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Debt-Equity Regulations – A Year in Review

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 [...]

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New Issue of ‘Focus on Tax Strategies and Developments’

We recently released the May 2016 issue of “Focus on Tax Strategies and Developments,” which can be viewed in its entirety here or through the links below. The issue includes four articles of interest to taxpayers:

Proposed Debt-Equity Regulations Have Dramatic Implications for Corporate Tax Planning and Compliance

By Thomas W. Giegerich and Michael J. Wilder

On April 4, 2016, the Internal Revenue Service (IRS) and US Department of the Treasury (Treasury)—without advance warning—released proposed regulations under Section 385 (the Proposed Regulations) that will, if finalized in their current form, have dramatic implications for US corporate tax planning and compliance.

The 2016 UK Budget – BEPS Measures and Tax Cuts

By James Ross

The 2016 UK Budget has generally been seen as good news for corporates, but it is not without potential concern, particularly for multinationals and private equity groups, who may need to re-evaluate longstanding financing structures.

Prescriptions of the Blue Book on the New Partnership Audit Rules

By Thomas W. Giegerich, Gary C. Karch, Kevin Spencer and Madeline Chiampou Tully

The Bipartisan Budget Act of 2015, signed into law in November, instituted a new regime for federal tax audits of entities treated as partnerships for US federal income tax purposes (the New Audit Rules) effective 2018. In March 2016, the Joint Committee on Taxation released its “General Explanation of Tax Legislation Enacted in 2015” (the Blue Book), which provides some background and explanation with respect to the New Audit Rules—this article discusses certain of the highlights of the Blue Book explanation.

Changes to China’s High and New Technology Enterprise (HNTE) Regime Both Sharpen Its Focus and Make Its Advantages More Broadly Available

By Robbie Chen

With the promulgation of the Corporate Income Tax (CIT) law in 2008, many preferential tax regimes (e.g. lower tax rates for foreign invested companies) were revoked. Under the CIT, the HNTE treatment, which reduces a qualified taxpayer’s applicable CIT rate from the standard 25 percent to 15 percent, is one of the few remaining tax preferences. As a result, any change to the HNTE rule attracts a great deal of attention.




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