Conduit Arrangements Regulations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8611]

RIN 1545-AS40

Conduit Arrangements Regulations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to conduit

financing arrangements issued under the authority granted by section

7701(l). The final regulations apply to persons engaging in multiple-

party financing arrangements. The final regulations are necessary to

determine whether such arrangements should be recharacterized under

section 7701(l).

EFFECTIVE DATE: The regulations are effective September 11, 1995.

FOR FURTHER INFORMATION CONTACT: Elissa J. Shendalman of the Office of

the Associate Chief Counsel (International), (202) 622-3870 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations

has been reviewed and approved by the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)) under control number 1545-1440. The estimated annual burden

per recordkeeper is 10 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attn:

Desk Officer for the Department of Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Background

On August 10, 1993, Congress enacted section 7701(l) of the

Internal Revenue Code (Code), which authorizes the

[[Page 40998]]

Secretary to ``prescribe regulations recharacterizing any multiple-

party financing transaction as a transaction directly among any 2 or

more parties where such recharacterization is necessary to prevent

avoidance of any tax imposed by [title 26].'' The legislative history

to section 7701(l) noted with approval a series of tax court and IRS

pronouncements that used ``substance over form'' principles to

recharacterize conduit financing arrangements, but stated that the

Secretary was not bound by the principles of these pronouncements in

developing regulations.

On October 14, 1994, the IRS published a notice of proposed

rulemaking in the Federal Register (59 FR 52110) under section 7701(l)

of the Code. These proposed regulations permit the district director to

disregard the participation of one or more intermediate entities in a

conduit financing arrangement for purposes of sections 871, 881, 1441,

and 1442.

Written comments responding to the notice were received, and a

public hearing was held on December 16, 1994. After considering the

written comments received and the statements made at the hearing, the

IRS and Treasury adopt the proposed regulation as revised by this

Treasury decision.

Explanation of Provisions and Summary of Significant Comments

A. Overview of Provisions

The final regulations make few substantive changes to the proposed

regulations. Most changes are in the nature of refinements to, and

clarifications of, the principles in the proposed regulations. It

should be noted that the IRS and Treasury will continue to monitor

conduit financing arrangements in the context of sections 871, 881,

1441 and 1442 after the publication of these final regulations. If the

rules announced herein do not sufficiently address the avoidance of

these taxes, the IRS and Treasury will consider modifying or

supplementing these rules as they find necessary.

Section 1.881-3(a)(2) of the final regulations provides definitions

of certain terms used throughout the regulations. A financing

arrangement is defined as a series of transactions by which one person

(the financing entity) advances money or other property, or grants

rights to use property, and another person (the financed entity)

receives money or other property, or the right to use property, if the

advance and receipt are effected through one or more other persons

(intermediate entities) and there are financing transactions linking

the financing entity, each of the intermediate entities, and the

financed entity. The final regulations supplement this basic rule with

an anti-abuse rule that allows the IRS to treat related persons as a

single entity where a taxpayer interposes a related person in an

arrangement that would otherwise qualify as a financing arrangement to

circumvent the application of the conduit rules.

A financing transaction includes a debt instrument, lease or

license. In addition, an equity instrument may qualify as a financing

transaction if the equity has certain debt-like characteristics. The

term financing transaction also includes any other advance of money or

property pursuant to which the transferee is obligated to repay or

return a substantial portion of the money or other property advanced or

the equivalent in value.

Section 1.881-3(a)(3)(i) authorizes the district director to

determine that an intermediate entity is a conduit entity under the

rules set forth in Sec. 1.881-3(a)(4). Section 1.881-3(a)(3)(ii)

describes the effects of conduit treatment. Section 1.881-

3(a)(3)(ii)(B) generally provides that the character of the payments

made under the recharacterized transaction (i.e. interest, rents, etc.)

is determined by reference to the character of the payments made to the

financing entity. However, if the financing transaction to which the

financing entity is a party gives rise to a type of payment that would

not be deductible if paid by the financed entity (e.g., dividends, as

determined under U.S. tax principles), the character of the payments is

not affected by the recharacterization.

Section 1.881-3(a)(3)(ii)(E) provides that a financing entity that

is unrelated to both the intermediate entity and the financed entity is

not liable for the tax imposed by section 881 unless it knows or has

reason to know of a conduit financing arrangement. Moreover, the final

regulations create a presumption that an unrelated financing entity

does not know or have reason to know of a conduit financing arrangement

where the intermediate entity that is a party to the financing

transaction with the financing entity is engaged in a substantial trade

or business.

Section 1.881-3(a)(4) provides the standards for determining

whether an intermediate entity is a conduit entity for purposes of

section 881. If an intermediate entity is related to either the

financing entity or the financed entity, the intermediate entity will

be a conduit entity only if (i) the participation of the intermediate

entity in the financing arrangement reduces the U.S. withholding tax

that otherwise would have been imposed, and (ii) the participation of

the intermediate entity in the financing arrangement is pursuant to a

plan one of the principal purposes of which is the avoidance of the

withholding tax.

If a financing arrangement involves multiple intermediate entities,

Sec. 1.881-3(a)(4)(ii)(A) provides that the district director will

determine whether each of the intermediate entities is a conduit

entity. The factors, presumptions, and other rules in the regulations

generally state how they should be applied in the case of multiple

intermediate entities. The regulations state that, if no such rule is

provided, the district director should apply principles consistent with

the standards described above. Section 1.881-3(a)(4)(ii)(B) provides a

general anti-abuse rule that allows the district director to treat

related intermediate entities as a single intermediate entity if he

determines that one of the principal purposes for the involvement of

multiple intermediate entities in the financing arrangement is to

prevent the characterization of an intermediate entity as a conduit

entity, to reduce the portion of a payment that is subject to

withholding tax or otherwise to circumvent the provisions of this

section. The district director's determination is to be based upon all

of the facts and circumstances, including, but not limited to, the

factors indicating whether the intermediate entity's participation in a

financing arrangement is pursuant to a tax avoidance plan.

Section 1.881-3(b) provides that the district director will weigh

all available evidence regarding the purposes for the intermediate

entity's participation in the financing arrangement. Moreover,

Sec. 1.881-3(b)(3) provides a presumption that a tax avoidance plan

does not exist where an intermediate entity that is related to either

the financing entity or the financed entity performs significant

financing activities with respect to the financing transactions making

up the financing arrangement.

In the case of an intermediate entity that is not related to either

the financing entity or the financed entity, the intermediate entity

will not be a conduit entity unless the requirements applicable to

related parties are met (that is, there is a reduction in the tax

imposed by section 881 and a tax avoidance plan) and, in addition, the

intermediate entity would not have participated in the financing

arrangement on substantially the same terms but for the fact that the

financing entity advanced money or property to (or entered into a lease

or license with) the intermediate entity. See Sec. 1.881-

[[Page 40999]]

3(a)(4)(i)(C). Under Sec. 1.881-3(c)(2), the district director may

presume that the intermediate entity would not have participated in the

financing arrangement on substantially the same terms but for the

financing transaction between the financing entity and the intermediate

entity if another person has provided a guarantee of the financed

entity's obligation to the intermediate entity. The term guarantee

includes, but is not limited to, a right of offset between the two

financing transactions to which the intermediate entity is a party.

Once the district director has disregarded the participation of a

conduit entity in a conduit financing arrangement, Sec. 1.881-

3(d)(1)(i) provides that a portion of each payment made by the financed

entity is recharacterized as a payment directly between the financed

entity and the financing entity. If the aggregate principal amount of

the financing transaction(s) to which the financed entity is a party is

less than or equal to the aggregate principal amount of the financing

transaction(s) linking any of the parties to the financing arrangement,

the entire amount of the payment by the financed entity shall be

recharacterized. If the aggregate principal amount of the financing

transaction(s) to which the financed entity is a party is greater than

the aggregate principal amount of the financing transaction(s) linking

any of the parties to the financing arrangement, then the

recharacterized portion shall be determined by multiplying the payment

by a fraction the numerator of which is equal to the lowest aggregate

principal amount of the financing transaction(s) linking any of the

parties to the financing arrangement and the denominator of which is

the aggregate principal amount of the financing transaction(s) to which

the financed entity is a party.

Under Sec. 1.881-3(d)(1)(ii)(A), the principal amount of a

financing transaction generally equals the amount of money, or the fair

market value of other property, advanced, or subject to a lease or

license, valued at the time of the financing transaction. However, in

the case of a financing arrangement where the same property is

advanced, or rights granted from the financing entity through the

intermediate entity (or entities) to the financed entity, the property

is valued on the date of the last financing arrangement. This rule is

intended to minimize the distortive effect of currency or other market

fluctuations when there is a time lag between financing transactions.

In addition, the principal amount of certain types of financing

transactions is subject to adjustment. Sections 1.881-3(d)(1)(ii) (B)

through (D) provide more detailed guidance regarding how these general

rules are applied to different types of financing transactions.

Section 1.881-4 uses the general recordkeeping requirements under

section 6001 to require a financed entity or any other person to keep

records relevant to determining whether such person is a party to a

financing arrangement and whether that financing arrangement may be

recharacterized under Sec. 1.881-3. Corporations that otherwise would

report certain information on total annual payments to related parties

pursuant to sections 6038(a) and 6038A(a) must also maintain such

records where the corporation knows or has reason to know that such

transactions are part of a financing arrangement. Specifically, the

final regulations require the entity to retain all records relating to

the circumstances surrounding its participation in the financing

transactions and financing arrangements, including minutes of board of

directors meetings and board resolutions and materials from investment

advisors regarding the structuring of the transaction.

Under Sec. 1.1441-7(d), any person that is a withholding agent for

purposes of section 1441 with respect to the transaction (whether the

financed entity or an intermediate entity that is treated as an agent

of the financing entity) must withhold in accordance with the

recharacterization if it knows or has reason to know that the financing

arrangement is a conduit financing arrangement. The final regulations

provide examples of how the ``knows or has reason to know'' standard,

which generally applies to all withholding agents, is to be applied in

this context.

B. Discussion of Significant Comments

Significant comments that relate to the application of the proposed

regulation and the responses to them, including an explanation of the

revisions made to the final regulation, are summarized below. Technical

or drafting comments that have been reflected in the final regulations

generally are not discussed.

1. General Approach

As described above, the final regulations adopt the general ``tax

avoidance'' standard of the proposed regulations. Several commentators

criticized the proposed regulations for setting forth new standards for

the recharacterization of conduit transactions. They argued that the

rulings that preceded these regulations required matching cash flows

from the financed entity to the conduit entity and from the conduit

entity to the financing entity. Some commentators argued that, because

in their view the regulations adopt new standards, the regulations

should only be effective for transactions entered into after the

enactment of section 7701(l), while others argued that the regulations

should only apply to transactions entered into after the publication of

the final regulations. Finally, some commentators suggested that the

regulations constituted an override of our treaty obligations and might

therefore be invalid.

The IRS and Treasury believe that pre-section 7701(l) conduit

rulings rested on a taxpayer having a tax avoidance purpose for

structuring its transactions. The fact that an intermediate entity

received and paid matching, or nearly matching, cash flows was evidence

that the participation of the intermediate entity in the transaction

did not serve a business purpose. Nevertheless, the fact that cash

flows were not matched did not mean that the transaction had a business

purpose.

The final regulations generally apply to payments made by financed

entities after the date which is 30 days after the date of publication

of the regulations because the IRS and Treasury believe that the

regulations reflect existing conduit principles. Moreover, even if the

regulations had adopted a new standard, it would be inappropriate to

grandfather transactions that admittedly had a tax avoidance purpose.

The final regulations do not apply to interest payments covered by

section 127(g)(3) of the Tax Reform Act of 1984, and to interest

payments with respect to other debt obligations issued prior to October

15, 1984 (whether or not such debt was issued by a Netherlands Antilles

corporation). Prior law continues to apply with respect to payments on

any such debt instruments.

As noted in the preamble to the proposed regulations, the IRS and

Treasury believe that these regulations supplement, but do not conflict

with, the limitation on benefits articles in tax treaties. They do so

by determining which person is the beneficial owner of income with

respect to a particular financing arrangement. Because the financing

entity is the beneficial owner of the income, it is entitled to claim

the benefits of any income tax treaty to which it is entitled to reduce

the amount of tax imposed by section 881 on that income. The conduit

entity, as an agent of the financing entity, cannot claim the benefits

of a treaty to reduce the amount of tax due under section 881

[[Page 41000]]

with respect to payments made pursuant to the financing arrangement.

2. Discretion given to District Director

a. Determination of whether conduit entity's participation will be

disregarded. Because the proposed regulations utilize a tax avoidance

test that depends on the facts and circumstances, discretion is given

to the district director to determine whether the participation of an

intermediate entity had as one of its principal purposes the avoidance

of U.S. withholding tax. Among other things, the district director may

determine the composition of the financing arrangement and the number

of parties to the financing arrangement.

Some commentators criticized this grant of discretion because they

claimed that the regulations provide insufficient guidance regarding

what factors the district director should take into account. Several

commentators proposed adding presumptions, making certain existing

presumptions irrebuttable or otherwise providing bright-line tests. One

commentator suggested that the district director's discretion to

determine the parties to a financing arrangement should be limited to

the extent necessary to ensure that a taxpayer could prove that a

different party that was entitled to treaty benefits was the real

financing entity. Finally, another commentator suggested that the

determination whether an intermediate entity's participation will be

disregarded should be subject to review by a central control board in

the National Office of the IRS.

Because the final regulations retain the facts and circumstances

test used in the proposed regulations, the final regulations do not

significantly reduce the district director's discretion. As discussed

below, it was not considered necessary to add additional factors

because the objective list of factors is not exclusive. The final

regulations do, however, provide more guidance regarding the tax

avoidance purpose test by adding several more examples. In addition,

the final regulations modify the factor relating to whether there has

been a significant reduction in tax to allow the taxpayer to produce

evidence that there was not a reduction in tax because the entity that

was the ultimate source of funds also was entitled to treaty benefits.

See Sec. 1.881-3(b)(2)(i).

The final regulations do not adopt the suggestion that the district

director's discretion be subject to review at the National Office

level. The final regulations, like the proposed regulations, provide

that the determination of whether a tax avoidance plan exists is based

on all of the facts and circumstances surrounding the intermediate

entity's participation in the financing arrangement. The IRS and

Treasury believe that such a determination would best be made at the

local level.

b. Judicial standard of review. Because the district director is

granted discretion by the regulations, his determinations generally

will be reviewed by the court under an abuse of discretion standard.

Commentators suggested that the district director's determination that

an intermediate entity's participation should be disregarded should be

reviewed by the court under this standard. One commentator instead

suggested that courts review a district director's determination using

a de novo standard of review. Another suggested that the IRS should be

afforded only its normal presumption of correctness. The final

regulations do not adopt these suggestions because they are

fundamentally inconsistent with the grant of discretion to the district

director.

3. Definitions

a. Financing transaction, in general. Commentators pointed out that

thedefinition of financing transaction in the proposed regulations

encompassed transactions that clearly were not meant to be covered by

the proposed regulations. For example, under the proposed regulations,

a foreign parent that contributed an existing note from its domestic

subsidiary to a foreign subsidiary in exchange for common stock of the

subsidiary that did not have any debt-like features nevertheless would

be treated as a financing entity because the foreign parent had made an

advance of property (the note) pursuant to which the foreign subsidiary

had ``become a party to an existing financing transaction''.

The definitions of financing transaction and financing arrangement

have been redrafted to address these concerns. See Sec. 1.881-3(a)(2)

(i) and (ii). The effect of the new definitions is to take a

``snapshot'' after all the transactions are in place to determine

whether there is a financing arrangement.

b. Equity. Commentators noted that the proposed regulations were

inconsistent in their treatment of how a controlling interest in a

corporation, either before or after a default, affected whether an

equity arrangement was a financing transaction. In addition,

commentators requested that the final regulations explicitly exempt

``common stock'' and ``ordinary preferred stock'' from treatment as

financing transactions.

In response to the first of these comments and in a general attempt

to clarify the types of equity instruments that are financing

transactions, the final regulations revise the definition of financing

transaction with respect to equity. See Sec. 1.881-3(a)(2)(ii) (A)(2)

and (B). The new definition provides that the right to elect the

majority of the board of directors will not, in and of itself, cause an

equity instrument to be a financing arrangement. See Sec. 1.881-

3(a)(2)(ii)(B)(2)(i).

As to the second suggestion, the final regulations do not create a

separate exception from the definition of financing transaction for

``common stock'' or ``ordinary perpetual preferred stock.'' Whether a

transaction constitutes a financing transaction depends upon the terms

of the transaction, not simply on the label attached to the

transaction. Moreover, because these terms are not themselves well-

defined in either the Code or common law, the IRS and Treasury believe

that excluding these categories of instruments would lead to disputes

as to whether a particular instrument is ``common stock'' or, if not,

whether it is ``ordinary'' perpetual preferred stock.

c. Guarantees. Commentators asked that final regulations explicitly

provide that guarantees are exempted from treatment as financing

transactions. The IRS and Treasury believe that the new definition of

financing transaction, which does not treat becoming a party to a

financing transaction as itself a financing transaction, clarifies that

a guarantee is not a financing transaction. Moreover, the final

regulations add an example to eliminate any doubt in this regard. See

Sec. 1.881-3(e) Example 1.

d. Leases and licenses. The proposed regulations provide that

leases and licenses are financing transactions. Some commentators

suggested that the regulations not include leases and licenses in the

definition of financing transaction or that the IRS reserve on the

subject of leases until it had more time to study the matter.

Other commentators proposed that certain types of leases, for

instance short-term leases and leveraged leases, be excluded from the

definition of financing transaction. The commentators pointed out that

certain leveraged leases would be subject to recharacterization under

the proposed regulations even though, in substance, the financing

arrangement is the equivalent of a loan from a financing entity

entitled to a zero rate of withholding on interest. Under Sec. 1.881-

3(d)(2) of the proposed regulations,

[[Page 41001]]

which provides that the nature of the recharacterized payments is

determined by reference to the transaction to which the financed entity

is a party, the participation of the intermediate entity in a leveraged

lease would substantially reduce the tax imposed under section 881 if

the treaty between the United States and the country in which the

lender was organized allowed withholding on rental payments. Because

all of the negative factors of Sec. 1.881-3(c)(2) and the ``but-for''

test of Sec. 1.881-3(b) of the proposed regulations are met in a

standard leveraged lease, this reduction in tax would allow the

district director to recharacterize the financing arrangement as a

conduit financing arrangement.

The IRS and Treasury believe that all leases and licenses, of

whatever duration, can be used by taxpayers to structure a conduit

financing arrangement. Accordingly, the final regulations continue to

include leases and licenses in the definition of financing transaction.

See Sec. 1.881-3(a)(2)(ii)(A)(3). However, the final regulations change

the character rule in the case of deductible payments. In those cases,

the character of the payments under the recharacterized transaction is

determined by reference to the financing transaction to which the

financing entity is a party. As a result, under the final regulations,

a leveraged lease generally will not be recharacterized as a conduit

arrangement if the ultimate lender would be entitled to an exemption

from withholding tax on interest received from the financed entity,

even if rental payments made by the financed entity to the financing

entity would have been subject to withholding tax.

e. Related. As noted above, it is more difficult for an

intermediate entity to be a conduit entity if it is not related to

either the financing entity or the financed entity. The definition of

persons who are related to another person generally follows the

definition used in section 6038A. One commentator suggested that the

final regulations eliminate the constructive ownership rule of section

267(c)(3) from the definition of related. The same commentator further

suggested that a person under common control within the meaning of

section 482 should not be a related person for purposes of this

regulation.

The IRS and Treasury believe that the term related should be

broadly defined to ensure that the additional protection from

recharacterization provided by the so-called ``but for'' test flows

only to those entities that are not under the effective control of

either the financing or the financed entity. Accordingly, the final

regulations retain the definition of related provided in the proposed

regulations. See Sec. 1.881-3(a)(2)(v).

4. Factors Indicating the Presence or Absence of a Tax Avoidance Plan

a. In general. The proposed regulations provide that whether the

participation of the intermediary in the financing arrangement is

pursuant to a tax avoidance plan is determined based on all the

relevant facts and circumstances. In addition, the proposed regulations

provide a list of some of the factors that will be taken into account:

the extent of the reduction in tax; the liquidity of the intermediate

entity; the timing of the transactions; and, in the case of related

entities, the nature of the business(es) of such entities.

Commentators asked that the final regulations adopt a number of

additional factors. For example, commentators asked that the

dissimilarity of cash flows or of financing transactions making up the

financing arrangement constitute a positive factor (i.e., a factor that

evidences the absence of a tax avoidance plan). Commentators also

suggested that the positive factors include the fact that income was

subject to net tax in the United States or in a foreign jurisdiction

or, alternatively, that the transaction reduced other U.S. or foreign

taxes more than it reduced the U.S. withholding tax (indicating that

the purpose of the transaction was to avoid taxes other than the tax

imposed by section 881).

The factors proposed by commentators generally relate to the issue

of whether there were purposes, other than the avoidance of the tax

imposed by section 881, for the participation of the intermediate

entity in the financing arrangement. The final regulations do not add

factors relating to purposes for the participation of an intermediate

entity in a financing arrangement. However, Sec. 1.881-3(b)(1) of the

final regulations addresses the issue by clarifying that the district

director will consider all available evidence regarding the purposes

for the participation of the intermediate entity.

b. Factor relating to a complementary or integrated business. One

of the factors listed in the proposed regulations is whether, if the

intermediate entity is related to the financed entity, the two parties

enter into a financing transaction to finance a trade or business

actively engaged in by the financed entity that forms a part of, or is

complementary to, a substantial trade or business actively engaged in

by the intermediate entity. One commentator expressed uncertainty as to

the policy behind this factor.

The intent of this factor was to take into account the fact that

related corporations engaged in integrated businesses may enter into

many financing transactions in the course of conducting those

businesses, the vast majority of which have no tax avoidance purpose.

Accordingly, Sec. 1.881-3(b)(2)(iv) of the final regulations clarifies

that the district director will take into account whether a transaction

is entered into in the ordinary course of integrated or complementary

trades or businesses in determining whether there is a tax avoidance

plan. In addition, the factor is broadened so as to apply not only to

transactions between the intermediate entity and the financed entity

but to transactions between any two parties to the financing

arrangement that are related to each other.

5. Presumption Regarding Significant Financing Activities

The proposed regulations provide that, in the case of an

intermediate entity that is related to either the financing entity or

the financed entity, a presumption of no tax avoidance arises where the

intermediate entity performs significant financing activities for such

entities. Among other things, the provision required employees of the

intermediate entity (other than an intermediate entity that earned

``active rents'' or ``active royalties'') to manage ``business risks''

arising from the transaction on an ongoing basis. The proposed

regulations provide an example showing that, if there are no such

business risks because the intermediate entity has hedged itself fully

at the time it entered into the financing transactions, the entity is

not described in the provision.

One commentator criticized the articulation of the significant

financing activities presumption in the proposed regulations on the

grounds that the test should be solely whether the participation of the

intermediate entity produces (or could be expected to produce)

efficiency savings through a reduction in overhead costs and the

ability to hedge the group's positions on a net basis. Another

commentator proposed extending the presumption for significant

financing activities to intermediate entities that are unrelated to

both the financed entity and the financing entity.

As to the first comment, the IRS and Treasury agree that there is

not a sufficient business purpose for the centralization of financing

activities of a group of related corporations in a single

[[Page 41002]]

corporation unless the taxpayer anticipates efficiency savings.

Although the prospect of such savings in general may establish a

business purpose for the establishment of the subsidiary, it does not

prevent the subsidiary from acting as a conduit with respect to any

particular financing arrangement. This is demonstrated by the hedging

example described above, the rationale for which is that either the

financed entity or the financing entity could have entered into the

long-term hedge so there is no economic justification for the

participation of the intermediate entity in the particular financing

arrangement. The IRS and Treasury believe that an affiliate that is not

taking a continuing active role in coordinating and managing a

financing transaction should not be entitled to the presumption that

its participation is not pursuant to a tax avoidance plan.

As to the suggestion of extending the significant financing

activities presumption to unrelated parties, the IRS and Treasury

believe that this extension would be inconsistent with the purpose of

the presumption. The significant financing presumption recognizes that

there are legitimate business reasons for conducting financing

activities through a centralized financing and hedging subsidiary. The

decision to have an unrelated intermediate entity participate in a

financing transaction is based on different considerations, including

the regulatory effects of such transactions and the interests of the

shareholders of the unrelated intermediary. These considerations are

addressed by providing that such entities will not be conduit entities

unless they satisfy the ``but for'' test. The final regulations do not

extend the significant financing activities presumption to unrelated

parties.

Accordingly, the requirements for the significant financing

activities presumption in Sec. 1.881-3(b)(3) of the final regulations

are generally the same as those in the proposed regulations. However,

the final regulations do add a requirement that the participation of

the intermediate entity generate efficiency savings, and change the

term business risks to market risks (to differentiate the risks of

currency and interest rate movements from other, primarily credit,

risks). In addition, one of the examples that illustrates the

significant financing activities presumption has been revised to

indicate that a finance subsidiary may be managing market risks even in

the case of a fully-hedged transaction if the intermediate entity

routinely terminates such long term arrangements when it finds cheaper

hedging alternatives. See Sec. 1.881-3(e) Example 22.

6. ``But for'' Test

a. In general. Under the proposed regulations, if the intermediate

entity is not related to either the financing entity or the financed

entity, the financing arrangement will not be recharacterized unless

the intermediate entity would not have participated in the financing

arrangement on substantially the same terms ``but for'' the fact that

the financing entity advanced money or property to (or entered into a

lease or license with) the intermediate entity.

Commentators asked for clarification regarding what it means for

terms to be not substantially the same. One commentator proposed using

the standards for material modifications under section 1001.

The IRS and Treasury believe that an attempt to set forth a

comprehensive system of bright-line rules like those suggested by

commentators would add unnecessary complexity to the regulation, given

its anti-abuse purpose. Accordingly, the final regulations make no

change to the proposed regulations in this regard.

b. Presumption where financing entity guarantees the liability of

the financed entity. Under the proposed regulations, it is presumed

that the intermediate entity would not have participated in the

financing arrangement on substantially the same terms if, in addition

to entering into a financing transaction with the intermediate entity,

the financing entity guarantees the financed entity's liabilities under

its financing transaction with the intermediate entity. A taxpayer may

rebut this presumption by producing clear and convincing evidence that

the intermediate entity would have participated in the financing

arrangement on substantially the same terms even if the financing

entity had not entered into a financing transaction with the

intermediate entity.

Several commentators asked for clarification of this presumption.

Some commentators suggested that the existence of a guarantee makes the

existence of the financing transaction between the financing entity and

the intermediate entity irrelevant to the determination of whether the

intermediate entity would have participated in the financing

arrangement on substantially the same terms. Another commentator

proposed eliminating the ``clear and convincing evidence'' standard on

the grounds that it is too difficult an evidentiary burden for the

taxpayer to overcome.

The presumption regarding guarantees originated in Rev. Rul. 87-89

(1987-2 C.B. 195), which articulated the ``but for'' test in

substantially the same terms as adopted in the final regulations. Rev.

Rul. 87-89 provided that a statutory or contractual right of offset is

presumptive evidence that the unrelated intermediary would not have

participated in the financing arrangement on substantially the same

terms without the financing transaction from the financing entity. The

proposed regulations extend the presumption to all guarantees in order

to prevent taxpayers from using forms of credit support other than the

right of offset to avoid this presumption. The final regulations retain

this rule. See Sec. 1.881-3(c)(2).

The final regulations also retain the ``clear and convincing

evidence'' standard. The taxpayer always must overcome the presumption

of correctness in favor of the government by a preponderance of the

evidence. Therefore, in order for this additional presumption to have

any effect, it is necessary to raise the evidentiary standard. In

addition, this standard of proof is not unreasonable, because an

intermediate entity that is unrelated to the financing entity and the

financed entity and that proves, by clear and convincing evidence, that

it would have entered into the financing arrangement on substantially

the same terms will avoid recharacterization as a conduit entity even

though its participation in the financing arrangement is pursuant to a

tax avoidance plan.

7. Multiple Intermediate Entities

a. In general. The proposed regulations provide guidance as to how

some but not all of the operative provisions and presumptions apply to

multiple intermediate entities. Several commentators asked that the

final regulations clarify the manner in which the operative rules apply

in the case of multiple intermediate entities. The final regulations

provide additional guidance in the relevant operative rules and

presumptions. In addition, the final regulations modify the example in

the proposed regulations relating to multiple intermediate entities to

clarify how some of these provisions and presumptions apply. See

Sec. 1.881-3(e) Example 8.

b. Special rule for related persons. Section 1.881-3(a)(4)(ii)(B)

of the proposed regulations allows the district director to treat

related persons as a single intermediate entity if he determines that

one of the principal purposes for the structuring of a transaction was

the avoidance of the

[[Page 41003]]

application of the conduit financing arrangement rules. Several

commentators suggested that the final regulations eliminate this

section. One commentator suggested that the rule be limited to

situations where one related corporation made an equity investment in

another. Another believed that the IRS and Treasury should ``wait and

see'' whether such a rule was really necessary to prevent taxpayers

from circumventing the conduit financing arrangement rules.

The IRS and Treasury believe that an anti-abuse rule is necessary

to prevent the circumvention of these rules through manipulation of the

definition of financing arrangement. Accordingly, Sec. 1.881-

3(a)(2)(i)(B) of the final regulations retains the related party anti-

abuse rule. Moreover, the final regulations include another more

general anti-abuse rule that allows the district director to treat

related intermediate entities as a single intermediate entity if he

determines that one of the principal purposes for the involvement of

multiple intermediate entities in the financing arrangement is to

prevent the characterization of an entity as a conduit, to reduce the

portion of a payment that is subject to withholding tax or otherwise to

circumvent any other provision of this section. See Sec. 1.881-

3(a)(4)(ii)(B). This rule prevents a taxpayer from structuring a

financing transaction with a small principal amount to reduce the

amount of the recharacterized payment, and thus replaces the second

half of the rule set forth in proposed regulation Sec. 1.881-

3(a)(4)(ii)(B). This rule is illustrated in Sec. 1.881-3(e) Example 7.

8. Principal Amount

The proposed regulations provide that the principal amount of a

financing transaction shall be determined on the basis of all of the

facts and circumstances. Under the proposed regulations, the principal

amount generally equals the amount of money, or the fair market value

of other property (determined as of the time that the financing

transaction is entered into), advanced in the financing transaction.

The principal amount of a financing transaction is subject to

adjustments, as appropriate.

Some commentators asked for clarification regarding whether

adjustments would be made to the principal amount of a financing

transaction to take account of amortization or depreciation. Another

commentator suggested that the final regulations provide that

calculations be performed in the functional currency of the

intermediate entity in order to isolate currency fluctuations.

The final regulations provide that adjustments for depreciation and

amortization are made when calculating the principal amount of a

leasing or licensing financing transaction. See Sec. 1.881-

3(d)(1)(ii)(A).

Although the IRS and Treasury agree that the effect of currency

fluctuations should be minimized, they believe that determining the

principal amount in the functional currency of the intermediate entity

would not always yield the correct result. Accordingly, the final

regulations eliminate currency and market fluctuations to the extent

possible by providing that, when the same property has been advanced by

the financing entity and received by the financed entity, the

determination of the principal amount is made as of the date the last

financing transaction is entered into. See Sec. 1.881-3(d)(1)(ii)(A).

An example has been added to demonstrate how this rule applies to

transactions in currencies other than the U.S. dollar. See Sec. 1.881-

3(e) Example 25.

9. Correlative Adjustments

The proposed regulations do not provide for correlative adjustments

in the case of the district director's recharacterization of a

financing arrangement as a transaction directly between a financing

entity and a financed entity.

Commentators have requested that taxpayers be allowed to make

correlative adjustments if their transactions are recharacterized.

Commentators generally would not, however, allow the IRS to make

correlative adjustments where such adjustments would result in greater

tax liability.

The final regulations, like the proposed regulations, do not

provide for correlative adjustments. The IRS and Treasury agree with

commentators that it is not appropriate to use regulations that are

intended to prevent the avoidance of tax under section 881 to

recharacterize transactions for purposes of other code sections.

Accordingly, taxpayers should not be able to use these regulations to

make correlative adjustments to their tax returns.

10. Recordkeeping and Reporting Requirements

The proposed regulations require corporations that would otherwise

report certain information on total annual payments to related parties

pursuant to sections 6038(a) and 6038A(a) to report such information on

a transaction-by-transaction basis where the corporation knows or has

reason to know that such transactions are part of a financing

arrangement. In addition, the proposed regulations require a financed

entity or any other person to keep records relevant to determining

whether such person is a party to a financing arrangement that is

subject to recharacterization as part of their general recordkeeping

requirements under section 6001.

Commentators criticized the reporting requirements imposed by the

proposed regulation as unduly burdensome in that they would require

reporting of all financing arrangements and not simply those subject to

recharacterization as conduit financing arrangements. Moreover, they

pointed out that, because the regulations only would require reporting

of those transactions to which the financed entity is a party, the

information reported would not be of significant value. The reported

information would not be sufficient to allow the IRS to connect the

reported financing transaction to the other financing transactions

making up a financing arrangement.

The final regulations eliminate the reporting requirements provided

in the proposed regulations and provide more specific guidance as to

the type of records affected entities must retain. The recordkeeping

requirements of Sec. 1.881-4 have been revised to incorporate all of

the information that entities would have had to report under the

proposed regulations. In addition, the final regulations require the

entity to retain all records relating to the circumstances surrounding

its participation in the financing transactions and financing

arrangements, including minutes of board of directors meetings and

board resolutions and materials from investment advisors regarding the

structuring of the transaction. See Sec. 1.881-4(c)(2).

11. Withholding Obligations

Under the proposed regulations, a person that is otherwise a

withholding agent is required to withhold tax under section 1441 or

section 1442 in accordance with the recharacterization of a financing

arrangement if the person knows or has reason to know that the

financing arrangement is subject to recharacterization under sections

871 or 881. Commentators asked for additional guidance regarding the

application of the ``know or have reason to know'' standard in the

context of conduit financing arrangements. The final regulations

include several examples regarding the circumstances in which a

financed entity does and does not have

[[Page 41004]]

reason to know of the existence of a conduit financing arrangement.

C. Status of Revenue Rulings

The proposed regulations did not address the status of the existing

revenue rulings relating to conduit arrangements. Commentators have

asked for guidance regarding their status.

Concurrent with the publication of these regulations, the IRS is

issuing a revenue ruling modifying the existing rulings. The revenue

ruling limits the application of the old revenue rulings in the context

of withholding tax to payments made before the effective date of the

final regulations and to other provisions not covered by the conduit

regulations.

Special Analyses

It has been determined that this Treasury decision 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. Accordingly, a regulatory

flexibility analysis is not required. This certification is based on

the information that follows. These regulations affect entities engaged

in cross-border multiple-party financing arrangements. It is assumed

that a substantial number of small entities will not engage in such

financing arrangements. Pursuant to section 7805(f) of the Internal

Revenue Code, the notice of proposed rulemaking preceding these

regulations was submitted to the Small Business Administration for

comment on its impact on small businesses.

Drafting Information: The principal author of these regulations

is Elissa J. Shendalman, Office of the Associate Chief Counsel

(International). However, other personnel from the IRS and the

Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entry for ``Sections 1.6038A-1 through 1.6038A-7'' and

adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.871-1 also issued under 26 U.S.C. 7701(l). * * *

Section 1.881-3 also issued under 26 U.S.C. 7701(l).

Section 1.881-4 also issued under 26 U.S.C. 7701(l). * * *

Section 1.1441-3 also issued under 26 U.S.C. 7701(l). * * *

Section 1.1441-7 also issued under 26 U.S.C. 7701(l). * * *

Section 1.6038A-1 also issued under 26 U.S.C. 6038A.

Section 1.6038A-2 also issued under 26 U.S.C. 6038A.

Section 1.6038A-3 also issued under 26 U.S.C. 6038A and 7701(l).

Section 1.6038A-4 also issued under 26 U.S.C. 6038A.

Section 1.6038A-5 also issued under 26 U.S.C. 6038A.

Section 1.6038A-6 also issued under 26 U.S.C. 6038A.

Section 1.6038A-7 also issued under 26 U.S.C. 6038A. * * *

Section 1.7701(l)-1 also issued under 26 U.S.C. 7701(l). * * *

Par. 2. In Sec. 1.871-1, paragraph (b)(7) is added to read as

follows:

Sec. 1.871-1 Classification and manner of taxing alien individuals.

* * * * *

(b) * * *

(7) Conduit financing arrangements. For rules regarding conduit

financing arrangements, see Secs. 1.881-3 and 1.881-4.

* * * * *

Par. 3. Sections 1.881-0, 1.881-3 and 1.881-4 are added to read as

follows:

Sec. 1.881-0 Table of contents.

This section lists the major headings for Secs. 1.881-1 through

1.881-4.

Sec. 1.881-1 Manner of Taxing Foreign Corporations

(a) Classes of foreign corporations.

(b) Manner of taxing.

(1) Foreign corporations not engaged in U.S. business.

(2) Foreign corporations engaged in U.S. business.

(c) Meaning of terms.

(d) Rules applicable to foreign insurance companies.

(1) Corporations qualifying under subchapter L.

(2) Corporations not qualifying under subchapter L.

(e) Other provisions applicable to foreign corporations.

(1) Accumulated earnings tax.

(2) Personal holding company tax.

(3) Foreign personal holding companies.

(4) Controlled foreign corporations.

(i) Subpart F income and increase of earnings invested in U.S.

property.

(ii) Certain accumulations of earnings and profits.

(5) Changes in tax rate.

(6) Consolidated returns.

(7) Adjustment of tax of certain foreign corporations.

(f) Effective date.

Sec. 1.881-2 Taxation of Foreign Corporations Not Engaged in U.S.

Business

(a) Imposition of tax.

(b) Fixed or determinable annual or periodical income.

(c) Other income and gains.

(1) Items subject to tax.

(2) Determination of amount of gain.

(d) Credits against tax.

(e) Effective date.

Sec. 1.881-3 Conduit Financing Arrangements

(a) General rules and definitions.

(1) Purpose and scope.

(2) Definitions.

(i) Financing arrangement.

(A) In general.

(B) Special rule for related parties.

(ii) Financing transaction.

(A) In general.

(B) Limitation on inclusion of stock or similar interests.

(iii) Conduit entity.

(iv) Conduit financing arrangement.

(v) Related.

(3) Disregard of participation of conduit entity.

(i) Authority of district director.

(ii) Effect of disregarding conduit entity.

(A) In general.

(B) Character of payments made by the financed entity.

(C) Effect of income tax treaties.

(D) Effect on withholding tax.

(E) Special rule for a financing entity that is unrelated to

both intermediate entity and financed entity.

(iii) Limitation on taxpayers's use of this section.

(4) Standard for treatment as a conduit entity.

(i) In general.

(ii) Multiple intermediate entities.

(A) In general.

(B) Special rule for related persons.

(b) Determination of whether participation of intermediate

entity is pursuant to a tax avoidance plan.

(1) In general.

(2) Factors taken into account in determining the presence or

absence of a tax avoidance purpose.

(i) Significant reduction in tax.

(ii) Ability to make the advance.

(iii) Time period between financing transactions.

(iv) Financing transactions in the ordinary course of business.

(3) Presumption if significant financing activities performed by

a related intermediate entity.

(i) General rule.

(ii) Significant financing activities.

(A) Active rents or royalties.

(B) Active risk management.

(c) Determination of whether an unrelated intermediate entity

would not have participated in financing arrangement on

substantially same terms.

(1) In general.

[[Page 41005]]

(2) Effect of guarantee.

(i) In general.

(ii) Definition of guarantee.

(d) Determination of amount of tax liability.

(1) Amount of payment subject to recharacterization.

(i) In general.

(ii) Determination of principal amount.

(A) In general.

(B) Debt instruments and certain stock.

(C) Partnership and trust interests.

(D) Leases and licenses.

(2) Rate of tax.

(e) Examples.

(f) Effective date.

Sec. 1.881-4 Recordkeeping Requirements Concerning Conduit

Financing Arrangements

(a) Scope.

(b) Recordkeeping requirements.

(1) In general.

(2) Application of sections 6038 and 6038A.

(c) Records to be maintained.

(1) In general.

(2) Additional documents.

(3) Effect of record maintenance requirement.

(d) Effective date.

Sec. 1.881-3 Conduit financing arrangements.

(a) General rules and definitions--(1) Purpose and scope. Pursuant

to the authority of section 7701(l), this section provides rules that

permit the district director to disregard, for purposes of section 881,

the participation of one or more intermediate entities in a financing

arrangement where such entities are acting as conduit entities. For

purposes of this section, any reference to tax imposed under section

881 includes, except as otherwise provided and as the context may

require, a reference to tax imposed under sections 871 or 884(f)(1)(A)

or required to be withheld under section 1441 or 1442. See Sec. 1.881-4

for recordkeeping requirements concerning financing arrangements. See

Secs. 1.1441-3(j) and 1.1441-7(d) for withholding rules applicable to

conduit financing arrangements.

(2) Definitions. The following definitions apply for purposes of

this section and Secs. 1.881-4, 1.1441-3(j) and 1.1441-7(d).

(i) Financing arrangement--(A) In general. Financing arrangement

means a series of transactions by which one person (the financing

entity) advances money or other property, or grants rights to use

property, and another person (the financed entity) receives money or

other property, or rights to use property, if the advance and receipt

are effected through one or more other persons (intermediate entities)

and, except in cases to which paragraph (a)(2)(i)(B) of this section

applies, there are financing transactions linking the financing entity,

each of the intermediate entities, and the financed entity. A transfer

of money or other property in satisfaction of a repayment obligation is

not an advance of money or other property. A financing arrangement

exists regardless of the order in which the transactions are entered

into, but only for the period during which all of the financing

transactions coexist. See Examples 1, 2, and 3 of paragraph (e) of this

section for illustrations of the term financing arrangement.

(B) Special rule for related parties. If two (or more) financing

transactions involving two (or more) related persons would form part of

a financing arrangement but for the absence of a financing transaction

between the related persons, the district director may treat the

related persons as a single intermediate entity if he determines that

one of the principal purposes for the structure of the financing

transactions is to prevent the characterization of such arrangement as

a financing arrangement. This determination shall be based upon all of

the facts and circumstances, including, without limitation, the factors

set forth in paragraph (b)(2) of this section. See Examples 4 and 5 of

paragraph (e) of this section for illustrations of this paragraph

(a)(2)(i)(B).

(ii) Financing transaction--(A) In general. Financing transaction

means--

(1) Debt;

(2) Stock in a corporation (or a similar interest in a partnership

or trust) that meets the requirements of paragraph (a)(2)(ii)(B) of

this section;

(3) Any lease or license; or

(4) Any other transaction (including an interest in a trust

described in sections 671 through 679) pursuant to which a person makes

an advance of money or other property or grants rights to use property

to a transferee who is obligated to repay or return a substantial

portion of the money or other property advanced, or the equivalent in

value. This paragraph (a)(2)(ii)(A)(4) shall not apply to the posting

of collateral unless the collateral consists of cash or the person

holding the collateral is permitted to reduce the collateral to cash

(through a transfer, grant of a security interest or similar

transaction) prior to default on the financing transaction secured by

the collateral.

(B) Limitation on inclusion of stock or similar interests--(1) In

general. Stock in a corporation (or a similar interest in a partnership

or trust) will constitute a financing transaction only if one of the

following conditions is satisfied--

(i) The issuer is required to redeem the stock or similar interest

at a specified time or the holder has the right to require the issuer

to redeem the stock or similar interest or to make any other payment

with respect to the stock or similar interest;

(ii) The issuer has the right to redeem the stock or similar

interest, but only if, based on all of the facts and circumstances as

of the issue date, redemption pursuant to that right is more likely

than not to occur; or

(iii) The owner of the stock or similar interest has the right to

require a person related to the issuer (or any other person who is

acting pursuant to a plan or arrangement with the issuer) to acquire

the stock or similar interest or make a payment with respect to the

stock or similar interest.

(2) Rules of special application--(i) Existence of a right. For

purposes of this paragraph (a)(2)(ii)(B), a person will be considered

to have a right to cause a redemption or payment if the person has the

right (other than rights arising, in the ordinary course, between the

date that a payment is declared and the date that a payment is made) to

enforce the payment through a legal proceeding or to cause the issuer

to be liquidated if it fails to redeem the interest or to make a

payment. A person will not be considered to have a right to force a

redemption or a payment if the right is derived solely from ownership

of a controlling interest in the issuer in cases where the control does

not arise from a default or similar contingency under the instrument.

The person is considered to have such a right if the person has the

right as of the issue date or, as of the issue date, it is more likely

than not that the person will receive such a right, whether through the

occurrence of a contingency or otherwise.

(ii) Restrictions on payment. The fact that the issuer does not

have the legally available funds to redeem the stock or similar

interest, or that the payments are to be made in a blocked currency,

will not affect the determinations made pursuant to this paragraph

(a)(2)(ii)(B).

(iii) Conduit entity means an intermediate entity whose

participation in the financing arrangement may be disregarded in whole

or in part pursuant to this section, whether or not the district

director has made a determination that the intermediate entity should

be disregarded under paragraph (a)(3)(i) of this section.

(iv) Conduit financing arrangement means a financing arrangement

that is effected through one or more conduit entities.

(v) Related means related within the meaning of sections 267(b) or

707(b)(1), or controlled within the meaning of section 482, and the

regulations under those sections. For purposes of

[[Page 41006]]

determining whether a person is related to another person, the

constructive ownership rules of section 318 shall apply, and the

attribution rules of section 267(c) also shall apply to the extent they

attribute ownership to persons to whom section 318 does not attribute

ownership.

(3) Disregard of participation of conduit entity--(i) Authority of

district director. The district director may determine that the

participation of a conduit entity in a conduit financing arrangement

should be disregarded for purposes of section 881. For this purpose, an

intermediate entity will constitute a conduit entity if it meets the

standards of paragraph (a)(4) of this section. The district director

has discretion to determine the manner in which the standards of

paragraph (a)(4) of this section apply, including the financing

transactions and parties composing the financing arrangement.

(ii) Effect of disregarding conduit entity--(A) In general. If the

district director determines that the participation of a conduit entity

in a financing arrangement should be disregarded, the financing

arrangement is recharacterized as a transaction directly between the

remaining parties to the financing arrangement (in most cases, the

financed entity and the financing entity) for purposes of section 881.

To the extent that a disregarded conduit entity actually receives or

makes payments pursuant to a conduit financing arrangement, it is

treated as an agent of the financing entity. Except as otherwise

provided, the recharacterization of the conduit financing arrangement

also applies for purposes of sections 871, 884(f)(1)(A), 1441, and 1442

and other procedural provisions relating to those sections. This

recharacterization will not otherwise affect a taxpayer's Federal

income tax liability under any substantive provisions of the Internal

Revenue Code. Thus, for example, the recharacterization generally

applies for purposes of section 1461, in order to impose liability on a

withholding agent who fails to withhold as required under Sec. 1.1441-

3(j), but not for purposes of Sec. 1.882-5.

(B) Character of payments made by the financed entity. If the

participation of a conduit financing arrangement is disregarded under

this paragraph (a)(3), payments made by the financed entity generally

shall be characterized by reference to the character (e.g., interest or

rent) of the payments made to the financing entity. However, if the

financing transaction to which the financing entity is a party is a

transaction described in paragraph (a)(2)(ii)(A)(2) or (4) of this

section that gives rise to payments that would not be deductible if

paid by the financed entity, the character of the payments made by the

financed entity will not be affected by the disregard of the

participation of a conduit entity. The characterization provided by

this paragraph (a)(3)(ii)(B) does not, however, extend to qualification

of a payment for any exemption from withholding tax under the Internal

Revenue Code or a provision of any applicable tax treaty if such

qualification depends on the terms of, or other similar facts or

circumstances relating to, the financing transaction to which the

financing entity is a party that do not apply to the financing

transaction to which the financed entity is a party. Thus, for example,

payments made by a financed entity that is not a bank cannot qualify

for the exemption provided by section 881(i) of the Code even if the

loan between the financed entity and the conduit entity is a bank

deposit.

(C) Effect of income tax treaties. Where the participation of a

conduit entity in a conduit financing arrangement is disregarded

pursuant to this section, it is disregarded for all purposes of section

881, including for purposes of applying any relevant income tax

treaties. Accordingly, the conduit entity may not claim the benefits of

a tax treaty between its country of residence and the United States to

reduce the amount of tax due under section 881 with respect to payments

made pursuant to the conduit financing arrangement. The financing

entity may, however, claim the benefits of any income tax treaty under

which it is entitled to benefits in order to reduce the rate of tax on

payments made pursuant to the conduit financing arrangement that are

recharacterized in accordance with paragraph (a)(3)(ii)(B) of this

section.

(D) Effect on withholding tax. For the effect of recharacterization

on withholding obligations, see Secs. 1.1441-3(j) and 1.1441-7(d).

(E) Special rule for a financing entity that is unrelated to both

intermediate entity and financed entity--(1) Liability of financing

entity. Notwithstanding the fact that a financing arrangement is a

conduit financing arrangement, a financing entity that is unrelated to

the financed entity and the conduit entity (or entities) shall not

itself be liable for tax under section 881 unless the financing entity

knows or has reason to know that the financing arrangement is a conduit

financing arrangement. But see Sec. 1.1441-3(j) for the withholding

agent's withholding obligations.

(2) Financing entity's knowledge--(i) In general. A financing

entity knows or has reason to know that the financing arrangement is a

conduit financing arrangement only if the financing entity knows or has

reason to know of facts sufficient to establish that the financing

arrangement is a conduit financing arrangement, including facts

sufficient to establish that the participation of the intermediate

entity in the financing arrangement is pursuant to a tax avoidance

plan. A person that knows only of the financing transactions that

comprise the financing arrangement will not be considered to know or

have reason to know of facts sufficient to establish that the financing

arrangement is a conduit financing arrangement.

(ii) Presumption regarding financing entity's knowledge. It shall

be presumed that the financing entity does not know or have reason to

know that the financing arrangement is a conduit financing arrangement

if the financing entity is unrelated to all other parties to the

financing arrangement and the financing entity establishes that the

intermediate entity who is a party to the financing transaction with

the financing entity is actively engaged in a substantial trade or

business. An intermediate entity will not be considered to be engaged

in a trade or business if its business is making or managing

investments, unless the intermediate entity is actively engaged in a

banking, insurance, financing or similar trade or business and such

business consists predominantly of transactions with customers who are

not related persons. An intermediate entity's trade or business is

substantial if it is reasonable for the financing entity to expect that

the intermediate entity will be able to make payments under the

financing transaction out of the cash flow of that trade or business.

This presumption may be rebutted if the district director establishes

that the financing entity knew or had reason to know that the financing

arrangement is a conduit financing arrangement. See Example 6 of

paragraph (e) of this section for an illustration of the rules of this

paragraph (a)(3)(ii)(E).

(iii) Limitation on taxpayer's use of this section. A taxpayer may

not apply this section to reduce the amount of its Federal income tax

liability by disregarding the form of its financing transactions for

Federal income tax purposes or by compelling the district director to

do so. See, however, paragraph (b)(2)(i) of this section for rules

regarding the taxpayer's ability to show that the participation of one

or more intermediate entities results in no significant reduction in

tax.

[[Page 41007]]

(4) Standard for treatment as a conduit entity--(i) In general. An

intermediate entity is a conduit entity with respect to a financing

arrangement if--

(A) The participation of the intermediate entity (or entities) in

the financing arrangement reduces the tax imposed by section 881

(determined by comparing the aggregate tax imposed under section 881 on

payments made on financing transactions making up the financing

arrangement with the tax that would have been imposed under paragraph

(d) of this section);

(B) The participation of the intermediate entity in the financing

arrangement is pursuant to a tax avoidance plan; and

(C) Either--

(1) The intermediate entity is related to the financing entity or

the financed entity; or

(2) The intermediate entity would not have participated in the

financing arrangement on substantially the same terms but for the fact

that the financing entity engaged in the financing transaction with the

intermediate entity.

(ii) Multiple intermediate entities--(A) In general. If a financing

arrangement involves multiple intermediate entities, the district

director will determine whether each of the intermediate entities is a

conduit entity. The district director will make the determination by

applying the special rules for multiple intermediate entities provided

in this section or, if no special rules are provided, applying

principles consistent with those of paragraph (a)(4)(i) of this section

to each of the intermediate entities in the financing arrangement.

(B) Special rule for related persons. The district director may

treat related intermediate entities as a single intermediate entity if

he determines that one of the principal purposes for the involvement of

multiple intermediate entities in the financing arrangement is to

prevent the characterization of an intermediate entity as a conduit

entity, to reduce the portion of a payment that is subject to

withholding tax or otherwise to circumvent the provisions of this

section. This determination shall be based upon all of the facts and

circumstances, including, but not limited to, the factors set forth in

paragraph (b)(2) of this section. If a district director determines

that related persons are to be treated as a single intermediate entity,

financing transactions between such related parties that are part of

the conduit financing arrangement shall be disregarded for purposes of

applying this section. See Examples 7 and 8 of paragraph (e) of this

section for illustrations of the rules of this paragraph (a)(4)(ii).

(b) Determination of whether participation of intermediate entity

is pursuant to a tax avoidance plan--(1) In general. A tax avoidance

plan is a plan one of the principal purposes of which is the avoidance

of tax imposed by section 881. Avoidance of the tax imposed by section

881 may be one of the principal purposes for such a plan even though it

is outweighed by other purposes (taken together or separately). In this

regard, the only relevant purposes are those pertaining to the

participation of the intermediate entity in the financing arrangement

and not those pertaining to the existence of a financing arrangement as

a whole. The plan may be formal or informal, written or oral, and may

involve any one or more of the parties to the financing arrangement.

The plan must be in existence no later than the last date that any of

the financing transactions comprising the financing arrangement is

entered into. The district director may infer the existence of a tax

avoidance plan from the facts and circumstances. In determining whether

there is a tax avoidance plan, the district director will weigh all

relevant evidence regarding the purposes for the intermediate entity's

participation in the financing arrangement. See Examples 11 and 12 of

paragraph (e) of this section for illustrations of the rule of this

paragraph (b)(1).

(2) Factors taken into account in determining the presence or

absence of a tax avoidance purpose. The factors described in paragraphs

(b)(2)(i) through (iv) of this section are among the facts and

circumstances taken into account in determining whether the

participation of an intermediate entity in a financing arrangement has

as one of its principal purposes the avoidance of tax imposed by

section 881.

(i) Significant reduction in tax. The district director will

consider whether the participation of the intermediate entity (or

entities) in the financing arrangement significantly reduces the tax

that otherwise would have been imposed under section 881. The fact that

an intermediate entity is a resident of a country that has an income

tax treaty with the United States that significantly reduces the tax

that otherwise would have been imposed under section 881 is not

sufficient, by itself, to establish the existence of a tax avoidance

plan. The determination of whether the participation of an intermediate

entity significantly reduces the tax generally is made by comparing the

aggregate tax imposed under section 881 on payments made on financing

transactions making up the financing arrangement with the tax that

would be imposed under paragraph (d) of this section. However, the

taxpayer is not barred from presenting evidence that the financing

entity, as determined by the district director, was itself an

intermediate entity and another entity should be treated as the

financing entity for purposes of applying this test. A reduction in the

absolute amount of tax may be significant even if the reduction in rate

is not. A reduction in the amount of tax may be significant if the

reduction is large in absolute terms or in relative terms. See Examples

13, 14 and 15 of paragraph (e) of this section for illustrations of

this factor.

(ii) Ability to make the advance. The district director will

consider whether the intermediate entity had sufficient available money

or other property of its own to have made the advance to the financed

entity without the advance of money or other property to it by the

financing entity (or in the case of multiple intermediate entities,

whether each of the intermediate entities had sufficient available

money or other property of its own to have made the advance to either

the financed entity or another intermediate entity without the advance

of money or other property to it by either the financing entity or

another intermediate entity).

(iii) Time period between financing transactions. The district

director will consider the length of the period of time that separates

the advances of money or other property, or the grants of rights to use

property, by the financing entity to the intermediate entity (in the

case of multiple intermediate entities, from one intermediate entity to

another), and ultimately by the intermediate entity to the financed

entity. A short period of time is evidence of the existence of a tax

avoidance plan while a long period of time is evidence that there is

not a tax avoidance plan. See Example 16 of paragraph (e) of this

section for an illustration of this factor.

(iv) Financing transactions in the ordinary course of business. If

the parties to the financing transaction are related, the district

director will consider whether the financing transaction occurs in the

ordinary course of the active conduct of complementary or integrated

trades or businesses engaged in by these entities. The fact that a

financing transaction is described in this paragraph (b)(2)(iv) is

evidence that the participation of the parties to that transaction in

the financing arrangement is not pursuant to a tax avoidance plan. A

loan will not be considered to occur in the ordinary

[[Page 41008]]

course of the active conduct of complementary or integrated trades or

businesses unless the loan is a trade receivable or the parties to the

transaction are actively engaged in a banking, insurance, financing or

similar trade or business and such business consists predominantly of

transactions with customers who are not related persons. See Example 17

of paragraph (e) of this section for an illustration of this factor.

(3) Presumption if significant financing activities performed by a

related intermediate entity--(i) General rule. It shall be presumed

that the participation of an intermediate entity (or entities) in a

financing arrangement is not pursuant to a tax avoidance plan if the

intermediate entity is related to either or both the financing entity

or the financed entity and the intermediate entity performs significant

financing activities with respect to the financing transactions forming

part of the financing arrangement to which it is a party. This

presumption may be rebutted if the district director establishes that

the participation of the intermediate entity in the financing

arrangement is pursuant to a tax avoidance plan. See Examples 21, 22

and 23 of paragraph (e) of this section for illustrations of this

presumption.

(ii) Significant financing activities. For purposes of this

paragraph (b)(3), an intermediate entity performs significant financing

activities with respect to such financing transactions only if the

financing transactions satisfy the requirements of either paragraph

(b)(3)(ii)(A) or (B) of this section.

(A) Active rents or royalties. An intermediate entity performs

significant financing activities with respect to leases or licenses if

rents or royalties earned with respect to such leases or licenses are

derived in the active conduct of a trade or business within the meaning

of section 954(c)(2)(A), to be applied by substituting the term

intermediate entity for the term controlled foreign corporation.

(B) Active risk management--(1) In general. An intermediate entity

is considered to perform significant financing activities with respect

to financing transactions only if officers and employees of the

intermediate entity participate actively and materially in arranging

the intermediate entity's participation in such financing transactions

(other than financing transactions described in paragraph

(b)(3)(ii)(B)(3) of this section) and perform the business activity and

risk management activities described in paragraph (b)(3)(ii)(B)(2) of

this section with respect to such financing transactions, and the

participation of the intermediate entity in the financing transactions

produces (or reasonably can be expected to produce) efficiency savings

by reducing transaction costs and overhead and other fixed costs.

(2) Business activity and risk management requirements. An

intermediate entity will be considered to perform significant financing

activities only if, within the country in which the intermediate entity

is organized (or, if different, within the country with respect to

which the intermediate entity is claiming the benefits of a tax

treaty), its officers and employees--

(i) Exercise management over, and actively conduct, the day-to-day

operations of the intermediate entity. Such operations must consist of

a substantial trade or business or the supervision, administration and

financing for a substantial group of related persons; and

(ii) Actively manage, on an ongoing basis, material market risks

arising from such financing transactions as an integral part of the

management of the intermediate entity's financial and capital

requirements (including management of risks of currency and interest

rate fluctuations) and management of the intermediate entity's short-

term investments of working capital by entering into transactions with

unrelated persons.

(3) Special rule for trade receivables and payables entered into in

the ordinary course of business. If the activities of the intermediate

entity consist in whole or in part of cash management for a controlled

group of which the intermediate entity is a member, then employees of

the intermediate entity need not have participated in arranging any

such financing transactions that arise in the ordinary course of a

substantial trade or business of either the financed entity or the

financing entity. Officers or employees of the financing entity or

financed entity, however, must have participated actively and

materially in arranging the transaction that gave rise to the trade

receivable or trade payable. Cash management includes the operation of

a sweep account whereby the intermediate entity nets intercompany trade

payables and receivables arising from transactions among the other

members of the controlled group and between members of the controlled

group and unrelated persons.

(4) Activities of officers and employees of related persons. Except

as provided in paragraph (b)(3)(ii)(B)(3) of this section, in applying

this paragraph (b)(3)(ii)(B), the activities of an officer or employee

of an intermediate entity will not constitute significant financing

activities if any officer or employee of a related person participated

materially in any of the activities described in this paragraph, other

than to approve any guarantee of a financing transaction or to exercise

general supervision and control over the policies of the intermediate

entity.

(c) Determination of whether an unrelated intermediate entity would

not have participated in financing arrangement on substantially the

same terms--(1) In general. The determination of whether an

intermediate entity would not have participated in a financing

arrangement on substantially the same terms but for the financing

transaction between the financing entity and the intermediate entity

shall be based upon all of the facts and circumstances.

(2) Effect of guarantee--(i) In general. The district director may

presume that the intermediate entity would not have participated in the

financing arrangement on substantially the same terms if there is a

guarantee of the financed entity's liability to the intermediate entity

(or in the case of multiple intermediate entities, a guarantee of the

intermediate entity's liability to the intermediate entity that

advanced money or property, or granted rights to use other property).

However, a guarantee that was neither in existence nor contemplated on

the last date that any of the financing transactions comprising the

financing arrangement is entered into does not give rise to this

presumption. A taxpayer may rebut this presumption by producing clear

and convincing evidence that the intermediate entity would have

participated in the financing transaction with the financed entity on

substantially the same terms even if the financing entity had not

entered into a financing transaction with the intermediate entity.

(ii) Definition of guarantee. For the purposes of this paragraph

(c)(2), a guarantee is any arrangement under which a person, directly

or indirectly, assures, on a conditional or unconditional basis, the

payment of another person's obligation with respect to a financing

transaction. The term shall be interpreted in accordance with the

definition of the term in section 163(j)(6)(D)(iii).

(d) Determination of amount of tax liability--(1) Amount of payment

subject to recharacterization--(i) In general. If a financing

arrangement is a conduit financing arrangement, a portion of each

payment made by the financed entity with respect to the

[[Page 41009]]

financing transactions that comprise the conduit financing arrangement

shall be recharacterized as a transaction directly between the financed

entity and the financing entity. If the aggregate principal amount of

the financing transaction(s) to which the financed entity is a party is

less than or equal to the aggregate principal amount of the financing

transaction(s) linking any of the parties to the financing arrangement,

the entire amount of the payment shall be so recharacterized. If the

aggregate principal amount of the financing transaction(s) to which the

financed entity is a party is greater than the aggregate principal

amount of the financing transaction(s) linking any of the parties to

the financing arrangement, then the recharacterized portion shall be

determined by multiplying the payment by a fraction the numerator of

which is equal to the lowest aggregate principal amount of the

financing transaction(s) linking any of the parties to the financing

arrangement (other than financing transactions that are disregarded

pursuant to paragraphs (a)(2)(i)(B) and (a)(4)(ii)(B) of this section)

and the denominator of which is the aggregate principal amount of the

financing transaction(s) to which the financed entity is a party. In

the case of financing transactions the principal amount of which is

subject to adjustment, the fraction shall be determined using the

average outstanding principal amounts for the period to which the

payment relates. The average principal amount may be computed using any

method applied consistently that reflects with reasonable accuracy the

amount outstanding for the period. See Example 24 of paragraph (e) of

this section for an illustration of the calculation of the amount of

tax liability.

(ii) Determination of principal amount--(A) In general. Unless

otherwise provided in this paragraph (d)(1)(ii), the principal amount

equals the amount of money advanced, or the fair market value of other

property advanced or subject to a lease or license, in the financing

transaction. In general, fair market value is calculated in U.S.

dollars as of the close of business on the day on which the financing

transaction is entered into. However, if the property advanced, or the

right to use property granted, by the financing entity is the same as

the property or rights received by the financed entity, the fair market

value of the property or right shall be determined as of the close of

business on the last date that any of the financing transactions

comprising the financing arrangement is entered into. In the case of

fungible property, property of the same type shall be considered to be

the same property. See Example 25 of paragraph (e) for an illustration

of the calculation of the principal amount in the case of financing

transactions involving fungible property. The principal amount of a

financing transaction shall be subject to adjustments, as set forth in

this paragraph (d)(1)(ii).

(B) Debt instruments and certain stock. In the case of a debt

instrument or of stock that is subject to the current inclusion rules

of sections 305(c)(3) or (e), the principal amount generally will be

equal to the issue price. However, if the fair market value on the

issue date differs materially from the issue price, the fair market

value of the debt instrument shall be used in lieu of the instrument's

issue price. Appropriate adjustments will be made for accruals of

original issue discount and repayments of principal (including accrued

original issue discount).

(C) Partnership and trust interests. In the case of a partnership

interest or an interest in a trust, the principal amount is equal to

the fair market value of the money or property contributed to the

partnership or trust in return for that partnership or trust interest.

(D) Leases or licenses. In the case of a lease or license, the

principal amount is equal to the fair market value of the property

subject to the lease or license on the date on which the lease or

license is entered into. The principal amount shall be adjusted for

depreciation or amortization, calculated on a basis that accurately

reflects the anticipated decline in the value of the property over its

life.

(2) Rate of tax. The rate at which tax is imposed under section 881

on the portion of the payment that is recharacterized pursuant to

paragraph (d)(1) of this section is determined by reference to the

nature of the recharacterized transaction, as determined under

paragraphs (a)(3)(ii)(B) and (C) of this section.

(e) Examples. The following examples illustrate this section. For

purposes of these examples, unless otherwise indicated, it is assumed

that FP, a corporation organized in country N, owns all of the stock of

FS, a corporation organized in country T, and DS, a corporation

organized in the United States. Country T, but not country N, has an

income tax treaty with the United States. The treaty exempts interest,

rents and royalties paid by a resident of one state (the source state)

to a resident of the other state from tax in the source state.

Example 1. Financing arrangement. (i) On January 1, 1996, BK, a

bank organized in country T, lends $1,000,000 to DS in exchange for

a note issued by DS. FP guarantees to BK that DS will satisfy its

repayment obligation on the loan. There are no other transactions

between FP and BK.

(ii) BK's loan to DS is a financing transaction within the

meaning of paragraph (a)(2)(ii)(A)(1) of this section. FP's

guarantee of DS's repayment obligation is not a financing

transaction as described in paragraphs (a)(2)(ii)(A)(1) through (4)

of this section. Therefore, these transactions do not constitute a

financing arrangement as defined in paragraph (a)(2)(i) of this

section.

Example 2. Financing arrangement. (i) On January 1, 1996, FP

lends $1,000,000 to DS in exchange for a note issued by DS. On

January 1, 1997, FP assigns the DS note to FS in exchange for a note

issued by FS. After receiving notice of the assignment, DS remits

payments due under its note to FS.

(ii) The DS note held by FS and the FS note held by FP are

financing transactions within the meaning of paragraph

(a)(2)(ii)(A)(1) of this section, and together constitute a

financing arrangement within the meaning of paragraph (a)(2)(i) of

this section.

Example 3. Financing arrangement. (i) On December 1, 1994 FP

creates a special purposes subsidiary, FS. On that date FP

capitalizes FS with $1,000,000 in cash and $10,000,000 in debt from

BK, a Country N bank. On January 1, 1995, C, a U.S. person,

purchases an automobile from DS in return for an installment note.

On August 1, 1995, DS sells a number of installment notes, including

C's, to FS in exchange for $10,000,000. DS continues to service the

installment notes for FS.

(ii) The C installment note now held by FS (as well as all of

the other installment notes now held by FS) and the FS note held by

BK are financing transactions within the meaning of paragraph

(a)(2)(ii)(A)(1) of this section, and together constitute a

financing arrangement within the meaning of paragraph (a)(2)(i) of

this section.

Example 4. Related persons treated as a single intermediate

entity. (i) On January 1, 1996, FP deposits $1,000,000 with BK, a

bank that is organized in country N and is unrelated to FP and its

subsidiaries. M, a corporation also organized in country N, is

wholly-owned by the sole shareholder of BK but is not a bank within

the meaning of section 881(c)(3)(A). On July 1, 1996, M lends

$1,000,000 to DS in exchange for a note maturing on July 1, 2006.

The note is in registered form within the meaning of section

881(c)(2)(B)(i) and DS has received from M the statement required by

section 881(c)(2)(B)(ii). One of the principal purposes for the

absence of a financing transaction between BK and M is the avoidance

of the application of this section.

(ii) The transactions described above would form a financing

arrangement but for the absence of a financing transaction between

BK and M. However, because one of the principal purposes for the

structuring of these financing transactions is to prevent

characterization of such arrangement as a financing arrangement, the

district director may treat the financing transactions between

[[Page 41010]]

FP and BK, and between M and DS as a financing arrangement under

paragraphs (a)(2)(i)(B) of this section. In such a case, BK and M

would be considered a single intermediate entity for purposes of

this section. See also paragraph (a)(4)(ii)(B) of this section for

the authority to treat BK and M as a single intermediate entity.

Example 5. Related persons treated as a single intermediate

entity. (i) On January 1, 1995, FP lends $10,000,000 to FS in

exchange for a 10-year note that pays interest annually at a rate of

8 percent per annum. On January 2, 1995, FS contributes $10,000,000

to FS2, a wholly-owned subsidiary of FS organized in country T, in

exchange for common stock of FS2. On January 1, 1996, FS2 lends

$10,000,000 to DS in exchange for an 8-year note that pays interest

annually at a rate of 10 percent per annum. FS is a holding company

whose most significant asset is the stock of FS2. Throughout the

period that the FP-FS loan is outstanding, FS causes FS2 to make

distributions to FS, most of which are used to make interest and

principal payments on the FP-FS loan. Without the distributions from

FS2, FS would not have had the funds with which to make payments on

the FP-FS loan. One of the principal purposes for the absence of a

financing transaction between FS and FS2 is the avoidance of the

application of this section.

(ii) The conditions of paragraph (a)(4)(i)(A) of this section

would be satisfied with respect to the financing transactions

between FP, FS, FS2 and DS but for the absence of a financing

transaction between FS and FS2. However, because one of the

principal purposes for the structuring of these financing

transactions is to prevent characterization of an entity as a

conduit, the district director may treat the financing transactions

between FP and FS, and between FS2 and DS as a financing

arrangement. See paragraph (a)(4)(ii)(B) of this section. In such a

case, FS and FS2 would be considered a single intermediate entity

for purposes of this section. See also paragraph (a)(2)(i)(B) of

this section for the authority to treat FS and FS2 as a single

intermediate entity.

Example 6. Presumption with respect to unrelated financing

entity. (i) FP is a corporation organized in country T that is

actively engaged in a substantial manufacturing business. FP has a

revolving credit facility with a syndicate of banks, none of which

is related to FP and FP's subsidiaries, which provides that FP may

borrow up to a maximum of $100,000,000 at a time. The revolving

credit facility provides that DS and certain other subsidiaries of

FP may borrow directly from the syndicate at the same interest rates

as FP, but each subsidiary is required to indemnify the syndicate

banks for any withholding taxes imposed on interest payments by the

country in which the subsidiary is organized. BK, a bank that is

organized in country N, is the agent for the syndicate. Some of the

syndicate banks are organized in country N, but others are residents

of country O, a country that has an income tax treaty with the

United States which allows the United States to impose a tax on

interest at a maximum rate of 10 percent. It is reasonable for BK

and the syndicate banks to have determined that FP will be able to

meet its payment obligations on a maximum principal amount of

$100,000,000 out of the cash flow of its manufacturing business. At

various times throughout 1995, FP borrows under the revolving credit

facility until the outstanding principal amount reaches the maximum

amount of $100,000,000. On December 31, 1995, FP receives

$100,000,000 from a public offering of its equity. On January 1,

1996, FP pays BK $90,000,000 to reduce the outstanding principal

amount under the revolving credit facility and lends $10,000,000 to

DS. FP would have repaid the entire principal amount, and DS would

have borrowed directly from the syndicate, but for the fact that DS

did not want to incur the U.S. withholding tax that would have

applied to payments made directly by DS to the syndicate banks.

(ii) Pursuant to paragraph (a)(3)(ii)(E)(1) of this section,

even though the financing arrangement is a conduit financing

arrangement (because the financing arrangement meets the standards

for recharacterization in paragraph (a)(4)(i)), BK and the other

syndicate banks have no section 881 liability unless they know or

have reason to know that the financing arrangement is a conduit

financing arrangement. Moreover, pursuant to paragraph

(a)(3)(ii)(E)(2)(ii) of this section, BK and the syndicate banks are

presumed not to know that the financing arrangement is a conduit

financing arrangement. The syndicate banks are unrelated to both FP

and DS, and FP is actively engaged in a substantial trade or

business--that is, the cash flow from FP's manufacturing business is

sufficient for the banks to expect that FP will be able to make the

payments required under the financing transaction. See Sec. 1.1441-

3(j) for the withholding obligations of the withholding agents.

Example 7. Multiple intermediate entities--special rule for

related persons. (i) On January 1, 1995, FP lends $10,000,000 to FS

in exchange for a 10-year note that pays interest annually at a rate

of 8 percent per annum. On January 2, 1995, FS contributes

$9,900,000 to FS2, a wholly-owned subsidiary of FS organized in

country T, in exchange for common stock and lends $100,000 to FS2.

On January 1, 1996, FS2 lends $10,000,000 to DS in exchange for an

8-year note that pays interest annually at a rate of 10 percent per

annum. FS is a holding company that has no significant assets other

than the stock of FS2. Throughout the period that the FP-FS loan is

outstanding, FS causes FS2 to make distributions to FS, most of

which are used to make interest and principal payments on the FP-FS

loan. Without the distributions from FS2, FS would not have had the

funds with which to make payments on the FP-FS loan. One of the

principal purposes for structuring the transactions between FS and

FS2 as primarily a contribution of capital is to reduce the amount

of the payment that would be recharacterized under paragraph (d) of

this section.

(ii) Pursuant to paragraph (a)(4)(ii)(B) of this section, the

district director may treat FS and FS2 as a single intermediate

entity for purposes of this section since one of the principal

purposes for the participation of multiple intermediate entities is

to reduce the amount of the tax liability on any recharacterized

payment by inserting a financing transaction with a low principal

amount.

Example 8. Multiple intermediate entities. (i) On January 1,

1995, FP deposits $1,000,000 with BK, a bank that is organized in

country T and is unrelated to FP and its subsidiaries, FS and DS. On

January 1, 1996, at a time when the FP-BK deposit is still

outstanding, BK lends $500,000 to BK2, a bank that is wholly-owned

by BK and is organized in country T. On the same date, BK2 lends

$500,000 to FS. On July 1, 1996, FS lends $500,000 to DS. FP pledges

its deposit with BK to BK2 in support of FS' obligation to repay the

BK2 loan. FS', BK's and BK2's participation in the financing

arrangement is pursuant to a tax avoidance plan.

(ii) The conditions of paragraphs (a)(4)(i)(A) and (B) of this

section are satisfied because the participation of BK, BK2 and FS in

the financing arrangement reduces the tax imposed by section 881,

and FS', BK's and BK2's participation in the financing arrangement

is pursuant to a tax avoidance plan. However, since BK and BK2 are

unrelated to FP and DS, under paragraph (a)(4)(i)(C)(2) of this

section, BK and BK2 will be treated as conduit entities only if BK

and BK2 would not have participated in the financing arrangement on

substantially the same terms but for the financing transaction

between FP and BK.

(iii) It is presumed that BK2 would not have participated in the

financing arrangement on substantially the same terms but for the

BK-BK2 financing transaction because FP's pledge of an asset in

support of FS' obligation to repay the BK2 loan is a guarantee

within the meaning of paragraph (c)(2)(ii) of this section. If the

taxpayer does not rebut this presumption by clear and convincing

evidence, then BK2 will be a conduit entity.

(iv) Because BK and BK2 are related intermediate entities, the

district director must determine whether one of the principal

purposes for the involvement of multiple intermediate entities was

to prevent characterization of an entity as a conduit entity. In

making this determination, the district director may consider the

fact that the involvement of two related intermediate entities

prevents the presumption regarding guarantees from applying to BK.

In the absence of evidence showing a business purpose for the

involvement of both BK and BK2, the district director may treat BK

and BK2 as a single intermediate entity for purposes of determining

whether they would have participated in the financing arrangement on

substantially the same terms but for the financing transaction

between FP and BK. The presumption that applies to BK2 therefore

will apply to BK. If the taxpayer does not rebut this presumption by

clear and convincing evidence, then BK will be a conduit entity.

Example 9. Reduction of tax. (i) On February 1, 1995, FP issues

debt to the public

[[Page 41011]]

that would satisfy the requirements of section 871(h)(2)(A) (relating

to obligations that are not in registered form) if issued by a U.S.

person. FP lends the proceeds of the debt offering to DS in exchange

for a note.

(ii) The debt issued by FP and the DS note are financing

transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of

this section and together constitute a financing arrangement within

the meaning of paragraph (a)(2)(i) of this section. The holders of

the FP debt are the financing entities, FP is the intermediate

entity and DS is the financed entity. Because interest payments on

the debt issued by FP would not have been subject to withholding tax

if the debt had been issued by DS, there is no reduction in tax

under paragraph (a)(4)(i)(A) of this section. Accordingly, FP is not

a conduit entity.

Example 10. Reduction of tax. (i) On January 1, 1995, FP

licenses to FS the rights to use a patent in the United States to

manufacture product A. FS agrees to pay FP a fixed amount in

royalties each year under the license. On January 1, 1996, FS

sublicenses to DS the rights to use the patent in the United States.

Under the sublicense, DS agrees to pay FS royalties based upon the

units of product A manufactured by DS each year. Although the

formula for computing the amount of royalties paid by DS to FS

differs from the formula for computing the amount of royalties paid

by FS to FP, each represents an arm's length rate.

(ii) Although the royalties paid by DS to FS are exempt from

U.S. withholding tax, the royalty payments between FS and FP are

income from U.S. sources under section 861(a)(4) subject to the 30

percent gross tax imposed by Sec. 1.881-2(b) and subject to

withholding under Sec. 1.1441-2(a). Because the rate of tax imposed

on royalties paid by FS to FP is the same as the rate that would

have been imposed on royalties paid by DS to FP, the participation

of FS in the FP-FS-DS financing arrangement does not reduce the tax

imposed by section 881 within the meaning of paragraph (a)(4)(i)(A)

of this section. Accordingly, FP is not a conduit entity.

Example 11. A principal purpose. (i) On January 1, 1995, FS

lends $10,000,000 to DS in exchange for a 10-year note that pays

interest annually at a rate of 8 percent per annum. As was intended

at the time of the loan from FS to DS, on July 1, 1995, FP makes an

interest-free demand loan of $10,000,000 to FS. A principal purpose

for FS' participation in the FP-FS-DS financing arrangement is that

FS generally coordinates the financing for all of FP's subsidiaries

(although FS does not engage in significant financing activities

with respect to such financing transactions). However, another

principal purpose for FS' participation is to allow the parties to

benefit from the lower withholding tax rate provided under the

income tax treaty between country T and the United States.

(ii) The financing arrangement satisfies the tax avoidance

purpose requirement of paragraph (a)(4)(i)(B) of this section

because FS participated in the financing arrangement pursuant to a

plan one of the principal purposes of which is to allow the parties

to benefit from the country T-U.S. treaty.

Example 12. A principal purpose. (i) DX is a U.S. corporation

that intends to purchase property to use in its manufacturing

business. FX is a partnership organized in country N that is owned

in equal parts by LC1 and LC2, leasing companies that are unrelated

to DX. BK, a bank organized in country N and unrelated to DX, LC1

and LC2, lends $100,000,000 to FX to enable FX to purchase the

property. On the same day, FX purchases the property and engages in

a transaction with DX which is treated as a lease of the property

for country N tax purposes but a loan for U.S. tax purposes.

Accordingly, DX is treated as the owner of the property for U.S. tax

purposes. The parties comply with the requirements of section 881(c)

with respect to the debt obligation of DX to FX. FX and DX

structured these transactions in this manner so that LC1 and LC2

would be entitled to accelerated depreciation deductions with

respect to the property in country N and DX would be entitled to

accelerated depreciation deductions in the United States. None of

the parties would have participated in the transaction if the

payments made by DX were subject to U.S. withholding tax.

(ii) The loan from BK to FX and from FX to DX are financing

transactions and, together constitute a financing arrangement. The

participation of FX in the financing arrangement reduces the tax

imposed by section 881 because payments made to FX, but not BK,

qualify for the portfolio interest exemption of section 881(c)

because BK is a bank making an extension of credit in the ordinary

course of its trade or business within the meaning of section

881(c)(3)(A). Moreover, because DX borrowed the money from FX

instead of borrowing the money directly from BK to avoid the tax

imposed by section 881, one of the principal purposes of the

participation of FX was to avoid that tax (even though another

principal purpose of the participation of FX was to allow LC1 and

LC2 to take advantage of accelerated depreciation deductions in

country N). Assuming that FX would not have participated in the

financing arrangement on substantially the same terms but for the

fact that BK loaned it $100,000,000, FX is a conduit entity and the

financing arrangement is a conduit financing arrangement.

Example 13. Significant reduction of tax. (i) FS owns all of the

stock of FS1, which also is a resident of country T. FS1 owns all of

the stock of DS. On January 1, 1995, FP contributes $10,000,000 to

the capital of FS in return for perpetual preferred stock. On July

1, 1995, FS lends $10,000,000 to FS1. On January 1, 1996, FS1 lends

$10,000,000 to DS. Under the terms of the country T-U.S. income tax

treaty, a country T resident is not entitled to the reduced

withholding rate on interest income provided by the treaty if the

resident is entitled to specified tax benefits under country T law.

Although FS1 may deduct interest paid on the loan from FS, these

deductions are not pursuant to any special tax benefits provided by

country T law. However, FS qualifies for one of the enumerated tax

benefits pursuant to which it may deduct dividends paid with respect

to the stock held by FP. Therefore, if FS had made a loan directly

to DS, FS would not have been entitled to the benefits of the

country T-U.S. tax treaty with respect to payments it received from

DS, and such payments would have been subject to tax under section

881 at a 30 percent rate.

(ii) The FS-FS1 loan and the FS1-DS loan are financing

transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of

this section and together constitute a financing arrangement within

the meaning of paragraph (a)(2)(i) of this section. Pursuant to

paragraph (b)(2)(i) of this section, the significant reduction in

tax resulting from the participation of FS1 in the financing

arrangement is evidence that the participation of FS1 in the

financing arrangement is pursuant to a tax avoidance plan. However,

other facts relevant to the presence of such a plan must also be

taken into account.

Example 14. Significant reduction of tax. (i) FP owns 90 percent

of the voting stock of FX, an unlimited liability company organized

in country T. The other 10 percent of the common stock of FX is

owned by FP1, a subsidiary of FP that is organized in country N.

Although FX is a partnership for U.S. tax purposes, FX is entitled

to the benefits of the U.S.-country T income tax treaty because FX

is subject to tax in country T as a resident corporation. On January

1, 1996, FP contributes $10,000,000 to FX in exchange for an

instrument denominated as preferred stock that pays a dividend of 7

percent and that must be redeemed by FX in seven years. For U.S. tax

purposes, the preferred stock is a partnership interest. On July 1,

1996, FX makes a loan of $10,000,000 to DS in exchange for a 7-year

note paying interest at 6 percent.

(ii) Because FX is required to redeem the partnership interest

at a specified time, the partnership interest constitutes a

financing transaction within the meaning of paragraph

(a)(2)(ii)(A)(2) of this section. Moreover, because the FX-DS note

is a financing transaction within the meaning of paragraph

(a)(2)(ii)(A)(1) of this section, together the transactions

constitute a financing arrangement within the meaning of (a)(2)(i)

of this section. Payments of interest made directly by DS to FP and

FP1 would not be eligible for the portfolio interest exemption and

would not be entitled to a reduction in withholding tax pursuant to

a tax treaty. Therefore, there is a significant reduction in tax

resulting from the participation of FX in the financing arrangement,

which is evidence that the participation of FX in the financing

arrangement is pursuant to a tax avoidance plan. However, other

facts relevant to the existence of such a plan must also be taken

into account.

Example 15. Significant reduction of tax. (i) FP owns a 10

percent interest in the profits and capital of FX, a partnership

organized in country N. The other 90 percent interest in FX is owned

by G, an unrelated corporation that is organized in country T. FX is

not engaged in business in the United States. On January 1, 1996, FP

contributes $10,000,000 to FX in exchange for an instrument

documented as perpetual subordinated debt that provides for

quarterly interest payments at 9 percent per annum. Under the terms

of the instrument, payments

[[Page 41012]]

on the perpetual subordinated debt do not otherwise affect the

allocation of income between the partners. FP has the right to

require the liquidation of FX if FX fails to make an interest

payment. For U.S. tax purposes, the perpetual subordinated debt is

treated as a partnership interest in FX and the payments on the

perpetual subordinated debt constitute guaranteed payments within

the meaning of section 707(c). On July 1, 1996, FX makes a loan of

$10,000,000 to DS in exchange for a 7-year note paying interest at 8

percent per annum.

(ii) Because FP has the effective right to force payment of the

``interest'' on the perpetual subordinated debt, the instrument

constitutes a financing transaction within the meaning of paragraph

(a)(2)(ii)(A)(2) of this section. Moreover, because the note between

FX and DS is a financing transaction within the meaning of paragraph

(a)(2)(ii)(A)(1) of this section, together the transactions are a

financing arrangement within the meaning of (a)(2)(i) of this

section. Without regard to this section, 90 percent of each interest

payment received by FX would be treated as exempt from U.S.

withholding tax because it is beneficially owned by G, while 10

percent would be subject to a 30 percent withholding tax because

beneficially owned by FP. If FP held directly the note issued by DS,

100 percent of the interest payments on the note would have been

subject to the 30 percent withholding tax. The significant reduction

in the tax imposed by section 881 resulting from the participation

of FX in the financing arrangement is evidence that the

participation of FX in the financing arrangement is pursuant to a

tax avoidance plan. However, other facts relevant to the presence of

such a plan must also be taken into account.

Example 16. Time period between transactions. (i) On January 1,

1995, FP lends $10,000,000 to FS in exchange for a 10-year note that

pays no interest annually. When the note matures, FS is obligated to

pay $24,000,000 to FP. On January 1, 1996, FS lends $10,000,000 to

DS in exchange for a 10-year note that pays interest annually at a

rate of 10 percent per annum.

(ii) The FS note held by FP and the DS note held by FS are

financing transactions within the meaning of paragraph

(a)(2)(ii)(A)(1) of this section and together constitute a financing

arrangement within the meaning of (a)(2)(i) of this section.

Pursuant to paragraph (b)(2)(iii) of this section, the short period

of time (twelve months) between the loan by FP to FS and the loan by

FS to DS is evidence that the participation of FS in the financing

arrangement is pursuant to a tax avoidance plan. However, other

facts relevant to the presence of such a plan must also be taken

into account.

Example 17. Financing transactions in the ordinary course of

business. (i) FP is a holding company. FS is actively engaged in

country T in the business of manufacturing and selling product A. DS

manufactures product B, a principal component in which is product A.

FS' business activity is substantial. On January 1, 1995, FP lends

$100,000,000 to FS to finance FS' business operations. On January 1,

1996, FS ships $30,000,000 of product A to DS. In return, FS creates

an interest-bearing account receivable on its books. FS' shipment is

in the ordinary course of the active conduct of its trade or

business (which is complementary to DS' trade or business.)

(ii) The loan from FP to FS and the accounts receivable opened

by FS for a payment owed by DS are financing transactions within the

meaning of paragraph (a)(2)(ii)(A)(1) of this section and together

constitute a financing arrangement within the meaning of paragraph

(a)(2)(i) of this section. Pursuant to paragraph (b)(2)(iv) of this

section, the fact that DS' liability to FS is created in the

ordinary course of the active conduct of DS' trade or business that

is complementary to a business actively engaged in by DS is evidence

that the participation of FS in the financing arrangement is not

pursuant to a tax avoidance plan. However, other facts relevant to

the presence of such a plan must also be taken into account.

Example 18. Tax avoidance plan--other factors. (i) On February

1, 1995, FP issues debt in Country N that is in registered form

within the meaning of section 881(c)(3)(A). The FP debt would

satisfy the requirements of section 881(c) if the debt were issued

by a U.S. person and the withholding agent received the

certification required by section 871(h)(2)(B)(ii). The purchasers

of the debt are financial institutions and there is no reason to

believe that they would not furnish Forms W-8. On March 1, 1995, FP

lends a portion of the proceeds of the offering to DS.

(ii) The FP debt and the loan to DS are financing transactions

within the meaning of paragraph (a)(2)(ii)(A)(1) of this section and

together constitute a financing arrangement within the meaning of

paragraph (a)(2)(i) of this section. The owners of the FP debt are

the financing entities, FP is the intermediate entity and DS is the

financed entity. Interest payments on the debt issued by FP would be

subject to withholding tax if the debt were issued by DS, unless DS

received all necessary Forms W-8. Therefore, the participation of FP

in the financing arrangement potentially reduces the tax imposed by

section 881(a). However, because it is reasonable to assume that the

purchasers of the FP debt would have provided certifications in

order to avoid the withholding tax imposed by section 881, there is

not a tax avoidance plan. Accordingly, FP is not a conduit entity.

Example 19. Tax avoidance plan--other factors. (i) Over a period

of years, FP has maintained a deposit with BK, a bank organized in

the United States, that is unrelated to FP and its subsidiaries. FP

often sells goods and purchases raw materials in the United States.

FP opened the bank account with BK in order to facilitate this

business and the amounts it maintains in the account are reasonably

related to its dollar-denominated working capital needs. On January

1, 1995, BK lends $5,000,000 to DS. After the loan is made, the

balance in FP's bank account remains within a range appropriate to

meet FP's working capital needs.

(ii) FP's deposit with BK and BK's loan to DS are financing

transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of

this section and together constitute a financing arrangement within

the meaning of paragraph (a)(2)(i) of this section. Pursuant to

section 881(i), interest paid by BK to FP with respect to the bank

deposit is exempt from withholding tax. Interest paid directly by DS

to FP would not be exempt from withholding tax under section 881(i)

and therefore would be subject to a 30% withholding tax.

Accordingly, there is a significant reduction in the tax imposed by

section 881, which is evidence of the existence of a tax avoidance

plan. See paragraph (b)(2)(i) of this section. However, the district

director also will consider the fact that FP historically has

maintained an account with BK to meet its working capital needs and

that, prior to and after BK's loan to DS, the balance within the

account remains within a range appropriate to meet those business

needs as evidence that the participation of BK in the FP-BK-DS

financing arrangement is not pursuant to a tax avoidance plan. In

determining the presence or absence of a tax avoidance plan, all

relevant facts will be taken into account.

Example 20. Tax avoidance plan--other factors. (i) Assume the

same facts as in Example 19, except that on January 1, 2000, FP's

deposit with BK substantially exceeds FP's expected working capital

needs and on January 2, 2000, BK lends additional funds to DS.

Assume also that BK's loan to DS provides BK with a right of offset

against FP's deposit. Finally, assume that FP would have lent the

funds to DS directly but for the imposition of the withholding tax

on payments made directly to FP by DS.

(ii) As in Example 19, the transactions in paragraph (i) of this

Example 20 are a financing arrangement within the meaning of

paragraph (a)(2)(i) and the participation of the BK reduces the

section 881 tax. In this case, the presence of funds substantially

in excess of FP's working capital needs and the fact that FP would

have been willing to lend funds directly to DS if not for the

withholding tax are evidence that the participation of BK in the FP-

BK-FS financing arrangement is pursuant to a tax avoidance plan.

However, other facts relevant to the presence of such a plan must

also be taken into account. Even if the district director determines

that the participation of BK in the financing arrangement is

pursuant to a tax avoidance plan, BK may not be treated as a conduit

entity unless BK would not have participated in the financing

arrangement on substantially the same terms in the absence of FP's

deposit with BK. BK's right of offset against FP's deposit (a form

of guarantee of BK's loan to DS) creates a presumption that BK would

not have made the loan to DS on substantially the same terms in the

absence of FP's deposit with BK. If the taxpayer overcomes the

presumption by clear and convincing evidence, BK will not be a

conduit entity.

Example 21. Significant financing activities. (i) FS is

responsible for coordinating the financing of all of the

subsidiaries of FP, which are engaged in substantial trades or

businesses and are located in country T, country N, and the United

States. FS maintains a centralized cash management accounting system

for FP and its subsidiaries in which it records all

[[Page 41013]]

intercompany payables and receivables; these payables and receivables

ultimately are reduced to a single balance either due from or owing

to FS and each of FP's subsidiaries. FS is responsible for

disbursing or receiving any cash payments required by transactions

between its affiliates and unrelated parties. FS must borrow any

cash necessary to meet those external obligations and invests any

excess cash for the benefit of the FP group. FS enters into interest

rate and foreign exchange contracts as necessary to manage the risks

arising from mismatches in incoming and outgoing cash flows. The

activities of FS are intended (and reasonably can be expected) to

reduce transaction costs and overhead and other fixed costs. FS has

50 employees, including clerical and other back office personnel,

located in country T. At the request of DS, on January 1, 1995, FS

pays a supplier $1,000,000 for materials delivered to DS and charges

DS an open account receivable for this amount. On February 3, 1995,

FS reverses the account receivable from DS to FS when DS delivers to

FP goods with a value of $1,000,000.

(ii) The accounts payable from DS to FS and from FS to other

subsidiaries of FP constitute financing transactions within the

meaning of paragraph (a)(2)(ii)(A)(1) of this section, and the

transactions together constitute a financing arrangement within the

meaning of paragraph (a)(2)(i) of this section. FS's activities

constitute significant financing activities with respect to the

financing transactions even though FS did not actively and

materially participate in arranging the financing transactions

because the financing transactions consisted of trade receivables

and trade payables that were ordinary and necessary to carry on the

trades or businesses of DS and the other subsidiaries of FP.

Accordingly, pursuant to paragraph (b)(3)(i) of this section, FS'

participation in the financing arrangement is presumed not to be

pursuant to a tax avoidance plan.

Example 22. Significant financing activities--active risk

management. (i) The facts are the same as in Example 21, except

that, in addition to its short-term funding needs, DS needs long-

term financing to fund an acquisition of another U.S. company; the

acquisition is scheduled to close on January 15, 1995. FS has a

revolving credit agreement with a syndicate of banks located in

Country N. On January 14, 1995, FS borrows 10 billion for 10

years under the revolving credit agreement, paying yen LIBOR plus 50

basis points on a quarterly basis. FS enters into a currency swap

with BK, an unrelated bank that is not a member of the syndicate,

under which FS will pay BK 10 billion and will receive $100

million on January 15, 1995; these payments will be reversed on

January 15, 2004. FS will pay BK U.S. dollar LIBOR plus 50 basis

points on a notional principal amount of $100 million semi-annually

and will receive yen LIBOR plus 50 basis points on a notional

principal amount of 10 billion quarterly. Upon the closing of

the acquisition on January 15, 1995, DS borrows $100 million from FS

for 10 years, paying U.S. dollar LIBOR plus 50 basis points

semiannually.

(ii) Although FS performs significant financing activities with

respect to certain financing transactions to which it is a party, FS

does not perform significant financing activities with respect to

the financing transactions between FS and the syndicate of banks and

between FS and DS because FS has eliminated all material market

risks arising from those financing transactions through its currency

swap with BK. Accordingly, the financing arrangement does not

benefit from the presumption of paragraph (b)(3)(i) of this section

and the district director must determine whether the participation

of FS in the financing arrangement is pursuant to a tax avoidance

plan on the basis of all the facts and circumstances. However, if

additional facts indicated that FS reviews its currency swaps daily

to determine whether they are the most cost efficient way of

managing their currency risk and, as a result, frequently terminates

swaps in favor of entering into more cost efficient hedging

arrangements with unrelated parties, FS would be considered to

perform significant financing activities and FS' participation in

the financing arrangements would not be pursuant to a tax avoidance

plan.

Example 23. Significant financing activities--presumption

rebutted. (i) The facts are the same as in Example 21, except that,

on January 1, 1995, FP lends to FS DM 15,000,000 (worth $10,000,000)

in exchange for a 10 year note that pays interest annually at a rate

of 5 percent per annum. Also, on March 15, 1995, FS lends

$10,000,000 to DS in exchange for a 10-year note that pays interest

annually at a rate of 8 percent per annum. FS would not have had

sufficient funds to make the loan to DS without the loan from FP. FS

does not enter into any long-term hedging transaction with respect

to these financing transactions, but manages the interest rate and

currency risk arising from the transactions on a daily, weekly or

quarterly basis by entering into forward currency contracts.

(ii) Because FS performs significant financing activities with

respect to the financing transactions between FS, DS and FP, the

participation of FS in the financing arrangement is presumed not to

be pursuant to a tax avoidance plan. The district director may rebut

this presumption by establishing that the participation of FS is

pursuant to a tax avoidance plan, based on all the facts and

circumstances. The mere fact that FS is a resident of country T is

not sufficient to establish the existence of a tax avoidance plan.

However, the existence of a plan can be inferred from other factors

in addition to the fact that FS is a resident of country T. For

example, the loans are made within a short time period and FS would

not have been able to make the loan to DS without the loan from FP.

Example 24. Determination of amount of tax liability. (i) On

January 1, 1996, FP makes two three-year installment loans of

$250,000 each to FS that pay interest at a rate of 9 percent per

annum. The loans are self-amortizing with payments on each loan of

$7,950 per month. On the same date, FS lends $1,000,000 to DS in

exchange for a two-year note that pays interest semi-annually at a

rate of 10 percent per annum, beginning on June 30, 1996. The FS-DS

loan is not self-amortizing. Assume that for the period of January

1, 1996 through June 30, 1996, the average principal amount of the

financing transactions between FP and FS that comprise the financing

arrangement is $469,319. Further, assume that for the period of July

1, 1996 through December 31, 1996, the average principal amount of

the financing transactions between FP and FS is $393,632. The

average principal amount of the financing transaction between FS and

DS for the same periods is $1,000,000. The district director

determines that the financing transactions between FP and FS, and FS

and DS, are a conduit financing arrangement.

(ii) Pursuant to paragraph (d)(1)(i) of this section, the

portion of the $50,000 interest payment made by DS to FS on June 30,

1996, that is recharacterized as a payment to FP is $23,450 computed

as follows: ($50,000 x $469,319/$1,000,000) = $23,450. The portion

of the interest payment made on December 31, 1996 that is

recharacterized as a payment to FP is $19,650, computed as follows:

($50,000 x $393,632/$1,000,000) = $19,650. Furthermore, under

Sec. 1.1441-3(j), DS is liable for withholding tax at a 30 percent

rate on the portion of the $50,000 payment to FS that is

recharacterized as a payment to FP, i.e., $7,035 with respect to the

June 30, 1996 payment and $5,895 with respect to the December 31,

1996 payment.

Example 25. Determination of principal amount. (i) FP lends DM

10,000,000 to FS in exchange for a ten year note that pays interest

semi-annually at a rate of 8 percent per annum. Six months later,

pursuant to a tax avoidance plan, FS lends DM 5,000,000 to DS in

exchange for a 10 year note that pays interest semi-annually at a

rate of 10 percent per annum. At the time FP make its loan to FS,

the exchange rate is DM 1.5/$1. At the time FS makes its loan to DS

the exchange rate is DM 1.4/$1.

(ii) FP's loan to FS and FS' loan to DS are financing

transactions and together constitute a financing arrangement.

Furthermore, because the participation of FS reduces the tax imposed

under section 881 and FS' participation is pursuant to a tax

avoidance plan, the financing arrangement is a conduit financing

arrangement.

(iii) Pursuant to paragraph (d)(1)(i) of this section, the

amount subject to recharacterization is a fraction the numerator of

which is the average principal amount advanced from FS to DS and the

denominator of which is the average principal amount advanced from

FP to FS. Because the property advanced in these financing

transactions is the same type of fungible property, under paragraph

(d)(1)(ii)(A) of this section, both are valued on the date of the

last financing transaction. Accordingly, the portion of the payments

of interest that is recharacterized is ((DM 5,000,000 x DM 1.4/$1)/

(DM 10,000,000 x DM 1.4/$1) or 0.5.

(f) Effective date. This section is effective for payments made by

financed entities on or after September 11, 1995. This section shall

not apply to interest payments covered by section 127(g)(3) of the Tax

Reform Act of 1984, and to interest payments with respect to other debt

obligations issued prior to October

[[Page 41014]]

15, 1984 (whether or not such debt was issued by a Netherlands Antilles

corporation).

Sec. 1.881-4 Recordkeeping requirements concerning conduit financing

arrangements.

(a) Scope. This section provides rules for the maintenance of

records concerning certain financing arrangements to which the

provisions of Sec. 1.881-3 apply.

(b) Recordkeeping requirements--(1) In general. Any person subject

to the general recordkeeping requirements of section 6001 must keep the

permanent books of account or records, as required by section 6001,

that may be relevant to determining whether that person is a party to a

financing arrangement and whether that financing arrangement is a

conduit financing arrangement.

(2) Application of Sections 6038 and 6038A. A financed entity that

is a reporting corporation within the meaning of section 6038A(a) and

the regulations under that section, and any other person that is

subject to the recordkeeping requirements of Sec. 1.6038A-3, must

comply with those recordkeeping requirements with respect to records

that may be relevant to determining whether the financed entity is a

party to a financing arrangement and whether that financing arrangement

is a conduit financing arrangement. Such records, including records

that a person is required to maintain pursuant to paragraph (c) of this

section, shall be considered records that are required to be maintained

pursuant to section 6038 or 6038A. Accordingly, the provisions of

sections 6038 and 6038A (including, without limitation, the penalty

provisions thereof), and the regulations under those sections, shall

apply to any records required to be maintained pursuant to this

section.

(c) Records to be maintained--(1) In general. An entity described

in paragraph (b) of this section shall be required to retain any

records containing the following information concerning each financing

transaction that the entity knows or has reason to know comprises the

financing arrangement--

(i) The nature (e.g., loan, stock, lease, license) of each

financing transaction;

(ii) The name, address, taxpayer identification number (if any) and

country of residence of--

(A) Each person that advanced money or other property, or granted

rights to use property;

(B) Each person that was the recipient of the advance or rights;

and

(C) Each person to whom a payment was made pursuant to the

financing transaction (to the extent that person is a different person

than the person who made the advance or granted the rights);

(iii) The date and amount of--

(A) Each advance of money or other property or grant of rights; and

(B) Each payment made in return for the advance or grant of rights;

(iv) The terms of any guarantee provided in conjunction with a

financing transaction, including the name of the guarantor; and

(v) In cases where one or both of the parties to a financing

transaction are related to each other or another entity in the

financing arrangement, the manner in which these persons are related.

(2) Additional documents. An entity described in paragraph (b) of

this section must also retain all records relating to the circumstances

surrounding its participation in the financing transactions and

financing arrangements. Such documents may include, but are not limited

to--

(i) Minutes of board of directors meetings;

(ii) Board resolutions or other authorizations for the financing

transactions;

(iii) Private letter rulings;

(iv) Financial reports (audited or unaudited);

(v) Notes to financial statements;

(vi) Bank statements;

(vii) Copies of wire transfers;

(viii) Offering documents;

(ix) Materials from investment advisors, bankers and tax advisors;

and

(x) Evidences of indebtedness.

(3) Effect of record maintenance requirement. Record maintenance in

accordance with paragraph (b) of this section generally does not

require the original creation of records that are ordinarily not

created by affected entities. If, however, a document that is actually

created is described in this paragraph (c), it is to be retained even

if the document is not of a type ordinarily created by the affected

entity.

(d) Effective date. This section is effective September 11, 1995.

This section shall not apply to interest payments covered by section

127(g)(3) of the Tax Reform Act of 1984, and to interest payments with

respect to other debt obligations issued prior to October 15, 1984

(whether or not such debt was issued by a Netherlands Antilles

corporation).

Par. 4. In Sec. 1.1441-3, the OMB parenthetical at the end of the

section is removed and paragraph (j) is added to read as follows:

Sec. 1.1441-3 Exceptions and rules of special application.

* * * * *

(j) Conduit financing arrangements--(1) Duty to withhold. A

financed entity or other person required to withhold tax under section

1441 with respect to a financing arrangement that is a conduit

financing arrangement within the meaning of Sec. 1.881-3(a)(2)(iv)

shall be required to withhold under section 1441 as if the district

director had determined, pursuant to Sec. 1.881-3(a)(3), that all

conduit entities that are parties to the conduit financing arrangement

should be disregarded. The amount of tax required to be withheld shall

be determined under Sec. 1.881-3(d). The withholding agent may withhold

tax at a reduced rate if the financing entity establishes that it is

entitled to the benefit of a treaty that provides a reduced rate of tax

on a payment of the type deemed to have been paid to the financing

entity. Section 1.881-3(a)(3)(ii)(E) shall not apply for purposes of

determining whether any person is required to deduct and withhold tax

pursuant to this paragraph (j), or whether any party to a financing

arrangement is liable for failure to withhold or entitled to a refund

of tax under sections 1441 or 1461 to 1464 (except to the extent the

amount withheld exceeds the tax liability determined under Sec. 1.881-

3(d)). See Sec. 1.1441-7(d) relating to withholding tax liability of

the withholding agent in conduit financing arrangements subject to

Sec. 1.881-3.

(2) Effective date. This paragraph (j) is effective for payments

made by financed entities on or after September 11, 1995. This

paragraph shall not apply to interest payments covered by section

127(g)(3) of the Tax Reform Act of 1984, and to interest payments with

respect to other debt obligations issued prior to October 15, 1984

(whether or not such debt was issued by a Netherlands Antilles

corporation).

Par. 5. In Sec. 1.1441-7, the OMB parenthetical at the end of the

section is removed and paragraph (d) is added to read as follows:

Sec. 1.1441-7 General provisions relating to withholding agents.

* * * * *

(d) Conduit financing arrangements--(1) Liability of withholding

agent. Subject to paragraph (d)(2) of this section, any person that is

required to deduct and withhold tax under Sec. 1.1441-3(j) is made

liable for that tax by section 1461. A person that is required to

deduct and withhold tax but fails to do so is liable for the payment

[[Page 41015]]

of the tax and any applicable penalties and interest.

(2) Exception for withholding agents that do not know of conduit

financing arrangement--(i) In general. A withholding agent will not be

liable under paragraph (d)(1) of this section for failing to deduct and

withhold with respect to a conduit financing arrangement unless the

person knows or has reason to know that the financing arrangement is a

conduit financing arrangement. This standard shall be satisfied if the

withholding agent knows or has reason to know of facts sufficient to

establish that the financing arrangement is a conduit financing

arrangement, including facts sufficient to establish that the

participation of the intermediate entity in the financing arrangement

is pursuant to a tax avoidance plan. A withholding agent that knows

only of the financing transactions that comprise the financing

arrangement will not be considered to know or have reason to know of

facts sufficient to establish that the financing arrangement is a

conduit financing arrangement.

(ii) Examples. The following examples illustrate the operation of

paragraph (d)(2) of this section.

Example 1. (i) DS is a U.S. subsidiary of FP, a corporation

organized in Country N, a country that does not have an income tax

treaty with the United States. FS is a special purpose subsidiary of

FP that is incorporated in Country T, a country that has an income

tax treaty with the United States that prohibits the imposition of

withholding tax on payments of interest. FS is capitalized with

$10,000,000 in debt from BK, a Country N bank, and $1,000,000 in

capital from FS.

(ii) On May 1, 1995, C, a U.S. person, purchases an automobile

from DS in return for an installment note. On July 1, 1995, DS sells

a number of installment notes, including C's, to FS in exchange for

$10,000,000. DS continues to service the installment notes for FS

and C is not notified of the sale of its obligation and continues to

make payments to DS. But for the withholding tax on payments of

interest by DS to BK, DS would have borrowed directly from BK,

pledging the installment notes as collateral.

(iii) The C installment note is a financing transaction, whether

held by DS or by FS, and the FS note held by BK also is a financing

transaction. After FS purchases the installment note, and during the

time the installment note is held by FS, the transactions constitute

a financing arrangement, within the meaning of Sec. 1.881-

3(a)(2)(i). BK is the financing entity, FS is the intermediate

entity, and C is the financed entity. Because the participation of

FS in the financing arrangement reduces the tax imposed by section

881 and because there was a tax avoidance plan, FS is a conduit

entity.

(iv) Because C does not know or have reason to know of the tax

avoidance plan (and by extension that the financing arrangement is a

conduit financing arrangement), C is not required to withhold tax

under section 1441. However, DS, who knows that FS's participation

in the financing arrangement is pursuant to a tax avoidance plan and

is a withholding agent for purposes of section 1441, is not relieved

of its withholding responsibilities.

Example 2. Assume the same facts as in Example, 1 except that C

receives a new payment booklet on which DS is described as

``agent''. Although C may deduce that its installment note has been

sold, without more C has no reason to know of the existence of a

financing arrangement. Accordingly, C is not liable for failure to

withhold, although DS still is not relieved of its withholding

responsibilities.

Example 3. (i) DC is a U.S. corporation that is in the process

of negotiating a loan of $10,000,000 from BK1, a bank located in

Country N, a country that does not have an income tax treaty with

the United States. Before the loan agreement is signed, DC's tax

lawyers point out that interest on the loan would not be subject to

withholding tax if the loan were made by BK2, a subsidiary of BK1

that is incorporated in Country T, a country that has an income tax

treaty with the United States that prohibits the imposition of

withholding tax on payments of interest. BK1 makes a loan to BK2 to

enable BK2 to make the loan to DC. Without the loan from BK1 to BK2,

BK2 would not have been able to make the loan to DC.

(ii) The loan from BK1 to BK2 and the loan from BK2 to DC are

both financing transactions and together constitute a financing

arrangement within the meaning of Sec. 1.881-3(a)(2)(i). BK1 is the

financing entity, BK2 is the intermediate entity, and DC is the

financed entity. Because the participation of BK2 in the financing

arrangement reduces the tax imposed by section 881 and because there

is a tax avoidance plan, BK2 is a conduit entity.

(iii) Because DC is a party to the tax avoidance plan (and

accordingly knows of its existence), DC must withhold tax under

section 1441. If DC does not withhold tax on its payment of

interest, BK2, a party to the plan and a withholding agent for

purposes of section 1441, must withhold tax as required by section

1441.

Example 4. (i) DC is a U.S. corporation that has a long-standing

banking relationship with BK2, a U.S. subsidiary of BK1, a bank

incorporated in Country N, a country that does not have an income

tax treaty with the United States. DC has borrowed amounts of as

much as $75,000,000 from BK2 in the past. On January 1, 1995, DC

asks to borrow $50,000,000 from BK2. BK2 does not have the funds

available to make a loan of that size. BK2 considers BK1 to enter

into a loan with DC but rejects this possibility because of the

additional withholding tax that would be incurred. Accordingly, BK2

borrows the necessary amount from BK1 with the intention of on-

lending to DC. BK1 does not make the loan directly to DC because of

the withholding tax that would apply to payments of interest from DC

to BK1. DC does not negotiate with BK1 and has no reason to know

that BK1 was the source of the loan.

(ii) The loan from BK2 to DC and the loan from BK1 to BK2 are

both financing transactions and together constitute a financing

arrangement within the meaning of Sec. 1.881-3(a)(2)(i). BK1 is the

financing entity, BK2 is the intermediate entity, and DC is the

financed entity. The participation of BK2 in the financing

arrangement reduces the tax imposed by section 881. Because the

participation of BK2 in the financing arrangement reduces the tax

imposed by section 881 and because there was a tax avoidance plan,

BK2 is a conduit entity.

(iii) Because DC does not know or have reason to know of the tax

avoidance plan (and by extension that the financing arrangement is a

conduit financing arrangement), DC is not required to withhold tax

under section 1441. However, BK2, who is also a withholding agent

under section 1441 and who knows that the financing arrangement is a

conduit financing arrangement, is not relieved of its withholding

responsibilities.

(3) Effective date. This paragraph (d) is effective for payments

made by financed entities on or after September 11, 1995. This

paragraph shall not apply to interest payments covered by section

127(g)(3) of the Tax Reform Act of 1984, and to interest payments with

respect to other debt obligations issued prior to October 15, 1984

(whether or not such debt was issued by a Netherlands Antilles

corporation).

Par. 6. In Sec. 1.6038A-3, paragraphs (b)(5) and (c)(2)(vii) are

added to read as follows:

Sec. 1.6038A-3 Record maintenance.

* * * * *

(b) * * *

(5) Records relating to conduit financing arrangements. See

Sec. 1.881-4 relating to conduit financing arrangements.

(c) * * *

(2) * * *

(vii) Records relating to conduit financing arrangements. See

Sec. 1.881-4 relating to conduit financing arrangements.

* * * * *

Par. 7. Section 1.7701(l)-1 is added to read as follows:

Sec. 1.7701(l)-1 Conduit financing arrangements.

(a) Scope. Section 7701(l) authorizes the issuance of regulations

that recharacterize 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 title 26 of the United States

Code.

(b) Regulations issued under authority of section 7701(l). The

following regulations are issued under the authority of section

7701(l)--

[[Page 41016]]

(1) Sec. 1.871-1(b)(7);

(2) Sec. 1.881-3;

(3) Sec. 1.881-4;

(4) Sec. 1.1441-3(j);

(5) Sec. 1.1441-7(d);

(6) Sec. 1.6038A-3(b)(5); and

(7) Sec. 1.6038A-3(c)(2)(vii).

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 8. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 9. In Sec. 602.101, paragraph (c) is amended by adding an

entry in numerical order and revising an entry to the table to read as

follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

------------------------------------------------------------------------

Current OMB

CFR part or section where identified and described control No.

------------------------------------------------------------------------

* * * * *

1.881-4.................................................... 1545-1440

* * * * *

Sec. 1.6038A-3............................................ 1545-1191

1545-1440

* * * * *

------------------------------------------------------------------------

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: July 26, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-19446 Filed 8-10-95; 8:45 am]

BILLING CODE 4830-01-U