On Oct. 13, 2016, the Treasury Department released the highly anticipated final and temporary “debt-equity” regulations under section 385. Since the regulations were released in proposed format on April 8, 2016, there has been a considerable amount of criticism from a wide range of affected parties. As discussed in prior Baker Tilly Tax insights, the regulations under section 385 aim to curb perceived abusive corporate structures and transactions that result in “earnings stripping.” These types of structures commonly arise in the context of corporate inversions. However, taxpayers have been critical the proposed regulations extended the reach beyond perceived abuses and expanded the scope to related-party debt in the ordinary course of business.
Since April, the Treasury and IRS have received a voluminous amount of comments and critical feedback regarding the proposed regulations. It appears the Treasury and IRS have taken these comments to heart by incorporating taxpayer-friendly changes into the final regulations. In particular, the Treasury addressed taxpayer’s concerns over cash pooling and the complexity for foreign multinationals. Nonetheless, careful attention to these new rules will be required by both domestic and foreign businesses.
Below is a high-level discussion regarding the various changes that have been incorporated into the final and temporary regulations. This list covers the major changes made given the taxpayer concerns expressed with the proposed regulations.
Exceptions for certain short-term financing and cash-management arrangements: When the proposed regulations were released, it was not clear whether certain intercompany cash-management arrangements would be subject to the rules under section 385 via the funding rule. The funding rule treats a purported debt instrument as stock if it was issued in exchange for property with the principal purpose of using the proceeds to fund a distribution to a controlling shareholder. By definition, this would cause commonly used intercompany cash-management arrangements to be recharacterized as stock under the funding rule.
The primary concern raised by taxpayers pertained to cash pooling transactions. To address these concerns, the Treasury and IRS provided relief to the funding rule for various forms of short-term lending (section 1.385-3T(b)(3)(vi)). Specifically, Treasury adopted two tests:
- the current assets test (generally allows a company to borrow up to the amount of their current assets); and
- the 270-day test (generally allows borrowings that satisfy a three-prong test on debt instruments of no more than 270 days).
The exceptions are intended to exempt certain transactions and common lending practices entered into under normal commercial terms from being subject to the final regulations.
Exclusion of foreign borrowers: The proposed regulations would have been applicable to expanded group instruments (EGIs) and debt instruments issued by both domestic and foreign corporations. The final regulations under section 385 will not apply to EGIs and debt instruments issued by foreign companies. This means any foreign company that issues debt to a related party will not be subject to the debt-to-equity recharacterization rules or documentation rules under sections 1.385-1 and 1.385-2, respectively. Accordingly, the regulations affect only U.S. borrowers (section 1.385(c)(2)). This modification drastically narrows the scope of the section 385 regulations by limiting its application to EGIs issued by domestic companies. The Treasury will continue to review whether foreign companies will be included in these final regulations at a later date.
Exclusion of S corporations, noncontrolled RICs and REITs: The final regulations exempt S corporations from the definition of expanded group members. In short, any EGIs and debt instruments issued by an S corporation will not be subject to the debt-to-equity recharacterization rules or documentation rules under sections 1.385-1 and 1.385-2, respectively. As noted in the preamble to the final regulations, the decision to exclude S corporations from the expanded group definition does not implicate the integrity of the section 385 policies as an S corporation cannot be owned by a foreign shareholder. Finally, this change removes S corporations from the possible scenario of debt being recast as equity and the entity running afoul of the one class of stock requirements for S corporations.
In addition, the final regulations exempt RICs or REITs from the definition of expanded group member unless the RIC or REIT is controlled by a member of the expanded group.
Extending the documentation requirement due dates: The proposed regulations required that an expanded group member must procure documentation that substantiates various factors as prescribed by the section 385 regulations within 30 days of the issuance of an EGI or debt instrument. The final regulations modify this onerous documentation requirement and now require the expanded group member have the same documentation in place by the tax return filing due date (including extensions) for the year in which the EGI or debt instrument is issued. This documentation requirement is required only for EGIs issued on or after Jan. 1, 2018. Therefore, taxpayers will have until the filing date of their taxable year that includes Jan. 1, 2018, to complete their documentation requirements under section 1.385-2.
Removal of general “bifurcation rule”: There was concern expressed by taxpayers over the “bifurcation rule” included within the proposed regulations. This rule afforded the Commissioner the ability to treat certain debt instruments as part debt and part stock. The proposed regulations did not include much guidance regarding the methodology for determining the portion of an interest to be treated as debt and which portion to be treated as stock. Furthermore, there was concern regarding how the payments on an instrument that was subsequently recharacterized as partial debt and partial stock would be treated for federal tax purposes.
To alleviate these concerns, the Treasury and IRS removed this general bifurcation rule from the final regulations. However, they will continue to review the bifurcation rule and consider its inclusion into these regulations at a future date.
The effective date of the final regulations is Oct. 21, 2016, and applies for taxable years ending on or after Jan. 19, 2017. Taxpayers should begin to assess the impact of the final regulations on their intra-group debt. As noted earlier, the effective date of the documentation requirements applies only to EGIs issued on or after Jan. 1, 2018. Therefore, taxpayers will have until the filing date of their taxable year that includes Jan. 1, 2018, to complete their documentation requirements.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.