Treasury and IRS Propose Removal of Section 385 Documentation Regulations


On September 21, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued proposed regulations (REG-130244-17, hereinafter, the Proposed Regulations) that propose the removal of final regulations under Section 385 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). The Proposed Regulations include conforming amendments to other final regulations to reflect the proposed removal of the Documentation Regulations. The final regulations to be amended and removed generally affect corporations that issue purported indebtedness to related corporations or partnerships.



Section 385 of the Code authorizes the Secretary of the Treasury to prescribe rules to determine whether an interest in a corporation is treated for purposes of the Code as stock or indebtedness (or as in part stock and in part indebtedness) by setting forth factors to be taken into account with respect to particular factual situations.
On October 21, 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) 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 (together, the Section 385 Regulations). For a discussion of the Section 385 Regulations, see our October 2016 Tax Alert.
Executive Order 13789, issued on April 21, 2017 (E.O. 13789), instructs the Secretary to review all significant tax regulations issued on or after January 1, 2016, and to take concrete action to alleviate the burdens of regulations that (i) impose an undue financial burden on U.S. taxpayers, (ii) add undue complexity to the federal tax laws, or (iii) exceed the statutory authority of the IRS.
E.O. 13789 further instructs the Secretary to submit to the President within 60 days a report (First Report) that identifies regulations that meet these criteria. Notice 2017-38 (2017-30 I.R.B. 147 (July 24, 2017)) included the Section 385 Regulations in a list of eight regulations identified by the Secretary in the First Report as meeting at least one of the first two criteria specified in E.O. 13789. E.O. 13789 also instructs the Secretary to submit to the President a second report (Second Report) that recommends specific actions to mitigate the burden imposed by regulations identified in the First Report. For a discussion of Notice 2017-38, see our August 2017 Tax Alert.
The final Documentation Regulations were originally promulgated to be applicable with respect to interests issued or deemed issued on or after January 1, 2018. However, in response to continued taxpayer concern with the application of the Documentation Regulations, and in light of contemplated further actions concerning the Section 385 Regulations in connection with the review of those regulations under E.O. 13789, Treasury determined that a further delay in the application of the Documentation Regulations would be appropriate. Accordingly, 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.
On October 16, 2017, the Secretary published the Second Report in the Federal Register (82 FR 48013 (October 16, 2017)) stating that Treasury is considering revoking the Documentation Regulations and is actively considering developing and proposing streamlined regulations. After careful consideration of the comments received on the Documentation Regulations in connection with E.O. 13789, including with respect to Notice 2017-36 and Notice 2017-38, the Proposed Regulations propose the removal of the Documentation Regulations.
The Preamble to the Proposed Regulations further provides that Treasury will continue to study the issues addressed by the Documentation Regulations and when that study is complete, Treasury may propose a modified version of the Documentation Regulations. Any such regulations would be substantially simplified and streamlined to reduce the burden on U.S. corporations and yet would still require sufficient documentation and other information for tax administration purposes. Further, they would include a prospective effective date to allow sufficient lead-time for taxpayers to design and implement systems to comply with those regulations.
The removal of the Documentation Regulations and conforming modifications are 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. However, taxpayers may rely on the Proposed Regulations, in their entirety, until the date a Treasury Decision adopting the Proposed Regulations as final regulations is published in the Federal Register.


BDO Insights

The proposed withdrawal of the Documentation Regulations may be welcome news for many taxpayers as the costs to comply with such requirements could be substantial.  Until further guidance is provided, U.S. multinationals should continue to employ strong documentation measures as a matter of best practice to support the bona fide debt characterization of such instruments for U.S. tax purposes.