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IRS removes Section 385 documentation rules

Concurrent proposal backs change to debt and equity regulations

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IRS removes Section 385 documentation rules The IRS issued final regulations (T.D. 9880) on Oct. 31 that repeal the documentation requirements under Treas. Reg. Sec. 1.385-2 that had to be met in order to treat certain related-party interests in a corporation as indebtedness for federal tax purposes. It also simultaneously released an advance notice of proposed rulemaking (REG-123112-19) that informs taxpayers of its intent to issue proposed regulations that would remove the per se aspects of the so-called “recast rules” under Treas. Reg. Sec. 1 .385-3.

The guidance provides welcome relief, but may not go far enough for some taxpayers. Many had hoped the Section 385 regulations would be withdrawn in their entirety. While the repeal of the documentation rules will reduce the administrative burden on affected taxpayers, the factors that were required to be documented are still relevant in determining whether an instrument will be treated as a debt instrument under existing case law. Taxpayers should therefore continue to consider the factors under existing authorities.

Although the proposed limitation on the scope of the recast rules is a generally favorable development, it is currently unclear how much the recast rules will be limited beyond the repeal of the per se rule. The proposed relief would also only apply to tax years beginning on or after the publication of final rules.

Additionally, the advanced notice of proposed rulemaking includes the guidance in Notice 2019-58 allowing taxpayers to rely on the October 2016 proposed regulations until further notice, provided that the taxpayer consistently applies the rules in their entirety. It is important to note that neither the notice nor the guidance included in the advance notice of proposed rulemaking alter the general rules of Treas. Reg. Sec. 1.385-3, which were released as final regulations in 2016. Rather, it allows taxpayers to rely on limited exceptions (and other coordinating rules) that were released concurrently to the final Section 385 regulations as temporary and proposed regulations. For more details on the notice and the expired Section 385 temporary regulations, see our prior coverage.

Background The IRS released final and temporary regulations on Oct. 21, 2016, that addressed whether a purported debt instrument issued to a related party is treated as stock or debt for U.S. federal tax purposes by:

  • Evaluating purported debt under common law principles and factors
  • Imposing strict documentation requirements on purported debt (documentation rules)
  • Targeting transactions involving purported debt that insert leverage without additional capital (the recast rules)

The rules applied to instruments issued by a domestic corporation to related parties that were members of its “expanded group” as defined in the regulations.

In April 2017, President Donald Trump issued Executive Order (EO) 13789 requiring the IRS to review all tax regulations issued since Jan. 1, 2016, and identify those that impose an undue financial burden on taxpayers, add undue complexity to the federal tax laws or exceed the statutory authority of the IRS.

Notice 2017-38, issued in July 2017, identified the documentation rules as one that met the criteria set forth in the executive order. The IRS also issued Notice 2017-36, which delayed the application of the documentation rules. Further, in October 2017, the IRS identified the documentation rules to be considered for partial revocation in a report to the president on “Identifying and Reducing Tax Regulatory Burdens.”

In September 2018, the IRS issued proposed regulations (REG-130244-17) that would remove the final regulations under Treas. Reg. Sec. 1.385-2. These proposed regulations indicated that taxpayers could rely on the removal of the documentation rules pending finalization. For more details, see our prior coverage.

Removal of documentation rules The documentation rules under Section 385 required taxpayers to prepare and maintain certain information supporting debt treatment for a particular instrument including:

  • The unconditional obligation to pay a sum certain
  • Creditor’s rights
  • A reasonable expectation of the borrower’s ability to repay
  • Actions evidencing a debtor-creditor relationship

If the required documentation was not prepared and maintained, an instrument under the purview of the documentation rules was treated as stock for tax purposes subject to some exceptions.

The final regulations finalize the September 2018 proposed regulations to remove the documentation rules. The IRS determined that the burdens imposed on taxpayers far outweigh the regulations’ intended benefits. The IRS also indicated that it will continue to consider the issues addressed by the documentation rules, and may propose a modified, substantially streamlined version of proposed rules that would ensure the collection of sufficient documentation and other necessary information. Any modified version would be issued with a prospective effective date far enough in advance to provide taxpayers sufficient time to implement and comply with the proposed rules. The IRS also invited taxpayers to comment on approaches that efficiently achieve a balance between efforts to minimize the taxpayer burden, while ensuring the collection of necessary information for tax administration.

Advance notice addressing the ‘funding rule’ The recast rules under Treas. Reg. Sec. 1 .385-3(b)(2) generally provide that the issuance of a debt instrument by a member of an expanded group to another member of the same expanded group in a distribution, or an economically similar transaction, may result in the treatment of the debt instrument as stock. These regulations include a “funding rule” under Treas. Reg. Sec 1.385-3(b)(3)(i) that treats a debt instrument as stock if it was issued in exchange for property, including cash, to fund a distribution to an expanded group member or another transaction that achieves an economically similar result. The funding rule contains a per se rule which treats a debt instrument as funding a distribution to an expanded group member or other transaction with a similar economic effect, if it was issued in exchange for property during the 36-month period before, or the 36-month period after, the issuer of the debt instrument made the distribution or undertook a transaction with a similar economic effect.

The advance notice of proposed rulemaking informs taxpayers of the IRS’s intent to promulgate “more streamlined and targeted” recast rules that would substantially modify the funding rule, including potentially eliminating the per se nature of the rule. The IRS suggested that the proposed regulations would apply the funding rule to a debt instrument only if its issuance has a sufficient factual connection to a distribution. In addition, the IRS is considering revisions to, or removal of, certain exceptions in the regulations. The IRS intends that the proposed regulations would apply to tax years beginning on or after the date the rules are finalized and published in the Federal Register. Treasury and the IRS have requested comments on all aspects of the recast rules.

Although the advance notice of proposed rulemaking acknowledges taxpayer comments recommending complete withdrawal of the recast rules, the IRS expressed apprehension about completely discarding the rules because it believes that a complete withdrawal could restore incentives for multinational corporations to generate additional interest deductions without new investment. Accordingly, the IRS concluded that the recast rules continue to be necessary at this time.

The advance notice of proposed rulemaking also provides that taxpayers may rely on proposed regulations issued in October 2016 until further notice. Treas. Reg. Secs. 1.385-3T and 1.385-4T expired on Oct. 13, 2019. Notice 2019-58 allowed taxpayers to rely on identical proposed regulations (which do not expire) for any period following the expiration of the temporary regulations. Taxpayers may only rely on the proposed regulations if applied consistently and entirely. This reflects the same guidance previously provided in Notice 2019-58, and supplants that notice.

As noted above, the notice nor the guidance included in the advance notice of proposed rulemaking change the general rules of Treas. Reg. Sec. 1.385-3 released as final regulations in 2016. Rather, it allows taxpayers to rely on limited exceptions (and other coordinating rules) that were released concurrently to the final section 385 regulations as temporary and proposed regulations.

Next steps The final regulations became effective on Nov. 4. Although the documentation rules have been removed, the factors that taxpayers were required to document under Treas. Reg. Sec. 1.385-2 are still relevant in establishing whether an instrument is debt. As such, taxpayers must still prudently evaluate whether an instrument is debt for federal income tax purposes under an abundant amount of established authorities.

The proposed rules discussed in the advanced notice of proposed rulemaking addressing the scope of the funding rule will be effective when final.

For more information contact:
David Sites
Partner
Washington National Tax Office 
Grant Thornton LLP
T +1 202 861 4104

Jeff Borghino
Partner, Corporate Tax
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1532

Josh Brady
Principal, Corporate Tax
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1563

Cory Perry
Senior Manager
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1509

Yasmin Dirks
Manager
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1506

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