The IRS has proposed to remove the Internal Revenue Code (IRC) Section 385 documentation regulations provided in Regulation (Reg.) Section 1.385-2. Although the proposed removal of the documentation rules will apply as of the date the proposed regulations are published as final in the Federal Register, taxpayers can rely on the proposed regulations until the final regulations are published.
The documentation regulations provide minimum documentation requirements that must be satisfied in order for certain related-party instruments to be treated as debt for federal tax purposes. They are part of final and temporary IRC Section 385 regulations adopted with T.D. 9790, I.R.B. 2016-45, 540. In addition to the documentation requirements, the IRC Section 385 regulations also include rules that recharacterize as equity certain debt issued in connection with distributions and acquisitions that do not result in new investment in the operations of the issuer. The IRC Section 385 regulations apply generally to debt instruments issued by a domestic corporations (or its disregarded entity) and held by members of the domestic corporation’s expanded group.
Documentation Regulations
The documentation rules generally require large corporations to document related-party loans just as all businesses do when they borrow from unrelated lenders. Reg. Section 1.385-2 prescribes the nature of the documentation necessary to substantiate the tax treatment of related-party instruments as debt. Taxpayers must be able to provide written evidence of four indebtedness factors analogous to those found in third-party loans.
Compliance with the documentation rules does not establish that an interest is debt. Instead, it serves only to satisfy the minimum documentation for making the determination under general federal tax principles. If a debt instrument is reclassified as stock due to a failure to meet the documentation requirements, it is treated as stock for all federal tax purposes.
Corporations must document relevant transactions under these rules if they are part of expanded affiliated groups and:
- stock of any member of the group is publicly traded;
- one or more members have total assets that exceed $100 million on any applicable financial statement or combination
of statements; or - one or more members have annual total revenue that exceeds $50 million on any applicable financial statement
or combination of statements.
The documentation regulations apply to relevant intercompany debt issued, beginning in 2019 and require that the taxpayer’s documentation for a given tax year be prepared by the time the borrower’s return is filed.
Executive Order 13789
Executive Order 13789, issued on April 21, 2017 (E.O. 13789), instructs the Treasury Secretary to identify significant tax regulations issued on or after January 1, 2016, that impose an undue financial burden on U.S. taxpayers, add undue complexity to the federal tax laws, or exceed the statutory authority of the IRS. The Treasury Secretary is instructed to take concrete actions to alleviate these burdens.
Based on E.O. 13789, the Treasury Department identified, among others, the Section 385 regulations adopted with T.D. 9790 as significant tax regulations that impose an undue financial burden on U.S. taxpayers and/or add undue complexity to the federal tax laws. In light of further actions in connection with the required review of the Section 385 regulations, and in response to continued taxpayer concern, the IRS has delayed the applicability date of the documentation regulations for 12 months. As a result, the documentation requirements apply to interests issued or deemed issued on or after January 1, 2019. As originally adopted, the final regulations applied to interests issued or deemed issued on or after January 1, 2018. In a later report, the Treasury has proposed to revoke the current documentation rules and replace them with substantially simplified and streamlined documentation rules.
Proposed Removal of Documentation Rules
The IRS has proposed to remove the documentation regulations after considering the comments received in connection with E.O. 13789, including with respect to Notice 2017-36 and Notice 2017-38. However, the IRS will continue to study the issues addressed by the documentation regulations. When the study is complete, the IRS may propose a modified version of the documentation regulations. The revised documentation rules:
- would be substantially simplified and streamlined to reduce the burden on U.S. corporations;
- would still require sufficient documentation and other information for tax administration purposes; and
- would be proposed with a prospective effective date to allow sufficient lead time for taxpayers to design and implement systems to comply with the revised requirements.
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