Federal tax: sections 355, 382, and 385; and new rules on partnership audits dominate landscape.

• Author: Reinstein, Todd
• Position: Internal Revenue Code - Tax Developments in 2016, part 1 - Cover story

This article reviews and analyzes recent law changes and IRS guidance for federal income tax issues this past year.

Section 385 Proposed Regulations--Impact on Related-Party Financing

Section 385 has been in the Internal Revenue Code since 1969. It was enacted to provide guidance for whether to classify an interest in a corporation as debt or equity, but it requires the adoption of regulations to be effective. There have been three previous attempts at adopting regulations, none of which made it past the proposal stage. For many years, courts filled in the gap by creating multifactor tests to determine whether an instrument was classified as debt or equity. On April 4, 2016, the Internal Revenue Service and the Treasury Department issued proposed regulations under Section 385. Final and temporary regulations were issued on October 13, 2016, providing a completely new way to analyze whether an instrument is debt or equity in certain related-party transactions. The regulations apply to covered debt instruments issued on or after April 4, 2016.

Certain Transactions in Which Debt May Be Recharacterized. An instrument issued to a member of an expanded group will be treated as equity for all federal income tax purposes if it is issued by a domestic corporation (other than an S Corporation, a RIC, or a REIT) in one of the following three transactions, outside of a federal consolidated return group:

1. As issuance of debt for no consideration (e.g., a dividend of a note),

2. A note issued in exchange for stock of a member of the expanded group (e.g., a Section 304 transaction), and

3. A note issued in internal asset reorganization (e.g., a cash "D" reorganization).

   An expanded group (EG) generally includes corporations connected through a common parent corporation by ownership of eighty percent vote or value, and it includes non-U.S. corporations and corporations that meet the ownership test through a partnership. Importantly, all corporations that are members of the same federal consolidated return group are treated as one corporation, so the reclassification rules will have no impact within a consolidated group.

   The Funding Rule

   If a taxpayer engages in a funding transaction that has as a principal purpose of funding one of the three transactions discussed previously, the instrument issued will be treated as stock. For example, assume that a foreign parent lends cash to a U.S. subsidiary in exchange for a note. If within thirty-six months the U.S. subsidiary makes a distribution to the foreign parent, subject to certain exceptions, the note issued in the original loan is recharacterized as equity as of the date of the dividend because it is the same result as having the U.S. subsidiary issue the note for no consideration. The funding rule applies whether the instrument is issued before or after the relevant distribution or acquisition. The per se rules do not apply to ordinary course debt instruments issued for property (i.e., purchases of inventory).

   Exceptions

   The threshold exception provides that these rules do not apply if the EG has total EG debt of $50 million or less. Additionally, the earnings and profits exception provides that the amount of any general rule or funding rule distribution or acquisition is reduced by the issuer's post-April 4, 2016, current and accumulated earnings and profits. Lastly, final regulations include exceptions for certain cash pooling, treasury centers, and entities like insurance companies and banks that are subject to regulation of their capital.

   Documentation Requirements. The regulations provide minimum documentation requirements that, if not met, set up a rebuttable presumption that an expanded group instrument (EGI) qualifies as debt. Although failure to meet the documentation requirements means an EGI is stock, satisfying those requirements is not conclusive evidence that the EGI is debt.

   The documentation requirements apply to an EGI if: (1) the stock of any member of the EG is publicly traded; (2) total assets on the EG's financial statements exceed $100 million; or (3) total revenue on the EG's financial statements exceeds $50 million. If the documentation rules apply, an EGI must be evidenced by documentation...