Reg-108060-15

Vol. 81

Friday,

No. 68

April 8, 2016

Part IV

Department of the Treasury

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Internal Revenue Service
26 CFR Part 1
Treatment of Certain Interests in Corporations as Stock or Indebtedness;
Proposed Rule

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

This document contains
proposed regulations under section 385
of the Internal Revenue Code (Code) that
would authorize the Commissioner to
treat certain related-party interests in a
corporation as indebtedness in part and
stock in part for federal tax purposes,
and establish threshold documentation
requirements that must be satisfied in
order for certain related-party interests
in a corporation to be treated as
indebtedness for federal tax purposes.
The proposed regulations also would
treat as stock certain related-party
interests that otherwise would be
treated as indebtedness for federal tax
purposes. The proposed regulations
generally affect corporations that issue
purported indebtedness to related
corporations or partnerships.
DATES: Written or electronic comments
and requests for a public hearing must
be received by July 7, 2016.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR (REG–108060–15), Room
5203, Internal Revenue Service, P.O.
Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions
may be hand-delivered Monday through
Friday between the hours of 8 a.m. and
4 p.m. to CC:PA:LPD:PR (REG–108060–
15), Courier’s Desk, Internal Revenue
Service, 1111 Constitution Avenue NW.,
Washington, DC 20224 or sent
electronically via the Federal
eRulemaking Portal at http://
www.regulations.gov (IRS REG–108060–
15).
FOR FURTHER INFORMATION CONTACT:
Concerning the proposed regulations
under §§ 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:

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

Paperwork Reduction Act
The collection of information
contained in this notice of proposed

Background
As described further in this preamble,
courts historically have analyzed

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG–108060–15]
RIN 1545–BN40

Treatment of Certain Interests in
Corporations as Stock or Indebtedness
Internal Revenue Service (IRS),
Treasury.
ACTION: Notice of proposed rulemaking.
AGENCY:

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SUMMARY:

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whether an interest in a corporation
should be treated as stock or
indebtedness for federal tax purposes by
applying various sets of factors to the
facts of a particular case. In 1969,
Congress enacted section 385 to
authorize the Secretary of the Treasury
(Secretary) to prescribe such regulations
as may be necessary or appropriate to
determine whether an interest in a
corporation is to be treated as stock or
indebtedness for purposes of the Code.
Because no regulations are currently in
effect under section 385, the case law
that developed before the enactment of
section 385 has continued to evolve and
to control the characterization of an
interest in a corporation as debt or
equity.
I. Section 385 Statute and Legislative
History
A. Original Enactment of Section 385
Section 385(a), as originally enacted
as part of the Tax Reform Act of 1969
(Pub. L. 91–172, 83 Stat. 487),
authorizes the Secretary to prescribe
such regulations as may be necessary or
appropriate to determine whether an
interest in a corporation is treated as
stock or indebtedness for purposes of
the Code.
Section 385(b) provides that the
regulations prescribed under section
385 shall set forth factors that are to be
taken into account in determining in a
particular factual situation whether a
debtor-creditor relationship exists or a
corporation-shareholder relationship
exists. Under section 385(b), those
factors may include, among other
factors, the following: (1) Whether there
is a written unconditional promise to
pay on demand or on a specified date
a sum certain in money in return for an
adequate consideration in money or
money’s worth, and to pay a fixed rate
of interest; (2) whether there is
subordination to or preference over any
indebtedness of the corporation; (3) the
ratio of debt to equity of the corporation;
(4) whether there is convertibility into
the stock of the corporation; and (5) the
relationship between holdings of stock
in the corporation and holdings of the
interest in question.
In enacting section 385(a) and (b),
Congress authorized the Secretary to
prescribe targeted rules to address
particular factual situations, stating:
In view of the uncertainties and difficulties
which the distinction between debt and
equity has produced in numerous situations
. . . the committee further believes that it
would be desirable to provide rules for
distinguishing debt from equity in the variety
of contexts in which this problem can arise.
The differing circumstances which
characterize these situations, however, would

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Federal Register / Vol. 81, No. 68 / Friday, April 8, 2016 / Proposed Rules
make it difficult for the committee to provide
comprehensive and specific statutory rules of
universal and equal applicability. In view of
this, the committee believes it is appropriate
to specifically authorize the Secretary of the
Treasury to prescribe the appropriate rules
for distinguishing debt from equity in these
different situations.

S. Rep. No. 91–552, at 138 (1969). The
legislative history further explains that
regulations applicable to a particular
factual situation need not rely on the
factors set forth in section 385(b):
The provision also specifies certain factors
which may be taken into account in these
[regulatory] guidelines. It is not intended that
only these factors be included in the
guidelines or that, with respect to a particular
situation, any of these factors must be
included in the guidelines, or that any of the
factors which are included by statute must
necessarily be given any more weight than
other factors added by regulations.

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Id. Accordingly, section 385(b) provides
the Secretary with discretion to
establish specific rules for determining
whether an interest is treated as stock or
indebtedness for federal tax purposes in
a particular factual situation.
B. 1989 and 1992 Amendments to
Section 385
Congress amended section 385 in
1989 and 1992. In 1989, the Omnibus
Budget Reconciliation Act of 1989 (Pub.
L. 101–239, 103 Stat. 2106) amended
section 385(a) to expressly authorize the
Secretary to issue regulations under
which an interest in a corporation is to
be treated as in part stock and in part
indebtedness. This amendment also
provides that any regulations so issued
may apply only with respect to
instruments issued after the date on
which the Secretary or the Secretary’s
delegate provides public guidance as to
the characterization of such instruments
(whether by regulation, ruling, or
otherwise). See Public Law 101–239,
sec. 7208(a)(2). The legislative history to
the 1989 amendment notes that, while
‘‘[t]he characterization of an investment
in a corporation as debt or equity for
Federal income tax purposes generally
is determined by reference to numerous
factors, . . . there has been a tendency
by the courts to characterize an
instrument entirely as debt or entirely as
equity.’’ H.R. Rep. No. 101–386, at
3165–66 (1989) (Conf. Rep.).
In 1992, Congress added section
385(c) to the Code as part of the Energy
Policy Act of 1992 (Pub. L. 102–486, 106
Stat. 2776). Section 385(c)(1) provides
that the issuer’s characterization (as of
the time of issuance) as to whether an
interest in a corporation is stock or
indebtedness shall be binding on such
issuer and on all holders of such interest
(but shall not be binding on the

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Secretary). Section 385(c)(2) provides
that, except as provided in regulations,
section 385(c)(1) shall not apply to any
holder of an interest if such holder on
his return discloses that he is treating
such interest in a manner inconsistent
with the initial characterization of the
issuer. Section 385(c)(3) authorizes the
Secretary to require such information as
the Secretary determines to be necessary
to carry out the provisions of section
385(c), including the information
necessary for the Secretary to determine
how the issuer characterized an interest
as of the time of issuance.
Congress added section 385(c) in
response to issuers and holders
characterizing a corporate instrument
inconsistently. H.R. Rep. No. 102–716,
at 3 (1992). For example, a corporate
issuer may designate an instrument as
indebtedness for federal tax purposes
and deduct as interest the amounts paid
on the instrument, while a corporate
holder may treat the instrument as stock
for federal tax purposes and claim a
dividends received deduction with
respect to the amounts paid on the
instrument. See id.
II. Regulations
There are no regulations currently in
effect under section 385. On March 24,
1980, the Department of the Treasury
(Treasury Department) and the IRS
published a notice of proposed
rulemaking (LR–1661) in the Federal
Register (45 FR 18959) under section
385 relating to the treatment of certain
interests in corporations as stock or
indebtedness. Final regulations (TD
7747) were published in the Federal
Register (45 FR 86438) on December 31,
1980. Subsequent revisions of the final
regulations were published in the
Federal Register on May 4, 1981,
January 5, 1982, and July 2, 1982 (46 FR
24945, 47 FR 147, and 47 FR 28915,
respectively). The Treasury Department
and the IRS published a notice of
proposed withdrawal of TD 7747 in the
Federal Register on July 6, 1983 (48 FR
31053), and in TD 7920, published in
the Federal Register (48 FR 50711) on
November 3, 1983, the Treasury
Department and the IRS withdrew TD
7747.
The Treasury Department and the IRS
have not previously published any
regulations regarding the 1989
amendment to section 385(a), which
authorizes the Secretary to issue
regulations that treat an interest in a
corporation as indebtedness in part or as
stock in part. In addition, no regulations
have been published with respect to the
1992 addition of section 385(c)
authorizing the Secretary to require
information related to an issuer’s initial

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characterization of an interest for federal
tax purposes or to affect the ability of a
holder to treat an interest inconsistent
with the initial treatment of the issuer.
III. Case Law
In the absence of regulations under
section 385, the pre-1969 case law has
continued to evolve and control the
characterization of an interest as debt or
equity for federal tax purposes. Under
that case law, courts apply inconsistent
sets of factors to determine if an interest
should be treated as stock or
indebtedness, subjecting substantially
similar fact patterns to differing
analyses. The result has been a body of
case law that perpetuates the
‘‘uncertainties and difficulties which
the distinction between debt and equity
has produced’’ and with which
Congress expressed concern when
enacting section 385. See S. Rep. No.
91–552, at 138. For example, in Fin Hay
Realty Co. v. United States, 398 F.2d
694 (3d Cir. 1968), the U.S. Court of
Appeals for the Third Circuit identified
sixteen factors relevant for
distinguishing between indebtedness
and stock:
(1) the intent of the parties; (2) the identity
between creditors and shareholders; (3) the
extent of participation in management by the
holder of the instrument; (4) the ability of the
corporation to obtain funds from outside
sources; (5) the ‘thinness’ of the capital
structure in relation to debt; (6) the risk
involved; (7) the formal indicia of the
arrangement; (8) the relative position of the
obligees as to other creditors regarding the
payment of interest and principal; (9) the
voting power of the holder of the instrument;
(10) the provision of a fixed rate of interest;
(11) a contingency on the obligation to repay;
(12) the source of the interest payments; (13)
the presence or absence of a fixed maturity
date; (14) a provision for redemption by the
corporation; (15) a provision for redemption
at the option of the holder; and (16) the
timing of the advance with reference to the
organization of the corporation.

Id. at 696. By contrast, in Estate of
Mixon v. United States, 464 F.2d 394
(5th Cir. 1972), the U.S. Court of
Appeals for the Fifth Circuit identified
thirteen factors that are similar to, but
not the same as, those used in Fin Hay
to distinguish between indebtedness
and stock:
(1) the names given to the certificates
evidencing the indebtedness; (2) The
presence or absence of a fixed maturity date;
(3) The source of payments; (4) The right to
enforce payment of principal and interest; (5)
participation in management flowing as a
result; (6) the status of the contribution in
relation to regular corporate creditors; (7) the
intent of the parties; (8) ‘thin’ or adequate
capitalization; (9) identity of interest between
creditor and stockholder; (10) source of
interest payments; (11) the ability of the

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

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

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Id. at 402. The weight given to the
various factors in a particular case also
differs, and is highly dependent upon
the relevant facts and circumstances.
See, e.g., J.S. Biritz Construction Co. v.
Commissioner, 387 F.2d 451, 456–57
(8th Cir. 1967) (stating that the factors
‘‘have varying degrees of relevancy,
depending on the particular factual
situation and are generally not all
applicable to any given case’’).
Under this facts-and-circumstances
analysis, as developed in the case law,
no single fact or circumstance is
sufficient to establish that an interest
should be treated as stock or
indebtedness. See, e.g., John Kelley Co.
v. Commissioner, 326 U.S. 521, 530
(1946) (‘‘[N]o one characteristic . . . can
be said to be decisive in the
determination of whether the
obligations are risk investments in the
corporations or debts.’’); Fin Hay, 398
F.2d at 697 (‘‘[N]either any single
criterion nor any series of criteria can
provide a conclusive answer in the
kaleidoscopic circumstances which
individual cases present.’’). It was this
emphasis on particular taxpayer facts
and circumstances, coupled with
inconsistent analysis of the relevant
factors by different courts, that led
Congress to delegate to the Secretary the
authority to provide regulations under
section 385 for distinguishing debt from
equity that could depart from the factors
developed in case law or enumerated in
the statute. See S. Rep. No. 91–552, at
138.
IV. Other Relevant Statutory Provisions
Section 701 provides that a
partnership as such shall not be subject
to federal income tax, but that persons
carrying on business as partners shall be
liable for federal income tax only in
their separate or individual capacities.
Section 1502 provides that the
Secretary shall prescribe such
regulations as the Secretary deems
necessary in order that the federal tax
liability of any affiliated group of
corporations making a consolidated
return and of each corporation in the
group, both during and after the period
of affiliation, may be returned,
determined, computed, assessed,
collected, and adjusted, in such manner
as clearly to reflect the federal income
tax liability and the various factors
necessary for the determination of such
liability, and in order to prevent
avoidance of such tax liability. In

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prescribing such regulations, section
1502 authorizes the Secretary to
prescribe rules that are different from
the provisions of chapter 1 of subtitle A
of the Code that would apply if such
corporations filed separate returns.
Section 7701(l) provides that the
Secretary may prescribe regulations
recharacterizing any multiple-party
financing transaction as a transaction
directly among any two or more of such
parties where the Secretary determines
that such recharacterization is
appropriate to prevent avoidance of any
tax imposed by the Code.
V. Earnings Stripping Guidance
Described in Notice 2014–52 and Notice
2015–79
Notice 2014–52, 2014–42 IRB 712
(Oct. 14, 2014), and Notice 2015–79,
2015–49 IRB 775 (Dec. 7, 2015),
described regulations that the Treasury
Department and the IRS intend to issue
with respect to corporate inversions and
related transactions. Notice 2014–52
and Notice 2015–79 also provided that
the Treasury Department and the IRS
expect to issue additional guidance to
further limit the benefits of postinversion tax avoidance transactions.
The notices stated, in particular, that the
Treasury Department and the IRS are
considering guidance to address
strategies that avoid U.S. tax on U.S.
operations by shifting or ‘‘stripping’’
U.S.-source earnings to lower-tax
jurisdictions, including through
intercompany debt.
VI. Purpose of the Proposed Regulations
These proposed regulations under
section 385 address whether an interest
in a related corporation is treated as
stock or indebtedness, or as in part stock
or in part indebtedness, for purposes of
the Code. While these proposed
regulations are motivated in part by the
enhanced incentives for related parties
to engage in transactions that result in
excessive indebtedness in the crossborder context, federal income tax
liability can also be reduced or
eliminated with excessive indebtedness
between domestic related parties. Thus,
the proposed rules apply to purported
indebtedness issued to certain related
parties, without regard to whether the
parties are domestic or foreign.
Nonetheless, the Treasury Department
and the IRS also have determined that
the proposed regulations should not
apply to issuances of interests and
related transactions among members of
a consolidated group because the
concerns addressed in the proposed
regulations generally are not present
when the issuer’s deduction for interest
expense and the holder’s corresponding

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interest income offset on the group’s
consolidated federal income tax return.
Section A of this Part VI addresses
bifurcation of interests that are
indebtedness in part but not in whole.
Section B of this Part VI addresses
documentation requirements for relatedparty indebtedness. Section C of this
Part VI addresses distributions of debt
instruments and similar transactions.
A. Interests That Are Indebtedness in
Part but Not in Whole
As previously noted, Congress
amended section 385(a) in 1989 to
authorize the issuance of regulations
permitting an interest in a corporation
to be treated as in part indebtedness and
in part stock. The legislative history to
the 1989 amendment explained that
‘‘there has been a tendency by the courts
to characterize an instrument entirely as
debt or entirely as equity.’’ H.R. Rep.
No. 101–386, at 562 (1989) (Conf. Rep.).
No regulations have been promulgated
under the amendment, however, and
this tendency by the courts has
continued to the present day.
Consequently, the Commissioner
generally is required to treat an interest
in a corporation as either wholly
indebtedness or wholly equity.
This all-or-nothing approach is
particularly problematic in cases where
the facts and circumstances surrounding
a purported debt instrument provide
only slightly more support for
characterization of the entire interest as
indebtedness than for equity
characterization, a situation that is
increasingly common in the relatedparty context. The Treasury Department
and the IRS have determined that the
all-or-nothing approach frequently fails
to reflect the economic substance of
related-party interests that are in form
indebtedness and gives rise to
inappropriate federal tax consequences.
Accordingly, the Treasury Department
and the IRS have determined that the
interests of tax administration would
best be served if the Commissioner were
able to depart from the all-or-nothing
approach where appropriate to ensure
that the provisions of the Code are
applied in a manner that clearly reflects
the income of related taxpayers. To that
end, these proposed regulations would
exercise the authority granted by section
385(a) to permit the Commissioner to
treat a purported debt instrument issued
between related parties as in part
indebtedness and in part stock for
federal tax purposes. However, the
proposed regulations would not permit
issuers and related holders to treat such
an instrument in a manner inconsistent
with the issuer’s initial characterization.
The proposed regulations described in

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Federal Register / Vol. 81, No. 68 / Friday, April 8, 2016 / Proposed Rules
Part IV.B.2 of the Explanation of
Provisions section of this preamble also
rely in part on the authority granted
under section 385(a) to treat interests as
in part indebtedness and in part stock
for federal tax purposes.
The proposed rule applies with
respect to parties that meet a lower 50percent threshold for relatedness than
the threshold applicable with respect to
other rules contained in these proposed
regulations. This is because, as noted in
Part VI of the Background section of this
preamble, federal income tax liability
can be reduced or eliminated by the
introduction of excessive indebtedness
between related parties, and this can be
accomplished without special
cooperation among the related parties
and regardless of other transactions
undertaken by the issuer or holder after
issuance. In addition, a 50-percent
relatedness threshold is consistent with
other provisions used in subchapter C of
the Code to identify a level of control or
ownership that can warrant different
federal tax consequences than those for
less-related parties.
The proposed rule merely permits the
Commissioner to treat a purported debt
instrument as in part indebtedness and
in part stock consistent with its
substance. Moreover, the proposed
regulations would not affect the
authority of the Commissioner to
disregard a purported debt instrument
as indebtedness or stock, to treat a
purported debt instrument as
indebtedness or equity of another entity,
or otherwise to treat a purported debt
instrument in accordance with its
substance. See, e.g., Plantation Patterns
v. Commissioner, 462 F.2d 712 (5th Cir.
1972).
The Treasury Department and the IRS
recognize that authorizing the
Commissioner to treat purported debt
instruments issued among unrelated
parties as indebtedness in part and stock
in part could result in unnecessary
uncertainty in the capital markets in the
absence of detailed standards for the
exercise of that authority. Similarly, any
exercise of this authority with respect to
related-party interests that are
denominated as other than indebtedness
would require more detailed guidance.
Thus, the proposed rule does not apply
in those contexts.
B. Related-Party Indebtedness
1. Background
Related-party indebtedness, like
indebtedness between unrelated
persons, may be respected as
indebtedness for federal tax purposes,
but only if there is intent to create a true
debtor-creditor relationship that results

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in bona fide indebtedness. While still
subject to the same multifactor analysis
used for characterizing interests issued
between third parties, ‘‘courts have
consistently recognized that
transactional forms between related
parties are susceptible of manipulation
and, accordingly, warrant a more
thorough and discerning examination
for tax characterization purposes.’’
PepsiCo Puerto Rico, Inc. v.
Commissioner, T.C. Memo 2012–269, at
51, citing United States v. Uneco, Inc.,
532 F.2d 1204, 1207 (8th Cir. 1976);
Cuyuna Realty Co. v. United States, 382
F.2d 298, 301 (Ct. Cl. 1967) (stating that
an advance between a parent
corporation and a subsidiary or other
affiliate under common control must be
subject to particular scrutiny ‘‘because
the control element suggests the
opportunity to contrive a fictional debt,
an opportunity less present in an armslength transaction between strangers.’’).
This scrutiny is warranted because
there is typically less economic
incentive for a related-party lender to
impose discipline on the legal
documentation and economic analysis
supporting the characterization of an
interest as indebtedness for federal tax
purposes. While a lender typically
carefully documents a loan to a third
party borrower and decides whether and
how much to lend based on that
documentation and objective financial
criteria, a related-party lender,
especially one that directly or indirectly
controls the borrower, may require only
simple (or even no) legal documentation
and may forgo any economic analysis
that would inform the lender of the
amount that the borrower could
reasonably be expected to repay.
The absence of reasonable diligence
by related-party lenders can have the
effect of limiting the factual record that
is available for additional scrutiny and
thorough examination. Nonetheless,
courts do not always require related
parties to engage in reasonable financial
analysis and legal documentation
similar to that which business
exigencies would incent third-parties in
connection with lending to unrelated
borrowers. See, e.g., C.M. Gooch Lumber
Sales Co. v. Commissioner, 49 T.C. 649
(1968) at 656 (noting that in the case of
related-party debt, ‘‘the absence of a
written debt instrument, security, or
provision for the payment of interest is
not controlling; formal evidences of
indebtedness are at best clues to proof
of the ultimate fact’’); see also Byerlite
Corp. v. Williams, 286 F.2d 285, 290–91
(6th Cir. 1960), citing Ewing v.
Commissioner, 5 T.C. Memo 908 (1946)
(‘‘The fact that advancements to a
corporation are made without requiring

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any evidence of indebtedness . . . was
not a controlling consideration . . .’’).
Historically, the absence of clear
guidance regarding the documentation
and information necessary to support
debt characterization in the relatedparty context did not pose a significant
obstacle, because the transactions
presented by cases such as Mixon, Fin
Hay, and their progeny were not
factually complex. Typically, the earlier
cases involved direct advances between
individual U.S. taxpayers and their
closely held domestic corporations. The
relevant documentation was readily
identifiable, available on hand, and able
to be analyzed by the Commissioner in
due course. Further, when the case law
was developing, the dollar amounts at
stake were comparatively modest. In Fin
Hay, the shareholder advances gave rise
to a total federal tax liability of $3,241;
in Mixon, the shareholder advances
gave rise to a total federal tax liability
of $126,964.
Increasingly, this is no longer the
case. Over time, the Treasury
Department and the IRS have observed
that business practices, structures, and
activities between related parties have
changed considerably. The Treasury
Department and the IRS acknowledge
that the size, activities, and financial
complexity of corporations and their
group structures have grown
exponentially, and understand that
these groups routinely include foreign
entities, sometimes from multiple
foreign jurisdictions, as well as federal
tax-indifferent domestic members. The
scope and complexity of intragroup
transactions has grown
commensurately. Examples include the
transactions at issue in PepsiCo Puerto
Rico, Inc. v. Commissioner and NA
General Partnership & Subsidiaries v.
Commissioner, T.C. Memo 2012–172,
both involving the global restructuring
of multinational corporate groups.
As a result of these developments, it
is increasingly problematic that there is
a lack of guidance prescribing the
information and documentation
necessary to support the
characterization of a purported debt
instrument as indebtedness in the
related-party context. The lack of such
guidance, combined with the sheer
volume of financial records taxpayers
produce in the ordinary course of
business, makes it difficult to identify
the documents that will ultimately be
required to support such a
characterization, particularly with
respect to whether a reasonable
expectation of repayment is present at
the time an interest is issued. The result
can be either the inadvertent omission
of necessary documents from disclosure

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to the IRS or the provision of vast
amounts of irrelevant documents and
material, such that forensic accounting
expertise is required to isolate and
evaluate relevant information. In either
case, the ability of the Commissioner to
administer the Code efficiently with
respect to related-party interests is
impeded. In addition, the absence of
guidance makes it difficult for U.S.
taxpayers to determine timely what
steps they must take to ensure that
essential records are not only prepared,
but also maintained in a manner that
will facilitate their being made available
upon request, particularly regarding
transactions with related parties whose
books and records are located in foreign
jurisdictions.
Finally, the dollar amounts at stake
have often become increasingly
significant. For example, the federal tax
liability at issue in PepsiCo was
$363,056,012; the federal tax liability at
issue in NA General Partnership was
$188,000,000. As a result, it has become
increasingly important to prescribe rules
that identify the types of documentation
and information necessary to support
the characterization of a related-party
interest as indebtedness for federal tax
purposes.
2. Proposed Regulations Addressing
Documentation Requirements
To address these concerns, the
Treasury Department and the IRS are
proposing rules, under the authority
granted in section 385(a) to prescribe
regulations to determine whether an
interest in a corporation is stock or
indebtedness, that prescribe the nature
of the documentation and information
that must be prepared and maintained
for a purported debt instrument issued
by a corporation to a related party to be
treated as indebtedness for federal tax
purposes. The proposed regulations are
intended to impose discipline on related
parties by requiring timely
documentation and financial analysis
that is similar to the documentation and
analysis created when indebtedness is
issued to third parties. This requirement
also serves to help demonstrate whether
there was intent to create a true debtorcreditor relationship that results in bona
fide indebtedness and also to help
ensure that the documentation
necessary to perform an analysis of a
purported debt instrument is prepared
and maintained. This approach is
consistent with the long-standing view
held by courts that the taxpayer has the
burden of substantiating its treatment of
an arrangement as indebtedness for
federal tax purposes. Hollenbeck v.
Commissioner, 422 F.2d 2, 4 (9th Cir.
1970).

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In general, the Treasury Department
and the IRS have determined that timely
preparation of documentation and
financial analysis evidencing four
essential characteristics of indebtedness
are a necessary factor in the
characterization of a covered interest as
indebtedness for federal tax purposes.
Those characteristics are: a legally
binding obligation to pay, creditors’
rights to enforce the obligation, a
reasonable expectation of repayment at
the time the interest is created, and an
ongoing relationship during the life of
the interest consistent with arms-length
relationships between unrelated debtors
and creditors. These characteristics are
drawn from the case law and are
consistent with the text of section
385(b)(1) and (5). While the proposed
regulations do not intend to alter the
general case law view of the importance
of these essential characteristics of
indebtedness, the proposed regulations
do require a degree of discipline in the
creation of necessary documentation,
and in the conduct of reasonable
financial diligence indicative of a true
debtor-creditor relationship, that
exceeds what is required under current
law. See, e.g., C.M. Gooch Lumber Sales
Co., 49 T.C. 649; Byerlite Corp., 286 F.2d
285.
The proposed regulations make clear
that the preparation and maintenance of
this documentation and information are
not dispositive in establishing that a
purported debt instrument is
indebtedness for federal tax purposes.
Rather, these requirements are necessary
to the conduct of the multi-factor
analysis used in the Mixon and Fin Hay
line of cases to determine the nature of
an interest as indebtedness for federal
tax purposes.
C. Certain Distributions of Debt
Instruments and Similar Transactions
1. In General
The Treasury Department and the IRS
have identified three types of
transactions between affiliates that raise
significant policy concerns and that
should be addressed under the
Secretary’s authority to prescribe rules
for particular factual situations: (1)
distributions of debt instruments by
corporations to their related corporate
shareholders; (2) issuances of debt
instruments by corporations in
exchange for stock of an affiliate
(including ‘‘hook stock’’ issued by their
related corporate shareholders); and (3)
certain issuances of debt instruments as
consideration in an exchange pursuant
to an internal asset reorganization.
Similar policy concerns arise when a
related-party debt instrument is issued

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in a separate transaction to fund (1) a
distribution of cash or other property to
a related corporate shareholder; (2) an
acquisition of affiliate stock from an
affiliate; or (3) certain acquisitions of
property from an affiliate pursuant to an
internal asset reorganization.
Accordingly, the proposed regulations
treat related-party debt instruments
issued in any of the foregoing
transactions as stock, subject to certain
exceptions.
Sections C.2 through C.5 of this Part
VI describe in greater detail the
purposes of the proposed regulations
that apply to these types of transactions.
Part IV of the Explanation of Provisions
section of this preamble describes in
detail the proposed regulations.
2. Debt Instrument Issued in a
Distribution
In Kraft Foods Co. v. Commissioner,
232 F.2d 118 (2d Cir. 1956), the U.S.
Court of Appeals for Second Circuit
addressed a situation in which a
domestic corporate subsidiary issued
indebtedness in the form of debentures
to its sole shareholder, also a domestic
corporation, in payment of a dividend.
The parent and subsidiary were
required to file separate returns under
the Code in effect during the years at
issue, and, before taking into account
the interest income and deductions on
the distributed indebtedness, the parent
corporation had losses and the
subsidiary was profitable.
The court considered arguments by
the government that the parentsubsidiary relationship warranted
additional scrutiny in determining
whether a debtor-creditor relationship
was established in substance. In
particular, the Commissioner argued
that, because the issuer subsidiary was
wholly-owned, ‘‘the sole stockholder
[could] deal as it please[d] with the
corporate entity it control[led]’’ and, as
a result, the transaction could have been
a sham. Id. at 123. The Commissioner
also argued that the debentures should
be treated as stock because no new
capital was introduced into the
subsidiary in connection with the
issuance of the debentures, see id. at
126–27, and because the taxpayer
conceded that the issuance of the
debentures in payment of the dividend
lacked a business purpose other than tax
minimization. See id. at 127–28.
In holding for the taxpayer, the
Second Circuit determined that the
debentures should be respected as
indebtedness because the debentures
were unambiguously denominated as
debt, were issued by and to real taxable
entities, and created real legal rights and
duties between the parties. See id. at

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Federal Register / Vol. 81, No. 68 / Friday, April 8, 2016 / Proposed Rules
127–28. In a dissenting opinion, Chief
Judge Clark supported ‘‘test[ing] the
genuineness of the intercorporate
indebtedness by objective standards’’
that would disregard indebtedness
issued in this circumstance, and warned
that the majority opinion would open ‘‘a
large leak . . . operable merely by
denominating an intercorporate
allocation of surplus a debt’’ and would
‘‘[s]urely . . . stimulate imitators.’’ Id. at
129.
Other courts have not given the same
level of deference to the form of a
transaction that the Second Circuit did
in Kraft and have treated purported
indebtedness as stock in similar
circumstances. For example, some
courts have closely scrutinized
situations in which indebtedness is
owed in proportion to stock ownership
to determine whether a debtor-creditor
relationship exists in substance. See,
e.g., Uneco, Inc. v. United States, 532
F.2d 1204, 1207 (8th Cir. 1976)
(‘‘Advances between a parent
corporation and a subsidiary or other
affiliate are subject to particular scrutiny
. . . .’’); Arlington Park Jockey Club, Inc.
v. Sauber, 262 F.2d 902, 906 (7th Cir.
1959) (‘‘It has been held that [a cash
advance made in proportion to stock
ownership] gives rise to a strong
inference that the advances represent
additional capital investment and not
loans.’’ (citing Schnitzer v.
Commissioner, 13 T.C. 43, aff’d 183
F.2d 70 (9th Cir. 1950))). Consistent
with those decisions, section 385(b)(5)
specifically authorizes the Secretary, in
issuing regulations distinguishing
between stock and indebtedness, to take
into account ‘‘the relationship between
holdings of stock in the corporation and
holdings of the interest in question.’’
Courts also have given weight to the
lack of new capital investment when a
closely-held corporation issues
indebtedness to a controlling
shareholder but receives no new
investment in exchange. See, e.g.,
Talbot Mills v. Commissioner, 146 F.2d
809 (1st Cir. 1944) (emphasizing that a
transaction involved no new
investment, did not affect proportionate
ownership, and was motivated
primarily by tax benefits in holding that
a closely-held corporation’s
participating notes should be treated as
stock when each stockholder exchanged
four-fifths of its existing stock for notes
with a face amount equal to the par
value of the stock surrendered), aff’d
sub nom, John Kelley Co. v.
Commissioner, 326 U.S. 521 (1946);
Sayles Finishing Plants, Inc. v. United
States, 399 F.2d 214 (Ct. Cl. 1968)
(noting that a ‘‘lack of new money can
be a significant factor in holding a

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purported indebtedness to be a capital
transaction, particularly when the facts
otherwise show that the purported
indebtedness was merely a continuation
of the stock interests allegedly
converted’’).
In many contexts, a distribution of a
debt instrument similar to the one at
issue in Kraft lacks meaningful non-tax
significance, such that respecting the
distributed instrument as indebtedness
for federal tax purposes produces
inappropriate results. For example,
inverted groups and other foreignparented groups use these types of
transactions to create interest
deductions that reduce U.S. source
income without investing any new
capital in the U.S. operations. In
addition, U.S.-parented groups obtain
distortive results by, for example, using
these types of transactions to create
interest deductions that reduce the
earnings and profits of controlled
foreign corporations (CFCs) and to
facilitate the repatriation of untaxed
earnings without recognizing dividend
income. An example of the latter type of
transaction could involve the
distribution of a note from a first-tier
CFC to its United States shareholder in
a taxable year when the distributing
CFC has no earnings and profits
(although lower-tier CFCs may) and the
United States shareholder has basis in
the CFC stock. In a later taxable year,
when the distributing CFC had untaxed
earnings and profits (such as by reason
of intervening distributions from lowertier CFCs), the CFC could use cash
attributable to the earnings and profits
to repay the note owed to its United
States shareholder. The taxpayer takes
the position that the note should be
respected as indebtedness and,
therefore, that the repayment of the note
does not result in any of the untaxed
earnings and profits of the CFC being
taxed as a dividend to the United States
shareholder.
In light of these policy concerns, the
proposed regulations treat a debt
instrument issued in fact patterns
similar to that in Kraft as stock. The
factors discussed in Kraft and Talbot
Mills, including the parent-subsidiary
relationship, the fact that no new capital
is introduced in connection with a
distribution of debentures, and the
typical lack of a substantial non-tax
business purpose, support the
conclusion that the issuance of a debt
instrument in a distribution is a
transaction that frequently has minimal
or nonexistent non-tax effects.
Moreover, although the holder of a debt
instrument has different legal rights
than a holder of stock, the distinction
between those rights usually has limited

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20917

significance when the parties are
related. Subsidiaries often do not have
significant amounts of debt financing
from unrelated lenders (other than trade
payables) and, to the extent they do,
they may minimize any potential impact
of related-party debt on unrelated
creditors, for example, by subordinating
the related-party debt instrument.
Thus, any non-tax effects of a
distribution of a debt instrument to an
affiliate are often minimized or
eliminated, allowing the related parties
to obtain significant federal tax benefits
at little or no cost. Accordingly, based
on these considerations, the Treasury
Department and the IRS have
determined that in fact patterns similar
to Kraft it is appropriate to treat a debt
instrument as stock.
3. Debt Instrument Issued in Exchange
for Affiliate Stock
The Treasury Department and the IRS
have determined that the issuance of a
related-party debt instrument to acquire
stock of a related person is similar in
many respects to a distribution of a debt
instrument and implicates similar
policy considerations. Recognizing the
economic similarities between
purchases of affiliate stock and
distributions, Congress enacted section
304 and its predecessors to prevent
taxpayers from acquiring affiliate stock
to convert what otherwise would be a
taxable dividend into a sale or exchange
transaction. See S. Rep. No. 83–1622 at
46 (1954) (noting that, under section
304, ‘‘where the effect of the sale [of
related-party stock] is in reality the
distribution of a dividend, it will be
taxed as such’’). Similarly, if the
proposed regulations addressed only
debt instruments issued in a
distribution, and not acquisitions of
affiliate stock that have the effect of a
distribution, taxpayers would readily
substitute the latter transaction for the
former in order to produce the
inappropriate tax result that the
proposed regulations are intended to
prevent.
Like distributions of debt instruments,
issuances of debt instruments to acquire
affiliate stock frequently have limited
non-tax significance, particularly in
relation to the significant federal tax
benefits that are generated in the
transaction. Such transactions do not
change the ultimate ownership of the
affiliate, and introduce no new
operating capital to either affiliate.
While the change in the direct
ownership of the affiliate’s stock may
have some non-tax significance in
certain circumstances, such as the
harmonization of a group’s corporate
structure following an acquisition, other

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purchases of affiliate stock, including
purchases of ‘‘hook stock’’ from a parent
in exchange for a debt instrument,
typically possess almost no non-tax
significance.
Accordingly, the proposed regulations
generally treat a debt instrument issued
in exchange for affiliate stock as stock.
4. Debt Instrument Issued Pursuant to
an Internal Asset Reorganization
The proposed regulations also address
certain debt instruments issued by an
acquiring corporation as consideration
in an exchange pursuant to an internal
asset reorganization. Internal asset
reorganizations can operate in a similar
manner to section 304 transactions as a
device to convert what otherwise would
be a distribution into a sale or exchange
transaction without having any
meaningful non-tax effect. Congress
noted this similarity in 1984 when it
harmonized the control requirement for
section 368(a)(1)(D) reorganizations
with the control requirement in section
304. See Staff of Joint Comm. on
Taxation, 98th Cong., General
Explanation of the Revenue Provisions
of the Deficit Reduction Act of 1984 193
(Comm. Print 1984) (‘‘The D
reorganization provisions address the
bail-out problem in the context of a
transfer of assets by 1 corporation to
another. Section 304 deals with the
problem in the context of a transfer of
stock by shareholders to a corporation
they control.’’).
Consider the following example: A
foreign parent corporation (Parent) owns
all of the stock of two U.S. subsidiaries,
S1 and S2. In a transaction qualifying as
a reorganization described in section
368(a)(1)(D), Parent transfers its stock in
S1 to S2 in exchange for a note issued
by S2, and S1 converts to a limited
liability company. For federal tax
purposes, S1 is treated as selling all of
its assets to S2 in exchange for a debt
instrument, and under section 356,
Parent is treated as receiving the S2 debt
instrument from S1 in a liquidating
distribution with respect to Parent’s S1
stock. This transaction has a similar
effect (and tax treatment) as a section
304 transaction in which S2 issues a
debt instrument to Parent in exchange
for S1 stock, with the only difference
being that S2 acquired the assets of S1
instead of the S1 stock and that Parent
received the debt instrument as a result
of the liquidation of S1.
This transaction introduces no new
capital into the P group, and does not
affect the ultimate ownership of the
assets held by S1 or S2. Furthermore, S1
generally would not be required to
recognize any built-in gain on the
transfer of its assets to S2. Although this

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transaction entails a transfer of assets
from S1 to S2, the tax costs (if any) and
the non-tax consequences that result
from this type of transaction among
related parties are typically insignificant
relative to the federal tax benefits
obtained through the introduction of a
related-party debt instrument.
Accordingly, the proposed regulations
treat a debt instrument issued by an
acquiring corporation as consideration
in an exchange pursuant to an internal
asset reorganization as stock, consistent
with the treatment of a debt instrument
issued in a distribution or in exchange
for affiliate stock.
5. Debt Instrument Issued With a
Principal Purpose of Funding Certain
Distributions and Acquisitions
The Treasury Department and the IRS
have determined that the policy
concerns implicated by the transactions
described in Sections C.2 through C.4 of
this Part VI are also present when a
corporation issues a debt instrument
with a principal purpose of funding
certain related-party transactions.
Specifically, the proposed regulations
treat a debt instrument issued for
property, including cash, as stock when
the debt instrument is issued to an
affiliate with a principal purpose of
funding (1) a distribution of cash or
other property to a related corporate
shareholder, (2) an acquisition of
affiliate stock from an affiliate, or (3)
certain acquisitions of property from an
affiliate pursuant to an internal asset
reorganization.
Without these funding provisions,
taxpayers that otherwise would have
issued a debt instrument in a one-step
transaction described in Sections C.2
through C.4 of this Part VI would be
able to use multi-step transactions to
avoid the application of these proposed
regulations while achieving
economically similar outcomes. For
example, a wholly-owned subsidiary
that otherwise would have distributed a
debt instrument to its parent
corporation in a distribution could,
absent these rules, borrow cash from its
parent and later distribute that cash to
its parent in a transaction that is
purported to be independent from the
borrowing. Like the distribution of a
note, this transaction, if respected,
would result in an increase of relatedparty debt, but no new net investment
in the operations of the subsidiary. The
parent corporation would have
effectively reshuffled its subsidiary’s
capital structure to obtain more
favorable federal tax treatment for the
subsidiary without affecting its control
over the subsidiary. The similarity
between these transactions indicates

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that they should be subject to similar tax
treatment.
The Treasury Department and the IRS
also have determined that a debt
instrument should be subject to these
funding rules regardless of whether the
funding affiliate (the lender) is a party
to the funded transaction. Otherwise, a
corporation could, for example, borrow
funds from a sister corporation and
immediately distribute those funds to
the common parent corporation.
Issuances of debt instruments to an
affiliate in order to fund a distribution
of property, an acquisition of affiliate
stock, or an acquisition of an affiliate’s
assets in a reorganization often would
confer significant federal tax benefits
without having a significant non-tax
impact, regardless of whether the lender
is also a party to the funded transaction.
Accordingly, the proposed regulations
treat as stock a debt instrument issued
to an affiliate to fund one of the
specified transactions regardless of
whether the lender is a party to the
funded transaction.
Explanation of Provisions
I. Overview
The proposed regulations provide
guidance regarding substantiation of the
treatment of certain interests issued
between related parties as indebtedness
for federal tax purposes, the treatment of
certain interests in a corporation as in
part indebtedness and in part stock, and
the treatment of distributions of debt
instruments and similar transactions
that frequently have only limited nontax effects. More specifically, the
proposed regulations are set forth in
four sections. First, proposed § 1.385–1
prescribes definitions and operating
rules applicable to the regulations under
section 385 generally, including a rule
treating members of a consolidated
group, as defined in § 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
taxpayers must prepare and maintain
within required timeframes to
substantiate the treatment of an interest
issued between related parties as
indebtedness for federal tax purposes.
Such substantiation is necessary, but
not sufficient, for a purported debt
interest that is within the scope of these
rules to be characterized as
indebtedness; general federal income
tax principles also apply in making such
a determination. Third, if the
application of proposed § 1.385–2 and

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general federal income tax principles
otherwise would result in treating an
interest issued to a related 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
frequently having only limited non-tax
effect, or is issued to fund such a
transaction. Finally, proposed § 1.385–4
provides operating rules for applying
proposed § 1.385–3 to interests that
cease to be between members of the
same consolidated group or interests
that become interests between members
of the same consolidated group.
II. Generally Applicable Definitions and
Special Rules

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A. Definition of Expanded Group
As previously discussed, the concerns
addressed by the proposed regulations
arise with respect to interests issued
among related parties. The scope of the
proposed regulations is therefore
generally limited to purported
indebtedness between members of an
expanded group. Proposed § 1.385–1,
which sets forth definitions generally
applicable to the regulations proposed
under section 385, defines the term
expanded group by reference to the term
affiliated group in section 1504(a).
However, the proposed regulations
broaden the definition in several ways.
Unlike an affiliated group, an expanded
group includes foreign and tax-exempt
corporations, as well as corporations
held indirectly, for example, through
partnerships. Further, in determining
relatedness, the proposed regulations
adopt the attribution rules of section
304(c)(3). The proposed regulations also
modify the definition of affiliated group
to treat a corporation as a member of an
expanded group if 80 percent of the vote
or value is owned by expanded group
members (instead of 80 percent of the
vote and value, as generally required
under section 1504(a)).
Through this definition of an
expanded group, the application of the
proposed regulations is limited to
transactions between highly-related
parties. Other rules, discussed in
Section III.A (limiting the application of
proposed § 1.385–2 to large taxpayers)
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

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generally of an exchange of purported
indebtedness for stock that is deemed to
occur under the proposed regulations.
Under those rules, on the date the
indebtedness is recharacterized as stock,
the indebtedness is deemed to be
exchanged, in whole or in part, for stock
with a value that is equal to the holder’s
adjusted basis in the portion of the
indebtedness that is treated as equity
under the regulations, and the issuer of
the indebtedness is deemed to retire the
same portion of the indebtedness for an
amount equal to its adjusted issue price
as of that date. This rule generally will
prevent both the holder and issuer from
realizing gain or loss from the deemed
exchange other than foreign exchange
gain or loss recognized by the issuer or
the holder under section 988.
C. Treatment of Certain Instruments as
in Part Indebtedness and as in Part
Stock
Proposed § 1.385–1 implements the
statutory authority under section 385(a)
to treat an instrument as part
indebtedness and part stock by
authorizing the Commissioner to treat
certain instruments issued between
related parties in this manner. Any such
treatment will occur only in the event
that the substance of the instrument is
regarded for federal tax purposes and
the instrument has met the
documentation and information
requirements in proposed § 1.385–2
(described subsequently in Section III),
if applicable. In addition, the
Commissioner is not required to treat
such an interest as indebtedness in part
and stock in part. For example, under
the proposed regulations, if an analysis
of a related-party interest that is
documented as a $5 million debt
instrument demonstrates that the issuer
cannot reasonably be expected to repay
more than $3 million of the principal
amount as of the issuance of the
interest, the Commissioner may treat the
interest as part indebtedness ($3
million) and part stock ($2 million). The
type of stock (for example, common
stock or preferred stock, section 306
stock, stock described in section
1504(a)(4)) that the instrument will be
treated as for federal tax purposes is
determined by taking into account the
terms of the instrument (for example,
voting and conversion rights and rights
relating to dividends, redemption,
liquidation, and other distributions).
The Treasury Department and the IRS
believe that this approach will facilitate
the treatment of purported debt
instruments issued between related
parties in a manner that is more
consistent with the substance of the
underlying transaction.

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Pursuant to section 385(c) and the
regulatory authority granted the
Secretary under section 385(c)(2), the
issuer of the interest, the holder of the
interest, and any other person relying on
the characterization of the interest as
indebtedness for federal tax purposes
are all required to treat the interest
consistent with the issuer’s initial
characterization. Thus, for example, a
holder may not disclose on its return
under section 385(c)(2) that it is treating
an EGI, as later defined in Section III.A
of this Explanation of Provisions, as
indebtedness in part or stock in part if
the issuer of the EGI treats the EGI as
indebtedness. This approach eliminates
cases in which members of the same
expanded group take contrary positions
as to the treatment of an EGI as
indebtedness, stock, or indebtedness in
part and stock in part.
The proposed regulations authorize
the treatment of an interest as
indebtedness in part and stock in part
in the case of instruments issued in the
form of debt between parties that are
related, but at a lesser degree of
relatedness than that required to include
them in an expanded group. Under the
proposed regulations, treatment as
indebtedness in part and stock in part
can apply to purported indebtedness
between members of modified expanded
groups (which are defined in the same
manner as expanded groups, but
adopting a 50-percent ownership test
and including certain partnerships and
other persons). The 50-percent
relatedness threshold contained in the
definition of modified expanded group
is consistent with other provisions used
in subchapter C of the Code to identify
a level of control or ownership that can
warrant different federal tax
consequences than those of less-related
parties. For example, a similar threshold
applies in determining whether (i)
control exists under section 304(c), (ii)
attribution to and from corporations is
applicable under section 318, (iii)
persons are related under section 267(b),
which is incorporated into numerous
provisions of the Code, (iv) a
redemption is substantially
disproportionate under section
302(b)(2), (v) a disqualified distribution
has occurred under section 355(d), (vi)
a distribution is subject to section
355(e), and (vii) corporations are under
common control for purposes of section
334. The Treasury Department and the
IRS request comments on whether it
would be helpful or appropriate to have
this rule apply more generally.
D. Consolidated Groups
As described in Part VI of the
Background section of this preamble,

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

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III. Substantiation of Related-Party
Indebtedness: Proposed § 1.385–2
A. In General
Proposed § 1.385–2 reflects the
importance of contemporaneous
documentation in identifying the rights,
obligations, and intent of the parties to
an instrument that is purported to be
indebtedness for federal tax purposes.
Such documentation is particularly
important to the analysis of instruments
issued between related parties. In
recognition of this importance, the
Treasury Department and the IRS are
exercising authority granted under
section 385(a) to treat the timely
preparation and maintenance of such
documentation as necessary factors to
be taken into account in determining
whether certain interests are properly
characterized as stock or indebtedness.
Accordingly, the proposed regulations
first prescribe the nature of the
documentation necessary to substantiate
the treatment of related-party
instruments as indebtedness and,
second, require that such
documentation be timely prepared and
maintained. The proposed regulations
further provide that, if the specified
documentation is not provided to the
Commissioner upon request, the
Commissioner will treat the preparation
and maintenance requirements as not
satisfied and will treat the instrument as
stock for federal tax purposes. The type
of stock (for example, common stock or
preferred stock, section 306 stock, stock
described in section 1504(a)(4)) that the
instrument will be treated as for federal
tax purposes is determined by taking
into account the terms of the instrument
(for example, voting and conversion
rights and rights relating to dividends,
redemption, liquidation, and other
distributions).
Satisfaction of the requirements of the
proposed regulations does not establish
that a related-party instrument is
indebtedness. Rather, satisfaction of the
proposed regulations acts as a threshold
test for allowing the possibility of

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indebtedness treatment after the
determination of an instrument’s
character is made under federal tax
principles developed under applicable
case law. If the requirements of the
proposed regulations are not satisfied,
the purported indebtedness would be
recharacterized as stock. In such a case,
any federal tax benefit claimed by the
taxpayer with respect to the treatment of
the interest as indebtedness will be
disallowed.
Judicial doctrines that disregard
transactions as having no substance
continue to be applicable and are not
affected by the proposed regulations.
Accordingly, proposed § 1.385–2
applies only to interests the substance of
which is potentially regarded as
indebtedness for federal tax purposes. In
addition, proposed § 1.385–2 does not
limit the ability of the IRS to request
information under any existing
authorities, such as the rules under
section 7602.
As discussed previously, these
proposed regulations apply only to
purported indebtedness issued among
entities that are highly related. Several
provisions of the proposed regulations
combine to effect this limitation.
First, proposed § 1.385–2 provides
rules only with respect to applicable
instruments, that is, interests issued in
the form of debt. Thus, these proposed
regulations do not apply to any interest
or arrangement that is not, in form,
indebtedness. The documentation and
other rules in proposed § 1.385–2(b) are
tailored to arrangements that in form are
traditional debt instruments and do not
address other arrangements that may be
treated as indebtedness under general
federal tax principles. The proposed
regulations under § 1.385–2 reserve with
respect to documentation of interests
that are not in form indebtedness.
Because there are a large number of
ways to document these arrangements,
rules that provide sufficient information
about these arrangements will need to
contain specific documentation and
timing requirements depending on the
type of arrangement. Accordingly, the
Treasury Department and the IRS
request comments regarding the
appropriate documentation and timing
requirements for the various forms that
these arrangements can take.
Second, proposed § 1.385–2 only
applies to applicable interests that are
issued and held by members of an
expanded group (expanded group
instruments, or EGI). For purposes of
§ 1.385–2, controlled partnerships are
treated as members of the expanded
group, and the term controlled
partnership is defined as any
partnership the capital or profits interest

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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 term
issuer means a person that is obligated
to satisfy any material payment
obligations created under the terms of
an EGI. For this purpose, a disregarded
entity can be treated as the issuer. A
person can be an issuer if that person is
expected to satisfy a material obligation
under an EGI, even if that person is not
the primary obligor. A guarantor,
however, is not an issuer unless the
guarantor is treated as the primary
obligor under federal tax principles.
See, e.g., Plantation Patterns, Inc. v.
Commissioner, 462 F.2d 712 (5th Cir.
1972).
Third, proposed § 1.385–2 is intended
to apply only to large taxpayer groups.
Accordingly, an EGI is not subject to
proposed § 1.385–2 unless the stock of
any member of the expanded group is
publicly traded, all or any portion of the
expanded group’s financial results are
reported on financial statements with
total assets exceeding $100 million, or
the expanded group’s financial results
are reported on financial statements that
reflect annual total revenue that exceeds
$50 million. The proposed regulations
provide guidance regarding the financial
statement or statements that are to be
used for purposes of determining the
expanded group’s assets and liabilities.
In general, this determination is made
by reference to a financial statement
required to be filed with the Securities
and Exchange Commission, a certified
audited financial statement that is
accompanied by the report of an
independent certified public accountant
(or in the case of a foreign entity, by the
report of a similarly qualified
independent professional) that is used
for certain purposes, or a financial
statement (other than a tax return)
required to be provided to the federal,
state, or foreign government or any
federal, state, or foreign agency. Because
this list represents a set of financial
statements created for other purposes
for persons outside the expanded group,
these financial statements are expected
to be sufficiently reliable for this
purpose. In addition, to prevent the use
of stale financial information, only
applicable financial statements prepared
within the three years of the EGI
becoming subject to the proposed
regulations are relevant for determining
whether an EGI is subject to the
proposed regulations under § 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

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Federal Register / Vol. 81, No. 68 / Friday, April 8, 2016 / Proposed Rules
documentation and information that
must be prepared and maintained to
support the characterization of an EGI as
indebtedness for federal tax purposes.
The regulations organize the
requirement into four categories, each
reflecting an essential characteristic of
indebtedness for federal tax purposes: a
binding obligation to repay the funds
advanced, creditor’s rights to enforce
the terms of the EGI, a reasonable
expectation that the advanced funds can
be repaid, and actions evidencing a
genuine debtor-creditor relationship.
Together these categories represent a
distillation of case law principles
established for determining that an
instrument is genuine indebtedness for
federal tax purposes.
The proposed regulations require that
the prescribed documentation and
information must be provided with
respect to each category. Failure to
provide the documentation and
information upon request by the
Commissioner will result in the
Commissioner treating the requirements
of this section as not satisfied. The four
categories are more specifically
described in the following four
paragraphs.
1. Binding Obligation to Repay. The
threshold requirement for indebtedness
is a binding legal obligation to repay the
funds advanced. The proposed
regulations require evidence of such
obligation in the form of timely
prepared written documentation
executed by the parties.
2. Creditor’s Rights to Enforce Terms.
The documents establishing the issuer’s
obligation to repay must also establish
that the creditor/holder has the legal
rights of a creditor to enforce the terms
of the EGI. The proposed regulations
give examples of such rights that
creditor/holder typically has, including
the right to trigger a default and the
right to accelerate payments. The
proposed regulations also give an
example of one right that a creditor/
holder must have, which is a superior
right to shareholders to share in the
assets of the issuer in the event that the
issuer is dissolved or liquidated.
3. Reasonable Expectation of
Repayment. The proposed regulations
also require the taxpayer to provide
timely prepared documentation
evidencing a reasonable expectation that
the issuer could in fact repay the
amount of a purported loan. The
proposed regulations give examples of
such documentation, including cash
flow projections, financial statements,
business forecasts, asset appraisals,
determination of debt-to-equity and
other relevant financial ratios of the
issuer (compared to industry averages).

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Special rules are provided to address
disregarded entities that issue an EGI.
4. Genuine Debtor-Creditor
Relationship. Finally, the taxpayer
asserting indebtedness treatment must
prepare and maintain timely evidence of
an ongoing debtor-creditor relationship.
This documentation can take two forms.
In the case of an issuer that complied
with the terms of the EGI, the
documentation must include timely
prepared documentation of any
payments on which the taxpayer relies
to establish such treatment under
general federal tax principles.
Alternatively, if the issuer failed to
comply with the terms of the EGI, either
by failing to make required payments or
by otherwise suffering an event of
default under the terms of the EGI, the
documentation must include evidence
of the holder’s reasonable exercise of the
diligence and judgment of a creditor.
The proposed regulations give examples
of such documentation, including
evidence of the holder’s efforts to
enforce the terms of the EGI, as well as
any efforts to renegotiate the EGI.
In general, the documentation must be
prepared no later than 30 calendar days
after the date of the relevant event,
which is generally the later of the date
that the instrument becomes an EGI or
the date that an expanded group
member becomes an issuer with respect
to an EGI. However, in the case of
documentation of the debtor-creditor
relationship, the regulations allow the
documentation to be prepared up to 120
calendar days after the payment or
relevant event occurred. This extended
period is intended to avoid inadvertent
failures to comply with the regulations
that may be more likely in the case of
events that occur during the life of an
EGI. If an applicable instrument is not
an EGI when issued, no documentation
is required under the proposed
regulations for any date before the date
the applicable instrument becomes an
EGI.
The proposed regulations provide
special rules for determining the
timeliness of documentation
preparation in the case of certain
revolving credit agreements and similar
arrangements and cash pooling
arrangements, generally looking to the
documents pursuant to which the
arrangements were established.
C. Maintenance Requirement
Under proposed § 1.385–2, the
documentation and information in the
four categories previously described
must be maintained for all taxable years
that the EGI is outstanding and until the
period of limitations expires for any
return with respect to which the federal

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tax treatment of the EGI is relevant. The
proposed regulations do not otherwise
specify where or in what manner such
records must be kept. The Treasury
Department and the IRS intend that
taxpayers have flexibility to determine
the manner in which the requirements
of the proposed regulations are satisfied.
D. Timing of Application of Rule
In general, proposed § 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 indebtedness, the issuer is
treated as issuing a new debt instrument
to the holder in exchange for the EGI
immediately before the transaction that
causes the instrument to cease to qualify
as an EGI.
If an applicable instrument is an EGI
when issued, determinations under
proposed § 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 resulting determination
is generally effective, when the
applicable instrument becomes an EGI.
However, if an EGI originally treated as
debt is later recharacterized as stock
because the documentation and
information cease to evidence an
ongoing debtor-creditor relationship, the
recharacterization will be effective as of
the time that the facts and
circumstances cease to evidence a
debtor-creditor relationship.
E. Consolidated Groups
Proposed § 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 instrument is treated as
becoming an EGI immediately after it
ceases to be an intercompany obligation.
F. Modifications to General Operation of
Proposed § 1.385–2
The proposed regulation includes a
number of provisions that modify the
general 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

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waivers of penalty if failure due to
reasonable cause) apply for purposes of
determining whether reasonable cause
exists in any particular case.
Second, to prevent abuse, proposed
§ 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
proposed § 1.385–2, the applicable
instrument is treated as an EGI and will
be subject to the provisions of the
proposed regulations. Such a situation
could occur if, for example, an
applicable interest was issued by an
expanded group member to a trust held
by members of the same expanded
group.
G. Effective Date of Proposed § 1.385–2
The provisions of § 1.385–2 are
proposed to be generally effective when
the regulations are published as final
regulations. 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 entity
classification election under
§ 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

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A. In General
Proposed §§ 1.385–3 and 1.385–4
provide rules that treat as stock certain
interests that otherwise would be
treated as indebtedness for federal
income tax purposes. Proposed § 1.385–
3 applies to debt instruments that are
within the meaning of section 1275(a)
and § 1.1275–1(d), as determined
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
contractual arrangement that constitutes
indebtedness under general principles
of federal income tax law. Thus, the
term debt instrument for purposes of
proposed §§ 1.385–3 and 1.385–4 means
an instrument 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
Department and the IRS plan to amend

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§ 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
another member of the same group
(expanded group debt instrument) in the
circumstances described in Section B of
this Part IV, unless an exception
described in Section C of this Part IV
applies. Detailed operating rules
regarding the recharacterization
(including with respect to partnerships)
are discussed in Section D of this Part
IV. A rule to prevent taxpayers from
affirmatively using proposed §§ 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
provides special rules to address the
treatment of consolidated groups. The
effective 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. Consistent with the
traditional case law debt-equity
analysis, when a debt instrument is
treated as stock under proposed § 1.385–
3, the terms of the debt instrument (for
example, voting rights or conversion
features) are taken into account for
purposes of determining the type of
stock resulting from the
recharacterization, including whether
such stock is preferred stock or common
stock.
B. Debt Instruments Treated as Stock
Proposed § 1.385–3 provides three
rules that treat an expanded group debt
instrument as stock: a general rule, a
funding rule, and an anti-abuse rule.
1. The General Rule
The general rule treats an expanded
group debt instrument as stock to the
extent it is issued by a corporation to a
member of the corporation’s expanded
group (1) in a distribution; (2) in
exchange for expanded group stock,
other than in an exempt exchange (as
defined later in this Section 1); or (3) in
exchange for property in an asset
reorganization, but only to the extent
that, pursuant to the plan of
reorganization, a shareholder that is a
member of the issuer’s expanded group
immediately before the reorganization
receives the debt instrument with
respect to its stock in the transferor
corporation. All or a portion of an
issuance of a debt instrument may be
described in more than one prong of the
general rule without changing the result

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that follows from being described in a
single prong.
For purposes of the first prong of the
general rule, the term distribution is
broadly defined as any distribution by a
corporation to a member of the
corporation’s expanded group with
respect to the distributing corporation’s
stock, regardless of whether the
distribution is treated as a dividend
within the meaning of section 316.
Thus, a debt instrument issued in
exchange for stock of the issuer of the
debt instrument (that is, in a redemption
under corporate law) is a distribution
that is covered by the first prong of the
general rule and an acquisition of
expanded group stock covered by the
second prong of the general rule.
The second prong of the general
rule—addressing debt instruments
issued in exchange for expanded group
stock—applies regardless of whether the
expanded group stock is acquired from
a shareholder of the issuer of the
expanded group stock, or directly from
the issuer. For an illustration of this rule
in a context where stock is not formally
issued because it would be a
‘‘meaningless gesture,’’ see Example 11
in § 1.385–3(g)(3) of the proposed
regulations.
For purposes of the second prong of
the general rule, the term exempt
exchange means an acquisition of
expanded group stock in which the
transferor and transferee of the stock are
parties to a reorganization that is an
asset reorganization, and either (i)
section 361(a) or (b) applies to the
transferor of the expanded group stock
and the stock is not transferred by
issuance; or (ii) section 1032 or
§ 1.1032–2 applies to the transferor of
the expanded group stock and the stock
is distributed by the transferee pursuant
to the plan of reorganization. As a
result, the second prong of the general
rule generally does not apply to a debt
instrument that is issued in exchange
for expanded group stock when section
361(a) or (b) applies to the transferor of
such stock. This limitation has the effect
of causing exchanges of expanded group
stock that are part of an asset
reorganization to be covered only by the
third prong of the general rule, which,
as discussed in the next paragraph,
imposes limitations on the application
of the general rule to exchanges that are
part of an asset reorganization.
The third prong of the general rule
applies to asset reorganizations among
corporations that are members of the
same expanded group. An asset
reorganization is a reorganization
within the meaning of section
368(a)(1)(A), (C), (D), (F), or (G).
Specifically, the third prong of the

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general rule applies to a debt instrument
issued in exchange for property in an
asset reorganization, but only to the
extent that, pursuant to the plan of
reorganization, a shareholder that is a
member of the issuer’s expanded group
immediately before the reorganization
receives the debt instrument with
respect to its stock in the transferor
corporation. The second step receipt of
the debt instrument by the expanded
group shareholder could be in the form
of a distribution of the debt instrument
to shareholders of the distributing
corporation in a divisive asset
reorganization, or in redemption of the
shareholder’s stock in the transferor
corporation in an acquisitive asset
reorganization. Because the third prong
of the general rule applies only to a debt
instrument that is received by a
shareholder with respect to its stock in
the transferor corporation, that debt
instrument would, absent the
application of § 1.385–3, be treated as
‘‘other property’’ within the meaning of
section 356.
The third prong of the general rule is
limited to debt instruments distributed
to shareholders pursuant to the
reorganization, and does not apply to
debt instruments exchanged for
securities or other debt interests
because, in that latter case, the newly
issued debt instrument is exchanged for
existing debt interests and thus no
additional debt is incurred by the
parties to the reorganization.

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2. The Funding Rule
a. Funded Transactions
The funding rule treats as stock an
expanded group debt instrument that is
issued with a principal purpose of
funding a transaction described in the
general rule (principal purpose debt
instrument). Specifically, a principal
purpose debt instrument is a debt
instrument issued by a corporation
(funded member) to another member of
the funded member’s expanded group in
exchange for property with a principal
purpose of funding (1) a distribution of
property by the funded member to a
member of the funded member’s
expanded group, other than a
distribution of stock pursuant to an
asset reorganization that is permitted to
be received without the recognition of
gain or income under section 354(a)(1)
or 355(a)(1) or, when section 356
applies, that is not treated as ‘‘other
property’’ or money described in section
356; (2) an acquisition of expanded
group stock, other than in an exempt
exchange, by the funded member from
a member of the funded member’s
expanded group in exchange for

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property other than expanded group
stock; or (3) the acquisition of property
by the funded member in an asset
reorganization but only to the extent
that, pursuant to the plan of
reorganization, a shareholder that is a
member of the funded member’s
expanded group immediately before the
reorganization receives ‘‘other property’’
or money within the meaning of section
356 with respect to its stock in the
transferor corporation.
Prongs (1) through (3) of the funding
rule are referred to in this Section 2 as
‘‘distributions or acquisitions.’’
Proposed § 1.385–3(b)(3)(iii) provides
that, if all or a portion of a distribution
or acquisition by a funded member is
described in more than one prong of the
funding rule, the funded member is
treated as engaging in only a single
distribution or acquisition for purposes
of applying the funding rule. The
funding rule addresses transactions that,
when viewed together, present similar
policy concerns as the transactions that
are subject to the general rule.
The first prong of the funding rule—
addressing a distribution by a funded
member—excludes a distribution of
stock permitted to be received without
the recognition of gain under section
355(a)(1) when the distribution is
pursuant to an asset reorganization (that
is, a divisive reorganization qualifying
under section 368(a)(1)(D)), but does not
exclude a distribution of stock that is
permitted to be received without the
recognition of gain under section
355(a)(1) when the transaction qualifies
under section 355 without also
qualifying as a reorganization (that is, a
distribution of the stock of a controlled
corporation without a related transfer of
property by the distributing corporation
to the controlled corporation pursuant
to the plan of reorganization). The
reason for this distinction is that the
controlled corporation in a divisive
reorganization described in section
368(a)(1)(D) acquires assets of the
distributing corporation and, as
described in Section B.2.b.v of this Part
IV, is treated as a successor of the
distributing corporation (and the
distributing corporation is treated as a
predecessor of the controlled
corporation) for purposes of the funding
rule. In contrast, when a distribution
transaction qualifies under section 355
without also qualifying as a
reorganization, the controlled
corporation does not acquire assets from
the distributing corporation as part of
the transaction and the corporations are
not treated as predecessor and successor
of each other for purposes of the
funding rule. Consistent with this
approach, proposed § 1.385–3 does not

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treat a section 355 distribution that is
part of a divisive reorganization as a
distribution for purposes of the funding
rule because the distributing
corporation and the controlled
corporation are both parties to the
reorganization and are both treated as
funded members to the extent of any
prior debt instrument issued by the
distributing corporation. For a further
illustration of this rule, see Example 10
in § 1.385–3(g)(3) of the proposed
regulations.
b. Determining Whether a Debt
Instrument Is Issued With a Principal
Purpose of Funding a Distribution or
Acquisition
The determination as to whether a
debt instrument is issued with a
principal purpose of funding a
distribution or acquisition is based on
all of the facts and circumstances. A
debt instrument may be treated as
issued with such a principal purpose
whether it is issued before or after a
distribution or acquisition.
i. Non-Rebuttable Presumption During
the 72-Month Period
Proposed § 1.385–3 also establishes a
non-rebuttable presumption that certain
expanded group debt instruments are
issued with a principal purpose of
funding a distribution or acquisition by
the funded member. Specifically, such a
principal purpose is deemed to exist if
the expanded group debt instrument is
issued by the funded member during the
period beginning 36 months before the
funded member makes a distribution or
acquisition and ending 36 months after
the distribution or acquisition (the 72month period). This per se rule does not
create a safe harbor. Accordingly, a debt
instrument issued outside the 72-month
period may be treated as having a
principal purpose of funding a
distribution or acquisition, based on the
facts and circumstances.
The Treasury Department and the IRS
have determined that this nonrebuttable presumption is appropriate
because money is fungible and because
it is difficult for the IRS to establish the
principal purposes of internal
transactions. In the absence of a per se
rule, taxpayers could assert that free
cash flow generated from operations
funded any distributions and
acquisitions, while any debt instrument
was incurred to finance the capital
needs of those operations. Because
taxpayers would be able to document
the purposes of funding transactions
accordingly, it would be difficult for the
IRS to establish that any particular debt
instrument was incurred with a
principal purpose of funding a

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distribution or acquisition. The
exception discussed in Section C of this
Part IV for distributions and
acquisitions that do not exceed current
year earnings and profits would
accommodate many ordinary course
distributions and acquisitions,
providing significant flexibility to avoid
the application of this per se rule. The
Treasury Department and the IRS have
determined that this exception, together
with the exception for a tainted debt
instrument that does not exceed $50
million, also discussed in Section C of
this Part IV, appropriately balance
between preventing tax-motivated
transactions among members of an
expanded group and accommodating
ordinary course transactions.

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ii. Exception to Non-Rebuttable
Presumption for Ordinary Course Debt
Instruments
An exception to this per se rule
applies to ordinary course debt
instruments. Proposed § 1.385–
3(b)(3)(iv)(B)(2) defines an ordinary
course debt instrument as a debt
instrument that arises in the ordinary
course of the issuer’s trade or business
in connection with the purchase of
property or the receipt of services to the
extent that it reflects an obligation to
pay an amount that is currently
deductible by the issuer under section
162 or currently included in the issuer’s
cost of goods sold or inventory,
provided that the amount of the
obligation outstanding at no time
exceeds the amount that would be
ordinary and necessary to carry on the
trade or business of the issuer if it was
unrelated to the lender. This exception
is intended to apply to debt instruments
that arise in connection with the
purchase of property or the receipt of
services between members of the same
expanded group in the ordinary course
of the purchaser’s or recipient’s trade or
business, and is not intended to apply
to intercompany financing or treasury
center activities or to capital
expenditures. An ordinary course debt
instrument is not subject to the per se
rule; however, it may be treated as
having a principal purpose of funding a
distribution or acquisition by the issuer,
based on the facts and circumstances.
iii. Ordering Rules
For purposes of applying the per se
rule, proposed § 1.385–3(b)(3)(iv)(B)(3)
includes an ordering rule that provides
that, when two or more debt
instruments may be treated as
potentially funding the same acquisition
or distribution, the debt instruments are
tested based on the order in which they
were issued. Thus, for example, if a

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company issues an expanded group debt
instrument of $100x in each of years 1
and 2, and then makes a distribution of
$150x in year 3, the distribution will
result in a recharacterization as of the
date of the distribution of $100x of the
year 1 debt instrument and $50x of the
year 2 debt instrument. For a further
illustration of this rule, see Example 6
in § 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
acquisition, the earliest distribution or
acquisition is treated as the first
distribution or acquisition that was
funded.
An exception to these ordering rules
applies when an acquisition of
expanded group stock by issuance
ceases to qualify for the exception from
the funding rule described in Section
C.3 of this Part IV. In that case, the
acquisition of expanded group stock is
treated as an acquisition that is subject
to the funding rule on the date that the
acquisition actually occurred, but debt
instruments issued, and other
distributions and acquisitions that
occurred, prior to the date that the
acquirer ceases to qualify for the
exception are ordered without regard to
the acquisition of expanded group stock
that previously was excepted from the
funding rule.
iv. Transition Rule
For a rule preventing the funding rule
from treating a debt instrument issued
on or after April 4, 2016 from being
treated as funding a distribution or
acquisition that occurred before April 4,
2016, see Section G of this Part IV.
v. Predecessor and Successor Rules
Finally, the funding rule provides that
references in the funding rule to the
funded member include any
predecessor or successor of such
member. A predecessor is defined to
include the distributor or transferor
corporation in a transaction described in
section 381(a) in which a member of the
expanded group is the acquiring
corporation, but also includes the
transferor corporation in a divisive
reorganization described in section
368(a)(1)(D) or (G). The term
predecessor does not include, with
respect to a controlled corporation, a
distributing corporation that distributed
the stock of the controlled corporation
pursuant to section 355(c). Similarly, a
successor is defined to include the
acquiring corporation in a transaction
described in section 381(a) in which a
member of the expanded group is the

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distributor or transferor corporation, but
also includes the acquiring corporation
in a divisive reorganization described in
section 368(a)(1)(D) or (G). The term
successor does not include, with respect
to a distributing corporation, a
controlled corporation the stock of
which was distributed by the
distributing corporation pursuant to
section 355(c). In addition, Section C.3
of this Part IV, which sets forth an
exception to the funding rule for certain
acquisitions of expanded group stock by
issuance, provides that the funded
member is treated as a predecessor of
the issuer and the issuer is treated as a
successor of the funded member to the
extent of the value of the acquired stock.
For an illustration of these rules, see
Examples 9, 10, and 12 in proposed
§ 1.385–3(g)(3).
3. The Anti-Abuse Rule
Proposed § 1.385–3(b)(4) also
provides that a debt instrument is
treated as stock if it is issued with a
principal purpose of avoiding the
application of the proposed regulations.
In addition, other interests that are not
debt instruments for purposes of
proposed §§ 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
illustrating situations where the antiabuse rule might apply. The anti-abuse
rule may apply, for example, if a debt
instrument is issued to, and later
acquired from, a person that is not a
member of the issuer’s expanded group
with a principal purpose of avoiding the
application of the proposed regulations.
In that situation, factors that may be
taken into account in determining the
presence or absence of a principal
purpose of avoiding the application of
the proposed regulations include the
time period between the issuance of the
debt instrument to the non-member and
the acquisition of the debt instrument
by a member of the issuer’s expanded
group, and whether there was a
significant change in circumstances
during that time period. For example, a
change of control of the issuer group (for
example, a cash acquisition of all of the
stock of the ultimate parent company of
the issuer) after the issuance and before
the acquisition of the debt instrument
that was not foreseeable when the debt
instrument was issued to the nonmember could indicate that the debt
instrument was not issued with a
principal purpose of avoiding the

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application of the proposed regulations.
In contrast, the issuance of a debt
instrument to a non-member after
discussions were underway regarding
the change-of-control transaction could
indicate that the debt instrument was
issued with a principal purpose of
avoiding the application of the proposed
regulations.
Other examples of when the antiabuse 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
instrument that is issued or transferred
in connection with a reorganization or
similar transaction with a principal
purpose of avoiding the application of
the proposed regulations. For a further
illustration of this rule, see Example 18
in § 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
between the general rule and the
funding rule. This coordination rule
provides that, to the extent all or a
portion of a debt instrument issued in
an asset reorganization is treated as
stock under the third prong of the
general rule (relating to a debt
instrument issued for property in an
asset reorganization), the distribution of
the deemed stock to a shareholder in the
asset reorganization is not also treated
as a distribution or acquisition by the
transferor corporation for purposes of
the funding rule. This coordination rule
addresses a specific potential overlap
situation where a debt instrument is
distributed to a shareholder pursuant to
an asset reorganization and is
characterized under the third prong of
the general rule as an issuance of stock.
When the issuance of the debt
instrument is characterized under the
general rule as an issuance of stock, the
stock may be treated as non-qualified
preferred stock for purposes of section
356. Nonqualified preferred stock
received by a shareholder in a
distribution is itself treated as ‘‘other

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property’’ for purposes of section 356.
This overlap rule provides that, if the
shareholder is deemed to receive
nonqualified preferred stock in the asset
reorganization, the distribution of the
nonqualified preferred stock in the asset
reorganization is not treated as a
distribution or acquisition for purposes
of the funding rule. For an illustration
of this rule, see Example 8 in § 1.385–
3(g)(3) of the proposed regulations.
C. Exceptions
Proposed § 1.385–3(c) provides three
exceptions from the application of
proposed § 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
exception pursuant to which
distributions and acquisitions described
in proposed § 1.385–3(b)(2) (the general
rule) or proposed § 1.385–3(b)(3)(ii) (the
funding rule) that do not exceed current
year earnings and profits (as described
in section 316(a)(2)) of the distributing
or acquiring corporation are not treated
as distributions or acquisitions for
purposes of the general rule or the
funding rule. For this purpose,
distributions and acquisitions are
attributed to current year earnings and
profits in the order in which they occur.
2. Threshold Exception
A second exception provides that an
expanded group debt instrument will
not be treated as stock if, when the debt
instrument is issued, the aggregate issue
price of all expanded group debt
instruments that otherwise would be
treated as stock under the proposed
regulations does not exceed $50 million
(the threshold exception). If the
expanded group’s debt instruments that
otherwise would be treated as stock
later exceed $50 million, then all
expanded group debt instruments that,
but for the threshold exception, would
have been treated as stock are treated as
stock, rather than only the amount that
exceeds $50 million. Thus, the
threshold exception is not an exemption
of the first $50 million of expanded
group debt instruments that otherwise
would be treated as stock under the
proposed regulations, but rather is only
intended to provide an exception from
the application of proposed § 1.385–3
for taxpayers that have not exceeded the
$50 million threshold. If the $50 million
threshold subsequently is exceeded, the
timing of the recharacterization of the
relevant debt instrument as stock
depends on when the debt instrument

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20925

was issued. If the debt instrument
ceases to qualify for the threshold
exception after the taxable year of its
issuance, the recharacterization is
treated as occurring on the date that the
threshold exception ceases to apply. If,
on the other hand, the debt instrument
ceases to qualify for the threshold
exception during the same taxable year
that the debt instrument is issued, the
debt instrument is treated as stock as of
the day that the debt instrument is
issued. Once the $50 million threshold
is exceeded, the threshold exception
will not apply to any debt instrument
issued by members of the expanded
group for so long as any instrument that
previously was treated as indebtedness
solely because of the threshold
exception remains outstanding, in order
to prevent the $50 million limitation
from refreshing after those instruments
are treated as stock.
The threshold exception is applied
after applying the exception for current
year earnings and profits. For an
illustration of the interaction of the
threshold exception and the exception
for current year earnings and profits, see
Example 17 in § 1.385–3(g)(3) of the
proposed regulations.
3. Exception for Funded Acquisitions of
Subsidiary Stock by Issuance
An acquisition of expanded group
stock will not be treated as an
acquisition described in the second
prong of the funding rule if (i) the
acquisition results from a transfer of
property by a funded member (the
transferor) to an issuer in exchange for
stock of the issuer, and (ii) for the 36month period following the issuance,
the transferor holds, directly or
indirectly, more than 50 percent of the
total combined voting power of all
classes of stock of the issuer entitled to
vote and more than 50 percent of the
total value of the stock of the issuer. For
purposes of this exception, a transferor’s
indirect stock ownership is determined
by applying the principles of section
958(a) without regard to whether an
intermediate entity is foreign or
domestic.
If the transferor ceases to meet the
ownership requirement at any time
during the 36-month period, the
acquisition of expanded group stock
will no longer qualify for the exception
and will be treated as an acquisition
described in the second prong of the
funding rule. In this case, for purposes
of applying the per se rule, the
acquisition may be treated as having
been funded by a debt instrument
issued during the 72-month period
determined with respect to the date of
the acquisition (rather than the date that

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the exception ceased to apply (the
cessation date)), but, in the case of a
debt instrument issued prior to the
cessation date, only to the extent that
such debt instrument is treated as
indebtedness as of the cessation date
(that is, a debt instrument not already
treated as stock).
The proposed regulations treat an
issuer and a transferor as a successor
and predecessor, respectively, for
purposes of the funding rule to the
extent of the value of the expanded
group stock acquired from the issuer.
However, for purposes of the per se rule,
the issuer and transferor are only treated
as successor and predecessor,
respectively, with respect to a debt
instrument issued by the transferor
during the period beginning 36 months
before the relevant issuance of
expanded group stock and ending 36
months after such issuance. Proposed
§ 1.385–3(f)(11) further limits the effect
of treating the issuer and transferor as
successor and predecessor by providing
that a distribution made by the issuer
directly to the transferor is not treated
as a distribution made by the transferor
for purposes of applying the funding
rule to a debt instrument of the
transferor.
For an illustration of this exception,
see Example 12 in § 1.385–3(g)(3) of the
proposed regulations.
D. Operating Rules
Proposed § 1.385–3(d) includes
operating rules for determining when a
debt instrument is treated as stock and
for certain deemed exchanges required
under the proposed regulations.
1. Timing of Stock Treatment

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a. Timing Under the General Rule
A debt instrument treated as stock
under the general rule is treated as stock
from the time when the debt instrument
is issued. In addition, and in contrast to
the funding rule, the treatment of a debt
instrument as stock pursuant to the
general rule may affect other aspects of
the tax treatment of the transaction in
which the debt instrument is issued. For
example, a distribution of a debt
instrument is treated as a distribution of
stock for all federal tax purposes and,
accordingly, is subject to section 305.
Similarly, a debt instrument issued in
exchange for expanded group stock is
treated as an acquisition of expanded
group stock in exchange for stock of the
issuing corporation. Because stock of
the issuing corporation is not treated as
‘‘property’’ within the meaning of
section 317, such transactions would
not, for example, be described in section
304(a)(1) or be subject to § 1.367(b)–10,

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both of which only apply to certain
acquisitions of stock for property.
b. Timing Under the Funding Rule
When the funding rule applies, a
principal purpose debt instrument also
is treated as stock from the time when
the debt instrument is issued, but only
to the extent it is issued in the same or
a subsequent taxable year as the
distribution or acquisition that the debt
instrument is treated as funding. To the
extent that a principal purpose debt
instrument is issued in a taxable year
preceding the taxable year in which the
distribution or acquisition that it is
treated as funding occurs, the debt
instrument is respected as indebtedness
until the date such distribution or
acquisition occurs, at which time it is
deemed to be exchanged (as described
in Section D.2 of this Part IV) for stock.
For these purposes, the relevant taxable
year is the taxable year of the funded
member. See Section C.3 of this Part IV
for a discussion of the timing rule when
the exception for funded acquisitions of
subsidiary stock by issuance ceases to
apply.
In contrast to transactions that are
characterized under the general rule,
when the funding rule applies, the tax
treatment of the distribution or
acquisition that the principal purpose
debt instrument is treated as funding is
never recharacterized under the
proposed regulations. Accordingly, in
the case of a section 301 distribution
that triggers the application of the
funding rule, section 301 will continue
to apply to the distribution without
regard to the fact that the debt
instrument that is treated as funding the
distribution is recharacterized as stock.
Similarly, the application of section 304
to a funded acquisition of expanded
group stock would not be affected by the
fact that the debt instrument that is
treated as funding the acquisition is
recharacterized as stock under the
funding rule.
c. Transitional Timing Rule
For an additional timing rule
addressing certain debt instruments
issued on or after April 4, 2016 and
before the date of publication in the
Federal Register of the Treasury
decision adopting proposed § 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

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described in Section C of this Part IV,
when the $50 million threshold
exception ceases to apply, all debt
instruments of the expanded group
issued in a prior taxable year that
previously was treated as indebtedness
because of the threshold exception is
treated as stock on the date that the
threshold exception ceases to apply. In
those situations the deemed exchange
rule described in Section B of Part II
applies. This deemed exchange rule
does not apply when a debt instrument
that is treated as stock under proposed
§ 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
member of the expanded group, or when
the obligor with respect to such debt
instrument ceases to be a member of the
expanded group that includes the
issuer, the interest ceases to be treated
as stock. This is because proposed
§ 1.385–3 generally applies only to a
debt instrument that is held by a
member of an expanded group. For
purposes of this rule, it should be noted
that a debt instrument held by a
partnership is considered held by its
partners, as described in Section D.4 of
this Part IV.
The proposed regulations provide
that, immediately before a debt
instrument that is treated as stock under
proposed § 1.385–3 ceases to be held by
a member of the expanded group, the
expanded group issuer is deemed to
issue a new debt instrument to the
expanded group holder in exchange for
the debt instrument that was treated as
stock. The proposed regulations provide
that this deemed issuance of the debt
instrument is not itself subject to the
general rule.
When a debt instrument treated as
stock pursuant to the funding rule
ceases to be treated as stock because it
is no longer an expanded group debt
instrument, all other debt instruments of
the issuer that are not currently treated
as stock are re-tested to determine
whether other debt instruments are
treated as funding the distribution or
acquisition that previously was treated
as funded by the debt instrument that
ceases to be treated as stock pursuant to
this rule. For an illustration of this rule,
see Example 7 in § 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

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Federal Register / Vol. 81, No. 68 / Friday, April 8, 2016 / Proposed Rules
aggregate approach to controlled
partnerships for purposes of the
proposed regulations. The legislative
history of subchapter K of chapter 1 of
the Code provides that, for purposes of
interpreting Code provisions outside of
that subchapter, a partnership may be
treated as either an entity separate from
its partners or an aggregate of its
partners, depending on which
characterization is more appropriate to
carry out the purpose of the particular
section under consideration. H.R. Conf.
Rep. No. 2543, 83rd Cong. 2d. Sess. 59
(1954). Thus, for example, when a
member of an expanded group becomes
a partner in a partnership that is a
controlled partnership with respect to
the expanded group, the member is
treated as acquiring its proportionate
share of the controlled partnership’s
assets. In addition, each expanded
group partner in a controlled
partnership is treated as (i) issuing its
proportionate share of any debt
instrument issued by the controlled
partnership, (ii) acquiring its
proportionate share of any expanded
group stock acquired by the controlled
partnership, and (iii) receiving its
proportionate share of any ‘‘other
property’’ received by the partnership in
a transaction described in section 356.
For this purpose, a partner’s
proportionate share is determined in
accordance with the partner’s share of
partnership profits. A partnership is a
controlled partnership if 80 percent or
more of the interests in the capital or
profits of the partnership are owned,
directly or indirectly, by one or more
members of an expanded group. For this
purpose, indirect ownership of a
partnership interest is determined based
on the indirect ownership rules of
section 304(c)(3).
If a debt instrument issued by a
controlled partnership were to be
recharacterized as equity in the
controlled partnership, the resulting
equity could give rise to guaranteed
payments that may be deductible or
gross income allocations to partners that
would reduce the taxable income of the
other partners that did not receive such
allocations. Therefore, under the
authority of section 7701(l) to
recharacterize multiple-party financing
transactions, proposed § 1.385–
3(d)(5)(ii) provides that, when a debt
instrument issued by a partnership is
recharacterized, in whole or in part,
under proposed § 1.385–3, the holder of
the recharacterized debt instrument is
treated as holding stock in the expanded
group partner or partners rather than as
holding a partnership interest in the
controlled partnership. The partnership

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and its partners must make appropriate
conforming adjustments to reflect the
expanded group partner’s treatment
under the proposed regulations. Any
such adjustments must be consistent
with the purposes of these proposed
regulations and must be made in a
manner that avoids the creation of, or
increase in, a disparity between the
controlled partnership’s aggregate basis
in its assets and the aggregate bases of
the partners’ respective interests in the
partnership. For an illustration of the
rules applicable to controlled
partnerships, see Examples 13, 14, and
15 in § 1.385–3(g)(3) of the proposed
regulations.
5. Notification of Inconsistent Treatment
Waived
Section 385(c)(1) provides that an
issuer’s characterization as of the time
of issuance of an interest as debt or
stock is binding on the issuer and on all
holders of the interest. Section 385(c)(2)
provides an exception to that rule if the
holder discloses on its return that the
holder is treating such interest in a
manner that is inconsistent with such
characterization. Section 385(c)(3)
provides that the Secretary is authorized
to require such information as the
Secretary determines to be necessary to
carry out the provisions of section
385(c). Under proposed § 1.385–3, a
holder may be required to treat an
interest as stock even though the issuer
treated it as debt when it was issued.
For example, a debt instrument may
first be treated as a principal purpose
debt instrument in a year that follows
the year in which the debt instrument
was issued. In that case, absent a
regulatory provision to the contrary, the
holder would be subject to the reporting
requirement described in section
385(c)(2).
The Treasury Department and the IRS
have determined that the
characterization and reporting
requirements in section 385(c) were not
intended to apply when regulations
under section 385 require an interest to
be recharacterized after the issuer’s
initial characterization of that interest.
Accordingly, the proposed regulations
provide that section 385(c)(1) does not
apply to a debt instrument to the extent
that it is treated as stock under the
proposed regulations.
6. Obligations of Disregarded Entities
Proposed § 1.385–3(d)(6) provides
that a debt instrument issued by a
disregarded entity that is treated as
stock under proposed § 1.385–3 is
treated as stock in the disregarded
entity’s owner rather than as an equity
interest in the disregarded entity.

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20927

Ordinarily, when a disregarded entity
becomes 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 Department
and the IRS have determined that
treating a debt instrument issued by a
disregarded 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),
proposed §§ 1.385–3 and 1.385–4 do not
apply to the extent a person enters into
a transaction that otherwise would be
subject to the proposed regulations with
a principal purpose of reducing its
federal tax liability or the federal tax
liability of another person by
disregarding the treatment of the debt
instrument that would occur without
regard to the proposed regulations.
F. Treatment of Consolidated Groups
As noted previously, the Treasury
Department and the IRS have
determined that a debt instrument
between members of the same
consolidated group does not raise the
same federal tax concerns as a debt
instrument between members of the
same expanded (but not consolidated)
group. Accordingly, proposed § 1.385–4
includes special rules, issued under the
authority of section 1502, for applying
§ 1.385–3 to consolidated groups,
including rules addressing the treatment
of a debt instrument issued by one
member of a consolidated group to
another member of the same
consolidated group (consolidated group
debt instrument) and rules regarding the
treatment of a debt instrument when it
ceases to be a consolidated group debt
instrument.
1. Consolidated Groups Treated as One
Corporation
For purposes of proposed § 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 consolidated
group in a distribution. The proposed
regulations define a consolidated group

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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 expanded group that is
not a member of its consolidated group
may be treated under the funding rule
as funding a distribution or acquisition
by another member of that consolidated
group, even though that other
consolidated group member was not the
issuer and thus was not funded directly.
Similarly, a debt instrument issued by
one consolidated group member to
another consolidated group member is
treated as stock under the general rule
when the debt instrument is distributed
by the holder to a member of the
expanded group that is not a member of
the same consolidated group, regardless
of whether the issuer itself distributed
the debt instrument. For an illustration
of this rule, see Example 1 in proposed
§ 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
addressing debt held or issued by a
consolidated group member that leaves
a consolidated group, but continues to
be a member of the expanded group
(such corporation, a departing member).
Generally, any consolidated group
debt instrument that is issued or held by
the departing member and that is not
treated as stock solely by reason of the
rule treating all members of a
consolidated group as one corporation
(exempt consolidated group debt
instrument) is deemed to be exchanged
for stock immediately after the
departing member leaves the group. Any
consolidated group debt instrument
issued or held by a departing member
that is not an exempt consolidated
group debt instrument (non-exempt
consolidated group debt instrument) is
treated as indebtedness unless and until
the non-exempt consolidated group debt
instrument is treated as a principal
purpose debt instrument under
proposed §§ 1.385–3(b)(3)(ii) and 1.385–
3(d)(1) as a result of a distribution or
acquisition described in proposed
§ 1.385–3(b)(3)(ii) that occurs after the
departure. However, solely for purposes
of applying the 72-month period under
the per se funding rule, the debt
instrument is treated as having been

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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
consolidated group as one corporation.
Thus, for example, the sale of a
consolidated group debt instrument to
an expanded group member that is not
a member of the consolidated group is
treated as an issuance of the debt
instrument to the transferee expanded
group member in exchange for property.
To the extent the debt instrument is
treated as stock upon being transferred,
the debt instrument is deemed to be
exchanged for stock immediately after
the debt instrument is transferred
outside of the consolidated group. For
an illustration of this rule, see Examples
1 and 2 in § 1.385–4(d)(3) of the
proposed regulations.
G. Proposed Effective/Applicability Date
and Transition Rules
Sections 1.385–3 and 1.385–4 are
proposed to apply to any debt
instrument issued on or after April 4,
2016 and to any debt instrument issued
before April 4, 2016 as a result of an
entity classification election made
under § 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 the Federal
Register of the Treasury decision
adopting this rule as a final regulation,
the debt instrument is treated as
indebtedness until the date that is 90
days after the date of publication in the
Federal Register of the Treasury
decision adopting this rule as a final
regulation. To the extent that the debt
instrument described in the preceding
sentence is held by a member of the
issuer’s expanded group on the date that
is 90 days after the date of publication
in the Federal Register of the Treasury
decision adopting this rule as a final
regulation, the debt instrument is
deemed to be exchanged for stock on the
date that is 90 days after the date of
publication in the Federal Register of
the Treasury decision adopting this rule
as a final regulation.

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In addition, for purposes of
determining whether a debt instrument
is a principal purpose debt instrument
described in proposed § 1.385–
3(b)(3)(iv), a distribution 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 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, is not
taken into account.
Statement of Availability of IRS
Documents
IRS Revenue Procedures, Revenue
Rulings notices, and other guidance
cited in this document are published in
the Internal Revenue Bulletin (or
Cumulative Bulletin) and are available
from the Superintendent of Documents,
U.S. Government Printing Office,
Washington, DC 20402, or by visiting
the IRS Web site at http://www.irs.gov.
Special Analyses
Executive Orders 13563 and 12866
direct agencies to assess costs and
benefits of available regulatory
alternatives and, if regulation is
necessary, to select regulatory
approaches that maximize net benefits
(including potential economic,
environmental, public health and safety
effects, distributive impacts, and
equity). Executive Order 13563
emphasizes the importance of
quantifying both costs and benefits, of
reducing costs, of harmonizing rules,
and of promoting flexibility. This rule
has been designated a ‘‘significant
regulatory action’’ under section 3(f) of
Executive Order 12866 and designated
as economically significant.
Accordingly, the rule has been reviewed
by the Office of Management and
Budget. A regulatory assessment for this
proposed rule is available in the docket
for this rulemaking on
www.regulations.gov.
Pursuant to the Regulatory Flexibility
Act (5 U.S.C. Chapter 6), it is hereby
certified that the proposed regulations
will not have a significant economic
impact on a substantial number of small
entities. Accordingly, an initial
regulatory flexibility analysis is not
required. The Commissioner and the
courts historically have analyzed
whether an interest in a corporation
should be treated as stock or
indebtedness for federal tax purposes by
applying various sets of factors to the
facts of a particular case. Proposed
§ 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,

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the Commissioner has the discretion to
treat certain interests in a corporation
for federal tax purposes as indebtedness
in part and stock in part. Proposed
§ 1.385–1 does not require taxpayers to
take any additional actions 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 instruments 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 member of the
expanded group is publicly traded, or
financial statements of the expanded
group or its members show total assets
exceeding $100 million or annual total
revenue exceeding $50 million. Because
the rules are limited to large expanded
groups, they will not affect a substantial
number of small entities.
Proposed § 1.385–3 provides rules
that treat as stock certain interests in a
corporation that are held by a member
of the corporation’s expanded group and
that otherwise would be treated as
indebtedness for federal tax purposes.
Proposed § 1.385–4 provides rules
regarding the application of proposed
§ 1.385–3 to members of a consolidated
group. Proposed § 1.385–3 includes
multiple exceptions that limit its
application. In particular, the threshold
exception provides that an expanded
group debt instrument will not be
treated as stock under proposed § 1.385–
3 if, when the debt instrument is issued,
the aggregate issue price of all expanded
group debt instruments that otherwise
would be treated as stock under
proposed § 1.385–3 does not exceed $50
million. The threshold exception also
governs the application of proposed
§ 1.385–3 rules to members of a
consolidated group described in
proposed § 1.385–4. Although 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 Advocacy of the Small

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Business Administration for comment
on their impact on small business.
Comments and Public Hearing
Before the proposed regulations are
adopted as final regulations,
consideration will be given to any
written (a signed original and eight
copies) or electronic comments that are
submitted timely to the IRS. The
Treasury Department and the IRS
request comments on all aspects of the
proposed rules, including comments on
the clarity of the proposed rules and
how they can be made more
administrable. In addition, comments
are requested on: (1) Other instruments
that should be subject to the proposed
regulations, including other types of
applicable instruments that are not
indebtedness in form that should be
subject to proposed § 1.385–2 and the
documentation requirements that
should apply to such applicable
instruments; (2) whether special rules
are warranted for cash pools, cash
sweeps, and similar arrangements for
managing cash of an expanded group;
(3) the rule addressing deemed
exchanges of an EGI and a debt
instrument; (4) the application of these
rules to any entity with respect to a year
in which the entity is not a U.S. person
(as defined in section 7701(a)(30)), is
not required to file a U.S. tax return, and
is not a CFC or a controlled foreign
partnership, but in a later year becomes
one of the foregoing; (5) whether certain
indebtedness commonly used by
investment partnerships, including
indebtedness issued by certain
‘‘blocker’’ entities, implicate similar
policy concerns as those motivating the
proposed regulations, such that the
scope of the proposed regulations
should be broadened; (6) whether
guidance is needed under section 909 to
the extent a U.S. equity hybrid
instrument arises solely by reason of the
application of proposed § 1.385–3; and
(7) the treatment of controlled
partnerships in proposed § 1.385–3 and
the collateral consequences of the
recharacterization and any
corresponding adjustments, including
the treatment of a partner’s
proportionate share of partnership
assets or debt instruments, of treating a
debt instrument issued by a controlled
partnership as stock in its expanded
group partners, including a situation in
which a recharacterization results in a
partnership owning stock of an
expanded group partner. Specifically,
the Treasury Department and the IRS
request comments on how to apply
proposed § 1.385–3 when expanded
group partners make distributions
subject to the funding rule with respect

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20929

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 locating debt
instruments in order to achieve results
that are contrary to the purposes of
these regulations, and, if so, whether the
anti-abuse rule in proposed § 1.385–
3(b)(4) or the rule prohibiting the
affirmative use of these rules by
taxpayers in proposed § 1.385–3(e) are
sufficient to address these concerns.
More generally, the Treasury
Department and the IRS request
comments on whether additional
guidance is necessary regarding the
manner by which issuers and holders
notify the Secretary of the intended
federal tax treatment of an interest in a
corporation.
The Treasury Department and the IRS
are aware that the issuance of preferred
equity by a controlled partnership to an
expanded group member may give rise
to similar concerns as debt instruments
of a controlled partnership issued to an
expanded group member, and that
controlled partnerships may, in some
cases, issue preferred equity with a
principal purpose of avoiding the
application of § 1.385–3 of the proposed
regulations. The Treasury Department
and the IRS are considering rules that
would treat preferred equity in a
controlled partnership as equity in the
expanded group partners, based on the
principles of the aggregate approach
used in proposed § 1.385–3(d)(5).
Comments are requested regarding the
recharacterization of preferred equity in
those circumstances. Until any such
guidance is issued, the IRS intends to
closely scrutinize, and may challenge
when the regulations become effective,
transactions in which a controlled
partnership issues preferred equity to an
expanded group member and, within
the relevant 72-month period, one or
more expanded group partners in the
controlled partnership engage in a
transaction described in § 1.385–
3(b)(3)(ii) of the proposed regulations.
Finally, regarding the request for
comments on whether guidance is
needed under section 909 when a U.S.
equity hybrid instrument arises solely
by reason of the application of § 1.385–
3: the application of proposed § 1.385–

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3 may give rise to a U.S. equity hybrid
instrument splitter arrangement 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
distributions out of earnings and profits
attributable 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 proliferation of U.S. hybrid
equity instrument splitter arrangements,
the Treasury Department and the IRS
request comments on whether
additional guidance is needed under
section 909, including to address any
uncertainty with respect to how U.S.
hybrid equity instrument splitter
arrangements are treated. All comments
will be available for public inspection
and copying at www.regulations.gov or
upon request.
Drafting Information
The principal authors of these
regulations are Eric D. Brauer of the
Office of Associate Chief Counsel
(Corporate) and Raymond J. Stahl of the
Office of Associate Chief Counsel
(International). However, other
personnel from the Treasury
Department and the IRS participated in
their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
Proposed Amendment to the
Regulations
Accordingly, 26 CFR part 1 is
proposed to be amended as follows:
PART I—INCOME TAXES
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:

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■

§ 1.385–1

General provisions.

(a) Overview. This section provides
definitions applicable to the regulations
under section 385 and operating rules
regarding the treatment of certain direct

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and indirect interests in corporations as
stock or indebtedness for federal tax
purposes. Section 1.385–2 provides
documentation and information
requirements necessary for certain
interests issued between members of an
expanded group (as defined in
paragraph (b)(3) of this section) to be
treated as indebtedness for federal tax
purposes. Section 1.385–3 provides
rules that treat as stock certain interests
in a corporation issued between
members of an expanded group in
connection with certain purported
distributions of debt instruments and
similar transactions. Section 1.385–4
provides special rules regarding the
transactions described in § 1.385–3 as
they relate to consolidated groups.
(b) Definitions. The definitions in this
paragraph (b) apply for purposes of the
regulations under section 385. For
additional definitions that apply for
purposes of § 1.385–2, see § 1.385–
2(a)(4). For additional definitions that
apply for purposes of §§ 1.385–3 and
1.385–4, see § 1.385–3(f).
(1) Controlled partnership. The term
controlled partnership means a
partnership with respect to which at
least 80 percent of the interests in
partnership capital or profits are owned,
directly or indirectly, by one or more
members of an expanded group. For this
purpose, indirect ownership of a
partnership interest is determined by
applying the principles of paragraph
(b)(3)(ii) of this section.
(2) Disregarded entity. The term
disregarded entity means a business
entity (as defined in § 301.7701–2(a) of
this chapter) that is disregarded as an
entity separate from its owner for
federal tax purposes under §§ 301.7701–
1 through 301.7701–3 of this chapter.
(3) Expanded group—(i) In general.
The term expanded group means an
affiliated group as defined in section
1504(a), determined:
(A) Without regard to paragraphs (1)
through (8) of section 1504(b);
(B) By substituting ‘‘directly or
indirectly’’ for ‘‘directly’’ in section
1504(a)(1)(B)(i); and
(C) By substituting ‘‘or’’ for ‘‘and’’ in
section 1504(a)(2)(A).
(ii) Indirect stock ownership. For
purposes of this paragraph (b)(3),
indirect stock ownership is determined
by applying the rules of section
304(c)(3).
(4) Modified controlled partnership.
The term modified controlled
partnership means a partnership with
respect to which at least 50 percent of
the interests in partnership capital or
profits are owned, directly or indirectly,
by one or more members of a modified
expanded group. For this purpose,

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indirect ownership of a partnership
interest is determined by applying the
principles of paragraph (b)(3)(ii) of this
section.
(5) Modified expanded group. The
term modified expanded group means
an expanded group, as defined in this
section, determined by substituting
‘‘50’’ for ‘‘80’’ in sections 1504(a)(2)(A)
and (B). If one or more members of a
modified expanded group own, directly
or indirectly, 50 percent of the interests
in partnership capital or profits of a
modified controlled partnership, the
modified controlled partnership is
treated as a member of the modified
expanded group. In addition, if a person
(as defined in section 7701(a)(1)) is
treated, under the rules of section 318,
as owning at least 50 percent of the
value of the stock of a modified
expanded group member, the person is
treated as a member of the modified
expanded group.
(c) Treatment of deemed exchange. If
a debt instrument (as defined in
§ 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
instrument or EGI for an amount equal
to its adjusted issue price as of the date
of the deemed exchange. In addition,
neither party accounts for any accrued
but unpaid qualified stated interest on
the debt instrument or EGI or any
foreign exchange gain or loss with
respect to that accrued but unpaid
qualified stated interest (if any) as of the
deemed exchange. Notwithstanding the
first sentence of this paragraph (c), the
rules of § 1.988–2(b)(13) apply to require
the holder and the issuer of a debt
instrument or an EGI that is deemed to
be exchanged in whole or in part for
stock pursuant to § 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 accrued but unpaid
qualified stated interest that is not taken
into account under this paragraph (c) at
the time of the deemed exchange. For
purposes of this paragraph (c), in
applying § 1.988–2(b)(13) the exchange

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

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§ 301.7701–3 of this chapter that is filed
on or after the date these regulations are
issued as final regulations in the
Federal Register. For purposes of
§§ 1.385–3 and 1.385–4, this section
applies to any debt instrument issued
on or after April 4, 2016, and to any
debt instrument treated as issued before
April 4, 2016 as a result of an entity
classification election made under
§ 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 federal tax purposes.
Satisfying the requirements of this
section does not establish that an
interest is indebtedness; such
satisfaction serves as a minimum
standard that enables this determination
to be made under general federal tax
principles. The rules of this section
must be interpreted and applied in a
manner that is consistent with and
reasonably carries out the purposes of
this section. Moreover, nothing in this
section prevents the Commissioner from
asserting that the substance of a
transaction involving an EGI (or the EGI
itself) is different from the form of the
transaction (or the EGI) or disregarding
the transaction (or the EGI) or treating
the transaction (or the EGI) in
accordance with its substance for
federal tax purposes. Such an assertion
may be made based on the
documentation or information received
pursuant to a request under this section
or a request for information under
section 7602. If, and only if, the
requirements of this section are
satisfied, the determination of the
federal tax treatment of the EGI is made
based on an analysis of the
documentation and information
prepared and maintained, other facts
and circumstances relating to the EGI,
and general federal tax principles. If the
requirements of this section are not
satisfied with respect to an EGI the
substance of which is regarded for
federal tax purposes, the EGI will be
treated as stock. This section does not

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otherwise affect the authority of the
Commissioner under section 7602 to
request and obtain documentation and
information regarding transactions and
instruments that purport to create an
interest in a corporation. If the
requirements of this section are satisfied
or otherwise do not apply, see §§ 1.385–
3 and 1.385–4 for additional rules for
determining whether and the extent to
which an interest otherwise treated as
indebtedness under general federal tax
principles is recharacterized as stock for
federal tax purposes.
(2) Application—(i) In general. This
section applies to an EGI only if—
(A) The stock of any member of the
expanded group is traded on (or subject
to the rules of) an established financial
market within the meaning of
§ 1.1092(d)–1(b);
(B) On the date that an applicable
instrument first becomes an EGI, total
assets exceed $100 million on any
applicable financial statement, or
(C) On the date that an applicable
instrument first becomes an EGI, annual
total revenue exceeds $50 million on
any applicable financial statement.
(ii) Non-U.S. dollar applicable
financial statements. If an applicable
financial statement is denominated in a
currency other than the U.S. dollar, the
total assets and annual total revenue are
translated into U.S. dollars at the spot
rate (as defined in § 1.988–1(d)) as of the
date of the applicable financial
statement.
(3) Consistency rule. If an issuer
characterizes an EGI as indebtedness,
the EGI will be respected as
indebtedness only if the requirements of
§ 1.385–2(b) are met with respect to the
EGI. If the issuer of an EGI characterizes
that EGI as indebtedness, the issuer, the
holder, and any other person relying on
the characterization of an EGI as
indebtedness for federal tax purposes is
required to treat the EGI as indebtedness
for all federal tax purposes. The
Commissioner is not bound by the
issuer’s characterization of an EGI.
(4) Definitions. The definitions in this
paragraph (a)(4) apply for purposes of
this section.
(i) Applicable instrument—(A) In
general. The term applicable instrument
means any interest issued or deemed
issued that is in form a debt instrument.
See paragraph (a)(4)(i)(B) of this section
for rules regarding an interest that is not
in form a debt instrument.
(B) [Reserved]
(ii) Expanded group instrument. The
term expanded group instrument (EGI)
means an applicable instrument an
issuer of which is one member of an
expanded group and the holder of

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which is another member of the same
expanded group.
(iii) Issuer. Solely for purposes of this
section, the term issuer means a person
(including a disregarded entity defined
in § 1.385–1(b)(2)) that is obligated to
satisfy any material obligations created
under the terms of an EGI. A person can
be an issuer if that person is expected
to satisfy a material obligation under an
EGI, even if that person is not the
primary obligor. A guarantor, however,
is not an issuer unless the guarantor is
expected to be the primary obligor.
(iv) Applicable financial statement.
For purposes of this section, the term
applicable financial statement means a
financial statement, listed in paragraphs
(a)(4)(iv)(A) through (C) of this section,
that includes the assets, portion of the
assets or annual total revenue of any
member of the expanded group and that
is prepared as of any date within 3 years
prior to the date the applicable
instrument at issue first becomes an
EGI. A financial statement that includes
the assets or annual total revenue of a
member of an expanded group may be
a separate company financial statement
of any member of the expanded group
or any consolidated financial statement
that includes the assets, portion of the
assets, or annual total revenue of any
member of the expanded group. A
financial statement includes—
(A) A financial statement required to
be filed with the Securities and
Exchange Commission (the Form 10–K
or the Annual Report to Shareholders);
(B) A certified audited financial
statement that is accompanied by the
report of an independent certified
public accountant (or in the case of a
foreign entity, by the report of a
similarly qualified independent
professional) that is used for—
(1) Credit purposes;
(2) Reporting to shareholders,
partners, or similar persons; or
(3) Any other substantial non-tax
purpose; or
(C) A financial statement (other than
a tax return) required to be provided to
the Federal, state, or foreign government
or any Federal, state, or foreign agency.
(b) Documentation and information
required to determine treatment—(1)
Preparation and maintenance of
documentation and information—(i) In
general. Except as otherwise provided
in this section, an EGI is treated for
federal tax purposes as stock if the
documentation and information
described in paragraph (b)(2) of this
section are not prepared, or the
maintenance requirements of paragraph
(b)(4) of this section are not satisfied. If
the requirements of this section are
satisfied, general federal tax principles

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apply to determine whether, or the
extent to which, the EGI is treated as
indebtedness for federal tax purposes.
This determination will take into
account the documentation and
information prepared, maintained, and
provided in accordance with this
section, as well as any additional facts
and circumstances. This section applies
to each EGI separately, but the same
documentation and information may
satisfy the requirements of this section
for more than one EGI.
(ii) Failure to provide documentation
and information described in paragraph
(b)(2) of this section. If a taxpayer
characterizes an EGI as indebtedness
and fails to provide the documentation
and information described in paragraph
(b)(2) of this section upon request by the
Commissioner, the Commissioner will
treat the requirements of this section as
not satisfied.
(2) Documentation and other
information required. This paragraph
(b)(2) describes the documentation and
information that must be prepared and
maintained to satisfy the requirements
of this section. In each case, the
documentation must include complete
and (if relevant) executed copies of all
instruments, agreements and other
documents evidencing the material
rights and obligations of the issuer and
the holder relating to the EGI, and any
associated rights and obligations of
other parties, such as guarantees and
subordination agreements. Additional
documentation and information may be
provided to supplement, but not
substitute for, the documentation and
information required under this section.
The documentation and information
must satisfy the following requirements:
(i) Unconditional obligation to pay a
sum certain. There must be written
documentation prepared by the time
required in paragraph (b)(3) of this
section establishing that the issuer has
entered into an unconditional and
legally binding obligation to pay a sum
certain on demand or at one or more
fixed dates.
(ii) Creditor’s rights. The written
documentation described in paragraph
(b)(2)(i) of this section must establish
that the holder has the rights of a
creditor to enforce the obligation. The
rights of a creditor typically include, but
are not limited to, the right to cause or
trigger an event of default or
acceleration of the EGI (when the event
of default or acceleration is not
automatic) for non-payment of interest
or principal when due under the terms
of the EGI and the right to sue the issuer
to enforce payment. The rights of a
creditor must include a superior right to

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shareholders to share in the assets of the
issuer in case of dissolution.
(iii) Reasonable expectation of ability
to repay EGI. There must be written
documentation prepared containing
information establishing that, as of the
date of issuance of the applicable
instrument and taking into account all
relevant circumstances (including all
other obligations incurred by the issuer
as of the date of issuance of the
applicable instrument or reasonably
anticipated to be incurred after the date
of issuance of the applicable
instrument), the issuer’s financial
position supported a reasonable
expectation that the issuer intended to,
and would be able to, meet its
obligations pursuant to the terms of the
applicable instrument. For this purpose,
if a disregarded entity is treated as the
issuer of an EGI, and the owner of the
disregarded entity has limited liability
within the meaning of § 301.7701–
3(b)(2)(ii) of this chapter, only the assets
and financial position of the disregarded
entity are relevant for purposes of this
paragraph (b)(2)(iii). If the owner of
such a disregarded entity does not have
limited liability within the meaning of
§ 301.7701–3(b)(2)(ii), all of the assets
and the financial position of the
disregarded entity and the owner are
relevant for purposes of this paragraph
(b)(2)(iii). The documentation may
include cash flow projections, financial
statements, business forecasts, asset
appraisals, determination of debt-toequity and other relevant financial
ratios of the issuer in relation to
industry averages, and other
information regarding the sources of
funds enabling the issuer to meet its
obligations pursuant to the terms of the
applicable instrument. If any member of
an expanded group relied on any report
or analysis prepared by a third party in
analyzing whether the issuer would be
able to meet its obligations pursuant to
the terms of the EGI, the documentation
must include the report or analysis. If
the report or analysis is protected or
privileged under law governing an
inquiry or proceeding with respect to
the EGI and the protection or privilege
is asserted, neither the existence nor the
contents of the report or analysis is
taken into account in determining
whether the requirements of this section
are satisfied.
(iv) Actions evidencing debtorcreditor relationship—(A) Payments of
principal and interest. If an issuer made
any payment of interest or principal
with respect to the EGI (whether in
accordance with the terms and
conditions of the EGI or otherwise,
including prepayments), and such
payment is claimed to support the

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treatment of the EGI as indebtedness
under general federal tax principles,
documentation must include written
evidence of such payment that is
prepared by the time required in
paragraph (b)(3) of this section. Such
evidence could include, for example, a
wire transfer record or a bank statement
reflecting the payment.
(B) Events of default and similar
events. If the issuer did not make a
payment of interest or principal that
was due and payable under the terms
and conditions of the EGI, or if any
other event of default or similar event
has occurred, there must be written
documentation, prepared, by the time
required in paragraph (b)(3) of this
section, evidencing the holder’s
reasonable exercise of the diligence and
judgment of a creditor. Such
documentation may include evidence of
the holder’s efforts to assert its rights
under the terms of the EGI, including
the parties’ efforts to renegotiate the EGI
or to mitigate the breach of an obligation
under the EGI, or any change in material
terms and conditions of the EGI, such as
maturity date, interest rate, or obligation
to pay interest or principal, and any
documentation detailing the holder’s
decision to refrain from pursuing any
actions to enforce payment.
(v) Additional information with
respect to an EGI evidenced by
documentation that does not in form
reflect indebtedness. This paragraph
(b)(1)(v) describes additional
information with respect to an EGI
evidenced by documentation that does
not in form reflect indebtedness.
(A)–(B) [Reserved]
(3) Timely preparation requirement—
(i) General rule. For purposes of this
section, the documentation described in
paragraphs (b)(2)(i), (ii) and (iii) of this
section will be treated as satisfying the
timely preparation requirement of this
paragraph (b)(3) if it is prepared no later
than 30 calendar days after the relevant
date, as defined in paragraph (b)(3)(ii) of
this section. The documentation
described in paragraph (b)(2)(iv) of this
section will be treated as satisfying the
timely preparation requirement of this
paragraph (b)(3) if it is prepared no later
than 120 calendar days after the relevant
date, as defined in paragraph (b)(3)(ii) of
this section, as applicable.
(ii) Relevant date. Subject to the
special rules in paragraph (b)(3)(iii) of
this section (relating to certain financial
arrangements not evidenced by an
instrument) and paragraph (c)(1) of this
section (relating to modifications to
certain requirements of this section), the
relevant date is as follows:
(A) For documentation and
information described in paragraphs

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(b)(2)(i) and (b)(2)(ii) of this section
(relating to issuer’s unconditional
obligation to repay and establishment of
holder’s creditor’s rights), the relevant
date is the date on which a member of
the expanded group becomes an issuer
of a new or existing EGI, without regard
to any subsequent deemed issuance of
the EGI under § 1.1001–3. In the case of
an applicable instrument that becomes
an EGI subsequent to issuance,
including an intercompany obligation,
as defined in § 1.1502–13(g)(2)(ii), that
ceases to be an intercompany obligation,
the relevant date is the day on which
the applicable instrument becomes an
EGI.
(B) For documentation and
information described in paragraph
(b)(2)(iii) of this section (relating to
reasonable expectation of issuer’s
repayment), the relevant dates are the
dates on which a member of the
expanded group becomes an issuer with
respect to an EGI and any later date on
which an issuance is deemed to occur
under § 1.1001–3 and any subsequent
relevant date that occurs under the
special rules in paragraph (b)(3)(iii) of
this section. In the case of an applicable
instrument that becomes an EGI
subsequent to issuance, the relevant
date is the day on which the applicable
instrument becomes an EGI and any
relevant date after the date that the
applicable instrument becomes an EGI.
(C) For documentation and
information described in paragraph
(b)(2)(iv)(A) of this section (relating to
payments of principal and interest),
each date on which a payment of
interest or principal is due, taking into
account all additional time permitted
under the terms of the EGI before there
is (or holder can declare) an event of
default for nonpayment, is a relevant
date.
(D) For documentation and
information described in paragraph
(b)(2)(iv)(B) of this section (relating to
events of default and similar events),
each date on which an event of default,
acceleration event or similar event
occurs under the terms of the EGI is a
relevant date. For example, if the terms
of the EGI require the issuer to maintain
certain financial ratios, any date on
which the issuer fails to maintain the
specified financial ratio (and such
failure results in an event of default
under the terms of the EGI) is a relevant
date.
(E) In the case of an applicable
instrument that becomes an EGI
subsequent to issuance, no date before
the applicable instrument becomes an
EGI is a relevant date.
(iii) Special rules for determining
relevant dates with respect to certain

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20933

financial arrangements. The relevant
dates with respect to the arrangements
described in this paragraph (b)(3)(iii)
include the date of the execution of the
legal documents governing the EGI and
the date of any amendment to those
documents that provides for an increase
in the permitted maximum amount of
principal. In addition—
(A) Revolving credit agreements and
similar agreements. Notwithstanding
paragraph (b)(2)(i) of this section, if an
EGI is not evidenced by a separate note
or other writing executed with respect
to the initial principal balance or any
increase in principal balance (for
example, an EGI documented as a
revolving credit agreement or an
omnibus agreement that governs open
account obligations), the EGI satisfies
the requirements of paragraph (b)(2)(i)
of this section only if the material
documentation associated with the EGI,
including all relevant enabling
documents, is prepared, maintained,
and provided in accordance with the
requirements of this section. Relevant
enabling documents may include board
of directors’ resolutions, credit
agreements, omnibus agreements,
security agreements, or agreements
prepared in connection with the
execution of the legal documents
governing the EGI as well as any
relevant documentation executed with
respect to an initial principal balance or
increase in the principal balance of the
EGI.
(B) Cash pooling arrangements.
Notwithstanding paragraph (b)(2)(i) of
this section, if an EGI is issued pursuant
to a cash pooling arrangement or
internal banking service that involves
account sweeps, revolving cash advance
facilities, overdraft set-off facilities,
operational facilities, or similar features,
the EGI satisfies the requirements of
paragraph (b)(2)(i) of this section only if
the material documentation governing
the ongoing operations of the cash
pooling arrangement or internal banking
service, including any agreements with
entities that are not members of the
expanded group, is prepared,
maintained, and provided in accordance
with the requirements of this section.
Such documentation must contain the
relevant legal rights and responsibilities
of any members of the expanded group
and any entities that are not members of
the expanded group in conducting the
operation of the cash pooling
arrangement or internal banking service.
(4) Maintenance requirements. The
documentation and information
described in paragraph (b)(2) of this
section must be maintained for all
taxable years that the EGI is outstanding
and until the period of limitations

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expires for any return with respect to
which the treatment of the EGI is
relevant. See section 6001 (requirement
to keep books and records).
(c) Operating rules—(1) Reasonable
cause exception. If the person
characterizing an EGI as indebtedness
for federal tax purposes establishes that
a failure to satisfy the requirements of
this section is due to reasonable cause,
appropriate modifications may be made
to the requirements of this section in
determining whether the requirements
of this section have been satisfied. The
principles of § 301.6724–1 of this
chapter apply in interpreting whether
reasonable cause exists in any particular
case.
(2) General application of section to
applicable instrument becoming or
ceasing to be an EGI—(i) Applicable
instrument becomes an EGI. If an
applicable instrument that is not an EGI
when issued subsequently becomes an
EGI, this section applies to the
applicable instrument immediately after
it becomes an EGI and thereafter.
(ii) EGI treated as stock ceases to be
an EGI. When an EGI treated as stock
due to the application of this section
ceases to be an EGI, the applicable
instrument is characterized at that time
under general federal tax principles. If,
under general federal tax principles, the
applicable instrument is treated as
indebtedness, the issuer is treated as
issuing a new instrument to the holder
in exchange for the EGI immediately
before the transaction that causes the
EGI treated as stock due to the
application of this section to cease to be
treated as an EGI. See § 1.385–1(c).
(3) Effective date for treatment of EGI
as stock under this section—(i) In
general. If an applicable instrument is
an EGI when issued and is determined
to be stock, in whole or in part, due to
the application of this section, the
applicable instrument or relevant
portion thereof is treated as stock from
the date it was issued. However, if an
applicable instrument is issued prior to
the time it becomes an EGI and is
determined to be stock, at the time it
becomes an EGI due to the application
of this section, it is treated as stock from
the date it becomes an EGI. See § 1.385–
2(c)(4) regarding intercompany
obligations (deemed issued immediately
after ceasing to be an intercompany
obligation for purposes of this section
and § 1.385–3).
(ii) EGI recharacterized as stock based
on behavior of issuer or holder after
issuance. Notwithstanding paragraph
(c)(3)(i) of this section, if an EGI initially
treated as indebtedness is
recharacterized as stock as a result of
failing to satisfy paragraph (b)(2)(iv) of

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this section (actions evidencing debtorcreditor relationship), the EGI will cease
to be treated as indebtedness as of the
time the facts and circumstances
regarding the behavior of the issuer or
the holder with respect to the EGI cease
to evidence a debtor-creditor
relationship. For purposes of
determining whether an EGI originally
treated as indebtedness ceases to be
treated as indebtedness by reason of
paragraph (b)(2)(iv) of this section, the
rules of this section apply before the
rules of § 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
held by members of consolidated
groups—(i) Consolidated group treated
as one corporation. Section 1.385–1(e)
provides that members of a consolidated
group are treated as one corporation.
Thus, during the time that the issuer
and the holder of an applicable
instrument are members of the same
consolidated group, the applicable
instrument is treated as not outstanding
for purposes of this section. As a result,
this section does not apply to any
applicable instrument that is an
intercompany obligation as defined in
§ 1.1502–13(g)(2)(ii).
(ii) Applicable instrument that ceases
to be an intercompany obligation. If an
applicable instrument ceases to be an
intercompany obligation and, as a
result, becomes an EGI, the applicable
instrument is treated as becoming an
EGI immediately after it ceases to be an
intercompany obligation. This
paragraph (c)(4)(i) does not affect the
application of the rules under § 1.1502–
13(g).
(5) Treatment of disregarded entities.
If a disregarded entity is the issuer of an
EGI and that EGI is treated as equity
under this section, the EGI is treated as
an equity interest in the disregarded
entity rather than stock in the
disregarded entity’s owner. See § 1.385–
2(c)(6)(ii) for rules regarding the
treatment of an EGI issued by a
controlled partnership.
(6) Applicable instruments issued or
held by controlled partnerships—(i)
Controlled partnerships included in
expanded group. For purposes of this
section, a controlled partnership (as
defined in § 1.385–1(b)(1)) is treated as
a member of an expanded group if one
or more members of the expanded group
own, directly or indirectly, 80 percent of
the interests in partnership capital or
profits of the controlled partnership.

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(ii) Treatment of EGI issued by a
controlled partnership that is
recharacterized under this section. If an
EGI that is issued by a controlled
partnership is recharacterized as stock
under this section, the EGI is treated as
an equity interest in the controlled
partnership.
(d) No affirmative use. The rules of
this section do not apply if there is a
failure to satisfy the requirements of
paragraph (b) of this section with a
principal purpose of reducing the
federal tax liability of any member or
members of the expanded group of the
issuer and holder of the EGI or any other
person relying on the characterization of
an EGI as indebtedness for federal tax
purposes.
(e) Anti-avoidance. If an applicable
instrument that is not an EGI is issued
with a principal purpose of avoiding the
purposes of this section, the applicable
instrument is treated as an EGI subject
to this section.
(f) Effective/applicability date. This
section applies to any applicable
instrument issued or deemed issued on
or after the date these regulations are
published as final regulations in the
Federal Register, and to any applicable
instrument treated as indebtedness
issued or deemed issued before the date
these regulations are issued as final
regulations if and to the extent it was
deemed issued as a result of an entity
classification election made under
§ 301.7701–3 of this chapter that is filed
on or after the date these regulations are
issued as final regulations in the
Federal Register.
■ 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
indebtedness for federal tax purposes.
Paragraph (b) of this section sets forth
situations in which a debt instrument is
treated as stock under this section.
Paragraph (c) of this section provides
three exceptions to the application of
paragraph (b) of this section. Paragraph
(d) of this section provides operating
rules. Paragraph (e) of this section limits
the affirmative use of this section.
Paragraph (f) of this section provides
definitions. Paragraph (g) of this section
provides examples illustrating the
application of the rules of this section.
Paragraph (h) of this section provides
dates of applicability. For rules
regarding the application of this section

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to members of a consolidated 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 portion thereof, that is not
characterized as stock under this section
is treated as stock or indebtedness under
applicable federal tax law, without
reference to this section.
(2) General rule. Except as provided
in paragraphs (c) and (e) of this section
and in § 1.385–4, a debt instrument is
treated as stock to the extent the debt
instrument is issued by a corporation to
a member of the corporation’s expanded
group as described in one or more of the
following paragraphs:
(i) In a distribution;
(ii) In exchange for expanded group
stock, other than in an exempt
exchange; or
(iii) In exchange for property in an
asset reorganization, but only to the
extent that, pursuant to the plan of
reorganization, a shareholder that is a
member of the issuer’s expanded group
immediately before the reorganization
receives the debt instrument with
respect to its stock in the transferor
corporation.
(3) Funding rule—(i) In general.
Except as provided in paragraphs (c)
and (e) of this section and in § 1.385–4,
a debt instrument is treated as stock to
the extent it is a principal purpose debt
instrument.
(ii) Principal purpose debt
instrument. For purposes of this
paragraph (b)(3), a debt instrument is a
principal purpose debt instrument to
the extent it is issued by a corporation
(funded member) to a member of the
funded member’s expanded group in
exchange for property with a principal
purpose of funding a distribution or
acquisition described in one or more of
the following paragraphs:
(A) A distribution of property by the
funded member to a member of the
funded member’s expanded group, other
than a distribution of stock pursuant to
an asset reorganization that is permitted
to be received without the recognition of
gain or income under section 354(a)(1)
or 355(a)(1) or, when section 356
applies, that is not treated as ‘‘other
property’’ or money described in section
356;
(B) An acquisition of expanded group
stock, other than in an exempt
exchange, by the funded member from
a member of the funded member’s
expanded group in exchange for
property other than expanded group
stock; or

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(C) An acquisition of property by the
funded member in an asset
reorganization but only to the extent
that, pursuant to the plan of
reorganization, a shareholder that is a
member of the funded member’s
expanded group immediately before the
reorganization receives ‘‘other property’’
or money within the meaning of section
356 with respect to its stock in the
transferor corporation.
(iii) Transactions described in more
than one paragraph. Solely for purposes
of this section, to the extent all or a
portion of a distribution or acquisition
by a funded member is described in
more than one of paragraphs (b)(3)(ii)(A)
through (C) of this section, the funded
member is treated as engaging in only a
single distribution or acquisition
described in paragraph (b)(3)(ii) of this
section.
(iv) Principal purpose—(A) In general.
Subject to paragraph (b)(3)(iv)(B)(1) of
this section, whether a debt instrument
is issued with a principal purpose of
funding a distribution or acquisition
described in paragraph (b)(3)(ii) of this
section is determined based on all the
facts and circumstances. A debt
instrument may be treated as issued
with a principal purpose of funding a
distribution or acquisition described in
paragraph (b)(3)(ii) of this section
regardless of whether it is issued before
or after such distribution or acquisition.
(B) Per se rule—(1) In general. Except
as provided in paragraph (b)(3)(iv)(B)(2)
of this section, a debt instrument is
treated as issued with a principal
purpose of funding a distribution or
acquisition described in paragraph
(b)(3)(ii) of this section if it is issued by
the funded member during the period
beginning 36 months before the date of
the distribution or acquisition, and
ending 36 months after the date of the
distribution or acquisition (72-month
period).
(2) Ordinary course exception.
Paragraph (b)(3)(iv)(B)(1) of this section
does not apply to a debt instrument that
arises in the ordinary course of the
issuer’s trade or business in connection
with the purchase of property or the
receipt of services to the extent that it
reflects an obligation to pay an amount
that is currently deductible by the issuer
under section 162 or currently included
in the issuer’s cost of goods sold or
inventory, provided that the amount of
the obligation outstanding at no time
exceeds the amount that would be
ordinary and necessary to carry on the
trade or business of the issuer if it was
unrelated to the lender.
(3) Multiple interests. If, pursuant to
paragraph (b)(3)(iv)(B) of this section,
two or more debt instruments may be

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treated as a principal purpose debt
instrument, the debt instruments are
tested under paragraph (b)(3)(iv)(B) of
this section based on the order in which
they were issued, with the earliest
issued debt instrument tested first. See
paragraph (g)(3) of this section, Example
6, for an illustration of this rule.
(4) Multiple distributions or
acquisitions. Except as provided in
paragraph (c)(3) of this section, if,
pursuant to paragraph (b)(3)(iv)(B) of
this section, a debt instrument may be
treated as funding more than one
distribution or acquisition described in
paragraph (b)(3)(ii) of this section, the
debt instrument is treated as funding
one or more distributions or
acquisitions based on the order in
which the distributions or acquisitions
occurred, with the earliest distribution
or acquisition treated as the first
distribution or acquisition that was
funded. See paragraph (g)(3) of this
section, Example 9, for an illustration of
this rule.
(v) Predecessors and successors. For
purposes of this paragraph (b)(3),
references to the funded member
include references to any predecessor or
successor of such member. See
paragraph (g)(3) of this section,
Examples 9, 10, and 12, for illustrations
of this rule.
(vi) Treatment of funded transactions.
When a debt instrument is treated as
stock pursuant to paragraph (b)(3) of
this section, the distribution or
acquisition described in paragraph
(b)(3)(ii) of this section that is treated as
funded by such debt instrument is not
recharacterized as a result of the
treatment of the debt instrument as
stock.
(4) Anti-abuse rule. A debt instrument
is treated as stock if it is issued with a
principal purpose of avoiding the
application of this section or § 1.385–4.
In addition, an interest that is not a debt
instrument for purposes of this section
and § 1.385–4 (for example, a contract to
which section 483 applies or a
nonperiodic swap payment) is treated as
stock if issued with a principal purpose
of avoiding the application of this
section or § 1.385–4. This paragraph
(b)(4) may apply, for example, if a debt
instrument is issued to, and later
acquired from, a person that is not a
member of the issuer’s expanded group
with a principal purpose of avoiding the
application of this section. Additional
examples of when this paragraph (b)(4)
could apply include, without limitation,
situations where, with a principal
purpose of avoiding the application of
this section, a debt instrument is issued
to a person that is not a member of the
issuer’s expanded group, and such

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person later becomes a member of the
issuer’s expanded group; a debt
instrument is issued to an entity that is
not taxable as a corporation for federal
tax purposes; or a member of the
issuer’s expanded group is substituted
as a new obligor or added as a co-obligor
on an existing debt instrument. This
paragraph (b)(4) also may apply to a
debt instrument that is issued or
transferred in connection with a
reorganization or similar transaction
with a principal purpose of avoiding the
application of this section or § 1.385–4.
See paragraph (g)(3) of this section,
Example 18, for an illustration of this
rule.
(5) Coordination between general rule
and funding rule. To the extent a debt
instrument is treated as stock under
paragraph (b)(2)(iii) of this section, the
distribution of the debt instrument
(which is treated as a distribution of
stock as a result of the application of
paragraph (b)(2)(iii) of this section)
pursuant to the same reorganization that
caused paragraph (b)(2)(iii) of this
section to apply is not also treated as a
distribution or acquisition described in
paragraph (b)(3)(ii) of this section. See
paragraph (g)(3) of this section, Example
8, for an illustration of this rule.
(c) Exceptions—(1) Exception for
current year earnings and profits. For
purposes of applying paragraphs (b)(2)
and (b)(3) of this section to a member of
an expanded group with respect to a
taxable year, the aggregate amount of
any distributions or acquisitions that are
described in paragraphs (b)(2) or
(b)(3)(ii) of this section are reduced by
an amount equal to the member’s
current year earnings and profits
described in section 316(a)(2). This
reduction is applied to the transactions
described in paragraphs (b)(2) and
(b)(3)(ii) of this section based on the
order in which the distribution or
acquisition occurs. See paragraph (g)(3)
of this section, Example 17, for an
illustration of this rule.
(2) Threshold exception. A debt
instrument is not treated as stock under
this section if, immediately after the
debt instrument is issued, the aggregate
adjusted issue price of debt instruments
held by members of the expanded group
that would be subject to paragraph (b)
of this section but for the application of
this paragraph (c)(2) does not exceed
$50 million. Once this threshold is
exceeded, this paragraph (c)(2) will not
apply to any debt instrument issued by
members of the expanded group for so
long as any debt instrument that
previously was treated as indebtedness
solely because of this paragraph (c)(2)
remains outstanding. For purposes of
this rule, any debt instrument that is not

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denominated in U.S. dollars is
translated into U.S. dollars at the spot
rate (as defined in § 1.988–1(d)) on the
date that the debt instrument is issued.
See paragraph (g)(3) of this section,
Example 17, for an illustration of this
rule. See paragraph (d)(1)(iii) of this
section for rules regarding the treatment
of a debt instrument that ceases to
qualify for the exception provided in
this paragraph (c)(2).
(3) Exception for funded acquisitions
of subsidiary stock by issuance. An
acquisition of expanded group stock
will not be treated as described in
paragraph (b)(3)(ii)(B) of this section if
the acquisition results from a transfer of
property by a funded member (the
transferor) to an expanded group
member (the issuer) in exchange for
stock of the issuer, provided that, for the
36-month period immediately following
the issuance, the transferor holds,
directly or indirectly, more than 50
percent of the total combined voting
power of all classes of stock of the issuer
entitled to vote and more than 50
percent of the total value of the stock of
the issuer. If the transferor ceases to
meet this ownership requirement at any
time during that 36-month period, then
on the date that the ownership
requirement ceases to be met (cessation
date), this paragraph (c)(3) ceases to
apply and the acquisition is treated as
an acquisition described in paragraph
(b)(3)(ii)(B) of this section. In this case,
for purposes of applying the per se rule,
the acquisition may be treated as having
been funded by any debt instrument
issued during the 72-month period
determined with respect to the date of
the acquisition (rather than with respect
to the cessation date), but, in the case of
a debt instrument issued prior to the
cessation date, only to the extent that
such debt instrument is treated as
indebtedness as of the cessation date
(that is, a debt instrument not already
treated as stock). For purposes of this
paragraph (c)(3), a transferor’s indirect
stock ownership is determined by
applying the principles of section 958(a)
without regard to whether an
intermediate entity is foreign or
domestic. See paragraph (d)(1)(v) of this
section for rules regarding the treatment
of a debt instrument that is treated as
funding an acquisition to which this
exception ceases to apply.
(d) Operating rules—(1) Timing. This
paragraph (d)(1) provides rules for
determining when a debt instrument is
treated as stock under paragraph (b) of
this section. For special rules regarding
the treatment of a deemed exchange of
a debt instrument that occurs pursuant
to paragraphs (d)(1)(ii), (d)(1)(iii),
(d)(1)(iv), or (d)(1)(v), see § 1.385–1(c).

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(i) General timing rule. Except as
otherwise provided in this paragraph
(d)(1), when paragraph (b) of this
section applies to treat a debt
instrument as stock, the debt instrument
is treated as stock when the debt
instrument is issued. When paragraph
(b)(3) of this section applies to treat a
debt instrument as stock when the debt
instrument is issued, see also paragraph
(b)(3)(vi) of this section.
(ii) Exception when a debt instrument
is treated as funding a distribution or
acquisition that occurs in a subsequent
taxable year. When paragraph
(b)(3)(iv)(B) of this section applies to
treat a debt instrument as funding a
distribution or acquisition described in
paragraph (b)(3)(ii) of this section that
occurs in a taxable year subsequent to
the taxable year in which the debt
instrument is issued, the debt
instrument is deemed to be exchanged
for stock when the distribution or
acquisition described in paragraph
(b)(3)(ii) of this section occurs. See
paragraph (g)(3) of this section, Example
9, for an illustration of this rule.
(iii) Exception when a debt
instrument ceases to qualify for the
threshold exception. A debt instrument
that previously was treated as
indebtedness pursuant to the threshold
exception set forth in paragraph (c)(2) of
this section is deemed to be exchanged
for stock when the debt instrument
ceases to qualify for the threshold
exception. Notwithstanding the
preceding sentence, if the debt
instrument was both issued and ceases
to qualify for the threshold exception
during the same taxable year, the
general timing rule of paragraph (d)(1)(i)
of this section applies. See paragraph
(g)(3) of this section, Example 17, for an
illustration of this rule.
(iv) Exception when a debt instrument
is re-tested under paragraph (d)(2) of
this section. When paragraph
(b)(3)(iv)(B) of this section applies to
treat a debt instrument as funding a
distribution or acquisition described in
paragraph (b)(3)(ii) of this section as a
result of a re-testing described in
paragraph (d)(2) of this section that
occurs in a taxable year subsequent to
the taxable year in which the debt
instrument is issued, the debt
instrument is deemed to be exchanged
for stock on the date of the re-testing.
See paragraph (g)(3) of this section,
Example 7, for an illustration of this
rule.
(v) Exception when a debt instrument
ceases to qualify for the exception for
acquisitions of subsidiary stock by
issuance. When paragraph (b)(3)(iv)(B)
and the modified ordering rule in
paragraph (c)(3) of this section apply to

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treat a debt instrument as funding an
acquisition of expanded group stock
that previously qualified for the
exception set forth in paragraph (c)(3) of
this section, the debt instrument is
deemed to be exchanged for stock on the
cessation date referred to in paragraph
(c)(3) of this section if the debt
instrument was issued in a taxable year
preceding the taxable year that includes
the cessation date. For all other debt
instruments that are treated as funding
an acquisition of expanded group stock
that previously qualified for the
exception set forth in paragraph (c)(3) of
this section, the general timing rule of
paragraph (d)(1)(i) of this section
applies.
(2) Debt instrument treated as stock
that leaves the expanded group. Subject
to paragraph (b)(4) of this section, when
the holder and issuer of a debt
instrument that is treated as stock under
this section cease to be members of the
same expanded group, either because
the debt instrument is transferred to a
person that is not a member of the
expanded group that includes the issuer
or because the holder or the issuer cease
to be members of the same expanded
group, the debt instrument ceases to be
treated as stock under this section. For
this purpose, immediately before the
transaction that causes the holder and
issuer of the debt instrument to cease to
be members of the same expanded
group, the issuer is deemed to issue a
new debt instrument to the holder in
exchange for the debt instrument that
was treated as stock in a transaction that
is disregarded for purposes of
paragraphs (b)(2) and (b)(3) of this
section. For purposes of paragraph
(b)(3)(iv)(B) of this section, when this
paragraph (d)(2) causes a debt
instrument that previously was treated
as stock pursuant to paragraph (b)(3) of
this section to cease to be treated as
stock, all other debt instruments of the
issuer that are not currently treated as
stock are re-tested to determine whether
those other debt instruments are treated
as funding the distribution or
acquisition that previously was treated
as funded by the debt instrument that
ceases to be treated as stock pursuant to
this paragraph (d)(2). See paragraph
(g)(3) of this section, Example 7, for an
illustration of this rule.
(3) Inapplicability of section 385(c)(1).
Section 385(c)(1) does not apply with
respect to a debt instrument to the
extent that it is treated as stock under
this section.
(4) Taxable year. For purposes of this
section, the term taxable year refers to
the taxable year of the issuer of the debt
instrument.

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(5) Treatment of partnerships—(i)
Application of aggregate treatment. For
purposes of this section, a controlled
partnership is treated as an aggregate of
its partners. Thus, for example, when a
corporation that is a member of an
expanded group becomes a partner in a
partnership that is a controlled
partnership with respect to that
expanded group, the corporation is
treated as acquiring its proportionate
share of the controlled partnership’s
assets. In addition, each expanded
group partner in a controlled
partnership is treated as issuing its
proportionate share of any debt
instrument issued by the controlled
partnership. For this purpose, a
partner’s proportionate share is
determined in accordance with the
partner’s share of partnership profits.
See paragraph (g)(3) of this section,
Example 13, for an illustration of this
rule.
(ii) Treatment of debt instruments
issued by partnerships. To the extent
that the application of the aggregate
approach in paragraph (d)(5)(i) of this
section causes a debt instrument issued
by a controlled partnership to be
recharacterized under paragraph (b) of
this section, then the holder of the
recharacterized debt instrument is
treated as holding stock in the expanded
group partners. In addition, the
partnership and its partners must make
appropriate conforming adjustments to
reflect this treatment. Any such
adjustments must be consistent with the
purposes of this section and must be
made in a manner that avoids the
creation of, or increase in, a disparity
between the controlled partnership’s
aggregate basis in its assets and the
aggregate bases of the partners’
respective interests in the partnership.
See paragraph (g)(3) of this section,
Examples 14 and 15, for an illustration
of this rule.
(6) Treatment of disregarded entities.
If a debt instrument of a disregarded
entity is treated as stock under this
section, such debt instrument is treated
as stock in the entity’s owner rather
than as an equity interest in the entity.
(e) No affirmative use. The rules of
this section and § 1.385–4 do not apply
to the extent a person enters into a
transaction that otherwise would be
subject to these rules with a principal
purpose of reducing the federal tax
liability of any member of the expanded
group that includes the issuer and the
holder of the debt instrument by
disregarding the treatment of the debt
instrument that would occur without
regard to this section.

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(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 term
asset reorganization means a
reorganization within the meaning of
section 368(a)(1)(A), (C), (D), (F), or (G).
(2) Controlled partnership. The term
controlled partnership has the meaning
specified in § 1.385–1(b)(1).
(3) Debt instrument. The term debt
instrument means an interest that
would, but for the application of this
section, be treated as a debt instrument
as defined in section 1275(a) and
§ 1.1275–1(d).
(4) Distribution. The term distribution
means any distribution made by a
corporation with respect to its stock.
(5) Exempt exchange. The term
exempt exchange means an acquisition
of expanded group stock in which the
transferor and transferee of the stock are
parties to an asset reorganization, and
either—
(i) Section 361(a) or (b) applies to the
transferor of the expanded group stock
and the stock is not transferred by
issuance; or
(ii) Section 1032 or § 1.1032–2 applies
to the transferor of the expanded group
stock and the stock is distributed by the
transferee pursuant to the plan of
reorganization.
(6) Expanded group. The term
expanded group has the meaning
specified in § 1.385–1(b)(3).
(7) Expanded group partner. The term
expanded group partner means any
person that is a partner in a controlled
partnership and that is a member of the
expanded group whose members own,
directly or indirectly, at least 80 percent
of the interests in the controlled
partnership’s capital or profits.
(8) Expanded group stock. The term
expanded group stock means, with
respect to a member of an expanded
group, stock of a member of the same
expanded group.
(9) Predecessor—(i) In general. The
term predecessor includes, with respect
to a corporation, the distributor or
transferor corporation in a transaction
described in section 381(a) in which the
corporation is the acquiring corporation.
For purposes of the preceding sentence,
the transferor corporation in a
reorganization within the meaning of
section 368(a)(1)(D) or (G) is treated as
a transferor corporation in a transaction
described in section 381(a) without
regard to whether the reorganization
meets the requirements of sections
354(b)(1)(A) and (B). The term
predecessor does not include, with
respect to a controlled corporation, a
distributing corporation that distributed

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the stock of the controlled corporation
pursuant to section 355(c).
(ii) Special rules for funded
acquisitions of subsidiary stock by
issuance. The term predecessor also
includes, with respect to an issuer that
issues stock to a transferor in a
transaction described in paragraph (c)(3)
of this section, the transferor, but, for
purposes of applying the per se rule in
paragraph (b)(3)(iv)(B)(1) of this section,
only with respect to a debt instrument
issued by the transferor during the 72month period determined with respect
to the transaction described in
paragraph (c)(3) of this section, and only
to the extent of the value of the
expanded group stock acquired from the
issuer in the transaction described in
paragraph (c)(3) of this section.
(10) Property. The term property has
the meaning specified in section 317(a).
(11) Successor—(i) In general. The
term successor includes, with respect to
a corporation, the acquiring corporation
in a transaction described in section
381(a) in which the corporation is the
distributor or transferor corporation. For
purposes of the preceding sentence, the
acquiring corporation in a
reorganization within the meaning of
section 368(a)(1)(D) or (G) is treated as
an acquiring corporation in a
transaction described in section 381(a)
without regard to whether the
reorganization meets the requirements
of sections 354(b)(1)(A) and (B). The
term successor does not include, with
respect to a distributing corporation, a
controlled corporation the stock of
which was distributed by the
distributing corporation pursuant to
section 355(c).
(ii) Special rules for funded
acquisitions of subsidiary stock by
issuance. The term successor also
includes, with respect to a transferor
that transfers property to an issuer in
exchange for stock of the issuer in a
transaction described in paragraph (c)(3)
of this section, the issuer, but, for
purposes of applying the per se rule in
paragraph (b)(3)(iv)(B)(1) of this section,
only with respect to a debt instrument
issued by the transferor during 72month period determined with respect
to the transaction described in
paragraph (c)(3) of this section, and only
to the extent of the value of the
expanded group stock acquired from the
issuer in the transaction described in
paragraph (c)(3) of this section. A
distribution by an issuer described in
paragraph (c)(3) of this section directly
to the transferor is not taken into
account for purposes of applying
paragraph (b)(3) of this section to a debt
instrument of the transferor.

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(g) Examples—(1) Assumed facts.
Except as otherwise stated, the
following facts are assumed for
purposes of the examples in paragraph
(g)(3) of this section:
(i) FP is a foreign corporation that
owns 100 percent of the stock of USS1,
a domestic corporation, 100 percent of
the stock of USS2, a domestic
corporation, and 100 percent of the
stock of FS, a foreign corporation;
(ii) USS1 owns 100 percent of the
stock of DS, a domestic corporation, and
CFC, which is a controlled foreign
corporation within the meaning of
section 957;
(iii) At the beginning of Year 1, FP is
the common parent of an expanded
group comprised solely of FP, USS1,
USS2, FS, DS, and CFC (the FP
expanded group);
(iv) The FP expanded group has more
than $50 million of debt instruments
described in paragraph (c)(2) of this
section at all times;
(v) No issuer of a debt instrument has
current year earnings and profits
described in section 316(a)(2);
(vi) All notes are debt instruments
described in paragraph (f)(3) of this
section;
(vii) No notes are eligible for the
ordinary course exception described in
paragraph (b)(3)(iv)(B)(2) of this section;
(viii) Each entity has as its taxable
year the calendar year;
(ix) PRS is a partnership for federal
income tax purposes;
(x) No corporation is a member of a
consolidated group, as defined in
§ 1.1502–1(h);
(xi) No domestic corporation is a
United States real property holding
corporation within the meaning of
section 897(c)(2); and
(xii) Each note is issued with
adequate stated interest (as defined in
section 1274(c)(2)).
(2) No inference. Except as provided
in this section, it is assumed for
purposes of the examples that the form
of each transaction is respected for
federal tax purposes. No inference is
intended, however, as to whether any
particular note would be respected as
indebtedness or as to whether the form
of any particular transaction described
in paragraph (g)(3) of this section would
be respected for federal tax purposes.
(3) Examples. The following examples
illustrate the rules of this section.
Example 1. Distribution of a debt
instrument. (i) Facts. On Date A in Year 1,
FS lends $100x to USS1 in exchange for
USS1 Note A. On Date B in Year 2, USS1
issues USS1 Note B, which is has a value of
$100x, to FP in a distribution.
(ii) Analysis. USS1 Note B is a debt
instrument that is issued by USS1 to FP, a

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member of USS1’s expanded group, in a
distribution. Accordingly, USS1 Note B is
treated as stock under paragraph (b)(2)(i) of
this section. Under paragraph (d)(1)(i) of this
section, USS1 Note B is treated as stock when
it is issued by USS1 to FP on Date B in Year
2. Accordingly, USS1 is treated as
distributing USS1 stock to its shareholder FP
in a distribution that is subject to section 305.
Because USS1 Note B is treated as stock for
federal tax purposes when it is issued by
USS1, USS1 Note B is not treated as property
for purposes of paragraph (b)(3)(ii)(A) of this
section because it is not property within the
meaning specified in section 317(a).
Accordingly, USS1 Note A is not treated as
funding the distribution of USS1 Note B for
purposes of paragraph (b)(3)(ii)(A) of this
section.
Example 2. Debt instrument issued for
expanded group stock that is exchanged for
stock in a corporation that is not a member
of the same expanded group. (i) Facts. UST
is a publicly traded domestic corporation. On
Date A in Year 1, USS1 issues USS1 Note to
FP in exchange for FP stock. On Date B of
Year 1, USS1 transfers the FP stock to UST’s
shareholders, which are not members of the
FP expanded group, in exchange for all of the
stock of UST.
(ii) Analysis. (A) Because USS1 and FP are
both members of the FP expanded group,
USS1 Note is treated as stock when it is
issued by USS1 to FP in exchange for FP
stock on Date A in Year 1 under paragraphs
(b)(2)(ii) and (d)(1)(i) of this section. This
result applies even though, pursuant to the
same plan, USS1 transfers the FP stock to
persons that are not members of the FP
expanded group. The exchange of USS1 Note
for FP stock is not an exempt exchange
within the meaning of paragraph (f)(5) of this
section.
(B) Because USS1 Note is treated as stock
for federal tax purposes when it is issued by
USS1, pursuant to section § 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

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section 317(a). Therefore, USS1’s acquisition
of FS stock from FP in exchange for USS1
Note is not an acquisition described in
section 304(a)(1).
(C) Because USS1 Note is treated as stock
for federal tax purposes when it is issued by
USS1, USS1 Note is not treated as
indebtedness for purposes of applying
paragraph (b)(3) of this section.
Example 4. Funding occurs in same
taxable year as distribution. (i) Facts. On
Date A in Year 1, FP lends $200x to CFC in
exchange for CFC Note A. On Date B in Year
1, CFC distributes $400x of cash to USS1 in
a distribution. CFC is not an expatriated
foreign subsidiary as defined in § 1.7874–
12T(a)(9).
(ii) Analysis. Under paragraph (b)(3)(iv)(B)
of this section, CFC Note A is treated as
issued with a principal purpose of funding
the distribution by CFC to USS1 because CFC
Note A is issued to a member of the FP
expanded group during the 72-month period
determined with respect to CFC’s
distribution to USS1. Accordingly, under
paragraphs (b)(3)(ii)(A) and (d)(1)(i) of this
section, CFC Note A is treated as stock when
it is issued by CFC to FP on Date A in Year
1.
Example 5. Additional funding. (i) Facts.
The facts are the same as in Example 4,
except that, in addition, on Date C in Year
2, FP lends an additional $300x to CFC in
exchange for CFC Note B.
(ii) Analysis. The analysis is the same as
in Example 4 with respect to CFC Note A.
CFC Note B is also issued to a member of the
FP expanded group during the 72-month
period determined with respect to CFC’s
distribution to USS1. Under paragraph
(b)(3)(iv)(B) of this section, CFC Note B is
treated as issued with a principal purpose of
funding the remaining portion of CFC’s
distribution to USS1, which is $200x.
Accordingly, $200x of CFC Note B is a
principal purpose debt instrument that is
treated as stock under paragraph (b)(3)(ii)(A)
of this section. Under paragraph (d)(1)(ii) of
this section, $200x of CFC Note B is deemed
to be exchanged for stock on Date C in Year
2. The remaining $100x of CFC Note B
continues to be treated as indebtedness.
Example 6. Funding involving multiple
interests. (i) Facts. On Date A in Year 1, FP
lends $300x to USS1 in exchange for USS1
Note A. On Date B in Year 2, USS1
distributes $300x of cash to FP. On Date C
in Year 3, FP lends another $300x to USS1
in exchange for USS1 Note B.
(ii) Analysis. (A) Under paragraph
(b)(3)(iv)(B)(3) of this section, USS1 Note A
is tested under paragraph (b)(3) of this
section before USS1 Note B is tested. USS1
Note A is issued during the 72-month period
determined with respect to USS1’s $300x
distribution to FP and, therefore, is treated as
issued with a principal purpose of funding
the distribution under paragraph
(b)(3)(iv)(B)(1) of this section. Beginning on
Date B in Year 2, USS1 Note A is a principal
purpose debt instrument that is treated as
stock under paragraphs (b)(3)(ii)(A) and
(d)(1)(ii) of this section.
(B) Under paragraph (b)(3)(iv)(B)(3) of this
section, USS1 Note B is tested under
paragraph (b)(3) of this section after USS1

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Note A is tested. Because USS1 Note A is
treated as funding the entire $300x
distribution by USS1 to FP, USS1 Note B will
continue to be treated as indebtedness.
Example 7. Re-testing. (i) Facts. The facts
are the same as in Example 6, except that on
Date D in Year 4, FP sells USS1 Note A to
Bank.
(ii) Analysis. (A) Under paragraph (d)(2) of
this section, USS1 Note A ceases to be treated
as stock when FP sells USS1 Note A to Bank
on Date D in Year 4. Immediately before FP
sells USS1 Note A to Bank, USS1 is deemed
to issue a debt instrument to FP in exchange
for USS1 Note A in a transaction that is
disregarded for purposes of paragraphs (b)(2)
and (b)(3) of this section.
(B) Under paragraph (d)(2) of this section,
after USS1 Note A is deemed exchanged,
USS1’s other debt instruments that are not
treated as stock as of Date D in Year 4 (USS1
Note B) are re-tested for purposes of
paragraph (b)(3)(iv)(B) of this section to
determine whether other USS1 debt
instruments are treated as funding the $300x
distribution by USS1 to FP on Date B in Year
2. USS1 Note B was issued by USS1 to FP
within the 72-month period determined with
respect to the $300x distribution. Under
paragraph (b)(3)(iv)(B)(1) of this section,
USS1 Note B is treated as issued with a
principal purpose of funding the $300x
distribution. Accordingly, USS1 Note B is a
principal purpose debt instrument under
paragraph (b)(3)(ii)(A) of this section that is
deemed to be exchanged for stock on Date D
in Year 4, the re-testing date, under
paragraph (d)(1)(iv) of this section. See
§ 1.385–1(c) for rules regarding the treatment
of this deemed exchange.
Example 8. Distribution of expanded group
stock and debt instrument in a
reorganization that qualifies under section
355. (i) Facts. On Date A in Year 1, FP lends
$200x to USS2 in exchange for USS2 Note.
In a transaction that is treated as independent
from the transaction on Date A in Year 1, on
Date B in Year 2, USS2 transfers a portion of
its assets to DS2, a newly-formed domestic
corporation, in exchange for all of the stock
of DS2 and DS2 Note. Immediately
afterwards, USS2 distributes all of the DS2
stock and the DS2 Note to FP with respect
to FP’s USS2 stock in a transaction that
qualifies under section 355. USS2’s transfer
of a portion of its assets qualifies as a
reorganization within the meaning of section
368(a)(1)(D). The DS2 stock has a value of
$150x and DS2 Note has a value of $50x. The
DS2 stock is not non-qualified preferred
stock as defined in section 351(g)(2). Absent
the application of this section, DS2 Note
would be treated by FP as ‘‘other property’’
within the meaning of section 356.
(ii) Analysis. (A) The contribution and
distribution transaction is a reorganization
within the meaning of section 368(a)(1)
involving a transfer of USS2’s property
described in section 361(a). Thus, DS2 Note
is a debt instrument that is issued by DS2 to
USS2, both members of the FP expanded
group, pursuant to an asset reorganization (as
defined in paragraph (f)(1) of this section),
and received by FP, another FP expanded
group member, with respect to FP’s USS2
stock. Accordingly, DS2 Note is treated as

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stock when it is issued by DS2 to USS2 on
Date B in Year 2 pursuant to paragraphs
(b)(2)(iii) and (d)(1)(i) of this section.
(B) Because DS2 Note is treated as stock
when it is issued, section 355(a)(1) rather
than section 356 may apply to FP on FP’s
receipt of DS2 Note. Alternatively, depending
on the terms of DS2 Note and other factors,
DS2 Note may be treated as non-qualified
preferred stock that is not treated as stock
pursuant to section 355(a)(3)(D). If DS2 Note
is treated as non-qualified preferred stock,
such stock would continue to be treated by
FP as ‘‘other property’’ for purposes of
section 356 under section 356(e). In that case,
USS2’s distribution of DS2 Note would be
treated as ‘‘other property’’ described in
section 356, and thus the distribution of DS2
note preliminarily would be described in
paragraph (b)(3)(ii)(A) of this section.
However, under paragraph (b)(5) of this
section, because DS2 Note is treated as stock
under paragraph (b)(2)(iii) of this section,
USS2’s distribution of DS2 Note to FP
pursuant to the plan of reorganization is not
also treated as a distribution or acquisition
described in paragraph (b)(3)(ii) of this
section that could cause USS2 Note to be a
principal purpose debt instrument.
(C) USS2’s distribution of $150x of actual
DS2 stock is a distribution of stock pursuant
to an asset reorganization that is permitted to
be received by FP without recognition of gain
under section 355(a)(1). Accordingly, USS2’s
distribution of the actual DS2 stock to FP is
not a distribution of property by USS2 for
purposes of paragraph (b)(3)(ii)(A) of this
section.
(D) USS2’s transfer of assets to DS2 in
exchange for DS2 stock is not an acquisition
described in paragraph (b)(3)(ii)(B) of this
section because USS2’s acquisition of DS2
stock is an exempt exchange. USS2’s
acquisition of DS2 stock is an exempt
exchange described in paragraph (f)(5)(ii) of
this section because USS2 and DS2 are both
parties to a reorganization that is an asset
reorganization, section 1032 applies to DS2,
the transferor of the expanded group stock,
and the DS2 stock is distributed by USS2, the
transferee, pursuant to the plan of
reorganization. Because USS2 has not made
a distribution or acquisition that is treated as
a distribution or acquisition for purposes of
paragraph (b)(3)(ii) of this section, USS2 Note
is not a principal purpose debt instrument.
Example 9. Funding a distribution by a
successor to funded member. (i) Facts. The
facts are the same as in Example 8, except
that on Date C in Year 3, DS2 distributes
$200x of cash to FP and, subsequently, on
Date D in Year 3, USS2 distributes $100x of
cash to FP.
(ii) Analysis. (A) DS2 is a successor with
respect to USS2 under paragraph (f)(11)(i) of
this section because DS2 is the acquiring
corporation in a reorganization within the
meaning of section 368(a)(1)(D). USS2 is a
predecessor with respect to DS2 under
paragraph (f)(9)(i) of this section because
USS2 is the transferor corporation in a
reorganization within the meaning of section
368(a)(1)(D). Accordingly, under paragraph
(b)(3)(v) of this section, a distribution by DS2
is treated as a distribution by USS2. Under
paragraph (b)(3)(iv)(B) of this section, USS2

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Note is treated as issued with a principal
purpose of funding the distribution by DS2
to FP because USS2 Note was issued during
the 72-month period determined with respect
to DS2’s $200x cash distribution.
Accordingly, USS2 Note is a principal
purpose debt instrument under paragraph
(b)(3)(ii)(A) of this section that is deemed to
be exchanged for stock on Date C in Year 3
under paragraph (d)(1)(ii) of this section. See
§ 1.385–1(c) for rules regarding the treatment
of this deemed exchange.
(B) Because the entire amount of USS2
Note is treated as funding DS2’s $200x
distribution to FP, under paragraph
(b)(3)(iv)(B)(4) of this section, USS2 Note is
not treated as funding the subsequent
distribution by USS2 on Date D in Year 3.
Example 10. Asset reorganization; section
354 qualified property. (i) Facts. On Date A
in Year 1, FS lends $100x to USS2 in
exchange for USS2 Note. On Date B in Year
2, in a transaction that qualifies as a
reorganization within the meaning of section
368(a)(1)(D), USS2 transfers all of its assets
to USS1 in exchange for stock of USS1 and
the assumption by USS1 of all of the
liabilities of USS2, and USS2 distributes to
FP, with respect to FP’s USS2 stock, all of the
USS1 stock that USS2 received. FP does not
recognize gain under section 354(a)(1).
(ii) Analysis. (A) USS1 is a successor with
respect to USS2 under paragraph (f)(11)(i) of
this section because USS1 is the acquiring
corporation in a reorganization within the
meaning of section 368(a)(1)(D). For purposes
of paragraph (b)(3) of this section, USS2 and
its successor, USS1, are funded members
with respect to USS2 Note. Although USS2,
a funded member, distributes property (USS1
stock) to its shareholder, FP, pursuant to the
reorganization, the distribution of USS1 stock
is not described in paragraph (b)(3)(ii)(A) of
this section because the property is permitted
to be received without the recognition of gain
under section 354(a)(1). The distribution of
USS1 stock is also not described in paragraph
(b)(3)(ii)(C) of this section because FP does
not receive the USS1 stock as ‘‘other
property’’ within the meaning of section 356.
(B) USS2’s exchange of assets for USS1
stock is not an acquisition described in
paragraph (b)(3)(ii)(B) of this section because
USS2’s acquisition of USS1 stock is an
exempt exchange. USS2’s acquisition of
USS1 stock is an exempt exchange described
in paragraph (f)(5)(ii) of this section because
USS1 and USS2 are both parties to a
reorganization, section 1032 applies to USS1,
the transferor of the expanded group stock,
and the USS1 stock is distributed by USS2,
the transferee, pursuant to the plan of
reorganization.
(C) Because neither USS1 nor USS2 has
made a distribution or acquisition described
in paragraph (b)(3)(ii) of this section, USS2
Note is not a principal purpose debt
instrument.
Example 11. Triangular reorganization. (i)
Facts. USS2 owns 100 percent of the stock of
DS2, a domestic corporation. On Date B in
Year 1, FP issues FP stock and FP Note to
USS1 as a contribution to capital. USS1 does
not formally issue additional USS1 stock to
FP in exchange for FP stock and FP Note, but
is treated as issuing stock to FP in an

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exchange to which section 351 applies.
Immediately afterwards, USS1 transfers the
FP stock and FP Note to DS2 in exchange for
all of DS2’s assets, and DS2 distributes the
FP stock and FP Note to USS2 with respect
to USS2’s DS2 stock in a liquidating
distribution.
(ii) Analysis. FP Note is issued by FP to
USS1 in exchange for stock of USS1 in an
exchange that is not an exempt exchange
described in paragraph (f)(5) of this section.
Under paragraph (b)(2)(ii) of this section, FP
Note is treated as stock beginning on Date B
in Year 1.
Example 12. Funded acquisition of
subsidiary stock by issuance; successor.
(i) Facts. On Date A in Year 1, FS lends
$100x to USS1 in exchange for USS1 Note.
On Date B in Year 1, USS1 transfers property
that has a value of $20x to CFC in exchange
for additional CFC stock that has a value of
$20x. On Date C in Year 2, CFC distributes
$20 cash to USS1. On Date D in Year 3, CFC
acquires stock of FS from FP in exchange for
$50x cash.
(ii) Analysis. (A) But for the exception in
paragraph (c)(3) of this section, USS1 Note
would be treated under paragraph
(b)(3)(iv)(B) of this section as issued with a
principal purpose of funding an acquisition
of expanded group stock described in
paragraph (b)(3)(ii)(B) of this section because
USS1 Note is issued to a member of the FP
expanded group during the 72-month period
determined with respect to USS1’s
acquisition of CFC stock on Date B in Year
1. However, because USS1’s acquisition of
CFC stock results from a transfer of property
from USS1 to CFC in exchange for CFC stock
and immediately after the transaction USS1
holds 100 percent of the stock of CFC, the
exception in paragraph (c)(3) of this section
applies. Accordingly, USS1’s acquisition of
CFC stock on Date B in Year 1 is not treated
as an acquisition of stock described in
paragraph (b)(3)(ii)(B) of this section, and
USS1 Note is not treated as stock.
(B) CFC is a successor with respect to USS1
under paragraph (f)(11)(ii) of this section. For
purposes of paragraph (b)(3)(iv)(B)(1) of this
section CFC is a successor only to the extent
of the value of the expanded group stock
acquired from CFC in the transaction
described in paragraph (c)(3) of this section.
(C) Under paragraph (f)(11)(ii) of this
section, CFC’s $20x cash distribution to
USS1 on Date C in Year 2 is not taken into
account for purposes of applying paragraph
(b)(3) of this section to USS1 Note.
(D) On Date D in Year 3, CFC continues to
be a successor to USS1 for purposes of
applying the per se rule in paragraph
(b)(3)(iv)(B) of this section. Accordingly,
USS1 Note is a principal purpose debt
instrument under paragraph (b)(3)(ii)(A) of
this section that is deemed to be exchanged
for stock on Date D in Year 3 under
paragraph (d)(1)(ii) of this section. See
§ 1.385–1(c) for rules regarding the treatment
of this deemed exchange.
Example 13. Distribution of a debt
instrument to partnership. (i) Facts. CFC and
FS are equal partners in PRS. PRS owns 100
percent of the stock of X Corp, a domestic
corporation. On Date A in Year 1, X Corp
issues X Note to PRS in a distribution.

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(ii) Analysis. (A) Under § 1.385–1(b)(3), in
determining whether X Corp is a member of
the expanded group that includes CFC and
FS, CFC and FS are each treated as holding
50 percent of the X Corp stock held by PRS.
Accordingly, 100 percent of X Corp’s stock is
treated as owned by CFC and FS under
§ 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.
Accordingly, for purposes of applying
paragraph (b) of this section, in Year 1, 50
percent of X Note is treated as issued to CFC
in a distribution and the other 50 percent of
X Note is treated as issued to FS in a
distribution. Therefore, under paragraphs
(b)(2)(i) and (d)(1)(i) of this section, X Note
is treated as stock beginning on Date A in
Year 1. Under paragraph (d)(5)(i) of this
section, CFC and FS are treated as holding X
Note solely for purposes of this section. For
all other federal tax purposes, X Note is
treated as stock in X Corp that is held by
PRS, and X Corp is treated as distributing its
stock to its shareholder in a distribution that
is subject to section 305.
Example 14. Loan to partnership; sameyear distribution. (i) Facts. The facts are the
same as in Example 13, except that X Corp
does not distribute X Note to PRS; instead,
on Date A in Year 1 FP lends $200x to PRS
in exchange for PRS Note. On Date B in Year
1, CFC distributes $100x to USS1 and FS
distributes $100x to FP. CFC is not an
expatriated foreign subsidiary as defined in
§ 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 72month periods determined with respect to
the distributions by CFC and FS. Under
paragraph (b)(3)(iv)(B)(1) of this section, PRS
Note is treated as issued with a principal
purpose of funding the distributions by CFC
and FS. Accordingly, under paragraphs
(b)(3)(ii)(A) and (d)(1)(i) of this section, PRS
Note is a principal purpose debt instrument
that is treated as stock when it is issued on
Date A in Year 1.
(B) Under paragraph (d)(5)(ii) of this
section, CFC and FS are each treated as
issuing $100x of stock to FP. Appropriate
conforming adjustments must be made to
CFC’s and FS’s interests in PRS to reflect the
deemed treatment of PRS Note as stock
issued by CFC and FS, which must be done
in a manner that avoids the creation of, or
increase in, a disparity between PRS’s
aggregate basis in its assets and the aggregate
bases of CFC’s and FS’s respective interests
in PRS. For example, reasonable and
appropriate adjustments may occur when the
following steps are deemed to occur on Date
A in Year 1:

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(1) CFC issues stock to FP in exchange for
$100x;
(2) FS issues stock to FP in exchange for
$100x;
(3) CFC contributes $100x to PRS in
exchange for a partnership interest in PRS;
and
(4) FS contributes $100x to PRS in
exchange for a partnership interest in PRS.
Example 15. Loan to partnership;
distribution in later year. (i) Facts. The facts
are the same as in Example 14, except that
CFC and FS do not make distributions on
Date B of Year 1; instead, CFC distributes
$100x to USS1 and FS distributes $100x to
FP on Date C of Year 2.
(ii) Analysis. (A) As in Example 14, CFC’s
and FS’s shares of PRS Note are each issued
to FP, a member of the same expanded group,
during the 72-month periods determined
with respect to the distributions by CFC and
FS. Under paragraph (b)(3)(iv)(B)(1) of this
section, PRS Note is treated as issued with
a principal purpose of funding the
distributions by CFC and FS. Accordingly,
PRS Note is a principal purpose debt
instrument that is treated as stock under
paragraph (b)(3)(i)(A) of this section. Under
paragraph (d)(1)(ii) of this section, PRS Note
is treated as stock on Date C in Year 2.
(B) Under paragraph (d)(5)(ii) of this
section, CFC and FS are each treated as
issuing $100x of stock to FP. Appropriate
conforming adjustments must be made to
CFC’s and FS’s interests in PRS to reflect the
deemed treatment of PRS Note as stock
issued by CFC and FS, which must be done
in a manner that avoids the creation of, or
increase in, a disparity between PRS’s
aggregate basis in its assets and the aggregate
bases of CFC’s and FS’s respective interests
in PRS. For example, reasonable and
appropriate adjustments may occur when the
following steps are deemed to occur on Date
C in Year 2:
(1) CFC assumes liability with respect to
$100x of PRS Note;
(2) FS assumes liability with respect to
$100x of PRS Note;
(3) CFC issues stock to FP in satisfaction
of the $100x of PRS Note assumed by CFC;
and
(4) FS issues stock to FP in satisfaction of
the $100x of PRS Note assumed by FS.
Example 16. Distribution of another
member’s debt instrument. (i) Facts. On Date
A in Year 1, CFC lends $100x to FS in
exchange for FS Note. On Date B in Year 2,
CFC distributes FS Note to USS1.
(ii) Analysis. Although CFC distributes FS
Note, which is a debt instrument, to USS1,
another member of CFC’s expanded group,
paragraph (b)(2)(i) of this section does not
apply because CFC is not the issuer of the FS
Note.
Example 17. Threshold exception and
current year earnings and profits exception.
(i) Facts. Before Date A in Year 1, the
members of FP’s expanded group hold no
outstanding debt instruments that otherwise
would be treated as stock under this section.
On Date A in Year 1, CFC issues CFC Note,
which has an issue price of $40 million, to
USS1 in a distribution. On Date B in Year 2,
USS1 issues USS1 Note, which has an issue
price of $20 million, to FP in a distribution.

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On Date C in Year 3, FS distributes $30
million in cash to FP. On Date D in Year 3,
DS lends $30 million to FS in exchange for
FS Note A. On Date E in Year 3, FS issues
FS Note B, which has an issue price of $19
million, to FP in a distribution. In Year 3, FS
has $35 million in earnings and profits
described in section 316(a)(2).
(ii) Analysis. (A) Because CFC does not
have earnings and profits described in
section 316(a)(2) in Year 1, the exception in
paragraph (c)(1) of this section does not
apply to CFC Note. Immediately after CFC
Note is issued to USS1 on Date A in Year 1,
the aggregate adjusted issue price of
outstanding debt instruments issued by
members of FP’s expanded group that would
be subject to paragraph (b) of this section but
for the application paragraph (c)(2) of this
section does not exceed $50 million.
Accordingly, the threshold exception
described in paragraph (c)(2) applies to the
CFC Note.
(B) Because USS1 does not have earnings
and profits described in section 316(a)(2) in
Year 2, the exception in paragraph (c)(1) of
this section does not apply to USS1 Note.
Immediately after USS1 Note is issued to FP
on Date B in Year 2, the aggregate adjusted
issue price of outstanding debt instruments
issued by members of the FP expanded group
that would be subject to paragraph (b) of this
section but for the application of paragraph
(c)(2) of this section exceeds $50 million.
Under paragraph (d)(1)(iii) of this section,
CFC Note is deemed to be exchanged for
stock on Date B in Year 2, when debt
instruments of the FP expanded group cease
to qualify for the threshold exception
described in paragraph (c)(2) of this section.
In addition, the threshold exception
described in paragraph (c)(2) of this section
does not apply to USS1 Note because,
immediately after USS1 Note is issued, the
aggregate adjusted issue price of outstanding
debt instruments issued by members of the
expanded group that would be subject to
paragraph (b) of this section but for the
application paragraph (c)(2) of this section
exceeds $50 million. Accordingly, USS1 Note
is treated as stock when it is issued on Date
B in Year 2.
(C) Under paragraph (c)(1) of this section,
for purposes of applying paragraphs (b)(2)
and (b)(3) of this section to a member of an
expanded group with respect to Year 3, the
aggregate amount of any distributions or
acquisitions by FS that are described in
paragraphs (b)(2) or (b)(3)(ii) of this section
are reduced by an amount equal to FS’s
current year earnings and profits described in
section 316(a)(2) for Year 3, which is $35
million. Thus, $35 million of distributions or
acquisitions by FS in Year 3 are not taken
into account for purposes of applying
paragraphs (b)(2) and (b)(3) of this section.
The reduction is applied first against FS’s
$30 million cash distribution on Date C in
Year 3 and second against FS’s $19 million
note distribution on Date E in Year 3.
Accordingly, under paragraph (c)(1) of this
section, FS Note A is not treated as stock
under paragraph (b)(3) of this section. In
addition, under paragraph (c)(1) of this
section a portion of FS Note B equal to $5
million is not treated as stock under
paragraph (b)(2) of this section.

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(D) When FS Note B is issued in Year 3,
CFC Note, which previously was treated as
indebtedness solely because of paragraph
(c)(2) of this section, remains outstanding.
Accordingly, the threshold exception
described in paragraph (c)(2) of this section
does not apply to FS Note B. Accordingly,
the remaining amount of FS Note B equal to
$14 million after applying the exception
under paragraph (c)(1) of this section is
treated as stock under paragraph (b)(2) of this
section.
Example 18. Distribution of a debt
instrument and issuance of a debt instrument
with a principal purpose of avoiding the
purposes of this section. (i) Facts. On Date A
in Year 1, USS1 issues USS1 Note A, which
has a value of $100x, to FP in a distribution.
On Date B in Year 1, with a principal
purpose of avoiding the application of this
section, FP sells USS1 Note A to Bank for
$100x of cash and lends $100x to USS1 in
exchange for USS1 Note B.
(ii) Analysis. USS1 Note A is a debt
instrument that is issued by USS1 to FP, a
member of USS1’s expanded group, in a
distribution. Accordingly, under paragraphs
(b)(2)(i) and (d)(1)(i) of this section, USS1
Note A is treated as stock when it is issued
by USS1 to FP on Date A in Year 1.
Accordingly, USS1 is treated as distributing
USS1 stock to its shareholder FP. Because
USS1 Note A is treated as stock of USS1,
USS1 Note A is not property as specified in
section 317(a) on Date A in Year 1. Under
paragraph (d)(2) of this section, USS1 Note A
ceases to be treated as stock when FP sells
USS1 Note A to Bank on Date B in Year 1.
Immediately before FP sells USS1 Note A to
Bank, USS1 is deemed to issue a debt
instrument to FP in exchange for USS1 Note
A in a transaction that is disregarded for
purposes of paragraphs (b)(2) and (b)(3) of
this section. USS1 Note B is not treated as
stock under paragraph (b)(3)(ii)(A) of this
section because the funded member, USS1,
has not made a distribution of property.
However, because the transactions occurring
on Date B of Year 1 were undertaken with a
principal purpose of avoiding the purposes of
this section, USS1 Note B is treated as stock
on Date B of Year 1 under paragraph (b)(4)
of this section.

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

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

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§ 1.385–4
groups.

Treatment of consolidated

(a) Scope. Section 1.385–1(e) provides
that members of a consolidated group
are treated as one corporation for
purposes of the regulations under
section 385. This section provides rules
for applying § 1.385–3 to consolidated
groups when an interest ceases to be a
consolidated group debt instrument or
becomes a consolidated group debt
instrument. For definitions applicable to
this section, see § 1.385–3(f).
(b) Debt instrument ceases to be a
consolidated group debt instrument but
continues to be an expanded group debt
instrument—(1) Member leaving the
group. When a corporation ceases to be
a member of the consolidated group but
continues to be a member of the
expanded group (such corporation, a
departing member), a debt instrument
that is issued or held by the departing
member is treated as indebtedness or
stock pursuant to paragraphs (b)(1)(i) or
(b)(1)(ii) of this section.
(i) Exempt consolidated group debt
instrument that ceases to be
consolidated group debt instrument.
Any exempt consolidated group debt
instrument that is issued or held by the
departing member is deemed to be
exchanged for stock immediately after
the departing member leaves the group.
For these purposes, the term exempt

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consolidated group debt instrument
means any debt instrument that was not
treated as stock solely by reason of the
departing member’s treatment under
§ 1.385–1(e). See paragraph (d) of this
section, Example 3, for an illustration of
this rule.
(ii) Non-exempt consolidated group
debt instrument that ceases to be
consolidated group debt instrument—
(A) In general. Any consolidated group
debt instrument issued or held by a
departing member that is not an exempt
consolidated group debt instrument
(non-exempt consolidated group debt
instrument) is treated as indebtedness
unless and until the non-exempt
consolidated group debt instrument is
treated as a principal purpose debt
instrument under § 1.385–3(b)(3)(ii) and
(d)(1) as a result of a distribution 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 72month period under § 1.385–
3(b)(3)(iv)(B) (the per se rule), a nonexempt consolidated group debt
instrument is treated as having been
issued when it was first treated as a
consolidated group debt instrument. For
all other purposes of applying § 1.385–
3, including for purposes of applying
§ 1.385–3(d), a non-exempt consolidated
group debt instrument is treated as
issued by the issuer of the debt
instrument immediately after the
departing member leaves the group.
(2) Consolidated group debt
instrument that is transferred outside of
the consolidated group. Solely for
purposes of § 1.385–3, when a member
of a consolidated group that holds a
consolidated group debt instrument
transfers the debt instrument to an
expanded group member that is not a
member of the consolidated group, the
debt instrument is treated as issued by
the issuer of the debt instrument (which
is treated as one corporation with the
transferor of the debt instrument
pursuant to § 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 determined in a manner that
is consistent with treating a
consolidated group as one corporation.
Thus, for example, the sale of a
consolidated group debt instrument to
an expanded group member that is not
a member of the consolidated group will
be treated as an issuance of the debt
instrument to the transferee expanded
group member in exchange for property.
To the extent the debt instrument is
treated as stock upon being transferred,
the debt instrument is deemed to be

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exchanged for stock immediately after
the debt instrument is transferred
outside of the consolidated group. For
examples illustrating this rule, see
paragraph (d) of this section, Examples
1 and 2.
(c) Debt instrument entering a
consolidated group. When a debt
instrument that is treated as stock under
§ 1.385–3 becomes a consolidated group
debt instrument, immediately before
that debt instrument becomes a
consolidated group debt instrument, the
issuer is treated as issuing a new debt
instrument to the holder in exchange for
the debt instrument that was treated as
stock in a transaction that is disregarded
for purposes of § 1.385–3(b).
(d) Examples—(1) Assumed facts.
Except as otherwise stated, the
following facts are assumed for
purposes of the examples in paragraph
(d)(3) of this section:
(i) FP is a foreign corporation that
owns 100 percent of the stock of USS1,
a domestic corporation, and 100 percent
of the stock of FS, a foreign corporation;
(ii) USS1 owns 100 percent of the
stock of DS1, a domestic corporation;
(iii) DS1 owns 100 percent of the
stock of DS2, a domestic corporation;
(iv) At the beginning of Year 1, FP is
the common parent of an expanded
group comprised solely of FP, USS1, FS,
DS1, and DS2 (the FP expanded group);
(v) USS1, DS1, and DS2 are members
of a consolidated group of which USS1
is the common parent (the USS1
consolidated group);
(vi) The FP expanded group has more
than $50 million of debt instruments
described in § 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
ordinary course exception described in
§ 1.385–3(b)(3)(iv)(B)(2);
(x) Each entity has as its taxable year
the calendar year;
(xi) No domestic corporation is a
United States real property holding
corporation within the meaning of
section 897(c)(2); and
(xii) Each note is issued with
adequate stated interest (as defined in
section 1274(c)(2)).
(2) No inference. Except as provided
in this section, it is assumed for
purposes of the examples that the form
of each transaction is respected for
federal tax purposes. No inference is

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intended, however, as to whether any
particular note would be respected as
indebtedness or as to whether the form
of any particular transaction described
in paragraph (d)(3) of this section would
be respected for federal tax purposes.
(3) Examples. The following examples
illustrate the rules of this section.
Example 1. Distribution of consolidated
group debt instrument. (i) Facts. On Date A
in Year 1, DS1 issues DS1 Note to USS1 in
a distribution. On Date B in Year 2, USS1
distributes DS1 Note to FP.
(ii) Analysis. Under § 1.385–1(e), the USS1
consolidated group is treated as one
corporation for purposes of § 1.385–3.
Accordingly, when DS1 issues DS1 Note to
USS1 in a distribution, DS1 is not treated as
issuing a debt instrument to another member
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
instrument. (i) Facts. On Date A in Year 1,
DS1 lends $200x to USS1 in exchange for
USS1 Note. On Date B in Year 2, USS1
distributes $200x to FP. On Date C in Year
2, DS1 sells USS1 Note to FS for $200x.
(ii) Analysis. Under § 1.385–1(e), the USS1
consolidated 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 distribution.
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

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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. Accordingly, when DS1
issues DS1 Note to USS1 in a distribution on
Date A in Year 1, DS1 is not treated as
issuing a debt instrument to a member of
DS’s expanded group in a distribution for
purposes of § 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 instrument 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,
immediately after DS1 leaves the USS1
consolidated group, DS1 Note A is deemed
to be exchanged for stock.
(B) DS1 Note B is a non-exempt
consolidated group debt instrument because
DS1 Note B, which is issued in exchange for
cash, would not be treated as stock even
absent the application of § 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 application of § 1.385–1(e).
Accordingly, under paragraph (b)(1)(ii)(A) of
this section, DS1 Note B is not treated as
stock when DS1 ceases to be a member of the
USS1 consolidated group, provided there are
no distributions or acquisitions described in
§ 1.385–3(b)(3)(ii) by DS1 that occur later in
Year 4 (after Date C).
Example 4. Distribution after a funded
consolidated group member leaves the
consolidated group. (i) Facts. The facts are
the same as in Example 3, except that on Date
D in Year 6, DS1 distributes $100x pro rata
to its shareholders ($75x to USS1 and $25x
to FP).
(ii) Analysis. The per se rule in § 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
consolidated group debt instrument when a
consolidated group member leaves the group.
(i) Facts. On Date A in Year 1, DS2 lends
$100x to DS1 in exchange for DS1 Note. On
Date B in Year 1, DS1 distributes $100x of
cash to USS1. On Date C in Year 1, FP
purchases 25 percent of DS2’s stock from
DS1, resulting in DS2 ceasing to be a member
of the USS1 consolidated group.
(ii) Analysis. After DS2 ceases to be a
member of the USS1 consolidated group, DS1
and USS1 continue to be treated as one
corporation under § 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 because 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

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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). Accordingly, under paragraph
(b)(1)(ii)(A) of this section, DS1 Note is not
treated as stock when it ceases to be a
consolidated group debt instrument,
provided there are no distributions or
acquisitions described in § 1.385–3(b)(3)(ii)
by DS1 that occur later in Year 1 (after Date
C).

(e) Effective/applicability date and
transition rules—(1) In general. This
section applies to any debt instrument
issued on or after April 4, 2016, and to
any debt instrument treated as issued
before April 4, 2016 as a result of an
entity classification election made
under § 301.7701–3 of this chapter that
is filed on or after April 4, 2016.
(2) Transition rule for distributions or
acquisitions occurring before April 4,
2016. For purposes of this section, a
distribution or acquisition described in
§ 1.385–3(b)(3)(ii) that occurs before
April 4, 2016, other than a distribution
or acquisition that is treated as
occurring before April 4, 2016 as a
result of an entity classification election
made under § 301.7701–3 of this chapter
that is filed on or after April 4, 2016, is
not taken into account.
(3) Transition rule for debt
instruments that would be treated as
stock prior to the date of publication in
the Federal Register of the Treasury
decision adopting this rule as a final
regulation. When this section otherwise
would treat a debt instrument as stock
prior to the date of publication in the
Federal Register of the Treasury
decision adopting this rule as a final
regulation, the debt instrument is
treated as indebtedness until the date
that is 90 days after the date of
publication in the Federal Register of
the Treasury decision adopting this rule
as a final regulation. To the extent that
the debt instrument described in the
preceding sentence is held by a member
of the issuer’s expanded group on the
date that is 90 days after the date of
publication in the Federal Register of
the Treasury decision adopting this rule
as a final regulation, the debt instrument
is deemed to be exchanged for stock on
the date that is 90 days after the date of
publication in the Federal Register of
the Treasury decision adopting this rule
as a final regulation.
John Dalrymple.
Deputy Commissioner for Services and
Enforcement.
[FR Doc. 2016–07425 Filed 4–4–16; 5:00 pm]
BILLING CODE 4830–01–P

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