Treasury Removes Section 385 Documentation Regulations and Announces Intent to Issue Proposed Section 385 Distribution Regulations

November 2019

Summary

On November 4, 2019, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) published in the Federal Register T.D. 9880, which removed final regulations setting forth minimum documentation requirements that ordinarily must be satisfied for certain related party interests in a corporation to be treated as indebtedness for federal tax purposes. In addition, Treasury announced in REG-123112-19 that it intends to issue proposed regulations regarding the treatment of certain interests in corporations as stock or indebtedness.
 

Details

Section 385 of the Code authorizes the Secretary to prescribe rules to determine whether an interest in a corporation is treated as stock or indebtedness (or as in part stock and in part indebtedness).
 
In October of 2016, Treasury published final and temporary regulations under Section 385, TD 9790 (I.R.B. 2016-46, 81 FR 72858 (October 21, 2016)). The final and temporary regulations under Section 385 are primarily comprised of (i) rules setting forth minimum documentation requirements that ordinarily must be satisfied for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes (the Documentation Regulations) and (ii) rules that treat as stock certain debt that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction that achieves an economically similar result (the Distribution Regulations). For a discussion of the Section 385 final regulations, see our October 2016 Tax Alert.
 
The Documentation Regulations were originally promulgated to be applicable with respect to interests issued or deemed issued on or after January 1, 2018. However, in Notice 2017-36 (2017-33 I.R.B. 208 (August 14, 2017)) Treasury announced the intent to amend the Documentation Regulations to delay the applicability of the regulations for 12 months, making the regulations applicable only to interests issued or deemed issued on or after January 1, 2019.
 
In September of 2018, Treasury issued proposed regulations that proposed the removal of the Documentation Regulations. The proposed regulations and conforming modifications were proposed to be applicable as of the date of publication in the Federal Register of a Treasury decision adopting these proposed regulations as final regulations, but taxpayers could rely on the proposed regulations, in their entirety, until the date a Treasury decision adopting the proposed regulations as final regulations was published in the Federal Register. For a discussion of these proposed regulations, see our September 2018 Tax Alert.
 
T.D. 9880 adopts these proposed regulations as final and removes the Documentation Regulations.  T.D. 9880 also adopts conforming amendments to other final regulations to reflect the removal of the documentation regulations. Treasury does note that it may propose a modified version of the Documentation Regulations. In any modified version, Treasury states that it would substantially simplify and streamline the proposal to minimize taxpayer burdens, while ensuring the collection of sufficient documentation and other information necessary for tax administration purposes.
 
The removal of the Documentation Regulations and the conforming modifications are effective as of November 4, 2019. For additional details, see T.D. 9880.
 
In REG-123112-19, Treasury also issued an advance notice of proposed rulemaking which announced its intent to issue proposed regulations modifying certain rules in the Distribution Regulations.
 
Under the Distribution Regulations’ general rule, 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.[1] The Distribution Regulations include a funding rule that treats as stock a debt instrument that is issued as part of a series of transactions that achieves a result similar to a distribution of a debt instrument.[2] Specifically, §1.385-3(b) treats as stock a debt instrument that 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.[3] Furthermore, the Distribution Regulations include 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 period beginning 36 months before and ending 36 months after the issuer of the debt instrument made the distribution or undertook a transaction with a similar economic effect.[4] The Distribution Regulations also include several exceptions limiting their scope.[5]
 
To make the Distribution Regulations more streamlined and targeted, Treasury states that it intends to issue proposed regulations substantially modifying the funding rule, including by withdrawing the per se rule. Treasury intends that the proposed regulations would not treat a debt instrument as funding a distribution or economically similar transaction solely because of their temporal proximity; rather, the proposed regulations would apply the funding rule to a debt instrument only if its issuance has a sufficient factual connection to a distribution to a member of the taxpayer’s expanded group or an economically similar transaction (for example, when the funding transaction and distribution or economically similar transaction are pursuant to an integrated plan). Thus, under the proposed regulations, a debt instrument issued without such a connection to a distribution or similar transaction would not be treated as stock. As a result, Treasury states that the proposed distribution regulations would be more streamlined and targeted while continuing to deter tax-motivated uneconomic activity. As part of the intended revisions of the funding rule, Treasury states that it is also considering substantial revisions to, or removal of, certain exceptions in the regulations, consistent with the revised standard. Treasury provides that the proposed distribution regulations would not alter materially the definition of a covered member (defined in §1.385-1(c)(2) as a member of an expanded group that is a domestic corporation).
 
The proposed regulations would apply to tax years beginning on or after the date of publication of the Treasury decision adopting those rules as final regulations in the Federal Register.
 
In the advance notice of proposed rulemaking, Treasury also announced that for periods after October 13, 2019 (the expiration date of the 2016 temporary regulations under Section 385), a taxpayer may rely on the 2016 proposed regulations under Section 385 until further notice is given, provided that the taxpayer consistently applies the rules in the proposed regulations in their entirety. For additional details, see REG-123112-19.
 

BDO Insights

Both the withdrawal of the Documentation Regulations and the proposed modifications to the Distribution Regulations scale back rules that were initially designed to prevent U.S. corporations from shifting profits offshore to avoid U.S. tax. Please contact an International Tax Specialist if you would like more information regarding the content of this tax alert.
 

CONTACT:
 
Joe Calianno
Partner and International Tax Technical Practice Leader, National Tax Office
  Monika Loving
Partner and International Tax Practice Leader

 
Brandon Boyle
Principal
  Reese Fredrickson
Partner

 
Annie Lee
Partner
  Chip Morgan
Partner

 
Robert Pedersen
Partner
  Jerry Seade
Principal

 
Natallia Shapel
Partner
  Sean Dokko
National Tax Office Managing Director
 

[1] See §1.385-3(b)(2).
[2] See §1.385-3(b)(3)(i).
[3] Id.
[4] See §1.385-3(b)(3)(iii).
[5] See, e.g., §1.385-3(c).