US Treasury's much-anticipated debt-equity regulations
Section 385 dictates equity treatment for some related party debt
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In April 2016, the Treasury proposed broad and controversial debt-equity regulations designed to limit erosion of the United States corporate tax base. The final and temporary regulations (the Regulations) issued Oct. 13, 2016, significantly improve upon the proposed regulations and place the focus squarely on certain areas in which the Treasury and the Internal Revenue Service (IRS) have viewed issuance of related party debt as inappropriate or abusive.
The Regulations provide rules that would characterize certain related party debt as equity and thereby eliminate interest deductions that that would otherwise be available to offset corporate income tax. They also provide documentation requirements that companies must meet to avoid a presumption of equity treatment for certain debt.
The Regulations generally apply to debt instruments between members of an expanded group of affiliated corporations (an EG). The good news is that they provide numerous exceptions intended to limit their potential application to transactions that do not raise the earnings stripping concerns that the Treasury intended to address. These exceptions in many instances exclude S corporations, banks, insurance companies, regulated investment companies (RIC) and real estate investment trust (REITs) from their scope.
Taking stock of the Regulations
Corporate taxpayers are taking notice of the Regulations, considering their applicability and effective dates. Companies may want to consider the following steps in response to the Regulations:
- Determine the existence of an EG and identify each member of the EG
- Identify debts issued by US corporations in the EG to other members of the EG (or certain related partnerships)
- Determine whether appropriate documentation is in place and if not, make sure documentation is in place by the applicable date
- Identify any recharacterized debt instruments resulting from application of the Regulations.
- Establish policies and procedures to track and comply with the recharacterization rules
- Where the Regulations might potentially provide undesirable results, consider alternative structures, bearing in mind other tax rules intended to address base erosion and profit shifting (BEPS)
- Perform a factual debt-equity analysis under general federal tax principles with respect to debt that is not subject to recharacterization under the Regulations
Download our white paper for additional discussion of the Regulations, including their documentation requirements and equity recharacterization rules.