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Spotlight

To the relief of many, the final and temporary Section 385 regulations released on 13 October are not as far-reaching as those originally issued in proposed form last April, significantly narrowing the universe of debt instruments subject to the Documentation Rule and the Recharacterization Rule. The effective date and applicability date were also eased in that the Documentation Rule applies only to debt instruments issued after 1 January 2018, and the Recharacterization Rule applies only to tax years ending in or after January 2017 and only to instruments issued on or after 5 April 2016. An ITS Alert provides an in-depth analysis of the recent guidance.

For now, at least for US federal tax purposes, the Documentation Rule and the Recharacterization Rule will apply only to debt issued by US corporations to expanded group members that are not part of the same US federal consolidated group. However, the US state and local income tax implications of these rules will need to be considered.

Regarding the Documentation Rule, the documentation preparation deadlines were extended. In the proposed regulations, documents were required to be prepared within 30 days (in some cases, 120 days) after the debt instrument was issued; now, documents are not required until the deadline, including extensions, that the tax return is due. Because of the delayed applicability date and the extension of the documentation preparation deadlines, taxpayers will have until the filing date of their US federal tax return for the tax year that includes 1 January 2018, to complete the Documentation Rule for the first time. Notwithstanding this extended period, the compliance burden for covered issuers remains substantial. Term loans, demand loans, cash pools (now including at least certain notional pools), trade payables and open accounts remain subject to the Documentation Rule.

Despite the reduced scope, the final Documentation Rule will require affected taxpayers to incur substantial investments associated with initial startup and infrastructure investment, as well as ongoing compliance with the regulations. In addition, the Treasury and the IRS reiterated their belief that the Documentation Rule distills the "best documentation practices under case law." This may presage additional IRS scrutiny of related-party debt instruments that are not literally subject to those rules under the final regulations. Therefore, taxpayers should take steps now to ensure that their intercompany financing, payables, and cash management processes and procedures will enable full compliance with the Documentation Rule.

Because of the generally taxpayer-favorable changes in the final regulations, the Recharacterization Rule will apply to fewer issuers, fewer transactions and fewer debt instruments. The final regulations will, however, significantly affect groups, such as foreign-based multinationals with a substantial US presence, in which domestic corporations issue debt instruments to expanded group members that are foreign or otherwise do not file a consolidated federal income tax return with the issuer.

While there are numerous exceptions to the Recharacterization Rule under Reg. Section 1.385-3, the onus will be on taxpayers to "prove out" that any particular distribution or acquisition within an expanded group qualifies for the particular claimed exception (e.g., that a covered member has sufficient expanded group earnings or qualified contributions, or that a debt instrument in question is a qualified short-term debt instrument).

The Recharacterization Rule will undoubtedly apply in unanticipated circumstances, so taxpayers are advised to consider the Recharacterization Rule — and the final regulations generally — in connection with all transactions involving debt instruments held by expanded group members, especially when corporations join an expanded group (bringing their acquisition and distribution history with them) and when the expanded group is headed by a non-US common parent. Taxpayers should take steps now both to inventory their debt instruments to determine whether any would be subject to the Recharacterization Rule and to put in place safeguards to ensure missteps do not occur.

Taxpayers should consider taking the following actions:

 — Inventory affected debt instruments and assess instruments subject to the Recharacterization Rule.

 — Remediate affected instruments while establishing policies and procedures to track and comply with the Recharacterization Rule.

 — Determine and, as appropriate, institute systems and procedures to comply with the Documentation Rule. For entities that are not subject to the Documentation Rule (e.g., foreign corporations), consider whether existing systems and procedures are sufficient given the US government's belief that the Documentation Rule distills the "best documentation practices under case law."

 — Analyze the potential US state and local income tax effects of both the Recharacterization Rule and the Documentation Rule to instruments issued solely within US federal consolidated groups.

 — Assess alternative strategies (legal entity, lending and pooling structures) with planned transactions. Taxpayers will need to ensure that their strategies also align with other broad-based government initiatives, such as OECD BEPS and UK anti-hybrid rules.

 — Drive multi-functional involvement (Tax, Treasury, Accounting, IT, M&A and Operations) to coordinate procedures in complying with the new requirements.

Government officials this week offered some insights into the final regulations package. A Treasury official addressed the fact that the newly-released regulations reserve in their application to foreign issuers. The official was quoted as saying that the government remains concerned about indebtedness issued by foreign issuers — including in regard to repatriation — and the area will be further reviewed. The preamble to the final and temporary regulations provides — and the government reiterated — that any new guidance in the area will be prospective.

The final and temporary regulations also reserved on the expanded group treatment of brother-sister groups with noncorporate owners, including investment funds treated as partnerships for US tax purposes. According to the official, while the concern remains, the government determined that addressing this issue at this time would have added too much additional complexity to the rules.

An IRS official also addressed the elimination of the controversial bifurcation rule in the proposed regulations from the final rules. The preamble to the final regulations notes that the government will continue to study the issue, and the IRS official confirmed it remains an active area. The official said the government originally proposed the bifurcation rule to address what it saw as over-leverage, in which debt was being issued with no realistic ability to repay the debt.

Moving forward, an IRS official this week said that with the release of the final Section 385 regulations, the government will now focus on cross-border intangible property transfers under Section 721 for partnerships, and Section 367 for corporations. The official let on that taxpayers should expect more flexibility in the pending Section 721 guidance than the Service originally let on in IRS Notice 2015-54.

Notice 2015-54 announced the government's intention to treat certain contributions of intangible property to partnerships as taxable transactions, notwithstanding the general rule that contributions of property to partnerships are nontaxable under Section 721(a). The Notice stated that these regulations will apply to transfers occurring on or after 6 August 2015, as well as to transfers treated as occurring before 6 August 2015, resulting from check-the-box elections that are filed on or after, but are effective on or before, that date.

Finally, the IRS on 14 October (IR-2016-133) announced that US taxpayers seeking unilateral advance pricing agreements (APAs) with Mexico for their maquiladora operations will not be exposed to double taxation as long as the intercompany pricing is under the framework to which the US and Mexican competent authorities have agreed in advance. An ITS Alert provides details.

The OECD announced on 20 October that, in furtherance of the Common Reporting Standard (CRS), there are now over 1,000 bilateral relationships in place to provide for the automatic exchange of financial information beginning in 2017. Most of the relationships are based on the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information. According to the OECD, 101 jurisdictions have now agreed to begin the automatic exchange of financial account information in September 2017 and 2018 under the CRS.

The OECD this week also released key documents that will form the basis of the Mutual Agreement Procedure (MAP) peer review and monitoring process under BEPS Action 14. Action 14 calls for effective dispute resolution mechanisms to resolve tax treaty-related disputes.