United States

New developments in debt equity regulations

Section 385 regulations remain in place, will be modified

TAX ALERT  | 

Treasury and the IRS recently released modifications  to regulations under Section 385 that treat some related party debt instruments as equity for federal income tax purposes, including key relief from the regulations’ onerous documentation requirements and addressing other areas. The new guidance does not make any significant changes to the regulations, but does announce the direction of some future changes. The new guidance takes the form of an advance notice of proposed rulemaking (the ANPRM, REG-123112-19) and final regulations (T.D. 9880). The guidance covers four areas (each is discussed further below): 

1. The section 385 regulations will be retained; since they will not be eliminated, the tax rules applicable to certain related party debt issuances will remain quite complicated;  

2. One of the harshest rules in the regulations – the per se funding rule – is to be replaced in the future by a less harsh rule yet to be proposed; 

3. Taxpayers may continue to rely on the text of temporary regulations that have expired, which may be beneficial to affected taxpayers; and 

4. The section 385 documentation requirements have been officially removed, as previously promised. 

1. Section 385 regulations to remain in effect 

The section 385 regulations in general

Regulations under section 385 issued in October of 2016 include recast rules that apply to certain debt instruments issued by members of an “expanded group” of corporations. The recast rules require treatment of some of those instruments as stock for federal income tax purposes. The recast rules apply in specified contexts including distributions within an expanded group, asset acquisitions from within the expanded group, and stock acquisitions within the expanded group. The intent of the recast rules generally was to prevent erosion of the U.S. tax base through placement of debt owed by a U.S. corporation to a foreign affiliate, which was a typical post-inversion planning technique. 

Section 385 regulations to be retained

The recast rules under the section 385 regulations can be burdensome, and the enactment of section 163(j) (discussed in our Alerts Dec. 22, 2017, April 5, 2018, and Nov. 30, 2018) significantly limits companies’ ability to reduce tax liability via interest expense deductions. As a result, Treasury and the IRS received comments requesting that the recast rules be eliminated. In the ANPRM, however, the government announced that the recast rules would be retained.  

2. Harsh per se funding rule to be relaxed, but remains in place for now 

The ANPRM announced that a particularly harsh aspect of the section 385 regulation would be removed in the future. However, it remains in place for now. 

The per se funding rule

The section 385 regulations’ funding rule expands the scope of the recast rule. As summarized above, the recast rules apply to debt in connection with corporate distributions (or certain other transactions). Under the per se funding rule, if certain debt instruments are issued within a 72-month period surrounding the occurrence of corporate distributions (or certain other transactions), the debt instrument is treated as funding that distribution (or other transaction) and thus subject to potential recast as equity under the regulations. Under the per se funding rule, the actual use(s) made of the debt proceeds is irrelevant. 

Because the actual use of debt proceeds is irrelevant under the per se funding rule, the rule is quite unfair. To illustrate, assume that a foreign parent corporation (FP) owns 100% of a U.S. subsidiary corporation (USS). In 2019, FP lends $100 million cash to USS and receives a debt instrument issued by USS. USS immediately uses all of the $100 million cash, plus $50 million of its own cash on hand, to purchase U.S. assets from an unrelated party for $150 million. In 2021, USS distributes $50 million of cash to FP. The per se funding rule treats the 2019 loan from FP as funding the entire $50 million 2021 distribution by USS to FP, and $50 million of the $100 million debt issued by USS to FP is recharacterized as stock under the section 385 regulations unless an exception applies.

Per se funding rule to be replaced 

Treasury and the IRS state in the ANPRM that they will replace the per se funding rule with a rule with one that is less harsh. The new rule has not been proposed yet. The ANPRM explains that the new rule would require a more clear connection between a borrowing and a distribution (or other triggering transaction). Mere proximity in time would not trigger application of the recast rules. The ANPRM suggested that an integrated plan involving the borrowing and distribution may be required in order to trigger the recast rule, and requested comments regarding what specific rule should be proposed in place of the per se funding rule. 

Replacement of the harsh per se funding rule would be welcome. At this time, however, the rule remains in effect. The ANPRM states that the replacement rule would be effective when it is finalized. 

3. Taxpayers may rely on text of expired temporary section 385 regulations 

Temporary and proposed regulations under section 385 issued in 2016 addressed some of the recast rules, along with some of the exceptions to the recast rules. They have not been finalized. The temporary section 385 regulations expired on Oct. 13, 2019. Just prior to their expiration, the IRS addressed the temporary section 385 regulations in Notice 2019-58. Under that Notice, and under the ANPRM (which supersedes it), a taxpayer may rely on the proposed section 385 regulations for periods following the expiration of the temporary section 385 regulations, provided that the taxpayer consistently applies all of the proposed regulations’ rules. Since the proposed regulations are identical to the temporary regulations, reliance on the proposed regulations would preserve the status quo.   

The temporary regulations included some aspects of the section 385 regulations applicable to consolidated groups of corporations and controlled partnerships, and include exceptions to the recast rules for certain short-term and working capital debt, ordinary course intercompany receivables incurred in purchasing inventory, and cash pool deposits. Companies that would benefit from these exceptions to the recast rules generally would choose to rely on the proposed regulations to obtain the same results. Companies in situations addressed in the consolidated group and controlled partnership areas of the temporary section 385 regulations should consider the pros and cons of relying on the proposed regulations. Although affected companies in many cases would choose to rely on the proposed regulations, each should consider its specific situation.

4. Official removal of the section 385 regulations’ documentation requirements 

On Oct. 31, 2019, the Treasury and the IRS published T.D. 9880 announcing the official removal of Treas. Reg. section 1.385-2, commonly referred to as the Documentation Regulations.

The Treasury and IRS published debt documentation requirements in 2016 as part of the section 385 regulation package. These documentation regulations never became effective (even though they were published as final regulations). They would have established burdensome minimum documentation requirements necessary for companies to meet in order to avoid default equity treatment of certain related party debt. 

Because of the section 385 documentation requirements’ burdensome nature, Treasury and the IRS delayed their scheduled applicability date by issuing Notice 2017-36. Soon thereafter, in its answer to the Executive Order 13789 issued April 21, 2017, the Treasury identified the documentation regulations as one of eight regulations imposing undue financial burden, or undue complexity (Notice 2017-38). In the following year, under a Notice of Proposed Ruling Making issued Sept. 21, 2018 (REG-130244-17), the Treasury proposed the removal of the documentation requirements, and authorized taxpayers to rely on the proposal. 

Now, the section 385 documentation requirements have officially been removed. Taxpayers should bear in mind, however, that documentation of related party loans often is necessary for treatment of the loans as debt for federal income tax purposes under federal tax case law. However, the documentation required under case law generally is not as extensive as that set out on the removed section 385 documentation rules. 

Conclusion

Treasury and the IRS have taken further steps toward rationalizing the overbroad set of debt-equity regulations originally issued in April of 2016 under section 385. The regulations’ debt-equity recast rules, however, will remain in place. As a result, U.S. corporations that plan to issue debt to a foreign affiliate or are otherwise subject to the section 385 regulations should discuss the regulations’ effects with their tax advisors. 

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