The final debt-equity regulations issued on May 13, 2020, finalize proposed section 385 regulations issued in 2016 without any substantive changes to the existing debt-equity regulations, and withdraw the temporary section 385 regulations issued in 2016. Taxpayers should consider the impact of these regulations on related party debt transactions to avoid recharacterization of debt into equity.
On May 13, 2020, the US Department of the Treasury and the Internal Revenue Service (IRS) issued final debt-equity regulations under section 385 (2020 Final Regulations). The 2020 Final Regulations finalize proposed section 385 regulations issued in 2016 without any substantive changes to the existing debt-equity regulations, and withdraw the temporary section 385 regulations issued in 2016.
Section 385 authorizes the IRS and the Treasury to issue regulations to determine whether an interest in a corporation may be treated as debt or equity for US federal income tax purposes. If a debt instrument is recharacterized as equity, then the interest expense associated with the debt would be disallowed. Taxpayers should consider the impact of these regulations on related party debt transactions to avoid recharacterization of debt into equity.
2016 Section 385 Regulations
On October 21, 2016, the Treasury and the IRS published final and temporary regulations under section 385 (2016 Final Regulations and 2016 Temporary Regulations, respectively). On the same day, the Treasury and the IRS issued proposed regulations that incorporate by reference the 2016 Temporary Regulations (the 2016 Proposed Regulations). Both the 2016 Final Regulations and the 2016 Temporary Regulations recharacterized certain “covered debt instruments“ as stock. Although the 2016 Temporary Regulations expired on October 13, 2019, taxpayers have been able to rely on the 2016 Proposed Regulations if they consistently applied the regulations in their entirety.
The 2016 Final and Temporary regulations set forth two sets of rules that significantly affected taxpayers, particularly multinationals: the documentation rules in Treas. Reg. section 1.385-2, and the distribution rules set forth in Treas. Reg. sections 1.385-3, 1.385-3T and 1.385-4T (Distribution Regulations). In November 2019, the Treasury and IRS withdrew the documentation rules, but indicated that they may introduce a modified, simpler documentation requirement in the future. The 2020 Final Regulations finalize the distribution rules set forth in the 2016 Temporary Regulations, which primarily relate to short-term debt instruments, controlled partnerships and consolidated groups.
Overview of the Distribution Regulations
Under the Distribution Regulations, if a covered member of an expanded group issues a covered debt instrument to another member of the expanded group in connection with a distribution, or an economically similar acquisition transaction, the covered debt instrument may be recharacterized as stock. An “expanded group“ generally includes all domestic and foreign corporations connected through one or more 80% stock ownership chains with a common parent where (i) the common parent owns directly or indirectly at least 80% of the vote or value of at least one such corporation, and (ii) one or more of such corporations own directly or indirectly at least 80% of the vote or value of each such corporations. The term “expanded group“ excludes S corporations, regulated investment companies and real estate investment trusts. A “covered member“ is a member of an expanded group that is a domestic corporation. A “covered debt instrument“ is generally a debt instrument issued after April 4, 2016, by a covered member that is not an excepted regulated financial company or a regulated insurance company. The term “covered debt instrument“ does not include certain debt instruments issued by a dealer in its ordinary course of business and certain contractual arrangements that are treated as debt instruments under other provisions of the Internal Revenue Code or Treasury regulations.
Special rules apply to the treatment of covered debt instruments in the case of controlled partnerships and consolidated groups. For example, the distribution regulations generally treat a controlled partnership as an aggregate of its expanded group partners. Thus, a debt instrument issued by a controlled partnership is treated as issued by the expanded group partners in proportion to their partnership interest. Also, members of a consolidated group are generally treated as one corporation, and a debt instrument issued by a member to a non-member is treated as issued by the consolidated group.
The Distribution Regulations further provide, pursuant to a funding rule, that a covered debt instrument is recharacterized as stock if it is (i) issued by one member to another member of the same expanded group in exchange for cash or property, and (ii) under the “per se funding rule“ or “principal purpose rule,“ treated as funding certain distributions to a member of the expanded group or certain acquisitions of property or stock of a member of the same expanded group. The principal purpose rule applies where a covered debt instrument is issued by a funding member outside of the per se funding period (as described below) with the principal purpose of funding such a distribution or covered acquisition transaction. Whether a covered debt instrument is issued with a principal purpose of funding a distribution or covered acquisition is determined based on all the facts and circumstances. “Qualified short-term debt instruments,“ such as certain short-term funding arrangements, ordinary-course loans, interest-free loans and cash-pooling arrangements, are excluded from these distribution provisions.
Future Withdrawal of the Per Se Funding Rule
Under the per se funding rule, a covered debt instrument is automatically treated as funding one of the above distributions or acquisitions if the covered debt instrument is issued in exchange for property within a 72-month window, beginning 36 months before and ending 36 months after the date of the distribution or acquisition. Since its issuance, the per se funding rule has been highly criticized because it would result in harsh consequences regardless of taxpayers‘ actual use of the proceeds from the covered debt instrument. On November 4, 2019, the IRS issued an advance notice of proposed rulemaking that announced that the Treasury and the IRS intended to propose streamlined and targeted recast rules under section 385, including by withdrawing the per se funding rule. According to the IRS, the new proposed regulations would not treat a debt instrument as funding a distribution or economically similar transaction solely because of their temporal proximity. Rather, the new proposed regulations would apply the funding rule to a debt instrument only if there is sufficient factual connection between the issuance of the debt instrument and the distribution or economically similar transaction.
Importantly, the 2020 Final Regulations simply finalized the 2016 Proposed Regulations and did not simplify the distribution rules or withdraw the per se funding rule. Instead, the IRS and the Treasury continue to study all appropriate modifications to the recharacterization rules under section 385 and “intend to issue proposed regulations modifying the Distribution Regulations to make them more streamlined and targeted, including by withdrawing the per se rule.“
Commentators speculated that the Treasury and the IRS would greatly limit the section 385 regulations once the guidance relating to the interest expense limitation under section 163(j) was finalized, or when the stricter interest expense limitation under section 163(j) takes effect. However, in response to the pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily lightened the interest expense limitation under section 163(j) by, among other things, increasing the limitation from 30% to 50% of a taxpayer’s adjusted taxable income for years beginning in both 2019 and 2020. The CARES Act also temporarily suspended the 80% limitation on net operating loss (NOL) carryforwards under section 172 for years beginning before 2021, and generally allows five-year NOL carrybacks. It is possible that the Treasury and the IRS decided to not scale back the Distribution Regulations at this time because the temporary modifications under the CARES Act already eased the restrictions on interest expense deduction and NOL usage. It is evident that the Treasury and IRS will finalize the Distribution Regulations in the future based upon their statements in the 2020 Final Regulations and other recent pronouncements, but the timing is unknown.
Taxpayers should continue to be mindful of the section 385 regulations‘ impact on related party debt transactions. While the documentation rules have been withdrawn, the distribution rules may still recharacterize certain related party debt instruments as equity in a variety of contexts, particularly where a domestic corporation borrows from a related foreign or domestic corporation that is not a member of the same consolidated group.