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IRS Removes "Section 385 Documentation" Requirements, Proposes New Rules on Distributions

mark.howe@cwt.com's picture
Commentary by Mark Howe

The IRS issued final regulations removing "Section 385 regulations" regarding specified documentation requirements. Section 385 provisions deal with the classification of related-party debt as debt or equity for U.S. federal income tax purposes. The new regulation is now in effect. The IRS also issued a proposed rulemaking that would modify Section 385 regulations regarding actual or deemed distributions. Comments on the proposed rule are due on February 3, 2020.

As previously covered, the Section 385 regulations are primarily composed of (i) rules establishing minimum documentation requirements that normally must be satisfied in order for purported debt obligations among related parties to be treated as debt for U.S. federal tax purposes, and (ii) rules that treat as stock certain debt that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction that achieves an economically similar result. The applicability date of the requirements was delayed until January 1, 2019, due to concerns from taxpayers that there was not enough time to come into compliance.

Pursuant to Executive Order 13789, the IRS was instructed to review tax regulations issued since January 1, 2016 and correct any (i) "undue financial burden on U.S. taxpayers," (ii) complexities or (iii) overreach of statutory authority. The Treasury previously recommended that the IRS remove Section 385 and replace it with "streamlined documentation rules" on October 4, 2017.

By this action, the IRS is enacting the Treasury's recommendation by removing Treasury Reg. 1.385-2 and adopting conforming amendments ("Documentation-Repealed Regulations"). Additionally, Treasury and the IRS provided notice that they intend to propose regulations that would replace parts of Section 385 concerning the treatment of certain interests in corporations as stock or indebtedness where an actual or deemed distribution to a related party is involved.

Commentary

This partial rollback of the Section 385 regulations (which had been, in part, aimed at inversions) liberalizes the documentation requirements for intercompany debt and expands the circumstances where such debt may be respected. While this rollback is being justified by, among other things, the Tax Cuts and Jobs Act's ("TCJA"s) limitation on interest deductibility, reduction in U.S. corporate rates and move toward a territorial tax system, it remains to be seen whether much of the TCJA will survive the next two election cycles.

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