Tax & Accounting Blog

U.S. Sets Date for Hearing on Section 385 Debt/Equity Proposed Regulations

BEPS, Blog, Checkpoint, ONESOURCE, Transfer Pricing June 23, 2016

On June 20, 2016,  U.S. Treasury and the IRS announced that a public hearing will be held at IRS headquarters in Washington, D.C., on July 14, 2016, concerning the  Section 385 debt/equity Proposed Regulations issued on April 4, 2016, that relate to the OECD BEPS Action 4 recommendations on interest limitations.

While the IRS has not yet announced who will be attending the hearing from Treasury or the IRS, many individuals called the IRS to be included on the hearing attendance list within hours of the IRS announcement. Anyone wishing to attend the hearing should contact Regina Johnson at (202) 317-6901.

IRS must receive comments on the Proposed Regulations by July 7, 2016. The June 20 IRS announcement contains the contact information for submitting any comments.

Background on Corporate Debt/Equity Rules

Pursuant to Section 385(c), a corporate issuer’s characterization at issuance of a corporate instrument as stock or debt is binding on the issuer and all holders (unless the holder discloses inconsistent treatment on its return), but is not binding on the IRS.

If the IRS determines that a corporation’s debt obligations should be treated as equity (stock), it will treat interest paid on the securities as nondeductible dividend income. While no single factor is controlling, the following factors are relevant in determining whether a corporate obligation is debt or equity for federal tax purposes:

  • The right to enforce payment of principal and interest.
  • Presence or absence of a maturity date.
  • Source of payments.
  • Status equal to or inferior to that of regular corporate creditors.
  • “Thin” or inadequate capitalization.
  • Intent of parties.
  • Identity of interest between creditor and stockholder.

Background on Section 385 Proposed Regs.

The Proposed Regulations address whether a direct or indirect interest in a related corporation is treated as stock, debt, or in part stock and in part debt, for U.S. federal tax purposes. The Proposed Regulations generally target related parties that engage in certain transactions using U.S. debt to “strip” U.S.-source earnings (through interest deductions) to lower-tax jurisdictions, but may apply without regard to whether the related parties are domestic or foreign. They also require the preparation and maintenance of extensive documentation to substantiate debt treatment between related parties.

Although the Proposed Regulations were released as part of a larger package of anti-inversion measures, they apply to many routine financial transactions (including cash pooling arrangements) and common Subchapter C transactions of U.S.-  and non-U.S.-based multinational enterprises (MNEs), regardless of whether the MNEs in question effected an inversion.

Because there are currently no Regulations 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.

If made final, the Proposed Regulations would:

  • Bifurcation rule. Provide IRS with the ability treat certain related-party debt as in part equity and in part debt based on relevant facts and circumstances;
  • Documentation rule. Impose extensive documentation and information requirements on “large taxpayer groups” for a purported debt instrument between members of an expanded group (EG) to be respected as debt—that is, not recast as equity.
  • Per se stock rule. Subject to certain exceptions, recast related-party debt instruments as equity for U.S. federal tax purposes when issued (1) as a distribution, (2) in exchange for related-party stock (e.g., in a Section 304 sale), (3) as consideration in an internal asset reorganization (e.g., boot in a  Section 368(a)(1)(D) reorganization), or (4) to fund a distribution, acquisition of related-party stock, or boot in an internal asset reorganization.

Courts have historically followed an all-or-nothing approach to treating interest in a corporation as wholly equity or wholly debt. The Proposed Regulations would allow the IRS Commissioner to depart from that approach (when appropriate) to ensure that the income of related taxpayers is reflected clearly.

Expected Entry Into Force of Proposed Regs

In general, the Proposed Regulations would apply to any applicable instrument issued or deemed issued on or after the date that these Regulations  are published as final  in the Federal Register and to any applicable instrument treated as indebtedness issued or deemed issued before the date that the Regulations  are issued as final  if and to the extent that it was deemed issued as a result of an entity classification election made under  Reg. 301.7701-3 that is filed on or after the date that these Regulations  are issued as final  in the Federal Register.

On May 24, 2016, U.S. Treasury Deputy Assistant Secretary for International Tax Affairs Robert Stack said during a KPMG webinar that the Proposed Regulations may be final by Labor Day 2016. However, Mr. Stack and Mark Mazur (Assistant Secretary for Tax Policy at Treasury) told U.S. Senate Democrat staffers during a meeting on June 10, 2016, that they may not be final until December 2016.

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