Section 385(a) provides that Treasury is authorized to issue regulations to determine whether an interest in a corporation is to be treated for purposes of the Code as stock or indebtedness. On April 4, 2016, Treasury and the Service issued proposed regulations (Proposed Regulations, found here) under section 385 that treat certain purported debt between related entities as stock for US federal income tax purposes. Treasury stated specifically that the regulations under section 385 had been issued to “address the issue of earnings stripping” in three ways – (1) “[t]argeting transactions that increase related-party debt that does not finance new investment in the United States”; (2) “[a]llowing the IRS on audit to divide a purported debt instrument into part debt and part stock”; and (3) “[r]equiring documentation for members of large groups to include key information for debt-equity tax analysis[.]”
Once the Proposed Regulations were issued, practitioners and industry groups of affected companies (among others) questioned whether the Proposed Regulations were narrowly tailored to serve these stated purposes, and observed that the Proposed Regulations represented a significant departure from past practice. The Proposed Regulations received widespread attention, and practitioner groups and others submitted numerous detailed formal comments before the regulations were finalized. Among the most important critiques, practitioners criticized the Proposed Regulations for their potential overbreadth in their application to foreign-to-foreign transactions, for their lack of a de minimis exception for smaller companies, and for the anticipated burden of the contemporaneous documentation requirements.
Treasury and the Service released final and temporary section 385 regulations (Final 385 Regulations, available here), which are effective as of October 21, 2016, the date of publication in the Federal Register. The Final 385 Regulations provide several exceptions not contained in the Proposed Regulations, including that the Final 385 Regulations apply only to debt instruments issued by a covered member, which is defined as a domestic corporation, to members of its expanded group. The Final 385 Regulations were accompanied by an unusually lengthy Preamble which purports to address major comments received during the notice-and-comment process.
Like the Proposed Regulations, the Final 385 Regulations contain the documentation rules that require specific substantiation in order to treat related-party instruments as debt. These rules are not effective for debt instruments issued prior to January 1, 2018. The Final 385 Regulations contain several modifications to the documentation rules. For example, the Proposed Regulations automatically recharacterized a purported debt instrument as equity in the event of a documentation failure. Under the Final 385 Regulations, if an expanded group is otherwise highly compliant with the documentation rules, then the Final 385 Regulations apply a rebuttable presumption with respect to a purported debt instrument under which a taxpayer can rebut an equity presumption by satisfying specific enumerated tests.
The Final 385 Regulations contain the recast rules issued in Prop. Treas. Reg. §1.385-3, but with significant modifications. In general terms, the Final 385 Regulations reduce the debt issuance to the extent the issuer has sufficient E&P accumulated after April 4, 2016, and/or qualified contributions. Although exceptions to the recast rules were expanded, the complex requirements and operating rules should be carefully studied to avoid traps for the unwary.
More detailed analysis of the Final 385 Regulations can be found here. It remains to be seen how the Final 385 Regulations will impact affected companies in practice, and what challenges may be raised to them.
