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How New Section 385 Regs Could Change the Corporate Tax Game

By Casey C. Sullivan, Esq. on July 19, 2016 | Last updated on March 21, 2019

In early April, the Treasury Department and IRS released new proposed regulations under Section 385 of the Internal Revenue Code. They have been called "sweeping" and "dramatic" by tax experts and partners at major firms across the board -- terms not usually associated with IRS regs. And they come as a bit of a surprise, having only been hinted to in earlier Treasury rule-making notices.

The new Section 385 regulations are so broad that they "fundamentally redefine the extent to which an intercompany instrument will constitute debt, irrespective of whether that group is inverted and who in the group issues it," as Kevin M. Cunningham, managing director of KMPG in the International group, explains in a new Special Report for Thomson Reuters Checkpoint. (Disclosure: Thomson Reuters is FindLaw's parent company.) Here's what in-house counsel need to know.

Dramatic Changes to Intercompany Debt

The proposed regulations are directed at corporate inversions, but they are not limited to cross-border transactions and will have significant impacts on almost all companies, inverted or not. Generally speaking, the new regulations accomplish three things:

1. They allow the IRS to treat a single debt instrument as both part debt and part equity.

2.They establish documentation and identification requirements and rules for treating a note as debt.

3.They treat certain debt instruments issued between affiliates as equity for federal income tax purposes.

So, how does that play out in the real world? As Cunningham explains:

[I]f a U.S. corporation were to issue a debt instrument to its non-U.S. corporate owner as a distribution with respect to its stock (e.g., as a dividend), the proposed regulations would generally recharacterize that debt as preferred equity.

The same goes if the company was to sell shares of its subsidiary to a second subsidiary in a Section 304 transaction -- again, the intercompany debt would be treated as stock. The goal is to hamper business maneuvers which the Treasury Department believes act "to create interest deductions that reduce U.S. source income without investing any new capital in the U.S. operations."

Where to Go From Here

The Section 385 regulations mark a major shift in the Treasury and IRS's handling of intercompany debt. For in-house counsel, the implications of these new regulations will be huge. Thankfully, you don't have to figure them out all on your own.

Thomson Reuters Checkpoint's Special Report, "The New Section 385 Proposed Regulations: No More Alice in Wonderland," offers a comprehensive view of the new regs and what they could mean to your company. They're specific enough to guide you through the proposed rule's implications, but accessible enough that you don't have to go back for an LL.M. in tax law. And it's free.

Since it comes from Checkpoint, the industry leader in tax and accounting information, you'll have the option of accessing a host of related online solutions from experts, providing you the research and guidance you need to navigate the new regulations.

Download the free Thomson Reuters Checkpoint Special Report, "The New Section 385 Proposed Regulations: No More Alice in Wonderland" here.

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