scribed in paragraph (c)(2)(iv)(A) of this
section (relating to payments of principal
and interest), each date on which a pay-
ment of interest or principal is due, taking
into account all additional time permitted
under the terms of the EGI before there is
(or holder can declare) an event of default
for nonpayment, is a relevant date.

(2) Default. For documentation and in-
formation described in paragraph (c)(2)
(iv)(B) of this section (relating to events
of default and similar events), each date
on which an event of default, acceleration
event or similar event occurs under the
terms of the EGI is a relevant date. For
example, if the terms of the EGI require
the issuer to maintain a certain financial
ratio, any date on which the issuer fails to
maintain the specified financial ratio (and
such failure results in an event of default
under the terms of the EGI) is a relevant
date.

(D) Applicable interest that becomes
an EGI. In the case of an applicable inter-
est that becomes an EGI subsequent to
issuance, no date before the applicable
interest becomes an EGI is a relevant date.

(E) Revolving credit agreements, om-
nibus, umbrella, master, cash pool, and
similar agreements-(1) Relevant dates
for purposes of indebtedness factors in
paragraphs (c)(2)(i) and (c)(2)(ii) of this
section for overall arrangements. In the
case of an arrangement described in para-
graph (c)(3)(i)(A) of this section for pur-
poses of the indebtedness factors in para-
graphs (c)(2)(i) and (c)(2)(ii) of this
section, each of the following dates is a
relevant date:

(i) The date of the execution of the
legal documents governing the overall ar-
rangement.

(ii) The date of any amendment to
those documents that provides for an in-
crease in the maximum amount of princi-
pal.

(iii) The date of any amendment to
those documents that permits an addi-
tional entity to borrow under the docu-
ments (but only with respect to EGIs is-
sued by that entity).

(2) Relevant dates for purposes of in-
debtedness factor in paragraph (c)(2)(iii)
of this section for overall arrangements.
The relevant dates with respect to the
arrangements described in paragraph
(c)(3)(i)(A) of this section for purposes of
the indebtedness factor in paragraph
(c)(2)(iii) of this section are-

(i) Each anniversary of the date of ex-
ecution of the legal documents during the
life of the legal documents; and

(ii) The date that a material event has
occurred in respect of an issuer, unless the
precise date on which a material event
occurred is uncertain, in which case a
taxpayer may use a date on which the
taxpayer reasonably believes that the ma-
terial event occurred.

(3) Relevant dates for EGIs docu-
mented under an overall arrangement. A
relevant date of an EGI under paragraphs
(c)(4)(ii)(A) through (C) of this section is
also a relevant date for each EGI docu-
mented under an overall arrangement de-
scribed in paragraph (c)(2)(iii) of this sec-
tion.

(5) Maintenance requirements. The
documentation and information described

in paragraph (c) of this section must be
maintained for all taxable years that the
EGI is outstanding and until the period of
limitations expires for any federal tax re-
turn with respect to which the treatment of
the EGI is relevant. See section 6001 (re-
quirement to keep books and records).

(d) Definitions. For purposes of this
section, the following definitions apply:

(1) Applicable financial statement. The
term applicable financial statement means
a financial statement that is described in
paragraphs (d)(1)(i) through (iii) of this
section, that includes the assets, portion of
the assets, or annual total revenue of any
member of the expanded group, and that is
prepared as of any date within 3 years
prior to the date the applicable interest at
issue first becomes an EGI. The financial
statement may be a separate company fi-
nancial statement of any member of the
expanded group, if done in the ordinary
course; otherwise, it is the consolidated
financial statement that includes the as-
sets, portion of the assets, or annual total
revenue of any member of the expanded
group. A financial statement includes-

(i) A financial statement required to be
filed with the Securities and Exchange
Commission (the Form 10-K or the An-
nual Report to Shareholders);

(ii) A certified audited financial state-
ment that is accompanied by the report of
an independent certified public accountant
(or in the case of a foreign entity, by the
report of a similarly qualified independent
professional) that is used for-

(A) Credit purposes;

(B) Reporting to shareholders, part-
ners, or similar persons; or

(iii) A financial statement (other than a
tax return) required to be provided to the
federal, state, or foreign government or
any federal, state, or foreign agency.

(2) Applicable interest-(i) In general.
Except to the extent provided in paragraph
(d)(2)(ii) and (iii) of this section, the term
applicable interest means-

(A) Any interest that is issued or
deemed issued in the legal form of a debt
instrument, which therefore does not in-
clude, for example, a sale-repurchase
agreement treated as indebtedness under
federal tax principles; or

(B) An intercompany payable and re-
ceivable documented as debt in a ledger,
accounting system, open account inter-
company debt ledger, trade payable, jour-
nal entry or similar arrangement if no
written legal instrument or written legal
arrangement governs the legal treatment
of such payable and receivable.

(ii) Certain intercompany obligations
and statutory or regulatory debt instru-
ments excluded. The term applicable in-
terest does not include-

(A) An intercompany obligation as de-
fined in § 1.1502-13(g)(2)(ii) or an inter-
est issued by a member of a consolidated
group and held by another member of the
same consolidated group, but only for the
period during which both parties are
members of the same consolidated group;
for this purpose, a member includes any
disregarded entity owned by a member;

(B) Production payments treated as a
loan under section 636(a) or (b);

(D) A debt instrument that is deemed to
arise under § 1.482-1(g)(3) (including ad-
justments made pursuant to Revenue Pro-
cedure 99-32, 1999-2 C.B. 296); or

(E) Any other instrument or interest
that is specifically treated as indebtedness
for federal tax purposes under a provision
of the Internal Revenue Code or the reg-
ulations thereunder.

(iii) Interests issued before January 1,
2018. The term applicable interest does
not include any interest issued or deemed
issued before January 1, 2018.

(3) Expanded Group Interest (EGI).
The term expanded group interest (EGI)
means an applicable interest the issuer of
which is a member of an expanded group
(or a disregarded entity whose regarded
owner is a member of an expanded group)
and the holder of which is another mem-
ber of the same expanded group, a disre-
garded entity whose regarded owner is
another member of the same expanded
group, or a controlled partnership (as de-
fined in § 1.385-1(c)(1)) with respect to
the same expanded group.

(4) Issuer. Solely for purposes of this
section, the term issuer means a person
(including a disregarded entity defined in
§ 1.385-1(c)(3)) that is obligated to sat-
isfy any material obligations created un-

der the terms of an EGI. A person can be
an issuer if that person is expected to
satisfy a material obligation under an EGI,
even if that person is not the primary
obligor. A guarantor, however, is not an
issuer unless the guarantor is expected to
be the primary obligor. An issuer may
include a person that, after the date that
the EGI is issued, becomes obligated to
satisfy a material obligation created under
the terms of an EGI. For example, a per-
son that becomes a co-obligor on an EGI
after the date of issuance of the EGI is an
issuer of the EGI for purposes of this
section if such person is expected to sat-
isfy the obligations thereunder without in-
demnification.

(5) Material event. The term material
event means, with respect to an entity-

(i) The entity comes under the jurisdic-
tion of a court in a case under-

(A) Title 11 of the United States Code
(relating to bankruptcy); or

(B) A receivership, foreclosure, or sim-
ilar proceeding in a federal or state court;

(ii) The entity becomes insolvent
within the meaning of section 108(d)(3);

(iii) The entity materially changes its
line of business;

(iv) The entity sells, alienates, distrib-
utes, leases, or otherwise disposes of 50
percent or more of the total fair market
value of its included assets; or

(v) The entity consolidates or merges
into another person and the person formed
by or surviving such merger or consolida-
tion does not assume liability for any of
the entity's outstanding EGIs as of the
time of the merger or consolidation.

(6) Included assets. The term included
assets means, with respect to an entity all
assets other than-

(i) Inventory sold in the ordinary
course of business;

(ii) Assets contributed to another entity
in exchange for equity in such entity; and

(iii) Investment assets such as portfolio
stock investments to the extent that other
investment assets or cash of equivalent
value is substituted.

(7) Regarded owner. For purposes of
this section, the term regarded owner
means a person (that is that is not a dis-
regarded entity) that is the single owner
(within the meaning of § 301.7701-
2(c)(2) of this chapter) of a disregarded
entity.

(e) Operating rules-(1) Applicable
interest that becomes an EGI. If an appli-
cable interest that is not an EGI becomes
an EGI, this section applies to the appli-
cable interest immediately after the appli-
cable interest becomes an EGI and at all
times thereafter during which the applica-
ble interest remains an EGI.

(2) EGI treated as stock ceases to be an
EGI. If an EGI treated as stock due to the
application of this section ceases to be an
EGI, the character of the applicable inter-
est is determined under general federal tax
principles at the time that the applicable
interest ceases to be an EGI. If the appli-
cable interest is characterized as indebted-
ness under general federal tax principles,
the issuer is treated for federal tax pur-
poses as issuing a new debt instrument to
the holder in exchange for the EGI imme-
diately before the transaction that causes
the EGI to cease to be treated as an EGI in
a transaction that is disregarded for pur-
poses of § 1.385-3(b)(2) and (3). See
§ 1.385-1(d).

(3) Date of characterizations under
this section-(i) In general. If an applica-
ble interest that is an EGI when issued is
determined to be stock due to the applica-
tion of this section, the EGI is treated as
stock from the date it was issued. How-
ever, if an applicable interest that is not an
EGI when issued subsequently becomes
an EGI and is then determined to be stock
due to the application of this section, the
EGI is treated as stock as of the date it
becomes an EGI.

(ii) Recharacterization of EGI based
on behavior of issuer or holder after issu-
ance. Notwithstanding paragraph (e)(3)(i)
of this section, if an EGI initially treated
as indebtedness is recharacterized as stock
as a result of failing to satisfy paragraph
(c)(2)(iv) of this section (actions evidenc-
ing debtor-creditor relationship), the EGI
will cease to be treated as indebtedness as
of the time the facts and circumstances
regarding the behavior of the issuer or the
holder with respect to the EGI cease to
evidence a debtor-creditor relationship.
For purposes of determining whether an
EGI originally treated as indebtedness
ceases to be treated as indebtedness by
reason of paragraph (c)(2)(iv) of this sec-
tion, the rules of this section apply before
the rules of § 1.1001-3. Thus, an EGI
initially treated as indebtedness may be

recharacterized as stock regardless of
whether the indebtedness is altered or
modified (as defined in § 1.1001-3(c))
and, in determining whether indebtedness
is recharacterized as stock, § 1.1001-
3(f)(7)(ii)(A) does not apply.

(4) Disregarded entities of regarded
corporate owners. This paragraph (e)(4)
applies to an EGI issued by a disregarded
entity, the regarded owner of which is a
covered member, if such EGI would, ab-
sent the application of this paragraph
(e)(4), be treated as stock under this sec-
tion. In this case, rather than the EGI
being treated as stock, the covered mem-
ber that is the regarded owner of the dis-
regarded entity is deemed to issue its
stock in the manner described in this para-
graph (e)(4). If the EGI would have been
recharacterized as stock from the date it
was issued under paragraph (e)(3)(i) of
this section, then the covered member is
deemed to issue its stock to the actual
holder to which the EGI was, in form,
issued. If the EGI would have been re-
characterized as stock at any other time,
then the covered member is deemed to
issue its stock to the holder of the EGI in
exchange for the EGI. In each case, the
covered member that is the regarded
owner of the disregarded entity is treated
as the holder of the EGI issued by the
disregarded entity, and the actual holder is
treated as the holder of the stock deemed
to be issued by the regarded owner. Under
federal tax principles, the EGI issued by
the disregarded entity generally is disre-
garded. The stock deemed issued is
deemed to have the same terms as the EGI
issued by the disregarded entity, other
than the identity of the issuer, and pay-
ments on the stock are determined by ref-
erence to payments made on the EGI is-
sued by the disregarded entity.

(f) Anti-avoidance. If an applicable in-
terest that is not an EGI is issued with a
principal purpose of avoiding the applica-
tion of this section, the applicable interest
is treated as an EGI subject to this section.

(g) Affirmative use. [Reserved].

(h) Example. The following example
illustrates the rules of this section. Except
as otherwise stated, the following facts are
assumed for purposes of the example in
this paragraph (h):

(1) FP is a foreign corporation that
owns 100% of the stock of USS1, a do-

mestic corporation, and 100% of the stock
of USS2, a domestic corporation.

(2) USS1 and USS2 file separate fed-
eral income tax returns and have a calen-
dar year taxable year.

(3) USS1 and USS2 timely file their
federal income tax returns on September
15 of the calendar year following each
taxable year.

(4) FP is traded on an established fi-
nancial market within the meaning of
§ 1.1092(d)-1(b).

Example. Application of paragraphs (c)(2)(iii)
and (c)(4) of this section to an EGI-(i) Facts. USS1
issues an EGI (EGI A) to FP on Date A in Year 1.
USS1 issues an EGI (EGI B) to USS2 on Date B in
Year 1. Date B is after Date A. USS1 issues another
EGI (EGI C) to FP on Date A in Year 2. USS1
prepares documentation sufficient to meet the re-
quirements of paragraphs (c)(2)(i) and (ii) of this
section on or before September 15 of Year 2. USS1,
FP and USS2 also contemporaneously document the
timely payment of interest by USS1 on EGI A and
EGI B sufficient to meet the requirements of para-
graph (c)(2)(iv) of this section. USS1 prepares doc-
umentation on Date C in Year 2, which is prior to
September 15, to satisfy the requirements of para-
graph (c)(2)(iii)(B) of this section (the credit analy-
sis). The credit analysis concludes that as of Date B
in Year 1, USS1 would be able to pay interest and
principal on an amount greater than the combined
principal amounts of EGI A, EGI B and EGI C.

(ii) Analysis. (A) P, USS1, and USS2 are mem-
bers of an expanded group. Because FP is traded on
an established financial market within the meaning
of § 1.1092(d)-1(b) and USS1 is a covered issuer,
EGI A, EGI B, and EGI C are subject to the rules of
this section.

(B) The documentation evidencing USS1's obli-
gation to pay a sum certain and the creditor's rights
of the holders was prepared by September 15, Year
2, which is the time for filing USS1's federal income
tax return (taking into account any applicable exten-
sions) for the taxable year that includes the relevant
date specified in paragraph (c)(4)(ii)(A) of this sec-
tion. Thus, USS1 is treated as having timely docu-
mented its obligation to pay a sum certain and the
creditor's rights of the holders of EGI A and EGI B
for purposes of paragraph (c)(4)(i) of this section.

(C) The credit analysis was prepared with a rel-
evant date of Date B of Year 1. EGI A was issued
prior to Date B in Year 1. Under paragraph
(c)(4)(ii)(B) of this section, the date when USS1
became an issuer of EGI A (Date A of Year 1) is a
relevant date for the documentation and information
described in paragraph (c)(2)(iii) of this section. As
a result, EGI A does not satisfy the indebtedness
factor in paragraph (c)(2)(iii) of this section (reason-
able expectation of ability to repay EGI).

(D) Similarly, under paragraph (c)(4)(ii)(B) of
this section, the date when USS1 became an issuer of
EGI B (Date B of Year 1) is a relevant date for the
documentation and information described in para-
graph (c)(2)(iii) of this section. The credit analysis
was timely prepared under paragraph (c)(4)(i) of this
section because it was prepared before the filing of

the USS1 federal income tax return for Year 1. As a
result, EGI B does satisfy the indebtedness factor in
paragraph (c)(2)(iii) of this section (reasonable ex-
pectation of ability to repay EGI).

(E) Finally, the date when USS1 became an
issuer of EGI C (Date A of Year 2) is also a relevant
date for the documentation and information de-
scribed in paragraph (c)(2)(iii) of this section. Under
paragraph (c)(2)(iii)(B) of this section, the credit
analysis can be used to support the reasonable ex-
pectation that USS1 has the ability to repay multiple
EGIs issued on any day within the 12-month period
following the analysis date. Date A of Year 2 is
within the 12-month period following the analysis
date. The credit analysis was timely prepared under
paragraph (c)(4)(i) of this section because it was
prepared before the filing of the USS1 federal in-
come tax return for Year 2. As a result, EGI C does
satisfy the indebtedness factor in paragraph
(c)(2)(iii) of this section (reasonable expectation of
ability to repay EGI).

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

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

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

(a) Scope. This section sets forth fac-
tors that control the determination of
whether an interest is treated as stock or
indebtedness. Specifically, this section ad-
dresses the issuance of a covered debt
instrument to a related person as part of a
transaction or series of transactions that
does not result in new investment in the
operations of the issuer. Paragraph (b) of
this section sets forth rules for determin-
ing when these factors are present, such
that a covered debt instrument is treated as
stock under this section. Paragraph (c) of
this section provides exceptions to the ap-
plication of paragraph (b) of this section.
Paragraph (d) of this section provides op-
erating rules. Paragraph (e) of this section
reserves on the affirmative use of this sec-
tion. Paragraph (f) of this section provides
rules for the aggregate treatment of con-
trolled partnerships. Paragraph (g) of this
section provides definitions. Paragraph (h)
of this section provides examples illustrat-
ing the application of the rules of this
section. Paragraph (j) of this section pro-
vides dates of applicability. For rules re-
garding the application of this section to
members of a consolidated group, see
generally § 1.385-4T.

(b) Covered debt instrument treated as
stock-(1) Effect of characterization as
stock. Except as otherwise provided in

paragraph (d)(7) of this section, to the
extent a covered debt instrument is treated
as stock under paragraphs (b)(2), (3), or
(4) of this section, it is treated as stock for
all federal tax purposes.

(2) General rule. Except as otherwise
provided in paragraphs (c) and (e) of this
section, a covered debt instrument is
treated as stock to the extent the covered
debt instrument is issued by a covered
member to a member of the covered mem-
ber's expanded group in one or more of
the following transactions:

(i) In a distribution;

(ii) In exchange for expanded group
stock, other than in an exempt exchange;
or

(iii) In exchange for property in an
asset reorganization, but only to the extent
that, pursuant to the plan of reorganiza-
tion, a shareholder in the transferor cor-
poration that is a member of the issuer's
expanded group immediately before the
reorganization receives the covered debt
instrument with respect to its stock in the
transferor corporation.

(3) Funding rule-(i) In general. Ex-
cept as otherwise provided in paragraphs
(c) and (e) of this section, a covered debt
instrument that is not a qualified short-
term debt instrument (as defined in para-
graph (b)(3)(vii) of this section) is treated
as stock to the extent that it is both issued
by a covered member to a member of the
covered member's expanded group in ex-
change for property and, pursuant to para-
graph (b)(3)(iii) or (b)(3)(iv) of this sec-
tion, treated as funding a distribution or
acquisition described in one or more of
paragraphs (b)(3)(i)(A) through (C) of this
section. A covered member that makes a
distribution or acquisition described in
paragraphs (b)(3)(i)(A) through (C) is re-
ferred to as a "funded member," regard-
less of when it issues a covered debt in-
strument in exchange for property.

(A) A distribution of property by the
funded member to a member of the
funded member's expanded group, other
than in an exempt distribution;

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

(C) An acquisition of property by the
funded member in an asset reorganization
but only to the extent that, pursuant to the
plan of reorganization, a shareholder in
the transferor corporation that is a mem-
ber of the funded member's expanded
group immediately before the reorganiza-
tion receives other property or money
within the meaning of section 356 with
respect to its stock in the transferor cor-
poration.

(ii) Transactions described in more
than one paragraph. For purposes of this
section, to the extent that a distribution or
acquisition by a funded member is de-
scribed in more than one of paragraphs
(b)(3)(i)(A) through (C) of this section,
the funded member is treated as making
only a single distribution or acquisition
described in paragraph (b)(3)(i) of this
section. In the case of an asset reorgani-
zation, to the extent an acquisition by the
transferee corporation is described in
paragraph (b)(3)(i)(C) of this section, a
distribution or acquisition by the trans-
feror corporation is not also described in
paragraph (b)(3)(i)(A) through (C) of this
section. For purposes of this paragraph
(b)(3)(ii), whether a distribution or acqui-
sition is described in paragraphs (b)(3)
(i)(A) through (C) of this section is deter-
mined without regard to paragraph (c) of
this section.

(iii) Per se funding rule-(A) In gen-
eral. A covered debt instrument is treated
as funding a distribution or acquisition
described in paragraphs (b)(3)(i)(A)
through (C) of this section if the covered
debt instrument is issued by a funded
member during the period beginning 36
months before the date of the distribution
or acquisition, and ending 36 months after
the date of the distribution or acquisition
(per se period).

(B) Multiple interests. If, pursuant to
paragraph (b)(3)(iii)(A) of this section,
two or more covered debt instruments
may be treated as stock by reason of this
paragraph (b)(3), the covered debt instru-
ments are tested under paragraph
(b)(3)(iii)(A) of this section based on the
order in which they are issued, with the
earliest issued covered debt instrument
tested first. See paragraph (h)(3) of this
section, Example 6, for an illustration of
this rule.

(C) Multiple distributions or acquisi-
tions. If, pursuant to paragraph (b)(3)
(iii)(A) of this section, a covered debt
instrument may be treated as funding
more than one distribution or acquisition
described in paragraphs (b)(3)(i)(A)
through (C) of this section, the covered
debt instrument is treated as funding one
or more distributions or acquisitions based
on the order in which the distributions or
acquisitions occur, with the earliest distri-
bution or acquisition treated as the first
distribution or acquisition that is funded.
See paragraph (h)(3) of this section, Ex-
ample 9, for an illustration of this rule.

(D) Transactions that straddle differ-
ent expanded groups-(1) In general. For
purposes of paragraph (b)(3)(iii)(A) of
this section, a covered debt instrument is
not treated as issued by a funded member
during the per se period with respect to a
distribution or acquisition described in
paragraphs (b)(3)(i)(A) through (C) of this
section if all of the conditions described in
paragraphs (b)(3)(iii)(D)(1)(i) through
(iii) of this section are satisfied.

(i) The distribution or acquisition oc-
curs prior to the issuance of the covered
debt instrument by the funded member or,
if the funded member is treated as making
the distribution or acquisition of a prede-
cessor or a successor, the predecessor or
successor is not a member of the ex-
panded group of which the funded mem-
ber is a member on the date on which the
distribution or the acquisition occurs.

(ii) The distribution or acquisition is
made by the funded member when the
funded member is a member of an ex-
panded group that does not have an ex-
panded group parent that is the funded
member's expanded group parent when
the covered debt instrument is issued. For
purposes of the preceding sentence, a ref-
erence to an expanded group parent in-
cludes a reference to a predecessor or suc-
cessor of the expanded group parent.

(iii) On the date of the issuance of the
covered debt instrument, the recipient
member (as defined in paragraph (b)(3)
(iii)(D)(2) of this section) is neither a
member nor a controlled partnership of an
expanded group of which the funded
member is a member.

(2) Recipient member. For purposes of
this paragraph (b)(3)(iii)(D), the term re-
cipient member means, with respect to a

distribution or acquisition by a funded
member described in paragraphs (b)(3)
(i)(A) through (C) of this section, the ex-
panded group member that receives a dis-
tribution of property, property in ex-
change for expanded group stock, or other
property or money within the meaning of
section 356 with respect to its stock in the
transferor corporation. For purposes of
this paragraph (b)(3)(iii)(D), a reference
to the recipient member includes a prede-
cessor or successor of the recipient mem-
ber or one or more other entities that, in
the aggregate, acquire substantially all of
the property of the recipient member.

(E) Modifications of a covered debt
instrument-(1) In general. For purposes
of paragraph (b)(3)(iii)(A) of this section,
if a covered debt instrument is treated as
exchanged for a modified covered debt
instrument pursuant to § 1.1001-3(b), the
modified covered debt instrument is
treated as issued on the original issue date
of the covered debt instrument.

(2) Effect of certain modifications. Not-
withstanding paragraph (b)(3)(iii)(E)(1)
of this section, if a covered debt instru-
ment is treated as exchanged for a modi-
fied covered debt instrument pursuant to
§ 1.1001-3(b) and the modification, or
one of the modifications, that results in the
deemed exchange includes the substitu-
tion of an obligor on the covered debt
instrument, the addition or deletion of a
co-obligor on the covered debt instrument,
or the material deferral of scheduled pay-
ments due under the covered debt instru-
ment, then the covered debt instrument is
treated as issued on the date of the deemed
exchange for purposes of paragraph
(b)(3)(iii)(A) of this section.

(3) Additional principal amount. For
purposes of paragraph (b)(3)(iii)(A) of
this section, if the principal amount of a
covered debt instrument is increased, the
portion of the covered debt instrument
attributable to such increase is treated as
issued on the date of such increase.

(iv) Principal purpose rule. For pur-
poses of this paragraph (b)(3), a covered
debt instrument that is not issued by a
funded member during the per se period
with respect to a distribution or acquisi-
tion described in paragraphs (b)(3)(i)(A)
through (C) of this section is treated as
funding the distribution or acquisition to
the extent that it is issued by a funded

member with a principal purpose of fund-
ing a distribution or acquisition described
in paragraphs (b)(3)(i)(A) through (C) of
this section. Whether a covered debt in-
strument is issued with a principal pur-
pose of funding a distribution or acquisi-
tion described in paragraphs (b)(3)(i)(A)
through (C) of this section is determined
based on all the facts and circumstances.
A covered debt instrument may be treated
as issued with a principal purpose of fund-
ing a distribution or acquisition described
in paragraphs (b)(3)(i)(A) through (C) of
this section regardless of whether it is
issued before or after the distribution or
acquisition.

(v) Predecessors and successors-(A)
In general. Subject to the limitations in
paragraph (b)(3)(v)(B) of this section, for
purposes of this paragraph (b)(3), refer-
ences to a funded member include refer-
ences to any predecessor or successor of
such member. See paragraph (h)(3) of this
section, Examples 9 and 10, for illustra-
tions of this rule.

(B) Limitations to the application of
the per se funding rule. For purposes of
paragraph (b)(3)(iii)(A) of this section, a
covered debt instrument issued by a
funded member that satisfies the condition
described in paragraph (b)(3)(iii)(A) with
respect to a distribution or acquisition de-
scribed in paragraphs (b)(3)(i)(A) through
(C) of this section made by a predecessor
or successor of the funded member is not
treated as issued during the per se period
with respect to the distribution or acquisi-
tion unless the conditions described in
paragraphs (b)(3)(v)(B)(1) and (2) of this
section are satisfied:

(1) The covered debt instrument is is-
sued by the funded member during the
period beginning 36 months before the
date of the transaction in which the pre-
decessor or successor becomes a prede-
cessor or successor and ending 36 months
after the date of the transaction.

(2) The distribution or acquisition is
made by the predecessor or successor dur-
ing the period beginning 36 months before
the date of the transaction in which the
predecessor or successor becomes a pre-
decessor or successor of the funded mem-
ber and ending 36 months after the date of
the transaction.

(vi) Treatment of funded transactions.
When a covered debt instrument is treated

as stock pursuant to paragraph (b)(3) of
this section, the distribution or acquisition
described in paragraphs (b)(3)(i)(A)
through (C) of this section that is treated
as funded by such covered debt instru-
ment is not recharacterized as a result of
the treatment of the covered debt instru-
ment as stock.

(vii) Qualified short-term debt instru-
ment. [Reserved]. For further guidance,
see § 1.385-3T(b)(3)(vii).

(viii) Distributions or acquisitions oc-
curring before April 5, 2016. A distribu-
tion or acquisition that occurs before April
5, 2016, is not taken into account for
purposes of applying this paragraph
(b)(3).

(4) Anti-abuse rule. If a member of an
expanded group enters into a transaction
with a principal purpose of avoiding the
purposes of this section or § 1.385-3T, an
interest issued or held by that member or
another member of the member's ex-
panded group may, depending on the rel-
evant facts and circumstances, be treated
as stock. Paragraphs (b)(4)(i) and (ii) of
this section include a non-exhaustive list
of transactions that could result in an in-
terest being treated as stock under this
paragraph (b)(4).

(i) Interests. An interest is treated as
stock if it is issued with a principal pur-
pose of avoiding the purposes of this sec-
tion or § 1.385-3T. Interests subject to
this paragraph (b)(4)(i) may include:

(A) An interest that is not a covered
debt instrument for purposes of this sec-
tion (for example, a contract to which
section 483 applies that is not otherwise a
covered debt instrument or a non-periodic
swap payment that is not otherwise a cov-
ered debt instrument).

(B) A covered debt instrument issued
to a person that is not a member of the
issuer's expanded group, if the covered
debt instrument is later acquired by a
member of the issuer's expanded group or
such person later becomes a member of
the issuer's expanded group.

(D) A covered debt instrument issued
in connection with a reorganization or
similar transaction.

(E) A covered debt instrument issued
as part of a plan or a series of transactions

to expand the applicability of the transi-
tion rules described in § 1.385-3(j)(2) or
§ 1.385-3T(k)(2).

(ii) Other transactions. A covered debt
instrument is treated as stock if the funded
member or any member of the expanded
group engages in a transaction (including
a distribution or acquisition) with a prin-
cipal purpose of avoiding the purposes of
this section or § 1.385-3T. Transactions
subject to this paragraph (b)(4)(ii) may
include:

(A) A member of the issuer's expanded
group is substituted as a new obligor or
added as a co-obligor on an existing cov-
ered debt instrument.

(B) A covered debt instrument is trans-
ferred in connection with a reorganization
or similar transaction.

(C) A covered debt instrument funds a
distribution or acquisition where the dis-
tribution or acquisition is made by a mem-
ber other than the funded member and the
funded member acquires the assets of the
other member in a transaction that does
not make the other member a predecessor
to the funded member.

(D) Members of a consolidated group
engage in transactions as part of a plan or
a series of transactions through the use of
the consolidated group rules set forth in
§ 1.385-4T, including through the use of
the departing member rules.

(5) Coordination between general rule
and funding rule in an asset reorganiza-
tion. For purposes of this section, a distri-
bution or acquisition described in para-
graph (b)(2) of this section is not also
described in paragraph (b)(3)(i) of this
section. In the case of an asset reorgani-
zation, an acquisition described in para-
graph (b)(2)(iii) of this section by the
transferee corporation is not also a distri-
bution or acquisition described in para-
graph (b)(3)(i) of this section by the trans-
feror corporation. For purposes of this
paragraph (b)(5), whether a distribution or
acquisition is described in paragraphs
(b)(2)(i) through (iii) of this section is
determined without regard to paragraph
(c) of this section.

(6) Non-duplication. Except as other-
wise provided in paragraph (d)(2) of this
section, to the extent a distribution or ac-
quisition described in paragraphs (b)(3)
(i)(A) through (C) of this section is treated
as funded by a covered debt instrument

under paragraph (b)(3) of this section, the
distribution or acquisition is not treated as
funded by another covered debt instru-
ment and the covered debt instrument is
not treated as funding another distribution
or acquisition for purposes of paragraph
(b)(3).

(c) Exceptions-(1) In general. This
paragraph (c) provides exceptions for pur-
poses of applying paragraphs (b)(2) and
(b)(3) of this section to a covered member.
These exceptions are applied in the fol-
lowing order: first, paragraph (c)(2) of this
section; second, paragraph (c)(3) of
this section; and, third, paragraph (c)(4) of
this section. The exceptions under
§ 1.385-3(c)(2) and (c)(3) apply to distri-
butions and acquisitions that are otherwise
described in paragraph (b)(2) or (b)(3)(i)
of this section after applying paragraphs
(b)(3)(ii) and (b)(5) of this section. Except
as otherwise provided, the exceptions are
applied by taking into account the aggre-
gate treatment of controlled partnerships
described in § 1.385-3T(f).

(2) Exclusions for transactions other-
wise described in paragraph (b)(2) or
(b)(3)(i) of this section-(i) Exclusion for
certain acquisitions of subsidiary stock-
(A) In general. An acquisition of ex-
panded group stock (including by issu-
ance) is not treated as described in
paragraph (b)(2)(ii) or (b)(3)(i)(B) of this
section if, immediately after the acquisi-
tion, the covered member that acquires the
expanded group stock (acquirer) controls
the member of the expanded group from
which the expanded group stock is ac-
quired (seller), and the acquirer does not
relinquish control of the seller pursuant to
a plan that existed on the date of the
acquisition, other than in a transaction in
which the seller ceases to be a member of
the expanded group of which the acquirer
is a member. For purposes of the preced-
ing sentence, an acquirer and seller do not
cease to be members of the same ex-
panded group by reason of a complete
liquidation described in section 331.

(B) Control. For purposes of this para-
graph (c)(2)(i) and paragraph (c)(3)(ii)(E)
of this section, control of a corporation
means the direct or indirect ownership of
more than 50 percent of the total com-
bined voting power of all classes of stock
of the corporation entitled to vote and
more than 50 percent of the total value of

the stock of the corporation. For purposes
of the preceding sentence, indirect owner-
ship is determined by applying the princi-
ples of section 958(a) without regard to
whether an intermediate entity is foreign
or domestic.

(C) Rebuttable presumption. For pur-
poses of paragraph (c)(2)(i)(A) of this sec-
tion, the acquirer is presumed to have a
plan to relinquish control of the seller on
the date of the acquisition if the acquirer
relinquishes control of the seller within
the 36-month period following the date of
the acquisition. The presumption created
by the previous sentence may be rebutted
by facts and circumstances clearly estab-
lishing that the loss of control was not
contemplated on the date of the acquisi-
tion and that the avoidance of the pur-
poses of this section or § 1.385-3T was
not a principal purpose for the subsequent
loss of control.

(ii) Exclusion for compensatory stock
acquisitions. An acquisition of expanded
group stock is not treated as described in
paragraph (b)(2)(ii) or (b)(3)(i)(B) of this
section if the expanded group stock is
delivered to individuals that are employ-
ees, directors, or independent contractors
in consideration for services rendered by
such individuals to a member of the ex-
panded group or a controlled partnership
in which a member of the expanded group
is an expanded group partner.

(iii) Exclusion for distributions or ac-
quisitions resulting from transfer pricing
adjustments. A distribution or acquisition
deemed to occur under § 1.482-1(g) (in-
cluding adjustments made pursuant to
Revenue Procedure 99-32, 1999-2 C.B.
296) is not treated as described in para-
graph (b)(3)(i)(A) or (B) of this section.

(iv) Exclusion for acquisitions of ex-
panded group stock by a dealer in secu-
rities. An acquisition of expanded group
stock by a dealer in securities (within the
meaning of section 475(c)(1)), or by an
expanded group partner treated as acquir-
ing expanded group stock pursuant to
§ 1.385-3T(f)(2) if the relevant controlled
partnership is a dealer in securities, is not
treated as described in paragraph (b)(2)(ii)
or (b)(3)(i)(B) of this section to the extent
the expanded group stock is acquired in
the ordinary course of the dealer's busi-
ness of dealing in securities. The preced-

ing sentence applies solely to the extent
that-

(A) The dealer accounts for the stock
as securities held primarily for sale to
customers in the ordinary course of busi-
ness;

(B) The dealer disposes of the stock
within a period of time that is consistent
with the holding of the stock for sale to
customers in the ordinary course of busi-
ness, taking into account the terms of the
stock and the conditions and practices pre-
vailing in the markets for similar stock
during the period in which it is held; and

(C) The dealer does not sell or other-
wise transfer the stock to a person in the
same expanded group, other than in a sale
to a dealer that in turn satisfies the require-
ments of paragraph (c)(2)(iv) of this sec-
tion.

(v) Exclusion for certain acquisitions
of expanded group stock resulting from
application of this section. The following
deemed acquisitions are not treated as ac-
quisitions of expanded group stock de-
scribed in paragraph (b)(3)(i)(B) of this
section, provided that they are not part of
a plan or arrangement to prevent the ap-
plication of paragraph (b)(3)(i) to a cov-
ered debt instrument:

(A) An acquisition of a covered debt
instrument that is treated as stock by
means of paragraph (b)(3) of this section.

(B) An acquisition of stock of a re-
garded owner that is deemed to be issued
under § 1.385-3T(d)(4).

(C) An acquisition of deemed partner
stock pursuant to a deemed transfer or a
specified event described in § 1.385-
3T(f)(4) or (5).

(3) Reductions for transactions de-
scribed in paragraph (b)(2) or (b)(3)(i) of
this section-(i) Reduction for expanded
group earnings-(A) In general. The ag-
gregate amount of any distributions or ac-
quisitions by a covered member described
in paragraph (b)(2) or (b)(3)(i) of this sec-
tion in a taxable year during the covered
member's expanded group period is re-
duced by the covered member's expanded
group earnings account (as defined in
paragraph (c)(3)(i)(B) of this section) for
the expanded group period as of the close
of the taxable year. The reduction de-
scribed in this paragraph (c)(3)(i)(A) ap-
plies to one or more distributions or ac-
quisitions based on the order in which the

distributions or acquisitions occur, regard-
less of whether any distribution or acqui-
sition would be treated as funded by a
covered debt instrument without regard to
this paragraph (c)(3).

(B) Expanded group earnings account.
The term expanded group earnings ac-
count means, with respect to a covered
member and an expanded group period (as
defined in paragraph (c)(3)(i)(E) of this
section) of the covered member, the ex-
cess, if any, of the covered member's ex-
panded group earnings (as defined in para-
graph (c)(3)(i)(C) of this section) for the
expanded group period over the covered
member's expanded group reductions (as
defined in paragraph (c)(3)(i)(D) of this
section) for the expanded group period.

(C) Expanded group earnings-(1) In
general. The term expanded group earn-
ings means, with respect to a covered
member and an expanded group period of
the covered member, the earnings and
profits accumulated by the covered mem-
ber during the expanded group period,
computed as of the close of the taxable
year of the covered member, without re-
gard to any distributions or acquisitions
by the covered member described in para-
graphs (b)(2) and (b)(3)(i) of this section.
Notwithstanding the preceding sentence,
the expanded group earnings of a covered
member do not include earnings and prof-
its accumulated by the covered member in
any taxable year ending before April 5,
2016.

(2) Special rule for change in ex-
panded group within a taxable year. For
purposes of calculating a covered mem-
ber's expanded group earnings for a tax-
able year that is not wholly included in an
expanded group period, the covered mem-
ber's expanded group earnings are ratably
allocated among the portion of the taxable
year included in the expanded group pe-
riod and the portion of the taxable year not
included in the expanded group period.
For purposes of the preceding sentence,
the expanded group period is determined
by excluding the day on which the cov-
ered member becomes a member of an
expanded group with the same expanded
group parent and including the day on
which the covered member ceases to be a
member of an expanded group with the
same expanded group parent.

(3) Look-thru rule for dividends-(i) In
general. For purposes of paragraph
(c)(3)(i)(C)(1) of this section, a dividend
from a member of the same expanded
group (distributing member) is not taken
into account for purposes of calculating a
covered member's expanded group earn-
ings, except to the extent the dividend is
attributable to earnings and profits accu-
mulated by the distributing member in a
taxable year ending after April 4, 2016,
during its expanded group period (quali-
fied earnings and profits). For purposes of
the preceding sentence, a dividend re-
ceived from a member (intermediate dis-
tributing member) is not taken into ac-
count for purposes of calculating the
qualified earnings and profits of a distrib-
uting member (or another intermediate
distributing member), except to the extent
the dividend is attributable to qualified
earnings and profits of the intermediate
distributing member. A dividend from
distributing member or an intermediate
distributing member is considered to be
attributable to qualified earnings and prof-
its to the extent thereof. If a controlled
partnership receives a dividend from a
distributing member and a portion of the
dividend is allocated (including through
one or more partnerships) to a covered
member, then, for purposes of this para-
graph (c)(3)(i)(C)(3), the covered member
is treated as receiving the dividend from
the distributing member.

(ii) Dividend. For purposes of para-
graph (c)(3)(i)(C)(3)(i) of this section, the
term dividend has the meaning specified
in section 316, including the portion of
gain recognized under section 1248 that is
treated as a dividend and deemed divi-
dends under section 367(b) and the regu-
lations thereunder. In addition, the term
dividend includes inclusions with respect
to stock (for example, inclusions under
sections 951(a) and 1293).

(4) Effect of interest deductions. For
purposes of calculating the expanded
group earnings of a covered member for a
taxable year, expanded group earnings are
calculated without regard to the applica-
tion of this section during the taxable year
to a covered debt instrument issued by the
covered member that was not treated as
stock under paragraph (b) of this section
as of the close of the preceding taxable
year, or, if the covered member is an

expanded group partner in a controlled
partnership that is the issuer of a debt
instrument, without regard to the applica-
tion of § 1.385-3T(f)(4)(i) during the tax-
able year with respect to the covered
member's share of the debt instrument. To
the extent that the application of this para-
graph (c)(3)(i)(C)(4) reduces the ex-
panded group earnings of the covered
member for the taxable year, the expanded
group earnings of the covered member are
increased as of the beginning of the suc-
ceeding taxable year during the expanded
group period.

(D) Expanded group reductions. The
term expanded group reductions means,
with respect to a covered member and an
expanded group period of the covered
member, the amounts by which acquisi-
tions or distributions described in para-
graph (b)(2) or (b)(3)(i) of this section
were reduced by reason of paragraph
(c)(3)(i)(A) of this section during the por-
tion of the expanded group period preced-
ing the taxable year.

(E) Expanded group period-(1) In
general. For purposes of this paragraph
(c)(3)(i) and paragraph (c)(3)(ii) of this
section, the term expanded group period
means, with respect to a covered member,
the period during which a covered mem-
ber is a member of an expanded group
with the same expanded group parent.

(2) Mere change. For purposes of para-
graph (c)(3)(i)(E)(1) of this section, an
expanded group parent that is a resulting
corporation (within the meaning of
§ 1.368-2(m)(1)) in a reorganization de-
scribed in section 368(a)(1)(F) is treated
as the same expanded group parent as an
expanded group parent that is a transferor
corporation (within the meaning of
§ 1.368-2(m)(1)) in the same reorganiza-
tion, provided that either-

(i) The transferor corporation is not a
covered member; or

(ii) Both the transferor corporation and
the resulting corporation are covered
members.

(F) Special rules for certain corporate
transactions-(1) Reduction for expanded
group earnings in an asset reorganiza-
tion. For purposes of applying paragraph
(c)(3)(i) of this section, a distribution or
acquisition described in paragraph (b)(2)
or (b)(3)(i) of this section that occurs pur-
suant to a reorganization described in sec-

tion 381(a)(2) is reduced solely by the
expanded group earnings account of the
acquiring member after taking into ac-
count the adjustment to its expanded
group earnings account provided in para-
graph (c)(3)(i)(F)(2)(ii) of this section.

(2) Effect of certain corporate transac-
tions on the calculation of expanded
group earnings account-(i) In general.
Section 381 and § 1.312-10 are not taken
into account for purposes of calculating a
covered member's expanded group earn-
ings account for an expanded group pe-
riod. The expanded group earnings ac-
count that a covered member succeeds to
under paragraphs (c)(3)(i)(F)(2)(ii)
through (iv) of this section is attributed to
the covered member's expanded group
period as of the close of the date of the
distribution or transfer.

(ii) Section 381 transactions. If a cov-
ered member (acquiring member) ac-
quires the assets of another covered mem-
ber (acquired member) in a transaction
described in section 381(a), and, immedi-
ately before the transaction, both corpora-
tions are members of the same expanded
group, then the acquiring member suc-
ceeds to the expanded group earnings ac-
count of the acquired member, if any,
determined after application of paragraph
(c)(3)(i) of this section with respect to the
final taxable year of the acquired member.

(iii) Section 1.312-10(a) transactions.
If a covered member (transferor member)
transfers property to another covered
member (transferee member) in a transac-
tion described in § 1.312-10(a), the ex-
panded group earnings account of the
transferor member is allocated between
the transferor member and the transferee
member in the same proportion as the
earnings and profits of the transferor
member are allocated between the trans-
feror member and the transferee member
under § 1.312-10(a).

the distributing member had transferred
the stock of the controlled member to a
newly formed corporation in a transaction
described in § 1.312-10(a). If the amount
of the decrease described in the preceding
sentence exceeds the expanded group
earnings account of the controlled mem-
ber immediately before the transaction de-
scribed in § 1.312-10(b), then the ex-
panded group earnings account of the
controlled member after the transaction is
equal to the amount of the decrease.

(G) Overlapping expanded groups. A
covered member that is a member of two
expanded groups at the same time has a
single expanded group earnings account
with respect to a single expanded group
period. In this case, the expanded group
period is determined by reference to the
shorter of the two periods during which
the covered member is a member of an
expanded group with the same expanded
group parent.

(ii) Reduction for qualified contribu-
tions-(A) In general. The amount of a
distribution or acquisition by a covered
member described in paragraph (b)(2) or
(b)(3)(i) of this section is reduced by the
aggregate fair market value of the stock
issued by the covered member in one or
more qualified contributions (as defined in
paragraph (c)(3)(ii)(B) of this section)
during the qualified period (as defined in
paragraph (c)(3)(ii)(C) of this section), but
only to the extent the qualified contribu-
tion or qualified contributions have not
reduced another distribution or acquisi-
tion. The reduction described in this para-
graph (c)(3)(ii)(A) applies to one or more
distributions or acquisitions based on the
order in which the distributions or acqui-
sitions occur, regardless of whether any
distribution or acquisition would be
treated as funded by a covered debt instru-
ment without regard to this paragraph
(c)(3).

(B) Qualified contribution. The term
qualified contribution means, with respect
to a covered member, except as provided
in paragraph (c)(3)(ii)(E) of this section, a
contribution of property, other than ex-
cluded property (defined in paragraph
(c)(3)(ii)(D) of this section), to the cov-
ered member by a member of the covered
member's expanded group (or by a con-
trolled partnership of the expanded group)
in exchange for stock.

(C) Qualified period. The term quali-
fied period means, with respect to a cov-
ered member, a qualified contribution, and
a distribution or acquisition described in
paragraph (b)(2) or (b)(3)(i) of this sec-
tion, the period beginning on the later of
the beginning of the periods described in
paragraphs (c)(3)(ii)(C)(1) and (2) of this
section, and ending on the earlier of the
ending of the periods described in para-
graphs (c)(3)(ii)(C)(1) and (2) of this sec-
tion or the date described in paragraph
(c)(3)(ii)(C)(3) of this section.

(1) The period beginning 36 months
before the date of the distribution or ac-
quisition, and ending 36 months after the
date of the distribution or acquisition.

(2) The covered member's expanded
group period (as defined in paragraph
(c)(3)(i)(E) of this section) that includes
the distribution or acquisition.

(3) The last day of the first taxable year
that a covered debt instrument issued by
the covered member would, absent the
application of this paragraph (c)(3)(ii)
with respect to the distribution or acquisi-
tion, be treated, in whole or in part, as
stock under paragraph (b) of this section
or, in the case of a covered debt instru-
ment issued by a controlled partnership in
which the covered member is an expanded
group partner, the covered debt instrument
would be treated, in whole or in part, as a
specified portion.

(D) Excluded property. The term ex-
cluded property means-

(1) Expanded group stock;

(2) Property acquired by the covered
member in an asset reorganization from a
member of the expanded group of which
the covered member is a member;

(3) A covered debt instrument of any
member of the same expanded group, in-
cluding a covered debt instrument issued
by the covered member;

(4) Property acquired by the covered
member in exchange for a covered debt
instrument issued by the covered member
that is recharacterized under paragraph
(b)(3) of this section;

(5) A debt instrument issued by a con-
trolled partnership of the expanded group
of which the covered member is a mem-
ber, including the portion of such a debt
instrument that is a deemed transferred
receivable or a retained receivable; and

(6) Any other property acquired by the
covered member with a principal purpose
to avoid the purposes of this section or
§ 1.385-3T, including a transaction in-
volving an indirect transfer of property
described in paragraphs (c)(3)(ii)(D)(1)
through (5) of this section.

(E) Excluded contributions-(1) Up-
stream contributions from certain subsid-
iaries. For purposes of paragraph
(c)(3)(ii)(B) of this section, a contribution
of property from a corporation (controlled
member) that the covered member con-
trols, within the meaning of paragraph
(c)(2)(i)(B) of this section, is not a quali-
fied contribution.

(2) Contributions to a predecessor or
successor. For purposes of paragraph
(c)(3)(ii)(B) of this section, a contribution
of property to a covered member from a
corporation of which the covered member
is a predecessor or successor, or from a
corporation controlled by that corporation
within the meaning of paragraph
(c)(2)(i)(B) of this section, is not a quali-
fied contribution.

(3) Contributions that do not increase
fair market value. A contribution of prop-
erty to a covered member that is not de-
scribed in paragraph (c)(3)(ii)(E)(1) or (2)
of this section is not a qualified contribu-
tion to the extent that the contribution
does not increase the aggregate fair mar-
ket value of the outstanding stock of the
covered member immediately after the
transaction and taking into account all re-
lated transactions, other than distributions
and acquisitions described in paragraphs
(b)(2) and (b)(3)(i) of this section.

(4) Contributions that become ex-
cluded contributions after the date of the
contribution. If a contribution of property
described in paragraph (c)(3)(ii)(E)(1) or
(2) of this section occurs before the cov-
ered member acquires control of the con-
trolled member described in paragraph
(c)(3)(ii)(E)(1) or before the transaction in
which the corporation described in para-
graph (c)(3)(ii)(E)(2) becomes a predeces-
sor or successor to the covered member,
the contribution of property ceases to be a
qualified contribution on the date that the
covered member acquires control of the
controlled member or on the date of
the transaction in which the corporation
becomes a predecessor or successor to the
covered member (transaction date). If the

contribution of property occurs within 36
months before the transaction date, the
covered member is treated as making a
distribution described in paragraph
(b)(3)(i)(A) of this section on the transac-
tion date equal to the amount by which
any distribution or acquisition described
in paragraph (b)(2) or (b)(3)(i) of this sec-
tion was reduced under paragraph
(c)(3)(ii)(A) of this section because the
contribution of property was treated as a
qualified contribution.

(F) Special rules for certain corporate
transactions-(1) Reduction for qualified
contributions in an asset reorganization.
For purposes of applying paragraph
(c)(3)(ii)(A) of this section, a distribution
or acquisition described in paragraph
(b)(2) or (b)(3)(i) of this section that oc-
curs pursuant to a reorganization de-
scribed in section 381(a)(2) is reduced
solely by the qualified contributions of the
acquiring member after taking into ac-
count the adjustment to its qualified con-
tributions provided in paragraph (c)(3)(ii)
(F)(2) of this section.

(2) Effect of certain corporate transac-
tions on the calculation of qualified con-
tributions-(i) In general. This paragraph
(c)(3)(ii)(F)(2) provides rules for allocat-
ing or reducing the qualified contributions
of a covered member as a result of certain
corporation transactions. For purposes of
paragraph (c)(3)(ii)(C)(1) of this section, a
qualified contribution that a covered
member succeeds to under paragraphs
(c)(3)(ii)(F)(2)(ii) and (iii) of this section
is treated as made to the covered member
on the date on which the qualified contri-
bution was made to the covered member
that received the qualified contribution.
For purposes of paragraph (c)(3)(ii)(C)(2)
of this section, a qualified contribution
that a covered member succeeds to under
paragraphs (c)(3)(ii)(F)(2)(ii) and (iii) of
this section is attributed to the covered
member's expanded group period as of
the close of the date of the distribution or
transfer. For purposes of paragraph
(c)(3)(ii)(C)(3) of this section, a qualified
contribution a covered member succeeds
to under paragraphs (c)(3)(ii)(F)(2)(ii) and
(iii) of this section is treated as made to
the covered member as of the close of the
date of the distribution or transfer.

(ii) Section 381 transactions. If a cov-
ered member (acquiring member) ac-

quires the assets of another covered mem-
ber (acquired member) in a transaction
described in section 381(a), and, immedi-
ately before the transaction, both corpora-
tions are members of the same expanded
group, the acquiring member succeeds to
the qualified contributions of the acquired
member, if any, adjusted for the applica-
tion of paragraph (c)(3)(ii)(E)(4) of this
section.

(iii) Section 1.312-10(a) transactions.
If a covered member (transferor member)
transfers property to another covered
member (transferee member) in a transac-
tion described in § 1.312-10(a), each
qualified contribution of the transferor
member is allocated between the trans-
feror member and the transferee member
in the same proportion as the earnings and
profits of the transferor member are allo-
cated between the transferor member and
the transferee member under § 1.312-
10(a).

(iv) Section 1.312-10(b) transactions.
If a covered member (distributing mem-
ber) distributes the stock of another cov-
ered member (controlled member) in a
transaction described in § 1.312-10(b),
each qualified contribution of the distrib-
uting member is decreased by the amount
that each qualified contribution of the dis-
tributing member would have been de-
creased under paragraph (c)(3)(ii)(F)
(2)(iii) of this section if the distributing
member had transferred the stock of the
controlled member to a newly formed cor-
poration in a transaction described in
§ 1.312-10(a). No amount of the qualified
contributions of the distributing member
is allocated to the controlled member.

(iii) Predecessors and successors. For
purposes of this paragraph (c)(3), refer-
ences to a covered member do not include
references to any corporation of which the
covered member is a predecessor or suc-
cessor. Accordingly, a distribution or ac-
quisition by a covered member described
in paragraphs (b)(3)(i)(A) through (C) is
reduced solely by the expanded group
earnings account of the covered member
(taking into account the application of
paragraph (c)(3)(i)(F)(2) of this section)
and the qualified contributions of the cov-
ered member (taking into account the ap-
plication of paragraph (c)(3)(ii)(F)(2) of
this section), notwithstanding that the dis-
tribution or acquisition is treated as made

by a funded member of which the covered
member is a predecessor or successor.

(iv) Ordering rule. The exceptions de-
scribed in this paragraph (c)(3) are applied
in the following order: first, paragraph
(c)(3)(i) of this section; and, second, para-
graph (c)(3)(ii) of this section.

(4) Threshold exception. A covered
debt instrument is not treated as stock
under this section if, immediately after the
covered debt instrument would be treated
as stock under this section but for the
application of this paragraph (c)(4), the
aggregate adjusted issue price of covered
debt instruments held by members of the
issuer's expanded group that would be
treated as stock under this section but for
the application of this paragraph (c)(4)
does not exceed $50 million. To the extent
a debt instrument issued by a controlled
partnership would be treated as a specified
portion (as defined in paragraph (g)(23) of
this section) but for the application of this
paragraph (c)(4), the debt instrument is
treated as a covered debt instrument de-
scribed in the preceding sentence for pur-
poses of this paragraph (c)(4). To the ex-
tent that, immediately after a covered debt
instrument would be treated as stock un-
der this section but for the application of
this paragraph (c)(4), the aggregate ad-
justed issue price of covered debt instru-
ments held by members of the issuer's
expanded group that would be treated as
stock under this section but for the appli-
cation of this paragraph (c)(4) exceeds
$50 million, only the amount of the cov-
ered debt instrument in excess of $50 mil-
lion is treated as stock under this section.
For purposes of this rule, any covered debt
instrument that is not denominated in U.S.
dollars is translated into U.S. dollars at the
spot rate (as defined in § 1.988-1(d)) on
the date that the covered debt instrument
is issued.

(d) Operating rules-(1) Timing. This
paragraph (d)(1) provides rules for deter-
mining when a covered debt instrument is
treated as stock under paragraph (b) of
this section. For special rules regarding
the treatment of a deemed exchange of a
covered debt instrument that occurs pur-
suant to paragraphs (d)(1)(ii), (d)(1)(iii),
or (d)(1)(iv) of this section, see § 1.385-
1(d).

(i) General timing rule. Except as oth-
erwise provided in this paragraph (d)(1),

when paragraph (b) of this section applies
to treat a covered debt instrument as stock,
the covered debt instrument is treated as
stock when the covered debt instrument is
issued. When paragraph (b)(3) of this sec-
tion applies to treat a covered debt instru-
ment as stock when the covered debt in-
strument is issued, see also paragraph
(b)(3)(vi) of this section.

(ii) Exception when a covered debt in-
strument is treated as funding a distribu-
tion or acquisition that occurs after the
issuance of the covered debt instrument.
When paragraph (b)(3)(iii) of this section
applies to treat a covered debt instrument
as funding a distribution or acquisition
described in paragraph (b)(3)(i)(A)
through (C) of this section that occurs
after the covered debt instrument is is-
sued, the covered debt instrument is
deemed to be exchanged for stock on the
date that the distribution or acquisition
occurs. See paragraph (h)(3) of this sec-
tion, Examples 4 and 9, for an illustration
of this rule.

(iii) Exception for certain predecessor
and successor transactions. To the extent
that a covered debt instrument would not
be treated as stock but for the fact that a
funded member is treated as the predeces-
sor or successor of another expanded
group member under paragraph (b)(3)(v)
of this section, the covered debt instru-
ment is deemed to be exchanged for stock
on the later of the date that the funded
member completes the transaction causing
it to become a predecessor or successor of
the other expanded group member or the
date that the covered debt instrument
would be treated as stock under paragraph
(d)(1)(i) or (ii) of this section.

(iv) Exception when a covered debt
instrument is re-tested under paragraph
(d)(2) of this section. When paragraph
(b)(3)(iii) of this section applies to treat a
covered debt instrument as funding a dis-
tribution or acquisition described in para-
graphs (b)(3)(i)(A) through (C) of this
section as a result of a re-testing described
in paragraph (d)(2)(ii) of this section that
occurs in a taxable year subsequent to the
taxable year in which the covered debt
instrument is issued, the covered debt in-
strument is deemed to be exchanged for
stock on the later of the date of the re-
testing or the date that the covered debt
instrument would be treated as stock un-

der paragraph (d)(1)(i) or (ii) of this sec-
tion. See paragraph (h)(3) of this section,
Example 7, for an illustration of this rule.

(2) Covered debt instrument treated as
stock that leaves the expanded group-(i)
Events that cause a covered debt instru-
ment to cease to be treated as stock. Sub-
ject to paragraph (b)(4) of this section, this
paragraph (d)(2)(i) applies with respect to
a covered debt instrument that is treated as
stock under this section when the holder
and issuer of a covered debt instrument
cease to be members of the same ex-
panded group, either because the covered
debt instrument is transferred to a person
that is not a member of the expanded
group that includes the issuer or because
the holder or the issuer ceases to be a
member of the same expanded group, or
in the case of a holder that is a controlled
partnership, when the holder ceases to be
a controlled partnership with respect to
the expanded group of which the issuer is
a member, either because the partnership
ceases to be a controlled partnership or
because the issuer ceases to be a member
of the same expanded group with respect
to which the holder is a controlled part-
nership. In such a case, the covered debt
instrument ceases to be treated as stock
under this section. For this purpose, im-
mediately before the transaction that
causes the holder and issuer of the cov-
ered debt instrument to cease to be mem-
bers of the same expanded group, or, if the
holder is a controlled partnership, that
causes the holder to cease to be a con-
trolled partnership with respect to the ex-
panded group of which the issuer is a
member, the issuer is deemed to issue a
new covered debt instrument to the holder
in exchange for the covered debt instru-
ment that was treated as stock in a trans-
action that is disregarded for purposes of
paragraphs (b)(2) and (b)(3) of this sec-
tion.

(ii) Re-testing of covered debt instru-
ments and certain distributions and acqui-
sitions-(A) General rule. For purposes
of paragraph (b)(3)(iii) of this section,
when paragraph (d)(2)(i) of this section or
§ 1.385-4T(c)(2) causes a covered debt
instrument that previously was treated as
stock pursuant to paragraph (b)(3) of this
section to cease to be treated as stock, all
other covered debt instruments of the is-
suer that are not treated as stock on the

date that the transaction occurs that causes
paragraph (d)(2)(i) of this section to apply
are re-tested to determine whether those
other covered debt instruments are treated
as funding the distribution or acquisition
that previously was treated as funded by
the covered debt instrument that ceases to
be treated as stock pursuant to paragraph
(d)(2)(i) of this section. In addition, a cov-
ered debt instrument that is issued after an
application of paragraph (d)(2)(i) of this
section and within the per se period may
also be treated as funding that distribution
or acquisition. See paragraph (h)(3) of this
section, Example 7, for an illustration of
this rule.

(B) Re-testing upon a specified event
with respect to a debt instrument issued by
a controlled partnership. If, with respect
to a covered member that is an expanded
group partner and a debt instrument issued
by the controlled partnership, there is re-
duction in the covered member's specified
portion under § 1.385-3T(f)(5)(i) by rea-
son of a specified event, the covered mem-
ber must re-test its debt instruments as
described in paragraph (d)(2)(ii)(A) of
this section.

(3) Inapplicability of section 385(c)(1).
Section 385(c)(1) does not apply with re-
spect to a covered debt instrument to the
extent that it is treated as stock under this
section.

(4) Treatment of disregarded entities.
[Reserved]. For further guidance, see
§ 1.385-3T(d)(4).

(5) Payments with respect to partially
recharacterized covered debt instru-
ments-(i) General rule. Except as other-
wise provided in paragraph (d)(5)(ii) of
this section, a payment with respect to an
instrument that is partially recharacterized
as stock is treated as made pro rata to the
portion treated as stock and to the portion
treated as indebtedness.

(ii) Special rule for payments not re-
quired pursuant to the terms of the instru-
ment. A payment with respect to an instru-
ment that is partially recharacterized as
stock and that is a payment that is not
required to be made pursuant to the terms
of the instrument (for example, a prepay-
ment of principal) may be designated by
the issuer and the holder as with respect to
the portion treated as stock or to the por-
tion treated as indebtedness, in whole or in

part. In the absence of such designation,
see paragraph (d)(5)(i) of this section.

(6) Treatment of a general rule trans-
action to which an exception applies. To
the extent a covered member would, ab-
sent the application of paragraph (c)(2) or
(c)(3) of this section, be treated as making
a distribution or acquisition described in
paragraph (b)(2) of this section, then,
solely for purposes of applying paragraph
(b)(3) of this section, the covered member
is treated as issuing the covered debt in-
strument issued in the distribution or ac-
quisition to a member of the covered
member's expanded group in exchange
for property.

(7) Treatment for purposes of section
1504(a)-(i) Debt instruments treated as
stock. A covered debt instrument that is
treated as stock under paragraph (b)(2),
(3), or (4) of this section and that is not
described in section 1504(a)(4) is not
treated as stock for purposes of determin-
ing whether the issuer is a member of an
affiliated group (within the meaning of
section 1504(a)).

(ii) Deemed partner stock and stock
deemed issued by a regarded owner. If
deemed partner stock or stock that is
deemed issued by a regarded owner under
§ 1.385-3T(d)(4) is not described in sec-
tion 1504(a)(4), then that stock is not
treated as stock for purposes of determin-
ing whether the issuer of the stock is a
member of an affiliated group (within the
meaning of section 1504(a)).

(e) No affirmative use. [Reserved]

(f) Treatment of controlled partner-
ships. [Reserved]. For further guidance,
see § 1.385-3T(f).

(g) Definitions. The definitions in this
paragraph (g) apply for purposes of this
section and §§ 1.385-3T and 1.385-4T.

(1) Asset reorganization. The term as-
set reorganization means a reorganization
described in section 368(a)(1)(A), (C),
(D), (F), or (G).

(2) Consolidated group. The term con-
solidated group has the meaning specified
in § 1.1502-1(h).

(3) Covered debt instrument-(i) In
general. The term covered debt instru-
ment means a debt instrument issued after
April 4, 2016, that is not a qualified dealer
debt instrument (as defined in paragraph
(g)(3)(ii) of this section) or an excluded
statutory or regulatory debt instrument (as

defined in paragraph (g)(3)(iii) of this sec-
tion), and that is issued by a covered
member that is not an excepted regulated
financial company (as defined in para-
graph (g)(3)(iv) of this section) or a reg-
ulated insurance company (as defined in
paragraph (g)(3)(v) of this section).

(ii) For purposes of this paragraph
(g)(3), the term qualified dealer debt in-
strument means a debt instrument that is
issued to or acquired by an expanded
group member that is a dealer in securities
(within the meaning of section 475(c)(1))
in the ordinary course of the dealer's busi-
ness of dealing in securities. The preced-
ing sentence applies solely to the extent
that-

(A) The dealer accounts for the debt
instruments as securities held primarily
for sale to customers in the ordinary
course of business;

(B) The dealer disposes of the debt
instruments (or the debt instruments ma-
ture) within a period of time that is con-
sistent with the holding of the debt instru-
ments for sale to customers in the ordinary
course of business, taking into account the
terms of the debt instruments and the con-
ditions and practices prevailing in the
markets for similar debt instruments dur-
ing the period in which it is held; and

(C) The dealer does not sell or other-
wise transfer the debt instrument to a
member of the dealer's expanded group
unless that sale or transfer is to a dealer
that satisfies the requirements of this para-
graph (g)(3)(ii).

(iii) For purposes of this paragraph
(g)(3), the term excluded statutory or reg-
ulatory debt instrument means a debt in-
strument that is described in any of the
following paragraphs:

(A) Production payments treated as a
loan under section 636(a) or (b).

(B) A "regular interest" in a real estate
mortgage investment conduit described in
section 860G(a)(1).

(C) A debt instrument that is deemed to
arise under § 1.482-1(g)(3) (including ad-
justments made pursuant to Revenue Pro-
cedure 99-32, 1999-2 C.B. 296).

(D) A stripped bond or coupon de-
scribed in section 1286, unless such in-
strument was issued with a principal pur-
pose of avoiding the purposes of this
section or § 1.385-3T.

(E) A lease treated as a loan under
section 467.

(iv) For purposes of this paragraph
(g)(3), the term excepted regulated finan-
cial company means a covered member
that is a regulated financial company (as
defined in paragraph (g)(3)(iv)(A) of this
section) or a member of a regulated finan-
cial group (as defined in paragraph
(g)(3)(iv)(B) of this section).

(A) Regulated financial company. For
purposes of paragraph (g)(3)(iv), the term
regulated financial company means-

(1) A bank holding company, as de-
fined in 12 U.S.C. 1841;

(2) A covered savings and loan holding
company, as defined in 12 CFR 217.2;

(3) A national bank;

(4) A bank that is a member of the
Federal Reserve System and is incorpo-
rated by special law of any State, or orga-
nized under the general laws of any State,
or of the United States, including a Morris
Plan bank, or other incorporated banking
institution engaged in a similar business;

(5) An insured depository institution,
as defined in 12 U.S.C. 1813(c)(2);

(6) A nonbank financial company sub-
ject to a determination under 12 U.S.C.
5323(a)(1) or (b)(1);

(7) A U.S. intermediate holding com-
pany formed by a foreign banking organi-
zation in compliance with 12 C.F.R.
252.153;

(8) An Edge Act corporation organized
under section 25A of the Federal Reserve
Act (12 U.S.C. 611-631);

(9) Corporations having an agreement
or undertaking with the Board of Gover-
nors of the Federal Reserve System under
section 25 of the Federal Reserve Act (12
U.S.C. 601-604a);

(10) A supervised securities holding
company, as defined in 12 U.S.C.
1850a(a)(5);

(11) A broker or dealer that is regis-
tered with the Securities and Exchange
Commission under 15 U.S.C. 78o(b);

(12) A futures commission merchant,
as defined in 7 U.S.C. 1a(28);

(13) A swap dealer, as defined in 7
U.S.C. 1a(49);

(14) A security-based swap dealer, as
defined in 15 U.S.C. 78c(a)(71);

(15) A Federal Home Loan Bank, as
defined in 12 U.S.C. 1422(1)(A);

(16) A Farm Credit System Institution
chartered and subject to the provisions of
the Farm Credit Act of 1971 (12 U.S.C.
2001 et seq.); or

(17) A small business investment com-
pany, as defined in 15 U.S.C. 662(3).

(B) Regulated financial group-(1)
General rule. For purposes of paragraph
(g)(3)(iv) of this section, except as other-
wise provided in paragraph (g)(3)(iv)
(B)(2) of this section, the term regulated
financial group means any expanded
group of which a covered member that is
a regulated financial company within the
meaning of paragraphs (g)(3)(iv)(A)(1)
through (10) of this section would be the
expanded group parent if no person
owned, directly or indirectly (as defined in
§ 1.385-1(c)(4)(iii)), the regulated finan-
cial company.

(2) Exception for certain non-financial
entities. A corporation is not a member of
a regulated financial group if it is held by
a regulated financial company pursuant to
12 U.S.C. 1843(k)(1)(B), 12 U.S.C.
1843(k)(4)(H), or 12 U.S.C. 1843(o).

(v) For purposes of this paragraph
(g)(3), the term regulated insurance com-
pany means a covered member that is-

(A) Subject to tax under subchapter L
of chapter 1 of the Internal Revenue Code;

(B) Domiciled or organized under the
laws of one of the 50 states or the District
of Columbia (for purposes of paragraph
(g)(3)(v) of this section, each being a
"state");

(C) Licensed, authorized, or regulated
by one or more states to sell insurance,
reinsurance, or annuity contracts to per-
sons other than related persons (within the
meaning of section 954(d)(3)) in such
states, but in no case will a corporation
satisfy the requirements of this paragraph
(g)(3)(v)(C) if a principal purpose for ob-
taining such license, authorization, or reg-
ulation was to qualify the issuer as a reg-
ulated insurance company; and

(D) Engaged in regular issuances of (or
subject to ongoing liability with respect
to) insurance, reinsurance, or annuity con-
tracts with persons that are not related
persons (within the meaning of section
954(d)(3)).

(4) Debt instrument. The term debt in-
strument means an interest that would, but
for the application of this section, be
treated as a debt instrument as defined in

section 1275(a) and § 1.1275-1(d), pro-
vided that the interest is not recharacter-
ized as stock under § 1.385-2.

(5) Deemed holder. [Reserved]. For
further guidance, see § 1.385-3T(g)(5).

(6) Deemed partner stock. [Reserved].
For further guidance, see § 1.385-
3T(g)(6).

(7) Deemed transfer. [Reserved]. For
further guidance, see § 1.385-3T(g)(7).

(8) Deemed transferred receivable.
[Reserved]. For further guidance, see
§ 1.385-3T(g)(8).

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

(10) Exempt distribution. The term ex-
empt distribution means either-

(i) A distribution of stock that is per-
mitted to be received without the recogni-
tion of gain or income under section
354(a)(1) or 355(a)(1), or, if section 356
applies, that is not treated as other prop-
erty or money described in section 356; or

(ii) A distribution of property in a com-
plete liquidation under section 336(a) or
337(a).

(11) Exempt exchange. The term ex-
empt exchange means an acquisition of
expanded group stock in which either-

(i) In a case in which the transferor and
transferee of the expanded group stock are
parties to an asset reorganization, either-

(A) Section 361(a) or (b) applies to the
transferor of the expanded group stock
and the stock is not transferred by issu-
ance; or

(B) Section 1032 or § 1.1032-2 applies
to the transferor of the expanded group
stock and the stock is distributed by the
transferee pursuant to the plan of reorga-
nization;

(ii) The transferor of the expanded
group stock is a shareholder that receives
property in a complete liquidation to
which section 331 or 332 applies; or

(iii) The transferor of the expanded
group stock is an acquiring entity that is
deemed to issue the stock in exchange for
cash from an issuing corporation in a
transaction described in § 1.1032-3(b).

(12) Expanded group partner. The
term expanded group partner means, with
respect to a controlled partnership of an
expanded group, a member of the ex-
panded group that is a partner (directly or

indirectly through one or more partner-
ships).

(13) Expanded group stock. The term
expanded group stock means, with respect
to a member of an expanded group, stock
of a member of the same expanded group.

(14) Funded member. The term funded
member has the meaning provided in
paragraph (b)(3)(i) of this section.

(15) Holder-in-form. [Reserved]. For
further guidance, see § 1.385-3T(g)(15).

(16) Issuance percentage. [Reserved].
For further guidance, see § 1.385-
3T(g)(16).

(17) Liquidation value percentage.
[Reserved]. For further guidance, see
§ 1.385-3T(g)(17).

(18) Member of a consolidated group.
The term member of a consolidated group
means a corporation described in
§ 1.1502-1(b).

(19) Per se period. The term per se
period has the meaning provided in para-
graph (b)(3)(iii)(A) of this section.

(20) Predecessor-(i) In general. Ex-
cept as otherwise provided in paragraph
(g)(20)(ii) of this section, the term prede-
cessor means, with respect to a corpora-
tion-

(A) The distributor or transferor corpo-
ration in a transaction described in section
381(a) in which the corporation is the
acquiring corporation; or

(B) The distributing corporation in a
distribution or exchange to which section
355 (or so much of section 356 that relates
to section 355) applies in which the cor-
poration is a controlled corporation.

(ii) Predecessor ceasing to be a mem-
ber of the same expanded group as cor-
poration. The term predecessor does not
include the distributing corporation de-
scribed in paragraph (g)(20)(i)(B) of this
section from the date that the distributing
corporation ceases to be a member of the
expanded group of which the controlled
corporation is a member.

(iii) Multiple predecessors. A corpora-
tion may have more than one predecessor,
including by reason of a predecessor of
the corporation having a predecessor or
successor. Accordingly, references to a
corporation also include references to a
predecessor or successor of a predecessor
of the corporation.

(21) Property. The term property has
the meaning specified in section 317(a).

(22) Retained receivable. [Reserved].
For further guidance, see § 1.385-
3T(g)(22).

(23) Specified portion. [Reserved]. For
further guidance, see § 1.385-3T(g)(23).

(24) Successor-(i) In general. Except
as otherwise provided in paragraph
(g)(24)(iii) of this section, the term suc-
cessor means, with respect to a corpora-
tion-

(A) The acquiring corporation in a
transaction described in section 381(a) in
which the corporation is the distributor or
transferor corporation;

(B) A controlled corporation in a dis-
tribution or exchange to which section
355 (or so much of section 356 that relates
to section 355) applies in which the cor-
poration is the distributing corporation; or

(C) Subject to the rules in paragraph
(g)(24)(ii) of this section, a seller in an
acquisition described in paragraph
(c)(2)(i)(A) of this section in which the
corporation is the acquirer.

(ii) Special rules for certain acquisi-
tions of subsidiary stock. The following
rules apply with respect to a successor
described in paragraph (g)(24)(i)(C) of
this section:

(A) The seller is a successor to the
acquirer only to the extent of the value
(adjusted as described in paragraph
(g)(24)(ii)(C) of this section) of the ex-
panded group stock acquired from the
seller in exchange for property (other than
expanded group stock) in the acquisition
described in paragraph (c)(2)(i)(A) of this
section.

(B) A distribution or acquisition by the
seller to or from the acquirer is not taken
into account for purposes of applying
paragraph (b)(3) of this section to a cov-
ered debt instrument of the acquirer.

(C) To the extent that a covered debt
instrument of the acquirer is treated as
funding a distribution or acquisition by
the seller described in paragraphs
(b)(3)(i)(A) through (C) of this section, or
would be treated but for the exceptions
described in paragraphs (c)(3)(i) and (ii)
of this section, the value of the expanded
group stock described in paragraph
(g)(24)(ii)(A) of this section is reduced by
an amount equal to the distribution or
acquisition for purposes of any further
application of paragraph (g)(24)(ii)(A) of

this section with respect to the acquirer
and seller.

(iii) Successor ceasing to be a member
of the same expanded group as corpora-
tion. The term successor does not include
a controlled corporation described in para-
graph (g)(24)(i)(B) of this section with
respect to a distributing corporation or a
seller described in paragraph (g)(24)(i)(C)
of this section with respect to an acquirer
from the date that the controlled corpora-
tion or the seller ceases to be a member
of the expanded group of which the con-
trolled corporation or acquirer, respec-
tively, is a member.

(iv) Multiple successors. A corporation
may have more than one successor, in-
cluding by reason of a successor of the
corporation having a predecessor or suc-
cessor. Accordingly, references to a cor-
poration also include references to a pre-
decessor or successor of a successor of the
corporation.

(25) Taxable year. The term taxable
year refers to the taxable year of the issuer
of the covered debt instrument.

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

(i) FP is a foreign corporation that
owns 100% of the stock of USS1, a cov-
ered member, 100% of the stock of USS2,
a covered member, and 100% of the stock
of FS, a foreign corporation;

(ii) USS1 owns 100% of the stock of
DS, a covered member, and CFC, which is
a controlled foreign corporation within the
meaning of section 957;

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

(iv) The FP expanded group has more
than $50 million of covered debt instru-
ments described in paragraph (c)(4) of this
section at all times;

(v) No issuer of a covered debt instru-
ment has a positive expanded group earn-
ings account within the meaning of para-
graph (c)(3)(i)(B) of this section or has
received qualified contributions within the
meaning of paragraph (c)(3)(ii) of this
section;

(vi) All notes are covered debt instru-
ments (as defined in paragraph (g)(3) of
this section) and are not qualified short-

term debt instruments (as defined in para-
graph (b)(3)(vii) of this section);

(vii) Each entity has as its taxable year
the calendar year;

(viii) PRS is a partnership for federal
income tax purposes;

(ix) No corporation is a member of a
consolidated group;

(x) No domestic corporation is a
United States real property holding corpo-
ration within the meaning of section
897(c)(2);

(xi) Each note is issued with adequate
stated interest (as defined in section
1274(c)(2)); and

(xii) Each transaction occurs after Jan-
uary 19, 2017.

(2) No inference. Except as otherwise
provided in this section, it is assumed for
purposes of the examples in paragraph
(h)(3) of this section that the form of each
transaction is respected for federal tax
purposes. No inference is intended, how-
ever, as to whether any particular note
would be respected as indebtedness or as
to whether the form of any particular
transaction described in an example in
paragraph (h)(3) of this section would be
respected for federal tax purposes.

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

Example 1. Distribution of a covered debt instru-
ment. (i) Facts. On Date A in Year 1, FS lends $100x
to USS1 in exchange for USS1 Note A. On Date B
in Year 2, USS1 issues USS1 Note B, which is has
a value of $100x, to FP in a distribution.

(ii) Analysis. USS1 Note B is a covered debt
instrument that is issued by USS1 to FP, a member
of the expanded group of which USS1 is a member,
in a distribution. Accordingly, USS1 Note B is
treated as stock under paragraph (b)(2)(i) of this
section. Under paragraph (d)(1)(i) of this section,
USS1 Note B is treated as stock when it is issued by
USS1 to FP on Date B in Year 2. Accordingly, USS1
is treated as distributing USS1 stock to its share-
holder FP in a distribution that is subject to section
305. Under paragraph (b)(5) of this section, because
the distribution of USS1 Note B is described in
paragraph (b)(2)(i) of this section, the distribution of
USS1 Note B is not treated as a distribution of
property described in paragraph (b)(3)(i)(A) of this
section. Accordingly, USS1 Note A is not treated as
funding the distribution of USS1 Note B for pur-
poses of paragraph (b)(3)(i)(A) of this section.

Example 2. Covered debt instrument issued for
expanded group stock that is exchanged for stock in
a corporation that is not a member of the same
expanded group. (i) Facts. UST is a publicly traded
domestic corporation. On Date A in Year 1, USS1
issues USS1 Note to FP in exchange for FP stock.
Subsequently, on Date B of Year 1, USS1 transfers
the FP stock to UST's shareholders, which are not

members of the FP expanded group, in exchange for
all of the stock of UST.

(ii) Analysis. (A) Because USS1 and FP are both
members of the FP expanded group, USS1 Note is
treated as stock when it is issued by USS1 to FP in
exchange for FP stock on Date A in Year 1 under
paragraphs (b)(2)(ii) and (d)(1)(i) of this section.
This result applies even though, pursuant to the same
plan, USS1 transfers the FP stock to persons that are
not members of the FP expanded group. The ex-
change of USS1 Note for FP stock is not an exempt
exchange within the meaning of paragraph (g)(11) of
this section.

(B) Because USS1 Note is treated as stock for
federal tax purposes when it is issued by USS1,
pursuant to section § 1.367(b)-10(a)(3)(ii) (defining
property for purposes of § 1.367(b)-10) there is no
potential application of § 1.367(b)-10(a) to USS1's
acquisition of the FP stock.

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

(ii) Analysis. (A) Because USS1 and FP are both
members of the FP expanded group, USS1 Note is
treated as stock when it is issued by USS1 to FP in
exchange for FS stock on Date A in Year 1 under
paragraphs (b)(2)(ii) and (d)(1)(i) of this section. The
exchange of USS1 Note for FS stock is not an
exempt exchange within the meaning of paragraph
(g)(11) of this section.

(B) Because USS1 Note is treated as stock for
federal tax purposes when it is issued by USS1,
USS1 Note is not treated as property for purposes of
section 304(a) because it is not property within the
meaning specified in section 317(a). Therefore,
USS1's acquisition of FS stock from FP in exchange
for USS1 Note is not an acquisition described in
section 304(a)(1).

Example 4. Funding occurs in same taxable year
as distribution. (i) Facts. On Date A in Year 1, FP
lends $200x to DS in exchange for DS Note A. On
Date B in Year 1, DS distributes $400x of cash to
USS1 in a distribution.

(ii) Analysis. Under paragraph (b)(3)(iii)(A) of
this section, DS Note A is treated as funding the
distribution by DS to USS1 because DS Note A is
issued to a member of the FP expanded group during
the per se period with respect to DS's distribution to
USS1. Accordingly, under paragraphs (b)(3)(i)(A)
and (d)(1)(ii) of this section, DS Note A is treated as
stock on Date B in Year 1.

Example 5. Additional funding. (i) Facts. The
facts are the same as in Example 4 of this paragraph
(h)(3), except that, in addition, on Date C in Year 2,
FP lends an additional $300x to DS in exchange for
DS Note B.

(ii) Analysis. The analysis is the same as in
Example 4 of this paragraph (h)(3) with respect to
DS Note A. DS Note B is also issued to a member of
the FP expanded group during the per se period with
respect to DS's distribution to USS1. Under para-
graphs (b)(3)(iii)(A) and (b)(6) of this section, DS
Note B is treated as funding only the remaining
portion of DS's distribution to USS1, which is
$200x. Accordingly, $200x of DS Note B is treated
as stock under paragraph (b)(3)(i)(A) of this section.
Under paragraph (d)(1)(i) of this section, $200x of

DS Note B is treated as stock when it is issued by DS
to FP on Date C in Year 2. The remaining $100x of
DS Note B continues to be treated as indebtedness.

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

(ii) Analysis. (A) Under paragraph (b)(3)(iii)(B)
of this section, USS1 Note A is tested under para-
graph (b)(3) of this section before USS1 Note B is
tested. USS1 Note A is issued during the per se
period with respect to USS1's $300x distribution to
FP and, therefore, is treated as funding the distribu-
tion under paragraph (b)(3)(iii)(A) of this section.
Beginning on Date B in Year 2, USS1 Note A is
treated as stock under paragraphs (b)(3)(i)(A) and
(d)(1)(ii) of this section.

(B) Under paragraph (b)(3)(iii)(B) of this sec-
tion, USS1 Note B is tested under paragraph (b)(3)
of this section after USS1 Note A is tested. Because
USS1 Note A is treated as funding the entire $300x
distribution by USS1 to FP, USS1 Note B will con-
tinue to be treated as indebtedness. See paragraph
(b)(6) of this section.

Example 7. Re-testing. (i) Facts. The facts are the
same as in Example 6 of this paragraph (h)(3), except
that on Date D in Year 4, FP sells USS1 Note A to
Bank.

(ii) Analysis. (A) Under paragraph (d)(2)(i) of
this section, USS1 Note A ceases to be treated as
stock when FP sells USS1 Note A to Bank on Date
D in Year 4. Immediately before FP sells USS1 Note
A to Bank, USS1 is deemed to issue a debt instru-
ment to FP in exchange for USS1 Note A in a
transaction that is disregarded for purposes of para-
graphs (b)(2) and (b)(3) of this section.

(B) Under paragraph (d)(2)(ii) of this section,
after USS1 Note A is deemed exchanged for a new
debt instrument, USS1's other covered debt instru-
ments that are not treated as stock as of Date D in
Year 4 (USS1 Note B) are re-tested for purposes of
paragraph (b)(3)(iii) of this section to determine
whether the instruments are treated as funding the
$300x distribution by USS1 to FP on Date B in Year
2. USS1 Note B was issued by USS1 to FP during
the per se period. Accordingly, USS1 Note B is
re-tested under paragraph (b)(3)(iii) of this section.
Under paragraph (b)(3)(iii) of this section, USS1
Note B is treated as funding the distribution on Date
C in Year 3 and, accordingly, is treated as stock
under paragraph (b)(3)(i)(A) of this section. USS1
Note B is deemed to be exchanged for stock on Date
D in Year 4, the re-testing date, under paragraph
(d)(1)(iv) of this section. See § 1.385-1(d) for rules
regarding the treatment of this deemed exchange.

Example 8. Distribution of expanded group stock
and covered debt instrument in a reorganization that
qualifies under section 355. (i) Facts. On Date A in
Year 1, FP lends $200x to USS2 in exchange for
USS2 Note. In a transaction that is treated as inde-
pendent from the transaction on Date A in Year 1, on
Date B in Year 2, USS2 transfers a portion of its
assets to DS2, a newly formed domestic corporation,
in exchange for all of the stock of DS2 and DS2
Note. Immediately afterwards, USS2 distributes all
of the DS2 stock and the DS2 Note to FP with

respect to FP's USS2 stock in a transaction that
qualifies under section 355. USS2's transfer of a
portion of its assets to DS2 qualifies as a reorgani-
zation described in section 368(a)(1)(D). The DS2
stock has a value of $150x and DS2 Note has a value
of $50x. The DS2 stock is not non-qualified pre-
ferred stock as defined in section 351(g)(2). Absent
the application of this section, DS2 Note would be
treated by FP as other property within the meaning
of section 356.

(ii) Analysis. (A) The contribution and distribu-
tion transaction is a reorganization described in sec-
tion 368(a)(1)(D) involving a transfer of property by
USS2 to DS2 in exchange for DS2 stock and DS2
Note. The transfer of property by USS2 to DS2 is a
contribution of excluded property described in para-
graph (c)(3)(ii)(D)(2) of this section and an excluded
contribution described in paragraph (c)(3)(ii)(E)(2)
of this section. Accordingly, USS2's contribution of
property to DS2 is not a qualified contribution de-
scribed in paragraph (c)(3)(ii)(B) of this section.

(B) DS2 Note is a covered debt instrument that is
issued by DS2 to USS2, both members of the FP
expanded group, in exchange for property of USS2
in an asset reorganization (as defined in paragraph
(g)(1) of this section), and received by FP, another
FP expanded group member immediately before the
reorganization, as other property with respect to FP's
USS2 stock. Accordingly, the transaction is de-
scribed in paragraph (b)(2)(iii) of this section, and
DS2 Note is treated as stock when it is issued by
DS2 to USS2 on Date B in Year 2 pursuant to
paragraphs (b)(2)(iii) and (d)(1)(i) of this section.

(C) Because the issuance of DS2 Note by DS2 in
exchange for the property of USS2 in an asset reor-
ganization is described in paragraph (b)(2)(iii) of this
section, the distribution and acquisition of DS2 Note
by USS2 is not treated as a distribution or acquisition
described in paragraph (b)(3)(i) of this section. Ac-
cordingly, USS2 Note is not treated as funding the
distribution of DS2 Note for purposes of paragraph
(b)(3)(i) of this section.

(D) USS2's acquisition of DS2 stock is not an
acquisition described in paragraph (b)(3)(i)(B) of
this section because it is an exempt exchange (as
defined in paragraph (g)(11) of this section). USS2's
acquisition of DS2 stock is an exempt exchange
because USS2 and DS2 are both parties to a reorga-
nization that is an asset reorganization, section 1032
applies to DS2, the transferor of the expanded group
stock, and the DS2 stock is distributed by USS2, the
transferee of the expanded group stock, pursuant to
the plan of reorganization.

(E) USS2's distribution of $150x of the DS2
stock is a distribution of stock that is permitted to be
received by FP without recognition of gain under
section 355(a)(1). Accordingly, USS2's distribution
of the DS2 stock (other than the DS2 Note) to FP is
an exempt distribution, and is not described in para-
graph (b)(3)(i)(A) of this section.

(F) Because USS2 has not made a distribution or
acquisition that is described in paragraph
(b)(3)(i)(A), (B), or (C) of this section, USS2 Note is
not treated as stock.

Example 9. Funding a distribution by a succes-
sor to funded member. (i) Facts. The facts are the
same as in Example 8 of this paragraph (h)(3), except
that on Date C in Year 3, DS2 distributes $200x of

cash to FP and, subsequently, on Date D in Year 3,
USS2 distributes $100x of cash to FP.

(ii) Analysis. (A) USS2 is a predecessor of DS2
under paragraph (g)(20)(i)(B) of this section and
DS2 is a successor to USS2 under paragraph
(g)(24)(i)(B) of this section because USS2 is the
distributing corporation and DS2 is the controlled
corporation in a distribution to which section 355
applies. Accordingly, under paragraph (b)(3)(v) of
this section, a distribution by DS2 is treated as
a distribution by USS2. Under paragraphs
(b)(3)(iii)(A) and (b)(3)(v)(B) of this section,
USS2 Note is treated as funding the distribution
by DS2 to FP because USS2 Note was issued
during the per se period with respect to DS2's
$200x cash distribution, and because both the is-
suance of USS2 Note and the distribution by DS2
occur during the per se period with respect to the
section 355 distribution. Accordingly, under para-
graphs (b)(3)(i)(A) and (d)(1)(ii) of this section,
USS2 Note is treated as stock beginning on Date C
in Year 3. See § 1.385-1(d) for rules regarding the
treatment of this deemed exchange.

(B) Because the entire amount of USS2 Note is
treated as funding DS2's $200x distribution to FP,
under paragraph (b)(3)(iii)(C) of this section, USS2
Note is not treated as funding the subsequent distri-
bution by USS2 on Date D in Year 3.

Example 10. Asset reorganization; section 354
qualified property. (i) Facts. On Date A in Year 1,
FS lends $100x to USS2 in exchange for USS2 Note.
On Date B in Year 2, in a transaction that qualifies as
a reorganization described in section 368(a)(1)(D),
USS2 transfers all of its assets to USS1 in exchange
for stock of USS1 and the assumption by USS1 of all
of the liabilities of USS2, and USS2 distributes to
FP, with respect to FP's USS2 stock, all of the USS1
stock that USS2 receives. FP does not recognize gain
under section 354(a)(1).

(ii) Analysis. (A) USS1 is a successor to USS2
under paragraph (g)(24)(i)(A) of this section. For
purposes of paragraph (b)(3) of this section, USS2
and, under paragraph (b)(3)(v)(A) of this section, its
successor, USS1, are funded members with respect
to USS2 Note. Although USS2, a funded member,
distributes property (USS1 stock) to its share-
holder, FP, pursuant to the reorganization, the
distribution of USS1 stock is not described in
paragraph (b)(3)(i)(A) of this section because the
stock is distributed in an exempt distribution (as
defined in paragraph (g)(10) of this section). In
addition, neither USS1's acquisition of the assets
of USS2 nor USS2's acquisition of USS1 stock is
described in paragraph (b)(3)(i)(C) of this section
because FP does not receive other property within
the meaning of section 356 with respect to its
stock in USS2.

(B) USS2's acquisition of USS1 stock is not an
acquisition described in paragraph (b)(3)(i)(B) of
this section because it is an exempt exchange (as
defined in paragraph (g)(11) of this section). USS2's
acquisition of USS1 stock is an exempt exchange
because USS1 and USS2 are both parties to an asset
reorganization, section 1032 applies to USS1, the
transferor of the USS1 stock, and the USS1 stock is
distributed by USS2, the transferee, pursuant to the
plan of reorganization. Furthermore, USS2's acqui-
sition of its own stock from FS is not an acquisition

described in paragraph (b)(3)(i)(B) of this section
because USS2 acquires its stock in exchange for
USS1 stock.

(C) Because neither USS1 nor USS2 has made a
distribution or acquisition described in paragraph
(b)(3)(i)(A), (B), or (C) of this section, USS2 Note is
not treated as stock under paragraph (b)(3)(iii)(A) of
this section.

Example 11. Distribution of a covered debt in-
strument and issuance of a covered debt instrument
with a principal purpose of avoiding the purposes of
this section. (i) Facts. On Date A in Year 1, USS1
issues USS1 Note A, which has a value of $100x, to
FP in a distribution. On Date B in Year 1, with a
principal purpose of avoiding the purposes of this
section, FP sells USS1 Note A to Bank for $100x of
cash and lends $100x to USS1 in exchange for USS1
Note B.

(ii) Analysis. USS1 Note A is a covered debt
instrument that is issued by USS1 to FP, a member
of USS1's expanded group, in a distribution. Ac-
cordingly, under paragraphs (b)(2)(i) and (d)(1)(i) of
this section, USS1 Note A is treated as stock when it
is issued by USS1 to FP on Date A in Year 1.
Accordingly, USS1 is treated as distributing USS1
stock to FP. Because the distribution of USS1 Note
A is described in paragraph (b)(2)(i) of this section,
the distribution of USS1 Note A is not described in
paragraph (b)(3)(i)(A) of this section under para-
graph (b)(5) of this section. Under paragraph
(d)(2)(i) of this section, USS1 Note A ceases to be
treated as stock when FP sells USS1 Note A to Bank
on Date B in Year 1. Immediately before FP sells
USS1 Note A to Bank, USS1 is deemed to issue a
debt instrument to FP in exchange for USS1 Note A
in a transaction that is disregarded for purposes of
paragraphs (b)(2) and (b)(3)(i) of this section. USS1
Note B is not treated as stock under paragraph
(b)(3)(i)(A) of this section because the funded mem-
ber, USS1, has not made a distribution of property.
However, because the transactions occurring on Date
B of Year 1 were undertaken with a principal pur-
pose of avoiding the purposes of this section, USS1
Note B is treated as stock on Date B of Year 1 under
paragraph (b)(4) of this section.

Example 12. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
12.

Example 13. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
13.

Example 14. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
14.

Example 15. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
15.

Example 16. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
16.

Example 17. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
17.

Example 18. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
18.

Example 19. [Reserved]. For further
guidance, see § 1.385-3T(h)(3), Example
19.

(i) [Reserved]

(j) Applicability date and transition
rules-(1) In general. This section applies
to taxable years ending on or after January
19, 2017.

(2) Transition rules-(i) Transition
rule for covered debt instruments that
would be treated as stock in taxable years
ending before January 19, 2017. If para-
graphs (b) and (d)(1) of this section, tak-
ing into account §§ 1.385-1, 1.385-3T,
and 1.385-4T, would have treated a cov-
ered debt instrument as stock in a taxable
year ending before January 19, 2017 but
for the application of paragraph (j)(1) of
this section, to the extent that the covered
debt instrument is held by a member of
the expanded group of which the issuer is
a member immediately after January 19,
2017, then the covered debt instrument is
deemed to be exchanged for stock imme-
diately after January 19, 2017.

(ii) Transition rule for certain covered
debt instruments treated as stock in tax-
able years ending on or after January 19,
2017. If paragraphs (b) and (d)(1) of this
section, taking into account §§ 1.385-1,
1.385-3T, and 1.385-4T, would treat a
covered debt instrument as stock on or
before January 19, 2017 but in a taxable
year ending on or after January 19, 2017,
that covered debt instrument is not treated
as stock during the 90-day period after
October 21, 2016. Instead, to the extent
that the covered debt instrument is held by
a member of the expanded group of which
the issuer is a member immediately after
January 19, 2017, the covered debt instru-
ment is deemed to be exchanged for stock
immediately after January 19, 2017.

(iii) Transition funding rule. When a
covered debt instrument would be rechar-
acterized as stock after April 4, 2016, and
on or before January 19, 2017 (the tran-
sition period), but that covered debt in-
strument is not recharacterized as stock on
such date due to the application of para-
graph (j)(1), (j)(2)(i), or (j)(2)(ii) of this
section, any payments made with respect
to such covered debt instrument (other
than stated interest), including pursuant to

a refinancing, after the date that the cov-
ered debt instrument would have been re-
characterized as stock and through the re-
maining portion of the transition period
are treated as distributions for purposes of
applying paragraph (b)(3) of this section
for taxable years ending on or after Janu-
ary 19, 2017. In addition, to the extent that
the holder and the issuer of the covered
debt instrument cease to be members of
the same expanded group during the tran-
sition period, the distribution or acquisi-
tion that would have caused the covered
debt instrument to be treated as stock is
available to be treated as funded by other
covered debt instruments of the issuer for
purposes of paragraph (b)(3) of this sec-
tion (to the extent provided in paragraph
(b)(3)(iii) of this section). The prior sen-
tence is applied in a manner that is con-
sistent with the rules set forth in paragraph
(d)(2) of this section.

(iv) Coordination between the general
rule and funding rule. When a covered
debt instrument would be recharacterized
as stock pursuant to paragraph (b)(2) of
this section after April 4, 2016, and on or
before January 19, 2017, but that covered
debt instrument is not recharacterized as
stock on such date due to the application
of paragraph (j)(1), (j)(2)(i), or (j)(2)(ii) of
this section, the issuance of such covered
debt instrument is not treated as a distribu-
tion or acquisition described in § 1.385-
3(b)(3)(i), but only to the extent that the
covered debt instrument is held by a mem-
ber of the expanded group of which the
issuer is a member immediately after Janu-
ary 19, 2017.

(v) Option to apply proposed regula-
tions. In lieu of applying §§ 1.385-1,
1.385-3, 1.385-3T, and 1.385-4T, tax-
payers may apply the provisions matching
§§ 1.385-1, 1.385-3, and 1.385-4 from
the Internal Revenue Bulletin (IRB)
2016-17 (https://www.irs.gov/pub/irs-irbs/
irb16-17.pdf) to all debt instruments is-
sued by a particular issuer (and members
of its expanded group that are covered
members) after April 4, 2016, and before
October 13, 2016, solely for purposes of
determining whether a debt instrument is
treated as stock, provided that those sec-
tions are consistently applied.

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

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

(a) [Reserved]. For further guidance,
see § 1.385-3(a).

(b)(1) through (b)(2). [Reserved]. For
further guidance, see § 1.385-3(b)(1)
through (b)(2).

(b)(3)(i) through (vi). [Reserved]. For
further guidance, see § 1.385-3(b)(3)(i)
through (vi).

(vii) Qualified short-term debt instru-
ment. The term qualified short-term debt
instrument means a covered debt instru-
ment that is described in paragraph
(b)(3)(vii)(A), (b)(3)(vii)(B), (b)(3)(vii)
(C),or (b)(3)(vii)(D) of this section.

(A) Short-term funding arrangement.
A covered debt instrument is described in
this paragraph (b)(3)(vii)(A) if the re-
quirements of the specified current assets
test described in paragraph (b)(3)
(vii)(A)(1) of this section or the 270-day
test described in paragraph (b)(3)(vii)
(A)(2) of this section (the alternative tests)
are satisfied, provided that an issuer may
only claim the benefit of one of the alter-
native tests with respect to covered debt
instruments issued by the issuer in the
same taxable year.

(1) Specified current assets test-(i) In
general. The requirements of this para-
graph (b)(3)(vii)(A)(1) are satisfied with
respect to a covered debt instrument if the
requirement of paragraph (b)(3)(vii)(A)
(1)(ii) of this section is satisfied, but only
to the extent the requirement of paragraph
(b)(3)(vii)(A)(1)(iii) of this section is sat-
isfied.

(ii) Maximum interest rate. The rate of
interest charged with respect to the cov-
ered debt instrument does not exceed an
arm's length interest rate, as determined
under section 482 and the regulations
thereunder, that would be charged with
respect to a comparable debt instrument of
the issuer with a term that does not exceed
the longer of 90 days and the issuer's
normal operating cycle.

(iii) Maximum outstanding balance.
The amount owed by the issuer under
covered debt instruments issued to mem-
bers of the issuer's expanded group that
satisfy the requirements of paragraph (b)
(3)(vii)(A)(1)(ii),(b)(3)(vii)(A)(2) (if the
covered debt instrument was issued in a
prior taxable year), (b)(3)(vii)(B), or (b)(3)

(vii)(C) of this section immediately after
the covered debt instrument is issued does
not exceed the maximum of the amounts
of specified current assets reasonably ex-
pected to be reflected, under applicable
accounting principles, on the issuer's bal-
ance sheet as a result of transactions in the
ordinary course of business during the
subsequent 90-day period or the issuer's
normal operating cycle, whichever is lon-
ger. For purposes of the preceding sen-
tence, in the case of an issuer that is a
qualified cash pool header, the amount
owed by the issuer shall not take into
account deposits described in paragraph
(b)(3)(vii)(D) of this section. Addition-
ally, the amount owned by any issuer shall
be reduced by the amount of the issuer's
deposits with a qualified cash pool header,
but only to the extent of amounts bor-
rowed from the same qualified cash pool
header that satisfy the requirements of
paragraph (b)(3)(vii)(A)(2) (if the covered
debt instrument was issued in a prior tax-
able year) or (b)(3)(vii)(A)(1)(ii) of this
section.

(iv) Specified current assets. For pur-
poses of paragraph (b)(3)(vii)(A)(1)(iii) of
this section, the term specified current as-
sets means assets that are reasonably ex-
pected to be realized in cash or sold (in-
cluding by being incorporated into
inventory that is sold) during the normal
operating cycle of the issuer, other than
cash, cash equivalents, and assets that are
reflected on the books and records of a
qualified cash pool header.

(v) Normal operating cycle. For pur-
poses of paragraph (b)(3)(vii)(A)(1) of
this section, the term normal operating
cycle means the issuer's normal operating
cycle as determined under applicable ac-
counting principles, except that if the is-
suer has no single clearly defined normal
operating cycle, then the normal operating
cycle is determined based on a reasonable
analysis of the length of the operating
cycles of the multiple businesses and their
sizes relative to the overall size of the
issuer.

(vi) Applicable accounting principles.
For purposes of paragraph (b)(3)(vii)(A)
(1) of this section, the term applicable
accounting principles means the financial
accounting principles generally accepted
in the United States, or an international
financial accounting standard, that is ap-

plicable to the issuer in preparing its fi-
nancial statements, computed on a consis-
tent basis.

(2) 270-day test-(i) In general. A
covered debt instrument is described in
this paragraph (b)(3)(vii)(A)(2) if the re-
quirements of paragraphs (b)(3)(vii)(A)
(2)(ii) through (b)(3)(vii)(A)(2)(iv) of this
section are satisfied.

(ii) Maximum term and interest rate.
The covered debt instrument must have a
term of 270 days or less or be an advance
under a revolving credit agreement or
similar arrangement and must bear a rate
of interest that does not exceed an arm's
length interest rate, as determined under
section 482 and the regulations thereun-
der, that would be charged with respect to
a comparable debt instrument of the issuer
with a term that does not exceed 270 days.

(iii) Lender-specific indebtedness limit.
The issuer is a net borrower from the
lender for no more than 270 days during
the taxable year of the issuer, and in the
case of a covered debt instrument out-
standing during consecutive tax years, the
issuer is a net borrower from the lender
for no more than 270 consecutive days, in
both cases taking into account only cov-
ered debt instruments that satisfy the re-
quirement of paragraph (b)(3)(vii)(A)
(2)(ii) of this section other than covered
debt instruments described in paragraph
(b)(3)(vii)(B) or (b)(3)(vii)(C) of this sec-
tion.

(iv) Overall indebtedness limit. The is-
suer is a net borrower under all covered
debt instruments issued to members of the
issuer's expanded group that satisfy the
requirements of paragraphs (b)(3)(vii)
(A)(2)(ii) and (iii) of this section, other
than covered debt instruments described
in paragraph (b)(3)(vii)(B) or (b)(3)(vii)
(C) of this section, for no more than 270
days during the taxable year of the issuer,
determined without regard to the identity
of the lender under such covered debt
instruments.

(v) Inadvertent error. An issuer's fail-
ure to satisfy the 270-day test will be
disregarded if the failure is reasonable in
light of all the facts and circumstances and
the failure is promptly cured upon discov-
ery. A failure to satisfy the 270-day test
will be considered reasonable if the tax-
payer maintains due diligence procedures
to prevent such failures, as evidenced by

having written policies and operational
procedures in place to monitor compliance
with the 270-day test and management-
level employees of the expanded group
having undertaken reasonable efforts to
establish, follow, and enforce such poli-
cies and procedures.

(B) Ordinary course loans. A covered
debt instrument is described in this para-
graph (b)(3)(vii)(B) if the covered debt
instrument is issued as consideration for
the acquisition of property other than
money in the ordinary course of the issu-
er's trade or business, provided that the
obligation is reasonably expected to be
repaid within 120 days of issuance.

(C) Interest-free loans. A covered debt
instrument is described in this paragraph
(b)(3)(vii)(C) if the instrument does not
provide for stated interest or no interest is
charged on the instrument, the instrument
does not have original issue discount (as
defined in section 1273 and the regula-
tions thereunder), interest is not imputed
under section 483 or section 7872 and the
regulations thereunder, and interest is not
required to be charged under section 482
and the regulations thereunder.

(D) Deposits with a qualified cash pool
header-(1) In general. A covered debt
instrument is described in this paragraph
(b)(3)(vii)(D) if it is a demand deposit
received by a qualified cash pool header
described in paragraph (b)(3)(vii)(D)(2)
of this section pursuant to a cash-
management arrangement described in
paragraph (b)(3)(vii)(D)(3) of this section.
This paragraph (b)(3)(vii)(D) does not ap-
ply if a purpose for making the demand
deposit is to facilitate the avoidance of the
purposes of this section or § 1.385-3 with
respect to a qualified business unit (as
defined in section 989(a) and the regula-
tions thereunder) (QBU) that is not a qual-
ified cash pool header.

(2) Qualified cash pool header. The
term qualified cash pool header means an
expanded group member, controlled part-
nership, or QBU described in § 1.989(a)-
1(b)(2)(ii), that has as its principal
purpose managing a cash-management ar-
rangement for participating expanded
group members, provided that the excess
(if any) of funds on deposit with such
expanded group member, controlled part-
nership, or QBU (header) over the out-
standing balance of loans made by the

header is maintained on the books and
records of the header in the form of cash
or cash equivalents, or invested through
deposits with, or the acquisition of obli-
gations or portfolio securities of, persons
that do not have a relationship to the
header (or, in the case of a header that is
a QBU described in § 1.989(a)-
1(b)(2)(ii), its owner) described in section
267(b) or section 707(b).

(3) Cash-management arrangement.
The term cash-management arrangement
means an arrangement the principal pur-
pose of which is to manage cash for par-
ticipating expanded group members. For
purposes of the preceding sentence, man-
aging cash means borrowing excess funds
from participating expanded group mem-
bers and lending funds to participating
expanded group members, and may also
include foreign exchange management,
clearing payments, investing excess cash
with an unrelated person, depositing ex-
cess cash with another qualified cash pool
header, and settling intercompany ac-
counts, for example through netting cen-
ters and pay-on-behalf-of programs.

(b)(viii) [Reserved]. For further guid-
ance, see § 1.385-3(b)(viii).

(d)(1) through (d)(3) [Reserved]. For
further guidance, see § 1.385-3(d)(1)
through (d)(3).

(4) Treatment of disregarded entities.
This paragraph (d)(4) applies to the extent
that a covered debt instrument issued by a
disregarded entity, the regarded owner of
which is a covered member, would, absent
the application of this paragraph (d)(4), be
treated as stock under § 1.385-3. In this
case, rather than the covered debt instru-
ment being treated as stock to such extent
(applicable portion), the covered member
that is the regarded owner of the disre-
garded entity is deemed to issue its stock
in the manner described in this paragraph
(d)(4). If the applicable portion otherwise
would have been treated as stock under
§ 1.385-3(b)(2), then the covered member
is deemed to issue its stock to the ex-
panded group member to which the cov-
ered debt instrument was, in form, issued
(or transferred) in the transaction de-
scribed in § 1.385-3(b)(2). If the applica-
ble portion otherwise would have been
treated as stock under § 1.385-3(b)(3)(i),

then the covered member is deemed to
issue its stock to the holder of the covered
debt instrument in exchange for a portion
of the covered debt instrument equal to
the applicable portion. In each case, the
covered member that is the regarded
owner of the disregarded entity is treated
as the holder of the applicable portion of
the debt instrument issued by the disre-
garded entity, and the actual holder is
treated as the holder of the remaining por-
tion of the covered debt instrument and
the stock deemed to be issued by the re-
garded owner. Under federal tax princi-
ples, the applicable portion of the debt
instrument issued by the disregarded en-
tity generally is disregarded. This para-
graph (d)(4) must be applied in a manner
that is consistent with the principles of
paragraph (f)(4) of this section. Thus, for
example, stock deemed issued is deemed
to have the same terms as the covered debt
instrument issued by the disregarded en-
tity, other than the identity of the issuer,
and payments on the stock are determined
by reference to payments made on the
covered debt instrument issued by the dis-
regarded entity. See § 1.385-4T(b)(3) for
additional rules that apply if the regarded
owner of the disregarded entity is a mem-
ber of a consolidated group. If the re-
garded owner of a disregarded entity is a
controlled partnership, then paragraph (f)
of this section applies as though the con-
trolled partnership were the issuer in form
of the debt instrument.

(d)(5) through (d)(7). [Reserved]. For
further guidance, see § 1.385-3(d)(5)
through (d)(7).

(e) [Reserved]. For further guidance,
see § 1.385-3(e).

(f) Treatment of controlled partner-
ships-(1) In general. For purposes of this
section and §§ 1.385-3 and 1.385-4T, a
controlled partnership is treated as an ag-
gregate of its partners in the manner de-
scribed in this paragraph (f). Paragraph
(f)(2) of this section sets forth rules con-
cerning the aggregate treatment when a
controlled partnership acquires property
from a member of the expanded group.
Paragraph (f)(3) of this section sets forth
rules concerning the aggregate treatment
when a controlled partnership issues a
debt instrument. Paragraph (f)(4) of this
section deems a debt instrument issued by
a controlled partnership to be held by an

expanded group partner rather than the
holder-in-form in certain cases. Paragraph
(f)(5) of this section sets forth the rules
concerning events that cause the deemed
results described in paragraph (f)(4) of
this section to cease. Paragraph (f)(6) of
this section exempts certain issuances of a
controlled partnership's debt to a partner
and a partner's debt to a controlled part-
nership from the application of this sec-
tion and § 1.385-3. For definitions appli-
cable for this section, see paragraph (g) of
this section and § 1.385-3(g). For exam-
ples illustrating the application of this sec-
tion, see paragraph (h) of this section.

(2) Acquisitions of property by a con-
trolled partnership-(i) Acquisitions of
property when a member of the expanded
group is a partner on the date of the
acquisition-(A) Aggregate treatment.
Except as otherwise provided in para-
graphs (f)(2)(i)(C) and (f)(6) of this sec-
tion, if a controlled partnership, with re-
spect to an expanded group, acquires
property from a member of the expanded
group (transferor member), then, for pur-
poses of this section and § 1.385-3, a
member of the expanded group that is an
expanded group partner on the date of the
acquisition is treated as acquiring its share
(as determined under paragraph (f)(2)
(i)(B) of this section) of the property. The
expanded group partner is treated as ac-
quiring its share of the property from the
transferor member in the manner (for ex-
ample, in a distribution, in an exchange
for property, or in an issuance), and on the
date on which, the property is actually
acquired by the controlled partnership
from the transferor member. Accordingly,
this section and § 1.385-3 apply to a
member's acquisition of property de-
scribed in this paragraph (f)(2)(i)(A) in
the same manner as if the member actu-
ally acquired the property from the trans-
feror member, unless explicitly provided
otherwise.

(B) Expanded group partner's share of
property. For purposes of paragraph
(f)(2)(i)(A) of this section, a partner's
share of property acquired by a controlled
partnership is determined in accordance
with the partner's liquidation value per-
centage (as defined in paragraph (g)(17)
of this section) with respect to the con-
trolled partnership. The liquidation value
percentage is determined on the date on

which the controlled partnership acquires
the property.

(C) Exception if transferor member is
an expanded group partner. If a transferor
member is an expanded group partner in
the controlled partnership, paragraph
(f)(2)(i)(A) of this section does not apply
to such partner.

(ii) Acquisitions of expanded group
stock when a member of the expanded
group becomes a partner after the acqui-
sition-(A) Aggregate treatment. Except
as otherwise provided in paragraph (f)
(2)(ii)(C) of this section, if a controlled
partnership, with respect to an expanded
group, owns expanded group stock, and a
member of the expanded group becomes
an expanded group partner in the con-
trolled partnership, then, for purposes of
this section and § 1.385-3, the member is
treated as acquiring its share (as deter-
mined under paragraph (f)(2)(ii)(B) of this
section) of the expanded group stock
owned by the controlled partnership. The
member is treated as acquiring its share of
the expanded group stock on the date on
which the member becomes an expanded
group partner. Furthermore, the member
is treated as if it acquires its share of the
expanded group stock from a member of
the expanded group in exchange for prop-
erty other than expanded group stock, re-
gardless of the manner in which the part-
nership acquired the stock and in which
the member acquires its partnership inter-
est. Accordingly, this section and § 1.385-
3 apply to a member's acquisition of ex-
panded group stock described in this para-
graph (f)(2)(ii)(A) in the same manner as
if the member actually acquired the stock
from a member of the expanded group in
exchange for property other than ex-
panded group stock, unless explicitly pro-
vided otherwise.

(B) Expanded group partner's share of
expanded group stock. For purposes of
paragraph (f)(2)(ii)(A) of this section, a
partner's share of expanded group stock
owned by a controlled partnership is de-
termined in accordance with the partner's
liquidation value percentage with respect
to the controlled partnership. The liquida-
tion value percentage is determined on the
date on which a member of the expanded
group becomes an expanded group partner
in the controlled partnership.

(C) Exception if an expanded group
partner acquires its interest in a con-
trolled partnership in exchange for ex-
panded group stock. Paragraph (f)(2)(ii)
(A) of this section does not apply to a
member of an expanded group that ac-
quires its interest in a controlled partner-
ship either from another partner in ex-
change solely for expanded group stock or
upon a partnership contribution to the
controlled partnership comprised solely of
expanded group stock.

(3) Issuances of debt instruments by a
controlled partnership to a member of an
expanded group-(i) Aggregate treat-
ment. If a controlled partnership, with re-
spect to an expanded group, issues a debt
instrument to a member of the expanded
group, then, for purposes of this section
and § 1.385-3, a covered member that is
an expanded group partner is treated as
the issuer with respect to its share (as
determined under paragraph (f)(3)(ii) of
this section) of the debt instrument issued
by the controlled partnership. This section
and § 1.385-3 apply to the portion of the
debt instrument treated as issued by the
covered member as described in this para-
graph (f)(3)(i) in the same manner as if the
covered member actually issued the debt
instrument to the holder-in-form, unless
otherwise provided. See paragraph (f)(4)
of this section, which deems a debt instru-
ment issued by a controlled partnership to
be held by an expanded group partner
rather than the holder-in-form in certain
cases.

(ii) Expanded group partner's share of
a debt instrument issued by a controlled
partnership-(A) General rule. An ex-
panded group partner's share of a debt
instrument issued by a controlled partner-
ship is determined on each date on which
the partner makes a distribution or acqui-
sition described in § 1.385-3(b)(2) or
(b)(3)(i) (testing date). An expanded
group partner's share of a debt instrument
issued by a controlled partnership to a
member of the expanded group is deter-
mined in accordance with the partner's
issuance percentage (as defined in para-
graph (g)(16) of this section) on the test-
ing date. A partner's share determined
under this paragraph (f)(3)(ii)(A) is ad-
justed as described in paragraph (f)(3)(ii)
(B) of this section.

(B) Additional rules if there is a spec-
ified portion with respect to a debt instru-
ment-(1) An expanded group partner's
share (as determined under paragraph
(f)(3)(ii)(A) of this section) of a debt in-
strument issued by a controlled partner-
ship is reduced, but not below zero, by the
sum of all of the specified portions (as
defined in paragraph (g)(23) of this sec-
tion), if any, with respect to the debt in-
strument that correspond to one or more
deemed transferred receivables (as de-
fined in paragraph (g)(8) of this section)
that are deemed to be held by the partner.

(2) If the aggregate of all of the ex-
panded group partners' shares (as deter-
mined under paragraph (f)(3)(ii)(A) of
this section and reduced under paragraph
(f)(3)(ii)(B)(1) of this section) of the debt
instrument exceeds the adjusted issue
price of the debt, reduced by the sum of all
of the specified portions with respect to
the debt instrument that correspond to one
or more deemed transferred receivables
that are deemed to be held by one or more
expanded group partners (excess amount),
then each expanded group partner's share
(as determined under paragraph (f)(3)
(ii)(A) of this section and reduced under
paragraph (f)(3)(ii)(B)(1) of this section)
of the debt instrument is reduced. The
amount of an expanded group partner's
reduction is the excess amount multiplied
by a fraction, the numerator of which is
the partner's share, and the denominator
of which is the aggregate of all of the
expanded group partners' shares.

(iii) Qualified short-term debt instru-
ment. The determination of whether a debt
instrument is a qualified short-term debt
instrument for purposes of § 1.385-
3(b)(3)(vii) is made at the partnership-
level without regard to paragraph (f)(3)(i)
of this section.

(4) Recharacterization when there is a
specified portion with respect to a debt
instrument issued by a controlled partner-
ship-(i) General rule. A specified por-
tion, with respect to a debt instrument
issued by a controlled partnership and an
expanded group partner, is not treated as
stock under § 1.385-3(b)(2) or (b)(3)(i).
Except as otherwise provided in para-
graphs (f)(4)(ii) and (f)(4)(iii) of this sec-
tion, the holder-in-form (as defined in
paragraph (g)(15) of this section) of the
debt instrument is deemed to transfer a

portion of the debt instrument (a deemed
transferred receivable, as defined in para-
graph (g)(8) of this section) with a prin-
cipal amount equal to the adjusted issue
price of the specified portion to the ex-
panded group partner in exchange for
stock in the expanded group partner
(deemed partner stock, as defined in para-
graph (g)(6) of this section) with a fair
market value equal to the principal
amount of the deemed transferred receiv-
able. Except as otherwise provided in
paragraph (f)(4)(vi) of this section (con-
cerning the treatment of a deemed trans-
ferred receivable for purposes of section
752) and paragraph (f)(5) of this section
(concerning specified events subsequent
to the deemed transfer), the deemed trans-
fer described in this paragraph (f)(4)(i) is
deemed to occur for all federal tax pur-
poses.

(ii) Expanded group partner is the
holder-in-form of a debt instrument. If the
specified portion described in paragraph
(f)(4)(i) of this section is with respect to
an expanded group partner that is the
holder-in-form of the debt instrument,
then paragraph (f)(4)(i) of this section will
not apply with respect to that specified
portion except that only the first sentence
of paragraph (f)(4)(i) of this section is
applicable.

(iii) Expanded group partner is a con-
solidated group member. This paragraph
(f)(4)(iii) applies when one or more ex-
panded group partners is a member of a
consolidated group that files (or is re-
quired to file) a consolidated U.S. federal
income tax return. In this case, notwith-
standing § 1.385-4T(b)(1) (which gener-
ally treats members of a consolidated
group as one corporation for purposes of
this section and § 1.385-3), the holder-in-
form of the debt instrument issued by the
controlled partnership is deemed to trans-
fer the deemed transferred receivable or
receivables to the expanded group partner
or partners that are members of a consol-
idated group that make, or are treated as
making under paragraph (f)(2) of this sec-
tion, the regarded distributions or acquisi-
tions (within the meaning of § 1.385-
4T(e)(5)) described in § 1.385-3(b)(2) or
(b)(3)(i) in exchange for deemed partner
stock in such partner or partners. To the
extent those regarded distributions or ac-
quisitions are made by a member of the

consolidated group that is not an ex-
panded group partner (excess amount), the
holder-in-form is deemed to transfer a
portion of the deemed transferred receiv-
able or receivables to each member of the
consolidated group that is an expanded
group partner in exchange for deemed
partner stock in the expanded group part-
ner. The portion is the excess amount mul-
tiplied by a fraction, the numerator of
which is the portion of the consolidated
group's share (as determined under para-
graph (f)(3)(ii) of this section) of the debt
instrument issued by the controlled part-
nership that would have been the ex-
panded group partner's share if the partner
was not a member of a consolidated
group, and the denominator of which is
the consolidated group's share of the debt
instrument issued by the controlled part-
nership.

(iv) Rules regarding deemed trans-
ferred receivables and deemed partner
stock-(A) Terms of deemed partner
stock. Deemed partner stock has the same
terms as the deemed transferred receiv-
able with respect to the deemed transfer,
other than the identity of the issuer.

(B) Treatment of payments with re-
spect to a debt instrument for which there
is one or more deemed transferred receiv-
ables. When a payment is made with re-
spect to a debt instrument issued by a
controlled partnership for which there is
one or more deemed transferred receiv-
ables, then, if the amount of the retained
receivable (as defined in paragraph
(g)(22) of this section) held by the holder-
in-form is zero and a single deemed
holder is deemed to hold all of the deemed
transferred receivables, the entire payment
is allocated to the deemed transferred re-
ceivables held by the single deemed
holder. If the amount of the retained re-
ceivable held by the holder-in-form is
greater than zero or there are multiple
deemed holders of deemed transferred re-
ceivables, or both, the payment is appor-
tioned among the retained receivable, if
any, and each deemed transferred receiv-
able in proportion to the principal amount
of all the receivables. The portion of a
payment allocated or apportioned to a re-
tained receivable or a deemed transferred
receivable reduces the principal amount
of, or accrued interest with respect to, as
applicable depending on the payment, the

retained receivable or deemed transferred
receivable. When a payment allocated or
apportioned to a deemed transferred re-
ceivable reduces the principal amount of
the receivable, the expanded group partner
that is the deemed holder with respect to
the deemed transferred receivable is
deemed to redeem the same amount of
deemed partner stock, and the specified
portion with respect to the debt instrument
is reduced by the same amount. When a
payment allocated or apportioned to a
deemed transferred receivable reduces ac-
crued interest with respect to the receiv-
able, the expanded group partner that is
the deemed holder with respect to the
deemed transferred receivable is deemed
to make a matching distribution in the
same amount with respect to the deemed
partner stock. The controlled partnership
is treated as the paying agent with respect
to the deemed partner stock.

(v) Holder-in-form transfers debt in-
strument in a transaction that is not a
specified event. If the holder-in-form
transfers the debt instrument (which is
disregarded for federal tax purposes) to a
member of the expanded group or a con-
trolled partnership (and therefore the
transfer is not a specified event described
in paragraph (f)(5)(iii)(F) of this section),
then, for federal tax purposes, the holder-
in-form is deemed to transfer the retained
receivable and the deemed partner stock
to the transferee.

(vi) Allocation of deemed transferred
receivable under section 752. A partner-
ship liability that is a debt instrument with
respect to which there is one or more
deemed transferred receivables is allo-
cated for purposes of section 752 without
regard to any deemed transfer.

(5) Specified events affecting owner-
ship following a deemed transfer-(i)
General rule. If a specified event (within
the meaning of paragraph (f)(5)(iii) of this
section) occurs with respect to a deemed
transfer, then, immediately before the
specified event, the expanded group part-
ner that is both the issuer of the deemed
partner stock and the deemed holder of the
deemed transferred receivable is deemed
to distribute the deemed transferred re-
ceivable (or portion thereof, as determined
under paragraph (f)(5)(iv) of this section)
to the holder-in-form in redemption of the
deemed partner stock (or portion thereof,

as determined under paragraph (f)(5)(iv)
of this section) deemed to be held by the
holder-in-form. The deemed distribution
is deemed to occur for all federal tax
purposes, except that the distribution is
disregarded for purposes of § 1.385-3(b).
Except when the deemed transferred re-
ceivable (or portion thereof, as determined
under paragraph (f)(5)(iv) of this section)
is deemed to be retransferred under para-
graph (f)(5)(ii) of this section, the princi-
pal amount of the retained receivable held
by the holder-in-form is increased by the
principal amount of the deemed trans-
ferred receivable, the deemed transferred
receivable ceases to exist for federal tax
purposes, and the specified portion (or
portion thereof) that corresponds to the
deemed transferred receivable (or portion
thereof) ceases to be treated as a specified
portion for purposes of this section and
§ 1.385-3.

(ii) New deemed transfer when a spec-
ified event involves a transferee that is a
covered member that is an expanded
group partner. If the specified event is
described in paragraph (f)(5)(iii)(E) of
this section, the holder-in-form of the debt
instrument is deemed to retransfer the
deemed transferred receivable (or portion
thereof, as determined under paragraph
(f)(5)(iv) of this section) that the holder-
in-form is deemed to have received pur-
suant to paragraph (f)(5)(i) of this section,
to the transferee expanded group partner
in exchange for deemed partner stock is-
sued by the transferee expanded group
partner with a fair market value equal to
the principal amount of the deemed trans-
ferred receivable (or portion thereof) that
is retransferred. For purposes of this sec-
tion, this deemed transfer is treated in the
same manner as a deemed transfer de-
scribed in paragraph (f)(4)(i) of this sec-
tion.

(iii) Specified events. A specified event,
with respect to a deemed transfer, occurs
when, immediately after the transaction
and taking into account all related trans-
actions:

(A) The controlled partnership that is
the issuer of the debt instrument either
ceases to be a controlled partnership or
ceases to have an expanded group partner
that is a covered member.

(B) The holder-in-form is a member of
the expanded group immediately before

the transaction, and the holder-in-form
and the deemed holder cease to be mem-
bers of the same expanded group for the
reasons described in § 1.385-3(d)(2).

(C) The holder-in-form is a controlled
partnership immediately before the trans-
action, and the holder-in-form ceases to be
a controlled partnership.

(D) The expanded group partner that is
both the issuer of deemed partner stock
and the deemed holder transfers (directly
or indirectly through one or more partner-
ships) all or a portion of its interest in the
controlled partnership to a person that nei-
ther is a covered member nor a controlled
partnership with an expanded group part-
ner that is a covered member. If there is a
transfer of only a portion of the interest,
see paragraph (f)(5)(iv) of this section.

(E) The expanded group partner that is
both the issuer of deemed partner stock
and the deemed holder transfers (directly
or indirectly through one or more partner-
ships) all or a portion of its interest in the
controlled partnership to a covered mem-
ber or a controlled partnership with an
expanded group partner that is a covered
member. If there is a transfer of only a
portion of the interest, see paragraph
(f)(5)(iv) of this section.

(F) The holder-in-form transfers the
debt instrument (which is disregarded for
federal tax purposes) to a person that is
neither a member of the expanded group
nor a controlled partnership. See para-
graph (f)(4)(v) of this section if the
holder-in-form transfers the debt instru-
ment to a member of the expanded group
or a controlled partnership.

(iv) Specified event involving a transfer
of only a portion of an interest in a con-
trolled partnership. If, with respect to a
specified event described in paragraph
(f)(5)(iii)(D) or (E) of this section, an ex-
panded group partner transfers only a por-
tion of its interest in a controlled partner-
ship, then, only a portion of the deemed
transferred receivable that is deemed to be
held by the expanded group partner is
deemed to be distributed in redemption of
an equal portion of the deemed partner
stock. The portion of the deemed trans-
ferred receivable referred to in the preced-
ing sentence is equal to the product of the
entire principal amount of the deemed
transferred receivable deemed to be held
by the expanded group partner multiplied

by a fraction, the numerator of which is
the portion of the expanded group part-
ner's capital account attributable to the
interest that is transferred, and the denom-
inator of which is the expanded group
partner's capital account with respect to
its entire interest, determined immediately
before the specified event.

(6) Issuance of a partnership's debt
instrument to a partner and a partner's
debt instrument to a partnership. If a con-
trolled partnership, with respect to an ex-
panded group, issues a debt instrument to
an expanded group partner, or if a covered
member that is an expanded group partner
issues a covered debt instrument to a con-
trolled partnership, and in each case, no
partner deducts or receives an allocation
of expense with respect to the debt instru-
ment, then this section and 1.385-3 do not
apply to the debt instrument.

(g)(1) through (4) [Reserved]. For fur-
ther guidance, see § 1.385-3(g)(1)
through (4).

(5) Deemed holder. The term deemed
holder means, with respect to a deemed
transfer, the expanded group partner that
is deemed to hold a deemed transferred
receivable by reason of the deemed trans-
fer.

(6) Deemed partner stock. The term
deemed partner stock means, with respect
to a deemed transfer, the stock deemed
issued by an expanded group partner as
described in paragraphs (f)(4)(i), (f)(4)
(iii), and (f)(5)(ii) of this section. The
amount of deemed partner stock is re-
duced as described in paragraphs (f)(4)
(iv)(B) and (f)(5)(i) of this section.

(7) Deemed transfer. The term deemed
transfer means, with respect to a specified
portion, the transfer described in para-
graph (f)(4)(i), (f)(4)(iii), or (f)(5)(ii) of
this section.

(8) Deemed transferred receivable.
The term deemed transferred receivable
means, with respect to a deemed transfer,
the portion of the debt instrument de-
scribed in paragraph (f)(4)(i), (f)(4)(iii), or
(f)(5)(ii) of this section. The deemed
transferred receivable is reduced as de-
scribed in paragraphs (f)(4)(iv)(B) and
(f)(5)(i) of this section.

(g)(9) through (14) [Reserved]. For
further guidance, see § 1.385-3(g)(9)
through (14).

(15) Holder-in-form. The term holder-
in-form means, with respect to a debt in-
strument issued by a controlled partner-
ship, the person that, absent the application
of paragraph (f)(4) of this section, would be
the holder of the debt instrument for federal
tax purposes. Therefore, the term holder-in-
form does not include a deemed holder (as
defined in paragraph (g)(5) of this section).

(16) Issuance percentage. The term is-
suance percentage means, with respect to
a controlled partnership and an expanded
group partner, the ratio (expressed as a
percentage) of the partner's reasonably
anticipated distributive share of all the
partnership's interest expense over a rea-
sonable period, divided by all of the part-
nership's reasonably anticipated interest
expense over that same period, taking into
account any and all relevant facts and
circumstances. The relevant facts and cir-
cumstances include, without limitation,
the term of the debt instrument; whether
the partnership anticipates issuing other
debt instruments; and the partnership's
anticipated section 704(b) income and ex-
pense, and the partners' respective antici-
pated allocation percentages, taking into
account anticipated changes to those allo-
cation percentages over time resulting, for
example, from anticipated contributions,
distributions, recapitalizations, or provi-
sions in the controlled partnership agree-
ment.

(17) Liquidation value percentage. The
term liquidation value percentage means,
with respect to a controlled partnership
and an expanded group partner, the ratio
(expressed as a percentage) of the liqui-
dation value of the expanded group part-
ner's interest in the partnership divided by
the aggregate liquidation value of all the
partners' interests in the partnership. The
liquidation value of an expanded group
partner's interest in a controlled partner-
ship is the amount of cash the partner
would receive with respect to the interest
if the partnership (and any partnership
through which the partner indirectly owns
an interest in the controlled partnership)
sold all of its property for an amount of
cash equal to the fair market value of the
property (taking into account section
7701(g)), satisfied all of its liabilities
(other than those described in § 1.752-7),
paid an unrelated third party to assume all
of its § 1.752-7 liabilities in a fully tax-

able transaction, and then the partnership
(and any partnership through which the
partner indirectly owns an interest in the
controlled partnership) liquidated.

(g)(18) through (g)(21) [Reserved]. For
further guidance, see § 1.385-3(g)(18)
through (g)(21).

(22) Retained receivable. The term re-
tained receivable means, with respect to a
debt instrument issued by a controlled
partnership, the portion of the debt instru-
ment that is not transferred by the holder-
in-form pursuant to one or more deemed
transfers. The retained receivable is ad-
justed for decreases described in para-
graph (f)(4)(iv)(B) of this section and in-
creases described in paragraph (f)(5)(i) of
this section.

(23) Specified portion. The term spec-
ified portion means, with respect to a debt
instrument issued by a controlled partner-
ship and a covered member that is an
expanded group partner, the portion of the
debt instrument that is treated under para-
graph (f)(3)(i) of this section as issued on
a testing date (within the meaning of para-
graph (f)(3)(ii) of this section) by the cov-
ered member and that, absent the applica-
tion of paragraph (f)(4)(i) of this section,
would be treated as stock under § 1.385-
3(b)(2) or (b)(3)(i) on the testing date. A
specified portion is reduced as described
in paragraphs (f)(4)(iv)(B) and (5)(i) of
this section.

(g)(24) through (25) [Reserved]. For
further guidance, see § 1.385-3(g)(24)
through (25).

(h) Introductory text through (h)(3),
Example 11 [Reserved]. For further guid-
ance, see § 1.385-3(h) introductory text
through (h)(3), Example 11.

Example 12. Distribution of a covered debt in-
strument to a controlled partnership. (i) Facts. CFC
and FS are equal partners in PRS. PRS owns 100%
of the stock in X Corp, a domestic corporation. On
Date A in Year 1, X Corp issues X Note to PRS in
a distribution.

(ii) Analysis. (A) Under § 1.385-1(c)(4), in de-
termining whether X Corp is a member of the FP
expanded group that includes CFC and FS, CFC and
FS are each treated as owning 50% of the X Corp
stock held by PRS. Accordingly, 100% of X Corp's
stock is treated as owned by CFC and FS, and X
Corp is a member of the FP expanded group.

(B) Together CFC and FS own 100% of the
interests in PRS capital and profits, such that PRS is
a controlled partnership under § 1.385-1(c)(1). CFC
and FS are both expanded group partners on the date
on which PRS acquired X Note. Therefore, pursuant
to paragraph (f)(2)(i)(A) of this section, each of CFC

and FS is treated as acquiring its share of X Note in
the same manner (in this case, by a distribution of X
Note), and on the date on which, PRS acquired X
Note. Likewise, X Corp is treated as issuing to each
of CFC and FS its share of X Note. Under paragraph
(f)(2)(i)(B) of this section, each of CFC's and FS's
share of X Note, respectively, is determined in ac-
cordance with its liquidation value percentage deter-
mined on Date A in Year 1, the date X Corp distrib-
uted X Note to PRS. On Date A in Year 1, pursuant
to paragraph (g)(17) of this section, each of CFC's
and FS's liquidation value percentages is 50%. Ac-
cordingly, on Date A in Year 1, under paragraph
(f)(2)(i)(A) of this section, for purposes of this sec-
tion and § 1.385-3, CFC and FS are each treated as
acquiring 50% of X Note in a distribution.

(C) Under § 1.385-3(b)(2)(i) and (d)(1)(i), X
Note is treated as stock on the date of issuance,
which is Date A in Year 1. Under paragraph
(f)(2)(i)(A) of this section, each of CFC and FS are
treated as acquiring 50% of X Note in a distribution
for purposes of this section and § 1.385-3. There-
fore, X Corp is treated as distributing its stock to
PRS in a distribution described in section 305.

Example 13. Loan to a controlled partnership;
proportionate distributions by expanded group part-
ners. (i) Facts. DS, USS2, and USP are partners in
PRS. USP is a domestic corporation that is not a
member of the FP expanded group. Each of DS and
USS2 own 45% of the interests in PRS profits and
capital, and USP owns 10% of the interests in PRS
profits and capital. The PRS partnership agreement
provides that all items of PRS income, gain, loss,
deduction, and credit are allocated in accordance
with the percentages in the preceding sentence. On
Date A in Year 1, FP lends $200x to PRS in ex-
change for PRS Note. PRS uses all $200x in its
business and does not distribute any money or other
property to a partner. Subsequently, on Date B in
Year 1, DS distributes $90x to USS1, USS2 distrib-
utes $90x to FP, and USP distributes $20x to its
shareholder. Each of DS's and USS2's issuance per-
centage is 45% on Date B in Year 1, the date of the
distributions and therefore a testing date under para-
graph (f)(3)(ii)(A) of this section.

(ii) Analysis. (A) DS and USS2 together own
90% of the interests in PRS profits and capital and
therefore PRS is a controlled partnership under
§ 1.385-1(c)(1). Under § 1.385-1(c)(2), each of DS
and USS2 is a covered member.

(B) Under paragraph (f)(3)(i) of this section,
each of DS and USS2 is treated as issuing its share
of PRS Note, and under paragraph (f)(3)(ii)(A) of
this section, DS's and USS2's share is each $90x
(45% of $200x). USP is not an expanded group
partner and therefore has no issuance percentage and
is not treated as issuing any portion of PRS Note.

(C) The $90x distributions made by DS to USS1
and by USS2 to FP are described in § 1.385-
3(b)(3)(i)(A). Under § 1.385-3(b)(3)(iii)(A), the por-
tions of PRS Note treated as issued by each of DS
and USS2 are treated as funding the distribution
made by DS and USS2 because the distributions
occurred within the per se period with respect to PRS
Note. Under § 1.385-3(b)(3)(i), the portions of PRS
Note treated as issued by each of DS and USS2
would, absent the application of (f)(4)(i) of this
section, be treated as stock of DS and USS2 on Date

B in Year 1, the date of the distributions. See
§ 1.385-3(d)(1)(ii). Under paragraph (g)(23) of this
section, each of the $90x portions is a specified
portion.

(D) Under paragraph (f)(4)(i) of this section, the
specified portions are not treated as stock under
§ 1.385-3(b)(3)(i). Instead, FP is deemed to transfer
a portion of PRS Note with a principal amount equal
to $90x (the adjusted issue price of the specified
portion with respect to DS) to DS in exchange for
deemed partner stock in DS with a fair market value
of $90x. Similarly, FP is deemed to transfer a portion
of PRS Note with a principal amount equal to $90
(the adjusted issue price of the specified portion with
respect to USS2) to USS2 in exchange for deemed
partner stock in USS2 with a fair market value of
$90x. The principal amount of the retained receiv-
able held by FP is $20x ($200x - $90x - $90x).

Example 14. Loan to a controlled partnership;
disproportionate distributions by expanded group
partners. (i) Facts. The facts are the same as in
Example 13 of this paragraph (h)(3), except that on
Date B in Year 1, DS distributes $45x to USS1 and
USS2 distributes $135x to FP.

(ii) Analysis. (A) The analysis is the same as in
paragraph (ii)(A) of Example 13 of this paragraph
(h)(3).

(B) The analysis is the same as in paragraph
(ii)(B) of Example 13 of this paragraph (h)(3).

(C) The $45x and $135x distributions made by
DS to USS1 and by USS2 to FP, respectively, are
described in § 1.385-3(b)(3)(i)(A). Under § 1.385-
3(b)(3)(iii)(A), the portion of PRS Note treated as
issued by DS is treated as funding the distribution
made by DS because the distribution occurred within
the per se period with respect to PRS Note, but under
§ 1.385-3(b)(3)(i), only to the extent of DS's $45x
distribution. USS2 is treated as issuing $90x of PRS
Note, all of which is treated as funding $90x of
USS2's $135x distribution under § 1.385-
3(b)(3)(iii)(A). Under § 1.385-3(b)(3)(i), absent the
application of (f)(4)(i) of this section, $45x of PRS
Note would be treated as stock of DS and $90x of
PRS Note would be treated as stock of USS2 on Date
B in Year 1, the date of the distributions. See
§ 1.385-3(d)(1)(ii). Under paragraph (g)(23) of this
section, $45x of PRS Note is a specified portion with
respect to DS and $90x of PRS Note is a specified
portion with respect to USS2.

(D) Under paragraph (f)(4)(i) of this section, the
specified portions are not treated as stock under
§ 1.385-3(b)(3)(i). Instead, FP is deemed to transfer
a portion of PRS Note with a principal amount equal
to $45x (the adjusted issue price of the specified
portion with respect to DS) to DS in exchange for
stock of DS with a fair market value of $90x. Sim-
ilarly, FP is deemed to transfer a portion of PRS
Note with a principal amount equal to $90 (the
adjusted issue price of the specified portion with
respect to USS2) to USS2 in exchange for stock of
USS2 with a fair market value of $90x. The principal
amount of the retained receivable held by FP is $65x
($200x - $45x - $90x).

Example 15. Loan to partnership; distribution in
later year. (i) Facts. The facts are the same as in
Example 13 of this paragraph (h)(3), except that
USS2 does not distribute $90x to FP until Date C in
Year 2, which is less than 36 months after Date A in

Year 1. No principal or interest payments are made
or required until Year 3. On Date C in Year 2, DS's,
USS2's, and USP's issuance percentages under para-
graph (g)(16) of this section are unchanged at 45%,
45%, and 10%, respectively.

(ii) Analysis. (A) The analysis is the same as in
paragraph (ii)(A) of Example 13 of this paragraph
(h)(3).

(B) The analysis is the same as in paragraph
(ii)(B) of Example 13 of this paragraph (h)(3).

(C) With respect to the distribution made by DS,
the analysis is the same as in paragraph (ii)(C) of
Example 13 of this paragraph (h)(3).

(D) With respect to the deemed transfer to DS,
the analysis is the same as in paragraph (ii)(D) of
Example 13 of this paragraph (h)(3). Accordingly,
the amount of the retained receivable held by FP as
of Date B in Year 1 is $110x ($200x - $90x).

(E) Under paragraph (f)(3)(ii)(A) of this section,
USS2's share of PRS Note is determined on Date C
in Year 2. On Date C in Year 2, DS's, USS2's, and
USP's respective shares of PRS Note under para-
graph (f)(3)(ii)(A) of this section $90x, $90x, and
$20x. However, because DS is treated as the issuer
with respect to a $90x specified portion of PRS Note,
DS's share of PRS Note is reduced by $90x to $0
under paragraph (f)(3)(ii)(B)(1) of this section. No
reduction to either of USS2's or USP's share of PRS
Note is required under paragraph (f)(3)(ii)(B)(2) of
this section because the aggregate of DS's, USS2's,
and USP's shares of PRS Note as reduced is $110x
(DS has a $0 share, USS2 has a $90x share, and USP
has a $20x share), which does not exceed $110x (the
$200x adjusted issue price of PRS Note reduced by
the $90x specified portion with respect to DS). Un-
der paragraph (f)(3)(i) of this section, USS2 is
treated as issuing its share of PRS Note.

(F) The $90x distribution made by USS2 to FP is
described in § 1.385-3(b)(3)(i)(A). Under § 1.385-
3(b)(3)(iii)(A), the portion of PRS Note treated as
issued by USS2 is treated as funding the distribution
made by USS2, because the distribution occurred
within the per se period with respect to PRS Note.
Accordingly, the portion of PRS Note treated as
issued by USS2 would, absent the application of
paragraph (f)(4)(i) of this section, be treated as stock
of USS2 under § 1.385-3(b)(3)(i) on Date C in Year
2. See § 1.385-3(d)(1)(ii). Under paragraph (g)(23)
of this section, the $90x portion is a specified por-
tion.

(G) Under paragraph (f)(4)(i) of this section, the
specified portion of PRS Note treated as issued by
USS2 is not treated as stock under § 1.385-
3(b)(3)(i). Instead, on Date C in Year 2, FP is
deemed to transfer a portion of PRS Note with a
principal amount equal to $90x (the adjusted issue
price of the specified portion with respect to USS2)
to USS2 in exchange for stock in USS2 with a fair
market value of $90x. The principal amount of the
retained receivable held by FP is reduced from
$110x to $20x.

Example 16. Loan to a controlled partnership;
partnership ceases to be a controlled partnership. (i)
Facts. The facts are the same as in Example 13 of
this paragraph (h)(3), except that on Date C in Year
4, USS2 sells its entire interest in PRS to an unre-
lated person.

(ii) Analysis. (A) On date C in Year 4, PRS
ceases to be a controlled partnership with respect to
the FP expanded group under § 1.385-1(c)(1). This
is the case because DS, the only remaining partner
that is a member of the FP expanded group, only
owns 45% of the total interest in PRS profits and
capital. Because PRS ceases to be a controlled part-
nership, a specified event (within the meaning of
paragraph (f)(5)(iii)(A) of this section) occurs with
respect to the deemed transfers with respect to each
of DS and USS2.

(B) Under paragraph (f)(5)(i) of this section, on
Date C in Year 4, immediately before PRS ceases to
be a controlled partnership, each of DS and USS2 is
deemed to distribute its deemed transferred receiv-
able to FP in redemption of FP's deemed partner
stock in DS and USS2. The specified portion that
corresponds to each of the deemed transferred re-
ceivables ceases to be treated as a specified portion.
Furthermore, the deemed transferred receivables
cease to exist, and the retained receivable held by FP
increases from $20x to $200x.

Example 17. Transfer of an interest in a partner-
ship to a covered member. (i) Facts. The facts are the
same as in Example 13 of this paragraph (h)(3),
except that on Date C in Year 4, USS2 sells its entire
interest in PRS to USS1.

(ii) Analysis. (A) After USS2 sells its interest in
PRS to USS1, DS and USS1 together own 90% of
the interests in PRS profits and capital and therefore
PRS continues to be a controlled partnership under
§ 1.385-1(c)(1). A specified event (within the mean-
ing of paragraph (f)(5)(iii)(E) of this section) occurs
as result of the sale only with respect to the deemed
transfer with respect to USS2.

(B) Under paragraph (f)(5)(i) of this section, on
Date C in Year 4, immediately before USS2 sells its
entire interest in PRS to USS1, USS2 is deemed to
distribute its deemed transferred receivable to FP in
redemption of FP's deemed partner stock in USS2.
Because the specified event is described in paragraph
(f)(5)(iii)(E) of this section, under paragraph
(f)(5)(ii) of this section, FP is deemed to retransfer
the deemed transferred receivable deemed received
from USS2 to USS1 in exchange for deemed partner
stock in USS1 with a fair market value equal to the
principal amount of the deemed transferred receiv-
able that is retransferred to USS1.

Example 18. Loan to partnership and all part-
ners are members of a consolidated group. (i) Facts.
USS1 and DS are equal partners in PRS. USS1 and
DS are members of a consolidated group, as defined
in § 1.1502-1(h). The PRS partnership agreement
provides that all items of PRS income, gain, loss,
deduction, and credit are allocated equally between
USS1 and DS. On Date A in Year 1, FP lends $200x
to PRS in exchange for PRS Note. PRS uses all
$200x in its business and does not distribute any
money or other property to any partner. On Date B in
Year 1, DS distributes $200x to USS1, and USS1
distributes $200x to FP. If neither of USS1 or DS
were a member of the consolidated group, each
would have an issuance percentage under paragraph
(g)(16) of this section, determined as of Date A in
Year 1, of 50%.

(ii) Analysis. (A) Pursuant to § 1.385-4T(b)(6),
PRS is treated as a partnership for purposes of
§ 1.385-3. Under § 1.385-4T(b)(1), DS and USS1

are treated as one corporation for purposes of this
section and § 1.385-3, and thus a single covered
member under § 1.385-1(c)(2). For purposes of this
section, the single covered member owns 100% of
the PRS profits and capital and therefore PRS is a
controlled partnership under § 1.385-1(c)(1). Under
paragraph (f)(3)(i) of this section, the single covered
member is treated as issuing all $200x of PRS Note
to FP, a member of the same expanded group as the
single covered member. DS's distribution to USS1 is
a disregarded distribution because it is a distribution
between members of a consolidated group that is
disregarded under the one-corporation rule of
§ 1.385-4T(b)(1). However, under § 1.385-
3(b)(3)(iii)(A), PRS Note, treated as issued by the
single covered member, is treated as funding the
distribution by USS1 to FP, which is described in
§ 1.385-3(b)(3)(i)(A) and which is a regarded dis-
tribution. Accordingly, PRS Note, absent the appli-
cation of (f)(4)(i) of this section, would be treated as
stock under § 1.385-3(b) on Date B in Year 1. Thus,
pursuant to paragraph (g)(23) of this section, the
entire PRS Note is a specified portion.

(B) Under paragraphs (f)(4)(i) and (iii) of this
section, the specified portion is not treated as stock
and, instead, FP is deemed to transfer PRS Note with
a principal amount equal to $200x to USS1 in ex-
change for stock of USS1 with a fair market value of
$200x. Under paragraph (f)(4)(iii) of this section, FP
is deemed to transfer PRS Note to USS1 because
only USS1 made a regarded distribution described in
§ 1.385-3(b)(3)(i).

Example 19. (i) Facts. DS owns DRE, a disre-
garded entity within the meaning of § 1.385-1(c)(3).
On Date A in Year 1, FP lends $200x to DRE in
exchange for DRE Note. Subsequently, on Date B in
Year 1, DS distributes $100x of cash to USS1.

(ii) Analysis. Under § 1.385-3(b)(3)(iii)(A),
$100x of DRE Note would be treated as funding the
distribution by DS to USS1 because DRE Note is
issued to a member of the FP expanded group during
the per se period with respect to DS's distribution0
to USS1. Accordingly, under § 1.385-3(b)(3)(i)(A)
and (d)(1)(ii), $100x of DRE Note would be treated
as stock on Date B in Year 1. However, under
paragraph (d)(4) of this section, DS, as the regarded
owner, within the meaning of § 1.385-1(c)(5), of
DRE is deemed to issue its stock to FP in exchange
for a portion of DRE Note equal to the $100x appli-
cable portion (as defined in paragraph (d)(4) of this
section). Thus, DS is treated as the holder of $100x
of DRE Note, which is disregarded, and FP is treated
as the holder of the remaining $100x of DRE Note.
The $100x of stock deemed issued by DS to FP has
the same terms as DRE Note, other than the issuer,
and payments on the stock are determined by refer-
ence to payments on DRE Note.

(i) through (j) [Reserved]

(k) Applicability date-(1) In general.
This section applies to taxable years end-
ing on or after January 19, 2017.

(2) Transition rules-(i) Transition
rule for covered debt instruments issued
by partnerships that would have had a
specified portion in taxable years ending
before January 19, 2017. If the application
of paragraphs (f)(3) through (5) of this

section and § 1.385-3 would have resulted
in a covered debt instrument issued by a
controlled partnership having a specified
portion in a taxable year ending before
January 19, 2017 but for the application of
paragraph (k)(1) of this section and
§ 1.385-3(j)(1), then, to the extent of the
specified portion immediately after Janu-
ary 19, 2017, there is a deemed transfer
immediately after January 19, 2017.

(ii) Transition rule for certain covered
debt instruments treated as having a spec-
ified portion in taxable years ending on or
after January 19, 2017. If the application
of paragraphs (f)(3) through (5) of this
section and § 1.385-3 would treat a cov-
ered debt instrument issued by a con-
trolled partnership as having a specified
portion that gives rise to a deemed transfer
on or before January 19, 2017 but in a
taxable year ending on or after January 19,
2017, that specified portion does not give
rise to a deemed transfer during the 90-
day period after October 21, 2016. In-
stead, to the extent of the specified portion
immediately after January 19, 2017, there
is a deemed transferred immediately after
January 19, 2017.

(iii) Transition funding rule. This para-
graph (k)(2)(iii) applies if the application
of paragraphs (f)(3) through (5) of this
section and § 1.385-3 would have resulted
in a deemed transfer with respect to a
specified portion of a debt instrument is-
sued by a controlled partnership on a date
after April 4, 2016, and on or before Jan-
uary 19, 2017 (the transition period) but
for the application of paragraph (k)(1),
(k)(2)(i), or (k)(2)(ii) of this section and
§ 1.385-3(j). In this case, any payments
made with respect to the covered debt
instrument (other than stated interest), in-
cluding pursuant to a refinancing, a por-
tion of which would be treated as made
with respect to deemed partner stock if
there would have been a deemed transfer,
after the date that there would have been a
deemed transfer and through the remain-
ing portion of the transition period are
treated as distributions for purposes of
applying § 1.385-3(b)(3) for taxable years
ending on or after January 19, 2017. In
addition, if an event occurs during the
transition period that would have been a
specified event with respect to the deemed
transfer described in the preceding sen-
tence but for the application of paragraph

(k)(1) of this section and § 1.385-3(j), the
distribution or acquisition that would have
resulted in the deemed transfer is avail-
able to be treated as funded by other cov-
ered debt instruments of the covered
member for purposes of § 1.385-3(b)(3)
(to the extent provided in § 1.385-
3(b)(3)(iii)). The prior sentence shall be
applied in a manner that is consistent with
the rules set forth in paragraph (f)(5) of
this section and § 1.385-3(d)(2)(ii).

(iv) Coordination between the general
rule and funding rule. This paragraph
(k)(2)(iv) applies when a covered debt
instrument issued by a controlled partner-
ship in a transaction described in § 1.385-
3(b)(2) would have resulted in a specified
portion that gives rise to a deemed transfer
on a date after April 4, 2016, and on or
before January 19, 2017, but there is not a
deemed transfer on such date due to the
application of paragraph (k)(1), (k)(2)(i),
or (k)(2)(ii) of this section and § 1.385-
3(j). In this case, the issuance of such
covered debt instrument is not treated as a
distribution or acquisition described in
§ 1.385-3(b)(3)(i), but only to the extent
of the specified portion immediately after
January 19, 2017.

(v) Option to apply proposed regula-
tions. See § 1.385-3(j)(2)(v).

(l) Expiration date. This section ex-
pires on October 11, 2019.

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

#### § 1.385-4T Treatment of consolidated groups.

(a) Scope. This section provides rules
for applying §§ 1.385-3 and 1.385-3T to
members of consolidated groups. Para-
graph (b) of this section sets forth rules
concerning the extent to which, solely for
purposes of applying §§ 1.385-3 and
1.385-3T, members of a consolidated
group that file (or that are required to file)
a consolidated U.S. federal income tax
return are treated as one corporation. Para-
graph (c) of this section sets forth rules
concerning the treatment of a debt instru-
ment that ceases to be, or becomes, a
consolidated group debt instrument. Para-
graph (d) of this section provides rules for
applying the funding rule of § 1.385-
3(b)(3) to members that depart a consoli-
dated group. For definitions applicable to

this section, see paragraph (e) of this sec-
tion and §§ 1.385-1(c) and 1.385-3(g).
For examples illustrating the application
of this section, see paragraph (f) of this
section.

(b) Treatment of consolidated groups-
(1) Members treated as one corporation.
For purposes of this section and
§§ 1.385-3 and 1.385-3T, and except as
otherwise provided in this section and
§ 1.385-3T, all members of a consoli-
dated group (as defined in § 1.1502-1(h))
that file (or that are required to file) a
consolidated U.S. federal income tax re-
turn are treated as one corporation. Thus,
for example, when a member of a consol-
idated group issues a covered debt instru-
ment that is not a consolidated group debt
instrument, the consolidated group gener-
ally is treated as the issuer of the covered
debt instrument for purposes of this sec-
tion and §§ 1.385-3 and 1.385-3T. Also,
for example, when one member of a con-
solidated group issues a covered debt in-
strument that is not a consolidated group
debt instrument and therefore is treated as
issued by the consolidated group, and an-
other member of the consolidated group
makes a distribution or acquisition de-
scribed in § 1.385-3(b)(3)(i)(A) through
(C) with an expanded group member that
is not a member of the consolidated group,
§ 1.385-3(b)(3)(i) may treat the covered
debt instrument as funding the distribution
or acquisition made by the consolidated
group. In addition, except as otherwise
provided in this section, acquisitions and
distributions described in § 1.385-3(b)(2)
and (b)(3)(i) in which all parties to the
transaction are members of the same con-
solidated group both before and after the
transaction are disregarded for purposes
of this section and §§ 1.385-3 and 1.385-
3T.

(2) One-corporation rule inapplicable
to expanded group member determina-
tion. The one-corporation rule in para-
graph (b)(1) of this section does not apply
in determining the members of an ex-
panded group. Notwithstanding the previ-
ous sentence, an expanded group does not
exist for purposes of this section and
§§ 1.385-3 and 1.385-3T if it consists
only of members of a single consolidated
group.

(3) Application of § 1.385-3 to debt
instruments issued by members of a con-

solidated group-(i) Debt instrument
treated as stock of the issuing member of
a consolidated group. If a covered debt
instrument treated as issued by a consoli-
dated group under the one-corporation
rule of paragraph (b)(1) of this section is
treated as stock under § 1.385-3 or
§ 1.385-3T, the covered debt instrument
is treated as stock in the member of the
consolidated group that would be the is-
suer of such debt instrument without re-
gard to this section. But see § 1.385-
3(d)(7) (providing that a covered debt
instrument that is treated as stock under
§ 1.385-3(b)(2), (3), or (4) and that is not
described in section 1504(a)(4) is not
treated as stock for purposes of determin-
ing whether the issuer is a member of an
affiliated group (within the meaning of
section 1504(a)).

(ii) Application of the covered debt in-
strument exclusions. For purposes of de-
termining whether a debt instrument is-
sued by a member of a consolidated group
is a covered debt instrument, each test
described in § 1.385-3(g)(3) is applied on
a separate member basis without regard to
the one-corporation rule in paragraph
(b)(1) of this section.

(iii) Qualified short-term debt instru-
ment. The determination of whether a
member of a consolidated group has is-
sued a qualified short-term debt instru-
ment for purposes of § 1.385-3(b)(3)(vii)
is made on a separate member basis with-
out regard to the one-corporation rule in
paragraph (b)(1) of this section.

(4) Application of the reductions of
§ 1.385-3(c)(3) to members of a consoli-
dated group-(i) Application of the re-
duction for expanded group earnings-
(A) In general. A consolidated group
maintains one expanded group earnings
account with respect to an expanded
group period, and only the earnings and
profits, determined in accordance with
§ 1.1502-33 (without regard to the appli-
cation of § 1.1502-33(b)(2), (e), and (f)),
of the common parent (within the mean-
ing of section 1504) of the consolidated
group are considered in calculating the
expanded group earnings for the expanded
group period of the consolidated group.
Accordingly, a regarded distribution or
acquisition made by a member of a con-
solidated group is reduced to the extent of

the expanded group earnings account of
the consolidated group.

(B) Effect of certain corporate trans-
actions on the calculation of expanded
group earnings-(1) Consolidation. A
consolidated group succeeds to the ex-
panded group earnings account of a join-
ing member under the principles of
§ 1.385-3(c)(3)(i)(F)(2)(ii).

(2) Deconsolidation-(i) In general.
Except as otherwise provided in para-
graph (b)(4)(i)(B)(2)(ii) of this section, no
amount of the expanded group earnings
account of a consolidated group for an
expanded group period, if any, is allocated
to a departing member. Accordingly, im-
mediately after leaving the consolidated
group, the departing member has no ex-
panded group earnings account with re-
spect to its expanded group period.

(ii) Allocation of expanded group earn-
ings to a departing member in a distribu-
tion described in section 355. If a depart-
ing member leaves the consolidated group
by reason of an exchange or distribution
to which section 355 (or so much of sec-
tion 356 that relates to section 355) ap-
plies, the expanded group earnings ac-
count of the consolidated group is
allocated between the consolidated group
and the departing member in proportion to
the earnings and profits of the consoli-
dated group and the earnings and profits
of the departing member immediately af-
ter the transaction.

(ii) Application of the reduction for
qualified contributions-(A) In general.
For purposes of applying § 1.385-
3(c)(3)(ii)(A) to a consolidated group-

(1) A qualified contribution to any
member of a consolidated group that re-
mains a member of the consolidated group
immediately after the qualified contribu-
tion from a person other than a member of
the same consolidated group is treated as
made to the one corporation provided in
paragraph (b)(1) of this section;

(2) A qualified contribution that causes
a member of a consolidated group to be-
come a departing member of that consol-
idated group is treated as made to the
departing member and not to the consoli-
dated group of which the departing mem-
ber was a member immediately prior to
the qualified contribution; and

(3) No contribution of property by a
member of a consolidated group to any

other member of the consolidated group is
a qualified contribution.

(B) Effect of certain corporate trans-
actions on the calculation of qualified
contributions-(1) Consolidation. A con-
solidated group succeeds to the qualified
contributions of a joining member under
the principles of § 1.385-3(c)(3)(ii)(F)
(2)(ii).

(2) Deconsolidation-(i) In general.
Except as otherwise provided in para-
graph (b)(4)(ii)(B)(2)(ii) of this section,
no amount of the qualified contributions
of a consolidated group for an expanded
group period, if any, is allocated to a
departing member. Accordingly, immedi-
ately after leaving the consolidated group,
the departing member has no qualified
contributions with respect to its expanded
group period.

(ii) Allocation of qualified contribu-
tions to a departing member in a distribu-
tion described in section 355. If a depart-
ing member leaves the consolidated group
by reason of an exchange or distribution
to which section 355 (or so much of sec-
tion 356 that relates to section 355) ap-
plies, each qualified contribution of the
consolidated group is allocated between
the consolidated group and the departing
member in proportion to the earnings and
profits of the consolidated group and the
earnings and profits of the departing mem-
ber immediately after the transaction.

(5) Order of operations. For purposes
of this section and §§ 1.385-3 and 1.385-
3T, the consequences of a transaction in-
volving one or more members of a con-
solidated group are determined as
provided in paragraphs (b)(5)(i) and (ii) of
this section.

(i) First, determine the characterization
of the transaction under federal tax law
without regard to the one-corporation rule
of paragraph (b)(1) of this section.

(ii) Second, apply this section and
§§ 1.385-3 and 1.385-3T to the transac-
tion as characterized to determine whether
to treat a debt instrument as stock, treating
the consolidated group as one corporation
under paragraph (b)(1) of this section, un-
less otherwise provided.

(6) Partnership owned by a consoli-
dated group. For purposes of this section
and §§ 1.385-3 and § 1.385-3T, and not-
withstanding the one-corporation rule of
paragraph (b)(1) of this section, a partner-

ship that is wholly owned by members of
a consolidated group is treated as a part-
nership. Thus, for example, if members of
a consolidated group own all of the inter-
ests in a controlled partnership that issues
a debt instrument to a member of the
consolidated group, such debt instrument
would be treated as a consolidated group
debt instrument because, under § 1.385-
3T(f)(3)(i), for purposes of this section
and § 1.385-3, a consolidated group
member that is an expanded group partner
is treated as the issuer with respect to its
share of the debt instrument issued by the
partnership.

(7) Predecessor and successor-(i) In
general. Pursuant to paragraph (b)(5) of
this section, the determination as to
whether a member of an expanded group
is a predecessor or successor of another
member of the consolidated group is made
without regard to paragraph (b)(1) of this
section. For purposes of § 1.385-3(b)(3),
if a consolidated group member is a pre-
decessor or successor of a member of the
same expanded group that is not a mem-
ber of the same consolidated group, the
consolidated group is treated as a prede-
cessor or successor of the expanded group
member (or the consolidated group of
which that expanded group member is a
member). Thus, for example, a departing
member that departs a consolidated group
in a distribution or exchange to which
section 355 applies is a successor to the
consolidated group and the consolidated
group is a predecessor of the departing
member.

(ii) Joining members. For purposes of
§ 1.385-3(b)(3), the term predecessor also
means, with respect to a consolidated
group, a joining member and the term
successor also means, with respect to a
joining member, a consolidated group.

(c) Consolidated group debt instru-
ments-(1) Debt instrument ceases to be a
consolidated group debt instrument but
continues to be issued and held by ex-
panded group members-(i) Consolidated
group member leaves the consolidated
group. For purposes of this section and
§§ 1.385-3 and 1.385-3T, when a debt
instrument ceases to be a consolidated
group debt instrument as a result of a
transaction in which the member of the
consolidated group that issued the instru-
ment (the issuer) or the member of the

consolidated group holding the instrument
(the holder) ceases to be a member of the
same consolidated group but both the is-
suer and the holder continue to be a mem-
ber of the same expanded group, the issuer
is treated as issuing a new debt instrument
to the holder in exchange for property
immediately after the debt instrument
ceases to be a consolidated group debt
instrument. To the extent the newly-issued
debt instrument is a covered debt instru-
ment that is treated as stock under
§ 1.385-3(b)(3), the covered debt instru-
ment is then immediately deemed to be
exchanged for stock of the issuer. For
rules regarding the treatment of the
deemed exchange, see § 1.385-1(d). For
examples illustrating this rule, see para-
graph (f) of this section, Examples 4
and 5.

(ii) Consolidated group debt instru-
ment that is transferred outside of the
consolidated group. For purposes of this
section and §§ 1.385-3 and 1.385-3T,
when a member of a consolidated group
that holds a consolidated group debt in-
strument transfers the debt instrument to
an expanded group member that is not a
member of the same consolidated group
(transferee expanded group member), the
debt instrument is treated as issued by the
consolidated group to the transferee ex-
panded group member immediately after
the debt instrument ceases to be a consol-
idated group debt instrument. Thus, for
example, for purposes of this section and
§§ 1.385-3 and 1.385-3T, the sale of a
consolidated group debt instrument to a
transferee expanded group member is
treated as an issuance of the debt instru-
ment by the consolidated group to the
transferee expanded group member in ex-
change for property. To the extent the
newly-issued debt instrument is a covered
debt instrument that is treated as stock
upon being transferred, the covered debt
instrument is deemed to be exchanged for
stock of the member of the consolidated
group treated as the issuer of the debt
instrument (determined under paragraph
(b)(3)(i) of this section) immediately after
the covered debt instrument is transferred
outside of the consolidated group. For
rules regarding the treatment of the
deemed exchange, see § 1.385-1(d). For
examples illustrating this rule, see para-

graph (f) of this section, Examples 2
and 3.

(iii) Overlap transactions. If a debt in-
strument ceases to be a consolidated
group debt instrument in a transaction to
which both paragraphs (c)(1)(i) and (ii) of
this section apply, then only the rules of
paragraph (c)(1)(ii) of this section apply
with respect to such debt instrument.

(iv) Subgroup exception. A debt instru-
ment is not treated as ceasing to be a
consolidated group debt instrument for
purposes of paragraphs (c)(1)(i) and (ii) of
this section if both the issuer and the
holder of the debt instrument are members
of the same consolidated group immedi-
ately after the transaction described in
paragraph (c)(1)(i) or (ii) of this section.

(2) Covered debt instrument treated as
stock becomes a consolidated group debt
instrument. When a covered debt instru-
ment that is treated as stock under
§ 1.385-3 becomes a consolidated group
debt instrument, then immediately after
the covered debt instrument becomes a
consolidated group debt instrument, the
issuer is deemed to issue a new covered
debt instrument to the holder in exchange
for the covered debt instrument that was
treated as stock. In addition, in a manner
consistent with § 1.385-3(d)(2)(ii)(A),
when the covered debt instrument that
previously was treated as stock becomes a
consolidated group debt instrument, other
covered debt instruments issued by the
issuer of that instrument (including a con-
solidated group that includes the issuer)
that are not treated as stock when the
instrument becomes a consolidated group
debt instrument are re-tested to determine
whether those other covered debt instru-
ments are treated as funding the regarded
distribution or acquisition that previously
was treated as funded by the instrument
(unless such distribution or acquisition is
disregarded under paragraph (b)(1) of this
section). Further, also in a manner consis-
tent with § 1.385-3(d)(2)(ii)(A), a cov-
ered debt instrument that is issued by the
issuer (including a consolidated group that
includes the issuer) after the application of
this paragraph and within the per se period
may also be treated as funding that re-
garded distribution or acquisition.

(3) No interaction with the intercom-
pany obligation rules of § 1.1502-13(g).
The rules of this section do not affect the

application of the rules of § 1.1502-13(g).
Thus, any deemed satisfaction and reissu-
ance of a debt instrument under § 1.1502-
13(g) and any deemed issuance and
deemed exchange of a debt instrument
under this paragraph (c) that arise as part
of the same transaction or series of trans-
actions are not integrated. Rather, each
deemed satisfaction and reissuance under
the rules of § 1.1502-13(g), and each
deemed issuance and exchange under the
rules of this section, are respected as sep-
arate steps and treated as separate trans-
actions.

(d) Application of the funding rule of
§ 1.385-3(b)(3) to members departing a
consolidated group. This paragraph (d)
provides rules for applying the funding
rule of § 1.385-3(b)(3) when a departing
member ceases to be a member of a con-
solidated group, but only if the departing
member and the consolidated group are
members of the same expanded group im-
mediately after the deconsolidation.

(1) Continued application of the one-
corporation rule. A disregarded distribu-
tion or acquisition by any member of the
consolidated group continues to be disre-
garded when the departing member ceases
to be a member of the consolidated group.

(2) Continued recharacterization of a
departing member's covered debt instru-
ment as stock. A covered debt instrument
of a departing member that is treated as
stock of the departing member under
§ 1.385-3(b) continues to be treated as
stock when the departing member ceases
to be a member of the consolidated group.

(3) Effect of issuances of covered debt
instruments that are not consolidated
group debt instruments on the departing
member and the consolidated group. If a
departing member has issued a covered
debt instrument (determined without re-
gard to the one-corporation rule of para-
graph (b)(1) of this section) that is not a
consolidated group debt instrument and
that is not treated as stock immediately
before the departing member ceases to be
a consolidated group member, then the
departing member (and not the consoli-
dated group) is treated as issuing the cov-
ered debt instrument on the date and in the
manner the covered debt instrument was
issued. If the departing member is not
treated as the issuer of a covered debt
instrument pursuant to the preceding sen-

tence, then the consolidated group contin-
ues to be treated as issuing the covered
debt instrument on the date and in the
manner the covered debt instrument was
issued.

(4) Treatment of prior regarded distri-
butions or acquisitions. This paragraph
(d)(4) applies when a departing member
ceases to be a consolidated group member
in a transaction other than a distribution to
which section 355 applies (or so much of
section 356 as relates to section 355), and
the consolidated group has made a re-
garded distribution or acquisition. In this
case, to the extent the distribution or ac-
quisition has not caused a covered debt
instrument of the consolidated group to be
treated as stock under § 1.385-3(b) on or
before the date the departing member
leaves the consolidated group, then-

(i) If the departing member made the
regarded distribution or acquisition (deter-
mined without regard to the one-
corporation rule of paragraph (b)(1) of
this section), the departing member (and
not the consolidated group) is treated as
having made the regarded distribution or
acquisition.

(ii) If the departing member did not
make the regarded distribution or acquisi-
tion (determined without regard to the
one-corporation rule of paragraph (b)(1)
of this section), then the consolidated
group (and not the departing member)
continues to be treated as having made the
regarded distribution or acquisition.

(e) Definitions. The definitions in this
paragraph (e) apply for purposes of this
section.

(1) Consolidated group debt instru-
ment. The term consolidated group debt
instrument means a covered debt instru-
ment issued by a member of a consoli-
dated group and held by a member of the
same consolidated group.

(2) Departing member. The term de-
parting member means a member of an
expanded group that ceases to be a mem-
ber of a consolidated group but continues
to be a member of the same expanded
group. In the case of multiple members
leaving a consolidated group as a result of
a single transaction that continue to be
members of the same expanded group, if
such members are treated as one corpora-
tion under paragraph (b)(1) of this section
immediately after the transaction, that one

corporation is a departing member with
respect to the consolidated group.

(3) Disregarded distribution or acqui-
sition. The term disregarded distribution
or acquisition means a distribution or ac-
quisition described in § 1.385-3(b)(2) or
(b)(3)(i) between members of a consoli-
dated group that is disregarded under the
one-corporation rule of paragraph (b)(1)
of this section.

(4) Joining member. The term joining
member means a member of an expanded
group that becomes a member of a con-
solidated group and continues to be a
member of the same expanded group. In
the case of multiple members joining a
consolidated group as a result of a single
transaction that continue to be members of
the same expanded group, if such mem-
bers were treated as one corporation under
paragraph (b)(1) of this section immedi-
ately before the transaction, that one cor-
poration is a joining member with respect
to the consolidated group.

(5) Regarded distribution or acquisi-
tion. The term regarded distribution or
acquisition means a distribution or acqui-
sition described in § 1.385-3(b)(2) or (b)
(3)(i) that is not disregarded under the
one-corporation rule of paragraph (b)(1)
of this section.

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

(i) FP is a foreign corporation that
owns 100% of the stock of USS1, a cov-
ered member, and 100% of the stock of
FS, a foreign corporation;

(ii) USS1 owns 100% of the stock of
DS1 and DS3, both covered members;

(iii) DS1 owns 100% of the stock of
DS2, a covered member;

(iv) FS owns 100% of the stock of
UST, a covered member;

(v) At the beginning of Year 1, FP is
the common parent of an expanded group
comprised solely of FP, USS1, FS, DS1,
DS2, DS3, and UST (the FP expanded
group);

(vi) USS1, DS1, DS2, and DS3 are
members of a consolidated group of
which USS1 is the common parent (the
USS1 consolidated group);

(vii) The FP expanded group has out-
standing more than $50 million of debt

instruments described in § 1.385-3(c)(4)
at all times;

(viii) No issuer of a covered debt in-
strument has a positive expanded group
earnings account, within the meaning of
§ 1.385-3(c)(3)(i)(B), or has received a
qualified contribution, within the meaning
of § 1.385-3(c)(3)(ii)(B);

(ix) All notes are covered debt instru-
ments, within the meaning of § 1.385-
3(g)(3), and are not qualified short-term
debt instruments, within the meaning of
§ 1.385-3(b)(3)(vii);

(x) All notes between members of a
consolidated group are intercompany ob-
ligations within the meaning of § 1.1502-
13(g)(2)(ii);

(xi) Each entity has as its taxable year
the calendar year;

(xii) No domestic corporation is a
United States real property holding corpo-
ration within the meaning of section
897(c)(2);

(xiii) Each note is issued with adequate
stated interest (as defined in section
1274(c)(2)); and

(xiv) Each transaction occurs after Jan-
uary 19, 2017.

(2) No inference. Except as otherwise
provided in this section, it is assumed for
purposes of the examples in paragraph
(f)(3) of this section that the form of each
transaction is respected for federal tax
purposes. No inference is intended, how-
ever, as to whether any particular note
would be respected as indebtedness or as
to whether the form of any particular
transaction described in an example in
paragraph (f)(3) of this section would be
respected for federal tax purposes.

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

Example 1. Order of operations. (i) Facts. On
Date A in Year 1, UST issues UST Note to USS1 in
exchange for DS3 stock representing less than 20%
of the value and voting power of DS3.

(ii) Analysis. UST is acquiring the stock of DS3,
the non-common parent member of a consolidated
group. Pursuant to paragraph (b)(5)(i) of this section,
the transaction is first analyzed without regard to the
one-corporation rule of paragraph (b)(1) of this sec-
tion, and therefore UST is treated as issuing a cov-
ered debt instrument in exchange for expanded
group stock. The exchange of UST Note for DS3
stock is not an exempt exchange within the meaning
of § 1.385-3(g)(11) because UST and USS1 are not
parties to an asset reorganization. Pursuant to para-
graph (b)(5)(ii), § 1.385-3 (including § 1.385-
3(b)(2)(ii)) is then applied to the transaction, thereby
treating UST Note as stock for federal tax purposes

when it is issued by UST to USS1. The UST Note is
not treated as property for purposes of section 304(a)
because it is not property within the meaning spec-
ified in section 317(a). Therefore, UST's acquisition
of DS3 stock from USS1 in exchange for UST Note
is not an acquisition described in section 304(a)(1).

Example 2. Distribution of consolidated group
debt instrument. (i) Facts. On Date A in Year 1, DS1
issues DS1 Note to USS1 in a distribution. On Date
B in Year 2, USS1 distributes DS1 Note to FP.

(ii) Analysis. Under paragraph (b)(1) of this sec-
tion, the USS1 consolidated group is treated as one
corporation for purposes of § 1.385-3. Accordingly,
when DS1 issues DS1 Note to USS1 in a distribution
on Date A in Year 1, DS1 is not treated as issuing a
debt instrument to another member of DS1's ex-
panded group in a distribution for purposes of
§ 1.385-3(b)(2), and DS1 Note is not treated as stock
under § 1.385-3. When USS1 distributes DS1 Note
to FP, DS1 Note is deemed satisfied and reissued
under § 1.1502-13(g)(3)(ii), immediately before
DS1 Note ceases to be an intercompany obligation.
Under paragraph (c)(1)(ii) of this section, when
USS1 distributes DS1 Note to FP, the USS1 consol-
idated group is treated as issuing DS1 Note to FP in
a distribution on Date B in Year 2. Accordingly, DS1
Note is treated as stock under § 1.385-3(b)(2)(i).
Under paragraph (c)(1)(ii) of this section, DS1 Note
is deemed to be exchanged for stock of the issuing
member, DS1, immediately after DS1 Note is trans-
ferred outside of the USS1 consolidated group. Un-
der paragraph (c)(3) of this section, the deemed
satisfaction and reissuance under § 1.1502-
13(g)(3)(ii) and the deemed issuance and exchange
under paragraph (c)(1)(ii) of this section, are re-
spected as separate steps and treated as separate
transactions.

Example 3. Sale of consolidated group debt in-
strument. (i) Facts. On Date A in Year 1, DS1 lends
$200x of cash to USS1 in exchange for USS1 Note.
On Date B in Year 2, USS1 distributes $200x of cash
to FP. Subsequently, on Date C in Year 2, DS1 sells
USS1 Note to FS for $200x.

(ii) Analysis. Under paragraph (b)(1) of this sec-
tion, the USS1 consolidated group is treated as one
corporation for purposes of § 1.385-3. Accordingly,
when USS1 issues USS1 Note to DS1 for property
on Date A in Year 1, the USS1 consolidated group is
not treated as a funded member, and when USS1
distributes $200x to FP on Date B in Year 2, that
distribution is a transaction described in § 1.385-
3(b)(3)(i)(A), but does not cause USS1 Note to be
recharacterized under § 1.385-3(b)(3). When DS1
sells USS1 Note to FS, USS1 Note is deemed satis-
fied and reissued under § 1.1502-13(g)(3)(ii), imme-
diately before USS1 Note ceases to be an intercom-
pany obligation. Under paragraph (c)(1)(ii) of this
section, when the USS1 Note is transferred to FS for
$200x on Date C in Year 2, the USS1 consolidated
group is treated as issuing USS1 Note to FS in
exchange for $200x on that date. Because USS1
Note is issued by the USS1 consolidated group to FS
within the per se period as defined in § 1.385-
3(g)(19) with respect to the distribution by the USS1
consolidated group to FP, USS1 Note is treated
as funding the distribution under § 1.385-
3(b)(3)(iii)(A) and, accordingly, is treated as stock
under § 1.385-3(b)(3). Under § 1.385-3(d)(1)(i) and

paragraph (c)(1)(ii) of this section, USS1 Note is
deemed to be exchanged for stock of the issuing
member, USS1, immediately after USS1 Note is
transferred outside of the USS1 consolidated group.
Under paragraph (c)(3) of this section, the deemed
satisfaction and reissuance under § 1.1502-
13(g)(3)(ii) and the deemed issuance and exchange
under paragraph (c)(1)(ii) of this section, are re-
spected as separate steps and treated as separate
transactions.

Example 4. Treatment of consolidated group
debt instrument and departing member's regarded
distribution or acquisition when the issuer of the
instrument leaves the consolidated group. (i) Facts.
The facts are the same as provided in paragraph
(f)(1) of this section, except that USS1 and FS own
90% and 10% of the stock of DS1, respectively. On
Date A in Year 1, DS1 distributes $80x of cash and
newly-issued DS1 Note, which has a value of $10x,
to USS1. Also on Date A in Year 1, DS1 distributes
$10x of cash to FS. On Date B in Year 2, FS
purchases all of USS1's stock in DS1 (90% of the
stock of DS1), resulting in DS1 ceasing to be a
member of the USS1 consolidated group.

(ii) Analysis. Under paragraph (b)(1) of this sec-
tion, the USS1 consolidated group is treated as one
corporation for purposes of § 1.385-3. Accordingly,
DS1's distribution of $80x of cash to USS1 on Date
A in Year 1 is a disregarded distribution or acquisi-
tion, and under paragraph (d)(1) of this section,
continues to be a disregarded distribution or acqui-
sition when DS1 ceases to be a member of the USS1
consolidated group. In addition, when DS1 issues
DS1 Note to USS1 in a distribution on Date A in
Year 1, DS1 is not treated as issuing a debt instru-
ment to a member of DS1's expanded group in a
distribution for purposes of § 1.385-3(b)(2)(i), and
DS1 Note is not treated as stock under § 1.385-
3(b)(2)(i). DS1's issuance of DS1 Note to USS1 is
also a disregarded distribution or acquisition, and
under paragraph (d)(1) of this section, continues to
be a disregarded distribution or acquisition when
DS1 ceases to be a member of the USS1 consoli-
dated group. The distribution of $10x cash by DS1 to
FS on Date A in Year 1 is a regarded distribution or
acquisition. When FS purchases 90% of the stock of
DS1's from USS1 on Date B in Year 2 and DS1
ceases to be a member of the USS1 consolidated
group, DS1 Note is deemed satisfied and reissued
under § 1.1502-13(g)(3)(ii), immediately before
DS1 Note ceases to be an intercompany obligation.
Under paragraph (c)(1)(i) of this section, for pur-
poses of § 1.385-3, DS1 is treated as satisfying the
DS1 Note with cash equal to the note's fair market
value, followed by DS1's issuance of a new note for
the same amount of cash immediately after DS1
Note ceases to be a consolidated group debt instru-
ment. Under paragraph (d)(4)(i) of this section, the
departing member, DS1 (and not the USS1 consoli-
dated group) is treated as having distributed $10x to
FS on Date A in Year 1 (a regarded distribution or
acquisition) for purposes of applying § 1.385-
3(b)(3) after DS1 ceases to be a member of the USS1
consolidated group. Because DS1 Note is reissued
by DS1 to USS1 within the per se period (as defined
in § 1.385-3(g)(19)) with respect to DS1's regarded
distribution to FS, DS1 Note is treated as funding the
distribution under § 1.385-3(b)(3)(iii)(A) and, ac-

cordingly, is treated as stock under § 1.385-3(b)(3).
Under § 1.385-3(d)(1)(i) and paragraph (c)(1)(i) of
this section, DS1 Note is immediately deemed to be
exchanged for stock of DS1 on Date B in Year 2.
Under paragraph (c)(3) of this section, the deemed
satisfaction and reissuance under § 1.1502-
13(g)(3)(ii) and the deemed issuance and exchange
under paragraph (c)(1)(i) of this section are respected
as separate steps and treated as separate transactions.
Under § 1.385-3(d)(7)(i), after DS1 Note is treated as
stock held by USS1, DS1 Note is not treated as stock
for purposes of determining whether DS1 is a member
of the USS1 consolidated group.

Example 5. Treatment of consolidated group
debt instrument and consolidated group's regarded
distribution or acquisition. (i) Facts. On Date A in
Year 1, DS1 issues DS1 Note to USS1. On Date B in
Year 2, USS1 distributes $100x of cash to FP. On
Date C in Year 3, USS1 sells all of its interest in DS1
to FS, resulting in DS1 ceasing to be a member of the
USS1 consolidated group.

(ii) Analysis. Under paragraph (b)(1) of this sec-
tion, the USS1 consolidated group is treated as one
corporation for purposes of § 1.385-3. Accordingly,
when DS1 issues DS1 Note to USS1 in a distribution
on Date A in Year 1, DS1 is not treated as issuing a
debt instrument to a member of DS1's expanded
group in a distribution for purposes of § 1.385-
3(b)(2)(i), and DS1 Note is not treated as stock under
§ 1.385-3(b)(2)(i). DS1's issuance of DS1 Note to
USS1 is also a disregarded distribution or acquisi-
tion, and under paragraph (d)(1) of this section,
continues to be a disregarded distribution or acqui-
sition when DS1 ceases to be a member of the USS1
consolidated group. The distribution of $100x cash
by DS1 to USS1 on Date B in Year 2 is a regarded
distribution or acquisition. When FS purchases all of
the stock of DS1 from USS1 on Date Cin Year 3 and
DS1 ceases to be a member of the USS1 consoli-
dated group, DS1 Note is deemed satisfied and reis-
sued under § 1.1502-13(g)(3)(ii), immediately be-
fore DS1 Note ceases to be an intercompany
obligation. Under paragraph (c)(1)(i) of this section,
for purposes of § 1.385-3, DS1 is treated as satisfy-
ing DS1 Note with cash equal to the note's fair
market value, followed by DS1's issuance of a new
note for the same amount of cash immediately after
DS1 Note ceases to be a consolidated group debt
instrument. Under paragraph (d)(4)(ii) of this sec-
tion, the USS1 consolidated group (and not DS1) is
treated as having distributed $100x to FP on Date B
in Year 2 (a regarded distribution or acquisition) for
purposes of applying § 1.385-3(b)(3) after DS1
ceases to be a member of the USS1 consolidated
group. Because DS1 has not engaged in a regarded
distribution or acquisition that would have been
treated as funded by the reissued DS1 Note, the
reissued DS1 Note is not treated as stock.

Example 6. Treatment of departing member's
issuance of a covered debt instrument. (i) Facts. On
Date A in Year 1, FS lends $100x of cash to DS1 in
exchange for DS1 Note. On Date B in Year 2, USS1
distributes $30x of cash to FP. On Date C in Year 2,
USS1 sells all of its DS1 stock to FP, resulting in
DS1 ceasing to be a member of the USS1 consoli-
dated group.

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

(g) Applicability date. This section ap-
plies to taxable years ending on or after
January 19, 2017.

(h) Expiration date. This section ex-
pires on October 11, 2019.

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

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

* * * * *

(3) [Reserved]. For further guidance,
see § 1.752-2T(c)(3).

* * * * *

(l) * * *

(4) [Reserved]. For further guidance,
see § 1.752-2T(1)(4).

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

§ 1.752-2T Partner's share of re-
course liabilities (temporary).
* * * * *

(c)* * *

(3) Allocation of debt deemed trans-
ferred to a partner pursuant to regula-
tions under section 385. For a special rule
regarding the allocation of a partnership
liability that is a debt instrument with re-
spect to which there is one or more
deemed transferred receivables within the
meaning of § 1.385-3T(g)(8), see
§ 1.385-3T(f)(4)(vi).
* * * * *

(l) * * *

(4) Paragraph (c)(3) of this section ap-
plies on or after January 19, 2017.

(m) Expiration date-(1) Paragraphs
(a) through (c)(2) and (d) through (l)(3) of
this section expire on October 4, 2019.

(2) Paragraphs (c)(3) and (l)(4) of this
section expire on October 11, 2019.

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

* * * * *

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

* * * * *

John Dalrymple
Deputy Commissioner for
Services and Enforcement.

Approved: October 11, 2016

Mark J. Mazur
Assistant Secretary of the
Treasury (Tax Policy).

(Filed by the Office of the Federal Register on October 13,
2016, 5:00 p.m., and published in the issue of the Federal
Register for October 21, 2016, 81 F.R. 72858)

# Part III. Administrative, Procedural, and Miscellaneous

## Guidance Concerning Use of 2017 CSO Tables Under Section 7702

Notice 2016-63

### SECTION 1. PURPOSE

This notice provides rules interpreting
the reasonable mortality charge require-
ment contained in § 7702(c)(3)(B)(i) of
the Internal Revenue Code (Code). Spe-
cifically, this notice supplements Notice
88-128, 1988-2 C.B. 540, and modifies
and supersedes Notice 2006-95, 2006-2
C.B. 848, by providing safe harbors re-
garding the use by taxpayers of the 1980
Commissioners' Standard Ordinary mor-
tality and morbidity tables (1980 CSO ta-
bles), the 2001 Commissioners' Standard
Ordinary mortality and morbidity tables
(2001 CSO tables), or the 2017 Commis-
sioners' Standard Ordinary mortality and
morbidity tables (2017 CSO tables) to de-
termine whether mortality charges are rea-
sonable. These safe harbors are designed
to assist taxpayers in complying with the
requirements of § 7702(c)(3)(B)(i).

## SECTION 2. BACKGROUND

Section 7702 defines the term "life in-
surance contract" for purposes of the
Code. Section 7702(a) provides that a
"life insurance contract" is any contract
that is a life insurance contract under the
applicable law, but only if such contract
either (1) meets the cash value accumula-
tion test of § 7702(b), or (2) both meets
the guideline premium requirements of
§ 7702(c) and falls within the cash value
corridor of § 7702(d). As originally en-
acted, § 7702 generally required the use of
"the mortality charges specified in the
contract" in the actuarial calculations un-
der the cash value accumulation test and
the guideline premium requirements. In
1988, § 7702 was amended to require the
use of "reasonable mortality charges" in
the determination of the cash value accu-
mulation test and guideline premium re-
quirements. Technical and Miscellaneous
Revenue Act of 1988 (1988 Act), Pub. L.
No. 100-647, § 5011(a).

Section 7702(c)(3)(B)(i) provides that
the guideline single premium under
§ 7702(c) is determined on the basis of
reasonable mortality charges that meet the
requirements (if any) prescribed in regu-
lations and that (except as provided in
regulations) do not exceed the mortality
charges specified in the prevailing com-
missioners' standard tables (as defined in
§ 807(d)(5)) as of the time the contract is
issued. The mortality charges specified in
§ 7702(c)(3)(B)(i) are also used for deter-
mining the "net single premium" (see
§ 7702(b)(2)(B)), and the "guideline level
premium" (see § 7702(c)(4)). The same
reasonable mortality charge standard ap-
plies for purposes of determining whether
a life insurance contract is a modified en-
dowment contract under § 7702A (see
§ 7702A(c)(1)(B)).

Section 807(d)(5)(A) provides that the
term "prevailing commissioners' standard
tables" means, with respect to any contract,
the most recent commissioners' standard ta-
bles prescribed by the National Association
of Insurance Commissioners (NAIC) that
are permitted to be used in computing re-
serves for that type of contract under the
insurance laws of at least 26 states when the
contract was issued. Section 807(d)(5)(B)
provides a 3-year transition period during
which an insurer may use either the newly
prevailing CSO tables or those that were
previously prevailing.

The 2017 CSO tables prescribed by the
NAIC will become the prevailing com-
missioners' standard tables within the
meaning of § 807(d)(5) on January 1,
2017. The 1980 CSO tables may still be
used in all states for contracts issued in
calendar years through 2008; and the 2001
CSO tables may still be used in all states
for contracts issued in calendar years 2005
through 2019. For contracts issued after
2008, and before January 1, 2017, use of
the 2001 CSO tables is mandatory. The
2017 CSO tables may be used for con-
tracts issued on or after January 1, 2017.
For contracts issued on or after January 1,
2020, use of the 2017 CSO tables will be
mandatory.

Notice 88-128 was issued after § 7702
was amended to require that only "reason-
able" mortality charges be taken into ac-
count for purposes of testing life insur-

ance contract qualification under § 7702.
Under Notice 88-128, interim safe har-
bors provided that the 1980 CSO tables
(and, for certain previously issued con-
tracts, the 1958 CSO tables) would satisfy
the requirement that mortality charges be
"reasonable" under § 7702(c)(3)(B)(i).
Notice 2006-95 supplemented Notice 88-
128 by providing additional safe harbors to
account for the promulgation of the 2001
CSO tables. Neither Notice 88-128, Notice
2006-95, nor this notice addresses the rea-
sonable mortality charge requirement in the
case of substandard risk underwriting. See
1988 Act § 5011(c)(2).

## SECTION 3. MODIFICATIONS TO NOTICE 2006-95

This notice makes several modifica-
tions to Notice 2006-95. First, it provides
safe harbors regarding the use by taxpay-
ers of the 2017 CSO tables for purposes of
§ 7702(c)(3)(B)(i). Second, it provides
that if the only change to an existing con-
tract is a reduction or deletion of benefits
provided under the contract, such a
change will not affect the determination of
the issue date of a contract for purposes of
the reasonable mortality charge safe har-
bor. This modification is consistent with
the treatment of a decrease in benefits for
purposes of § 7702A. The legislative his-
tory of § 7702A states that a decrease in
future benefits under a contract is not con-
sidered a material change, which would
result in the contract being treated as a
new contract subject to new testing as of
the date of the material change. H.R. Rep.
No. 100-1104, at 101 (1988) (Conf.
Rep.), 1988-3 C.B. 591; cf. § 7702(f)(7)
(reduction in future benefits is an event
requiring appropriate adjustments of de-
terminations under § 7702). Third, it pro-
vides that changes, modifications, or ex-
ercises of contractual provisions referred
to in section 5.02 of this notice include
reinstatement of a contract as required un-
der applicable state or foreign law.

## SECTION 4. SAFE HARBORS UNDER SECTION 7702

The following safe harbors apply for
purposes of determining reasonable mor-
tality charges under § 7702:

.01 Notice 88-128. The interim rules
described in Notice 88-128 remain in ef-
fect, except as otherwise modified by this
notice.

.02 1980 CSO tables. A mortality
charge with respect to a life insurance
contract will satisfy the requirements of
§ 7702(c)(3)(B)(i) so long as (1) the mor-
tality charge does not exceed 100 percent
of the applicable mortality charge set forth
in the 1980 CSO tables; (2) the contract is
issued in a state that permits or requires
the use of the 1980 CSO tables at the time
the contract is issued; and (3) the contract
is issued before January 1, 2009.

.03 2001 CSO tables. A mortality
charge with respect to a life insurance
contract will satisfy the requirements of
§ 7702(c)(3)(B)(i) so long as (1) the mor-
tality charge does not exceed 100 percent
of the applicable mortality charge set forth
in the 2001 CSO tables; (2) the mortality
charge does not exceed the mortality
charge specified in the contract at issu-
ance; (3) either (a) the contract is issued
after December 31, 2008, or (b) the con-
tract is issued before January 1, 2009, in a
state that permits or requires the use of the
2001 CSO tables at the time the contract is
issued; and (4) the contract is issued be-
fore January 1, 2020.

.04 2017 CSO tables. A mortality
charge with respect to a life insurance
contract will satisfy the requirements of
§ 7702(c)(3)(B)(i) so long as (1) the mor-
tality charge does not exceed 100 percent
of the applicable mortality charge set forth
in the 2017 CSO tables; (2) the mortality
charge does not exceed the mortality
charge specified in the contract at issu-
ance; and (3) either (a) the contract is
issued after December 31, 2019, or (b) the
contract is issued before January 1, 2020,
in a state that permits or requires the use
of the 2017 CSO tables at the time the
contract is issued.

## SECTION 5. ISSUE DATE OF CONTRACTS

.01 For purposes of this notice, the date
on which a contract is issued generally is
determined according to the standards that
applied for purposes of the original effec-
tive date of § 7702. See H.R. Rep. No.
98-861, at 1076 (1984) (Conf. Rep.),
1984-3 (Vol. 2) C.B. 330; see also 1 Staff
of Senate Comm. on Finance, 98th Cong.,

2d Sess., Deficit Reduction Act of 1984,
Explanation of Provisions Approved by
the Committee on March 21, 1984, at 579
(Comm. Print 1984). Thus, contracts re-
ceived in exchange for existing contracts
are to be considered new contracts issued on
the date of the exchange. For these pur-
poses, a change in an existing contract is not
considered to result in an exchange if the
terms of the resulting contract (that is,
the amount and pattern of death benefit, the
premium pattern, the rate or rates guaran-
teed on issuance of the contract, and mor-
tality and expense charges) are the same as
the terms of the contract prior to the change.

.02 Notwithstanding section 5.01 of
this notice, if a life insurance contract
satisfied section 4.01, 4.02, or 4.03 of this
notice when originally issued, a change
from the previous tables to the 2001 or
2017 CSO tables is not required if: (1) the
change, modification, or exercise of a
right to modify or add benefits is pursuant
to the terms of the contract; (2) the state in
which the contract is issued does not re-
quire use of the 2001 or 2017 CSO tables
for that contract under its standard valua-
tion and minimum nonforfeiture laws; and
(3) the contract continues upon the same
policy form or blank. Additionally, a
change from the previous tables to the
2001 or 2017 CSO table is not required if
the only change to an existing contract is
a reduction or deletion of benefits pro-
vided under the contract.

.03 The changes, modifications, or ex-
ercises of contractual provisions referred
to in section 5.02 of this notice include (1)
the addition or removal of a rider; (2) the
addition or removal of a qualified addi-
tional benefit (QAB); (3) an increase or
decrease in death benefit (whether or not
the change is underwritten); (4) a change
in death benefit option (such as a change
from an option 1 to option 2 contract or
vice versa); (5) reinstatement of a policy
within 90 days after its lapse or reinstate-
ment of a policy as required under appli-
cable state or foreign law; and (6) recon-
sideration of ratings based on rated
condition, lifestyle, or activity (such as a
change from smoker to nonsmoker status).

## SECTION 6. RULES FOR GENDER OR SMOKER-BASED TABLES

For purposes of sections 4.03 and 4.04
of this notice (the 2001 and 2017 CSO

safe harbors), mortality charges that do
not exceed the applicable charges in
gender- or smoker- based variations of the
2001 or 2017 CSO tables will be treated
as reasonable mortality charges, provided
the following requirements are satisfied:

.01 Unisex tables. If a state permits or
requires minimum nonforfeiture values
for all contracts issued under a plan of
insurance to be determined using the 2001
or the 2017 CSO Gender-Blended Mortal-
ity tables ("unisex tables"), then the appli-
cable mortality charges in those tables are
treated as reasonable mortality charges for
female insureds provided the same tables
are used to determine mortality charges
for male insureds.

.02 Smoker/nonsmoker tables. If a state
permits minimum nonforfeiture values for
all contracts issued under a plan of insur-
ance to be determined using the 2001 or
the 2017 CSO Smoker and Nonsmoker
Mortality tables (“smoker/nonsmoker ta-
bles"), then the applicable mortality
charges in those tables for smoker in-
sureds are treated as reasonable mortality
charges provided nonsmoker tables are
used to determine nonsmoker mortality
charges.

## SECTION 7. EFFECT UPON OTHER PUBLICATIONS

This notice supplements Notice 88-
128 and modifies and supersedes Notice
2006-95.

## SECTION 8. EFFECTIVE DATE

This notice is effective October 19,
2016.

## DRAFTING INFORMATION

The principal author of this notice is
Alexis A. MacIvor of the Office of Associ-
ate Chief Counsel (Financial Institutions &
Products). For further information regarding
this notice, contact Ms. MacIvor at (202)
317-6995 (not a toll-free number).

26 CFR 601. 602: Tax forms and instructions. (Also Part I, Sections 6041, 6051, 6071, 6081, 6091; 1.6041-1, 1.6041-2, 31.6051-1, 31.6051-2, 31.6071(a)-1,
31.6081(a)-1, 31.6091-1.)

### Rev. Proc. 2016-54

NOTE. This revenue procedure will be reproduced as the next revision of IRS Publication 1141, General Rules and Specifications
for Substitute Forms W-2 and W-3.

TABLE OF CONTENTS

Part 1 - GENERAL

685

Section 1.1 - Purpose

685

Section 1.2 - What's New

687

Section 1.3 - General Rules for Paper Forms W-2 and W-3

687

Section 1.4 - General Rules for Filing Forms W-2 (Copy A) Electornically

689

Part 2 - SPECIFICATIONS FOR SUBSTITUTE FORMS W-2 AND W-3

689

Section 2.1 - Specifications for Red-Ink Substitute Form W-2 (Copy A) and Form W-3 Filed with the SSA

689

Section 2.2 - Specifications for Substitute Black-and-White Copy A and W-3 Forms Filed with the SSA

692

Section 2.3 - Requirements for Substitute Forms Furnished to Employees (Copies B, C, and 2 of Form W-2)

694

Section 2.4 - Electronic Delivery of Form W-2 and W-2c Recipient Statements

697

Part 3 - ADDITIONAL INSTRUCTIONS

698

Section 3.1 - Additional Instructions for Form Printers

698

Section 3.2 - Instructions for Employers

698

Section 3.3 - OMB Requirements for Both Red-Ink and Black-and-White Copy A and W-3 Substitute Forms

699

Section 3.4 - Order Forms and Instructions

700

Section 3.5 - Effect on Other Documents

700

Section 3.6 - Exhibits.

700

### Part 1 General

Section 1.1 - Purpose

.01 The purpose of this revenue procedure is to state the requirements of the Internal Revenue
Service (IRS) and the Social Security Administration (SSA) regarding the preparation and use of
substitute forms for Form W-2, Wage and Tax Statement, and Form W-3, Transmittal of Wage
and Tax Statements, for wages paid during the 2016 calendar year.

.02 For purposes of this revenue procedure, substitute Form W-2 (Copy A) and substitute Form
W-3 are forms that are not printed by the IRS. Copy A or any other copies of a substitute Form
W-2 or a substitute Form W-3 must conform to the specifications in this revenue procedure to
be acceptable to the IRS and the SSA. No IRS office is authorized to allow deviations from this
revenue procedure. Preparers should also refer to the 2016 General Instructions for Forms W-2
and W-3 for details on how to complete these forms. See Section 3.4, for information on
obtaining the official IRS forms and instructions. See Sections 2.3 and 2.4, for requirements for
the copies of substitute forms furnished to employees and for electronic delivery of recipient
statements.

.03 For purposes of this revenue procedure, the official IRS-printed red dropout ink Forms W-2
(Copy A) and W-3, and their exact substitutes, are referred to as "red-ink." The SSA-approved
black-and-white Forms W-2 (Copy A) and W-3 are referred to as "substitute black-and-white
Copy A" and "substitute black-and-white W-3" forms.

Any questions about the red-ink Form W-2 (Copy A) and Form W-3 and the substitute employee
statements should be emailed to Substituteforms@irs.gov. Please enter "Substitute Forms" on the
subject line. Or send your questions to:
Internal Revenue Service
Attn: Substitute Forms Program
SE:W:CAR:MP:P:TP
5000 Ellin Rd., C6-440
Lanham, MD 20706

Any questions about the black-and-white Copy A and W-3 forms should be emailed to
copy.a.forms@ssa.gov or sent to:

Social Security Administration
Direct Operations Center
Attn: Substitute Black-and-White Copy A Forms, Room 341
1150 E. Mountain Drive
Wilkes-Barre, PA 18702-7997

Note. You should receive a response from either the IRS or the SSA within 30 days.

.04 Some Forms W-2 that include logos, slogans, and advertisements (including advertisements
for tax preparation software) may be confused with questionable Forms W-2. An employee may
not recognize the importance of the employee copy for tax reporting purposes due to the use of
logos, slogans, and advertisements. Thus, the IRS has determined that logos, slogans, and
advertising will not be allowed on Copy A of Forms W-2, Forms W-3, or any employee copies
reporting wages paid during the 2010 calendar year, and thereafter, with the following exceptions
for the employee copies:

· Forms may include the exact name of the employer or agent, primary trade name, trademark,
service mark, or symbol of the employer or agent.

· Forms may include an embossment or watermark on the information return (and copies) that is a
representation of the name, a primary trade name, trademark, service mark, or symbol of the
employer or agent.

· Presentation may be in any typeface, font, stylized fashion, or print color normally used by the
employer or agent, and used in a non-intrusive manner.

· These items must not materially interfere with the ability of the recipient to recognize, understand,
and use the tax information on the employee copies.

· Corrected information on information returns and employee copies that was shown on Forms W-2
for amounts paid before January 1, 2011, is an exception.

The IRS e-file logo on the IRS official employee copies may be included, but it is not required,
on any of the substitute form copies.

The information return and employee copies must clearly identify the employer's name associated
with its employer identification number.

Logos and slogans, may be used on permissible enclosures, such as a check or account statement,
other than information returns and payee copies.

Forms W-2 and W-3 are subject to annual review and possible change. This revenue procedure
may be revised to state other requirements of the IRS and the SSA regarding the preparation and
use of substitute forms for Form W-2 and Form W-3 for wages paid during the 2016 calendar
year, at a future date. If you have comments about the restrictions on including logos, slogans, and
advertising on information returns and employee copies, send or email your comments to: Internal
Revenue Service, Attn: Substitute Forms Program, SE:W:CAR:MP:P:TP, 5000 Ellin Road,
C6-440, Lanham, MD 20706, or Substituteforms@irs.gov.

.05 The Internal Revenue Service/Information Returns Branch (IRS/IRB) maintains a centralized
customer service call site to answer questions related to information returns (Forms W-2, W-3,
W-2c, W-3c, 1099 series, 1096, etc.). You can reach the call site at 1-866-455-7438 (toll-free)

or 304-263-8700 (not a toll-free number). Persons with a hearing or speech disability with access
to Telecommunication Device for the Deaf (TDD) can call 304-579-4827 (not a toll-free number).
You may also email questions to mccirp@irs.gov. Do not submit employee information via email,
because electronic mail is not secure and the information may be compromised.

IRS/IRB does not process information returns which are filed on paper forms. IRS/IRB does not
process Forms W-2 (Copy A). Forms W-2 (Copy A) prepared on paper or electronically must be
filed with the SSA. IRS/IRB does, however, process waiver requests (Form 8508) and extension
of time to file requests (Form 8809) for Forms W-2 (Copy A) and requests for an extension of
time to furnish the employee copies of Form W-2. See Publication 1220, Specifications for
Electronic Filing of Forms 1097, 1098, 1099, 3921, 3922, 5498, and W-2G, for information on
waivers and extensions of time.

.06 The following form instructions and publications provide more detailed filing procedures for
certain information returns:

· General Instructions for Forms W-2 and W-3, (Including Forms W-2AS, W-2CM, W-2GU,
W-2VI, W-3SS, W-2c, and W-3c).

· Publication 1223, General Rules and Specifications for Substitute Forms W-2c and W-3c.

Section 1.2 - What's New

.01 Submission address change. The address for sending substitute black-and-white Copy A and
W-3 for SSA approval has been changed to Social Security Administration, Direct Operations
Center, Attn. Black-and-White Copy A Forms, Room 341, 1150 E. Mountain Drive, Wilkes-
Barre, PA 18702-7997. (See Section 2.2.04 for more information.)

.02 Filing address change. The address for filing paper Forms W-2 and W-3 has been changed
to Social Security Administration, Direct Operations Center, Wilkes-Barre, PA 18769-0001. If
you use an IRS-approved private delivery service, add "ATTN: W-2 Process, 1150 E. Mountain
Dr." to the address and change the Zip code to "18702-7997."

.03 Editorial changes. We made editorial changes. Redundancies were eliminated as much as
possible.

#### Section 1.3 - General Rules for Paper Forms W-2 and W-3

.01 Employers not filing electronically must file paper Forms W-2 (Copy A) along with Form
W-3 with the SSA by using either the official IRS form or a substitute form that exactly meets
the specifications shown in Parts 2 and 3 of this revenue procedure.

Note. Substitute territorial forms (W-2AS, W-2GU, W-2VI, W-3SS) should also conform to the
specifications as outlined in this revenue procedure. These forms require the form designation
("W-2AS," "W-2GU," "W-2VI") on Copy A to be in black ink. If you are an employer in the
Commonwealth of the Northern Mariana Islands, you must contact Department of Finance,
Division of Revenue and Taxation, Commonwealth of the Northern Mariana Islands, P.O. Box
5234 CHRB, Saipan, MP 96950 or www.cnmidof.net to get Form W-2CM and instructions for
completing and filing the form. For information on Forms 499R-2/W-2PR, use this website:
www.hacienda.gobierno.pr.

Employers who file with the SSA electronically or on paper may design their own statements to
furnish to employees. These employee statements designed by employers must comply with the
requirements shown in Parts 2 and 3.

.02 Red-ink substitute forms that completely conform to the specifications contained in this
revenue procedure may be privately printed without prior approval from the IRS or the SSA. Only
the substitute black-and-white Copy A and W-3 forms need to be submitted to the SSA for
approval, prior to their use (see Section 2.2).

.03 As in the past, SSA-approved black-and-white Copy A and Form W-3 may be generated
using a printer by following all guidelines and specifications (also see Section 2.2). In general,
regardless of the method of entering data, using black ink on Forms W-2 and W-3 provides better
readability for processing by scanning equipment. Colors other than black are not easily read by
the scanner and may result in delays or errors in the processing of Forms W-2 (Copy A) and W-3.
The printing of the data should be centered within the boxes. The size of the variable data must
be printed in a font no smaller than 10-point.

Note. With the exception of the identifying number, the year, the form number for Form W-3,
and the corner register marks, the preprinted form layout for the red-ink Forms W-2 (Copy A)
and W-3 must be in Flint J-6983 red OCR dropout ink or an exact match.

.04 Substitute forms filed with the SSA and substitute copies furnished to employees that do not
conform to these specifications are unacceptable. Forms W-2 (Copy A) and W-3 filed with the
SSA that do not conform may be returned. In addition, penalties may be assessed for not
complying with the form specifications.

.05 Substitute red-ink forms should not be submitted to either the IRS or the SSA for specific
approval. If you are uncertain of any specification and want clarification, do the following.

1\. Submit a letter or email citing the specification to the appropriate address in Section 1.1.

2\. State your understanding of the specification.

3\. Enclose an example (if appropriate) of how the form would appear if produced using your
understanding.

4\. Be sure to include your name, complete address, phone number, and if applicable, your email
address with your correspondence.

.06 Any questions about the specifications, especially those for the red-ink Form W-2 (Copy A)
and Form W-3, should be emailed to: Substituteforms@irs.gov. Please enter "Substitute Forms"
on the subject line. Or send your questions to:

Internal Revenue Service
Attn: Substitute Forms Program
SE:W:CAR:MP:P:TP
5000 Ellin Rd., C6-440
Lanham, MD 20706

Any questions about the substitute black-and-white Copy A and W-3 should be emailed to
copy.a.forms@ssa.gov or sent to:

Social Security Administration
Direct Operations Center
Attn: Substitute Black-and-White Copy A Forms, Room 341
1150 E. Mountain Drive
Wilkes-Barre, PA 18702-7997

Note. You should receive a response within 30 days from either the IRS or the SSA.

.07 Forms W-2 and W-3 are subject to annual review and possible change. Therefore, employers
are cautioned against overstocking supplies of privately printed substitutes.

.08 Separate instructions for Forms W-2 and W-3 are provided in the 2016 General Instructions
for Forms W-2 and W-3. Form W-3 should be used only to transmit paper Forms W-2

(Copy A). Form W-3 is a single sheet including only essential filing information. Be sure to make
a copy of your completed Form W-3 for your records. You can order current year official IRS
Forms W-2, W-2AS, W-2GU, W-2VI, W-3, and W-3SS, and the 2016 General Instructions for
Forms W-2 and W-3, online at https://www.irs.gov/businesses. Click on the Online Ordering for
Information Returns and Employer Returns link. The IRS provides only cutsheet sets of Forms
W-2 and cutsheets of Form W-3.

.09 Because substitute Forms W-2 (Copy A) and W-3 are machine-imaged and scanned by the
SSA, the forms must meet the same specifications as the official IRS Forms W-2 and W-3 (as
shown in the exhibits).

#### Section 1.4 - General Rules for Filing Forms W-2 (Copy A) Electronically

.01 Employers must file Forms W-2 (Copy A) with the SSA electronically if they are required
to file 250 or more for a calendar year unless the IRS grants a waiver. For details, get the 2016
General Instructions for Forms W-2 and W-3. The SSA publication EFW2, Specifications for
Filing Forms W-2 Electronically, contains specifications and procedures for electronic filing of
Form W-2 information with the SSA. Employers are cautioned to obtain the most recent revision
of EFW2 (and supplements) due to any subsequent changes in specifications and procedures.

.02 You may obtain a copy of the EFW2 by:

· Accessing the SSA website at: www.socialsecurity.gov/employer/pub.htm. Enter "EFW2" in the
search box.

.03 Electronic filers do not file a paper Form W-3. See the SSA publication EFW2 for guidance
on transmitting Form W-2 (Copy A) information to SSA electronically.

.04 Employers filing fewer than 250 Forms W-2 are encouraged to electronically file Forms W-2
(Copy A) with the SSA. Doing so will enhance the timeliness and accuracy of forms processing.
You may visit the SSA's employer website at www.socialsecurity.gov/employer. This helpful site
has links to Business Services Online (BSO) and tutorials on registering and using BSO to file
your Forms W-2.

.05 Employers who do not comply with the electronic filing requirements for Form W-2 (Copy
A) and who are not granted a waiver by the IRS may be subject to penalties. Employers who file
Form W-2 information with the SSA electronically must not send the same data to the SSA on
paper Forms W-2 (Copy A). Any duplicate reporting may subject filers to unnecessary contacts
by the SSA or the IRS.

## Part 2 Specifications for Substitute Forms W-2 and W-3

### Section 2.1 - Specifications for Red-Ink Substitute Form W-2 (Copy A) and Form W-3 Filed with the SSA

.01 The official IRS-printed red dropout ink Form W-2 (Copy A) and W-3 and their exact
substitutes are referred to as red-ink in this revenue procedure. Employers may file substitute
Forms W-2 (Copy A) and W-3 with the SSA. The substitute forms must be exact replicas of the
official IRS forms with respect to layout and content because they will be read by scanner
equipment.

Note. Even the slightest deviation can result in incorrect scanning, and may affect money amounts
reported for employees.

.02 Paper used for cutsheets and continuous-pinfed forms for substitute Form W-2 (Copy A) and
Form W-3 that are to be filed with the SSA must be white 100% bleached chemical wood, 18-20
pound paper only, optical character recognition (OCR) bond produced in accordance with the
following specifications:

· Acidity: Ph value, average, not less than

4.5

· Basis weight: 17 x 22 inch 500 cut sheets, pound

18-20

· Metric equivalent-gm./sq. meter

(a tolerance of +5 pct. is allowed)

68-75

· Stiffness: Average, each direction, not less than-milligrams

Cross direction

Machine direction

· Tearing strength: Average, each direction, not less than-grams

· Opacity: Average, not less than-percent

· Reflectivity: Average, not less than-percent

· Thickness: Average-inch

0.0038

Metric equivalent-mm

0.097

(a tolerance of +0.0005 inch (0.0127 mm) is allowed) Paper cannot vary more than 0.0004 inch (0.0102 mm) from one edge to the other.

. Porosity: Average, not less than-seconds

· Finish (smoothness): Average, each side-seconds

20-55

(for information only) the Sheffield equivalent-units

170-d200

· Dirt: Average, each side, not to exceed-parts per million

Note. Reclaimed fiber in any percentage is permitted, provided the requirements of this standard
are met.

.03 All printing of red-ink substitute Forms W-2 (Copy A) and W-3 must be in Flint red OCR
dropout ink except as specified below. The following must be printed in nonreflective black ink:

· Identifying number "22222" or "33333" at the top of the forms.

· Tax year at the bottom of the forms.

· The four (4) corner register marks on the forms.

· The form identification number ("W-3") at the bottom of Form W-3.

· All the instructions below Form W-3 beginning with "Send this entire page .... " line to the bottom
of Form W-3.

.04 The vertical and horizontal spacing for all federal payment and data boxes on Forms W-2 and
W-3 must meet specifications. On Form W-3 and Form W-2 (Copy A), all the perimeter rules
must be 1-point (0.014-inch), while all other rules must be one-half point (0.007-inch). Vertical
rules must be parallel to the left edge of the form; horizontal rules parallel to the top edge.

.05 The official red-ink Form W-3 and Form W-2 (Copy A) are 7.50 inches wide. Employers
filing Forms W-2 (Copy A) with the SSA on paper must also file a Form W-3. Form W-3 must
be the same width (7.50 inches) as the Form W-2. One Form W-3 is printed on a standard-size,
8.5 x 11-inch page. Two official Forms W-2 (Copy A) are contained on a single 8.5 x 11-inch
page (exclusive of any snap-stubs).

.06 The top, left, and right margins for the Form W-2 (Copy A) and Form W-3 are 0.50 inches
(1/2 inch). All margins must be free of printing except for the words "DO NOT STAPLE" on
red-ink Form W-3. The space between the two Forms W-2 (Copy A) is 1.33 inches.

.07 The identifying numbers are "22222" for Form W-2 (Copies A (and 1)) and "33333" for Form
W-3. No printing should appear anywhere near the identifying numbers.

Note. The identifying number must be printed in nonreflective black ink in OCR-A font of 10
characters per inch.

.08 The depth of the individual scannable image on a page must be the same as that on the official
IRS forms. The depth from the top line to the bottom line of an individual Form W-2 (Copy A)
must be 4.17 inches and the depth from the top line to the bottom line of Form W-3 must be 4.67
inches.

.09 Continuous-pinfed Forms W-2 (Copy A) must be separated into 11-inch deep pages. The
pinfed strips must be removed when Forms W-2 (Copy A) are filed with the SSA. The two Forms
W-2 (Copy A) on the 11-inch page must not be separated (only the pages are to be separated
(burst)). The words "Do Not Cut, Fold, or Staple Forms on This Page" must be printed twice
between the two Forms W-2 (Copy A) in Flint red OCR dropout ink. All other copies (Copies
1, B, C, 2, and D) must be able to be distinguished and separated into individual forms.

.10 Box 12 of Form W-2 (Copy A) contains four entry boxes - 12a, 12b, 12c, and 12d. Do not
make more than one entry per box. Enter your first code in box 12a (for example, enter Code D
in box 12a, not 12d, if it is your first entry). If more than four items need to be reported in box
12, use a second Form W-2 to report the additional items (see "Multiple forms" in the 2016
General Instructions for Forms W-2 and W-3). Do not report the same federal tax data to the SSA
on more than one Form W-2 (Copy A). However, repeat the identifying information (employee's
name, address, and SSN; employer's name, address, and EIN) on each additional form.

.11 The checkboxes in box 13 of Form W-2 (Copy A) and in box b of Form W-3 must be 0.14
inches each. The space before the first checkbox is 0.24 inches; the space between the first and
second checkbox and between the second and third checkbox must be 0.36 inches; the space
between the third checkbox to the right border of box 13 should be 0.32 inches (see Exhibit A).

Note. More than 50% of an applicable checkbox must be covered by an "X."

.12 All substitute Forms W-2 (Copy A) and W-3 in the red-ink format must have the tax year,
form number, and form title printed on the bottom face of each form using type identical to that
of the official IRS form. The red-ink substitute Form W-2 (Copy A) and Form W-3 must have
the form producer's EIN entered directly to the left of "Department of the Treasury," in red.

.13 The words "For Privacy Act and Paperwork Reduction Act Notice, see the separate instruc-
tions." must be printed in Flint red OCR dropout ink in the same location as on the official Form
W-2 (Copy A). The words "For Privacy Act and Paperwork Reduction Act Notice, see the
separate instructions." must be printed at the bottom of the page of Form W-3 in black ink.

.14 The Office of Management and Budget (OMB) Number must be printed on substitute Forms
W-3 and W-2 (on each ply) in the same location as on the official IRS forms.

.15 All substitute Forms W-3 must include the instructions that are printed on the same sheet
below the official IRS form.

.16 The back of substitute Form W-2 (Copy A) and Form W-3 must be free of all printing.

.17 All copies must be clearly legible. Fading must be minimized to assure legibility.

.18 Chemical transfer paper is permitted for Form W-2 (Copy A) only if the following standards
are met:

· Only chemically-backed paper is acceptable for Form W-2 (Copy A). Front and back chemically-
treated paper cannot be processed properly by scanning equipment.

· Chemically-transferred images must be black.

· Carbon-coated forms are not permitted.

.19 The Government Printing Office (GPO) symbol and the Catalog Number (Cat. No.) must be
deleted from substitute Form W-2 (Copy A) and Form W-3.

### Section 2.2 - Specifications for Substitute Black-and-White Copy A and W-3 Forms Filed with the SSA

.01 The SSA-approved substitute black-and-white Forms W-2 (Copy A) and W-3 are referred to
as substitute black-and-white Copy A and W-3.

Specifications for the substitute black-and-white Copy A and W-3 are similar to the red-ink forms
(Section 2.1) except for the items that follow (see Exhibits D and E). Exhibits are samples only
and must not be downloaded to meet tax obligations.

1\. Forms must be printed on 8.5 x 11-inch single-sheet paper only. There must be two Forms W-2
(Copy A) printed on a page. There must be no horizontal perforations between the two Forms
W-2 (Copy A) on each page.

2\. All forms and data must be printed in nonreflective black ink only.

3\. The data and forms must be programmed to print simultaneously. Forms cannot be produced
separately from wage data entries.

4\. The forms must not contain corner register marks.

5\. The forms must not contain any shaded areas, including those boxes that are entirely shaded
on the red-ink forms.

6\. Identifying numbers on both Form W-2 ("22222") and Form W-3 ("33333") must be
preprinted in 14-point Arial bold font or a close approximation.

7\. The form numbers ("W-2" and "W-3") must be in 18-point Arial font or a close approxima-
tion. The tax year (for example, "2016") on Forms W-2 (Copy A) and W-3 must be in 20-point
Arial font or a close approximation.

8\. No part of the box titles or the data printed on the forms may touch any of the vertical or
horizontal lines, nor should any of the data intermingle with the box titles. The data should be
centered in the boxes.

9\. Do not print any information in the margins of the substitute black-and-white Copy A and W-3
forms (for example, do not print "DO NOT STAPLE" in the top margin of Form W-3).

10\. The word "Code" must not appear in box 12 on Form W-2 (Copy A).

11\. A 4-digit vendor code preceded by four zeros and a slash (for example, 0000/9876) must
appear in 12-point Arial font, or a close approximation, under the tax year in place of the Cat. No.
on Form W-2 (Copy A) and in the bottom right corner of the "For Official Use Only" box at the
bottom of Form W-3. Do not display the form producer's EIN to the left of "Department of the
Treasury." The vendor code will be used to identify the form producer.

12\. Do not print Catalog Numbers (Cat. No.) on either Form W-2 (Copy A) or Form W-3.

13\. Do not print the checkboxes in:

· Box 13 of Form W-2 (Copy A). The "X" should be programmed to be printed and centered
directly below the applicable box title.

14\. Do not print dollar signs. If there are no money amounts being reported, the entire field should
be left blank.

15\. The space between the two Forms W-2 (Copy A) is 1.33 inches.

.02 You must submit samples of your substitute black-and-white Copy A and W-3 forms to the
SSA. Only black-and-white substitute Forms W-2 (Copy A) and W-3 for tax year 2016 will be
accepted for approval by the SSA. Questions regarding other red-ink forms (that is, red-ink Forms
W-2c, W-3c, 1099 series, 1096, etc.) must be directed to the IRS only.

.03 You will be required to send one set of blank and one set of dummy-data substitute
black-and-white Copy A and W-3 forms for approval. Sample data entries should be filled in to
the maximum length for each box entry, preferably using numeric data or alpha data, depending
upon the type required to be entered. Include in your submission the name, telephone number, fax
number, and email address of a contact person who can answer questions regarding your sample
forms.

.04 To receive approval, you may first contact the SSA at copy.a.forms@ssa.gov to obtain a
template and further instructions in PDF or Excel format. You may also send your 2016 sample
substitute black-and-white Copy A and W-3 forms to:

Social Security Administration
Direct Operations Center
Attn: Substitute Black-and-White Copy A Forms, Room 341
1150 E. Mountain Drive
Wilkes-Barre, PA 18702-7997

Send your sample forms via private mail carrier or certified mail in order to verify their receipt.
You can expect approval (or disapproval) by the SSA within 30 days of receipt of your sample
forms.

.05 The 4-digit vendor code preceded by four zeros and a slash (0000/9876) must be preprinted
on the sample substitute black-and-white Copy A and W-3 forms. Forms not containing a vendor
code will be rejected and will not be submitted for testing or approval. If you have a valid vendor
code provided to you through the National Association of Computerized Tax Processors, you
should use that code. If you do not have a valid vendor code, contact the Social Security
Administration at copy.a.forms@ssa.gov to obtain an SSA-issued code. (Additional information
on vendor codes may be obtained from the SSA or the National Association of Computerized Tax
Processors (NACTP) via email at president@nactp.org.)

Note. Vendor codes from the NACTP are required by those companies producing the W-2
family of forms as part of a product for resale to be used by multiple employers and payroll
professionals. Employers developing Forms W-2 or W-3 to be used only for their individual
company require a vendor code issued by Social Security Administration.

.06 If you use forms produced by a vendor and have questions concerning approval, do not
send the forms to the SSA for approval. Instead, you may contact the software vendor to obtain
a copy of SSA's dated approval notice supplied to that vendor.

.07 In response to feedback from the user community, the SSA (and the IRS) have added a 2-D
barcoded version for the substitute Form W-2 and Form W-3 to the list of acceptable submission
formats. This version is an optional alternative to the non-barcoded substitute Forms W-2 and
W-3. Both versions are fully supported by the SSA. At this time, neither the IRS nor the SSA
mandates the use of 2-D barcoded substitute forms.

Note. The data contained in the barcode must not differ from the data displayed on the form. If
they differ, the data in the barcode will be ignored and the data displayed on the form will be
considered the submission. This also occurs when the barcode is not read correctly. The
information on the form needs to be manually keyed into the database.

To get the barcode information:

· See the SSA's BSO website at www.socialsecurity.gov/bso,

· Get the PDF version of the specifications at copy.a.forms@ssa.gov,

· Download the substitute W3/W2 2-D barcoding standards from www.socialsecurity.gov/
employer/subBarCodeStd.pdf.

If you are using a form produced by another vendor that contains a 2-D barcode, you must submit
the form for approval using your own NACTP code. Prior to sending your first submission for
approval, contact the SSA at copy.a.forms@ssa.gov to register your NACTP code and explain
what forms you want to submit.

### Section 2.3 - Requirements for Substitute Forms Furnished to Employees (Copies B, C, and 2 of Form W-2)

Note. Rules in Section 2.3 apply only to employee copies of Form W-2 (Copies B, C, and 2).
Printers are cautioned that the paper filers who send Forms W-2 (Copy A) to the SSA must follow
the requirements in Sections 2.1 and/or 2.2 above.

.01 All employers (including those who file electronically) must furnish employees with at least
two copies of Form W-2 (three or more for employees required to file a state, city, or local income
tax return). The following rules are guidelines for preparing employee copies.

The dimensions of these copies (Copies B, C, and 2), but not Copy A, may differ from the dimensions
of the official IRS form to allow space for reporting additional information, including additional entries
such as withholding for health insurance, union dues, bonds, or charity in box 14. The limitation of a
maximum of four items in box 12 of Form W-2 applies only to Copy A, which is filed with the SSA.

Note. Payee statements (Copies B, C, and 2 of Form W-2) may be furnished electronically if
employees give their consent (as described in Treasury Regulations Section 31.6051-1(j). See
also Publication 15-A, Employer's Supplemental Tax Guide.

.02 The minimum dimensions for employee copies only (not Copy A) of Form W-2 should be
2.67 inches deep by 4.25 inches wide. The maximum dimensions should be no more than 6.50
inches deep by no more than 8.50 inches wide.

Note. The maximum and minimum size specifications in this document are for tax year 2016 only
and may change in future years.

.03 Either horizontal or vertical format is permitted (see Exhibit D).

.04 The paper for all copies must be white and printed in black ink. The substitute Copy B, which
employees are instructed to attach to their federal income tax returns, should be at least 9-pound
paper (basis 17 x 22-500).Other copies furnished to employees should also be at least 9-pound
paper (basis 17 x 22-500) unless a state, city, or local government provides other specifications.

.05 Employee copies of Form W-2 (Copies B, C, and 2), including those that are printed on a
single sheet of paper, must be easily separated. The best method of separation is to provide
perforations between the individual copies. Each copy should be easily distinguished whatever
method of separation is used.

Note. Perforation does not apply to printouts of copies of Forms W-2 that are furnished electronically
to employees (as described in Treasury Regulations Section 31.6051-1(j)). However, these employees
should be cautioned to carefully separate the copies of Form W-2. See Publication 15-A, Employer's
Supplemental Tax Guide, for information on electronically furnishing Forms W-2 to employees.

.06 Interleaved carbon and chemical transfer paper employee copies must be clearly legible.
Fading must be minimized to assure legibility.

.07 The electronic tax logo on the IRS official employee copies is not required on any of the
substitute form copies. To avoid confusion and questions by employees, employers are encour-
aged to delete the identifying number ("22222") from the employee copies of Form W-2.

.08 All substitute employee copies must contain boxes, box numbers, and box titles that match the
official IRS Form W-2. Boxes that do not apply can be deleted. However, certain core boxes must
be included. The placement, numbering, and size of this information is specified as follows:

. The core boxes must be printed in the exact order shown on the official IRS form. The items and
box numbers that constitute the core data are:

Box 1 - Wages, tips, other compensation,

Box 2 - Federal income tax withheld,

Box 3 - Social security wages,

Box 4 - Social security tax withheld,

Box 5 - Medicare wages and tips, and

Box 6 - Medicare tax withheld.

· The core data boxes (1 through 6) must be placed in the upper right of the form. Substitute
vertical-format copies may have the core data across the top of the form. Boxes or other
information will definitely not be permitted to the right of the core data.

· The form title, number, or copy designation (B, C, or 2) may be at the top of the form. Also,
a reversed or blocked-out area to accommodate a postal permit number or other postal
considerations is allowed in the upper right.

· Boxes 1 through 6 must each be a minimum of 11/8 inches wide x 1/4 inch deep.

· Other required boxes are:

a) Employee's social security number,

b) Employer identification number (EIN),

c) Employer's name, address, and ZIP code,

e) Employee's name, and

f) Employee's address and ZIP code.

Identifying items must be present on the form and be in boxes similar to those on the official IRS
form. However, they may be placed in any location other than the top or upper right. You do not
need to use the lettering system (a-c,e-f) used on the official IRS form. The employer identifi-
cation number (EIN) may be included with the employer's name and address and not in a separate
box.

Note. Box d ("Control number") is not required.

.09 All copies of Form W-2 furnished to employees must clearly show the form number, the form
title, and the tax year prominently displayed together in one area of the form. The title of Form
W-2 is "Wage and Tax Statement." It is recommended (but not required) that this be located on
the bottom left of substitute Forms W-2. The reference to the "Department of the Treasury -
Internal Revenue Service" must be on all copies of substitute Forms W-2 furnished to employees.
It is recommended (but not required) that this be located on the bottom right of Form W-2.

.10 If the substitute employee copies are labeled, the forms must contain the applicable descrip-
tion:

· "Copy B, To Be Filed With Employee's FEDERAL Tax Return."

· "Copy C, For EMPLOYEE'S RECORDS."

· "Copy 2, To Be Filed With Employee's State, City, or Local Income Tax Return."

It is recommended (but not required) that these be located on the lower left of Form W-2. If the
substitute employee copies are not labeled as to the disposition of the copies, then written
notification using similar wording must be provided to each employee.

.11 The tax year (for example, 2016) must be clearly printed on all copies of substitute Form W-2.
It is recommended (but not required) that this information be in the middle at the bottom of the
Form W-2. The use of 24-pt. OCR-A font is recommended (but not required).

.12 Boxes 1 and 2 (if applicable) on Copy B must be outlined in bold 2-point rule or highlighted
in some manner to distinguish them. If "Allocated tips" are being reported, it is recommended
(but not required) that box 8 also be outlined. If reported, "Social security tips" (box 7) must be
shown separately from "Social security wages" (box 3).

Note. Boxes 8 and 9 may be omitted if not applicable.

.13 If employers are required to withhold and report state or local income tax, the applicable
boxes are also considered core information and must be placed at the bottom of the form. State
information is included in:

· Box 15 (State, Employer's state ID number)

· Box 16 (State wages, tips, etc.)

· Box 17 (State income tax)

Local information is included in:

· Box 18 (Local wages, tips, etc.)

· Box 19 (Local income tax)

· Box 20 (Locality name)

.14 Boxes 7 through 14 may be omitted from substitute employee copies unless the employer
must report any of that information to the employee. For example, if an employee did not have
"Social security tips" (box 7), the form could be printed without that box. But if an employer
provided dependent care benefits, the amount must be reported separately, shown in box 10, and
labeled "Dependent care benefits."

.15 Employers may enter more than four codes in box 12 of substitute Copies B, C, and 2 (and
1 and D) of Form W-2, but each entry must use Codes A-EE (see the 2016 General Instructions
for Forms W-2 and W-3).

.16 If an employer has employees in any of the three categories in box 13, all checkbox headings
must be shown and the proper checkmark made, when applicable.

.17 Employers may use box 14 for any other information that they wish to give to their
employees. Each item must be labeled. (See the instructions for box 14 in the 2016 General
Instructions for Forms W-2 and W-3.)

.18 The front of Copy C of a substitute Form W-2 must contain the note "This information is
being furnished to the Internal Revenue Service. If you are required to file a tax return, a
negligence penalty or other sanction may be imposed on you if this income is taxable and you fail
to report it."

.19 Instructions similar to those contained on the back of Copies B, C, and 2 of the official IRS
Form W-2 must be provided to each employee. An employer may modify or delete instructions
that do not apply to its employees. (For example, remove Railroad Retirement Tier 1 and Tier 2

compensation information for nonrailroad employees or information about dependent care ben-
efits that the employer does not provide.)

.20 Employers must notify their employees who have no income tax withheld that they may be
able to claim a tax refund because of the earned income credit (EIC). They will meet this
notification requirement if they furnish a substitute Form W-2 with the EIC notice on the back
of Copy B, IRS Notice 797, Possible Federal Tax Refund Due to the Earned Income Credit (EIC),
or on their own statement containing the same wording. They may also change the font on Copies
B, C, and 2 so that the EIC notification and Form W-2 instructions fit differently. For more
information about notification requirements, see Notice 1015, "Have You Told Your Employees
About the Earned Income Credit (EIC)?"

Note. An employer does not have to notify any employee who claimed exemption from
withholding on Form W-4, Employee's Withholding Allowance Certificate, for the calendar
year.

#### Section 2.4 - Electronic Delivery of Form W-2 and W-2c Recipient Statements

.01 If you are required to furnish a written statement (Copy B or an acceptable substitute) to a
recipient, then you may furnish the statement electronically instead of on paper. This includes
furnishing the statement to recipients of Forms W-2 and W-2c.

If you meet the requirements listed below, you are treated as furnishing the statement timely.

.02 The recipient must consent in the affirmative and not have withdrawn the consent before the
statement is furnished. The consent by the recipient must be made electronically in a way that
shows that he or she can access the statement in the electronic format in which it will be furnished.

You must notify the recipient of any hardware or software changes prior to furnishing the
statement. A new consent to receive the statement electronically is required after the new
hardware or software is put into service.

Prior to furnishing the statement electronically, the employer must provide to the employee a clear
and conspicuous disclosure statement containing each of the disclosures described in Treasury
Regulations Section 31.6051-1 or Publication 15-A.

· If the recipient does not consent to receive the statement electronically, a paper copy will be
provided.

· The scope and duration of the consent. For example, whether the consent applies to every year the
statement is furnished or only until January 31 immediately following the date of the consent.

· How to obtain a paper copy after giving consent.

· How to withdraw the consent. The consent may be withdrawn at any time by furnishing the
withdrawal in writing (electronically or on paper) to the person whose name appears on the
statement. Confirmation of the withdrawal also will be in writing (electronically or on paper).

· Notice of termination. The notice must state under what conditions the statements will no longer
be furnished to the recipient.

· Procedures to update the recipient's information.

· A description of the hardware and software required to access, print and retain a statement, and a
date the statement will no longer be available on the website.

.03 Additionally, you must:

· Ensure the electronic format contains all the required information and complies with the guidelines
in this document.

· If posting the statement on a website, post it for the recipient to access on or before the January 31 due
date through October 15 of that year.

· Inform the recipient, in person, electronically or by mail, of the posting and how to access and print
the statement.

## Part 3 Additional Instructions

### Section 3.1 - Additional Instructions for Form Printers

.01 If electronic media is not used for filing with the SSA, the substitute copies of Forms W-2
(either red-ink or substitute black-and-white forms) should be assembled in the same order as the
official IRS Forms W-2. Copy A should be first, followed sequentially by perforated sets (Copies
1, B, C, 2, and D).

.02 The substitute form to be filed by the employer with the SSA must carry the designation
"Copy A."

Note. Electronic filers do not submit either red-ink or substitute black-and-white paper Form W-2
(Copy A) or Form W-3 to the SSA.

.03 Substitute forms (red-ink or substitute black-and-white Copy A or W-3) do not require a copy
to be retained by employers (Copy D of Form W-2). However, employers must retain copies of
the Forms W-2 filed with SSA or have the ability to reconstruct the data for at least four years.
Employers must be able to generate a facsimile of Form W-2 (Copy A), in case of loss.

.04 Except for copies in the official assembly, no additional copies that may be prepared by
employers should be placed ahead of Form W-2 (Copy C) "For EMPLOYEE'S RECORDS."

.05 You must provide instructions similar to those contained on the back of Copies B, C, and 2
of the official IRS Form W-2 to each employee. You may print them on the back of the substitute
Copies B, C, and 2 or provide them to employees on a separate statement. You do not need to use
the back of Copy 2. If you do not use Copy 2, you may include all the information that appears
on the back of the official Copies B, C, and 2 on the back of your substitute Copies B and C only.
As an example, you may use the "Note" on the back of the official Copy C as the dividing point
between the text for your substitute Copies B and C. Do not print these instructions on the back
of Copy 1. Any Forms W-2 (Copy A) and W-3 that are filed with the SSA must have no printing
on the reverse side.

### Section 3.2 - Instructions for Employers

.01 Only originals of Form W-2 (Copy A) and Form W-3 may be filed with the SSA. Carbon
copies and photocopies are unacceptable.

.02 Employers should type or machine-print data entries on plain paper forms whenever possible.
Ensure good quality by using a high-quality type face, inserting data in the middle of blocks that are
well separated from other printing and guidelines, and taking any other measures that will guarantee
clear, sharp images. Black ink must be used with no script type, inverted font, italics, or dual-case
alpha characters.

Note. 12-point Courier font is preferred by the SSA.

.03 Form W-2 (Copy A) requires decimal entries for wage data. Do not print dollar signs with
money amounts on Forms W-2 (Copy A) and W-3.

.04 The employer must provide a machine-scannable Form W-2 (Copy A). The employer must also
provide employee copies (Copies B, C, and 2) that are legible and able to be photocopied (by the
employee). Do not print any data in the top margin of the payee copies of the forms.

.05 Any printing in box d (Control number) on Form W-2 or box a on Form W-3 may not touch any
vertical or horizontal lines and should be centered in the box.

.06 The filer's employer identification number (EIN) must be entered in box b of Form W-2 and
box e of Form W-3. The EIN entered on Form(s) W-2 (box b) and Form W-3 (box e) must be
the same as on Forms 941, 941-SS, 943, 944, CT-1, Schedule H (Form 1040), or any other
corresponding forms filed with the IRS. Be sure to use EIN format (00-0000000) rather than SSN
format (000-00-0000).

.07 The employer's name, address, and EIN may be preprinted.

### Section 3.3 - OMB Requirements for Both Red-Ink and Black-and-White Copy A and W-3 Substitute Forms

.01 The Paperwork Reduction Act (the Act) of 1995 (Public Law 104-13) requires the following:

· The Office of Management and Budget (OMB) approves all IRS tax forms that are subject to the
Act.

· Each IRS form contains (in or near the upper right corner) the OMB approval number, if assigned.
(The official OMB numbers may be found on the official IRS printed forms and are also shown
on the forms in Exhibits A, B, C, E, and F.)

· Each IRS form (or its instructions) states:

1\. Why the IRS needs the information,

2\. How it will be used, and

3\. Whether or not the information is required to be furnished to the IRS.

.02 This information must be provided to any users of official or substitute IRS forms or
instructions.

.03 The OMB requirements for substitute IRS Form W-2 (Copy A) and Form W-3 are the
following.

· Any substitute form or substitute statement to a recipient must show the OMB number as it
appears on the official IRS form.

· The OMB number (1545-0008) must appear exactly as shown on the official IRS form.

. For any copy of Form W-2 other than Copy A, the OMB number must use one of the following
formats:

1\. OMB No. 1545-xxxx (preferred) or

2\. OMB # 1545-xxxx (acceptable).

.04 Any substitute Form W-2 (Copy A only) and Form W-3 must state "For Privacy Act and
Paperwork Reduction Act Notice, see the separate instructions." If no instructions are provided
to users of your forms, you must furnish them with the exact text of the Privacy Act and
Paperwork Reduction Act Notice.

### Section 3.4 - Order Forms and Instructions

.01 You can order IRS Forms W-2, Forms W-3, the General Instructions for Forms W-2 and
W-3, and other tax material, online at IRS.gov. Click on the Forms and Pubs link and then the
Order Forms and Pubs link or by clicking on www.irs.gov/businesses and then the Online
Ordering for Information Returns and Employer Returns link.

.02 Copies of Form W-2 (Copy A) and Form W-3 downloaded from IRS.gov cannot be used for
filing with the SSA. These copies of Forms W-2 and W-3 are for information purposes only.

### Section 3.5 - Effect on Other Documents

.01 Publication 1141, Revised 10-2015, is superseded.

### Section 3.6 - Exhibits

Exhibits A through F provide the general measurements for Forms W-2 and W-3 as discussed
in this revenue procedure. Certain exhibits show a 0000/ in the location designated for your
vendor code. See Section 2.2.01, item 11, and Section 2.2.05 for more information.

Exhibit A - Form W-2 (Copy A) (Red-Ink) 2016

Exhibit B - Form W-2 (Copy B) 2016

Exhibit C - Form W-3 (Red-Ink) 2016

Exhibit D - Form W-2 (Copy A) (Substitute Black-and-White) 2016

Exhibit E - Form W-3 (Substitute Black-and-White) 2016

Exhibit F - Form W-2 Alternative Employee Copies (Illustrating Horizontal and
Vertical Formats)

### Exhibit A

22222

14 in Void a .44 in

Employee's social security

number

For Official Use Only . OMB No. 1545-0008

33 in

b Employer identification number (EIN)

1 Wages

tips, other compensation

2 Federal income tax withheld

c Employer's name, address, and ZIP code

5.50 in

3 Social

security wages

4 Social security tax withheld

5 Medicare

wages and tips

6 Medicare tax withheld

7 Social

security tips

8 Allocated tips

d Control number

4.17 in

10 Dependent care benefits

e Employee's first name and initial

Last name

Suff.

Nonqualified plans

12a See instructions for box 12 .

f Employee's address and ZIP code

13 Statutor employe ☐

Hetrement Bian Third-party sicik pay ☒ ☐

12b 50 in

14 Other

.14 in

12c

12d 33 in

15 State

Employer's state ID number

16 8 State wages,

ps, etc.

17 State income tax 1

Local wages, tips, etc.

19 Local in

me tax

20 Locality name

.67 in

7.50 in

50 in

.10 in

.50 in

Form
W-2
Wage and Tax Statement

2016

Department of the Treasu y-Internal Revenue Service
For Privacy Act and Paperwork Reduction
Act Notice, set the separate instructions.

Copy A For Social Security Administration - Send this entire page with
Form W-3 to the Social Security Administration; photocopies are not acceptable.

Do Not Cut, Fold, or Staple Forms on This Page

Cat. No. 10134D
1.33 in

.90 in

.70 in
1.80 in

22222
☐
Void

a Employee's social security number

For Official Use Only
UMB NO. 1545-0008

4.10 in

b Employer identification number (EIN)

Wages. tips. other compensation
1

2 Federal income tax withheld

c Employer's name, address, and ZIP code

3 Social security wages

4
Social security tax withheld

4.10 in

5 Medicare wages and tips
1.70 in

6 Medicare tax withheld
1.70 in

7 Social security tips

8 Allocated tips

d Control number

10
0 Dependent care benefits

.30 in

e Employee's first name and initial

Last name

S
uff.

1.90 in

1.90in

11 Nonqualified plans
.36 in

12a See instructions for box 12

24 in

.36 in

.32 in

2.20in

Statutory

employee

Retiremer
plan

Third pa

siçik, pay

12b

14 Other

12c

:
.50 in

12d

f Employee's address and ZIP code
15 State

Employer's state ID number
2.20 in

16 State wages, tips, etc.
1.20 in

State income tax

Local wages, tips, etc.

19
Local income tax

1.10 in

1.20 in

1.10 in

Locality name
70 in

40 in

Form
W-2
Wage and Tax Statement

2016

Department of the Treasury-Internal Revenue Service
For Privacy Act and Paperwork Reduction
Act Notice, see the separate instructions.

Copy A For Social Security Administration - Send this entire page with
Form W-3 to the Social Security Administration; photocopies are not acceptable.

Cat. No. 10134D

# Exhibit B

a Employee's social security number

Safe, accurate, Rse + file Visit the IRS (website at OMB No. 1545-0008 FAST! Use www.irs.gov/efile

b Employer identification number (EIN)

1 Wages, tipa, other compensation

2 Federal income tax withheld

c Employer's name, address, and ZIP code

3 Social security wages

4 Social security tax withhoki

5 Medicare wages and tips

6 Medicare tax withheld

7 Social security tips

8 Allocated tips

d Control number

10 Dependent care benefits

e Employee's first name and initial Last name Suff f Employee's address and ZIP code

11 Nonqualified plans

12a See instructions for box 12

13 Statutory employee Pietrement plan Theo-Dity ☐ ☐ ☐

12b 8

14 Other

12c S

2 12d

15 State

Employer's state ID number

16 State wages, tips, etc.

17 State income tax

18 Local wages, tips, etc

19 Local income tax

20 Locality name

Form
W-2
Wage and Tax
Statement
2016
0000/

Department of the Treasury- Internal Revenue Service

Copy B-To Be Filed With Employee's FEDERAL Tax Return.
This information is being furnished to the Intemal Revenue Service.

## Exhibit C

Form W-3 (Red Ink)

7.50 in

.50 in

DO NOT STAPLE

33333

Control number

For Off

ial Use Only-

5.00 in

.85 in

1.65 in

OMBN
1545-0008

b
Kind

of
Payer
(Check one)

941
☐
CT-1
☐
.36 in

Military
☐
Hshld

943
☐
Medicare
govt emp
☐

36 in

944
☐

Kind
of
Employer
(Check one)

None apply
☐
State/local
non-5010
☐

5010 non-govt.
☐

Third-party
sick pay
(Check it
applicable)

1.20 in

50 in

emp

☐

State/local 5010
☐
Federal govt
☐

c Total number of Forms W-2
1.60 in

d Establishment number
1.60 in

1 Wages, tips. other compensation

2 Federal income tax withheld
.14 in

.50 in

· Employer identification number (EIN)

3 Social security wages

4 Social security tax withheld

f Employer's name

5 Medicare wages and tips

6 Medicare tax withheld

4.67 in

7 Social security tips
2.15 in

8 Allocated tips

2.15 in

3.20 in

10 Dependent care benefits

11 Nonqualified plans

12a Deferred compensation

g Employer's address and ZIP code

h Other EIN used this year

13 For third-party sick pay use only

12b

15 State

Employer's state ID number

14 Income tax withheld by payer of third-party sick pay

Under penalties of perjury. I declare that I have examined this return and accompanying documents and, to the best of my knowledge and belief, they are true, correct, and
complete

.50 in

Signature

Title

Date

Form
W-3 Transmittal of Wage and Tax Statements

2016

Department of the Treasury
Internal Revenue Service

Send this entire page with the entire Copy A page of Form(s) W-2 to the Social Security Administration (SSA).
Photocopies are not acceptable. Do not send Form W-3 if you filed electronically with the SSA.
Do not send any payment (cash, checks, money orders, etc.) with Forms W-2 and W-3.

Reminder

Separate instructions. See the 2016 General Instructions for Forms
W-2 and W-3 for information on completing this form. Do not file Form
W-3 for Form(s) W-2 that were submitted electronically to the SSA.

Purpose of Form

A Form W-3 Transmittal is completed only when paper Copy A of
Form(s) W-2, Wage and Tax Statement, is being filed. Do not file Form
W-3 alone. All paper forms must comply with IRS standards and be
machine readable. Photocopies are not acceptable. Use a Form W-3
even if only one paper Form W-2 is being filed. Make sure both the Form
W-3 and Form(s) W-2 show the correct tax year and Employer
Identification Number (EIN). Make a copy of this form and keep it with
Copy D (For Employer) of Form(s) W-2 for your records. The IRS
recommends retaining copies of these forms for four years.

5.33in

When To File
Mail Form W-3 with Copy A of Forin(s) W-2 by January 31, 2017.
Where To File Paper Forms

E-Filing

The SSA strongly suggests employers report Form W-3 and Forms W-2
Copy A electronically instead of on paper. The SSA provides two free
e-filing options on its Business Services Online (BSO) website:

Send this entire page with the entire Copy A page of Form(s) W-2 to:

. W-2 Online. Use fill-in forms to create, save, print, and submit up to
50 Forms W-2 at a time to the SSA.

. File Upload. Upload wage files to the SSA you have created using
payroll or tax software that formats the files according to the SSA's
Specifications for Filing Forms W-2 Electronically (EFW2).

Social Security Administration
Direct Operations Center
Wilkes-Barre, PA 18769-0001

W-2 Online fill-in forms or file uploads will be on time if submitted by
January 31, 2017. For more information, go to www.socialsecurity.gov/
employer. First time filers, select "Go to Register"; returning filers select
"Go To Log in."

Note: If you use "Certified Mail" to file, change the ZIP code to
"18769-0002." If you use an IRS-approved private delivery service, add
"ATTN: W-2 Process, 1150 E. Mountain Dr." to the address and change
the ZIP code to "18702-7997." See Publication 15 (Circular E),
Employer's Tax Guide, for a list of RS-approved private delivery
services.

For Privacy Act and Paperwork Reduction Act Notice, see the separate instructions.

60 in 2.60 in

16 State wages, tips, eto.

17 State income tax

18 Local wages, tips, eto

19 Local income tax 33 in

Employer's contact person

Employer's telephone number

For Official Use Only

Employer's fax number

Employer's email address

# Exhibit D

.90 in

.70 in

1.80 in

22222

Void ☐

Employes's socke security Hunsen For OMB

Official Use Only No. 1545-0008

b Employer identification number

(IN)

1 Wages, tipo, other con

pensation

2 Federal income tax withhold

c Employer's name, address, and ZIP code

3 Social security wage

4 Social security tax withheld

5 Medicare wages and

tips

6 Medicare tax withheld

7 Social security tips

8 Allocated tips

d Control number

4.17 in

10 Dependent care benefits

e Employee's first name and initial

Last name

Suff

11 1 Nonqualified plans

12a See instructions for box 12

13 Statutory employee Hetrement plan ☐ ☐

Third-party sick pay ☐

12b 4

14 Other

12G

12d

f Employee's address and ZIP code

.50 in

15 State

Employer's state ID number

16 State wages, tips, etc.

17
7 State income tax

Local wages,

ips, eto

19
Local income tax
20

Locality name

.40 in

1.80 in

1.20 in

1.10 in

1.20 ir

1.10 in

.70 in

Form
W-2
Wage and Tax Statement

2016

Copy A For Social Security Administration - Send this entire page with 0000/
Form W-3 to the Social Security Administration; photocopies are not acceptable.

Do Not Cut, Fold, or Staple Forms on This Page

1.33 in

Departnight of the Treasury-Internal Revenue Service
For Privacy Act and Paperwork Reduction
Act Notice, see the separate instructions.
83 in

.50 in

22222

Void ☐

a Employee's social security number For OMB

Official Use Only No. 1545-0008

b Employer identification number (EIN)

1 Wages, tipe, other compensation

2 Federal income tax withheld

c Employer's name, address, and ZIP code

3 Social security wages

4 Social security tax withhold

5 Medicare wages and tips

6 Medicare tax withheld

7 Social security tips

8 Allocated tips

d Control number

10 Dependent care benefits

e Employee's first name and initial

Last name

Suff

11 Nonqualified plans

12a See instructions for box 12

13 Wautory employee Resrement plan Third-party siok pay ☐ ☐ ☐

12b A

14 Other

12c C

B 12d 4

f Employee's address and ZIP code

15 State

Employer's state ID number

16 State wages, tips, etc.

17 State income tax

18 Local wages, tips, etc.

19 Local income tax

20 Locality name

Form
W-2
Wage and Tax Statement

2016

Department of the Treasury-Internal Revenue Service
For Privacy Act and Paperwork Reduction
Act Notice, see the separate instructions.

Copy A For Social Security Administration - Send this entire page with 0000/
Form W-3 to the Social Security Administration; photocopies are not acceptable.

50 in

.50 in

33333

a Control number

For Official Use Only OMB No. 1545-0008 .67 in

b 941 Military 943 944 Kind ☐ 36 in ☐ 36 in ☐ .36 in ☐ 36 in

None apply 501c non-govt Third-party

Kind 1.40 in 55 in 1.25 in ☐ ☐ sick pay

Of Payer (Check one)

CT-1

Hshld emp Medicare govt. emp

OT Employer Statelocal non-501c State/local 5010 Federal govt (Check if applicable)

☐

☐ ☐

(Check one) ☐

☐ 66 in ☐ ☐

c Total number of Forms W-2

d Establishment number

1 Wages, tips, other compensation

2 Federal income tax withheld

e Employer identification number (EIN)

3 Social security wages

4 Social security tax withheld

Employer's name

5 Medicare wages and tips

6 Medicare tax withheld

1.00 in g Employer's address and ZIP code

7 Social security tips

8 Allocated tips

10 Dependent care benefits

11 Nonqualified plans

12a Deferred compensation

h Other EIN used this year

13 For third-party sick pay use only

12b

15 State

Employer's state ID number

14 Income tax withheld by payer of third-party sick pay

16 State wages, tips, etc

17 State income tax

18 Local wages, tips, etc

19 Local income tax

Employer's contact person 3.20 in

Employer's telephone number

For Official Use Only 33 in

2.15 in

Employer's fax number

Employer's email address 4.30 in

DO NOT STAPLE

1.20 in

Under penalties of perjury, I declare that I haveexamined this return and accompanying documents and, to the best of my knowledge and belief, they are true, correct, and
complete

.50 in

Signature

Title

Date

Form
W-3 Transmittal of Wage and Tax Statements

2016
Department of the Treasury
Internal Revenue Service

Reminder

## Purpose of Form

When To File
Mail Form W-3 with Copy A of Form(s) W-2 by January 31, 2017.
Where To File Paper Forms
Send this entire page with the entire Copy A page of Form(s) W-2 to:
Social Security Administration
Direct Operations Center
Wilkes-Barre, PA 18769-0001

## E-Filing

The SSA strongly suggests employers report Form W-3 and Forms W-2
Copy A electronically instead of on paper. The SSA provides two free
e-filing options on its Business Services Online (BSO) website:
. W-2 Online. Use fill-in forms to create, save, print, and submit up to
50 Forms W-2 at a time to the SSA.

. File Upload. Upload wage files to the SSA you have created using
payroll or tax software that formats the files according to the SSA's
Specifications for Filing Forms W-2 Electronically (EFW2).

For Privacy Act and Paperwork Reduction Act Notice, see the separate instructions.

a Employee's social security number

Safe, accurate, FAST! Use RS e + file Visit the IRS website at OMB No. 1545-0008 www.irs.gov/efile

b Employer identification number (EIN)

1 Wages, tips, other compensation

2 Federal income tax withheld

c Employer's name, address, and ZIP code

3 Social security wages

4 Social security tax withhold

5 Medicare wages and tips

6 Medicare tax withheld

7 Social security tips

8 Allocated tips

d Control number

10 Dependent care benefits

e Employee's first name and initial Last name f Employee's address and ZIP code

Suff.

11 Nonqualified plans

12a See instructions for box 12

13 Statutory employee Retirement Third-party plan s ** pay ☐ ☐ ☐

12b % =

14 Other

12c S

12d

15 State

Employer's state ID number

16 State wages, tips, etc.

17 State income tax

18 Local wages, tips, etc.

19 9 Local income tax

20 Locality name

Form
W-2
Wage and Tax
Statement

2016
0000/

Department of the Treasury-Internal Revenue Service

Copy B-To Be Filed With Employee's FEDERAL Tax Return.
This information is being furnished to the Intemal Revenue Service.

Wages, tips, other compensation
1

2
Federal income tax withheld

3 Social security wages

4 Social secunty tax withheld

5 Medicare wages and tips

6 Medicare tæ; withheld

Employee's social security number

Employer identification number (EIN)

Employer's name, address and, ZIP code

Employee's name

Employes's address and ZIP code

16 34 Employer's state ID number

18 Local wages, tips, etc

16 State wages, tipo, efc

19 Local income tax

17 State income fax:

20 Localty name

Copy B To Be Filed With Employee's FEDERAL Tax Return.

Form W-2
Wage and Tax
Ştaternerif

2016
0000/

Department of the Treasury-
Internal Revenue Service

Note: Exhibit F displays examples of how Form W-2
Copy B can be furnished to employees. Copy B can
be furnished in horizontal or vertical format.
Specifications and requirements for employee
copies can be found in Section 2.3 - Requirements
for Substitute Forms Furnished to Employees
(Copies B, C, and 2 of Form W-2).

Although employee copies can be manipulated,
Section 2.3 has specific requirements for core data
boxes that must be present on substitute employee
copies.

## 26 CFR 601.602: Tax forms and instructions.

(Also Part I, §§ 1, 23, 25A, 32, 36B, 42, 45R, 55, 59, 62, 63, 68, 125, 132(f), 135, 137, 146, 147, 148, 151, 179, 213, 220, 221, 512, 513, 831, 877, 877A, 911, 2010,
2032A, 2503, 2523, 4161, 4261, 5000A, 6033, 6039F, 6323, 6334, 6601, 6651, 6652, 6695, 6698, 6699, 6721, 6722, 7345, 7430, 7702B; 1.148-5.)

# Rev. Proc. 2016-55

Table of Contents

## SECTION 1. PURPOSE

SECTION 2. CHANGES

## SECTION 3. 2017 ADJUSTED ITEMS

Code Section

.01 Tax Rate Tables

1(a)-(e)

.02 Unearned Income of Minor Children Taxed as if Parent's Income ("Kiddie Tax").

1(g)

.03 Adoption Credit

.04 Lifetime Learning Credit

25A

.05 Earned Income Credit

.06 Refundable Credit for Coverage Under a Qualified Health Plan

36B(f)(2)(B)

.07 Rehabilitation Expenditures Treated as Separate New Building

42(e)

.08 Low-Income Housing Credit

42(h)

.09 Employee Health Insurance Expense of Small Employers

45R

.10 Exemption Amounts for Alternative Minimum Tax

.11 Alternative Minimum Tax Exemption for a Child Subject to the "Kiddie Tax"

59(j)

.12 Certain Expenses of Elementary and Secondary School Teachers

62(a)(2)(D)

.13 Transportation Mainline Pipeline Construction Industry Optional Expense Substantiation Rules for Payments to Employees under Accountable Plans

62(c)

.14 Standard Deduction

.15 Overall Limitation on Itemized Deductions

.16 Cafeteria Plans

125

.17 Qualified Transportation Fringe Benefit

132(f)

.18 Income from United States Savings Bonds for Taxpayers Who Pay Qualified Higher Education Expenses

135

.19 Adoption Assistance Programs

137

.20 Private Activity Bonds Volume Cap

146(d)

.21 Loan Limits on Agricultural Bonds

147(c)(2)

.22 General Arbitrage Rebate Rules

148(f)

.23 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow

148

.24 Personal Exemption

151

.25 Election to Expense Certain Depreciable Assets

179

.26 Eligible Long-Term Care Premiums

213(d)(10)

.27 Medical Savings Accounts

220

.28 Interest on Education Loans

221

.29 Treatment of Dues Paid to Agricultural or Horticultural Organizations

512(d)

.30 Insubstantial Benefit Limitations for Contributions Associated With Charitable Fund-Raising Campaigns

513(h)

.31 Tax on Insurance Companies Other than Life Insurance Companies

831

.32 Expatriation to Avoid Tax

877

.33 Tax Responsibilities of Expatriation

877A

Code Section

.34 Foreign Earned Income Exclusion

911

.35 Unified Credit Against Estate Tax

2010

.36 Valuation of Qualified Real Property in Decedent's Gross Estate

2032A

.37 Annual Exclusion for Gifts

2503; 2523

.38 Tax on Arrow Shafts

4161

.39 Passenger Air Transportation Excise Tax

4261

.40 Requirement to Maintain Minimum Essential Coverage

5000A

.41 Reporting Exception for Certain Exempt Organizations with Nondeductible Lobbying Expenditures

6033(e)(3)

.42 Notice of Large Gifts Received from Foreign Persons

6039F

.43 Persons Against Whom a Federal Tax Lien Is Not Valid

6323

.44 Property Exempt from Levy

6334

.45 Interest on a Certain Portion of the Estate Tax Payable in Installments

6601(j)

.46 Failure to File Tax Return

6651

.47 Failure to File Certain Information Returns, Registration Statements, etc.

6652

.48 Other Assessable Penalties With Respect to the Preparation of Tax Returns for Other Persons

6695

.49 Failure to File Partnership Return

6698

.50 Failure to File S Corporation Return

6699

.51 Failure to File Correct Information Returns

6721

.52 Failure to Furnish Correct Payee Statements

6722

.53 Revocation or Denial of Passport in Case of Certain Tax Delinquencies

7345

.54 Attorney Fee Awards

7430

.55 Periodic Payments Received under Qualified Long-Term Care Insurance Contracts or under Certain Life Insurance Contracts

7702B(d)

SECTION 4. EFFECTIVE DATE

SECTION 5. DRAFTING
INFORMATION

SECTION 1. PURPOSE

This revenue procedure sets forth
inflation-adjusted items for 2017.

# SECTION 2. CHANGES

.01 Section 101 of the Protecting
Americans from Tax Hikes Act (PATH
Act) of 2015, enacted as part of the Con-
solidated Appropriations Act, 2016, Pub.
L. 114-113, div. Q, made permanent the
earned income threshold of $3,000 used in
§ 24(d)(1)(B)(i) to determine the refund-
able portion of the child tax credit under
§ 24.

.02 Section 102 of the PATH Act made
permanent the enhanced American Op-
portunity Tax Credit under § 25A(i). The
Hope Scholarship Credit under § 25A(b)
(1), as increased under § 25A(i) (the
American Opportunity Tax Credit), is an
amount equal to 100 percent of qualified
tuition and related expenses not in excess

of $2,000, plus 25 percent of those ex-
penses in excess of $2,000, but not in
excess of $4,000. Accordingly, the maxi-
mum Hope Scholarship Credit allowable
under § 25A(b)(1) is $2,500.

.03 Section 103 of the PATH Act made
permanent under § 32 the enhanced
earned income tax credit percentage for an
eligible individual with 3 or more quali-
fying children and the phaseout percent-
ages. The PATH Act also made perma-
nent an increase of $5,000 in the phaseout
amount to reduce the marriage penalty
and the indexing of this amount for infla-
tion.

.04 Section 333 of the PATH Act mod-
ifies the § 831(b) eligibility rules for a
property and casualty insurance company
to elect to be taxed only on taxable invest-
ment income. The provision increases the
amount of the limit on net written premi-
ums or direct written premiums (which-
ever is greater) from $1,200,000 to
$2,200,000 and indexes this amount for
inflation effective for tax years beginning
after December 31, 2016.

.05 Section 202 of the Airport and Air-
ways Extension Act of 2015, Pub. L.

114-55, amended § 4261(k)(1)(A)(ii) of
the Internal Revenue Code (which gov-
erns the period of applicability of
§ 4261(a), 4261(b)(1), (c)(1), and (c)(3)).
The effect of this amendment was to tem-
porarily extend the passenger air transpor-
tation excise taxes of 7.5% on the amount
paid for taxable transportation, $3.00 for
each domestic segment of taxable trans-
portation, $12.00 for amounts paid for any
transportation beginning or ending in the
United States (i.e., international travel),
and $6.00 for each domestic segment be-
ginning or ending in Alaska or Hawaii.
These excise taxes applied to transporta-
tion that began during the period ending
March 31, 2016. Section 202 of the Air-
port and Airway Extension Act of 2016,
Pub. L. 114-141, extended these excise
taxes through July 15, 2016, and Section
1202 of FAA Extension, Safety, and Se-
curity Act of 2016, Pub. L. 114-190, ex-
tended these excise taxes through Septem-
ber 30, 2017.

.06 The Patient Protection and Afford-
able Care Act, Pub. L. 111-148, and the
Health Care and Education Reconciliation
Act of 2010, Pub. L. 111-152 (collec-

tively, the Affordable Car Act) enacted
§ 5000A, Requirement to Maintain Mini-
mum Essential Coverage. For taxable
years beginning in 2014, most individuals
are subject to a penalty for each month for
which they fail to have minimum essential
health coverage for themselves or their
dependents. For calendar years beginning
after 2016, the applicable dollar amount
used to determine the penalty under
§ 5000A(c) for failure to maintain mini-
mum essential coverage is adjusted for
inflation.

.07 Section 921 of the Trade Facilita-
tion and Trade Enforcement Act of 2015,

Pub. L. 114-125, increased the amount of
the additional tax under § 6651(a) for fail-
ure to file a tax return within 60 days of
the due date of such return (determined
with regard to any extensions of time for
filing). For returns required to be filed in
calendar years after 2015, the amount of
the addition tax shall not be less than the
lesser of $205 (increased from $135) or
100 percent of the amount required to
shown as tax on such returns.

.08 Section 32101 of the Fixing Ame-
rica's Surface Transportation Act (FAST
Act) of 2015, Pub. L. 114-94, added
§ 7345, Revocation of Denial of Passport

in Case of Certain Tax Delinquencies, to
the Internal Revenue Code. The provision
applies to a seriously delinquent tax debt,
which generally includes any outstanding
Federal tax liability (including interest
and any penalties) in excess of $50,000
(adjusted for inflation for a calendar year
beginning after 2016) for which a notice
of lien or notice of levy has been filed.

# SECTION 3. 2017 ADJUSTED ITEMS

.01 Tax Rate Tables. For taxable years
beginning in 2017, the tax rate tables un-
der § 1 are as follows:

TABLE 2 - Section 1(b) - Heads of Households

TABLE 1 - Section 1(a) - Married Individuals Filing Joint Returns and Surviving Spouses

If Taxable Income Is:

The Tax Is:

Not over $18,650

10% of the taxable income

Over $18,650 but not over $75,900

$1,865 plus 15% of the excess over $18,650

Over $75,900 but not over $153,100

$10,452.50 plus 25% of the excess over $75,900

Over $153,100 but not over $233,350

$29,752.50 plus 28% of the excess over $153,100

Over $233,350 but not over $416,700

$52,222.50 plus 33% of the excess over $233,350

Over $416,700 but not over $470,700

$112,728 plus 35% of the excess over $416,700

Over $470,700

$131,628 plus 39.6% of the excess over $470,700

If Taxable Income Is:

The Tax Is:

Not over $13,350

10% of the taxable income

Over $13,350 but not over $50,800
Over $50,800 but not over $131,200
Over $131,200 but not over $212,500
Over $212,500 but not over $416,700
Over $416,700 not over $444,550
Over $444,550

$1,335 plus 15% of the excess over $13,350
$6,952.50 plus 25% of the excess over $50,800
$27,052.50 plus 28% of the excess over $131,200
$49,816.50 plus 33% of the excess over $212,500
$117,202.50 plus 35% of the excess over $416,700
$126,950 plus 39.6% of the excess over $444,550

TABLE 3 - Section 1(c) - Unmarried Individuals (other than Surviving Spouses and Heads of Households)

If Taxable Income Is:

The Tax Is:

Not over $9,325

10% of the taxable income

Over $9,325 but not over $37,950

$932.50 plus 15% of the excess over $9,325

Over $37,950 but not over $91,900

$5,226.25 plus 25% of the excess over $37,950

Over $91,900 but not over $191,650

$18,713.75 plus 28% of the excess over $91,900

Over $191,650 but not over $416,700

$46,643.75 plus 33% of the excess over $191,650

Over $416,700 not over $418,400

$120,910.25 plus 35% of the excess over $416,700

Over $418,400

$121,505.25 plus 39.6% of the excess over $418,400

TABLE 4 - Section 1(d) - Married Individuals Filing Separate Returns

If Taxable Income Is:

The Tax Is:

Not over $9,325

10% of the taxable income

Over $9,325 but not over $37,950

$932.50 plus 15% of the excess over $9,325

Over $37,950 but not over $76,550

$5,226.25 plus 25% of the excess over $37,950

Over $76,550 but not over $116,675

$14,876.25 plus 28% of the excess over $76,550

Over $116,675 but not over $208,350

$26,111.25 plus 33% of the excess over $116,675

Over $208,350 not over $235,350

$56,364 plus 35% of the excess over $208,350

Over $235,350

$65,814 plus 39.6% of the excess over $235,350

TABLE 5 - Section 1(e) - Estates and Trusts

If Taxable Income Is:

The Tax Is:

Not over $2,550

15% of the taxable income

Over $2,550 but not over $6,000

$382.50 plus 25% of the excess over $2,550

Over $6,000 but not over $9,150

$1,245 plus 28% of the excess over $6,000

Over $9,150 but not over $12,500

$2,127 plus 33% of the excess over $9,150

Over $12,500

$3,232.50 plus 39.6% of the excess over $12,500

.02 Unearned Income of Minor Chil-
dren Taxed as if Parent's Income (the
"Kiddie Tax"). For taxable years begin-
ning in 2017, the amount in § 1(g)(4)
(A)(ii)(I), which is used to reduce the net
unearned income reported on the child's
return that is subject to the "kiddie tax," is
$1,050. This $1,050 amount is the same
as the amount provided in § 63(c)(5)(A),
as adjusted for inflation. The same $1,050
amount is used for purposes of § 1(g)(7)
(that is, to determine whether a parent
may elect to include a child's gross in-
come in the parent's gross income and to
calculate the "kiddie tax"). For example,
one of the requirements for the parental
election is that a child's gross income is
more than the amount referenced in
§ 1(g)(4)(A)(ii)(I) but less than 10 times
that amount; thus, a child's gross income
for 2017 must be more than $1,050 but
less than $10,500.

.03 Adoption Credit. For taxable years
beginning in 2017, under § 23(a)(3) the

credit allowed for an adoption of a child
with special needs is $13,570. For taxable
years beginning in 2017, under § 23(b)(1)
the maximum credit allowed for other
adoptions is the amount of qualified adop-
tion expenses up to $13,570. The avail-
able adoption credit begins to phase out
under § 23(b)(2)(A) for taxpayers with
modified adjusted gross income in excess
of $203,540 and is completely phased out
for taxpayers with modified adjusted gross
income of $243,540 or more. (See section
3.19 of this revenue procedure for the
adjusted items relating to adoption assis-
tance programs.)

.04 Lifetime Learning Credit. For tax-
able years beginning in 2017, a taxpayer's
modified adjusted gross income in excess
of $56,000 ($112,000 for a joint return) is
used to determine the reduction under
§ 25A(d)(2) in the amount of the Lifetime
Learning Credit otherwise allowable un-
der § 25A(a)(2).

.05 Earned Income Credit.

(1) In general. For taxable years begin-
ning in 2017, the following amounts are
used to determine the earned income
credit under § 32(b). The "earned income
amount" is the amount of earned income
at or above which the maximum amount
of the earned income credit is allowed.
The "threshold phaseout amount" is the
amount of adjusted gross income (or, if
greater, earned income) above which the
maximum amount of the credit begins to
phase out. The "completed phaseout
amount" is the amount of adjusted gross
income (or, if greater, earned income) at
or above which no credit is allowed. The
threshold phaseout amounts and the com-
pleted phaseout amounts shown in the ta-
ble below for married taxpayers filing a
joint return include the increase provided
in § 32(b)(3)(B)(i), as adjusted for infla-
tion for taxable years beginning in 2017.

Item

Number One

of Qualifying Two

Children Three or More

None

Earned Income Amount

$10,000

$14,040

$6,670

Maximum Amount of Credit

$3,400

$5,616

$6,318

$510

Threshold Phaseout Amount (Single, Surviving Spouse, or Head of Household)

$18,340

$8,340

Completed Phaseout Amount (Single, Surviving Spouse, or Head of Household)

$39,617

$45,007

$48,340

$15,010

Threshold Phaseout Amount (Married Filing Jointly)

$23,930

$13,930

Item

Number of Qualifying Children

One

Two

Three or More

None

Completed Phaseout Amount (Married Filing Jointly)

$45,207

$50,597

$53,930

$20,600

The instructions for the Form 1040 se-
ries provide tables showing the amount of
the earned income credit for each type of
taxpayer.

(2) Excessive Investment Income. For
taxable years beginning in 2017, the

earned income tax credit is not allowed
under § 32(i)(1) if the aggregate amount
of certain investment income exceeds
$3,450.

.06 Refundable Credit for Coverage
Under a Qualified Health Plan. For tax-

able years beginning in 2017, the limita-
tion on tax imposed under § 36B(f)(2)(B)
for excess advance credit payments is de-
termined using the following table:

If the household income (expressed as a percent of poverty line) is:

The limitation amount for unmarried individuals (other than surviving spouses and heads of household) is:

The limitation amount for all other taxpayers is:

Less than 200%

$300

$600

At least 200% but less than 300%

$750

$1,500

At least 300% but less than 400%

$1,275

$2,550

.07 Rehabilitation Expenditures
Treated as Separate New Building. For
calendar year 2017, the per low-income
unit qualified basis amount under
§ 42(e)(3)(A)(ii)(II) is $6,700.

.08 Low-Income Housing Credit. For
calendar year 2017, the amount used un-
der § 42(h)(3)(C)(ii) to calculate the State
housing credit ceiling for the low-income

housing credit is the greater of (1) $2.35
multiplied by the State population, or (2)
$2,710,000.

.09 Employee Health Insurance Ex-
pense of Small Employers. For taxable
years beginning in 2017, the dollar
amount in effect under § 45R(d)(3)(B) is
$26,200. This amount is used under
§ 45R(c) for limiting the small employer

health insurance credit and under
§ 45R(d)(1)(B) for determining who is an
eligible small employer for purposes of
the credit.

.10 Exemption Amounts for Alternative
Minimum Tax. For taxable years begin-
ning in 2017, the exemption amounts un-
der § 55(d)(1) are:

Joint Returns or Surviving Spouses

$84,500

Unmarried Individuals (other than Surviving Spouses)

$54,300

Married Individuals Filing Separate Returns

$42,250

Estates and Trusts

$24,100

For taxable years beginning in 2017,
come above which the 28 percent tax rate
under § 55(b)(1), the excess taxable in-
applies is:

Married Individuals Filing Separate Returns

$93,900

Joint Returns, Unmarried Individuals (other than surviving spouses), and Estates and Trusts

$187,800

For taxable years beginning in 2017,
termine the phaseout of the exemption
the amounts used under § 55(d)(3) to de-
amounts are:

Joint Returns or Surviving Spouses

$160,900

Unmarried Individuals (other than Surviving Spouses)

$120,700

Married Individuals Filing Separate Returns and Estates and Trusts

$80,450

.11 Alternative Minimum Tax Exemp-
tion for a Child Subject to the "Kiddie
Tax." For taxable years beginning in
2017, for a child to whom the § 1(g)
"kiddie tax" applies, the exemption
amount under §§ 55 and 59(j) for pur-
poses of the alternative minimum tax un-
der § 55 may not exceed the sum of (1) the
child's earned income for the taxable year,
plus (2) $7,500.

.12 Certain Expenses of Elementary
and Secondary School Teachers. For tax-
able years beginning in 2017, under
§ 62(a)(2)(D) the amount of the deduction
allowed under § 162 which consists of

expenses paid or incurred by an eligible
educator in connection with books, sup-
plies (other than nonathletic supplies for
courses of instruction in health or physical
education), computer equipment (includ-
ing related software and services) and
other equipment, and supplementary ma-
terials used by the eligible educator in the
classroom is $250.

.13 Transportation Mainline Pipeline
Construction Industry Optional Expense
Substantiation Rules for Payments to Em-
ployees under Accountable Plans. For cal-
endar year 2017, an eligible employer
may pay certain welders and heavy equip-

ment mechanics an amount of up to $17
per hour for rig-related expenses that are
deemed substantiated under an account-
able plan if paid in accordance with Rev.
Proc. 2002-41, 2002-1 C.B. 1098. If the
employer provides fuel or otherwise reim-
burses fuel expenses, up to $11 per hour is
deemed substantiated if paid under Rev.
Proc. 2002-41.

.14 Standard Deduction.

(1) In general. For taxable years begin-
ning in 2017, the standard deduction
amounts under § 63(c)(2) are as follows:

Filing Status

Standard Deduction

Married Individuals Filing Joint Returns and Surviving Spouses (§ 1(a))

$12,700

Heads of Households (§ 1(b))

$9,350

Unmarried Individuals (other than Surviving Spouses and Heads of Households) (§ 1(c))

$6,350

Married Individuals Filing Separate Returns (§ 1(d))

$6,350

(2) Dependent. For taxable years be-
ginning in 2017, the standard deduction
amount under § 63(c)(5) for an individual
who may be claimed as a dependent by
another taxpayer cannot exceed the
greater of (1) $1,050, or (2) the sum of
$350 and the individual's earned income.

(3) Aged or blind. For taxable years
beginning in 2017, the additional standard
deduction amount under § 63(f) for the
aged or the blind is $1,250. The additional
standard deduction amount is increased to
$1,550 if the individual is also unmarried
and not a surviving spouse.

.15 Overall Limitation on Itemized De-
ductions. For taxable years beginning in
2017, the applicable amounts under § 68
(b) are $313,800 in the case of a joint
return or a surviving spouse, $287,650 in
the case of a head of household, $261,500
in the case of an individual who is not
married and who is not a surviving spouse
or head of household, and $156,900 in the
case of a married individual filing a sep-
arate return.

.16 Cafeteria Plans. For the taxable
years beginning in 2017, the dollar limi-
tation under § 125(i) on voluntary em-
ployee salary reductions for contributions
to health flexible spending arrangements
is $2,600.

.17 Qualified Transportation Fringe
Benefit. For taxable years beginning in
2017, the monthly limitation under
§ 132(f)(2)(A) regarding the aggregate
fringe benefit exclusion amount for trans-
portation in a commuter highway vehicle
and any transit pass is $255. The monthly
limitation under § 132(f)(2)(B) regarding
the fringe benefit exclusion amount for
qualified parking is $255.

.18 Income from United States Savings
Bonds for Taxpayers Who Pay Qualified
Higher Education Expenses. For taxable
years beginning in 2017, the exclusion
under § 135, regarding income from
United States savings bonds for taxpayers
who pay qualified higher education ex-
penses, begins to phase out for modified
adjusted gross income above $117,250 for
joint returns and $78,150 for all other
returns. The exclusion is completely
phased out for modified adjusted gross
income of $147,250 or more for joint re-
turns and $93,150 or more for all other
returns.

.19 Adoption Assistance Programs. For
taxable years beginning in 2017, under
§ 137(a)(2), the amount that can be ex-
cluded from an employee's gross income
for the adoption of a child with special
needs is $13,570. For taxable years begin-
ning in 2017, under § 137(b)(1) the max-

imum amount that can be excluded from
an employee's gross income for the
amounts paid or expenses incurred by an
employer for qualified adoption expenses
furnished pursuant to an adoption assis-
tance program for other adoptions by the
employee is $13,570. The amount exclud-
able from an employee's gross income
begins to phase out under § 137(b)(2)(A)
for taxpayers with modified adjusted gross
income in excess of $203,540 and is com-
pletely phased out for taxpayers with
modified adjusted gross income of
$243,540 or more. (See section 3.03 of
this revenue procedure for the adjusted
items relating to the adoption credit.)

.20 Private Activity Bonds Volume
Cap. For calendar year 2017, the amounts
used under § 146(d) to calculate the State
ceiling for the volume cap for private ac-
tivity bonds is the greater of (1) $100
multiplied by the State population, or (2)
$305,315,000.

.21 Loan Limits on Agricultural Bonds.
For calendar year 2017, the loan limit
amount on agricultural bonds under
§ 147(c)(2)(A) for first-time farmers is
$524,200.

.22 General Arbitrage Rebate Rules.
For bond years ending in 2017, the
amount of the computation credit deter-
mined under the permission to rely on

§ 1.148-3(d)(4) of the proposed Income
Tax Regulations is $1,670.

.23 Safe Harbor Rules for Broker Com-
missions on Guaranteed Investment Con-
tracts or Investments Purchased for a
Yield Restricted Defeasance Escrow. For
calendar year 2017, under § 1.148-
5(e)(2)(iii)(B)(1), a broker's commission
or similar fee for the acquisition of a guar-
anteed investment contract or investments
purchased for a yield restricted defeasance

escrow is reasonable if (1) the amount of
the fee that the issuer treats as a qualified
administrative cost does not exceed the
lesser of (A) $39,000, and (B) 0.2 percent
of the computational base (as defined in
§ 1.148-5(e)(2)(iii)(B)(2)) or, if more,
$4,000; and (2) the issuer does not treat
more than $111,000 in brokers' commis-
sions or similar fees as qualified adminis-
trative costs for all guaranteed investment
contracts and investments for yield re-

stricted defeasance escrows purchased
with gross proceeds of the issue.

.24 Personal Exemption.

(1) For taxable years beginning in
2017, the personal exemption amount un-
der § 151(d) is $4,050.

(2) Phaseout. For taxable years begin-
ning in 2017, the personal exemption
phases out for taxpayers with the follow-
ing adjusted gross income amounts:

Filing Status

AGI - Beginning of Phaseout

AGI - Completed Phaseout

Married Individuals Filing Joint Returns and Surviving Spouses (§ 1(a))

$313,800

$436,300

Heads of Households (§ 1(b))

$287,650

$410,150

Unmarried Individuals (other than Surviving Spouses and Heads of Households) (§ 1(c)

$261,500

$384,000

Married Individuals Filing Separate Returns (§ 1(d))

$156,900

$218,150

.25 Election to Expense Certain Depre-
ciable Assets. For taxable years beginning
in 2017, under § 179(b)(1), the aggregate
cost of any § 179 property that a taxpayer
elects to treat as an expense cannot exceed
$510,000. Under § 179(b)(2), the

$510,000 limitation is reduced (but not
below zero) by the amount the cost of
§ 179 property placed in service during
the 2017 taxable year exceeds $2,030,000.
.26 Eligible Long-Term Care Premi-
ums. For taxable years beginning in 2017,

the limitations under § 213(d)(10), regard-
ing eligible long-term care premiums in-
cludible in the term "medical care," are as
follows:

Attained Age Before the Close of the Taxable Year

Limitation on Premiums

40 or less

$410

More than 40 but not more than 50

$770

More than 50 but not more than 60

$1,530

More than 60 but not more than 70

$4,090

More than 70

$5,110

.27 Medical Savings Accounts.

(1) Self-only coverage. For taxable
years beginning in 2017, the term "high
deductible health plan" as defined in
§ 220(c)(2)(A) means, for self-only cov-
erage, a health plan that has an annual
deductible that is not less than $2,250 and
not more than $3,350, and under which
the annual out-of-pocket expenses re-
quired to be paid (other than for premi-
ums) for covered benefits do not exceed
$4,500.

(2) Family coverage. For taxable years
beginning in 2017, the term "high deduct-
ible health plan" means, for family cover-
age, a health plan that has an annual de-
ductible that is not less than $4,500 and
not more than $6,750, and under which
the annual out-of-pocket expenses re-
quired to be paid (other than for premi-

ums) for covered benefits do not exceed
$8,250.

.28 Interest on Education Loans. For
taxable years beginning in 2017, the
$2,500 maximum deduction for interest
paid on qualified education loans under
§ 221 begins to phase out under
§ 221(b)(2)(B) for taxpayers with modi-
fied adjusted gross income in excess of
$65,000 ($135,000 for joint returns), and
is completely phased out for taxpayers
with modified adjusted gross income of
$80,000 or more ($165,000 or more for
joint returns).

.29 Treatment of Dues Paid to Agricul-
tural or Horticultural Organizations. For
taxable years beginning in 2017, the lim-
itation under § 512(d)(1), regarding the
exemption of annual dues required to be

paid by a member to an agricultural or
horticultural organization, is $162.

.30 Insubstantial Benefit Limitations
for Contributions Associated with Chari-
table Fund-Raising Campaigns.

(1) Low cost article. For taxable years
beginning in 2017, for purposes of defin-
ing the term "unrelated trade or business"
for certain exempt organizations under
§ 513(h)(2), "low cost articles" are articles
costing $10.70 or less.

(2) Other insubstantial benefits. For
taxable years beginning in 2017, under
§ 170, the $5, $25, and $50 guidelines in
section 3 of Rev. Proc. 90-12, 1990-1
C.B. 471 (as amplified by Rev. Proc. 92-
49, 1992-1 C.B. 987, and modified by
Rev. Proc. 92-102, 1992-2 C.B. 579), for
the value of insubstantial benefits that
may be received by a donor in return for a

contribution, without causing the contri-
bution to fail to be fully deductible, are
$10.70, $53.50, and $107, respectively.

.31 Tax on Insurance Companies Other
than Life Insurance Companies. For tax-
able years beginning in 2017, under
§ 831(b)(2)(A)(i) the amount of the limit
on net written premiums or direct written
premiums (whichever is greater) is
$2,250,000 to elect the alternative tax for
certain small companies under § 831(b)(1)
to be taxed only on taxable investment
income.

.32 Expatriation to Avoid Tax. For cal-
endar year 2017, under § 877A(g)(1)(A),
unless an exception under § 877A
(g)(1)(B) applies, an individual is a cov-
ered expatriate if the individual's "aver-
age annual net income tax" under
§ 877(a)(2)(A) for the five taxable years
ending before the expatriation date is
more than $162,000.

.33 Tax Responsibilities of Expatria-
tion. For taxable years beginning in 2017,
the amount that would be includible in the
gross income of a covered expatriate by
reason of § 877A(a)(1) is reduced (but not
below zero) by $699,000.

.34 Foreign Earned Income Exclusion.
For taxable years beginning in 2017, the
foreign earned income exclusion amount
under § 911(b)(2)(D)(i) is $102,100.

.35 Unified Credit Against Estate Tax.
For an estate of any decedent dying in
calendar year 2017, the basic exclusion
amount is $5,490,000 for determining the
amount of the unified credit against estate
tax under § 2010.

.36 Valuation of Qualified Real Prop-
erty in Decedent's Gross Estate. For an
estate of a decedent dying in calendar year
2017, if the executor elects to use the
special use valuation method under
§ 2032A for qualified real property, the
aggregate decrease in the value of quali-
fied real property resulting from electing
to use § 2032A for purposes of the estate
tax cannot exceed $1,120,000.

.37 Annual Exclusion for Gifts.

(1) For calendar year 2017, the first
$14,000 of gifts to any person (other than
gifts of future interests in property) are not

included in the total amount of taxable
gifts under § 2503 made during that year.

(2) For calendar year 2017, the first
$149,000 of gifts to a spouse who is not a
citizen of the United States (other than
gifts of future interests in property) are not
included in the total amount of taxable
gifts under §§ 2503 and 2523(i)(2) made
during that year.

.38 Tax on Arrow Shafts. For calendar
year 2017, the tax imposed under
§ 4161(b)(2)(A) on the first sale by the
manufacturer, producer, or importer of
any shaft of a type used in the manufac-
ture of certain arrows is $0.50 per shaft.

.39 Passenger Air Transportation Ex-
cise Tax. For calendar year 2017, the tax
under § 4261(b)(1) on the amount paid for
each domestic segment of taxable air
transportation is $4.10. For calendar year
2017, the tax under § 4261(c)(1) on any
amount paid (whether within or without
the United States) for any international air
transportation, if the transportation begins
or ends in the United States, generally is
$18. Under § 4261(c)(3), however, a
lower amount applies under § 4261(c)(1)
to a domestic segment beginning or end-
ing in Alaska or Hawaii, and the tax ap-
plies only to departures. For calendar year
2017, the rate is $9.

.40 Requirement to Maintain Minimum
Essential Coverage. For calendar year
2017, the applicable dollar amount used to
determine the penalty under § 5000A(c)
for failure to maintain minimum essential
coverage is $695.

.41 Reporting Exception for Certain
Exempt Organizations with Nondeduct-
ible Lobbying Expenditures. For taxable
years beginning in 2017, the annual per
person, family, or entity dues limitation to
qualify for the reporting exception under
§ 6033(e)(3) (and section 5.05 of Rev.
Proc. 98-19, 1998-1 C.B. 547), regard-
ing certain exempt organizations with
nondeductible lobbying expenditures, is
$113 or less.

.42 Notice of Large Gifts Received
from Foreign Persons. For taxable years
beginning in 2017, § 6039F authorizes the
Treasury Department and the Internal

Revenue Service to require recipients of
gifts from certain foreign persons to report
these gifts if the aggregate value of gifts
received in the taxable year exceeds
$15,797.

.43 Persons Against Whom a Federal
Tax Lien Is Not Valid. For calendar year
2017, a federal tax lien is not valid against
(1) certain purchasers under § 6323(b)(4)
who purchased personal property in a ca-
sual sale for less than $1,540, or (2) a
mechanic's lienor under § 6323(b)(7) who
repaired or improved certain residential
property if the contract price with the
owner is not more than $7,690.

.44 Property Exempt from Levy. For
calendar year 2017, the value of property
exempt from levy under § 6334(a)(2)
(fuel, provisions, furniture, and other
household personal effects, as well as
arms for personal use, livestock, and poul-
try) cannot exceed $9,200. The value of
property exempt from levy under
§ 6334(a)(3) (books and tools necessary
for the trade, business, or profession of the
taxpayer) cannot exceed $4,600.

.45 Interest on a Certain Portion of the
Estate Tax Payable in Installments. For an
estate of a decedent dying in calendar year
2017, the dollar amount used to determine
the "2-percent portion" (for purposes of
calculating interest under § 6601(j)) of the
estate tax extended as provided in § 6166
is $1,490,000.

.46 Failure to File Tax Return. For tax
years beginning in 2017, the amount of
the additional tax under § 6651(a) for fail-
ure to file a tax return within 60 days of
the due date of such return (determined
with regard to any extensions of time for
filing) shall not be less than the lesser of
$210 or 100 percent of the amount re-
quired to shown as tax on such returns.

.47 Failure to File Certain Information
Returns, Registration Statements, etc. For
tax years beginning in 2017, the penalty
amounts under § 6652(c) are:

(1) for failure to file a return required
under § 6033(a)(1) (relating to returns by
exempt organization) or § 6012(a)(6) (re-
lating to returns by political organiza-
tions):

Scenario

Daily Penalty

Maximum Penalty

Organization (§ 6652(c)(1)(A))

$20

Lessor of $10,000 or 5% of gross receipts of the organization for the year.

Organization with gross receipts exceeding $1,028,500 (§ 6652(c)(1)(A))

$100

$51,000

Managers (§ 6652(c)(1)(B))

$10

$5,000

Public inspection of annual returns and reports (§ 6652(c)(1)(C))

$20

$10,000

Public inspection of applications for exemption and notice of status (§ 6652(c)(1)(D))

$20

No Limits

## (2) for failure to file a return required tain trust) or § 6043(b) (relating to termi- nations, etc., of exempt organizations):

### under § 6034 (relating to returns by cer-

Scenario

Daily Penalty

Maximum Penalty

Organization or trust (§ 6652(c)(2)(A))

$10

$5,000

Managers (§ 6652(c)(2)(B))

$10

$5,000

Split-Interest Trust (§ 6652(c)(2)(C)(ii))

$20

$10,000

Any trust with gross receipts exceeding $257,000 (§ 6652(c)(2)(C)(ii))

$100

$51,000

(3) for failure to file a disclosure re-
quired under § 6033(a)(2):

Scenario

Daily Penalty

Maximum Penalty

Tax-exempt entity (§ 6652(c)(3)(A))

$100

$51,000

Failure to comply with written demand (§ 6652(c)(3)(B)(ii))

$100

$10,000

.48 Other Assessable Penalties With
Respect to the Preparation of Tax Returns
for Other Persons. For tax years begin-

ning in 2017, the penalty amounts under
§ 6695 are:

Scenario

Per Return or Claim for Refund

Maximum Penalty

Failure to furnish copy to taxpayer (§ 6695(a))

$50

$25,500

Failure to sign return (§ 6695(b))

$50

$25,500

Failure to furnish identifying number (§ 6695(c))

$50

$25,500

Failure to retain copy or list (§ 6695(d))

$50

$25,500

Failure to file correct information returns (§ 6695(e))

$50 per return and item in return

$25,500

Negotiation of check (§ 6695(f))

$510 per check

No limit

Failure to be diligent in determining eligibility for child tax credit, American opportunity tax credit, and earned income credit (§ 6695(g))

$510 per return

No limit

.49 Failure to File Partnership Return.
For tax years beginning in 2017, the dollar
amount used to determine amount of the
penalty under § 6698(b)(1) is $200.

.50 Failure to File S Corporation Re-
turn. For tax years beginning in 2017, the

dollar amount used to determine amount
of the penalty under § 6699(b)(1) is $200.

.51 Failure to File Correct Information
Returns. For tax years beginning in 2017,
the penalty amounts under § 6721 are:

(1) for persons with average annual
gross receipts for the most recent three
taxable years of more than $5,000,000, for
failure to file correct information returns
are:

Scenario

Penalty Per Return

Calendar Year Maximum

General Rule (§ 6721(a)(1))

$260

$3,218,500

Corrected on or before 30 days after required filing date (§ 6721(b)(1))

$50

$536,000

Corrected after 30th day but on or before August 1 (§ 6721(b)(2))

$100

$1,609,000

(2) for persons with average annual
gross receipts for the most recent three
taxable years of $5,000,000 or less, for

failure to file correct information returns

are:

Scenario

Penalty Per Return

Calendar Year Maximum

General Rule (§ 6721(d)(1)(A))

$260

$1,072,500

Corrected on or before 30 days after required filing date (§ 6721(d)(1)(B))

$50

$187,500

Corrected after 30th day but on or before August 1 (§ 6721(d)(1)(C))

$100

$536,000

(3) for failure to file correct informa-
tion returns due to intentional disregard of

the filing requirement (or the correct in-
formation reporting requirement) are:

Scenario

Penalty Per Return

Calendar Year Maximum

Return other than a return required to be filed under §§ 6045(a), 6041A(b), 6050H, 6050I, 6050J, 6050K, or 6050L (§ 6721(e)(2)(A))

Greater of (i) $530, or (ii) 10% of aggregate amount of items required to be reported correctly

No limit

Return required to be filed under §§ 6045(a), 6050K, or 6050L (§ 6721(e)(2)(B))

Greater of (i) $530, or (ii) 5% of aggregate amount of items required to be reported correctly

No limit

Return required to be filed under § 6050I(a) (§ 6721(e)(2)(C))

Greater of (i) $26,820, or (ii) amount of cash received up to $107,000

No limit

Return required to be filed under § 6050V (§ 6721(e)(2)(D))

Greater of (i) $530, or (ii) 10% of the value of the benefit of any contract with respect to which information is required to be included on the return

No limit

.52 Failure to Furnish Correct Payee
Statements. For tax years beginning in
2017, the penalty amounts under § 6722
are:

(1) for persons with average annual
gross receipts for the most recent three
taxable years of more than $5,000,000, for

failure to file correct information returns
are:

Scenario

Penalty Per Return

Calendar Year Maximum

General Rule (§ 6722(a)(1))

$260

$3,218,500

Corrected on or before 30 days after required filing date (§ 6722(b)(1))

$50

$536,000

Corrected after 30th day but on or before August 1 (§ 6722(b)(2))

$100

$1,609,000

(2) for persons with average annual
able years of $5,000,000 or less, for fail-
ure to file correct information returns are:

gross receipts for the most recent 3 tax-

Scenario

Penalty Per Return

Calendar Year Maximum

General Rule (§ 6722(d)(1)(A))

$260

$1,072,500

Scenario

Penalty Per Return

Calendar Year Maximum

Corrected on or before 30 days after required filing date (§ 6722(d)(1)(B))

$50

$187,500

Corrected after 30th day but on or before August 1 (§ 6722(d)(1)(C))

$100

$536,000

(3) for failure to file correct payee
statements due to intentional disregard of
the requirement to furnish a payee state-

ment (or the correct information reporting
requirement) are:

Scenario

Penalty Per Return

Calendar Year Maximum

Statement other than a statement required under §§ 6045(b), 6041A(e) (in respect of a return required under § 6041A(b)), 6050H(d), 6050J(e), 6050K(b), or 6050L(c) (§ 6722(e)(2)(A))

Greater of (i) $530, or (ii) 10% of aggregate amount of items required to be reported correctly

No limit

Payee statement required under §§ 6045(b), 6050K(b), or 6050L(c) (§ 6722(e)(2)(B))

Greater of (i) $530, or (ii) 5% of aggregate amount of items required to be reported correctly

No limit

.53 Revocation or Denial of Passport
in Case of Certain Tax Delinquencies. For
calendar year 2017, the amount of a seri-
ous delinquent tax debt under § 7345 is
$50,000.

.54 Attorney Fee Awards. For fees in-
curred in calendar year 2017, the attorney
fee award limitation under § 7430(c)(1)
(B)(iii) is $200 per hour.

.55 Periodic Payments Received under
Qualified Long-Term Care Insurance
Contracts or under Certain Life Insurance
Contracts. For calendar year 2017, the
stated dollar amount of the per diem lim-
itation under § 7702B(d)(4), regarding pe-
riodic payments received under a qualified
long-term care insurance contract or peri-
odic payments received under a life insur-
ance contract that are treated as paid by
reason of the death of a chronically ill
individual, is $360.

# SECTION 4. EFFECTIVE DATE

.01 General Rule. Except as provided
in section 4.02, this revenue procedure

applies to taxable years beginning in
2017.

.02 Calendar Year Rule. This revenue
procedure applies to transactions or events
occurring in calendar year 2017 for pur-
poses of sections 3.07 (rehabilitation ex-
penditures treated as separate new build-
ing), 3.08 (low-income housing credit),
3.13 (transportation mainline pipeline
construction industry optional expense
substantiation rules for payments to em-
ployees under accountable plans), 3.20
(private activity bonds volume cap), 3.21
(loan limits on agricultural bonds), 3.22
(general arbitrage rebate rules), 3.23 (safe
harbor rules for broker commissions on
guaranteed investment contracts or invest-
ments purchased for a yield restricted de-
feasance escrow), 3.32 (expatriation to
avoid taxes), 3.35 (unified credit against
estate tax), 3.36 (valuation of qualified
real property in decedent's gross estate),
3.37 (annual exclusion for gifts), 3.38 (tax
on arrow shafts), 3.39 (passenger air
transportation excise tax), 3.40 (require-

ment to maintain minimum essential cov-
erage), 3.43 (persons against whom a fed-
eral tax lien is not valid), 3.44 (property
exempt from levy), 3.45 (interest on a
certain portion of the estate tax payable in
installments), 3.53 (revocation or denial
of passport in case of certain tax delin-
quencies), 3.54 (attorney fee awards), and
3.55 (periodic payments received under
qualified long-term care insurance con-
tracts or under certain life insurance con-
tracts).

# SECTION 5. DRAFTING INFORMATION

The principal author of this revenue
procedure is William Ruane of the Office
of Associate Chief Counsel (Income Tax
& Accounting). For further information
regarding this revenue procedure, contact
Mr. Ruane at (202) 317-4718 (not a toll-
free number).

# Part IV. Items of General Interest

Notice of proposed
rulemaking by cross-
reference to temporary
regulation.

## Treatment of Certain Interests in Corporations as Stock or Indebtedness

### REG-130314-16

AGENCY: Internal Revenue Service (IRS),
Treasury.

ACTION: Notice of proposed rulemaking
by cross-reference to temporary regulation.

SUMMARY: The Department of the
Treasury (Treasury Department) and the
IRS are issuing temporary regulations that
affect corporations and partnerships that
issue purported indebtedness to related
corporations or partnerships in the Rules
and Regulations section of this issue of
the Internal Revenue Bulletin. The tem-
porary regulations provide rules address-
ing the treatment of instruments issued by
partnerships, consolidated groups, and
certain transactions involving qualified
cash-management arrangements. The text
of the temporary regulations also serves as
the text of these proposed regulations.

DATES: Written or electronic comments
and requests for a public hearing must be
received by January 19, 2017.

ADDRESSES: Send submissions to: CC:
PA:LPD:PR (REG-130314-16), room
5203, Internal Revenue Service, P.O. Box
7604, Ben Franklin Station, Washington,
DC 20224. Submissions may be hand-
delivered Monday through Friday be-
tween the hours of 8 a.m. and 4 p.m. to
CC:PA:LPD:PR (REG-130314-16),
Courier's Desk, Internal Revenue Service,
1111 Constitution Avenue NW, Washing-
ton, DC 20224, or sent electronically via
the Federal eRulemaking Portal at http://
www.regulations.gov (IRS REG-130314-
16).

FOR FURTHER INFORMATION CON-
TACT:Concerning the proposed regula-
tions, Austin M. Diamond-Jones, (202)

317-5363, or Joshua G. Rabon, (202) 317-
6937; concerning submissions of com-
ments or requests for a public hearing,
Regina Johnson, (202) 317-5177 (not toll-
free numbers).

SUPPLEMENTARY INFORMATION:
Background

The temporary regulations in the Rules
and Regulations section of this issue of
the Internal Revenue Bulletin contain
rules under sections 385 and 752 of the
Internal Revenue Code (Code) that estab-
lish requirements that ordinarily must be
satisfied in order for certain related-party
interests in a corporation to be treated as
indebtedness for federal tax purposes. The
text of the temporary regulations also
serves as the text of the proposed regula-
tions herein. The preamble to the tempo-
rary regulations explains the temporary
regulations and the corresponding pro-
posed regulations.

### Special Analyses

#### I. Regulatory Planning and Review

Executive Orders 13563 and 12866 di-
rect agencies to assess costs and benefits
of available regulatory alternatives and, if
regulation is necessary, to select regula-
tory approaches that maximize net bene-
fits (including potential economic, envi-
ronmental, public health and safety
effects, distributive impacts, and equity).
Executive Order 13563 emphasizes the
importance of quantifying both costs and
benefits, of reducing costs, of harmoniz-
ing rules, and of promoting flexibility. Re-
lated rules in the final and temporary reg-
ulations under section 385 in TD 9790,
published in the Rules and Regulations
section of this issue of the Internal Rev-
enue Bulletin, have been designated a
"significant regulatory action" under sec-
tion 3(f) of Executive Order 12866. For a
discussion of the economic impact of
those final and temporary regulations, as
well as these proposed regulations, please
see the Regulatory Assessment accompa-
nying TD 9790, published in the Rules
and Regulations section of this issue of
the Internal Revenue Bulletin.

#### II. Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility
Act (5 U.S.C. Chapter 6), it is hereby
certified that the final and temporary reg-
ulations in TD 9790, published in the
Rules and Regulations section of this is-
sue of the Internal Revenue Bulletin,
and accordingly, these proposed regula-
tions proposed by cross-reference to the
temporary regulations, will not have a sig-
nificant economic impact on a substantial
number of small entities. Accordingly, a
regulatory flexibility analysis is not re-
quired.

To facilitate the federal tax analysis of
an interest in a corporation, taxpayers are
required under existing law to substantiate
their classification of an interest as stock
or indebtedness for federal tax purposes.
Section 1.385-3 provides that certain in-
terests in a corporation that are held by a
member of the corporation's expanded
group and that otherwise would be treated
as indebtedness for federal tax purposes
are treated as stock. Section 1.385-3T
provides that for certain debt instruments
issued by a controlled partnership, the
holder is deemed to transfer all or a por-
tion of the debt instrument to the partner
or partners in the partnership in exchange
for stock in the partner or partners. Sec-
tion 1.385-4T provides rules regarding
the application of §§ 1.385-3 and
1.385-3T to members of a consolidated
group. Sections 1.385-3 and 1.385-3T in-
clude multiple exceptions that limit their
application. In particular, the threshold
exception provides that the first $50 mil-
lion of expanded group debt instruments
that otherwise would be reclassified as
stock or deemed to be transferred to a
partner in a controlled partnership under
§ 1.385-3 or § 1.385-3T will not be re-
classified or deemed transferred under
§ 1.385-3 or § 1.385-3T. Although it is
possible that the classification rules in
§§ 1.385-3, 1.385-3T, and 1.385-4T
could have an effect on small entities, the
threshold exception of the first $50 mil-
lion of debt instruments otherwise subject
to recharacterization or deemed transfer
under §§ 1.385-3, 1.385-3T, and
1.385-4T makes it unlikely that a sub-

stantial number of small entities will be
affected by §§ 1.385-3T or 1.385-4T.

Pursuant to section 7805(f) of the
Code, the final regulations in TD 9790,
published in the Rules and Regulations
section of this issue of the Internal Rev-
enue Bulletin, have been submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
their impact on small business. Comments
were received requesting that the mone-
tary thresholds contained in proposed
§§ 1.385-2, 1.385-3, and 1.385-4 be in-
creased in order to mitigate the impact on
small businesses. These comments are ad-
dressed in Parts IV.B.1.d and V.E.4 of the
Summary of Comments and Explanation
of Revisions in the preamble of TD 9790,
published in the Rules and Regulations
section of this issue of the Internal Rev-
enue Bulletin. No comments were re-
ceived concerning the economic impact
on small entities from the Small Business
Administration.

## Comments and Requests for Public Hearing

Before these proposed regulations are
adopted as final regulations, consideration
will be given to any comments that are
submitted timely to the IRS as prescribed
in this preamble under the "Addresses"
heading. Treasury and the IRS request
comments on all aspects of the proposed
rules. All comments will be available at
www.regulations.gov or upon request. A
public hearing will be scheduled if re-
quested in writing by any person that
timely submits electronic or written com-
ments. If a public hearing is scheduled,
notice of the date, time, and place for the
public hearing will be published in the
Federal Register.

## Drafting Information

* * * * *

## Proposed Amendments to the Regulations

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

### PART 1-INCOME TAXES

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

Authority: 26 U.S.C. 7805

Section 1.385-4 also issued under 26
U.S.C. 385 and 1502.

Par. 2. Section 1.385-3 is amended by:

1\. Revising paragraph (b)(3)(vii).

2\. Revising paragraph (d)(4).

3\. Revising paragraph (f).

4\. Revising paragraphs (g)(5)-(8),
(15)-(17), and (22)-(23).

5\. Revising Example 12 through Exam-
ple 19 in paragraph (h)(3).

6\. Adding paragraph (k).

The revisions and additions read as fol-
lows:

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

* * * * *

(b) * * *

(3) * * *

(vii) [The text of the proposed amend-
ment to § 1.385-3(b)(3)(vii) is the same as
the text of § 1.385-3T(b)(3)(vii) pub-
lished elsewhere in this issue of the Inter-
nal Revenue Bulletin.]

* * * * *

(d) * * *

(4) [The text of the proposed amend-
ment to § 1.385-3(d)(4) is the same as the
text of § 1.385-3T(d)(4) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

* * * * *

(f) [The text of the proposed amend-
ment to § 1.385-3(f) is the same as the
text of § 1.385-3T(f) published elsewhere
in this issue of the Internal Revenue Bul-
letin.]

(g) * * *

(5) [The text of the proposed amend-
ment to § 1.385-3(g)(5) is the same as the
text of § 1.385-3T(g)(5) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

(6) [The text of the proposed amend-
ment to § 1.385-3(g)(6) is the same as the

text of § 1.385-3T(g)(6) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

(7) [The text of the proposed amend-
ment to § 1.385-3(g)(7) is the same as the
text of § 1.385-3T(g)(7) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

(8) [The text of the proposed amend-
ment to § 1.385-3(g)(8) is the same as the
text of § 1.385-3T(g)(8) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

* * * * *

(15) [The text of the proposed amend-
ment to § 1.385-3(g)(15) is the same as
the text of § 1.385-3T(g)(15) published
elsewhere in this issue of the Internal
Revenue Bulletin.]

(16) [The text of the proposed amend-
ment to § 1.385-3(g)(16) is the same as
the text of § 1.385-3T(g)(16) published
elsewhere in this issue of the Internal
Revenue Bulletin.]

(17) [The text of the proposed amend-
ment to § 1.385-3(g)(16) is the same as
the text of § 1.385-3T(g)(17) published
elsewhere in this issue of the Internal
Revenue Bulletin.]

* * * * *

(22) [The text of the proposed amend-
ment to § 1.385-3(g)(22) is the same as
the text of § 1.385-3T(g)(22) published
elsewhere in this issue of the Internal
Revenue Bulletin.]

(23) [The text of the proposed amend-
ment to § 1.385-3(g)(23) is the same as
the text of § 1.385-3T(g)(23) published
elsewhere in this issue of the Internal
Revenue Bulletin.]

* * * * *

(h) * * *

(3) * * *

Example 12. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
12 is the same as the text of § 1.385-
3T(h)(3), Example 12 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 13. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
13 is the same as the text of § 1.385-
3T(h)(3), Example 13 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 14. [The text of the proposed
amendment to § 1.385-3(h)(3), Example

14 is the same as the text of § 1.385-
3T(h)(3), Example 14 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 15. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
15 is the same as the text of § 1.385-
3T(h)(3), Example 15 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 16. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
16 is the same as the text of § 1.385-
3T(h)(3), Example 16 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 17. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
17 is the same as the text of § 1.385-
3T(h)(3), Example 17 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 18. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
18 is the same as the text of § 1.385-
3T(h)(3), Example 18 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

Example 19. [The text of the proposed
amendment to § 1.385-3(h)(3), Example
19 is the same as the text of § 1.385-
3T(h)(3), Example 19 published else-
where in this issue of the Internal Reve-
nue Bulletin.]

* * * * *

(k) [The text of the proposed amend-
ment to § 1.385-3(k) is the same as the
text of § 1.385-3T(k) published elsewhere
in this issue of the Internal Revenue Bul-
letin.]

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

§ 1.385-4 Treatment of consolidated
groups.

[The text of proposed § 1.385-4 is the
same as the text of § 1.385-4T published
elsewhere in this issue of the Internal
Revenue Bulletin.]

Par. 4. Section 1.752-2 is amended by:

1\. Revising paragraph (c)(3).

2\. Revising paragraph (l)(4).

The addition and revision read as fol-
lows

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

* * * * *

(3) [The text of the proposed amend-
ment to § 1.752-2(c)(3) is the same as the
text of § 1.752-2T(c)(3) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

* * * * *

(l) * * *

(4) [The text of the proposed amend-
ment to § 1.752-2(1)(4) is the same as the
text of § 1.752-2T(1)(4) published else-
where in this issue of the Internal Reve-
nue Bulletin.]

John Dalrymple

Deputy Commissioner for
Services and Enforcement.

(Filed by the Office of the Federal Register on October 13,
2016, 5:00 p.m., and published in the issue of the Federal
Register for October 21, 2016, 81 F.R. 72851)

## Relief for Victims of Hurricane Matthew

## Announcement 2016-39

Purpose

This announcement provides relief to
taxpayers who have been adversely af-
fected by Hurricane Matthew and who
have retirement assets in qualified em-
ployer plans that they would like to use to
alleviate hardships caused by Hurricane
Matthew. In addition, this announcement
provides relief from certain verification
procedures that may be required under
retirement plans with respect to loans and
hardship distributions. The relief provided
under this announcement is in addition to
the relief already provided by the Service
pursuant to News Release IR-2016-135
under § 7508A of the Internal Revenue
Code ("Code") for victims of Hurricane
Matthew. (For a listing of employee
benefit-related acts and deadlines that, un-
der the News Release, were postponed
until March 15, 2017, in response to Hur-
ricane Matthew, see the regulations under
§ 7508A and Section 8 of Rev. Proc.
2007-56, 2007-2 C.B. 388.)

### Background

The laws relating to qualified employer
plans impose various limitations on the
permissibility of loans and distributions
from those plans. For example, § 401(k)
(2)(B)(i) of the Code provides that in the
case of a § 401(k) plan that is part of a
profit-sharing or stock bonus plan, elec-
tive deferrals may be distributed only in
certain situations, one of which is on ac-
count of hardship. Section 403(b)(11) pro-
vides similar rules with respect to elective
deferrals under a § 403(b) plan. Section
457(d)(1)(A) provides that a plan de-
scribed in § 457(b) may not permit distri-
butions before the occurrence of certain
enumerated events, one being when the
participant is faced with an unforeseeable
emergency. Certain other types of plans or
accounts are not permitted to make in-
service distributions (distributions to a
participant who is still an employee) even
if there is a hardship. For example, in-
service hardship distributions are gener-
ally not permitted from pension plans or
from accounts holding qualified nonelec-
tive contributions ("QNECs") described
in § 401(m)(4)(C) or qualified matching
contributions ("QMACs") described in
§ 401(k)(3)(D)(ii)(I). However, Rev. Rul.
2004-12, 2004-2 C.B. 478, holds that if
amounts attributable to rollover contribu-
tions are separately accounted for within a
plan, those amounts may be distributed at
any time, pursuant to the employee's re-
quest. Section 72(p) imposes certain re-
quirements relating to plan loans. Unless
those requirements are satisfied, a loan is
treated as a distribution under the plan.

In order to make a loan or distribution
(including a hardship distribution), a plan
must contain language authorizing the
loan or distribution. Also, except to the
extent a distribution consists of already-
taxed amounts, the distribution will be
includible in gross income and generally
subject to the 10-percent additional tax
under § 72(t). Similar rules relating to
income inclusion and taxation apply to a
distribution from an IRA.

Plan provisions and regulations under
certain Code sections establish verifica-
tion procedures that a plan must follow
before loans or distributions can be made
from the plan. For example, the regula-
tions under § 401(k) set forth certain cri-

teria an employee must meet in order to
receive a hardship distribution. A plan
may contain procedures designed to con-
firm that the criteria have been satisfied.

Relief

As described below, a qualified em-
ployer plan will not be treated as failing to
satisfy any requirement under the Code or
regulations merely because the plan
makes a loan, or a hardship distribution
for a need arising from Hurricane Mat-
thew, to an employee or former employee
whose principal residence on October 4,
2016, (October 3, 2016, for Florida) was
located in one of the counties identified
for individual assistance by the Federal
Emergency Management Agency
("FEMA") because of the devastation
caused by Hurricane Matthew or whose
place of employment was located in one
of these counties on that applicable date or
whose lineal ascendant or descendant, de-
pendent, or spouse had a principal resi-
dence or place of employment in one of
these counties on that date. These counties
identified for individual assistance by
FEMA are in Florida, Georgia, North Car-
olina and South Carolina and can be found
on FEMA's website at https://www.fema.
gov/disasters. If additional counties in
these or other states are identified by
FEMA for individual assistance because
of damage related to Hurricane Matthew,
the relief provided in this announcement
will also apply, from the date specified by
FEMA as the beginning of the incident
period, and that date should be substituted
for references to October 4, 2016, in this
announcement. Plan administrators may
rely upon representations from the em-
ployee or former employee as to the need
for and amount of a hardship distribution,
unless the plan administrator has actual
knowledge to the contrary, and the distribu-
tion is treated as a hardship distribution for
all purposes under the Code and regulations.

For purposes of this announcement, a
"qualified employer plan" means a plan or
contract meeting the requirements of
§ 401(a), 403(a) or 403(b), and, for pur-
poses of the hardship relief, that could, if
it contained enabling language, make
hardship distributions. For purposes of
this paragraph, a "qualified employer
plan" also means a plan described in
§ 457(b) maintained by an eligible em-

ployer described in § 457(e)(1)(A), and
any hardship arising from Hurricane Mat-
thew is treated as an "unforeseeable emer-
gency" for purposes of distributions from
such plans. For example, a profit-sharing
or stock bonus plan that currently does not
provide for hardship or other in-service
distributions may nevertheless make hard-
ship distributions related to Hurricane
Matthew pursuant to this announcement,
except from QNEC or QMAC accounts or
from earnings on elective contributions
(see below for plan amendment require-
ments). A defined benefit or money pur-
chase plan, which generally cannot make
in-service hardship distributions, may not
make hardship distributions pursuant to
this announcement, other than from a sep-
arate account, if any, within the plan con-
taining either employee contributions or
rollover amounts.

The amount available for hardship dis-
tribution is limited to the maximum
amount that would be permitted to be
available for a hardship distribution under
the plan under the Code and regulations.
However, the relief provided by this an-
nouncement applies to any hardship of the
employee, not just the types enumerated
in the regulations, and no post-distribution
contribution restrictions are required. For
example, regulations under § 401(k) pro-
vide safe harbor hardship distribution stan-
dards under which a hardship is deemed to
exist only for certain enumerated events,
and, after receipt of the hardship amount,
the employee is prohibited from making
contributions for at least 6 months. Plans
need not follow these rules with respect to
hardship distributions for which relief is
provided under this announcement.

To make a loan or hardship distribution
pursuant to the relief provided in this an-
nouncement, a qualified employer plan
that does not provide for them must be
amended to provide for loans or hardship
distributions no later than the end of the
first plan year beginning after December
31, 2016. To qualify for the relief under
this announcement, a hardship distribu-
tion must be made on account of a hard-
ship resulting from Hurricane Matthew
and be made on or after October 4, 2016,
(October 3, 2016, for Florida) and no later
than March 15, 2017. Plan loans made
pursuant to this announcement must sat-
isfy the requirements of § 72(p).

In addition, a retirement plan will not
be treated as failing to follow procedural
requirements for plan loans (in the case of
retirement plans other than IRAs) or dis-
tributions (in the case of all retirement
plans, including IRAs) imposed by the
terms of the plan merely because those
requirements are disregarded for any pe-
riod beginning on or after October 4,
2016, (October 3, 2016, for Florida) and
continuing through March 15, 2017, with
respect to loans or distributions to individ-
uals described in the first paragraph under
"Relief", above, provided the plan admin-
istrator (or financial institution in the case of
distributions from IRAs) makes a good-faith
diligent effort under the circumstances to
comply with those requirements. However,
as soon as practicable, the plan administra-
tor (or financial institution in the case of
IRAs) must make a reasonable attempt to
assemble any forgone documentation. For
example, if spousal consent is required for a
plan loan or distribution and the plan terms
require production of a death certificate if
the employee claims his or her spouse is
deceased, the plan will not be disqualified
for failure to operate in accordance with its
terms if it makes a loan or distribution to an
individual described in the first paragraph
under "Relief" in the absence of a death
certificate if it is reasonable to believe, un-
der the circumstances, that the spouse is
deceased, the loan or distribution is made no
later than March 15, 2017, and the plan
administrator makes reasonable efforts to
obtain the death certificate as soon as prac-
ticable. For purposes of this announcement,
"retirement plan" has the same meaning as
"eligible retirement plan" under § 402(c)
(8)(B).

Taxpayers are reminded that in general
the normal spousal consent rules continue
to apply, and, except to the extent the
distribution consists of already-taxed
amounts, any distribution made pursuant
to the relief provided in this announce-
ment will be includible in gross income
and generally subject to the 10-percent
additional tax under § 72(t).

The Department of Labor has advised
Treasury and the IRS that it will not treat
any person as having violated the provi-
sions of Title I of the Employee Retire-
ment Income Security Act solely because
that person complied with the provisions
of this announcement.

# Definition of Terms

Revenue rulings and revenue procedures
(hereinafter referred to as "rulings") that
have an effect on previous rulings use the
following defined terms to describe the
effect:

Amplified describes a situation where
no change is being made in a prior pub-
lished position, but the prior position is
being extended to apply to a variation of
the fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that
the same principle also applies to B, the
earlier ruling is amplified. (Compare with
modified, below).

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

Distinguished describes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.

Modified is used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A

and B, the prior ruling is modified because
it corrects a published position. (Compare
with 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 in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.

Revoked describes situations where the
position in the previously published ruling
is not correct and the correct position is
being stated in a new ruling.

Superseded describes a situation where
the new ruling does nothing more than
restate the substance and situation of a
previously published ruling (or rulings).
Thus, the term is used to republish under
the 1986 Code and regulations the same
position published under the 1939 Code
and regulations. The term is also used
when it is desired to republish in a single
ruling a series of situations, names, etc.,
that were previously published over a pe-
riod of time in separate rulings. If the new
ruling does more than restate the sub-

stance of a prior ruling, a combination of
terms is used. For example, modified and
superseded describes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is
self contained. In this case, the previously
published ruling is first modified and then,
as modified, is superseded.

Supplemented is used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names
in subsequent rulings. After the original
ruling has been supplemented several
times, a new ruling may be published that
includes the list in the original ruling and
the additions, and supersedes all prior rul-
ings in the series.

Suspended is used in rare situations to
show that the previous published rulings
will not be applied pending some future
action such as the issuance of new or
amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.

# Abbreviations

The following abbreviations in current
use and formerly used will appear in ma-
terial published in the Bulletin.

A-Individual.

Acq .- Acquiescence.

B-Individual.

BE-Beneficiary.

F.R .- Federal Register.

FUTA-Federal Unemployment Tax Act.

FX-Foreign corporation.

G.C.M .- Chief Counsel's Memorandum.

GE-Grantee.

TFE-Transferee.

TFR-Transferor.

CI-City.

GR-Grantor.

IC-Insurance Company.

TP-Taxpayer.

Ct.D .- Court Decision.

I.R.B .- Internal Revenue Bulletin.

TR-Trust.

CY-County.

LE-Lessee.

TT-Trustee.

D-Decedent.

LP-Limited Partner.

U.S.C .- United States Code.

DC-Dummy Corporation.

X-Corporation.

DE-Donee.

Del. Order-Delegation Order.

Nonacq .- Nonacquiescence.

O Organization.

DR-Donor.

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.

BK-Bank.

B.T.A .- Board of Tax Appeals.

T.C .- Tax Court.

C-Individual.

T.D .- Treasury Decision.

C.B .- Cumulative Bulletin.

CFR-Code of Federal Regulations.

GP-General Partner.

T.I.R .- Technical Information Release.

COOP-Cooperative.

LR-Lessor.

M-Minor.

Y-Corporation.

Z-Corporation.

DISC-Domestic International Sales Corporation.

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.

T-Target Corporation.

Numerical Finding List1

Proposed Regulations :- Continued

Treasury Decisions :- Continued

Bulletin 2016-27 through 2016-45

REG-131418-14, 2016-33 I.R.B. 248

9786, 2016-42 I.R.B. 442 9790, 2016-45 I.R.B. 540

REG-102516-15, 2016-32 I.R.B. 231

Action on Decision:

REG-109086-15, 2016-30 I.R.B. 171 REG-134016-15, 2016-31 I.R.B. 205

2016-01, 2016-16 I.R.B. 580

REG-101689-16, 2016-30 I.R.B. 170

2016-02, 2016-31 I.R.B. 193

REG-103058-16, 2016-33 I.R.B. 238

2016-03, 2016-40 I.R.B. 424

REG-105005-16, 2016-38 I.R.B. 380

REG-108792-16, 2016-36 I.R.B. 320

Announcements:

REG-108934-16, 2016-44 I.R.B. 532

REG-123600-16, 2016-43 I.R.B. 523

2016-21, 2016-27 I.R.B. 8

REG-130314-16, 2016-45 I.R.B. 718

2016-23, 2016-27 I.R.B. 10

2016-24, 2016-30 I.R.B. 170

2016-25, 2016-31 I.R.B. 205

Revenue Procedures:

2016-26, 2016-38 I.R.B. 389

2016-37, 2016-29 I.R.B. 136

2016-27, 2016-33 I.R.B. 238

2016-39, 2016-30 I.R.B. 164

2016-28, 2016-34 I.R.B. 272

2016-40, 2016-32 I.R.B. 228

2016-29, 2016-34 I.R.B. 272

2016-41, 2016-30 I.R.B. 165

2016-30, 2016-37 I.R.B. 355

2016-42, 2016-34 I.R.B. 269

2016-31, 2016-38 I.R.B. 392

2016-43, 2016-36 I.R.B. 316

2016-32, 2016-40 I.R.B. 434

2016-44, 2016-36 I.R.B. 316

2016-33, 2016-39 I.R.B. 422

2016-45, 2016-37 I.R.B. 344

2016-34, 2016-39 I.R.B. 422

2016-46, 2016-37 I.R.B. 345

2016-35, 2016-39 I.R.B. 423

2016-47, 2016-37 I.R.B. 346

2016-36, 2016-39 I.R.B. 423

2016-48, 2016-37 I.R.B. 348

2016-37, 2016-39 I.R.B. 423

2016-49, 2016-42 I.R.B. 462

2016-38, 2016-43 I.R.B. 523

2016-50, 2016-43 I.R.B. 522

2016-39, 2016-45 I.R.B. 720

2016-51, 2016-42 I.R.B. 465

2016-52, 2016-42 I.R.B. 520

Notices:

2016-53, 2016-44 I.R.B. 530

2016-40, 2016-27 I.R.B. 4

2016-54, 2016-45 I.R.B. 685

2016-41, 2016-27 I.R.B. 5

2016-55, 2016-45 I.R.B. 707

2016-42, 2016-29 I.R.B. 67

2016-43, 2016-29 I.R.B. 132

Revenue Rulings:

2016-44, 2016-29 I.R.B. 132

2016-45, 2016-29 I.R.B. 135

2016-17, 2016-27 I.R.B. 1

2016-46, 2016-31 I.R.B. 202

2016-18, 2016-31 I.R.B. 194

2016-47, 2016-35 I.R.B. 276

2016-19, 2016-35 I.R.B. 273

2016-48, 2016-33 I.R.B. 235

2016-20, 2016-36 I.R.B. 279

2016-49, 2016-34 I.R.B. 265

2016-23, 2016-39 I.R.B. 382

2016-50, 2016-38 I.R.B. 384

2016-24, 2016-39 I.R.B. 395

2016-51, 2016-37 I.R.B. 344

2016-25, 2016-41 I.R.B. 435

2016-52, 2016-40 I.R.B. 425

2016-26, 2016-45 I.R.B. 538

2016-53, 2016-39 I.R.B. 421

2016-54, 2016-40 I.R.B. 429

Treasury Decisions:

2016-55, 2016-40 I.R.B. 432

2016-57, 2016-40 I.R.B. 432

9773, 2016-29 I.R.B. 56

2016-58, 2016-41 I.R.B. 438

9774, 2016-30 I.R.B. 151

2016-59, 2016-42 I.R.B. 457

9775, 2016-30 I.R.B. 159

2016-60, 2016-42 I.R.B. 458

9776, 2016-32 I.R.B. 222

2016-63, 2016-45 I.R.B. 683

9777, 2016-36 I.R.B. 282

9778, 2016-31 I.R.B. 196

Proposed Regulations:

9779, 2016-33 I.R.B. 233 9781, 2016-35 I.R.B. 274

REG-163113-02, 2016-36 I.R.B. 329

9782, 2016-36 I.R.B. 301

REG-147196-07, 2016-29 I.R.B. 32

9783, 2016-39 I.R.B. 396

REG-123854-12, 2016-28 I.R.B. 15

9784, 2016-39 I.R.B. 402

REG-150992-13, 2016-44 I.R.B. 537

9785, 2016-38 I.R.B. 375

1A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2016-01 through 2016-26 is in Internal Revenue Bulletin
2016-26, dated June 27, 2016.

## Finding List of Current Actions on Previously Published Items1

Bulletin 2016-27 through 2016-45

Notices:

2009-89
Modified by
Notice 2016-51, 2016-37 I.R.B. 344

2012-54
Obsoleted by
Notice 2016-51, 2016-37 I.R.B. 344

2013-1
Modified by
Notice 2016-41, 2016-27 I.R.B. 5

2013-1
Superseded by
Notice 2016-41, 2016-27 I.R.B. 5

2013-67
Modified by
Notice 2016-51, 2016-37 I.R.B. 344

2015-63
Superseded by
Notice 2016-58, 2016-41 I.R.B. 438

### Revenue Procedures:

2003-16
Modified by
Rev. Proc. 2016-47, 2016-37 I.R.B. 346

2007-44
Clarified by
Rev. Proc. 2016-37, 2016-29 I.R.B. 136

2007-44
Modified by
Rev. Proc. 2016-37, 2016-29 I.R.B. 136

2007-44
Superseded by
Rev. Proc. 2016-37, 2016-29 I.R.B. 136

2009-33
Modified by
Rev. Proc. 2016-48, 2016-37 I.R.B. 348

2015-36
Modified by
Rev. Proc. 2016-37, 2016-29 I.R.B. 136

2016-3
Modified by
Rev. Proc. 2016-40, 2016-32 I.R.B. 228

Revenue Procedures :- Continued

2016-3
Modified by
Rev. Proc. 2016-45, 2016-37 I.R.B. 228

2016-3
Supplemented by
Rev. Proc. 2016-50, 2016-43 I.R.B. 522

2016-29
Modified by
Rev. Proc. 2016-39, 2016-30 I.R.B. 164

### Treasury Decisions:

2013-17
Obsoleted by
T.D. 9785 2016-38 I.R.B. 375

2014-12
Modified by
T.D. 9776 2016-32 I.R.B. 222

"A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2016-01 through 2016-26 is in Internal Revenue Bulletin
2016-26, dated June 27, 2016.

# Internal Revenue Service Washington, DC 20224

Official Business
Penalty for Private Use, $300

# INTERNAL REVENUE BULLETIN

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

# We Welcome Comments About the Internal Revenue Bulletin

If you have comments concerning the format or production of the Internal Revenue Bulletin or suggestions for improving it, we
would be pleased to hear from you. You can email us your suggestions or comments through the IRS Internet Home Page
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Internal Revenue Bulletin 2016-45 (PDF rendition): IRS Notices

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