On October 13, 2016, the Treasury Department and the Internal Revenue Service released final and temporary regulations under Section 385 of the Internal Revenue Code. Section 385 of the Code authorizes the Treasury Department to issue regulations to determine whether an interest in a corporation is treated as equity or debt for federal tax purposes. The proposed regulations published a few months before the October announcement stirred controversy because of the expected impact on multi-national enterprises with U.S. presence, namely, higher tax payments and disruptions to business operations. . Now, that the regulations have come into force, after incorporating significant changes, corporations are struggling to determine the implications of the changes from the draft regulations, understand the effects of the final Section 385 regulations, and implement the necessary changes.
In general, Section 163 of the Code creates tax deductions to interest payments, as opposed to payments for stock ownership that are treated as non-deductible dividends. This distinction creates important incentives for corporations to characterize their instruments as debt in order to reduce U.S. tax liability, which is amongst the highest in the world.
The Section 385 Regulations came in response to the practice of "earning stripping,” a tax scheme widely used by multinational corporations. This scheme involves using a related entity based in a low tax jurisdiction to loan funds to the US corporation. The U.S. corporation pays a tax-deductible interest on the loan, which reduces the corporation's taxable income in the U.S., and the interest payment is subject to tax in the foreign jurisdiction at the lower tax rate (which is often zero percent, e.g. Bermuda and the Cayman Islands).
The Regulations provide the relevant factors for assessing the nature of instruments issued between related corporations, how such factors may be evaluated, and when the presence of certain factors will be determinative. The first part of the Regulations (§ 1.385-1) sets its scope and defines key terms. Most notably, the Regulations only apply to domestic corporations (“covered members”). This is a step back from the Proposed Regulations, which applied to foreign issuers as well.
The second part of the Regulations (§ 1.385-2) describes the documentation corporations must provide to the IRS to classify the related-party instrument as debt, with a focus on documents that are analogous to those found in unrelated third-party loans. The IRS will look for the following indicia, among others, before categorizing the instrument as debt: evidence of unconditional and binding obligation to make interest and principal payments on certain fixed dates; creditor rights for the holder of the loan, including superior rights to shareholders in the case of dissolution; a reasonable expectation of the borrower’s ability to repay the loan; and evidence of conduct consistent with a debtor-creditor relationship.
The third part of the Regulations (§§ 1.385-2 and 1.385-3T), deals with the re-characterization as equity of instruments which companies intend to treat as debt for tax purposes. This situation often arises in convoluted multi-step transactions, which could be tailored to meet the traditional debt-equity tests. In such cases, the characterization of the debt as equity will prevent the corporation from deducting the interest from the taxable income.
Who is affected by the Regulations?
The Regulations limit both the type and size of businesses, and the types of transactions and activities, to which they apply. In particular, § 1.385-2 only applies to related groups of corporations where the stock of at least one member is publicly traded, the group's reported assets exceed $100 million, or the group’s annual revenue exceeds $50 million. Because there is no general definition of a “Small Business” in the Code, these asset and revenue limits are designed to surpass the maximum receipts threshold used by the Small Business Administration in defining “Small Businesses.”
In addition, S corporations, non-controlled Regulated Investment Companies (RICs), and Real Estate Investment Trusts (REITs) are exempt from all aspects of these Regulations. Similarly, the regulations do not apply to debt instruments between members of the same consolidated U.S. tax group.
Recommendations and Possible Changes
The Regulations will significantly affect foreign-based multinationals with a substantial U.S. presence. While there are many exceptions to the rules, corporations are responsible for showing that a particular debt instrument distributed in a group falls within one of these exceptions. Further, corporations need to review all current intragroup loans and inspect their compliance with the new Regulations. Lastly, looking forward, U.S. corporations should consider the Regulations in upcoming transactions, especially those involving debt instruments issued to foreign entities in the group, and assess other strategies to minimize tax exposure.
The full extent of the Regulations’ effect is unclear. Their importance is largely dependent on the tax reform planned by House Republicans and the Trump administration. President Trump publicly endorses corporate tax cuts and regulatory rollback as part of a tax regime overhaul. While the reform is reportedly “very well finalized”, the administration did not release any specific details as to what it entails. Nonetheless, until further notice, U.S. corporations are required to implement the Regulations and comply with them in all applicable transactions.
Mica Ruppin is an Israeli lawyer currently pursuing an LLM in Corporation Law at NYU. Prior to attending NYU, Mica worked in the commercial litigation department of one of Israel’s top law firms, before joining the Israeli Embassy in Washington, D.C. as an International Finance Institutions Consultant. She graduated magna cum laude from the Interdisciplinary Center (IDC) in Israel, with a dual degree in Law and Accounting (LL.B/B.A).