Final Debt/Equity Regulations

On May 13, 2020, the IRS finalized the “debt/equity” regulations under Section 385 by publishing T.D. 9897. These final regulations implement the 2016 proposed regulations1 (the “2016 Proposed Regulations”) that cross referenced temporary regulations2 (the “2016 Temporary Regulations”) issued in 2016. There were no substantive changes in the final regulations from the 2016 Proposed Regulations or the 2016 Temporary Regulations.

The “debt/equity” regulations under Section 385 provide that the IRS may recast related-party debt instruments as equity interests in certain circumstances.3 These regulations focus on covered debt instruments4 issued between members of the same “expanded group”, which is defined as a group of corporations connected through stock ownership with a common parent corporation if the parent owns directly or indirectly 80 percent vote or value of at least one of such other corporations and 80 percent vote or value of each of such other corporations is owned directly or indirectly by such group of corporations.5 In particular, Treas. Reg. § 1.385-3 recasts a covered debt instrument as an equity interest when such covered debt instrument is issued by a U.S. corporation that is a member of an expanded group (a “covered member”6), to another member of the covered member’s expanded group (whether U.S. or non-U.S.) as part of a transaction (or series of transactions) that does not result in a new investment in the operations of the issuer. Such transactions include covered debt instruments issued (i) in a distribution, (ii) in exchange for expanded group stock, other than in an exempt exchange, or (iii) in certain exchanges for property in an asset reorganization (each, a “Recast Transaction”).7

Treas. Reg. § 1.385-3 contains a “funding rule”, which treats as equity interests certain covered debt instruments to the extent that such instruments are both issued by a covered member to a member of the covered member’s expanded group in exchange for property and treated as funding certain (i) distributions, (ii) acquisitions of another expanded member’s stock, or (iii) exchanges for property in asset reorganizations8 (each, a “Defunding Transaction”) under the “per se funding rule” or the “principal purpose rule.” The per se funding rule recasts a covered debt instrument as an equity interest if a covered member9 enters into a Defunding Transaction within 36 months before or after the issuance of the covered debt instrument (i.e., within a 72 month period with the debt instrument issuance at the midpoint of this time-frame).10 The principal purpose rule applies to covered debt instruments not within the per se funding rule where the covered debt instrument is issued by a covered member with a principal purpose of funding a Defunding Transaction.11

The 2016 Temporary Regulations consist of Temp. Treas. Reg. § 1.385-3T and Temp. Treas. Reg. § 1.385-4T which apply Treas. Reg. § 1.385-3 (together, the “Distribution Regulations”) to controlled partnerships12, entities disregarded as separate from their owner for federal income tax purposes (“DREs”), and consolidated groups. Additionally, Temp. Treas. Reg. § 1.385-3T describes the “qualified short-term debt instruments” exception to the “funding rule.”

Temp. Treas. Reg. § 1.385-3T describes the application of Treas. Reg. § 1.385-3 to controlled partnerships and DREs. As non-corporate entities, partnerships and DREs are outside the definition of “covered member” and therefore not otherwise subject to the Distribution Regulations. Temp. Treas. Reg. § 1.385-3T treats controlled partnerships as an aggregate of their partners for certain transactions, including acquisitions of property, acquisitions of expanded group stock, and issuances of debt instruments.{13}} Covered debt instruments issued by a controlled partnership are generally treated as issued by its partners who are covered members.14 A similar rule applies to a DRE, whose regarded owner is a covered member, which issues a covered debt instrument in order to treat the covered member as the issuer.15 To the extent that a controlled partnership’s debt instrument would be recast as an equity interest under Treas. Reg. § 1.385-3(b), the regulations contain a “deemed conduit” approach.16 The regulations deem the expanded group member, who is the creditor of the controlled partnership (and therefore, the expanded group partner), to transfer a portion of the debt instrument17 in exchange for stock of the expanded group partner.18 The portion of debt instrument deemed to be transferred is the “specified portion”, which is each expanded group partner’s share of the debt instrument issued by the controlled partnership.19

Temp. Treas. Reg. § 1.385-3T(b)(3)(vii) provides an exception to the “funding rule” for qualified short-term debt instruments. Debt instruments will qualify as a qualified short-term debt instrument if they meet certain requirements under the regulations, including debt instruments that (i) meet the specified current assets test or 270 day test, (ii) are issued in the ordinary course of business expected to be repaid within 120 days of issuance, (iii) are interest-free debt instruments, or (iv) are demand deposits received by a qualified cash pool header.20 Under Treas. Reg. § 1.385-3(b)(3)(i) such instruments will not be treated as funding a Funding Transaction.

Temp. Treas. Reg. § 1.385-4T provides rules for applying Treas. Reg. § 1.385-3 to consolidated groups in order to account for their unique tax treatment. Generally a consolidated group is treated as one corporation for purposes of the Distribution Regulations (the “one-corporation rule”), and therefore debt instruments issued between members of a consolidated group are generally not subject to the Distribution Regulations (each such debt instrument, a “consolidated group debt instrument”).21 Where a member of a consolidated group issues a covered debt instrument to an entity outside of the consolidated group, the consolidated group is treated as the issuer.22 The regulations also provide guidance on when a consolidated group member who had made an issued a debt instrument that would otherwise be potentially subject to the Distribution Regulations absent the one-corporation rule, leaves the consolidated group23 or when a covered debt instrument recast as an equity interest becomes a consolidated group debt instrument.

Finally, while the 2016 Proposed Regulations and the 2016 Temporary Regulations were adopted without substantive changes, taxpayers should be mindful that the relevant tax rules are complex and special care should be taken to understand both the benefits and collateral consequences that can arise from engaging in transactions that the IRS may recast. Additionally, the IRS has indicated they may streamline Treas. Reg. § 1.385-3, but until such time the final regulations should be followed.

[[13]]Temp. Treas. Reg. § 1.385-3T(f).[[13]]

Endnotes

  1. REG-130314, 81 FR 72751.
  2. 81 FR 72858.
  3. See generally, Treas. Reg. § 1.385-3, Temp. Treas. Reg. § 1.385-3T, and Temp. Treas. Reg. § 1.385-4T.
  4. A “covered debt instrument” is defined under Treas. Reg. § 1.385-3(g)(3)(i) as a debt instrument issued after April 4, 2016.
  5. Treas. Reg. § 1.385-1(c)(4).
  6. Treas. Reg. § 1.385-1(c)(2).
  7. Treas. Reg. § 1.385-3(b)(2).
  8. Treas. Reg. § 1.385-3(b)(3). Such distributions or acquisitions are defined as: (i) a distribution of property by the funded member to a member of the funded member’s expanded group, other than in an exempt distribution; (ii) an acquisition of expanded group stock, other than an exempt exchange, by the funded member from a member of the funded member’s expanded group in exchange for property other than expanded group stock; or (iii) an acquisition of property by the funded member in an asset reorganization but only to the extent that, pursuant to the plan of reorganization, a shareholder in the transferor corporation that is a member of the funded member’s expanded group immediately before the reorganization receives other property or money within the meaning of Section 356 with respect to its stock in the transferor corporation.
  9. The regulations use the term “funded member”, which is defined as a covered member that enters a Defunding Transaction regardless of when it issues a covered debt instrument in exchange for property. Treas. Reg. § 1.385-3(b)(3)(i).
  10. Treas. Reg. § 1.385-3(b)(3)(iii).
  11. Treas. Reg. § 1.385-3(b)(3)(iv).
  12. Treas. Reg. § 1.385-1(c)(1), “The term controlled partnership means, with respect to an expanded group, a partnership with respect to which at least 80 percent of the interests in partnership capital or profits are owned, directly or indirectly, by one or more members of the expanded group.”
  13. Temp. Treas. Reg. § 1.385-3T(f)(3)(i).
  14. Temp. Treas. Reg. § 1.385-3T(d)(4).
  15. Temp. Treas. Reg. § 1.385-3T(f)(4).
  16. The regulations refer to this portion as the “deemed transferred receivable”, which is determined under Temp. Treas. Reg. § 1.385-3T(4)(f)(i).
  17. Temp. Treas. Reg. § 1.385-3T(4)(f)(i).
  18. See generally,Temp. Treas. Reg. § 1.385-3T(4)(f)(3)&(4).
  19. See generally, Temp. Treas. Reg. § 1.385-3T(4)(b)(3)(vii).
  20. Temp. Treas. Reg. § 1.385-4T(b)(1). Temp. Treas. Reg. § 1.385-4T(e)(1), “The term consolidated group debt instrument means a covered debt instrument issued by a member of a consolidated group and held by a member of the same consolidated group.”
  21. Temp. Treas. Reg. § 1.385-4T(b)(1)
  22. Temp. Treas. Reg. § 1.385-4T(c)(1)(i).
  23. Temp. Treas. Reg. § 1.385-4T(c)(2).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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