The IRS has proposed removing the Section 385 documentation regulations provided in Reg. §1.385-2. However, taxpayers may rely on this proposed removal until final regulations are published.
The documentation regulations provide minimum documentation requirements for treating certain related-party instruments as debt for federal tax purposes. They are part of final and temporary Section 385 regulations adopted with T.D. 9790, I.R.B. 2016-45, 540.
In addition to the documentation requirements, the Section 385 regulations also include debt recharacterization rules. These rules 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 Section 385 regulations apply generally to debt instruments that are:
- issued by a domestic corporation or its disregarded entity, and
- held by members of the domestic corporation’s expanded group.
Overview of Section 385 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. §1.385-2 prescribes the nature of the documentation necessary to substantiate the tax treatment of related-party instruments as debt. Under these rules, taxpayers must be able to provide written evidence of four indebtedness factors analogous to those found in third-party loans.
However, 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. Moreover, 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.
In addition, corporations that belong to an expanded affiliated group must document relevant transactions under these rules if:
- 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 applicable financial statements; or
- one or more members have annual total revenue that exceeds $50 million on any applicable financial statement or combination of applicable financial statements.
However, the documentation regulations apply to relevant intercompany debt issued beginning in 2019. They also require the taxpayer to prepare its documentation for a given tax year by the time the borrower’s return is filed.
Executive Order 13789
The president issued Executive Order 13789 on April 21, 2017 (E.O. 13789). It 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 order also instructs the Treasury Secretary to take concrete actions to alleviate the burdens of such regulations.
Treasury Reports Regarding Section 385 Regulations
Under the Executive Order, the Treasury Department identified 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 (Notice 2017-38, I.R.B. 2017-30, 147).
The IRS responded by delaying 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 documentation regulations applied to interests issued or deemed issued on or after January 1, 2018 (Notice 2017-36, I.R.B. 2017-33, 208).
In a later report, the Treasury proposed to revoke the current documentation rules and replace them with substantially simplified and streamlined documentation rules (Treasury Department News Release, TDNR SM-0172, October 4, 2017; U.S. Department of the Treasury, Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (Executive Order 13789), October 2, 2017).
Proposed Removal of Section 385 Documentation Rules
Now the IRS has proposed the complete removal of the documentation regulations. 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. Moreover, these revised documentation rules would:
- be substantially simplified and streamlined to reduce the burden on U.S. corporations;
- still require sufficient documentation and other information for tax administration purposes; and
- be proposed with a prospective effective date to allow sufficient lead-time for taxpayers to design and implement systems to comply with the revised documentation requirements.
In addition, members of the public may comment on these proposed changes. The IRS must receive the comments by December 23, 2018.
Proposed Regulations, NPRM REG-130244-17