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:
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:
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.
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