On April 4, 2016, the Treasury and the IRS released proposed regulations under Code Sec. 3851 addressing whether purported indebtedness issued to certain related parties will be treated as stock or indebtedness, or as in part stock and in part indebtedness (the "Proposed Regulations").2 Although they were issued with other proposed regulations focused on preventing inversion transactions, the Proposed Regulations contain sweeping rules that would recharacterize many related-party debt instruments without regard to whether the parties are foreign or domestic.3 This article provides a general summary of the Proposed Regulations, while pointing out a few of the key concerns that have been identified so far. It also raises the question of whether Proposed Reg. §1.385-3, if finalized with its proposed effective date, could be viewed as an impermissibly retroactive regulation and how any changes to the Proposed Regulations adopted in final regulations should be considered.
II. Code Sec. 385
Some brief history of Code Sec. 385 is warranted to understand some of the concerns with the Proposed Regulations. Code Sec. 385(a), enacted by Congress in 1969, authorizes the Treasury Secretary "to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness." It was intended that the regulations under Code Sec. 385 set forth factors that are to be taken into account to determine whether a debtorcreditor relationship exists or a corporation-shareholder relationship exists in a particular factual situation. Under Code Sec. 385(b), those factors may include, among other factors, the following: "(1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest; (2) whether there is subordination to or preference over any indebtedness of the corporation; (3) the ratio of debt to equity of the corporation; (4) whether there is convertibility into the stock of the corporation; and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question."
In 1989, Congress amended Code Sec. 385(a) to authorize the Secretary to issue regulations under which an interest in a corporation is treated as in part stock and in part indebtedness by adding the parenthetical "or as in part stock and in part indebtedness" to the end of the section.4 This amendment provided that any regulations so issued may apply only with respect to instruments issued after the date on which the Secretary or the Secretary's delegate provides public guidance as to the characterization of such instruments (whether by regulation, ruling or otherwise). A short time thereafter, in 1992, Congress added Code Sec. 385(c) to prevent issuers and holders from inconsistently characterizing the same corporate instrument.5 Code Sec. 385(c) provides that "[t]he characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary)"; however, as provided in regulations, the issuer's characterization would not be binding on a holder that discloses such inconsistent treatment. Further, the Secretary was authorized to require under regulations such information as determined necessary to carry out Code Sec. 385(c).
Although final regulations under Code Sec. 385 were issued in 1980, after subsequent revisions to those regulations, they were withdrawn in 1983 because they did not "fully reflect the Treasury or IRS position on debt/equity matters."6 The Treasury and the IRS previously had not issued any regulations regarding the 1989 amendment to Code Sec. 385(a), which authorizes the Secretary to issue regulations that treat an interest in a corporation as indebtedness in part or as stock in part. In addition, no regulations have been issued under Code Sec. 385(c), which authorizes the Secretary to require information related to an issuer's initial characterization of an interest for federal tax purposes or to affect the ability of a holder to treat an interest inconsistent with the initial treatment of the issuer.
III. Proposed Regulations
There are three main aspects to the Proposed Regulations: the bifurcation rule contained in Proposed Reg. §1.385-1(d), the documentation and record-keeping rules of Proposed Reg. §1.385-2 and the transaction-based rules in Proposed Reg. §1.385-3. It is important to understand first what types of related-party indebtedness would be impacted by the Proposed Regulations.
1. Which Taxpayers Would Be Subject to the Proposed Regulations?
The Proposed Regulations generally would apply to an "expanded group instrument" (EGI), that is, an interest in the form of a debt instrument7 issued by a member of an "expanded group" to another member of the same "expanded group."8 The IRS and Treasury intended to apply the Proposed Regulations to transactions between "highly related" parties.9
An expanded group is based on the definition of an affiliated group under Code Sec. 1504(a) with three important modifications to broaden it: (i) an expanded group includes all corporations (e.g., foreign corporations, S corporations, real estate investment trusts, regulated investment companies and tax-exempt corporations); (ii) corporations can be held both directly or indirectly by the common parent; and (iii) the ownership threshold is reduced to 80-percent vote or value (as opposed to both vote "and" value).10 While the definition has been broadened dramatically, the Proposed Regulations retain (i) the requirement of Code Sec. 1504(a) that there be a common parent corporation (even though it can now be, for example, a foreign corporation or an S corporation) and (ii) the requirement in Code Sec. 1504(a)(1)(B)(ii) that stock of each includible corporation (other than the parent) must be owned directly by one or more other includible corporations.11 In light of the modification to allow the parent to own indirectly stock of another corporation, it is not clear whether the IRS or Treasury intended to keep these requirements in the Proposed Regulations. Furthermore, the Proposed Regulations adopt the attribution rules of Code Sec. 304(c)(3) for purposes of indirect ownership.12 As such, ownership of stock can be attributed proportionately from a corporation where a person owns five percent or more in value of a corporation and can be attributed proportionately to a corporation from a person who owns stock representing five percent or more in value of the corporation.
Notably, the Proposed Regulations treat consolidated groups as one corporation and therefore generally do not apply to instruments between members of a consolidated group.13 The Proposed Regulations do not apply to members of a consolidated group because "the concerns addressed in the proposed regulations generally are not present when the issuer's deduction for interest expense and the holder's corresponding interest income offset on the group's consolidated federal income tax return."14
For purposes of Proposed Reg. §1.385-2, which are the documentation rules discussed below, controlled partnerships are treated as members of the expanded group, and the term "controlled partnership" is defined as any partnership, the capital or profits interest in which is 80-percent directly or indirectly owned by members of an expanded group.15 If an EGI that is issued by a controlled partnership is recharacterized as stock under Proposed Reg. §1.385-2, the instrument is treated as an equity interest in the controlled partnership.16 One interesting question is whether the IRS and Treasury have authority to recharacterize interests in partnerships under Code Sec. 385, which only addresses interests in corporations.
2. Documentation Requirements
An issuer of an EGI is required to produce information and documentation under Proposed Reg. §1.385-2 in order to substantiate its position that an instrument is debt for U.S. tax purposes. These documentation and information requirements only apply where "the stock of any member of the expanded group is publicly traded, all or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding $100 million, or the expanded group's financial results are reported on financial statements that reflect annual total revenue that exceeds $50 million."17 Commentators have pointed out that the documentation requirements are onerous and broad because if they apply, there are no exceptions for small or ordinary course loans.18
The documentation and information requirements that must be satisfied are: (i) a legally binding obligation to pay, (ii) creditors' rights to enforce the obligation, (iii) a reasonable expectation of repayment at the time the interest is created and (iv) an ongoing relationship during the life of the interest consistent with arm's-length relationships between unrelated debtors and creditors.19 The documentation is to be maintained throughout all tax years the EGI is outstanding and until the statute of limitations expires for any return with respect to which the treatment of the EGI is relevant.20 The following guidance has been provided on how to satisfy the documentation requirements of the Proposed Regulations:
- A Binding Obligation to Repay. There must be written documentation timely prepared showing a binding legal obligation on behalf of the issuer to repay a sum certain on demand or at one or more fixed dates.21
- Creditor's Rights to Enforce Terms. A holder must have the legal rights of a creditor to enforce the terms of the EGI. These rights typically include the right to trigger an event of default, the right to accelerate payments and the right to sue the issuer to enforce payments. Furthermore, the holder must have the "superior right" to share in the assets of the issuer in the event the issuer is dissolved or liquidated.22
- Reasonable Expectation of Repayment. There must be written documentation evidencing that the issuer's financial position supports "a reasonable expectation that the issuer intended to, and would be able to, meet its obligations" under the terms of the EGI.23 This documentation may include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity and other relevant financial ratios of the issuer (compared to industry averages), and other information regarding the sources of funds enabling the issuer to meet its obligations pursuant to the terms of the EGI.24 It is not clear under the Proposed Regulations what other funds can be considered in this ability-to-pay analysis. Any final regulations should clarify that it will be acceptable for a taxpayer to show the ability to borrow from third parties to support an expectation of repayment.
- Actions Evidencing a Genuine Debtor-Creditor Relationship. The taxpayer must provide evidence of an ongoing debtor-creditor relationship. This would include timely documentation of payments under the EGI of both principal and interest, such as a wire transfer record or a bank statement reflecting the payment.25 In the alternative of nonpayment or default under the EGI, the Proposed Regulations require evidence of a holder's reasonable exercise of the diligence and judgment of a creditor. The Proposed Regulations provide an example of documentation showing the holder's efforts to enforce the terms of the EGI or otherwise renegotiate the EGI in the event of default or similar events.26 This requirement creates an unrealistic scenario where in the event of default, a wholly owned subsidiary would be required to seek judgment from its parent (or vice versa) as if it were a third-party creditor.
The documentation required with respect to the first three requirements must be prepared no later than 30 calendar days after the instrument becomes an EGI or the date the expanded group member becomes an issuer with respect to an EGI. For evidence of debtor-creditor relationship, the Proposed Regulations provide that documentation must be provided up to 120 calendar days after the payment or relevant event has occurred.27 The relevant date for the debtor-creditor relationship documentation generally is when payment of interest or principal under the EGI is due or, in the event of default or similar event, the date of such default or similar event.28 One significant question is whether the need to document a reasonable ability to pay upon a deemed modification of an existing EGI means that Reg. §1.1001-3(f)(7), which generally ignores a deterioration in the financial condition of an obligor, no longer applies in the context of modifications of related-party indebtedness.29
The purpose for the information and documentation requirements is to "require a degree of discipline in the creation of necessary documentation, and in the conduct of reasonable financial diligence indicative of a true debtorcreditor relationship, that exceeds what is required under current law."30 As such, these requirements are intended to better equip the IRS to analyze whether an EGI is appropriately characterized as debt for U.S. tax purposes. Satisfying the documentation requirements will not establish that an interest is debt for U.S. tax purposes but rather "acts as a threshold test for allowing the possibility of indebtedness treatment."31 If, and only if, the documentation requirements are satisfied may the federal tax treatment be determined based on the information prepared and maintained by the taxpayer, "other facts and circumstances relating to the EGI and general federal tax principles."32
If the documentation requirements are not satisfied with respect to an EGI, then the EGI will be treated as stock.33 This is a truly draconian penalty for failing to satisfy certain record-keeping requirements. In light of the purpose of the documentation requirements, which is to enable the IRS to determine whether instruments should be characterized as debt, equity or part debt and part equity in order to more accurately reflect the true substance and economics of the instrument, this penalty is disproportionately more severe and inconsistent with this purpose.
Furthermore, once an EGI is characterized as indebtedness, assuming the documentation and information requirements have been satisfied, the issuer, holders and any other person relying on the characterization of the EGI as debt for federal tax purposes must treat the EGI as such for all federal tax purposes. However, the IRS is not bound by the characterization of an EGI.34
The Proposed Regulations provide for a "reasonable cause exception," which allows the IRS to modify the requirements of Proposed Reg. §1.385-2 for taxpayers whose failure to comply with the requirements was due to reasonable cause.35
In addition, there is a "no affirmative use" provision in the Proposed Regulations that prohibit the intentional failure of the information and documentation requirements with the principal purpose of reducing the federal tax liability of any member or members of its expanded group.36 Lastly, there is an "anti-avoidance" provision that recharacterizes instruments that would not be considered EGIs as an EGI if such instrument had a principal purpose of avoiding the information and documentation requirements found in Proposed Reg. §1.385-2.37 The Preamble provides an example of the anti-avoidance provision whereby a member of an expanded group issues an instrument to a trust held by members of the same expanded group.38
3. Bifurcation Rule
As the Preamble notes, there has been a long tendency by courts to characterize an instrument as either wholly debt or wholly stock, which is problematic in cases where the facts and circumstances "provide only slightly more support for characterization of the entire interest as indebtedness than for equity characterization, a situation that is increasingly common in the related-party context."39 The Treasury and the IRS decided that this "all-or-nothing approach frequently fails to reflect the economic substance of related-party interests that are in form indebtedness and gives rise to inappropriate federal tax consequences."40
As such, Proposed Reg. §1.385-1(d) provides: "The Commissioner may treat an EGI ... as in part indebtedness and in part stock to the extent that an analysis, as of the issuance of the EGI, of the relevant facts and circumstances concerning the EGI (taking into account any application of sec. 1.385-2) under general federal tax principles results in a determination that the EGI is properly treated for federal tax purposes as indebtedness in part and stock in part." This rule applies to debt issued within a modified expanded group (that is, a 50-percent vote or value threshold, rather than 80 percent); in addition, for purposes of this rule, any person (including an individual, trust or partnership) who is treated under the constructive ownership rules of Code Sec. 318 as owning at least 50 percent of the stock of a modified expanded group member will be treated as a member of the modified expanded group.41 Although the Proposed Regulations do not provide any formal guidance, reasons for a debt instrument to be bifurcated likely would include that the issuer is too thinly capitalized to support the full amount of the debt or that the instrument includes equity-like features, such as equity kickers. The sole example provided in the Preamble involved a related-party interest that was documented as a $5 million debt instrument, but analysis demonstrated that as of the issuance the issuer could not reasonably be expected to repay more than $3 million of the principal amount as of its issuance, so the Preamble concluded that it would be appropriate for the IRS to treat the interest as part indebtedness ($3 million) and part stock ($2 million).42
The bifurcation rule, like the documentation rules, only applies to instruments that are debt in form. As such, it would not apply to sale-repurchase agreements, sale-leaseback transactions or instruments treated as debt by statute (e.g., REMIC regular interests that could be in the form of equity). Taxpayers may not affirmatively use this provision to treat an instrument as part debt, part equity. This provision applies only to instruments issued (or deemed issued) on or after the date the regulations are finalized.
4. Transaction Rules of Proposed Reg. §1.385-3
Proposed Reg. §1.385-3 contains two rules that may recharacterize a debt instrument that otherwise qualifies as debt under Proposed Reg. §§1.385-1 and -2 (and under general tax principles) as stock: (i) debt issued to an expanded group member in a distribution or as consideration in certain transactions will be recharacterized as stock (the "General Rule"), and (ii) debt issued to an expanded group member in exchange for cash will be recharacterized as stock if a distribution or other transaction described in the General Rule occurs within three years before or after the debt is issued or the debt is issued with a principal purpose of funding such distribution or other transaction (the "Funding Rule").
Under the General Rule, a debt instrument (which includes an interest that is treated as debt, even if it is not in the form of debt) is treated as stock if it is issued by a corporation to a member of the corporation's expanded group: (i) in a distribution in which a subsidiary distributes a note to its parent, (ii) in exchange for expanded group stock (e.g., in a Code Sec. 304 transaction) or (iii) as consideration in certain asset reorganizations (e.g., in a D reorganization).43
The Funding Rule treats as stock any debt instrument issued by a corporation (that is, the "Funded Member") to fund one of the three identified transactions. Thus, the Funding Rule generally applies if a debt instrument is issued to fund: (i) a distribution of property by the Funded Member to a member of the Funded Member's expanded group; (ii) an acquisition of expanded group stock, other than in an "exempt exchange"; or (iii) an acquisition of property by the Funded Member in an asset reorganization. 44 When the Funding Rule applies, it changes the character of the funding, but not of the other transaction that was funded by the recharacterized debt instrument.
Under an irrebuttable presumption, because money is fungible, a debt instrument is treated as stock if it is issued by the Funded Member during the period beginning 36 months before the date of the distribution or acquisition and ending 36 months after the date of a distribution or acquisition by the Funded Member.45 There is a narrow exception to this per se rule for extensions of credit for sale of inventory and the receipt of services in the ordinary course of business. This rule feels particularly draconian, as a taxpayer could be completely unaware that a distribution three years prior could impact whether a related-party debt is treated as equity for U.S. tax purposes. While money generally is fungible, it feels inappropriate to treat money in 2017 as fungible with money in 2020.
There are several exceptions to the General Rule and the Funding Rule. First, for purposes of applying the General Rule and the Funding Rule, the aggregate amount of any distributions or acquisitions is reduced by an amount equal to the current-year earnings and profits of the distributing or acquiring corporation.46 Second, a debt instrument will not be treated as stock under the General Rule and the Funding Rule if, when the instrument is issued, the aggregate issue price of all expanded group debt instruments that would otherwise be treated as stock under the Proposed Regulations does not exceed $50 million.47 This exception, however, functions as a cliff, such that all such debt is treated as equity once the $50 million threshold is exceeded. Third, an exception to the Funding Rule exists for funding acquisitions of subsidiary stock from the subsidiary.48 Specifically, an acquisition of expanded group stock will not be treated as an acquisition for purposes of the Funding Rule if: (i) the acquisition results from a transfer of property by a funded member (the transferor) to an issuer in exchange for stock of the issuer; and (ii) for the 36-month period following the issuance of subsidiary stock, the transferor holds, directly or indirectly, more than 50 percent of the vote and value of the stock of the issuer.
Under a broad anti-abuse rule, a debt instrument will be treated as stock if it is issued with a principal purpose of avoiding the application of the Proposed Regulations.49 Furthermore, interests that are not debt instruments for purposes of Proposed Reg. §§1.385-3 and 1.385-4 (for example, contracts to which Code Sec. 483 applies or nonperiodic swap payments) would be treated as stock if issued with a principal purpose of avoiding the application of Proposed Regulations. According to examples in the Proposed Regulations, the anti-abuse rule may be applicable where (i) a debt instrument is issued to, and later acquired from, a person that is not a member of the issuer's expanded group; (ii) a debt instrument is issued to a person that is not a member of the issuer's expanded group, and such person later becomes a member of the issuer's expanded group; (iii) a debt instrument is issued to an entity that is not taxable as a corporation; or (iv) a member of the issuer's expanded group is substituted as a new obligor or added as a co-obligor on an existing debt instrument, in each case, where the debt instrument is issued with a principal purpose of avoiding the application of the General Rule and the Funding Rule. Additionally, a taxpayer is prohibited from affirmatively relying on the Proposed Regulations to the extent that the taxpayer enters into a transaction that otherwise would be subject to the Proposed Regulations with a principal purpose of reducing the U.S. tax liability of any member of the expanded group.
The Proposed Regulations take an aggregate approach to controlled partnerships in order to prevent avoidance of these rules through the use of partnerships.50 That is, where a member of an expanded group is a partner in a "controlled partnership" with respect to the expanded group, the member is treated as (i) owning its proportionate share of the partnership's assets, (ii) issuing its proportionate share of any partnership debt instrument, (iii) acquiring its proportionate share of any expanded group stock acquired by the controlled partnership and (iv) receiving its proportionate share of any "other property" received by the partnership in a transaction described in Code Sec. 356. A partnership is a "controlled partnership" if 80 percent or more of the interests in the capital or profits of the partnership are owned, directly or indirectly (under Code Sec. 304(c)(3)), by one or more members of an expanded group. The Proposed Regulations treat all members of a consolidated group as one corporation. Consequently, debt between consolidated group members is not subject to recharacterization under the Proposed Regulations. When a debt ceases to be an intercompany obligation (but remains within an expanded group), it is treated as an EGI immediately afterward and becomes subject to the documentation requirements of Proposed Reg. §1.385-2 and the recharacterization rules of Proposed Reg. §1.385-3.
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* The author thanks Robert A. Rudnick and Eric Grosshandler for helpful comments on an earlier draft.
1 Unless otherwise stated, "Code Sec." references are to the Internal Revenue Code of 1986, as amended (the "Code"), and "Reg. §" references are to the Treasury regulations promulgated thereunder.
3 Preamble to the Proposed Regulations (the "Preamble"), at 12.
4 Act Sec. 7208(a)(2) of P.L. 101-239, 103 Stat. 2106 (1989).
5 P.L. 102-486, 106 Stat. 2776 (1992). See H.R. Rep. No. 102-716, at 3 (1992).
6 See T.D. 7747 (45 FR 86438), Dec. 31, 1980; subsequently proposed to be withdrawn in 48 Fed. Reg. 31053 and withdrawn by T.D. 7920 (48 FR 50711), Nov. 3, 1983.
7 Proposed Reg. §1.385-2(a)(4)(i).
8 Preamble, at 31.
9 Preamble, at 32, 37.
10 Proposed Reg. §1.385-1(b)(3)(i).
11 Code Sec. 1504(a)(1)(B)(ii) ["stock meeting the requirements of paragraph (2) in each of the includible corporations (except the common parent) is owned directly by 1 or more of the other includible corporations"]; Proposed Reg. §1.385-1(b)(3)(i) (which makes no changes to Code Sec. 1504(a)(1)(B)(ii)).
12 Proposed Reg. §1.385-1(b)(3)(ii).
13 Proposed Reg. §1.385-1(e).
14 Preamble, at 35.
15 Proposed Reg. §1.385-2(c)(6)(i); Proposed Reg.
16 Proposed Reg. §1.385-2(c)(6)(ii).
17 Preamble, at 38. See Proposed Reg. §1.385-2(a)(2)(i)(B) and (C) ("[O]n the date that an applicable instrument first becomes an EGI, total assets exceed $100 million on any applicable financial statement, or on the date that an applicable instrument first becomes an EGI, annual total revenue exceeds $50 million on any applicable financial statement."). The Proposed Regulations are not clear on whether issuers or expanded groups who first surpass the thresholds in a given year must start compliance on the day it surpasses the threshold, since the beginning of the year that it first exceeds the threshold or once that year's financial statements are reported.
18 See Letter from United States Council for International Business in response to the collection of information requirements contained in the notice of proposed rulemaking (Section 385—REG 108060-15), Public Submission Posted: June 7, 2016, ID: IRS-2016-0014-0057, at 1 ("The costs could run to hundreds of millions or even billions of dollars across all persons affected by the regulations. This is in part because the documentation requirements are so broad with no exception for small or ordinary course loans, thereby potentially applying to hundreds of thousands or millions of loans per corporate group.").
19 Proposed Reg. §1.385-2(b)(2); Preamble, at 19–20.
20 Proposed Reg. §1.385-2(b)(4).
21 Proposed Reg. §1.385-2(b)(2)(i).
22 Preamble, at 40; Proposed Reg. §1.385-2(b)(2)(ii).
23 Proposed Reg. §1.385-2(b)(2)(iii).
24 Preamble, at 40–41; Proposed Reg. §1.385- 2(b)(2)(iii).
25 Proposed Reg. §1.385-2(b)(2)(iv)(A).
26 Proposed Reg. §1.385-2(b)(2)(iv)(B).
27 Proposed Reg. §1.385-2(b)(3)(i).
28 Proposed Reg. §1.385-2(b)(3)(ii)(C)-(D).
29 See William Davis & Lee Sheppard, Debt-Equity Rules May Change Current Law, 2016 TNT 89-6 (May 9, 2016) ("When there is a refinancing, a taxpayer must consider again the creditworthiness of the borrower, [Treasury tax deputy tax legislative counsel] Vallabhaneni said ... He articulated that it is not the intention to repeal reg. section 1.1001-3(f)(7) for related parties, but that if there is going to be a new instrument, the creditworthiness must be tested again. He added that the issue will likely need to be clarified in the final regulations.").
30 Preamble, at 20.
31 Preamble, at 36.
32 Proposed Reg. §1.385-2(a)(1).
33 Id. In addition, if specified documentation is not provided to the IRS upon request, the IRS may treat the preparation and maintenance of documentation as not satisfied. Preamble, at 36.
34 Proposed Reg. §1.385-2(c).
35 Preamble, at 43; Proposed Reg. §1.385-2(c)(1).
36 Proposed Reg. §1.385-2(d).
37 Proposed Reg. §1.385-2(e).
38 Preamble, at 44.
39 Preamble, at 13.
41 Proposed Reg. §1.385-1(b)(5) ("In addition, if a person (as defined in section 7701(a)(1)) is treated, under the rules of section 318, as owning at least 50 percent of the value of the stock of a modified expanded group member, the person is treated as a member of the modified expanded group.").
42 Preamble, at 33.
43 Proposed Reg. §1.385-3(b)(2).
44 Proposed Reg. §1.385-3(b)(3)(ii).
45 Proposed Reg. §1.385-3(b)(3)(iv)(B).
46 Proposed Reg. §1.385-3(c)(1).
47 Proposed Reg. §1.385-3(c)(2).
48 Proposed Reg. §1.385-3(c)(3).
49 Proposed Reg. §1.385-3(b)(4).
50 Proposed Reg. §1.385-3(d)(5).
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