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Editorial 6 MIN READ

Section 385 documentation: the January 1, 2018 date is now on the table

Treasury's review of the 2016 debt-equity regs is due this week, and the documentation rules are the piece most likely to slip

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 5 sections
  1. What the rules actually require
  2. Who has to care
  3. Why this week matters
  4. What to do, and not to do, this month
  5. Sources

reasury owes the President a report today on which tax regulations issued since January 1, 2016 impose undue burdens. The Section 385 documentation regulations, scheduled to take effect January 1, 2018, are the candidate everyone in the corporate tax bar expects to see on the list. Whether that means formal delay, rewrite, or partial withdrawal is the question of the next sixty days.

The rules themselves are real and on the books. They were finalized on October 13, 2016 and published as T.D. 9790 in the Federal Register on October 21, 2016 (81 FR 72858). A tax director sizing an intercompany loan today has to assume the documentation regime applies to instruments issued after year-end, because nothing has yet been said that moves the date. A tax director preparing a 2018 compliance build has reasonable grounds to slow down.

What the rules actually require

Section 385, enacted in 1969, authorizes Treasury to issue regulations defining when an interest in a corporation is debt, equity, or part of each. For forty-seven years Treasury used that authority sparingly. The 2016 package — Regs. §§ 1.385-1 through 1.385-4 — is the most aggressive exercise of it on record.

Two pieces matter operationally. The first is § 1.385-2, the documentation regulation. It tells a related-party corporate group that unless it documents an intercompany debt instrument contemporaneously and along four specified dimensions, the instrument will be treated as equity for every federal tax purpose. The four factors are: a binding obligation to pay a sum certain; creditor's rights to enforce payment; a reasonable expectation of repayment; and conduct consistent with a genuine debtor-creditor relationship.

The timing is the part that makes compliance officers sweat. Documentation of the first three factors must be prepared by the tax-return due date (including extensions) for the year in which the "relevant date" occurs — 30 days from issuance for the instrument terms, 120 days from a payment or default event for the course-of-conduct evidence. If the deadline is missed and no exception applies, the instrument is recharacterized as stock. Interest deductions disappear. Withholding obligations change. Earnings-and-profits accounts move. The downstream tax consequences are disproportionate to the paperwork sin.

The second piece is § 1.385-3, the transaction recast rule. It converts certain intercompany loans into equity if they are issued in a distribution, in exchange for expanded-group stock, or in certain asset reorganizations — or, under the per-se funding rule, if they are issued within a 72-month window that includes such a transaction. The recast rules took effect for transactions occurring on or after April 5, 2016, with actual recharacterization deferred to January 19, 2017 (90 days after T.D. 9790). They are already live.

Who has to care

The expanded-group concept, which is what triggers either set of rules, sweeps in any chain of corporations connected by 80-percent vote-or-value ownership to a common parent (see 26 C.F.R. § 1.385-1). That is broader than the consolidated-return group and narrower than the controlled-group definition most M&A lawyers carry around in their heads. A family-held holding company with two operating subsidiaries clears the threshold. So does a private-equity portfolio holding structure that layers a U.S. blocker under a Cayman fund.

The documentation regulation has a small-issuer carve-out. A group escapes § 1.385-2 if no expanded-group member is traded on an established financial market, total expanded-group assets do not exceed $100 million on any applicable financial statement, and total expanded-group revenue does not exceed $50 million. Treasury's preamble estimated the thresholds exclude about 99 percent of C corporation filers while retaining roughly 85 percent of C corporation economic activity. Those are reasonable numbers to think with. A seed-stage holding group is out. A family-office real-estate portfolio that rolled up seven LLCs into a C-corp two years ago is probably out. A mid-market distributor with one Canadian subsidiary and $180 million in assets is in.

The recast rule (§ 1.385-3) has a separate buffer: the first $50 million of covered debt within an expanded group is disregarded. That sounds generous until you notice the per-se funding rule aggregates over six years.

Why this week matters

On April 21, 2017, the President issued Executive Order 13789, directing Treasury to identify significant tax regulations finalized on or after January 1, 2016 that impose undue financial burden, add undue complexity, or exceed statutory authority. The order required an interim report to the President within sixty days. Sixty days from April 21 is today. Treasury has not yet announced whether the report will be released on schedule or a few days late, but the universe of candidate regulations is small — Treasury and the IRS finalized on the order of a hundred tax regulations in the window — and the Section 385 package is on every external list in circulation.

Treasury's posture toward the 385 package over the last several months has been consistent with the expectation that something will move. In a Department press release and testimony before Senate Finance this spring, Secretary Mnuchin has singled out the 385 regulations as burdensome. The Tax Executives Institute, the U.S. Chamber, the Securities Industry and Financial Markets Association, and roughly forty other trade groups have filed comment letters asking for delay of § 1.385-2 or outright withdrawal. None of that is binding. All of it is signal.

What will likely come out of the interim report is an announcement that § 1.385-2 is under reconsideration and a signal about timing. A formal delay of the January 1, 2018 applicability date would need a separate notice or amendment; it cannot happen by press release. Taxpayers cannot rely on an intention to delay. But the operational question every mid-market tax department is asking — whether to sign the check for the November compliance build — now has at least a plausible "wait three weeks" answer.

What to do, and not to do, this month

Do not treat the documentation rules as a dead letter. They are finalized regulations. A company with a January 1, 2018 applicability exposure that has not started its intercompany-debt inventory is already behind; if the rules stand, documentation within 30 days of post-year-end issuances is not a December project.

Do not build the full compliance infrastructure this quarter if you can defer it. A group that would comfortably meet the documentation standard with a six-month build is not the one to worry about here. The worry is the group that was about to spend $400,000 on a compliance platform to automate 30-day documentation packets. That capital is worth holding for two to three months.

Do revisit the recast rule exposure regardless. Section 1.385-3 is already in force. The transactions that trigger it — related-party distributions, share-for-note exchanges, certain reorganizations — happen quietly. A tax director who has not walked the last 18 months of intercompany transactions against the per-se funding rule should do that this summer. Whatever Treasury does with the documentation rules, the recast piece is the part that bites first.

The most honest frame for the 385 regulations right now is the one practitioners have used privately since October: Treasury wrote a rule set sized for the hundred inverted multinationals it was chasing, and the rule set caught several thousand ordinary corporate groups in the same net. The interim report is the first official acknowledgement that somebody noticed. What happens after that is the part worth watching.

Sources

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