Proposed regulations addressing debt versus equity under IRC Section 385 recently were released. If adopted, the proposed regulations would represent a significant change for corporations that issue debt instruments to related business entities. Section 385 authorizes the U.S. Department of the Treasury to prescribe regulations as necessary or appropriate to determine whether an interest in a corporation is treated as stock or indebtedness for purposes of the IRC. Section 385 also provides the Treasury Department with discretion to establish specific rules for determining whether an interest is treated as stock or indebtedness for federal tax purposes in a particular factual situation.
Under proposed Regulation 1.385-1, an instrument issued by a corporation would be subject to the new rules if the debt instrument is issued to a member of its “expanded group.” The expanded group is defined as the issuer’s affiliated group under Section 1504(a), with the following modifications:
- The expanded group includes foreign corporations and tax-exempt entities.
- The expanded group includes corporations held through partnerships.
- The attribution rules of Section 304(c)(3) are used to determine ownership.
- A corporation would be treated as a member of an expanded group under a test of 80 percent vote or value, not the 80 percent vote and value test required for affiliation under Section 1504.
A debt instrument issued to a member of the expanded group is referred to as an expanded group instrument (EGI).
Proposed Regulation 1.385-1 also gives the IRS the authority to bifurcate a debt instrument as part debt, part equity. Under the proposed regulation, if, for an EGI that is documented as a $5 million debt instrument, it is demonstrated that the issuer cannot reasonably be expected to repay more than $3 million of the principal amount as of the issuance of the interest, the IRS may treat the interest as $3 million of debt and $2 million of stock. The IRS would have the ability to bifurcate a debt instrument between related parties using the EGI definition above but with a 50 percent ownership threshold instead of an 80 percent threshold.
Proposed Regulation 1.385-2 imposes contemporaneous documentation requirements that must be met for an EGI to qualify as debt for federal income tax purposes. The documentation rules apply if any of the following apply:
- The stock of any member of the expanded group is traded on or subject to the rules of an established financial market.
- On the date that an applicable instrument first becomes an EGI, total assets exceed $100 million on any applicable financial statement.
- On the date that an applicable instrument first becomes an EGI, annual total revenue exceeds $50 million on any applicable financial statement.
Applicable financial statements include financial statements filed with the Securities and Exchange Commission, audited financial statements, and any financial statement filed with a federal, state, or foreign regulatory agency.
The written contemporaneous documentation must include the following information:
- The issuer must have an unconditional obligation to pay a sum certain to the holder.
- The holder of the EGI must have typical creditor rights.
- The issuer must document a reasonable expectation of its ability to repay the EGI.
- The issuer must take action evidencing a debtor-creditor relationship, such as the actual transfer of funds for the payment of principal and interest.
- If the issuer of the EGI does not make payments when due, or if an event of default occurs, there must be written documentation demonstrating the holder's reasonable exercise of the diligence and judgment of a creditor.
- There are additional contemporaneous documentation requirements for EGIs that in form do not reflect indebtedness.
If the documentation requirements are not satisfied, the EGI will be treated as equity. However, satisfying the documentation standards does not automatically result in classification as a debt instrument. The EGI still must satisfy all other requirements of the IRC to be treated as a debt instrument.
The proposed regulation does not apply to loans among taxpayers that file a consolidated federal income tax return. Because many states do not follow the federal consolidated return rules, businesses should treat all intercompany loans as if they are subject to these rules. These rules would be effective when adopted as final regulations.
Proposed Regulation 1.385-3 is targeted at specific transactions in which a corporation distributes its own debt to shareholders. It treats an EGI as stock to the extent it is issued by a corporation to a member of the corporation's expanded group in one of these ways:
- In a distribution
- In exchange for expanded group stock, other than in a tax-free asset acquisition
- In exchange for property in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the issuer's expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation
Proposed Regulation 1.385-3 also treats an EGI as stock if issued in exchange for property with a principal purpose of:
- Funding a distribution or acquisition
- A distribution of property by the funded member to a member of the expanded group
- An acquisition of expanded group stock
- An acquisition of property by the funded member in an asset reorganization
The proposed regulation establishes a nonrebuttable presumption that EGI debt is issued to fund a distribution or acquisition if the EGI debt is issued by the funded member during the period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution or acquisition (the 72-month period). This rule does not create a safe harbor, and an EGI debt instrument issued outside the 72-month period still may be treated as having a principal purpose of funding a distribution or acquisition based on the facts and circumstances.
For example, if a foreign parent has a loan to a U.S. subsidiary and within 72 months of issuing EGI the U.S. subsidiary declares a dividend that exceeds its current earnings and profits, the EGI is reclassified to equity for all purposes of the IRC. This portion of the proposed regulations would apply to any debt issued on or after April 4, 2016. If a debt instrument is issued after April 4 and under Regulation 1.385-3 it is treated as stock, the instrument would be considered debt until 90 days after the regulations are finalized.
The proposed regulations are sweeping in scope and, because of their varying effective dates, will require businesses to review all related-party financing agreements.