United States

Section 385 debt-equity regulations finalized; status quo maintained

TAX ALERT  | 

Treasury and the IRS have released final regulations that essentially maintain the status quo for rules that treat certain party debt instruments as equity for federal income tax purposes. A recent Treasury decision (T.D. 9897) has finalized proposed regulations originally issued in October 2016 without substantive changes. 

No significant change made 

These final regulations do not significantly change the debt-equity rules in the section 385 regulations, given that taxpayers were authorized to rely on the proposed regulations under a November 2019 advance notice of proposed rulemaking (the ANPRM, REG-123112-19). Finalization does make mandatory application of certain aspects of the section 385 regulations that were contained in the proposed regulations, including rules applicable to consolidated groups of corporations and controlled partnerships, and 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. Finalization is effective May 14, 2020, but many affected taxpayers already applied these rules, particularly taxpayers that could benefit from applying the exceptions.  

While the November 2019 ANPRM announced the direction of future changes to the section 385 regulations, those changes are not included in the final regulations issued now in May 2020. Treasury and the IRS had announced in the ANPRM that they plan to replace one of the harshest provisions of the section 385 regulations – the per se funding rule. However, that rule remains in effect. 

Section 385 regulations recast certain debt instruments as equity

The regulations under section 385 include recast rules that apply to certain debt instruments issued by members of an expanded group of corporations. 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. The recast rules require treatment of certain debt instruments as stock for federal income tax purposes. 

The recast rules generally are intended to apply in apply to debt issued in connection with specified transactions (Targeted Transactions). Targeted Transactions include distributions within an expanded group, asset acquisitions from within the expanded group and stock acquisitions within the expanded group. The per se funding rule expands the scope of the recast rule to certain debt issuances issued within a 72-month period surrounding the date of a Targeted Transaction; the rule recast such debt as stock. Because the actual use of debt proceeds is irrelevant under the per se funding rule, the rule is quite unfair.

For discussion of the section 385 regulations issued in October 2016, see our White Paper Treasury’s much anticipated debt-equity regulations. For further discussion of the November 2019 ANPRM, see our prior Alert New developments in debt equity regulations.  

Conclusion

Treasury and the IRS have finalized proposed regulations under section 385 in a way that essentially preserves the status quo for these debt-equity rules. Liberalization of the unfair per se funding rule remains on the horizon – perhaps the distant horizon. 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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