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IRS Proposes Removal of IRC Sec. 385 Debt-Equity Documentation Regulations

In what seems like a never ending saga, the IRS on September 21, 2018 issued proposed regulations removing the final documentation regulations under Treas. Reg. Sec. 1.385-2. Those final regulations require specified documentation to be satisfied in order for certain related party interests in a corporation to be treated as indebtedness rather than as equity for federal tax purposes.

What the Removal of the Documentation Requirements Does Not Do

Note that other sections of the debt-equity regulations were not withdrawn.  Therefore, the relevance of “common law” to the debt versus equity determination that is part of Treas. Reg. Sec. 1.385-1 is still critical.  Moreover, the per se equity characterization of certain targeted transactions still remains in the Treas. Reg. Sec. 1.385-3 regulations.   However, the Tax Cuts and Jobs Act has substantially reduced the viability of these transactions.

How We Got to Where We Are

In 2016, the Treasury and IRS published final and temporary regulations under IRC Sec. 385 that (1) allow the IRS to treat certain debt instruments issued between members of an “expanded group” (as that term is defined in Treas. Reg. Sec. 1.385-1(c)(4)) as debt in part and stock in part for federal tax purposes (Treas. Reg. Sec. 1.385-1); (2) establish extensive documentation requirements for members of an expanded group for purposes of the debt-equity analysis (Treas. Reg. Sec. 1.385-2); and (3) treat as equity certain interests in a corporation issued between members of an expanded group that would otherwise be treated as debt for federal tax purposes (Treas. Reg. Sec. 1.385-3).

Upon their issuance in 2016, the regulations were subject to criticism as being burdensome, complex and not workable.

An Executive Order (13789) issued in April 2017 directed the Treasury to examine all significant tax regulations issued on or after January 1, 2016 to determine whether any of the regulatory projects (1) imposed an undue financial burden on U.S. taxpayers; (2) added undue complexity to the federal tax laws; or (3) exceeded the statutory authority of the IRS.  According to the executive order, Treasury was to take “appropriate steps” to delay or suspend the effective date of the identified regulations and to modify or rescind the regulations, through notice and comment rulemaking.

In Notice 2017-38, the IRS and Treasury subsequently identified the documentation regulations under IRC Sec. 385 as one of the eight tax regulations either imposing an undue financial burden on taxpayers or adding excessive complexity to the tax system.

In July 2017, the IRS released Notice 2017-36 that delayed the application of the documentation regulations under Treas. Reg. Sec. 1.385-2 by one year (so that at that time, the documentation regulations would apply only to interests issued or deemed issued on or after January 1, 2019).  

Observations:

The preamble notes that the IRS will study the issues and may release revised regulations in a simplified form.  Also, until finalized, taxpayers may rely on the proposed regulations in their entirety.

In the interim, documenting debt and abiding by the terms of the debt and paying interest and principal is advisable. The recent Tax Court case, Illinois Tool Works v. Commissioner, T.C. Memo 2018-121, provides a useful reminder of the IRS’ attitude towards documentation of intercompany debt and a helpful summary of the various “common law” factors. The litigating position of the IRS is that intercompany debt instruments need to look more like what a third-party lender would expect.

 

Charles Brezak is an International Tax Services Group Director with over 30 years experience advising clients on cross-border tax planning.

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