US Section 385 Final and Proposed Debt Equity Rules: Some Breathing Room

March 16, 2017

US Tax Alert:

The IRS finalized the proposed regulations issued in April 2016 with Final and Proposed Regulations issued on October 13, 2016, after receiving more than 200 comments and concerned letters from members of Congress.  They backed off some of their harsher, proposed rules, in some cases eliminating parts of the rule, providing additional time before they become effective and reserving (delaying) on others.

Documentation Requirements:

  • Delayed Implementation – This requirement will only apply to debt issued on or after January 1, 2018. This provides additional time before documents that comply with these requirements must be used.  This will give companies time to develop the agreements and procedures they will need to implement within their groups.
  • Timely Preparation of Documentation – This has been changed from 30 days after debt issuance to the more reasonable due date of the tax return for the taxable year of issuance, including extensions.
  • Rebuttable Presumption Replaces “Per Se” Rule – Failure to fully comply with the documentation requirements no longer results in automatic reclassification from debt to equity, provided there has been substantial compliance with the rule.

Scope Changes:

  • Elimination of the Bifurcation Rule – The ability of the IRS to split an instrument into part debt and part equity has (at least temporarily) been eliminated. It is again an all or nothing reclassification.  However, having raised this issue, taxpayers may find it being raised and negotiated on audits rather than risk losing the entire issue.
  • Exclusion of Certain Taxpayers from Rules – Foreign issuers (such as Controlled Foreign Corporations – CFCs) and S Corporations have been removed from coverage under the rules. For foreign issuers, it is again a situation where they are reserved (delayed) at this time and the IRS will continue to examine the issue.

Changes to Debt Instrument Classification Rules:

  • Cash Management Arrangements and Other Short-Term Debt Instruments – The Funding Rule exception for ordinary course obligations has been expanded to include certain cash pool borrowings and other types of short-term borrowings, provided certain tests are met. If the cash pooling arrangement does not meet these tests, then it will be required to meet all of the documentation requirements related to normal Expanded Group Indebtedness (EGI) rules.  This can be an issue since the indebtedness is constantly changing and a “new” loan is being made.  “Master Agreements” are possible in this situation. However, it must describe the relationship among the parties and an annual credit analysis will be required to be prepared.
  • Expanded $50 Million Exception – The final rules remove the “cliff effect” of the proposed threshold so that all taxpayers can exclude the first $50 million of indebtedness that otherwise might be recharacterized. Previously, the rule required the recharacterization to impact the indebtedness from dollar one once it exceeded $50 million.

Considerations:

  • Documentation – Even if a taxpayer does not exceed the $50 million threshold, they should consider adopting better documentation that meets the four requirements of the regulations. This is because the IRS is obviously focused on this issue and still can review this issue under the common law provisions of the past.  While it does not have to be fully compliance, having started this process is prudent and will prepare it in case it later becomes subject to the rules. 
  • Cash Pooling – If the taxpayer has a cash pooling arrangement, but is of a size so that the $50 million threshold is not anticipated to be exceeded (plus the other size requirements), then it may not need to worry about meeting the specific terms of the short-term requirements that result in cash pooling arrangements being excluded from the EGI rules. It can just rely on the $50 million exemption.  This might occur where the cash pooling entity has borrowed funds externally to fund the cash pool that covers working capital.  Note that the cash pooling exception only applies to the “Qualified Cash Pool Header” entity and not to the other participants in the pool.

Please contact your trusted DMCL advisor to learn how these potential changes could affect you and to learn how we can help you by identifying constructive planning opportunities.