Final Section 385 Regulations on the Characterization of Debt

The IRS recently finalized regulations under Section 385. This brings to an intermediate conclusion the saga of the §385 regulations.  

The IRS surprised many tax professionals in April 2016 with the issuance of proposed regulations under §385 regarding the classification of instruments as debt or equity. We note that the 2016 regulations were not the government’s first attempt at issuing regulations under §385. Enacted in 1969, §385 was an attempt to restrict corporations from excessive interest deductions on instruments that should be more properly classified as equity. Because interest is a deductible business expense and principal can be repaid on a note with little to no tax effect, related-party loans were a common tax planning tool for foreign-owned companies as well as domestic-controlled groups of corporations. The statute did not define the law but rather authorized the Secretary to issue regulations implementing §385 and provided a list of factors relevant to the determination, including an unconditional promise to pay; subordination over other debt; the obligor’s debt-to-equity ratio; convertibility into stock; and the relationship of the debt holder to the obligor.

After Congress enacted §385,  the U.S. Department of the Treasury (Treasury) waited 11 years to issue proposed regulations in 1980. The regulations were heavily criticized and were withdrawn. Revised regulations were then proposed in 1982, but again, due to intense criticism, the proposed regulations were withdrawn in 1983. No further activity on the debt/equity regulatory project occurred until April 2016, when the Obama administration wanted to put an end to the uncertainty of the treatment of debt instruments. More importantly, it wanted to protect the U.S. tax base from erosion due to interest. The Treasury proposed four regulations under §385:

1. 1.385-1 – Overview and definitions
2. 1.385-2 – Treatment of certain interests between members of an expanded group (Documentation Regulations)
3. 1.385-3 – Transactions in which debt proceeds are distributed or that have a similar effect (Distribution Regulations)
4. 1.385-4 – Treatment of consolidated groups

In a hurried attempt to finalize the regulations prior to the change in the presidential administration, the Treasury issued 1.385-1, 1.385-2, and 1.385-3 as final regulations in October 2016. Contemporaneous with the issuance of the final regulations, the Treasury also issued 1.385-4T, treatment of consolidated groups, as a temporary regulation as well as 1.385-3T, which addressed qualified short-term debt instruments and the treatment of controlled partnerships under the Distribution Regulations. The regulations were generally to be effective for tax years ending after January 19, 2017. 
 
Following the change in the Oval Office, the Trump administration issued an Executive Order in April 2017 that instructed the Secretary of the Treasury to review all regulations issued after January 1, 2016, to determine if the regulations:

1. Impose an undue financial burden on U.S. taxpayers
2. Add undue complexity to the federal tax laws
3. Exceed the statutory authority of the IRS

The Secretary issued reports later in 2017 indicating the Treasury was considering revoking the Documentation Regulations and re-evaluating the Distribution Regulations in light of tax reform that was under consideration at the time. Indeed, in late 2017, President Trump signed into law the Tax Cuts and Jobs Act, which significantly altered corporate taxation of debt instruments by modifying §163(j), the interest-stripping regime, and §267A, involving hybrid instruments. Both sections significantly limit a corporation’s ability to deduct interest expense.

In September 2018, the Treasury proposed removing the Documentation Regulations, and in November 2019, the Documentation Regulations were removed. In October 2019, three years after regulations 1.385-3T and 1.385-4T were issued in temporary form, they expired, leaving 1.385-1, 1.385-2, and the previously issued portion of 1.385-3 as final regulations. No regulations were effective for the treatment of consolidated groups (-4) or for guidance on controlled partnerships or short-term debt instruments (-3). As the development and review of the regulations continued to drag on, the Treasury issued guidance permitting taxpayers to follow the 2016 proposed regulations until further notice. 

After further review, the Treasury has now determined the Distribution Regulations are necessary in some form. The Treasury is undertaking a review to determine if the Distribution Regulations can be streamlined and more targeted at specific abuses. Therefore, the May 2020 activity finalized the regulations … for now.  

What do the Distribution Regulations do?

Technical analysis of the Distribution Regulations is beyond the scope of this article. To briefly summarize, the intent of the Distribution Regulations is to treat a debt instrument as equity and deny an interest deduction where the instrument has been issued with no incremental investment on the part of the owner/creditor. This can occur where a U.S. corporation distributes a debt instrument:

1. As a dividend out of earnings and profits (E&P) 
2. As a distribution where a corporation has no E&P
3. In an exchange for stock of a group member
4. In exchange for assets in certain asset reorganizations
5. In any transaction or series of transactions that have a similar effect

Certain exceptions apply, such as short-term debt instruments, which are limited to 270 days and require an arm’s-length interest rate, debt incurred to acquire stock used for compensation, and a debt instrument as the result of a transfer pricing adjustment.

The regulations require examination of a 72-month window—36 months prior to the issuance of a debt instrument and 36 months subsequent—to determine if the issuance funded the debt instrument. The regulations also include a principal purpose test under which a debt instrument that otherwise may escape recharacterization can be recharacterized if the issuance had a principal purpose of avoiding the regulations.

Recharacterization applies beyond a $50 million threshold—it does not apply unless debt exceeds $50 million and then only to the extent of the amount in excess of $50 million. In addition, special rules apply where a corporation joins or leaves the related group of companies.

The section of the regulations regarding affirmative use by taxpayers implies that taxpayers are bound by the form of the transaction and may not use the regulation to recharacterize what is in form a debt instrument. We note that this section of the regulations is reserved, so future guidance on this issue may be forthcoming.

One item of note regarding the treatment of partners and partnerships is that controlled partnerships are treated as an aggregate of the partners, not as an entity. Therefore, the actions of the partnership are deemed to be conducted by the partners, which could lead to triggering recharacterization.

So what does the conclusion of this lengthy and somewhat controversial regulatory project mean for companies with related-party debts?

Finalizing these regulations is not a seminal event, but it does mark the end of this phase of the regulatory project. The determination as to whether a debt instrument is respected as a debt instrument must first pass common law analysis. If a debt instrument is determined to be debt under common law principles, one must then apply the Distribution Regulations to determine if the instrument must be recharacterized as equity. Note that the recharacterization of debt under the Distribution Regulations applies only to U.S. obligors, not to foreign obligors. Therefore, U.S. multinationals need not apply the Distribution Regulations to debt instruments where a foreign person has issued debt to a U.S. person.

The Distribution Regulations are here to stay and must be evaluated when issuing new obligations. More importantly, corporate treasury personnel, tax advisors, and auditors should review the issuance of any debt instruments that have occurred in the prior 36 months to verify the recharacterization rules of the Distribution Regulations do not apply.  

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