In Notice 2019-58, released October 11, 2019, the IRS announced that taxpayers may continue to rely on the October 2016 proposed regulations on characterizing certain corporate interests as stock or debt under IRC Section 385, even though the related temporary regulations expired on October 13, 2019.

The expiration of a significant portion of the overall regulatory framework is expected to raise numerous questions regarding ongoing taxpayer compliance with the regulations that remain in place.

Background

The October 2016 proposed regulations consisted of a cross-reference to the temporary regulations issued at the same time as the final IRC Section 385 regulations (TD 9790). See Tax Alert 2016–1776 for a full explanation of the final and temporary regulations.

The final and temporary regulations (i) established extensive documentation requirements that must be satisfied for a debt instrument to constitute indebtedness for US federal tax purposes (Treas. Reg. Section 1.385-2); and (ii) recharacterized a debt instrument issued after April 4, 2016, as stock if the instrument was issued as part of a transaction listed in Treas. Reg. Section 1.385-3 and Treas. Reg. Section 1.385-3T. Proposed regulations were subsequently issued proposing to revoke the documentation rules. (See Tax Alert 2018-1878 for details.)

Notice 2019-58

The October 2016 proposed regulations were to apply to tax years ending on or after January 19, 2017, and do not expire. Notice 2019-58 made clear that taxpayers may rely on the October 2016 proposed regulations for periods after the temporary regulations expire until further notice is given, provided that taxpayers consistently apply the proposed rules in their entirety.

Implications

Significant portions of Treas. Reg. Section 1.385-3 that were final, including the essential recharacterization rules of Treas. Reg. Section 1.385-3(b), are not affected by Notice 2019-58. Those portions of the IRC Section 385 regulations that have expired (for which the October 2016 proposed regulations remain in place) generally define the "qualified short-term debt" exception and address the treatment of controlled partnerships. In addition, Treas. Reg. Section 1.385-4T, which provided special rules for consolidated return groups, also expired. Thus, these subject areas are likely to be most affected by the expiration of the temporary regulations.

We expect that many taxpayers will simply continue applying the entire IRC Section 385 regulatory framework, including the October 2016 proposed regulations representing the expired portions of the IRC Section 385 regulatory regime. This expectation is based partly on the assumption that Notice 2019-58 is not the Government's final word on when debt instruments might be recharacterized as equity. The Office of Information and Regulatory Affairs is currently reviewing other guidance involving the IRC Section 385 regulations, the details of which are unclear. Thus, there may be a relatively small "gap period," or window of time, between the expiration of the IRC Section 385 temporary regulations and whatever new direction, if any, that Treasury may announce for the treatment of covered debt instruments.

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