United States: Treasury Finalizes And Significantly Modifies The Debt-Equity Regulations Under Section 385

New final and temporary regulations under Section 385, addressing the treatment of related-party debt, significantly narrow parts of the controversial proposed regulations released in April.

The proposed regulations were widely perceived as interfering with various ordinary business transactions that involve related parties as well as common treasury management techniques, such as cash pooling. Read Grant Thornton LLP's previous coverage on the proposed regulations here.

The new guidance, released on Oct. 13, includes final and temporary regulations (T.D. 9790) intended to deter certain "earnings stripping transactions" that are often used as domestic, international or state and local tax planning strategies. The regulations are part of the IRS and Treasury's continued assault on inversion transactions, but also have a broader impact on many transactions both domestic and cross-border.

The final and temporary regulations include numerous modifications intended to minimize the burdens of compliance under the regulations and also reduce "collateral consequences" resulting from noncompliance. In other areas, however, the government did not modify or narrow the regulations as requested by stakeholders and commentators.

Final and temporary regulations

The final and temporary regulations amend the proposed regulations to address a number of key concerns raised by the public. The final and temporary regulations, along with the preamble, are voluminous, exceeding 500 pages. Although there are many notable changes, some of the most significant are briefly highlighted below. The regulations become effective (except for certain retroactive aspects) upon formal issuance, which is expected to occur on or about Oct. 21.

Key changes to the scope

The new regulations significantly amend the scope of the proposed regulations in three key areas.

First, the final regulations do not apply to debt issued by foreign corporations.

Second, subchapter S corporations, non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs) are exempt from nearly all aspects of the final regulations. However, RICs and REITs continue to be subject to the regulations if they are controlled by members of an otherwise existing expanded group.

Third, the final regulations eliminate the bifurcation rule, which authorized the IRS to bifurcate certain related-party debt into part debt and part stock. However, the preamble notes that Treasury and the IRS will continue to study the issue.

Key changes to the documentation requirements

The new regulations amend the timing requirements for preparation and maintenance of documentation. The final regulations treat documentation and financial analysis as 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.

Under the proposed regulations, a documentation failure with respect to a debt instrument resulted in per se equity treatment. The final regulations, however, provide limited relief such that if an expanded group is otherwise "highly compliant" with the documentation rules, then taxpayers may be able to rebut, in some cases, the presumption that the documentation failure results in automatic equity recharacterization.

Finally, the new regulations provide for delayed implementation of the documentation requirements. The documentation requirements will apply only to debt instruments issued on or after Jan. 1, 2018.

Key changes to the recast rules

The final regulations provide much needed relief from many aspects of the recast rules. The numerous changes to the recast rules include, among others:

  • Exclusion of debt instruments issued by certain regulated entities, including financial entities, financial groups and insurance companies.
  • Exceptions for certain treasury management techniques, including cash pooling, by excluding deposits pursuant to a cash management arrangement as well as certain advances that finance short-term liquidity needs.
  • Narrowing of the funding rule by preventing certain "cascading" consequences.
  • Expansion of the earnings and profits (E&P) exception to include all the E&P of a corporation that accumulated while it was a member of the same expanded group for tax years ending after April 4, 2016.
  • Removal of the "cliff effect" of the threshold exception under the proposed regulations, which affords all taxpayers the ability to exclude the first $50 million of indebtedness that otherwise would be recharacterized under the recast rules.
  • Allowance for netting of certain contributions against distributions between the same two entities, such that an equity recast is applicable only to the "net reduction" to the subsidiary's capital.
  • Exception for the acquisition of stock delivered to employees, directors and independent contractors as compensation for services.
  • Exception for debt issued by a partnership, although debt issued to a partnership by a "covered member" continues to be subject to the documentation rules.

Treasury and the IRS believe that the changes implemented reduce the scope of the regulations to apply only in particular factual situations where there are elevated concerns about related-party debt's being used to create significant federal tax benefits without having meaningful non-tax effects (e.g., inserting new capital).

Many negative aspects remain

Despite the taxpayer-favorable amendments provided by the final regulations, Treasury and the IRS declined to provide relief for many problematic aspects of the proposed regulations, as requested by taxpayers and other stakeholders. A few notable examples include:

  • The recast rules apply retroactively to April 4, 2016.
  • Cash pooling arrangements and regulated entities are not exempt from the documentation rules.
  • Debt issued by a partnership is subject to the recast rules under the "aggregate model" if the partnership has partners that are members of an expanded group.
  • Most important, the final regulations provide no exception to the per se funding rule. Consequently, any debt issued within 36 months before or 36 months after a "tainted transaction" is automatically recast as equity to the extent of the amount of the tainted transaction.

Preliminary observations

Despite the significant revisions made to the proposed regulations, the final regulations retain significant consequences for noncompliance and continue to impact many related-party funding, reorganizations and other ordinary course transactions. Taxpayers should carefully analyze the final and temporary regulations regarding any instruments issued on or after April 4, 2016.

Given the significant consequences that remain, taxpayers should exercise extreme caution when entering into any related-party lending transactions in order to avoid the many pitfalls for the unwary included in the final regulations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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