IRS Removes Section 385 Documentation Rules, But Keeps Distribution Rules

(Parker Tax Publishing May 2020)

The IRS issued final regulations under Code Sec. 385 on the treatment of certain interests in corporations as stock or indebtedness. The final regulations generally affect corporations, including those that are partners of certain partnerships, when those corporations or partnerships issue purported indebtedness to related corporations or partnerships. T.D. 9897.

Background

Code Sec. 385 authorizes the IRS to issue rules to determine whether an interest in a corporation is treated as stock or indebtedness (or as in part stock and in part indebtedness). In 2016, the IRS published T.D. 9790, which included final and temporary regulations under Code Sec. 385 (2016 Final Regulations and Temporary Regulations, respectively, and together, the 2016 Regulations). On the same date, the IRS also issued proposed regulations under Code Sec. 385 in REG - 130314 - 16 (2016 Proposed Regulations).

The 2016 Regulations and the 2016 Proposed Regulations address the classification of certain related-party debt as stock or indebtedness (or as in part stock and in part indebtedness) for U.S. federal income tax purposes. The 2016 Regulations included documentation rules set forth in Reg. Sec. 1.385-2 (the Documentation Regulations). Reg. Sec. 1.385-2 provided minimum standards on documentation needed to substantiate the treatment of certain related-party instruments as indebtedness. The 2016 Regulations also included Reg. Secs. 1.385-3, 1.385-3T, and 1.385-4T, which treat certain indebtedness as stock 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 (the Distribution Regulations). The Distribution Regulations apply to tax years ending on or after January 19, 2017. The Temporary Regulations set forth rules regarding the treatment under the Distribution Regulations of certain qualified short-term debt instruments, transactions involving controlled partnerships, and transactions involving consolidated groups. The Temporary Regulations apply to tax years ending on or after January 19, 2017, and expired on October 13, 2019. The 2016 Proposed Regulations are proposed to apply to tax years ending on or after January 19, 2017.

On April 21, 2017, President Trump issued Executive Order 13789 (E.O. 13789). E.O. 13789 instructs the Treasury 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.

On September 24, 2018, the IRS published proposed regulations that proposed removal of the Documentation Regulations. Subsequently, in T.D. 9880, the IRS finalized without change the proposed regulations removing the Documentation Regulations.

On October 28, 2019, the IRS issued Notice 2019-58, which announced that, following the expiration of the Temporary Regulations, a taxpayer may rely on the 2016 Proposed Regulations until further notice, provided that the taxpayer consistently applies the rules in the 2016 Proposed Regulations in their entirety. On November 4, 2019, the IRS published an advance notice of proposed rulemaking (the ANPRM), which announced that the IRS intended to propose more streamlined and targeted Distribution Regulations. The ANPRM also obsoleted Notice 2019 - 58 and announced that a taxpayer may rely on the 2016 Proposed Regulations until further notice, provided that the taxpayer consistently applies the rules in the 2016 Proposed Regulations in their entirety. In T.D. 9897, issued on May 14, 2020, the IRS finalized the 2016 Proposed Regulations without any substantive change (the 2020 Final Regulations).

In response to E.O. 13789 and the 2018 Proposed Regulations, several practitioners recommended that the Treasury Department and the IRS also revoke the Distribution Regulations. In the ANPRM, the IRS stated that it was cognizant that a complete withdrawal of the Distribution Regulations could restore incentives for multinational corporations to generate additional interest deductions without new investment. Accordingly, the IRS determined that the Distribution Regulations continue to be necessary. The ANPRM also announced that the Treasury Department and the IRS intend to propose more streamlined and targeted Distribution Regulations.

Distribution Regulations

Under the Distribution Regulations' general rule, the issuance of a debt instrument by a member of an expanded group to another member of the same expanded group in a distribution, or an economically similar acquisition transaction, may result in the treatment of the debt instrument as stock. The Distribution Regulations also include a funding rule that treats as stock a debt instrument that is issued as part of a series of transactions that achieves a result similar to a general rule transaction. Specifically, Reg. Sec. 1.385-3(b) treats as stock a debt instrument that was issued in exchange for property, including cash, to fund a distribution to an expanded group member or another acquisition transaction that achieves an economically similar result. Furthermore, the Distribution Regulations include a per se rule, which treats a debt instrument as funding a distribution to an expanded group member or other acquisition transaction with a similar economic effect if it was issued in exchange for property during the period beginning 36 months before and ending 36 months after the issuer of the debt instrument made the distribution or undertook an acquisition transaction with a similar economic effect.

The Distribution Regulations also include several exceptions limiting their scope and generally apply to transactions among members of an expanded group of corporations, which is generally defined by reference to the term ''affiliated group'' in Code Sec. 1504(a), with several modifications, such as including foreign corporations in the expanded group. The Distribution Regulations also generally apply only to ''covered debt instruments'' that are issued by ''covered members'' other than certain regulated financial companies and regulated insurance companies.

A covered member is a member of an expanded group that is a domestic corporation. A covered debt instrument is generally a debt instrument that is issued after April 4, 2016, other than certain excluded specialized debt instruments. In addition to these scope limitations, the funding rule also excludes qualified short-term debt instruments, as defined in Reg. Sec. 1.385-3(b)(3)(vii).

For a discussion of the characterization of corporate instruments as debt or stock, see Parker Tax ¶45,310.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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