Final and temporary regulations were released under Section 385 of the Internal Revenue Code (IRC) in October 2016. These regulations establish documentation requirements that must be satisfied in order for a debt instrument to constitute indebtedness for federal tax purposes. In addition, the regulations recharacterize a debt instrument as stock if the instrument is issued in one of a number of specified transactions or if the instrument funds such a transaction.
While broad in application, the final regulations have a narrower application than the proposed regulations, significantly reducing the number of taxpayers and transactions affected. For financial services companies, the application of the rules may be even narrower. Following are some of the significant implications of the regulations for financial services companies.
Section 385 Overview
As a general rule, the debt-versus-equity determination focuses on five factors provided in the IRC and 11 factors derived through case law. Those factors are:
- Intent of the parties
- Identity between creditors and shareholders
- Extent of participation by the holder in managing the instrument
- Ability of the corporation to obtain funds from outside sources
- "Thinness" of the capital structure in relation to debt
- Risk involved
- Formal indications of the arrangement
- Relative position of the holder of the instrument to other creditors regarding the payment of interest and principal
- Voting power of the holder of the instrument
- Provision of a fixed rate of interest
- A contingency on the obligation to repay
- Source of the interest payments
- Presence or absence of a fixed maturity date
- Provision for the corporation’s redemption option
- Provision for the holder’s redemption option
- Timing of the advance with reference to the organization of the corporation
Ultimately, the test for debt-versus-equity requires a subjective analysis of these factors to determine if a debt instrument in fact is treated as equity.
U.S. Treasury Regulation Section 1.385-2 provides rules about the documentation and information necessary for determining whether certain instruments will be treated as indebtedness for federal tax purposes. Failure to comply with the documentation requirements will cause an instrument to be treated as equity for tax purposes. However, compliance with documentation rules does not mean that the instrument will be treated as a debt instrument for tax purposes. Rather, it merely satisfies the minimum documentation required in order for the debt-versus-equity determination to be made according to the factors previously listed.
The documentation rules generally apply to expanded group interests (EGIs) issued between covered members of an expanded group of corporations.1 However, an EGI is subject to the documentation requirements only if any of the following conditions apply:
- The stock of any member of the expanded group is publicly traded.
- Total assets of the expanded group exceed $100 million.
- Total annual revenue of the expanded group exceeds $50 million.
The new documentation rules implement two broad sets of rules relative to preparation and maintenance of documentation for intercompany borrowings. The first set of rules addresses the required form of the legal documents establishing the EGI. These documents must 1) include an unconditional promise to pay and 2) provide creditor rights to the lender. The second set of rules requires the holder of the instrument to prepare written documentation demonstrating 1) reasonable expectation of repayment based on credit analysis of the borrower and 2) exercise of creditor rights in the event of a nonpayment or default event.
The regulations provide two important exceptions to the documentation rules that are advantageous to financial institutions. First, S corporation banks will be exempt from these rules, as S corporations are not subject to the new Section 385 regulations. Additionally, an exemption from the documentation requirements is provided for debt issued between members of an affiliated group of corporations eligible to file a consolidated return. This exception effectively eliminates the documentation requirements for financial institutions unless debt is issued to a foreign parent corporation or a foreign subsidiary. However, the documentation rules do apply to intercompany arrangements between a bank and a captive real estate investment trust (REIT), as the captive REIT is ineligible to file a consolidated return with the bank. Even though the documentation requirements will not apply to most financial institutions, compliance with the requirements is still recommended to document compliance with debt characterization.
General and Funding Rules
Under Treasury Regulation Section 1.385-3, a debt instrument is treated as stock to the extent it is issued 1) in a distribution, 2) in exchange for expanded group stock, or 3) in exchange for property in an asset reorganization (the general rule). Additionally, a covered debt instrument is treated as stock if it is issued by a covered member (the funded member) to a member of the issuer’s expanded group with a principal purpose of engaging in certain enumerated prohibited transactions (the funding rule).
The final regulations contain a broad exception to the general and funding rules for debt issued by an “excepted regulated financial company,” which includes a U.S. corporation that is a “regulated financial company” or a member of a “regulated financial group.” A regulated financial company includes bank holding companies, national banks, and insured depository institutions. A regulated financial group is an expanded group that contains a regulated financial entity. Consequently, most domestic entities owned by U.S.-based financial institutions services companies likely will qualify for this exception and, therefore, be exempt from the general or funding rules.2
1 An EGI is any interest issued on or after Jan. 1, 2018, between expanded group members that is in the legal form of a debt instrument or an intercompany payable and receivable documented as debt in a ledger, trade payable, journal entry, or similar arrangement if no written legal instrument governs the payable and receivable. A covered member is a domestic corporation that is a member of an expanded group. An expanded group is one or more chains of corporations connected through stock ownership with a common parent owning directly or indirectly at least 80 percent of the vote or value of the corporation’s stock.
2 The definition of a regulated financial group excludes companies that are owned by a regulated financial company pursuant to 12 U.S.C. 1843(k)(1)(B), 12 U.S.C. 1843(k)(4)(H), or 12 U.S.C. 1843(o).