Internal Revenue Code (IRC) Section (§) 385(a) provides that the Secretary of the Treasury is authorized to prescribe regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness (or as in-part stock and in-part indebtedness). Prior to the issuance of Treasury guidance, the determination of whether an interest represented debt or equity was determined under common law debt versus equity factors.
Proposed regulations were issued in April 2016 under IRC § 385 (the 2016 Proposed Regulations). The 2016 Proposed Regulations were issued as part of a broader inversion package targeting the benefit of post-inversion tax avoidance by earnings stripping. The 2016 Proposed Regulations focused only on financial instruments issued with respect to related parties and not unrelated parties. Specifically, the 2016 Proposed Regulations applied the debt versus equity determination to instruments issued in transactions including (a) debt instruments distributed by corporations to their related corporate shareholders; (b) issuances of debt instruments by corporations in exchange for stock of an affiliate; (c) issuances of debt instruments as consideration as part of an internal asset reorganization (collectively the Distribution Regulations).
The 2016 Proposed Regulations also include rules that would authorize the Commissioner to treat a related-party interest in a corporation as indebtedness in part and as stock in part, consistent with its substance and establish documentation requirements that must be satisfied for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. The documentation requirements were later removed in October 2019 after the Treasury and the IRS published T.D. 9880.
On October 21, 2016, final and temporary regulations were issued which retained the general framework of the 2016 Proposed Regulations but made several significant modifications that reduced the reach of the 2016 Proposed Regulations (2016 Temporary Regulations). The most significant modification in the 2016 Temporary Regulations was to exclude foreign issuers but the regulations did reserve on the application of the regulations to indebtedness issued by foreign corporations. Subsequent to the release of the 2016 Treasury Regulations, significant portions of the regulations were withdrawn on May 13, 2020 by Treasury Decision 9897.
On May 13, 2020, the IRS and the Treasury finalized the 2016 Proposed Regulations and withdrew the 2016 Temporary Regulations (2020 Final Regulations)
The Final Section 385 Regulations
The 2016 Proposed Regulations were adopted with no substantive changes in the 2020 Final Regulations. Accordingly, the 2020 Final Regulations make mandatory the following rules contained in the 2016 Proposed Regulations:
- Certain qualified short-term debt instruments are exempt from the Distribution Regulations. These instruments include short-term funding arrangements, ordinary course loans, interest-free loans, and deposits with a qualified cash pool header.
- Controlled partnerships do not recharacterize their debt instruments as stock. Instead, the debt instrument is treated as an exchange for stock of the controlled group partners. A controlled partnership, which is a partnership where at least 80% of the interests are held either directly or indirectly by its expanded group members, is generally treated as an aggregate of its partners.
- All members of a consolidated group that file a consolidated U.S. Federal income tax return will be treated as one corporation. Thus, when a member of a consolidated group issues a covered debt instrument that is not a consolidated group debt instrument, the consolidated group is treated as the issuer of the debt instrument.
The IRS announced in guidance in October and November 2019 that taxpayers could rely on the 2016 Proposed Regulations provided they were applied consistently in their entirety. The portions of the 2020 Final Regulations relating to qualified short-term debt instruments and the treatment of controlled partnerships apply to tax years ending after January 19, 2017 (and for debt instruments issued after April 4, 2016). The portions of the 2020 Final Regulations on consolidated groups apply solely to tax years for which a U.S. Federal income tax return is due, determined without regard to extensions, after May 14, 2020.
Tax Planning Implications
The 2020 Final Regulations primarily affect corporations, including those that are partners of controlled partnerships. Corporations that issue debt instruments to related corporations or partnerships should reevaluate the issuance date of the instruments to determine whether they will be treated as stock under the 2020 Final Regulations. Corporations should analyze their short-term debt instruments to determine if they are exempt from the Distribution Regulations. Since the 2020 Final Regulations are finalized without substantive changes to the 2016 Proposed Regulations, corporations that have consistently and entirely applied the 2016 Proposed Regulations will most likely not have to reevaluate their respective tax positions.
In its release of the 2020 Final Regulations, the Treasury stated that it intends to issue proposed regulations modifying the Distribution Regulations to make them more streamlined and targeted. It is also planning on withdrawing the ”per se” rule, though no timeline is indicated on the release of the new proposed regulations for comment.