# Treatment of Obligation-Shifting Transactions

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## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** December 27, 1996
- **Citation:** 61 FR 68175

## Text

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.
---------------------------------------------------------------------------

\3\ This section appears in proposed regulation published on
June 3, 1996 (IA-292-84, 61 FR 27834, 27845).
---------------------------------------------------------------------------

(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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A96-32670. Public record. Not legal advice.