November 30, 2016 Final Section 385 regulations will affect tax-exempt organizations Executive summary On October 13, 2016, the Internal Revenue Service (IRS) and the Treasury Department (Treasury) released the highly anticipated final and temporary regulations under Section 385 (collectively, the Final Regulations) on the classification of certain intercompany loans as debt or equity for federal income tax purposes. The Final Regulations were published in the Federal Register on October 21, 2016. Several comments received by Treasury during the comment period to the proposed regulations (Proposed Regulations) that were issued in April 2016 specifically requested exceptions for corporations exempt from taxation under Section 501. The Final Regulations did not adopt the recommendation to exclude tax-exempt corporations from the scope of the rules. The Final Regulations apply to tax-exempt organizations and will significantly affect a wide range of ordinary course business and financing transactions. Tax-exempt organizations interested in ensuring the treatment of related-party indebtedness as debt versus that of stock will need to satisfy the regulations' extensive documentation requirements of the Final Regulations. Failure to properly follow the documentation requirements could result in significant tax implications to the tax-exempt organizations or their affiliates. The general rules surrounding the Final Regulations and their applicability to tax-exempt corporations are discussed in detail below. Overview When Congress enacted Section 385 in 1969, it authorized Treasury to establish rules indicating whether an interest in a corporation is to be treated for purposes of the Internal Revenue Code as stock or debt (or as part stock and part debt) by setting forth factors to be taken into account as applied to particular factual situations. The Final Regulations represent the IRS and Treasury's latest effort to provide guidance under such authority. Like the Proposed Regulations, the Final Regulations establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as debt for federal tax purposes, and they also treat as stock certain related-party interests that otherwise would be treated as debt for federal tax purposes. According to the preamble to the Final Regulations (Preamble) prepared by Treasury, two general policy concerns serve as the underpinnings for the new debt-equity rules. First, Treasury and the IRS believe that related parties do not have the same commercial incentives as exist with unrelated parties to properly document their interests in one another. This makes it difficult to determine whether a debtor-creditor relationship is truly present. From a tax perspective, because debt, as opposed to equity, creates the possibility of tax deductible interest expense, a taxpayer has significant tax incentive to characterize an interest in a related corporation as debt. For related parties, such tax motivations may be more important than the commercial consequences of such characterization. Consequently, the Final Regulations were considered necessary to impose minimum documentation requirements for certain "highly-related" taxpayers to substantiate their intent to create a debt instrument and to ensure that their conduct throughout the term of the loan transaction is consistent with a debtor-creditor relationship. Secondly, Treasury and the IRS believe that distribution of a note or issuance of a purported debt instrument by a corporation to a controlling shareholder (or a person related to a controlling shareholder), followed by a distribution of the proceeds to a controlling shareholder, raise their own concerns. Such transactions have potential to create significant tax benefits, but do not carry meaningful non-tax significance (e.g., they do not finance new investment in the operations of the borrower). Consequently, rules are necessary to deal with such situations that involve highly-related parties to establish that the interest is treated as equity rather than as debt. Prior to the issuance of the Final Regulations, the characterization of related-party debt was largely covered by a complicated body of case law. The Final Regulations supplement existing law by: — Creating significant documentation requirements for certain taxpayers (the Documentation Rule). The Documentation Rule mandates that particular documentation and information be present to support certain related-party corporate debt instruments. It re-characterizes those instruments as stock for federal income tax purposes if the rules are not satisfied. — Re-characterizing certain related-party corporate debt instruments issued after April 4, 2016, as stock (even if the Documentation Rule is satisfied) if the instrument: (a) is issued in one or more of the several specified "tainted" transactions; or (b) funds a tainted transaction (collectively referred to as the Recharacterization Rules). These are separately discussed further below. General provisions (Treas. Reg. Section 1.385-1) The Documentation Rule and the Recharacterization Rules target debt instruments that would otherwise constitute indebtedness for federal tax purposes and are issued by a "covered member" to a member of its "expanded group". However, the Final Regulations contain significant modifications to the Proposed Regulations that were issued in April, and result in their reduced scope. An initial core determination is ascertaining who is within the "expanded group". An "expanded group" generally includes the members of an "affiliated group" under Section 1504(a), with three important modifications: 1. An expanded group includes foreign corporations, tax-exempt corporations and insurance corporations. These entities are otherwise excluded from the definition of an "includible corporation" under Section 1504(b), which is a basic component for determining whether a corporation is a member of a federal affiliated group. 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 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). 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). As the Preamble suggests, Treasury purposely decided to include tax-exempt corporations as members of the expanded group. In our view, in determining whether an interest in a non-stock tax-exempt corporation meets the ownership test noted previously, all facts and circumstances should be considered as to whether such interests confer all the rights that ordinarily attend stock ownership. Another important consideration rests in the concept of a "covered member." A covered member is defined as a member of an expanded group that is a domestic corporation. As a result, the present scope of the Final Regulations is limited to debt instruments that are issued by a domestic corporation. The Final Regulations do not apply to foreign issuers and do not address domestic branches of foreign issuers. The Final Regulations are designed, however, so that debt instruments issued by foreign borrowers could be brought within the scope of the Final Regulations in the future. Treasury and the IRS have requested comments on the future application to foreign corporate issuers. The Final Regulations also removed the provision of the Proposed Regulations allowing for the bifurcation of a debt instrument within a modified expanded group as being part debt and part equity. The Proposed Regulation's bifurcation provision had departed substantially from the common law "all-or-nothing" approach to characterizing a purported debt instrument wholly as either debt or equity. The "Documentation Rule" (Treas. Reg. Section 1.385-2) Treas. Reg. Section 1.385-2 provides the minimum documentation requirements necessary for substantiating the treatment of certain expanded group instruments (EGIs) of covered members (Covered EGIs) as debt for US federal tax purposes. The stated purposes of the Documentation Rule are: (1) to provide guidance regarding the documentation and other information that must be prepared, maintained and provided by the taxpayer to support debt treatment; and (2) to establish certain operating rules, presumptions and factors in the determination of whether a particular instrument will be treated as debt for US federal tax purposes. As the Preamble acknowledges, the Documentation Rule is "consistent with best documentation practices under case law, but many taxpayers do not currently follow best documentation practices." In that regard, the Documentation Rule elevates the importance of documentation as it is intended to aid in IRS audits and to prevent taxpayers from characterizing intercompany debt with the benefit of hindsight. Compliance with the Documentation Rule does not ensure that an EGI will be treated as debt but merely enables the taxpayer to move forward in its determination under general debt-versus-equity US federal tax principles established under both common law as described in Treas. Reg. Section 1.385-1(b) and the new rules in Treas. Reg. Sections 1.385-3, 1.385-3T and 1.385-4. If a taxpayer is unable to satisfy the requirements of the Documentation Rule, however, the EGI generally is treated as stock for all US federal tax purposes, unless the taxpayer meets an exception from per se stock treatment under Treas. Reg. Section 1.385-2(b)(2). Documentation and other information to evidence indebtedness There are four documentation requirements that Treasury and the IRS consider to be key substantive evidence of the intent to characterize an EGI as debt-versus-equity for US federal tax purposes. Other relevant factors are taken into account but have less influence, with the relative weight of each lesser factor based on facts and circumstances. The indebtedness factors include those similar to what are found in third-party loans. This generally means that taxpayers must be able to show: 1. An unconditional and binding obligation to make interest and principal payments on certain fixed dates For a more detailed discussion of these requirements, see Tax Alerts 2016-632 and 2016-1776. The Final Regulations also contain certain other noteworthy clarifications and revisions to the indebtedness factors in response to requests from commenters, including: — Use of third-party standards to meet certain documentation requirements. A market-standard safe harbor under which documentation customarily used in comparable third-party transactions for debt transactions may be used to satisfy the indebtedness factors related to both creditor's rights and an unconditional obligation to pay a sum certain. Thus, for example, documentation similar to that used by a taxpayer for third-party trade payables will generally satisfy the requirements of the Documentation Rule for trade payables with members of the expanded group. — Use of refinancing assumptions in credit analyses. Credit analyses required under the reasonable expectation of repayment documentation requirement may assume that the principal amount of an EGI may be satisfied with the proceeds of another borrowing by the issuer to the extent that such borrowing could occur on similar terms with a third party. — Single, annual credit analysis for multiple EGIs issued by the same issuer. A single credit analysis may be prepared on an annual basis and used for all interests issued by an issuer, up to an overall amount of indebtedness set forth in the annual credit analysis, absent a "material event" of an issuer. — Evidence from third-party lenders. Evidence that a third-party lender would have made a loan to the issuer with the same or substantially similar terms as the EGI may be included as documentation of the reasonable expectation of repayment factor. The extent of this new provision is not described in the Preamble and is not clear. Excluded transactions The Preamble notes that Treasury and the IRS generally declined to adopt commenters' requests for exclusions from the Documentation Rule for several categories of transactions believed not to raise earnings-stripping concerns. Therefore, ordinary-course transactions, cash pooling and similar arrangements, trade payables, and working capital debt financing, for example, are subject to the Documentation Rule to the extent they constitute Covered EGIs, even though such transactions may be excluded from the Recharacterization Rules. Excluded and covered entities The Documentation Rule does not apply unless the stock of any member of the expanded group is publicly traded, if all or any portion of the expanded group's financial results is reported on financial statements with total assets exceeding $100 million, or if the expanded group's financial results are reported on financial statements that reflect annual total revenue exceeding $50 million. Interests issued by one member of a US federal consolidated group to another member of the same US federal consolidated group are not subject to the Documentation Rule. Treasury feels that the comprehensive documentation requirements under the consolidated tax return regime are a more than adequate alternative. The Final Regulations exclude such interests by amending the scope of an "applicable interest," which is an essential element for whether an instrument is an EGI. An applicable interest does not include 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, but only for the period during which both parties are members of the same consolidated group. Consequently, the Documentation Rule is limited to debt instruments issued by a domestic corporation and held by an unconsolidated affiliate, such as trade payables to foreign subsidiaries, obligations of domestic subsidiaries owed to a foreign parent and brother-sister affiliates, Section 956 loans from subsidiaries, instruments between domestic entities that are not part of the same consolidated group, and debts between private investment funds that have a common corporate owner. As noted in the Preamble, Treasury did not carve out an exception from the Documentation Rule for tax-exempt corporations since tax-exempt corporations cannot be members of a consolidated income tax return and, therefore, the comprehensive documentation requirements applicable to such returns are absent. Further, tax-exempt corporations may still be subject to tax on unrelated business income, so concerns are still present relating to related-party indebtedness. In addition, Treasury noted that many tax-exempt corporations own taxable C corporation subsidiaries. Consequently, instruments issued by a US tax-exempt corporation to an affiliated taxable corporation (and from an affiliated domestic taxable corporation to an affiliated tax-exempt corporation) are potentially subject to the Documentation Rule. The rules also likely apply to instruments between affiliated tax-exempt corporations when the proceeds are used to further an unrelated trade or business activity. Timing and rebuttable presumption Another significant change from the Proposed Regulations is a substantial delay in the effective date for the Documentation Rule in that it applies only to an EGI that is issued or deemed issued on or after January 1, 2018. Consequently, an EGI issued or deemed issued before January 1, 2018, will not be subject to the Documentation Rule. The Final Regulations also replaced the proposed timely preparation requirements with an obligation that documentation and financial analysis must be prepared by the time that the issuer's federal income tax return must be filed, including any extensions. The effect of this change, in combination with the Final Regulations' new timely preparation requirements, is that, for the tax year that includes January 1, 2018 (and for every year thereafter), taxpayers will have until the filing date (including extensions) of the return for that tax year to complete the documentation requirements for any EGI issued on or after January 1, 2018. In addition to the reasonable cause exception in the Proposed Regulations, the Final Regulations provide two new exceptions to per se stock characterization for EGIs that fail to satisfy the requirements of the Documentation Rule. First, they provide a rebuttable presumption when an expanded group objectively demonstrates, based on a complicated formula, a high degree of compliance with the Documentation Rule. Second, they provide an exception when the taxpayer timely discovers and remedies a ministerial or non-material failure or error. Other clarifications and revisions — Exceptions to per se stock characterization — Application to interests issued by disregarded entities. 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 to issue stock to the formal holder of the interest in the disregarded entity. As the Preamble acknowledges, this provision ensures that a disregarded entity would not be treated as a partnership as a result of noncompliance with the Documentation Rule. — Authorization of master agreements. The Final Regulations clarify 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. Taxpayers should note that the Documentation Rule also 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. — Affirmative use reservation. The Proposed Regulations prohibited taxpayers from affirmatively using the Documentation Rule — by non-compliance — to convert debt instruments into stock. The Final Regulations are now reserved on this point while Treasury and the IRS further consider the issues. Certain distributions of debt instruments and similar transactions (the Recharacterization Rules) (Treas. Reg. Sections 1.385-3, 1.385-3T and 1.385-4T) The Recharacterization Rules in the Final Regulations retain the same general framework as the Proposed Regulations, but their application has narrowed considerably. Specifically, Treas. Reg. Section 1.385-3 and Treas. Reg. Section 1.385-3T operate to recast a debt instrument issued after April 4, 2016 as stock (even if the Documentation Rule is satisfied) if the instrument is issued by a member of the expanded group in a "tainted transaction" to another member of the expanded group (the General Rule). Treas. Reg. Section 1.385-4T (which governs the treatment of federal consolidated groups for purposes of the Recharacterization Rules) 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). Consequently, the Recharacterization Rules do not apply to such a consolidated group. However, the Recharacterization Rules do apply to tax-exempt corporations because they cannot be included in a consolidated return. Instruments considered "tainted" under the General Rule component of the Recharacterization Rules include those issued in: i. A distribution (such as the payment of a dividend in the form of a note payable) ii. An acquisition of expanded group member stock or iii. An internal asset reorganization under Section 368(a)(1)(A), (C), (D), (F) or (G) Treasury and the IRS believe that the policy concerns underlying the tainted 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 tainted transaction. Accordingly, to support the General Rule, Treas. Reg. Section 1.385-3 includes both a "Funding Rule" and an "Anti-abuse Rule." The Funding Rule component of the Recharacterization Rules is intended to prevent taxpayers from achieving in multiple steps what the General Rule prevents taxpayers from achieving in one step. The Funding Rule treats as stock any debt instrument that is issued by a covered member to another member of the expanded group in exchange for property with the principal purpose of funding a tainted transaction. The Final Regulations retain a non-rebuttable presumption that any debt instrument issued by a funded member during the period beginning 36 months before and ending 36 months after a tainted transaction occurs is treated as stock. The Anti-abuse Rule treats a covered debt instrument as stock if it is issued with a principal purpose of avoiding the application of the Funding Rule. Whether a covered debt instrument is subject to the Anti-abuse Rule is based on all the facts and circumstances. In addition, the Preamble states that the IRS intends to closely scrutinize, and may use the Anti-abuse Rule to challenge, transactions in which a controlled partnership issues preferred equity to an expanded group member and the rules of Treas. Reg. Section 1.385-3T(f) would have applied had the preferred equity been denominated as a debt instrument issued by the partnership. The Proposed Regulations prohibited taxpayers from affirmatively using the Recharacterization Rules to convert debt instruments into stock. The Final Regulations reserve on this point while Treasury and the IRS study the issue. There are a number of exceptions to the General Rule and the Funding Rule. The temporary regulations expanded the "ordinary course exception" to include short-term debt instruments and cash pooling arrangements. Under the current ordinary course exception, the Funding Rule does not apply to "qualified short-term debt instruments," which included interest-free loans, short-term funding arrangements, ordinary course loans, and deposits with a qualified cash pool header. The Final Regulations include two categories of exceptions that relate to distributions and acquisitions: exclusions described in Treas. Reg. Section 1.385-3(c)(2), which include a subsidiary stock acquisition exception, a compensatory stock acquisition exception, an exception to address the potential iterative application of the funding rule; and reductions described in Treas. Reg. Section 1.385-3(c)(3), which are an expanded group earnings reduction and a qualified contribution reduction. The exclusions and reductions of Treas. Reg. Section 1.385-3(c)(2) and (3) operate independently of any exclusion with respect to the definition of a covered debt instrument as well as the exclusion of qualified short-term debt instruments noted previously. Therefore, to the extent an exception applies to a distribution or acquisition, either the distribution or acquisition is treated as not described in the General Rule or Funding Rule, or the amount of the distribution or acquisition subject to the General Rule or Funding Rule is reduced. A third type of exception, the $50 million threshold exception described in Treas. Reg. Section 1.385-3(c)(4), applies to covered debt instruments that otherwise would be treated as stock under Treas. Reg. Section 1.385-3(b) because such instruments are treated as funding one or more distributions or acquisitions, after taking into account the exclusions and reductions. The threshold exception overrides Treas. Reg. Section 1.385-3(b) for the first $50 million dollars of debt instruments that otherwise would be treated as stock under the General Rule and Funding Rule. A distribution or acquisition treated as funded by a covered debt instrument is still treated as funded by a covered debt instrument notwithstanding the application of the threshold exception. As a result, the distribution or acquisition cannot be "matched" with another covered debt instrument to cause additional re-characterizations under the Funding Rule. The Final Regulations exclude various instruments from the definition of covered debt instruments, including real estate mortgage investment conduit (REMIC) regular interests, stripped bonds under Section 1286 instruments, and leases treated as loans under Section 467. Implications to tax-exempt corporations The Final Regulations significantly affect a wide range of ordinary course business and financing transactions for a variety of corporations, including tax-exempt organizations. Specifically, these regulations operate to expand the IRS's ability to recast related-party debt as equity. The Final Regulations, like the Proposed Regulations, adopt the principle that intercompany debt between the members of a federal consolidated group will generally fall outside the scope of the Documentation Rule for purposes of the documentation requirement. The rules will apply to a tax-exempt organization and its related taxable corporations, however, because they cannot join together in a consolidated income tax return filing. In certain jurisdictions, nonprofit corporations can be organized under state law on a non-stock basis. In order to determine whether the requisite ownership interests for applicability of the Final Regulations exist for a tax-exempt corporation formed under state law as a nonstock nonprofit corporation, some analysis will be needed in order to determine if the interests held by the organization's members, trustees, or directors carry all the rights that ordinarily attend stock ownership. If they do, then such a nonprofit corporation might be considered a member of an expanded group. This analysis could prove to be complicated, and likely will require the input of tax advisors and legal counsel. Tax-exempt organizations that are subject to the Final Regulations and desire to ensure the treatment of related-party indebtedness as debt versus that of stock will need to satisfy the extensive documentation requirements of the Final Regulations. Such documentation requirements operate to create added administrative and compliance burdens. The failure to properly follow the documentation requirements could also result in significant tax implications to the tax-exempt entity or its affiliate. 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 requirements of the Documentation Rule could be deemed to have additional equity in that taxable subsidiary. This might cause the taxable corporation to fail the affiliation requirements for inclusion in a consolidated income tax return. It is noteworthy that Treasury did carve out an exception to this potential disaffiliation consequence for instruments converted to stock under the Recharacterization Rules. In addition, recharacterization to equity could negatively affect the taxable corporation's interest expense income tax deduction (subject to any possible limitation of that interest expense deduction under Section 163(j)). On the other hand, tax-exempt organizations may view a debt-to-stock recharacterization by the IRS favorably since it may work to reduce their unrelated business taxable income (UBTI). Dividends or capital gains received by a tax-exempt organization are generally excluded from UBTI (unless paid with respect to debt-finance property), whereas interest income received from a controlled corporation as part of a payment on a debt may be UBTI under Section 512(b)(13). So, an IRS recharacterization of amounts paid under an intercompany transaction from interest income to dividends or capital gains will generally be favorable to the tax-exempt organization. The Final Regulations retain the 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. Tax-exempt organizations that are potentially affected by the Final Regulations have time to prepare for the documentation requirements. The Documentation Rule applies only to relevant debt instruments issued on or after January 1, 2018. The documentation for such instruments is generally 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" (typically the issuance date of the EGI). Theoretically then, a calendar-year tax-exempt corporation that receives a full extension of time to file Form 990 would not need to have its first documentation in place for an EGI issued on or after January 1, 2018 until November 15, 2019. Even with these far-off timeframes in mind, however, tax-exempt organizations might want to consider reviewing the existing documentation related to debt to determine whether changes in policies, procedures or practices need to be implemented for EGIs or debt instruments to be issued on or after January 1, 2018. This is particularly important since these new rules are effectively an embodiment of historical common law principles. The Documentation Rule 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 provide a guideline of common law principles to substantiate that any loans between the tax-exempt organization and its physicians/employees are bona-fide. The Recharacterization Rules apply to relevant debt instruments issued after April 4, 2016. Complicated transition rules provide that instruments issued after April 4, 2016, and before January 19, 2017, will be re-characterized as stock on January 19, 2017, subject to an anti-abuse rule. Moreover, during the 90-day period following the Final Regulations' publication in the Federal Register (October 21, 2016), any outstanding or otherwise tainted instruments may be cured via repayment. (Organizations should be aware though that a repayment itself may have implications under the Recharacterization Rules.) Accordingly, any covered debt instrument issued after April 4, 2016 and before the 90-day window after publication will not be re-characterized until 90 days after the publication date. The effective date for the documentation rules is extended until January 1, 2018. 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 or a significant modification of the instrument. For state tax implications, please see EY Alert 2016-1919. Please contact your EY Tax Professional for further information. ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg ———————————————
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