October 17, 2016
Treasury Issues Final Section 385 Regulations on Reclassification of Related Party Corporate Debt
On October 14, 2016, the U.S. Treasury Department issued final regulations addressing whether an interest in a corporation is to be treated as stock or indebtedness for tax purposes. Originally proposed in April, these sweeping rules were announced as part of the government's aggressive campaign to curb the use of corporate inversions and other multinational strategies that were discredited as U.S tax avoidance schemes.
While inversion strategies seek the reduction of U.S. tax liability through the use of corporate debt-related expenses paid to U.S. operations relocated offshore, these Section 385 regulations affecting the classification of corporate debt instruments impact a much broader range of corporate transactions, and will force U.S. companies and their foreign affiliates to re-examine their current tax and legal structure.
Under the statutory authority granted by Congress under Section 385, the proposed regulations addressed the treatment of an interest in a corporation as stock or indebtedness. In contrast to prior regulatory and judicial approaches to determining the character of a corporate interest that relied on a facts and circumstances analysis of certain listed factors, the proposed regulations employed fixed standards, "irrebuttable" presumptions, and in some cases mandated "conclusive" treatment, to define the federal tax treatment, including:
- Treat as stock certain related party interests that would otherwise be treated as indebtedness for federal tax purposes;
- Authorize the Commissioner to treat certain related party interests in a corporation as part-stock and part-indebtedness for federal tax purposes; and
- Require extensive, contemporaneous documentation for the related-party corporate interests to be treated as indebtedness for federal tax purposes.
Treasury entertained comments to the proposed rules, and issued these final regulations ignoring pleas from Congressional leaders, industry and the tax community to take a more measured approach and issue the regulations as a second set of proposals, or as temporary rules. The final rules provide some relief for transactions among foreign affiliates of U.S. companies, banks and insurance companies. Further, relief was provided for foreign-to-foreign instruments, "cash-pooling arrangements" and, significantly, to S Corporations. However, the rules maintain their focus on limiting the ability of U.S. companies to obtain debt treatment of corporate instruments, thereby limiting interest deductions and changing the tax treatment of principal repayments, by reclassifying the instrument as equity investments.
Although the final rules mitigate the onerous 30-day documentation standard, failure of which would have resulted in automatic reclassification of the corporate instrument as equity, companies will incur significant cost and time in compiling the required documentation prior to filing their tax returns. The effective date for the documentation requirements was extended to January 2018. However, the "look-back" effective date for reclassifying debt as equity for instruments issued on or after April 14, 2016, has been retained by the final rules.
The impact of these final Section 385 regulations to U.S. companies and their foreign subsidiaries could be significant. Debt held or issued with related parties that are part of the new "expanded group" definition established by the regulations should be reviewed to identify potential exposures created by the final regulations. Additionally, the documentation supporting the debt arrangements must be reviewed to determine whether the new documentation requirements apply and, if so, meet the new standards. The commercial viability of the debt arrangements, and the capacity of the debtors to make timely payment on interest and principal, should be assessed and documented.
Should you have any questions related to the Section 385 debt reclassification regulations, contact your Marcum Tax Advisor.