On October 13, 2016, the Internal Revenue Service (“IRS”) and U.S. Treasury Department (“Treasury”) announced the final regulations under Section 385 of the U.S. tax code to address earnings stripping. The new regulations aim to limit the ability of companies to lower their tax bills through transactions involving debt by recharacterizing certain cross-border intercompany debt instruments as equity for U.S. tax purposes. The regulations will also require large corporations claiming interest deductions to document loans to and from their affiliates.
The final Section 385 regulations, originally issued in April 2016, went through an unprecedented volume of taxpayer comments and an unsuccessful congressional effort to block their issuance. The regulations retained much of the original framework, though, after taking the concerns of companies into account, the Treasury implemented significant carve-outs and limitations to the rules.
Notably, the final regulations will: (a) treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes under the Recharacterization Rule; and (b) establish extensive documentation requirements with respect to related-party indebtedness under the Documentation Rule. The Recharacterization Rule will generally apply to tax years ending on or after 90 days after the final regulations are published in January 2017, and will not apply to debt instruments issued prior to April 5, 2016. The Documentation Rule will generally apply to debt instruments issued on or after January 1, 2018.
During the commentary period, the Treasury stated the rule changes would cut down on cross-border mergers levelling the playing field between U.S. and non-U.S. businesses, however critics maintained it would make it harder to do business in the United States by keeping millions of dollars of investment and jobs away. After the commentary period closed, the Treasury assured that comments and recommendations from businesses, tax experts, the public and lawmakers were carefully considered, and the final rule addresses the concerns by more narrowly focusing the regulations on aggressive tax avoidance tactics and providing certain exemptions.
The Treasury has issued a Fact Sheet on the new regulations, available here.