Narrowed Scope of Final and Temporary Sec. 385 Regulations Provide Relief for Some but Not All Taxpayers
On October 13, 2016, IRS and Treasury Department released final and temporary regulations under Sec. 385, (collectively, the Final 385 Regulations), concerning the treatment of certain related-party interests in corporations as stock or indebtedness for federal income tax purposes.
The Final 385 Regulations adopt portions of the proposed regulations issued on April 4, 2016, but are significantly narrower in scope. As a result, the Final 385 Regulations limit the number of taxpayers and transactions affected by the regulations and are a welcome result for many taxpayers and tax professionals who provided comment letters to IRS outlining the added burden the proposed regulations would have caused. For those taxpayers still subject to the Final 385 Regulations, the consequences can be quite serious and the compliance burdens remain heavy.
The Final 385 Regulations treat as stock certain related-party interests that otherwise would be treated as indebtedness and establish threshold documentation requirements that ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness.
Application of the Final 385 Regulations is dependent on the relationship and the aggregate amount of debt outstanding between related-party members. Members of a U.S. consolidated group are treated as a single entity, and thus the Final 385 Regulations do not apply to debt between consolidated group members. Below is a discussion of some of the key changes in the scope and application of the Final 385 Regulations.
Removal of Bifurcation Rule:
The Final 385 Regulations do not include a general bifurcation rule, which would have provided IRS, upon audit, with the authority to bifurcate certain interests between related-parties into part debt and part equity. Many taxpayers commented that the rule did not provide specific guidance or articulate clear standards for its application by revenue agents. As a result, the Treasury Department and IRS reserved on this issue but will continue to study the treatment of an instrument as part debt and part stock. In the meantime, with the removal of the bifurcation rule, the debt versus equity classification for U.S. federal income tax purposes remains an all-or-nothing determination.
S Corp Exclusion:
One of the main concerns for S corporations after the release of the proposed regulations was the potential to invalidate an S Election if related-party debt was re-characterized as equity and deemed to create a prohibited second class of stock. To address this issue, the Final 385 Regulations exclude S corporations, along with non-controlled RICs and REITs from the definition of an expanded group, thereby exempting these entities from application of the regulations.
Foreign Issuer Exclusion:
The Final 385 Regulations reserve on all aspects of their application to foreign issuers but will continue to review this issue. The Final 385 Regulations apply only to expanded group instruments (EGIs) and debt instruments issued by a covered member, meaning a member of the expanded group that is a domestic corporation. As a result, all debt issued by foreign corporations, including both controlled foreign corporations (CFCs) and other foreign affiliates is excluded. Excluding debt issued by foreign corporations from the scope of the Final 385 Regulations eliminates the issue under the proposed regulations that the re-characterization of foreign debt could potentially result in the loss of foreign tax credits.
Besides a few additional exceptions, most of the re-characterization rules in the proposed regulations were retained in the Final 385 Regulations. Subject to certain exceptions, the General Rule and Funding Rule still apply and related-party debt instruments will be re-characterized as equity if issued (i) as a distribution, (ii) in exchange for related-party stock, (iii) as consideration in an internal asset reorganization, or (iv) to fund a distribution, acquisition of related-party stock or boot in an internal asset reorganization.
Among the new exceptions, the Final 385 Regulations (i) exclude instruments issued by regulated financial groups and insurance entities, (ii) exclude cash pools and short-term loans, (iii) expand the exception for distributions of E&P, (iv) allow netting of distributions against certain capital contributions, (v) exclude stock acquisitions related to employee compensation plans, (vi) limit certain cascading re-characterizations, and (vii) provide modified rules for instruments issued by disregarded entities and controlled partnerships.
The Final 385 Regulations also eliminate the proposed regulations’ 30-day timely preparation requirement and instead treat documentation and financial analysis as timely prepared if it is prepared by the time that the issuer’s federal income tax return is filed (taking into account all applicable extensions).
In addition, the Final 385 Regulations provide that, if an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than a per se re-characterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument. Under the proposed regulations, failure to satisfy the documentation requirements automatically recast the debt instrument into stock.
The general effective date of the Final 385 Regulations is January 19, 2017. However, IRS has provided some relief regarding application of the re-characterization rule through a final transition period and delayed implementation of the documentation requirements. Taxpayers also have the option to apply the proposed regulations for debt instruments issued after April 4, 2016, and before October 13, 2016.
The Final 385 Regulations provide a final transition period that generally exempts debt from re-characterization if it is settled on or prior to January 19, 2017. The final transition period covers debt issued between April 4, 2016 and January 19, 2017, that otherwise would have been recast under the re-characterization rules. Any debt that is not settled during this final transition period will be automatically re-characterized as equity on January 20, 2017.
The documentation requirements apply only to debt instruments issued on or after January 1, 2018.
While fewer taxpayers are affected by the Final 385 Regulations, those that remain within the scope of the regulations will find the consequences are quite serious and the documentation requirements, once effective, are quite burdensome.
The general effective date of January 19, 2017 provides taxpayers with three months from the date the regulations were finalized to clean up their related-party group obligations to remove the risk of re-characterization. Taxpayers should take an immediate inventory of their related-party debt obligations to determine those debt instruments impacted by the regulations and assess instruments subject to the re-characterization rules. If there are debt instruments that are subject to re-characterization taxpayers should take advantage of the delay in automatic re-characterization prior to January 19, 2017 to remediate these impacted debt instruments by paying off debt. In addition, taxpayers should work with their tax professionals to establish policies and procedures for complying with the re-characterization rules and documentation requirements on a go-forward basis.