Six months after issuing controversial proposed regulations under Sec. 385 that would recharacterize certain transactions between related parties that are ostensibly debt as equity—curbing the practice of “earnings stripping”—the IRS issued final and temporary regulations (T.D. 9790) that expand on and modify the proposed rules. The regulations establish threshold documentation requirements that ordinarily must be satisfied for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes, and treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes. The rules finalize proposed regulations issued in April (REG-108060-15), with a number of changes in response to “numerous detailed and thoughtful comments” the IRS received.
Editor's note: These regulations were identified as burdensome by the Treasury Department in July 2017 and are being reviewed for possible modification or withdrawal. See "Treasury Identifies 8 Regulations as Burdensome."
The new rules are part of the Treasury Department’s larger effort to curb corporate inversions. According to Treasury, after a corporate inversion, multinational corporations often use a technique called earnings stripping to minimize U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country, which results in large interest deductions in the United States without requiring the company to finance new investment in the United States. These regulations prevent earnings stripping by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances, turning deductible interest payments into taxable dividends.
The rules also require corporations claiming interest deductions on related-party loans to document the loans, which is the common practice for third-party loans. Because using related-party debt to minimize income tax liabilities is not limited to the cross-border context, these rules also apply to related U.S. affiliates of a corporate group.
Many of the comments the IRS received were concerned that the proposed regulations would impose unjustified compliance burdens and would not achieve the regulations’ stated policy objectives of preventing related entities from minimizing their income tax liability by issuing debt.
According to the IRS, the regulations as amended achieve a better balance by restricting their application in order to minimize their effect on regular business activities. Exceptions have been added for various ordinary business transactions.
First off, the regulations provide a broad exemption for cash pools and other loans that are short-term in both form and substance, and therefore, according to the IRS, do not pose a significant earnings-stripping risk. These are changes the AICPA had requested in its comments on the proposed regulations.
The regulations also exempt transactions between the following entities from the rules:
- Transactions between foreign issuers, between S corporations, and between regulated investment companies (RICs or mutual funds) and real estate investment trusts (REITs), other than those owned by affiliated groups of companies, because the income tax consequences of mischaracterizing equity instruments as debt in these circumstances are limited. The AICPA had requested that exceptions be put in place to ensure that S corporations would not inadvertently terminate their status if debt is reclassified as equity, an issue the proposed regulations did not consider.
- Transactions between regulated financial companies are exempt because they are already subject to supervisory and regulatory requirements that restrict their ability to issue intercompany debt.
- Transactions between regulated insurance companies because they are subject to state insurance regulation and therefore have a limited ability to issue instruments inappropriately characterized as debt.
The final regulations do not apply to debt instruments issued by partnerships (the AICPA had questioned Treasury’s authority to extend the final regulations to debt instruments issued by partnerships). The regulations do include an anti-abuse provision to prevent the use of a controlled partnership to avoid the rules.
Another major change in response to comments is that the regulations abandon the bifurcation rule, which would have allowed the IRS to treat certain debt instruments as part debt and part equity. The IRS noted, however, that it continues to study the need for a bifurcation rule.
The proposed rules required corporations to document their debt instruments within a short period after the transaction occurs. In response to comments, the final rules treat documentation as timely prepared if it is prepared by the due date of the debt issuer’s tax return (including extensions).
In a final bit of relief for taxpayers, the effective date for the documentation rules was pushed back, so they apply to debt instruments issued on or after Jan. 1, 2018. And while the rest of the rules were proposed to generally be effective when made final, the IRS has instead provided taxpayers a 90-day time frame, so the other rules are generally effective on or after Jan. 19, 2017.
—Sally P. Schreiber (email@example.com) is a Tax Adviser senior editor.