Concerns over Scope and Feasibility Generally Addressed; but Documentation Requirements Remain.
1) Effective Date of Documentation Rules Delayed
Under the Proposed Regulations, the documentation rules were to apply to any debt issued on or after the date the Proposed Regulations were finalized. Under the final regulations however, the effective date for documentation was delayed and instead applies to debt issued on or after January 1, 2018, providing taxpayers more than a year to prepare.
2) Documentation Deadline Extended
Under the Proposed Regulations, documentation was due within 30 (or in some cases 120) days of the issuance of the debt. Under the Final Regulations, the documentation deadline was extended to the taxpayer's federal income tax filing (inclusive of any extensions) for the tax year in which the debt is issued.
3) Narrowed Reach
Under the Proposed Regulations, the documentation requirements applied to almost all purported debt with few exceptions. Under the Final Regulations, the scope was narrowed to apply to purported debt issued by a "Covered Member" defined generally as a U.S. corporation. For the purposes of 1.385-2, this explicitly excludes debt issued by:
Foreign entities, including CFCs (Controlled Foreign Corporations);
S Corporations; and
Non-controlled RICs (Regulated Investment Companies) or REITs (Real Estate Investment Trusts).
Disregarded entities owned by a Covered Member are not exempt from the documentation requirements under 1.385-2.
The thresholds of assets greater than $100M, annual revenues over $50M, or any member of the Expanded Group having publicly traded stock still apply.
4) Substantive Documentation Requirements Remain
While the final regulations offer a more reasonable approach to documentation compliance, they continue to require demonstration of the following four factors:
The issuer's binding obligation to pay a sum certain;
The holder's rights to enforce payment;
A reasonable expectation of repayment; and
A course of conduct that is generally consistent with a debtor-creditor relationship.
This represents the minimum documentation standard for the determination that the purported debt is in fact debt for federal income tax purposes.
5) Introduction of a Safe Harbor
In response to comments requesting a "market standard safe harbor," the Final Regulations provide that documentation customarily used in third-party transactions can be used to satisfy the factors above related to unconditional obligation to pay a sum certain and creditor’s rights. This may be particularly beneficial to trade payables transactions.
6) Annual Ability-to-Pay Analyses Ease Documentation Burden
In certain instances, the Final Regulations (unlike the Proposed Regulations) allow the taxpayer to perform an annual credit analysis of an issuer and use it to assess the issuer’s ability to repay with regards to multiple instruments, assuming no material changes throughout the course of the year. In other words, the annual analysis assesses the maximum level of debt an issuer can bear rather than requiring an analysis for every financing flow, as was the case under the proposed regulations. This is especially useful for high volume financing transactions covered by an overall arrangement (e.g., a revolving credit agreement, omnibus, umbrella, master, cash pool, or similar).
7) Refinancing Assumptions Explicitly Allowed
The Final Regulations clarify and make explicit that when performing an ability-to-repay analysis, the taxpayer can consider refinancing of existing debt of the issuer. In other words, the ability-to-repay a specific debt can be satisfied with the proceeds for another debt issuance, assuming the subsequent debt occurs at similar terms to a third-party issuance.
8) Creditor's Rights may be Implicit
The Final Regulations allow taxpayers to avoid making specific mention to creditor's rights in intercompany agreements, provided that the rights are created by local governing law and that the documentation makes specific reference to the local law.
9) Bifurcation Removed
Under the Proposed Regulations, the concept of "bifurcation" was introduced whereby the Internal Revenue Service could determine that an instrument was in part debt and in part equity should the taxpayer fail to demonstrate that the issuer could service 100 percent of the purported debt. This concept was ultimately not included in the final regulations.
10) Automatic Recharacterization Eased
Under the Proposed Regulations, failure to comply with the documentation rules resulted in the automatic recharacterization of the instrument as stock. The final regulations make certain exceptions to this per se treatment for "highly compliant" Expanded Groups, which in some cases may rebut the recast of an instrument (known as rebuttable presumption). That said, there is a very strict definition of "high compliant."
Duff & Phelps has assisted numerous taxpayers prepare for the documentation provisions associated with the 385 Regulations. Our independence, our world-renowned debt structuring and capital markets services, and our deep expertise in valuation and transfer pricing provide us with a unique ability to assist with intercompany debt financing.