IRS Issues Final Regulations Under Section 385

On May 13, the Internal Revenue Service (IRS) issued final regulations under Internal Revenue Code (IRC) Section 385. As expected, the final regulations excluded the documentation requirements previously included in Section 1.385-2. The elimination of the documentation requirements was a welcome relief to taxpayers as they would have created a significant burden on many businesses. Another welcome change from the initial regulations relates to the exclusion of S-Corporations and the aggregate treatment of partnerships. The final regulations treat partnerships as an aggregate of its partners where the potential re-characterization is assessed at the entity level. The final regulations also exclude instruments issued by non-U.S. corporations, which greatly reduces potential complexity for U.S. shareholders of controlled foreign corporations.

While the changes referenced above reduce the scope of application of the final regulations, there are still many traps for the unwary and potential implications of Section 385. The most commonly affected category of taxpayers will be inbound U.S. subsidiaries of foreign corporations. Where such U.S. corporations are debtors to foreign affiliates, the regulations bear further scrutiny.

The general principle of the regulations is that a covered debt instrument is treated as stock where it is issued to a member of the expanded group in a distribution, in exchange for stock or as part of an asset reorganization. The definition of the expanded group can itself be complex depending on the organizational structure. Group members that file a consolidated federal return are considered one taxpayer for purposes of these regulations.

The regulations also have a broad “funding rule” that casts a wide net to potentially pull in most debt instruments that do not meet one of the exemption criteria. To the extent debt is recharacterized, deductions for interest payments are disallowed and payments of interest and principal may be treated as dividends subject to withholding tax.

The most commonly applied exemptions will likely be for short-term loans that are a “qualified short-term debt instrument.” These fall into four main categories, but care must be taken not to violate the regulations and trigger the debt to equity reclassification rules.

  • 1
    Short Term Funding Arrangements
    Short-term loans can generally be exempted where they meet the requirements to be classified as a current asset under the taxpayers applicable accounting principles. There is also a safe harbor for short-term funding arrangements of less than 270 days. The interest rate and terms of these arrangements must be reasonable under an arms-length standard. While the exemption here is broad, it requires monitoring to ensure the loan doesn’t drift out of bounds.
  • 2
    Ordinary Course Loans
    This exemption applies to loans in connection with the acquisition of property (such as inventory) where the loans are reasonably expected to be repaid within 120 days. For taxpayers claiming this exemption, monitoring of days outstanding will be key to ensure that loans are repaid in a timely manner.
  • 3
    Interest Free Loans
    Loans that do not bear interest, do not have original issue discount and are not subject to the imputation of interest under other code sections are generally exempt from recharacterization under Section 385.
  • 4
    Cash Pool Deposits
    Many organizations use a cash pooling entity or unit to manage cash flow for members of the group. The regulations acknowledge this approach and generally allow an exception for deposits by a group member with the cash pooling manager. The exemption is subject to broad anti-abuse rules.

The regulations contain a variety of other exceptions that can apply in different unique scenarios. These exceptions include certain acquisitions of subsidiary stock, certain stock compensation arrangements, transfer pricing adjustment related distributions, acquisitions by a dealer in securities and a reduction to the recharacterized amount for qualified contributions. These provisions are complex and very fact-dependent. Care should be taken when applying these exceptions.

Once a debt is deemed subject to recharacterization, there is a threshold exception for aggregate debt of less than $50 million. The amount subject to the threshold is further reduced by the accumulated earnings and profits (E&P) of the issuer and also reduced by qualified contributions to the issuer.

The key takeaway is to evaluate debts to an expanded group member that are issued or modified after the effective date of the regulations (generally April 4, 2016) to ensure that they qualify under one of the exemption provisions. To the extent that a debt does not meet one of the exception criteria, it will likely be considered a covered debt instrument and be subject to recharacterization.

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