Executive summary

On Thursday, October 13, the Treasury Department and IRS released final and temporary regulations under Section 385 (the Final and Temporary Regulations). Had they been finalized as originally released, the proposed regulations under Section 385, issued on April 4, 2016 (the Proposed Regulations), would have caused a significant departure from decades of debt-equity case law in related-party contexts and imposed an extraordinary compliance burden. The Final and Temporary Regulations have scaled back many of the provisions of the Proposed Regulations and provided a variety of exceptions for financial services companies, but they will still impose a significant compliance burden on some taxpayers and limit certain common tax-planning strategies by companies outside the financial services industry.

The first important effective date will likely be January 19, 2017. To the extent that taxpayers have any debt instruments negatively affected by the "transactional rules" (described below) that were issued after April 4, 2016, inaction will cause those instruments to be recast into equity as of that date. A summary of several key exceptions and effective dates is contained in Appendix A.

On balance, the changes made in the Final and Temporary Regulations should provide significant relief for financial services companies compared to the rules contained in the Proposed Regulations. The exception granted in the Final and Temporary Regulations for debt instruments issued by foreign entities (applicable to both the documentation requirements contained in Treas. Reg. Section 1.385-2 and the so-called tainted transaction rules (the Transactional Rules) contained in Treas. Reg. Section 1.385-3) significantly limits scope of the potential application of the regulations for US-headquartered financial services companies. As a result, in many instances the Final and Temporary Regulations will have a greater effect on non-US headquartered multinationals. More generally, particularly as it relates to the Transactional Rules contained in Treas. Reg. Section 1.385-3, specific exceptions granted for regulated financial services companies provide welcome relief from the Proposed Regulations.

Significant scope changes (in general)

In perhaps the most broad-reaching change from the Proposed Regulations, the Final and Temporary Regulations apply only to debt instruments issued by US borrowers; the application to non-US issuers has been reserved for both the documentation requirements and the Transactional Rules. The US consolidated group exception has been modified but maintained. These changes significantly reduce the effect of the Final and Temporary Regulations, although it does not fully neutralize them. The regulations are structurally designed such that Treasury and IRS could bring debt instruments issued by foreign borrowers within the scope in the future, so this will continue to be an item that bears monitoring.

The Final and Temporary Regulations removed the IRS's ability to bifurcate a debt instrument and treat it in part as equity and in part as debt. The Proposed Regulations' bifurcation provision departed from the historic "all-or-nothing" approach to characterizing a purported debt instrument as either debt or equity.

The Final and Temporary Regulations will apply when a US corporation issues debt to a holder outside of its US consolidated group (e.g., trade payables to non-US subsidiaries, Section 956 loans from subsidiaries, obligations of US subsidiaries owed to non-US parent and brother-sister affiliates, instruments between US entities that are not part of the same consolidated group, debts between private investment funds that share a corporate owner).

S corporations and non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs) are exempt from all aspects of the Final and Temporary Regulations. (For additional discussion of the S corporation exemption, see Tax Alert 2016-1763.)

The application of the Final and Temporary Regulations at a state level to debt instruments within a US consolidated federal tax group is still an area of uncertainty and should be considered. Treasury specifically acknowledged the state and local income tax implications of the Proposed Regulations. The modification to the documentation requirements appears to respond to these same state and local income tax concerns. It does not appear, however, that Treasury has alleviated the potential that the new rules may apply much more broadly for state and local income tax purposes than for federal income tax purposes.

Effective date

The Final and Temporary Regulations generally apply to tax years ending on or after 90 days after the date the Final and Temporary Regulations are published in the Federal Register (scheduled for October 21, 2016). The Transactional Rules apply to debt issued after April 4, 2016; the effects of any recast will not occur until 90 days after the Final and Temporary Regulations are published in the Federal Register. The documentation requirements only apply to related-party debt issued on or after January 1, 2018.

Documentation requirements (Treas. Reg. Section 1.385-2)

The documentation requirements do not include any broad exceptions specifically for financial services companies. However, with the retention of the exclusion for instruments within a US federal consolidated group and the exception for debt instruments issued by foreign borrowers, financial services companies should be similarly positioned with respect to other multinational companies relative to the documentation requirements.

Financial services companies, particularly those headquartered outside the United States, could still face significant administrative burden in complying with the documentation requirements when specific exceptions do not apply.

The Final and Temporary regulations contained a number of important changes to the documentation requirements, which include the following:

— The Final and Temporary Regulations relax the 30-day and 120-day requirement and instead require documentation to be in place by the due date (including extensions) of the issuer's US tax return. Combined with the January 1, 2018 date indicated earlier, this means that the documentation requirements first need to be satisfied for any debts issued on or after January 1, 2018, at the time of filing the tax return for the first tax year ending after January 1, 2018. In addition, the Final and Temporary Regulations provide limited remedies for taxpayers that issue instruments that fail one or more of the documentation requirements (e.g., a rebuttable presumption of equity characterization for instruments issued by members of expanded groups that are "highly compliant" with rules, based on specific numerical thresholds).

— The Final and Temporary Regulations contain more clarity than the Proposed Regulations as to how the requirements can be satisfied for cash pooling, revolving credit facilities, and intercompany deposits with a related-party bank through the use of master / umbrella agreements with annual testing of the borrowers' debt capacity, rather than at the time each draw is made.

— The Final and Temporary Regulations confirm that documentation of a kind customarily used in comparable third-party transactions is generally sufficient to satisfy the requirements for written documentation of an unconditional obligation to pay a determinable sum certain and evidence of creditor's rights.

— The Final and Temporary Regulations clarify the interaction of the documentation requirements with Treas. Reg. Section 1.1001-3, and the instances when and how, the documentation requirements are to be satisfied on the modification of debts.

— While the documentation requirements in the Final and Temporary Regulations do not include a blanket exclusion for debt issued by regulated entities, provisions in certain instruments issued by a regulated financial company or a regulated insurance company (as defined in the Final and Temporary Regulations) that may be required by regulators for such instruments to qualify as regulatory capital will not cause an instrument to fail the documentation requirements. This is favorable for certain Tier 1 and 2 capital instruments (when they otherwise qualify as debt for US tax purposes), as well as surplus notes of US insurance companies.

— Reinsurance is not subject to the documentation requirements because it is not debt in legal form.

Transactional Rules (Treas. Reg. Section 1.385-3)

The Proposed Regulations contained rules on distributions of debt instruments and other similar so-called tainted transactions that, under the Proposed Regulations, would be recharacterized as equity for US tax purposes. They also contained broad provisions treating debt viewed as funding any such transactions as per se equity. These provisions of the Final and Temporary Regulations will apply to any debt instrument issued after April 4, 2016, although any such recast will not occur unless and until the instrument remains outstanding 90 days after the regulations are published in the Federal Register.

The most significant development for financial services companies is that the Final and Temporary regulations include a broad exception to the Transactional Rules for instruments issued by (as opposed to held by) "regulated financial companies." These companies include a bank, bank holding company, non-bank financial company, US International Holding Company of a foreign bank, Edge Act corporation, broker/dealer and swap dealer, as each of these entity types is defined by the applicable regulatory rules cited in the Final and Temporary Regulations.

In addition, all subsidiaries of a regulated financial company (except for subsidiaries of a bank holding company held under the complementary activities authority, merchant banking authority, or grandfathered commodities activities authority provided by Sections 4(k)(1)(B), 4(k)(4)(H), and 4(o) of the Bank Holding Company Act, respectively) are treated as part of the bank holding company's or savings and loan holding company's regulated financial group. Thus, these non-financial companies will continue to be subject to the Transactional Rules unless another exception applies (e.g., the foreign issuer exception). Non-bank subsidiaries that engage in "activities that are financial in nature" generally can qualify for the exception. Among others, such activities include:

— Lending, exchanging, transferring, investing for others, or safeguarding money or securities

— Insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death, or providing and issuing annuities, and acting as principal, agent, or broker for purposes of the foregoing, in any state

— Providing financial, investment or economic advisory services, including advising an investment company

— Issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly

— Underwriting, dealing in, or making a market in securities

On the other hand, subsidiaries engaged in activities that are "complementary" to financial activities cannot qualify for the exception. Service companies would generally fall into this category and would be subject to the Transactional Rules absent another exception. Merchant banking investments and activities are described in 12 USC 1843(k)(4)(H) and generally include undertakings such as holding investment interests of securities or other private equity investment endeavors. Finally, bank holding companies with subsidiaries permitted to undertake commodities sales and trading activities under 12 USC 1843(o) would also be subject to the Transactional Rules. Furthermore, debt issued by a regulated insurance company is also exempt from the Transactional Rules, but the issuer must itself qualify as a regulated insurance company that is licensed to transact third-party business.

As a result, significant relief has been afforded to multinational banks in that most of the entities within their structure are financial in nature and subsidiaries of a bank holding company, thereby excepting them from the Transactional Rules. In some instances, however, the regulations will have a greater effect on non-US headquartered multinationals than US headquartered ones given the different ways US and non-US companies raise funding.

In addition, the regulations may affect banks with investment banking and diversified investing models more adversely than those with traditional operating models / revenue streams given the exceptions from the "regulated financial group" definition.

Other important aspects of the Regulations include:

— The Final and Temporary Regulations retain the 72-month per se "funding rule," along with a principal purpose test for events that occur outside the 72-month period. The funding rule that is part of the Transactional Rules provides for equity recharacterization of a related-party debt instrument if the US issuer enters into a tainted transaction (e.g., a distribution) in the 72-month period beginning three years before the date the debt is issued (but not earlier than April 5, 2016).

— A general exclusion of certain cash pooling and cash management arrangements under the Transactional Rules is included in the Final and Temporary Regulations as well as certain advances that finance short-term liquidity needs. The rules include "similar agreements" in this exclusion and should presumably include deposits with a bank that resides within the structure, as well as cash sweeps among affiliates of a financial services company.

The exception is intended to exclude covered debt instruments 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. The short-term exception may be available for: (1) debt instruments with terms of 270 days or less; (2) debt issued as consideration for property other than money in the ordinary course of the issuer's trade or business; (3) interest-free loans; and (4) deposits with a cash pool header. Each of these exceptions has restrictions that should be carefully considered.

— The Final and Temporary Regulations expand the current year earnings and profits (E&P) exception that was included in the Proposed Regulations to include all of a corporation's E&P that was accumulated after April 4, 2016, and derived while the entity was a member of the same expanded group. There are many details on how the E&P exception applies, including provisions to prevent pre-April 5, 2016 earnings from qualifying for the E&P exception when it is distributed to higher-tier entities.

— The Final and Temporary Regulations remove the "cliff effect" of the $50 million threshold by generally providing for an exception for the first $50 million of indebtedness that would otherwise be recharacterized.

— Under the Final and Temporary Regulations, certain contributions of property can be netted against distributions and transactions with similar economic effect. In this regard, the regulations allow a taxpayer to reduce the amount of its distributions and acquisitions that otherwise could cause an equal amount of the taxpayer's debt to be recharacterized as equity by the amount of the contributions to the taxpayer's capital. This effectively treats distributions and acquisitions as funded by new equity contributions before related-party borrowings and ensuring that companies that have not seen a reduction in net equity are not subject to the rules.

— The Final and Temporary Regulations provide an exclusion from the acquisition of the expanded group stock rule and funding corollary to the extent the acquired expanded group stock is delivered to individuals in consideration for services rendered to any member of the issuer's expanded group as an employee, a director or an independent contractor. This exclusion applies to an acquisition of expanded group stock regardless of whether the acquisition is in exchange for actual property or deemed property under Treas. Reg. Section 1.1032-3(b).

— The 90-day transition rule included in the Proposed Regulations allowing taxpayers to unwind any post-April 4, 2016 debt that could be recharacterized under these provisions has been retained, though the transition rule is expanded slightly to (i) allow for unwind of debt issued after 90 days following the date the regulations are published in the Federal Register and (ii) recharacterize "tainted" debt that remains outstanding only after the end of the 90-day period.

— The Final and Temporary Regulations narrow the application of the funding rule by preventing, in certain circumstances, the so-called cascading consequence of recharacterizing a debt instrument as stock. This would have arisen, for example, when the recharacterization of a debt instrument as stock was itself treated as an acquisition of expanded group stock for purposes of the funding rule.

— Reinsurance is not subject to the Transactional Rules because it does not constitute "indebtedness" within the meaning of Section 1275. For similar reasons, insurance transactions should not be subject to the documentation requirements.

Key implications and considerations

Although regulated financial companies are excepted from the Transactional Rules of Treas. Reg. Section 1.385-3, they are not excepted from the documentation requirements of Treas. Reg. Section 1.385-2. There are a number of other rules that differ in their application between -2 and -3, and care should be given before concluding that a debt instrument is fully outside the scope of the Final and Temporary Regulations.

The documentation requirements could still place a significant administrative burden on financial services companies. In addition, taxpayers will need to account for a separate calculation of relevant expanded group members' post-April 4, 2016 E&P, as noted.

The documentation requirements (-2) and Transactional Rules (-3) are now consistent in that recharacterization of a debt instrument issued by a disregarded entity is considered an equity interest in the regarded parent rather than in the disregarded entity itself. Previously, under the Proposed Regulations, recharacterization of a debt instrument issued by a disregarded entity due to failure to comply with the documentation requirement resulted in a deemed equity interest in the disregarded entity, which could have effectively converted the disregarded entity into a partnership for US tax purposes. Debt recharacterized as stock under the documentation requirements, however, is considered in determining whether the issuer remains part of a consolidated group, whereas debt recharacterized under the Transactional Rules is not.

The documentation requirements only apply to instruments that are debt in form, while the Transactional Rules apply to instruments that are treated as debt for US tax purposes (such as repos and finance leases).

The Final and Temporary Regulations do not adopt special rules for debt instruments used by investment partnerships, including indebtedness issued by certain "blocker" entities.

Under the Final and Temporary Regulations, for purposes of the expanded group definition, any vote held by an investment advisor, or an entity related to the investment advisor, should not be ignored. Because a common investment manager controls voting interest in a group of investment funds, such funds may be part of an expanded group. To the extent that an investment advisor and its investment funds constitute an expanded group, intercompany financing transitions among such parties are subject to the Final and Temporary Regulations.

Treasury declined to provide the insurance industry with relief when a newly acquired life insurance subsidiary cannot join a consolidated group under the life-nonlife rules of Section 1504(c)(2). Therefore, these insurance companies will need to rely on other exceptions.

Recommended next steps

To better understand the effect of the Section 385 Regulations on your business, we recommend the following approach:

— Immediately assess whether there are any debt instruments that could be recharacterized under the Transactional Rules as of January 19, 2017.

— Explore processes and compliance solutions to monitor debt instruments that are not exempt from the Final and Temporary Regulations.

— Begin engaging with internal stakeholders affected by the Section 385 Regulations.

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ATTACHMENT

Overview of exceptions and effective dates for Section 385 Final and Temporary Regulations