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(iii) Except in the case of a leveraged (ii) Special rule for leveraged leases. lease described in paragraph (b)(7)(ii) of For purposes of this paragraph (b), the this section, involves credit enhance- term “credit enhancement" shall not ment within the meaning of paragraph include any device under which any (b)(7) of this section or, with respect to person that is not a related person loans made on or after October 14, 1988, within the meaning of $1.861-8T(C)(2) does not under the terms of the loan agrees to guarantee, without recourse documents, prohibit the acquisition by to the lessor or any person related to the holder of bond insurance or similar the lessor, a lessor's payment of prinforms of credit enhancement;

cipal and interest on indebtedness that (iv) Involves the purchase of inven- was incurred in order to purchase or tory;

improve an asset that is depreciable (v) Involves the purchase of any fi- tangible personal property or deprenancial asset, including stock in a cor- ciable tangible real property and the poration, an interest in a partnership land on which such real property is sitor a trust, or the debt obligation of any uated) that is leased to a lessee that is obligor (although interest incurred in not a related person in a transaction order to purchase certain financial in- that constitutes a lease for federal instruments may qualify for direct allo- come tax purposes. cation under paragraph (c) of this sec- (iii) Syndication of credit risk and sale tion);

of loan participations. The term “syn(vi) Involves interest expense that dication of credit risk” refers to an arconstitutes qualified residence interest rangement in which one primary lender as defined in section 163(h)(3); or

secures the promise of a secondary (vii) [Reserved)

lender to bear a portion of the primary (5) Economic significance. Indebtedness lender's credit risk on a loan. The term that otherwise qualifies under para- “sale of loan participations” refers to graph (b)(2) shall nonetheless be sub- an arrangement in which one primary ject to apportionment under $1.861-9T lender divides a loan into several porif, taking into account all the facts and tions, sells and assigns all rights with circumstances, the transaction (includ- respect to one or more portions to paring the security arrangement) lacks ticipating secondary lenders, and does economic significance.

not remain at risk in any manner with (6) Cross collateralization. The term respect to the portion assigned. For "cross collateralization” refers to the purposes of this paragraph (b), the synpledge as security for a loan of

dication of credit risk shall constitute (i) Any asset of the borrower other credit enhancement because the prithan the identified property described mary lender can look to secondary in paragraph (b)(2) of this section, or lenders for payment of the loan, not

(ii) Any asset belonging to any re- withstanding limitations on lated person,

defined in $1.861- amount of the secondary lender's li8T(C)(2).

ability. Conversely, the sale of loan (7) Credit enhancement-(i) In general. participations does not constitute credExcept provided in paragraph it enhancement, because the holder of (b)(7)(ii) of this section, the term each portion of the loan can look solely "credit enhancement” refers to any de- to the asset securing the loan and not vice, including a contract, letter of to the credit or other assets of any percredit, or guaranty, that expands the son. creditor's rights, directly or indirectly, (8) Other arrangements that do not conbeyond the identified property pur- stitute cross collateralization or credit enchased, constructed, or improved with hancement. For purposes of paragraphs the funds advanced and, thus effec- (b) (6) and (7) of this section, the foltively provides as security for a loan lowing arrangements do not constitute the assets of any person other than the cross collateralization or credit enborrower. The acquisition of bond in- hancement: surance any other contract of (i) Integrated projects. A taxpayer's suretyship by an initial or subsequent pledge of multiple assets of an inteholder of an obligation shall constitute grated project, provided that the intecredit enhancement.

grated project. An integrated project





consists of functionally related and geographically contiguous assets that, as to the taxpayer, are used in the same trade or business.

(ii) Insurance. A taxpayer's purchase of third-party casualty and liability insurance on the collateral or, by contract, bearing the risk of loss associated with destruction of the collateral or with respect to the attachment of third party liability claims.

(iii) After-acquired property. Extension of a creditor's security interest to improvements made to the collateral, provided that the extension does not constitute excess collateralization under paragraph (b)(6), determined by taking into account the value of improvements at the time the improvements are made and the value of the original property at the time the loan was made.

(iv) Warranties of completion and maintenance. A taxpayer's warranty to a creditor that it will complete construction or manufacture of the collateral or that it will maintain the collateral in good condition.

(v) Substitution of collateral. A taxpayer's right to substitute collateral under any loan contract. However, after the right is exercised, the loan shall no longer constitute qualified nonrecourse indebtedness.

(9) Refinancings. If a taxpayer refinances qualified nonrecourse indebtedness (as defined in paragraph (b)(2) of this section) with new indebtedness, such new indebtedness shall continue to qualify only if

(i) The principal amount of the new indebtedness does not exceed by more than five percent the remaining principal amount of the original indebtedness,

(ii) The term of the new indebtedness does not exceed by more than six months the remaining term of the original indebtedness, and

(iii) The requirements of this paragraph (other than those of paragraph (b)(2) (i) and (ii) of this section) are satisfied at the time of the refinancing, and the exclusions contained in this paragraph (b)(4) do not apply.

(10) Post-construction permanent financing. Financing that is obtained after the completion of constructed property will be deemed to satisfy the

requirements of paragraph (b)(2) (i) and (ii) of this section if

(i) The financing is obtained within one year after the constructed property or substantially all of a constructed integrated project (as defined in paragraph (b)(9)(i) of this section) is placed in service for purposes of section 167; and

(ii) The financing does not exceed the cost of construction (including construction period interest).

(11) Assumptions of pre-existing qualified nonrecourse indebtedness. If a transferee of property that is subject to qualified nonrecourse indebtedness assumes such indebtedness, the indebtedness shall continue to constitute qualified nonrecourse indebtedness, provided that the assumption in no way alters the qualified status of the debt.

(12) Excess collateralization. [Reserved]

(c) Direct allocations in the case of certain integrated financial transactions—(1) General rule. Interest expense incurred on funds borrowed in connection with an integrated financial transaction (as defined in paragraph (c)(2) of this section) shall be directly allocated to the income generated by the investment funded with the borrowed amounts.

(2) Definition. The term "integrated financial transaction” refers to any transaction in which

(i) The taxpayer

(A) Incurs indebtedness for the purpose of making an identified term investment,

(B) Identifies the indebtedness as incurred for such purpose at the time the indebtedness is incurred, and

(C) Makes the identified term investment within ten business days after incurring the indebtedness;

(ii) The return on the investment is reasonably expected to be sufficient throughout the term of the investment to fulfill the terms and conditions of the loan agreement with respect to the amount and timing of payments of principal and interest or original issue discount;

(iii) The income constitutes interest or original issue discount or would constitute income equivalent to interest if earned by a controlled foreign corporation (as described in $1.954–2T(h));

(iv) The debt incurred and the investment mature within ten business days of each other;

(v) The investment does not relate in any way to the operation of, and is not made in the normal course of, the trade or business of the taxpayer or any related person, including the financing of the sale of goods or the performance of services by the taxpayer or any related person, or the compensation of the taxpayer's employees (including any contribution or loan to an employee stock ownership plan (as defined in section 4975(e)(7)) or other plan that is qualified under section 401(a)); and

(vi) The borrower does not constitute a financial services entity (as defined in section 904 and the regulations thereunder).

(3) Rollovers. In the event that a taxpayer sells of otherwise liquidates an investment described in paragraph (c)(2) of this section, the interest expense incurred on the borrowing shall, subsequent to that liquidation, no longer qualify for direct allocation under this paragraph (c).

(4) Examples. The principles of this paragraph (c) may be demonstrated by the following examples.

Erample 1. X is a manufacturer and does not constitute a financial services entity as defined in the regulations under section 904. On January 1, 1988, X borrows $100 for 6 months at an annual interest rate of 10 percent. X identifies on its books and records by the close of that day that the indebtedness is being incurred for the purpose of making an investment that is intended to qualify as an integrated financial transaction. On January 5, 1988, X uses the proceeds to purchase a portfolio of stock that approximates the composition of the Standard & Poor's 500 Index. On that day, X also enters into a forward sale contract that requires X to sell the stock on June 1, 1988 for $110. X identifies on its books and records by the close of January 5, 1988, that the portfolio stock purchases and the forward sale contract constitute part of the integrated financial transaction with respect to which the identified borrowing was incurred. Under $1.954–2T(h), the income derived from the transaction would constitute income equivalent to interest. Assuming that the return on the investment to be derived on June 1, 1988, will be sufficient to pay the interest due on June 1, 1988, the interest on the borrowing is directly allocated to the gain from the investment.

Erample 2. X does not constitute a financial services entity as defined in the regula

tions under section 904. X is in the business of, among other things, issuing credit cards to consumers and purchasing from merchants who accept the X card the receivables of consumers who make purchases with the X card. X borrows from Y in order to purchase X credit card receivables from 2, a merchant. Assuming that the Y borrowing satisfies the other requirements of paragraph (C)(2) of this section, the transaction nonetheless cannot constitute an integrated financial transaction because the purchase relates to the operation of X's trade or business.

Example 3. Assume the same facts as in Example 2, except that X borrows in order to purchase the receivables of A, a merchant who does not accept the X card and is not otherwise engaged directly or indirectly in any business transaction with X. Because the borrowing is not related to the operation of X's trade or business, the borrowing may qualify as an integrated financial transaction if the other requirements of paragraph (c)(2) of this section are satisfied.

(d) Special rules. In applying paragraphs (b) and (c) of this section, the following special rules shall apply.

(1) Related person transactions. The rules of this section shall not apply to the extent that any transaction

(i) Involves either indebtedness between related persons (as defined in section $1.861-8T(C)(2)) or indebtedness incurred from unrelated persons for the purpose of purchasing property from a related person; or

(ii) Involves the purchase of property that is leased to a related person (as defined in $1.861-8T(c)(2)) in a transaction described in paragraph (b) of this section. If a taxpayer purchases property and leases such property in whole or in part to a related person, a portion of the interest incurred in connection with such an acquisition, based on the ratio that the value of the property leased to the related person bears to the total value of the property, shall not qualify for direct allocation under this section.

(2) Consideration of assets or income to which interest is directly allocated in apportioning other interest expense. In apportioning interest expense under $1.861-9T, the year-end value of any asset to which interest expense is directly allocated under this section during the current taxable year shall be reduced to the extent provided in $ 1.861-9T(g)(2)(iii) to reflect the portion


of the principal amount of the indebt- members of the affiliated group (as deedness outstanding at year-end relat- fined in $1.861-11T(d)). ing to the interest which is directly al- (ii) Step 2: Compute aggregate debt-tolocated. A similar adjustment shall be asset ratio of all related controlled foreign made to the end-of-year value of assets corporations. The aggregate debt-tofor the prior year for purposes of deter- asset ratio of all related controlled formining the beginning-of-year value of eign corporations is the ratio beassets for the current year. These ad- tweenjustments shall be made prior to aver- (A) The average aggregate month-end aging beginning-of-year and end-of- debt level of all related controlled foryear values pursuant to $1.861-9T(g)(2). eign corporations for their taxable In apportioning interest expense under years ending during the related United the modified gross income method,

States shareholder's taxable year takgross income shall be reduced by the

ing into account only indebtedness amount of income to which interest ex- owing to persons other than the related pense is directly allocated under this United States shareholder or the resection.

lated United States shareholder's other (e) Treatment of certain related con

related controlled foreign corporations trolled foreign corporation indebtedness

("third party indebtedness”), and (1) In general. In taxable years begin

(B) The aggregate value (tax book or ning after 1987, if a United States

fair market) of the assets of all related shareholder has incurred substantially

controlled foreign corporations for disproportionate indebtedness in rela

their taxable years ending during the tion to the indebtedness of its related

related United States shareholder's controlled foreign corporations so that

taxable year excluding stockholdings such corporations have excess related

in and obligations of the related United

States shareholder the related person indebtedness (as determined under step 4 in subdivision (iv) of this

United States shareholder's other re

lated controlled foreign corporations. paragraph (e)(1), the third party interest expense of the related United

(iii) Step 3: Compute aggregate related States shareholder (excluding amounts

person debt of all related controlled forallocated under paragraphs (b) and (c))

eign corporations. This amount equals in an amount equal to the interest in

the average aggregate month-end debt come received on such excess related

level of all related controlled foreign person indebtedness shall be allocated

corporations for their taxable years

ending with or within the related to gross income in the various separate

United States shareholder's taxable limitation categories described in section 904(d)(1) in the manner prescribed

year, taking into account only debt

which is owned to the related United in step 6 in subdivision (vi) of this

States shareholder (“related person inparagraph (e)(1). This computation

debtedness''). shall be performed as follows.

(iv) Step 4: Computation of excess re(i) Step 1: Compute the debt-to-asset

lated person indebtedness and computaratio of the related United States share- tion of the income therefrom—(A) General holder. The debt-to-asset ratio of the

rule. If the ratio computed under step 2 related United States shareholder is

is less than applicable percentage of the ratio between

the ratio computed under step 1, the (A) The average month-end debt level taxpayer shall add to the aggregate of the related United States share

third party indebtedness of all related holder taking into account debt owing controlled foreign corporations deterto any obligee who is not a related per- mined under paragraph (e)(1)(ii)(A) of son as defined in section 81.861-8T(C)(2), this section that portion of the related and

person indebtedness computed under (B) The value of assets (tax book or step 3 that, when combined with the fair market) of the related United aggregate third party indebtedness of States shareholder including stock- all controlled foreign corporations, holdings and obligations of related con- makes the ratio computed under step 2 trolled foreign corporations but exclud- equal to applicable percentage of the ing stockholdings and obligations of ratio computed under step 1. The

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amount of aggregate related person debt that is so added to the aggregate third party debt of related controlled foreign corporations is considered to constitute excess related person indebtedness. For purposes of this paragraph (e)(1)(iv)(A), the term “applicable percentage” means the designated percentages for taxable years beginning during the following calendar years:

States shareholder's debt-to-asset ratio may be adjusted to reflect the amount by which its debt and assets would be reduced had the related controlled foreign corporations incurred the excess related party indebtedness directly to third parties. In such case, the ratio computed in Step 1 is adjusted to reflect a reduction of both portions of the ratio by the amount of excess related person indebtedness as computed under this paragraph (e)(1)(ii)(A). Excess related person indebtedness may be computed under the following formula, under which excess related person indebtedness equals the smallest positive amount (not exceeding the aggregate amount of related controlled foreign corporation indebtedness) that is a solution to the following formula (with X equalling the amount of excess related person indebtedness):

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Aggregate third party debt of related US shareholder - X Applicable percentage

Х US shareholder assets – X

Aggregate third party debt

of related CFCs+X
Related CFC assets

for year

Guidance concerning the solution of this equation is set forth in Erample (2) of $1.861-12(k).

(C) Computation of interest income received on excess related party indebtedness. The amount of interest income received on excess related person indebtedness equals the total interest income on related person indebtedness derived by the related United States shareholder during the taxable year multiplied by the ratio of excess related person indebtedness over the aggregate related person indebtedness for the taxable year.

(v) Step 5: Determine the aggregate amount of related controlled foreign corporation obligations held by the related United States shareholder in each limitation category. The aggregate amount of related controlled foreign corporation obligations held by the related United States shareholder in each limitation category equals the sum of the value of all such obligations in each limitation category. Solely for purposes of this paragraph (e)(1)(v), each debt obligation in a related controlled foreign corporation held by a related United

States shareholder shall be attributed to separate limitation categories in the same manner as the stock of the obligor would be attributed under the rules of $1.861-12T(C)(3), whether or nor such stock is held directly by such related United States shareholder.

(vi) Step 6: Direct allocation of United States shareholder third party interest erpense. Third party interest expense of the related United States shareholder equal to the amount of interest income received on excess related person indebtedness as determined in step 4 shall be allocated among the various separate limitation categories in proportion to the relative aggregate amount of related controlled foreign corporation obligations held by the related United States shareholder in each such category, as determined under step 5. The remaining portion of third party interest expense will be apportioned provided in $81.861–8T through 1.861–13T, excluding this paragraph.

(2) Definitions—(i) United States shareholder. For purposes of this paragraph, the term “United States shareholder"


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