Final and Temporary Section 385 Regulations

On October 13, 2016, the IRS and Treasury released final and temporary regulations under section 385 addressing the classification of intercompany loans as debt or equity for U.S. tax purposes. The final regulations, effective on October 21, 2016 followed the release of proposed regulations in April 2016.

The proposed and final regulations establish documentation requirements which must be met for certain related party interests to be treated as debt for U.S. tax purposes. As compared to the proposed regulations, the final regulations provide significant relief for many taxpayers. This memorandum highlights some of the significant changes to the proposed regulations.

Regulations apply only to U.S. Domestic Corporations

In perhaps the most significant change to the proposed regulations, the final regulations restrict the definition of “covered member” to a member of an expanded group that is a domestic corporation. This welcome change is intended to exclude debt issued between two foreign entities that does not have relevance from a U.S. tax perspective. The change to the covered member definition also exempts debt issued by U.S. partnerships from the documentation rules (except partnerships controlled by domestic corporations).

The final regulations reserve on the application of the rules to foreign issues.

Effective Dates

Under the final regulations, the documentation rules apply to debt issued on or after January 1, 2018. The proposed regulations would have applied to debt issued on or after the date the regulations became final. The effective date for the “recast” rules continues to apply to transactions occurring and debt issued on or after April 4, 2016; however, there is a “final transition period” that exempts debt from the recast rules if it is settled within 90 days of October 21, 2016.

S Corporations and non-controlled RICs and REITS excluded from Definition of Expanded Group

The final regulations eliminate the potential for inadvertent termination of an “S Election” that could have occurred if debt issued by the S corporation were recharacterized as equity and treated as a second class of stock.

The regulations also exclude RICs and REITs unless they are controlled by members of the expanded group.

Elimination of the Bifurcation Rule

The proposed regulations included a bifurcation rule that would have allowed the IRS to determine that a portion of a debt instrument should be treated as equity under certain circumstances. The final regulations do not include the rule and, as a result, classification will continue to be all or nothing. However, in the preamble to the regulations IRS and Treasury indicate that they will continue to study the issue.

Extension of Time to Prepare Documentation

The final regulations significantly modify the “timely preparation of documentation requirement” from 30 days after the “relevant date” (usually the date of issuance of the instrument) to the due date, including extensions of the tax return that includes the relevant date.

Rebuttable Presumption: The final regulations permit “highly compliant” taxpayers to rebut the assumption that failure to meet the documentation requirements results in debt being recharacterized as equity. To be considered “highly compliant” the expanded group must meet one of four tests for the year in which there is an undocumented debt.

Exceptions for Certain Debt Instruments

Regulated Financial Groups: The final regulations do not apply to regulated financial companies nor to regulated insurance companies subject to specific regulatory capital and leverage requirements. The regulations continue to apply to captive insurance companies and non-insurance entities within an insurance group.

Cash Pooling and Short-Term Debt Instruments: The exclusion of foreign-to-foreign transactions in the final regulations has significantly reduced concerns that were raised following the release of the proposed regulations concerning the use of cash pooling arrangements. The final regulations do not exempt cash pooling arrangements from the documentation rules; however, additional detail is provided regarding how to satisfy the four requirements of the documentation rules through the use of “umbrella” or “master” credit agreements.

Recharacterization Rules:

72-Month Rule: The final regulations retain the “72-Month” funding rule which provides that any debt instrument issued within 36 months before or after a taxpayer’s implementation of a “tainted” transaction will be recharacterized as equity. The non-rebuttable principal purpose presumption rule was also left intact.

Exceptions to In-Scope Debt: The final regulations do add several categories of debt that are exempt for the funding rule, including:

  • A demand deposit received by a “qualified cash pool header” pursuant to a cash management arrangement.
  • A short-term funding arrangement based on the current assets reported on the issuer’s financial statements or debt instruments having a term of 270 days or less.
  • An “ordinary course” loan issued for property other than cash provided it is expected to be repaid within 120 days.
  • An interest free loan that is not required to carry interest under the applicable U.S. tax rules.

Expanded E&P exception: The final regulations expand the earnings and profits exception to include all earnings and profits accumulated while the corporation was a member of the same expanded group and after April 4, 2016.

$50 Million exception: Under the final regulations the cliff effect of the proposed regulations is removed so that all the taxpayers can exclude the first $50 million of debt that may otherwise be subject to recharacterization.

“Cascading” transactions limitation: The final regulations narrow the application of the funding rule by preventing the ability of a recast debt instrument to taint other debt instruments even after the recast debt is repaid.

In Summary

The final regulations provide significant relief for multinational taxpayers through eliminating problematic provisions, scaling back the applicability of the rules to only include domestic corporations, providing exemptions for S corporations and certain regulated financial entities, making some favorable changes to the recast rules, simplifying documentation rules for cash pooling arrangements, and delaying the effective date. Taxpayers and practitioners welcome these changes; however, the regulations remain very detailed and complex. U.S. multinationals with related party debt will need to pay close attention to the new rules and the recharacterization rules in particular.