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October 20, 2016

On the evening of October 13, 2016, the United States Treasury Department and IRS released final and temporary Section 385 Regulations (“Final Regulations”) regarding purported related-party debt instruments. These Final Regulations revise the highly controversial proposed regulations issued in April 2016 to address a number of concerns identified during the public comment period. Earlier this week, A&M Taxand spoke at the Tax Executive Institute’s annual conference to share our insights and confirm our thinking on key portions of the regulations with other tax practitioners as well as many Treasury Department officials.

Below we summarize how the final regulations may generally impact U.S. and non-U.S. multinationals and provide an overview of the key provisions, noting significant changes from the proposed regulations.

U.S. Controlled Domestic Corporations Can Breathe a Bit Easier

The Final Regulations have significantly less overall applicability for U.S. multinationals. Only debts of a U.S. issuer that are owed to a related party outside of its U.S. consolidated return group are subject to the rules. In other words, loans from controlled foreign corporations (CFCs) to CFCs are excluded for now, as are loans from U.S. corporations to CFCs. When the dust settles, it appears the rules might only apply to formal loans and other amounts payable (e.g., trade payables) to CFCs. In some complicated structures, these rules might also apply to loans from U.S. corporations to other domestic expanded group members that are not included in the same consolidated U.S. tax return.

U.S. multinationals will also benefit from a reduced compliance burden and delays in the effective dates for the documentation rules.

Foreign-Controlled Domestic Corporations Will Bear the Brunt of the Burden of the Final Regulations

On the other hand, foreign controlled domestic corporations (FCDCs) will be most significantly impacted by the Final Regulations, with imminent impact on current and future intercompany capital structures, intercompany lending and ordinary intercompany transactions.

Although FCDCs will still potentially be subject to a heavy compliance burden, they will receive the same benefits of delayed effective dates for the documentation rules as U.S. multinationals.

Other Key Provisions of the Final Regulations

After extensive comments from practitioners, the IRS and Treasury have removed and reserved on the general bifurcation rule contained in the proposed regulations.

The Final Regulations exclude S corporations, controlled partnerships, non-controlled regulated investment companies (RICs) and non-controlled real estate investment trusts (REITs) from the definition of “expanded group member.” They also do not apply to debt instruments issued by certain financial or insurance companies that are subject to strict regulatory oversight.

Documentation Requirements Delayed but Still Extensive

Taxpayers subject to the documentation requirements will have an extension of the period required to timely prepare documentation from the 30-day requirement under the proposed regulations to the due date (including extensions) for filing the issuer’s federal income tax return. Further, the documentation requirements do not apply to debts issued prior to January 1, 2018.

New Exceptions From Recast Penalty

As a general rule, failure to satisfy the documentation requirements still means that a debt instrument will automatically be recast as stock. However, another concession, in response to comments from taxpayers and others, is a new rebuttable presumption for otherwise “highly compliant” expanded groups. Undocumented debt instruments issued by members of highly compliant groups will only be presumed to be stock, subject to rebuttal by the taxpayer based on common law debt/equity factors.

There is also a reasonable cause exception and an exception for taxpayer-initiated correction of “ministerial or non-material failure or error” (undefined terms).

Cash pooling and similar short-term debt arrangements are not excluded from the scope of the Final Regulations, but “master” agreements may be used to comply with the documentation requirements.

Expanded Exceptions Under the “Tainted Transaction” Rules

Under the Final Regulations, FCDCs remain subject to the tainted transaction rules under 1.385-3. The exceptions in the Final Regulations have been broadened such that the earnings and profits (E&P) reduction to the amount of tainted transactions now includes all E&P accumulated after April 4, 2016. Under the proposed regulations, the E&P reduction was limited to current E&P.

The Final Regulations also include a threshold exception on the first $50 million of indebtedness that otherwise would be recharacterized as stock.

There are many other details and favorable exceptions contained in the Final Regulations, but generally, the Final Regulations retain the basic regime introduced under the proposed regulations.

Alvarez & Marsal Taxand Says:

While the Final Regulations are designed primarily to target inverted structures, they have broad application to all FCDCs and some potentially significant application to U.S. controlled multinationals.

FCDCs have a significant amount of analysis to undertake under these Final Regulations.

This doesn’t mean that U.S. multinationals are completely off the hook. Some U.S. multinationals could still be caught in the details.

The extensive and highly complicated Final Regulations can present a host of unintended and harmful consequences for the ill-prepared taxpayer. With the harsh penalty of a transaction intended to be debt being automatically recast as equity, all taxpayers should analyze these rules when entering into intercompany debt instruments.

In light of this, Alvarez & Marsal Taxand will be following this edition of Tax Advisor Weekly with practical guidelines on how to comply with the documentation rules laid out in the Final Regulations and more detailed insights on the transaction rules, notably how they will affect FCDCs. 

Michael Crafton and Alexander Hill contributed to this article.

Related Issues:

IRS Steps Up Enforcement, Challenging Related-Party Debt

On Monday, July 25, the IRS posted a revised version of a previously issued Chief Counsel Notice making it clear that any case in exam or litigation raising an issue under Internal Revenue Code Section 385 must be coordinated with the Associate Chief Counsel (ACC) offices. This increased IRS focus on related-party indebtedness should serve as a call to taxpayers to review all existing related-party debt to identify and remediate, where possible, any exposures.

Proposed New Documentation Rules for Related-Party Debt: A Practical Approach

As is often the case in practical tax planning, “an ounce of prevention is worth a pound of cure.” On April 4, 2016, the IRS and Treasury issued proposed regulations under the authority of Section 385 of the Internal Revenue Code. Numerous commentators have questioned the IRS and Treasury’s authority to create several of the rules in these regulations. As a result, their validity may or may not be upheld in court, if the regulations are finalized as proposed. Unfortunately, while the possibility of a future court battle between taxpayers and the IRS over these regulations may be of major academic interest, it is of no present or practical help to internal tax departments that are undoubtedly asking the questions, “What do these regulations mean to my company? What should I be doing about them now?”