10 June 2016 New IRC Section 385 regulations would require increased documentation requirements for tax-exempt organizations On April 4, 2016, the Treasury Department and the Internal Revenue Service released proposed regulations (REG-108060-15) under IRC Section 385 (the Proposed Regulations). Among other things (see below), the Proposed Regulations would establish extensive documentation requirements in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. As described below, the Proposed Regulations would have far-reaching consequences for corporations that issue debt instruments to related corporations and partnerships, including such debt issued by tax-exempt corporations. IRC Section 385(a) authorizes the Treasury Department to issue regulations that may be necessary or appropriate to determine whether an interest in a corporation is treated as stock or indebtedness for federal tax purposes. As the preamble to the Proposed Regulations notes, when Congress enacted IRC Section 385 in 1969, it authorized the Treasury Department and the IRS to establish factors to indicate "for a particular factual situation whether a debtor-creditor relationship exists or a corporate-shareholder relationship exists." The Proposed Regulations provide rules for when certain related-party interests in a corporation may be treated, for federal tax purposes, in whole or in part, as stock rather than debt. The preamble states that the Proposed Regulations were motivated in part by policy concerns relating to transactions that result in excessive debt between related parties in the cross-border context. Nevertheless, the preamble goes on to state, because transactions that result in excessive debt between related parties in the domestic context can implicate similar policy concerns, 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; the policy concerns addressed in the Proposed Regulations, the preamble explains, are not present in those cases, because the issuer's interest expense is offset by the holder's interest income. With one exception, the Proposed Regulations would generally apply only to debt instruments between members of an "expanded group." The term "expanded group" is defined by reference to the term affiliated group in IRC Section 1504(a), with three key modifications. First, an expanded group includes foreign and tax-exempt corporations, as well as corporations held through controlled partnerships. Second, the attribution rules of IRC Section 304(c)(3) would apply for purposes of determining relatedness. Third, the Proposed Regulations would treat a corporation as a member of an expanded group if 80% of the vote or value (not vote and value) is owned by expanded group members. The balance of this Alert discusses the important documentation features of the Proposed Regulations. Prop. Reg. Section 1.385-2 would establish documentation requirements that must be satisfied for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. The stated purpose of these documentation requirements is to provide the IRS with information necessary to analyze the nature of an instrument for federal tax purposes. As the preamble acknowledges, Prop. Reg. Section 1.385-2 would require "a degree of discipline in the nature of the necessary documentation, and in the conduct of financial diligence indicative of a true debtor-creditor relationship, that exceeds what is required under current law." Prop. Reg. Section 1.385-2 would generally apply only to interests that are issued in the form of debt. Furthermore, Prop. Reg. Section 1.385-2 is intended to apply only to "large taxpayer groups." Thus, a related-party debt instrument is not subject to Prop. Reg. Section 1.385-2 unless: (i) the stock of any member of the expanded group is publicly traded, (ii) all or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding $100 million, or (iii) all or any portion of the expanded group's financial results are reported on financial statements that reflect annual total revenue over $50 million. The central provisions of Prop. Reg. Section 1.385-2 are the set of requirements concerning the type of documentation and other information that must be prepared and maintained with respect to a related-party debt instrument. Under Prop. Reg. Section 1.385-2, a taxpayer seeking to establish that a purported debt instrument is indebtedness for federal tax purposes would have to provide documentation establishing: (i) a binding obligation to repay the funds advanced; (ii) creditor's rights to enforce the terms of the debt; (iii) a reasonable expectation that the funds advanced can be repaid (e.g., cash flow projections or other relevant financial data), and (iv), actions evidencing an ongoing genuine debtor-creditor relationship after the instrument is issued. With respect to the fourth category, the form of the documentation would depend on whether the issuer complies with the terms of the debt. If it does, the documentation would have to include timely prepared documentation of any payments supporting the treatment of the debt instrument as indebtedness for federal tax purposes. On the other hand, if the issuer fails to comply with the terms of the debt (e.g., fails to make one or more required payments), the documentation would have to include evidence of the holder's reasonable exercise of the diligence and judgment of a creditor, including the parties' efforts to renegotiate the terms of the debt. As a practical matter, this means that, if a debtor company is unable to make a scheduled payment, the parties must promptly document the creditor's agreement to extend the time for the payment and to provide for interest on the deferred payment consistent with an arm's-length debtor-creditor relationship. In general, the required documentation must be prepared no later than 30 calendar days after the date that the debt instrument comes to be held by an expanded group member. In the case of documentation of the debtor-creditor relationship, however, the regulations allow the documentation to be prepared up to 120 calendar days after the payment or relevant event occurred. Prop. Reg. Section 1.385-2 would generally apply to an interest at the time it becomes held by an expanded group member (an "expanded group instrument" or "EGI"), and would cease to apply to the instrument when it is no longer held by an expanded group member. Accordingly, if a debt instrument that was characterized as stock under the rules of Prop. Reg. Section 1.385-2 ceased to be subject to Prop. Reg. Section 1.385-2, the character of the instrument at the time of the cessation would be determined by applying general tax principles. If, under general tax principles, the interest were treated as indebtedness, the issuer would be treated as issuing a new debt instrument to the holder in exchange for the debt instrument (previously characterized as stock) immediately before the transaction that caused the instrument to cease to be subject to Prop. Reg. Section 1.385-2. If an EGI issued by an entity that would otherwise be a disregarded entity were treated as equity under Prop. Reg. Section 1.385-2, the EGI would be characterized as an equity interest in the entity issuing the instrument. Similarly, if a controlled partnership issued an EGI that was treated as equity under Prop. Reg. Section 1.385-2, the EGI would be characterized as an equity interest in the controlled partnership. Prop. Reg. Section 1.385-2 would not apply if there were a failure to satisfy the requirements of that section with a principal purpose of reducing the federal tax liability of any member or members of the expanded group of the issuer and holder of the EGI or any other person relying on the characterization of an EGI as indebtedness for federal tax purposes. Prop. Reg. Section 1.385-2 would generally apply to related-party interests in a corporation issued on or after the date the Proposed Regulations are issued as final regulations. For this purpose, an issuance includes a deemed issuance as a result of an entity classification election and presumably also includes a deemed reissuance under Regulation Section 1.1001-3. In addition to the documentation requirements, the IRS issued proposed regulations under IRC Section 385 that address other concerns. Specifically, Prop. Reg. Section 1.385-1 would authorize the Commissioner to treat a related-party interest in a corporation as indebtedness in part and as stock in part, consistent with its substance. 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. Specifically, Treasury and the IRS identified three types of transactions that they believe raise significant policy concerns and therefore should be addressed under IRC Section 385: (1) distributions of debt instruments by corporations to their related corporate shareholders; (2) issuances of debt instruments by corporations in exchange for stock of an affiliate (e.g., in connection with an IRC Section 304 sale); and (3) certain issuances of debt instruments as consideration in an exchange pursuant to an internal asset reorganization. The policy concerns implicated by the transactions described in the general rule also arise when a corporation issues a debt instrument to a related party with a principal purpose of funding a distribution or an acquisition described in the general rule. Accordingly, Prop. Reg. Section 1.385-3 includes a funding rule, which treats as stock certain related-party debt instruments that are issued with such a purpose. Furthermore, Prop. Reg. Section 1.385-3 would establish a non-rebuttable presumption that an expanded group debt instrument is issued with such a principal purpose if it is issued by the funded member during the period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution or acquisition. Prop. Reg. Section 1.385-3 also sets forth an anti-abuse rule, under which a debt instrument is treated as stock if it is issued with a principal purpose of avoiding the application of the Proposed Regulations. Prop. Reg. Section 1.385-3 includes a non-exhaustive list of examples showing the circumstances in which the anti-abuse rule might apply. 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. Tax Alert 2016-632 provides additional information regarding the Proposed Regulations. If finalized in their current form, the Proposed Regulations would dramatically affect a wide range of transactions and ordinary course corporate finance and tax operations. The Proposed Regulations reach well beyond the "corporate inversion" transactions that may have been their primary impetus and would 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, taxable REIT subsidiaries, and for tax-exempt organizations. In many of these situations, every financing of a subsidiary would need to be documented in accordance with the standards set forth in Prop. Reg. Section 1.385-2(b). Otherwise, such "debt" would not be treated as debt for federal income tax purposes. For those systems that meet the definition of an expanded group, the documentation requirements that comprise Prop. Reg. Section 1.385-2 would become an additional administrative and compliance burden. Failure to follow these rules could have significant negative income tax implications. The proposed rules do not apply to corporations included in a consolidated income tax return because there is no need for re-characterization as the income tax consequences are typically eliminated in consolidation. However, the proposed rules will apply to a tax-exempt organization and its related taxable corporations because they cannot join in a consolidated income tax return filing. For example, a tax-exempt member of the expanded group that loans money directly to a taxable subsidiary that is a component member of a consolidated group and does not follow the documentation requirements could be deemed to have additional equity in that taxable subsidiary. This might cause the taxable entity to fail the affiliation requirements for inclusion in a consolidated income tax return. In addition, re-characterization could negatively impact the taxable subsidiary's interest income tax deduction (subject to any possible limitation under IRC Section 163(j)). For a tax-exempt recipient, a re-characterization may actually reduce its unrelated business taxable income (UBTI) due to the fact that dividends and capital gains are generally excluded from UBTI (unless paid with respect to debt-financed property), whereas interest received from a controlled corporation may be subject to taxation pursuant to IRC Section 512(b)(13). The Proposed Regulations contain anti-abuse provisions, indicating that the regulations would not apply if the principle purpose of noncompliance is tax avoidance. This provision could be a trap for the unwary should the IRS not accept an organization's business reasons for a transaction, even if it meets all the documentation requirements. Lastly, the Proposed Regulations should be viewed in light of any individual debt that the organization may have issued, such as employee or physician loans. While not directly applicable to these types of debt transactions, the documentation provisions of the Proposed Regulations provide a guideline that organizations may want to follow in order to substantiate that any loans between the tax-exempt organization and its physicians/employees are bona-fide debt. We understand that the government expects to finalize these regulations quickly. Exempt organizations that are potentially affected by them should take steps now to ensure that they are prepared to comply. Although the Proposed Regulations 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. Exempt organizations should review the documentation related to the debt to determine whether it would pass muster under Prop. Reg. Section 1.385-2(b) and begin considering how to establish that the issuers of those debt instruments have the capacity to pay the interest and principal due thereon. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg
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