IRS Finalizes Section 385 Earnings Stripping Regulations
Corporate & Finance Alert
On October 18, 2016, the United States Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) issued final and temporary regulations (“Final Regulations”) under Section 385 of the Internal Revenue Code of 1986, as amended (the “Code”) addressing the treatment of certain related party debt for U.S. federal income tax purposes. T.D. 9790. These regulations had been proposed on April 4, 2016 (the “Proposed Regulations”).
As previously discussed in the Gibbons Corporate & Finance Alert published in May 2016, the Proposed Regulations (1) allowed the IRS to treat certain debt instruments issued between members of an expanded group (as that term is defined in Proposed Regulation Section 1.385-1(b)(3)) as debt in part and stock in part for federal tax purposes (Prop. Treas. Reg. Section 1.385-1); (2) established extensive documentation requirements for members of an expanded group for purposes of the debt-equity analysis (Prop. Treas. Reg. Section 1.385-2); and (3) treated as stock certain interests in a corporation issued between members of an expanded group that would otherwise be treated as debt for federal tax purposes (Prop. Treas. Reg. Section 1.385-3).
Under these regulations, the definition of an expanded group instrument (“EGI”) is important because many of the Section 385 rules apply to applicable instruments issued by one member of an expanded group to a holder who is (i) also a member of the same expanded group, (ii) a disregarded entity owned by a member of the same expanded group, or (iii) a controlled partnership with respect to the same expanded group.
The structure of the Final Regulations remains generally the same as the Proposed Regulations. However, the Final Regulations do make a number of significant changes to the Proposed Regulations, including (1) a number of new exceptions applicable to transactions between foreign subsidiaries of U.S. companies, transactions between members of regulated financial groups, and cash pooling and similar short-term arrangements, (2) expanded exceptions for ordinary course transactions, and distributions out of “future” earnings and profits, and (3) revised effective dates and certain transition periods.
2. Treatment of a Debt Instrument as Debt in Part and Stock in Part under Treas. Reg. Section 1.385-1
While, in general, instruments are treated as entirely debt or entirely stock for federal tax purposes, Proposed Regulation Section 1.385-1(d) authorized the IRS to treat any EGI as part-debt and part-equity, consistent with the substance of the instrument (for example, because the issuer could reasonably be expected to service only 80% of the debt, as opposed to the full 100% of the debt). Significantly, the Final Regulations do not contain any discussion of the part-debt and part-equity recharacterization rule under Prop. Treas. Reg. Section 1.385-1(d), suggesting that under the Final Regulations, instruments will be characterized as either entirely debt or entirely stock. The IRS and the Treasury reserved on this issue in the final regulations.
3. Additional Constraints on Scope of New Rules
In a significant limitation on the scope of the regulations, the Final Regulations will apply only to instruments issued by members of an expanded group that are domestic corporations for federal income tax purposes. The Final Regulations reserve on the treatment of instruments issued by foreign corporations, including both controlled foreign corporations (“CFC’s) and non-U.S. controlled foreign corporations.
In general, an expanded group consists of one or more chains of corporations connected through stock ownership with a common parent corporation but only if (i) the expanded group parent owns, directly or indirectly, at least 80% vote or value in at least one of the other corporations, and (ii) at least 80% of the vote or value in each of the other corporations (other than the parent) is owned directly or indirectly by one or more of the other corporations. Critically, the definition of “expanded group” under the Final Regulations, although still based on concepts similar to those used to define the term “affiliated group” in Code Section 1504(a), has been narrowed as follows:
- S corporations have been excluded from the definition.
- RICs and REITs have generally been excluded from the definition, except if controlled by members of the expanded group.
- “Direct or indirect” ownership will generally be determined under Code Section 318, with certain modifications. However, the IRS reserved on the application of the “downward attribution” rules under Code Section 318(a)(3), which, if those rules applied, could result in “brother-sister” groups of affiliated corporations that are commonly controlled by non-corporate owners being members of a single affiliated group.
- The option attribution rules in Code Section 318(a)(4) will apply only to options, as defined in Treas. Reg. Section 1.1504-4(d), that are reasonably certain to be exercised as described in Treas. Reg. Section 1.1504-4(g) and, in the case of an option within a consolidated group, only if the option is treated as stock or as exercised under Treas. Reg. Section 1.1504-4(b).
4. Documentation Requirements for Purposes of Debt-Equity Analysis under Treas. Reg. Section 1.385-2
Under the Proposed Regulations, taxpayers would be required to comply with certain strict documentation requirements in order for certain EGIs to be treated as debt for federal tax purposes. Specifically, in order to establish that a purported EGI is indebtedness for federal tax purposes, the taxpayer would need to show: (1) an unconditional and binding obligation to pay a sum certain on demand or at a specified time; (2) that the holder has the rights of a creditor to enforce the terms of the debt; (3) a reasonable expectation that the debt will be repaid; and (4) ongoing actions or behavior evidencing a true debtor-creditor relationship between the parties. Failure to satisfy the documentation requirements under the proposed rules would automatically recast the instrument into stock. The documentation requirements apply to an EGI if (i) the stock of any expanded group member is traded on an “established financial market,” (ii) on the date the applicable instrument becomes an EGI, the expanded group’s total assets exceed $100 million on any “Applicable Financial Statement,” or (iii) on the date the applicable instrument first becomes an EGI, the expanded group’s total annual revenue exceeds $50 million on any Applicable Financial Statement.
The Final Regulations retain the above rule, but include several significant changes, exceptions and clarifications, the most significant of which are as follows.
First, the Final Regulations apply to “in-form” debt instruments for federal income tax purposes issued by U.S. corporations to members of its expanded group outside of the issuer’s U.S. consolidated group, including specifically debt that is evidenced only through journal entries, in-trade accounts, or another accounting system that does not generally form part of a company’s long-term liabilities from an accounting perspective and is not corroborated by a separate legal agreement. The Treasury and the IRS reserved on the application of Treas. Reg. Section 1.385-2 to debt that is not debt “in form.”
Second, while the Final Regulations retain the “relevant date” concept of 30 days from date of issuance or 120 days from creditor event articulated in Prop. Treas. Reg. Section 1.385-2, the substantive documentation now must be completed only by the due date of the tax return for the taxable year that the “relevant date” falls within (including extensions), and thus no longer by the relevant date itself. Therefore, the “relevant date” now serves as the marker to associate the event with a particular year’s tax return and is not itself an effective date or applicability date. Even more importantly, the documentation rules apply only to debt issued on or after January 1, 2018, potentially significantly delaying their implementation and providing a helpful transition period for companies to develop the necessary systems and agreements to comply with the rules going forward.
Third, as mentioned above, the Proposed Regulations provided that the failure to satisfy the documentation requirements resulted in the automatic recast of a debt instrument into stock. The Final Regulations slightly relax the rule by allowing taxpayers that are “highly compliant” with the rules to rebut the presumption that the undocumented EGI should be treated as stock. The Final Regulations also retain a “reasonable cause” exception for curing a missed documentation requirement, applying the principles of Treas. Reg. Section 301.6724-1.
Fourth, the Final Regulations provide a number of special rules regarding the application of the documentation requirements to revolving credit arrangements, cash pooling arrangements and similar arrangements that cover multiple EGIs under a master agreement. The Final Regulations also provide exceptions from the documentation requirements for certain EGIs issued by regulated financial institutions and insurance companies.
Fifth, the Final Regulations will not apply to certain interests, including obligations that are treated as debt under other provisions of the Code or Treasury regulations, such as obligations between members of a consolidated group, production payments treated as a loan under Code Section 636(a) or (b), REMIC regular interests, and debt instruments deemed to arise under Treas. Reg. Section 1.482-1(g)(3).
Sixth, the Final Regulations clarify and provide several new rules relating to the requirement that there exist written documentation establishing the reasonable expectation of the issuer to repay any EGI. The Final Regulations also provide a safe harbor pursuant to which documentation that is customarily used in comparable third-party transactions may be used to satisfy the documentation requirements to establish an unconditional obligation to pay a sum certain and to show the existence of creditors’ rights.
Finally, the Final Regulations provide that if an obligation of a disregarded entity that is owned by a corporate member of an expanded group is treated as stock as a consequence of failing to meet the documentation requirements, the stock is treated as having been issued by the corporate owner of the disregarded entity. This rule changes the result under the proposed regulations, which would have caused the disregarded entity to become a partnership for tax purposes.
5. Distributions of Debt Instruments and Related Transactions under Treas. Reg. 1.385-3
Under Treas. Reg. Section 1.385-3(b)(2), the IRS will recast as stock certain interests in a corporation issued to a member of the corporation’s expanded group if they’re issued (1) in a distribution with no cash received in exchange therefor; (2) in exchange for expanded group stock, other than in an exempt exchange; or (3) in exchange for property in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the issuer’s expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation. Instruments issued by certain regulated entities are exempt from the above rules.
Treas. Reg. Sections 1.385-3(b)(3) and 1.385-3(b)(4) will recast a debt instrument as stock to the extent the instrument is issued by a corporation to a member of the corporation’s expanded group in exchange for property with a principal purpose of funding a distribution or an acquisition described in (1) through (3) above (the “Funding Rule”), or if the instrument is issued with a principal purpose of avoiding the application of the regulations.
Whether a debt instrument is issued with a principal purpose of funding a distribution or an acquisition described in (1) through (3) above is based on all the facts and circumstances, subject, however, to a non-rebuttable presumption that an expanded group debt instrument is issued with such a principal purpose if it is issued by the funded member during the period beginning 36 months before and ending 36 months after the funded member makes a distribution or acquisition. This 72-month per se period, contained in the Proposed Regulations, remains in the same form in the Final Regulations, with no exceptions, except as discussed as follows.
The Final Regulations retain the “ordinary course” exception to the rule in Treas. Reg. Section 1.385-3(b)(3) for loans issued as consideration for the acquisition of property, other than money, in the ordinary course of the issuer’s trade or business and that is reasonably expected to be repaid within 120 days of the issuance. This is an expansion of the ordinary course exception in the Proposed Regulations, which only covered amounts payable with respect to expenses that are deductible under Code Section 162 or includible in the issuer’s cost of goods sold or inventory.
The Final Regulations also contain several new categories of debt instruments that are exempt from the Funding Rule. These are:
- Debt instruments issued by certain regulated entities subject to specific regulatory capital or leverage requirements (but not captive insurance companies or non-insurance entities within an insurance group);
- One of two alternative “short-term” funding arrangements, i.e., if the debt instrument meets either the “specified current assets test” or the “270-day test”;
- Interest-free loans which do not provide for stated interest, original issue discount, imputed interest under Code Sections 483 or 7872, and which are exempt from bearing an arm’s-length interest rate under Code Section 482; and
- Demand deposits placed with the “qualified cash pool header” entity pursuant to a “cash management arrangement.”
The Final Regulations also retain and add to the current year earnings and profits exception to Treas. Reg. Section 1.385-3 contained in the Proposed Regulations. First, the exception permits all E&P that accumulate in years ending after April 4, 2016 to be included in the “buffer” that prevents recharacterization of debt instruments under Treas. Reg. Section 1.385-3. Second, after taking into account other exceptions, including the earnings and profits exception, taxpayers will be permitted to net “qualified contributions” of non-excluded property into a subsidiary against distributions and acquisitions by the subsidiary, with the effect that only debt equal to the “net reduction” of the subsidiary’s capital amount is subject to recharacterization. Also excepted are acquisitions of expanded group stock delivered to employees, directors, or independent contractors in consideration for services rendered to the expanded group, and certain acquisitions of expanded group stock by a dealer in securities in its ordinary course of dealing.
Finally, certain distributions and acquisitions are exempted from the Funding Rule, including:
- Deemed distributions and acquisitions resulting from transfer pricing adjustments under Code Section 482;
- Distributions of property in a complete liquidation under Code Sections 331 or 332; and
- Distributions of stock under Code Section 355 not preceded by a “D” reorganization.
6. Effective Date
Treas. Reg. Section 1.385-1 applies to taxable years ending on or after January 19, 2017 (90 days after October 21, 2016, the date of publication of the Final Regulations in the Federal Register).
Under the Proposed Regulations, the rules related to the documentation requirements were to be effective for debt issued on or after the date the regulations were finalized. The rules under Prop. Treas. Reg. Section 1.385-3 and 1.385-4 applied to debt instruments issued on or after April 4, 2016, but such debt instruments would retain their characterization as debt until 90 days after the final regulations were published in the Federal Register.
As mentioned above, the Final Regulations offer significant relief with respect to the effective date of the documentation requirements under Treas. Reg. Section 1.385-2. First, Treas. Reg. Section 1.385-2 applies only to debt issued on or after January 1, 2018, and to debt issued after that date pursuant to an “overall arrangement” in effect prior to that date. Second and more significantly, the documentation requirements are only required to be completed as of the filing of the tax return for the taxable year of the “relevant event,” effectively providing taxpayers with an additional year to comply with the rules.
Treas. Reg. Section 1.385-3 applies to taxable years ending on or after January 19, 2017 with respect to debt instruments issued after April 4, 2016 (90 days after the publication of the Final Regulations in the Federal Register). Any debt that would have been recast between April 4, 2016 and January 19, 2017 is subject to recast upon the end of the transition period. Significantly, although no instrument will be treated as stock prior to January 19, 2017, payments other than stated interest on instruments that would have been recast as stock absent the effective date of Treas. Reg. Section 1.385-3 or the transition rules will constitute distributions for purposes of the Funding Rule.
Lastly, under the Final Regulations, taxpayers may elect to consistently apply the proposed versions of §§ 1.385-1, -3 and -4 to debt issued on or after April 4, 2016, and before October 13, 2016, the date of adoption of the Final Regulations, as long as the rules are applied consistently.
The narrower scope of the Final Regulations reflects a significant effort by the Treasury and the IRS to limit the burden of the regulations under Code Section 385. The Final Regulations contain many new terms and concepts that bear close scrutiny, however, and professional tax advice should be sought with respect to their application to various transactions going forward.