Proposed 385 Regulations Target Related Party Debt-Equity Issues

Proposed 385 Regulations Target Related Party Debt-Equity Issues

The types of transactions targeted appear to include debt through note distributions in the inbound and outbound context, and debt repatriation in the outbound context. Even though these Proposed Regulations generally apply to multinational companies, the concepts contained in the regulations may be considered for smaller companies and is not limited to the transactions discussed below.

If finalized, Proposed Regulations under Code Section 385 (the “Proposed Regs”) would:

1. Treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes;
2. Authorize the Commissioner of the IRS (the “Commissioner”) to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes;
3. Establish extensive documentation requirements in order for certain related party interests in a corporation to be treated as indebtedness for federal tax purposes.

The Proposed Regs would authorize the IRS to treat certain instruments issued between related parties as stock or indebtedness, or part indebtedness and part stock. Any such treatment would occur only in the event that the substance of the instrument supports such treatment, and the instrument has met the documentation and information requirements discussed below (if applicable). One major change in the Proposed Regs is the IRS would now be able to effectively classify a non-instrument as part equity/part debt; it is not an all-or-none determination anymore. However, the IRS would not be required to treat the interest in this manner.

The Proposed Regs would provide rules requiring documentation establishing a debt as bona fide. The Proposed Regs would: (i) prescribe the nature of the documentation necessary to substantiate the treatment of related-party instruments as indebtedness; and (ii) require that such documentation be timely prepared and maintained. Furthermore, if the specified documentation was not provided to IRS upon request, the IRS would treat the preparation and maintenance requirements as not satisfied, and treat the instrument as stock for federal tax purposes.

The Proposed Regs would provide three rules that treat an expanded group instrument (“EGI”) as stock, including a general rule, a funding rule, and an anti-abuse rule.

These rules are as follows:

1. The general rule would treat EGI as stock to the extent it was issued by a corporation to a member of the corporation’s expanded group: (i) in a distribution; (ii) in exchange for expanded group stock, other than in an exempt exchange; or (iii) in exchange for property in an asset reorganization, subject to limitations.
2. The funding rule would treat EGI as stock if the goal was to fund a principal purpose debt instrument. Specifically, a principal purpose debt instrument would be a debt instrument issued by a corporation (funded member) to another member of the funded member’s expanded group in exchange for property, with a principal purpose of funding:
   • a distribution of property by the funded member to a member of the funded member’s expanded group, subject to certain exceptions;
   • an acquisition of expanded group stock, subject to certain exceptions; or
   • the acquisition of property by the funded member in an asset reorganization, subject to specific limitations in the Regulations.
3. Under the anti-abuse rule, a debt instrument would be treated as stock if it was issued with a principal purpose of avoiding the application of the Proposed Regs.

The Proposed Regs would be limited in scope as they would apply to the characterization of indebtedness between members of an “expanded group.” The term “expanded group” would be defined by referencing the term “affiliated group,” as described in Code Section 1504(a).

However, the Proposed Regs would also broaden this definition in the following ways:

• Unlike an affiliated group, an expanded group would include foreign and tax-exempt corporations, as well as corporations held indirectly (i.e. through partnerships);
• In determining relatedness, the Proposed Regs would adopt the related corporation constructive ownership/attribution rules;
• The Proposed Regs also would modify the definition of affiliated group to treat a corporation as a member of an expanded group if 80% of the vote or value is owned by expanded group members (as opposed to 80% of the vote and value).

Proposed Regs 1.385-1 and 1.385-2 would apply to any applicable instrument issued or deemed issued on or after the date the Proposed Regs are published as final. Prop Regs 1.385-3 and 1.385-4 would apply to any debt instrument issued on or after April 4, 2016.

It appears that the proposed regulations may have significant unintended consequences that will impact non-abusive activities, such as the potential effect on a broad range of business transactions, including, but not limited to, standard cash-management techniques. The complexity of these proposed changes is making it difficult for the tax community to finalize its analysis of the proposed regulations prior to the original July 7, 2016 deadline. As such, there have been numerous requests to Treasury for the comment period to be extended, at a minimum, for an additional 90 days, which would be October 5, 2016.

1. See the Proposed Regs for possible application of these rules to entity classification elections made near the date the Regs become final.
2. See the Proposed Regs for possible application of these rules to entity classification elections made near April 4, 2016. Additionally, there are transition rules for certain distributions or acquisitions occurring before April 4, 2016 that would not be taken into account, and certain debt instruments would continue to be treated as debt instru-ments until 90 days after the date the Proposed Regs are made final.

Author: CJ Stroh| [email protected]

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.