By Jason Fritts
January 30, 2017
The U.S. Department of Treasury and the Internal Revenue Service released final and temporary regulations under Internal Revenue Code Section 385 on October 13, 2016. The newly released Section 385 regulations address whether certain financial transactions between related parties will be treated as debt or equity. U.S. companies with related party financing will need to review their applicable transactions to ensure compliance.
The Section 385 regulations became effective October 21, 2016, although various other application dates may apply as noted below. The Section 385 regulations provide guidance on related party debt through four separate sections:
The Section 385 regulations modify the proposed Section 385 regulations that were issued on April 4, 2016. However, the final Section 385 regulations largely preserve the proposed regulations, including exemptions for cash pools, short-term loans, foreign-to-foreign transactions, regulated financial entities, and pass-through entities, and documentation relief for debt issued by U.S. corporations.
Changes and Impact
The following summarizes the changes reflected in the Section 385 regulations and highlights the profile of companies impacted and the nature of the impact.
No Application of Foreign Borrowers - Unlike the proposed regulations, the Section 385 regulations broadly exempt all debt issued by foreign corporations, including both controlled foreign corporations (CFCs) and non-U.S. controlled foreign corporations. However, U.S. and foreign transfer pricing rules and documentation requirements still apply to all related party financing transactions.
Limited Application to U.S. Borrowers: The Section 385 regulations are limited to debt instruments (expanded group (EG) instruments (EGIs)) issued by certain members of an affiliated group that are domestic corporations for U.S. tax purposes. The Section 385 regulations do not apply to S corporations, non-controlled real estate investment trusts (REITs), regulated investment companies (RICs), certain financial organizations or foreign cash pooling arrangements. The Section 385 regulations can be expected to have limited application to U.S.-parented multinational groups where the group’s domestic corporations join in filing a consolidated return.
The Section 385 regulations target the inbound financing of a foreign-based multinational’s domestic subsidiaries, but do not address the financing of such group’s U.S. branch operations.
Elimination of Bifurcation Rule: The Section 385 regulations do not include a general bifurcation rule, but the preamble to the regulations states that U.S. Treasury and the IRS will continue to study this issue. The bifurcation rule set forth in the proposed regulations seemed to provide the commissioner with discretion to treat a debt instrument between two members of the same modified EG as part debt and part stock (i.e., to ‘bifurcate’ the interest). The changed position means that under the Section 385 regulations, the debt versus equity classification for U.S. tax purposes generally remains an “all-or-nothing” determination.
Documentation Rule: The Section 385 regulations limit the scope of the documentation rules by applying them only to debt issued by U.S. corporations, and modify the filing requirements and the consequences of non-compliance. Foreign cash pools, debt issued by S corporations, REITs, RICs and controlled partnerships are generally also excluded. Debt issued by a disregarded entity (DRE) of a relevant domestic corporation is subject to the documentation rules, but if such debt is recast, it is converted into equity of the DRE’s regarded owner (the relevant domestic corporation) and not into debt of the DRE.
The final documentation rules apply only to an EGI issued on or after January 1, 2018.
Re-characterization Rules: Subject to certain exceptions, the proposed regulations re-characterized related-party debt instruments as stock, for all U.S. tax purposes, when issued: (i) as a distribution, (ii) in exchange for related-party stock (e.g., section 304 sale), (iii) as consideration in an internal asset reorganization (e.g., a boot D reorganization), or (iv) to fund a distribution, acquisition of related-party stock, or boot in an internal asset reorganization. Despite requests for withdrawal or complete modification of the re-characterization rules, they were retained in the Section 385 regulations with some minor modifications.
The re-characterization rules are applicable only to debt instruments issued on or after April 4, 2016. And, in accordance with the Section 385 regulations, the application date provided in the proposed regulations for re-characterization is expanded so that any debt instrument that is subject to re-characterization, but that is issued on or before January 19, 2017, will not be re-characterized until immediately after January 19, 2017.
Depending on specific facts and circumstances, the Section 385 regulations could impact domestic companies and foreign companies with U.S. operations. Specifically, they may require modifications to existing organizational structures, funding strategies, and related processes and technology in order to mitigate the risk of having debt re-characterized as equity. In order to better understand the effect the Section 385 regulations may have on your current business strategy and the funding of group members, we recommend that companies conduct an assessment of the impact the Section 385 regulations will have on your organization, including current and prospective operations.
Contact your Eide Bailly professional or a member of our international tax team for additional information or assistance in complying with the Section 385 regulations.