Section 385 of the Internal Code enacted in 1969 is a provision that I barely remember from tax school as one of the forgotten and under utilized pieces of the Code. Since passing into law, there has never been any finalized regulations on this provision, (one attempt more than 35 years ago) unlike the thousands and thousands of pages of Regs elsewhere. Up until now, it would seem that there was no need. There are scores and scores of precedent and case law. But as liberals say, never let an opportunity to screw the taxpayer, cause confusion and disrupt business go undone.
Therefore, and April 4th, the U.S. Treasury Department issued proposed Regulations on this non-problem.
Section 385 authorizes the Secretary of the Treasury to issue regulations "as may be necessary or appropriate to determine whether an interest in a corporation is to be treated... as stock or indebtedness." In addition, the provision suggests various factors to be taken into account in making a debt or equity determination--such as: (a) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money, and to pay a fixed rate of interest;(b) whether there is subordination to or preference over other indebtedness of the corporation;(c) the debt-to-equity ratio of the corporation; (d) whether the purported debt is convertible into stock of the corporation; and the relationship between holdings of stock in the corporation and holdings of the interest in question. A copy of the Law in full is at the end.
I have had a chance to review the proposed Regulations. Whoa.They are quite broad and seem to abandon the long-standing approach in reclassifying instruments as equity that have been denominated as debt. The Regs instead examine the relationship of the parties to the instrument, the context in which it was issued, and the relevant documentation to determine whether there is sufficient support for the claim of debt treatment. In addition, and even more troubling is the Regulations also abandon the practice and authority treating an instrument as either debt or equity in its entirety and introduces the possibility an instrument can be characterized as part debt, part equity, presumably by IRS fiat.
So what difference does it make? Debt or Equity? Plenty. First, understand that tax liberals (defined as those who want to generate more tax money to spend and generally do not understand normal commercial practices.) loathe debt.
Some of the reasons are easy to understand.
- 1nterest payable on debt is fully deductible while distributions on equity interests are not deductible.
- Interest is fully taxable to the non-corporate creditor as ordinary income. Distributions with respect to equity interests held by non-corporate shareholders may also be taxed as ordinary income, but only to the extent of the corporation's earnings and profits.
- Interest is fully taxable as ordinary income, while dividends are either "eliminated" by filing a consolidated return, or are partially taxed due to the dividends received deduction.
- Repayment of debt is a tax-free return of capital to the creditor to the extent of the creditor's tax basis in the debt. Repayment to a shareholder's is usually treated as a dividend.
- Characterization of purported debt as equity might disqualify a corporation's Subchapter S election.
There are other ramifications but I will not dwell on all of them. It boils down, interest deduction against no deduction at all.
Although the Section 385 proposed regulations were issued in conjunction with temporary regulations targeting cross border mergers or what is horribly referred to as “inversion transactions,” they appear to limit the effectiveness of certain types of tax planning by characterizing related party financings as equity, even if they are in form of straight debt instruments and characterize as equity broad categories of related party debt transactions.
This is mean stuff and would seem to me to have a real effect on routine cash management including the use of cash pooling.
I do not believe the Treasury Department rationale that the Regs are intended to limit the earnings stripping benefits of cross border mergers. The proposed Regulations, if adopted without change will apply, and are intended to apply, to a broad range of transactions and would significantly impact many ordinary business transactions and re-structurings of both domestic and foreign corporations.
The issuance of the Regulations is an action trying to solve a problem that did not really exist. It is a ham handed attempt to inject last minute government fiat by a waning Administration.
The rush to get these finalized, change the rules, expand the authority of the tax authorities without any advance notice and a short process of review and comment does not befit sound tax policy.
This is a very complicated, complexed and technical area. There is a coalition business groups working on the issue. Their approach as far as I can determine is timid given the impact but perhaps a combination of Congressional concern and common sense will bring some modifications. I would not hold my breath on that occurring.
Remember to Write in Mr. Giant for President--the better alternative
385. Treatment of certain interests in corporations as stock or indebtedness
(a) Authority to prescribe regulations
The Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness).
The regulations prescribed under this section shall set forth factors, which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. The factors so set forth in the regulations may include among other factors:
(1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,
(2) whether there is subordination to or preference over any indebtedness of the corporation,
(3) the ratio of debt to equity of the corporation,
(4) whether there is convertibility into the stock of the corporation, and
(5) the relationship between holdings of stock in the corporation and holdings of the interest in question.
(c) Effect of classification by issuer
(1) In general
The characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary).
(2) Notification of inconsistent treatment
Except as provided in regulations, paragraph (1) shall not apply to any holder of an interest if such holder on his return discloses that he is treating such interest in a manner inconsistent with the characterization referred to in paragraph (1).
The Secretary is authorized to require such information as the Secretary determines to be necessary to carry out the provisions of this subsection.
Enacted as part of Tax Reform Act of 1969