On May 13, 2020, the Department of the Treasury and the Internal Revenue Service (“IRS”) issued final regulations under Section 385 of the Internal Revenue Code (“Code”), T.D. 9897 (“Final Regulations”), which address the classification of certain related party debt as stock or equity for U.S. Federal income tax purposes. The Final Regulations adopt, without any substantive changes, the 2016 proposed regulations, REG-130314-16 (“Proposed Regulations”) while leaving open issues related to distribution regulations to be addressed in future IRS guidance, as further discussed below.
The IRS initially issued proposed regulations under Section 385 of the Code in 2016 out of concern for certain earnings-stripping and tax-avoidance transactions. After numerous comments about the expansive reach of the regulations, the IRS issued the Proposed Regulations and T.D. 9790 consisting of final regulations (“Final Regulations”) and temporary regulations (“Temporary Regulations”) in October of 2016, which limited the scope of the rules by applying them only to certain covered debt instruments issued by U.S. domestic corporations. The Final, Temporary and Proposed Regulations contained a complex set of rules, which consisted of four main sections: (i) Regs. § 1.385-1 addressing general rules and definitions, (ii) Regs. § 1.385-2 addressing specific documentation requirements for debt obligations (“documentation rules”), (iii) Regs. § 1.385-3 addressing rules that operate to recast debt into equity for U.S. Federal income tax purposes; and (iv) Regs. § 1.385-4 addressing consolidated groups and treatment under recast rules.
Out of the combined 2016 guidance, Regs. §§ 1.385-3, 1.385-3T, and 1.385-4T are commonly referred to as the distribution regulations (“Distribution Regulations”) and include provisions related to the reclassification of certain debt to stock if such debt was issued by a corporation to an expanded group member in a distribution or an economically similar transaction. For these purposes, an “expanded group” is defined under the affiliation rules of Section 1504(a) of the Code subject to certain modifications. The Distribution Regulations include (i) a funding rule which treats a covered debt instrument as stock if the covered debt instrument is exchanged for property, including cash, to fund a distribution to an expanded group member, and (ii) a per se rule, which treats a covered debt instrument as stock if issued by a covered member of an expanded group member within a 36-month period, either preceding or subsequent, of an acquisition or distribution.
In October of 2019, the IRS permanently removed the documentation rules under Regs. § 1.385-2 in compliance with Executive Order 13789 on the basis that such rules were too burdensome for taxpayers. Pursuant to the expiration of the Temporary Regulations on October 13, 2019, the IRS issued Notice 2019-58, which announced that taxpayers can rely on the Proposed Regulations until further notice. In November of 2019, the IRS issued an advance notice of proposed rulemaking, REG-123112-19 (“Advance Notice”) announcing its intention to issue proposed regulations that would streamline and simplify the Distribution Regulations and permitting taxpayers to rely on the Proposed Regulations until further notice if the taxpayers otherwise applied the regulations consistently in their entirety.
The Final Regulations provide final rules on the reclassification of certain related party debt as stock and address the treatment of qualified short-term debt instruments, controlled partnership transactions and application of the rules to the consolidated group members. The Final Regulations include multiple exceptions that limit the application of Section 385 rules, including the threshold exception for members of consolidated groups, which provide that the first $50 million of expanded group debt instruments would not be reclassified as stock. The Final Regulations also contain an anti-abuse provision that allows the IRS to recharacterize debt as stock if the principal purpose of the transaction is to avoid the regulations. In the preamble to the Final Regulations, the IRS noted that it plans to continue to study the appropriate approach to revising the Distribution Regulations. Thus, as previously indicated in the Advance Notice, the IRS intends to issue additional guidance in the future to provide for more streamlined and targeted Distribution Regulations.
The Final Regulations apply to taxable years ending after January 19, 2017, except for Regs. §§ 1.385-3(f)(4)(iii) and 1.385-4, which provide rules for members of consolidated groups subject to Section 1502 of the Code and apply to taxable years for which a consolidated U.S. Federal income tax return is due, without extensions, after May 14, 2020.
If you have any questions about the information in this alert, please contact Richard Lieberman (312-627-2250 or RLieberman@dykema.com), Michael Cumming (248-203-0740 or MCumming@dykema.com), Scott Kocienski (248-203-0868 or SKocienski@dykema.com), Asel Lindsey (210-554-5298 or ALindsey@dykema.com), Nardeen Dalli (248-203-0793 or NDalli@dykema.com), or your Dykema relationship attorney.