Proposed Removal of Section 385 Documentation Regulations
Preamble to Prop Reg REG-130244-17; Prop Reg § 1.385-1, Prop Reg § 1.385-2 [Removing Reg. § 1.385-2], Prop Reg § 1.385-3, Prop Reg § 1.1275-1
IRS has issued proposed reliance regs that would remove the Code Sec. 385 documentation requirements—i.e., the portion of the final Code Sec. 385 regs issued in 2016 that provided rules for the documentation necessary to determine whether certain related party interests in a corporation are treated as stock or indebtedness for federal tax purposes. The documentation requirements, applicability of which had already been delayed until 2019, had been identified for potential removal last year pursuant to President Trump’s directive to reduce regulatory burdens.
Background. Code Sec. 385(a) authorizes IRS to prescribe such regs as may be 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.
In April 2016, IRS published proposed regs under Code Sec. 385 concerning the treatment of certain interests in corporations as stock or indebtedness. Included in those proposed regs was Prop Reg § 1.385-2, which set out the documentation requirements, as well as rules that treat as stock certain debt 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.
As described by IRS, the documentation requirements were intended to: (i) provide guidance regarding the documentation and other information that must be prepared, maintained, and provided for use in the determination of whether an instrument subject to the documentation requirements will be treated as indebtedness for federal tax purposes; and (ii) establish certain operating rules, presumptions, and factors to be taken into account in the making of any such determination. Under the proposed regs, the documentation requirements would have applied to interests issued or deemed issued on or after the date the proposed regs were finalized. (See “New proposed regs on when related party debt is treated as equity.”)
In October 2016, IRS issued final regs that included final documentation requirements. (T.D. 9790, 10/13/2016; see “Final, temp, and proposed regs provide when related party debt is treated as equity.”) In response to the concern expressed by taxpayers that the proposed regs provided inadequate time to begin complying with the documentation requirements, these requirements were made applicable only with respect to interests issued or deemed issued on or after Jan. 1, 2018. (Reg. § 1.385-1(f), Reg. § 1.385-2(d)(2)(iii) and Reg. § 1.385-2(i))
In April 2017, President Trump issued Executive Order (EO) 13789, titled “Identifying and Reducing Tax Regulatory Burdens,” which required a retrospective review of all significant tax regs issued after Jan. 1, 2016, and directed Treasury to identify any that impose an undue financial burden on taxpayers, add undue complexity to Federal tax laws, or exceed IRS’s statutory authority. Among the regs subsequently identified by Treasury were the Code Sec. 385regs (including the documentation requirements). (Notice 2017-38; see “Eight significant tax regs listed on the chopping block under executive order.”)
In July 2017, IRS announced that it would delay the effective date of the documentation requirements by 12 months, until 2019. (Notice 2017-36; see “IRS postpones debt-equity reg documentation requirements for one year.”)
Costs and benefits analysis. Pursuant to EO 12866, IRS also provided anticipated economic effects of the documentation requirements. Among other findings, IRS noted that the regs would have affected approximately 6,300, or 0.4%, of C corporation taxpayers, generally reflecting the largest C corporation tax filers. IRS also determined that removal of the documentation requirements would (i) reduce revenue by approximately $407 million over the 2019-2028 period; (ii) reduce compliance costs by $924 million over the same period; (iii) slightly increase the ability of some taxpayers to engage in “earnings stripping”; and (iv) increase IRS’s costs of evaluating whether purported debt transactions are legitimate loans.
Proposed revisions. The new proposed regs would remove Reg. § 1.385-2—which provides the documentation requirements—in its entirety.
In addition, the proposed regs would make a number of conforming amendments throughout Reg. § 1.385-1, to Reg. § 1.385-3(g)(4), and to Reg. § 1.1275-1(d) to reflect the removal of Reg. § 1.385-2.
IRS stated that, while it is currently proposing to remove the documentation requirements, it may propose a modified version of the documentation regs at a later date following its study of the issues they were intended to remedy, but noted that any such regs would be simplified and streamlined and would have an effective date that would give taxpayers sufficient lead time to comply.
Proposed effective/applicability date. The proposed removal of the documentation requirements and other conforming modifications are proposed to be applicable as of the publication date of a Treasury Decision adopting them as final regs. However, taxpayers may rely on them until that publication date.
References: For debt vs. equity, see FTC 2d/FIN ¶ K-5790 et seq.; United States Tax Reporter ¶ 3854 et seq.