US Inbound: Treasury and IRS revoke §385 Documentation Regulations and will revise Distribution Regulations
David Forst and James Fuller of Fenwick & West discuss the recent changes which modify the exisiting Section 385 regulations.
The US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have revoked (or let expire) final and temporary regulations, and stated their intention to modify other regulations, regarding inter-company debt.
All regulations establishing minimum documentation requirements for debt obligations among related parties to be treated as debt for federal tax purposes (Documentation Regulations) have been revoked or allowed to expire. Regulations which treat as stock certain debt 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 (Distribution Regulations) will be modified.
Treasury and the IRS stated that the Distribution Regulations address debt instruments that do not finance any new investment in the operations of the borrower and therefore have the potential to create significant federal tax benefits, including interest deductions that erode the US tax base, without having meaningful non-tax significance. According to Treasury and the IRS, a complete withdrawal of the Distribution Regulations could restore incentives for multinational corporations to generate additional interest deductions without new investment. Accordingly, Treasury and the IRS have determined that the Distribution Regulations continue to be necessary at this time.
However, Treasury and the IRS intend to issue proposed regulations modifying the Distribution Regulations to make them more streamlined and targeted. They intend to issue proposed regulations substantially modifying the funding rule, including by withdrawing the per se rule. They also intend that the proposed regulations would not treat a debt instrument as funding a distribution or economically similar transaction solely because of their temporal proximity. Rather, the proposed regulations would apply the funding rule to a debt instrument only if its issuance has a sufficient factual connection to a distribution to a member of the taxpayer's expanded group or an economically similar transaction. For example, in a scenario when the funding transaction and distribution or economically similar transaction are pursuant to an integrated plan.
Thus, under the proposed regulations, a debt instrument issued without such a connection to a distribution or similar transaction would not be treated as stock. As a result, according to Treasury and the IRS, the proposed distribution regulations would be more streamlined and targeted while continuing to deter tax-motivated uneconomic activity.
The regulations would apply to taxable years beginning on or after the date they are finalised. For periods after October 13 2019 (the expiration date of the temporary distribution regulations), a taxpayer may rely on the 2016 Regulations until further notice is given, provided that they consistently apply the rules in their entirety.