Treatment of Obligation-Shifting Transactions

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209817-96]

RIN 1545-AU19

Treatment of Obligation-Shifting Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

treatment of certain multiple-party financing transactions in which one

party realizes income from leases or similar agreements and another

party claims deductions related to that income. In order to prevent tax

avoidance, the proposed regulations recharacterize these transactions

in a manner that clearly reflects income. The proposed regulations

affect only persons that engage in these transactions. The regulations

generally do not apply to routine transactions lacking characteristics

of tax avoidance. This document also provides notice of a public

hearing on the proposed regulations.

DATES: Written comments, requests to appear, and outlines of topics to

be discussed at the public hearing scheduled for April 29, 1997, at 10

a.m. must be received by April 8, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209817-96), Room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209817-96), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue NW,

Washington, DC. Alternatively, taxpayers may submit comments

electronically via the Internet by selecting the ``Tax Regs'' option of

the IRS Home Page, or by submitting comments directly to the IRS

Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in the IRS Auditorium,

Internal Revenue Building,

[[Page 68176]]

7th Floor, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Jonathan Zelnik at (202) 622-3940; concerning submissions and the

hearing, Christina Vasquez at (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC

20224. Comments on the collection of information should be received by

April 8, 1997. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the collection will have a practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of service to provide information.

The collection of information is in Sec. 1.7701(l)-2(j). This

information is required by the IRS to verify pass-through entity

compliance with Sec. 1.7701(l)-2. This information will be used to

determine whether the amount of tax has been computed correctly. The

collection of information is mandatory. The likely recordkeepers are

businesses and other organizations. Estimated total annual

recordkeeping burden: 500 hours. Estimated average annual burden per

recordkeeper: 5 hours. Estimated number of recordkeepers: 100.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax information are confidential, as required by 26 U.S.C. 6103.

Background

The IRS and Treasury Department have become aware of multiple-party

financing transactions (``stripping transactions'') intended to allow

one party to realize income from a lease or similar agreement and to

allow another party to report deductions related to that income (for

example, cost recovery or rental expenses). Notice 95-53, 1995-2 C.B.

334, describes several examples of these transactions, including

transferred basis transactions, transfers of partnership interests, and

variations involving licenses, service contracts, and prepayment,

front-loading, and retention of rights to receive future payments.

Notice 95-53 states the position of the IRS that the claimed tax

treatment of these transactions improperly separates income from

related deductions and that the transactions do not produce the tax

consequences desired by the parties. The notice also states that

regulations will be issued under section 7701(l) of the Internal

Revenue Code recharacterizing stripping transactions any significant

element of which is entered into or undertaken on or after October 13,

1995. The notice requested comments regarding those regulations.

The IRS received only one set of comments in response to Notice 95-

53. Those comments recommended that the regulations under section

7701(l) address a broader class of transactions than was described in

the notice. Specifically, they recommended that the regulations defer

the recognition of income in circumstances where there is an advance

receipt or assignment of future income and there is the potential for

the transactions to become stripping transactions. They also

recommended that the regulations recharacterize these transactions

without regard to whether there is a tax avoidance purpose. The

comments reflected a desire for the regulations to produce an economic

accrual of income and to enable taxpayers to determine the proper tax

accounting for their transactions without regard to subsequent events.

The proposed regulations generally follow the notice and do not

expand the class of transactions subject to recharacterization. The

regulations do not require taxpayers to make any assumptions as to

subsequent events. They are intended to produce tax results that

conform to the economic substance of the transactions that they

address. Furthermore, the regulations generally apply to transactions

whether or not the parties have a tax avoidance purpose.

Explanation of Provisions

1. General Approach

Section 7701(l) authorizes the Secretary to ``prescribe regulations

recharacterizing any multiple-party financing transaction as a

transaction directly among any 2 or more of such parties where the

Secretary determines that such recharacterization is appropriate to

prevent avoidance of any tax imposed by [the Internal Revenue Code].''

The proposed regulations recharacterize transactions in which the

transferee (``the assuming party'') assumes obligations or acquires

property subject to obligations under an existing lease or similar

agreement and the transferor (``the property provider'') or any other

party has already received or retains the right to receive amounts that

are allocable to periods after the transfer. The recharacterization

reflects the general principle that a taxpayer who is treated for

federal income tax purposes as the owner of rental property must

recognize income that accrues during its period of ownership. , e.g.,

Steinway & Sons v. Commissioner, 46 T.C. 375 (1966), acq., 1967-2 C.B.

3; Alstores Realty Corp. v. Commissioner, 46 T.C. 363 (1966), acq.,

1967-2 C.B. 1.

For the period in which an assuming party in such a transaction is

a party to the lease or similar agreement, the recharacterization

requires the assuming party to report income on a level-rent basis

calculated using the rules of the constant rental accrual method

described in Sec. 1.467-3(d) as proposed on June 3, 1996 (IA-292-84, 61

FR 27834, 27844). Thus, the assuming party is required to recognize

rental income for the period in which it owns the property or leasehold

interest. In addition, the transaction is recharacterized to include

additional consideration in the form of a note provided by the assuming

party to the property provider for the transfer of the property,

resulting in interest income and expense for which the parties must

account as appropriate. The property provider also must adjust its

income for any differences between amounts it recognized and amounts it

would have recognized if it had reported income on a level-rent basis

for the periods that it owned the property or leasehold

[[Page 68177]]

interest. Finally, to account for any differences in timing or amount

between payments the property provider actually receives after the

transaction and payments treated as being made to the property provider

under the note from the assuming party, the property provider is

treated as an obligor or obligee under a second loan, for which the

property provider must account accordingly.

2. Obligation-shifting Tsransactions

The proposed regulations are not intended to recharacterize

transactions with little potential for tax avoidance. Taken together,

the definition of ``obligation-shifting transaction'' and the

enumerated exceptions limit the scope of the regulations to

transactions that are not routine and that involve shifting of

substantial amounts of income away from the taxpayer that recognizes

deductions related to the income.

The proposed regulations apply to obligation-shifting transactions,

which are defined as any transaction in which an assuming party assumes

a property provider's obligations to a property user (or acquires

property subject to a property provider's obligations to a property

user) under a lease or similar agreement if the property provider or

any other party has already received, or retains the right to receive,

amounts that are allocable to periods after the transaction. The

regulations define obligations under a lease or similar agreement as

including a continuing obligation to make property available to the

lessee or the ultimate user of the property. These obligations

typically give rise to deductions, such as for cost recovery or, in the

case of a master-lease/sublease arrangement, for payments under a

master lease. The advance receipt of amounts that are allocable to

periods after the obligation- shifting transaction often results in

accelerated taxable income for the recipient. Thus, the definition

describes transactions in which there is the potential for one party to

recognize income but a different party to recognize deductions

associated with that income.

In some transactions identified in Notice 95-53, one party sells,

assigns, or otherwise transfers to a third party the right to receive

future payments under a lease and includes as current income the amount

received as consideration for the transfer. The underlying property

(subject to the lease) is later transferred in a transaction intended

to qualify as a transferred basis transaction. These transactions are

within the scope of the regulations because the property transferee

assumes obligations or acquires the property subject to the obligation

to make the property available to the lessee and the property

transferor already received amounts that are allocable to periods after

the transaction by reason of the assignment of rights to receive future

payments. In other transactions, the property transferor does not

assign the right to future rental amounts but instead receives

prepayment from the lessee or retains the right to receive future

amounts over time. Both variations likewise are within the scope of the

regulations.

The proposed regulations adopt an aggregate view of partnerships,

treating each partner as having a proportionate share of the rights and

obligations of the partnership. Thus, for example, if a partnership

assigns its right to receive future amounts under a lease and allocates

to its current partners the amount recognized, a later transfer of a

partnership interest is an obligation-shifting transaction because the

transferee partner assumes an allocable share of the partnership's

obligation to make the property available to the lessee and because the

transferor partner is treated as having already received amounts that

are allocable to periods after the transaction. See Example 3 of the

proposed regulations. In appropriate cases, the IRS may assert other

authorities to prevent the use of a partnership to effect an improper

separation of income from related deductions. See, e.g., Sec. 1.701-

2(d) (Example 7).

The proposed regulations also generally treat an obligation-

shifting transaction as occurring if a subsidiary that is a member of a

consolidated group becomes a nonmember at a time when the subsidiary

has received payments under a lease or similar agreement that are

allocable to periods after the transaction.

3. Lease or Similar Agreement

Under the proposed regulations, an obligation-shifting transaction

involves a lease or similar agreement. The regulations define this term

broadly to include any contract for the use or enjoyment of tangible or

intangible property, including leaseholds, licenses, other non-fee

interests in property, and other contracts (including service

contracts) involving the use or enjoyment of property if the value of

that use or enjoyment is more than de minimis. The proposed

regulations, therefore, do not apply to service contracts that do not

involve the use or enjoyment of property. The definition of obligation-

shifting transaction, however, does not restrict the IRS's ability to

challenge these transactions under other authorities. For instance,

even if a transaction is not within the scope of the proposed

regulation, the IRS may challenge it under one or more of the

authorities identified in Notice 95-53.

The IRS requests comments on whether additional guidance is needed

on the definition of lease or similar agreement.

4. Exceptions

The proposed regulations are not intended to recharacterize

otherwise routine transactions, such as the incorporation of an entire

line of business that does not involve significant shifting of income

and deductions. See Rev. Rul. 80-198, 1980-2 C.B. 113, subject to the

limitations described therein. Accordingly, the regulations provide a

number of objective exceptions that generally will protect routine

transactions from recharacterization. The regulations do not apply to

transactions in which the amounts that are allocable to future periods

but are not transferred are less than or equal to $100,000. The

regulations do not apply to transactions in which total payments

(including the aggregate expected future value of all contingent

consideration) under the lease or similar agreement are not reasonably

expected to exceed $250,000. The regulations do not apply to

transactions in which the fair market value of the property that is

subject to the lease or similar agreement and is transferred in the

obligation-shifting transaction, plus the value of the amounts that are

already received or retained by the property provider but are allocable

to periods after the obligation-shifting transaction, is less than ten

percent of the total assets (other than Class I and Class II assets as

described in Sec. 1.1060-1T(d) and debt issued by the property

provider) transferred by the property provider in the transaction. The

regulations do not apply to transactions in which the lease or similar

agreement is a disqualified leaseback or long-term agreement within the

meaning of Sec. 1.467-3(b). The regulations do not apply to

transactions described in section 381(a), unless the transaction is

deemed to be an obligation-shifting transaction under proposed

Sec. 1.7701(l)-2(k). Finally, the regulations provide that a

transaction is exempt from recharacterization if the parties to the

transaction establish to the satisfaction of the Commissioner that the

transaction does not present a significant potential for tax avoidance.

Because the purpose of recharacterization under section 7701(l) is

to prevent tax avoidance, these objective exceptions are unavailable

for

[[Page 68178]]

transactions entered into with a principal purpose of substantially

reducing the present value of the aggregate tax liability of the

property provider, the assuming party, and any other party whose

taxable income is determined by reference to the taxable income of the

property provider or the assuming party.

5. Recharacterization

The proposed regulations recharacterize an obligation- shifting

transaction in order to ensure that the property provider and the

assuming party both report the income from the underlying property

allocable to their respective periods of ownership.

For purposes of determining the amounts that are allocable to

periods under the lease or similar agreement, the proposed regulations

apply a rent-leveling process based on the constant rental accrual

method described in Sec. 1.467-3(d) to all amounts that are treated as

payable under the lease or similar agreement. At the time of the

obligation-shifting transaction, the level rental amount is determined

for the entire term of the lease or similar agreement using 110 percent

of the applicable Federal rate based on that term. The amounts that are

treated as payable under the lease or similar agreement at the time of

the obligation-shifting transaction are the amounts that have already

been paid to the property provider and the future amounts that,

immediately before the obligation-shifting transaction, are payable to

the property provider. Thus, if the property provider assigns the right

to receive payments to a third party in exchange for consideration, the

consideration is treated as an amount received under the lease or

similar agreement. Because the property provider no longer has the

right to receive the payments assigned to the third party, those

payments (whether past or future) are not treated as amounts that are

payable to the property provider for purposes of calculating the level

rental amount.

The proposed regulations recharacterize an obligation- shifting

transaction by treating the assuming party and the property provider as

follows:

The assuming party is treated as acquiring the right to receive all

amounts that are allocable to periods after the obligation-shifting

transaction. The assuming party includes these amounts in income for

the periods that it owns the property.

To reflect the amounts that the assuming party is treated as

receiving under the recharacterization but that it does not actually

receive, the assuming party also is treated as providing additional

consideration to the property provider in the form of a note (a

``section 7701(l) note''). The original principal balance of the

section 7701(l) note equals the excess of the present value of the

amounts that are allocable to periods after the obligation-shifting

transaction over the present value of the amounts that are payable to

the assuming party.

The property provider must adjust its income to the extent that it

accounted for income under the lease or similar agreement before the

obligation-shifting transaction in a manner inconsistent with the

level-rent method described above. The adjustment, which can increase

or decrease the property provider's income, equals the principal

balance of the section 467 loan that would have existed if the property

provider had been using the constant rental accrual method to account

for amounts under the lease or similar agreement that are allocable to

periods before the obligation-shifting transaction, reduced by any

existing section 467 loan if the lease or similar agreement is a

section 467 rental agreement. The constant rental amount is calculated

using the amounts that are treated as payable under the lease or

similar agreement.

Finally, to account for any differences in timing or amount between

payments the property provider actually receives after the obligation-

shifting transaction and payments treated as being made to the property

provider under the section 7701(l) note, the property provider is

treated as a party to a loan (a ``section 7701(l) rent-leveling

loan''). The section 7701(l) rent-leveling loan is created at the time

of the obligation-shifting transaction. Its balance at that time equals

the section 467 loan that would have existed if the property provider

had been using the constant rental accrual method to account for

amounts under the lease or similar agreement that are allocable to

periods before the obligation-shifting transaction. Thus, in the

periods after the obligation-shifting transaction, the property

provider must account for any interest expense or income resulting from

the section 7701(l) rent-leveling loan, in addition to any interest

income or expense resulting from the section 7701(l) note.

Although section 467 may not apply to an obligation-shifting

transaction, the effect of the proposed regulations is to

recharacterize the transaction to produce the constant rental amount

and associated loans that the parties would have been treated as having

if the lease or similar agreement had been a section 467 rental

agreement (modified to reflect the amounts already received or payable

to the property provider immediately before the obligation-shifting

transaction) and had been subject to the constant rental accrual

method. Thus, the assuming party is treated as if it had purchased the

property in part with a note, had obtained the right to receive rental

amounts on the constant rental accrual method during its ownership of

the property, and had used those amounts to service the note. For the

property provider, the proposed regulations provide a

recharacterization that is similar (but not identical) to the treatment

required when a lessor disposes of property subject to a section 467

rental agreement that was accounted for under the constant rental

accrual method.

The proposed regulations provide the exclusive recharacterization

of an obligation-shifting transaction for a property provider and an

assuming party. Thus, if an obligation-shifting transaction is

recharacterized under this section and the lease or similar agreement

is a section 467 rental agreement, the rules of this section supersede

the rules of Secs. 1.467-1 through 1.467-8 as proposed on June 3, 1996

(IA-292-84, 61 FR 27834) for the property provider (the transferor) and

the assuming party (the transferee). The assuming party's income after

the obligation-shifting transaction is determined under this section

and not under Sec. 1.467-7(e)(1). Similarly, the rules provided in

Sec. 1.467-7(e)(2) for determining the amount of the section 467 loan

for the period after the transfer, the amount realized by the property

provider, and the assuming party's basis in the property do not apply

to obligation-shifting transactions recharacterized by this section.

The recharacterization does not affect the property user or rent

factor (if any), because, even though they are parties to the multiple-

party financing transaction, no adjustment to their treatment of the

transaction is necessary to prevent the avoidance of tax. Cf.

Sec. 1.881-3(a)(3)(ii)(A) (limiting purposes for which conduit

financing arrangements are recharacterized). Thus, if the lease or

similar agreement is a section 467 rental agreement, the property user

must continue to take section 467 rent and section 467 interest into

account without regard to the obligation-shifting transaction and the

recharacterization under this section. See Sec. 1.467-7(e)(1).

6. Issues Not Addressed

The proposed regulations do not address transactions in which a

taxpayer assigns rights to future income

[[Page 68179]]

but does not transfer the underlying property to another taxpayer,

except as provided in the special rules regarding pass-through entities

and consolidated groups.

7. Proposed Effective Date

Notice 95-53 states that the regulations under section 7701(l) will

be effective ``with respect to stripping transactions any significant

element of which is entered into or undertaken on or after October 13,

1995.'' The regulations are proposed to adopt the effective date stated

in the notice.

Special Analyses

It is hereby certified that these regulations do not have a

significant economic impact on a substantial number of small entities.

This certification is based on the understanding of the IRS that the

total number of entities engaging in transactions affected by these

regulations is not substantial and, of those entities, most are not

small entities within the meaning of the Regulatory Flexibility Act (5

U.S.C. chapter 6). Therefore, a Regulatory Flexibility Analysis is not

required. It has been determined that this notice of proposed

rulemaking is not a significant regulatory action as defined in E.O.

12866. Therefore, a regulatory assessment is not required. Pursuant to

section 7805(f) of the Internal Revenue Code, this notice of proposed

rulemaking will be submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comments on its impact on small

businesses.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for April 29, 1997, at 10 a.m.

in the IRS Auditorium, Internal Revenue Building, 7th Floor, 1111

Constitution Avenue NW, Washington, DC. Because of access restrictions,

visitors will not be admitted beyond the building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments and submit an outline of the topics to be

discussed and the time to be devoted to each topic (a signed original

and eight (8) copies) by April 8, 1997.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Jonathan R. Zelnik,

Office of the Assistant Chief Counsel (Financial Institutions &

Products). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

an entry in numerical order to read as follows:

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

Section 1.7701(l)-2 also issued under 26 U.S.C. 7701(l). * * *

Par. 2. Section 1.7701(l)-1 is amended as follows:

1. Paragraphs (b)(6) and (b)(7) are revised.

2. Paragraph (b)(8) is added.

The revisions and addition reads as follows:

Sec. 1.7701(l)-1 Conduit financing arrangements.

* * * * *

(b) * * *

* * * * *

(6) Section 1.6038A-3(b)(5);

(7) Section 1.6038A-3(c)(2)(vii); and

(8) Section 1.7701(l)-2.

Par. 3. Section 1.7701(l)-2 is added under the center heading

``General Actuarial Valuations'' to read as follows:

Sec. 1.7701(l)-2 Treatment of obligation-shifting transactions.

(a) Purpose. The purpose of this section is to prevent avoidance of

tax by parties participating in multiple-party financing transactions

that involve an assumption of obligations under a lease or similar

agreement. This section should be interpreted in a manner consistent

with this purpose.

(b) In general. Obligation-shifting transactions as defined in

paragraph (h)(1) of this section are recharacterized in the manner

described in paragraph (d) of this section unless an exception in

paragraph (c) of this section applies.

(c) Exceptions--(1) In general. Paragraph (d) of this section does

not apply if any of the following is satisfied:

(i) The aggregate amounts that have already been received by or are

payable to the property provider but are allocable to periods

(including partial periods) after the obligation-shifting transaction

(as determined under paragraph (g) of this section) are less than or

equal to $100,000.

(ii) The sum of the aggregate payments (including contingent

payments) under the lease or similar agreement and the aggregate value

of other consideration (including contingent consideration) to be

received under the lease or similar agreement is not reasonably

expected to exceed $250,000. The rules of Sec. 1.467-1(c)(4)(ii) \1\

apply in determining the amount described in this paragraph (c)(1)(ii).

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\1\ This section appears in proposed regulations published on

June 3, 1996 (IA-292-84, 61 FR 27834, 27839).

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(iii) The fair market value of the leased property is less than ten

percent of the aggregate fair market value of all of the property

(excluding Class I assets as described in Sec. 1.1060-1T(d)(1), Class

II assets as described in Sec. 1.1060-1T(d)(2)(i), and debt issued by

the property provider) that the property provider transfers to the

assuming party as part of the same transaction or series of related

transactions. For this purpose, the fair market value of the leased

property is the sum of--

(A) The fair market value of the property subject to the lease or

similar agreement and transferred in the obligation-shifting

transaction, plus

(B) The value of the amounts that have already been received under

the lease or similar agreement or are retained by the property provider

or any other party but are allocable to periods (including partial

periods) after the obligation-shifting transaction.

(iv) The agreement(s) between the property provider and the

property user is a disqualified leaseback or long-term agreement within

the meaning of Sec. 1.467-3(b).\2\

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\2\ This section appears in proposed regulations published on

June 3, 1996 (IA-292-84, 61 FR 27834, 17844).

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(v) The transaction is described in section 381(a), unless the

transaction is deemed to be an obligation-shifting transaction under

paragraph (k) of this section.

(vi) The Commissioner determines that the transaction does not

[[Page 68180]]

substantially reduce the present value of the tax liability of the

assuming party or otherwise result in the avoidance of tax.

(2) Limitation on exceptions. The exceptions listed in paragraph

(c)(1) of this section do not apply to obligation-shifting transactions

entered into with a principal purpose of substantially reducing the

present value of the aggregate tax liability of the assuming party, the

property provider, and any person whose taxable income is determined

(in whole or in part) by reference to the taxable income of the

property provider or the assuming party.

(d) Recharacterization of obligation-shifting transaction--(1) In

general. In order to clearly reflect the income of the assuming party

and the property provider, an obligation-shifting transaction is

recharacterized as follows:

(i) Assuming party treated as receiving all allocable rents. The

assuming party is treated as acquiring the right to receive (and as

receiving when due) all amounts under the lease or similar agreement

that are allocable (as determined under paragraph (g) of this section)

to periods (including partial periods) after the obligation-shifting

transaction. Thus, the assuming party must include these amounts in

income in the periods to which they are allocable.

(ii) Assuming party treated as issuing section 7701(l) note. The

assuming party is treated as issuing to the property provider, as

additional consideration in the obligation-shifting transaction, a

section 7701(l) note, with terms as described in paragraph (e) of this

section. Accordingly, the assuming party and the property provider must

account for interest expense and income from the section 7701(l) note

in the periods (including partial periods) following the obligation-

shifting transaction.

(2) Section 7701(l) rent-leveling loan and adjustment to property

provider's income--(i) Section 7701(l) rent-leveling loan. To account

for any differences in timing or amount between payments actually

received by the property provider after the obligation-shifting

transaction and payments (as described in paragraph (e)(3) of this

section) treated as being made under the section 7701(l) note, the

property provider is treated as a party to a section 7701(l) rent-

leveling loan, with terms as described in paragraph (f) of this

section. Accordingly, the property provider must account for interest

expense or income (as appropriate) in the periods (including partial

periods) following the obligation-shifting transaction.

(ii) Adjustment to property provider's income. To account for any

differences between amounts previously included by the property

provider and amounts that are allocable to periods before the

obligation-shifting transaction, on the date on which the obligation-

shifting transaction is consummated, the property provider must treat

as an item of expense or income (as appropriate)--

(A) The principal balance of the section 7701(l) rent-leveling

loan, minus

(B) The principal balance (plus interest not already included in

the principal balance) of the property provider's section 467 loan (if

any) as determined under the principles of Sec. 1.467-4(a)(4) \3\ and

existing as of that date.

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\3\ This section appears in proposed regulation published on

June 3, 1996 (IA-292-84, 61 FR 27834, 27845).

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(3) Exclusive recharacterization. If the lease or similar agreement

is a section 467 rental agreement, the property provider and the

assuming party must account for the recharacterized transaction under

the provisions of this section and not under the provisions of

Secs. 1.467-1 through 1.467-8.\4\

---------------------------------------------------------------------------

\4\ These sections appear in proposed regulations published on

June 3, 1996 (IA-292-84, 61 FR 27834).

---------------------------------------------------------------------------

(e) Section 7701(l) note--(1) Principal. On the date on which the

obligation-shifting transaction is consummated, the principal balance

of the section 7701(l) note equals the excess of--

(i) The present value of the amounts that are allocable to periods

(including partial periods) after the obligation-shifting transaction,

over

(ii) The present value of the amounts that are payable to the

assuming party.

(2) Present value, yield, and compounding period. For purposes of

paragraph (e)(1) of this section, present value is determined under the

rules of Sec. 1.467-2(d)\5\. The yield of the section 7701(l) note

equals 110 percent of the applicable Federal rate on the date on which

the obligation-shifting transaction is consummated, based on the

remaining term of the lease or similar agreement. The compounding

period for determining both the original principal balance and the

yield must equal the period used in determining the amounts that are

allocable (as determined under paragraph (g) of this section) to

periods under the lease or similar agreement.

---------------------------------------------------------------------------

\5\ This section appears in proposed regulations published on

June 3, 1996 (IA-292-84, 61 FR 27834, 27842).

---------------------------------------------------------------------------

(3) Repayment schedule--(i) Amount. The payment for each period

under the section 7701(l) note is--

(A) The amount that is taken into account by the assuming party

under paragraph (d)(1)(i) of this section, minus

(B) The amount received by the assuming party for that period.

(ii) Timing. The timing of section 7701(l) note payments, as

determined under paragraph (e)(3)(i) of this section, is the same as

the timing of the payments taken into account by the assuming party

under paragraph (d)(1)(i) of this section.

(4) Debt for all purposes. A section 7701(l) note is debt for all

purposes of the Internal Revenue Code. The principal balance of the

section 7701(l) note after the obligation-shifting transaction may be

positive or negative. If the principal balance is positive, the note

represents an amount owed by the assuming party to the property

provider, and if the principal balance is negative, the note represents

an amount owed by the property provider to the assuming party.

(f) Section 7701(l) rent-leveling loan--(1) Principal. On the date

on which the obligation-shifting transaction is consummated, the

principal balance of the section 7701(l) rent-leveling loan equals the

principal balance (plus any interest not already included in the

principal balance) of the section 467 loan as determined under

Sec. 1.467-4(b) that would have existed as of that date if--

(i) The amounts payable under the lease or similar agreement were

the amounts described in paragraphs (g)(1) and (g)(2) of this section,

and

(ii) The property provider had reported all items of income and

expense with respect to the lease or similar agreement by applying the

constant rental accrual method described in Sec. 1.467-3(d) and by

determining the section 467 rent for each period in accordance with

Sec. 1.467-1(d)(2)(i).

(2) Yield and compounding period. The yield of the section 7701(l)

rent-leveling loan equals 110 percent of the applicable Federal rate on

the date on which the obligation-shifting transaction is consummated,

based on the original term of the lease or similar agreement. The

compounding period for determining the yield must equal the period used

in determining the amounts that are allocable (as determined under

paragraph (g) of this section) to periods under the lease or similar

agreement.

(3) Repayment schedule--(i) Amount. The property provider's payment

(or receipt) for each period under the section 7701(l) rent-leveling

loan is--

(A) The amount (as described in paragraph (e)(3)(i) of this

section)

[[Page 68181]]

treated as paid in satisfaction of the section 7701(l) note, minus

(B) The amount received by the property provider under the lease or

similar agreement for that period.

(ii) Timing. The timing of section 7701(l) rent-leveling loan

payments, as determined under paragraph (f)(3)(i) of this section, is

governed by paragraph (g) of this section (and thus, is the same as the

timing of the payments taken into account by the assuming party under

paragraph (d)(1)(i) of this section).

(4) Debt for all purposes. A section 7701(l) rent-leveling loan is

debt for all purposes of the Internal Revenue Code. The principal

balance of the section 7701(l) rent-leveling loan may be positive or

negative. If the principal balance is positive, the amount represents a

loan on which the property provider is the obligee, and if the

principal balance is negative, the amount represents a loan on which

the property provider is the obligor.

(g) Determining amounts that are allocable to periods under the

lease or similar agreement. The amounts that are allocable to periods

under a lease or similar agreement are determined (immediately before

the obligation-shifting transaction is consummated) by applying the

constant rental accrual method described in Sec. 1.467-3(d) from the

inception of the lease or similar agreement based on--

(1) The amounts that have already been received under the lease or

similar agreement, and

(2) The amounts that are payable under the lease or similar

agreement.

(h) Definitions. The following definitions apply solely for

purposes of this section.

(1) An obligation-shifting transaction is any transaction in which

an assuming party assumes a property provider's obligations to a

property user (or acquires property subject to a property provider's

obligations to a property user) under a lease or similar agreement if

the property provider or any other party has already received, or

retains the right to receive, amounts that are allocable to periods

after the transaction.

(2) A property user is any person with the right to use property

under a lease or similar agreement.

(3) A property provider is any person (other than an assuming party

in its capacity as such) that is obligated to make property available

to a property user on account of a lease or similar agreement.

(4) An assuming party is any person that assumes obligations or

acquires property subject to obligations under an existing lease or

similar agreement with a property user.

(5) A lease or similar agreement is any contract for the use or

enjoyment of tangible or intangible property, including leaseholds,

licenses, other non-fee interests in property, and other contracts

(including service contracts) involving the use or enjoyment of

property if the fair market value of that use or enjoyment is more than

de minimis.

(6) Obligations under a lease or similar agreement include the

continuing obligation to make property subject to a lease or similar

agreement available to a property user. To the extent that an assuming

party assumes obligations of a property provider or acquires property

subject to obligations of a property provider, the obligations shall

not thereafter be treated as obligations of the property provider.

(7) Amounts that have already been received under the lease or

similar agreement include consideration received (as of the date on

which the obligation-shifting transaction is consummated) for assigning

the rights to receive payments under the lease or similar agreement.

(8) Amounts that are payable under the lease or similar agreement

do not include payments the rights to which have been assigned in an

arm's-length transaction to an unrelated third person in exchange for

consideration.

(9) A section 7701(l) note is indebtedness arising from the

recharacterization described in paragraph (d)(1)(ii) of this section.

The terms of a section 7701(l) note are described in paragraph (e) of

this section.

(10) A section 7701(l) rent-leveling loan is indebtedness arising

from the recharacterization described in paragraph (d)(2)(i) of this

section. The terms of a section 7701(l) rent-leveling loan are

described in paragraph (f) of this section.

(i) Reserved.

(j) Pass-through entity look-through rule. For purposes of

determining whether any person is a property user, a property provider,

or an assuming party, the person is treated as having the rights and

obligations of any pass-through entity in which the person is a

partner, shareholder, beneficiary, or other participant, but only to

the extent of the person's allocable share of pass-through entity items

relating to the property. The pass-through entity must reflect the

required recharacterization on its books.

(k) Consolidated group rule. For purposes of this section, if a

subsidiary is a member of a consolidated group and the subsidiary or a

successor becomes a nonmember (other than in a transaction described in

Sec. 1.1502-13(j)(5)), the nonmember (whether or not a separate legal

entity) will be treated as a separate corporation that acquires the

assets and assumes the obligations of the subsidiary. For example,

assume that P sells all the stock of S, previously a wholly-owned

subsidiary of P and a member of the P consolidated group, and that, at

the time of the sale, S already has received amounts under a lease that

are allocable to periods after the sale. Under this paragraph (k), an

obligation-shifting transaction occurs when S becomes a nonmember. S,

as a nonmember, is treated as having assumed the obligations under the

lease. Therefore, S must adjust its income as provided in paragraph

(d)(2)(ii) of this section immediately before it becomes a nonmember of

the consolidated group. After the sale, S is treated as both a property

provider and an assuming party in the obligation-shifting transaction.

(l) Reserved.

(m) Examples. The following examples illustrate the rules of this

section. Each example assumes that all taxpayers use the calendar year

as the taxable year, all payment periods are the calendar year, and

none of the rental agreements are disqualified leasebacks or long-term

agreements under Sec. 1.467-3(b). Except as otherwise provided, none of

the exceptions in paragraph (c)(1) of this section apply. The examples

read as follows:

Example 1. Retained rents; section 351 transfer--(i) Facts. (A)

On January 1, 2001, A leases property to B for a five-year period.

The lease provides for rent of $10,000,000 per year, payable

annually on December 31.

(B) On January 1, 2002, A transfers the leased property to D in

exchange for D preferred stock. A retains the right to receive the

remaining four years of rent from B. As part of the same

transaction, C transfers $100,000,000 to D in exchange for D common

stock. After the transaction, A and C own 100 percent of the stock

of D. Assume the transaction meets all of the requirements of

section 351. C and D are members of the same consolidated group as

defined in Sec. 1.1502-1(h). One hundred ten percent of the

applicable Federal rate based on annual compounding is 7 percent.

(ii) Obligation-shifting transaction. B is a property user

because B has the right to use the property under the lease with A.

A is a property provider because A is obligated to make the property

available to B on account of the lease. D is an assuming party

because in the January 1, 2002, transaction D acquires the property

subject to A's obligations under the lease to make the property

available to B for the remaining four years of the lease. The

transaction is an obligation-shifting transaction because D is an

assuming party

[[Page 68182]]

and A retains the right to receive rent from B allocable to periods

after the transaction.

(iii) Recharacterization. As of January 1, 2002, the transaction

is recharacterized as follows:

(A) Under the constant rental accrual method described in

Sec. 1.467-3(d), the amount accruing for each calendar year period

under the lease is $10,000,000. D is treated as acquiring the right

to receive the amounts allocable to the four periods after the

obligation-shifting transaction. Thus, in 2002, 2003, 2004, and

2005, D must recognize $10,000,000 rental income.

(B) The principal balance of the section 7701(l) note equals

$33,872,112.56, with a yield equal to 7 percent based on annual

compounding. As part of the obligation-shifting transaction, D is

treated as having given A the section 7701(l) note as additional

consideration. The amount of the section 7701(l) note is treated as

``other property'' transferred from D to A in the section 351

exchange. D is treated as making section 7701(l) note payments to A.

A has interest income on the section 7701(l) note. D has interest

expense on the section 7701(l) note. A and D account for the section

7701(l) note as follows:

Section 7701(1) Note

----------------------------------------------------------------------------------------------------------------

Beginning

Taxable year ending balance Payment Interest Principal

----------------------------------------------------------------------------------------------------------------

12/31/02...................................... $33,872,112.56 $10,000,000.00 $2,371,047.88 $7,628,952.12

12/31/03...................................... 26,243,160.44 10,000,000.00 1,837,021.23 8,162,978.77

12/31/04...................................... 18,080,181.67 10,000,000.00 1,265,612.72 8,734,387.28

12/31/05...................................... 9,345,794.39 10,000,000.00 654,205.61 9,345,794.39

----------------------------------------------------------------------------------------------------------------

(C) Because the amount A recognized in the year before the

obligation-shifting transaction equals the amount A would have

recognized under the constant rental accrual method, A's adjustment

to income on the consummation of the obligation-shifting transaction

is $0.

(D) At the time of the obligation-shifting transaction, the

principal balance of the section 7701(l) rent-leveling loan equals

$0. Furthermore, because the amounts A actually receives each year

after the obligation-shifting transaction, $10,000,000, equal the

amounts D is treated as paying A under the section 7701(l) note,

$10,000,000, the balance of the section 7701(l) rent-leveling loan

equals $0 for all periods after the obligation-shifting transaction.

Thus, A has no interest income or expense arising from the section

7701(l) rent-leveling loan.

Example 2. Rents already received; section 351 transfer--(i)

Facts. (A) On January 1, 2001, X leases property to Y for a seven-

year period. The XY lease provides for rent of $900,000 per year,

payable annually on December 31. Also on January 1, 2001, Y leases

the property to Z for a five-year period. The YZ lease provides for

rent payable on December 31 of each year as follows: $800,000 in

2001, $900,000 in 2002, $1,000,000 in 2003, $1,100,000 in 2004, and

$1,200,000 in 2005.

(B) On December 31, 2001, Y sells to F the right to receive all

rents from Z for 2002 through 2005. F pays Y $3,146,345.27. Y

includes the $3,146,345.27 as ordinary income.

(C) On January 1, 2002, Y contributes to S cash of $2,500,000,

Y's rights and obligations under the lease with X, and Y's rights

and obligations under the lease with Z in exchange for S preferred

stock. As part of the same transaction, P transfers cash of

$7,500,000 to S in exchange for S common stock. After the

transaction, Y and P own 100 percent of the stock of S. Assume the

transaction meets all of the requirements of section 351. S and P

are members of the same consolidated group as defined in

Sec. 1.1502-1(h). One hundred ten percent of the applicable Federal

rate based on annual compounding is 10 percent.

(ii) Obligation-shifting transaction. Z is a property user

because Z has the right to use the property under the YZ lease. Y is

a property provider because Y is obligated to make the property

available to Z. S is an assuming party because in the January 1,

2002, transaction, S assumes Y's obligations under the YZ lease to

make the property available for the remaining four years of the

lease. The transaction is an obligation-shifting transaction because

S is an assuming party and Y has already received amounts allocable

to periods after the transaction (Y sold to F the right to receive

rent payments under the YZ lease for 2002 through 2005).

(iii) Recharacterization. As of January 1, 2002, the transaction

is recharacterized as follows:

(A) Under the constant rental accrual method described in

Sec. 1.467-3(d), the amount accruing for each calendar year period

under the YZ lease is $946,396.31, based on the $800,000 Y received

from Z on December 31, 2001, and the $3,146,345.27 Y received from F

on December 31, 2001. S is treated as acquiring the right to receive

the amounts allocable to the four periods after the obligation-

shifting transaction. Thus, S must recognize $946,396.31 of rental

income for each of the four periods following the obligation-

shifting transaction.

(B) The principal balance of the section 7701(l) note equals

$2,999,948.96, with a yield equal to 10 percent based on annual

compounding. As part of the obligation-shifting transaction, S is

treated as having given Y the section 7701(l) note as additional

consideration. The amount of the section 7701(l) note is treated as

``other property'' transferred from S to Y in the section 351

exchange. S is treated as making section 7701(l) note payments to Y.

Y has interest income on the section 7701(l) note. S has interest

expense on the section 7701(l) note. S and Y account for the section

7701(l) note as follows:

Section 7701(l) Note

----------------------------------------------------------------------------------------------------------------

Beginning

Taxable year ending balance Payment Interest Principal

----------------------------------------------------------------------------------------------------------------

12/31/02........................................ $2,999,948.96 $946,396.31 $299,994.90 $646,401.41

12/31/03........................................ 2,353,547.55 946,396.31 235,354.75 711,041.56

12/31/04........................................ 1,642,505.99 946,396.31 164,250.60 782,145.71

12/31/05........................................ 860,360.28 946,396.31 86,036.03 860,360.28

----------------------------------------------------------------------------------------------------------------

(C) At the time of the obligation-shifting transaction, the

principal balance of the section 467 loan that would have existed if

Y had reported all items of income and expense by applying the

constant rental accrual method equals negative $2,999,948.96. Thus,

in computing its income on the consummation of the obligation-

shifting transaction, Y must take into account an expense equal to

$2,999,948.96.

(D) At the time of the obligation-shifting transaction, the

principal balance of the section 7701(l) rent-leveling loan equals

negative $2,999,948.96. Y must account for the section 7701(l) rent-

leveling loan as follows:

[[Page 68183]]

Section 7701(l) Rent-Leveling Loan

----------------------------------------------------------------------------------------------------------------

Beginning

Taxable year ending balance Payment Interest Principal

----------------------------------------------------------------------------------------------------------------

12/31/02....................................... ($2,999,948.96) ($946,396.31) ($299,994.90) ($646,401.41)

12/31/03....................................... (2,353,547.55) (946,396.31) (235,354.75) (711,041.56)

12/31/04....................................... (1,642,505.99) (946,396.31) (164,250.60) (782,145.71)

12/31/05....................................... (860,360.28) (946,396.31) (86,036.03) (860,360.28)

----------------------------------------------------------------------------------------------------------------

Example 3. Rents already received; sale of a partnership

interest--(i) Facts. (A) On January 1, 2001, A, B, and C form

partnership PRS by contributing $3,600,000, $396,000, and $4,000,

respectively, for proportionate interests (90.0 percent, 9.9

percent, and 0.1 percent, respectively) in the capital and profits

of PRS. On the same day, PRS purchases property for $4,000,000 and

leases the property to X for a five-year period. The lease provides

for rent payable on December 31 of each year as follows: $800,000 in

2001, $900,000 in 2002, $1,000,000 in 2003, $1,100,000 in 2004, and

$1,200,000 in 2005.

(B) On December 31, 2001, PRS sells to F the right to receive

all rents from X for 2002 through 2005. F pays PRS $3,146,345.27.

PRS treats the $3,146,345.27 as ordinary income allocated

$2,831,710.74 to A, $311,488.18 to B, and $3,146.35 to C. One

hundred ten percent of the applicable Federal rate based on annual

compounding is 10 percent.

(C) Immediately following the sale of the rents, A sells its

entire partnership interest to D based on the fair market value of

90 percent of PRS's assets. PRS does not have an election in effect

under section 754.

(ii) Obligation-shifting transaction. X is a property user

because X has the right to use the property under the lease with

PRS. A is a property provider as to its share of the partnership's

obligations under the lease to make the property available to X. D

is an assuming party because D acquires A's partnership interest

subject to A's share of the partnership's obligations under the

lease with X to make the property available for the remaining four

years of the agreement. The transaction is an obligation-shifting

transaction because D is an assuming party and A has already

received income allocable to periods after the transaction (A

received allocations of income from the sale of the right to receive

rents under the lease in 2002 through 2005). Thus, D is treated as

assuming 90 percent of the partnership's obligations under the

lease.

(iii) Recharacterization. As of January 1, 2002, the transaction

is recharacterized as follows:

(A) Under the constant rental accrual method described in

Sec. 1.467-3(d), the amount accruing for each calendar year period

under the lease is $946,396.31, based on the $800,000 PRS received

from X and the $3,146,345.27 PRS received from F. A's share of the

amount payable in each calendar year period under the lease is

$851,756.68 (90 percent of $946,396.31). D is treated as acquiring

the right to A's 90 percent share of the amounts allocable to the

four periods after the obligation-shifting transaction. Thus, D must

recognize $851,756.68 of rental income for each of the four periods

following the obligation-shifting transaction.

(B) The principal balance of the section 7701(l) note equals

$2,699,954.06, with a yield equal to 10 percent based on annual

compounding. As part of the obligation-shifting transaction, D is

treated as having given A the section 7701(l) note as additional

consideration. D is treated as making section 7701(l) note payments

to A. A has interest income on the section 7701(l) note. D has

interest expense on the section 7701(l) note. A and D account for

the section 7701(l) note as follows:

Section 7701(l) Note

----------------------------------------------------------------------------------------------------------------

Taxable year ending Beginning balance Payment Interest Principal

----------------------------------------------------------------------------------------------------------------

12/31/02........................ $2,699,954.06 $851,756.68 $269,995.41 $581,761.27

12/31/03........................ 2,118,192.79 851,756.68 211,819.28 639,937.40

12/31/04........................ 1,478,255.39 851,756.68 147,825.54 703,931.14

12/31/05........................ 774,324.25 851,756.68 77,432.42 774,324.26

----------------------------------------------------------------------------------------------------------------

(C) At the time of the obligation-shifting transaction, the

principal balance of the section 467 loan that would have existed if

PRS had reported all items of income and expense by applying the

constant rental accrual method equals negative $2,999,948.96. Thus,

in computing its income on the consummation of the obligation-

shifting transaction, A must take into account an expense equal to

$2,699,954.06 (90 percent of $2,999,948.96).

(D) At the time of the obligation shifting transaction, the

principal balance of the section 7701(l) rent-leveling loan equals

negative $2,699,954.06. A must account for the section 7701(l) rent-

leveling loan as follows:

Section 7701(l) Rent-leveling Loan

----------------------------------------------------------------------------------------------------------------

Taxable year ending Beginning balance Payment Interest Principal

----------------------------------------------------------------------------------------------------------------

12/31/02........................ ($2,699,954.06) ($851,756.68) ($269,995.41) ($581,761.27)

12/31/03........................ (2,118,192.79) (851,756.68) (211,819.28) (639,937.40)

12/31/04........................ (1,478,255.39) (851,756.68) (147,825.54) (703,931.14)

12/31/05........................ (774,324.25) (851,756.68) (77,432.42) (774,324.26)

----------------------------------------------------------------------------------------------------------------

Example 4. Exception where aggregate amounts retained or already

received are less than or equal to $100,000; section 351 transfer--

(i) Facts. (A) On January 1, 2001, A leases property to B for a

five-year period. The lease provides for rent of $1,000,000 for

2001, and $875,000 for the each of the remaining four years of the

lease. Rent is payable annually on December 31.

(B) On January 1, 2002, A transfers the leased property along

with the right to receive rent payments for 2002 through 2005 to D

in exchange for D preferred stock. As part of the same transaction,

C transfers $1,000,000 to D in exchange for D common stock. After

the transaction, A and C own 100 percent of the stock of D. Assume

that the transaction meets all of the requirements of

[[Page 68184]]

section 351. C and D are members of the same consolidated group as

described in Sec. 1.1502-1(h). Assume that A, C, and D did not enter

into the transaction with a principal purpose of substantially

reducing the present value of their aggregate tax liabilities. One

hundred ten percent of the applicable Federal rate based on annual

compounding is 7 percent.

(ii) Obligation-shifting transaction. A is a property provider

because it is obligated to make property available to B on account

of a lease or similar agreement. B is a property user because it has

the right to use property under its lease with A. D is an assuming

party because, in the January 1, 2002, transaction, it acquires the

property subject to A's obligation to make the property available to

B for the remaining term of the lease. The transaction between A and

D is an obligation-shifting transaction because D is an assuming

party and A retains the right to receive amounts from B allocable to

periods after the transaction.

(iii) Availability of exception. Even though the transaction

between A and D is an obligation-shifting transaction, it is not

recharacterized under this section. As of the date of the

transaction, A has already received $1,000,000. Under the constant

rental accrual method described in Sec. 1.467-3(d), the constant

rental amount accruing for each calendar year during the lease is

$903,491.90. The aggregate amount that has already been received by

A but that is allocable to periods after the obligation-shifting

transaction is $1,000,000 minus $903,491.90, or $96,508.10. Because

this amount is less than $100,000, the transaction is excepted from

recharacterization under paragraph (c)(1)(i) of this section.

Example 5. Exception where fair market value of leased property

is less than 10 percent of value of all property transferred;

incorporation of existing business--(i) Facts. (A) On January 1,

2001, A leases property to B for a five-year period. The lease

provides for rent of $1,000,000 per year, payable annually on

December 31.

(B) On January 1, 2003, the fair market value of the leased

property is $4,000,000. On that date, A transfers the property,

together with $3,000,000 of Class I and Class II assets and other

property with a fair market value of $39,000,000, in exchange for

all of the common stock of C. A retains the right to receive the

remaining three rent payments from B. The fair market value of the

rent payments retained by A is $2,486,851.99 (based on a discount

rate of 10 percent). The fair market value of the property subject

to the lease and transferred to B, reflecting A's retention of the

right to the remaining three rent payments, is $1,513,148.01. Assume

that the transaction meets all of the requirements of section 351.

Assume that A and C did not enter into the transaction with a

principal purpose of substantially reducing the present value of

their aggregate tax liabilities.

(ii) Obligation-shifting transaction. A is a property provider

because it is obligated to make property available to B on account

of a lease or similar agreement. B is a property user because it has

the right to use property under its lease with A. C is an assuming

party because, in the January 1, 2003, transaction, it acquires the

property subject to A's obligation to make the property available to

B for the remaining three years of the lease. The transaction

between A and C is an obligation-shifting transaction because C is

an assuming party and A retains the right to receive amounts from B

allocable to periods after the transaction.

(iii) Availability of exception. Even though the transaction

between A and C is an obligation-shifting transaction, it is not

recharacterized under this section. The fair market value of the

leased property equals $4,000,000. The fair market value of the

property subject to the lease and transferred to B is $1,513,148.01,

and the fair market value of the rents retained is $2,486,851.99.

The aggregate fair market value of all of the property transferred,

excluding Class I assets, Class II assets, and debt issued by the

property provider, as part of the same transaction is $43,000,000

($4,000,000 leased property plus $39,000,000 other property,

excluding Class I assets, Class II assets, and debt issued by the

property provider). Because the value of the leased property,

$4,000,000, is less than 10 percent of $43,000,000, the transaction

is excepted from recharacterization under paragraph (c)(1)(iii) of

this section.

(n) Effective date. This section applies to obligation-shifting

transactions any significant element of which was entered into or

undertaken on or after October 13, 1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-32670 Filed 12-26-96; 8:45 am]

BILLING CODE 4830-01-P