Code Section 385 deals with the classification of certain interests in corporations as either “debt” or “equity” interests. The Code Section was originally enacted over 40 years ago, and later amended twice. The Code section itself provides scant guidance on the subject and gives the US Internal Revenue Service (IRS) authority to issue Treasury Regulations to determine whether an interest in a corporation should be classified as debt or stock (equity) in the corporation.
The history of the IRS’ Treasury Regulations projects dealing with Code Section 385 confirm that this is a difficult topic to grasp and on which to provide guidance. Decades ago, the IRS had initially issued Treasury Regulations but later withdrew them. (See Treasury Decision 7920 1983-2 C.B. 69 withdrawing Treasury Decision 7747 Relating to Debt and Equity). In April of this year, the IRS issued Proposed Treasury Regulations (REG-108060-15) under Code Section 385 addressing whether an interest in a related corporation should be treated as stock or debt, or as “part” stock / “part” debt. The Proposed Regulations were highly controversial and created a great deal of concern among tax professionals. Among other concerns, the Proposed Regulations were viewed as interfering with numerous ordinary business transactions that involved related parties as well as common treasury management techniques (for example, cash pooling arrangements).
Finally – Some “Final” Regulations
On October 13, 2016, the IRS issued Final and Temporary Regulations (“Regulations”) under Section 385 (TD 9790). In response to the voluminous public comments, the Regulations contain some helpful modifications to the Proposed Treasury Regulations. Treasury and the IRS believe that the amended rules contained in the Regulations reduce the reach of the regulations so that they apply only in certain fact patterns where concerns are raised that related-party debts are being used to create significant federal tax benefits without having any meaningful non-tax effects. On the upside, a review of the Regulations indicates they will apply to fewer taxpayers and instruments than would have been the case under the Proposed Regulations. On the downside, the scope of the Regulations does remain significantly broad.
Remember, these “debt-equity” Regulations permit the IRS to recharacterize an interest between related corporations as stock or debt; thus they do not apply, for example, to the situation when an individual shareholder makes a “loan” to his corporation. Application of the Regulations is circumscribed to “expanded group indebtedness” (EGI). EGI is defined as an applicable instrument of which both the issuer and the holder are members of the same “expanded group,” the definition of which limits application of the rules to transactions between closely-related parties.
Section 385 and the Regulations, generally do not recharacterize “debt” so as to treat it as another kind of equity, for example, an interest in a partnership. The Regulations apply principally to corporations that have other corporate affiliates. Nonetheless, the Regulations include special rules to deal with partnerships and disregarded entities that have corporate owners, or that own corporations and therefore are included in the corporation’s expanded group.
Reduced Scope: Foreign Corporations Are Exempt
It is with a sigh of relief that I report the Regulations do not apply to debt issued by foreign (non-US) corporations. This change is of particular note to multinational groups. The IRS has elected to “reserve” for the time being the application of the final regulations to instruments that are issued by foreign corporations. For this purpose, a US branch of a foreign issuer is included in the exemption. By electing to “reserve” application of the final regulations to foreign issuers, application is thus indefinitely postponed for this group.
In applying this exemption for foreign corporations, look only to the foreign-status of the issuer of the instrument. Only the issuer must be a foreign person; the identity (foreign or US) of the holder is not relevant. By way of illustration, if a debt instrument is issued by a controlled foreign corporation (CFC) to a related CFC or to a related US corporation, the transaction will not be subject to the Regulations.
This carve-out is very important. Along with another exemption, it means that the Regulations will apply principally when instruments are issued by domestic corporations to related foreign corporations, or when they are issued between related domestic corporations that fall outside of the consolidated group context.
Other Key Changes
The final Regulations eliminate the so-called “Bifurcation Rule”, which authorized the IRS to bifurcate certain related-party debt into “part debt” and “part equity”. The preamble to the Regulations notes that Treasury and the IRS will continue to study this issue.
The final Regulations relax the timing requirements for preparation and maintenance of documentation. Under the Regulations, documentation will be considered timely prepared if it is prepared by the time the issuer’s federal income tax return is filed (including extensions) for the taxable year in which the debt is issued.
With respect to failures in documentation, the Regulations are a welcome relief from the rules contained in the Proposed Regulations. The Proposed Regulations provided that a documentation failure with respect to a debt instrument resulted in “per se” equity treatment. The final Regulations provide limited relief. In certain cases, if an expanded group is otherwise “highly compliant” with the documentation rules, then taxpayers may be able to rebut the presumption mandating an automatic characterization as “equity”.
The Regulations also provide for delayed implementation of the documentation requirements by making them applicable only to debt instruments issued on or after Jan. 1, 2018.
Many other changes have been made to the final Regulations that go beyond the scope of this blog piece. The new rules will force corporate groups with significant operations and US members to carefully review and likely change their practices regarding funds transfers between members; new procedures will have to be implemented to ensure that the documentation requirements are being satisfied; and transactions will require careful on-going monitoring.
Transactions Outside the Regulations
As set out above, the Regulations will not apply to all cases. Many taxpayers will still struggle with classification of an interest as “debt” or “equity” and the tax cost for getting it wrong can be very steep. Such taxpayers and their advisors should remember that case law on this topic has been used to classify an interest as either “debt” or “equity” since the enactment of Code Section 385 many decades ago. The case law has continued to develop over the years. My earlier blog posts here and here have detailed the factors examined by the Courts in making a “debt” versus “equity” determination.
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