by Julie Martin, Editor, MNE Tax
The US IRS on September 21 proposed to remove the hotly contested Section 385 debt-equity documentation regulations and work toward developing replacement guidance.
Finalized in 2016 during the last weeks of the Obama administration, the regulations require multinationals that issue related-party debt to provide information to the IRS that establishes that the instrument should be treated as debt for tax purposes, rather than as equity. The documentation requirement is a minimum requirement for an instrument to be considered debt; the IRS can still reclassify an instrument as stock if the documentation shows such classification is appropriate.
Differing opinions
The regulations, which have yet to enter into effect, have been hailed by some as a needed tool to shut down a tax avoidance technique known as interest stripping, used by multinationals. At the same time, the regulations have been denounced by multinationals and their advisors as being overbroad and hitting many ordinary business transactions.
Citing these opposing views, the IRS proposes to withdraw the Section 385 debt-equity documentation regulations and further study the problems that the regs sought to remedy. When that study is complete, the government may propose a modified version of the documentation regulations, the Service said.
“Any such regulations would be substantially simplified and streamlined to reduce the burden on US corporations and yet would still require sufficient documentation and other information for tax administration purposes,” the government said.
Moreover, the Service promised that any new regulations would bear a prospective effective date, giving taxpayers ample time to put in place systems needed to comply.
Friday’s action does not affect portions of final Section 385 regulations that treat as stock certain debt that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction that achieves an economically similar result.
Business opposition
Since their introduction as proposed rules in April 2016, the Section 385 debt-equity documentation regulations have been vigorously opposed by multinational groups for adding unacceptable levels of complexity, cost, and burdens.
Despite this chorus of opposition, the rules were finalized with some taxpayer-favorable modifications in October 2016 and were set to enter into effect January 1, 2018.
The final regulations were subsequently identified by Treasury in July 2017 as qualifying for revision under President Trump’s executive order mandating a reduction in regulatory burden, however.
One month later, in Notice 2017-36, the regs’ effective date was delayed by one year to January 1, 2019, as Treasury reassessed the rules and solicited additional taxpayer feedback.
Earnings stripping concerns
According to the Service, while business groups again responded to its request for feedback asking the government to limit or remove the Section 385 debt-equity documentation regulations, almost 500 public interest groups and other associations and more than 68,000 individual taxpayers urged Treasury to retain or strengthen the regulations.
“[T]hese commenters view the Section 385 Regulations as an important step in leveling the playing field for small, domestic businesses that cannot take advantage of earnings stripping tax planning, thus allowing such domestic businesses to compete with large multinational companies based solely on their products and services, and not their ability to take advantage of tax planning. Also, these commenters argued that allowing large multinational corporations to shift earnings offshore does not create jobs or economic growth in the United States and only serves to disadvantage domestic companies,” the Service said.
Interest stripping occurs when a multinational group member located in a low-tax country issues a debt instrument to a related group company located higher-tax country, such as the US. The company located in the low tax rate country receives taxable interest income on the debt, while the entity located in the high tax rate country can take interest deductions in an equivalent amount. Because of the mismatch in tax rates, the scheme reduces overall taxes paid the group, shifting income from the higher tax country to the lower tax country, and, at the same time, does not otherwise change the group’s overall financial situation.
The Service has asked for public feedback on its proposal to withdraw the Section 385 debt-equity documentation regulations by late December.
Julie Martin
Julie Martin is the founder of MNE Tax. She edits the publication and regularly contributes articles on new developments in cross-border business taxation.
Julie has worked as a tax journalist and editor for more than 13 years. Prior to that, she worked as an in-house tax attorney in New York. She also holds an LLM in taxation from New York University School of Law.
Julie can be reached at [email protected].
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