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 pre-mRNA. 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 DNA.RNA 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.