Cap formation is the first step of pre-mRNA processing in eukaryotic cells. Immediately after transcription initiation, capping enzyme (CE) is recruited to RNA polymerase II (Pol II) by the phosphorylated carboxyl-terminal domain of the Pol II largest subunit (CTD), allowing cotranscriptional capping of the nascent premRNA. Recent studies have indicated that CE affects transcription elongation and have suggested a checkpoint model in which cotranscriptional capping is a necessary step for the early phase of transcription. To investigate further the role of the CTD in linking transcription and processing, we generated a fusion protein of the mouse CTD with T7 RNA polymerase (CTD-T7 RNAP). Unexpectedly, in vitro transcription assays with CTD-T7 RNAP showed that CE promotes formation of DNA⅐RNA hybrids or R loops. Significantly, phosphorylation of the CTD was required for CE-dependent R-loop formation (RLF), consistent with a critical role for the CTD in CE recruitment to the transcription complex. The guanylyltransferase domain was necessary and sufficient for RLF, but catalytic activity was not required. In vitro assays with appropriate synthetic substrates indicate that CE can promote RLF independent of transcription. ASF/SF2, a splicing factor known to prevent RLF, and GTP, which affects CE conformation, antagonized CE-dependent RLF. Our findings suggest that CE can play a direct role in transcription by modulating displacement of nascent RNA during transcription.RNA displacement ͉ RNA polymerase II ͉ RNA processing R NA polymerase II (Pol II) plays a critical role not only in the transcription of mRNA precursors, but also in their subsequent processing. The best characterized example is cotranscriptional cap formation, which is achieved by the physical interaction of capping enzymes (CEs) with the phosphorylated carboxyl-terminal domain of the Pol II largest subunit (CTD) (1-5). The CTD, composed mainly of a repeated heptapeptide motif, YSPTSPS, is extensively phosphorylated, and its regulation is tightly controlled during the transcription cycle (6-8). Phosphorylation of serine-5 in the heptad repeats, by Cdk7 in human and Kin28 in yeast, occurs shortly after transcription initiation and is required for cotranscriptional recruitment of CE (9, 10).The formation of the 5Ј-terminal m7G(5Ј)ppp(5Ј)N cap is the first step of pre-mRNA processing and involves a series of three enzymatic reactions. RNA triphosphatase (RTPase) removes a phosphate from the 5Ј end of the nascent transcript, RNA guanylyltransferase (GTase) transfers GMP from GTP to the diphosphate RNA terminus, and RNA (guanine-N7) methyltransferase (MTase) adds a methyl group (11). In budding yeast, capping is carried out by three polypeptides that are encoded separately (12). Cet1 (RTPase) interacts with Ceg1 (GTase), and this interaction is critical for stimulating Ceg1 activity (13). Abd1 (MTase) and Ceg1 bind directly to the phosphorylated CTD (2, 3). Mammalian CEs consist of two components, a bifunctional CE (with an N-terminal RTPase domain and C-t...