In 2016, the Obama administration issued a series of rules and regulations designed to stem the flow of corporate inversions – transactions where U.S. corporations moved offshore to avoid the high 35% U.S. corporate tax rate. One such effort focused on cracking down on stripping U.S. income out of the U.S. by loaning funds to a related, foreign corporation. The Obama administration issued regulations under Section 385 of the Internal Revenue Code that treated such loans as equity instead of debt, thereby denying the U.S. corporation interest expense on the loan and imposing dividend treatment on the distributions. The Section 385 regulations also established record keeping requirements for the loans that businesses found onerous, although this rule never went into effect.
One of President Trump’s first actions in the tax area was to order the Treasury Department to review all existing regulations and identify those that were unduly burdensome on taxpayers. The Section 385 regulations were one of the eight regulations identified by Treasury, although at that time Treasury proposed revoking the record keeping requirement but retaining the other provisions until tax reform was enacted allowing for a lower corporate tax rate. President Trump then successfully enacted the 2017 Tax Cuts and Jobs Act, which reduced the corporate income tax rate from 35% to 21%. The Act also imposed restrictions on the ability to claim interest expense deductions for intercompany loans. Because of these changes, and existing anti-tax avoidance rules that remain in place, Treasury believes that the Section 385 regulations are no longer necessary to prevent inversions.
Accordingly, Treasury announced yesterday that it is scaling back the Section 385 regulations, although it stopped short of full repeal. Treasury officially repealed the regulation that provided for the record keeping requirements. In addition, Treasury announced that it will be repealing the rule that treats intercompany debt as “per se” equity if funding occurs within 36 months of the debt issuance. Instead, Treasury will introduce a new rule that will treat intercompany debt as equity if the “issuance has a sufficient factual connection to a distribution to a member of the taxpayer’s expanded group or an economically similar transaction.” Treasury noted that this would streamline distribution regulations while still deterring tax motivated uneconomic activity. Treasury will be accepting comments for the next three months regarding the upcoming proposed regulation. We will update you regarding any further developments when the proposed regulation is released.