The Final §385 Regulations (Part I) - Classifying Interests in a Corporation

Bloomberg BNA Tax Management International Journal

On October 13, 2016, the IRS and Treasury Department issued much anticipated regulations (the “Final” or “Temporary” Regulations) under Internal Revenue Code section 385.  These regulations, which consist of both temporary [1] and final regulations, aim to prevent multinational corporations from reducing their U.S. taxable income through “earnings stripping” practices.  To achieve this end, the regulations provide a framework to determine whether certain interests in related entities are to be treated as equity rather than as debt for tax purposes.  On April 4, 2016, the Treasury Department and IRS had promulgated proposed regulations to this effect (the “Proposed Regulations”).  The Proposed Regulations were among the most ambitious and aggressive tax provisions issued in recent memory, and were criticized by many as anywhere from overly broad to unfair and unadministrable.  While the Final Regulations make clear that the Treasury Department and IRS considered the criticism, the Final and Temporary Regulations do retain some of the teeth, and all of the bulk, of the Proposed Regulations.  Like the Proposed Regulations, the Final and Temporary Regulations are organized into four sections:  (1) general provisions, (2) documentation requirements, (3) transactional rules, and (4) consolidated return provisions.  In the Proposed Regulations, the relevant provisions appeared in Prop. Reg. §§ 1.385-1 to -4.  The final package consists of Final Regulations § 1.385-1, -2 and -3 and Temp. Reg. §1.385-3T and -4T.

Partners Peter Connors and Barbara de Marigny offer an in-depth look at the new regulations in this article published in Tax Management International Journal.

[1] While Temporary Regulations have immediate force of law, they expire at the end of three years.  Typically, they will be finalized within that time frame.