Internal Revenue Bulletin 2016-17 (PDF rendition): IRS Revenue Procedures

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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–108060–15, page 636.
This document contains proposed regulations under section
385 of the Internal Revenue Code (Code) that would authorize
the Commissioner to treat certain related party interests in a
corporation as indebtedness in part and stock in part for
federal tax purposes, and establish threshold documentation
requirements that must be satisfied in order for certain related
party interests in a corporation to be treated as indebtedness for
federal tax purposes. The proposed regulations also would treat
as stock certain related party interests that otherwise would be
treated as indebtedness for federal tax purposes. The proposed
regulations generally affect corporations that issue purported
indebtedness to related corporations or partnerships.
Rev. Proc. 2016–18, page 635.
This revenue procedure provides an updated list of countries
with which the IRS and Treasury have determined that it is
appropriate to have an automatic exchange relationship with
respect to the bank deposit interest information collected
under Sections 1.6049–4(b)(5) and 1.6049–8 of the Income
Tax Regulations. This revenue procedure is a March 2016
supplement to Rev. Proc. 2014–64, 2014–53 I.R.B. 1022,
which was last supplemented by Rev. Proc. 2015–50,
2015–42 I.R.B 583 in September 2015.
EXEMPT ORGANIZATIONS
Announcement 2016–15, page 636.
Revocation of IRC 501(c)(3) Organizations for failure to meet
the code section requirements. Contributions made to the
organizations by individual donors are no longer deductible
under IRC 170(b)(1)(A).
Finding Lists begin on page ii.
Bulletin No. 2016–17
April 25, 2016

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.
April 25, 2016Bulletin No. 2016–17

Part III. Administrative, Procedural, and Miscellaneous
26 CFR 1.6049.00 – 00: Returns Relating to Pay-
ments of Interest
(Also: 1.3406.07– 00 Exceptions to Backup With-
holding)
Rev. Proc. 2016–18
SECTION 1. PURPOSE
This revenue procedure supplements the
listing in Revenue Procedure 2014 – 64,
2014 –53 I.R.B. 1022, as previously sup-
plementedbyRev.Proc.2015–50,
2015– 42 I.R.B. 583, of the countries with
which the Department of the Treasury
(Treasury Department) and the Internal
Revenue Service (IRS) have determined
that it is appropriate to have an automatic
exchange relationship with respect to the
information collected under §§ 1.6049 –
4(b)(5) and 1.6049 – 8 of the Income Tax
Regulations.
SECTION 2. BACKGROUND
Sections 1.6049 – 4(b)(5) and 1.6049 – 8(a),
as revised by TD 9584, require the report-
ing of certain deposit interest paid to non-
resident alien individuals on or after Jan-
uary 1, 2013. Rev. Proc. 2012–24,
2012–20 I.R.B. 913, was published con-
temporaneously with the publication of
TD 9584. Section 4 of that revenue pro-
cedure identified the countries with which
the Treasury Department and the IRS had
determined that it was appropriate to have
an automatic exchange relationship with
respect to the information collected under
§§ 1.6049 – 4(b)(5) and 1.6049 – 8. Rev.
Proc. 2012–24 was updated and super-
seded by Rev. Proc. 2014 – 64, Section 4
of which contained an updated list of
countries with which an automatic ex-
change relationship had been determined
appropriate. Rev. Proc. 2014 – 64 was sup-
plemented by Rev. Proc. 2015–50, which
added 16 countries to that list. This reve-
nue procedure further supplements Rev.
Proc. 2014 – 64 by adding three countries
(Azerbaijan, Jamaica, and the Slovak Re-
public) to the list of countries in Section 4
of Rev. Proc. 2014 – 64.
SECTION 3. SUPPLEMENT TO
REV. PROC. 2014–64
Section 4 of Rev. Proc. 2014 – 64, as
supplemented by Rev. Proc. 2015–50, is
further supplemented to read as follows:
The following list identifies the coun-
tries with which the automatic exchange
oftheinformationcollectedunder
§§ 1.6049 – 4(b)(5) and 1.6049 – 8 has
been determined by the Treasury Depart-
ment and the IRS to be appropriate:
Australia
Azerbaijan
Brazil
Canada
Czech Republic
Denmark
Estonia
Finland
France
Germany
Gibraltar
Guernsey
Hungary
Iceland
India
Ireland
Isle of Man
Italy
Jamaica
Jersey
Latvia
Liechtenstein
Lithuania
Luxembourg
Malta
Mauritius
Mexico
Netherlands
New Zealand
Norway
Poland
Slovak Republic
Slovenia
South Africa
Spain
Sweden
United Kingdom
SECTION 4. EFFECT ON OTHER
DOCUMENTS
Rev. Proc. 2014 – 64, as supplemented
by Rev. Proc. 2015–50, is further supple-
mented.
SECTION 5. DRAFTING
INFORMATION
The principal author of this revenue
procedure is Jackie Bennett Manasterli of
the Office of Associate Chief Counsel (In-
ternational). For further information re-
garding this revenue procedure contact
Ms. Manasterli at (202) 317-5218 (not a
toll-free number).
Bulletin No. 2016–17April 25, 2016
635

Part IV. Items of General Interest
Deletions From Cumulative
List of Organizations,
Contributions to Which are
Deductible Under Section
170 of the Code
Announcement 2016–15
Table of Contents
The Internal Revenue Service has re-
voked its determination that the organiza-
tions listed below qualify as organizations
described in sections 501(c)(3) and
170(c)(2) of the Internal Revenue Code of
1986.
Generally, the IRS will not disallow
deductions for contributions made to a
listed organization on or before the date of
announcement in the Internal Revenue
Bulletin that an organization no longer
qualifies. However, the IRS is not pre-
cluded from disallowing a deduction for
any contributions made after an organiza-
tion ceases to qualify under section
170(c)(2) if the organization has not
timely filed a suit for declaratory judg-
ment under section 7428 and if the con-
tributor (1) had knowledge of the revoca-
tion of the ruling or determination letter,
(2) was aware that such revocation was
imminent, or (3) was in part responsible
for or was aware of the activities or omis-
sions of the organization that brought
about this revocation.
If on the other hand a suit for declara-
tory judgment has been timely filed, con-
tributions from individuals and organiza-
tions described in section 170(c)(2) that
are otherwise allowable will continue to
be deductible. Protection under section
7428(c) would begin on April 25, 2016
and would end on the date the court first
determines the organization is not de-
scribed in section 170(c)(2) as more par-
ticularly set for in section 7428(c)(1). For
individual contributors, the maximum de-
duction protected is $1,000, with a hus-
band and wife treated as one contributor.
This benefit is not extended to any indi-
vidual, in whole or in part, for the acts or
omissions of the organization that were
the basis for revocation.
NAME OF ORGANIZATIONEffective Date of RevocationLOCATION
Cloverfield 180, Inc.January 1, 2013Van Wert, Ohio
Texas Cave ConservancyJanuary 1, 2012Cedar Park, TX
Notice of Proposed
Rulemaking
Treatment of Certain
Interests in Corporations as
Stock or Indebtedness
REG–108060–15
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION:Notice of proposed rulemaking.
SUMMARY: This document contains
proposed regulations under section 385 of
the Internal Revenue Code (Code) that
would authorize the Commissioner to
treat certain related-party interests in a
corporation as indebtedness in part and
stock in part for federal tax purposes, and
establish threshold documentation re-
quirements that must be satisfied in order
for certain related-party interests in a cor-
poration to be treated as indebtedness for
federal tax purposes. The proposed regu-
lations also would treat as stock certain
related-partyintereststhatotherwise
would be treated as indebtedness for fed-
eral tax purposes. The proposed regula-
tions generally affect corporations that is-
sue purported indebtedness to related
corporations or partnerships.
DATES: Written or electronic comments
and requests for a public hearing must be
received by July 7, 2016.
ADDRESSES: Send submissions to: CC:
PA:LPD:PR (REG–108060 –15), room
5203, Internal Revenue Service, P.O. Box
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand-
delivered Monday through Friday be-
tween thehours of 8 a.m. and 4 p.m. to
CC:PA:LPD:PR (REG–108060 –15), Cou-
rier’s Desk, Internal Revenue Service, 1111
Constitution Avenue NW, Washington, DC
20224 or sent electronically via the Federal
eRulemaking Portal athttp://www.regulations.
gov(IRS REG–108060 –15).
FOR FURTHER INFORMATION
CONTACT:Concerning the proposed reg-
ulations under §§ 1.385–1 and 1.385–2, Eric
D. Brauer, (202) 317-5348; concerning the
proposed regulations under §§ 1.385–3 and
1.385– 4, Raymond J. Stahl, (202) 317-
6938; concerning submissions of comments
or requests for a public hearing, Regina
Johnson, (202) 317-5177 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information con-
tained in this notice of proposed rulemak-
ing has been submitted to the Office of
Management and Budget in accordance
with the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)). Comments on
the collection of information should be
sent to the Office of Management and
Budget, Attn: Desk Officer for the Depart-
ment of the Treasury, Office of Informa-
tion and Regulatory Affairs, Washington,
DC 20503, with copies to the Internal
Revenue Service, Attn: IRS Reports
Clearance Officer, SE:W:CAR:MP:T:T:
SP, Washington, DC 20224. Comments
on the collection of information should be
received by June 7, 2016. Comments are
specifically requested concerning:
Whether the proposed collection of in-
formation is necessary for the proper per-
April 25, 2016Bulletin No. 2016–17
636

formance of the functions of the IRS, in-
cluding whether the information will have
practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information;
How the quality, utility, and clarity of
the information to be collected may be
enhanced;
How the burden of complying with the
proposed collection of information may
be minimized, including through the ap-
plication of automated collection tech-
niques or other forms of information tech-
nology; and
Estimates ofcapital or start-up costs and
costs of operation, maintenance, and pur-
chase of services to provide information.
The collection of information in this
proposed regulation is in§ 1.385–2(b)(2).
This collection of information is neces-
sary to determine whether certain interests
between members of an expanded affili-
ated group are to be treated as stock or
indebtedness for federal tax purposes. The
likely respondents are entities that are af-
filiates of publicly traded entities or meet
certain thresholds on their financial state-
ments.
Estimated total annual reporting bur-
den: 735,000 hours.
Estimated average annual burden per
respondent: 35 hours.
Estimated number of respondents:
21,000.
Estimated frequency of responses:
Monthly.
An agency may not conduct or spon-
sor, and a person is not required to re-
spond to, a collection of information un-
less it displays a valid control number
assigned by the Office of Management
and Budget.
Background
As described further in this preamble,
courts historically have analyzed whether
an interest in a corporation should be
treated as stock or indebtedness for fed-
eral tax purposes by applying various sets
of factors to the facts of a particular case.
In 1969, Congress enacted section 385 to
authorize the Secretary of the Treasury
(Secretary) to prescribe such regulations
as may be necessary or appropriate to
determine whether an interest in a corpo-
ration is to be treated as stock or indebt-
edness for purposes of the Code. Because
no regulations are currently in effect un-
der section 385, the case law that devel-
oped before the enactment of section 385
has continued to evolve and to control the
characterization of an interest in a corpo-
ration as debt or equity.
I.Section 385 Statute and Legislative
History
A.Original Enactment of Section 385
Section 385(a), as originally enacted as
part of the Tax Reform Act of 1969 (Pub.
L. No. 91–172, 83 Stat. 487), authorizes
the Secretary to prescribe such regulations
as may be necessary or appropriate to
determine whether an interest in a corpo-
ration is treated as stock or indebtedness
for purposes of the Code.
Section 385(b) provides that the regu-
lations prescribed under section 385 shall
set forth factors that are to be taken into
account in determining in a particular fac-
tual situation whether a debtor-creditor
relationship exists or a corporation-
shareholder relationship exists. Under sec-
tion 385(b), those factors may include,
among other factors, the following: (1)
whether there is a written unconditional
promise to pay on demand or on a speci-
fied date a sum certain in money in return
for an adequate consideration in money or
money’s worth, and to pay a fixed rate of
interest; (2) whether there is subordination
to or preference over any indebtedness of
the corporation; (3) the ratio of debt to
equity of the corporation; (4) whether
there is convertibility into the stock of the
corporation; and (5) the relationship be-
tween holdings of stock in the corporation
and holdings of the interest in question.
In enacting section 385(a) and (b),
Congress authorized the Secretary to pre-
scribe targeted rules to address particular
factual situations, stating:
In view of the uncertainties and dif-
ficulties which the distinction be-
tween debt and equity has produced
in numerous situations...thecom-
mittee further believes that it would
be desirable to provide rules for dis-
tinguishing debt from equity in the
variety of contexts in which this
problem can arise. Thediffering cir-
cumstances which characterize these
situations, however, would make it
difficult for the committee to provide
comprehensive and specific statutory
rules of universal and equal applica-
bility. In view of this, the committee
believes it is appropriate to specifi-
cally authorize the Secretary of the
Treasury to prescribe the appropriate
rules for distinguishing debt from eq-
uity in these different situations.
S. Rep. No. 91–552, at 138 (1969). The
legislative history further explains that
regulations applicable to a particular fac-
tual situation need not rely on the factors
set forth in section 385(b):
The provision also specifies certain
factors which may be taken into ac-
count in these [regulatory] guide-
lines. It is not intended that only
these factors be included in the
guidelines or that, with respect to a
particular situation, any of these
factors must be included in the
guidelines, or that any of the factors
which are included by statute must
necessarily be given any more
weight than other factors added by
regulations.
Id.Accordingly, section 385(b) pro-
vides the Secretary with discretion to es-
tablish specific rules for determining
whether an interest is treated as stock or
indebtedness for federal tax purposes in a
particular factual situation.
B.1989 and 1992 Amendments to
Section 385
Congress amended section 385 in 1989
and 1992. In 1989, the Omnibus Budget
Reconciliation Act of 1989 (Pub. L. No.
101–239, 103 Stat. 2106) amended sec-
tion 385(a) to expressly authorize the Sec-
retary to issue regulations under which an
interest in a corporation is to be treated as
in part stock and in part indebtedness.
This amendment also provides that any
regulations so issued may apply only with
respect to instruments issued after the date
on which the Secretary or the Secretary’s
delegate provides public guidance as to
the characterization of such instruments
(whether by regulation, ruling, or other-
wise).SeePub. L. No. 101–239, sec.
7208(a)(2). The legislative history to the
1989 amendment notes that, while “[t]he
characterization of an investment in a cor-
poration as debt or equity for Federal in-
come tax purposes generally is deter-
Bulletin No. 2016–17April 25, 2016
637

mined by reference to numerous factors, .
. . there has been a tendency by the courts
to characterize an instrument entirely as
debt or entirely as equity.” H.R. Rep. No.
101–386, at 3165– 66 (1989) (Conf. Rep.).
In 1992, Congress added section
385(c) to the Code as part of the Energy
Policy Act of 1992 (Pub. L. No. 102– 486,
106 Stat. 2776). Section 385(c)(1) pro-
vides that the issuer’s characterization (as
of the time of issuance) as to whether an
interest in a corporation is stock or indebt-
edness shall be binding on such issuer and
on all holders of such interest (but shall
not be binding on the Secretary). Section
385(c)(2) provides that, except as pro-
vided in regulations, section 385(c)(1)
shall not apply to any holder of an interest
if such holder on his return discloses that
he is treating such interest in a manner
inconsistent with the initial characteriza-
tion of the issuer. Section 385(c)(3) autho-
rizes the Secretary to require such infor-
mation as the Secretary determines to be
necessary to carry out the provisions of
section 385(c), including the information
necessary for the Secretary to determine
how the issuer characterized an interest as
of the time of issuance.
Congress added section 385(c) in re-
sponse to issuers and holders characteriz-
ing a corporate instrument inconsistently.
H.R. Rep. No. 102–716, at 3 (1992). For
example, a corporate issuer may designate
an instrument as indebtedness for federal
tax purposes and deduct as interest the
amounts paid on the instrument, while a
corporate holder may treat the instrument
as stock for federal tax purposes and claim
a dividends received deduction with re-
spect to the amounts paid on the instru-
ment.See id.
II.Regulations
There are no regulations currently in
effect under section 385. On March 24,
1980, the Department of the Treasury
(Treasury Department) and the IRS pub-
lished a notice of proposed rulemaking
(LR–1661) in theFederal Register(45
FR 18959) under section 385 relating to
the treatment of certain interests in corpo-
rations as stock or indebtedness. Final reg-
ulations (TD 7747) were published in the
Federal Register(45 FR 86438) on De-
cember 31, 1980. Subsequent revisions of
the final regulations were published in the
Federal Registeron May 4, 1981, Janu-
ary 5, 1982, and July 2, 1982 (46 FR
24945, 47 FR 147, and 47 FR 28915,
respectively). The Treasury Department
and the IRS published a notice of pro-
posed withdrawal of TD 7747 in theFed-
eral Registeron July 6, 1983 (48 FR
31053), and in TD 7920, published in the
Federal Register(48 FR 50711) on No-
vember 3, 1983, the Treasury Department
and the IRS withdrew TD 7747.
The Treasury Department and the IRS
have not previously published any regula-
tions regarding the 1989 amendment to
section 385(a), which authorizes the Sec-
retary to issue regulations that treat an
interest in a corporation as indebtedness in
part or as stock in part. In addition, no
regulations have been published with re-
spect to the 1992 addition of section
385(c) authorizing the Secretary to require
information related to an issuer’s initial
characterization of an interest for federal
tax purposes or to affect the ability of a
holder to treat an interest inconsistent with
the initial treatment of the issuer.
III.Case Law
In the absence of regulations under sec-
tion 385, the pre-1969 case law has con-
tinued to evolve and control the charac-
terization of an interest as debt or equity
for federal tax purposes. Under that case
law, courts apply inconsistent sets of fac-
tors to determine if an interest should be
treated as stock or indebtedness, subject-
ing substantially similar fact patterns to
differing analyses. The result has been a
body of case law that perpetuates the “un-
certainties and difficulties which the dis-
tinction between debt and equity has pro-
duced”andwithwhichCongress
expressed concern when enacting section
385.SeeS. Rep. No. 91–552, at 138. For
example, inFin Hay Realty Co. v. United
States, 398 F.2d 694 (3d Cir. 1968), the
U.S. Court of Appeals for the Third Cir-
cuit identified sixteen factors relevant for
distinguishing between indebtedness and
stock:
(1) the intent of the parties; (2) the
identitybetweencreditorsand
shareholders; (3) the extent of par-
ticipation in management by the
holder of the instrument; (4) the
ability of the corporation to obtain
funds from outside sources; (5) the
‘thinness’ of the capital structure in
relation to debt; (6) the risk in-
volved; (7) the formal indicia of the
arrangement; (8) the relative posi-
tion of the obligees as to other cred-
itors regarding the payment of inter-
est and principal; (9) the voting
power of the holder of the instru-
ment; (10) the provision of a fixed
rate of interest; (11) a contingency
on the obligation to repay; (12) the
source of the interest payments; (13)
the presence or absence of a fixed
maturity date; (14) a provision for
redemption by the corporation; (15)
a provision for redemption at the
option of the holder; and (16) the
timing of the advance with refer-
ence to the organization of the
corporation.
Id.at 696. By contrast, inEstate of
Mixon v. United States, 464 F.2d 394 (5th
Cir. 1972), the U.S. Court of Appeals for
the Fifth Circuit identified thirteen factors
that are similar to, but not the same as,
those used inFin Hayto distinguish be-
tween indebtedness and stock:
(1) the names given to the certifi-
cates evidencing the indebtedness;
(2) The presence or absence of a
fixed maturity date; (3) The source
of payments; (4) The right to en-
force payment of principal and in-
terest; (5) participation in manage-
ment flowing as a result; (6) the
status of the contribution in relation
to regular corporate creditors; (7)
the intent of the parties; (8) ‘thin’ or
adequate capitalization; (9) identity
of interest between creditor and
stockholder; (10) source of interest
payments; (11) the ability of the
corporation to obtain loans from
outside lending institutions; (12) the
extent to which the advance was
used to acquire capital assets; and
(13) the failure of the debtor to re-
pay on the due date or to seek a
postponement.
Id.at 402. The weight given to the
various factors in a particular case also
differs, and is highly dependent upon the
relevant facts and circumstances.See, e.g.,
J.S. Biritz Construction Co. v. Commis-
sioner, 387 F.2d 451, 456 –57 (8th Cir.
1967) (stating that the factors “have vary-
ing degrees of relevancy, depending on
the particular factual situation and are
April 25, 2016Bulletin No. 2016–17
638

generally not all applicable to any given
case”).
Underthisfacts-and-circumstances
analysis, as developed in the case law, no
single fact or circumstance is sufficient to
establish that an interest should be treated
as stock or indebtedness.See, e.g.,John
Kelley Co. v. Commissioner, 326 U.S.
521, 530 (1946) (“[N]o one characteristic
. . . can be said to be decisive in the
determination of whether the obligations
are risk investments in the corporations or
debts.”);Fin Hay, 398 F.2d at 697
(“[N]either any single criterion nor any
series of criteria can provide a conclusive
answer in the kaleidoscopic circumstances
which individual cases present.”). It was
this emphasis on particular taxpayer facts
and circumstances, coupled with inconsis-
tent analysis of the relevant factors by
different courts, that led Congress to del-
egate to the Secretary the authority to pro-
vide regulations under section 385 for dis-
tinguishing debt from equity that could
depart from the factors developed in case
law or enumerated in the statute.SeeS.
Rep. No. 91–552, at 138.
IV.Other Relevant Statutory Provisions
Section 701 provides that a partnership
as such shall not be subject to federal
income tax, but that persons carrying on
business as partners shall be liable for
federal income tax only in their separate
or individual capacities.
Section 1502 provides that the Secre-
tary shall prescribe such regulations as the
Secretary deems necessary in order that
the federal tax liability of any affiliated
group of corporations making a consoli-
dated return and of each corporation in the
group, both during and after the period of
affiliation, may be returned, determined,
computed, assessed, collected, and ad-
justed, in such manner as clearly to reflect
the federal income tax liability and the
various factors necessary for the determi-
nation of such liability, and in order to
prevent avoidance of such tax liability. In
prescribing such regulations, section 1502
authorizes the Secretary to prescribe rules
that are different from the provisions of
chapter 1 of subtitle A of the Code that
would apply if such corporations filed
separate returns.
Section 7701(l) provides that the Sec-
retary may prescribe regulations recharac-
terizing any multiple-party financing
transaction as a transaction directly
among any two or more of such parties
where the Secretary determines that such
recharacterization is appropriate to pre-
vent avoidance of any tax imposed by the
Code.
V.Earnings Stripping Guidance
Described in Notice 2014 –52 and Notice
2015–79
Notice 2014 –52, 2014 – 42 IRB 712
(Oct. 14, 2014), and Notice 2015–79,
2015– 49 IRB 775 (Dec. 7, 2015), de-
scribed regulations that the Treasury De-
partment and the IRS intend to issue with
respect to corporate inversions and related
transactions. Notice 2014 –52 and Notice
2015–79 also provided that the Treasury
Department and the IRS expect to issue
additional guidance to further limit the
benefits of post-inversion tax avoidance
transactions. The notices stated, in partic-
ular, that the Treasury Department and the
IRS are considering guidance to address
strategies that avoid U.S. tax on U.S. op-
erations by shifting or “stripping” U.S.-
source earnings to lower-tax jurisdictions,
including through intercompany debt.
VI.Purpose of the Proposed
Regulations
These proposed regulations under sec-
tion 385 address whether an interest in a
related corporation is treated as stock or
indebtedness, or as in part stock or in part
indebtedness, for purposes of the Code.
While these proposed regulations are mo-
tivated in part by the enhanced incentives
for related parties to engage in transac-
tions that result in excessive indebtedness
in the cross-border context, federal in-
come tax liability can also be reduced or
eliminated with excessive indebtedness
between domestic related parties. Thus,
the proposed rules apply to purported in-
debtedness issued to certain related par-
ties, without regard to whether the parties
are domestic or foreign. Nonetheless, the
Treasury Department and the IRS also
have determined that the proposed regu-
lations should not apply to issuances of
interests and related transactions among
members of a consolidated group because
the concerns addressed in the proposed
regulations generally are not present when
the issuer’s deduction for interest expense
and the holder’s corresponding interest in-
come offset on the group’s consolidated
federal income tax return.
Section A of this Part VI addresses
bifurcation of interests that are indebted-
ness in part but not in whole. Section B of
this Part VI addresses documentation re-
quirements for related-party indebtedness.
Section C of this Part VI addresses distri-
butions of debt instruments and similar
transactions.
A.Interests that are Indebtedness in
Part but Not in Whole
Aspreviouslynoted,Congress
amended section 385(a) in 1989 to autho-
rize the issuance of regulations permitting
an interest in a corporation to be treated as
in part indebtedness and in part stock. The
legislative history to the 1989 amendment
explained that “there has been a tendency
by the courts to characterize an instrument
entirely as debt or entirely as equity.”
H.R. Rep. No. 101–386, at 562 (1989)
(Conf. Rep.). No regulations have been
promulgated under the amendment, how-
ever, and this tendency by the courts has
continued to the present day. Conse-
quently, the Commissioner generally is
required to treat an interest in a corpora-
tion as either wholly indebtedness or
wholly equity.
This all-or-nothing approach is partic-
ularly problematic in cases where the facts
and circumstances surrounding a pur-
ported debt instrument provide only
slightly more support for characterization
of the entire interest as indebtedness than
for equity characterization, a situation that
is increasingly common in the related-
party context. The Treasury Department
and the IRS have determined that the all-
or-nothing approach frequently fails to re-
flect the economic substance of related-
partyintereststhatareinform
indebtedness and gives rise to inappropri-
ate federal tax consequences. Accord-
ingly, the Treasury Department and the
IRS have determined that the interests of
tax administration would best be served if
the Commissioner were able to depart
from the all-or-nothing approach where
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639

appropriate to ensure that the provisions
of the Code are applied in a manner that
clearly reflects the income of related tax-
payers. To that end, these proposed regu-
lations would exercise the authority
granted by section 385(a) to permit the
Commissioner to treat a purported debt
instrument issued between related parties
as in part indebtedness and in part stock
for federal tax purposes. However, the
proposed regulations would not permit is-
suers and related holders to treat such an
instrument in a manner inconsistent with
the issuer’s initial characterization. The
proposed regulations described in Part
IV.B.2 of the Explanation of Provisions
section of this preamble also rely in part
on the authority granted under section
385(a) to treat interests as in part indebt-
edness and in part stock for federal tax
purposes.
The proposed rule applies with respect
to parties that meet a lower 50-percent
threshold for relatedness than the thresh-
old applicable with respect to other rules
contained in these proposed regulations.
This is because, as noted in Part VI of the
Background section of this preamble, fed-
eral income tax liability can be reduced or
eliminated by the introduction of exces-
sive indebtedness between related parties,
and this can be accomplished without spe-
cial cooperation among the related parties
and regardless of other transactions under-
taken by the issuer or holder after issu-
ance. In addition, a 50-percent relatedness
threshold is consistent with other provi-
sions used in subchapter C of the Code
to identify a level of control or owner-
ship that can warrant different federal
tax consequences than those for less-
related parties.
The proposed rule merely permits the
Commissioner to treat a purported debt
instrument as in part indebtedness and in
part stock consistent with its substance.
Moreover,theproposedregulations
would not affect the authority of the Com-
missioner to disregard a purported debt
instrument as indebtedness or stock, to
treat a purported debt instrument as in-
debtedness or equity of another entity, or
otherwise to treat a purported debt instru-
ment in accordance with its substance.
See, e.g.,Plantation Patterns v. Commis-
sioner, 462 F.2d 712 (5th Cir. 1972).
The Treasury Department and the IRS
recognize that authorizing the Commis-
sioner to treat purported debt instruments
issued among unrelated parties as indebt-
edness in part and stock in part could
result in unnecessary uncertainty in the
capital markets in the absence of detailed
standards for the exercise of that author-
ity. Similarly, any exercise of this author-
ity with respect to related-party interests
that are denominated as other than indebt-
edness would require more detailed guid-
ance. Thus, the proposed rule does not
apply in those contexts.
B.Related-Party Indebtedness
1.Background
Related-party indebtedness, like in-
debtedness between unrelated persons,
may be respected as indebtedness for fed-
eral tax purposes, but only if there is intent
to create a true debtor-creditor relation-
ship that results in bona fide indebtedness.
While still subject to the same multifactor
analysis used for characterizing interests
issued between third parties, “courts have
consistently recognized that transactional
forms between related parties are suscep-
tible of manipulation and, accordingly,
warrant a more thorough and discerning
examination for tax characterization pur-
poses.”PepsiCo Puerto Rico, Inc. v. Com-
missioner, T.C. Memo 2012–269, at 51,
citing United States v. Uneco, Inc., 532
F.2d 1204, 1207 (8th Cir. 1976);Cuyuna
Realty Co. v. United States, 382 F.2d 298,
301 (Ct. Cl. 1967) (stating that an advance
between a parent corporation and a sub-
sidiary or other affiliate under common
control must be subject to particular
scrutiny “because the control element
suggests the opportunity to contrive a
fictional debt, an opportunity less pres-
ent in an arms-length transaction be-
tween strangers.”).
This scrutiny is warranted because
there is typically less economic incentive
for a related-party lender to impose disci-
pline on the legal documentation and eco-
nomic analysis supporting the character-
ization of an interest as indebtedness for
federal tax purposes. While a lender typ-
ically carefully documents a loan to a
third party borrower and decides whether
and how much to lend based on that doc-
umentation and objective financial crite-
ria, a related-party lender, especially one
that directly or indirectly controls the bor-
rower, may require only simple (or even
no) legal documentation and may forgo
any economic analysis that would inform
the lender of the amount that the borrower
could reasonably be expected to repay.
The absence of reasonable diligence by
related-party lenders can have the effect
of limiting the factual record that is avail-
able for additional scrutiny and thorough
examination. Nonetheless, courts do not
always require related parties to engage in
reasonable financial analysis and legal
documentation similar to that which busi-
ness exigencies would incent third-parties
in connection with lending to unrelated
borrowers.See, e.g.,C.M. Gooch Lumber
Sales Co. v. Commissioner, 49 T.C. 649
(1968) at 656 (noting that in the case of
related-party debt, “the absence of a writ-
ten debt instrument, security, or provision
for the payment of interest is not control-
ling; formal evidences of indebtedness are
at best clues to proof of the ultimate
fact”);see also Byerlite Corp. v. Williams,
286 F.2d 285, 290 –91 (6th Cir. 1960),
citing Ewing v. Commissioner, 5 T.C.
Memo 908 (1946) (“The fact that ad-
vancements to a corporation are made
without requiring any evidence of indebt-
edness...wasnotacontrolling consid-
eration . . .”).
Historically, the absence of clear guid-
ance regarding the documentation and in-
formation necessary to support debt char-
acterization in the related-party context
did not pose a significant obstacle, be-
cause the transactions presented by cases
such asMixon,Fin Hay, and their progeny
were not factually complex. Typically, the
earlier cases involved direct advances be-
tween individual U.S. taxpayers and their
closely held domestic corporations. The
relevant documentation was readily iden-
tifiable, available on hand, and able to be
analyzed by the Commissioner in due
course. Further, when the case law was
developing, the dollar amounts at stake
were comparatively modest. InFin Hay,
the shareholder advances gave rise to a
total federal tax liability of $3,241; in
Mixon, the shareholder advances gave rise
to a total federal tax liability of $126,964.
Increasingly, this is no longer the case.
Over time, the Treasury Department and
April 25, 2016Bulletin No. 2016–17
640

the IRS have observed that business prac-
tices, structures, and activities between re-
lated parties have changed considerably.
The Treasury Department and the IRS ac-
knowledge that the size, activities, and
financial complexity of corporations and
their group structures have grown expo-
nentially, and understand that these
groups routinely include foreign entities,
sometimes from multiple foreign jurisdic-
tions, as well as federal tax-indifferent
domestic members. The scope and com-
plexity of intragroup transactions has
grown commensurately. Examples in-
clude the transactions at issue inPepsiCo
Puerto Rico, Inc. v. CommissionerandNA
General Partnership & Subsidiaries v.
Commissioner, T.C. Memo 2012–172,
both involving the global restructuring of
multinational corporate groups.
As a result of these developments, it is
increasingly problematic that there is a
lack of guidance prescribing the informa-
tion and documentation necessary to sup-
port the characterization of a purported
debt instrument as indebtedness in the
related-party context. The lack of such
guidance, combined with the sheer vol-
ume of financial records taxpayers pro-
duce in the ordinary course of business,
makes it difficult to identify the docu-
ments that will ultimately be required to
support such a characterization, particu-
larly with respect to whether a reasonable
expectation of repayment is present at the
time an interest is issued. The result can
be either the inadvertent omission of nec-
essary documents from disclosure to the
IRS or the provision of vast amounts of
irrelevant documents and material, such
that forensic accounting expertise is re-
quired to isolate and evaluate relevant in-
formation. In either case, the ability of the
Commissioner to administer the Code ef-
ficiently with respect to related-party in-
terests is impeded. In addition, the ab-
sence of guidance makes it difficult for
U.S. taxpayers to determine timely what
steps they must take to ensure that essen-
tial records are not only prepared, but also
maintained in a manner that will facilitate
their being made available upon request,
particularly regarding transactions with
related parties whose books and records
are located in foreign jurisdictions.
Finally, the dollar amounts at stake
have often become increasingly signifi-
cant. For example, the federal tax liability
at issue inPepsiCowas $363,056,012; the
federal tax liability at issue inNA General
Partnershipwas $188,000,000. As a re-
sult, it has become increasingly important
to prescribe rules that identify the types of
documentation and information necessary
to support the characterization of a
related-party interest as indebtedness for
federal tax purposes.
2.Proposed Regulations Addressing
Documentation Requirements
To address these concerns, the Trea-
sury Department and the IRS are propos-
ing rules, under the authority granted in
section 385(a) to prescribe regulations to
determine whether an interest in a corpo-
ration is stock or indebtedness, that pre-
scribe the nature of the documentation and
information that must be prepared and
maintained for a purported debt instru-
ment issued by a corporation to a related
party to be treated as indebtedness for
federal tax purposes. The proposed regu-
lations are intended to impose discipline
on related parties by requiring timely doc-
umentation and financial analysis that is
similar to the documentation and analysis
created when indebtedness is issued to
third parties. This requirement also serves
to help demonstrate whether there was
intent to create a true debtor-creditor re-
lationship that results in bona fide indebt-
edness and also to help ensure that the
documentation necessary to perform an
analysis of a purported debt instrument is
prepared and maintained. This approach is
consistent with the long-standing view
held by courts that the taxpayer has the
burden of substantiating its treatment of
an arrangement as indebtedness for fed-
eral tax purposes.Hollenbeck v. Commis-
sioner, 422 F.2d 2, 4 (9th Cir. 1970).
In general, the Treasury Department
and the IRS have determined that timely
preparation of documentation and finan-
cial analysis evidencing four essential
characteristics of indebtedness are a nec-
essary factor in the characterization of a
covered interest as indebtedness for fed-
eral tax purposes. Those characteristics
are: a legally binding obligation to pay,
creditors’ rights to enforce the obligation,
a reasonable expectation of repayment at
the time the interest is created, and an
ongoing relationship during the life of the
interest consistent with arms-length rela-
tionships between unrelated debtors and
creditors. These characteristics are drawn
from the case law and are consistent with
the text of section 385(b)(1) and (5).
While the proposed regulations do not in-
tend to alter the general case law view of
the importance of these essential charac-
teristics of indebtedness, the proposed
regulations do require a degree of disci-
pline in the creation of necessary docu-
mentation, and in the conduct of reason-
able financial diligence indicative of a true
debtor-creditor relationship, that exceeds
what is required under current law.See,
e.g.,C.M. Gooch Lumber Sales Co.,49
T.C. 649;Byerlite Corp., 286 F.2d 285.
The proposed regulations make clear
that the preparation and maintenance of
this documentation and information are
not dispositive in establishing that a pur-
ported debt instrument is indebtedness for
federal tax purposes. Rather, these re-
quirements are necessary to the conduct of
the multi-factor analysis used in the
MixonandFin Hayline of cases to deter-
mine the nature of an interest as indebt-
edness for federal tax purposes.
C.Certain Distributions of Debt
Instruments and Similar Transactions
1.In General
The Treasury Department and the IRS
have identified three types of transactions
between affiliates that raise significant
policy concerns and that should be ad-
dressed under the Secretary’s authority to
prescribe rules for particular factual situ-
ations: (1) distributions of debt instru-
ments by corporations to their related cor-
porate shareholders; (2) issuances of debt
instruments by corporations in exchange
for stock of an affiliate (including “hook
stock” issued by their related corporate
shareholders); and (3) certain issuances of
debt instruments as consideration in an
exchange pursuant to an internal asset re-
organization. Similar policy concerns
arise when a related-party debt instrument
is issued in a separate transaction to fund
(1) a distribution of cash or other property
to a related corporate shareholder; (2) an
acquisition of affiliate stock from an affil-
iate; or (3) certain acquisitions of property
Bulletin No. 2016–17April 25, 2016
641

from an affiliate pursuant to an internal
asset reorganization. Accordingly, the
proposed regulations treat related-party
debt instruments issued in any of the fore-
going transactions as stock, subject to cer-
tain exceptions.
Sections C.2 through C.5 of this Part
VI describe in greater detail the purposes
of the proposed regulations that apply to
these types of transactions. Part IV of the
Explanation of Provisions section of this
preamble describes in detail the proposed
regulations.
2.Debt Instrument Issued in a
Distribution
InKraft Foods Co. v. Commissioner,
232 F.2d 118 (2d Cir. 1956), the U.S.
Court of Appeals for Second Circuit ad-
dressed a situation in which a domestic
corporate subsidiary issued indebtedness
in the form of debentures to its sole share-
holder, also a domestic corporation, in
payment of a dividend. The parent and
subsidiary were required to file separate
returns under the Code in effect during the
years at issue, and, before taking into ac-
count the interest income and deductions
on the distributed indebtedness, the parent
corporation had losses and the subsidiary
was profitable.
The court considered arguments by the
government that the parent-subsidiary re-
lationship warranted additional scrutiny in
determining whether a debtor-creditor re-
lationship was established in substance. In
particular, the Commissioner argued that,
because the issuer subsidiary was wholly-
owned, “the sole stockholder [could] deal
as it please[d] with the corporate entity it
control[led]” and, as a result, the transac-
tion could have been a sham.Id.at 123.
The Commissioner also argued that the
debentures should be treated as stock be-
cause no new capital was introduced into
the subsidiary in connection with the is-
suance of the debentures,see id.at 126 –
27, and because the taxpayer conceded
that the issuance of the debentures in pay-
ment of the dividend lacked a business
purpose other than tax minimization.See
id.at 127–28.
In holding for the taxpayer, the Second
Circuit determined that the debentures
should be respected as indebtedness be-
cause the debentures were unambiguously
denominated as debt, were issued by and
to real taxable entities, and created real
legal rights and duties between the parties.
See id.at 127–28. In a dissenting opinion,
Chief Judge Clark supported “test[ing] the
genuineness of the intercorporate indebt-
edness by objective standards” that would
disregard indebtedness issued in this cir-
cumstance, and warned that the majority
opinion would open “a large leak...
operable merely by denominating an in-
tercorporate allocation of surplus a debt”
and would “[s]urely...stimulate imita-
tors.”Id.at 129.
Other courts have not given the same
level of deference to the form of a trans-
action that the Second Circuit did inKraft
and have treated purported indebtedness
as stock in similar circumstances. For ex-
ample, some courts have closely scruti-
nized situations in which indebtedness is
owed in proportion to stock ownership to
determine whether a debtor-creditor rela-
tionship exists in substance.See, e.g.,Un-
eco, Inc. v. United States, 532 F.2d 1204,
1207 (8th Cir. 1976) (“Advances between
a parent corporation and a subsidiary or
other affiliate are subject to particular
scrutiny....”);Arlington Park Jockey
Club, Inc. v. Sauber, 262 F.2d 902, 906
(7th Cir. 1959) (“It has been held that [a
cash advance made in proportion to stock
ownership] gives rise to a strong inference
that the advances represent additional cap-
ital investment and not loans.” (citing
Schnitzer v. Commissioner, 13 T.C. 43,
aff’d183 F.2d 70 (9th Cir. 1950))). Con-
sistent with those decisions, section
385(b)(5) specifically authorizes the Sec-
retary, in issuing regulations distinguish-
ing between stock and indebtedness, to
take into account “the relationship be-
tween holdings of stock in the corporation
and holdings of the interest in question.”
Courts also have given weight to the
lack of new capital investment when a
closely-held corporation issues indebted-
ness to a controlling shareholder but re-
ceives no new investment in exchange.
See, e.g.,Talbot Mills v. Commissioner,
146 F.2d 809 (1st Cir. 1944) (emphasizing
that a transaction involved no new invest-
ment, did not affect proportionate owner-
ship, and was motivated primarily by tax
benefits in holding that a closely-held cor-
poration’s participating notes should be
treated as stock when each stockholder
exchanged four-fifths of its existing stock
for notes with a face amount equal to the
par value of the stock surrendered),aff’d
sub nom,John Kelley Co. v. Commis-
sioner, 326 U.S. 521 (1946);Sayles Fin-
ishing Plants, Inc. v. United States, 399
F.2d 214 (Ct. Cl. 1968) (noting that a
“lack of new money can be a significant
factor in holding a purported indebtedness
to be a capital transaction, particularly
when the facts otherwise show that the
purported indebtedness was merely a con-
tinuation of the stock interests allegedly
converted”).
In many contexts, a distribution of a
debt instrument similar to the one at issue
inKraftlacks meaningful non-tax signif-
icance, such that respecting the distributed
instrument as indebtedness for federal tax
purposes produces inappropriate results.
For example, inverted groups and other
foreign-parented groups use these types of
transactions to create interest deductions
that reduce U.S. source income without
investing any new capital in the U.S. op-
erations.Inaddition,U.S.-parented
groups obtain distortive results by, for ex-
ample, using these types of transactions to
create interest deductions that reduce the
earnings and profits of controlled foreign
corporations (CFCs) and to facilitate the
repatriation of untaxed earnings without
recognizing dividend income. An exam-
ple of the latter type of transaction could
involve the distribution of a note from a
first-tier CFC to its United States share-
holder in a taxable year when the distrib-
uting CFC has no earnings and profits
(although lower-tier CFCs may) and the
United States shareholder has basis in the
CFC stock. In a later taxable year, when
the distributing CFC had untaxed earnings
and profits (such as by reason of interven-
ing distributions from lower-tier CFCs),
the CFC could use cash attributable to the
earnings and profits to repay the note
owed to its United States shareholder. The
taxpayer takes the position that the note
should be respected as indebtedness and,
therefore, that the repayment of the note
does not result in any of the untaxed earn-
ings and profits of the CFC being taxed as
a dividend to the United States share-
holder.
In light of these policy concerns, the
proposed regulations treat a debt instru-
ment issued in fact patterns similar to that
April 25, 2016Bulletin No. 2016–17
642

inKraftas stock. The factors discussed in
KraftandTalbot Mills, including the
parent-subsidiary relationship, the fact
that no new capital is introduced in con-
nection with a distribution of debentures,
and the typical lack of a substantial non-
tax business purpose, support the conclu-
sion that the issuance of a debt instrument
in a distribution is a transaction that fre-
quently has minimal or nonexistent non-
tax effects. Moreover, although the holder
of a debt instrument has different legal
rights than a holder of stock, the distinc-
tion between those rights usually has lim-
ited significance when the parties are re-
lated. Subsidiaries often do not have
significant amounts of debt financing from
unrelated lenders (other than trade pay-
ables) and, to the extent they do, they may
minimize any potential impact of related-
party debt on unrelated creditors, for ex-
ample, by subordinating the related-party
debt instrument.
Thus, any non-tax effects of a distribu-
tion of a debt instrument to an affiliate are
often minimized or eliminated, allowing
the related parties to obtain significant
federal tax benefits at little or no cost.
Accordingly, based on these consider-
ations, the Treasury Department and the
IRS have determined that in fact patterns
similar toKraftit is appropriate to treat a
debt instrument as stock.
3.Debt Instrument Issued in Exchange
for Affiliate Stock
The Treasury Department and the IRS
have determined that the issuance of a
related-party debt instrument to acquire
stock of a related person is similar in
many respects to a distribution of a debt
instrument and implicates similar policy
considerations. Recognizing the economic
similarities between purchases of affiliate
stock and distributions, Congress enacted
section 304 and its predecessors to pre-
vent taxpayers from acquiring affiliate
stock to convert what otherwise would be
a taxable dividend into a sale or exchange
transaction.SeeS. Rep. No. 83–1622 at
46 (1954) (noting that, under section 304,
“where the effect of the sale [of related-
party stock] is in reality the distribution of
a dividend, it will be taxed as such”).
Similarly, if the proposed regulations ad-
dressed only debt instruments issued in a
distribution, and not acquisitions of affil-
iate stock that have the effect of a distri-
bution, taxpayers would readily substitute
the latter transaction for the former in
order to produce the inappropriate tax re-
sult that the proposed regulations are in-
tended to prevent.
Like distributions of debt instruments,
issuances of debt instruments to acquire
affiliate stock frequently have limited
non-tax significance, particularly in rela-
tion to the significant federal tax benefits
that are generated in the transaction. Such
transactions do not change the ultimate
ownership of the affiliate, and introduce
no new operating capital to either affiliate.
While the change in the direct ownership
of the affiliate’s stock may have some
non-tax significance in certain circum-
stances, such as the harmonization of a
group’s corporate structure following an
acquisition, other purchases of affiliate
stock, including purchases of “hook
stock” from a parent in exchange for a
debt instrument, typically possess almost
no non-tax significance.
Accordingly, the proposed regulations
generally treat a debt instrument issued in
exchange for affiliate stock as stock.
4.Debt Instrument Issued Pursuant to
an Internal Asset Reorganization
The proposed regulations also address
certain debt instruments issued by an ac-
quiring corporation as consideration in an
exchange pursuant to an internal asset re-
organization. Internal asset reorganiza-
tions can operate in a similar manner to
section 304 transactions as a device to
convert what otherwise would be a distri-
bution into a sale or exchange transaction
without having any meaningful non-tax
effect. Congress noted this similarity in
1984 when it harmonized the control re-
quirement for section 368(a)(1)(D) reor-
ganizations with the control requirement
in section 304.SeeStaff of Joint Comm.
on Taxation, 98th Cong., General Expla-
nation of the Revenue Provisions of the
Deficit Reduction Act of 1984 193
(Comm. Print 1984) (“The D reorganiza-
tion provisions address the bail-out prob-
lem in the context of a transfer of assets
by 1 corporation to another. Section 304
deals with the problem in the context of a
transfer of stock by shareholders to a cor-
poration they control.”).
Consider the following example: A
foreign parent corporation (Parent) owns
all of the stock of two U.S. subsidiaries,
S1 and S2. In a transaction qualifying as a
reorganizationdescribedinsection
368(a)(1)(D), Parent transfers its stock in
S1 to S2 in exchange for a note issued by
S2, and S1 converts to a limited liability
company. For federal tax purposes, S1 is
treated as selling all of its assets to S2 in
exchange for a debt instrument, and under
section 356, Parent is treated as receiving
the S2 debt instrument from S1 in a liq-
uidating distribution with respect to Pa-
rent’s S1 stock. This transaction has a
similar effect (and tax treatment) as a sec-
tion 304 transaction in which S2 issues a
debt instrument to Parent in exchange for
S1 stock, with the only difference being
that S2 acquired the assets of S1 instead of
the S1 stock and that Parent received the
debt instrument as a result of the liquida-
tion of S1.
This transaction introduces no new
capital into the P group, and does not
affect the ultimate ownership of the assets
held by S1 or S2. Furthermore, S1 gener-
ally would not be required to recognize
any built-in gain on the transfer of its
assets to S2. Although this transaction en-
tails a transfer of assets from S1 to S2, the
tax costs (if any) and the non-tax conse-
quences that result from this type of trans-
action among related parties are typically
insignificant relative to the federal tax
benefits obtained through the introduction
of a related-party debt instrument. Ac-
cordingly, the proposed regulations treat a
debt instrument issued by an acquiring
corporation as consideration in an ex-
change pursuant to an internal asset reor-
ganization as stock, consistent with the
treatment of a debt instrument issued in a
distribution or in exchange for affiliate
stock.
5.Debt Instrument Issued with a
Principal Purpose of Funding Certain
Distributions and Acquisitions
The Treasury Department and the IRS
have determined that the policy concerns
implicated by the transactions described
in Sections C.2 through C.4 of this Part VI
are also present when a corporation issues
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643

a debt instrument with a principal purpose
of funding certain related-party transac-
tions. Specifically, the proposed regula-
tions treat a debt instrument issued for
property, including cash, as stock when
the debt instrument is issued to an affiliate
with a principal purpose of funding (1) a
distribution of cash or other property to a
related corporate shareholder, (2) an ac-
quisition of affiliate stock from an affili-
ate, or (3) certain acquisitions of property
from an affiliate pursuant to an internal
asset reorganization.
Without these funding provisions, tax-
payers that otherwise would have issued a
debt instrument in a one-step transaction
described in Sections C.2 through C.4 of
this Part VI would be able to use multi-
step transactions to avoid the application
of these proposed regulations while
achieving economically similar outcomes.
For example, a wholly-owned subsidiary
that otherwise would have distributed a
debt instrument to its parent corporation
in a distribution could, absent these rules,
borrow cash from its parent and later dis-
tribute that cash to its parent in a transac-
tion that is purported to be independent
from the borrowing. Like the distribution
of a note, this transaction, if respected,
would result in an increase of related-
party debt, but no new net investment in
the operations of the subsidiary. The par-
ent corporation would have effectively re-
shuffled its subsidiary’s capital structure
to obtain more favorable federal tax treat-
ment for the subsidiary without affecting
its control over the subsidiary. The simi-
larity between these transactions indicates
that they should be subject to similar tax
treatment.
The Treasury Department and the IRS
also have determined that a debt instru-
ment should be subject to these funding
rules regardless of whether the funding
affiliate (the lender) is a party to the
funded transaction. Otherwise, a corpora-
tion could, for example, borrow funds
from a sister corporation and immediately
distribute those funds to the common par-
ent corporation. Issuances of debt instru-
ments to an affiliate in order to fund a
distribution of property, an acquisition of
affiliate stock, or an acquisition of an af-
filiate’s assets in a reorganization often
would confer significant federal tax bene-
fits without having a significant non-tax
impact, regardless of whether the lender is
also a party to the funded transaction.
Accordingly, the proposed regulations
treat as stock a debt instrument issued to
an affiliate to fund one of the specified
transactions regardless of whether the
lender is a party to the funded transaction.
Explanation of Provisions
I.Overview
The proposed regulations provide
guidance regarding substantiation of the
treatment of certain interests issued be-
tween related parties as indebtedness for
federal tax purposes, the treatment of cer-
tain interests in a corporation as in part
indebtedness and in part stock, and the
treatment of distributions of debt instru-
ments and similar transactions that fre-
quently have only limited non-tax effects.
More specifically, the proposed regula-
tions are set forth in four sections. First,
proposed § 1.385–1 prescribes definitions
and operating rules applicable to the regu-
lations under section 385 generally, includ-
ing a rule treating members of a consoli-
dated group, as defined in § 1.1502–1(h), as
one corporation. Proposed § 1.385–1(d)
also provides that the Commissioner has
the discretion to treat certain interests in a
corporation for federal tax purposes as
indebtedness in part and stock in part.
Second, proposed § 1.385–2 addresses the
documentation and information that tax-
payers must prepare and maintain within
required timeframes to substantiate the
treatment of an interest issued between
related parties as indebtedness for federal
tax purposes. Such substantiation is nec-
essary, but not sufficient, for a purported
debt interest that is within the scope of
these rules to be characterized as indebt-
edness; general federal income tax princi-
ples also apply in making such a determi-
nation. Third, if the application of
proposed § 1.385–2 and general federal
income tax principles otherwise would re-
sult in treating an interest issued to a re-
lated party as indebtedness for federal tax
purposes, proposed § 1.385–3 provides
additional rules that may treat the interest,
in whole or in part, as stock for federal tax
purposes if it is issued in a distribution or
other transaction that is identified as fre-
quently having only limited non-tax ef-
fect, or is issued to fund such a transac-
tion.Finally,proposed§1.385– 4
provides operating rules for applying pro-
posed § 1.385–3 to interests that cease to
be between members of the same consol-
idated group or interests that become in-
terests between members of the same con-
solidated group.
II.Generally Applicable Definitions and
Special Rules
A.Definition of Expanded Group
As previously discussed, the concerns
addressed by the proposed regulations
arise with respect to interests issued
among related parties. The scope of the
proposed regulations is therefore gener-
ally limited to purported indebtedness be-
tween members of an expanded group.
Proposed § 1.385–1, which sets forth def-
initions generally applicable to the regu-
lations proposed under section 385, de-
fines the termexpanded groupby
reference to the term affiliated group in
section 1504(a). However, the proposed
regulations broaden the definition in sev-
eral ways. Unlike an affiliated group, an
expanded group includes foreign and tax-
exempt corporations, as well as corpora-
tions held indirectly, for example, through
partnerships. Further, in determining re-
latedness, the proposed regulations adopt
the attribution rules of section 304(c)(3).
The proposed regulations also modify the
definition of affiliated group to treat a
corporation as a member of an expanded
group if 80 percent of the vote or value is
owned by expanded group members (in-
stead of 80 percent of the vote and value, as
generally required under section 1504(a)).
Through this definition of an expanded
group, the application of the proposed reg-
ulations is limited to transactions between
highly-related parties. Other rules, dis-
cussed in Section III.A (limiting theappli-
cation of proposed § 1.385–2 to large tax-
payers) and Section IV.C ($50 million
threshold exception for proposed § 1.385–3)
of this Explanation of Provisions limit the
application of the proposed regulations to
large taxpayers.
B.Treatment of Deemed Exchanges
Proposed § 1.385–1 includes rules that
prescribe the effects under the Code gen-
April 25, 2016Bulletin No. 2016–17
644

erally of an exchange of purported indebt-
edness for stock that is deemed to occur
under the proposed regulations. Under
those rules, on the date the indebtedness is
recharacterized as stock, the indebtedness
is deemed to be exchanged, in whole or in
part, for stock with a value that is equal to
the holder’s adjusted basis in the portion
of the indebtedness that is treated as 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. This rule generally will pre-
vent both the holder and issuer from real-
izing gain or loss from the deemed ex-
change other than foreign exchange gain
or loss recognized by the issuer or the
holder under section 988.
C.Treatment of Certain Instruments as
in Part Indebtedness and as in Part
Stock
Proposed § 1.385–1 implements the
statutory authority under section 385(a) to
treat an instrument as part indebtedness
and part stock by authorizing the Com-
missioner to treat certain instruments is-
sued between related parties in this man-
ner. Any such treatment will occur only in
the event that the substance of the instru-
ment is regarded for federal tax purposes
and the instrument has met the documen-
tation and information requirements in
proposed § 1.385–2 (described subse-
quently in Section III), if applicable. In
addition, the Commissioner is not re-
quired to treat such an interest as indebt-
edness in part and stock in part. For ex-
ample, under the proposed regulations, if
an analysis of a related-party interest that
is documented as a $5 million debt instru-
ment demonstrates that the issuer cannot
reasonably be expected to repay more
than $3 million of the principal amount as
of the issuance of the interest, the Com-
missioner may treat the interest as part
indebtedness ($3 million) and part stock
($2 million). The type of stock (for exam-
ple, common stock or preferred stock, sec-
tion 306 stock, stock described in section
1504(a)(4)) that the instrument will be
treated as for federal tax purposes is de-
termined by taking into account the terms
of the instrument (for example, voting and
conversion rights and rights relating to
dividends, redemption, liquidation, and
other distributions).
The Treasury Department and the IRS
believe that this approach will facilitate
the treatment of purported debt instru-
ments issued between related parties in a
manner that is more consistent with the
substance of the underlying transaction.
Pursuant to section 385(c) and the reg-
ulatory authority granted the Secretary un-
der section 385(c)(2), the issuer of the
interest, the holder of the interest, and any
other person relying on the characteriza-
tion of the interest as indebtedness for
federal tax purposes are all required to
treat the interest consistent with the issu-
er’s initial characterization. Thus, for ex-
ample, a holder may not disclose on its
return under section 385(c)(2) that it is
treating an EGI, as later defined in Section
III.A of this Explanation of Provisions, as
indebtedness in part or stock in part if the
issuer of the EGI treats the EGI as indebt-
edness. This approach eliminates cases in
which members of the same expanded
group take contrary positions as to the
treatment of an EGI as indebtedness,
stock, or indebtedness in part and stock in
part.
The proposed regulations authorize the
treatment of an interest as indebtedness in
part and stock in part in the case of instru-
ments issued in the form of debt between
parties that are related, but at a lesser
degree of relatedness than that required to
include them in an expanded group. Under
the proposed regulations, treatment as in-
debtedness in part and stock in part can
apply to purported indebtedness between
members ofmodified expanded groups
(which are defined in the same manner as
expandedgroups,butadoptinga
50-percent ownership test and including
certain partnerships and other persons).
The 50-percent relatedness threshold con-
tained in the definition ofmodified ex-
panded groupis consistent with other pro-
visions used in subchapter C of the Code
to identify a level of control or ownership
that can warrant different federal tax con-
sequences than those of less-related par-
ties. For example, a similar threshold ap-
plies in determining whether (i) control
exists under section 304(c), (ii) attribution
to and from corporations is applicable un-
der section 318, (iii) persons are related
under section 267(b), which is incorpo-
rated into numerous provisions of the
Code, (iv) a redemption is substantially
disproportionate under section 302(b)(2),
(v) a disqualified distribution has occurred
under section 355(d), (vi) a distribution is
subject to section 355(e), and (vii) cor-
porations are under common control for
purposes of section 334. The Treasury
Department and the IRS request com-
ments on whether it would be helpful or
appropriate to have this rule apply more
generally.
D.Consolidated Groups
As described in Part VI of the Back-
ground section of this preamble, many of
the concerns regarding related-party in-
debtedness are not present in the case of
indebtedness between members of a con-
solidated group. Accordingly, the pro-
posed regulations under section 385 do
not apply to interests between members of
a consolidated group, although general
federal tax principles continue to apply.
Proposed § 1.385–1(e) achieves this result
by treating a consolidated group as one
corporation. See Section III.A and Section
IV.F of this Part for additional rules af-
fecting consolidated groups.
III.Substantiation of Related-Party
Indebtedness: Proposed § 1.385–2
A.In General
Proposed § 1.385–2 reflects the impor-
tance of contemporaneous documentation
in identifying the rights, obligations, and
intent of the parties to an instrument that
is purported to be indebtedness for federal
tax purposes. Such documentation is par-
ticularly important to the analysis of in-
struments issued between related parties.
In recognition of this importance, the
Treasury Department and the IRS are ex-
ercising authority granted under section
385(a) to treat the timely preparation and
maintenance of such documentation as
necessary factors to be taken into account
in determining whether certain interests
are properly characterized as stock or in-
debtedness. Accordingly, the proposed
regulations first prescribe the nature of the
documentation necessary to substantiate
the treatment of related-party instruments
as indebtedness and, second, require that
Bulletin No. 2016–17April 25, 2016
645

such documentation be timely prepared
and maintained. The proposed regulations
further provide that, if the specified doc-
umentation is not provided to the Com-
missioner upon request, the Commis-
sioner will treat the preparation and
maintenance requirements as not satisfied
and will treat the instrument as stock for
federal tax purposes. The type of stock
(for example, common stock or preferred
stock, section 306 stock, stock described
in section 1504(a)(4)) that the instrument
will be treated as for federal tax purposes
is determined by taking into account the
terms of the instrument (for example, vot-
ing and conversion rights and rights relat-
ing to dividends, redemption, liquidation,
and other distributions).
Satisfaction of the requirements of the
proposed regulations does not establish
that a related-party instrument is indebt-
edness. Rather, satisfaction of the pro-
posed regulations acts as a threshold test
for allowing the possibility of indebted-
ness treatment after the determination of
an instrument’s character is made under
federal tax principles developed under ap-
plicable case law. If the requirements of
the proposed regulations are not satisfied,
the purported indebtedness would be re-
characterized as stock. In such a case, any
federal tax benefit claimed by the taxpayer
with respect to the treatment of the inter-
est as indebtedness will be disallowed.
Judicial doctrines that disregard trans-
actions as having no substance continue to
be applicable and are not affected by the
proposed regulations. Accordingly, pro-
posed § 1.385–2 applies only to interests
the substance of which is potentially re-
garded as indebtedness for federal tax pur-
poses. In addition, proposed § 1.385–2
does not limit the ability of the IRS to
request information under any existing au-
thorities, such as the rules under section
7602.
As discussed previously, these pro-
posed regulations apply only to purported
indebtedness issued among entities that
are highly related. Several provisions of
the proposed regulations combine to ef-
fect this limitation.
First, proposed § 1.385–2 provides
rules only with respect toapplicable in-
struments, that is, interests issued in the
form of debt. Thus, these proposed regu-
lations do not apply to any interest or
arrangement that is not, in form, indebt-
edness. The documentation and other
rules in proposed § 1.385–2(b) are tailored
to arrangements that in form are tradi-
tional debt instruments and do not address
other arrangements that may be treated as
indebtedness under general federal tax
principles. The proposed regulations un-
der § 1.385–2 reserve with respect to doc-
umentation of interests that are not in
form indebtedness. Because there are a
large number of ways to document these
arrangements, rules that provide sufficient
information about these arrangements will
need to contain specific documentation
and timing requirements depending on the
type of arrangement. Accordingly, the
Treasury Department and the IRS request
comments regarding the appropriate doc-
umentation and timing requirements for
the various forms that these arrangements
can take.
Second, proposed § 1.385–2 only ap-
plies to applicable interests that are issued
and held by members of an expanded
group (expanded group instruments,or
EGI). For purposes of § 1.385–2, con-
trolled partnerships are treated as mem-
bers of the expanded group, and the term
controlled partnershipis defined as any
partnership the capital or profits interest in
which is 80-percent owned by members of
the expanded group. Proposed § 1.385–2
provides that, solely for purposes of
§ 1.385–2, the termissuermeans a person
that is obligated to satisfy any material
payment obligations created under the
terms of an EGI. For this purpose, a dis-
regarded entity can be treated as the is-
suer. A person can be an issuer if that
person is expected to satisfy a material
obligation under an EGI, even if that per-
son is not the primary obligor. A guaran-
tor, however, is not an issuer unless the
guarantor is treated as the primary obligor
under federal tax principles.See, e.g.,
Plantation Patterns, Inc. v. Commis-
sioner, 462 F.2d 712 (5th Cir. 1972).
Third, proposed § 1.385–2 is intended
to apply only to large taxpayer groups.
Accordingly, an EGI is not subject to pro-
posed § 1.385–2 unless the stock of any
member of the expanded group is publicly
traded, all or any portion of the expanded
group’s financial results are reported on
financial statements with total assets ex-
ceeding $100 million, or the expanded
group’s financial results are reported on
financial statements that reflect annual to-
tal revenue that exceeds $50 million. The
proposed regulations provide guidance re-
garding the financial statement or state-
ments that are to be used for purposes of
determining the expanded group’s assets
and liabilities. In general, this determina-
tion is made by reference to a financial
statement required to be filed with the
Securities and Exchange Commission, a
certified audited financial statement that is
accompanied by the report of an indepen-
dent certified public accountant (or in the
case of a foreign entity, by the report of a
similarly qualified independent profes-
sional) that is used for certain purposes, or
a financial statement (other than a tax re-
turn) required to be provided to the fed-
eral, state, or foreign government or any
federal, state, or foreign agency. Because
this list represents a set of financial state-
ments created for other purposes for per-
sons outside the expanded group, these
financial statements are expected to be
sufficiently reliable for this purpose. In
addition, to prevent the use of stale finan-
cial information, only applicable financial
statements prepared within the three years
of the EGI becoming subject to the pro-
posed regulations are relevant for deter-
mining whether an EGI is subject to the
proposed regulations under § 1.385–2.
B.Types of Documentation and Other
Information Required
The core of proposed § 1.385–2 is the
guidance regarding the nature of the doc-
umentation and information that must be
prepared and maintained to support the
characterization of an EGI as indebted-
ness for federal tax purposes. The regula-
tions organize the requirement into four
categories, each reflecting an essential
characteristic of indebtedness for federal
tax purposes: a binding obligation to re-
pay the funds advanced, creditor’s rights
to enforce the terms of the EGI, a reason-
able expectation that the advanced funds
can be repaid, and actions evidencing a
genuine debtor-creditor relationship. To-
gether these categories represent a distil-
lation of case law principles established
for determining that an instrument is
genuine indebtedness for federal tax
purposes.
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646

The proposed regulations require that
the prescribed documentation and infor-
mation must be provided with respect to
each category. Failure to provide the doc-
umentation and information upon request
by the Commissioner will result in the
Commissioner treating the requirements
of this section as not satisfied. The four
categories are more specifically described
in the following four paragraphs.
1.Binding Obligation to Repay. The
threshold requirement for indebtedness is
a binding legal obligation to repay the
funds advanced. The proposed regulations
require evidence of such obligation in the
form of timely prepared written documen-
tation executed by the parties.
2.Creditor’s Rights to Enforce Terms.
The documents establishing the issuer’s
obligation to repay must also establish
that the creditor/holder has the legal rights
of a creditor to enforce the terms of the
EGI. The proposed regulations give exam-
ples of such rights that creditor/holder
typically has, including the right to trigger
a default and the right to accelerate pay-
ments. The proposed regulations also give
an example of one right that a creditor/
holder must have, which is a superior right
to shareholders to share in the assets of the
issuer in the event that the issuer is dis-
solved or liquidated.
3.Reasonable Expectation of Repay-
ment. The proposed regulations also re-
quire the taxpayer to provide timely pre-
pareddocumentationevidencinga
reasonable expectation that the issuer
could in fact repay the amount of a pur-
ported loan. The proposed regulations
give examples of such documentation, in-
cluding cash flow projections, financial
statements, business forecasts, asset ap-
praisals, determination of debt-to-equity
and other relevant financial ratios of the
issuer (compared to industry averages).
Special rules are provided to address dis-
regarded entities that issue an EGI.
4.Genuine Debtor-Creditor Relation-
ship. Finally, the taxpayer asserting in-
debtedness treatment must prepare and
maintain timely evidence of an ongoing
debtor-creditor relationship. This docu-
mentation can take two forms. In the case
of an issuer that complied with the terms
of the EGI, the documentation must in-
clude timely prepared documentation of
any payments on which the taxpayer relies
to establish suchtreatment under general
federal tax principles. Alternatively, if the
issuer failed to comply with the terms of the
EGI, either by failing to make required pay-
ments or by otherwise suffering an event of
default under the terms of the EGI, the doc-
umentation must include evidence of the
holder’s reasonable exercise of the diligence
and judgment of a creditor. The proposed
regulations give examples of such docu-
mentation, including evidence of the hold-
er’s efforts to enforce the terms of the EGI,
as well as any efforts to renegotiate the EGI.
In general, the documentation must be
prepared no later than 30 calendar days
after the date of the relevant event, which
is generally the later of the date that the
instrument becomes an EGI or the date
that an expanded group member becomes
an issuer with respect to an EGI. How-
ever, in the case of documentation of the
debtor-creditor relationship, the regula-
tions allow the documentation to be pre-
pared up to 120 calendar days after the
payment or relevant event occurred. This
extended period is intended to avoid inad-
vertent failures to comply with the regu-
lations that may be more likely in the case
of events that occur during the life of an
EGI. If an applicable instrument is not an
EGI when issued, no documentation is
required under the proposed regulations
for any date before the date the applicable
instrument becomes an EGI.
The proposed regulations provide spe-
cial rules for determining the timeliness of
documentation preparation in the case of
certain revolving credit agreements and
similar arrangements and cash pooling ar-
rangements, generally looking to the doc-
uments pursuant to which the arrange-
ments were established.
C.Maintenance Requirement
Under proposed § 1.385–2, the docu-
mentation and information in the four cat-
egories previously described must be
maintained for all taxable years that the
EGI is outstanding and until the period of
limitations expires for any return with re-
spect to which the federal tax treatment of
the EGI is relevant. The proposed regula-
tions do not otherwise specify where or in
what manner such records must be kept.
The Treasury Department and the IRS in-
tend that taxpayers have flexibility to de-
termine the manner in which the require-
ments of the proposed regulations are
satisfied.
D.Timing of Application of Rule
In general, proposed § 1.385–2 will
apply to an applicable instrument at the
time it becomes an EGI and thereafter. If
an EGI that was characterized as stock
under the rules of § 1.385–2 ceases to be
an EGI, general federal tax principles will
apply to determine its character at the time
it ceases to be an EGI; if, under general
federal tax principles, it is treated as in-
debtedness, the issuer is treated as issuing
a new debt instrument to the holder in
exchange for the EGI immediately before
the transaction that causes the instrument
to cease to qualify as an EGI.
If an applicable instrument is an EGI
when issued, determinations under pro-
posed § 1.385–2 are generally effective
from the issuance date. If an applicable
instrument was not an EGI when issued,
proposed § 1.385–2 applies, and any re-
sulting determination is generally effec-
tive, when the applicable instrument be-
comes an EGI. However, if an EGI
originally treated as debt is later recharac-
terized as stock because the documenta-
tion and information cease to evidence an
ongoing debtor-creditor relationship, the
recharacterization will be effective as of
the time that the facts and circumstances
cease to evidence a debtor-creditor
relationship.
E.Consolidated Groups
Proposed § 1.385–1(e) provides that
members of a consolidated group are
treated as one corporation. Proposed
§ 1.385–2(c)(4)(ii) further provides that if
an applicable instrument ceases to be an
intercompany obligation and, as a result,
becomes an EGI subject to the rules of
proposed § 1.385–2, the applicable instru-
ment is treated as becoming an EGI im-
mediately after it ceases to be an inter-
company obligation.
F.Modifications to General Operation
of Proposed § 1.385–2
The proposed regulation includes a
number of provisions that modify the gen-
Bulletin No. 2016–17April 25, 2016
647

eral rules of § 1.385–2 in order to provide
flexibility in appropriate circumstances or
to prevent abuse. First, the requirements
of proposed § 1.385–2 may be modified if
a taxpayer’s failure to comply with the
requirements is attributable to reasonable
cause. The principles of § 301.6724 –1
(relating to waivers of penalty if failure
due to reasonable cause) apply for pur-
poses of determining whether reasonable
cause exists in any particular case.
Second, to prevent abuse, proposed
§ 1.385–2 prohibits the affirmative use of
the rules in the proposed regulations to
support a particular characterization of an
instrument. Thus, if a taxpayer fails to
satisfy the requirements of proposed
§ 1.385–2 with a principal purpose of
reducing the federal tax liability of any
member of the expanded group, the rules
of the proposed regulations do not apply.
Third, if an applicable instrument that
is not an EGI is issued with a principal
purpose of avoiding the purposes of pro-
posed § 1.385–2, the applicable instru-
ment is treated as an EGI and will be
subject to the provisions of the proposed
regulations. Such a situation could occur
if, for example, an applicable interest was
issued by an expanded group member to a
trust held by members of the same ex-
panded group.
G.Effective Date of Proposed § 1.385–2
The provisions of § 1.385–2 are pro-
posed to be generally effective when the
regulations are published as final regula-
tions. Proposed § 1.385–2 would apply to
any applicable instrument issued on or
after that date, as well as to any applicable
instrument treated as issued as a result of an
entityclassificationelectionunder
§ 301.7701–3 made on or after the date the
regulations are issued as final regulations.
IV.Certain Distributions of Debt
Instruments and Similar Transactions
A.In General
Proposed §§ 1.385–3 and 1.385– 4 pro-
vide rules that treat as stock certain inter-
ests that otherwise would be treated as
indebtedness for federal income tax pur-
poses. Proposed § 1.385–3 applies to debt
instruments that are within the meaning of
section 1275(a) and § 1.1275–1(d), as de-
termined without regard to the application
of proposed § 1.385–3. Section 1275(a)
and § 1.1275–1(d) generally define a debt
instrument as any instrument or contrac-
tual arrangement that constitutes indebt-
edness under general principles of federal
income tax law. Thus, the termdebt in-
strumentforpurposesofproposed
§§ 1.385–3 and 1.385– 4 means an instru-
ment that satisfies the requirements of
proposed §§ 1.385–1 and 1.385–2 and that
is indebtedness under general principles of
federal income tax law. The Treasury De-
partment and the IRS plan to amend
§ 1.1275–1(d) to coordinate § 1.1275–1(d)
with the regulations under section 385 when
the proposed regulations are finalized.
Specifically, proposed § 1.385–3 treats
as stock certain debt instruments issued by
one member of an expanded group to an-
other member of the same group (ex-
panded group debt instrument) in the cir-
cumstances described in Section B of this
Part IV, unless an exception described in
Section C of this Part IV applies. Detailed
operating rules regarding the recharacter-
ization (including with respect to partner-
ships) are discussed in Section D of this
Part IV. A rule to prevent taxpayers from
affirmatively using proposed §§ 1.385–3
and 1.385– 4 is discussed in Section E of
this Part IV. Section F of this Part IV
discusses proposed § 1.385– 4, which pro-
vides special rules to address the treat-
ment of consolidated groups. The effec-
tive date of proposed §§ 1.385–3 and
1.385– 4 is discussed in Section G of this
Part IV.
To the extent proposed § 1.385–3 treats
an interest as stock, the interest is treated
as stock for all federal tax purposes. Con-
sistent with the traditional case law debt-
equity analysis, when a debt instrument is
treatedasstockunderproposed
§ 1.385–3, the terms of the debt instru-
ment (for example, voting rights or con-
version features) are taken into account
for purposes of determining the type of
stock resulting from the recharacteriza-
tion, including whether such stock is pre-
ferred stock or common stock.
B.Debt Instruments Treated as Stock
Proposed § 1.385–3 provides three
rules that treat an expanded group debt
instrument as stock: a general rule, a fund-
ing rule, and an anti-abuse rule.
1.The General Rule
The general rule treats an expanded
group debt instrument as stock to the ex-
tent it is issued by a corporation to a
member of the corporation’s expanded
group (1) in a distribution; (2) in exchange
for expanded group stock, other than in an
exempt exchange (as defined later in this
Section 1); or (3) in exchange for property
in an asset reorganization, but only to the
extent that, pursuant to the plan of reor-
ganization, a shareholder that is a member
of the issuer’s expanded group immedi-
ately before the reorganization receives
the debt instrument with respect to its
stock in the transferor corporation. All or
a portion of an issuance of a debt instru-
ment may be described in more than one
prong of the general rule without chang-
ing the result that follows from being de-
scribed in a single prong.
For purposes of the first prong of the
general rule, the termdistributionis
broadly defined as any distribution by a
corporation to a member of the corpora-
tion’s expanded group with respect to the
distributing corporation’s stock, regard-
less of whether the distribution is treated
as a dividend within the meaning of sec-
tion 316. Thus, a debt instrument issued in
exchange for stock of the issuer of the
debt instrument (that is, in a redemption
under corporate law) is a distribution that
is covered by the first prong of the general
rule and an acquisition of expanded group
stock covered by the second prong of the
general rule.
The second prong of the general rule –
addressing debt instruments issued in ex-
change for expanded group stock – ap-
plies regardless of whether the expanded
group stock is acquired from a share-
holder of the issuer of the expanded group
stock, or directly from the issuer. For an
illustration of this rule in a context where
stock is not formally issued because it
would be a “meaningless gesture,” see
Example 11 in § 1.385–3(g)(3) of the pro-
posed regulations.
For purposes of the second prong of the
general rule, the termexempt exchange
means an acquisition of expanded group
stock in which the transferor and trans-
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feree of the stock are parties to a reorga-
nization that is an asset reorganization,
and either (i) section 361(a) or (b) applies
to the transferor of the expanded group
stock and the stock is not transferred
by issuance; or (ii) section 1032 or
§ 1.1032–2 applies to the transferor of the
expanded group stock and the stock is
distributed by the transferee pursuant to
the plan of reorganization. As a result, the
second prong of the general rule generally
does not apply to a debt instrument that is
issued in exchange for expanded group
stock when section 361(a) or (b) applies to
the transferor of such stock. This limita-
tion has the effect of causing exchanges of
expanded group stock that are part of an
asset reorganization to be covered only by
the third prong of the general rule, which,
as discussed in the next paragraph, im-
poses limitations on the application of the
general rule to exchanges that are part of
an asset reorganization.
The third prong of the general rule
applies to asset reorganizations among
corporations that are members of the same
expanded group. Anasset reorganization
is a reorganization within the meaning of
section 368(a)(1)(A), (C), (D), (F), or (G).
Specifically, the third prong of the general
rule applies to a debt instrument issued in
exchange for property in an asset reorga-
nization, but only to the extent that, pur-
suant to the plan of reorganization, a
shareholder that is a member of the issu-
er’s expanded group immediately before
the reorganization receives the debt in-
strument with respect to its stock in the
transferor corporation. The second step
receipt of the debt instrument by the ex-
panded group shareholder could be in the
form of a distribution of the debt instru-
ment to shareholders of the distributing
corporation in a divisive asset reorganiza-
tion, or in redemption of the shareholder’s
stock in the transferor corporation in an
acquisitive asset reorganization. Because
the third prong of the general rule applies
only to a debt instrument that is received
by a shareholder with respect to its stock
in the transferor corporation, that debt in-
strument would, absent the application of
§ 1.385–3, be treated as “other property”
within the meaning of section 356.
The third prong of the general rule is
limited to debt instruments distributed to
shareholders pursuant to the reorganiza-
tion, and does not apply to debt instru-
ments exchanged for securities or other
debt interests because, in that latter case,
the newly issued debt instrument is ex-
changed for existing debt interests and
thus no additional debt is incurred by the
parties to the reorganization.
2.The Funding Rule
a.Funded Transactions
The funding rule treats as stock an ex-
panded group debt instrument that is is-
sued with a principal purpose of funding a
transaction described in the general rule
(principal purpose debt instrument). Spe-
cifically, a principal purpose debt instru-
ment is a debt instrument issued by a
corporation (funded member) to another
member of the funded member’s ex-
panded group in exchange for property
with a principal purpose of funding (1) a
distribution of property by the funded
member to a member of the funded mem-
ber’s expanded group, other than a distri-
bution of stock pursuant to an asset reor-
ganization that is permitted to be received
without the recognition of gain or income
under section 354(a)(1) or 355(a)(1) or,
when section 356 applies, that is not
treated as “other property” or money de-
scribed in section 356; (2) an acquisition
of expanded group stock, other than in an
exempt exchange, by the funded member
from a member of the funded member’s
expanded group in exchange for property
other than expanded group stock; or (3)
the acquisition of property by the funded
member in an asset reorganization but
only to the extent that, pursuant to the plan
of reorganization, a shareholder that is a
member of the funded member’s ex-
panded group immediately before the re-
organization receives “other property” or
money within the meaning of section 356
with respect to its stock in the transferor
corporation.
Prongs (1) through (3) of the funding
rule are referred to in this Section 2 as
“distributions or acquisitions.” Proposed
§ 1.385–3(b)(3)(iii) provides that, if all or
a portion of a distribution or acquisition
by a funded member is described in more
than one prong of the funding rule, the
funded member is treated as engaging in
only a single distribution or acquisition
for purposes of applying the funding rule.
The funding rule addresses transactions
that, when viewed together, present simi-
lar policy concerns as the transactions that
are subject to the general rule.
The first prong of the funding rule –
addressing a distribution by a funded
member – excludes a distribution of stock
permitted to be received without the rec-
ognition of gain under section 355(a)(1)
when the distribution is pursuant to an
asset reorganization (that is, a divisive
reorganization qualifying under section
368(a)(1)(D)), but does not exclude a dis-
tribution of stock that is permitted to be
received without the recognition of gain
under section 355(a)(1) when the transac-
tion qualifies under section 355 without
also qualifying as a reorganization (that is,
a distribution of the stock of a controlled
corporation without a related transfer of
property by the distributing corporation to
the controlled corporation pursuant to the
plan of reorganization). The reason for
this distinction is that the controlled cor-
poration in a divisive reorganization de-
scribed in section 368(a)(1)(D) acquires
assets of the distributing corporation and,
as described in Section B.2.b.v of this Part
IV, is treated as a successor of the distrib-
uting corporation (and the distributing
corporation is treated as a predecessor of
the controlled corporation) for purposes of
the funding rule. In contrast, when a dis-
tribution transaction qualifies under sec-
tion 355 without also qualifying as a re-
organization, the controlled corporation
does not acquire assets from the distribut-
ing corporation as part of the transaction
and the corporations are not treated as
predecessor and successor of each other
for purposes of the funding rule. Consis-
tentwiththisapproach,proposed
§ 1.385–3 does not treat a section 355
distribution that is part of a divisive reor-
ganization as a distribution for purposes
of the funding rule because the distribut-
ing corporation and the controlled corpo-
ration are both parties to the reorganiza-
tion and are both treated as funded
members to the extent of any prior debt
instrument issued by the distributing cor-
poration. For a further illustration of this
rule, see Example 10 in § 1.385–3(g)(3) of
the proposed regulations.
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649

b.Determining Whether a Debt
Instrument Is Issued with a Principal
Purpose of Funding a Distribution or
Acquisition
The determination as to whether a debt
instrument is issued with a principal pur-
pose of funding a distribution or acquisi-
tion is based on all of the facts and cir-
cumstances. A debt instrument may be
treated as issued with such a principal
purpose whether it is issued before or after
a distribution or acquisition.
i.Non-Rebuttable Presumption During
the 72-Month Period
Proposed § 1.385–3 also establishes a
non-rebuttable presumption that certain
expanded group debt instruments are is-
sued with a principal purpose of funding a
distribution or acquisition by the funded
member. Specifically, such a principal
purpose is deemed to exist if the expanded
group debt instrument is issued by the
funded member during the period begin-
ning 36 months before the funded member
makes a distribution or acquisition and
ending 36 months after the distribution or
acquisition (the 72-month period). This
per se rule does not create a safe harbor.
Accordingly, a debt instrument issued out-
side the 72-month period may be treated
as having a principal purpose of funding a
distribution or acquisition, based on the
facts and circumstances.
The Treasury Department and the IRS
have determined that this non-rebuttable
presumptionisappropriatebecause
money is fungible and because it is diffi-
cult for the IRS to establish the principal
purposes of internal transactions. In the
absence of a per se rule, taxpayers could
assert that free cash flow generated from
operations funded any distributions and
acquisitions, while any debt instrument
was incurred to finance the capital needs
of those operations. Because taxpayers
would be able to document the purposes
of funding transactions accordingly, it
would be difficult for the IRS to establish
that any particular debt instrument was
incurred with a principal purpose of fund-
ing a distribution or acquisition. The ex-
ception discussed in Section C of this Part
IV for distributions and acquisitions that
do not exceed current year earnings and
profits would accommodate many ordi-
nary course distributions and acquisitions,
providing significant flexibility to avoid
the application of this per se rule. The
Treasury Department and the IRS have
determined that this exception, together
with the exception for a tainted debt in-
strument that does not exceed $50 million,
also discussed in Section C of this Part IV,
appropriately balance between preventing
tax-motivated transactions among mem-
bers of an expanded group and accommo-
dating ordinary course transactions.
ii.Exception to Non-Rebuttable
Presumption for Ordinary Course Debt
Instruments
An exception to this per se rule applies
to ordinary course debt instruments. Pro-
posed § 1.385–3(b)(3)(iv)(B)(2) defines
an ordinary course debt instrument as a
debt instrument that arises in the ordinary
course of the issuer’s trade or business in
connection with the purchase of property
or the receipt of services to the extent that
it reflects an obligation to pay an amount
that is currently deductible by the issuer
under section 162 or currently included in
the issuer’s cost of goods sold or inven-
tory, provided that the amount of the ob-
ligation outstanding at no time exceeds
the amount that would be ordinary and
necessary to carry on the trade or business
of the issuer if it was unrelated to the
lender. This exception is intended to apply
to debt instruments that arise in connec-
tion with the purchase of property or the
receipt of services between members of
the same expanded group in the ordinary
course of the purchaser’s or recipient’s
trade or business, and is not intended to
apply to intercompany financing or trea-
sury center activities or to capital expen-
ditures. An ordinary course debt instru-
ment is not subject to the per se rule;
however, it may be treated as having a
principal purpose of funding a distribution
or acquisition by the issuer, based on the
facts and circumstances.
iii.Ordering Rules
For purposes of applying the per se
rule, proposed § 1.385–3(b)(3)(iv)(B)(3)
includes an ordering rule that provides
that, when two or more debt instruments
may be treated as potentially funding the
same acquisition or distribution, the debt
instruments are tested based on the order
in which they were issued. Thus, for ex-
ample, if a company issues an expanded
group debt instrument of $100x in each of
years 1 and 2, and then makes a distribution
of $150x in year 3, the distribution will
result in a recharacterization as of the date of
the distribution of $100x of the year 1 debt
instrument and $50x of the year 2 debt in-
strument. For a further illustration of this
rule, see Example 6 in § 1.385–3(g)(3) of
the proposed regulations.
A second ordering rule in proposed
§ 1.385–3(b)(3)(iv)(B)(4) provides that,
when a debt instrument may be treated as
funding more than one distribution or ac-
quisition, the earliest distribution or acqui-
sition is treated as the first distribution or
acquisition that was funded.
An exception to these ordering rules
applies when an acquisition of expanded
group stock by issuance ceases to qualify
for the exception from the funding rule
described in Section C.3 of this Part IV. In
that case, the acquisition of expanded
group stock is treated as an acquisition
that is subject to the funding rule on the
date that the acquisition actually occurred,
but debt instruments issued, and other dis-
tributions and acquisitions that occurred,
prior to the date that the acquirer ceases to
qualify for the exception are ordered with-
out regard to the acquisition of expanded
group stock that previously was excepted
from the funding rule.
iv.Transition Rule
For a rule preventing the funding rule
from treating a debt instrument issued on
or after April 4, 2016 from being treated
as funding a distribution or acquisition
that occurred before April 4, 2016, see
Section G of this Part IV.
v.Predecessor and Successor Rules
Finally, the funding rule provides that
references in the funding rule to the
funded member include any predecessor
or successor of such member. Apredeces-
soris defined to include the distributor or
transferor corporation in a transaction de-
scribed in section 381(a) in which a mem-
ber of the expanded group is the acquiring
corporation, but also includes the trans-
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650

feror corporation in a divisive reorganiza-
tion described in section 368(a)(1)(D) or
(G). The term predecessor does not in-
clude, with respect to a controlled corpo-
ration, a distributing corporation that dis-
tributed the stock of the controlled
corporation pursuant to section 355(c).
Similarly, asuccessoris defined to in-
clude the acquiring corporation in a trans-
action described in section 381(a) in
which a member of the expanded group is
the distributor or transferor corporation,
but also includes the acquiring corpora-
tion in a divisive reorganization described
in section 368(a)(1)(D) or (G). The term
successor does not include, with respect to
a distributing corporation, a controlled
corporation the stock of which was dis-
tributed by the distributing corporation
pursuant to section 355(c). In addition,
Section C.3 of this Part IV, which sets
forth an exception to the funding rule for
certain acquisitions of expanded group
stock by issuance, provides that the
funded member istreated as a predecessor
of the issuer and the issuer is treated as a
successor of the funded member to the ex-
tent of the value of the acquired stock. For
an illustration of these rules, see Examples
9, 10, and 12 in proposed § 1.385–3(g)(3).
3.The Anti-Abuse Rule
Proposed § 1.385–3(b)(4) also pro-
vides that a debt instrument is treated as
stock if it is issued with a principal pur-
pose of avoiding the application of the
proposed regulations. In addition, other
interests that are not debt instruments for
purposes of proposed §§ 1.385–3 and
1.385– 4 (for example, contracts to which
section 483 applies or nonperiodic swap
payments) are treated as stock if issued
with a principal purpose of avoiding the
application of proposed §§ 1.385–3 or
1.385– 4.
Proposed § 1.385–3(b)(4) includes a
non-exhaustive list of examples illustrat-
ing situations where the anti-abuse rule
might apply. The anti-abuse rule may ap-
ply, for example, if a 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 application of the pro-
posed regulations. In that situation, factors
that may be taken into account in deter-
mining the presence or absence of a prin-
cipal purpose of avoiding the application
of the proposed regulations include the
time period between the issuance of the
debt instrument to the non-member and
the acquisition of the debt instrument by a
member of the issuer’s expanded group,
and whether there was a significant
change in circumstances during that time
period. For example, a change of control
of the issuer group (for example, a cash
acquisition of all of the stock of the ulti-
mate parent company of the issuer) after
the issuance and before the acquisition of
the debt instrument that was not foresee-
able when the debt instrument was issued
to the non-member could indicate that the
debt instrument was not issued with a
principal purpose of avoiding the applica-
tion of the proposed regulations. In con-
trast, the issuance of a debt instrument to
a non-member after discussions were un-
derway regarding the change-of-control
transaction could indicate that the debt
instrument was issued with a principal
purpose of avoiding the application of the
proposed regulations.
Other examples of when the anti-abuse
rule could apply include situations where,
with a principal purpose of avoiding the
application of proposed § 1.385–3: (i) a
debt instrument is issued to a person that
is not a member of the issuer’s expanded
group and that person later becomes a
member of the issuer’s expanded group;
(ii) a debt instrument is issued to an entity
that is not taxable as a corporation for
federal tax purposes (for example, a trust
that is beneficially owned by an expanded
group member); or (iii) a member of the
issuer’s expanded group is substituted as a
new obligor or added as a co-obligor on
an existing debt instrument. The anti-
abuse rule also could apply to a debt in-
strument that is issued or transferred in
connection with a reorganization or similar
transaction with a principal purpose of
avoiding the application of the proposed
regulations. For a further illustration of this
rule, see Example 18 in § 1.385–3(g)(3) of
the proposed regulations.
4.Coordination Between General Rule
and Funding Rule
Proposed § 1.385–3(b)(5) includes a
rule to address a potential overlap be-
tween the general rule and the funding
rule. This coordination rule provides that,
to the extent all or a portion of a debt
instrument issued in an asset reorganiza-
tion is treated as stock under the third
prong of the general rule (relating to a
debt instrument issued for property in an
asset reorganization), the distribution of
the deemed stock to a shareholder in the
asset reorganization is not also treated as a
distribution or acquisition by the trans-
feror corporation for purposes of the fund-
ing rule. This coordination rule addresses
a specific potential overlap situation
where a debt instrument is distributed to a
shareholder pursuant to an asset reorgani-
zation and is characterized under the third
prong of the general rule as an issuance of
stock. When the issuance of the debt in-
strument is characterized under the gen-
eral rule as an issuance of stock, the stock
may be treated as non-qualified preferred
stock for purposes of section 356. Non-
qualified preferred stock received by a
shareholder in a distribution is itself
treated as “other property” for purposes of
section 356. This overlap rule provides
that, if the shareholder is deemed to re-
ceive nonqualified preferred stock in the
asset reorganization, the distribution of
the nonqualified preferred stock in the as-
set reorganization is not treated as a dis-
tribution or acquisition for purposes of the
funding rule. For an illustration of this
rule, see Example 8 in § 1.385–3(g)(3) of
the proposed regulations.
C.Exceptions
Proposed § 1.385–3(c) provides three
exceptions from the application of pro-
posed § 1.385–3(b) for transactions that
otherwise could result in a debt instrument
being treated as stock.
1.Exception for Current Year Earnings
and Profits
As noted in Section B.2 of this Part IV,
proposed § 1.385–3(c)(1) includes an ex-
ception pursuant to which distributions
and acquisitions described in proposed
§ 1.385–3(b)(2) (the general rule) or pro-
posed § 1.385–3(b)(3)(ii) (the funding
rule) that do not exceed current year earn-
ings and profits (as described in section
316(a)(2)) of the distributing or acquiring
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651

corporation are not treated as distributions
or acquisitions for purposes of the general
rule or the funding rule. For this purpose,
distributions and acquisitions are attrib-
uted to current year earnings and profits in
the order in which they occur.
2.Threshold Exception
A second exception provides that an
expanded group debt instrument will not
be treated as stock if, when the debt in-
strument 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). If the expanded group’s debt in-
struments that otherwise would be treated
as stock later exceed $50 million, then all
expanded group debt instruments that, but
for the threshold exception, would have
been treated as stock are treated as stock,
rather than only the amount that exceeds
$50 million. Thus, the threshold exception
is not an exemption of the first $50 million
of expanded group debt instruments that
otherwise would be treated as stock under
the proposed regulations, but rather is
only intended to provide an exception
fromtheapplicationofproposed
§ 1.385–3 for taxpayers that have not ex-
ceeded the $50 million threshold. If the
$50 million threshold subsequently is ex-
ceeded, the timing of the recharacteriza-
tion of the relevant debt instrument as
stock depends on when the debt instru-
ment was issued. If the debt instrument
ceases to qualify for the threshold excep-
tion after the taxable year of its issuance,
the recharacterization is treated as occur-
ring on the date that the threshold excep-
tion ceases to apply. If, on the other hand,
the debt instrument ceases to qualify for
the threshold exception during the same
taxable year that the debt instrument is
issued, the debt instrument is treated as
stock as of the day that the debt instru-
ment is issued. Once the $50 million
threshold is exceeded, the threshold ex-
ception will not apply to any debt instru-
ment issued by members of the expanded
group for so long as any instrument that
previously was treated as indebtedness
solely because of the threshold excep-
tion remains outstanding, in order to
prevent the $50 million limitation from
refreshing after those instruments are
treated as stock.
The threshold exception is applied af-
ter applying the exception for current year
earnings and profits. For an illustration of
the interaction of the threshold exception
and the exception for current year earn-
ings and profits, see Example 17 in
§ 1.385–3(g)(3) of the proposed regula-
tions.
3.Exception for Funded Acquisitions
of Subsidiary Stock by Issuance
An acquisition of expanded group
stock will not be treated as an acquisition
described in the second prong of the fund-
ing rule if (i) the acquisition results from a
transfer of property by a funded member
(the transferor) to an issuer in exchange
for stock of the issuer, and (ii) for the
36-month period following the issuance,
the transferor holds, directly or indirectly,
more than 50 percent of the total com-
bined voting power of all classes of stock
of the issuer entitled to vote and more than
50 percent of the total value of the stock
of the issuer. For purposes of this excep-
tion, a transferor’s indirect stock owner-
ship is determined by applying the princi-
ples of section 958(a) without regard to
whether an intermediate entity is foreign
or domestic.
If the transferor ceases to meet the
ownership requirement at any time during
the 36-month period, the acquisition of
expanded group stock will no longer qual-
ify for the exception and will be treated as
an acquisition described in the second
prong of the funding rule. In this case, for
purposes of applying the per se rule, the
acquisition may be treated as having been
funded by a debt instrument issued during
the 72-month period determined with re-
spect to the date of the acquisition (rather
than the date that the exception ceased to
apply (the cessation date)), but, in the case
of a debt instrument issued prior to the
cessation date, only to the extent that such
debt instrument is treated as indebtedness
as of the cessation date (that is, a debt
instrument not already treated as stock).
The proposed regulations treat an is-
suer and a transferor as a successor and
predecessor, respectively, for purposes of
the funding rule to the extent of the value
of the expanded group stock acquired
from the issuer. However, for purposes of
the per se rule, the issuer and transferor
are only treated as successor and prede-
cessor, respectively, with respect to a debt
instrument issued by the transferor during
the period beginning 36 months before the
relevant issuance of expanded group stock
and ending 36 months after such issuance.
Proposed § 1.385–3(f)(11) further limits
the effect of treating the issuer and trans-
feror as successor and predecessor by pro-
viding that a distribution made by the is-
suer directly to the transferor is not treated
as a distribution made by the transferor for
purposes of applying the funding rule to a
debt instrument of the transferor.
For an illustration of this exception, see
Example 12 in § 1.385–3(g)(3) of the pro-
posed regulations.
D.Operating Rules
Proposed § 1.385–3(d) includes oper-
ating rules for determining when a debt
instrument is treated as stock and for cer-
tain deemed exchanges required under the
proposed regulations.
1.Timing of Stock Treatment
a.Timing under the General Rule
A debt instrument treated as stock un-
der the general rule is treated as stock
from the time when the debt instrument is
issued. In addition, and in contrast to the
funding rule, the treatment of a debt in-
strument as stock pursuant to the general
rule may affect other aspects of the tax
treatment of the transaction in which the
debt instrument is issued. For example, a
distribution of a debt instrument is treated
as a distribution of stock for all federal tax
purposes and, accordingly, is subject to
section 305. Similarly, a debt instrument
issued in exchange for expanded group
stock is treated as an acquisition of ex-
panded group stock in exchange for stock
of the issuing corporation. Because stock
of the issuing corporation is not treated as
“property” within the meaning of section
317, such transactions would not, for ex-
ample, be described in section 304(a)(1)
or be subject to § 1.367(b)–10, both of
which only apply to certain acquisitions of
stock for property.
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b.Timing under the Funding Rule
When the funding rule applies, a prin-
cipal purpose debt instrument also is
treated as stock from the time when the
debt instrument is issued, but only to the
extent it is issued in the same or a subse-
quent taxable year as the distribution or
acquisition that the debt instrument is
treated as funding. To the extent that a
principal purpose debt instrument is is-
sued in a taxable year preceding the tax-
able year in which the distribution or ac-
quisition that it is treated as funding
occurs, the debt instrument is respected as
indebtedness until the date such distribu-
tion or acquisition occurs, at which time it
is deemed to be exchanged (as described
in Section D.2 of this Part IV) for stock.
For these purposes, the relevant taxable
year is the taxable year of the funded
member. See Section C.3 of this Part IV
for a discussion of the timing rule when the
exception for funded acquisitions of subsid-
iary stock by issuance ceases to apply.
In contrast to transactions that are char-
acterized under the general rule, when the
funding rule applies, the tax treatment of
the distribution or acquisition that the
principal purpose debt instrument is
treated as funding is never recharacterized
under the proposed regulations. Accord-
ingly, in the case of a section 301 distri-
bution that triggers the application of the
funding rule, section 301 will continue to
apply to the distribution without regard to
the fact that the debt instrument that is
treated as funding the distribution is re-
characterized as stock. Similarly, the ap-
plication of section 304 to a funded acqui-
sition of expanded group stock would not
be affected by the fact that the debt instru-
ment that is treated as funding the acqui-
sition is recharacterized as stock under the
funding rule.
c.Transitional Timing Rule
For an additional timing rule address-
ing certain debt instruments issued on or
after April 4, 2016 and before the date of
publication in theFederal Registerof the
Treasury decision adopting proposed
§ 1.385–3 as a final regulation, see section
G of this Part IV.
2.Deemed Exchange
As described in Section D.1 of this Part
IV, the funding rule can apply to treat a
debt instrument as stock in a taxable year
that is subsequent to the taxable year in
which the debt instrument is issued. In
addition, as described in Section C of this
Part IV, when the $50 million threshold
exception ceases to apply, all debt instru-
ments of the expanded group issued in a
prior taxable year that previously was
treated as indebtedness because of the
threshold exception is treated as stock on
the date that the threshold exception
ceases to apply. In those situations the
deemed exchange rule described in Sec-
tion B of Part II applies. This deemed
exchange rule does not apply when a debt
instrument that is treated as stock under
proposed § 1.385–3 leaves the expanded
group, as described in Section D.3 of this
Part IV.
3.Debt Instrument that Leaves the
Expanded Group
When a debt instrument that is treated
as stock under proposed § 1.385–3 is
transferred to a person that is not a mem-
ber of the expanded group, or when the
obligor with respect to such debt instru-
ment ceases to be a member of the ex-
panded group that includes the issuer, the
interest ceases to be treated as stock. This
is because proposed § 1.385–3 generally
applies only to a debt instrument that is
held by a member of an expanded group.
For purposes of this rule, it should be
noted that a debt instrument held by a
partnership is considered held by its part-
ners, as described in Section D.4 of this
Part IV.
The proposed regulations provide that,
immediately before a debt instrument that
is treated as stock under proposed
§ 1.385–3 ceases to be held by a member
of the expanded group, the expanded
group issuer is deemed to issue a new debt
instrument to the expanded group holder
in exchange for the debt instrument that
was treated as stock. The proposed regu-
lations provide that this deemed issuance
of the debt instrument is not itself subject
to the general rule.
When a debt instrument treated as
stock pursuant to the funding rule ceases
to be treated as stock because it is no
longer an expanded group debt instru-
ment, all other debt instruments of the
issuer that are not currently treated as
stock are re-tested to determine whether
other debt instruments are treated as
funding the distribution or acquisition
that previously was treated as funded by
the debt instrument that ceases to be
treated as stock pursuant to this rule. For
an illustration of this rule, see Example
7 in § 1.385–3(g)(3) of the proposed
regulations.
4.Treatment of Partnerships
To prevent avoidance of these rules
through the use of partnerships, proposed
§ 1.385–3(d)(5) takes an aggregate ap-
proach to controlled partnerships for pur-
poses of the proposed regulations. The
legislative history of subchapter K of
chapter 1 of the Code provides that, for
purposes of interpreting Code provisions
outside of that subchapter, a partnership
may be treated as either an entity separate
from its partners or an aggregate of its
partners, depending on which character-
ization is more appropriate to carry out the
purpose of the particular section under
consideration. H.R. Conf. Rep. No. 2543,
83rd Cong. 2d. Sess. 59 (1954). Thus, for
example, when a member of an expanded
group becomes a partner in a partnership
that is a controlled partnership with re-
spect to the expanded group, the member
is treated as acquiring its proportionate
share of the controlled partnership’s as-
sets. In addition, each expanded group
partner in a controlled partnership is
treated as (i) issuing its proportionate
share of any debt instrument issued by the
controlled partnership, (ii) acquiring its
proportionate share of any expanded
group stock acquired by the controlled
partnership, and (iii) receiving its propor-
tionate share of any “other property” re-
ceived by the partnership in a transaction
described in section 356. For this purpose,
a partner’s proportionate share is deter-
mined in accordance with the partner’s
share of partnership profits. A partnership
is acontrolled partnershipif 80 percent or
more of the interests in the capital or
profits of the partnership are owned, di-
rectly or indirectly, by one or more mem-
bers of an expanded group. For this pur-
Bulletin No. 2016–17April 25, 2016
653

pose, indirect ownership of a partnership
interest is determined based on the indi-
rect ownership rules of section 304(c)(3).
If a debt instrument issued by a con-
trolled partnership were to be recharacter-
ized as equity in the controlled partner-
ship, the resulting equity could give rise to
guaranteed payments that may be deduct-
ible or gross income allocations to part-
ners that would reduce the taxable income
of the other partners that did not receive
such allocations. Therefore, under the au-
thority of section 7701(l) to recharacterize
multiple-party financing transactions, pro-
posed § 1.385–3(d)(5)(ii) provides that,
when a debt instrument issued by a part-
nership is recharacterized, in whole or in
part, under proposed § 1.385–3, the holder
of the recharacterized debt instrument is
treated as holding stock in the expanded
group partner or partners rather than as
holding a partnership interest in the con-
trolled partnership. The partnership and its
partners must make appropriate conform-
ing adjustments to reflect the expanded
group partner’s treatment under the pro-
posed regulations. Any such adjustments
must be consistent with the purposes of
these proposed regulations and must be
made in a manner that avoids the creation
of, or increase in, a disparity between the
controlled partnership’s aggregate basis in
its assets and the aggregate bases of the
partners’ respective interests in the part-
nership. For an illustration of the rules
applicable to controlled partnerships, see
Examples 13, 14, and 15 in § 1.385–
3(g)(3) of the proposed regulations.
5.Notification of Inconsistent Treatment
Waived
Section 385(c)(1) provides that an is-
suer’s characterization as of the time of
issuance of an interest as debt or stock is
binding on the issuer and on all holders of
the interest. Section 385(c)(2) provides an
exception to that rule if the holder dis-
closes on its return that the holder is treat-
ing such interest in a manner that is in-
consistent with such characterization.
Section 385(c)(3) provides that the Secre-
tary is authorized to require such informa-
tion as the Secretary determines to be
necessary to carry out the provisions of sec-
tion 385(c). Under proposed § 1.385–3, a
holder may be required to treat an interest as
stock even though the issuer treated it as
debt when it was issued. For example, a
debt instrument may first be treated as a
principal purpose debt instrument in a year
that follows the year in which the debt in-
strument was issued. In that case, absent a
regulatory provision to the contrary, the
holder would be subject to the reporting
requirement described in section 385(c)(2).
The Treasury Department and the IRS
have determined that the characterization
and reporting requirements in section
385(c) were not intended to apply when
regulations under section 385 require an
interest to be recharacterized after the is-
suer’s initial characterization of that inter-
est. Accordingly, the proposed regulations
provide that section 385(c)(1) does not
apply to a debt instrument to the extent
that it is treated as stock under the pro-
posed regulations.
6.Obligations of Disregarded Entities
Proposed § 1.385–3(d)(6) provides that
a debt instrument issued by a disregarded
entity that is treated as stock under pro-
posed § 1.385–3 is treated as stock in the
disregarded entity’s owner rather than as
an equity interest in the disregarded entity.
Ordinarily, when a disregarded entity be-
comes an entity with more than one equity
owner, the disregarded entity converts to a
partnership.See, e.g., § 301.7701–3(f)(2);
Rev. Rul. 99 –5, 1999 –1 C.B. 434. Under
these circumstances, the Treasury Depart-
ment and the IRS have determined that
treating a debt instrument issued by a dis-
regarded entity that is treated as stock
under proposed § 1.385–3 as stock in its
owner, rather than as an equity interest in
the disregarded entity, is consistent with,
and addresses similar policy concerns as,
the rules applicable to a debt instrument
issued by a controlled partnership, which
are described in Section D.4 of this Part IV.
E.No Affirmative Use
Under proposed § 1.385–3(e), pro-
posed §§ 1.385–3 and 1.385– 4 do not
apply to the extent a person enters into a
transaction that otherwise would be sub-
ject to the proposed regulations with a
principal purpose of reducing its federal
tax liability or the federal tax liability of
another person by disregarding the treat-
ment of the debt instrument that would
occur without regard to the proposed
regulations.
F.Treatment of Consolidated Groups
As noted previously, the Treasury De-
partment and the IRS have determined
that a debt instrument between members
of the same consolidated group does not
raise the same federal tax concerns as a
debt instrument between members of the
same expanded (but not consolidated)
group. Accordingly, proposed § 1.385– 4
includes special rules, issued under the
authority of section 1502, for applying
§ 1.385–3 to consolidated groups, includ-
ing rules addressing the treatment of a
debt instrument issued by one member of
a consolidated group to another member
of the same consolidated group (consoli-
dated group debt instrument) and rules
regarding the treatment of a debt instru-
ment when it ceases to be a consolidated
group debt instrument.
1.Consolidated Groups Treated as One
Corporation
For purposes of proposed § 1.385–3,
all members of a consolidated group are
treated as one corporation. Accordingly,
proposed § 1.385–3 does not apply to a
consolidated group debt instrument. Thus,
for example, the proposed regulations do
not treat as stock a debt instrument that is
issued by one member of a consolidated
group to another member of the consoli-
dated group in a distribution. The proposed
regulations define a consolidated group in
the same manner as the consolidated return
regulations.See§ 1.1502–1(h).
As a result of treating all members of a
consolidated group as one corporation for
purposes of applying proposed § 1.385–3,
a debt instrument issued to or by one
member of a consolidated group generally
is treated as issued to or by all members of
the same consolidated group. Thus, a debt
instrument issued by one consolidated
group member to a member of its ex-
panded group that is not a member of its
consolidated group may be treated under
the funding rule as funding a distribution
or acquisition by another member of that
consolidated group, even though that
other consolidated group member was not
April 25, 2016Bulletin No. 2016–17
654

the issuer and thus was not funded di-
rectly. Similarly, a debt instrument issued
by one consolidated group member to an-
other consolidated group member is
treated as stock under the general rule
when the debt instrument is distributed by
the holder to a member of the expanded
group that is not a member of the same
consolidated group, regardless of whether
the issuer itself distributed the debt instru-
ment. For an illustration of this rule, see
Example 1 in proposed § 1.385– 4(d)(3).
2.Debt Instrument that Ceases to Be a
Consolidated Group Debt Instrument but
Continues to Be an Expanded Group
Debt Instrument
Proposed § 1.385– 4 includes rules ad-
dressing debt held or issued by a consol-
idated group member that leaves a consol-
idated group, but continues to be a
member of the expanded group (such cor-
poration, adeparting member).
Generally, any consolidated group debt
instrument that is issued or held by the
departing member and that is not treated
as stock solely by reason of the rule treat-
ing all members of a consolidated group
as one corporation (exempt consolidated
group debt instrument) is deemed to be
exchanged for stock immediately after the
departing member leaves the group. Any
consolidated group debt instrument issued
or held by a departing member that is not
an exempt consolidated group debt instru-
ment (non-exempt consolidated group debt
instrument) is treated as indebtedness unless
and until the non-exempt consolidated
group debt instrument is treated as a princi-
pal purpose debt instrument under proposed
§§ 1.385–3(b)(3)(ii) and 1.385–3(d)(1) as a
result of a distribution or acquisition de-
scribed in proposed § 1.385–3(b)(3)(ii) that
occurs after the departure. However, solely
for purposes of applying the 72-month pe-
riod under the per se funding rule, the debt
instrument is treated as having been issued
when it was first treated as a consolidated
group debt instrument.
When a member of a consolidated
group transfers a consolidated group debt
instrument to an expanded group member
that is not a member of the consolidated
group, the debt instrument is treated as
issued by the issuer of the debt instrument
(which is treated as one corporation with
the transferor of the debt instrument) to
the transferee expanded group member on
the date of the transfer. For purposes of
proposed § 1.385–3, the consequences of
the transfer are determined in a manner
that is consistent with treating a consoli-
dated group as one corporation. Thus, for
example, the sale of a consolidated group
debt instrument to an expanded group
member that is not a member of the con-
solidated group is treated as an issuance of
the debt instrument to the transferee ex-
panded group member in exchange for
property. To the extent the debt instru-
ment is treated as stock upon being
transferred, the debt instrument is
deemed to be exchanged for stock im-
mediately after the debt instrument is
transferred outside of the consolidated
group. For an illustration of this rule,
see Examples 1 and 2 in § 1.385– 4(d)(3)
of the proposed regulations.
G.Proposed Effective/Applicability Date
and Transition Rules
Sections 1.385–3 and 1.385– 4 are pro-
posed to apply to any debt instrument
issued on or after April 4, 2016 and to any
debt instrument issued before April 4,
2016 as a result of an entity classification
election made under § 301.7701–3 that is
filed on or after April 4, 2016. However,
when §§ 1.385–3(b) and 1.385–3(d)(1)(i)
through (d)(1)(v), or § 1.385– 4 of the
proposed regulations, otherwise would
treat a debt instrument as stock prior to the
date of publication in theFederal Regis-
terof the Treasury decision adopting this
rule as a final regulation, the debt instru-
ment is treated as indebtedness until the
date that is 90 days after the date of pub-
lication in theFederal Registerof the
Treasury decision adopting this rule as a
final regulation. To the extent that the debt
instrument described in the preceding sen-
tence is held by a member of the issuer’s
expanded group on the date that is 90 days
after the date of publication in theFederal
Registerof the Treasury decision adopt-
ing this rule as a final regulation, the debt
instrument is deemed to be exchanged for
stock on the date that is 90 days after the
date of publication in theFederal Regis-
terof the Treasury decision adopting this
rule as a final regulation.
In addition, for purposes of determin-
ing whether a debt instrument is a princi-
pal purpose debt instrument described in
proposed § 1.385–3(b)(3)(iv), a distribu-
tion or acquisition described in proposed
§ 1.385–3(b)(3)(ii) that occurs before
April 4, 2016, other than a distribution or
acquisition that is treated as occurring be-
fore April 4, 2016 as a result of an entity
classificationelectionmadeunder
§ 301.7701–3 that is filed on or after April
4, 2016, is not taken into account.
Statement of Availability of IRS
Documents
IRS Revenue Procedures, Revenue
Rulings notices, and other guidance cited
in this document are published in the In-
ternal Revenue Bulletin (or Cumulative
Bulletin) and are available from the Su-
perintendent of Documents, U.S. Govern-
ment Printing Office, Washington, DC
20402, or by visiting the IRS website at
http://www.irs.gov.
Special Analyses
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 proposed rule is avail-
able in the docket for this rulemaking on
www.regulations.gov.
Pursuant to the Regulatory Flexibility
Act (5 U.S.C. Chapter 6), it is hereby
certified that the proposed regulations will
not have a significant economic impact on
a substantial number of small entities. Ac-
cordingly, an initial regulatory flexibility
analysis is not required. The Commis-
sioner and the courts historically have an-
alyzed whether an interest in a corporation
Bulletin No. 2016–17April 25, 2016
655

should be treated as stock or indebtedness
for federal tax purposes by applying var-
ious sets of factors to the facts of a par-
ticular case. Proposed § 1.385–1 provides
that in connection with determining
whether an interest in a corporation
should be treated as stock or indebtedness
for federal tax purposes, the Commis-
sioner has the discretion to treat certain
interests in a corporation for federal tax
purposes as indebtedness in part and stock
in part. Proposed § 1.385–1 does not re-
quire taxpayers to take any additional ac-
tions or to engage in any new procedures
or documentation. Because proposed
§ 1.385–1 contains no such requirements,
it does not have an effect on small entities.
To facilitate the federal tax analysis of
an interest in a corporation, taxpayers are
required to substantiate their classification
of an interest as stock or indebtedness for
federal tax purposes. Proposed § 1.385–2
provides documentation requirements to
substantiate the treatment of certain
related-party instruments as indebtedness.
First, these rules apply only to debt instru-
ments in form issued within expanded
groups of corporations and other entities.
Second, proposed § 1.385–2 only applies
to expanded groups if the stock of a mem-
ber of the expanded group is publicly
traded, or financial statements of the ex-
panded group or its members show total
assets exceeding $100 million or annual
total revenue exceeding $50 million. Be-
cause the rules are limited to large ex-
panded groups, they will not affect a sub-
stantial number of small entities.
Proposed § 1.385–3 provides rules that
treat as stock certain interests in a corpo-
ration that are held by a member of the
corporation’s expanded group and that
otherwise would be treated as indebted-
ness for federal tax purposes. Proposed
§ 1.385– 4 provides rules regarding the
application of proposed § 1.385–3 to
members of a consolidated group. Pro-
posed § 1.385–3 includes multiple excep-
tions that limit its application. In particu-
lar, the threshold exception provides that
an expanded group debt instrument will
not be treated as stock under proposed
§ 1.385–3 if, when the debt instrument is
issued, the aggregate issue price of all
expanded group debt instruments that oth-
erwise would be treated as stock under
proposed § 1.385–3 does not exceed $50
million. The threshold exception also gov-
erns the application of proposed § 1.385–3
rules to members of a consolidated group
described in proposed § 1.385– 4. Al-
though it is possible that the classification
rules in proposed §§ 1.385–3 and 1.385– 4
could have an effect on small entities, the
threshold exception makes it unlikely that
a substantial number of small entities will
be affected by proposed §§ 1.385–3 and
1.385– 4. Pursuant to section 7805(f) of
the Code, these regulations have been
submitted to the Chief Counsel for Ad-
vocacy of the Small Business Adminis-
tration for comment on their impact on
small business.
Comments and Public Hearing
Before the proposed regulations are ad-
opted as final regulations, consideration
will be given to any written (a signed
original and eight copies) or electronic
comments that are submitted timely to the
IRS. The Treasury Department and the
IRS request comments on all aspects of
the proposed rules, including comments
on the clarity of the proposed rules and
how they can be made more administra-
ble. In addition, comments are requested
on: (1) other instruments that should be
subject to the proposed regulations, in-
cluding other types of applicable instru-
ments that are not indebtedness in form
that should be subject to proposed
§ 1.385–2 and the documentation require-
ments that should apply to such applicable
instruments; (2) whether special rules are
warranted for cash pools, cash sweeps,
and similar arrangements for managing
cash of an expanded group; (3) the rule
addressing deemed exchanges of an EGI
and a debt instrument; (4) the application
of these rules to any entity with respect to
a year in which the entity is not a U.S.
person (as defined in section 7701(a)(30)),
is not required to file a U.S. tax return, and
is not a CFC or a controlled foreign part-
nership, but in a later year becomes one of
the foregoing; (5) whether certain indebt-
edness commonly 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; (6) whether guid-
ance is needed under section 909 to the
extent a U.S. equity hybrid instrument
arises solely by reason of the application
of proposed § 1.385–3; and (7) the treat-
ment of controlled partnerships in pro-
posed § 1.385–3 and the collateral conse-
quences of the recharacterization and any
corresponding adjustments, including the
treatment of a partner’s proportionate
share of partnership assets or debt instru-
ments, of treating a debt instrument issued
by a controlled partnership as stock in its
expanded group partners, including a sit-
uation in which a recharacterization re-
sults in a partnership owning stock of an
expanded group partner. Specifically, the
Treasury Department and the IRS request
comments on how to apply proposed
§ 1.385–3 when expanded group partners
make distributions subject to the funding
rule with respect to some, but not all,
partnership debt instruments; when one or
more, but not all, expanded group partners
make a distribution subject to the funding
rule with respect to part or all of their
share of the partnership debt instrument;
and how to address such distributions
when a controlled partnership has one or
more partners that are not expanded group
members. The Treasury Department and
the IRS also request comments on
whether the objective rules in proposed
§ 1.385–3(d)(5) have the potential to be
manipulated, including by selectively lo-
cating debt instruments in order to achieve
results that are contrary to the purposes of
these regulations, and, if so, whether the
anti-abuse rule in proposed § 1.385–
3(b)(4) or the rule prohibiting the affirma-
tive use of these rules by taxpayers in
proposed § 1.385–3(e) are sufficient to
address these concerns.
More generally, the Treasury Depart-
ment and the IRS request comments on
whether additional guidance is necessary
regarding the manner by which issuers
and holders notify the Secretary of the
intended federal tax treatment of an inter-
est in a corporation.
The Treasury Department and the IRS
are aware that the issuance of preferred
equity by a controlled partnership to an
expanded group member may give rise to
similar concerns as debt instruments of a
controlled partnership issued to an ex-
panded group member, and that controlled
partnerships may, in some cases, issue
preferred equity with a principal purpose
April 25, 2016Bulletin No. 2016–17
656

of avoiding the application of § 1.385–3
of the proposed regulations. The Treasury
Department and the IRS are considering
rules that would treat preferred equity in a
controlled partnership as equity in the ex-
panded group partners, based on the prin-
ciples of the aggregate approach used in
proposed § 1.385–3(d)(5). Comments are
requested regarding the recharacterization
of preferred equity in those circumstances.
Until any such guidance is issued, the IRS
intends to closely scrutinize, and may
challenge when the regulations become
effective, transactions in which a con-
trolled partnership issues preferred equity
to an expanded group member and, within
the relevant 72-month period, one or more
expanded group partners in the controlled
partnership engage in a transaction de-
scribed in § 1.385–3(b)(3)(ii) of the pro-
posed regulations.
Finally, regarding the request for com-
ments on whether guidance is needed un-
der section 909 when a U.S. equity hybrid
instrument arises solely by reason of the
application of § 1.385–3: the application
of proposed § 1.385–3 may give rise to a
U.S. equity hybrid instrument splitter ar-
rangement under § 1.909 –2(b)(3)(i) (for
example when indebtedness issued by one
CFC to another CFC is treated as equity
under proposed § 1.385–3). When this
occurs, payments made pursuant to the
instrument generally would result in dis-
tributions out of earnings and profits at-
tributable pro rata to related income and
other income, as described in §§ 1.909 –3
and 1.909 – 6(d). Given that these section
385 regulations may give rise to a prolif-
eration of U.S. hybrid equity instrument
splitter arrangements, the Treasury De-
partment and the IRS request comments
on whether additional guidance is needed
under section 909, including to address
any uncertainty with respect to how U.S.
hybrid equity instrument splitter ar-
rangements are treated. All comments
will be available for public inspection
and copying at www.regulations.gov or
upon request.
Drafting Information
The principal authors of these regula-
tions are Eric D. Brauer of the Office of
Associate Chief Counsel (Corporate) and
Raymond J. Stahl of the Office of Asso-
ciate Chief Counsel (International). How-
ever, other personnel from the Treasury
Department and the IRS participated in
their development.
*****
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and record-
keeping requirements.
Proposed Amendment to the
Regulations
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
PART I—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries in
numerical order to read in part as follows:
Authority: 26 U.S.C. 7805***
Section 1.385–1 also issued under 26
U.S.C. 385.
Section 1.385–2 also issued under 26
U.S.C. 385 and 26 U.S.C. 1502.
Section 1.385–3 also issued under 26
U.S.C. 385, 26 U.S.C. 701, and 7701(l).
Section 1.385– 4 also issued under 26
U.S.C. 385 and 26 U.S.C. 1502.
Par. 2. Section 1.385–1 is added to read
as follows:
§ 1.385–1 General provisions.
(a)Overview. This section provides
definitions applicable to the regulations
under section 385 and operating rules re-
garding the treatment of certain direct and
indirect interests in corporations as stock
or indebtedness for federal tax purposes.
Section 1.385–2 provides documentation
and information requirements necessary
for certain interests issued between mem-
bers of an expanded group (as defined in
paragraph (b)(3) of this section) to be
treated as indebtedness for federal tax pur-
poses. Section 1.385–3 provides rules that
treat as stock certain interests in a corpo-
ration issued between members of an ex-
panded group in connection with certain
purported distributions of debt instru-
ments and similar transactions. Section
1.385– 4 provides special rules regarding
the transactions described in § 1.385–3 as
they relate to consolidated groups.
(b)Definitions. The definitions in this
paragraph (b) apply for purposes of the
regulations under section 385. For addi-
tional definitions that apply for purposes
of § 1.385–2, see § 1.385–2(a)(4). For
additional definitions that apply for pur-
poses of §§ 1.385–3 and 1.385– 4, see
§ 1.385–3(f).
(1)Controlled partnership. The term
controlled partnershipmeans 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. For this purpose, indirect
ownership of a partnership interest is de-
termined by applying the principles of
paragraph (b)(3)(ii) of this section.
(2)Disregarded entity. The termdisre-
garded entitymeans 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 tax pur-
poses under §§ 301.7701–1 through
301.7701–3 of this chapter.
(3)Expanded group—(i)In general.
The termexpanded groupmeans an affil-
iated group as defined in section 1504(a),
determined:
(A) Without regard to paragraphs (1)
through (8) of section 1504(b);
(B) By substituting “directly or indi-
rectly”for“directly”insection
1504(a)(1)(B)(i); and
(C) By substituting “or” for “and” in
section 1504(a)(2)(A).
(ii)Indirect stock ownership. For pur-
poses of this paragraph (b)(3), indirect
stock ownership is determined by apply-
ing the rules of section 304(c)(3).
(4)Modified controlled partnership.
The termmodified controlled partnership
means a partnership with respect to which
at least 50 percent of the interests in part-
nership capital or profits are owned, di-
rectly or indirectly, by one or more mem-
bers of a modified expanded group. For
this purpose, indirect ownership of a part-
nership interest is determined by applying
the principles of paragraph (b)(3)(ii) of
this section.
(5)Modified expanded group. The term
modified expanded groupmeans an ex-
panded group, as defined in this section,
determined by substituting “50” for “80”
in sections 1504(a)(2)(A) and (B). If one
or more members of a modified expanded
group own, directly or indirectly, 50 per-
cent of the interests in partnership capital
or profits of a modified controlled partner-
Bulletin No. 2016–17April 25, 2016
657

ship, the modified controlled partnership
is treated as a member of the modified
expanded group. In addition, if a person
(as defined in section 7701(a)(1)) is
treated, under the rules of section 318, as
owning at least 50 percent of the value of
the stock of a modified expanded group
member, the person is treated as a member
of the modified expanded group.
(c)Treatment of deemed exchange.Ifa
debt instrument (as defined in § 1.385–
3(f)(3)) or an EGI (as defined in § 1.385–
2(a)(4)(ii)) is deemed to be exchanged, in
whole or in part, for stock pursuant to
§ 1.385–2(c)(3)(ii), § 1.385–3(d)(1)(ii),
§ 1.385–3(d)(1)(iii), § 1.385–3(d)(1)(iv),
§ 1.385–3(d)(1)(v), § 1.385–3(h)(3), or
§ 1.385– 4(e)(3), the holder is treated as
having realized an amount equal to the
holder’s adjusted basis in that portion of
the indebtedness or EGI as of the date of
the deemed exchange (and as having basis
in the stock deemed to be received equal
to that amount), and the issuer is treated as
having retired that portion of the debt in-
strument 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. Notwithstanding
the first sentence of this paragraph (c), the
rules of § 1.988 –2(b)(13) apply to require
the holder and the issuer of a debt instru-
ment or an EGI that is deemed to be
exchanged in whole or in part for stock
pursuant to § 1.385–2(c)(3)(ii), § 1.385–
3(d)(1)(ii), § 1.385–3(d)(1)(iii), § 1.385–
3(d)(1)(iv), § 1.385–3(d)(1)(v), § 1.385–
3(h)(3), or § 1.385– 4(e)(3) to recognize
any exchange gain or loss, other than any
exchange gain or loss with respect to ac-
crued but unpaid qualified stated interest
that is not taken into account under this
paragraph (c) at the time of the deemed
exchange. For purposes of this paragraph
(c), in applying § 1.988 –2(b)(13) the ex-
change gain or loss under section 988 is
treated as the total gain or loss on the
exchange.
(d)Treatment as indebtedness in
part—(1)In general. The Commissioner
may treat an EGI (as defined in § 1.385–
2(a)(4)(ii) and described in paragraph
(d)(2) of this section) as in part indebted-
ness and in part stock to the extent that an
analysis, as of the issuance of the EGI, of
the relevant facts and circumstances con-
cerning the EGI (taking into account any
application of § 1.385–2) under general
federal tax principles results in a determi-
nation that the EGI is properly treated for
federal tax purposes as indebtedness in
part and stock in part. For example, if the
Commissioner’s analysis supports a rea-
sonable expectation that, as of the issu-
ance of the EGI, only a portion of the
principal amount of an EGI will be repaid
and the Commissioner determines that the
EGI should be treated as indebtedness in
part and stock in part, the EGI may be
treated as indebtedness in part and stock
in part in accordance with such determi-
nation, provided the requirements of
§ 1.385–2, if applicable, are otherwise
satisfied and the application of federal tax
principles supports this treatment. The is-
suer of an EGI, the holder of an EGI, and
any other person relying on the character-
ization of an EGI as indebtedness for fed-
eral tax purposes are required to treat the
EGI consistent with the issuer’s initial
characterization. Thus, for example, a
holder may not disclose on its return un-
der section 385(c)(2) that it is treating an
EGI as indebtedness in part or stock in
part if the issuer of the EGI treats the EGI
as indebtedness.
(2)EGI described in this paragraph
(d)(2). An EGI is described in this para-
graph (d)(2) if it is an applicable instru-
ment (as defined in § 1.385–2(a)(4)(i)) an
issuer of which is one member of a mod-
ified expanded group and the holder of
which is another member of the same
modified expanded group.
(e)Treatment of consolidated groups.
For purposes of the regulations under sec-
tion 385, all members of a consolidated
group (as defined in § 1.1502–1(h)) are
treated as one corporation.
(f)Effective/applicability date. This
section applies to any applicable instru-
ment issued or deemed issued on or after
the date these regulations are published as
final regulations in theFederal Register,
and to any applicable instrument treated
as indebtedness issued or deemed issued
before the date these regulations are is-
sued as final regulations if and to the
extent it was deemed issued as a result of
an entity classification election made un-
der § 301.7701–3 of this chapter that is
filed on or after the date these regulations
are issued as final regulations in theFed-
eral Register. For purposes of §§ 1.385–3
and 1.385– 4, this section applies to any
debt instrument issued on or after April 4,
2016 and to any debt instrument treated as
issued before April 4, 2016 as a result of
an entity classification election made un-
der § 301.7701–3 of this chapter that is
filed on or after April 4, 2016.
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)General—(1)Scope. This section
prescribes threshold requirements that
must be satisfied regarding the preparation
and maintenance of documentation and
information with respect to an expanded
group instrument (an EGI, as defined in
paragraph (a)(4)(ii) of this section). The
purpose of preparing and maintaining the
documentation and information required
by this section is to enable an analysis to
be made whether an EGI is appropriately
treated as stock or indebtedness for fed-
eral tax purposes. Satisfying the require-
ments of this section does not establish
that an interest is indebtedness; such sat-
isfaction serves as a minimum standard
that enables this determination to be made
under general federal tax principles. The
rules of this section must be interpreted
and applied in a manner that is consistent
with and reasonably carries out the pur-
poses of this section. Moreover, nothing
in this section prevents the Commissioner
from asserting that the substance of a
transaction involving an EGI (or the EGI
itself) is different from the form of the
transaction (or the EGI) or disregarding
the transaction (or the EGI) or treating the
transaction (or the EGI) in accordance
with its substance for federal tax purposes.
Such an assertion may be made based on
the documentation or information re-
ceived pursuant to a request under this
section or a request for information under
section 7602. If, and only if, the require-
ments of this section are satisfied, the de-
termination of the federal tax treatment of
the EGI is made based on an analysis of
the documentation and information pre-
April 25, 2016Bulletin No. 2016–17
658

pared and maintained, other facts and cir-
cumstances relating to the EGI, and gen-
eralfederaltaxprinciples.Ifthe
requirements of this section are not satis-
fied with respect to an EGI the substance
of which is regarded for federal tax pur-
poses, the EGI will be treated as stock.
This section does not otherwise affect the
authority of the Commissioner under sec-
tion 7602 to request and obtain documen-
tation and information regarding transac-
tions and instruments that purport to
create an interest in a corporation. If the
requirements of this section are satisfied
or otherwise do not apply, see §§ 1.385–3
and 1.385– 4 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.
(2)Application—(i)In general. This
section applies to an EGI only if—
(A) The stock of any member of the
expanded group is traded on (or subject to
the rules of) an established financial market
within the meaning of § 1.1092(d)–1(b);
(B) On the date that an applicable in-
strument first becomes an EGI, total assets
exceed $100 million on any applicable
financial statement, or
(C) On the date that an applicable in-
strument first becomes an EGI, annual
total revenue exceeds $50 million on any
applicable financial statement.
(ii)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 total assets
and annual total revenue are translated
into U.S. dollars at the spot rate (as de-
fined in § 1.988 –1(d)) as of the date of the
applicable financial statement.
(3)Consistency rule. If an issuer char-
acterizes an EGI as indebtedness, the EGI
will be respected as indebtedness only if
the requirements of § 1.385–2(b) are met
with respect to the EGI. If the issuer of an
EGI characterizes that EGI as indebted-
ness, the issuer, the holder, and any other
person relying on the characterization of
an EGI as indebtedness for federal tax
purposes is required to treat the EGI as
indebtedness for all federal tax purposes.
The Commissioner is not bound by the
issuer’s characterization of an EGI.
(4)Definitions. The definitions in this
paragraph (a)(4) apply for purposes of this
section.
(i)Applicable instrument—(A)In gen-
eral. The termapplicable instrument
means any interest issued or deemed is-
sued that is in form a debt instrument. See
paragraph (a)(4)(i)(B) of this section for
rules regarding an interest that is not in
form a debt instrument.
(B)[Reserved]
(ii)Expanded group instrument. The
termexpanded group instrument(EGI)
means an applicable instrument an issuer
of which is one member of an expanded
group and the holder of which is another
member of the same expanded group.
(iii)Issuer. Solely for purposes of this
section, the termissuermeans a person
(including a disregarded entity defined in
§ 1.385–1(b)(2)) that is obligated to sat-
isfy any material obligations created un-
der the terms of an EGI. A person can be
an issuer if that person is expected to
satisfy a material obligation under an EGI,
even if that person is not the primary
obligor. A guarantor, however, is not an
issuer unless the guarantor is expected to
be the primary obligor.
(iv)Applicable financial statement. For
purposes of this section, the termapplica-
ble financial statementmeans a financial
statement,listedinparagraphs
(a)(4)(iv)(A) through (C) of this section,
that includes the assets, portion of the
assets or annual total revenue of any
member of the expanded group and that is
prepared as of any date within 3 years
prior to the date the applicable instrument
at issue first becomes an EGI. A financial
statement that includes the assets or an-
nual total revenue of a member of an
expanded group may be a separate com-
pany financial statement of any member
of the expanded group or any 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—
(A) A financial statement required to
be filed with the Securities and Exchange
Commission (the Form 10 –K or the An-
nual Report to Shareholders);
(B) 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—
(1) Credit purposes;
(2) Reporting to shareholders, partners,
or similar persons; or
(3) Any other substantial non-tax pur-
pose; or
(C) A financial statement (other than a
tax return) required to be provided to the
Federal, state, or foreign government or
any Federal, state, or foreign agency.
(b)Documentation and information re-
quired to determine treatment—(1)Prep-
aration and maintenance of documenta-
tion and information—(i)In general.
Except as otherwise provided in this sec-
tion, an EGI is treated for federal tax
purposes as stock if the documentation
and information described in paragraph
(b)(2) of this section are not prepared, or
the maintenance requirements of para-
graph (b)(4) of this section are not satis-
fied. If the requirements of this section are
satisfied, general federal tax principles ap-
ply to determine whether, or the extent to
which, the EGI is treated as indebtedness
for federal tax purposes. This determina-
tion will take into account the documen-
tation and information prepared, main-
tained, and provided in accordance with
this section, as well as any additional facts
and circumstances. This section applies to
each EGI separately, but the same docu-
mentation and information may satisfy the
requirements of this section for more than
one EGI.
(ii)Failure to provide documentation
and information described in paragraph
(b)(2) of this section. If a taxpayer char-
acterizes an EGI as indebtedness and fails
to provide the documentation and infor-
mation described in paragraph (b)(2) of
this section upon request by the Commis-
sioner, the Commissioner will treat the re-
quirements of this section as not satisfied.
(2)Documentation and other informa-
tion required. This paragraph (b)(2) de-
scribes the documentation and informa-
tion that must be prepared and maintained
to satisfy the requirements of this section.
In each case, the documentation must in-
clude complete and (if relevant) executed
copies of all instruments, agreements and
other documents evidencing the material
rights and obligations of the issuer and the
holder relating to the EGI, and any asso-
ciated rights and obligations of other par-
Bulletin No. 2016–17April 25, 2016
659

ties, such as guarantees and subordination
agreements. Additional documentation
and information may be provided to
supplement, but not substitute for, the
documentation and information required
under this section. The documentation
and information must satisfy the follow-
ing requirements:
(i)Unconditional obligation to pay a
sum certain. There must be written docu-
mentation prepared by the time required
in paragraph (b)(3) of this section estab-
lishing that the issuer has entered into an
unconditional and legally binding obliga-
tion to pay a sum certain on demand or at
one or more fixed dates.
(ii)Creditor’s rights. The written doc-
umentationdescribedinparagraph
(b)(2)(i) of this section must establish that
the holder has the rights of a creditor to
enforce the obligation. The rights of a
creditor typically include, but are not 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 a superior right to
shareholders to share in the assets of the
issuer in case of dissolution.
(iii)Reasonable expectation of ability
to repay EGI. There must be written doc-
umentation prepared containing informa-
tion establishing that, as of the date of
issuance of the applicable instrument 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 instrument or
reasonably anticipated to be incurred after
the date of issuance of the applicable in-
strument), the issuer’s financial position
supported a reasonable expectation that
the issuer intended to, and would be able
to, meet its obligations pursuant to the
terms of the applicable instrument. For
this purpose, if a disregarded entity is
treated as the issuer of an EGI, and the
owner of the disregarded entity has lim-
ited liability within the meaning of
§ 301.7701–3(b)(2)(ii) of this chapter,
only the assets and financial position of
the disregarded entity are relevant for pur-
poses of this paragraph (b)(2)(iii). If the
owner of such a disregarded entity does
not have limited liability within the mean-
ing of § 301.7701–3(b)(2)(ii), all of the
assets and the financial position of the
disregarded entity and the owner are rel-
evant for purposes of this paragraph
(b)(2)(iii). The documentation may in-
clude cash flow projections, financial
statements, business forecasts, asset ap-
praisals, determination of debt-to-equity
and other relevant financial ratios of the
issuer in relation to industry averages, and
other information regarding the sources of
funds enabling the issuer to meet its obli-
gations pursuant to the terms of the appli-
cable instrument. If any member of an
expanded group relied on any report or
analysis prepared by a third party in ana-
lyzing whether the issuer would be able to
meet its obligations pursuant to the terms
of the EGI, the documentation must in-
clude the report or analysis. If the report
or analysis is protected or privileged un-
der law governing an inquiry or proceed-
ing with respect to the EGI and the pro-
tection or privilege is asserted, neither the
existence nor the contents of the report or
analysis is taken into account in determin-
ing whether the requirements of this sec-
tion are satisfied.
(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 and conditions of the EGI or
otherwise, including prepayments), and
such payment is claimed to support the
treatment of the EGI as indebtedness un-
der general federal tax principles, docu-
mentation must include written evidence
of such payment that is prepared by the
time required in paragraph (b)(3) of this
section. Such evidence could include, for
example, a wire transfer record or a bank
statement reflecting the payment.
(B)Events of default and similar
events. If the issuer did not make a pay-
ment of interest or principal that was due
and payable under the terms and condi-
tions of the EGI, or if any other event of
default or similar event has occurred,
there must be written documentation, pre-
pared, by the time required in paragraph
(b)(3) of this section, evidencing the hold-
er’s reasonable exercise of the diligence
and judgment of a creditor. Such docu-
mentation may include evidence of the
holder’s efforts to assert its rights under
the terms of the EGI, including the par-
ties’ efforts to renegotiate the EGI or to
mitigate the breach of an obligation under
the EGI, or any change in material terms
and conditions of the EGI, such as matu-
rity date, interest rate, or obligation to pay
interest or principal, and any documenta-
tion detailing the holder’s decision to re-
frain from pursuing any actions to enforce
payment.
(v)Additional information with respect
to an EGI evidenced by documentation
that does not in form reflect indebtedness.
This paragraph (b)(1)(v) describes addi-
tional information with respect to an EGI
evidenced by documentation that does not
in form reflect indebtedness.
(A)–(B)[Reserved]
(3)Timely preparation requirement—
(i)General rule. For purposes of this sec-
tion, the documentation described in para-
graphs (b)(2)(i), (ii) and (iii) of this
section will be treated as satisfying the
timely preparation requirement of this
paragraph (b)(3) if it is prepared no later
than 30 calendar days after the relevant
date, as defined in paragraph (b)(3)(ii) of
this section. The documentation described
in paragraph (b)(2)(iv) of this section will
be treated as satisfying the timely prepa-
ration requirement of this paragraph (b)(3)
if it is prepared no later than 120 calendar
days after the relevant date, as defined in
paragraph (b)(3)(ii) of this section, as
applicable.
(ii)Relevant date. Subject to the spe-
cial rules in paragraph (b)(3)(iii) of this
section (relating to certain financial ar-
rangements not evidenced by an instru-
ment) and paragraph (c)(1) of this section
(relating to modifications to certain re-
quirements of this section), therelevant
dateis as follows:
(A) For documentation and informa-
tion described in paragraphs (b)(2)(i) and
(b)(2)(ii) of this section (relating to issu-
er’s unconditional obligation to repay and
establishmentofholder’screditor’s
rights), the relevant date is the date on
which a member of the expanded group
becomes an issuer of a new or existing
EGI, without regard to any subsequent
deemed issuance of the EGI under
§ 1.1001–3. In the case of an applicable
instrument that becomes an EGI subse-
quent to issuance, including an intercom-
April 25, 2016Bulletin No. 2016–17
660

pany obligation, as defined in § 1.1502–
13(g)(2)(ii),thatceasestobean
intercompany obligation, the relevant date
is the day on which the applicable instru-
ment becomes an EGI.
(B) For documentation and informa-
tion described in paragraph (b)(2)(iii) of
this section (relating to reasonable expec-
tation of issuer’s repayment), the relevant
dates are the dates on which a member of
the expanded group becomes an issuer
with respect to an EGI and any later date
on which an issuance is deemed to occur
under § 1.1001–3 and any subsequent rel-
evant date that occurs under the special
rules in paragraph (b)(3)(iii) of this sec-
tion. In the case of an applicable instru-
ment that becomes an EGI subsequent to
issuance, the relevant date is the day on
which the applicable instrument becomes
an EGI and any relevant date after the date
that the applicable instrument becomes an
EGI.
(C) For documentation and informa-
tion described in paragraph (b)(2)(iv)(A)
of this section (relating to payments of
principal and interest), each date on which
a payment of interest or principal is due,
taking into account all additional time per-
mitted under the terms of the EGI before
there is (or holder can declare) an event of
default for nonpayment, is a relevant date.
(D) For documentation and informa-
tion described in paragraph (b)(2)(iv)(B)
of this section (relating to events of de-
fault and similar events), each date on
which an event of default, acceleration
event or similar event occurs under the
terms of the EGI is a relevant date. For
example, if the terms of the EGI require
the issuer to maintain certain financial ra-
tios, any date on which the issuer fails to
maintain the specified financial ratio (and
such failure results in an event of default
under the terms of the EGI) is a relevant
date.
(E) In the case of an applicable instru-
ment that becomes an EGI subsequent to
issuance, no date before the applicable
instrument becomes an EGI is a relevant
date.
(iii)Special rules for determining rel-
evant dates with respect to certain finan-
cial arrangements. The relevant dates
with respect to the arrangements de-
scribed in this paragraph (b)(3)(iii) in-
clude the date of the execution of the legal
documents governing the EGI and the
date of any amendment to those docu-
ments that provides for an increase in the
permitted maximum amount of principal.
In addition —
(A)Revolving credit agreements and
similaragreements.Notwithstanding
paragraph (b)(2)(i) of this section, if an
EGI is not evidenced by a separate note or
other writing executed with respect to the
initial principal balance or any increase in
principal balance (for example, an EGI
documented as a revolving credit agree-
ment or an omnibus agreement that gov-
erns open account obligations), the EGI
satisfies the requirements of paragraph
(b)(2)(i) of this section only if the material
documentation associated with the EGI,
including all relevant enabling docu-
ments, is prepared, maintained, and pro-
vided in accordance with the requirements
of this section. Relevant enabling docu-
ments may include board of directors’ res-
olutions, credit agreements, omnibus
agreements,securityagreements,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.
(B)Cash pooling arrangements. Not-
withstanding paragraph (b)(2)(i) of this
section, if an EGI is issued pursuant to a
cash pooling arrangement or internal
banking service that involves account
sweeps, revolving cash advance facilities,
overdraft set-off facilities, operational fa-
cilities, or similar features, the EGI satis-
fiestherequirementsofparagraph
(b)(2)(i) of this section only if the material
documentation governing the ongoing op-
erations of the cash pooling arrangement
or internal banking service, including any
agreements with entities that are not mem-
bers of the expanded group, is prepared,
maintained, and provided in accordance
with the requirements of this section. Such
documentation must contain the relevant
legal rights and responsibilities of any
members of the expanded group and any
entities that are not members of the ex-
panded group in conducting the operation
of the cash pooling arrangement or inter-
nal banking service.
(4)Maintenance requirements. The
documentation and information described
in paragraph (b)(2) of this section must be
maintained for all taxable years that the
EGI is outstanding and until the period of
limitations expires for any return with re-
spect to which the treatment of the EGI is
relevant. See section 6001 (requirement to
keep books and records).
(c)Operating rules—(1)Reasonable
cause exception. If the person character-
izing an EGI as indebtedness for federal
tax purposes establishes that a failure to
satisfy the requirements of this section is
due to reasonable cause, appropriate mod-
ifications may be made to the require-
ments of this section in determining
whether the requirements of this section
have been satisfied. The principles of
§ 301.6724 –1 of this chapter apply in
interpreting whether reasonable cause ex-
ists in any particular case.
(2)General application of section to
applicable instrument becoming or ceas-
ing to be an EGI—(i)Applicable instru-
ment becomes an EGI. If an applicable
instrument that is not an EGI when issued
subsequently becomes an EGI, this sec-
tion applies to the applicable instrument
immediately after it becomes an EGI and
thereafter.
(ii)EGI treated as stock ceases to be
an EGI. When an EGI treated as stock due
to the application of this section ceases to
be an EGI, the applicable instrument is
characterized at that time under general
federal tax principles. If, under general
federal tax principles, the applicable in-
strument is treated as indebtedness, the
issuer is treated as issuing a new instru-
ment to the holder in exchange for the
EGI immediately before the transaction
that causes the EGI treated as stock due to
the application of this section to cease to
be treated as an EGI. See § 1.385–1(c).
(3)Effective date for treatment of EGI
as stock under this section—(i)In gen-
eral. If an applicable instrument is an EGI
when issued and is determined to be stock,
in whole or in part, due to the application
of this section, the applicable instrument
or relevant portion thereof is treated as
stock from the date it was issued. How-
ever, if an applicable instrument is is-
sued prior to the time it becomes an EGI
and is determined to be stock, at the
time it becomes an EGI due to the ap-
plication of this section, it is treated as
stock from the date it becomes an EGI.
Bulletin No. 2016–17April 25, 2016
661

See § 1.385–2(c)(4) regarding intercom-
pany obligations (deemed issued imme-
diately after ceasing to be an intercom-
pany obligation for purposes of this
section and § 1.385–3).
(ii)EGI recharacterized as stock based
on behavior of issuer or holder after issu-
ance. Notwithstanding paragraph (c)(3)(i)
of this section, if an EGI initially treated
as indebtedness is recharacterized as stock
as a result of failing to satisfy paragraph
(b)(2)(iv) of this section (actions 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 (b)(2)(iv) of this sec-
tion, the rules of this section apply before
the rules of § 1.1001–3, such that an EGI
initially treated as indebtedness may be
recharacterized as stock regardless of
whether the indebtedness is altered or
modified (as defined in § 1.1001–3(c))
and, in determining whether indebtedness
is recharacterized as stock, § 1.1001–
3(f)(7)(ii)(A) does not apply.
(4)Applicable instruments issued and
heldbymembersofconsolidated
groups—(i)Consolidated group treated
as one corporation. Section 1.385–1(e)
provides that members of a consolidated
group are treated as one corporation.
Thus, during the time that the issuer and
the holder of an applicable instrument are
members of the same consolidated group,
the applicable instrument is treated as not
outstanding for purposes of this section.
As a result, this section does not apply to
any applicable instrument that is an inter-
companyobligationasdefinedin
§ 1.1502–13(g)(2)(ii).
(ii)Applicable instrument that ceases
to be an intercompany obligation.Ifan
applicable instrument ceases to be an in-
tercompany obligation and, as a result,
becomes an EGI, the applicable instru-
ment is treated as becoming an EGI im-
mediately after it ceases to be an inter-
companyobligation.Thisparagraph
(c)(4)(i) does not affect the application of
the rules under § 1.1502–13(g).
(5)Treatment of disregarded entities.
If a disregarded entity is the issuer of an
EGI and that EGI is treated as equity
under this section, the EGI is treated as an
equity interest in the disregarded entity
rather than stock in the disregarded enti-
ty’s owner. See § 1.385–2(c)(6)(ii) for
rules regarding the treatment of an EGI
issued by a controlled partnership.
(6)Applicable instruments issued or
held by controlled partnerships—(i)Con-
trolled partnerships included in expanded
group. For purposes of this section, a con-
trolled partnership (as defined in § 1.385–
1(b)(1)) is treated as a member of an ex-
panded group if one or more members of
the expanded group own, directly or indi-
rectly, 80 percent of the interests in part-
nership capital or profits of the controlled
partnership.
(ii)Treatment of EGI issued by a con-
trolled partnership that is recharacterized
under this section. If an EGI that is issued
by a controlled partnership is recharacter-
ized as stock under this section, the EGI is
treated as an equity interest in the con-
trolled partnership.
(d)No affirmative use. The rules of this
section do not apply if there is a failure to
satisfy the requirements of paragraph (b)
of this section with a principal purpose of
reducing the federal tax liability of any
member or members of the expanded
group of the issuer and holder of the EGI
or any other person relying on the charac-
terization of an EGI as indebtedness for
federal tax purposes.
(e)Anti-avoidance. If an applicable in-
strument that is not an EGI is issued with
a principal purpose of avoiding the pur-
poses of this section, the applicable instru-
ment is treated as an EGI subject to this
section.
(f)Effective/applicability date. This
section applies to any applicable instru-
ment issued or deemed issued on or after
the date these regulations are published as
final regulations in theFederal Register,
and to any applicable instrument treated
as indebtedness issued or deemed issued
before the date these regulations are is-
sued as final regulations if and to the
extent it was deemed issued as a result of
an entity classification election made un-
der § 301.7701–3 of this chapter that is
filed on or after the date these regulations
are issued as final regulations in theFed-
eral Register.
Par. 4. Section 1.385–3 is added to read
as follows:
§ 1.385–3 Certain distributions of debt
instruments and similar transactions.
(a)Scope. This section provides rules
that treat as stock certain interests in a
corporation that are held by a member of
the corporation’s expanded group and that
otherwise would be treated as indebted-
ness for federal tax purposes. Paragraph
(b) of this section sets forth situations in
which a debt instrument is treated as stock
under this section. Paragraph (c) of this
section provides three exceptions to the
application of paragraph (b) of this sec-
tion. Paragraph (d) of this section provides
operating rules. Paragraph (e) of this sec-
tion limits the affirmative use of this sec-
tion. Paragraph (f) of this section provides
definitions. Paragraph (g) of this section
provides examples illustrating the applica-
tion of the rules of this section. Paragraph
(h) of this section provides dates of appli-
cability. For rules regarding the applica-
tion of this section to members of a con-
solidated group, see § 1.385– 4.
(b)Debt instrument treated as stock—
(1)Effect of characterization as stock.To
the extent a debt instrument is treated as
stock under paragraphs (b)(2), (3), or (4)
of this section, it is treated as stock for all
federal tax purposes. Any interest, or por-
tion thereof, that is not characterized as
stock under this section is treated as stock
or indebtedness under applicable federal
tax law, without reference to this section.
(2)General rule. Except as provided in
paragraphs (c) and (e) of this section and
in § 1.385– 4, a debt instrument is treated
as stock to the extent the debt instrument
is issued by a corporation to a member of
the corporation’s expanded group as de-
scribed in one or more of the following
paragraphs:
(i) In a distribution;
(ii) In exchange for expanded group
stock, other than in an exempt exchange;
or
(iii) In exchange for property in an
asset reorganization, but only to the extent
that, pursuant to the plan of reorganiza-
tion, a shareholder that is a member of the
issuer’s expanded group immediately be-
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662

fore the reorganization receives the debt
instrument with respect to its stock in the
transferor corporation.
(3)Funding rule—(i)In general. Ex-
cept as provided in paragraphs (c) and (e)
of this section and in § 1.385– 4, a debt
instrument is treated as stock to the extent
it is a principal purpose debt instrument.
(ii)Principal purpose debt instrument.
For purposes of this paragraph (b)(3), a
debt instrument is a principal purpose debt
instrument to the extent it is issued by a
corporation (funded member) to a mem-
ber of the funded member’s expanded
group in exchange for property with a
principal purpose of funding a distribution
or acquisition described in one or more of
the following paragraphs:
(A) A distribution of property by the
funded member to a member of the
funded member’s expanded group, other
than a distribution of stock pursuant to an
asset reorganization that is permitted to be
received without the recognition of gain
or income under section 354(a)(1) or
355(a)(1) or, when section 356 applies,
that is not treated as “other property” or
money described in section 356;
(B) An acquisition of expanded group
stock, other than in an exempt exchange,
by the funded member from a member of
the funded member’s expanded group in
exchange for property other than ex-
panded group stock; or
(C) An acquisition of property by the
funded member in an asset reorganization
but only to the extent that, pursuant to the
plan of reorganization, a shareholder that
is a member of the funded member’s ex-
panded group immediately before the re-
organization receives “other property” or
money within the meaning of section 356
with respect to its stock in the transferor
corporation.
(iii)Transactions described in more
than one paragraph. Solely for purposes
of this section, to the extent all or a por-
tion of a distribution or acquisition by a
funded member is described in more than
one of paragraphs (b)(3)(ii)(A) through
(C) of this section, the funded member is
treated as engaging in only a single distri-
bution or acquisition described in para-
graph (b)(3)(ii) of this section.
(iv)Principal purpose—(A)In gen-
eral. Subject to paragraph (b)(3)(iv)(B)(1)
of this section, whether a debt instrument
is issued with a principal purpose of fund-
ing a distribution or acquisition described
in paragraph (b)(3)(ii) of this section is
determined based on all the facts and cir-
cumstances. A debt instrument may be
treated as issued with a principal purpose
of funding a distribution or acquisition
described in paragraph (b)(3)(ii) of this
section regardless of whether it is issued
before or after such distribution or acqui-
sition.
(B)Per se rule—(1)In general. Except
as provided in paragraph (b)(3)(iv)(B)(2)
of this section, a debt instrument is treated
as issued with a principal purpose of fund-
ing a distribution or acquisition described
in paragraph (b)(3)(ii) of this section if it
is issued by the funded member during the
period beginning 36 months before the
date of the distribution or acquisition, and
ending 36 months after the date of the
distribution or acquisition (72-month
period).
(2)Ordinary course exception. Para-
graph (b)(3)(iv)(B)(1) of this section does
not apply to a debt instrument that arises
in the ordinary course of the issuer’s trade
or business in connection with the pur-
chase of property or the receipt of services
to the extent that it reflects an obligation
to pay an amount that is currently deduct-
ible by the issuer under section 162 or
currently included in the issuer’s cost of
goods sold or inventory, provided that the
amount of the obligation outstanding at no
time exceeds the amount that would be
ordinary and necessary to carry on the
trade or business of the issuer if it was
unrelated to the lender.
(3)Multiple interests. If, pursuant to
paragraph (b)(3)(iv)(B) of this section,
two or more debt instruments may be
treated as a principal purpose debt instru-
ment, the debt instruments are tested un-
der paragraph (b)(3)(iv)(B) of this section
based on the order in which they were
issued, with the earliest issued debt instru-
ment tested first. See paragraph (g)(3) of
this section,Example 6, for an illustration
of this rule.
(4)Multiple distributions or acquisi-
tions. Except as provided in paragraph
(c)(3) of this section, if, pursuant to para-
graph (b)(3)(iv)(B) of this section, a debt
instrument may be treated as funding
more than one distribution or acquisition
described in paragraph (b)(3)(ii) of this
section, the debt instrument is treated as
funding one or more distributions or ac-
quisitions based on the order in which the
distributions or acquisitions occurred,
with the earliest distribution or acquisition
treated as the first distribution or acquisi-
tion that was funded. See paragraph (g)(3)
of this section,Example 9, for an illustra-
tion of this rule.
(v)Predecessors and successors. For
purposes of this paragraph (b)(3), refer-
ences to the funded member include ref-
erences to any predecessor or successor of
such member. See paragraph (g)(3) of this
section,Examples 9,10, and12, for illus-
trations of this rule.
(vi)Treatment of funded transactions.
When a debt instrument is treated as stock
pursuant to paragraph (b)(3) of this sec-
tion, the distribution or acquisition de-
scribed in paragraph (b)(3)(ii) of this sec-
tion that is treated as funded by such debt
instrument is not recharacterized as a re-
sult of the treatment of the debt instrument
as stock.
(4)Anti-abuse rule. A debt instrument
is treated as stock if it is issued with a
principal purpose of avoiding the applica-
tion of this section or § 1.385– 4. In addi-
tion, an interest that is not a debt instru-
ment for purposes of this section and
§ 1.385– 4 (for example, a contract to
which section 483 applies or a nonperi-
odic swap payment) is treated as stock if
issued with a principal purpose of avoid-
ing the application of this section or
§ 1.385– 4. This paragraph (b)(4) may ap-
ply, for example, if a debt instrument 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 application of this section.
Additional examples of when this para-
graph (b)(4) could apply include, without
limitation, situations where, with a princi-
pal purpose of avoiding the application of
this section, a debt instrument is issued to
a person that is not a member of the issu-
er’s expanded group, and such person
later becomes a member of the issuer’s
expanded group; a debt instrument is is-
sued to an entity that is not taxable as a
corporation for federal tax purposes; or a
member of the issuer’s expanded group is
substituted as a new obligor or added as a
co-obligor on an existing debt instrument.
This paragraph (b)(4) also may apply to a
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663

debt instrument that is issued or trans-
ferred in connection with a reorganization
or similar transaction with a principal pur-
pose of avoiding the application of this
section or § 1.385– 4. See paragraph (g)(3)
of this section,Example 18, for an illus-
tration of this rule.
(5)Coordination between general rule
and funding rule. To the extent a debt
instrument is treated as stock under para-
graph (b)(2)(iii) of this section, the distri-
bution of the debt instrument (which is
treated as a distribution of stock as a result
of the application of paragraph (b)(2)(iii)
of this section) pursuant to the same reor-
ganizationthatcausedparagraph
(b)(2)(iii) of this section to apply is not
also treated as a distribution or acquisition
described in paragraph (b)(3)(ii) of this
section. See paragraph (g)(3) of this sec-
tion,Example 8, for an illustration of this
rule.
(c)Exceptions—(1)Exception for cur-
rent year earnings and profits. For pur-
poses of applying paragraphs (b)(2) and
(b)(3) of this section to a member of an
expanded group with respect to a taxable
year, the aggregate amount of any distri-
butions or acquisitions that are described
in paragraphs (b)(2) or (b)(3)(ii) of this
section are reduced by an amount equal to
the member’s current year earnings and
profits described in section 316(a)(2). This
reduction is applied to the transactions
describedinparagraphs(b)(2)and
(b)(3)(ii) of this section based on the order
in which the distribution or acquisition
occurs. See paragraph (g)(3) of this sec-
tion,Example 17, for an illustration of this
rule.
(2)Threshold exception. A debt instru-
ment is not treated as stock under this
section if, immediately after the debt in-
strument is issued, the aggregate adjusted
issue price of debt instruments held by
members of the expanded group that
would be subject to paragraph (b) of this
section but for the application of this para-
graph (c)(2) does not exceed $50 million.
Once this threshold is exceeded, this para-
graph (c)(2) will not apply to any debt
instrument issued by members of the ex-
panded group for so long as any debt
instrument that previously was treated as
indebtedness solely because of this para-
graph (c)(2) remains outstanding. For pur-
poses of this rule, any debt instrument that
is not denominated in U.S. dollars is trans-
lated into U.S. dollars at the spot rate (as
defined in § 1.988 –1(d)) on the date that
the debt instrument is issued. See para-
graph (g)(3) of this section,Example 17,
for an illustration of this rule. See para-
graph (d)(1)(iii) of this section for rules
regarding the treatment of a debt instru-
ment that ceases to qualify for the excep-
tion provided in this paragraph (c)(2).
(3)Exception for funded acquisitions
of subsidiary stock by issuance. An acqui-
sition of expanded group stock will not be
treatedasdescribedinparagraph
(b)(3)(ii)(B) of this section if the acquisi-
tion results from a transfer of property by
a funded member (the transferor) to an
expanded group member (the issuer) in
exchange for stock of the issuer, provided
that, for the 36-month period immediately
following the issuance, the transferor
holds, directly or indirectly, more than 50
percent of the total combined voting
power of all classes of stock of the issuer
entitled to vote and more than 50 percent
of the total value of the stock of the issuer.
If the transferor ceases to meet this own-
ership requirement at any time during that
36-month period, then on the date that the
ownership requirement ceases to be met
(cessation date), this paragraph (c)(3)
ceases to apply and the acquisition is
treated as an acquisition described in para-
graph (b)(3)(ii)(B) of this section. In this
case, for purposes of applying the per se
rule, the acquisition may be treated as
having been funded by any debt instru-
ment issued during the 72-month period
determined with respect to the date of the
acquisition (rather than with respect to the
cessation date), but, in the case of a debt
instrument issued prior to the cessation
date, only to the extent that such debt
instrument is treated as indebtedness as of
the cessation date (that is, a debt instru-
ment not already treated as stock). For
purposes of this paragraph (c)(3), a trans-
feror’s indirect stock ownership is deter-
mined by applying the principles of sec-
tion 958(a) without regard to whether an
intermediate entity is foreign or domestic.
See paragraph (d)(1)(v) of this section for
rules regarding the treatment of a debt
instrument that is treated as funding an
acquisition to which this exception ceases
to apply.
(d)Operating rules—(1)Timing. This
paragraph (d)(1) provides rules for deter-
mining when a debt instrument is treated
as stock under paragraph (b) of this sec-
tion. For special rules regarding the treat-
ment of a deemed exchange of a debt
instrument that occurs pursuant to para-
graphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), or
(d)(1)(v), see § 1.385–1(c).
(i)General timing rule. Except as oth-
erwise provided in this paragraph (d)(1),
when paragraph (b) of this section applies
to treat a debt instrument as stock, the debt
instrument is treated as stock when the
debt instrument is issued. When paragraph
(b)(3) of this section applies to treat a debt
instrument as stock when the debt instru-
ment is issued, see also paragraph
(b)(3)(vi) of this section.
(ii)Exception when a debt instrument
is treated as funding a distribution or ac-
quisition that occurs in a subsequent tax-
able year. When paragraph (b)(3)(iv)(B)
of this section applies to treat a debt in-
strument as funding a distribution or ac-
quisition described in paragraph (b)(3)(ii)
of this section that occurs in a taxable year
subsequent to the taxable year in which
the debt instrument is issued, the debt
instrument is deemed to be exchanged for
stock when the distribution or acquisition
described in paragraph (b)(3)(ii) of this
section occurs. See paragraph (g)(3) of
this section,Example 9, for an illustration
of this rule.
(iii)Exception when a debt instrument
ceases to qualify for the threshold excep-
tion. A debt instrument that previously
was treated as indebtedness pursuant to
the threshold exception set forth in para-
graph (c)(2) of this section is deemed to
be exchanged for stock when the debt
instrument ceases to qualify for the
threshold exception. Notwithstanding the
preceding sentence, if the debt instrument
was both issued and ceases to qualify for
the threshold exception during the same
taxable year, the general timing rule of
paragraph (d)(1)(i) of this section applies.
See paragraph (g)(3) of this section,Ex-
ample 17, for an illustration of this rule.
(iv)Exception when a debt instrument
is re-tested under paragraph (d)(2) of this
section. When paragraph (b)(3)(iv)(B) of
this section applies to treat a debt instru-
ment as funding a distribution or acquisi-
tion described in paragraph (b)(3)(ii) of
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664

this section as a result of a re-testing de-
scribed in paragraph (d)(2) of this section
that occurs in a taxable year subsequent to
the taxable year in which the debt instru-
ment is issued, the debt instrument is
deemed to be exchanged for stock on the
date of the re-testing. See paragraph (g)(3)
of this section,Example 7, for an illustra-
tion of this rule.
(v)Exception when a debt instrument
ceases to qualify for the exception for
acquisitions of subsidiary stock by issu-
ance. When paragraph (b)(3)(iv)(B) and
the modified ordering rule in paragraph
(c)(3) of this section apply to treat a debt
instrument as funding an acquisition of
expanded group stock that previously
qualified for the exception set forth in
paragraph (c)(3) of this section, the debt
instrument is deemed to be exchanged for
stock on the cessation date referred to in
paragraph (c)(3) of this section if the debt
instrument was issued in a taxable year
preceding the taxable year that includes
the cessation date. For all other debt in-
struments that are treated as funding an
acquisition of expanded group stock that
previously qualified for the exception set
forth in paragraph (c)(3) of this section,
the general timing rule of paragraph
(d)(1)(i) of this section applies.
(2)Debt instrument treated as stock
that leaves the expanded group. Subject to
paragraph (b)(4) of this section, when the
holder and issuer of a debt instrument that
is treated as stock under this section cease
to be members of the same expanded
group, either because the debt instrument
is transferred to a person that is not a
member of the expanded group that in-
cludes the issuer or because the holder or
the issuer cease to be members of the
same expanded group, the debt instrument
ceases to be treated as stock under this
section. For this purpose, immediately be-
fore the transaction that causes the holder
and issuer of the debt instrument to cease
to be members of the same expanded
group, the issuer is deemed to issue a new
debt instrument to the holder in exchange
for the debt instrument that was treated as
stock in a transaction that is disregarded
for purposes of paragraphs (b)(2) and
(b)(3) of this section. For purposes of
paragraph (b)(3)(iv)(B) of this section,
when this paragraph (d)(2) causes a debt
instrument that previously was treated as
stock pursuant to paragraph (b)(3) of this
section to cease to be treated as stock, all
other debt instruments of the issuer that
are not currently treated as stock are re-
tested to determine whether those other
debt instruments are treated as funding the
distribution or acquisition that previously
was treated as funded by the debt instru-
ment that ceases to be treated as stock
pursuant to this paragraph (d)(2). See
paragraph (g)(3) of this section,Example
7, for an illustration of this rule.
(3)Inapplicability of section 385(c)(1).
Section 385(c)(1) does notapply with
respect to a debt instrument to the extent
that it is treated as stock under this
section.
(4)Taxable year. For purposes of this
section, the termtaxable yearrefers to the
taxable year of the issuer of the debt in-
strument.
(5)Treatment of partnerships—(i)Ap-
plication of aggregate treatment. For pur-
poses of this section, a controlled partner-
ship is treated as an aggregate of its
partners. Thus, for example, when a cor-
poration that is a member of an expanded
group becomes a partner in a partnership
that is a controlled partnership with respect
to that expanded group, the corporation is
treated as acquiring its proportionate share
of the controlled partnership’s assets. In ad-
dition, each expanded group partner in a
controlled partnership is treated as issuing
its proportionate share of any debt instru-
ment issued by the controlled partnership.
For this purpose, a partner’s proportionate
share is determined in accordance with the
partner’s share of partnership profits. See
paragraph (g)(3) of this section,Example
13, for an illustration of this rule.
(ii)Treatment of debt instruments is-
sued by partnerships. To the extent that
the application of the aggregate approach
in paragraph (d)(5)(i) of this section
causes a debt instrument issued by a con-
trolled partnership to be recharacterized
under paragraph (b) of this section, then
the holder of the recharacterized debt in-
strument is treated as holding stock in the
expanded group partners. In addition, the
partnership and its partners must make
appropriate conforming adjustments to re-
flect this treatment. Any such adjustments
must be consistent with the purposes of
this section and must be made in a manner
that avoids the creation of, or increase in,
a disparity between the controlled partner-
ship’s aggregate basis in its assets and the
aggregate bases of the partners’ respective
interests in the partnership. See paragraph
(g)(3) of this section,Examples 14and15,
for an illustration of this rule.
(6)Treatment of disregarded entities.
If a debt instrument of a disregarded entity
is treated as stock under this section, such
debt instrument is treated as stock in the
entity’s owner rather than as an equity
interest in the entity.
(e)No affirmative use. The rules of this
section and § 1.385– 4 do not apply to the
extent a person enters into a transaction
that otherwise would be subject to these
rules with a principal purpose of reducing
the federal tax liability of any member of
the expanded group that includes the is-
suer and the holder of the debt instrument
by disregarding the treatment of the debt
instrument that would occur without
regard to this section.
(f)Definitions. The definitions in this
paragraph (f) apply for purposes of this
section and for purposes of § 1.385– 4.
(1)Asset reorganization. The termasset
reorganizationmeans a reorganization
within the meaning of section 368(a)(1)(A),
(C), (D), (F), or (G).
(2)Controlled partnership. The term
controlled partnershiphas the meaning
specified in § 1.385–1(b)(1).
(3)Debt instrument. The termdebt in-
strumentmeans 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).
(4)Distribution. The termdistribution
means any distribution made by a corpo-
ration with respect to its stock.
(5)Exempt exchange. The termexempt
exchangemeans an acquisition of ex-
panded group stock in which the trans-
feror and transferee of the stock are par-
ties to an asset reorganization, and
either—
(i) Section 361(a) or (b) applies to the
transferor of the expanded group stock
and the stock is not transferred by
issuance; or
(ii)Section 1032 or § 1.1032–2 ap-
plies to the transferor of the expanded
group stock and the stock is distributed
by the transferee pursuant to the plan of
reorganization.
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665

(6)Expanded group. The termex-
panded grouphas the meaning specified
in § 1.385–1(b)(3).
(7)Expanded group partner. The term
expanded group partnermeans any per-
son that is a partner in a controlled part-
nership and that is a member of the ex-
panded group whose members own,
directly or indirectly, at least 80 percent of
the interests in the controlled partner-
ship’s capital or profits.
(8)Expanded group stock. The term
expanded group stockmeans, with respect
to a member of an expanded group, stock
of a member of the same expanded group.
(9)Predecessor—(i)In general. The
termpredecessorincludes, with respect to
a corporation, the distributor or transferor
corporation in a transaction described in
section 381(a) in which the corporation is
the acquiring corporation. For purposes of
the preceding sentence, the transferor cor-
poration in a reorganization within the
meaning of section 368(a)(1)(D) or (G) is
treated as a transferor corporation in a
transaction described in section 381(a)
without regard to whether the reorganiza-
tion meets the requirements of sections
354(b)(1)(A) and (B). The term predeces-
sor does not include, with respect to a
controlled corporation, a distributing cor-
poration that distributed the stock of the
controlled corporation pursuant to section
355(c).
(ii)Special rules for funded acquisi-
tions of subsidiary stock by issuance. The
term predecessor also includes, with re-
spect to an issuer that issues stock to a
transferor in a transaction described in
paragraph (c)(3) of this section, the trans-
feror, but, for purposes of applying the per
se rule in paragraph (b)(3)(iv)(B)(1)of
this section, only with respect to a debt
instrument issued by the transferor during
the 72-month period determined with re-
spect to the transaction described in para-
graph (c)(3) of this section, and only to the
extent of the value of the expanded group
stock acquired from the issuer in the trans-
action described in paragraph (c)(3) of
this section.
(10)Property. The termpropertyhas
the meaning specified in section 317(a).
(11)Successor—(i)In general. The
termsuccessorincludes, with respect to a
corporation, the acquiring corporation in a
transaction described in section 381(a) in
which the corporation is the distributor or
transferor corporation. For purposes of the
preceding sentence, the acquiring corpo-
ration in a reorganization within the
meaning of section 368(a)(1)(D) or (G) is
treated as an acquiring corporation in a
transaction described in section 381(a)
without regard to whether the reorganiza-
tion meets the requirements of sections
354(b)(1)(A) and (B). The term successor
does not include, with respect to a distrib-
uting corporation, a controlled corpora-
tion the stock of which was distributed by
the distributing corporation pursuant to
section 355(c).
(ii)Special rules for funded acquisi-
tions of subsidiary stock by issuance. The
term successor also includes, with respect
to a transferor that transfers property to an
issuer in exchange for stock of the issuer
in a transaction described in paragraph
(c)(3) of this section, the issuer, but, for
purposes of applying the per se rule in
paragraph (b)(3)(iv)(B)(1) of this section,
only with respect to a debt instrument
issued by the transferor during 72-month
period determined with respect to the
transaction described in paragraph (c)(3)
of this section, and only to the extent of
the value of the expanded group stock
acquired from the issuer in the transaction
described in paragraph (c)(3) of this sec-
tion. A distribution by an issuer described
in paragraph (c)(3) of this section directly
to the transferor is not taken into account
for purposes of applying paragraph (b)(3)
of this section to a debt instrument of the
transferor.
(g)Examples—(1)Assumed facts. Ex-
cept as otherwise stated, the following
facts are assumed for purposes of the ex-
amples in paragraph (g)(3) of this section:
(i) FP is a foreign corporation that
owns 100 percent of the stock of USS1, a
domestic corporation, 100 percent of the
stock of USS2, a domestic corporation,
and 100 percent of the stock of FS, a
foreign corporation;
(ii) USS1 owns 100 percent of the
stock of DS, a domestic corporation, and
CFC, which is a controlled foreign corpo-
ration within the meaning of section 957;
(iii) At the beginning of Year 1, FP is
the common parent of an expanded group
comprised solely of FP, USS1, USS2, FS,
DS, and CFC (the FP expanded group);
(iv) The FP expanded group has more
than $50 million of debt instruments de-
scribed in paragraph (c)(2) of this section
at all times;
(v) No issuer of a debt instrument has
current year earnings and profits described
in section 316(a)(2);
(vi) All notes are debt instruments de-
scribed in paragraph (f)(3) of this section;
(vii) No notes are eligible for the ordi-
nary course exception described in para-
graph (b)(3)(iv)(B)(2) of this section;
(viii) Each entity has as its taxable year
the calendar year;
(ix) PRS is a partnership for federal
income tax purposes;
(x) No corporation is a member of a
consolidatedgroup,asdefinedin
§ 1.1502–1(h);
(xi) No domestic corporation is a
United States real property holding corpo-
ration within the meaning of section
897(c)(2); and
(xii) Each note is issued with adequate
stated interest (as defined in section
1274(c)(2)).
(2)No inference. Except as provided in
this section, it is assumed for purposes of
the examples that the form of each trans-
action is respected for federal tax pur-
poses. No inference is intended, however,
as to whether any particular note would be
respected as indebtedness or as to whether
the form of any particular transaction de-
scribed in paragraph (g)(3) of this section
would be respected for federal tax pur-
poses.
(3)Examples
. The following examples
illustrate the rules of this section.
Example 1.Distribution of a debt instrument. (i)
Facts. On Date A in Year 1, FS lends $100x to USS1
in exchange for USS1 Note A. On Date B in Year 2,
USS1 issues USS1 Note B, which is has a value of
$100x, to FP in a distribution.
(ii)Analysis. USS1 Note B is a debt instrument
that is issued by USS1 to FP, a member of USS1’s
expanded group, in a distribution. Accordingly,
USS1 Note B is treated as stock under paragraph
(b)(2)(i) of this section. Under paragraph (d)(1)(i) of
this section, USS1 Note B is treated as stock when it
is issued by USS1 to FP on Date B in Year 2.
Accordingly, USS1 is treated as distributing USS1
stock to its shareholder FP in a distribution that is
subject to section 305. Because USS1 Note B is
treated as stock for federal tax purposes when it is
issued by USS1, USS1 Note B is not treated as
property for purposes of paragraph (b)(3)(ii)(A) of
this section because it is not property within the
meaning specified in section 317(a). Accordingly,
USS1 Note A is not treated as funding the distribu-
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666

tion of USS1 Note B for purposes of paragraph
(b)(3)(ii)(A) of this section.
Example 2.Debt instrument issued for expanded
group stock that is exchanged for stock in a corpo-
ration that is not a member of the same expanded
group. (i)Facts. UST is a publicly traded domestic
corporation. On Date A in Year 1, USS1 issues
USS1 Note to FP in exchange for FP stock. On Date
B of Year 1, USS1 transfers the FP stock to UST’s
shareholders, which are not members of the FP ex-
panded 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 (f)(5) of
this section.
(B) Because USS1 Note is treated as stock for
federal tax purposes when it is issued by USS1,
pursuant to section § 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.
(C) Because paragraph (b)(2) of this section
treats USS1 Note as stock for federal tax purposes
when it is issued by USS1, USS1 Note is not treated
as indebtedness for purposes of applying paragraph
(b)(3) of this section.
Example 3.Issuance of a note in exchange for
expanded group stock. (i)Facts. On Date A in Year
1, USS1 issues USS1 Note to FP in exchange for 40
percent of the FS stock owned by FP.
(ii)Analysis. (A) Because USS1 and FP are both
members of the FP expanded group, USS1 Note is
treated as stock when it is issued by USS1 to FP in
exchange for FS stock on Date A in Year 1 under
paragraphs (b)(2)(ii) and (d)(1)(i) of this section. The
exchange of USS1 Note for FS stock is not an
exempt exchange within the meaning of paragraph
(f)(5) of this section because USS1 and FP are not
parties to a reorganization.
(B) Because USS1 Note is treated as stock for
federal tax purposes when it is issued by USS1,
USS1 Note is not treated as property for purposes of
section 304(a) because it is not property within the
meaning specified in section 317(a). Therefore,
USS1’s acquisition of FS stock from FP in exchange
for USS1 Note is not an acquisition described in
section 304(a)(1).
(C) Because USS1 Note is treated as stock for
federal tax purposes when it is issued by USS1,
USS1 Note is not treated as indebtedness for pur-
poses of applying paragraph (b)(3) of this section.
Example 4.Funding occurs in same taxable year
as distribution. (i)Facts. On Date A in Year 1, FP
lends $200x to CFC in exchange for CFC Note A.
On Date B in Year 1, CFC distributes $400x of cash
to USS1 in a distribution. CFC is not an expatriated
foreign subsidiary as defined in § 1.7874 –12T(a)(9).
(ii)Analysis. Under paragraph (b)(3)(iv)(B) of
this section, CFC Note A is treated as issued with a
principal purpose of funding the distribution by CFC
to USS1 because CFC Note A is issued to a member
of the FP expanded group during the 72-month pe-
riod determined with respect to CFC’s distribution to
USS1. Accordingly, under paragraphs (b)(3)(ii)(A)
and (d)(1)(i) of this section, CFC Note A is treated as
stock when it is issued by CFC to FP on Date A in
Year 1.
Example 5.Additional funding. (i)Facts. The
facts are the same as inExample 4, except that, in
addition, on Date C in Year 2, FP lends an additional
$300x to CFC in exchange for CFC Note B.
(ii)Analysis. The analysis is the same as in
Example 4with respect to CFC Note A. CFC Note B
is also issued to a member of the FP expanded group
during the 72-month period determined with respect
to CFC’s distribution to USS1. Under paragraph
(b)(3)(iv)(B) of this section, CFC Note B is treated
as issued with a principal purpose of funding the
remaining portion of CFC’s distribution to USS1,
which is $200x. Accordingly, $200x of CFC Note B
is a principal purpose debt instrument that is treated
as stock under paragraph (b)(3)(ii)(A) of this section.
Under paragraph (d)(1)(ii) of this section, $200x of
CFC Note B is deemed to be exchanged for stock on
Date C in Year 2. The remaining $100x of CFC Note
B continues to be treated as indebtedness.
Example 6.Funding involving multiple interests.
(i)Facts. On Date A in Year 1, FP lends $300x to
USS1 in exchange for USS1 Note A. On Date B in
Year 2, USS1 distributes $300x of cash to FP. On
Date C in Year 3, FP lends another $300x to USS1
in exchange for USS1 Note B.
(ii)Analysis.(A)Underparagraph
(b)(3)(iv)(B)(3) of this section, USS1 Note A is
tested under paragraph (b)(3) of this section before
USS1 Note B is tested. USS1 Note A is issued
during the 72-month period determined with respect
to USS1’s $300x distribution to FP and, therefore, is
treated as issued with a principal purpose of funding
the distribution under paragraph (b)(3)(iv)(B)(1)of
this section. Beginning on Date B in Year 2, USS1
Note A is a principal purpose debt instrument that is
treated as stock under paragraphs (b)(3)(ii)(A) and
(d)(1)(ii) of this section.
(B) Under paragraph (b)(3)(iv)(B)(3) of this 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.
Example 7.Re-testing. (i)Facts. The facts are the
same as inExample 6, except that on Date D in Year
4, FP sells USS1 Note A to Bank.
(ii)Analysis. (A) Under paragraph (d)(2) of this
section, USS1 Note A ceases to be treated as stock
when FP sells USS1 Note A to Bank on Date D in
Year 4. Immediately before FP sells USS1 Note A to
Bank, USS1 is deemed to issue a debt instrument to
FP in exchange for USS1 Note A in a transaction
that is disregarded for purposes of paragraphs (b)(2)
and (b)(3) of this section.
(B) Under paragraph (d)(2) of this section, after
USS1 Note A is deemed exchanged, USS1’s other
debt instruments that are not treated as stock as of
Date D in Year 4 (USS1 Note B) are re-tested for
purposes of paragraph (b)(3)(iv)(B) of this section to
determine whether other USS1 debt instruments are
treated as funding the $300x distribution by USS1 to
FP on Date B in Year 2. USS1 Note B was issued by
USS1 to FP within the 72-month perioddetermined
with respect to the $300x distribution. Under paragraph
(b)(3)(iv)(B)(1) of this section, USS1 Note B is treated
as issued with a principal purpose of funding the $300x
distribution. Accordingly, USS1 Note B is a principal
purpose debt instrument under paragraph (b)(3)(ii)(A)
of this section that is deemed to be exchanged for stock
on Date D in Year 4, the re-testing date, under para-
graph (d)(1)(iv) of this section. See § 1.385–1(c) for
rules regarding the treatment of this deemed exchange.
Example 8.Distribution of expanded group stock
and debt instrument in a reorganization that quali-
fies under section 355. (i)Facts. On Date A in Year
1, FP lends $200x to USS2 in exchange for USS2
Note. In a transaction that is treated as independent
from the transaction on Date A in Year 1, on Date B
in Year 2, USS2 transfers a portion of its assets to
DS2, a newly-formed domestic corporation, in ex-
change for all of the stock of DS2 and DS2 Note.
Immediately afterwards, USS2 distributes all of the
DS2 stock and the DS2 Note to FP with respect to
FP’s USS2 stock in a transaction that qualifies under
section 355. USS2’s transfer of a portion of its assets
qualifies as a reorganization within the meaning of
section 368(a)(1)(D). The DS2 stock has a value of
$150x and DS2 Note has a value of $50x. The DS2
stock is not non-qualified preferred stock as defined
in section 351(g)(2). Absent the application of this
section, DS2 Note would be treated by FP as “other
property” within the meaning of section 356.
(ii)Analysis. (A) The contribution and distribu-
tion transaction is a reorganization within the mean-
ing of section 368(a)(1) involving a transfer of
USS2’s property described in section 361(a). Thus,
DS2 Note is a debt instrument that is issued by DS2
to USS2, both members of the FP expanded group,
pursuant to an asset reorganization (as defined in
paragraph (f)(1) of this section), and received by FP,
another FP expanded group member, with respect to
FP’s USS2 stock. Accordingly, DS2 Note is treated
as stock when it is issued by DS2 to USS2 on Date
B in Year 2 pursuant to paragraphs (b)(2)(iii) and
(d)(1)(i) of this section.
(B) Because DS2 Note is treated as stock when it
is issued, section 355(a)(1) rather than section 356
may apply to FP on FP’s receipt of DS2 Note.
Alternatively, depending on the terms of DS2 Note
and other factors, DS2 Note may be treated as non-
qualified preferred stock that is not treated as stock
pursuant to section 355(a)(3)(D). If DS2 Note is
treated as non-qualified preferred stock, such stock
would continue to be treated by FP as “other prop-
erty” for purposes of section 356 under section
356(e). In that case, USS2’s distribution of DS2
Note would be treated as “other property” described
in section 356, and thus the distribution of DS2 note
preliminarily would be described in paragraph
(b)(3)(ii)(A) of this section. However, under para-
graph (b)(5) of this section, because DS2 Note is
treated as stock under paragraph (b)(2)(iii) of this
section, USS2’s distribution of DS2 Note to FP
pursuant to the plan of reorganization is not also
treated as a distribution or acquisition described in
paragraph (b)(3)(ii) of this section that could
cause USS2 Note to be a principal purpose debt
instrument.
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(C) USS2’s distribution of $150x of actual DS2
stock is a distribution of stock pursuant to an asset
reorganization that is permitted to be received by FP
withoutrecognitionofgainundersection
355(a)(1). Accordingly, USS2’s distribution of the
actual DS2 stock to FP is not a distribution of
property by USS2 for purposes of paragraph
(b)(3)(ii)(A) of this section.
(D) USS2’s transfer of assets to DS2 in exchange
for DS2 stock is not an acquisition described in
paragraph (b)(3)(ii)(B) of this section because
USS2’s acquisition of DS2 stock is an exempt ex-
change. USS2’s acquisition of DS2 stock is an ex-
empt exchange described in paragraph (f)(5)(ii) of
this section because USS2 and DS2 are both parties
to a reorganization that is an asset reorganization,
section 1032 applies to DS2, the transferor of the
expanded group stock, and the DS2 stock is distrib-
uted by USS2, the transferee, pursuant to the plan of
reorganization. Because USS2 has not made a dis-
tribution or acquisition that is treated as a distribu-
tion or acquisition for purposes of paragraph
(b)(3)(ii) of this section, USS2 Note is not a principal
purpose debt instrument.
Example 9.Funding a distribution by a succes-
sor to funded member. (i)Facts. The facts are the
same as inExample 8, except that on Date C in Year
3, DS2 distributes $200x of cash to FP and, subse-
quently, on Date D in Year 3, USS2 distributes
$100x of cash to FP.
(ii)Analysis. (A) DS2 is a successor with respect
to USS2 under paragraph (f)(11)(i) of this section
because DS2 is the acquiring corporation in a reor-
ganizationwithinthemeaningofsection
368(a)(1)(D). USS2 is a predecessor with respect to
DS2 under paragraph (f)(9)(i) of this section because
USS2 is the transferor corporation in a reorganiza-
tion within the meaning of section 368(a)(1)(D).
Accordingly, under paragraph (b)(3)(v) of this sec-
tion, a distribution by DS2 is treated as a distribution
by USS2. Under paragraph (b)(3)(iv)(B) of this sec-
tion, USS2 Note is treated as issued with a principal
purpose of funding the distribution by DS2 to FP
because USS2 Note was issued during the 72-month
period determined with respect to DS2’s $200x cash
distribution. Accordingly, USS2 Note is a principal
purposedebtinstrumentunderparagraph
(b)(3)(ii)(A) of this section that is deemed to be
exchanged for stock on Date C in Year 3 under
paragraph (d)(1)(ii) of this section. See § 1.385–1(c)
for rules regarding the treatment of this deemed
exchange.
(B) Because the entire amount of USS2 Note is
treated as funding DS2’s $200x distribution to FP,
under paragraph (b)(3)(iv)(B)(4) of this section,
USS2 Note is not treated as funding the subsequent
distribution by USS2 on Date D in Year 3.
Example 10.Asset reorganization; section 354
qualified property. (i)Facts. On Date A in Year 1,
FS lends $100x to USS2 in exchange for USS2 Note.
On Date B in Year 2, in a transaction that qualifies as
a reorganization within the meaning of section
368(a)(1)(D), USS2 transfers all of its assets to
USS1 in exchange for stock of USS1 and the as-
sumption 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 re-
ceived. FP does not recognize gain under section
354(a)(1).
(ii)Analysis. (A) USS1 is a successor with re-
spect to USS2 under paragraph (f)(11)(i) of this
section because USS1 is the acquiring corporation in
a reorganization within the meaning of section
368(a)(1)(D). For purposes of paragraph (b)(3) of
this section, USS2 and its successor, USS1, are
funded members with respect to USS2 Note. Al-
though USS2, a funded member, distributes property
(USS1 stock) to its shareholder, FP, pursuant to the
reorganization, the distribution of USS1 stock is not
described in paragraph (b)(3)(ii)(A) of this section
because the property is permitted to be received
without the recognition of gain under section
354(a)(1). The distribution of USS1 stock is also not
described in paragraph (b)(3)(ii)(C) of this section
because FP does not receive the USS1 stock as
“other property” within the meaning of section 356.
(B) USS2’s exchange of assets for USS1 stock is
notanacquisitiondescribedinparagraph
(b)(3)(ii)(B) of this section because USS2’s acquisi-
tion of USS1 stock is an exempt exchange. USS2’s
acquisition of USS1 stock is an exempt exchange
described in paragraph (f)(5)(ii) of this section be-
cause USS1 and USS2 are both parties to a reorga-
nization, section 1032 applies to USS1, the trans-
feror of the expanded group stock, and the USS1
stock is distributed by USS2, the transferee, pursuant
to the plan of reorganization.
(C) Because neither USS1 nor USS2 has made a
distribution or acquisition described in paragraph
(b)(3)(ii) of this section, USS2 Note is not a principal
purpose debt instrument.
Example 11.Triangular reorganization. (i)
Facts. USS2 owns 100 percent of the stock of DS2,
a domestic corporation. On Date B in Year 1, FP
issues FP stock and FP Note to USS1 as a contribu-
tion to capital. USS1 does not formally issue addi-
tional USS1 stock to FP in exchange for FP stock
and FP Note, but is treated as issuing stock to FP in
an exchange to which section 351 applies. Immedi-
ately afterwards, USS1 transfers the FP stock and FP
Note to DS2 in exchange for all of DS2’s assets, and
DS2 distributes the FP stock and FP Note to USS2
with respect to USS2’s DS2 stock in a liquidating
distribution.
(ii)Analysis. FP Note is issued by FP to USS1 in
exchange for stock of USS1 in an exchange that is
not an exempt exchange described in paragraph
(f)(5) of this section. Under paragraph (b)(2)(ii) of
this section, FP Note is treated as stock beginning on
Date B in Year 1.
Example 12.Funded acquisition of subsidiary
stock by issuance; successor.
(i)Facts. On Date A in Year 1, FS lends $100x
to USS1 in exchange for USS1 Note. On Date B in
Year 1, USS1 transfers property that has a value of
$20x to CFC in exchange for additional CFC stock
that has a value of $20x. On Date C in Year 2, CFC
distributes $20 cash to USS1. On Date D in Year 3,
CFC acquires stock of FS from FP in exchange for
$50x cash.
(ii)Analysis. (A) But for the exception in para-
graph (c)(3) of this section, USS1 Note would be
treated under paragraph (b)(3)(iv)(B) of this section
as issued with a principal purpose of funding an
acquisition of expanded group stock described in
paragraph (b)(3)(ii)(B) of this section because USS1
Note is issued to a member of the FP expanded
group during the 72-month period determined with
respect to USS1’s acquisition of CFC stock on Date
B in Year 1. However, because USS1’s acquisition
of CFC stock results from a transfer of property from
USS1 to CFC in exchange for CFC stock and im-
mediately after the transaction USS1 holds 100 per-
cent of the stock of CFC, the exception in paragraph
(c)(3) of this section applies. Accordingly, USS1’s
acquisition of CFC stock on Date B in Year 1 is not
treated as an acquisition of stock described in para-
graph (b)(3)(ii)(B) of this section, and USS1 Note is
not treated as stock.
(B) CFC is a successor with respect to USS1
under paragraph (f)(11)(ii) of this section. For pur-
poses of paragraph (b)(3)(iv)(B)(1) of this section
CFC is a successor only to the extent of the value
of the expanded group stock acquired from CFC in
the transaction described in paragraph (c)(3) of
this section.
(C) Under paragraph (f)(11)(ii) of this section,
CFC’s $20x cash distribution to USS1 on Date C in
Year 2 is not taken into account for purposes of
applying paragraph (b)(3) of this section to USS1
Note.
(D) On Date D in Year 3, CFC continues to be a
successor to USS1 for purposes of applying the per
se rule in paragraph (b)(3)(iv)(B) of this section.
Accordingly, USS1 Note is a principal purpose debt
instrument under paragraph (b)(3)(ii)(A) of this sec-
tion that is deemed to be exchanged for stock on
Date D in Year 3 under paragraph (d)(1)(ii) of this
section. See § 1.385–1(c) for rules regarding the
treatment of this deemed exchange.
Example 13.Distribution of a debt instrument to
partnership. (i)Facts. CFC and FS are equal part-
ners in PRS. PRS owns 100 percent of the stock of
X Corp, a domestic corporation. On Date A in Year
1, X Corp issues X Note to PRS in a distribution.
(ii)Analysis. (A) Under § 1.385–1(b)(3), in de-
termining whether X Corp is a member of the ex-
panded group that includes CFC and FS, CFC and
FS are each treated as holding 50 percent of the X
Corp stock held by PRS. Accordingly, 100 percent
of X Corp’s stock is treated as owned by CFC and
FS under § 1.385–1(b)(3)(i)(B), and X Corp is a
member of the FP expanded group.
(B) Together CFC and FS own 100 percent of the
interests in PRS capital and profits, such that PRS is
a controlled partnership described in § 1.385–
1(b)(1). Under paragraph (d)(5)(i) of this section,
solely for purposes of this section, when X Corp
issues X Note to PRS, proportionate shares of X
Note are treated as issued to CFC and FS. Accord-
ingly, for purposes of applying paragraph (b) of this
section, in Year 1, 50 percent of X Note is treated as
issued to CFC in a distribution and the other 50
percent of X Note is treated as issued to FS in a
distribution. Therefore, under paragraphs (b)(2)(i)
and (d)(1)(i) of this section, X Note is treated as
stock beginning on Date A in Year 1. Under para-
graph (d)(5)(i) of this section, CFC and FS are
treated as holding X Note solely for purposes of
this section. For all other federal tax purposes, X
Note is treated as stock in X Corp that is held by
PRS, and X Corp is treated as distributing its stock
April 25, 2016Bulletin No. 2016–17
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to its shareholder in a distribution that is subject to
section 305.
Example 14.Loan to partnership; same-year dis-
tribution. (i)Facts. The facts are the same as in
Example 13, except that X Corp does not distribute
X Note to PRS; instead, on Date A in Year 1 FP
lends $200x to PRS in exchange for PRS Note. On
Date B in Year 1, CFC distributes $100x to USS1
and FS distributes $100x to FP. CFC is not an
expatriatedforeignsubsidiaryasdefinedin
§ 1.7874 –12T(a)(9).
(ii)Analysis. (A) Under paragraph (d)(5)(i) of
this section, solely for purposes of this section, CFC
and FS are each treated as issuing $100x of PRS
Note on Date A in Year 1, which represents their
proportionate shares of PRS Note. CFC’s and FS’s
shares of PRS Note are each issued to FP, a member
of the same expanded group, during the 72-month
periods determined with respect to the distributions
by CFC and FS. Under paragraph (b)(3)(iv)(B)(1)of
this section, PRS Note is treated as issued with a
principal purpose of funding the distributions by
CFC and FS. Accordingly, under paragraphs
(b)(3)(ii)(A) and (d)(1)(i) of this section, PRS Note
is a principal purpose debt instrument that is treated
as stock when it is issued on Date A in Year 1.
(B) Under paragraph (d)(5)(ii) of this section,
CFC and FS are each treated as issuing $100x of
stock to FP. Appropriate conforming adjustments
must be made to CFC’s and FS’s interests in PRS to
reflect the deemed treatment of PRS Note as stock
issued by CFC and FS, which must be done in a
manner that avoids the creation of, or increase in, a
disparity between PRS’s aggregate basis in its assets
and the aggregate bases of CFC’s and FS’s respec-
tive interests in PRS. For example, reasonable and
appropriate adjustments may occur when the follow-
ing steps are deemed to occur on Date A in Year 1:
(1) CFC issues stock to FP in exchange for
$100x;
(2) FS issues stock to FP in exchange for $100x;
(3) CFC contributes $100x to PRS in exchange
for a partnership interest in PRS; and
(4) FS contributes $100x to PRS in exchange for
a partnership interest in PRS.
Example 15.Loan to partnership; distribution in
later year. (i)Facts. The facts are the same as in
Example 14, except that CFC and FS do not make
distributions on Date B of Year 1; instead, CFC
distributes $100x to USS1 and FS distributes $100x
to FP on Date C of Year 2.
(ii)Analysis. (A) As inExample 14, CFC’s and
FS’s shares of PRS Note are each issued to FP, a
member of the same expanded group, during the
72-month periods determined with respect to the
distributions by CFC and FS. Under paragraph
(b)(3)(iv)(B)(1) of this section, PRS Note is treated
as issued with a principal purpose of funding the
distributions by CFC and FS. Accordingly, PRS
Note is a principal purpose debt instrument that is
treated as stock under paragraph (b)(3)(i)(A) of this
section. Under paragraph (d)(1)(ii) of this section,
PRS Note is treated as stock on Date C in Year 2.
(B) Under paragraph (d)(5)(ii) of this section,
CFC and FS are each treated as issuing $100x of
stock to FP. Appropriate conforming adjustments
must be made to CFC’s and FS’s interests in PRS to
reflect the deemed treatment of PRS Note as stock
issued by CFC and FS, which must be done in a
manner that avoids the creation of, or increase in, a
disparity between PRS’s aggregate basis in its assets
and the aggregate bases of CFC’s and FS’s respec-
tive interests in PRS. For example, reasonable and
appropriate adjustments may occur when the follow-
ing steps are deemed to occur on Date C in Year 2:
(1) CFC assumes liability with respect to $100x
of PRS Note;
(2) FS assumes liability with respect to $100x of
PRS Note;
(3) CFC issues stock to FP in satisfaction of the
$100x of PRS Note assumed by CFC; and
(4) FS issues stock to FP in satisfaction of the
$100x of PRS Note assumed by FS.
Example 16.Distribution of another member’s
debt instrument. (i)Facts. On Date A in Year 1, CFC
lends $100x to FS in exchange for FS Note. On Date
B in Year 2, CFC distributes FS Note to USS1.
(ii)Analysis. Although CFC distributes FS Note,
which is a debt instrument, to USS1, another mem-
ber of CFC’s expanded group, paragraph (b)(2)(i) of
this section does not apply because CFC is not the
issuer of the FS Note.
Example 17.Threshold exception and current
year earnings and profits exception. (i)Facts. Before
Date A in Year 1, the members of FP’s expanded
group hold no outstanding debt instruments that oth-
erwise would be treated as stock under this section.
On Date A in Year 1, CFC issues CFC Note, which
has an issue price of $40 million, to USS1 in a
distribution. On Date B in Year 2, USS1 issues
USS1 Note, which has an issue price of $20 million,
to FP in a distribution. On Date C in Year 3, FS
distributes $30 million in cash to FP. On Date D in
Year 3, DS lends $30 million to FS in exchange for
FS Note A. On Date E in Year 3, FS issues FS Note
B, which has an issue price of $19 million, to FP in
a distribution. In Year 3, FS has $35 million in
earnings and profits described in section 316(a)(2).
(ii)Analysis. (A) Because CFC does not have
earnings and profits described in section 316(a)(2) in
Year 1, the exception in paragraph (c)(1) of this
section does not apply to CFC Note. Immediately
after CFC Note is issued to USS1 on Date A in Year
1, the aggregate adjusted issue price of outstanding
debt instruments issued by members of FP’s ex-
panded group that would be subject to paragraph (b)
of this section but for the application paragraph
(c)(2) of this section does not exceed $50 million.
Accordingly, the threshold exception described in
paragraph (c)(2) applies to the CFC Note.
(B) Because USS1 does not have earnings and
profits described in section 316(a)(2) in Year 2, the
exception in paragraph (c)(1) of this section does not
apply to USS1 Note. Immediately after USS1 Note is
issued to FP on Date B in Year 2, the aggregate
adjusted issue price of outstanding debt instruments
issued by members of the FP expanded group that
would be subject to paragraph (b) of this section but
for the application of paragraph (c)(2) of this section
exceeds $50 million. Under paragraph (d)(1)(iii) of
this section, CFC Note is deemed to be exchanged
for stock on Date B in Year 2, when debt instruments
of the FP expanded group cease to qualify for the
threshold exception described in paragraph (c)(2) of
this section. In addition, the threshold exception de-
scribed in paragraph (c)(2) of this section does not
apply to USS1 Note because, immediately after
USS1 Note is issued, the aggregate adjusted issue
price of outstanding debt instruments issued by
members of the expanded group that would be sub-
ject to paragraph (b) of this section but for the
application paragraph (c)(2) of this section exceeds
$50 million. Accordingly, USS1 Note is treated as
stock when it is issued on Date B in Year 2.
(C) Under paragraph (c)(1) of this section, for
purposes of applying paragraphs (b)(2) and (b)(3) of
this section to a member of an expanded group with
respect to Year 3, the aggregate amount of any
distributions or acquisitions by FS that are described
in paragraphs (b)(2) or (b)(3)(ii) of this section are
reduced by an amount equal to FS’s current year
earnings and profits described in section 316(a)(2)
for Year 3, which is $35 million. Thus, $35 million
of distributions or acquisitions by FS in Year 3 are
not taken into account for purposes of applying para-
graphs (b)(2) and (b)(3) of this section. The reduc-
tion is applied first against FS’s $30 million cash
distribution on Date C in Year 3 and second against
FS’s $19 million note distribution on Date E in Year
3. Accordingly, under paragraph (c)(1) of this sec-
tion, FS Note A is not treated as stock under para-
graph (b)(3) of this section. In addition, under para-
graph (c)(1) of this section a portion of FS Note B
equal to $5 million is not treated as stock under
paragraph (b)(2) of this section.
(D) When FS Note B is issued in Year 3, CFC
Note, which previously was treated as indebtedness
solely because of paragraph (c)(2) of this section,
remains outstanding. Accordingly, the threshold ex-
ception described in paragraph (c)(2) of this section
does not apply to FS Note B. Accordingly, the re-
maining amount of FS Note B equal to $14 million
after applying the exception under paragraph (c)(1)
of this section is treated as stock under paragraph
(b)(2) of this section.
Example 18.Distribution of a debt instrument
and issuance of a debt instrument with a principal
purpose of avoiding the purposes of this section. (i)
Facts. On Date A in Year 1, USS1 issues USS1 Note
A, which has a value of $100x, to FP in a distribu-
tion. On Date B in Year 1, with a principal purpose
of avoiding the application of this section, FP sells
USS1 Note A to Bank for $100x of cash and lends
$100x to USS1 in exchange for USS1 Note B.
(ii)Analysis. USS1 Note A is a debt instrument
that is issued by USS1 to FP, a member of USS1’s
expanded group, in a distribution. Accordingly, un-
der paragraphs (b)(2)(i) and (d)(1)(i) of this section,
USS1 Note A is treated as stock when it is issued by
USS1 to FP on Date A in Year 1. Accordingly, USS1
is treated as distributing USS1 stock to its share-
holder FP. Because USS1 Note A is treated as stock
of USS1, USS1 Note A is not property as specified
in section 317(a) on Date A in Year 1. Under para-
graph (d)(2) of this section, USS1 Note A ceases to
be treated as stock when FP sells USS1 Note A to
Bank on Date B in Year 1. Immediately before FP
sells USS1 Note A to Bank, USS1 is deemed to issue
a debt instrument to FP in exchange for USS1 Note
A in a transaction that is disregarded for purposes of
paragraphs (b)(2) and (b)(3) of this section. USS1
Note B is not treated as stock under paragraph
(b)(3)(ii)(A) of this section because the funded mem-
ber, USS1, has not made a distribution of property.
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669

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.
(h)Effective/applicability date and
transition rules—(1)In general. This sec-
tion applies to any debt instrument issued
on or after April 4, 2016, and to any debt
instrument treated as issued before April
4, 2016 as a result of an entity classifica-
tion election made under § 301.7701–3 of
this chapter that is filed on or after April 4,
2016.
(2)Transition rule for distributions or
acquisitions occurring before April 4,
2016. For purposes of paragraph (b)(3)(iv)
of this section, a distribution or acquisi-
tion described in paragraph (b)(3)(ii) of
this section that occurs before April 4,
2016, other than a distribution or acquisi-
tion that is treated as occurring before
April 4, 2016 as a result of an entity
classificationelectionmadeunder
§ 301.7701–3 of this chapter that is filed
on or after April 4, 2016, is not taken into
account.
(3)Transition rule for debt instruments
that would be treated as stock prior to the
date of publication in theFederal Regis-
terof the Treasury decision adopting this
rule as a final regulation. When para-
graphs (b) and (d)(1)(i) through (v) of this
section otherwise would treat a debt in-
strument as stock prior to the date of pub-
lication in theFederal Registerof the
Treasury decision adopting this rule as a
final regulation, the debt instrument is
treated as indebtedness until the date that
is 90 days after the date of publication in
theFederal Registerof the Treasury de-
cision adopting this rule as a final regula-
tion. To the extent that the debt instrument
described in the preceding sentence is
held by a member of the issuer’s ex-
panded group on the date that is 90 days
after the date of publication in theFederal
Registerof the Treasury decision adopt-
ing this rule as a final regulation, the debt
instrument is deemed to be exchanged for
stock on the date that is 90 days after the
date of publication in theFederal Regis-
terof the Treasury decision adopting this
rule as a final regulation.
Par. 5. Section 1.385– 4 is added to
read as follows:
§ 1.385– 4 Treatment of consolidated
groups.
(a)Scope. Section 1.385–1(e) provides
that members of a consolidated group are
treated as one corporation for purposes of
the regulations under section 385. This
sectionprovidesrulesforapplying
§ 1.385–3 to consolidated groups when an
interest ceases to be a consolidated group
debt instrument or becomes a consoli-
dated group debt instrument. For defini-
tions applicable to this section, see
§ 1.385–3(f).
(b)Debt instrument ceases to be a con-
solidated group debt instrument but con-
tinues to be an expanded group debt in-
strument—(1)Member leaving the group.
When a corporation ceases to be a mem-
ber of the consolidated group but contin-
ues to be a member of the expanded group
(such corporation, adeparting member), a
debt instrument that is issued or held by
the departing member is treated as indebt-
edness or stock pursuant to paragraphs
(b)(1)(i) or (b)(1)(ii) of this section.
(i)Exempt consolidated group debt in-
strument that ceases to be consolidated
group debt instrument. Any exempt con-
solidated group debt instrument that is
issued or held by the departing member is
deemed to be exchanged for stock imme-
diately after the departing member leaves
the group. For these purposes, the term
exempt consolidated group debt instru-
mentmeans any debt instrument that was
not treated as stock solely by reason of the
departingmember’streatmentunder
§ 1.385–1(e). See paragraph (d) of this
section,Example 3, for an illustration of
this rule.
(ii)Non-exempt consolidated group
debt instrument that ceases to be consol-
idated group debt instrument—(A)In
general. Any consolidated group debt in-
strument issued or held by a departing
member that is not an exempt consoli-
dated group debt instrument (non-exempt
consolidated group debt instrument)is
treated as indebtedness unless and until
the non-exempt consolidated group debt
instrument is treated as a principal pur-
pose debt instrument under § 1.385–
3(b)(3)(ii) and (d)(1) as a result of a dis-
tribution or acquisition described in
§ 1.385–3(b)(3)(ii) that occurs after the
departure.
(B)Coordination with funding rule.
Solely for purposes of applying the 72-
monthperiodunder§1.385–
3(b)(3)(iv)(B) (the per se rule), a non-
exemptconsolidatedgroupdebt
instrument is treated as having been is-
sued when it was first treated as a consol-
idated group debt instrument. For all other
purposes of applying § 1.385–3, including
for purposes of applying § 1.385–3(d), a
non-exempt consolidated group debt in-
strument is treated as issued by the issuer
of the debt instrument immediately after
the departing member leaves the group.
(2)Consolidated group debt instru-
ment that is transferred outside of the
consolidated group. Solely for purposes
of § 1.385–3, when a member of a con-
solidated group that holds a consolidated
group debt instrument transfers the debt
instrument to an expanded group member
that is not a member of the consolidated
group, the debt instrument is treated as
issued by the issuer of the debt instrument
(which is treated as one corporation with
the transferor of the debt instrument pur-
suant to § 1.385–1(e)) to the transferee
expanded group member on the date of
the transfer. For purposes of § 1.385–3,
the consequences of such transfer are de-
termined in a manner that is consistent
with treating a consolidated group as one
corporation. Thus, for example, the sale of
a consolidated group debt instrument to an
expanded group member that is not a
member of the consolidated group will be
treated as an issuance of the debt instru-
ment to the transferee expanded group
member in exchange for property. To the
extent the debt instrument is treated as
stock upon being transferred, the debt in-
strument is deemed to be exchanged for
stock immediately after the debt instru-
ment is transferred outside of the consol-
idated group. For examples illustrating
this rule, see paragraph (d) of this section,
Examples 1and2.
(c)Debt instrument entering a consol-
idated group. When a debt instrument that
is treated as stock under § 1.385–3 be-
comes a consolidated group debt instru-
ment, immediately before that debt instru-
ment becomes a consolidated group debt
instrument, the issuer is treated as issuing
a new debt instrument to the holder in
exchange for the debt instrument that was
April 25, 2016Bulletin No. 2016–17
670

treated as stock in a transaction that is
disregarded for purposes of § 1.385–3(b).
(d)Examples—(1)Assumed facts. Ex-
cept as otherwise stated, the following
facts are assumed for purposes of the ex-
amples in paragraph (d)(3) of this section:
(i) FP is a foreign corporation that
owns 100 percent of the stock of USS1, a
domestic corporation, and 100 percent of
the stock of FS, a foreign corporation;
(ii) USS1 owns 100 percent of the
stock of DS1, a domestic corporation;
(iii) DS1 owns 100 percent of the stock
of DS2, a domestic corporation;
(iv) At the beginning of Year 1, FP is
the common parent of an expanded group
comprised solely of FP, USS1, FS, DS1,
and DS2 (the FP expanded group);
(v) USS1, DS1, and DS2 are members
of a consolidated group of which USS1 is
the common parent (the USS1 consoli-
dated group);
(vi) The FP expanded group has more
than $50 million of debt instruments de-
scribed in § 1.385–3(c)(2) at all times;
(vii) No issuer of a debt instrument has
current year earnings and profits described
in section 316(a)(2);
(viii) All notes are debt instruments
described in § 1.385–3(f)(3) and therefore
have satisfied any requirements under
§ 1.385–2, if applicable, and are respected
as debt instruments under general federal
tax principles;
(ix) No notes are eligible for the ordi-
narycourseexceptiondescribedin
§ 1.385–3(b)(3)(iv)(B)(2);
(x) Each entity has as its taxable year
the calendar year;
(xi) No domestic corporation is a
United States real property holding corpo-
ration within the meaning of section
897(c)(2); and
(xii) Each note is issued with adequate
stated interest (as defined in section
1274(c)(2)).
(2)No inference. Except as provided in
this section, it is assumed for purposes of
the examples that the form of each trans-
action is respected for federal tax pur-
poses. No inference is intended, however,
as to whether any particular note would be
respected as indebtedness or as to whether
the form of any particular transaction de-
scribed in paragraph (d)(3) of this section
would be respected for federal tax pur-
poses.
(3)Examples. The following examples
illustrate the rules of this section.
Example 1.Distribution of consolidated group
debt instrument. (i)Facts. On Date A in Year 1, DS1
issues DS1 Note to USS1 in a distribution. On Date
B in Year 2, USS1 distributes DS1 Note to FP.
(ii)Analysis. Under § 1.385–1(e), the USS1 con-
solidated group is treated as one corporation for
purposes of § 1.385–3. Accordingly, when DS1 is-
sues DS1 Note to USS1 in a distribution, DS1 is not
treated as issuing a debt instrument to another mem-
ber of DS1’s expanded group in a distribution for
purposes of § 1.385–3, and DS1 Note is not treated
as stock under § 1.385–3. Under paragraph (b)(2) of
this section, when USS1 distributes DS1 Note to FP,
the USS1 consolidated group is treated as issuing a
debt instrument to FP in a distribution. Accordingly,
DS1 Note is treated as DS1 stock under § 1.385–
3(b)(2)(i). For this purpose, DS1 Note is deemed to
be exchanged for stock immediately after DS1 Note
is transferred outside of the USS1 consolidated
group.
Example 2.Sale of consolidated group debt in-
strument. (i)Facts. On Date A in Year 1, DS1 lends
$200x to USS1 in exchange for USS1 Note. On Date
B in Year 2, USS1 distributes $200x to FP. On Date
C in Year 2, DS1 sells USS1 Note to FS for $200x.
(ii)Analysis. Under § 1.385–1(e), the USS1 con-
solidated group is treated as one corporation for
purposes of § 1.385–3. Accordingly, when USS1
issues USS1 Note to DS1 on Date A in Year 1, USS1
is not treated as a funded member, and when USS1
distributes $200x to FP on Date B in Year 2,
§ 1.385–2(b)(3) does not apply. Under paragraph
(b)(2) of this section, when DS1 sells USS1 Note to
FS, the USS1 consolidated group is treated as issuing
USS1 Note to FS in exchange for $200x on Date C
in Year 2. Because USS1 Note was issued by the
USS1 consolidated group to FS within 36 months of
the distribution by the USS1 consolidated group to
FP, § 1.385–3(b)(3)(iv)(B)(1) treats USS1 Note as
issued with a principal purpose of funding that dis-
tribution. Accordingly, USS1 Note is a principal
purpose debt instrument that is treated as USS1 stock
under § 1.385–3(b)(3)(ii)(A). Under paragraph
(b)(2) of this section, immediately after USS1 Note
is transferred outside of the USS1 consolidated
group, USS1 Note is deemed to be exchanged for
stock.
Example 3.Treatment of exempt consolidated
group debt instrument when a consolidated group
member leaves the consolidated group. (i)Facts.On
Date A in Year 1, DS1 issues DS1 Note A to USS1
in a distribution. On Date B in Year 2, USS1 lends
$100x to DS1 in exchange for DS1 Note B. On Date
C in Year 4, FP purchases 25 percent of DS1’s stock
from USS1, resulting in DS1 ceasing to be a member
of the USS1 consolidated group.
(ii)Analysis. (A) Under § 1.385–1(e), the USS1
consolidated group is treated as one corporation for
purposes of § 1.385–3 until Date C in Year 4. Ac-
cordingly, when DS1 issues DS1 Note to USS1 in a
distribution on Date A in Year 1, DS1 is not treated
as issuing a debt instrument to a member of DS’s
expanded group in a distribution for purposes of
§ 1.385–3(b)(2), and DS1 Note A is not treated as
stock under § 1.385–3 on Date A in Year 1. DS1
Note A is an exempt consolidated group debt instru-
ment because DS1 Note A is not treated as stock on
Date A in Year 1 solely by reason of § 1.385–1(e).
Under paragraph (b)(1)(i) of this section, immedi-
ately after DS1 leaves the USS1 consolidated group,
DS1 Note A is deemed to be exchanged for stock.
(B) DS1 Note B is a non-exempt consolidated
group debt instrument because DS1 Note B, which is
issued in exchange for cash, would not be treated as
stock even absent the application of § 1.385–1(e)
because there have been no transactions described in
§ 1.385–3(b)(3)(ii) that would have been treated as
funded by DS1 Note B in the absence of the appli-
cation of § 1.385–1(e). Accordingly, under para-
graph (b)(1)(ii)(A) of this section, DS1 Note B is not
treated as stock when DS1 ceases to be a member of
the USS1 consolidated group, provided there are no
distributions or acquisitions described in § 1.385–
3(b)(3)(ii) by DS1 that occur later in Year 4 (after
Date C).
Example 4.Distribution after a funded consoli-
dated group member leaves the consolidated group.
(i)Facts. The facts are the same as inExample 3,
except that on Date D in Year 6, DS1 distributes
$100x pro rata to its shareholders ($75x to USS1 and
$25x to FP).
(ii)Analysis. The per se rule in § 1.385–
3(b)(3)(iv)(B)(1) does not apply to DS1 Note B and
the distribution on Date D in Year 6 because under
section (b)(1)(ii)(B) of this section, for purposes of
applying § 1.385–3(b)(3)(iv)(B)(1), DS1 Note B is
treated as issued on Date B in Year 2, which is more
than 36 months before Date D in Year 6.
Example 5.Treatment of non-exempt consoli-
dated group debt instrument when a consolidated
group member leaves the group. (i)Facts. On Date
A in Year 1, DS2 lends $100x to DS1 in exchange
for DS1 Note. On Date B in Year 1, DS1 distributes
$100x of cash to USS1. On Date C in Year 1, FP
purchases 25 percent of DS2’s stock from DS1,
resulting in DS2 ceasing to be a member of the USS1
consolidated group.
(ii)Analysis. After DS2 ceases to be a member of
the USS1 consolidated group, DS1 and USS1 con-
tinue to be treated as one corporation under § 1.385–
1(e), such that DS1’s distribution of cash to USS1 on
Date B in Year 1 continues to be disregarded for
purposes of § 1.385–3. Accordingly, DS1 Note is a
non-exempt consolidated group debt instrument be-
cause DS1 Note, which is issued in exchange for
cash, would not be treated as stock even absent the
application of § 1.385–1(e) to DS2, because, taking
into account the continued application of § 1.385–
1(e) to USS1 and DS1, DS1 Note does not fund any
transaction described in § 1.385–3(b)(3)(ii). Accord-
ingly, under paragraph (b)(1)(ii)(A) of this section,
DS1 Note is not treated as stock when it ceases to be
a consolidated group debt instrument, provided there
are no distributions or acquisitions described in
§ 1.385–3(b)(3)(ii) by DS1that occur later in Year
1 (after Date C).
(e)Effective/applicability date and
transition rules—(1)In general. This sec-
tion applies to any debt instrument issued
on or after April 4, 2016, and to any debt
instrument treated as issued before April
4, 2016 as a result of an entity classifica-
tion election made under § 301.7701–3 of
Bulletin No. 2016–17April 25, 2016
671

this chapter that is filed on or after April 4,
2016.
(2)Transition rule for distributions or
acquisitions occurring before April 4,
2016. For purposes of this section, a dis-
tributionoracquisitiondescribedin
§ 1.385–3(b)(3)(ii) that occurs before April
4, 2016, other than a distribution or acqui-
sition that is treated as occurring before
April 4, 2016 as a result of an entity classi-
fication election made under § 301.7701–3
of this chapter that is filed on or after April
4, 2016, is not taken into account.
(3)Transition rule for debt instruments
that would be treated as stock prior to the
date of publication in theFederal Regis-
terof the Treasury decision adopting this
rule as a final regulation.When this sec-
tion otherwise would treat a debt instru-
ment as stock prior to the date of publica-
tion in theFederal Registerof the
Treasury decision adopting this rule as a
final regulation, the debt instrument is
treated as indebtedness until the date that
is 90 days after the date of publication in
theFederal Registerof the Treasury de-
cision adopting this rule as a final regula-
tion. To the extent that the debt instrument
described in the preceding sentence is
held by a member of the issuer’s ex-
panded group on the date that is 90 days
after the date of publication in theFederal
Registerof the Treasury decision adopt-
ing this rule as a final regulation, the debt
instrument is deemed to be exchanged for
stock on the date that is 90 days after the
date of publication in theFederal Regis-
terof the Treasury decision adopting this
rule as a final regulation.
John Dalrymple.
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on April 4, 2016,
5:00 p.m., and published in the issue of the Federal Register
for April 8, 2016, 80 F.R. 20912)
April 25, 2016Bulletin No. 2016–17
672

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:
Amplifieddescribes 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).
Clarifiedis 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.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis 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 andclarified, above).
Obsoleteddescribes 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.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
being stated in a new ruling.
Supersededdescribes 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
supersededdescribes 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.
Supplementedis 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.
Suspendedis 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.
BK—Bank.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Cooperative.
Ct.D.—Court Decision.
CY—County.
D—Decedent.
DC—Dummy Corporation.
DE—Donee.
Del. Order—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Employer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduciary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Foreign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Federal Unemployment Tax Act.
FX—Foreign corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grantee.
GP—General Partner.
GR—Grantor.
IC—Insurance Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited Partner.
LR—Lessor.
M—Minor.
Nonacq.—Nonacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Personal Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Partnership.
PTE
—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Real Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsidiary.
S.P.R.—Statement of Procedural Rules.
Stat.—Statutes at Large.
T—Target Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Transferee.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpayer.
TR—Trust.
TT—Trustee.
U.S.C.—United States Code.
X—Corporation.
Y—Corporation.
Z—Corporation.
Bulletin No. 2016–17April 25, 2016
i

Numerical Finding List
1
Bulletins 2016 –1 through 2016 –17
Announcements:
2016 –1, 2016 –3 I.R.B.283
2016-2, 2016-3 I.R.B.283
2016-3, 2016-4 I.R.B.294
2016-4, 2016-6 I.R.B.313
2016-5, 2016-8 I.R.B.356
2016-6, 2016-10 I.R.B.409
2016-7, 2016-8 I.R.B.356
2016-8, 2016-9 I.R.B.367
2016-9, 2016-9 I.R.B.367
2016-10, 2016-9 I.R.B.367
2016-11, 2016-10 I.R.B.411
2016-12, 2016-16 I.R.B.589
2016-13, 2016-13 I.R.B.514
2016-14, 2016-14 I.R.B.535
2016-15, 2016-17 I.R.B.636
Notices:
2016-1, 2016-2 I.R.B.265
2016-2, 2016-2 I.R.B.265
2016-3, 2016-3 I.R.B.278
2016-4, 2016-3 I.R.B.279
2016-5, 2016-6 I.R.B.302
2016-6, 2016-4 I.R.B.287
2016-7, 2016-5 I.R.B.296
2016-8, 2016-6 I.R.B.304
2016-9, 2016-6 I.R.B.306
2016-10, 2016-6 I.R.B.307
2016-11, 2016-6 I.R.B.312
2016-12, 2016-6 I.R.B.312
2016-13, 2016-7 I.R.B.314
2016-14, 2016-7 I.R.B.315
2016-15, 2016-13 I.R.B.486
2016-16, 2016-7 I.R.B.318
2016-17, 2016-9 I.R.B.358
2016-18, 2016-9 I.R.B.359
2016-19, 2016-9 I.R.B.362
2016-20, 2016-9 I.R.B.362
2016-21, 2016-12 I.R.B.465
2016-22, 2016-13 I.R.B.488
2016-23, 2016-13 I.R.B.490
2016-24, 2016-13 I.R.B.492
2016-25, 2016-13 I.R.B.493
2016-26, 2016-14 I.R.B.533
2016-27, 2016-15 I.R.B.576
2016-28, 2016-15 I.R.B.576
Proposed Regulations:
REG-103380-05, 2016-16 I.R.B.614
REG-118867-10, 2016-10 I.R.B.411
REG-147310-12, 2016-7 I.R.B.336
REG-150349-12, 2016-11 I.R.B.440
REG-138344-13, 2016-4 I.R.B.294
REG-123867-14, 2016-12 I.R.B.484
Proposed Regulations:—Continued
REG-125761-14, 2016-7 I.R.B.322
REG-100861-15, 2016-8 I.R.B.356
REG-108060-15, 2016-17 I.R.B.636
REG-109822-15, 2016-14 I.R.B.535
REG-127923-15, 2016-12 I.R.B.473
REG-129067-15, 2016-10 I.R.B.421
REG-134122-15, 2016-7 I.R.B.334
REG-101701-16, 2016-9 I.R.B.368
Revenue Procedures:
2016-1, 2016-1 I.R.B.1
2016-2, 2016-1 I.R.B.102
2016-3, 2016-1 I.R.B.126
2016-4, 2016-1 I.R.B.142
2016-5, 2016-1 I.R.B.188
2016-6, 2016-1 I.R.B.200
2016-7, 2016-1 I.R.B.239
2016-8, 2016-1 I.R.B.243
2016-10, 2016-2 I.R.B.270
2016-11, 2016-2 I.R.B.274
2016-13, 2016-4 I.R.B.290
2016-14, 2016-9 I.R.B.365
2016-15, 2016-11 I.R.B.435
2016-16, 2016-10 I.R.B.394
2016-17, 2016-11 I.R.B.436
2016-18, 2016-17 I.R.B.635
2016-19, 2016-13 I.R.B.497
2016-20, 2016-13 I.R.B.499
2016-21, 2016-14 I.R.B.533
2016-22, 2016-15 I.R.B.577
2016-23, 2016-16 I.R.B.581
Revenue Rulings:
2016-1, 2016-2 I.R.B.262
2016-2, 2016-4 I.R.B.284
2016-3, 2016-3 I.R.B.282
2016-4, 2016-6 I.R.B.299
2016-5, 2016-8 I.R.B.344
2016-6, 2016-14 I.R.B.519
2016-7, 2016-10 I.R.B.391
2016-8, 2016-11 I.R.B.426
2016-9, 2016-14 I.R.B.530
2016-10, 2016-15 I.R.B.545
Treasury Decisions:
9745, 2016-2 I.R.B.256
9746, 2016-14 I.R.B.515
9748, 2016-8 I.R.B.347
9749, 2016-10 I.R.B.373
9750, 2016-10 I.R.B.374
9751, 2016-10 I.R.B.379
9752, 2016-10 I.R.B.385
9753, 2016-11 I.R.B.426
9754, 2016-11 I.R.B.432
9755, 2016-12 I.R.B.442
Treasury Decisions:—Continued
9756, 2016-12 I.R.B.450
9757, 2016-12 I.R.B.462
9759, 2016-15 I.R.B.545
9760, 2016-15 I.R.B.564
1
A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2015–27 through 2015–52 is in Internal Revenue Bulletin
2015–52, dated December 28, 2015.
April 25, 2016Bulletin No. 2016–17
ii

Finding List of Current Actions on
Previously Published Items
1
Bulletins 2016 –1 through 2016 –17
Announcements:
2007-21
Modified by
Ann. 2016-1, 2016-3 I.R.B.283
Notices:
2005-50
Modified by
Notice 2016-2, 2016-2 I.R.B.265
2007-59
Revoked by
Notice 2016-16, 2016-7 I.R.B.318
2013-54
Supplemented by
Notice 2016-17, 2016-9 I.R.B.358
2014-79
Superseded by
Notice 2016-1, 2016-2 I.R.B.265
2015-52
Supplemented by
Notice 2016-17, 2016-9 I.R.B.358
2015-87
Supplemented by
Notice 2016-17, 2016-9 I.R.B.358
Revenue Procedures:
1987-24
Superseded by
Rev. Proc. 2016-22, 2016-15 I.R.B.577
2003-36
Superseded by
Rev. Proc. 2016-19, 2016-13 I.R.B.497
2014-56
Superseded by
Rev. Proc. 2016-20, 2016-13 I.R.B.499
2014-64
Supplemented by
Rev. Proc. 2016-18, 2016-17 I.R.B.635
2015-1
Superseded by
Rev. Proc. 2016-2, 2016-1 I.R.B.1
2015-2
Superseded by
Rev. Proc. 2016-2, 2016-1 I.R.B.102
Revenue Procedures:—Continued
2015-3
Superseded by
Rev. Proc. 2016-3, 2016-1 I.R.B.126
2015-5
Superseded by
Rev. Proc. 2016-5, 2016-1 I.R.B.142
2015-7
Superseded by
Rev. Proc. 2016-7, 2016-1 I.R.B.188
2015-8
Superseded by
Rev. Proc. 2016-8, 2016-1 I.R.B.200
2015-9
Superseded by
Rev. Proc. 2016-5, 2016-1 I.R.B.239
2015-10
Superseded by
Rev. Proc. 2016-10, 2016-2 I.R.B.270
2015-19
Amplified by
Rev. Proc. 2016-23, 2016-16 I.R.B.581
2015-19
Modified by
Rev. Proc. 2016-23, 2016-16 I.R.B.581
2015-22
Superseded by
Rev. Proc. 2016-8, 2016-01 I.R.B.243
2015-50
Supplemented by
Rev. Proc. 2016-18, 2016-17 I.R.B.635
2015-53
Modified by
Rev. Proc. 2016-11, 2016-2 I.R.B.274
Revenue Rulings:
2005-3
Modified by
Rev. Rul. 2016-8, 2016-11 I.R.B.426
2008-15
Revoked by
Rev. Rul. 2016-3, 2016-3 I.R.B.282
1
A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2015–27 through 2015–52 is in Internal Revenue Bulletin
2015–52, dated December 28, 2015.
Bulletin No. 2016–17April 25, 2016
iii

INTERNAL REVENUE BULLETIN
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