The Internal Revenue Service has issued final and temporary regulations under Internal Revenue Code Section 385, relating to the characterization of related party securities as debt or equity for U.S. tax purposes. The new package (Treasury Decision 9790), which was released on October 13 and published in the Federal Register on October 21, responds to a large volume of commentary received after proposed Section 385 regulations were issued in April. The scope of the regulations has been significantly narrowed, and the overall compliance burden has been reduced. However, the fundamental structure of the regulations remains largely unchanged, so corporate taxpayers should continue to prepare for compliance with the rules.
Highlights of significant changes between the proposed and final regulations include the following:
Definitions and General Rules
- For now, securities issued by foreign companies are excluded from the regulations. The IRS has reserved the right to issue rules applicable to foreign issuers in the future.
- Securities issued by S corporations are similarly excluded, as a result of the revised definition of an “expanded group.”
- Membership in an expanded group is determined by reference to Internal Revenue Code Section 318 constructive ownership rules, with a narrowing of those rules that generally prevents brother-sister groups from being treated as an expanded group.
- The controversial “bifurcation” rule, which could have caused an instrument to be treated as part debt and part equity if a borrower was found to be not sufficiently creditworthy with respect to the instrument, has been eliminated.
- The general effective date has been pushed back to January 19, 2017 (90 days after publication in the Federal Register).
- Providing significant relief to a taxpayers’ compliance burden, the former mandate to produce documentation on an instrument-by-instrument basis within 30 days of issuance has been replaced with a stipulation to prepare a single documentation report, on or before the due date (including extensions of time) of the return, covering all issuances during the tax return year.
- The per se recharacterization rule for undocumented instruments has been relaxed. Taxpayers that are “highly compliant” will be allowed to rebut the presumption of equity status for a small number of instruments that are not documented properly.
- The rules that previously imposed a heavy burden on cash pooling, revolving credit agreements and similar arrangements have been relaxed significantly. Borrowings under a “master agreement” can be documented on an aggregate basis for the taxable year, based on a single credit analysis.
- The effective date of the documentation rules has been delayed by over a year. As the rules now apply to instruments issued on or after January 1, 2018, taxpayers will have time during 2017 to develop and test systems and processes, allowing for a prepared implementation of the rules.
- In general, the rules that treat purported debt as per se equity (when issued in certain intra-corporate group transactions) are retained in the final rules. These rules cover debt issued by one member of an expanded group to another member as part of a distribution, an acquisition of member stock, or an exchange for member assets in certain types or reorganizations. The final rules also retain the controversial “funding rule” that treats debt as equity if issued within a 72-month period surrounding the date of a distribution or acquisition
- However, the final rules carve out a fairly broad exception for “qualified short-term debt instruments” that either satisfy a debt-to-working-capital-ratio test or a 270-day test. A similar carve-out for “ordinary course loans” protects inter-company trade payables from recharacterization.
- As provided in proposed regulations, the first $50 million of intra-group debt that is otherwise subject to the recharacterization rules is exempt. However, the “cliff effect” approach contained in the proposed regulations was replaced with a stipulation in the final rules to include only intra-group debt in excess of $50 million as subject to recharacterization.
- The proposed regulations’ exception for distributions and exemptions not exceeding current earnings and profits (“E&P”) has been expanded to include both current E&P and E&P accumulated after April 4, 2016. Taxpayers that are concerned about the potential application of these rules would be well-advised to complete and retain a careful E&P study that documents the balance as of April 4, 2016.
- A number of other exceptions have been added, including an exception for certain capital contributions and an exception for constructive distributions and capital contributions resulting from transfer pricing adjustments.
Overall, the final and temporary regulations are significantly more taxpayer-friendly than the proposed regulations. However, they still impose substantial compliance burdens on domestic corporate groups. As taxpayers approach the effective date of the documentation rules, taxpayers should develop and test their systems to ensure timely documentation compliance. In addition, taxpayers that have intra-group debt that is potentially subject to recharacterization, or taxpayers considering an issuance of such debt, should carefully explore alternative means of financing their operations that escape the ambit of the final rules.
It is imperative to get your tax advisors involved early to make sure your loans comply with the new rules. Make sure your CBIZ MHM tax professional is an integral part of the team as soon as you start thinking about loans to related companies.
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