The US government on 4 April issued highly anticipated anti-corporate inversion regulations. Moreover, the US government also published far-reaching proposed regulations that could recharacterize certain debt as equity that would have an impact on virtually all US multinationals and many, if not most non-US based multinationals with US operations.

First, the IRS issued final, temporary (TD 9761) and proposed (REG-135734-14) regulations that modify the application of Sections 7874 and 367 to inversion transactions and limiting the US tax benefits of certain post-inversion planning. The temporary regulations adopt with some modifications provisions described in IRS Notice 2014-52 and Notice 2015-79, and add new provisions not included in the earlier notices.

The preamble to the temporary regulations divides the rules into three parts: (1) rules addressing certain transactions structured to avoid the purposes of Section 7874; (2) rules addressing post-inversion transactions; and (3) certain miscellaneous provisions.

The new rules included in the temporary regulations, as well as the changes to the rules described in the 2014 and 2015 Notices, generally apply to acquisitions or post-inversion transactions completed on or after 4 April 2016. However, the rules described in the 2014 notice apply to acquisitions completed on or after 22 September 2014, and the rules described in the 2015 notice apply to acquisitions completed on or after 19 November 2015. An ITS Alert provides details.

Even more importantly, the IRS on the same day issued lengthy proposed regulations (REG-108060-15) under Section 385 to address earnings stripping. (Section 385(a) authorizes Treasury to issue regulations to determine whether an interest in a corporation is treated as stock or indebtedness for federal tax purposes. There are no regulations currently in effect under Section 385.)

The newly proposed regulations would:

— Treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes
— Authorize the IRS Commissioner to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes
— Establish extensive documentation requirements in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes

Prop. Reg. Section 1.385-3 provides rules that would treat as stock certain related-party debt instruments that otherwise would be treated as indebtedness for federal tax purposes, if the instruments are issued as part of certain related-party transactions. Prop. Reg. Section 1.385-4 provides rules for applying Prop. Reg. Section 1.385-3 to a consolidated group when an interest ceases to be a consolidated group debt instrument or becomes a consolidated group debt instrument.

The proposed regulations would generally apply to foreign and domestic related parties alike. The proposed regulations would not apply, however, to issuances of debt and related transactions between members of a consolidated group.

As written, the proposed regulations would have far-reaching consequences for corporations that issue debt instruments to related corporations and partnerships.

Attention should be given to the effective dates. Significantly, although Prop. Reg. Section 1.385-3 becomes effective only when issued as a final regulation, it would generally apply to debt instruments issued on or after 4 April 2016. The rules of Reg. Section 1.385-3, however, would treat as stock a debt instrument issued prior to the date the final regulations only after the 90-day period following the adoption of the final regulations. Thus, during this period, taxpayers may avoid the application of the rules of Reg. Section 1.385-3 by repaying or otherwise eliminating related-party debt instruments that would otherwise be treated as stock. Similar effective date rules apply for purposes of Prop. Reg. Section 1.385-4.

In general, the authority to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes and the extensive documentation requirements would be effective for instruments issued on or after the publication of final regulations.

The proposed Section 385 regulations are some of the most important rules issued by the government in many years. If finalized in their current form, the proposed regulations would dramatically affect a wide range of M&A transactions and ordinary course corporate finance and tax operations; they go far-beyond inversion transactions. They extend to routine financing transactions for both non-US-based and US-based multinational corporations, for some majority-owned subsidiaries, for private equity funds and their portfolio companies, and for taxable REIT subsidiaries.

The proposed Section 385 regulations would also dramatically affect many commonplace subchapter C nonrecognition transactions.

EY understands that the government expects to finalize these regulations quickly. Taxpayers that are potentially affected by these rules should take steps now to ensure that they are prepared to comply.

Note that although the proposed regulations generally would not apply to debt instruments that are now outstanding, such instruments could easily become subject to the regulations through an entity classification election or a significant modification of the instrument. Taxpayers should take an inventory of all debt they hold or have issued where the holder and the issuer are related parties, but not members of the same affiliated group. An ITS Alert provides details.