Recharacterizing Financing Arrangements Involving Fast-pay Stock

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104072-97]

RIN 1545-AV07

Recharacterizing Financing Arrangements Involving Fast-pay Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations that

recharacterize, for tax purposes, financing arrangements involving

fast-pay stock. The regulations are necessary to prevent taxpayers from

using fast-pay stock to achieve inappropriate tax avoidance. The

regulations affect corporations that issue fast-pay stock, holders of

fast-pay stock, and other shareholders that may claim tax benefits

purported to result from arrangements involving fast-pay stock. This

document also provides notice of a public hearing on the proposed

regulations.

DATES: Written and electronic comments must be received by April 6,

1999. Outlines of topics to be discussed at the public hearing

scheduled for April 8, 1999, at 10 a.m. must be received by March 18,

1999.

ADDRESSES: Send submissions: to CC:DOM:CORP:R (REG-104072-97), room

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

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

104072-97), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

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

IRS Home Page or by submitting them directly to the IRS Internet site

at http://www.irs.ustreas.gov/prod/tax__regs/comments.html. The public

hearing will be held in room 2615, 1111 Constitution Avenue, NW.,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Jonathan Zelnik at (202) 622-3940; concerning submissions of comments,

the hearing, and/or to be placed on the building access list to attend

the hearing, LaNita VanDyke at (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

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

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

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

Department of the Treasury, Office of Information and Regulatory

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

Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC

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

March 8, 1999. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the collection will have a practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

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

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

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

maintenance, and purchase of services to provide information.

The collection of information is in Sec. 1.7701(l)-3(f) and

Sec. 1.7701(l)-3(g). The collection of information is mandatory. The

likely respondents are individuals, businesses, and other

organizations.

Estimated total annual burden: 50 hours

Estimated average annual burden per respondent: 1 hour

Estimated number of respondents: 50

Estimated annual frequency of responses: Annually

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

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

information displays a valid control number assigned by the Office of

Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

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

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

Background

On February 27, 1997, the IRS issued Notice 97-21, 1997-1 C.B. 407,

which relates to financing arrangements involving fast-pay stock. Among

other things, the notice informs the public that the IRS and Treasury

Department expect to issue regulations recharacterizing these

arrangements to prevent tax avoidance. Notice 97-21 requested comments,

but none have been received.

Explanation of Provisions

A. Tax-Avoidance Arrangements Using Fast-Pay Stock

Notice 97-21 addresses two-party financing arrangements that are

structured as multi-party arrangements to let one or more of the

parties avoid tax. Instead of one party directly providing financing to

the other, they both acquire stock (with different characteristics) in

a conduit entity. The arrangement is structured so that the party

providing the financing has a decreasing claim on the conduit entity

[[Page 806]]

(and its assets) while the party receiving the financing has an

increasing claim on the conduit entity (and its assets). Economically,

both parties benefit from the conduit entity's income. For tax

purposes, however, the entity's income is allocated almost entirely to

the party providing the financing, allowing the other party to claim

unwarranted tax benefits.

Notice 97-21 describes in detail a typical fast-pay stock financing

arrangement. The parties to the arrangement include: (1) a person

seeking financing (the sponsor), (2) investors who are willing to

provide financing and typically are not subject to federal income tax

(the investors), and (3) a corporation that is generally subject to tax

only at the shareholder level (a conduit entity). The conduit entity

issues a class of self-amortizing stock (the fast-pay stock) to the

investors and a class of other stock (the benefited stock) to the

sponsor. The fast-pay stock is structured so that during an initial

period, the dividends made with respect to the stock are substantial

and relatively certain while the dividends made with respect to the

benefited stock are insignificant. After the initial period, the

dividend rate of the fast-pay stock, the stock's effective redemption

value, or both, decline.

Economically, the fast-pay stock is self-amortizing because the

distributions made with respect to the fast-pay stock are in part a

return on the investors' investment and in part a return of their

investment. For tax purposes, however, the parties characterize the

fast-pay stock distributions entirely as dividends (that is, entirely

as a return on the investment). Consequently, the investors' reported

taxable income -- overstated dividend income followed by an overstated

capital loss on disposition of the fast-pay stock--fails to clearly

reflect their economic income. (Investors that are tax-exempt suffer no

disadvantage from this arrangement.)

Characterizing the distributions made with respect to the fast-pay

stock solely as dividends has the corresponding effect of understating

the taxable income on the benefited stock (the stock held by the

sponsor) during the initial period. Instead of receiving dividends

attributable to its share of the conduit entity's income, the sponsor's

economic income takes the form of an increasing ownership interest in

the conduit entity. Because the fast-pay stock is economically self-

amortizing, each distribution reduces the investors' claim on the

conduit entity (and its assets) and increases the sponsor's claim. By

treating a fast-pay arrangement according to its form, the sponsor

reports taxable income that fails to clearly reflect its economic

income. An individual sponsor, for example, reports little or no

dividend income. Instead, the individual reports gain on disposing of

its benefited stock; thus, deferring tax on its economic income and

converting that income from ordinary to capital. A corporate sponsor

not only reports little or no dividend income, but can avoid reporting

gain on the disposition of its benefited stock, thereby entirely

eliminating tax on its economic income. (If a corporate sponsor has a

sufficient interest in the conduit entity, the sponsor may succeed to

the conduit entity's assets tax-free by liquidating or reorganizing the

conduit entity; thus, avoiding a taxable disposition of the benefited

stock).

In substance, the investors (the fast-pay shareholders) are

financing the sponsor's investment in the conduit entity. Although

nominally shareholders in the conduit entity, the investors have a

limited, diminishing claim to the entity (and its assets). The

sponsor's claim, by contrast, is residual and long-term. Thus, a fast-

pay arrangement is effectively a leveraged arrangement in which the

sponsor uses untaxed income from the conduit entity to repay the

investors.

B. The Proposed Regulations

1. In General

To prevent the avoidance of tax, the Secretary may issue

regulations under section 7701(l) recharacterizing any multiple-party

financing transaction as a transaction directly among any two or more

of the parties. The proposed regulations exercise this authority by

recharacterizing certain fast-pay arrangements. A fast-pay arrangement

is any financing arrangement in which a corporation has outstanding two

or more classes of stock, one of which is fast-pay stock. The

regulations identify fast-pay arrangements and recharacterize certain

of them as arrangements directly between the holders of the fast-pay

stock and the other shareholders (the benefited shareholders) in the

corporation. The regulations also impose reporting requirements on

certain corporations with outstanding fast-pay stock and on certain

shareholders that participate in fast-pay arrangements. These reporting

requirements apply to all fast-pay arrangements, whether or not they

are subject to recharacterization.

Notice 97-21 describes specific models for recharacterizing fast-

pay arrangements. For purposes of determining the income of the

shareholders of a corporation with outstanding fast-pay stock, these

models ignore the separate existence of the corporation and treat the

fast-pay shareholders and benefited shareholders as owning the

corporation's underlying assets. Although this approach prevents tax

avoidance, the IRS and Treasury Department have concluded that it may

not best reflect the financing relationship between the fast-pay

shareholders and the benefited shareholders. In addition, the approach

of the notice may be difficult for taxpayers to apply if the

corporation has a complex capital structure, multiple assets (including

active businesses), or both.

To address these concerns, the proposed regulations treat the fast-

pay shareholders as acquiring instruments issued by the benefited

shareholders instead of acquiring interests in the assets of the

corporation. This approach better reflects the financing relationship

between the fast-pay shareholders and the benefited shareholders. It

also removes the burden of determining each party's ownership interest

in the assets of the corporation. Thus, the regulations provide an

approach that is easier to apply and more narrowly tailored than the

models described in Notice 97-21.

2. Fast-Pay Stock and Benefited Stock

Under the proposed regulations, stock is fast-pay stock if it is

structured to provide for dividends that economically represent a

return (in whole or in part) of the holder's investment rather than

only a return on the holder's investment. Stock is presumed to be fast-

pay stock if it has, by design, a dividend rate that is reasonably

expected to decline, or an issue price that exceeds the amount at which

the holder can be compelled to dispose of the stock. A taxpayer may

rebut these presumptions only by clearly showing that no dividend

represents an economic return (in whole or in part) of the holder's

investment.

Generally, whether stock is fast-pay stock must be determined based

on all the facts and circumstances, including any related agreements

such as options or forward contracts. A related agreement is any direct

or indirect, oral or written, agreement between the holder of the stock

and the issuing corporation, or between the holder of the stock and one

or more other shareholders in the corporation. The determination that

stock is fast-pay stock is made when the stock is issued, and whenever

there is a significant modification in the terms of the stock or the

related agreements, or a significant change in the relevant facts and

circumstances.

[[Page 807]]

The proposed regulations define benefited stock by reference to

fast-pay stock. With respect to a class of fast-pay stock, all other

stock in the corporation (including any other class of fast-pay stock)

is benefited stock. For fast-pay arrangements in which there is more

than one class of benefited stock, the parties must apply the general

recharacterization rules among the different classes as appropriate to

match the arrangement's economic substance.

3. Fast-Pay Arrangements Subject to Recharacterization

Under the proposed regulations, if the corporation with outstanding

fast-pay stock is either a regulated investment company (RIC) or a real

estate investment trust (REIT), the fast-pay arrangement is

automatically recharacterized. If the corporation is neither a RIC nor

a REIT, the Commissioner may (at the Commissioner's discretion)

recharacterize the fast-pay arrangement in cases where the Commissioner

determines that a principal purpose for the structure of the fast-pay

arrangement is the avoidance of tax. This rule applies to all parties

to a fast-pay arrangement, without regard to whether such parties

acquired their interests as part of an initial offering or later (by

purchase or other transfer).

By not automatically recharacterizing all fast-pay arrangements,

the regulations prevent taxpayers from using the recharacterization

rules for other tax avoidance purposes. For example, shareholders of a

controlled foreign corporation cannot circumvent the purposes of United

States tax law (including treaties) by using the recharacterization

rules to exploit inconsistencies between the treatment of a fast-pay

arrangement by the United States and foreign jurisdictions. It is

expected that the Commissioner will closely scrutinize fast-pay

arrangements in which the corporation with outstanding fast-pay stock

is a foreign corporation.

4. Model for Recharacterizing Fast-Pay Arrangements

a. In General

The proposed regulations treat the fast-pay shareholders as holding

financing instruments issued by the benefited shareholders rather than

as holding fast-pay stock in the corporation. The corporation is the

paying agent on the financing instruments but has no other relationship

to the fast-pay shareholders.

Under the proposed regulations, the financing instruments have the

same payment terms as the fast-pay stock. The timing and amount of

payments made with respect to the financing instruments, therefore,

match the timing and amount of distributions made with respect to the

fast-pay stock. Nothing in the regulations characterizes the financing

instruments. The character of the financing instruments (for example,

stock or debt) must be determined under general tax principles and

depends on all the facts and circumstances.

The benefited shareholders are treated as first issuing the

financing instruments in exchange for cash equal to the fair market

value of the fast-pay stock (taking into account any related

agreements), and then as contributing the cash to the corporation

(thereby increasing their basis in the benefited stock). Distributions

made with respect to the fast-pay stock are treated as first made with

respect to the benefited stock, and then as used by the benefited

shareholders to make payments on the financing instruments.

b. Rule for Multiple Classes of Benefited Stock

The proposed regulations do not describe detailed rules for fast-

pay arrangements in which there is more than one class of benefited

shareholders. Instead, as mentioned before, the regulations provide a

general rule that requires recharacterization among the different

classes as appropriate to match the economic substance of the fast-pay

arrangement.

c. Rules for Disposition of Benefited Stock

The proposed regulations provide special rules for dispositions of

benefited stock. On the sale of benefited stock, in addition to any

consideration actually received, the seller is treated as receiving the

amount necessary to terminate its position with respect to the

financing instruments at fair market value. Similarly, the buyer is

treated as paying that amount and as issuing new financing instruments

to the fast-pay shareholders.

d. Rule Preserving Pre-effective Date Gain

The proposed regulations provide a special basis adjustment rule to

ensure that unrealized gain on benefited stock is not inappropriately

eliminated. Because the regulations do not apply to amounts accrued or

paid in taxable years ending before February 27, 1997 (pre-effective

years), a benefited shareholder will have economic income, but not

taxable income, attributable to pre-effective years if the form of a

fast-pay arrangement is respected for those years. This economic income

is reflected as unrealized gain in the benefited stock.

Absent a special basis adjustment rule, the general

recharacterization rule would eliminate this unrealized gain. Although

the regulations do not apply to amounts accrued or paid in pre-

effective years, the regulations recharacterize fast-pay arrangements

from their inception. Thus, in cases in which the fast-pay arrangement

was entered into in a pre-effective year, the general

recharacterization rule increases a benefited shareholder's basis in

its stock as of the inception of the transaction, even though the

regulations do not require the benefited shareholder to include deemed

dividend distributions attributable to the pre-effective years.

Consequently, this increase in basis without corresponding dividend

income eliminates the unrealized gain from the pre-effective years.

To preserve the unrealized gain resulting from the economic income

attributable to pre-effective years, the proposed regulations provide a

special basis adjustment rule. After taking into account any basis

increase under the general rule, a benefited shareholder must decrease

its basis in its benefited stock by the amount (if any) that (1) its

taxable income attributable to the fast-pay arrangement for pre-

effective years, computed by recharacterizing the fast-pay arrangement

under the regulations, exceeds (2) its taxable income attributable to

the fast-pay arrangement for pre-effective years, computed without

applying the recharacterization rules of the regulations. In this way,

a benefited shareholder's economic income attributable to taxable years

before the effective date of the regulations is not eliminated by the

basis provisions of the general recharacterization rules and may be

realized when the benefited shareholder disposes of its benefited

stock.

e. Rule Prohibiting the Affirmative Use of These Regulations To Avoid

Tax Imposed by the Code

The proposed regulations prohibit a taxpayer from affirmatively

using the automatic recharacterization rules if a principal purpose for

using such rules is the avoidance of any tax imposed by the Code. With

respect to such a taxpayer, the Commissioner may depart from the

automatic recharacterization rules and treat (for all purposes of the

Code) the fast-pay arrangement in accordance with its form or its

economic substance. This anti-abuse rule applies on a taxpayer-by-

[[Page 808]]

taxpayer basis. For example, if a foreign person acquires fast-pay

stock in a REIT and a principal purpose for acquiring such stock is to

reduce United States withholding taxes by applying the automatic

recharacterization rules, the Commissioner may, for purposes of

determining the foreign person's United States tax consequences

(namely, withholding tax), depart from the automatic recharacterization

rules and treat the foreign person as holding fast-pay stock in the

REIT.

5. Withholding

A corporation that issues fast-pay stock is a withholding agent for

payments made (or deemed made) under a fast-pay arrangement. Generally,

if a fast-pay arrangement is recharacterized under the automatic

recharacterization rules, a withholding agent must withhold in

accordance with the transaction as recharacterized. A different rule

applies, however, if the withholding agent knows or has reason to know

that any taxpayer entered into the fast-pay arrangement with a

principal purpose of using the recharacterization rules to avoid tax

under section 871(a) or section 881. In that case, for each payment

made (or deemed made) to such taxpayer under the arrangement, the

withholding agent must withhold under section 1441 or section 1442 the

higher of (1) the amount of withholding that applies to such payment

determined under the form of the arrangement, or (2) the amount of

withholding that applies to such payment determined under the automatic

recharacterization rules. Also, when the withholding agent knows or has

reason to know that the Commissioner has exercised the discretion to

depart from the automatic recharacterization rules for a taxpayer, the

withholding agent must withhold on payments made (or deemed made) to

that taxpayer in accordance with the characterization of the fast-pay

arrangement imposed by the Commissioner.

The withholding agent's liability to withhold on payments to

foreign individuals is described in new proposed Sec. 1.1441-7(g). The

same rules apply to payments (or deemed payments) to foreign

corporations under Sec. 1.1442-1.

6. Reporting Requirements

In general, a corporation that has fast-pay stock outstanding at

any time during the taxable year must attach a statement to its federal

income tax return. This rule does not apply to a corporation that is a

controlled foreign corporation (CFC) as defined in section 957, a

foreign personal holding company (FPHC) as defined in section 552, or a

passive foreign investment company (PFIC) as defined in section 1297.

Instead, certain shareholders (and officers and directors of FPHCs) of

those corporations must attach a statement to their returns.

The statement must identify the corporation that has outstanding

fast-pay stock and must recite the terms of the fast-pay stock and the

date on which the fast-pay stock was issued. In addition, to the extent

the filing person knows or has reason to know such information, the

statement must contain the names and the taxpayer identification

numbers of the shareholders of any class of stock that is not traded on

an established securities market as described in Sec. 1.7704-1(b).

7. Election To Limit Taxable Income Attributable to a Recharacterized

Fast-Pay Arrangement for Taxable Years Ending After February 26, 1997,

and Before the Date These Regulations Are Published as Final

Regulations in the Federal Register

The regulations are proposed to be effective February 27, 1997, and

to cover all taxable years ending after February 26, 1997. Thus, the

regulations will apply to all amounts accrued or paid on or after the

first day of the first taxable year ending after February 26, 1997.

Because the proposed effective date relates to the date Notice 97-

21 was issued to the public, and because the regulations adopt

different recharacterization rules from the ones described in the

notice, the regulations permit a shareholder of a recharacterized fast-

pay arrangement to limit its taxable income attributable to the

arrangement for certain taxable years. Specifically, for taxable years

ending after February 26, 1997, and before the date these regulations

are finalized, a shareholder may limit its taxable income attributable

to a fast-pay arrangement recharacterized under the regulations, to the

taxable income that would result if the fast-pay arrangement were

recharacterized under Notice 97-21. Any amount excluded under the limit

must be included as an adjustment to taxable income in the

shareholder's first taxable year that includes the date the regulations

are finalized. Under the regulations, a shareholder that has elected to

apply the limit must include a statement in its books and records

identifying each fast-pay arrangement for which the election was made,

and the amount excluded from taxable income under the election for each

fast-pay arrangement.

Shareholders who take advantage of the limit enjoy only a deferral

of taxable income: Any amount excluded under the limit is later

included as an adjustment. Thus, the sole benefit of making the

election is a timing difference. This result is appropriate because

over the life of a fast-pay arrangement a shareholder has the same

amount of taxable income whether the fast-pay arrangement is

recharacterized under Notice 97-21 or under the regulations. The IRS

and Treasury Department invite comments concerning the limit and

whether there are fast-pay arrangements in which any difference between

a shareholder's taxable income determined under Notice 97-21 and the

shareholder's taxable income determined under the regulations is other

than a timing difference.

Notice 97-21 describes two types of fast-pay arrangements. Hence,

calculating the limit requires appropriately recharacterizing the fast-

pay arrangement under the notice. In the first type of fast-pay

arrangement that the notice describes, the corporation with outstanding

fast-pay stock holds income-producing assets issued by a third party.

Notice 97-21 treats the benefited shareholders (one of which is called

the ``sponsor'' in the notice) as acquiring the assets of the

corporation directly from the sellers of those assets. The notice

treats the fast-pay shareholders (called ``investors'' in the notice)

as acquiring the assets of the corporation either from the sellers of

those assets or from the benefited shareholders in an income

``stripping'' transaction. Thus, both the fast-pay shareholders and

benefited shareholders are regarded as owning directly the

corporation's assets.

In the second type of fast-pay arrangement that Notice 97-21

describes, the corporation with outstanding fast-pay stock holds a debt

instrument issued by the sponsor (a benefited shareholder). In this

situation, the notice treats the sponsor as having issued one or more

instruments directly to the holders of the fast-pay stock. Thus, for

purposes of determining the sponsor's taxable income, the sponsor's

obligation under any asset held by the corporation is ignored.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It is hereby certified that

these regulations will not have a significant economic impact on a

substantial number of small entities.

[[Page 809]]

This certification is based on the understanding of the IRS and

Treasury Department that the total number of fast-pay arrangements is

fewer than 100, that the number of entities engaging in transactions

affected by these regulations is not substantial and, of those

entities, few or none are small entities within the meaning of the

Regulatory Flexibility Act (5 U.S.C. chapter 6). Therefore, a

Regulatory Flexibility Analysis is not required. Pursuant to section

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

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

Small Business Administration for comments on its impact on small

businesses.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any electronic and written comments (a

signed original and eight (8) copies) that are submitted timely to the

IRS. All comments will be available for public inspection and copying.

The IRS and Treasury Department specifically request comments on the

clarity of the proposed rule and how it may be made easier to

understand.

A public hearing has been scheduled for April 8, 1999, beginning at

10 a.m. in room 2615 of the Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

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

wish to present oral comments at the hearing must submit written or

electronic comments by April 6, 1999 and submit an outline of the

topics to be discussed and the time to be devoted to each topic (a

signed original and eight (8) copies) by March 18, 1999.

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

comments.

An agenda showing the scheduling of the speakers will be prepared

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

agenda will be available free of charge at the hearing.

Proposed Effective Date

These regulations are proposed to be effective February 27, 1997,

and apply to taxable years ending after February 26, 1997. Thus, all

amounts accrued or paid on or after the first day of the first taxable

year ending after February 26, 1997, will be subject to the

regulations, regardless of when a particular share of the stock or a

particular debt instrument was issued.

The statement required under Sec. 1.7701(l)-3(f) is proposed to

apply to taxable years (of the taxpayer required to file the statement)

ending after the date the regulations are published as final

regulations in the Federal Register.

Drafting Information

The principal authors of these regulations are Jonathan Zelnik and

Marshall Feiring of the Office of the Assistant Chief Counsel

(Financial Institutions & Products). However, other personnel from the

IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

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

an entry in numerical order to read as follows:

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

Section 1.7701(l)-3 also issued under 26 U.S.C. 7701(l). * * *

Par. 2. Section 1.1441-7 is amended as follows:

1. Paragraph (g) is redesignated as paragraph (h) and revised.

2. New paragraph (g) is added.

The addition and revision read as follows:

Sec. 1.1441-7 General provisions relating to withholding agents.

* * * * *

(g) Fast-pay arrangements--(1) In general. A corporation that

issues fast-pay stock in a fast-pay arrangement described in

Sec. 1.7701(l)-3(b)(1) is a withholding agent with respect to fast-pay

dividends paid under the arrangement and any deemed payments with

respect to the arrangement under the recharacterization rules of

Sec. 1.7701(l)-3(c). Except as provided in this paragraph (g)(1) or in

paragraph (g)(2) of this section, the withholding tax rules under

section 1441 and section 1442 apply with respect to a fast-pay

arrangement described in Sec. 1.7701(l)-3(c)(1)(i) in accordance with

the recharacterization rules provided in Sec. 1.7701(l)-3(c). In all

cases, notwithstanding paragraph (g)(2) of this section, if at any time

the withholding agent knows or has reason to know that the Commissioner

has exercised the discretion under Sec. 1.7701(l)-3(d) to depart from

the recharacterization rules of Sec. 1.7701(l)-3(c) for a taxpayer, the

withholding agent must withhold on payments made (or deemed made) to

that taxpayer in accordance with the characterization of the fast-pay

arrangement imposed by the Commissioner under Sec. 1.7701(l)-3(d).

(2) Exception. If at any time the withholding agent knows or has

reason to know that any taxpayer entered into a fast-pay arrangement

with a principal purpose of applying the recharacterization rules of

Sec. 1.7701(l)-3(c) to avoid tax under section 871(a) or section 881,

then for each payment made or deemed made to such taxpayer under the

arrangement, the withholding agent must withhold, under section 1441 or

section 1442, the higher of--

(i) The amount of withholding that would apply to such payment

determined under the form of the arrangement; or

(ii) The amount of withholding that would apply to deemed payments

determined under the recharacterization rules of Sec. 1.7701(l)-3(c).

(3) Liability. Any person required to deduct and withhold tax under

this paragraph (g) is made liable for that tax by section 1461, and is

also liable for applicable penalties and interest for failing to comply

with section 1461.

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

paragraph (g):

Example 1. REIT W issues shares of fast-pay stock to foreign

individual A, a resident of Country C. United States source

dividends paid to residents of C are subject to a 30 percent

withholding tax. W issues all shares of benefited stock to foreign

individuals who are residents of Country D. D's income tax

convention with the United States reduces the United States

withholding tax on dividends to 15 percent. Under Sec. 1.7701(l)-

3(c), the dividends paid by W to A are deemed to be paid by W to the

benefited shareholders. W has reason to know that A entered into the

fast-pay arrangement with a principal purpose of using the

recharacterization rules of Sec. 1.7701(l)-3(c) to reduce United

States withholding tax. W must withhold at the 30 percent rate on

the dividends deemed paid to its benefited shareholders because the

amount of withholding that applies to such payments

[[Page 810]]

determined under the form of the arrangement is higher than the

amount of withholding that applies to such payments determined under

Sec. 1.7701(l)-3(c).

Example 2. The facts are the same as in Example 1 of this

paragraph (g)(4) except that W does not know, or have reason to

know, that A entered the arrangement with a principal purpose of

using the recharacterization rules of Sec. 1.7701(l)-3(c) to reduce

United States withholding tax. Further, the Commissioner has not

exercised the discretion under Sec. 1.7701(l)-3(d) to depart from

the recharacterization rules of Sec. 1.7701(l)-3(c). Accordingly, W

must withhold tax at a 15 percent rate on the dividends deemed paid

to the benefited shareholders.

(5) Effective date. This paragraph (g) applies to payments made (or

deemed made) on or after January 6, 1999.

(h) Effective date. Except as otherwise provided in paragraph

(f)(3) or (g)(5) of this section, this section applies to payments made

after December 31, 1999.

Par. 3. Section 1.7701(l)-3 is added to read as follows:

Sec. 1.7701(l)-3 Recharacterizing financing arrangements involving

fast-pay stock.

(a) Purpose and scope. This section is intended to prevent the

avoidance of tax by persons participating in fast-pay arrangements (as

defined in paragraph (b)(1) of this section) and should be interpreted

in a manner consistent with this purpose. This section applies to all

fast-pay arrangements. Paragraph (c) of this section recharacterizes

certain fast-pay arrangements to ensure the participants are taxed in a

manner reflecting the economic substance of the arrangements. Paragraph

(f) of this section imposes reporting requirements on certain

participants.

(b) Definitions--(1) Fast-pay arrangement. A fast-pay arrangement

is any arrangement in which a corporation has outstanding for any part

of its taxable year two or more classes of stock, at least one of which

is fast-pay stock.

(2) Fast-pay stock--(i) Defined. Stock is fast-pay stock if it is

structured so that dividends (as defined in section 316) paid by the

corporation with respect to the stock are economically (in whole or in

part) a return of the holder's investment (as opposed to only a return

on the holder's investment). Unless clearly demonstrated otherwise,

stock is presumed to be fast-pay stock if--

(A) It is structured to have a dividend rate that is reasonably

expected to decline (as opposed to a dividend rate that is reasonably

expected to fluctuate or remain constant); or

(B) It is issued for an amount that exceeds (by more than a de

minimis amount, as determined under the principles of Sec. 1.1273-1(d))

the amount at which the holder can be compelled to dispose of the

stock.

(ii) Determination. The determination of whether stock is fast-pay

stock is based on all the facts and circumstances, including any

related agreements such as options or forward contracts. A related

agreement is any direct or indirect agreement or understanding, oral or

written, between the holder of the stock and the issuing corporation,

or between the holder of the stock and one or more other shareholders

in the corporation. The determination is made when the stock is issued

and whenever there is a significant modification in the terms of the

stock or the related agreements, or a significant change in the

relevant facts and circumstances.

(3) Benefited stock defined. With respect to a class of fast-pay

stock, all other stock in the corporation (including any other class of

fast-pay stock) is benefited stock.

(c) Recharacterization of certain fast-pay arrangements--(1) Scope.

This paragraph (c) applies to any fast-pay arrangement--

(i) In which the corporation that has outstanding fast-pay stock is

a regulated investment company (RIC) (as defined in section 851) or a

real estate investment trust (REIT) (as defined in section 856); or

(ii) If the Commissioner determines that a principal purpose for

the structure of the fast-pay arrangement is the avoidance of any tax

imposed by the Code. Application of this paragraph (c)(1)(ii) is at the

Commissioner's discretion, and a determination under this paragraph

(c)(1)(ii) applies to all parties to the fast-pay arrangement,

including transferees.

(2) Recharacterization. A fast-pay arrangement described in

paragraph (c)(1) of this section is recharacterized as an arrangement

directly between the benefited shareholders and the fast-pay

shareholders. The inception and resulting relationships of the

recharacterized arrangement are deemed to be as follows:

(i) Relationship between benefited shareholders and fast-pay

shareholders. The benefited shareholders issue financial instruments

(the financing instruments) directly to the fast-pay shareholders in

exchange for cash equal to the fair market value of the fast-pay stock

at the time of issuance (taking into account any related agreements).

The financing instruments have the same payment terms as the fast-pay

stock. Thus, the timing and amount of the payments made with respect to

the financing instruments always match the timing and amount of the

distributions made with respect to the fast-pay stock.

(ii) Relationship between benefited shareholders and corporation.

The benefited shareholders contribute to the corporation the cash they

receive for issuing the financing instruments. Distributions made with

respect to the fast-pay stock are distributions made by the corporation

with respect to the benefited shareholders' benefited stock.

(iii) Relationship between fast-pay shareholders and corporation.

For purposes of determining the relationship between the fast-pay

shareholders and the corporation, the fast-pay stock is ignored. The

corporation is the paying agent of the benefited shareholders with

respect to the financing instruments.

(3) Other rules--(i) Character of the financing instruments. The

character of a financing instrument (for example, stock or debt) is

determined under general tax principles and depends on all the facts

and circumstances.

(ii) Multiple classes of benefited stock. If there is more than one

class of benefited stock, the recharacterization rules of this

paragraph (c) apply among the different classes as appropriate to match

the economic substance of the fast-pay arrangement.

(iii) Sale of benefited stock. If one person sells benefited stock

to another--

(A) In addition to any consideration actually paid and received for

the benefited stock, the buyer is deemed to pay and the seller is

deemed to receive the amount necessary to terminate the seller's

position in the financing instruments at fair market value; and

(B) The buyer is deemed to issue financing instruments to the fast-

pay shareholders in exchange for the amount necessary to terminate the

seller's position in the financing instruments.

(iv) Adjustment to basis for amounts accrued or paid in taxable

years ending before February 27, 1997. In the case of a fast-pay

arrangement involving amounts accrued or paid in taxable years ending

before February 27, 1997, and recharacterized under this paragraph (c),

a benefited shareholder must decrease its basis in any benefited stock

(as determined under paragraph (c)(2)(ii) of this section) by the

amount (if any) that--

(A) Its income attributable to the benefited stock (reduced by

deductions attributable to financing instruments) for taxable years

ending before February 27, 1997, computed by recharacterizing the fast-

pay arrangement this under this paragraph (c); exceeds

[[Page 811]]

(B) Its income attributable to such stock for taxable years ending

before February 27, 1997, computed without applying the rules of this

paragraph (c).

(d) Prohibition against affirmative use of recharacterization by

taxpayers. A taxpayer may not use the rules of paragraph (c) of this

section if a principal purpose for using such rules is the avoidance of

any tax imposed by the Code. Thus, with respect to such taxpayer, the

Commissioner may depart from the rules of this section and

recharacterize (for all purposes of the Code) the fast-pay arrangement

in accordance with its form or its economic substance. For example, if

a foreign person acquires fast-pay stock in a REIT and a principal

purpose for acquiring such stock is to reduce United States withholding

taxes by applying the rules of paragraph (c) of this section, the

Commissioner may, for purposes of determining the foreign person's

United States tax consequences (namely, withholding tax), depart from

the rules of paragraph (c) of this section and treat the foreign person

as holding fast-pay stock in the REIT.

(e) Examples. The following examples illustrate the rules of

paragraph (c) of this section:

Example 1. Decline in dividend rate. (i) Facts. Corporation X

issues 100 shares of A Stock and 100 shares of B Stock for $1,000

per share. By its terms, a share of B Stock is reasonably expected

to pay a $110 dividend in years 1 through 10 and a $30 dividend each

year thereafter. If X liquidates, the holder of a share of B Stock

is entitled to a preference equal to the share's issue price.

Otherwise, the B Stock cannot be redeemed at either X's or the

shareholder's option.

(ii) Analysis. When issued, the B Stock has a dividend rate that

is reasonably expected to decline from an annual rate of 11 percent

of its issue price to an annual rate of 3 percent of its issue

price. Since the B Stock is structured to have a declining dividend

rate, the B Stock is fast-pay stock, and the A Stock is benefited

stock.

Example 2. Issued at a premium. (i) Facts. The facts are the

same as in Example 1 of this paragraph (e) except that a share of B

Stock is reasonably expected to pay an annual $110 dividend as long

as it is outstanding, and Corporation X has the right to redeem the

B Stock for $400 a share at the end of year 10.

(ii) Analysis. The B Stock is structured so that the issue price

of the B Stock ($1,000) exceeds (by more than a de minimis amount)

the price at which the holder can be compelled to dispose of the

stock ($400). Thus, the B Stock is fast-pay stock, and the A Stock

is benefited stock.

Example 3. Recharacterization illustrated. (i) Facts. On

formation, REIT Y issues 100 shares of C Stock and 100 shares of D

Stock for $1,000 per share. By its terms, a share of D Stock is

reasonably expected to pay a $110 dividend in years 1 through 10 and

a $30 dividend each year thereafter. In years 1 through 10, persons

holding a majority of the D Stock must consent before Y may take any

action that would result in Y liquidating or dissolving, merging or

consolidating, losing its REIT status, or selling substantially all

of its assets. Thereafter, Y may take these actions without consent

so long as the D Stock shareholders receive $400 in exchange for

their D Stock.

(ii) Analysis. When issued, the D Stock has a dividend rate that

is reasonably expected to decline from an annual rate of 11 percent

of its issue price to an annual rate of 3 percent of its issue

price. In addition, the $1,000 issue price of a share of D Stock

exceeds the price at which the shareholder can be compelled to

dispose of the stock ($400). Thus, the D Stock is fast-pay stock,

and the C Stock is benefited stock. Because Y is a REIT, the fast-

pay arrangement is recharacterized under paragraph (c) of this

section.

(iii) Recharacterization. The fast-pay arrangement is

recharacterized as follows:

(A) Under paragraph (c)(2)(i) of this section, the C Stock

shareholders are treated as issuing financing instruments to the D

Stock shareholders in exchange for $100,000 ($1,000, the fair market

value of each share of D Stock, multiplied by 100, the number of

shares).

(B) Under paragraph (c)(2)(ii) of this section, the C Stock

shareholders are treated as contributing $200,000 to Y (the $100,000

received for the financing instruments, plus the $100,000 actually

paid for the C Stock) in exchange for the C Stock.

(C) Under paragraph (c)(2)(ii) of this section, each

distribution with respect to the D Stock is treated as a

distribution with respect to the C Stock.

(D) Under paragraph (c)(2)(iii) of this section, the C Stock

shareholders are treated as making payments with respect to the

financing instruments, and Y is treated as the paying agent of the

financing instruments for the C Stock shareholders.

Example 4. Transfer of benefited stock illustrated. (i) Facts.

The facts are the same as in Example 3 of this paragraph (e). Near

the end of year 5, a person holding one share of C Stock sells it

for $1,300. The buyer is unrelated to REIT Y or to any of the D

Stock shareholders. At the time of the sale, the amount needed to

terminate the seller's position in the financing instruments at fair

market value is $747.

(ii) Benefited shareholder's treatment on sale. Under paragraph

(c)(3)(iii)(A) of this section, the seller's amount realized is

$2,047 ($1,300, the amount actually received, plus $747, the amount

necessary to terminate the seller's position in the financing

instruments at fair market value). The seller's gain on the sale of

the common stock is $47 ($2,047, the amount realized, minus $2,000,

the seller's basis in the common stock). The seller has no income or

deduction with respect to terminating its position in the financing

instruments.

(iii) Buyer's treatment on purchase. Under paragraph

(c)(3)(iii)(A) of this section, the buyer's basis in the share of D

Stock is $2,047 ($1,300, the amount actually paid, plus $747, the

amount needed to terminate the seller's position in the financing

instruments at fair market value). Under paragraph (c)(3)(iii)(B) of

this section, simultaneous with the sale, the buyer is treated as

issuing financing instruments to the fast-pay shareholders in

exchange for $747, the amount necessary to terminate the seller's

position in the financing instruments at fair market value.

Example 5. Fast-pay arrangement involving amounts accrued or

paid in a taxable year ending before February 27, 1997. (i) Facts. Y

is a calendar year taxpayer. In June 1996, Y acquires shares of REIT

T benefited stock for $15,000. In December 1996, Y receives

dividends of $100. Under the recharacterization rules of paragraph

(c)(2) of this section, Y's 1996 income attributable to the

benefited stock is $1,200, Y's 1996 deduction attributable to

financing instruments is $500, and Y's basis in the benefited stock

is $25,000.

(ii) Analysis. Under paragraph (c)(3)(iv) of this section, Y's

basis in the benefited stock is reduced by $600. This is the amount

by which Y's 1996 income from the fast-pay arrangement as

recharacterized under this section ($1,200 of income attributable to

the benefited stock less $500 of deductions attributable to the

financing instruments), exceeds Y's 1996 income from the fast-pay

arrangement as not recharacterized under this section ($100 of

income attributable to the benefited stock). Thus, in 1997 when the

fast-pay arrangement is recharacterized, Y's basis in the benefited

stock is $24,400.

(f) Reporting requirement--(1) Filing requirements--(i) In general.

A corporation that has fast-pay stock outstanding at any time during

the taxable year must attach the statement described in paragraph

(f)(2) of this section to its federal income tax return for such

taxable year. This paragraph (f)(1)(i) does not apply to a corporation

described in paragraph (f)(1)(ii), (iii), or (iv) of this section.

(ii) Controlled foreign corporation. In the case of a controlled

foreign corporation (CFC), as defined in section 957, that has fast-pay

stock outstanding at any time during its taxable year (during which

time it was a CFC), each controlling United States shareholder (within

the meaning of Sec. 1.964-1(c)(5)) must attach the statement described

in paragraph (f)(2) of this section to the shareholder's Form 5471 for

the CFC's taxable year. The provisions of section 6038 and the

regulations under section 6038 apply to any statement required by this

paragraph (f)(1)(ii).

(iii) Foreign personal holding company. In the case of a foreign

personal holding company (FPHC), as defined in section 552, that has

fast-pay stock outstanding at any time during its taxable year (during

which time it was a FPHC), each United States citizen or resident who

is an officer, director, or 10-percent shareholder (within the meaning

of section 6035(e)(1)) of such FPHC must attach the statement described

in paragraph (f)(2) of this

[[Page 812]]

section to his or her Form 5471 for the FPHC's taxable year. The

provisions of sections 6035 and 6679 and the regulations under sections

6035 and 6679 apply to any statement required by this paragraph

(f)(1)(iii).

(iv) Passive foreign investment company. In the case of a passive

foreign investment company (PFIC), as defined in section 1297, that has

fast-pay stock outstanding at any time during its taxable year (during

which time it was a PFIC), each shareholder that has elected (under

section 1295) to treat the PFIC as a qualified electing fund and knows

or has reason to know that the PFIC has outstanding fast-pay stock must

attach the statement described in paragraph (f)(2) of this section to

the shareholder's Form 8621 for the PFIC's taxable year. Each

shareholder owning 10 percent or more of the shares of the PFIC (by

vote or value) is presumed to know that the PFIC has issued fast-pay

stock. The provisions of sections 1295(a)(2) and 1298(f) and the

regulations under sections 1295(a)(2) and 1298(f) (including

Sec. 1.1295-1T(f)(2)) apply to any statement required by this paragraph

(f)(1)(iv).

(2) Statement. The statement required under this paragraph (f) must

say, ``This fast-pay stock disclosure statement is required by

Sec. 1.7701(l)-3(f) of the income tax regulations.'' The statement must

also identify the corporation that has outstanding fast-pay stock and

must contain the date on which the fast-pay stock was issued, the terms

of the fast-pay stock, and (to the extent the filing person knows or

has reason to know such information) the names and taxpayer

identification numbers of the shareholders of any class of stock that

is not traded on an established securities market (as described in

Sec. 1.7704-1(b)).

(g) Effective date--(1) In general. Except as provided in paragraph

(g)(4) of this section (relating to reporting requirements), this

section applies to taxable years ending after February 26, 1997. Thus,

all amounts accrued or paid during the first taxable year ending after

February 26, 1997, are subject to this section.

(2) Election to limit taxable income attributable to a

recharacterized fast-pay arrangement for taxable years ending after

February 26, 1997, and before the date these regulations are published

as final regulations in the Federal Register--(i) Limit and adjustment.

For taxable years ending after February 26, 1997, and before the date

these regulations are published as final regulations in the Federal

Register, a shareholder may limit its taxable income attributable to a

fast-pay arrangement recharacterized under paragraph (c) of this

section, to the taxable income that would result if the fast-pay

arrangement were recharacterized under Notice 97-21, 1997-1 C.B. 407,

see Sec. 601.601(d)(2) of this chapter. Any amount a shareholder

excludes from taxable income under this paragraph (g)(2)(i) must be

included as an adjustment to taxable income in the shareholder's first

taxable year that includes the date these regulations are published as

final regulations in the Federal Register. A shareholder that has

elected to limit its taxable income under this paragraph (g)(2)(i) must

include a statement in its books and records identifying each fast-pay

arrangement to which the limit was applied and providing the amount

excluded from taxable income for each such fast-pay arrangement.

(ii) The following examples illustrate the rules of this paragraph

(g)(2). For purposes of these examples, assume that the last year a

shareholder may limit its taxable income under this paragraph (g)(2) is

1998. The examples are as follows:

Example 1. Fast-pay arrangement recharacterized under Notice 97-

21; REIT holds third-party debt--(i) Facts. (A) REIT Y is formed on

January 1, 1998, at which time it issues 1,000 shares of fast-pay

stock and 1,000 shares of benefited stock for $100 per share. Y and

all of its shareholders have calendar taxable years. All

shareholders of Y have elected to accrue market discount based on a

constant interest rate, to include the market discount in income as

it accrues, and to amortize bond premium.

(B) For years 1 through 5, the fast-pay stock has an annual

dividend rate of $17 per share ($17,000 for the class); in later

years, the fast-pay stock has an annual dividend rate of $1 per

share ($1,000 for the class). At the end of year 5, and thereafter,

a share of fast-pay stock can be acquired by Y in exchange for $50

($50,000 for the class).

(C) On the day Y is formed, it acquires a five-year mortgage

note (the note) issued by an unrelated third party for $200,000. The

note provides for annual interest payments on December 31 of $18,000

(a coupon interest rate of 9.0 percent, compounded annually), and

one payment of principal at the end of 5 years. The note can be

prepaid, in whole or in part, at any time.

(ii) Recharacterization under Notice 97-21. (A) In general. One

way to recharacterize the fast-pay arrangement under Notice 97-21 is

to treat the fast-pay shareholders and the benefited shareholders as

if they jointly purchased the note from the issuer with the

understanding that over the five-year term of the note the benefited

shareholders would use their share of the interest to buy (on a

dollar-for-dollar basis) the fast-pay shareholders' portion of the

note. The benefited shareholders' and the fast-pay shareholders'

yearly taxable income under Notice 97-21 can then be calculated

after determining their initial portions of the note and whether

those initial portions are purchased at a discount or premium.

(B) Determining initial portions of the debt instrument. The

fast-pay shareholders' and the benefited shareholders' initial

portions of the note can be determined by comparing the present

values of their expected cash flows. As a class, the fast-pay

shareholders expect to receive cash flows of $135,000 (five annual

payments of $17,000, plus a final payment of $50,000). As a class,

the benefited shareholders expect to receive cash flows of $155,000

(five annual payments of $1,000, plus a final payment of $150,000).

Using a discount rate equal to the yield to maturity (as determined

under Sec. 1.1272-1(b)(1)(i)) of the mortgage note (9.0 percent,

compounded annually), the present value of the fast-pay

shareholders' cash flows is $98,620, and the present value of the

benefited shareholders' cash flows is $101,380. Thus, the fast-pay

shareholders initially acquire 49 percent of the note at a $1,380

premium (that is, they paid $100,000 for $98,620 of principal in the

note). The benefited shareholders initially acquire 51 percent of

the note at a $1,380 discount (that is, they paid $100,000 for

$101,380 of principal in the note). Under section 171, the fast-pay

shareholders' premium is amortizable based on their yield in their

initial portion of the note (8.57 percent, compounded annually). The

benefited shareholders' discount accrues based on the yield in their

initial portion of the note (9.35 percent, compounded annually).

(C) Taxable income under Notice 97-21. Under Notice 97-21, the

fast-pay shareholders' 1998 taxable income attributable to the fast-

pay arrangement is $8,574 ($8.57 per $100 invested), computed by

subtracting the amortizable premium ($302) from the interest income

from their portion of the note ($8,876). The benefited shareholders'

1998 taxable income attributable to the fast-pay arrangement is

$9,353 ($9.35 per $100 invested), computed by adding the accrued

discount ($229) to the interest income from their portion of the

note ($9,124).

(iii) Taxable income under the recharacterization of this

section. Assume the financing instruments are debt instruments.

Under the recharacterization rules of paragraph (c) of this section,

the fast-pay shareholders' 1998 taxable income attributable to the

fast-pay arrangement is $8,574 ($8.57 per $100 invested), which is

the interest income from the financing instruments. The benefited

shareholders' 1998 taxable income attributable to the fast-pay

arrangement is $9,426 ($9.43 per share of benefited stock), computed

by subtracting the interest income accrued on the financing

instruments ($8,574) from the dividend income actually and deemed

paid on the benefited stock ($18,000).

(iv) Limit on taxable income under this paragraph (g)(2). (A)

Fast-pay shareholders. For 1998, the fast-pay shareholders have the

same taxable income under the recharacterization of Notice 97-21

($8,574) as they have under the recharacterization of paragraph (c)

of this section ($8,574). Thus,

[[Page 813]]

the limit under paragraph (g)(2)(i) of this section is unavailable

to the fast-pay shareholders.

(B) Benefited shareholders. For 1998, the benefited shareholders

have taxable income attributable to the fast-pay arrangement of

$9,353 ($9.35 per $100 invested) under the recharacterization of

Notice 97-21, and taxable income of $9,426 ($9.43 per share of

benefited stock) under the recharacterization of paragraph (c) of

this section. Thus, under paragraph (g)(2)(i) of this section, a

benefited shareholder may elect to limit its taxable income

attributable to the fast-pay arrangement to $9.35 for each share of

benefited stock. Any amount an electing shareholder excludes from

taxable income($0.08 per share of benefited stock) must later be

included as an adjustment. (If all benefited shareholders elect the

limit, then as a class the later adjustment to taxable income is

$73.)

Example 2. REIT holds debt issued by a benefited shareholder.

(i) Facts. The facts are the same as in Example 1 of this paragraph

(g)(2) except that corporation Z holds 800 shares (80 percent) of

the benefited stock, and Z, instead of a third party, issues the

mortgage note acquired by Y.

(ii) Recharacterization under Notice 97-21. Because Y holds a

debt instrument issued by Z, the fast-pay arrangement is

recharacterized under Notice 97-21 as an arrangement in which Z

issued one or more instruments directly to the fast-pay shareholders

and the other benefited shareholders. Consistent with this

recharacterization, Z is treated as issuing a debt instrument to the

fast-pay shareholders for $100,000. The debt instrument provides for

five annual payments of $17,000 and an additional payment of $50,000

in year five. Thus, the debt instrument's yield to maturity is 8.57

percent per annum, compounded annually. Z is also treated as issuing

a debt instrument to the other benefited shareholders for $20,000

(200 shares multiplied by $100, or 20 percent of the $100,000 paid

to Y by the benefited shareholders as a class). This debt instrument

provides for five annual payments of $200 and an additional payment

of $30,000 in year five. The debt instrument's yield to maturity is

9.30 percent per annum, compounded annually. For 1998, Z's interest

expense is $10,435 ($8,574 attributable to the debt instruments held

by the fast-pay shareholders, and $1,861 attributable to the debt

instruments held by the other benefited shareholders).

(iii) Recharacterization under this section. Assume the

financing instruments are debt instruments. Under the

recharacterization rules of paragraph (c) of this section, for 1998,

Z has dividend income of $14,400 (800 shares multiplied by $18, or

80 percent of $18,000), and total interest expense of $24,859

($18,000 of interest accrued on the note held by Y, and $6,859 of

interest accrued on the financing instruments).

(iv) Limit on taxable income under this paragraph (g)(2). For

1998, Z has a taxable loss attributable to the fast-pay arrangement

of $10,435 under the recharacterization of Notice 97-21, and a

taxable loss of $10,459 ($14,400 of dividends, minus $24,859 of

total interest expense) under the recharacterization of paragraph

(c) of this section. Thus, for 1998, Z's taxable loss attributable

to the fast-pay arrangement is $10,459 (the amount determined under

paragraph (c) of this section), and the limit of paragraph (g)(2)(i)

of this section is unavailable to Z.

(3) Rule to comply with this section. To comply with this section

for each taxable year in which it failed to do so, a taxpayer should

file an amended return. For taxable years ending before the date these

regulations are published as final regulations, a taxpayer that has

complied with Notice 97-21, 1997-1 C.B. 407 (see Sec. 601.601(d)(2) of

this chapter), is considered to have complied with this section.

(4) Reporting requirements. The reporting requirements of paragraph

(f) of this section apply to taxable years (of the person required to

file the statement) ending after the date these regulations are

published as final regulations in the Federal Register.

John M. Dalrymple,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-178 Filed 1-5-99; 8:45 am]

BILLING CODE 4830-01-U