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On October 13, 2016, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) released much-anticipated final and temporary debt-equity regulations under Section 385 (TD 9790; collectively, the Final Regulations) which follow the release of extremely controversial proposed regulations by just six months (REG-108060-15; the Proposed Regulations). Like the Proposed Regulations, the Final Regulations establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a domestic corporation to be treated as debt, and they also treat as stock certain related-party interests in a domestic corporation that otherwise would be treated as debt. On the other hand, the extremely controversial and somewhat ambiguous "bifurcation" rule in the Proposed Regulations (which would have implemented the authority granted the IRS in IRC Section 385 to reclassify certain instruments as part debt and part equity) was not included in the Final Regulations. In response to over 200 comment letters, the IRS significantly narrowed the scope from what had been in the Proposed Regulations. Moreover, while focused on the federal income tax consequences of related-party transactions and providing a broad exception for transactions between members of a federal consolidated group, the Final Regulations, like the Proposed Regulations before them, appear to continue to have potentially broad, unexpected and unclear consequences for state income tax purposes.

Please refer to our Tax Alert 2016-1776 (dated October 19, 2016), Final and temporary Section 385 regulations significantly narrow scope of earlier proposed regulations, for detailed information on the Final Regulations. For background on the Proposed Regulations that were released on April 4, 2016, please refer to our Tax Alert 2016-632 (dated April 7, 2016), New Section 385 regulations would treat certain related-party corporate interests as stock, rather than debt, for federal tax purposes, as well as our Tax Alert 2016-0824 (dated May 6, 2016), Proposed IRC Section 385 debt/equity regulations have state income tax implications.

Although the Final Regulations retain much of the general approach of the Proposed Regulations, they also contain numerous and significant modifications. Regardless, it is clear that the Final Regulations represent a significant change in federal tax policy and will affect the realm of state income tax because they affect the determination of the tax base. Consequently, it is important for taxpayers to understand the Final Regulations and quickly consider their possible state income tax implications.

The election of President-elect Donald Trump on November 8, 2016, along with the continued control of both the Senate and the House by Republicans, could increase the odds for federal tax reform that could impact the Final Regulations. Taxpayers should carefully monitor legislative and administrative developments in the coming months for any such changes.

Overview of the Final Regulations

Policy rationale

According to the preamble to the Final Regulations (Preamble) prepared by Treasury, two general policy concerns underlie the new debt-equity rules: 1) the Treasury and the IRS believed that taxpayers were issuing to highly-related persons debt instruments that did not finance new investment in the operations of the borrower and thus, potentially created substantial federal tax benefits without meaningful non-tax significance; and 2) the Treasury and the IRS believed that minimum documentation requirements, prepared timely, were necessary to substantiate a taxpayer's intent to create debt instruments between highly-related parties. The Preamble states that the Final Regulations were intended to address these concerns, while at the same time balancing the burden the Final Regulations would impose on taxpayers. The Treasury and the IRS continued the significant exception from the application of the Final Regulations for transactions among members of the same federal consolidated group, concluding that application of the Final Regulations to such transactions was unnecessary as such transactions were already subject to significant regulation under the intercompany transaction provisions of the federal consolidated return regulations.

Departure from existing law

Prior to the issuance of the Final Regulations, the evaluation and ultimate characterization of related-party debt was the object of a complicated body of case law. The Final Regulations augment existing law by:

— Establishing extensive documentation requirements for "large taxpayer groups"¹ that mandate the preparation and maintenance of specific documentation and information to support certain related-party corporate debt instruments (e.g., loan documents, analyses of the debtor's ability to repay the debt, ongoing payments), and recharacterize those instruments as stock for federal income tax purposes if the rules are not satisfied (the Documentation Rule which is found in Treas. Reg. Section 1.385-2); and

— Recharacterizing certain related-party corporate debt instruments issued after April 4, 2016, as stock (even if the Documentation Rule is satisfied) if the instrument is: (a) issued in one or more of the following "tainted" transactions: (i) in a distribution (such as the payment of a dividend in the form of a note payable), (ii) in an acquisition of expanded group member stock, or (iii) in an internal asset reorganization under IRC Sections 368(a)(1)(A), (C), (D), (F) or (G) (the Transaction Recharacterization Rule); or (b) issued within 36 months before or after engaging in a similar transaction (the Funding Recharacterization Rule, and collectively referred to as the Recharacterization Rules which are found in Treas. Reg. Sections 1.385-3, 1.385-3T and 1.385-4T).²

A welcome change from the Proposed Regulations was the removal of the general "bifurcation" rule authorized by IRC Section 385(a) that would have allowed the IRS to bifurcate an instrument into part debt and part equity based upon an analysis of the relevant facts and circumstances. Instead, the Treasury and the IRS stated in the Preamble that while the bifurcation rule is not included in the Final Regulations, they will continue to study this issue. For state income tax purposes, Treasury's elimination of the bifurcation rule from the Final Regulations may be one of the most beneficial changes from the Proposed Regulations. Armed with the potential independent ability to reclassify debt in seemingly different proportions from the IRS, state income taxpayers could have faced great uncertainty as to how instruments could be classified for state income tax purposes.

In addition, if an interest issued by a disregarded entity is characterized as equity because of noncompliance with the Documentation Rule, the Final Regulations deem the regarded corporate owner of the disregarded entity (and not the disregarded entity itself as under the Proposed Regulations) to issue stock to the formal holder of the interest in the disregarded entity. As the Preamble to the Final Regulations acknowledges, this provision ensures that a disregarded entity would not be treated as a partnership as a result of noncompliance with the Documentation Rule.

New definitions

Four new tax law definitions in the Final Regulations are essential to understanding the application of the rules:

— The Documentation Rule in Treas. Reg. Section 1.385-2 only applies to an expanded group instrument (EGI),³ which is generally defined as a debt instrument (called an "applicable instrument" in the Final Regulations)⁴ in which the issuer and holder are members of the same expanded group.⁵

— The Recharacterization Rules in Treas. Reg. Sections 1.385-3, 1.385-3T and 1.385-4T only apply to a covered debt instrument (CDI),⁶ which is generally defined as a "debt instrument"⁷ issued after April 4, 2016, in which the issuer and holder are members of the same expanded group.⁸

— The Final Regulations limit the present scope of the Documentation Rule and the Recharacterization Rules only to relevant instruments issued by a US domestic corporation. Treas. Reg. Section 1.385-1(c)(2)(i) achieves this result by introducing the new fundamental concept of a "covered member", which is defined as a member of an expanded group that is a domestic corporation. Accordingly, both the Documentation Rule and the Recharacterization Rules apply only to a relevant debt instrument issued by a covered member (or a disregarded entity of a covered member) and held by a member of the covered member's expanded group.⁹

— An expanded group¹⁰ generally includes the corporate members of an "affiliated group" under IRC Section 1504(a) with three key modifications:

1) An expanded group includes foreign corporations, tax-exempt corporations and insurance corporations (entities that are excluded from the definition of an "includible corporation" under IRC Section 1504(b), which is a foundational definition for purposes of determining whether a corporation is a member of a federal affiliated group), while S corporations, non-controlled regulated investments companies (RICs) and non-controlled real estate investment trusts (REITs) are excluded from an expanded group, as are partnerships;

2) The constructive ownership rules of IRC Section 318(a) generally apply for purposes of determining relatedness, subject to certain modifications (which have the effect of preventing brother-sister groups with non-corporate ownership from being treated as an expanded group); and

3) An expanded group includes any of the aforementioned entities if 80% of the vote OR value is owned directly or indirectly by other members of the expanded group (far more expansive than the definition of an "affiliated group," which requires 80% of vote AND value).

Consolidated group exclusion/exception

The Proposed Regulations provided a broad "consolidated group exception" which generally meant that the debt-equity rules under IRC Section 385 would not have applied to related-party debt when the parties were members of the same federal consolidated group. Under the preamble to the Proposed Regulations, Treasury explained that application of the rules to transactions between members of consolidated group were unnecessary since the corresponding interest income and interest expense offset in the consolidated federal income tax return and the consolidated return regulations provided ample protection against the perceived abuses.¹¹ The consolidated group exception applied for purposes of all of the Proposed Regulations, and the IRS described the consolidated group exception as the "one-corporation" approach. The Final Regulations eliminated the broadly applied consolidated group exception contained in Prop. Treas. Reg. Section 1.385-1(e) but has retained the concept, though in different and reduced ways, for both the Documentation Rule and the Recharacterization Rules.

Although the consolidated group exception no longer applies to the Documentation Rule, the Final Regulations now exclude from the crucial term "applicable interest" (defined in Treas. Reg. Section 1.385-2(d)(2)(ii)(A) and which is a foundational element for whether an instrument is an EGI) " … an intercompany obligation as defined in [Treas. Reg. Section] 1.1502-13(g)(2)(ii) or an interest issued by a member of a consolidated group and held by another member of the same consolidated group, but only for the period during which both parties are members of the same consolidated group" (hereafter referred to as the "documentation consolidated group exclusion").¹² This means that intercompany debt between corporate members of the same federal consolidated group continues to fall outside the scope of the Documentation Rule for federal income tax purposes (but also continues to fall under common law principles).

The consolidated group "one-corporation" approach has been modified and now applies only to the Recharacterization Rules as directed in Treas. Reg. Section 1.385-4T (which governs the treatment of federal consolidated groups for purposes of the Recharacterization Rules). Specifically, Treas. Reg. Section 1.385-4T(b)(1) provides that, for purposes of applying the federal consolidated group rules and Recharacterization Rules, "all members of a consolidated group (as defined in [Treas. Reg. Section] 1.1502-1(h)) that file (or that are required to file) a consolidated US federal income tax return are treated as one corporation" (added language emphasized and hereafter referred to as the "recharacterization consolidated group exception"). The Treasury and the IRS made clear in the Preamble that this modification responds to a specific request by a commenter of the state income tax implications of the Proposed Regulations,¹³ stating that "[t]he comment suggested that this concern could be mitigated in states that adhere to the literal language of the [S]ection 385 regulations by modifying [Prop. Reg. Section] 1.385-1(e) to provide that 'all members of a consolidated group (as defined in [Treas. Reg. Section] 1.1502-1(h)) that file (or that are required to file) consolidated US federal income tax returns are treated as one corporation.' The temporary regulations adopt this recommendation."¹⁴

Effective dates

The Final Regulations were published in the Federal Register on October 21, 2016, and they generally apply to taxable years ending on or after January 19, 2017 (which is 90 days after that publication date). Having said that:

— Providing breathing room to taxpayers to prepare, the Documentation Rule applies only to relevant debt instruments issued on or after January 1, 2018, and, perhaps even more significantly, the documentation generally is not required to be completed until the due date of the issuer's return, including extensions, for the tax year that includes the "relevant date" (in many cases, the date of the EGI's issuance). Theoretically, upon extension, that means a calendar year-end taxpayer would not have to have its first documentation in place for an EGI until October 2019 (although, most certainly, all taxpayers would want to begin the process as soon after the January 1, 2018, implementation date as possible, if not before, particularly since these new rules are effectively a "distillation" of historical common law principles.

— The Recharacterization Rules apply to relevant debt instruments issued after April 4, 2016 (thus, debt instruments issued on or before that date do not fall under these new rules). Complicated transition rules provide that CDIs issued after April 4, 2016, and before January 19, 2017, will be recharacterized as stock on January 19, 2017, subject to an anti-abuse rule. Moreover, during that 90-day period following their publication in the Federal Register, any outstanding or otherwise tainted CDIs may be "cured" via repayment, although taxpayers should be aware of the fact that a repayment itself may have implications under the Recharacterization Rules.

Moreover, relevant transactions that could be characterized as debt instruments could easily become subject to the requirements of the Final Regulations in the future through, for example, an entity classification election, a significant modification of the instrument or simply a change in the consolidated group affecting a covered member.

Potential state income tax implications

The Council of State Governments in a release stated that because the federal government views corporate inversions and the practice of earnings stripping as transactions that deprive the US of taxable income, state governments will likely view them as reducing state government revenue as well.¹⁵ When income is stripped out of the US federal tax base, it is also stripped out of the state tax base. (How much generally depends on the structure and nuances of each state's income tax law.)

Since the determination of state taxable income in virtually every state depends, either directly or indirectly, upon the determination of federal taxable income, the Final Regulations will likely affect state income taxation (as would any federal or international tax law change that affects the consolidated federal income tax return). If a state does not, however, strictly apply the documentation consolidated group exclusion under Treas. Reg. Section 1.385-2(d)(2)(ii)(A) or the recharacterization consolidated group exception under Treas. Reg. Section 1.385-4T(b)(1), or if there is a reasonable risk of non-conformity, and these states attempt to apply these rules to purely domestic transactions, the state income tax effect may be much more significant. For example, taxpayers may be obligated to document debt transactions solely for state income tax purposes when they would have no reason to do so for federal income tax purposes because the transactions qualify under the documentation consolidated group exclusion. Similarly, taxpayers may need to avoid certain transactions under the Recharacterization Rules solely for state income tax purposes when they would have no reason to do so for federal income tax purposes because they qualify under the recharacterization consolidated group exception.

Since most separate company reporting states (and some unitary combined reporting states) don't align with the federal consolidated filing group and make it clear that they do not follow the federal consolidated return regulations in any case, it is unclear whether states will recognize that the new definitional exclusion applies to "applicable instruments" for purposes of the Documentation Rule, and it is still unclear whether states will adhere to the one-corporation approach that is embedded in the recharacterization consolidated group exception (even as modified). If the Final Regulations apply to transactions among members of a federal consolidated group solely for state income tax purposes, a variety of potential unintended state consequences may arise, as further described below.

State conformity to the Final Regulations, the documentation consolidated group exclusion and the recharacterization consolidated group exception

All states generally conform to IRC Section 385, directly or indirectly, by either using federal taxable income as the starting point for determining state taxable income or by incorporating by specific reference sections of the Internal Revenue Code. California is an example of the latter. (California incorporates all of Subchapter C of the Internal Revenue Code into its corporation tax law,¹⁶ as well as all final and temporary regulations,¹⁷ although it is in the distinct minority of states that incorporate provisions of the IRC by direct reference.) Since most states simply use the federal determination of taxable income as their starting point for determining state taxable income or adopt the IRC as of a specific or rolling conformity date, determinations by the IRS under IRC Section 385 and the Final Regulations are generally expected to be "baked into" these states' determination of state taxable income. Of course, these are broad generalizations with many variations among the states, and we acknowledge that states might enact statutes or promulgate regulations that adopt, modify or decouple from the Final Regulations.¹⁸

Regardless, the key state income tax issue under the Proposed Regulations was whether states would strictly conform to the consolidated group exception found in Prop. Treas. Reg. Section 1.385-1(e). Similarly, the key state income tax issue under the Final Regulations is whether states will strictly conform to the new documentation consolidated group exclusion under Treas. Reg. Section 1.385-2(d)(2)(ii)(A) and the modified recharacterization consolidated group exception under Treas. Reg. Section 1.385-4T(b)(1). This means that the central issue surrounding the topic of conformity is whether states that do not permit the filing of consolidated returns or that do not explicitly adopt the federal consolidated return regulations will read the documentation consolidated group exclusion and/or the recharacterization consolidated group exception as permitting them to subject transactions among members of a federal consolidated group to the full application of the Final Regulations for state (but not federal) income tax purposes. Given the differences in the makeup of members included in federal and state income tax return groups, this conformity topic creates a variety of interesting questions, including the following:

— If a state strictly follows the documentation consolidated group exclusion under Treas. Reg. Section 1.385-2(d)(2)(ii)(A), does that mean the state will follow the federal rule and not require compliance with the Documentation Rule under Treas. Reg. Section 1.385-2 even if it does not necessarily adopt the federal consolidated group concept?

— Moreover, even if a state determines that it will comply with the documentation consolidated group exclusion, would it affirmatively take steps to decouple from the provisions through statutory, regulatory or related administrative means?

— Alternatively, what if a state determines that the documentation consolidated group exclusion under Treas. Reg. Section 1.385-2(d)(2)(ii)(A) does not apply at all and it is free to apply the rules to all EGIs since it doesn't recognize a federal consolidated group?

— Does non-recognition of the documentation consolidated group exclusion by a state mean that taxpayers in those states would have to comply with all of the documentation and information requirements for all intercompany transactions intended to be characterized as debt even though they are not required to do so for federal income tax purposes since they are covered by the exclusion?

— If a state strictly follows the recharacterization consolidated group exception under Treas. Reg. Section 1.385-4T(b)(1), does that mean the state will follow the federal rule and not require compliance with the Recharacterization Rules under Treas. Reg. Section 1.385-3 even if it does not necessarily adopt the federal consolidated group concept?

— Moreover, even if a state determines that it will comply with the recharacterization consolidated group exception, would it affirmatively take steps to decouple from the provisions through statutory, regulatory or related administrative means?

— Alternatively, what if a state determines that the recharacterization consolidated group exception under Treas. Reg. Section 1.385-4T(b)(1) does not apply at all and it is free to apply the rules to all CDIs since it doesn't recognize a federal consolidated group?

— Does non-recognition of the recharacterization consolidated group exception by a state mean that taxpayers in those states would have to recharacterize certain transactions identified in Treas. Reg. Section 1.385-3 as equity even though they would not be characterized as such for federal income tax purposes because of the exception?

— Could there be differences in the amount of the "expanded group earnings account" that is available for the E&P exception to the Recharacterization Rules for federal and state income tax purposes?

— For purposes of the Recharacterization Rules, will states follow the exclusion for a non-financial member of a "regulated financial group"?

— Since each state's taxing statute is unique and each state is sovereign, does this mean every state could approach the questions above differently such that results could vary widely from state to state?

— Might transactions among members of a unitary combined group be excluded for state income tax purposes even though all of those members are not members of the same federal consolidated group?

— Even though the Final Regulations provide various exclusions and exceptions for S corporations, non-controlled REITs and RICs and certain regulated financial entities, are such exclusions and exceptions available for state income tax purposes if they treat such entities differently under state tax laws (e.g., a state does not recognize an S corporation election and instead treats such an entity as a C corporation for state income tax purposes)?

— Most importantly, do the states have the ability, independent of the IRS, to require taxpayers to comply with the Final Regulations? Can states administer and determine debt-equity matters independently of the IRS?

Unintended consequences?

If the states generally conform to the Final Regulations but don't strictly conform to the documentation consolidated group exclusion and the recharacterization consolidated group exception, or if they attempt to independently apply the Final Regulations, it could create myriad disconcerting state income tax issues, including the following:

— For state income tax purposes, it could create significant cross-equity ownership issues within a federal consolidated group and possibly dilute stock ownership in some members below the 80% threshold required by IRC Section 368(c), thereby creating non-conformity problems in M&A transactions, subsidiary liquidations, distributions (including ineligibility for state dividends received deductions) and internal reorganizations for state tax purposes only. For example, dilution of direct ownership by one corporation because of the recharacterization of debt as stock in the hands of another under the Documentation Rule might result in a limited liability company conversion transaction being disqualified for tax-free treatment under the subsidiary liquidation rules of Section 332 and instead being treated as a taxable liquidation solely for state income tax purposes. In addition, the Funding Recharacterization Rule might be implicated.

— Certain intercompany interest deductions could be disallowed even if they might otherwise qualify for an exception from a state's related-party interest expense addback statute.

— If debt is recharacterized as equity, a parent corporation may no longer have the requisite direct percentage of ownership in a subsidiary to qualify for: (a) a state's dividends received deduction (remember that principal and interest payments are recharacterized as distributions that could be dividends, return of basis or capital gain based on the extent of the E&P and capitalization of the distributing corporation, and those amounts could be different for state income tax purposes than they are for federal income tax purposes); (b) an exception from a state's related-party interest expense addback statute; and/or (c) special entity classification rules.

— Apportionment factors could be impacted to the extent that principal and interest payments are recharacterized as distributions, particularly since interest income oftentimes is included in sales factors while dividends are not.

— If debt is recharacterized as equity, it could impact above-the-line state non-income based taxes, such as equity-based franchise taxes and gross receipts taxes, to the extent such states do not follow GAAP in calculating their tax base and/or apportionment factors.

— Traditional domestic cash management/pooling/sweep arrangements, including non-interest bearing intercompany accounts, could fall under special documentation requirements for purposes of the Documentation Rule.

Practical implications

The Preamble to the Final Regulations indicates that their purpose is to address various concerns over the use of intercompany debt. Many states have already expended considerable effort addressing this issue, as evidenced by related-party interest expense addback legislation, tax haven legislation, transfer pricing and unitary combined reporting that simply do not exist in the context of the federal income tax laws. In addition, some states have already started to react to inversion transactions by proposing punitive non-income tax legislation, such as placing a ban on awarding incentives to inverted companies and prohibiting state pension funds from investing in inverted corporations. Moreover, the states have important policy goals that are furthered by conformity to the federal tax base, including administrative simplification and judicial requirements of fair apportionment and due process. In some cases, these state challenges to intercompany transactions predate the new Final Regulations.

To date, no state taxing authority has issued any official guidance on how it intends to apply these debt-equity rules, neither while in proposed form nor now that they are finalized.¹⁹ In some cases, it could be years before taxpayers find out how a state applies the Final Regulations, or they may not know until they are audited, or they may never know with any high degree of certainty. It is possible that many states will choose conformity with the federal income tax treatment based on automatic ties to federal taxable income and/or ease of administering their tax systems (when conforming to other areas of the IRC). However, states also may attempt, and may have the ability under technical interpretations of the Final Regulations, to apply these new rules based on differences between the federal and state filing groups or selectively to affiliated debt arrangements that they find troubling. Further monitoring of the state responses to the Final Regulations will be required, particularly since many states may need to issue interpretive or implementing regulations.

Regardless of the tax technical merits supporting the arguments for or against general conformity to the Final Regulations, strict conformity to the documentation consolidated group exclusion and/or strict conformity to the recharacterization consolidated group exception, affected taxpayers are encouraged to consider the risks and associated consequences with any potential recharacterizations as stock rather than debt for purported debt instruments that are otherwise exempt from the Final Regulations for federal income tax purposes but may not be exempt for state income tax purposes. Accordingly, in an effort to manage potential state income tax risks and associated consequences with the Final Regulations:

— Documentation: Taxpayers should consider the practical and tax technical merits of meeting the Documentation Rule under Treas. Reg. Section 1.385-2 for relevant debt instruments between members of the federal consolidated group, even if they are not required to for federal income tax purposes, to avoid the risks of states (or the IRS) challenging the debt characterization in the future. As a best practice, this might include implementing necessary changes to cash management and cash pooling arrangements, as well as creating corresponding written master agreements, in an effort to meet the Documentation Rule.

— Tainted transactions: Taxpayers might want to avoid future domestic transactions that would risk being classified as "tainted" transactions under the Transaction Recharacterization Rule, as well as be wary of the Funding Recharacterization Rule, under Treas. Reg. Sections 1.385-3, 1.385-3T and 1.385-4T as if they applied to purely domestic transactions in order to minimize the risk of being recharacterized as debt for state income tax purposes. Consideration should be given to alternative transactions or, at a minimum, the increased risk profile of such transactions should be appreciated and documented.

— Co-obligation: Taxpayers should consider the feasibility of making more domestic entities co-obligated on third-party debt in an effort to reduce reliance on intercompany debt in the future (but specific tax technical issues must be analyzed when considering the potential merits).

— Intercompany account clean-up: Taxpayers should consider cleaning up intercompany balances among members of the federal consolidated group via properly structured and sequenced netting, contributions, distributions and payoffs (but, as noted above, be wary of the Funding Recharacterization Rule).

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ENDNOTES

¹ The documentation requirements under Treas. Reg. Section 1.385-2 apply only if on the date that an "applicable interest" first becomes an "expanded group instrument": (a) the stock of any member of the expanded group (as defined herein) is publicly traded; (b) all or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding $100 million; or (c) the expanded group's financial results are reported on financial statements that reflect annual total revenue over $50 million.

² The Final Regulations expand the earnings and profits (E&P) exception in the Proposed Regulations for purposes of the Recharacterization Rules. Specifically, the Proposed Regulations exempted debt instruments issued in distribution or acquisition transactions described under the Recharacterization Rules to the extent of the issuer's current E&P. The Final Regulations exempt debt instruments issued in distribution or acquisition transactions described under the Recharacterization Rules to the extent of a covered member's "expanded group earnings account" which is generally defined as all E&P accumulated in taxable years ending after April 4, 2016, and derived while the entity was a member of the same expanded group (a federal consolidated group has one expanded group earnings account and only the E&P of the common parent of that consolidated group is considered in calculating the expanded group earnings). Accordingly, a distribution or an acquisition that would otherwise be subject to the Recharacterization Rules is excluded to the extent of the balance in the expanded group earnings account. The expanded group earnings account is reduced based on the order in which the distributions or acquisitions occur, regardless of whether a transaction would otherwise be subject to the Recharacterization Rules. The exception also includes provisions to prevent reuse of E&P. The Treasury and the IRS stated in the Preamble that facilitating the exception through a building account eliminates the "use it or lose it" characteristic of the exception in the Proposed Regulations.

³ Treas. Reg. Section 1.385-2(d)(3) (defining "expanded group instrument" or "EGI").

⁴ Treas. Reg. Section 1.385-2(d)(2) (generally defining "applicable interest" as "any interest that is issued or deemed issued in the legal form of a debt instrument", as well as an "intercompany payable and receivable documented as debt in a ledger, accounting system, open account intercompany debt ledger, trade payable, journal entry or similar arrangement if no written legal instrument or written legal arrangement governs the legal treatment of such payable and receivable"). Note, however, that Treas. Reg. Section 1.385-2(c)(3) clarifies the ability of expanded group members to satisfy the requirements of the Documentation Rule for EGIs issued under revolving credit agreements, cash pooling arrangements and other similar arrangements by establishing overall legal documents governing the arrangement. If an EGI is issued under such an arrangement, the reasonable-expectation-of-repayment documentation requirement must be met at least annually. Also note that the Documentation Rule may now apply to notional pooling arrangements to the extent a notional cash pool provider operates as an intermediary. This will require taxpayers to undertake a separate analysis of any notional pools with US participants.

⁵ The Final Regulations clarify the application of the Documentation Rule to certain interests issued by regulated financial services entities and insurance companies that are required by regulators to include particular terms.

⁶ Treas. Reg. Section 1.385-3(g)(3) (defining "covered debt instrument" or "CDI"). Note, however, that Treas. Reg. Section 1.385-3(b)(3)(i) specifically excludes a "qualified short-term debt instrument" from the application of the Funding Recharacterization Rule which, according to Treas. Reg. Sections 1.385-3(b)(3)(vii) and 1.385-3T(b)(3)(vii), generally includes certain cash pooling and cash management arrangements, as well as certain advances that finance short-term liquidity needs and ordinary-course transactions."

⁷ Treas. Reg. Section 1.385-3(g)(4) (generally defining "debt instrument" as "an interest that would, but for the application of [the Recharacterization Rules], be treated as a debt instrument as defined in [IRC] [S]ection 1275(a) and [Treas. Reg. Section] 1.1275-1(d), provided that the interest is not recharacterized as stock under [the Documentation Rule])."

⁸ The Recharacterization Rules generally do not apply to a CDI issued by a "regulated financial company" (including a member of a "regulated financial group") or a "regulated insurance company", all as defined under the Final Regulations.

⁹ See Treas. Reg. Sections 1.385-3(b)(2) and 1.385-3(b)(3)(i), respectively.

¹⁰ Treas. Reg. Section 1.385-1(c)(4) (defining "expanded group").

¹¹ Prop. Treas. Reg. Section 1.385-1(e) specifically provided: "Treatment of consolidated groups. For purposes of the regulations under [IRC] [S]ection 385, all members of a consolidated group (as defined in [Treas. Reg. Section] 1.1502-1(h)) are treated as one corporation." See also the preamble to the Proposed Regulations ("Nonetheless, the Treasury Department and the IRS also have determined that the [P]roposed [R]egulations should not apply to issuances of interests and related transactions among members of a consolidated group because the concerns addressed in the [P]roposed [R]egulations generally are not present when the issuer's deduction for interest expense and the holder's corresponding interest income offset on the group's consolidated federal income tax return."). Treas. Reg. Section 1.1502-1(h) provides that "[t]he term 'consolidated group' means a group filing (or required to file) consolidated returns for the tax year." Treas. Reg. Section 1.1502-1(a) provides that "[t]he term 'group' means an affiliated group of corporations as defined in [IRC Section] 1504."

¹² Interestingly, there is no definition of "consolidated group" for purposes of Documentation Rule under Treas. Reg. Section 1.385-2. The only definition for "consolidated group" is found in Treas. Reg. Section 1.385-3(g)(2) which indicates that the term has the meaning specified in Treas. Reg. Section 1.1502-1(h), and this definition applies for purposes of the Recharacterization Rules. Despite this oversight, it would be difficult to impute a definition other than that in Treas. Reg. Section 1.1502-1(h), particularly when well established cannons of statutory construction would look to adjoining sections of statutes and regulations for definition when one isn't otherwise provided.

¹³ In the Preamble, the Treasury and the IRS acknowledged receiving state and local tax comments regarding the Proposed Regulations and indicated "[c]omments noted that the [Proposed Regulations] add complexity to state and local tax systems and may result in additional state tax costs and compliance burdens for taxpayers. In particular, a comment noted that, if a state applies the one-corporation rule based on the composition of the state filing group rather than the federal consolidated group, transactions could be subject to the regulations for state income tax purposes even when the transactions are not subject to the regulations for federal income tax purposes."

¹⁴ Another important change from the Proposed Regulations is that the Final Regulations provide ordering rules in applying the recharacterization consolidated group exception. A taxpayer is first required to determine the characterization of the transaction under federal tax law without regard to the exception, and then the taxpayer has the option of applying the exception to the transaction to determine whether to treat the CDI as stock. That means that taxpayers are required to first determine whether the transaction is one that runs afoul of the Recharacterization Rules regardless of whether the recharacterization consolidated group exception applies.

¹⁵ Stockdale, Jerry, The Council on State Governments, New Treasury Rules Could Affect Federal and State Tax Revenue, April 18, 2016 (available on the Internet here (last accessed Nov. 8, 2016)).

¹⁶ See Cal. Rev. & Tax Code Section 24451.

¹⁷ Id. Section 23051.5(d) ("Internal Revenue Code"; Applicability of code and regulations to part; Definitions and terminology).

¹⁸ Moreover, some have theorized that since IRC Section 385 grants legislative rulemaking authority to the IRS, courts may conclude that the Final Regulations are not even part of the interpretative rules of the IRC and thus, inapplicable for state income tax purposes. See Faber, Peter L., SALT Implications of Final Section 385 Debt-Equity Regulations, Oct. 26, 2016 (available on the website of McDermott Will & Emery here (last accessed on Nov. 8, 2016)). ("Will states that generally conform to the [IRC] be required to adopt the [F]inal [R]egulations or their principles? Although the [F]inal [R]egulations have been adopted pursuant to a statutory mandate, they are not part of the [IRC]. While regulations adopted pursuant to a statutory authorization are entitled to greater deference than normal interpretative regulations, they are not part of the law and are subject to judicial review.")

¹⁹ It is interesting to note that at the Multistate Tax Commission's annual meeting in Kansas City in late July 2016, a number of representatives of the state tax authorities began to discuss the Proposed Regulations, and several informally concluded that states should be able to apply the substantive provisions of the Proposed Regulations in cases when the IRS has not applied them due to the consolidated group exception. See Hamilton, Amy, MTC Counsel Discusses State Tax Implications of IRS Debt-Equity Rules, 81 State Tax Notes 335 (July 27, 2016). ("States should be able to apply the substantive provisions of the IRS's proposed debt-equity rules in cases when the IRS has not made an adjustment due to the federal consolidated group exception, Multistate Tax Commission Counsel Bruce Fort said at a July 26 Uniformity Committee public session in Kansas City, Missouri.")