Treasury, IRS Issue Temporary and Final Regulations Affecting Related-Party Financing

October 15, 2016

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Introduction

On April 4, 2016, the Treasury Department and the IRS issued proposed regulations under section 385 (REG-108060-15) that proposed to greatly expand the IRS’s ability to recast related-party debt as equity.  These regulations caused considerable concern within the business community and on Capitol Hill.  (For prior coverage, click here, here, here, here, and here.)  The proposed regulations generated 29,600 comments to Treasury, 145 of which were unique and commented on substantive aspects of the proposed regulations, and innumerable pieces of commentary.  In addition, 16 speakers testified at the public hearing.

On October 13, a mere six months after the regulations were proposed, Treasury and the IRS issued final and temporary regulations.  These regulations contain some significant changes to the proposed package.  The changes, described below, were generally welcomed, though concern remains about portions of the package.  Accompanying the temporary and final regulations were proposed regulations cross-referencing the temporary regulations.  Comments are due on the proposed regulations on approximately January 19, 2017 (90 days after publication in the Federal Register, currently scheduled for October 21).

This update provides a closer look at the regulations and the key changes.  We continue to digest and analyze the regulations and will provide further in-depth analysis on targeted aspects of the regulations. 

Background

Enacted as part of the Tax Reform Act of 1969, section 385(a) authorizes Treasury to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is treated as stock or debt for purposes of the Internal Revenue Code.  Section 385(b) sets forth factors to take into account in determining whether an instrument is debt or equity.  In 1989, Congress amended section 385(a) to authorize the issuance of regulations permitting an interest in a corporation to be treated as part stock and part debt.

Treasury and the IRS’s last attempt to issue regulations under section 385 was not successful; final regulations were withdrawn in 1983 without ever entering into force.  Since then, because no regulations were in effect under section 385, case law has generally controlled the characterization of an interest in a corporation as debt or equity.

Definitions and General Applicability

The proposed regulations generally applied to debt instruments between members of an “expanded group,” which was defined by reference to the term “affiliated group” in section 1504(a) with several modifications.  Specifically, an expanded group included foreign corporations, tax-exempt corporations, life insurance companies, S corporations, regulated investment companies (RICs), and real estate investment trusts (REITs). 

The final regulations modify the definition of expanded group by adding certain exclusions and revising the technical rules for determining the relationship necessary for members.  The most significant modifications are the exclusions.  S Corporations, non-controlled RICs, and non-controlled REITs are excluded from the scope of expanded group and therefore are exempt from all aspects of the final regulations.  RICs and REITs that are controlled by members of the same expanded group continue to be subject to the regulations.  The final regulations continue to include tax-exempt organizations and insurance companies within the scope of expanded group.  (Note, however, that there are certain exemptions for specific insurance companies, discussed below).

In addition, the final regulations reserve on all aspects of their application to foreign issuers.  As a result, the final regulations do not apply to debt instruments that are issued by foreign issuers.  A debt instrument issued by a domestic issuer to a foreign member of the expanded group continues to be subject to the regulations.  The final regulations add the concept of a “covered member” to distinguish between expanded group members to which the final regulations apply (domestic issuers) and expanded group members to which the final regulations do not apply (foreign issuers). 

In addition to new exclusions, the final regulations also make technical modifications to the definition of expanded group.  The final regulations continue to use the definition of the term “affiliated group” in section 1504(a) as the starting point for the definition of expanded group (but applying an ownership threshold of 80% of the vote OR value of that entity rather than vote AND value as in section 1504(a)).  The final regulations address an inconsistency in the proposed regulations’ application of indirect ownership principles to ensure that it applies to the subsidiary corporations as well as the parent corporation.  “Indirectly” is defined by reference to the constructive ownership rules in section 318, with certain modifications.  However, this creates the possibility that two “brother-sister” groups of entities owned by different parties could be treated as part of the same expanded group.  Treasury and the IRS continue to study this and, therefore, the final regulations reserve on the application of the constructive ownership rules to brother-sister groups. 

The final regulations also clarify that the time to test a relationship for purposes of determining whether an entity is a member of an expanded group for purposes of the funding rule (discussed further below) is immediately before the relevant distribution or acquisition potentially subject to the funding rule.

Bifurcation Rule

The proposed regulations provided a “bifurcation rule” under which the IRS would have been allowed to treat an instrument as part debt and part stock to the extent that “an analysis, as of the date of issuance of the EGI [expanded group instrument], of the relevant facts and circumstances . . . under general federal tax principles results in a determination that the EGI is properly treated for federal tax purposes as indebtedness in part and stock in part.”  The bifurcation rule would have applied to parties in a “modified expanded group,” which used a lower 50% threshold for relatedness. 

The proposed regulations provided little detail on the application of the bifurcation rule, apart from an example in which the IRS was permitted to treat a portion of a debt instrument as equity because the IRS’s “analysis supports a reasonable expectation that, as of the issuance of the EGI, only a portion of the principal amount of an EGI will be repaid.”  The bifurcation rule presented significant uncertainties given this lack of guidance, particularly due to the fact that the bifurcation would not happen until an IRS audit and the degree of discretion granted to the IRS.

Treasury and the IRS decided not to include the bifurcation rule in the final regulations.  This is a surprising development, and it is unclear what motivated the decision to remove the bifurcation rule.  Accordingly, the IRS is generally still required to use an all-or-nothing approach by treating an interest in a corporation as either wholly indebtedness or wholly equity.  In response to the proposed bifurcation rule, Treasury and the IRS received many comments requesting additional guidance concerning how the portion of a bifurcated interest treated as stock would be determined, and how payments on such bifurcated interest would be treated for federal tax purposes.  Treasury and the IRS stated that they continue to study the comments received and have asked for additional comments as they look further at the bifurcation issue.  Any subsequently issued guidance will not apply to interests issued before the date of that guidance.

Documentation Rules

The proposed regulations included rules that prescribed the nature of the minimum documentation necessary to substantiate that four factors were satisfied for an instrument between expanded group members to be treated as “indebtedness” for federal tax purposes: (1) the issuer’s binding obligation to pay a sum certain; (2) the holder’s rights to enforce payment; (3) a reasonable expectation of repayment; and (4) a course of conduct that is generally consistent with a debtor-creditor relationship.  Documentation satisfying these four factors was required if one of the following conditions was present: (1) the stock of any expanded group member is publicly traded; (2) the expanded group has total assets exceeding $100 million; or (3) the expanded group has total annual revenue that exceeds $50 million.  The final regulations retain these requirements.

Rebuttable Presumption if Highly Compliant.  Under the proposed regulations, if documentation sufficient to satisfy all four of these factors was not present, then the instrument was automatically treated as equity and not debt.  The final regulations relax this rule to a rebuttable presumption that the instrument is equity and not debt when the documentation requirements for an individual instrument are not satisfied.  To rebut the presumption, the taxpayer can demonstrate that it is otherwise highly compliant with the documentation rules for debt instruments between expanded group members generally by showing either that a high percentage of expanded group instruments (at least 90%  of the aggregate adjusted issue price) comply with the documentation requirements or the non-compliant debt instruments are not material (i.e., no covered instrument with an issue price in excess of $100 million failed to comply and the average total number is less than five percent, or no covered instrument with an issue price in excess of $25 million failed to comply and the average number is less than 10%).

Extended Time Periods.  Under the proposed regulations, documentation of an issuer’s binding obligation to pay a sum certain, the holder’s rights to enforce payment, and a reasonable expectation of repayment to satisfy factors (1), (2), and (3) above were required to be prepared within 30 days of the instrument’s date of issuance.  In addition, documentation of a course of conduct generally consistent with a debtor-creditor relationship to satisfy factor (4) was required to be prepared within 120 days of the “relevant date” of the actions in the course of conduct.  The final regulations extend these time periods and require that the documentation be prepared by the time that the issuer’s federal income tax return must be filed (taking into account any extensions) for the tax year of the relevant date.

Delayed Effective Date.  The final regulations delay the effective date of the documentation rules so that these rules only apply to instruments that are issued on or after January 1, 2018.  This delay combined with the modifications to the time periods means that taxpayers will have until the filing date of their taxable year that includes January 1, 2018 to comply with the documentation requirements.

Certain Debt Recharacterized as Equity

The final regulations retain the general and funding rules of the proposed regulations without significant change.  Instead, the regulations make significant modifications to the exceptions to reduce the scope of the rules and mitigate their effect on ordinary business transactions.

General Rule.  As in the proposed regulations, the general rule provides that any debt instrument issued by a covered member of an expanded group to another member of the same expanded group is automatically recharacterized as stock if it is issued in one of three transactions (“covered transactions”):  (1) in a distribution; (2) in exchange for the stock of a member of the expanded group; and (3) as boot in an internal asset reorganization. 

One commenter questioned why the regulations only applied to asset reorganizations and not to other acquisitions of assets, but the final regulations did not extend the general rule to such acquisitions.  Thus, for example, an internal acquisition can be structured as a taxable transfer of assets, or interests in a disregarded entity, without triggering recharacterization.

Funding Rule.  The funding rule generally treats as stock any debt instrument issued by a covered member (the funded member) to another member of the expanded group in exchange for property that is treated as funding one of the three covered transactions.  The final regulations also retain the “per se funding rule” of the proposed regulations, which is an irrebuttable presumption that any debt instrument that is issued by a funded member during the period beginning 36 months before and ending 36 months after the covered transaction is a covered debt instrument.  However, the final regulations reorganize the funding rule so that the per se funding rule is the general rule and a principal purpose rule provides a backstop for transactions occurring outside of the per se period.

Commenters had pointed out numerous negative collateral effects of the per se funding rule.  For example, the deemed issuance of stock could cause a transaction to fail to satisfy the control requirement of numerous nonrecognition provisions, trigger an ownership change under section 382, or cause a deconsolidation of a consolidated group.  The Treasury Department and IRS specifically rejected requested changes to address these collateral effects, reasoning that they do not arise uniquely as a result of the application of the funding rule.

Exceptions to the General/Funding Rules

The action in the temporary and final regulations is in the scope of the exceptions to the general and funding rules.  The regulations make significant changes to the exceptions that were in the proposed regulations and add several new ones.

Cash Pooling/Short-Term Debt Instruments.  By far the most substantial change to the exceptions was the expansion of the ordinary course exception in the proposed regulations to encompass short-term debt instruments and cash pooling arrangements.  The substantial nature of the change probably explains why this exception was contained in the temporary regulations instead of the final regulations, so that Treasury and the IRS can receive comments on it.  The proposed regulations contained a narrow exception to the per se funding rule for debt instruments arising in the ordinary course of business in connection with the purchase of property or the receipt of services, but only to the extent that it was deductible under section 162 or included in cost of goods sold or inventory.  The temporary regulations significantly expand this exception to address the application of the funding rule to common cash-management techniques.  

Under the temporary regulations, the funding rule does not apply to “qualified short-term debt instruments,” which is defined to include (1) short-term funding arrangements, (2) ordinary course loans, (3) interest-free loans, and (4) deposits with a qualified cash pool header. 

  • The short-term funding arrangements category contains two tests designed to exclude covered debt instruments that are issued as part of arrangements, including cash pooling arrangements, to meet short-term funding needs that arise in the ordinary course of the issuer’s business.  In addition, the interest rate charged must not exceed an arm’s length rate.  The first test, the “specified current assets test,” generally requires that the issuer’s overall outstanding balance for short-term instruments does not exceed an amount reasonably necessary to satisfy short-term financing needs.  The second test, the “270-day test,” generally requires that an instrument have a term of 270 days or less or be an advance under a revolving credit agreement or similar arrangement.  In addition, under the 270-day test, there are limitations on issuer’s ability to be a net borrower from the lender. 
  • The ordinary course loans category includes debt issued as consideration for the acquisition of property other than money in the ordinary course of the issuer’s trade or business, provided that the obligation is reasonably expected to be repaid within 120 days of issuance.  This is broader than the ordinary course exception in the proposed regulations.
  • The interest-free loans category includes instruments that do not provide for any type of interest (i.e., stated, original issue discount, or imputed). 
  • The category for deposits with a qualified cash pool header permits covered members to maintain net deposits with a qualified cash pool header pursuant to a cash-management arrangement, which would include borrowing excess funds from participating expanded group members and lending such funds to other participating expanded group members, managing foreign exchange risks, clearing payments, investing excess cash with an unrelated person, depositing excess cash with another qualified cash pool header, and settling intercompany accounts.  A qualified cash pool header is generally an expanded group member, controlled partnership, or qualified business unit that is owned by an expanded group member and that has as its principal purpose managing a cash-management arrangement for participating expanded group members. 

Earnings and Profits Exception.  The proposed regulations provided that the aggregate amount of covered transactions was reduced to the extent of the current year earnings and profits.  This exception was intended to accommodate ordinary course distributions.  Many commenters pointed out that limiting the exception to current year earnings and profits was too narrow, in part because it was difficult to compute by the close of the year, but more importantly, it would incentivize taxpayers to “use or lose” their current earnings and profits through annual distributions.  The final regulations expand the earnings and profits exception to take into account all earnings and profits accumulated by a corporation during its membership in an expanded group, but the earnings and profits are limited to those accumulated in taxable years ending after April 4, 2016 (the date of the proposed regulations).

Subsidiary Stock Acquisition Exception.  The proposed regulations contained an exception from the funding rule for an acquisition of stock of an expanded group member (the issuer) by a funded member (the transferor), provided that for the 36-month period immediately following the issuance, the transferor held more than 50% of the stock (by vote and value).  The final regulations expand this exception in a few ways.  First, the final regulations include acquisitions of existing subsidiary stock in addition to initial issuances.  Second, the exception applies for purposes of the general rule in addition to the funding rule.  Third, the 36-month holding period is converted to a rebuttable presumption so that the transferor can show that a relinquishment of control was not part of a plan that existed at the time of the acquisition.  Finally, a loss of 50% control is disregarded if the transferor and issuer cease to be members of the same expanded group as part of the transaction.

Threshold Rule.  The proposed regulations provided that a debt instrument would not be recharacterized as stock if, at the time the debt was issued, the aggregate issue price of all expanded group instruments that otherwise would be treated as stock under the proposed regulations does not exceed $50 million.  However, the threshold exception had a cliff effect – once the $50 million threshold was met, then all the debt instruments were recharacterized as stock.  In response to comments, the final regulations eliminate the cliff effect and permit exclusion of the first $50 million of expanded group debt.

Netting of Qualified Capital Contributions.  Many commenters complained that the proposed regulations looked to gross acquisitions and distributions and did not provide credit for capital contributions, reasoning that to the extent of capital contributions, a distribution does not reduce a member’s net equity.  The final regulations provide that a covered transaction is reduced by the aggregate fair market value of the stock issued by the covered member in one or more qualified contributions made during the period beginning 36 months before and ending 36 months after the covered transaction (but only up to the end of the tax year in which the note is recharacterized as stock).  There are a number of exclusions from the definition of qualified contribution.

Compensatory Stock Acquisitions.  The final regulations provide an exception from the general and funding rules for acquisitions of expanded group stock if it is delivered to individuals in consideration for services rendered as an employee, director, or independent contractor.

Acquisitions by Dealers in Securities.  In response to comments, the final regulations provide an exception for acquisitions of expanded group stock by a dealer in securities acquired in the ordinary course of the dealer’s business. 

Iterative Recharacterizations.  Commenters had pointed out that when a debt instrument is recharacterized as stock, the holder is treated as acquiring stock of an expanded group member.  If that member were itself funded, the recharacterization could, in turn, trigger the application of the funding rule to recharacterize the holder’s own borrowing.  The final regulations include a limited exception to the funding rule for acquisitions of expanded group stock that result from the application of the general or funding rules.

Certain Nontaxable Distributions.  In response to comments that tax-free liquidations and spin-offs constituted distributions under the proposed regulations that inappropriately triggered the funding rule, the final regulations include exceptions for distributions in complete liquidation and section 355 distributions (whether or not preceded by a divisive D reorganization).

Instruments Expressly Treated as Debt Under the Internal Revenue Code.  Commenters noted that debt instruments that are expressly treated as debt under the Code should not be subject to recharacterization.  The final regulations exclude various such instruments from the definition of covered debt instruments, including real estate mortgage investment conduit (REMIC) regular interests, stripped bonds under section 1286 instruments, and leases treated as loans under section 467.

Impact on Foreign and Cross-Border Transactions

Comments on the proposed regulations raised numerous concerns regarding the international tax implications of recharacterization of debt as equity, including under US tax treaties.  For example, comments observed that applying the rule to foreign issuers would cause significant complexity and have numerous potentially negative collateral tax consequences (such as causing a foreign issuer to no longer qualify for treaty benefits with respect to US-source income under a treaty limitation on benefits test where debt is recharacterized as equity).  The final regulations respond to these concerns by reserving on application to foreign issuers, including controlled foreign corporations, with the preamble observing that “U.S. tax implications are less direct and of a different nature” in this context. 

To avoid adverse withholding tax and other consequences, the regulations also provide an exception from the funding rule for distributions and acquisitions deemed to occur as a result of transfer pricing adjustments under section 482.  The preamble to the regulations also responds to several comments regarding the consistency of the regulations with US treaty obligations, stating that the rules are consistent with treaty rules governing the character of payments, the arm’s length principle, and non-discrimination provisions.

Partnerships and Disregarded Entities

The proposed regulations applied in varying ways to partnerships and disregarded entities, in an apparent effort to prevent corporations from avoiding these rules through the use of controlled pass-through entities.  While the proposed rules caused a great deal of concern and raised many uncertainties (see prior DTU coverage for more details), overall, with respect to partnerships and S corporations, the final regulations stand as a marked improvement over the proposed regulations. 

Documentation Rules.  The final regulations appear to pull back almost completely from the initial proposal to apply the documentation rules to debt issued by partnerships and S corporations.  As discussed above, the final regulations exempt S corporations entirely, so the concerns over the potential for the loss of S corporation status (due to S corporation debt being recast into a prohibited second class of stock or into stock held by an ineligible shareholder) have been eliminated.  Also, the concerns that debt issued by a partnership could be recast as equity of the partnership, and, thereby, lead to a number of subchapter K consequences for pre-existing partners seem to have been eliminated, except for the potential application of an anti-abuse rule. 

General and Funding Rules.  The general and funding rules continue to apply to partnerships, although only to a subset – termed “controlled partnerships.”  These controlled partnership rules constitute an application of the aggregate theory of partnerships (as did the proposed regulations applicable to partnerships).  In general, the rules seem aimed at debt issuances and related transactions that would otherwise be ensnared by the general and funding rules but for the interposition of one or more controlled partnerships.  Again, since S corporations are exempt from the final regulations, they have been spared from the general and funding rules.

Exceptions for Certain Regulated Entities

Many commenters requested exceptions for entities, such as insurance companies or financial institutions, which are subject to non-tax regulatory requirements that impose significant limitations on their debt.

Definition of Covered Debt Instruments.  The final regulations include an exception from the definition of covered debt instruments for debt instruments issued by regulated insurance companies; that is insurance companies that are subject to risk-based capital requirements under state law.  The preamble indicates that Treasury and the IRS have determined that these risk-based capital requirements mitigate the risk that these entities would engage in the types of transaction of concern in these regulations.  The regulations define a regulated insurance company as a company that is: (1) subject to tax under subchapter L; (2) organized under the laws of a state; (3) licensed, authorized, or regulated by one or more states to sell insurance to unrelated persons; and (4) engaged in regular issuances of insurance with unrelated persons.

The preamble specifically notes that captive insurance and reinsurance companies do not fall within this exclusion for regulated insurance companies because they are not subject to the same risk-based capital requirements or other regulation and oversight.  For the same reasons, the final rules also do not exclude members of an insurance company’s group that are not regulated insurance companies. 

Documentation Rule.  The final regulations contain exceptions from the documentation rules for certain regulated entities, including regulated financial services entities and regulated insurance companies.  Under this exception, certain debt instruments issued by a regulated financial company or a regulated insurance company are treated as meeting the documentation rules as long as the instrument contains terms necessary to meet certain regulatory capital or other requirements, or if certain payment conditions are required by the regulator.  The preamble notes that Treasury and the IRS are still considering additional guidance to address certain issues required by regulators that raise common law debt-equity issues. 

General and Funding Rules.  The final regulations also limit the application of the general rule and the funding rule to debt instruments issued by certain regulated financial companies and regulated insurance companies.  Generally, the excepted regulated financial companies include financial institutions with specific regulatory or capital requirements, such as bank holding companies, national and state banks that are members of the Federal Reserve System, registered broker-dealers, nonbank financial companies subject to a determination by the Financial Stability Oversight Council, and Federal Home Loan Banks.  In exempting these regulated institutions, Treasury and the IRS indicated that these institutions have capital or leverage requirements that “most directly constrain the ability of such institutions to engage in the transactions that are intended to be addressed by the final and temporary regulations.” 

Consolidated Groups

The proposed regulations treated a consolidated group as one corporation and, therefore, did not apply to instruments between members of a consolidated group.  However, instruments between a member of the consolidated group, on the one hand, and an entity owned through a partnership or a controlled foreign corporation, on the other, were subject to the proposed regulations.  The temporary and final regulations continue to treat consolidated groups as one corporation, but only for purposes of the general and funding rules.

Documentation Rules. Under the proposed documentation rules, members of a consolidated group were generally treated as one corporation.  Although the one-corporation approach was intended to exempt interests issued between consolidated group members from the documentation rules, this approach presented concerns regarding both the implementation of the rule and its effect on other Internal Revenue Code provisions.  In issuing the final regulations, Treasury and the IRS reconsidered the use of the one-corporation approach and determined that a better approach would be to exclude obligations between consolidated group members from the category of instruments subject to the documentation rules.  This approach retains the general exclusion for intercompany obligations while eliminating many of the questions and concerns raised by various comments (e.g., whether a particular group member, or the group as a whole, would be the issuer of a covered debt instrument). 

Effect of Debt Recharacterization on Section 1504(a) Affiliation.  Under the final and temporary regulations, debt instruments treated as stock under the general and funding rules are not treated as stock for purposes of determining whether a corporation is a member of an affiliated group under section 1504(a).  Accordingly, the recharacterization of a covered debt instrument issued by a member of a consolidated group under the final regulations will not result in a deconsolidation of the member.

Treatment of Consolidated Groups – New Temporary Regulations.  The proposed regulations provided specific rules for applying the general and funding rules to members of consolidated groups.  Those rules, with certain modifications, are adopted as temporary regulations.  The temporary regulations clarify several aspects of the operation of the general and funding rules to consolidated group members, including rules that provide the following:

  • Because the one-corporation rule applies only for purpose of the general/funding rules and not for the documentation rule, the rule is moved from Treas. Reg. § 1.385-1 (general rules) to § 1.385-4T (consolidated return rules).
  • A partnership whose partners are all members of the same consolidated group is treated as a partnership, and a covered debt instrument between a consolidated group member and such a wholly owned partnership is treated as a consolidated group debt instrument.
  • A debt instrument issued by a member of a consolidated group, if treated as stock under the regulations, is treated as stock in the particular member that is the issuer of the debt instrument.
  • With regard to the application of the funding rule, when a member of an expanded group becomes a member of a consolidated group and continues to be a member of the same expanded group, the joining member and the consolidated group that it joins are a predecessor and successor, respectively.
  • In applying the modified earnings and profits exception, a consolidated group has one account and only the earnings and profit of the common parent (generally determined in accordance with Treas. Reg. § 1.1502-33) are considered.  Rules are also provided to determine when and to what extent a consolidated group or a departing member succeeds to the expanded group earnings account of a joining member or group, respectively.
  • The determination of whether a debt instrument issued by a consolidated group member is a covered debt instrument is made on a separate member basis, as is the determination of whether a member has issued a qualified short-term debt instrument.
  • Detailed provisions with respect to the consequences of a debt instrument that ceases to be a consolidated group instrument but continues to be held by members of the same expanded group, with a focus on issues raised by departing members.  Such provisions include a subgroup exception, under which an instrument remains a consolidated group debt instrument if the issuer and holder depart one consolidated group and together join another consolidated group within the same expanded group. 

Procedural Observations

Temporary and Final Regulations.  While many commentators, concerned about Treasury’s ability to get the final rules right, urged Treasury to re-propose the regulations instead of finalizing, Treasury declined to do so.  Instead, most of the proposed regulations were finalized, and others were issued as temporary regulations (while still others were reserved for further consideration).  Specifically, the rules applicable to partnerships and disregarded entities, the rules applicable to consolidated groups, and the new exception for cash pooling and short-term debt instruments were issued in temporary form.  Issuing rules in temporary form represents a compromise in that the rules can have an immediate effect, but Treasury still has additional time to receive feedback and made additional modifications, if necessary, before finalizing when the temporary regulations expire in three years. 

Administrative Procedure Act (APA).  These regulations represent one of the most significant packages since the Tax Court in Altera v. Commissioner struck down regulations under section 482 on APA grounds.  In Altera, the Tax Court held that the IRS did not sufficiently consider public comments offered during the notice and comment process under the APA.  These regulations offer roughly 380 pages of explanation, in what appears to be an effort to inoculate the regulations from similar APA challenges.  It remains to be seen if they will be successful, but the clear lesson to be drawn from post-Altera regulations is that comments matter.  Taxpayers would be wise to make their concerns known to Treasury during the notice and comment process and preserve a newly-widened door to challenge regulations that don’t sufficiently consider these concerns.   

Cost Benefit Analysis/OMB Review.  In general, Treasury has taken the position that the economic impact of tax regulations derive from the Tax Code, not the regulations themselves.  Thus, most tax regulations are not considered significant regulatory action requiring the Office of Management and Budget (OMB) review and a cost-benefit analysis.  The section 385 regulations, however, are an exception, because they are considered “legislative regulations;” in other words, the statute contains a grant of authority and the rules themselves are contained in the regulations rather than the statute.  Given their expansive scope, the regulations were designated as a significant regulatory action and the preamble devotes almost 20 pages to a discussion of the effects of the regulations on the economy.  The analysis concludes that the changes between proposed and final regulations significantly reduce the compliance and administrative burden while still limiting transactions that inappropriately reduce US tax revenue.

Interestingly, these regulations seem to have drawn public, and more specifically, Congressional, attention to the general position that tax regulations do not have inherent economic impact and are not subject to the same level of review as regulations from other agencies.  It remains to be seen, however, whether more tax regulations will be subject to greater scrutiny and subject to further regulatory review as a result of the attention focused on the section 385 regulations.

Effective Dates.  As under the proposed regulations, the rules generally apply to debt issued after the date the proposed regulations were issued (April 4, 2016), with a general effective date 90 days after the final regulations are published in the Federal Register.  Commenters asserted that applying the rules to debt instruments issued after the date of the proposed regulations, instead of the date the rules are finalized would be an impermissible retroactive application of the rules.  While stating that they did not agree with these comments, Treasury and the IRS nevertheless revised the applicability dates to apply only to taxable years ending on or after 90 days after the publication of the final and temporary regulations.  Accordingly, any covered debt instrument issued after April 4, 2016 and before the 90-day window after publication will not be recharacterized until 90 days after the publication date.  Thus, the preamble asserts that because the regulations do not affect a taxpayer’s tax liability with respect to a debt instrument until at least 90 days after the date the final and temporary regulations are published, the regulations cannot be considered retroactive.

Further, as discussed above, the effective date for the documentation rules is extended until January 1, 2018.