Companies (foreign and domestic) should begin identifying their debt issued to related parties that could be affected by proposed regulations under Section 385.¹ If finalized as proposed, the regulations could result in certain related party debt being treated as equity for US federal income tax purposes. The issues are complex, and the final regulations could be published soon. While still unclear what the final regulations may say (e.g., whether the regulations will be approved in their proposed form or whether significant changes will be made), companies should not delay in taking inventory of their related party interests.

The proposed regulations would establish extensive threshold documentation and information requirements for certain related party interests in a corporation to qualify for possible debt treatment for US federal tax purposes. Satisfying these requirements does not guarantee debt treatment, but if those documentation requirements are not met, the regulations would:

— Treat as stock certain related party interests that are now treated as debt for US federal tax purposes
— Authorize the IRS to split certain related party interests into part stock and part debt for US federal tax purposes

The proposed rules could have far-reaching implications for companies that issued debt to related parties, including eliminating or reducing interest expense deductions, triggering US withholding tax obligations and increasing US taxation of overseas earnings. As proposed, there would be limited windows of opportunity for companies to establish the required documentation thresholds and/or take other actions to solidify debt treatment.

Key considerations

The proposed regulations would generally be effective when they are finalized and approved, but if finalized as proposed, some provisions could apply to debt instruments issued on or after April 4, 2016. Companies should begin identifying the population of related party interests that may need to be evaluated if and when the regulations are finalized.

Income tax accounting considerations

The proposed regulations would not change the financial reporting basis under US GAAP of related party interests. However, the proposed regulations may change the US federal tax treatment of related party interests. Once published, companies should consider the possible accounting and financial reporting effects of any change in the US federal tax treatment on their related party interests due to the final regulations. Examples of potential changes may include:

— A company may see a change in its calculation of taxable earnings. For example, a US company that has historically deducted interest paid on debt issued to a related party would no longer be able to do so if that debt is recharacterized as equity.
— A company may identify uncertain tax positions for related party interests if the related party interests could be recharacterized as equity. When final regulations are published, a company would consider whether the classification of its related party interests as debt or equity constitutes an uncertain tax position, and if so, account for such positions accordingly. Uncertain tax positions related to intercompany interests are recognized and measured the same way as other uncertain tax positions. That is, they are recognized when a company concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination by the relevant taxing authority. Only tax positions that meet the more-likely-than-not threshold for recognition should be measured within the financial statements. A recognized tax position is measured at the largest amount of benefit that is more likely than not (determined by cumulative probability) of being realized upon ultimate settlement with the taxing authority.

Internal control considerations

If the regulations are finalized as proposed, companies will have to have processes and controls in place to properly identify, evaluate and account for the matters noted above. For example, management should have processes and controls in place to identify and assess the impact of related party interests, including related party debt arrangements. Management's controls will need to assess the terms of the arrangements and determine whether the company has or will be able to comply with proposed documentation requirements within the required timeframe. Due to the US federal tax technical issues involved, management might consider implementing controls consisting of several levels of review, including the company's treasury department and outside experts.

Implications

Due to the complexity of the issues involved and the likely short timeframe before the regulations are finalized, companies should take the following steps to review their related party interests as soon as practicable:

— Identify population of related party interests and gather existing documentation
— If finalized, develop processes and precise controls to evaluate the terms of the related party interests
— If finalized, assess the accounting implications of debt that would be recharacterized to equity

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RELATED RESOURCES

— For more information about EY's Tax Accounting services, visit us at www.ey.com/US/TaxAccounting
— For more information about EY's Tax Accounting University education program for clients, visit us at www.ey.com/TAU

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ENDNOTES

¹    Prop. Treas. Reg. Sections 1.385-1 through 1.385-4, REG-108060-15.