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Treatment of Certain Interests in Corporation as Stock or Indebtedness

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In October 2016, the U.S. Treasury Department and the IRS issued final and temporary regulations under Section 385 of the Internal Revenue Code (the 385 Regulations) through Treasury Decision (T.D.) 9790.

The purpose of the regulations is to:

  1. establish threshold documentation requirements that ordinarily must be satisfied in order that certain related-party interests in a corporation be treated as indebtedness for federal tax purposes; and
  2. treat as stock (i.e., equity) certain related-party interests that otherwise would be treated as indebtedness for U.S. federal income tax purposes.

Code Section 385 was intended to authorize the IRS to prescribe rules as necessary to determine whether an interest in a corporation should be considered stock or indebtedness or part stock and part indebtedness. The 385 Regulations attempt to settle the characterization of the interest since there were no prior guidelines in place for Sec. 385 and reliance was placed mostly on case law on the matter.

The IRS is aware that many domestic corporations take advantage of the so-called “earnings stripping” rule to minimize U.S. taxes by paying deductible interest to a related foreign affiliate located in a low tax jurisdiction. This is a scheme commonly used to strip a U.S. entity of its taxable base and siphon off profit outside the country by way of interest deduction (rather than as a nondeductible dividend payment).

The 385 Regulations intend to close this loophole. The 385 Regulations restrict the ability of a corporate entity to erode earnings by treating financial instruments which look to be debt at face-value as equity if certain conditions are not met. Specifically, the regulations now require that corporations claiming interest deductions on related-party loans provide documentation regarding the loan transaction similar to what is commonly required in an unrelated loan transaction.

It is worth noting that the new regulations also apply to debt instruments issued by a domestic corporation to certain related persons. More specifically, the 385 Regulations that apply to debt instruments are:

  1. issued by a “covered member,” which is currently defined to mean a domestic corporation, or a disregarded entity to a covered member; and
  2. held by a member of the domestic corporation’s “expanded group,” which generally includes all corporations connected to a common parent that owns, directly or indirectly, 80% of the vote or value of each such corporation.

The term “covered member” does not currently include foreign issuers, such as CFCs, but the Treasury Department has indicated that any subsequent guidance that may include foreign issuers will have prospective effect only. S Corporations and non-controlled RICs and REITs are exempt from the coverage of the 385 Regulations. Likewise, debt instruments held by members of a consolidated group are outside the purview of the regulations. Debt instruments in the context of investment partnerships, including indebtedness issued by certain “blocker” entities are not addressed in the regulations.

In the 385 Regulations, there is only one treatment of an instrument-it’s either debt or equity. There is no bifurcation that would allow the dual treatment of a single instrument as part debt and part equity.

The general provision in the regulations is effective and applies to taxable years on or after 90 days after the publication date of the 385 Regulations in the Federal Register.

In summary, the new 385 Regulations impose contemporaneous documentation requirements on certain related-party debt instruments issued by domestic corporations as conditions for the treatment of such instruments as debt. If the requirements are not met, such instruments are treated as equity.

 

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.

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