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Business Tax

IRS Finalizes Corporation Related Party Debt Regs

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

IRS has finalized, without substantive change, 2016 proposed regs that treat certain indebtedness as stock that is issued by a corporation to a controlling shareholder in a distribution or similar transaction.


In 2016, IRS issued final and temporary regs under Code Sec. 385 that, among other things, treated certain indebtedness as stock that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction that achieves an economically similar result. See Final, temp, and proposed regs provide when related party debt is treated as equity.

Specifically, Reg. § 1.385-3 and 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 doesn’t 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.

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 Reg. § 1.385-3T and Reg. § 1.385-4T).

The text of the temporary regs also serves as the text of contemporaneously issued proposed regs.

IRS finalizes the proposed regs.

IRS has now finalized the 2016 proposed regs without substantive change and has withdrawn the temporary regs. (TD 9897)

Applicability dates.

The amendments to Reg §1.385-3, other than Reg §1.385-3(f)(4)(iii), apply to tax years ending after January 19, 2017. Reg §1.385-3(f)(4)(iii) (“Expanded group partner is a consolidate group member”) and Reg § 1.385-4 provide rules applicable to members of consolidated groups and are issued under Code Sec. 1502Code Sec. 1503(a) provides in general, that in any case in which a consolidated return is made or is required to be made, the tax is to be determined, computed, assessed, collected, and adjusted in accordance with the regs under Code Sec. 1502 prescribed before the last day prescribed by law for the filing of such return. Thus, Reg §1.385-3(f)(4)(iii) and Reg §1.385-4 apply to tax years for which the U.S. Federal income tax return is due, without extensions, after May 14, 2020.  (TD 9897)

The temporary regs apply to tax years ending on or after January 19, 2017, and before October 13, 2019. For rules applying Reg §1.385-3T(f)(4)(iii) and Reg §1.385-4T to tax years ending on or after January 19, 2017 and for which the U.S. Federal income tax return was due, without extensions, on or before May 14, 2020, see Reg §1.385-3T and Reg §1.385-4T (as contained in 26 CFR in part 1 revised as of April 1, 2019). The provisions in the temporary regs and the corresponding provisions in the new final regs are substantially identical.  (TD 9897)

For certain tax years for which the U.S. Federal income tax return was due, without extensions, on or before May 14, 2020, there may be a period after October 13, 2019, to which neither Reg §1.385-3T(f)(4)(iii) and Reg §1.385-4T nor Reg §1.385-3(f)(4)(iii) and Reg §1.385-4 apply. The new final regs allow a taxpayer to choose to apply Reg §1.385-3(f)(4)(iii), Reg §1.385-4, or both to such period, provided that all members of the expanded group apply that section or sections. Accordingly, a taxpayer can choose to apply the new final regs to the period, if any, to which neither the temporary regs nor the new final regs apply. (TD 9897)

To continue your research on debt vs. equity, see FTC 2d/FIN ¶ K-5812 et seq.; United States Tax Reporter ¶ 3854 et seq.


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