On Nov. 4, 2019, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) published final debt-equity regulations (the Final Regulations) and an advance notice of proposed rulemaking (the Advance Notice) under Section 385. The guidance package affords the prospect of limited future relief to taxpayers subject to the burdensome requirements of current regulations under Section 385 that, under certain circumstances, recast debt between related parties as equity for U.S. federal income tax purposes. While many had anticipated a substantial overhaul, if not a complete withdrawal, of the October 2016 Regulations, the guidance package falls far short of such expectations. It merely finalizes the proposed removal of the stringent documentation requirements set forth in the October 2016 Regulations with respect to related party indebtedness (the Documentation Rules), and indicates that Treasury and the Service contemplate the issuance of proposed regulations containing certain inchoate rules that would modify — but not eliminate — current rules treating as stock certain indebtedness issued by a corporation to a controlling shareholder in a distribution or pursuant to another related-party transaction achieving an economically similar result (the Distribution Rules). In the meantime, the current Distribution Rules remain in effect unaltered.
Section 385, originally enacted as part of the Tax Reform Act of 1969, authorizes the Secretary of the Treasury to prescribe such regulations “as may be necessary or appropriate” to determine whether an interest in a corporation is treated as stock or indebtedness, in whole or in part, for purposes of the Code. Section 385(b) provides that such regulations shall set forth factors to be taken into account in determining whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists with respect to a particular factual situation.
Regulations under Section 385 were initially promulgated in 1980 and were revised several times, before ultimately being withdrawn in 1983 on the ground that such regulations did not fully represent the position of Treasury or the Service on matters concerning debt and equity. The Service issued limited published guidance in the area for a lengthy period of time following such withdrawal. Thirty-three years later, in April 2016, Treasury and the Service issued proposed regulations under Section 385 (the April 2016 Proposed Regulations) that proposed to (i) treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes (the Bifurcation Rule), (ii) establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes (i.e., the Documentation Rules) and (iii) treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes (i.e., the Distribution Rules). A public hearing was held and almost 30,000 written comments were submitted with respect to the April 2016 Proposed Regulations. In response to the comments received, the October 2016 Regulations substantially curtailed the scope of the April 2016 Proposed Regulations in an effort to achieve a better balance between minimizing taxpayer burdens and fulfilling stated policy objectives. Among other things, the October 2016 Regulations excluded foreign issuers from their reach and discarded the Bifurcation Rule. The October 2016 Regulations also loosened the Documentation Rules and delayed their implementation, and made significant changes to the Distribution Rules, exempting many issuers from the application of the rules as originally proposed.
Removal of the Documentation Rules
The Documentation Rules sought to prescribe the documentation necessary to substantiate treatment of related-party interests as indebtedness for U.S. federal income tax purposes, including documentation of factors analogous to those found in loan agreements between unrelated parties. Taxpayers were required to satisfy the Documentation Rules in order for an instrument between members of an expanded group issued (or deemed issued) on or after Jan. 1, 2018, to be treated as debt (subject to reasonable cause and ministerial error exceptions, as well as an anti-avoidance rule). Compliance with such requirements was not sufficient to establish that an interest was indebtedness, but rather was a necessary first step before any determination could be made as to whether an interest was properly so treated under general tax principles. The Documentation Rules applied if (i) the stock of any member of the expanded group was publicly traded or (ii) all or any portion of the financial results of an expanded group member was reported on (a) financial statements filed with the Securities and Exchange Commission or provided to another governmental agency or (b) certified audited financial statements prepared for a substantial nontax purpose, in each case showing total assets exceeding $100 million or total revenue exceeding $50 million.
To comply with the Documentation Rules, a taxpayer would have needed to provide or otherwise establish (i) evidence of an unconditional and binding obligation to repay the funds advanced, (ii) creditors’ rights to enforce the terms of the debt, (iii) a reasonable expectation of the borrower’s ability to repay and (iv) actions evidencing an ongoing genuine debtor-creditor relationship. If the requisite documentation was not properly maintained or provided to the Service upon request, the instrument was automatically treated as equity unless the taxpayer could establish that it was otherwise “highly compliant” (as defined) with the Documentation Rules.
The Final Regulations remove the Documentation Rules in their entirety, and adopt conforming amendments, effective as of Nov. 4, 2019. According to the Preamble to the Final Regulations, benefits the Documentation Rules had been designed to confer in helping to reduce foreign acquisitions of U.S. assets and interest stripping were undercut by the reduction of the statutory corporate tax rate, amendments to the interest-stripping rules of Section 163(j) and enactment of the Base Erosion Anti-Abuse Tax as part of the 2017 Tax Cuts and Jobs Act.
Retention of the Distribution Rules
The Distribution Rules were crafted to combat the issuance of debt instruments that do not finance any new investment in the operations of the borrower and have the potential to create significant U.S. federal income tax benefits without having meaningful nontax effects. In brief, under the general rule, subject to certain exceptions, debt held by a member of an expanded group will be treated as equity if the debt is issued by a group member in a distribution, in exchange for stock of an expanded group member (other than in an exempt exchange) or in exchange for property in certain asset reorganizations (the Basic Distribution Rule).
In addition to the Basic Distribution Rule, debt issued to an expanded group member in exchange for cash or other property is recharacterized as equity if issued for the principal purpose of funding a distribution or acquisition of the types described above (the Funding Rule), subject to certain exceptions. Although the determination of whether the debt was issued with such a principal purpose depends on all the facts and circumstances, under a per se rule a debt instrument will automatically be so treated if it is issued within 36 months before or after the date of the acquisition or distribution and does not arise in the ordinary course of the issuer’s trade or business (the Per Se Funding Rule). Intent is irrelevant.
After more than two years of studying the issue, Treasury and the Service concluded that a complete withdrawal of the Distribution Rules could embolden multinational corporations to generate interest deductions without spurring new investment. As a result, Treasury and the Service have opted to keep the Distribution Rules in place, much to the consternation of many taxpayers. However, consistent with the Report, the Advance Notice indicates that Treasury and the Service intend to issue more streamlined and targeted Distribution Rules in the form of proposed regulations. In that connection, Treasury and the Service contemplate that the Funding Rule will be “substantially” modified, and that the Per Se Funding Rule will be withdrawn. In lieu of automatically treating a debt instrument as funding a distribution or similar transaction based on timing, the future funding rule will apply to a debt instrument only if there is a sufficient factual connection between the issuance and the distribution or similar transaction (e.g., if they are pursuant to an integrated plan). If no such connection exists, the debt instrument would not be treated as stock (assuming it otherwise qualifies as indebtedness under general tax principles). Comments are requested as to the appropriate standard for determining the existence of a proscribed factual connection, as well as whether specific factors pointing in favor of, or against, such a connection should be delineated in the proposed regulations.
The changes envisaged by the Advance Notice are a step in the right direction, but are by no means a panacea for taxpayer angst over the Distribution Rules. Disappointingly, the Advance Notice fails to include any provision enabling taxpayers to rely on the Advance Notice’s description of intended changes to the Distribution Rules. Instead, the Advance Notice simply provides that the contemplated proposed regulations modifying the Funding Rule would apply to taxable years beginning on or after the date of publication of such regulations as final regulations. Thus, for the time being, taxpayers must continue to abide by the Distribution Rules — including the Per Se Funding Rule — as currently written, as if the Advance Notice had not been issued.