Seyfarth Synopsis: On October 13, 2016 the IRS and Treasury Department published over 500 pages of final and temporary regulations under Code Section 385 (the “Final Regulations”). Drafted to curtail tax benefits accrued by multi-national companies utilizing inter-company debt, and issued a mere six months after the issuance of controversial proposed regulations (the “Proposed Regulations”), the Final Regulations largely maintain the structure of the Proposed Regulations. Nevertheless, the IRS and Treasury Department responded favorably to much of the commentary submitted by tax practitioners in response to the Proposed Regulations, and made several compromises that ease the burden, and alleviate some of the uncertainty, of the new rules.
Code Section 385 - A Historical Perspective
Code Section 385(a), added to the Internal Revenue Code in 1969 (and only nominally amended since), authorizes the Secretary of the Treasury to prescribe regulations to assist with determining whether an interest in a corporation should be treated as debt or equity. Notwithstanding such authority, the IRS and Treasury Department generally remained silent on this issue, choosing not to finalize any regulations under Code Section 385.1 As a result, this issue has largely been left to judicial interpretation, and courts have developed and applied various iterations of a multi-factor test to determine whether an interest in a corporation should be properly respected as debt or re-characterized as stock. The multi-factor tests turned on the facts and circumstances of each situation and remained subject to the vagaries of interpretation by different courts and judges, leading many practitioners over the years to call for regulations (as authorized by the Code) to clarify the rules.
In a classic case of “be careful what you wish for,” the IRS and Treasury Department published the Proposed Regulations on April 4, 2016. Though the Proposed Regulations were published as part of a larger initiative by the government to curb cross-border “inversion transactions,” tax practitioners quickly realized that, if finalized in their proposed form, the Proposed Regulations would have very broad and far reaching implications, and would materially impact business operations of large multi-national corporations.
The Proposed Regulations
The Proposed Regulations set forth bright-line rules to be applied when determining whether certain related-party debt instruments should be reclassified as stock for U.S. federal income tax purposes. Of course, one of the primary consequences of such re-characterization is eliminating the accompanying tax benefits (including interest deductions). The Proposed Regulations were drafted to apply to non-consolidated corporate groups (referred to as the “expanded group”).2 Put differently, the Proposed Regulations, by their terms, applied to transactions between related corporations3 that do not otherwise file as a consolidated group. The objective was, it would seem, to target corporate groups that are generally not permitted to file on a consolidated basis, that is, those comprised of both U.S. and foreign corporations.
(i) General Rules and Definitions4
Definitionally, the Proposed Regulations cast a wide net. Any issuer of a debt instrument within an expanded group was subject to the Proposed Regulations, including entities otherwise subject to regulatory oversight and entities that could suffer material and irreversible tax consequences if their debt instruments were re-characterized as equity, such as disregarded entities (“DREs”) and S-corporations.
One of the more prominent procedural rules set forth in Proposed Regulations was the bifurcation rule. The bifurcation rule generally permitted the IRS to bifurcate a purported debt instrument and treat it partially as debt and partially as stock. Conceptually, the bifurcation rule provided the IRS with flexibility during an audit examination, hopefully leading to quicker and more palatable settlements with taxpayers.
(ii) Documentation and Record Keeping Requirements5
The Proposed Regulations provided for reclassification of “expanded group instruments” (“EGIs”)6 as stock if extensive documentation and record keeping requirements were not satisfied on a current and ongoing basis. Though compliance with the documentation requirements did not ensure the EGI would be respected as debt, failure to comply would (subject to a limited reasonable cause exception) automatically cause the EGI to be reclassified as stock in the issuer. Under the Proposed Regulations, the expanded groups had 30 days to properly document the transaction (i.e., that the borrower is legally obligated to repay a definite sum on demand or at some point certain) and 120 days to document certain elements of the debtor/creditor relationship (which must be updated on an on-going basis). At its core, Proposed Regulation 1.385-2 attempted to ensure that intercompany debt has the same appearance (from a documentary perspective) as independent third party (i.e., bank) debt.7
(iii) Per Se Reclassification Rules8
The Proposed Regulations identified certain disfavored transactions that would automatically result in debt instruments being re-characterized as stock. The disfavored transactions were generally referred to as the “general rule.” The general rule was supported and strengthened by the “funding rule.”9 The general rule established rules whereby debt instruments issued by one member of an expanded group to another member of the expanded group would be re-characterized as stock if the debt instrument was issued: (i) in a distribution, (ii) in exchange for stock of a member of the expanded group, or (iii) in exchange for property as part of an asset reorganization (i.e., as boot).
The funding rule supported and strengthened the general rule by establishing that debt instruments issued by a member of an expanded group to another member of the expanded group, which debt instruments had a “principal purpose” of funding a transaction described in (i) - (iii), would be re-characterized as stock of the issuer. Importantly, such a debt instrument would be irrebutably presumed to have a “principal purpose” of funding a transaction described in (i) - (iii) if it was issued within 3 years before or 3 years after such transaction.10
The Proposed Regulations did include a few exceptions to the general rule and the funding rule, including (A) excluding debt instruments from the general rule and funding rule if the expanded group’s total debt that would otherwise be subject to the Proposed Regulations was less than $50 million (the “$50mm Exception”), and (B) mitigating the impact of the Proposed Regulations by reducing the amount of a distribution or acquisition that would otherwise trigger the Proposed Regulations by the subject member’s current earnings and profits (the “Current E&P Rule”). However, notwithstanding the IRS’s and Treasury Department’s intentions, both exceptions were very limiting in operation. The $50 million exception was drafted as a “cliff” rule, presumably with the limited objective of excluding smaller corporations from application of the Proposed Regulations.11 The Current E&P Rule encouraged distribution of debt instruments on a current basis as there was no provision to account for earnings and profits accumulated after April 4, 2016.12
Proposed Regulation 1.385-4 provided guidance on application of Proposed Regulation 1.385-3 in the event debt becomes (or ceases to be) a consolidated group debt.
The Final Regulations
Though they generally maintain the structure and integrity of the Proposed Regulations, the Final Regulations are notable for how they change the Proposed Regulations, presumably in response to extensive comments submitted by tax practitioners highlighting the potential impact of the Proposed Regulations on day-to-day and ordinary course business dealings of large multi-national companies. Among the more material changes to the Proposed Regulations are the following:
(i) General Rules and Definitions13
Significantly cutting back the rule in the Proposed Regulations which would have applied to expanded groups without regard to whether the issuer was a domestic or foreign corporation, the Final Regulations only apply to debt instruments and EGIs issued by domestic members of an expanded group.14 Further limiting the application of the Proposed Regulations, the Final Regulations exclude S-corporations and certain otherwise regulated entities (such as RICs and REITs) from the definition of “expanded group,” thus generally exempting such entities from application of the Final Regulations.15 The exclusion of S-corporations is particularly impactful, as (and as noted above) under the Proposed Regulations, an S-corporation’s status as an S-corporation was at risk if its debt instrument was re-characterized into (potentially a second class of) stock.
Additionally, the Final Regulations eliminate the bifurcation rule. Though, conceptually, the bifurcation rule would have provided the IRS with flexibility to settle audits in a more efficient manner, many tax practitioners questioned the practical application of the rule in the absence of specific guidance. Consequently, the removal of the bifurcation rule from the Final Regulation means an analysis and examination under Code Section 385 is “all or nothing.”
Final Regulation 1.385-1 applies to taxable years ending on or after January 19, 2017 (i.e., 90 days after the scheduled publication date (in the federal register) of the Final Regulations).
(ii) Documentation and Record Keeping Requirements16
The 30 day and 120 day compliance periods are, in form, retained. However, rather than establish deadlines, they are now reference dates. Specifically, taxpayers have until their tax return due date (including extensions) for the tax year in which the 30 day/120 day compliance period ends to complete their substantive documentation. The Final Regulations also include a life preserver for taxpayers that are largely compliant. While the Proposed Regulations automatically reclassified noncompliant EGIs as stock (notwithstanding any accompanying facts and circumstances), the Final Regulations permit taxpayers who are largely compliant with the Final Regulations to rebut the presumption that such EGI is stock. Though likely an uphill battle, under this “rebuttable presumption” rule taxpayers can present the relevant facts and circumstances to make their case.
Additionally, the Final Regulations address the treatment of disregarded entities (“DREs”) that are subsidiaries of corporate members of an expanded group. Under the Proposed Regulation, if an EGI issued by such a DRE was re-characterized as stock, the DRE ran the risk of converting into a partnership for federal tax income tax purposes. The Final Regulations still require DREs to comply with the documentation requirements, but provide that re-characterization of an EGI issued by a DRE will be treated as stock of the DRE’s parent, thereby preserving the disregarded status of the DRE.
Finally, many commentators and tax practitioners expressed concern that the Proposed Regulations would have an unreasonable impact on expanded groups that use a cash pooling or other inter-company financing arrangements. The Final Regulations address these concerns in Final Regulations 1.385-2 and 1.385-3 (see below for changes made to Final Regulation 1.385-3). With respect to the documentation and record keeping requirements, and in an effort to mitigate the need to document every transaction in certain ordinary course intercompany financing arrangements, Final Regulation 1.385-2 provides for the use of master credit agreements (subject to various compliance requirements) in certain instances.
Final Regulation 1.385-2 applies to EGIs issued after January 1, 2018.
(iii) Per Se Reclassification Rules17
While the Proposed Regulations included a limited exception for certain “ordinary course” intercompany payables, the Final Regulations include welcome relief from the general rule and the funding rule for certain “short-term debt instruments.” Per the preamble to the Final Regulations, the expanded exception is intended to “facilitate non-tax motivated cash management techniques, such as cash pooling, or revolving credit agreements, as well as ordinary course short-term lending outside a formal cash- management arrangement.”18 Specifically, the exception is expanded to include (i) certain short-term funding arrangements;19 (ii) ordinary course loans issued for the acquisition of property and reasonably expected to be repaid within 120 days, (iii) certain interest free loans, and (iv) certain deposits made with a qualified cash pool header pursuant to a cash-management plan.
Additionally, the Final Regulations expand the two exceptions set forth in the Proposed Regulations (and described above) and made them more taxpayer friendly.
- The $50mm Exception was modified by eliminating the “cliff” effect. Whereas the Proposed Regulations provided that the exception did not apply to any debt instruments once the expanded group reached $50 million of outstanding debt, the Final Regulations provide that only debt instruments in excess of $50 million are treated as stock.
- The Current E&P Exception was adjusted in two key ways. First, all earnings and profits (and not just current earnings and profits) accumulated after April 4, 2016 can be used to offset the application of the Final Regulations to distributions or acquisitions (this expansion theoretically eliminates the incentive to distribute all debt instruments in real time to the extent of current earnings and profits). Second, distributions and acquisitions can be offset by “qualified contributions” of non-excluded property20 made within 3 years before or after the subject acquisition or distribution.
Finally, commenters expressed concern that re-characterization of debt instruments as stock could trigger a cascading parade of horribles for an expanded group, with each re-characterized debt instrument triggering re-characterization of another loan within the expanded group. Sensitive to such possibility, the Final Regulations include a bit of protection for taxpayers. Specifically, if the funding rule re-characterizes a debt instrument as stock, that re-characterized stock cannot in-turn be used to re-characterize other debt instruments further down or up the corporate chain.
Final Regulations 1.385-3 and 1.385-4 apply to tax years ending on or after January 19, 2017, with respect to debt instruments issued on or after April 4, 2016.
The Proposed Regulations shook the tax planning community. Many tax practitioners advocated for the complete repeal of the Proposed Regulations, claiming that they pushed the boundaries (or, outright overstepped the boundaries) of the IRS’s and Treasury Department’s rule making authority. In the Final Regulations, the IRS responded favorably to much of the overwhelming negative response of the tax bar by tightening the focus of the Final Regulations on earnings stripping by U.S. Corporations. Perhaps the most significant take-away from the Final Regulations for tax practitioners and businesses is more clarity on who is not subject to the Final Regulations (notably, S-corporations and non-controlled RICs and REITs). Although the Final Regulations addressed and mitigated many of the glaring concerns raised by commenters in response to the Proposed Regulations, the Final Regulations remain onerous, broad, and complicated, and largely retain the per se reclassification rule, one of the more controversial aspects of the Proposed Regulations.
Given the sheer volume of information included in the Final Regulations, additional issues are bound to be uncovered as they are applied to various scenarios and transactions that have not yet been considered. Companies, particularly those with multi-national operations, are advised to consult with their tax advisers (both lawyers and accountants) early and often to ensure initial and ongoing compliance with the Final Regulations.