Final and temporary regulations released under Section 385 on Oct. 13 address the treatment of related-party debt instruments as equity. While broad in application, the final regulations have a narrower application than the proposed regulations, which significantly reduces the number of taxpayers and transactions affected. 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 with discretion to establish specific rules for determining whether an interest is treated as stock or indebtedness for federal tax purposes.
The most significant change in the final regulations limits the scope of the regulations to expanded group debt instruments (EGI) of U.S. issuers. The IRS has deferred any guidance related to debt of foreign issuers.
Other significant changes to the scope of the final regulations include:
- S corporations, noncontrolled regulated investment companies (RICs), and real estate investment trusts (REITs) are exempt from all aspects of the final regulations. EGIs between captive REITs and RICs will continue to be subject to the regulations.
- The final regulations do not include a general bifurcation rule. The Treasury and the IRS will continue to study this issue. The proposed regulations gave the IRS the authority to bifurcate an EGI into a debt instrument and an equity instrument.
The final regulations include the following significant changes to the documentation requirements of Treasury Regulation Section 1.385-2:
- The 30-day timely preparation requirement that was in the proposed regulations is eliminated, and documentation and financial analysis is treated 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), for the year in which credit was extended.
- If an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than per se recharacterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument.
- The documentation requirements will apply only to expanded group indebtedness issued on or after Jan. 1, 2018.
The final and temporary regulations make the following significant changes to the rules regarding distributions of debt instruments and similar transactions under Treasury Regulation Section 1.385-3:
- Exempt debt instruments issued by certain specified financial entities, financial groups (including banks, bank holding companies, and broker dealers), and insurance companies that are subject to a specified degree of regulatory oversight regarding their capital structure.
- Generally exclude from the scope of Section 1.385-3 deposits pursuant to a cash management arrangement as well as certain advances that finance short-term liquidity needs.
- Narrow the application of the funding rule by preventing, in certain circumstances, the so-called cascading consequence of recharacterizing a debt instrument as stock.
- Expand the earnings and profits exception to include all the earnings and profits of a corporation that were accumulated while it was a member of the same expanded group and after the day that the proposed regulations were issued.
- Remove the “cliff effect” of the threshold exception under the proposed regulations so all taxpayers can exclude the first $50 million of indebtedness that otherwise would be recharacterized.
- Provide an exception pursuant to which certain contributions of property are “netted” against distributions and transactions with similar economic effect.
- Provide an exception for the acquisition of stock delivered to employees, directors, and independent contractors as consideration for the provision of services.
Treasury Regulation Section 1.385-3 applies to taxable years ending on or after Jan. 19, 2017, for debt instruments issued after April 4, 2016. Pursuant to transition rules, no instrument will be treated as stock prior to Jan. 19, 2017. Taxpayers may elect to apply the proposed regulations for debt instruments issued between April 4 and Oct. 13, 2016.
The final regulations continue to apply to loans to and from controlled partnerships. A partnership is a controlled partnership if 80 percent of the interests in partnership profits or capital are owned directly or indirectly by members of an expanded group.