Proposed Section 385 Regulations

In April 2016, IRS issued proposed regulations under IRC section 385 which would dramatically change the treatment of intercompany debt issued among the members of certain corporate groups. The proposed regulations would apply to debt instruments issued on or after April 4, 2016 if finalize. Based on the President’s public remarks targeting corporate inversions, tax professionals expect IRS to finalize this package before the end of the Obama Administration. In general, the proposed regulations would:

• Treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes.
• Authorize the IRS to treat certain related-party interests in a corporate as indebtedness in part and stock in part for federal tax purposes.
• Established extensive documentation requirements in order for certain related-party interest in a corporation to be treated as indebtedness for federal tax purposes.

If the documentation and information requirements are not satisfied on a timely basis, then the instrument will be treated as equity for federal income tax purposes. The documentation and information that must be prepared on a timely basis to satisfy the requirements of this section include written documentation establishing:

• That the issuer has entered into an unconditional and legally binding obligation to pay on demand at one or more fixed dates,
• That the holder has the rights of creditor to enforce the obligation,
• That, as of the date of issuance of the instrument and taking into account all the relevant circumstances, the issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the terms of the instrument,
• Evidence of payments of principal and interest, and in the event payments were not made, the holder’s efforts to assert its rights as creditor.

Take Away

When companies issue debt instruments to related corporations and partnerships, the instruments must have characteristics in form and in substance, and must fulfill documentation requirement provided under the 385 regulations to avoid any complicit with taxing authorities.