Internal Revenue Code (Code) Section 385 provides that the US Department of the Treasury (Treasury) is authorized to issue regulations to determine whether an interest in a corporation is to be treated for purposes of the Code as stock or indebtedness. After decades of inaction, proposed regulations were issued on April 14, 2016. The proposed regulations were not well-received; the tax bar had serious and substantial comments to the proposed regulations. Among the most important critiques, there were criticisms for the potential overbreadth of the regulations’ application to foreign-to-foreign transactions, the lack of a de minimis exception for smaller companies and for the anticipated burden of the contemporaneous documentation requirements.

Treasury released final regulations under Code Section 385, which are effective as of October 21, 2016. Although the proposed regulations were changed in some respects, the final regulations retained strict documentation requirements.

In Executive Order 13789, the President called on Treasury to identify and reduce tax regulatory burdens that impose undue financial burdens on US taxpayers, or otherwise add undue complexity to federal tax law. In response, Treasury indicated on October 2, 2017, that it would potentially revoke the documentation requirements under the proposed regulations. Continue Reading The Slow Death of the Section 385 Regulations

In a surprising decision, the US Tax Court (Tax Court) concluded that the pregame away-city meals provided to the Boston Bruins hockey team was not subject to the 50 percent deduction disallowance on the basis that the meals were both for the “convenience of the employer” and were provided at an “employer operated eating facility.” In Jacobs v. Commissioner, 148 TC No 24 (June 26, 2017), the court found that meals—consisting of dinner, breakfast, lunch and snacks—were served in a room provided without charge by the hotel and to all employees of the Bruins traveling to the games.

Most businesses are well aware of the 50 percent deduction disallowance provided in Internal Revenue Code (IRC) Section 274(n)(1), which applies to meals provided to executives or other employees traveling for the business purpose of the employer. “De-minimis” meals (those which are provided infrequently and low in value), however, are excepted from the 50 percent disallowance. Also exempt are those meals provided at employer-operated eating facilities, (e.g., the company cafeteria) and meeting the following requirements:

  • the facility is located on or near the business premises of the employer;
  • the revenue derived from the facility normally equals or exceeds the direct operating costs of the facility; and
  • the facility is available on substantially the same terms to each member of a group of employees that is defined under a reasonable classification which does not discriminate in favor of highly compensated employees.

IRC Section 119(a) allows an employee to exclude the value of any meals furnished by or on behalf of his employer if the meals are furnished on the employer’s business premise for the convenience of the employer. Generally, the expenses of IRC Section 119 meals can be used to satisfy the requirement that the revenue from the eating facility equal direct operating costs.

In Jacobs, the Tax Court concluded that the group meals served in the away-city hotel rooms provided at the hotels where the Bruins hockey team stayed for the games was an “employer operated eating facility,” which deems the rooms as the “eating facility” and “on the business premises of the employer” for purposes of the requirements. The rooms were also considered the business premises of the employer for purposes of the IRC Section 119 requirement. In light of its holding, the Tax Court did not need to address the taxpayer’s alternative argument that the meals were expenses for entertainment sold to customers under IRC Section 274(n)(2)(A).

Practice Point: The decision in Jacobs is seemingly expansive in permitting employers to deduct meals provided away from what has traditionally been considered an employer facility. The decision may provide an opportunity to employers to seek additional expense deductions.

Section 385(a) provides that Treasury is authorized to issue regulations to determine whether an interest in a corporation is to be treated for purposes of the Code as stock or indebtedness. On April 4, 2016, Treasury and the Service issued proposed regulations (Proposed Regulations, found here) under section 385 that treat certain purported debt between related entities as stock for US federal income tax purposes. Treasury stated specifically that the regulations under section 385 had been issued to “address the issue of earnings stripping” in three ways – (1) “[t]argeting transactions that increase related-party debt that does not finance new investment in the United States”; (2) “[a]llowing the IRS on audit to divide a purported debt instrument into part debt and part stock”; and (3) “[r]equiring documentation for members of large groups to include key information for debt-equity tax analysis[.]”

Once the Proposed Regulations were issued, practitioners and industry groups of affected companies (among others) questioned whether the Proposed Regulations were narrowly tailored to serve these stated purposes, and observed that the Proposed Regulations represented a significant departure from past practice. The Proposed Regulations received widespread attention, and practitioner groups and others submitted numerous detailed formal comments before the regulations were finalized. Among the most important critiques, practitioners criticized the Proposed Regulations for their potential overbreadth in their application to foreign-to-foreign transactions, for their lack of a de minimis exception for smaller companies, and for the anticipated burden of the contemporaneous documentation requirements.

Treasury and the Service released final and temporary section 385 regulations (Final 385 Regulations, available here), which are effective as of October 21, 2016, the date of publication in the Federal Register. The Final 385 Regulations provide several exceptions not contained in the Proposed Regulations, including that the Final 385 Regulations apply only to debt instruments issued by a covered member, which is defined as a domestic corporation, to members of its expanded group. The Final 385 Regulations were accompanied by an unusually lengthy Preamble which purports to address major comments received during the notice-and-comment process.

Like the Proposed Regulations, the Final 385 Regulations contain the documentation rules that require specific substantiation in order to treat related-party instruments as debt. These rules are not effective for debt instruments issued prior to January 1, 2018. The Final 385 Regulations contain several modifications to the documentation rules. For example, the Proposed Regulations automatically recharacterized a purported debt instrument as equity in the event of a documentation failure. Under the Final 385 Regulations, if an expanded group is otherwise highly compliant with the documentation rules, then the Final 385 Regulations apply a rebuttable presumption with respect to a purported debt instrument under which a taxpayer can rebut an equity presumption by satisfying specific enumerated tests.

The Final 385 Regulations contain the recast rules issued in Prop. Treas. Reg. §1.385-3, but with significant modifications. In general terms, the Final 385 Regulations reduce the debt issuance to the extent the issuer has sufficient E&P accumulated after April 4, 2016, and/or qualified contributions. Although exceptions to the recast rules were expanded, the complex requirements and operating rules should be carefully studied to avoid traps for the unwary.

More detailed analysis of the Final 385 Regulations can be found here. It remains to be seen how the Final 385 Regulations will impact affected companies in practice, and what challenges may be raised to them.