Treatment of Certain Interests in Corporations as Stock or Indebtedness

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9790]

RIN 1545-BN40

Treatment of Certain Interests in Corporations as Stock or Indebtedness

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Final regulations and temporary regulations.

SUMMARY:

This document contains final and temporary regulations under section 385 of the Internal Revenue Code (Code) that establish threshold documentation requirements that ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes, and treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes. The final and temporary regulations generally affect corporations, including those that are partners of certain partnerships, when those corporations or partnerships issue purported indebtedness to related corporations or partnerships.

DATES:

Effective Date:

These regulations are effective on October 21, 2016.

Applicability Dates:

For dates of applicability, see §§ 1.385-1(f), 1.385-2(i), 1.385-3(j), 1.385-3T(k), 1.385-4T(g), and 1.752-2T(l)(4).

FOR FURTHER INFORMATION CONTACT:

Concerning the final and temporary regulations, Austin M. Diamond-Jones, (202) 317-5363, and Joshua G. Rabon, (202) 317-6938 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these regulations has been reviewed and approved by the Office of Management and Budget under control number 1545-2267. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

I. In General

On April 8, 2016, the Department of the Treasury (Treasury Department) and the IRS published proposed regulations (REG-108060-15) under section 385 of the Code (proposed regulations) in the

Federal Register

(81 FR 20912) concerning the treatment of certain interests in corporations as stock or indebtedness. A public hearing was held on July 14, 2016. The Treasury Department and the IRS also received numerous written comments in response to the proposed regulations. All comments are available at

www.regulations.gov

or upon request. The comments received in writing and at the public hearing were carefully considered in developing the final and temporary regulations. In addition, certain portions of the proposed regulations that were substantially revised based on comments received are being issued as temporary regulations. The text of the temporary regulations serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject published in the Proposed Rules section of this issue of the

Federal Register

. In addition, this Treasury decision reserves on the application of certain portions of the proposed regulations pending additional study.

II. Summary of Section 385 and the Proposed Regulations

Section 385 authorizes the Secretary of the Treasury to prescribe rules to determine whether an interest in a corporation is treated for purposes of the Code as stock or indebtedness (or as in part stock and in part indebtedness) by setting forth factors to be taken into account with respect to particular factual situations. Under this authority, the proposed regulations provided specific factors that, when present in the context of purported debt instruments issued between highly-related corporations, would be dispositive.

Specifically, proposed § 1.385-2 provided that the absence of timely preparation of documentation and financial analysis evidencing four essential characteristics of indebtedness would be a dispositive factor requiring a purported debt instrument to be treated as stock for federal tax purposes. Because related parties do not deal independently with each other, it can be difficult for the IRS to determine whether there was an intent to create an actual debtor-creditor relationship in this context, particularly when the parties do not document the terms governing the arrangement or analyze the creditworthiness of the borrower contemporaneously with the loan, each as unrelated parties would do. For this reason, the proposed regulations prescribed the nature of the documentation necessary to substantiate the treatment of related-party instruments as indebtedness, including documentation to establish an expectation of repayment and a course of conduct that is generally consistent with a debtor-creditor relationship. Proposed § 1.385-2 required that such documentation be timely prepared and maintained, and provided that, if the specified documentation was not provided to the Commissioner upon request, the instrument would be treated as stock for federal tax purposes.

Proposed § 1.385-3 identified an additional dispositive factor that indicates the existence of a corporation-shareholder relationship, rather than a debtor-creditor relationship: The issuance of a purported debt instrument to a controlling shareholder in a distribution or in another transaction that achieves an economically similar result. These purported debt instruments do not finance any new investment in the operations of the borrower and therefore have the potential to create significant federal tax benefits, including interest deductions that erode the U.S. tax base, without having meaningful non-tax significance.

Proposed § 1.385-3 also included a “funding rule” that treated as stock a purported debt instrument that is issued as part of a series of transactions that achieves a result similar to a distribution of a debt instrument. Specifically, proposed § 1.385-3 treated as stock a purported debt instrument that was issued in exchange for property, including cash, with a principal purpose of using the proceeds to fund a distribution to a controlling shareholder or another transaction that achieves an economically similar result. Furthermore, the proposed regulations included a “per se” application of the funding rule that treated a purported debt instrument as funding a distribution or other transaction with a similar economic effect if it was issued in exchange for property (other than in the ordinary course of purchasing goods or services from an affiliate) during the period beginning 36 months before and ending 36 months after the funded member made the distribution or undertook the transaction with a similar economic effect.

Proposed § 1.385-3 included exceptions that were intended to limit the scope of the section to transactions undertaken outside of the ordinary course of business by large taxpayers

with complex organizational structures. The proposed regulations also included an anti-abuse provision to address a purported debt instrument issued with a principal purpose of avoiding the application of the proposed regulations. Proposed § 1.385-4 provided rules for applying proposed § 1.385-3 in the context of consolidated groups.

Finally, proposed § 1.385-1(d) provided the Commissioner with the discretion to treat certain interests in a corporation for federal tax purposes as indebtedness in part and stock in part (a “bifurcation rule”).

III. Overview of Significant Modifications To Minimize Burdens

In response to the proposed regulations, the Treasury Department and the IRS received numerous detailed and thoughtful comments (including comments provided at the public hearing) suited to the highly technical nature of certain of the proposed rules. The Treasury Department and the IRS carefully considered these comments. Many of the comments expressed concern that the proposed regulations would impose compliance burdens and result in collateral consequences that were not justified by the stated policy objectives of the proposed regulations. In response to the comments received, the final and temporary regulations substantially revise the proposed regulations to achieve a better balance between minimizing the burdens imposed on taxpayers and fulfilling the important policy objectives of the proposed regulations. The remainder of this Part III summarizes the most noteworthy modifications included in the final and temporary regulations, which are the following:

Changes to the overall scope of the regulations:

•

Exclusion of foreign issuers.

The final regulations reserve on all aspects of their application to foreign issuers; as a result, the final regulations do not apply to foreign issuers.

•

Exclusion of S corporations and non-controlled RICs and REITs.

S corporations and non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs) are exempt from all aspects of the final regulations.

•

Removal of general bifurcation rule.

The final regulations do not include a general bifurcation rule. The Treasury Department and the IRS will continue to study this issue.

Significant changes to the documentation requirements in § 1.385-2:

•

Extension of period required for timely preparation.

The final regulations eliminate the proposed regulations' 30-day timely preparation requirement, and instead treat documentation and financial analysis as timely prepared if it is prepared by the time that the issuer's federal income tax return is filed (taking into account all applicable extensions).

•

Rebuttable presumption based on compliance with documentation requirements.

The final regulations provide that, if an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than per se recharacterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument.

•

Delayed implementation.

The final regulations apply only to debt instruments issued on or after January 1, 2018.

Significant changes to the rules regarding distributions of debt instruments and similar transactions under § 1.385-3:

•

Exclusion of debt instruments issued by regulated financial groups and insurance entities.

The final and temporary regulations do not apply to debt instruments issued by certain specified financial entities, financial groups, and insurance companies that are subject to a specified degree of regulatory oversight regarding their capital structure.

•

Treatment of cash management arrangements and other short-term debt instruments.

The final and temporary regulations generally exclude from the scope of § 1.385-3 deposits pursuant to a cash management arrangement as well as certain advances that finance short-term liquidity needs.

•

Limiting certain “cascading” recharacterizations.

The final and temporary regulations narrow the application of the funding rule by preventing, in certain circumstances, the so-called “cascading” consequence of recharacterizing a debt instrument as stock.

•

Expanded earnings and profits exception.

The final and temporary regulations expand the earnings and profits exception to include all the earnings and profits of a corporation that were accumulated while it was a member of the same expanded group and after the day that the proposed regulations were issued.

•

Expanded access to $50 million exception.

The final and temporary regulations remove the “cliff effect” of the threshold exception under the proposed regulations, so that all taxpayers can exclude the first $50 million of indebtedness that otherwise would be recharacterized.

•

Credit for certain capital contributions.

The final and temporary regulations provide an exception pursuant to which certain contributions of property are “netted” against distributions and transactions with similar economic effect.

•

Exception for equity compensation.

The final and temporary regulations provide an exception for the acquisition of stock delivered to employees, directors, and independent contractors as consideration for the provision of services.

•

Expansion of 90-day delay for recharacterization.

The 90-day delay provided in the proposed regulations for debt instruments issued on or after April 4, 2016, but prior to the publication of final regulations, is expanded so that any debt instrument that is subject to recharacterization but that is issued on or before January 19, 2017, will not be recharacterized until immediately after January 19, 2017.

The foregoing changes significantly reduce the number of taxpayers and transactions affected by the final and temporary regulations. As narrowed, many issuers are entirely exempt from the application of §§ 1.385-2 and 1.385-3. Moreover, with respect to the large domestic issuers that are subject to § 1.385-3, that section is substantially revised to better focus on extraordinary transactions that have the effect of introducing related-party debt without financing new investment in the operations of the issuer. The final and temporary regulations thus apply in particular factual situations where there are elevated concerns about related-party debt being used to create significant federal tax benefits without having meaningful non-tax effects.

Summary of Comments and Explanation of Revisions

I. In General

The Treasury Department and the IRS received numerous comments requesting that various entities be excluded from the scope of the proposed regulations. After considering the comments received, the Treasury Department and the IRS have adopted several of these recommendations. As an alternative to excluding certain entities from the scope of the regulations, many comments also suggested adopting special rules or narrower technical exceptions to provide relief for particular issues. In many cases, adopting the broader comment to exclude certain entities from the scope of the final and

temporary regulations renders such alternative proposals moot. For example, comments requested a rule providing that recharacterized debt of an S corporation will not be treated as a second class of stock for purposes of section 1361(b)(1)(D). This comment is moot because the final and temporary regulations do not contain a general bifurcation rule and provide that S corporations are not treated as members of an expanded group (as described in Part III.B.2.b of the Summary of Comments and Explanation of Revisions) and therefore are not subject to the final and temporary regulations. Although the Treasury Department and the IRS considered all comments received, this preamble generally does not discuss comments suggesting alternative approaches to the extent such comments are rendered moot by adopting a broader comment. Similarly, because the final and temporary regulations do not contain the general bifurcation rule of proposed § 1.385-1(d), this preamble does not discuss that rule or the comments received with respect to it.

Many comments requested that the regulations include examples illustrating the application of specific rules of the proposed regulations to specific fact patterns. Where appropriate to illustrate the basic application of rules to common fact patterns, the final and temporary regulations provide the requested examples. In some cases, the Treasury Department and the IRS determined that a modification of a rule rendered such request moot or that a clarification of a rule was sufficient to illustrate the point the requested example would clarify. In other cases, the Treasury Department and the IRS clarified the issue through discussion in this preamble.

Numerous comments recommended that the Treasury Department and the IRS extend the deadline for receiving comments. Many of those comments recommended a 90-day extension. Other comments recommended that the Treasury Department and the IRS continue to solicit and consider taxpayer feedback outside of the comment period.

The Treasury Department and the IRS declined to extend the standard 90-day comment period because numerous detailed and substantive comments were received before the deadline. The proposed regulations provided that written or electronic comments and requests for a public hearing had to be received by July 7, 2016, which was 90 days after the publication of the notice of proposed regulations in the

Federal Register

. A public hearing was held on July 14, 2016. Sixteen speakers or groups of speakers spoke at the public hearing. Over 29,600 written comments were received, of which 145 were unique and commented on specific substantive aspects of the proposed regulations. Of the written comments, 6 were received after July 7, 2016, and all were considered in drafting the final and temporary regulations.

The final and temporary regulations reserve on several issues raised in comments, and this preamble includes a new request for comments regarding the type of rules that should apply in those contexts. See Future Guidance and Request for Comments. The Treasury Department and the IRS believe that all remaining issues raised in the comments are appropriately addressed in the changes described in this preamble, and, in the time since the comment period closed, have not been made aware of any particular additional issues that would benefit from an extended comment period.

In addition, because aspects of the final and temporary regulations apply to debt instruments issued after April 4, 2016, the Treasury Department and the IRS determined that it is important for taxpayers and for tax administration to issue the final and temporary regulations expeditiously after giving due consideration to all comments received.

II. Comments Regarding Authority To Issue Regulations Under Section 385

A. Interpretation of Authority Under Section 385

Various comments asserted that the proposed regulations were an invalid exercise of regulatory authority under section 385, including because the regulations were motivated in part by the concern over excessive interest deductions and that such purpose is not authorized by section 385.

The Treasury Department and the IRS have determined that the final and temporary regulations are a valid exercise of authority under section 385. Section 385(a) vests the Secretary with authority to promulgate such rules as may be necessary or appropriate to determine whether, for federal tax purposes, an interest in a corporation is treated as stock or indebtedness (or as in part stock and in part indebtedness). The final and temporary regulations exercise this authority consistent with Congress's mandate by providing factors that determine whether a purported debt interest is treated as stock, indebtedness, or in part stock and in part indebtedness in particular factual situations involving transactions among highly-related corporations (relatedness itself being a factor explicitly enumerated in section 385(b)(5)). Section 385 does not limit the Treasury Department and the IRS to issuing regulations only for certain purposes.

Consistent with section 385(a), the Treasury Department and the IRS have concluded that the regulations are necessary and appropriate. With respect to the documentation rules in § 1.385-2, as Congress observed when it enacted section 385, historically there has been considerable confusion regarding whether various interests are debt or equity or some combination of the two.

See

S. Rep. No. 91-552, at 138 (1969). The Treasury Department and the IRS have observed that this uncertainty has been particularly acute in the context of related-party debt instruments. Section 1.385-2 of the final regulations helps to resolve this uncertainty with respect to the particular factual situation of transactions among highly-related corporations by providing guidance on the type of documentation that is required to support debt classification. Focusing on this particular factual situation is appropriate because such debt raises unique concerns. Related parties do not have the same commercial incentives as unrelated parties to properly document their interests in one another, making it difficult to determine whether there exists an actual debtor-creditor relationship. In addition, because debt, in contrast to equity, gives rise to deductible interest payments, there are often significant tax incentives to characterize interests in a corporation as debt, which may be far more important than the practical commercial consequences of such characterization. Accordingly, when a controlling shareholder (or a party related to a controlling shareholder) invests in a corporation, it is necessary and appropriate to require the shareholder to document that an analysis was undertaken to establish an expectation of repayment and that the parties' conduct throughout the term of the loan is consistent with a debtor-creditor relationship.

With respect to the rules described in §§ 1.385-3, 1.385-3T, and 1.385-4T, a distribution of a note or an issuance of a purported debt instrument by a corporation to a controlling shareholder (or a person related to a controlling shareholder) followed by a distribution of the proceeds to a controlling shareholder, either actually or in substance, raises additional, unique concerns. These purported debt instruments have the potential to create significant federal tax benefits, but lack

meaningful non-tax significance, including because they do not finance new investment in the operations of the borrower. In the context of highly-related corporations, it is a necessary and appropriate exercise of the Secretary's rulemaking authority to provide that when this factor and the relatedness factor are present, an interest is treated as equity rather than indebtedness.

Various comments also asserted that the regulations are inconsistent with the Treasury Department and the IRS's statutory authority under section 385 because they fail to provide a rule of general application and instead address only a particular set of instruments that raise certain policy concerns.

The Treasury Department and the IRS have concluded that these comments lack merit. Section 385 does not require the promulgation of rules of general applicability. Nothing in section 385 requires the Treasury Department and the IRS to provide a universal definition of debt and equity that would apply to all possible transactions. Instead, the statute authorizes the Secretary to prescribe factors “with respect to a particular factual situation,” as opposed to all possible fact patterns. The statute's legislative history reinforces the validity of this approach by noting the difficulty of legislating “comprehensive and specific statutory rules of universal and equal applicability” and the desirability of addressing the characterization of an interest as debt or equity across “numerous [and] different situations.” S. Rep. No. 91-552, at 138.

The regulations follow this approach by addressing the characterization of interests in the particular factual situation of transactions among highly-related corporations. This is a context in which there is particular confusion regarding what is required in order to establish that a debtor-creditor relationship exists. In addition, in this context there are unique issues with respect to the ability to claim significant federal tax benefits through the creation of indebtedness that often lacks meaningful non-tax effects. The use of section 385's regulatory authority to provide guidelines for documentation is necessary and appropriate to provide greater certainty in determining the nature of interests in a context where there are often no third-party checks. Further, the use of this authority to identify determinative factors (the lack of new capital along with relatedness) is also necessary and appropriate to ensure that the significant tax advantages that accompany debt (in particular, the significant deductions that can be claimed) are limited to circumstances in which there is a financing of new investment.

Several comments asserted that regulations promulgated under section 385 must consist of a list of factors to be weighed on a case-by-case basis, and that the proposed regulations deviated from this requirement by providing dispositive factors.

The Treasury Department and the IRS have concluded that the authority under section 385 does not include such a limitation. Section 385(b) authorizes the Secretary to “set forth factors which are to be taken into account in determining with respect to a particular factual situation” whether an instrument is debt or equity. The final and temporary regulations include two factors that are specifically listed in section 385(b) (both of which are critical factors traditionally relied on by courts): The presence of a “written” promise to pay (section 385(b)(1)) and the relationship between holdings of stock in the corporation and holdings of the interest in question (section 385(b)(5)). Two other factors included in the regulations have been cited in the case law: Whether debt finances new investment in the operations of the borrower, and whether the taxpayer can demonstrate that at the time the advance was made the borrower could reasonably be expected to repay the loan. In the particular factual situation of loans between highly-related corporations, a factual situation in which the relatedness factor described in section 385(b)(5) is amplified, the final and temporary regulations appropriately elevate the importance of the other factors listed above.

Section 385(b) does not require the Secretary to set forth any particular factors (regulations “may include” certain enumerated factors), nor does it prescribe the weight to be given to any selected factors, only that they “are to be taken into account.” Those decisions are left to the discretion of the Secretary.

See

S. Rep. No. 91-552, at 138 (1969) (“The provision also specifies certain factors which may be taken into account in these [regulatory] guidelines. It is not intended that only these factors be included in the guidelines or that, with respect to a particular situation, any of these factors must be included in the guidelines, or that any of the factors which are included by statute must necessarily be given any more weight than other factors added by regulations.”). As the legislative history makes clear, the Treasury Department and the IRS have the authority also to omit factors in particular factual situations and instead emphasize certain other factors. The factors identified and taken into account in the regulations therefore fall within the authority conveyed by section 385. In addition, the fact that the final and temporary regulations provide for particular weighting of these factors (including treating certain factors as dispositive in a particular context) is consistent with the Secretary's discretion to “set forth factors which are to be taken into account.”

Congress enacted section 385 to resolve the confusion created by the multi-factor tests traditionally utilized by courts, which produced inconsistent and unpredictable results.

See

S. Rep. No. 91-552, at 138 (1969). The congressional objective of providing clarity regarding the characterization of instruments would be undermined if the regulations authorized by section 385 were required to replicate the flawed multi-factor tests in the case law that motivated the enactment of section 385. Nothing in section 385 requires a case-by-case approach. The statute does not specify what level of generality is required in respect of a “particular factual situation,” and the Treasury Department and the IRS reasonably interpret this phrase to include the subset of transactions that take place among highly-related corporations. Furthermore, as discussed throughout this Part II.A, the legislative history indicates that Congress intended to grant the Secretary broad authority to provide different rules for distinguishing debt from equity in different situations or contexts.

See also

S. Rep. No. 91-552, at 138 (discussing the need for debt/equity rules given “the variety of contexts in which this problem can arise”).

To underscore the regulations' consistency with the reference in section 385(b) to factors that are to be taken into account in particular factual situations, the final and temporary regulations first provide in § 1.385-1(b) a general rule that effectively implements the common law factors. Therefore, whether an interest is classified as debt or equity ordinarily will be determined based on common law, including the factors prescribed under common law. In the particular factual situation of a purported debt instrument issued between members of an expanded group, § 1.385-2 provides a minimum standard of documentation that must be met in order for an instrument to be treated as debt based on an application of the common law factors and adjusts the weighting of certain common law factors, while § 1.385-3 elevates two particular common law factors (the lack of new

investment in the operations of the issuer and relatedness) into determinative factors. The regulations' enumeration of these factors to determine the characteristics of an instrument is entirely consistent with the plain text of section 385.

Finally, several comments asserted that proposed § 1.385-3 set forth an inappropriate list of factors by exclusively considering circumstances outside the four corners of the instrument, such as the transaction in which the instrument is issued and the use of the funds received in exchange therefor, without regard to the characteristics of the instrument itself.

The Treasury Department and the IRS have concluded that the authority granted by section 385 is plainly broader than interpreted by the comments. As noted above, section 385 authorizes the Secretary to determine which factors must be taken into account when determining the nature of an interest in a particular factual situation. Nothing in the statute requires the Secretary to consider specific factors or, conversely, to disregard other factors. In any event, the factors set forth in the regulations derive from common law debt-equity analyses, which have, among various considerations, often looked beyond the characteristics of the instrument. For instance, Congress identified the relatedness of the parties to the transaction as among the factors that “may” be set forth under section 385,

see

section 385(b)(5) (“the relationship between holdings of stock in the corporation and holdings of the interest in question”), and this factor has been relied upon by numerous courts in similar factual situations. Likewise, the lack of new capital investment created by an issuance of debt is also a common law debt-equity factor.

See,

e.g., Talbot Mills

v.

Comm'r,

146 F.2d 809, 811 (1st Cir. 1944),

aff'd sub nom, John Kelley Co.

v.

Comm'r,

326 U.S. 521 (1946);

Kraft Foods Co.

v.

Comm'r,

232 F.2d 118, 126-27 (2d Cir. 1956).

B. Consideration of Costs

Various comments contended that the Treasury Department and the IRS failed to consider costs in the proposed regulations, that the consideration given to the costs imposed by the regulations was insufficient, or that the proposed regulations' analysis did not accurately reflect the costs of the proposed regulations. One comment cited the Supreme Court's decision in

Michigan

v.

EPA,

135 S. Ct. 2699 (2015), as imposing an obligation to consider costs as part of establishing the appropriateness of regulation, claiming that the Treasury Department and the IRS failed to meet this obligation in the proposed regulations. Another comment asserted that the proposed regulations failed to comply with Executive Order 12866's instruction to assess the costs of regulatory action.

The Treasury Department and the IRS disagree with these comments. The final and temporary regulations are a necessary and appropriate exercise of the Secretary's authority based on the reasons described in Section A of this Part II and the analysis of the regulations' costs and benefits. The Treasury Department and the IRS do not agree with comments that the holding of

Michigan

v.

EPA

compels consideration of costs in every instance. In any event, the Treasury Department and the IRS analyzed the costs and benefits of the proposed regulations in a regulatory impact analysis. This regulatory impact analysis was conducted consistent with the proposed regulations' designation as a “significant regulatory action” under Executive Order 12866.

See https://www.regulations.gov/document?D=IRS-2016-0014-0001.

The Treasury Department and the IRS received extensive comments regarding the costs of the proposed regulations and the regulatory impact analysis that accompanied the proposed regulations. The Treasury Department and the IRS carefully considered those comments in revising the proposed rules to significantly reduce compliance burdens and in developing the regulatory impact analysis of costs and benefits that accompanies and supports the final and temporary regulations. The regulatory impact analysis of the final and temporary regulations is consistent with Executive Order 12866.

As explained in greater detail in Part I of the Special Analyses, the Treasury Department and the IRS estimate that the aspects of the regulations that will apply most broadly (§ 1.385-2) will impact only 6,300 of the roughly 1.6 million C corporations in the United States (0.4 percent). The total start-up expenses for these affected taxpayers is estimated to be $224 million in 2016 dollars, with ongoing annual compliance costs estimated to be $56 million in 2016 dollars, or an average of $8,900 per firm. By comparison, the regulations will significantly reduce the tax revenue losses achieved by the avoidance strategies that these regulations address. Annualizing over the period from 2017 to 2026, the regulations are estimated to yield tax revenue of between $461 million per year (7% discount rate) or $600 million per year (3% discount rate) in 2016 dollars. The analysis concludes that the tax revenues generated from reduced tax avoidance would be at least 6 to 7 times as large as the compliance costs. The analysis also explains the additional, non-quantifiable benefits the regulations will generate, such as increased tax compliance system-wide, efficiency and growth benefits, and lower tax administration costs for the IRS. The analysis supports the conclusion that the regulations are an appropriate and effective exercise of the Treasury Department and the IRS's authority. The Office of Management and Budget reviewed and approved the analysis. The analysis and its conclusions rebut the assertions in comments that the Treasury Department and the IRS failed to consider costs, did not adequately consider costs, or did not accurately estimate costs.

As set forth in this Part II.B, the Treasury Department and the IRS disagree with the comment that the proposed regulations failed to comply with Executive Order 12866. Moreover, section 10 of Executive Order 12866 clearly states that the Order “does not create any right or benefit, substantive or procedural, enforceable at law”; rather, the Order “is intended only to improve the internal management of the Federal Government.”

III. Comments and Changes to § 1.385-1—General Provisions

A. General Approach

1. Regulations Limited to U.S. Borrowers

The proposed regulations applied to certain EGIs and debt instruments issued by corporations to members of the same expanded group without regard to the residency of the issuer. Numerous comments recommended that the regulations not apply to foreign borrowers, including in particular transactions where both the borrower and the lender are foreign corporations (foreign-to-foreign transactions). These comments pointed to various concerns, including the complexity of applying the regulations to potentially hundreds of foreign entities in a multinational group and certain unique consequences that would follow from such application, such as a loss of foreign tax credits. Some comments also questioned the purpose of applying the rules to foreign borrowers. Other comments acknowledged that the United States can have an interest in the tax treatment of indebtedness issued by foreign corporations, in particular indebtedness issued by controlled foreign corporations (CFCs), but observed that the United States' interest is less direct, and of a different nature, than in the

case of indebtedness issued by U.S. borrowers.

The Treasury Department and the IRS have determined that the application of the final and temporary regulations to indebtedness issued by foreign corporations requires further study. Accordingly, the final and temporary regulations apply only to EGIs and debt instruments issued by members of an expanded group that are domestic corporations (including corporations treated as domestic corporations for federal income tax purposes, such as pursuant to section 953(d), section 1504(d), or section 7874(b)), and reserve on the application to EGIs and debt instruments issued by foreign corporations. The final and temporary regulations achieve this result by creating a new term “covered member,” which is defined as a member of an expanded group that is a domestic corporation, and reserves on the inclusion of foreign corporations.

One comment questioned how the proposed regulations would apply to U.S. branches of a foreign issuer. Although it is possible to increase the debt attributable to a U.S. branch through issuances of debt by the foreign owner to a related party, the various requirements on allocating liabilities between a branch and its home office (whether under the Code or a relevant bilateral tax treaty) raise unique issues. This preamble does not address those issues because the final and temporary regulations reserve on their application to foreign issuers, including with respect to U.S. branches of foreign issuers.

2. Treatment of Consolidated Groups as One Corporation

Proposed § 1.385-1(e) treated members of a consolidated group as one corporation for purposes of the regulations under section 385.

As discussed in Part IV.B.1.b of this Summary of Comments and Explanation of Revisions, the final regulations do not apply the rule in proposed § 1.385-1(e) to § 1.385-2. Instead § 1.385-2 provides that an interest issued by a member of a consolidated group and held by another member of the same consolidated group is not within the scope of an applicable interest as defined in § 1.385-2. As a result, such an interest is not subject to the documentation rules in § 1.385-2. Sections 1.385-3, 1.385-3T, and 1.385-4T continue to treat members of a consolidated group as one corporation. Because the rule described in proposed § 1.385-1(e) is now only applicable for purposes of §§ 1.385-3 and 1.385-3T and relates to the treatment of consolidated groups, the rule is moved to § 1.385-4T. See Part VI of this Summary of Comments and Explanation of Revisions for a discussion of the comments and revisions to the rules regarding the application of §§ 1.385-3 and 1.385-3T to consolidated groups.

B. Definitions

1. Controlled Partnership

One comment requested that the regulations clarify that non-controlled partnerships are outside the scope of the regulations. The Treasury Department and the IRS have determined that proposed § 1.385-3 was sufficiently clear that the partnership-specific provisions only applied to controlled partnerships and their partners. Therefore, the regulations do not contain clarifying language to that effect. The application of §§ 1.385-3 and 1.385-3T to controlled partnerships is discussed further in Parts V.H.3 and 4 of this Summary of Comments and Explanation of Revisions.

a. Determining Partners' Interests in Partnership Capital or Profits

The proposed regulations defined the term controlled partnership as a partnership with respect to which at least 80 percent of the interests in partnership capital or profits are owned, directly or indirectly, by one or more members of an expanded group.

A comment recommended the adoption of rules for determining whether members of an expanded group own 80 percent of the capital or profits interests of a partnership. The determination of whether a partner's share of partnership profits or capital is above or below a threshold is necessary to apply various provisions of the Code or regulations. In most cases, neither term is defined with specificity.

See, e.g.,

sections 163(j)(4)(B)(i) and (j)(6)(D)(ii)(II), 613A(d)(3)(B), 707(b)(1) and (2), and 708(b)(1)(B), as well as § 1.731-2(e)(4)(ii). The Treasury Department and the IRS decline to provide more specific rules regarding the determination of profits or capital interests in the context of identifying a controlled partnership for purposes of the section 385 regulations.

The comment also specifically recommended that, for purposes of measuring partners' profits interests, consideration be given to the use of a reasonable estimate of the partners' aggregate profit shares over time in order to prevent a partnership from flipping in and out of controlled partnership status (for example, when profit allocations are based on distribution waterfalls, which shift over time). This recommendation, made in the context of identifying controlled partnerships, echoed other comments regarding the determination of a partner's share of profits for purposes of applying the aggregate approach to partnerships under proposed § 1.385-3. The Treasury Department and the IRS recognize that a partner's share of partnership profits may not always be knowable with certainty, regardless of the purpose for making such determination. However, such determination must always be made in a reasonable manner. In some cases, that reasonable determination will require a partner or the partnership to make estimates regarding a partnership's profitability over some period of time.

The comment also recommended that the definition of a controlled partnership should not take percentages of capital interests into account, but should instead focus solely on a metric based on cumulative shares of profits. The Treasury Department and the IRS have determined that such a limitation would be inappropriate because in certain circumstances a partner's share of capital may be a good metric for identifying control.

As an alternative, the comment recommended that a shift in capital that is small or transitory be disregarded for purposes of the controlled partnership definition. The Treasury Department and the IRS have determined that such a rule would be difficult to administer because it would result in an additional deemed fiction—that is, a partner's share of capital for this purpose could be different from the partner's actual share. The test for control looks to shares of profits or capital, not profits and capital, and because the threshold is 80 percent, small or transitory shifts in capital that would result in a partnership becoming or ceasing to be a controlled partnership should happen infrequently.

b. Indirect Ownership

A comment requested confirmation that determining the status of a partnership as a controlled partnership is a separate and independent inquiry from determining the status of a corporation as an expanded group member. The comment suggested that it was unclear whether, in applying the section 318(a) attribution rules to determine “partnership interest” ownership, such partnership interests are then treated as actually owned for purposes of then applying the section 318(a) attribution rules to determine “stock” ownership. The final regulations clarify that determining the status of a partnership as a controlled

partnership is a separate and independent inquiry from determining the status of a corporation as an expanded group member.

c. Unincorporated Organizations

One comment requested that the regulations not treat certain unincorporated organizations described in § 1.761-2 as controlled partnerships. The final regulations clarify that an unincorporated organization described in § 1.761-2 that elects to be excluded from all of subchapter K is not a controlled partnership. Thus, the Treasury Department and the IRS anticipate that such unincorporated organizations will apply the rules of section 385 in a manner consistent with their pure aggregate treatment.

d. Treatment as a Publicly Traded Partnership

A comment expressed concern that a debt instrument issued by a securitization vehicle organized as a partnership that is treated as stock in the expanded group partner under the proposed regulations could be treated as a partnership interest within the meaning of § 1.7704-1(a)(2)(i)(B) because a “partnership interest” for this purpose can include certain derivative and other indirect contract rights and interests with respect to a partnership. The comment stated that many securitization transactions require an unqualified opinion of tax counsel that the entity is not a publicly traded partnership treated as a corporation for federal income tax purposes, and that the recharacterization rules create uncertainty in this regard.

Section 1.385-2 of the final regulations does not explicitly apply to a debt instrument issued by a controlled partnership. While such a debt instrument may be subject to the anti-avoidance rule in § 1.385-2(f), the concern raised in the comment would only arise under the final regulations if the debt instrument is issued with a principal purpose of avoiding the application of § 1.385-2.

Similarly, § 1.385-3T(f)(4) provides that a debt instrument issued by a controlled partnership is not recharacterized as stock. Instead, as described in more detail in Part V.H.4 of this Summary of Comments and Explanation of Revisions, the holder of a debt instrument (holder-in-form) all or a portion of which otherwise would be treated as stock is deemed to transfer such debt instrument to the partner or partners in the controlled partnership in exchange for stock in the partner or partners. While the deemed partner stock that the holder-in-form of the debt instrument would receive in exchange for the deemed transfer of all or a portion of the debt instrument to the partner or partners in the controlled partnership may be a non-debt financial instrument or contract the value of which is determined in whole or in part by reference to the partnership that issued the debt instrument pursuant to § 1.7704-1(a)(2), the qualified dealer debt instrument exception in the final and temporary regulations is expected to address this issue. That exception applies to make a debt instrument acquired by a dealer in securities not a covered debt instrument, and therefore, not subject to the rules that could result in deemed partner stock.

2. Expanded Group

a. General Framework

The proposed regulations defined the term expanded group by reference to the term “affiliated group” in section 1504(a), with several modifications. Section 1504(a) defines an affiliated group for various purposes under the Code, including for purposes of defining an affiliated group of corporations that are permitted to file a consolidated return. Comments expressed concern that the proposed regulations' modifications to the definition in section 1504(a) for purposes of defining an expanded group would treat certain corporations as members of the same expanded group in situations where the corporations are not “highly related,” which would not be consistent with the policy concerns that the regulations are intended to address. In particular, many comments described the proposed regulations' adoption of the attribution rules of sections 304(c)(3) and 318 in the definition of an expanded group as overly broad. Comments also requested that certain corporations not be included in an expanded group because their special federal tax status made their treatment as an expanded group member less relevant to the policy concerns of the proposed regulations.

Many comments proposed changes to the definition of an expanded group to better align that definition with the regulations' policy concerns, with the majority of the comments recommending changes that would retain section 1504 as the starting point for the definition, including adjustments to the attribution rules of sections 304(c)(3) and 318. However, two comments suggested that section 1563 would be a preferable starting point. Section 1563 defines a “controlled group of corporations” for various purposes under the Code. One comment suggested that, to the extent the regulations treat corporations that are commonly controlled by non-corporate persons (for example, individuals, family members, or partnerships) as an expanded group (brother-sister groups), section 1563, with certain modifications, would be a better starting point than section 1504. Another comment asserted that the attribution rules in section 1563 would be more effective at including in an expanded group only the most highly-related entities. Other comments recommended that brother-sister groups should not be treated as a single expanded group in any case.

As described in more detail in Sections B.2.b through B.2.g of this Part III, the final regulations continue to define the term expanded group using concepts similar to those used to define the term “affiliated group” in section 1504(a). However, changes have been made and new examples added to address concerns expressed in comments regarding both the asserted overbreadth with respect to the types of corporations included in the proposed definition of an expanded group and with respect to the indirect ownership rules under the proposed regulations. Changes also have been made in response to comments to clarify other situations in which entities inadvertently were not treated as members of an expanded group under the proposed regulations but where the policy goals of the regulations clearly are implicated.

Additionally, the modifications that were made to the section 1504-based definition of an expanded group in response to the majority of comments achieve the same results that the two comments proposing a section 1563 approach indicated would be achieved through the use of a section 1563 starting point. Accordingly, the Treasury Department and the IRS decline to adopt the recommendation to use section 1563 concepts in defining an expanded group. The Treasury Department and the IRS have determined that the modifications discussed in Sections B.2.a through g of this Part III more precisely define an expanded group to address those situations in which highly-related corporations implicate the policy goals of the regulations.

b. Exclusion of Certain Entities

In defining an expanded group, the proposed regulations included several modifications to the definition of an affiliated group under section 1504(a). Unlike an affiliated group, an expanded group was defined to include corporations that, under section 1504(b),

would not be included within an affiliated group, including foreign corporations, tax-exempt corporations, S corporations, and RICs and REITs. In addition, indirect stock ownership was taken into account for purposes of the stock ownership requirement of section 1504(a)(1)(B)(i). Finally, the proposed regulations also modified the definition of affiliated group to treat a corporation as a member of an expanded group if 80 percent of the vote

or

value is owned by expanded group members (a disjunctive test) rather than 80 percent of the vote

and

value (a conjunctive test), as required under section 1504(a).

Numerous comments requested exclusions from the definition of an expanded group for entities described in sections 1504(b)(6) (RICs and REITs) and 1504(b)(8) (S corporations). Comments noted that RICs, REITs, and S corporations generally are not subject to corporate level taxation either because of the flow-through treatment accorded under the Code (in the case of an S corporation generally) or because of the dividends paid deduction that can have a similar effect (in the case of a RIC or REIT). In that respect, comments asserted that RICs, REITs, and S corporations are similar to non-controlled partnerships, which the proposed regulations would not have included in an expanded group. Comments also noted that the recharacterization of an instrument issued by an S corporation, REIT, or RIC could jeopardize the entity's federal tax status. Consequently, comments suggested that the regulations exclude S corporations, REITs, and RICs from any expanded group.

In response to these comments, the final regulations exempt S corporations from being expanded group members. The final regulations also exempt RICs or REITs from being expanded group members unless the RIC or REIT is controlled by members of the expanded group. The Treasury Department and the IRS have determined that an S corporation, RIC, or REIT that otherwise would be the parent of an expanded group is generally analogous to a non-controlled partnership. Under both the proposed and the final regulations, a non-controlled partnership that would, if it were a corporation, be the parent of an expanded group is excluded from the expanded group because, by definition, the partnership is not a corporation and only corporations can be members of an expanded group. Consistent with the partnership's status generally as an aggregate of its owners, the partnership should not be a member of the expanded group if its partners would not be members. S corporations, RICs, and REITs have similar flow-through characteristics as partnerships and therefore also should not be members of the expanded group, despite otherwise being corporations that could own stock of members of an expanded group.

However, the final regulations continue to treat a RIC or REIT that is controlled by members of the expanded group as a member of the expanded group. Similar to a controlled partnership, a controlled RIC or REIT should not be able to break affiliation with respect to an otherwise existing expanded group. Unlike partnerships, RICs and REITs are corporations and in certain limited cases are subject to federal income tax at the entity level. Therefore, the final regulations continue to treat controlled RICs and REITs as members of an expanded group, rather than as aggregates of their owners. Because an S corporation cannot be owned by persons other than U.S. resident individuals, certain trusts, and certain exempt organizations, an S corporation cannot be controlled by members of an expanded group in a manner that implicates the policies underlying the final and temporary regulations. S corporations are therefore excluded from the definition of an expanded group member for all purposes of the final and temporary regulations.

Several comments specifically requested exceptions for corporations exempt from taxation under section 501 and insurance companies subject to taxation under section 801. The final regulations do not adopt the recommendation to exclude these corporations from the definition of an expanded group. Although generally exempt from taxation, section 501 corporations may still be subject to tax on unrelated business income and therefore still present concerns relating to related-party indebtedness. In addition, while section 501 corporations are themselves generally tax exempt, they may own taxable C corporation subsidiaries. Even though S corporations and non-controlled REITs and RICs may also own taxable C corporation subsidiaries, in those situations income of the S corporation, REIT, or RIC is generally included in the income of their owners, whereas unrelated business taxable income of a corporation that is exempt from taxation under section 501 is not includible in another taxpayer's income. With respect to insurance companies subject to taxation under section 801, like other corporations, they may also use related-party indebtedness to reduce their taxable income. However, as discussed in Part V.G.2 of this Summary of Comments and Explanation of Revisions, the final and temporary regulations exclude from the application of § 1.385-3 debt instruments issued by certain regulated insurance companies, which generally include insurance companies subject to taxation under section 801.

Finally, one comment requested “specific evidence-based findings” justifying the inclusion of any entity described in section 1504(b) in an expanded group, while another comment asserted that defining a new category of related parties as an expanded group, rather than relying on a statutory definition such as an “affiliated group,” was an inappropriate use of the regulatory process. Section 385 authorizes regulations that affect the treatment of certain interests in corporations as stock or indebtedness. However, the regulations limit their application to expanded group members and are premised on a broad definition of expanded group that generally applies to all types of corporations that are closely related. In defining an expanded group, the Treasury Department and the IRS are not constrained to include only “includible corporations” for purposes of determining an affiliated group of corporations under section 1504(a) or to rely on other predefined groups. The exclusion of specific types of corporations under section 1504(b) is intended to ensure that only certain corporations are permitted to benefit from consolidation for U.S. federal income tax purposes. An exclusion of a certain type of corporation from the expanded group definition, on the other hand, results from a determination by the Treasury Department and the IRS that indebtedness between such entity and its affiliates does not sufficiently implicate the policy concerns of section 385 to subject the corporation to the final and temporary regulations.

c. Indirect Stock Ownership

To determine indirect stock ownership for purposes of defining an expanded group, the proposed regulations applied the constructive ownership rules of section 304(c)(3), which in turn applies section 318(a) subject to certain modifications. This Part III.B.2.c discusses comments related to indirect ownership and the application of section 318(a).

i. Indirect Ownership Under Section 1504(a)(1)(B)(ii)

For purposes of defining an expanded group, proposed § 1.385-1(b)(3)(i)(B) modified section 1504(a)(1)(B)(i) by providing that a common parent must

own 80 percent of the vote or value of at least one other includible corporation (without regard to section 1504(b)) “directly or indirectly” rather than “directly.” The proposed regulations did not include a similar modification to section 1504(a)(1)(B)(ii) (relating to the required ownership in includible corporations (without regard to section 1504(b)) other than the common parent); specifically, the regulations required that 80 percent of the vote or value of each includible corporation be owned “directly” by one or more includible corporations other than the common parent. Several comments recommended that, for purposes of defining an expanded group, section 1504(b)(1)(B)(ii) also be modified by substituting “directly or indirectly” for “directly.”

In response to comments, the final regulations extend the “directly or indirectly” language to both the common-parent test of section 1504(a)(1)(B)(i) and the each-includible-corporation test of section 1504(a)(1)(B)(ii). Accordingly, the indirect ownership rules of section 318, as modified by § 1.385-1(c)(4)(iii) (discussed in detail in Section B.2.c.ii of this Part III) apply for purposes of both tests in section 1504(a)(1)(B). However, to make clear that the ownership tests of section 1504(a)(1)(B) apply to all corporations that can be members of an expanded group (as opposed to only includible corporations within the meaning of section 1504(b)), the final regulations provide the modified section 1504(a)(1)(B) tests in their entirety rather than by cross-reference to section 1504(a)(1)(B). Therefore, federal tax principles that are applicable in determining whether a corporation is a member of an affiliated group under section 1504(a)(1) and (a)(2) are generally applicable in determining whether a corporation is a member of an expanded group.

ii. Definition of Indirect Ownership

As noted in Section B.2.c of this Part III, the proposed regulations cross referenced the rules of section 304(c)(3), which themselves cross reference section 318(a) (with certain modifications), to define indirect ownership. In order to clarify how to determine indirect ownership for purposes of determining an expanded group, the final and temporary regulations cross reference section 318 and the regulations thereunder with modifications, rather than cross reference section 304(c)(3). The regulations under section 318(a) and, with respect to certain options, the regulations under section 1504, apply when determining a shareholder's indirect ownership for purposes of the final regulations.

One comment suggested that the regulations should indicate that indirect stock ownership is determined by “applying the constructive ownership rules of section 304(c)(3),” given that section 304(c)(3) refers to constructive ownership rather than indirect stock ownership. The final regulations do not adopt this comment and instead define indirect stock ownership by reference to the “constructive ownership rules” of section 318, with appropriate modifications.

iii. Stock Owned Through Partnerships

Under section 318(a)(2)(A), stock owned by a partnership is considered owned “proportionately” by its partners. Comments requested guidance on how “proportionately” should be determined under section 318(a)(2)(A) for purposes of determining stock ownership under the proposed regulations. Comments noted that, in the partnership context, determining the value of a partnership interest is not always straightforward, which makes it difficult to determine partners' proportionate interests in a partnership. To address these issues, comments requested safe harbors, including a safe harbor based on the liquidation value of a partner's interest.

The final regulations do not provide guidance on how “proportionately” should be determined under section 318(a)(2)(A) for purposes of determining stock ownership. The proper interpretation of “proportionately” in the context of section 318(a)(2)(A) is relevant to many provisions.

See

sections 304(c)(3) (providing constructive ownership rules for purposes of determining control), 355(e)(4)(C)(ii) (providing attribution rules applicable on a distribution of stock and securities of a controlled corporation), and 958(b) (regarding constructive ownership of stock for many international provisions). Thus, the Treasury Department and the IRS have determined that providing guidance on this issue is beyond the scope of these regulations because these regulations do not require a different application of section 318(a)(2)(A).

iv. Hook Equity

A comment requested guidance regarding the application of the rules of section 318 to ownership structures involving hook equity. The comment indicated that the proposed regulations would increase the circumstances under which hook equity arises, increasing the need for guidance on the treatment of hook equity under section 318 under current law.

The Treasury Department and the IRS have concluded that the constructive ownership rules of section 318 already address the effect of hook equity. In general, under section 318(a)(2), the equity in the entity owning the hook equity can be attributed, in whole or in part, to the non-hook equity holder. Under section 318(a)(5)(A), stock constructively owned by a person by reason of section 318(a)(2) is considered as actually owned by such person. Section 318(a)(5)(A) permits a recursive application of section 318(a)(2), pursuant to which a non-hook equity holder is treated as owning a percentage of the hook equity owned.

See

Examples 3 and 4 of § 1.385-1(c)(4)(vii).

v. Downward Attribution and Brother-Sister Groups

Comments recommended that, for purposes of the expanded group definition, the “downward attribution” rule of section 318(a)(3)(A) be modified to prevent taxpayers that are not highly-related from being treated as members of the same expanded group. Under section 318(a)(3)(A), all of the stock owned by a partner is treated as owned by the partnership, regardless of the partner's ownership interest in the partnership. Thus, for example, assume that USS1 owns a 1 percent interest in PRS, a partnership. Further assume that USS1 wholly owns S1, which wholly owns S2. PRS wholly owns S3. S1, S2, and S3 are all corporations. Pursuant to section 318(a)(3)(A), PRS is treated as wholly owning S1 and S2 (after application of section 318(a)(2)(A)). Under section 318(a)(3)(C), S3 is treated as owning S1 and S2. As a result, S1, S2, and S3 would comprise an expanded group under the proposed regulations despite minimal common ownership between S3 and the other corporations.

To address fact patterns similar to the example above, comments recommended that the section 318(a)(3)(A) downward attribution rule apply only from partners with a specific threshold ownership interest in a partnership, such as partners that own 50 percent or 80 percent of the interests in a partnership. Other comments suggested different solutions to the same problem, including limiting section 318(a)(3)(A) attribution to situations in which related parties owned 80 percent or more of the interests in a partnership, or modifying section 318(a)(3)(A) attribution for these purposes such that a partnership is treated as owning only a proportionate amount of any stock owned by a partner. As an alternative,

one comment recommended that the regulations include an override rule, pursuant to which two entities will not be treated as members of the same expanded group unless one of the entities has a direct or indirect ownership interest of 80 percent or more in the other entity, while applying proportionality principles under this override rule. One comment specifically requested that the downward attribution rule of section 318(a)(3)(A) be limited for purposes of applying the threshold rule of proposed § 1.385-3(c)(2).

Comments also requested similar limits on downward attribution to entities other than partnerships. Specifically, comments recommended that section 318(a)(3) in general should apply only when the interest holder owns 80 percent or more of the entity, or that section 318(a)(3)(C) be modified to provide that the corporation is attributed only a proportionate amount of the stock owned by its shareholder. One comment asserted, without explanation, that an expanded group should be determined entirely without reference to section 318(a)(3) or similar rules.

The principal consequence of requiring downward attribution for purposes of determining indirect ownership under the proposed regulations is that an expanded group included so-called “brother-sister” groups of affiliated corporations that are commonly controlled by non-corporate owners. Similarly, the principal consequence of applying section 318(a)(1) (in connection with section 318(a)(3)), which attributes stock owned by individual members of a family, would also be the treatment of brother-sister groups with non-corporate owners as part of an expanded group. The Treasury Department and the IRS continue to study the issue of brother-sister groups, including the implications of applying the final and temporary regulations to groups with identical members but different expanded group member corporate parents. As a result, the final regulations reserve on the application of section 318(a)(1) and (a)(3) for purposes of determining indirect ownership pending further study.

vi. Option Attribution

A comment requested that, for purposes of determining an expanded group, the option attribution rule of section 318(a)(4) should not apply. The comment suggested that the anti-abuse rule should instead expressly apply to the use of options to avoid the expanded group definition. The comment asserted that it would not be appropriate, for example, to treat a 50-50 joint venture between unrelated corporations as an expanded group member of one or both corporations because of the existence of buy-sell rights that are common in many joint ventures.

The final regulations limit the application of the option attribution rule of section 318(a)(4) in two respects. First, the rule only applies to options that are described in § 1.1504-4(d), which can include: Call or put options, warrants, convertible obligations, redemption agreements, or any instrument (other than stock) that provides for the right to issue, redeem, or transfer stock, and cash settlement options, phantom stock, stock appreciation rights, or any other similar interests. Second, the rule only applies to the extent the options are reasonably certain to be exercised based on all the facts and circumstances as described in § 1.1504-4(g). By limiting the application of the option attribution rule in this manner, the Treasury Department and the IRS intend that ownership of stock will be attributed to an option holder only in the limited circumstances in which the option is analogous to actual stock ownership.

The final regulations also provide a special rule for indirect ownership through options for certain members of consolidated groups. Under this special rule, in applying section 318(a)(4) to an option issued by a member of a consolidated group (other than the common parent of the consolidated group), section 318(a)(4) only applies to the option if the option is treated as stock or as exercised under § 1.1504-4(b) for purposes of determining whether a corporation is a member of an affiliated group. This rule is intended to address cases where, because of the reasonable anticipation requirement of § 1.1504-4(b)(2)(i)(A), members of a consolidated group could theoretically be treated as members of different expanded groups.

vii. Knowledge of Constructive Ownership

A comment indicated that, under the proposed regulations' attribution rules, it would be difficult in certain cases to determine whether entities are treated as members of the same expanded group. The comment requested that a person should be treated as owning stock by reason of attribution solely to the extent such person has actual knowledge of a relationship or should have reasonably known of such relationship after due investigation. The comment did not specify the relationship with respect to which the proposed knowledge qualifier would apply (for example, whether the entities would need to have actual knowledge of their status as members of an expanded group, or if they would only require actual knowledge of the applicable relationship described in section 318 (as modified by section 304(c)(3)).

The final regulations do not adopt a knowledge qualifier with respect to the application of the attribution rules. The attribution rules in the final regulations are similar to attribution rules that are applicable under other Code sections, which are based on objective metrics rather than a subjective determination that would be difficult for the IRS and taxpayers to administer. Furthermore, in the case of highly-related groups, the requisite information needed to determine constructive ownership should be readily available to group members. Therefore, the Treasury Department and the IRS do not expect there will be situations in which taxpayers would be unable to determine constructive ownership after reasonable investigation and legal analysis.

d. Time for Determining Member Status

Comments requested that the regulations clarify when a corporation's status as a member of an expanded group is determined for purposes of § 1.385-3. Several comments recommended that the regulations adopt a “snapshot” approach, under which a corporation's membership in an expanded group is tested immediately before a transaction that is subject to the regulations. In the alternative, one comment suggested that, for purposes of determining whether a corporation has become a member of an expanded group at the time of a distribution or acquisition, its membership should be determined at the close of the transaction or series of related transactions that include the distribution or acquisition. For example, assume FP, a foreign corporation, owns a minority equity interest in USS1, a domestic corporation, with an unrelated party owning the remainder of USS1's stock. USS1 issues a note to FP to redeem FP's stock in USS1. Pursuant to the same plan, FP purchases 100 percent of USS1's stock from the unrelated party. If this comment were adopted, FP and USS1 would be treated as members of the same expanded group at the time of the USS1 redemption because at the close of a series of transactions, FP and USS1 are members of the same expanded group. Accordingly, the USS1 note would be subject to recharacterization under § 1.385-3.

The Treasury Department and the IRS have determined that a snapshot

approach to determining expanded group status is more administrable and results in more consistent outcomes than determining expanded group membership after the transaction and a series of related transactions. Accordingly, the final regulations provide that the determination of whether a corporation is a member of an expanded group at the time of a distribution or acquisition described in § 1.385-3(b)(2) or (b)(3)(ii) is made immediately before such distribution or acquisition.

e. Exceptions for Certain Stock Holdings

i. Voting Rights Held by Investment Advisors

A comment recommended that, for purposes of the expanded group definition, any vote held by an investment advisor, or an entity related to the investment advisor, should be ignored. The comment indicated that private investment funds are typically structured so that the fund's investment adviser, or a related entity, owns the voting interests in the investment fund (which may be taxable as a corporation for federal income tax purposes), while investors own non-voting interests in the fund that represent most of the fund's value. As a result, groups of investment funds managed by the same investment manager may be part of an expanded group because a common investment adviser, or a related entity, controls all of the voting interests in the investment funds. Furthermore, the comment noted that because an investment advisor generally owes separate duties to its investment funds, it does not enter into transactions to shift tax obligations from one fund to another, in contrast to a typical corporate structure.

The final regulations do not adopt this recommendation. The Treasury Department and the IRS disagree that any fiduciary duty owed by an investment advisor to its funds places meaningful limits on the ability for such funds to transact with each other through loans. To the extent that an investment advisor and its investment funds constitute an expanded group, it does not follow that intercompany transactions among such parties that give rise to tax benefits for one or more of them would be violative of fiduciary duties. In addition, unlike certain companies subject to regulation and oversight,

see

Part V.G.1 and 2 of this Summary of Comments and Explanation of Revisions, these funds are not subject to capital or leverage requirements that restrict their ability to issue debt. Without such restrictions, investment advisors that control investment funds may cause the funds to engage in transactions otherwise subject to the final and temporary regulations.

ii. Interests Required To Be Held by Law

A comment requested that, for purposes of determining membership in an expanded group, stock ownership should be disregarded to the extent that the stock is required to be held by law. The comment offered as an example risk retention rules applicable to asset-backed securities, which generally require sponsors to retain either five percent of the most subordinate tranche of a securitization vehicle or to retain a portion of each tranche of the securitization vehicle's securities.

The Treasury Department and the IRS decline to adopt this recommendation for purposes of defining an expanded group because the expanded group definition is already limited to corporations with a high degree of relatedness. However, as discussed in Part V.F.5 of this Summary of Comments and Explanation of Revisions, the final and temporary regulations adopt certain recommended changes to limit the application of § 1.385-3 in certain securitization transactions.

f. Investment Blockers

The preamble to the proposed regulations requested comments on whether certain debt instruments used by investment partnerships, including indebtedness issued by certain “blocker” entities, implicate similar policy concerns as those motivating the proposed regulations, such that the scope of the proposed regulations should be broadened. Several comments recommended that the scope of the proposed regulations should not be broadened to apply to such transactions (by, for example, treating a partnership that owns 80 percent or greater of the stock of a blocker corporation as an expanded group member). The final and temporary regulations do not adopt special rules for debt instruments used by investment partnerships, including indebtedness issued by certain “blocker” entities. The Treasury Department and the IRS continue to study these structures and these transactions in the context of the section 385 regulations.

g. Overlapping Expanded Groups

One comment requested clarification that, although a corporation may be a member of multiple expanded groups, any particular expanded group can have only one common parent, such that having a common expanded group member does not cause overlapping expanded groups to be treated as a single expanded group. For example, the comment requested clarification that if USS1, a domestic corporation, owned 80% of the value of X, a corporation, and USS2, also a corporation, owned 80% of the vote of X, USS1 and USS2 would not be treated as members of the same expanded group by virtue of being common parents with respect to X.

The Treasury Department and the IRS agree that, while a corporation can be a member of more than one expanded group (overlapping expanded groups), an expanded group can have only a single common parent (an expanded group parent). The final regulations add an example to clarify that the expanded group parents of overlapping expanded groups are not themselves members of the same expanded group. See § 1.385-1(c)(4)(vii)

Example 1.

C. Deemed Exchange Rule

Under the proposed regulations, the recharacterization of an interest that was treated as debt when issued and then later characterized under the proposed regulations as stock gave rise to a deemed exchange of that interest for stock. Comments requested further guidance to address the tax implications of the deemed exchange of a debt instrument for stock under the proposed regulations. Comments requested clarification regarding the extent to which gain or loss would be recognized on the deemed exchange, as well as the treatment of any gain or loss recognized.

Comments also requested clarity on the treatment of the deemed exchange when an interest previously treated as stock under the regulations ceases to be between two members of an expanded group and, as a result, is recharacterized as indebtedness. A number of comments requested that the regulations minimize the collateral consequences when an interest treated as equity under the regulations leaves the group, and urged that the consequences be similar to those occurring when an interest originally treated as debt is recharacterized as stock. Of particular concern was the treatment of accrued but unpaid interest; comments asked for clarification of the treatment of such amounts as part of the redemption price, noting that such treatment should be consistent with the original issue discount rules. One comment requested confirmation that the deemed exchange that occurs when an issuer or holder leaves the expanded group should be treated as a section 302(a) redemption with sale or exchange treatment.

In addition, comments requested further guidance on the treatment of tax

attributes of an interest following the deemed exchange, including clarification of the treatment of foreign exchange gain or loss on qualified stated interest (QSI) and of the continued deductibility of QSI. Comments asked that the regulations address the various consequences of repayment of indebtedness that is treated as stock, including for example the effects on the basis of the stock upon redemption.

Comments also requested that the regulations clarify that the deemed exchange rule applies notwithstanding section 108(e)(8), which treats the satisfaction of indebtedness with a payment of corporate stock as a payment of an amount of money equal to the fair market value of the stock for purposes of determining the income from discharge of indebtedness.

The final regulations address these comments by adding a sentence to clarify that the rule that excludes QSI from the computation that takes place pursuant to the exchange does not affect the rules that otherwise apply to the debt instrument or EGI before the date of the deemed exchange. Thus, for example, the regulations do not affect the issuer's deduction of unpaid QSI that accrued before the date of the deemed exchange, provided that such interest would otherwise be deductible. The final regulations also clarify that the rule that treats a holder as realizing an amount equal to the holder's adjusted basis in a debt instrument or EGI that is deemed to be exchanged for stock, as well as the rule that treats an issuer as retiring the debt instrument or EGI for an amount equal to its adjusted issue price as of the date of the deemed exchange, apply for all federal tax purposes.

A new paragraph is added to the final regulations to specifically provide that, when an issuer of a debt instrument or an EGI treated as a debt instrument is treated as retiring all of or a portion of the debt instrument or EGI in exchange for stock, the stock is treated as having a fair market value equal to the adjusted issue price of the debt instrument or EGI as of the date of the deemed exchange for purposes of section 108(e)(8). This clarification also responds to the treatment of foreign exchange gain or loss, which generally follows the realization rules on indebtedness.

The final regulations do not otherwise change the rules in the proposed regulations that address the treatment of a deemed exchange. In particular, the regulations treat a debt instrument recharacterized as equity under § 1.385-3 that leaves an expanded group as the issuance of a new debt instrument rather than reinstating the original debt instrument. In the case of an EGI recharacterized as equity under § 1.385-2 that subsequently leaves the expanded group, federal tax principles apply to determine whether the interest is treated as a debt instrument and, if so, a new debt instrument is deemed exchanged for the EGI before it leaves the expanded group. Treating a debt instrument as newly issued in this context matches the treatment of an intercompany obligation that leaves a consolidated group in § 1.1502-13(g)(3)(ii)(A). The final and temporary regulations provide no additional rules because there are detailed rules in sections 1273 and 1274 that describe how to determine issue price when a debt instrument is issued for stock.

The final regulations include a rule that coordinates § 1.385-1(d) with the modified approach in the temporary regulations for controlled partnerships in § 1.385-3T(f) and the modified approach in the final and temporary regulations for disregarded entities in §§ 1.385-2(e)(4) and 1.385-3T(d)(4). The temporary regulations addressing partnerships in § 1.385-3T(f)(4) provide that a debt instrument that is issued by a partnership that becomes a deemed transferred receivable, in whole or in part, is deemed to be exchanged by the holder for deemed partner stock.

See

Part V.H.4 of this Summary of Comments and Explanation of Revisions. The final and temporary regulations addressing disregarded entities in §§ 1.385-2(e)(4) and 1.385-3T(d)(4) provide that an EGI or debt instrument that is issued by a disregarded entity is deemed to be exchanged for stock of the regarded owner.

See

Parts IV.A.4 and V.H.5 of this Summary of Comments and Explanation of Revisions.

D. Payments Made on Bifurcated Instruments

Proposed § 1.385-1(d) contained a general bifurcation rule that permitted the Commissioner to treat certain debt instruments as in part indebtedness and in part stock (that is, to “bifurcate” the interest). Bifurcation of an interest could occur if an analysis of the relevant facts and circumstances under general federal tax principles resulted in a determination that the interest should be bifurcated as of its issuance into part stock and part indebtedness for federal tax purposes.

The Treasury Department and the IRS received many comments requesting additional guidance concerning how the portion of a bifurcated interest treated as stock would be determined, and how payments on such bifurcated interest would be treated for federal tax purposes. As noted in Part III of the Background, the final regulations do not contain a general bifurcation rule. The Treasury Department and the IRS continue to study the comments received. See the discussion regarding the treatment of payments with respect to debt instruments that are bifurcated pursuant to § 1.385-3 in Part V.B.3 of this Summary of Comments and Explanation of Revisions.

IV. Comments and Changes to § 1.385-2—Treatment of Certain Interests Between Members of an Expanded Group

A. In General

The Treasury Department and the IRS received a significant number of comments on the rules of proposed § 1.385-2 requiring preparation and maintenance of certain documentation with respect to an expanded group interest (EGI). As noted in Part II of the Background, proposed § 1.385-2 prescribed the nature of the minimum documentation necessary to substantiate the presence of four factors that are essential to the treatment of an EGI as indebtedness for federal tax purposes. The four factors are: (1) The issuer's binding obligation to pay a sum certain; (2) the holder's rights to enforce payment; (3) a reasonable expectation of repayment; and (4) a course of conduct that is generally consistent with a debtor-creditor relationship.

Comments received with respect to proposed § 1.385-2 include the following:

• Comments regarding the necessity of proposed § 1.385-2;

• Requests to extend the timely preparation periods;

• Requests to reconsider per se stock treatment for an undocumented EGI; and

• Requests that certain issuers or interests be exempted from proposed § 1.385-2 based on a lack of earnings-stripping potential.

While a number of the comments received were critical of proposed § 1.385-2, the Treasury Department and the IRS also received a number of comments that supported the goals of the documentation rules.

As noted in Part III of the Background and discussed in the remainder of this Part IV, the final regulations address many of the concerns raised in comments by adopting the following modifications:

• First, the final regulations narrow the application of § 1.385-2 by excluding an EGI issued by a foreign issuer or an S corporation, and generally excluding interests issued by REITs, RICs, and controlled partnerships.

• Second, the final regulations replace the proposed 30-day (and 120-day) timely preparation requirements with a requirement that documentation and financial analysis be prepared by the time that the issuer's federal income tax return is filed (taking into account all applicable extensions).

• Third, the final regulations provide a rebuttable presumption to characterization as stock for EGIs that fail to satisfy the documentation rules, provided the expanded group demonstrates a high degree of compliance with § 1.385-2. If an expanded group does not demonstrate a high degree of compliance with § 1.385-2, an EGI for which the requirements of the documentation rules are not satisfied would be treated as stock for federal tax purposes.

• Fourth, the final regulations clarify the application of the documentation rules to certain interests issued by regulated financial services entities and insurance companies that are required by regulators to include particular terms.

• Fifth, the final regulations clarify the ability of expanded group members to satisfy the documentation rules for EGIs issued under revolving credit agreements, cash pooling arrangements, and similar arrangements by establishing overall legal arrangements (master agreements).

• Finally, § 1.385-2 applies only with respect to an EGI that is issued on or after January 1, 2018. The effect of this change in combination with the final regulations' new timely preparation requirements is that taxpayers will have until the filing date of their taxable year that includes January 1, 2018, to complete the documentation requirements under § 1.385-2.

This Part IV addresses these modifications and additional changes suggested by comments that the Treasury Department and the IRS have adopted or declined to adopt in the final regulations.

1. Necessity of Documentation Rules

Some of the comments perceived the proposed documentation rules as beyond what would be necessary to impose discipline on related-party transactions, and some perceived the recharacterization of indebtedness as stock as a penalty disproportionate to the concern addressed by the proposed regulations. A number of comments considered the proposed documentation rules to be duplicative of existing rules and regulations that place on taxpayers both the burden of proof and the obligation to keep appropriate books and records. As a result, many of those comments urged the complete withdrawal of proposed § 1.385-2.

Some comments suggested that the regulatory approach of characterizing an EGI as stock where adequate documentation is not prepared and maintained should be abandoned in favor of seeking legislation that would provide authority to the Treasury Department and the IRS to impose a monetary fine in such cases. Some comments noted that the documentation rules are, to some extent, duplicative of documentation requirements under section 6662 (relating to the accuracy-related penalty for underpayments) and suggested the adoption of the principles of § 1.6662-6(d)(2)(iii)(B) (providing documentation rules for transfer pricing analysis purposes) to give taxpayers more guidance on the requirements of the regulations. Alternatively, some comments suggested relocating the proposed documentation rules under sections 6662 or 482. A number of comments urged that, in any event, the regulations should require only that a taxpayer's position with respect to the characterization of an interest as indebtedness be reasonable based on the available facts and circumstances instead of requiring documentation of prescribed factors, regardless of whether the IRS necessarily agreed with the taxpayer's characterization. Comments also suggested that the documentation rules would need to be revised in some manner, because the comments asserted that such rules could not override “substantial compliance” principles under common law.

However, in recognition of the policy concerns stated by the Treasury Department and the IRS, virtually all of these comments also suggested modifications to make the documentation rules of proposed § 1.385-2 more reasonable and administrable for both taxpayers and the IRS. Provided certain modifications were made to relax the burden of the documentation rules, many comments stated that taxpayers could comply with such modified rules. A number of comments suggested streamlining the documentation requirements, for example, by allowing (i) master agreements to support multiple transactions, (ii) balance sheets to evidence solvency, and (iii) the advance preparation of credit analysis of issuers. While many comments recognized the value of the certainty that could come from increased specificity and objective rules, many comments were equally concerned that the regulations be flexible regarding the manner in which the documentation rules apply.

The Treasury Department and the IRS have determined that the documentation rules of proposed § 1.385-2 further important tax administration purposes. Moreover, the Treasury Department and the IRS have determined that the presence or absence of documentation evidencing the four indebtedness factors is more than a ministerial issue to be policed with a fine or penalty. These factors are substantive evidence of the intent to characterize an EGI as indebtedness for federal tax purposes. In addition, characterizing purported indebtedness as stock is not a penalty for failing to meet a ministerial requirement. Such characterization results from a failure to evidence the intent of the parties when the issuer characterizes the EGI for federal tax purposes or from a failure to act consistent with such characterization during the life of the purported indebtedness. As noted earlier in this Section A, the Treasury Department and the IRS have determined that many of the concerns raised by comments can and should be addressed by modifying the approach taken in proposed § 1.385-2 and, as discussed in the remainder of this Section A, that many of the modifications suggested by comments would enhance both the reasonableness and effectiveness of the final regulations.

2. Timely Preparation Requirement

Under proposed § 1.385-2, documentation of an EGI issuer's binding obligation to pay a sum certain, the holder's rights under the terms of the EGI to enforce payment, and the reasonable expectation of repayment under the terms of the EGI generally would be required to be prepared within 30 days of the “relevant date” to which the documentation relates. Documentation of actions evidencing a debtor-creditor relationship would be required to be prepared within 120 days of the “relevant date” to which the actions relate.

Many comments raised concerns with the proposed timeliness rules. Some comments noted that the documentation rules did not correspond to business practice, were not reasonable, and would be impossible to satisfy without an expense to taxpayers far in excess of any benefit to be achieved. Comments argued that there was no administrative need for the documentation to be done in the timeframes specified, as the documentation would not be required until requested by the IRS in audit.

The timely preparation requirements in proposed § 1.385-2 were intended to approximate third-party practice with

respect to contemporaneous documentation of relevant events demonstrating the creation of a debtor-creditor relationship. The documentation rules relating to post-issuance actions or inaction of issuers and holders were intended to demonstrate that the issuer and holder continued such a relationship. Thus, the Treasury Department and the IRS have determined that it is not appropriate for taxpayers to prepare documentation of the four indebtedness factors only if the IRS requests such information during an audit. Documentation prepared during an audit could not reasonably be viewed as contemporaneous evidence of the intent of the taxpayers when an EGI was issued.

After consideration of the comments, however, the Treasury Department and the IRS have determined that the objectives of the proposed regulations can still be achieved while allowing taxpayers more time to satisfy the documentation requirements. Many comments suggested that a reasonable and appropriate time for requiring compliance with the documentation rules would be by the time that the issuer's federal income tax return must be filed (taking into account any extensions) for the tax year of the relevant date. This timeframe would also be consistent with the framework of section 385(c), under which an issuer and holder provide notice to the Commissioner of their characterization of an interest on their tax returns. The Treasury Department and the IRS have determined that documentation prepared within such a timeframe could provide reasonable evidence of the intent of the issuer and the holder in connection with the issuance of the EGI. Accordingly, the final regulations adopt this comment for all documentation required to be prepared with respect to a relevant date for an EGI that is subject to the documentation rules (a covered EGI).

3. Per Se Stock Treatment

Under proposed § 1.385-2, if the documentation rules for an EGI were not satisfied, the EGI would be automatically treated as stock for federal tax purposes. The overwhelming response from comments was that this aspect of the documentation rules was too harsh. As described in Part V.B of this Summary of Comments and Explanation of Revisions, comments noted numerous and potentially adverse consequences from characterizing purported indebtedness as stock, including purported indebtedness issued by foreign issuers.

Comments stated that, because of the per se aspect of the documentation rules, the penalty of recharacterization would often be substantially disproportionate to the failure to comply with the documentation rules, as arguably minor instances of noncompliance could trigger a recharacterization of an interest as stock for federal tax purposes with potentially severe consequences. Comments also raised concerns that the per se aspect of the documentation rules would automatically treat an interest as stock for federal tax purposes without allowing for an alternative characterization of a transaction, such as, in substance, a distribution or contribution of purported financing proceeds.

Comments offered various solutions to address these concerns. A number of comments urged that, before any consequences attached, taxpayers be allowed to cure any defect in their documentation. Some comments urged that, instead of characterization of purported indebtedness as stock for federal tax purposes, the penalty for a failure to satisfy the documentation rules could be a denial of any interest deduction under section 163; similarly, other comments suggested allowing taxpayers to make an election to forego interest deductions under section 163 to cure any documentation defect. Some comments suggested that the bifurcation rule in proposed § 1.385-1(d) could be used to reach a more proportionate characterization result.

Section 385(a) directs that regulations promulgated under that section be applicable for all purposes of the Code. Accordingly, the Treasury Department and the IRS do not consider it appropriate to limit the federal tax consequences of the characterization of a covered EGI under § 1.385-2 to particular Code provisions, such as section 163. Instead, as discussed in Part V.B of this Summary of Comments and Explanation of Revisions with respect to §§ 1.385-3, 1.385-3T, and 1.385-4T, the final regulations generally retain the approach of the proposed regulations under which related-party indebtedness treated as stock by application of § 1.385-2 is stock for all U.S. federal tax purposes, including for purposes of applying section 1504(a) in the context of § 1.385-2.

As discussed in Sections A.3.a through c of this Part IV, the risk of per se stock characterization as a result of a documentation failure is substantially reduced under the final regulations by the addition of rebuttable presumption rules.

a. Availability of Rebuttable Presumption

If the expanded group demonstrates a high degree of compliance with the documentation rules, the final regulations provide a rebuttable presumption (rather than a per se characterization) that a covered EGI that is noncompliant with the requirements of § 1.385-2 is treated as stock for federal tax purposes. To demonstrate a high-degree of compliance with the documentation rules, a taxpayer must demonstrate that one of two tests is met. Under the first test, a taxpayer must demonstrate that covered EGIs representing at least 90 percent of the aggregate adjusted issue price of all covered EGIs within the expanded group comply with § 1.385-2. Under the second test, a taxpayer must demonstrate either that (1) no covered EGI with an issue price in excess of $100,000,000 failed to comply with § 1.385-2 and less than 5 percent of the covered EGIs outstanding failed to comply with § 1.385-2 or (2) that no covered EGI with an issue price in excess of $25,000,000 failed to comply with § 1.385-2 and less than 10 percent of the covered EGIs outstanding failed to comply with § 1.385-2.

If eligible, an expanded group member can rebut the presumption that a covered EGI is stock with evidence that the issuer intended to create indebtedness for federal tax purposes and that there are sufficient factors present to treat the covered EGI as indebtedness for federal tax purposes.

Several comments suggested that the final regulations include a de minimis rule excepting interests under a certain amount, specified as either a fixed dollar amount or a percentage of assets. The Treasury Department and the IRS are concerned that this would provide a ready method for circumventing the rules and so decline to adopt this suggestion. However, the rebuttable presumption rule contained in the final regulations would operate to mitigate these concerns. In particular, the second test for demonstrating a high degree of compliance with the documentation rules permits a simplified calculation based only on the number of covered EGIs that failed to comply with § 1.385-2. This test reflects an understanding by the Treasury Department and the IRS that simplified compliance rules are appropriate where relatively smaller EGIs fail to comply with § 1.385-2.

In cases where the rebuttable presumption rule applies, the final regulations provide that in applying federal tax principles to the determination of whether an EGI is

indebtedness or stock, the indebtedness factors in the documentation rules are significant factors to be taken into account. The final regulations further provide that other factors that are relevant are taken into account in the determination as lesser factors.

b. Ministerial or Non-Material Failure or Errors

The final regulations adopt a rule intended to safeguard against characterizing a covered EGI as stock for federal tax purposes if the failure to comply with the documentation rules is attributable to a minor error of a ministerial or non-material nature, such as a clerical error. In such a case, if a taxpayer discovers and corrects the documentation failure or error before discovery by the Commissioner, the failure or error will not be taken into account in determining whether the requirements of the documentation rules have been satisfied.

c. Reasonable Cause Exception

Proposed § 1.385-2 included an exception that would allow for “appropriate modifications” to the documentation requirements when a failure to satisfy the requirements was due to reasonable cause (the reasonable cause exception). Proposed § 1.385-2 adopted the principles of § 301.6724-1 for purposes of determining whether reasonable cause exists in any particular case. These principles provide that a reasonable cause exception will apply if there are significant mitigating factors with respect to the failure or if the failure arose from events beyond the control of the members of the expanded group. Moreover, these principles provide that, in order for the reasonable cause exception to apply, the members of the expanded group must act in a responsible manner, both before and after the time that the failure occurred. Thus, under proposed § 1.385-2, if the reasonable cause exception did not apply, any failure to comply with the documentation requirements would give rise to a characterization as stock.

Comments viewed the exception as unnecessarily narrow in scope and unclear in application and effect. Some comments suggested adding factors to be considered and guidance about how modifications would be made to the rules. Suggestions for a more lenient standard included exceptions for “good cause,” “good faith,” “reasonable behavior,” “innocent error,” “unintentional,” “inadvertent,” or “lacking willfulness.”

The Treasury Department and the IRS have determined that given the rebuttable presumption rule and the ministerial error rule adopted in the final regulations, the scope of the reasonable cause exception is appropriate. Accordingly, the final regulations retain the reasonable cause exception, including its incorporation of the principles of § 301.6724-1 for guidance concerning its application. In addition, the final regulations provide that once a taxpayer establishes that the reasonable cause exception applies to an EGI, the taxpayer must prepare proper documentation in respect of the EGI.

4. Treatment of EGI Issued by Disregarded Entities

Comments raised a number of questions and concerns regarding the characterization of an interest issued by a disregarded entity under proposed § 1.385-2. The concerns largely centered on the collateral consequences of treating the interest as equity in the issuing legal entity, because in such a case the entity would have at least two members and therefore would be treated as a partnership under § 301.7701-2(c)(1) rather than as a disregarded entity under § 301.7701-2(c)(2). This change in treatment could create the potential for gain recognition and additional significant collateral issues.

The Treasury Department and the IRS have determined that the analysis of whether there is a reasonable expectation of repayment of an interest must be made with respect to the legal entity (whether regarded or disregarded for federal tax purposes) that issued the interest for non-tax purposes, taking into account the extent to which other entities may have legal liability for the obligations of the issuing entity. In addition, documentation in respect of the other indebtedness factors must be prepared and maintained for the legal entity (whether regarded or disregarded for federal tax purposes) that issued the interest for non-tax purposes. To avoid the effects that could occur if an interest issued by a disregarded entity is characterized as equity under the documentation rules, § 1.385-2 provides, under the authority of section 7701(l), that, in such cases, the regarded corporate owner of the disregarded entity is deemed to issue stock to the formal holder of the interest in the disregarded entity (and, if the recharacterization occurs later than the issuance of the interest, in exchange for that interest). The stock deemed issued is deemed to have the same terms as the interest issued by the disregarded entity, other than the identity of the issuer, and payments on the stock are determined by reference to payments made on the interest issued by the disregarded entity.

5. Exemption Based on Lack of Earnings-Stripping Potential

Some comments requested that the final regulations exclude from the documentation rules several categories of transactions believed not to raise earnings-stripping concerns. For example, many comments requested that transactions done in the ordinary course of business be exempt from the documentation rules. These comments argued in part that the sheer volume of such transactions would render any documentation requirement overly burdensome, especially given the proposed 30-day time period for the completion of such documentation and the proposed consequence of failing to prepare and maintain such documentation. These comments also asserted that the nature of ordinary course transactions makes them an unlikely means of accomplishing abuse and a poor candidate for ultimate recharacterization as stock.

Some comments argued that this rationale would also support an exemption from proposed § 1.385-2 for all interests created under cash pooling and similar arrangements. Other comments urged that all trade payables and any debt that financed working capital needs be excluded from proposed § 1.385-2. A number of these comments recognized the difficulty of determining how such transactions could be identified and suggested various formulas. For example, some comments suggested formulas based on an average balance over a specified period or the average length of time outstanding. Other suggested methods included formulas based on the relationship of the underlying transaction to the operation of the business, such as financing inventory, services, fixed assets, rent, or royalties.

In addition to comments based on the nature of particular transactions, there were requests to limit application of the proposed documentation rules to the extent that the terms of a particular arrangement do not present earnings-stripping potential. Thus, for example, some comments suggested exemptions be made for purported indebtedness that is short term, with a low rate of interest (or no interest), or that is issued and held within the expanded group for a limited period.

The Treasury Department and the IRS considered these requests for exclusions from the regulations under § 1.385-2, but generally declined to adopt them, principally because the goal of the documentation rules is not solely to prevent earnings-stripping. Rather, the documentation rules are also intended

to facilitate tax administration by imposing minimum documentation standards for transactions between highly related persons to determine the federal tax treatment of covered EGIs. Such minimum documentation standards are warranted as related-party transactions have historically raised concerns as to the use of purported indebtedness and the lack of proper documentation to verify the nature of the interest purported to be indebtedness. Adopting the broad exceptions urged by comments would undermine this goal. In addition, it is unclear how to administer an exemption from requirements to document ordinary course arrangements because, if taxpayers do not otherwise adequately document such arrangements, it is unclear how to determine whether they are, in fact, ordinary course arrangements.

B. Scope of Covered EGIs

Many of the modifications suggested by comments would reduce the number of persons, types of entities, or transactions that would be covered by the regulations under § 1.385-2. Comments regarding the scope of proposed § 1.385-2 as applied to particular categories of issuers or transactions not addressed elsewhere in this Summary of Comments and Explanation of Revisions are addressed in this Section B.

1. Scope of Issuers

Under proposed § 1.385-2, an issuer of an interest included, solely for purposes of the documentation rules, a person (including a disregarded entity) that is obligated to satisfy any material obligations created under the terms of an EGI. Proposed § 1.385-2 also treated a person as an issuer if such person was expected to satisfy any material obligations created under the terms of an EGI. Comments asked for clarification regarding the circumstances under which someone other than the person that is primarily liable under the terms of an EGI (the primary obligor), including a co-obligor, would be expected to satisfy an obligation created under the terms of the EGI.

Similar to the documentation rules in proposed § 1.385-2, the final regulations provide that the term issuer means any person obligated to satisfy any material obligations created under the terms of an EGI, without regard to whether the person is the primary obligor. The Treasury Department and the IRS intend that the question of whether a person other than the primary obligor under the EGI is to be treated as its issuer should be analyzed under the principles of section 357(d), which contains a similar analysis with respect to liability assumptions. One comment asked for clarification as to when an obligor could be treated as an issuer for this purpose. An issuer for this purpose could include a guarantor of a primary obligor's obligations created under the terms of an EGI if the guarantor is expected to satisfy any of the material obligations under that EGI. An issuer could also include a person that assumes (as determined under section 357(d)) any material obligation under the EGI, even if such assumption occurs after the date of the issuance of the EGI.

a. Partnerships

Comments raised a number of concerns with the application of proposed § 1.385-2 to controlled partnerships. Although the four indebtedness factors at the core of the documentation rules are important factors in determining the federal tax treatment of purported indebtedness issued by any entity, after consideration of the issues raised by the comments, the Treasury Department and the IRS have determined that the documentation rules should not generally apply to partnerships under the final regulations. However, the Treasury Department and the IRS remain concerned that expanded group members could use partnerships (or other non-corporate entities) with a principal purpose of avoiding the application of the documentation rules. Accordingly, such transactions remain subject to the final regulations' anti-abuse rule.

In addition, because controlled partnerships are not treated as expanded group members under the final regulations, § 1.385-2 provides that an EGI issued by an expanded group member and held by a controlled partnership with respect to the same expanded group is a covered EGI.

b. Consolidated Groups

For purposes of proposed § 1.385-2, members of a consolidated group were generally treated as “one corporation” and so interests issued between members of the consolidated group were not subject to the documentation rules. However, as noted in Parts III.A.2 and VI.A of this Summary of Comments and Explanation of Revisions, the one-corporation approach gave rise to numerous questions and concerns about both the implementation of the rule and the effect of this rule on the application of other provisions of the Code.

There were two reasons for excluding indebtedness between members of a consolidated group from the application of the documentation rule. The principal reason was that the consolidated return regulations, specifically § 1.1502-13(g), already provide a comprehensive regime governing substantially all obligations between members. This is not the case with respect to indebtedness between consolidated group members and nonmembers, even if highly related. The second reason was that, in the very few cases where such obligations would not be subject to § 1.1502-13(g), the inapplicability of § 1.1502-13(g) would generally be of limited duration and, in the meantime, all items of income, gain, deduction, and loss attributable to the obligation would offset on the consolidated federal income tax return.

The Treasury Department and the IRS have determined that the existing regulations governing obligations between members of a consolidated group are sufficiently comprehensive to warrant the exclusion of these obligations from the documentation rules. However, the Treasury Department and the IRS have reconsidered the use of the one-corporation approach with respect to § 1.385-2 and determined that a simpler, more targeted approach would be to exclude obligations between consolidated group members from the category of instruments subject to the documentation rules. This approach, as provided in § 1.385-2(d)(2)(ii)(A) of the final regulations, retains the general exclusion for intercompany obligations while eliminating many of the questions and concerns raised by comments, such as the question of whether a particular member of a consolidated group (or the consolidated group as a whole) would be the issuer of an EGI.

The final regulations do not, however, adopt the suggestion to expand the exception to exclude other obligations, such as obligations between affiliated corporations that are not includible corporations under section 1504(b) (such as a REIT or RIC) or that are prohibited from joining the group under section 1504(c) (certain insurance companies) and obligations between group members and controlled partnerships. In such cases, even though the obligations may generate items that may be reflected in a consolidated federal income tax return, none of the obligations generating the items are governed by the consolidated return regulations.

The final regulations also do not adopt the request to limit the consequences of characterizing an EGI as stock under § 1.385-2, for example, by disregarding such stock for purposes

of determining affiliation. The Treasury Department and the IRS view the characterization of an EGI as stock under § 1.385-2 as a determination that general federal tax principles would preclude a characterization of the interest as indebtedness. Thus, the Treasury Department and the IRS have determined that it is appropriate to treat an EGI characterized as stock pursuant to § 1.385-2 as stock for federal tax purposes generally.

c. Regulated Entities

A number of comments were received requesting exemptions from the documentation rules for various regulated entities, such as insurance companies, financial institutions, and securities brokers or dealers. Comments stated that a rationale for the proposed documentation rules, facilitating tax administration by imposing minimal documentation standards for transactions between highly-related persons, is addressed by existing non-tax regulations and oversight already imposed on these entities. The Treasury Department and the IRS recognize that the various requirements noted by comments, such as the Basel III framework and increased capitalization requirements, risk management ratios, and liquidity requirements that are applicable to certain regulated financial entities, all afford increased assurance regarding certain aspects of the documentation requirements, particularly with respect to the creditworthiness of the issuer.

Accepting the fact that non-tax regulations may constrain the terms and conditions of the obligations issued and held by entities subject to those regulations does not, however, change the fact that a determination of whether an EGI is characterized as stock or indebtedness for federal tax purposes is made under federal tax principles. This determination necessarily involves the preparation of documentation in respect of the four indebtedness factors. In addition, a non-tax regulator may not have the same interests as the Treasury Department and the IRS. Such a non-tax regulator may not constrain (and in some cases may encourage) actions to lower federal tax costs for the entities that it regulates so that more assets may be available to the depositors in, or creditors of, such entities.

Accordingly, the Treasury Department and the IRS have determined that it is not appropriate to exclude taxpayers from the documentation rules on the grounds that some of the documentation and information required may also be required by and provided to non-tax regulators. Indeed, to the extent the final regulations require documentation that is otherwise prepared and maintained under requirements imposed by non-tax regulators, such as may be required under regulations under 12 CFR part 223 (Regulation W) issued by the Board of Governors of the Federal Reserve System, any additional burden imposed by the final regulations is reduced.

d. Expanded Groups Subject to§ 1.385-2

Under proposed § 1.385-2, an EGI would not be subject to the documentation rules unless (i) the stock of any member of the expanded group was publicly traded, (ii) all or any portion of the expanded group's financial results were reported on financial statements with total assets exceeding $100 million, or (iii) the expanded group's financial results were reported on financial statements that reflect annual total revenue exceeding $50 million.

A number of comments suggested raising the asset and revenue thresholds, particularly for regulated businesses with high asset levels relative to revenue, such as banks, or for issuers with high amounts of revenue but low profit margins, such as construction companies. However, comments did not suggest particular levels to which the asset or revenue thresholds should be raised. As a result of the modifications made to § 1.385-2 in the final regulations, the Treasury Department and the IRS have determined that the application of the documentation rules will be appropriately restricted to minimize burden and therefore decline to adopt this suggestion.

Accordingly, the final regulations continue to provide that an EGI is not subject to the documentation rules unless one of the following three conditions is present. First, if the stock of any member of the expanded group is publicly traded. Second, if all or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding $100 million. Or third, if the expanded group's financial results are reported on financial statements that reflect annual total revenue that exceeds $50 million.

2. Special Categories of EGIs

a. Certain Interests of Regulated Entities

Many of the comments submitted by or on behalf of regulated entities requested that, if a broad exception were not adopted for regulated entities, certain arrangements should be excluded from the documentation rules. As an example, several comments requested an ordinary course exception to the documentation rules applicable to all payments on insurance contracts, funds-withheld arrangements in connection with reinsurance, funds-withheld reinsurance, and surplus notes. Comments noted the need for further guidance on the documentation that would be required for many of these interests, as they are typically executed by contract, not loan documents. The Treasury Department and the IRS do not agree that there is a need for guidance with respect to reinsurance or funds-withheld reinsurance, because these arrangements are not debt in form and are typically governed by the terms of a reinsurance contract (and other ancillary contracts). As such, they are not covered EGIs under the final regulations.

Comments also suggested that the final regulations create safe harbor exceptions for instruments issued to satisfy regulatory capital requirements and regulatory instruments issued in the legal form of debt that contain required features that could impair their characterization as debt, such as instruments with loss-absorbing capacity that are required by the Federal Reserve Board. For example, if a borrower's obligation to pay interest or principal, or a holder's right to enforce such payment, is conditioned upon the issuer receiving regulatory approval, but the instrument otherwise satisfies the unconditional obligation to pay a sum certain and creditor rights factors, comments argued that the required regulatory approval should not prevent the interest from being treated as debt. Similarly, comments requested the final regulations provide that, if regulatory approval delays an action, such delay will not prevent an issuer from satisfying the timeliness requirement.

The Treasury Department and the IRS agree that certain regulated entities may be required in some cases to issue an instrument that would be indebtedness under federal tax principles but for certain terms or conditions imposed by a regulator. To address this situation, the final regulations provide an exception from the documentation requirements for certain instruments issued by an excepted regulated financial company or a regulated insurance company, as those terms are defined in § 1.385-3(g). An EGI issued by an excepted regulated financial company is considered to meet the documentation rules as long as it contains terms required by a regulator of that issuer in order for the EGI to satisfy regulatory capital or similar rules that govern resolution or orderly liquidation. An EGI issued by a regulated insurance

company issuer is considered to meet the documentation rules even though the instrument requires the issuer to receive approval or consent of an insurance regulatory authority before making payments of principal or interest on the EGI. In both cases, the regulations require that the parties expect at the time of issuance that the EGI will be paid in accordance with its terms and that the parties prepare and maintain the documentation necessary to establish that the instrument in question qualifies for the exception.

The Treasury Department and the IRS are aware that certain instruments required by regulators raise common law debt-equity issues that extend beyond the scope of these regulations. The scope and the form of additional guidance to address these instruments are under consideration.

b. Certain Interests Characterized Under the Code or Other Regulations

Several comments requested clarification that instruments that are specifically treated as indebtedness under the Code and the regulations thereunder, such as mineral production payments under section 636, are not treated as applicable instruments, and accordingly not treated as EGIs subject to proposed § 1.385-2. The final regulations clarify that such instruments are not subject to the documentation rules.

c. Master Agreements, Revolving Credit Agreements, and Cash Pooling Arrangements

Under proposed § 1.385-2, members of an expanded group using revolving credit agreements, cash pooling arrangements, and similar arrangements under a master agreement were generally required to prepare and maintain documentation for the master agreement as a whole (rather than for each individual transaction), but comments contained a number of questions concerning the requirements applicable to these master agreements.

Some comments requested that master agreements be excluded altogether from the documentation rules, excluded at least for specific activities, or excluded if their terms exceeded those given by third parties. These comments argued that such agreements were not likely vehicles for earnings stripping. The Treasury Department and the IRS decline to provide an exemption for these master agreements because if such an exemption were granted, such master agreements could replace all other forms of indebtedness between highly-related parties, resulting in avoidance of the documentation rules. In addition, interests issued under these master agreements must be characterized for federal tax purposes, and there is no clear justification for treating such interests as exempt from the modified documentation requirements in the final regulations based on the fact that these interests are documented under a master agreement.

Many comments focused on solutions for making the application of the documentation rules to master agreements simpler, clearer, more workable for taxpayers, and more administrable for the IRS. Comments requested that the basic operation of the rules governing master agreements be clarified to provide certainty for taxpayers that (i) a comprehensive agreement such as a revolving credit agreement could satisfy the documentation requirements and (ii) individual draws under the revolving credit agreement would not be treated as separate loans for purposes of the documentation rules. Comments also requested additional definitions and rules, for example clarifying the interaction of the documentation rules and § 1.1001-3(f)(7) and the treatment of a cash pool financing both ordinary course and capital expenditures. The Treasury Department and the IRS decline to provide special rules under § 1.385-2 for the cash pool financing of ordinary course and capital expenditures. In general, the question of whether an EGI is ordinary course or is used for capital expenditures is not relevant to the question of whether the EGI is indebtedness for federal tax purposes. In particular, this question is not relevant to determine whether there is an unconditional obligation to pay a sum certain, whether there are creditor's rights under the EGI, whether the parties have a reasonable expectation of repayment, or whether the parties' actions are consistent with a debtor-creditor relationship. As a result, the final regulations provide that an EGI issued under a cash pool arrangement must meet the same documentation requirements regardless of whether the EGI funds ordinary course expenses or capital expenditures.

The policy behind § 1.1001-3(f)(7) is to encourage workouts when debtors have difficulty repaying their obligations to third-party creditors. In such a case, the debtor (and any shareholders of the debtor), have different economic interests from the creditors, and any modifications to a debt instrument are likely to meaningfully maintain the rights of the creditors. In the case of highly-related entities that meet the definition of expanded group, these different economic interests are not present. As a result, the final regulations provide that the rules of § 1.385-2 apply before the rules of § 1.1001-3(f)(7). The final regulations therefore require documentation as of certain deemed reissuances under § 1.1001-3 (even in cases where § 1.1001-3(f)(7) would not require an analysis of whether a modification resulted in an instrument being treated as an instrument that is not indebtedness for federal income tax purposes).

Many comments suggested that the number of credit analyses required for master agreements be limited. For example, several comments asserted that the time for testing the issuer's ability to repay should be limited to the time of an interest's issuance. Comments also suggested that EGIs issued under master agreements should require credit analysis only upon the execution of the master agreement and subsequently upon an increase of the credit limit under the master agreement, provided that the amount of credit and term of the master agreement is reasonable. Comments generally suggested that the credit analysis be required to be repeated on a specified schedule, ranging from three to five years. The Treasury Department and the IRS generally agree with a specified schedule approach for determining the required credit analysis with respect to master agreements but have concerns about potential changes in an issuer's creditworthiness over longer periods. Because such agreements among members of an expanded group do not generally contain covenants, financial information provision, and other protections analogous to those in similar arrangements among unrelated parties, it is necessary to require a credit analysis under these agreements more frequently than every three to five years.

The Treasury Department and the IRS have addressed these comments by clarifying in the final regulations that with respect to EGIs governed by a master agreement or similar arrangement, a single credit analysis may be prepared and used on an annual basis for all interests issued by a covered member up to an overall amount of indebtedness (including interests that are not EGIs) set forth in the annual credit analysis. The final regulations make it clear that the first such annual credit analysis should be performed upon the execution of the documents related to the overall arrangement. The only exception to this annual credit analysis rule is when the issuer has undergone a material change within the year intended to be covered by the annual credit analysis. In this

case, the final regulations require a second credit analysis to be performed with a relevant date on or after the date of the material change. This requirement is consistent with commercial practice with respect to revolving credit agreements, which typically contain covenants requiring such terms.

Some comments requested clarification of the treatment of notional cash pools, noting that such arrangements are not documented as debt in form between expanded group members. The final regulations do not adopt this comment except to clarify that a notional cash pool is generally subject to the same documentation requirements as other cash pools when the notional cash pool provider operates as an intermediary. For example, a notional cash pool in which the cash received by a non-member cash pool provider from expanded group members is required to equal or exceed the amount loaned to expanded group members will generally be treated as a loan directly between expanded group members, even though the interests may be in form documented as debt between an expanded group member and a non-member facilitator. See, Rev. Rul. 87-89 (1987-2 C.B. 195). Such arrangements present the same issues as other related-party instruments and arrangements transacted under a master agreement and should be subject to the documentation rules. Because these arrangements are administered by a non-member, it is generally expected that most of the documentation required under the final regulations would already be prepared, limiting the incremental burden of the final regulations on these arrangements.

Several comments also suggested limiting the application of the documentation rules to amounts in excess of average balances. The final regulations do not adopt this approach because almost all provisions of the Internal Revenue Code pertaining to indebtedness and stock analyze particular interests, not average or net balances. Thus, to apply the documentation rules to average or net balances would not adequately serve the purpose of determining whether a particular interest is properly treated as indebtedness or stock for federal tax purposes.

Comments also noted that coming into compliance following finalization of the regulations would be facilitated by allowing an extended time frame to document these arrangements and by excluding balances outstanding on the effective date of the final regulations. The final regulations implement this comment. Only interests issued or deemed issued on or after January 1, 2018, including EGIs issued on or after January 1, 2018 under a master agreement in place before January 1, 2018, will be subject to § 1.385-2.

C. Indebtedness Factors Generally

While many comments acknowledged a need for documentation rules, there were two overarching concerns with respect to the form of such rules. First, comments suggested that the requirements be made as streamlined as possible. Second, comments requested clarification of the indebtedness factors so that taxpayers could have certainty about what information is requested and what documentation will satisfy the requirements of the regulations.

Some comments suggested that the Treasury Department and the IRS publish a form that taxpayers could use to report new loans or payments, with sufficient instructions to forestall debate over whether adequate documentation is provided. Under such an approach, if the form were properly completed with respect to an interest, an audit would then proceed to the merits of the debt-equity determination for the interest. The Treasury Department and the IRS have determined that the modifications made in the final regulations address these concerns. Other comments suggested providing for a level of documentation scaled to the principal amount of the loan, or that would be reduced in the case of loan guaranteed by a solvent parent or affiliate. The Treasury Department and the IRS do not adopt this suggestion. Such an approach would allow taxpayers to use numerous smaller loans to avoid the full application of the documentation rules.

Several comments suggested using a “market standard safe harbor” that would treat the documentation requirements as satisfied by the documentation customarily used in third-party transactions. The final regulations adopt this comment and provide that such documentation may be used to satisfy the indebtedness factors related to an unconditional obligation to pay a sum certain and creditor's rights.

A number of comments also requested guidance regarding the effect of a significant modification of an instrument under section 1001 and under § 1.1001-3. The consensus among comments was that the final regulations should provide that when there is a modification of an interest, as long as such modification is not very significant, no additional documentation should be required. The Treasury Department and the IRS have decided that a deemed reissuance under § 1.1001-3 represents a case where the economic rights and obligations of the issuer and holder have changed in a meaningful way. As a result, the final regulations provide that the deemed reissuance of an EGI under § 1.1001-3 generally requires a new credit analysis to be performed (unless an annual credit analysis is in place at the time of the deemed reissuance). However, the final regulations do not require new documentation in respect of the factors regarding an unconditional obligation to pay a sum certain or creditor's rights, as of such a deemed reissuance, unless such deemed reissuance relates to an alteration in the terms of the EGI reflected under an express written agreement or written amendment to the EGI.

Finally, comments noted that it was unclear who was required to prepare and maintain the documentation, and some of these comments made suggestions as to the persons that should be required to prepare and maintain the documentation. Proposed § 1.385-2 did not include any requirement in this respect because the taxpayer is in the best position to determine who should prepare and maintain its documents; the IRS's interest in this respect is limited to requiring that the proper documentation be prepared and maintained and ensuring that the IRS may obtain the documentation. In addition, if the documentation rules contained specific requirements as to the person or persons required to prepare and maintain documentation, such requirements would imply that an interest does not comply with the documentation rules (even when appropriate documentation was prepared and maintained) merely because the wrong member of the expanded group prepared or maintained the documentation for the interest. Such arguments would be harmful to taxpayers and would not advance the policy goals of the documentation rules. Thus, proposed § 1.385-2 was purposely silent on the question of who must prepare and maintain documentation. The final regulations continue this same approach.

1. Unconditional Obligation To Pay a Sum Certain

Comments requested several clarifications regarding the requirement that there be an unconditional obligation to pay a sum certain. A number of comments asked for clarification that an obligation would not automatically fail because of a contingency or because it was a nonrecourse obligation. Several comments also requested a clarification

that the sum need only be an amount that is reasonably determinable as opposed to a specified total amount due on a single specified date. A number of other comments also requested confirmation that, if a borrower's binding obligation to pay under an interest is subject to the condition of a regulatory approval before repayment, but otherwise satisfies the requirement that there be an unconditional obligation to pay a sum certain, the fact that regulatory approval is required before repayment should not prevent the interest from satisfying that requirement. The Treasury Department and the IRS generally agree with these comments, and the final regulations provide rules clarifying these points. The effect of a contingency that may result in the repayment of less than an instrument's issue price has not been addressed by the Treasury Department or the IRS, and the documentation rules are not the appropriate place for guidance in that area. The final regulations provide that the documentation must establish that the issuer has an unconditional and legally binding obligation to pay a fixed or determinable sum certain on demand or at one or more fixed dates, without elaborating on the amount of the sum certain.

2. Creditor's Rights

Comments requested a number of clarifications regarding the requirement that the documents evidence the creditor's right to enforce the obligation. The most common concern raised by comments was that the requirement be modified to recognize that creditor's rights are often established by law, and, in such cases, would not necessarily be included in the loan documentation. Comments requested that the rules treat this requirement as established in such cases, without regard to whether the rights are reiterated in the loan documents. In such cases, comments requested that creditor's rights be respected without requiring additional documentation.

The final regulations adopt this comment with one modification. If creditor's rights are created under local law without being reflected in writing in a loan agreement and no creditor's rights are written as part of the documentation of an interest, the documentation must refer to the law that governs interpretation and enforcement (for example, Delaware law or bankruptcy law). This requirement verifies that the issuer and holder did intend to create creditor's rights and assists the IRS in confirming that such creditor's rights apply to the holder of the interest.

Several comments requested clarification that the fact that a note is nonrecourse does not prevent the satisfaction of the creditor's rights requirement. Further, comments requested clarification that, if a creditor only has rights to certain assets under the terms of an interest, the reference to assets of the issuer means only those assets, and such a limitation would not result in the interest failing to satisfy the creditor's rights indebtedness factor. The final regulations clarify these points.

Finally, a number of comments suggested that the final regulations remove the proposed prohibition on subordination to shareholders in the case of dissolution. The principal concern of the comments was that, if, for example, one EGI (EGI#1) issued by an issuer were subordinate to another EGI (EGI#2) issued by the same issuer, and EGI#2 were recharacterized as stock under the proposed § 1.385-3 regulations, EGI#1 would fail this requirement because it would be subordinate to EGI#2 (which is treated as stock for federal tax purposes). In such case, EGI#1, because it is subordinate to EGI#2, would be subordinate to shareholders (the holders of EGI#2) in a dissolution of the issuer and would therefore violate the proposed prohibition on subordination to shareholders in the case of dissolution. The Treasury Department and the IRS have considered this comment and determined that it would be appropriate to disregard subordination if the recharacterization occurred as a result of § 1.385-3 and the final regulations reflect that decision. However, because a characterization under the documentation rules speaks to the substance of the interest itself, including whether the interest properly could be indebtedness for federal tax purposes under general federal tax principles, the Treasury Department and the IRS do not agree that it is appropriate to disregard a characterization caused by the documentation rules of § 1.385-2 for this purpose.

One comment asked for clarification that equitable subordination imposed by a court would not affect this determination. The Treasury Department and the IRS are not aware of a situation in which it would be appropriate to disregard equitable subordination as a factor in determining whether an interest is properly indebtedness or stock, and so the final regulations do not adopt this comment.

Several comments noted that subordination to later issued, unrelated-party indebtedness is common and should not be a negative factor. The Treasury Department and the IRS do not expect this circumstance will cause a problem under the regulations, as the unrelated-party indebtedness is not subject to recharacterization under the final regulations and the documentation rules only require that an interest be superior to the rights of shareholders, rather than debt holders.

3. Reasonable Expectation of Ability To Repay EGI

A number of comments requested clarifications regarding the requirement that there be a reasonable expectation of the issuer's ability to repay its obligation. Comments also requested that the final regulations clarify that the expectation is subjective and that the creditor should be given reasonable latitude based on its business judgment. In addition, comments requested that the regulations should specify how frequently credit analysis is required. For example, some comments suggested that an approach similar to that taken for master agreements be adopted to allow a single agreement and a single credit analysis (done annually or at other specified intervals) to document multiple loans by expanded group members to a particular member. Other comments requested that the regulations should clarify whether it is only necessary to retest credit worthiness as often as is typical under commercial practice, or whether an annual analysis is sufficient. In response to these comments, the final regulations assist in implementing the documentation requirements for multiple EGIs issued by the same issuer by making it clear that a single credit analysis may be prepared on an annual basis and used for all interests issued by the issuer, up to an overall amount of indebtedness set forth in the annual credit analysis.

With respect to the time for measuring an issuer's reasonable expectation of ability to repay an EGI, comments presumed that the issue date of the interest would be the appropriate date to measure. Although comments also noted that there are questions as to when this measuring date would arise. Comments also suggested that the reasonable expectation of ability to repay could be reevaluated if there is a deemed reissuance of the interest under the rules of section 1001, unless the parties can show a third party would have agreed to a modification.

The regulations retain the requirement that documentation be prepared and maintained containing

information establishing that, as of the date of issuance of the EGI, the issuer's financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the terms of the EGI. The rules addressing the reasonable expectation of repayment factor thus retain the EGI's issuance date as the appropriate date for measuring the issuer's financial position. Issuance dates are to be determined under federal tax principles.

With respect to whether the issuer's financial position supports a reasonable expectation that the issuer intended to, and would be able to meet its obligations pursuant to the terms of the obligation, comments requested that the application of a creditworthiness test of the issuer's financial position be excluded if the indebtedness is secured by specific property of the issuer. In response to this concern, the final regulations clarify that if the EGI is nonrecourse to the issuer, then the documentation to support such indebtedness must include the value of property available to support repayment of the nonrecourse EGI.

Comments suggested that the creditworthiness of the issuer could be determined by a confirmation of the creditworthiness of the issuer by a third party or internal staff of the issuer. They further suggested that the regulations could provide safe harbors for creditworthiness using ratios such as a minimum debt-to-equity or “EBIDTA”-to-interest ratios. Comments also requested that the regulations provide a list of documents that would satisfy the reasonable expectation requirement, which could include documents that would be sufficient (but not necessary) to show that the obligation could have been issued on the same terms with a third party. The final regulations clarify that documentation may include cash flow projections and similar economic analyses prepared by either the members of the expanded group of the issuer or third parties.

Comments also requested clarification that refinancing would be an acceptable method to repay an EGI and that a refinancing does not adversely impact and may be assumed as part of the credit analysis; in other words, if the issuer could have issued the obligation to a third party with the ability to refinance the obligation on its maturity date, then the issuer would satisfy this requirement. Moreover, comments were of the view that in fact, a borrower's ability to refinance obligations when due should be a positive factor in a credit analysis. The final regulations provide that the credit analysis may assume that the principal amount of an EGI may be satisfied with the proceeds of another borrowing by the issuer to the extent that such borrowing could occur on similar terms with a third party.

Comments requested clarity as to whose credit is being analyzed, specifically, whether it is only the “recipient” of funds or, if the issuer is a member of consolidated group, whether it is the entire consolidated group. Because the final regulations remove the one-corporation rule for purposes of the documentation rules, the member that is the issuer of an interest would be analyzed for this purpose.

One comment requested that the regulations clarify limits on privileged documents and provide specific limitations regarding the ability of the IRS to request, review, and maintain such information. The final regulations do not adopt this comment. The IRS routinely reviews and maintains confidential taxpayer information as part of its tax administration function, and strong protections for confidential taxpayer information already exist.

4. Actions Evidencing Debtor-Creditor Relationship

Comments requested clarification that certain types of payments such as payments-in-kind, additions to principal, and payments of interest could be evidenced by journal entries in centralized cash management systems in which payables and receivables are managed. They also noted that the journal entries could be made with respect to the treasury center in such cases. The Treasury Department and the IRS agree that as long as a payment is in fact made and a written record of the payment is prepared and maintained, the documentation rules should not require that the payment be made or recorded in any particular manner. However, the Treasury Department and the IRS have determined that there is no need to expressly note that payments-in-kind or additions to principal should be included because these actions generally would take place and be recorded in as a part of journal entries reflecting a payment of interest. As a result, the final regulations adopt these comments in respect of journal entries (other than with respect to payments-in-kind or additions to principal).

Comments requested that the rules make clear that the existence of creditors' rights is more important than their exercise. They urged a flexible approach that included much deference to the judgment of the creditor, suggesting a generous period in which to act on default. Comments noted that common law recognizes that choosing not to enforce the terms of the obligation may be completely consistent with indebtedness treatment and does not necessarily require an interest to be characterized as stock. For example, if the debtor's position deteriorates, if a default could trigger other default events, or if there are reasons to expect the debtor's situation to improve, a creditor may be well advised to choose forbearance. There may also be legal constraints or obligations arising out of the relationship between an issuer and holder that are in an expanded group that prevent or forestall enforcement action, including fraudulent conveyance laws.

Most comments, however, sought a clear affirmation that this rule relates only to the documentation required, not the substantive evaluation of the creditor's actions. The Treasury Department and the IRS agree that this rule addresses only the requirement to document actions. However, the rules also require that an explanation be documented for inaction by a creditor upon failure of the issuer to comply with the terms of purported indebtedness and that the explanation for such inaction is an indebtedness factor. In the context of highly-related parties, where economic interests of the issuer and holder are aligned, there is a greater need for scrutiny where there is nonperformance and no assertion of creditor's rights. The lack of an explanation for such inaction may give rise to a substantive determination that the parties did not intend to create indebtedness in substance or ceased to treat an interest as indebtedness. Thus, the final regulations do not provide any specific guidance that addresses the comments related to the substantive evaluation of the actions the debtor or creditor must take. The final regulations provide a cross reference to § 1.1001-3(c)(4)(ii), which provides rules regarding when a forbearance may be a modification of a debt instrument and therefore may result in an exchange subject to § 1.1001-1(a). As later discussed, such an exchange could be a relevant date under the documentation rules.

5. Requests for Additional Guidance

Many comments requested more detail about the type and extent of documentation that would be necessary in order to satisfy the documentation rules, often suggesting that examples and specific guidelines should be included in the regulations. Comments expressed concern that the lack of such guidelines would cause administrative difficulties, as agents would request,

and taxpayers would produce, unnecessary documentation. As a result, time would be spent unnecessarily on disputes over whether the documentation rules were satisfied instead of on the underlying substantive determination of the character of the interest at issue.

Comments suggested the issuance of audit guidelines, the use of “fast track” review by the IRS Office of Appeals, and the admission of these issues relating to the satisfaction of the documentation rules into the pre-filing agreement program as ways to facilitate administration for taxpayers and the IRS alike. The IRS agrees that these administrative procedures could assist both taxpayers and the IRS in the efficient resolution of cases. They are available under generally applicable criteria and procedures.

The Treasury Department and the IRS have considered these comments and agree that the purpose of the documentation rules is not to prepare and maintain unnecessary documentation. Rather, the purpose of the documentation rules is to provide a taxpayer with guidance regarding what broad categories of information are necessary to be documented to evidence the creation of a debtor-creditor relationship, as well as to facilitate tax administration.

D. Specific Technical Questions

1. Relevant Dates

Under proposed § 1.385-2, the relevant date for purposes of documenting the issuer's unconditional obligation to repay and the creditor's right to repayment was generally either the date that an expanded group member issued an EGI or the date that an instrument became an EGI. The relevant date for purposes of documenting the reasonable expectation of repayment was generally either the date that an expanded group member issued an EGI, the date that an EGI was deemed reissued under § 1.1001-3, or the date that an instrument became an EGI. The relevant date for purposes of documenting actions evidencing a debtor-creditor relationship was generally either the date that a payment was made or the date on which an event of default occurred. Proposed § 1.385-2 provided that no date before the applicable instrument becomes an EGI is a relevant date.

Some comments suggested that the “relevant date” be the same for the documentation requirements regarding the issuer's obligations, the holder's rights, or the reasonable expectation of payment. The Treasury Department and the IRS have not adopted this suggestion because these dates will not and should not always match. For example, under a revolving credit agreement individual draws would typically be made at different times than the requisite credit analysis of the borrower. The Treasury Department and the IRS have determined that the appropriate times for retesting the reasonable expectation of repayment and for documenting other indebtedness factors may differ. For example, if there is a material event affecting the solvency or business of the issuer, an updated analysis of the reasonable expectation of repayment may be appropriate, even where the legal documents related to an interest have not been modified.

In addition, proposed § 1.385-2 provided that the relevant date with respect to cash pools, master agreements, and similar arrangements included the date of the execution of the legal documents governing the arrangement and the date of any amendment to those documents that provides for an increase in the permitted maximum amount of principal.

Comments suggested that relevant dates for such arrangements should include only the dates that the arrangement is put into place, new members are added, or the maximum loan amount is increased. The final regulations clarify that these dates are generally the relevant dates for these arrangements. However, as previously discussed, an annual credit analysis (as well as a credit analysis as of a material event of an issuer) must be performed under these arrangements and, as a result, the final regulations provide that relevant dates for that credit analysis include the anniversary of the credit analysis as well as the date of any material event of the issuer.

2. Maintenance Requirements

Proposed § 1.385-2 provided that required documentation must be maintained for all taxable years that an EGI is outstanding, until the period of limitations expires for any federal tax return with respect to which the treatment of the EGI is relevant. Comments raised concerns that this rule was burdensome and requested that the final regulations include a practical way to limit the length of time that documentation must be maintained. The Treasury Department and the IRS do not adopt this request because they consider it inappropriate to permit the destruction of documentation while such documentation is relevant for federal tax purposes because this would be inconsistent with the requirements of section 6001 (requirement to keep books and records).

3. Period When § 1.385-2 Characterization Is Given Effect

a. Debt Instrument Becomes an EGI

Proposed § 1.385-2 provided that, in the case of an interest that was an EGI when issued, if the EGI is determined to be stock as a result of the documentation rules, the EGI is generally treated as stock as of its issuance. The exception to this general rule was if the failure to comply with the documentation rules related to an action evidencing a debtor-creditor relationship;

This text is long and has been trimmed here. Open the source document for the complete record.