[Federal Register Volume 64, Number 3 (Wednesday, January 6, 1999)]
[Proposed Rules]
[Pages 805-813]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-178]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-104072-97]
RIN 1545-AV07
Recharacterizing Financing Arrangements Involving Fast-pay Stock
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations that
recharacterize, for tax purposes, financing arrangements involving
fast-pay stock. The regulations are necessary to prevent taxpayers from
using fast-pay stock to achieve inappropriate tax avoidance. The
regulations affect corporations that issue fast-pay stock, holders of
fast-pay stock, and other shareholders that may claim tax benefits
purported to result from arrangements involving fast-pay stock. This
document also provides notice of a public hearing on the proposed
regulations.
DATES: Written and electronic comments must be received by April 6,
1999. Outlines of topics to be discussed at the public hearing
scheduled for April 8, 1999, at 10 a.m. must be received by March 18,
1999.
ADDRESSES: Send submissions: to CC:DOM:CORP:R (REG-104072-97), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
104072-97), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit
comments via the Internet by selecting the ``Tax Regs'' option of the
IRS Home Page or by submitting them directly to the IRS Internet site
at http://www.irs.ustreas.gov/prod/tax__regs/comments.html. The public
hearing will be held in room 2615, 1111 Constitution Avenue, NW.,
Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Jonathan Zelnik at (202) 622-3940; concerning submissions of comments,
the hearing, and/or to be placed on the building access list to attend
the hearing, LaNita VanDyke at (202) 622-7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review 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, OP:FS:FP, Washington, DC
20224. Comments on the collection of information should be received by
March 8, 1999. Comments are specifically requested concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the Internal Revenue Service,
including whether the collection will have a practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information (see below);
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 is in Sec. 1.7701(l)-3(f) and
Sec. 1.7701(l)-3(g). The collection of information is mandatory. The
likely respondents are individuals, businesses, and other
organizations.
Estimated total annual burden: 50 hours
Estimated average annual burden per respondent: 1 hour
Estimated number of respondents: 50
Estimated annual frequency of responses: Annually
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number assigned by the Office of
Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax information are confidential, as required by 26 U.S.C. 6103.
Background
On February 27, 1997, the IRS issued Notice 97-21, 1997-1 C.B. 407,
which relates to financing arrangements involving fast-pay stock. Among
other things, the notice informs the public that the IRS and Treasury
Department expect to issue regulations recharacterizing these
arrangements to prevent tax avoidance. Notice 97-21 requested comments,
but none have been received.
Explanation of Provisions
A. Tax-Avoidance Arrangements Using Fast-Pay Stock
Notice 97-21 addresses two-party financing arrangements that are
structured as multi-party arrangements to let one or more of the
parties avoid tax. Instead of one party directly providing financing to
the other, they both acquire stock (with different characteristics) in
a conduit entity. The arrangement is structured so that the party
providing the financing has a decreasing claim on the conduit entity
[[Page 806]]
(and its assets) while the party receiving the financing has an
increasing claim on the conduit entity (and its assets). Economically,
both parties benefit from the conduit entity's income. For tax
purposes, however, the entity's income is allocated almost entirely to
the party providing the financing, allowing the other party to claim
unwarranted tax benefits.
Notice 97-21 describes in detail a typical fast-pay stock financing
arrangement. The parties to the arrangement include: (1) a person
seeking financing (the sponsor), (2) investors who are willing to
provide financing and typically are not subject to federal income tax
(the investors), and (3) a corporation that is generally subject to tax
only at the shareholder level (a conduit entity). The conduit entity
issues a class of self-amortizing stock (the fast-pay stock) to the
investors and a class of other stock (the benefited stock) to the
sponsor. The fast-pay stock is structured so that during an initial
period, the dividends made with respect to the stock are substantial
and relatively certain while the dividends made with respect to the
benefited stock are insignificant. After the initial period, the
dividend rate of the fast-pay stock, the stock's effective redemption
value, or both, decline.
Economically, the fast-pay stock is self-amortizing because the
distributions made with respect to the fast-pay stock are in part a
return on the investors' investment and in part a return of their
investment. For tax purposes, however, the parties characterize the
fast-pay stock distributions entirely as dividends (that is, entirely
as a return on the investment). Consequently, the investors' reported
taxable income -- overstated dividend income followed by an overstated
capital loss on disposition of the fast-pay stock--fails to clearly
reflect their economic income. (Investors that are tax-exempt suffer no
disadvantage from this arrangement.)
Characterizing the distributions made with respect to the fast-pay
stock solely as dividends has the corresponding effect of understating
the taxable income on the benefited stock (the stock held by the
sponsor) during the initial period. Instead of receiving dividends
attributable to its share of the conduit entity's income, the sponsor's
economic income takes the form of an increasing ownership interest in
the conduit entity. Because the fast-pay stock is economically self-
amortizing, each distribution reduces the investors' claim on the
conduit entity (and its assets) and increases the sponsor's claim. By
treating a fast-pay arrangement according to its form, the sponsor
reports taxable income that fails to clearly reflect its economic
income. An individual sponsor, for example, reports little or no
dividend income. Instead, the individual reports gain on disposing of
its benefited stock; thus, deferring tax on its economic income and
converting that income from ordinary to capital. A corporate sponsor
not only reports little or no dividend income, but can avoid reporting
gain on the disposition of its benefited stock, thereby entirely
eliminating tax on its economic income. (If a corporate sponsor has a
sufficient interest in the conduit entity, the sponsor may succeed to
the conduit entity's assets tax-free by liquidating or reorganizing the
conduit entity; thus, avoiding a taxable disposition of the benefited
stock).
In substance, the investors (the fast-pay shareholders) are
financing the sponsor's investment in the conduit entity. Although
nominally shareholders in the conduit entity, the investors have a
limited, diminishing claim to the entity (and its assets). The
sponsor's claim, by contrast, is residual and long-term. Thus, a fast-
pay arrangement is effectively a leveraged arrangement in which the
sponsor uses untaxed income from the conduit entity to repay the
investors.
B. The Proposed Regulations
1. In General
To prevent the avoidance of tax, the Secretary may issue
regulations under section 7701(l) recharacterizing any multiple-party
financing transaction as a transaction directly among any two or more
of the parties. The proposed regulations exercise this authority by
recharacterizing certain fast-pay arrangements. A fast-pay arrangement
is any financing arrangement in which a corporation has outstanding two
or more classes of stock, one of which is fast-pay stock. The
regulations identify fast-pay arrangements and recharacterize certain
of them as arrangements directly between the holders of the fast-pay
stock and the other shareholders (the benefited shareholders) in the
corporation. The regulations also impose reporting requirements on
certain corporations with outstanding fast-pay stock and on certain
shareholders that participate in fast-pay arrangements. These reporting
requirements apply to all fast-pay arrangements, whether or not they
are subject to recharacterization.
Notice 97-21 describes specific models for recharacterizing fast-
pay arrangements. For purposes of determining the income of the
shareholders of a corporation with outstanding fast-pay stock, these
models ignore the separate existence of the corporation and treat the
fast-pay shareholders and benefited shareholders as owning the
corporation's underlying assets. Although this approach prevents tax
avoidance, the IRS and Treasury Department have concluded that it may
not best reflect the financing relationship between the fast-pay
shareholders and the benefited shareholders. In addition, the approach
of the notice may be difficult for taxpayers to apply if the
corporation has a complex capital structure, multiple assets (including
active businesses), or both.
To address these concerns, the proposed regulations treat the fast-
pay shareholders as acquiring instruments issued by the benefited
shareholders instead of acquiring interests in the assets of the
corporation. This approach better reflects the financing relationship
between the fast-pay shareholders and the benefited shareholders. It
also removes the burden of determining each party's ownership interest
in the assets of the corporation. Thus, the regulations provide an
approach that is easier to apply and more narrowly tailored than the
models described in Notice 97-21.
2. Fast-Pay Stock and Benefited Stock
Under the proposed regulations, stock is fast-pay stock if it is
structured to provide for dividends that economically represent a
return (in whole or in part) of the holder's investment rather than
only a return on the holder's investment. Stock is presumed to be fast-
pay stock if it has, by design, a dividend rate that is reasonably
expected to decline, or an issue price that exceeds the amount at which
the holder can be compelled to dispose of the stock. A taxpayer may
rebut these presumptions only by clearly showing that no dividend
represents an economic return (in whole or in part) of the holder's
investment.
Generally, whether stock is fast-pay stock must be determined based
on all the facts and circumstances, including any related agreements
such as options or forward contracts. A related agreement is any direct
or indirect, oral or written, agreement between the holder of the stock
and the issuing corporation, or between the holder of the stock and one
or more other shareholders in the corporation. The determination that
stock is fast-pay stock is made when the stock is issued, and whenever
there is a significant modification in the terms of the stock or the
related agreements, or a significant change in the relevant facts and
circumstances.
[[Page 807]]
The proposed regulations define benefited stock by reference to
fast-pay stock. With respect to a class of fast-pay stock, all other
stock in the corporation (including any other class of fast-pay stock)
is benefited stock. For fast-pay arrangements in which there is more
than one class of benefited stock, the parties must apply the general
recharacterization rules among the different classes as appropriate to
match the arrangement's economic substance.
3. Fast-Pay Arrangements Subject to Recharacterization
Under the proposed regulations, if the corporation with outstanding
fast-pay stock is either a regulated investment company (RIC) or a real
estate investment trust (REIT), the fast-pay arrangement is
automatically recharacterized. If the corporation is neither a RIC nor
a REIT, the Commissioner may (at the Commissioner's discretion)
recharacterize the fast-pay arrangement in cases where the Commissioner
determines that a principal purpose for the structure of the fast-pay
arrangement is the avoidance of tax. This rule applies to all parties
to a fast-pay arrangement, without regard to whether such parties
acquired their interests as part of an initial offering or later (by
purchase or other transfer).
By not automatically recharacterizing all fast-pay arrangements,
the regulations prevent taxpayers from using the recharacterization
rules for other tax avoidance purposes. For example, shareholders of a
controlled foreign corporation cannot circumvent the purposes of United
States tax law (including treaties) by using the recharacterization
rules to exploit inconsistencies between the treatment of a fast-pay
arrangement by the United States and foreign jurisdictions. It is
expected that the Commissioner will closely scrutinize fast-pay
arrangements in which the corporation with outstanding fast-pay stock
is a foreign corporation.
4. Model for Recharacterizing Fast-Pay Arrangements
a. In General
The proposed regulations treat the fast-pay shareholders as holding
financing instruments issued by the benefited shareholders rather than
as holding fast-pay stock in the corporation. The corporation is the
paying agent on the financing instruments but has no other relationship
to the fast-pay shareholders.
Under the proposed regulations, the financing instruments have the
same payment terms as the fast-pay stock. The timing and amount of
payments made with respect to the financing instruments, therefore,
match the timing and amount of distributions made with respect to the
fast-pay stock. Nothing in the regulations characterizes the financing
instruments. The character of the financing instruments (for example,
stock or debt) must be determined under general tax principles and
depends on all the facts and circumstances.
The benefited shareholders are treated as first issuing the
financing instruments in exchange for cash equal to the fair market
value of the fast-pay stock (taking into account any related
agreements), and then as contributing the cash to the corporation
(thereby increasing their basis in the benefited stock). Distributions
made with respect to the fast-pay stock are treated as first made with
respect to the benefited stock, and then as used by the benefited
shareholders to make payments on the financing instruments.
b. Rule for Multiple Classes of Benefited Stock
The proposed regulations do not describe detailed rules for fast-
pay arrangements in which there is more than one class of benefited
shareholders. Instead, as mentioned before, the regulations provide a
general rule that requires recharacterization among the different
classes as appropriate to match the economic substance of the fast-pay
arrangement.
c. Rules for Disposition of Benefited Stock
The proposed regulations provide special rules for dispositions of
benefited stock. On the sale of benefited stock, in addition to any
consideration actually received, the seller is treated as receiving the
amount necessary to terminate its position with respect to the
financing instruments at fair market value. Similarly, the buyer is
treated as paying that amount and as issuing new financing instruments
to the fast-pay shareholders.
d. Rule Preserving Pre-effective Date Gain
The proposed regulations provide a special basis adjustment rule to
ensure that unrealized gain on benefited stock is not inappropriately
eliminated. Because the regulations do not apply to amounts accrued or
paid in taxable years ending before February 27, 1997 (pre-effective
years), a benefited shareholder will have economic income, but not
taxable income, attributable to pre-effective years if the form of a
fast-pay arrangement is respected for those years. This economic income
is reflected as unrealized gain in the benefited stock.
Absent a special basis adjustment rule, the general
recharacterization rule would eliminate this unrealized gain. Although
the regulations do not apply to amounts accrued or paid in pre-
effective years, the regulations recharacterize fast-pay arrangements
from their inception. Thus, in cases in which the fast-pay arrangement
was entered into in a pre-effective year, the general
recharacterization rule increases a benefited shareholder's basis in
its stock as of the inception of the transaction, even though the
regulations do not require the benefited shareholder to include deemed
dividend distributions attributable to the pre-effective years.
Consequently, this increase in basis without corresponding dividend
income eliminates the unrealized gain from the pre-effective years.
To preserve the unrealized gain resulting from the economic income
attributable to pre-effective years, the proposed regulations provide a
special basis adjustment rule. After taking into account any basis
increase under the general rule, a benefited shareholder must decrease
its basis in its benefited stock by the amount (if any) that (1) its
taxable income attributable to the fast-pay arrangement for pre-
effective years, computed by recharacterizing the fast-pay arrangement
under the regulations, exceeds (2) its taxable income attributable to
the fast-pay arrangement for pre-effective years, computed without
applying the recharacterization rules of the regulations. In this way,
a benefited shareholder's economic income attributable to taxable years
before the effective date of the regulations is not eliminated by the
basis provisions of the general recharacterization rules and may be
realized when the benefited shareholder disposes of its benefited
stock.
e. Rule Prohibiting the Affirmative Use of These Regulations To Avoid
Tax Imposed by the Code
The proposed regulations prohibit a taxpayer from affirmatively
using the automatic recharacterization rules if a principal purpose for
using such rules is the avoidance of any tax imposed by the Code. With
respect to such a taxpayer, the Commissioner may depart from the
automatic recharacterization rules and treat (for all purposes of the
Code) the fast-pay arrangement in accordance with its form or its
economic substance. This anti-abuse rule applies on a taxpayer-by-
[[Page 808]]
taxpayer basis. For example, if a foreign person acquires fast-pay
stock in a REIT and a principal purpose for acquiring such stock is to
reduce United States withholding taxes by applying the automatic
recharacterization rules, the Commissioner may, for purposes of
determining the foreign person's United States tax consequences
(namely, withholding tax), depart from the automatic recharacterization
rules and treat the foreign person as holding fast-pay stock in the
REIT.
5. Withholding
A corporation that issues fast-pay stock is a withholding agent for
payments made (or deemed made) under a fast-pay arrangement. Generally,
if a fast-pay arrangement is recharacterized under the automatic
recharacterization rules, a withholding agent must withhold in
accordance with the transaction as recharacterized. A different rule
applies, however, if the withholding agent knows or has reason to know
that any taxpayer entered into the fast-pay arrangement with a
principal purpose of using the recharacterization rules to avoid tax
under section 871(a) or section 881. In that case, for each payment
made (or deemed made) to such taxpayer under the arrangement, the
withholding agent must withhold under section 1441 or section 1442 the
higher of (1) the amount of withholding that applies to such payment
determined under the form of the arrangement, or (2) the amount of
withholding that applies to such payment determined under the automatic
recharacterization rules. Also, when the withholding agent knows or has
reason to know that the Commissioner has exercised the discretion to
depart from the automatic recharacterization rules for a taxpayer, the
withholding agent must withhold on payments made (or deemed made) to
that taxpayer in accordance with the characterization of the fast-pay
arrangement imposed by the Commissioner.
The withholding agent's liability to withhold on payments to
foreign individuals is described in new proposed Sec. 1.1441-7(g). The
same rules apply to payments (or deemed payments) to foreign
corporations under Sec. 1.1442-1.
6. Reporting Requirements
In general, a corporation that has fast-pay stock outstanding at
any time during the taxable year must attach a statement to its federal
income tax return. This rule does not apply to a corporation that is a
controlled foreign corporation (CFC) as defined in section 957, a
foreign personal holding company (FPHC) as defined in section 552, or a
passive foreign investment company (PFIC) as defined in section 1297.
Instead, certain shareholders (and officers and directors of FPHCs) of
those corporations must attach a statement to their returns.
The statement must identify the corporation that has outstanding
fast-pay stock and must recite the terms of the fast-pay stock and the
date on which the fast-pay stock was issued. In addition, to the extent
the filing person knows or has reason to know such information, the
statement must contain the names and the taxpayer identification
numbers of the shareholders of any class of stock that is not traded on
an established securities market as described in Sec. 1.7704-1(b).
7. Election To Limit Taxable Income Attributable to a Recharacterized
Fast-Pay Arrangement for Taxable Years Ending After February 26, 1997,
and Before the Date These Regulations Are Published as Final
Regulations in the Federal Register
The regulations are proposed to be effective February 27, 1997, and
to cover all taxable years ending after February 26, 1997. Thus, the
regulations will apply to all amounts accrued or paid on or after the
first day of the first taxable year ending after February 26, 1997.
Because the proposed effective date relates to the date Notice 97-
21 was issued to the public, and because the regulations adopt
different recharacterization rules from the ones described in the
notice, the regulations permit a shareholder of a recharacterized fast-
pay arrangement to limit its taxable income attributable to the
arrangement for certain taxable years. Specifically, for taxable years
ending after February 26, 1997, and before the date these regulations
are finalized, a shareholder may limit its taxable income attributable
to a fast-pay arrangement recharacterized under the regulations, to the
taxable income that would result if the fast-pay arrangement were
recharacterized under Notice 97-21. Any amount excluded under the limit
must be included as an adjustment to taxable income in the
shareholder's first taxable year that includes the date the regulations
are finalized. Under the regulations, a shareholder that has elected to
apply the limit must include a statement in its books and records
identifying each fast-pay arrangement for which the election was made,
and the amount excluded from taxable income under the election for each
fast-pay arrangement.
Shareholders who take advantage of the limit enjoy only a deferral
of taxable income: Any amount excluded under the limit is later
included as an adjustment. Thus, the sole benefit of making the
election is a timing difference. This result is appropriate because
over the life of a fast-pay arrangement a shareholder has the same
amount of taxable income whether the fast-pay arrangement is
recharacterized under Notice 97-21 or under the regulations. The IRS
and Treasury Department invite comments concerning the limit and
whether there are fast-pay arrangements in which any difference between
a shareholder's taxable income determined under Notice 97-21 and the
shareholder's taxable income determined under the regulations is other
than a timing difference.
Notice 97-21 describes two types of fast-pay arrangements. Hence,
calculating the limit requires appropriately recharacterizing the fast-
pay arrangement under the notice. In the first type of fast-pay
arrangement that the notice describes, the corporation with outstanding
fast-pay stock holds income-producing assets issued by a third party.
Notice 97-21 treats the benefited shareholders (one of which is called
the ``sponsor'' in the notice) as acquiring the assets of the
corporation directly from the sellers of those assets. The notice
treats the fast-pay shareholders (called ``investors'' in the notice)
as acquiring the assets of the corporation either from the sellers of
those assets or from the benefited shareholders in an income
``stripping'' transaction. Thus, both the fast-pay shareholders and
benefited shareholders are regarded as owning directly the
corporation's assets.
In the second type of fast-pay arrangement that Notice 97-21
describes, the corporation with outstanding fast-pay stock holds a debt
instrument issued by the sponsor (a benefited shareholder). In this
situation, the notice treats the sponsor as having issued one or more
instruments directly to the holders of the fast-pay stock. Thus, for
purposes of determining the sponsor's taxable income, the sponsor's
obligation under any asset held by the corporation is ignored.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It is hereby certified that
these regulations will not have a significant economic impact on a
substantial number of small entities.
[[Page 809]]
This certification is based on the understanding of the IRS and
Treasury Department that the total number of fast-pay arrangements is
fewer than 100, that the number of entities engaging in transactions
affected by these regulations is not substantial and, of those
entities, few or none are small entities within the meaning of the
Regulatory Flexibility Act (5 U.S.C. chapter 6). Therefore, a
Regulatory Flexibility Analysis is not required. Pursuant to section
7805(f) of the Internal Revenue Code, this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comments on its impact on small
businesses.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic and written comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. All comments will be available for public inspection and copying.
The IRS and Treasury Department specifically request comments on the
clarity of the proposed rule and how it may be made easier to
understand.
A public hearing has been scheduled for April 8, 1999, beginning at
10 a.m. in room 2615 of the Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the 10th Street entrance, located
between Constitution and Pennsylvania Avenues, NW. In addition, all
visitors must present photo identification to enter the building.
Because of access restrictions, visitors will not be admitted beyond
the immediate entrance area more than 15 minutes before the hearing
starts. For information about having your name placed on the building
access list to attend the hearing, see the FOR FURTHER INFORMATION
CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written or
electronic comments by April 6, 1999 and submit an outline of the
topics to be discussed and the time to be devoted to each topic (a
signed original and eight (8) copies) by March 18, 1999.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Proposed Effective Date
These regulations are proposed to be effective February 27, 1997,
and apply to taxable years ending after February 26, 1997. Thus, all
amounts accrued or paid on or after the first day of the first taxable
year ending after February 26, 1997, will be subject to the
regulations, regardless of when a particular share of the stock or a
particular debt instrument was issued.
The statement required under Sec. 1.7701(l)-3(f) is proposed to
apply to taxable years (of the taxpayer required to file the statement)
ending after the date the regulations are published as final
regulations in the Federal Register.
Drafting Information
The principal authors of these regulations are Jonathan Zelnik and
Marshall Feiring of the Office of the Assistant Chief Counsel
(Financial Institutions & Products). However, other personnel from the
IRS and Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.7701(l)-3 also issued under 26 U.S.C. 7701(l). * * *
Par. 2. Section 1.1441-7 is amended as follows:
1. Paragraph (g) is redesignated as paragraph (h) and revised.
2. New paragraph (g) is added.
The addition and revision read as follows:
Sec. 1.1441-7 General provisions relating to withholding agents.
* * * * *
(g) Fast-pay arrangements--(1) In general. A corporation that
issues fast-pay stock in a fast-pay arrangement described in
Sec. 1.7701(l)-3(b)(1) is a withholding agent with respect to fast-pay
dividends paid under the arrangement and any deemed payments with
respect to the arrangement under the recharacterization rules of
Sec. 1.7701(l)-3(c). Except as provided in this paragraph (g)(1) or in
paragraph (g)(2) of this section, the withholding tax rules under
section 1441 and section 1442 apply with respect to a fast-pay
arrangement described in Sec. 1.7701(l)-3(c)(1)(i) in accordance with
the recharacterization rules provided in Sec. 1.7701(l)-3(c). In all
cases, notwithstanding paragraph (g)(2) of this section, if at any time
the withholding agent knows or has reason to know that the Commissioner
has exercised the discretion under Sec. 1.7701(l)-3(d) to depart from
the recharacterization rules of Sec. 1.7701(l)-3(c) for a taxpayer, the
withholding agent must withhold on payments made (or deemed made) to
that taxpayer in accordance with the characterization of the fast-pay
arrangement imposed by the Commissioner under Sec. 1.7701(l)-3(d).
(2) Exception. If at any time the withholding agent knows or has
reason to know that any taxpayer entered into a fast-pay arrangement
with a principal purpose of applying the recharacterization rules of
Sec. 1.7701(l)-3(c) to avoid tax under section 871(a) or section 881,
then for each payment made or deemed made to such taxpayer under the
arrangement, the withholding agent must withhold, under section 1441 or
section 1442, the higher of--
(i) The amount of withholding that would apply to such payment
determined under the form of the arrangement; or
(ii) The amount of withholding that would apply to deemed payments
determined under the recharacterization rules of Sec. 1.7701(l)-3(c).
(3) Liability. Any person required to deduct and withhold tax under
this paragraph (g) is made liable for that tax by section 1461, and is
also liable for applicable penalties and interest for failing to comply
with section 1461.
(4) Examples. The following examples illustrate the rules of this
paragraph (g):
Example 1. REIT W issues shares of fast-pay stock to foreign
individual A, a resident of Country C. United States source
dividends paid to residents of C are subject to a 30 percent
withholding tax. W issues all shares of benefited stock to foreign
individuals who are residents of Country D. D's income tax
convention with the United States reduces the United States
withholding tax on dividends to 15 percent. Under Sec. 1.7701(l)-
3(c), the dividends paid by W to A are deemed to be paid by W to the
benefited shareholders. W has reason to know that A entered into the
fast-pay arrangement with a principal purpose of using the
recharacterization rules of Sec. 1.7701(l)-3(c) to reduce United
States withholding tax. W must withhold at the 30 percent rate on
the dividends deemed paid to its benefited shareholders because the
amount of withholding that applies to such payments
[[Page 810]]
determined under the form of the arrangement is higher than the
amount of withholding that applies to such payments determined under
Sec. 1.7701(l)-3(c).
Example 2. The facts are the same as in Example 1 of this
paragraph (g)(4) except that W does not know, or have reason to
know, that A entered the arrangement with a principal purpose of
using the recharacterization rules of Sec. 1.7701(l)-3(c) to reduce
United States withholding tax. Further, the Commissioner has not
exercised the discretion under Sec. 1.7701(l)-3(d) to depart from
the recharacterization rules of Sec. 1.7701(l)-3(c). Accordingly, W
must withhold tax at a 15 percent rate on the dividends deemed paid
to the benefited shareholders.
(5) Effective date. This paragraph (g) applies to payments made (or
deemed made) on or after January 6, 1999.
(h) Effective date. Except as otherwise provided in paragraph
(f)(3) or (g)(5) of this section, this section applies to payments made
after December 31, 1999.
Par. 3. Section 1.7701(l)-3 is added to read as follows:
Sec. 1.7701(l)-3 Recharacterizing financing arrangements involving
fast-pay stock.
(a) Purpose and scope. This section is intended to prevent the
avoidance of tax by persons participating in fast-pay arrangements (as
defined in paragraph (b)(1) of this section) and should be interpreted
in a manner consistent with this purpose. This section applies to all
fast-pay arrangements. Paragraph (c) of this section recharacterizes
certain fast-pay arrangements to ensure the participants are taxed in a
manner reflecting the economic substance of the arrangements. Paragraph
(f) of this section imposes reporting requirements on certain
participants.
(b) Definitions--(1) Fast-pay arrangement. A fast-pay arrangement
is any arrangement in which a corporation has outstanding for any part
of its taxable year two or more classes of stock, at least one of which
is fast-pay stock.
(2) Fast-pay stock--(i) Defined. Stock is fast-pay stock if it is
structured so that dividends (as defined in section 316) paid by the
corporation with respect to the stock are economically (in whole or in
part) a return of the holder's investment (as opposed to only a return
on the holder's investment). Unless clearly demonstrated otherwise,
stock is presumed to be fast-pay stock if--
(A) It is structured to have a dividend rate that is reasonably
expected to decline (as opposed to a dividend rate that is reasonably
expected to fluctuate or remain constant); or
(B) It is issued for an amount that exceeds (by more than a de
minimis amount, as determined under the principles of Sec. 1.1273-1(d))
the amount at which the holder can be compelled to dispose of the
stock.
(ii) Determination. The determination of whether stock is fast-pay
stock is based on all the facts and circumstances, including any
related agreements such as options or forward contracts. A related
agreement is any direct or indirect agreement or understanding, oral or
written, between the holder of the stock and the issuing corporation,
or between the holder of the stock and one or more other shareholders
in the corporation. The determination is made when the stock is issued
and whenever there is a significant modification in the terms of the
stock or the related agreements, or a significant change in the
relevant facts and circumstances.
(3) Benefited stock defined. With respect to a class of fast-pay
stock, all other stock in the corporation (including any other class of
fast-pay stock) is benefited stock.
(c) Recharacterization of certain fast-pay arrangements--(1) Scope.
This paragraph (c) applies to any fast-pay arrangement--
(i) In which the corporation that has outstanding fast-pay stock is
a regulated investment company (RIC) (as defined in section 851) or a
real estate investment trust (REIT) (as defined in section 856); or
(ii) If the Commissioner determines that a principal purpose for
the structure of the fast-pay arrangement is the avoidance of any tax
imposed by the Code. Application of this paragraph (c)(1)(ii) is at the
Commissioner's discretion, and a determination under this paragraph
(c)(1)(ii) applies to all parties to the fast-pay arrangement,
including transferees.
(2) Recharacterization. A fast-pay arrangement described in
paragraph (c)(1) of this section is recharacterized as an arrangement
directly between the benefited shareholders and the fast-pay
shareholders. The inception and resulting relationships of the
recharacterized arrangement are deemed to be as follows:
(i) Relationship between benefited shareholders and fast-pay
shareholders. The benefited shareholders issue financial instruments
(the financing instruments) directly to the fast-pay shareholders in
exchange for cash equal to the fair market value of the fast-pay stock
at the time of issuance (taking into account any related agreements).
The financing instruments have the same payment terms as the fast-pay
stock. Thus, the timing and amount of the payments made with respect to
the financing instruments always match the timing and amount of the
distributions made with respect to the fast-pay stock.
(ii) Relationship between benefited shareholders and corporation.
The benefited shareholders contribute to the corporation the cash they
receive for issuing the financing instruments. Distributions made with
respect to the fast-pay stock are distributions made by the corporation
with respect to the benefited shareholders' benefited stock.
(iii) Relationship between fast-pay shareholders and corporation.
For purposes of determining the relationship between the fast-pay
shareholders and the corporation, the fast-pay stock is ignored. The
corporation is the paying agent of the benefited shareholders with
respect to the financing instruments.
(3) Other rules--(i) Character of the financing instruments. The
character of a financing instrument (for example, stock or debt) is
determined under general tax principles and depends on all the facts
and circumstances.
(ii) Multiple classes of benefited stock. If there is more than one
class of benefited stock, the recharacterization rules of this
paragraph (c) apply among the different classes as appropriate to match
the economic substance of the fast-pay arrangement.
(iii) Sale of benefited stock. If one person sells benefited stock
to another--
(A) In addition to any consideration actually paid and received for
the benefited stock, the buyer is deemed to pay and the seller is
deemed to receive the amount necessary to terminate the seller's
position in the financing instruments at fair market value; and
(B) The buyer is deemed to issue financing instruments to the fast-
pay shareholders in exchange for the amount necessary to terminate the
seller's position in the financing instruments.
(iv) Adjustment to basis for amounts accrued or paid in taxable
years ending before February 27, 1997. In the case of a fast-pay
arrangement involving amounts accrued or paid in taxable years ending
before February 27, 1997, and recharacterized under this paragraph (c),
a benefited shareholder must decrease its basis in any benefited stock
(as determined under paragraph (c)(2)(ii) of this section) by the
amount (if any) that--
(A) Its income attributable to the benefited stock (reduced by
deductions attributable to financing instruments) for taxable years
ending before February 27, 1997, computed by recharacterizing the fast-
pay arrangement this under this paragraph (c); exceeds
[[Page 811]]
(B) Its income attributable to such stock for taxable years ending
before February 27, 1997, computed without applying the rules of this
paragraph (c).
(d) Prohibition against affirmative use of recharacterization by
taxpayers. A taxpayer may not use the rules of paragraph (c) of this
section if a principal purpose for using such rules is the avoidance of
any tax imposed by the Code. Thus, with respect to such taxpayer, the
Commissioner may depart from the rules of this section and
recharacterize (for all purposes of the Code) the fast-pay arrangement
in accordance with its form or its economic substance. For example, if
a foreign person acquires fast-pay stock in a REIT and a principal
purpose for acquiring such stock is to reduce United States withholding
taxes by applying the rules of paragraph (c) of this section, the
Commissioner may, for purposes of determining the foreign person's
United States tax consequences (namely, withholding tax), depart from
the rules of paragraph (c) of this section and treat the foreign person
as holding fast-pay stock in the REIT.
(e) Examples. The following examples illustrate the rules of
paragraph (c) of this section:
Example 1. Decline in dividend rate. (i) Facts. Corporation X
issues 100 shares of A Stock and 100 shares of B Stock for $1,000
per share. By its terms, a share of B Stock is reasonably expected
to pay a $110 dividend in years 1 through 10 and a $30 dividend each
year thereafter. If X liquidates, the holder of a share of B Stock
is entitled to a preference equal to the share's issue price.
Otherwise, the B Stock cannot be redeemed at either X's or the
shareholder's option.
(ii) Analysis. When issued, the B Stock has a dividend rate that
is reasonably expected to decline from an annual rate of 11 percent
of its issue price to an annual rate of 3 percent of its issue
price. Since the B Stock is structured to have a declining dividend
rate, the B Stock is fast-pay stock, and the A Stock is benefited
stock.
Example 2. Issued at a premium. (i) Facts. The facts are the
same as in Example 1 of this paragraph (e) except that a share of B
Stock is reasonably expected to pay an annual $110 dividend as long
as it is outstanding, and Corporation X has the right to redeem the
B Stock for $400 a share at the end of year 10.
(ii) Analysis. The B Stock is structured so that the issue price
of the B Stock ($1,000) exceeds (by more than a de minimis amount)
the price at which the holder can be compelled to dispose of the
stock ($400). Thus, the B Stock is fast-pay stock, and the A Stock
is benefited stock.
Example 3. Recharacterization illustrated. (i) Facts. On
formation, REIT Y issues 100 shares of C Stock and 100 shares of D
Stock for $1,000 per share. By its terms, a share of D Stock is
reasonably expected to pay a $110 dividend in years 1 through 10 and
a $30 dividend each year thereafter. In years 1 through 10, persons
holding a majority of the D Stock must consent before Y may take any
action that would result in Y liquidating or dissolving, merging or
consolidating, losing its REIT status, or selling substantially all
of its assets. Thereafter, Y may take these actions without consent
so long as the D Stock shareholders receive $400 in exchange for
their D Stock.
(ii) Analysis. When issued, the D Stock has a dividend rate that
is reasonably expected to decline from an annual rate of 11 percent
of its issue price to an annual rate of 3 percent of its issue
price. In addition, the $1,000 issue price of a share of D Stock
exceeds the price at which the shareholder can be compelled to
dispose of the stock ($400). Thus, the D Stock is fast-pay stock,
and the C Stock is benefited stock. Because Y is a REIT, the fast-
pay arrangement is recharacterized under paragraph (c) of this
section.
(iii) Recharacterization. The fast-pay arrangement is
recharacterized as follows:
(A) Under paragraph (c)(2)(i) of this section, the C Stock
shareholders are treated as issuing financing instruments to the D
Stock shareholders in exchange for $100,000 ($1,000, the fair market
value of each share of D Stock, multiplied by 100, the number of
shares).
(B) Under paragraph (c)(2)(ii) of this section, the C Stock
shareholders are treated as contributing $200,000 to Y (the $100,000
received for the financing instruments, plus the $100,000 actually
paid for the C Stock) in exchange for the C Stock.
(C) Under paragraph (c)(2)(ii) of this section, each
distribution with respect to the D Stock is treated as a
distribution with respect to the C Stock.
(D) Under paragraph (c)(2)(iii) of this section, the C Stock
shareholders are treated as making payments with respect to the
financing instruments, and Y is treated as the paying agent of the
financing instruments for the C Stock shareholders.
Example 4. Transfer of benefited stock illustrated. (i) Facts.
The facts are the same as in Example 3 of this paragraph (e). Near
the end of year 5, a person holding one share of C Stock sells it
for $1,300. The buyer is unrelated to REIT Y or to any of the D
Stock shareholders. At the time of the sale, the amount needed to
terminate the seller's position in the financing instruments at fair
market value is $747.
(ii) Benefited shareholder's treatment on sale. Under paragraph
(c)(3)(iii)(A) of this section, the seller's amount realized is
$2,047 ($1,300, the amount actually received, plus $747, the amount
necessary to terminate the seller's position in the financing
instruments at fair market value). The seller's gain on the sale of
the common stock is $47 ($2,047, the amount realized, minus $2,000,
the seller's basis in the common stock). The seller has no income or
deduction with respect to terminating its position in the financing
instruments.
(iii) Buyer's treatment on purchase. Under paragraph
(c)(3)(iii)(A) of this section, the buyer's basis in the share of D
Stock is $2,047 ($1,300, the amount actually paid, plus $747, the
amount needed to terminate the seller's position in the financing
instruments at fair market value). Under paragraph (c)(3)(iii)(B) of
this section, simultaneous with the sale, the buyer is treated as
issuing financing instruments to the fast-pay shareholders in
exchange for $747, the amount necessary to terminate the seller's
position in the financing instruments at fair market value.
Example 5. Fast-pay arrangement involving amounts accrued or
paid in a taxable year ending before February 27, 1997. (i) Facts. Y
is a calendar year taxpayer. In June 1996, Y acquires shares of REIT
T benefited stock for $15,000. In December 1996, Y receives
dividends of $100. Under the recharacterization rules of paragraph
(c)(2) of this section, Y's 1996 income attributable to the
benefited stock is $1,200, Y's 1996 deduction attributable to
financing instruments is $500, and Y's basis in the benefited stock
is $25,000.
(ii) Analysis. Under paragraph (c)(3)(iv) of this section, Y's
basis in the benefited stock is reduced by $600. This is the amount
by which Y's 1996 income from the fast-pay arrangement as
recharacterized under this section ($1,200 of income attributable to
the benefited stock less $500 of deductions attributable to the
financing instruments), exceeds Y's 1996 income from the fast-pay
arrangement as not recharacterized under this section ($100 of
income attributable to the benefited stock). Thus, in 1997 when the
fast-pay arrangement is recharacterized, Y's basis in the benefited
stock is $24,400.
(f) Reporting requirement--(1) Filing requirements--(i) In general.
A corporation that has fast-pay stock outstanding at any time during
the taxable year must attach the statement described in paragraph
(f)(2) of this section to its federal income tax return for such
taxable year. This paragraph (f)(1)(i) does not apply to a corporation
described in paragraph (f)(1)(ii), (iii), or (iv) of this section.
(ii) Controlled foreign corporation. In the case of a controlled
foreign corporation (CFC), as defined in section 957, that has fast-pay
stock outstanding at any time during its taxable year (during which
time it was a CFC), each controlling United States shareholder (within
the meaning of Sec. 1.964-1(c)(5)) must attach the statement described
in paragraph (f)(2) of this section to the shareholder's Form 5471 for
the CFC's taxable year. The provisions of section 6038 and the
regulations under section 6038 apply to any statement required by this
paragraph (f)(1)(ii).
(iii) Foreign personal holding company. In the case of a foreign
personal holding company (FPHC), as defined in section 552, that has
fast-pay stock outstanding at any time during its taxable year (during
which time it was a FPHC), each United States citizen or resident who
is an officer, director, or 10-percent shareholder (within the meaning
of section 6035(e)(1)) of such FPHC must attach the statement described
in paragraph (f)(2) of this
[[Page 812]]
section to his or her Form 5471 for the FPHC's taxable year. The
provisions of sections 6035 and 6679 and the regulations under sections
6035 and 6679 apply to any statement required by this paragraph
(f)(1)(iii).
(iv) Passive foreign investment company. In the case of a passive
foreign investment company (PFIC), as defined in section 1297, that has
fast-pay stock outstanding at any time during its taxable year (during
which time it was a PFIC), each shareholder that has elected (under
section 1295) to treat the PFIC as a qualified electing fund and knows
or has reason to know that the PFIC has outstanding fast-pay stock must
attach the statement described in paragraph (f)(2) of this section to
the shareholder's Form 8621 for the PFIC's taxable year. Each
shareholder owning 10 percent or more of the shares of the PFIC (by
vote or value) is presumed to know that the PFIC has issued fast-pay
stock. The provisions of sections 1295(a)(2) and 1298(f) and the
regulations under sections 1295(a)(2) and 1298(f) (including
Sec. 1.1295-1T(f)(2)) apply to any statement required by this paragraph
(f)(1)(iv).
(2) Statement. The statement required under this paragraph (f) must
say, ``This fast-pay stock disclosure statement is required by
Sec. 1.7701(l)-3(f) of the income tax regulations.'' The statement must
also identify the corporation that has outstanding fast-pay stock and
must contain the date on which the fast-pay stock was issued, the terms
of the fast-pay stock, and (to the extent the filing person knows or
has reason to know such information) the names and taxpayer
identification numbers of the shareholders of any class of stock that
is not traded on an established securities market (as described in
Sec. 1.7704-1(b)).
(g) Effective date--(1) In general. Except as provided in paragraph
(g)(4) of this section (relating to reporting requirements), this
section applies to taxable years ending after February 26, 1997. Thus,
all amounts accrued or paid during the first taxable year ending after
February 26, 1997, are subject to this section.
(2) Election to limit taxable income attributable to a
recharacterized fast-pay arrangement for taxable years ending after
February 26, 1997, and before the date these regulations are published
as final regulations in the Federal Register--(i) Limit and adjustment.
For taxable years ending after February 26, 1997, and before the date
these regulations are published as final regulations in the Federal
Register, a shareholder may limit its taxable income attributable to a
fast-pay arrangement recharacterized under paragraph (c) of this
section, to the taxable income that would result if the fast-pay
arrangement were recharacterized under Notice 97-21, 1997-1 C.B. 407,
see Sec. 601.601(d)(2) of this chapter. Any amount a shareholder
excludes from taxable income under this paragraph (g)(2)(i) must be
included as an adjustment to taxable income in the shareholder's first
taxable year that includes the date these regulations are published as
final regulations in the Federal Register. A shareholder that has
elected to limit its taxable income under this paragraph (g)(2)(i) must
include a statement in its books and records identifying each fast-pay
arrangement to which the limit was applied and providing the amount
excluded from taxable income for each such fast-pay arrangement.
(ii) The following examples illustrate the rules of this paragraph
(g)(2). For purposes of these examples, assume that the last year a
shareholder may limit its taxable income under this paragraph (g)(2) is
1998. The examples are as follows:
Example 1. Fast-pay arrangement recharacterized under Notice 97-
21; REIT holds third-party debt--(i) Facts. (A) REIT Y is formed on
January 1, 1998, at which time it issues 1,000 shares of fast-pay
stock and 1,000 shares of benefited stock for $100 per share. Y and
all of its shareholders have calendar taxable years. All
shareholders of Y have elected to accrue market discount based on a
constant interest rate, to include the market discount in income as
it accrues, and to amortize bond premium.
(B) For years 1 through 5, the fast-pay stock has an annual
dividend rate of $17 per share ($17,000 for the class); in later
years, the fast-pay stock has an annual dividend rate of $1 per
share ($1,000 for the class). At the end of year 5, and thereafter,
a share of fast-pay stock can be acquired by Y in exchange for $50
($50,000 for the class).
(C) On the day Y is formed, it acquires a five-year mortgage
note (the note) issued by an unrelated third party for $200,000. The
note provides for annual interest payments on December 31 of $18,000
(a coupon interest rate of 9.0 percent, compounded annually), and
one payment of principal at the end of 5 years. The note can be
prepaid, in whole or in part, at any time.
(ii) Recharacterization under Notice 97-21. (A) In general. One
way to recharacterize the fast-pay arrangement under Notice 97-21 is
to treat the fast-pay shareholders and the benefited shareholders as
if they jointly purchased the note from the issuer with the
understanding that over the five-year term of the note the benefited
shareholders would use their share of the interest to buy (on a
dollar-for-dollar basis) the fast-pay shareholders' portion of the
note. The benefited shareholders' and the fast-pay shareholders'
yearly taxable income under Notice 97-21 can then be calculated
after determining their initial portions of the note and whether
those initial portions are purchased at a discount or premium.
(B) Determining initial portions of the debt instrument. The
fast-pay shareholders' and the benefited shareholders' initial
portions of the note can be determined by comparing the present
values of their expected cash flows. As a class, the fast-pay
shareholders expect to receive cash flows of $135,000 (five annual
payments of $17,000, plus a final payment of $50,000). As a class,
the benefited shareholders expect to receive cash flows of $155,000
(five annual payments of $1,000, plus a final payment of $150,000).
Using a discount rate equal to the yield to maturity (as determined
under Sec. 1.1272-1(b)(1)(i)) of the mortgage note (9.0 percent,
compounded annually), the present value of the fast-pay
shareholders' cash flows is $98,620, and the present value of the
benefited shareholders' cash flows is $101,380. Thus, the fast-pay
shareholders initially acquire 49 percent of the note at a $1,380
premium (that is, they paid $100,000 for $98,620 of principal in the
note). The benefited shareholders initially acquire 51 percent of
the note at a $1,380 discount (that is, they paid $100,000 for
$101,380 of principal in the note). Under section 171, the fast-pay
shareholders' premium is amortizable based on their yield in their
initial portion of the note (8.57 percent, compounded annually). The
benefited shareholders' discount accrues based on the yield in their
initial portion of the note (9.35 percent, compounded annually).
(C) Taxable income under Notice 97-21. Under Notice 97-21, the
fast-pay shareholders' 1998 taxable income attributable to the fast-
pay arrangement is $8,574 ($8.57 per $100 invested), computed by
subtracting the amortizable premium ($302) from the interest income
from their portion of the note ($8,876). The benefited shareholders'
1998 taxable income attributable to the fast-pay arrangement is
$9,353 ($9.35 per $100 invested), computed by adding the accrued
discount ($229) to the interest income from their portion of the
note ($9,124).
(iii) Taxable income under the recharacterization of this
section. Assume the financing instruments are debt instruments.
Under the recharacterization rules of paragraph (c) of this section,
the fast-pay shareholders' 1998 taxable income attributable to the
fast-pay arrangement is $8,574 ($8.57 per $100 invested), which is
the interest income from the financing instruments. The benefited
shareholders' 1998 taxable income attributable to the fast-pay
arrangement is $9,426 ($9.43 per share of benefited stock), computed
by subtracting the interest income accrued on the financing
instruments ($8,574) from the dividend income actually and deemed
paid on the benefited stock ($18,000).
(iv) Limit on taxable income under this paragraph (g)(2). (A)
Fast-pay shareholders. For 1998, the fast-pay shareholders have the
same taxable income under the recharacterization of Notice 97-21
($8,574) as they have under the recharacterization of paragraph (c)
of this section ($8,574). Thus,
[[Page 813]]
the limit under paragraph (g)(2)(i) of this section is unavailable
to the fast-pay shareholders.
(B) Benefited shareholders. For 1998, the benefited shareholders
have taxable income attributable to the fast-pay arrangement of
$9,353 ($9.35 per $100 invested) under the recharacterization of
Notice 97-21, and taxable income of $9,426 ($9.43 per share of
benefited stock) under the recharacterization of paragraph (c) of
this section. Thus, under paragraph (g)(2)(i) of this section, a
benefited shareholder may elect to limit its taxable income
attributable to the fast-pay arrangement to $9.35 for each share of
benefited stock. Any amount an electing shareholder excludes from
taxable income($0.08 per share of benefited stock) must later be
included as an adjustment. (If all benefited shareholders elect the
limit, then as a class the later adjustment to taxable income is
$73.)
Example 2. REIT holds debt issued by a benefited shareholder.
(i) Facts. The facts are the same as in Example 1 of this paragraph
(g)(2) except that corporation Z holds 800 shares (80 percent) of
the benefited stock, and Z, instead of a third party, issues the
mortgage note acquired by Y.
(ii) Recharacterization under Notice 97-21. Because Y holds a
debt instrument issued by Z, the fast-pay arrangement is
recharacterized under Notice 97-21 as an arrangement in which Z
issued one or more instruments directly to the fast-pay shareholders
and the other benefited shareholders. Consistent with this
recharacterization, Z is treated as issuing a debt instrument to the
fast-pay shareholders for $100,000. The debt instrument provides for
five annual payments of $17,000 and an additional payment of $50,000
in year five. Thus, the debt instrument's yield to maturity is 8.57
percent per annum, compounded annually. Z is also treated as issuing
a debt instrument to the other benefited shareholders for $20,000
(200 shares multiplied by $100, or 20 percent of the $100,000 paid
to Y by the benefited shareholders as a class). This debt instrument
provides for five annual payments of $200 and an additional payment
of $30,000 in year five. The debt instrument's yield to maturity is
9.30 percent per annum, compounded annually. For 1998, Z's interest
expense is $10,435 ($8,574 attributable to the debt instruments held
by the fast-pay shareholders, and $1,861 attributable to the debt
instruments held by the other benefited shareholders).
(iii) Recharacterization under this section. Assume the
financing instruments are debt instruments. Under the
recharacterization rules of paragraph (c) of this section, for 1998,
Z has dividend income of $14,400 (800 shares multiplied by $18, or
80 percent of $18,000), and total interest expense of $24,859
($18,000 of interest accrued on the note held by Y, and $6,859 of
interest accrued on the financing instruments).
(iv) Limit on taxable income under this paragraph (g)(2). For
1998, Z has a taxable loss attributable to the fast-pay arrangement
of $10,435 under the recharacterization of Notice 97-21, and a
taxable loss of $10,459 ($14,400 of dividends, minus $24,859 of
total interest expense) under the recharacterization of paragraph
(c) of this section. Thus, for 1998, Z's taxable loss attributable
to the fast-pay arrangement is $10,459 (the amount determined under
paragraph (c) of this section), and the limit of paragraph (g)(2)(i)
of this section is unavailable to Z.
(3) Rule to comply with this section. To comply with this section
for each taxable year in which it failed to do so, a taxpayer should
file an amended return. For taxable years ending before the date these
regulations are published as final regulations, a taxpayer that has
complied with Notice 97-21, 1997-1 C.B. 407 (see Sec. 601.601(d)(2) of
this chapter), is considered to have complied with this section.
(4) Reporting requirements. The reporting requirements of paragraph
(f) of this section apply to taxable years (of the person required to
file the statement) ending after the date these regulations are
published as final regulations in the Federal Register.
John M. Dalrymple,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-178 Filed 1-5-99; 8:45 am]
BILLING CODE 4830-01-U
