In 518-page TD 9790 , October 13, 2016, IRS issued final and Temporary Regulations ("final Regulations") under Section 385 that (1) establish threshold documentation requirements that ordinarily must be satisfied so that certain related-party interests in a corporation are treated as indebtedness for federal tax purposes; and (2) treat certain other related-party interests as stock. IRS said that these controversial Regulations are an important step in addressing earnings stripping, a commonly used technique to minimize taxes after an inversion.
Section 385(a) authorizes IRS to prescribe Regulations as necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness, or part stock and part indebtedness, for purposes of the Code. Because no final Regulations were currently in effect under Section 385 , the case law that developed before the enactment of Section 385 has continued to evolve and to control the characterization of an interest in a corporation as debt or equity.
According to the Preamble, after a corporate inversion, multinational corporations often use earnings stripping to minimize U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country. This commonly used technique can generate large interest deductions without requiring a company to finance new investment in the U.S. The final Regulations restrict the ability of corporations to strip earnings by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances. In addition, they require that corporations claiming interest deductions on related-party loans provide documentation for the loans, similar to the common practice for third-party loans. Because the ability to minimize income tax liabilities through the issuance of related-party financial instruments is not limited to the cross-border context, the new Regulations also apply to related U.S. affiliates of a corporate group.
On April 4, 2016, Treasury and the IRS issued controversial Proposed Regulations under Section 385 (REG-108060-15), 1 which (1) authorized IRS to treat certain related-party interests in a corporation as indebtedness in part and stock in part; (2) established documentation requirements that must be satisfied for certain related-party interests in a corporation to be treated as indebtedness; and (3) treated as stock certain related-party interests that otherwise would be treated as indebtedness. The Proposed Regulations provided specific factors that, when present in the context of purported debt instruments issued between highly related corporations, would be dispositive in determining whether an interest in a corporation is treated for tax purposes as stock or indebtedness (or as part stock and part indebtedness). The Proposed Regulations were met with a firestorm of criticism from congressional lawmakers and numerous business segments regarding numerous unintended consequences of the Proposed Regulations and expressing concern that the Proposed Regulations would hurt U.S. businesses and the economy.
Prop. Reg. 1.385-2 said that the absence of timely preparation of documentation and financial analysis evidencing four essential characteristics of indebtedness would be a dispositive factor requiring a purported debt instrument to be treated as stock for federal tax purposes. The Proposed Regulations prescribed the nature of the documentation necessary to substantiate the treatment of related-party instruments as indebtedness, including documentation to establish an expectation of repayment and a course of conduct that is generally consistent with a debtor-creditor relationship. Prop. Reg. 1.385-2 required that such documentation be timely prepared and maintained and if the specified documentation was not provided to IRS on request, the instrument would be treated as stock for federal tax purposes.
Prop. Reg. 1.385-3 identified an additional dispositive factor that indicates the existence of a corporation-shareholder relationship rather than a debtor-creditor relationship: the issuance of a purported debt instrument to a controlling shareholder in a distribution or another transaction that achieves an economically similar result. These purported debt instruments do not finance any new investment in the operations of the borrower and so have the potential to create significant federal tax benefits, including interest deductions that erode the U.S. tax base, without having meaningful nontax significance.
Prop. Reg. 1.385-3 also included a "funding rule" that treated as stock a purported debt instrument that is issued as part of a series of transactions that achieve a result similar to a distribution of a debt instrument. Specifically, Prop. Reg. 1.385-3 treated as stock a purported debt instrument that was issued in exchange for property, including cash, with a principal purpose of using the proceeds to fund a distribution to a controlling shareholder or to fund another transaction that achieves an economically similar result. Further, the Proposed Regulations included a "per se" application of the funding rule that treated a purported debt instrument as funding a distribution or other transaction with a similar economic effect if it was issued in exchange for property (other than in the ordinary course of purchasing goods or services from an affiliate) during the period beginning 36 months before and ending 36 months after the funded member made the distribution or undertook the transaction that had a similar economic effect.
Prop. Reg. 1.385-3 included exceptions that were intended to limit the scope of the Regulations to transactions undertaken outside the ordinary course of business by large taxpayers with complex organizational structures. The Proposed Regulations also included an anti-abuse provision to address a purported debt instrument issued with a principal purpose of avoiding the application of the Proposed Regulations. Prop. Reg. 1.385-4 provided rules for applying Prop. Reg. 1.385-3 in the context of consolidated groups.
Prop. Reg. 1.385-1(d) gave IRS the discretion to treat certain interests in a corporation for federal tax purposes as indebtedness in part and stock in part ("bifurcation rule"). Thus, IRS could split a single financial instrument between related parties into components of debt and equity when appropriate.
Final and Temporary Regulations
IRS says that, in response to the comments received, the final Regulations substantially revised the Proposed Regulations to minimize the burdens on taxpayers, and target narrowly the transactions of greatest concern while still being administrable. Notably, the final Regulations do not include the bifurcation rule. IRS is continuing to study the potential issues raised by such a rule.
Another significant change from the Proposed Regulations is one in scope-the final Regulations do not apply to foreign issuers. IRS said in the Preamble to TD 9790 that the Regulations "reserve on all aspects of their application to foreign issuers."
Documentation. Reg. 1.385-2 prescribes the nature of the documentation necessary to substantiate the tax treatment of related-party instruments as indebtedness, including documentation of factors analogous to those in third-party loans. Generally, this means that taxpayers must be able to provide such things as evidence of an unconditional and binding obligation to make interest and principal payments on certain fixed dates; evidence that the holder of the loan has the rights of a creditor, including rights superior to shareholders in a dissolution; evidence of a reasonable expectation of the borrower's ability to repay the loan; and evidence of conduct consistent with a debtor-creditor relationship. These documentation rules would apply to relevant intercompany debt issued by U.S. borrowers beginning in 2018 and would require that the taxpayer's documentation for a given tax year be prepared by the time that the borrower's federal income tax return is filed.
Reg. 1.385-2 exempts from some of the documentation requirements debt instruments issued by regulated financial service entities to the extent that the debt instruments contain terms required by a regulator to satisfy regulatory requirements or require a regulator's approval before principal or interest is paid. Similar carve-outs are provided for insurance companies, which are subject to similar regulatory requirements, as well as for transactions between certain types of entities (e.g., S corporations, mutual funds) for which IRS has determined that the income tax consequences of mischaracterizing equity instruments as debt are limited (see Fact Sheet).
Reg. 1.385-2 applies only to related groups of corporations when the stock of at least one member is publicly traded or the group's applicable financial statements report assets exceeding $100 million or annual revenue exceeding $50 million. IRS said that these thresholds exclude about 99% of C corporation taxpayers while retaining 85% of economic activity as measured by total income. IRS also said that approximately 1.5 million out of 1.6 million C corporation tax filers are single entities and so have no affiliates with which to engage in "tax arbitrage."
"Highly related parties. " Reg. 1.385-3 and Temp. Reg. 1.385-3T provide rules that can recharacterize purported debt of U.S. issuers as equity if the interest is among highly related parties (in general, those that meet an 80% common ownership test and thus have aligned economic interests) and does not finance new investment. These rules are intended to address transactions that create significant U.S. federal tax benefits while lacking meaningful legal or economic significance. Subject to a variety of exceptions for more ordinary course transactions, the rules recharacterize a note that is distributed from a U.S. issuer to a parent corporation, or other highly related entity, as equity. The rules also apply to the use of notes to fund acquisitions of related-party stock and internal asset reorganizations, as well as multi-step transactions that have an economically similar result.
Exceptions/exclusions. Various exceptions and exclusions in Reg. 1.385-3 are intended to exempt certain transactions and certain common commercial lending practices from being subject to the rules when compliance burdens or efficiency costs are likely to be elevated and potential improvements in tax compliance modest. These include the following:
"Cash pool borrowing and other short-term debt. Reg. 1.385-3 excludes "cash pool" borrowing and other short-term debt, by excluding loans that are short-term in form and substance. The exception for short-term debt allows companies to transfer cash around an affiliated group efficiently to meet the day-to-day global cash needs of the business without resorting to third-party borrowing to avoid Reg. 1.385-3 .
Expanded E&P exception. When applying the Reg. 1.385-3 rules, an expanded earnings and profits (E&P) exception takes into account a corporation's E&P accumulated after April 4, 2016, as opposed to limiting distributions to the amount of E&P generated each year. This ensures that companies are not incentivized to make distributions that use up their current E&P before it becomes unusable in the next tax year.
However, the accumulated E&P available to offset distributions or acquisitions resets to zero when there is a change (1) in control of the issuer, due, for example, to the issuer being acquired by an unrelated party; or (2) of expanded group parent (including in an inversion). These limitations avoid creating incentives for companies (including inverted companies) to acquire or undertake transactions with companies rich in accumulated earnings to circumvent the Regulations by relying on previously accumulated E&P. This exception is of limited benefit to inverted corporations seeking to acquire new U.S. targets or to U.S. corporations themselves that undertake an inversion that results in a new foreign parent, which could otherwise represent a major source of tax revenue loss.
Capital contributions. The final Regulations allow a taxpayer to reduce the amount of its distributions and acquisitions that otherwise could cause an equal amount of the taxpayer's debt to be recharacterized as equity by the amount of the contributions to the taxpayer's capital. This has the effect of treating distributions and acquisitions as funded by new equity contributions before being considered related-party borrowings and ensuring that companies that have not seen a reduction in net equity are not subject to the rules.
"Cliff effect." The final Regulations expand access to the $50 million indebtedness exception by removing the "cliff effect" of the threshold exception under the Proposed Regulations, with the result that all taxpayers can exclude the first $50 million of indebtedness that otherwise would be recharacterized. Eliminating the $50 million cliff has little tax revenue effect but eliminates a potential economic distortion to the financing choices of corporations near the threshold.
Documentation rules. The final Regulations also reduce and relax the documentation rules, including by (1) delaying the documentation requirements in Reg. 1.385-2 until January 1, 2018; (2) extending the compliance period for documenting a loan from 30 days after issuance (or other relevant date) to the date when the borrower's tax return is filed; and (3) easing the documentation rules so that a failure with respect to documentation of a particular instrument does not automatically result in recharacterization as equity, when a group is otherwise substantially compliant with the rules.
Consolidated groups. Temp. Reg. 1.385-4T includes special rules for applying Reg. 1.385-3 to consolidated groups, consistent with the general purpose of Reg. 1.385-3 (and Temp. Regs. 1.385-3T and 1.385-4T ). Reg. 1.385-3 applies only to debt issued after April 4, 2016, the date that the Proposed Regulations were published; as a result, it grandfathers intragroup debt issued before that date.
Effect of final Regulations. These changes in the final Regulations from the Proposed Regulations significantly reduce the number of taxpayers and transactions affected. As narrowed, many issuers are entirely exempt from the application of Regs. 1.385-2 and 1.385-3 . Further, with respect to the large domestic issuers that are subject to Reg. 1.385-3 , that section is substantially revised to better focus on extraordinary transactions that have the effect of introducing related-party debt without financing new investment in the operations of the issuer. Accordingly, the final Regulations apply in particular factual situations where there are elevated concerns about related-party debt being used to create significant federal tax benefits without having meaningful non-tax effects. Any intragroup debt recharacterized as equity by the Regulations eliminates the ability of the purported borrower to deduct interest from its taxable income.
Other changes from Prop. Regs. The final Regulations contain other significant changes from the Proposed Regulations, including:
Rebuttable presumption. The final Regulations provide that if an expanded group is otherwise generally compliant with the documentation requirements, a rebuttable presumption rather than per se recharacterization as stock applies in the event of a documentation failure with respect to a purported debt instrument.
Funding rule. The final Regulations narrow the application of the funding rule by preventing, in certain circumstances, the "cascading" consequence of recharacterizing a debt instrument as stock, that is, situations in which the recharacterization of one covered debt instrument could lead to deemed transactions that result in the recharacterization of one or more other covered debt instruments in the same expanded group.
Debt issue date. The final Regulations apply only to debt instruments issued on or after Jan. 1, 2018.
Employee comp. exception. The final Regulations provide an exception for the acquisition of stock delivered to employees, directors, and independent contractors as consideration for the provision of services. Distributions (payments to affiliated companies) out of E&P associated with employee compensation plans will not cause debt issued by a corporation to be recharacterized as equity.
Netting exception. The final Regulations provide an exception under which certain contributions of property are "netted" against distributions and transactions with similar economic effect.
Delayed date expanded. The 90-day delay in the Proposed Regulations for debt instruments issued on or after April 4, 2016, but before publication of final Regulations, is expanded so that any debt instrument that is subject to recharacterization but that is issued on or before January 19, 2017, will not be recharacterized until immediately after January 19, 2017.
Joseph Calianno, Partner and International Technical Tax Practice Leader for BDO USA, LLP, and a member of the Journal's Board of Advisors, provided the following comments on the final Regulations: "The Section 385 Proposed Regulations issued in April 2016 were drafted with a very broad scope and application. Most corporations, industry groups, and tax practitioners criticized the Proposed Regulations because of the broad scope and breadth. Although the final Regulations did not adopt all taxpayer comments, several comments were adopted such that the final Regulations represent a much more targeted, scaled-back approach to addressing debt-equity issues compared with the Proposed Regulations. For instance, the scope of the final Regulations was narrowed significantly in that the final Regulations do not apply to foreign issuers (they reserve on all aspects of their application to foreign issuers) and provide targeted exclusions for certain types of entities, such as S corporations and noncontrolled RICs and REITs. The elimination of the general bifurcation rule that was in Prop. Reg. 1.385-1(d) also was a welcome change.
Further, there were significant developments in the documentation area, including extension of the time period required for timely preparation (documentation and financial analysis treated as timely prepared if prepared by the time that the issuer's federal tax return is filed, taking into account all applicable extensions); a rule that if an expanded group is otherwise compliant with the documentation requirements, a rebuttable presumption, rather than a per se recharacterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument; and a delayed implementation (the final Regulations apply only to debt instruments issued on or after January 1, 2018).
There were also several positive changes to the recast rules under Reg. 1.385-3 , including generally excluding from the scope of that Regulation deposits pursuant to cash management arrangements as well as certain advances that finance short-term liquidity when certain requirements are met, expanding certain exceptions in the Regulations, and removing the cliff effect of the $50 million threshold exception under the Proposed Regulations so that all taxpayers can exclude the first $50 million of indebtedness that otherwise would be recharacterized."
1 See Harter, Hermann, and Junge, " Section 385 Proposed Regulations Would Vitiate Internal Cash Management Operations," 27 JOIT 26 (July 2016) ; PwC, " Section 385 Prop. Regs. Would Have Profound Impact on Related-Party Financings," 27 JOIT 49 (July 2016) .