Final earnings-stripping regulations exempt many taxpayers.

• Author: Schreiber, Sally P.

Six months after issuing controversial proposed regulations under Sec. 385 that would recharacterize certain transactions between related parties that are ostensibly debt as equity--curbing the practice of "earnings stripping"--the IRS issued final and temporary regulations (T.D. 9790) that expand on and modify the proposed rules. The regulations establish threshold documentation requirements that ordinarily must be satisfied for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes, and treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes. The rules finalize proposed regulations issued in April (REG-108060-15), with a number of changes in response to "numerous detailed and thoughtful comments" the IRS received.

The new rules are part of the Treasury Department's larger effort to curb corporate inversions. According to Treasury, after a corporate inversion, multinational corporations often use a technique called earnings stripping to minimize U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country, which results in large interest deductions in the United States without requiring the company to finance new investment in the United States. These regulations prevent earnings stripping by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances, turning deductible interest payments into taxable dividends.

The rules also require corporations claiming interest deductions on related-party loans to document the loans, which is the common practice for third-party loans. Because using related-party debt to minimize income tax liabilities is not limited to the cross-border context, these rules also apply to related U.S. affiliates of a corporate group.

Many of the comments the IRS received were concerned that the proposed regulations would impose unjustified compliance burdens and would not achieve the regulations' stated policy objectives of preventing related entities from minimizing their income tax liability by issuing debt.

According to the IRS, the regulations as amended achieve a better balance by restricting their application in order to minimize their effect on regular business activities. Exceptions have been added for various ordinary business transactions.

First, the regulations provide a broad exemption for cash pools...