Is an interest in a related corporation treated as stock or indebtedness, or as in part stock and in part indebtedness?
On April 4, 2016, the IRS and the U.S. Treasury Department issued proposed regulations (REG-108060-15) under Code Sec. 385 that address this question. If finalized, Code Sec. 385 would drastically change the treatment of intercompany debt issued among members of particular corporate entities. Some experts have characterized the Code Sec. 385 proposed regulations as the one of the most significant changes to the income tax law ever undertaken via administrative authority.
At Skoda Minotti, the largest impact we see is on companies that have loans between U.S. and foreign affiliates.
It appears that the proposed Code Sec. 385 regulations are intended to limit the usefulness of certain types of tax planning by describing related party financings as equity—even if they are straight debt instruments. In certain circumstances, the Code Sec. 385 regulations would re-characterize debt instruments issued between affiliates as stock for U.S. federal income tax purposes that would, in most cases, be viewed as preferred equity. With limited exceptions, the proposed regulations would apply to debt instruments issued on or after April 4, 2016.
A U.S. Treasury Department press release described these regulations simply as designed to “reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping.”
With both Republicans and Democrats expressing concern over the seemingly unintended broad application of these regulations, one would reasonably conclude that the final regulations will likely change with a more limited scope.
We will continue to monitor activity surrounding Code Sec. 385 and keep you apprised of the latest developments. For questions regarding Code Sec. 385 or other tax matters, please contact Jason Rauhe, CPA at 440-449-6800 or email Jason.