If pleasure is the absence of pain, as one panelist suggested at TEI’s recent Annual Conference in Philadelphia, then the final Section 385 regulations, released October 13, are a welcome pleasure compared to what might have been. The final regulations, summarized in this issue’s cover feature on page 20, seem to spare corporate taxpayers many difficulties that would have emerged under the regulations first proposed in early April. TEI’s International Tax and Federal Income Tax Committees submitted a joint comment this past July that suggested several adjustments to the proposed regulations. The final regulations incorporated many of those suggestions.
The proposed regulations would have given IRS examiners a substantial power: to split a purported debt instrument partly into debt and partly into equity, depending on the circumstances. TEI suggested a twenty-five percent floor for equity treatment in such a bifurcation. This floor heads off the significant difficulties that could accompany an otherwise immaterial tax adjustment after an instrument is split into, say, ninety-nine percent debt and one percent equity. The final regulations avoid bifurcation altogether and reserve the issue for future consideration.
The proposed regulations also contained strict documentation requirements for debt instruments, the better to make intercorporate documents resemble arm’s-length debt documentation. Under the proposed regulations, this documentation had to be completed within thirty days of issuance. Among its comments, TEI suggested that taxpayers should have until they file their returns to complete it, and Treasury incorporated this new deadline in the final regulations.
Finally, and perhaps most ominously, the proposed regulations would have recharacterized certain everyday lending-type transactions generally not done for tax-planning reasons, such as cash pools and ordinary-course lending for the purchase of tangible personal property. TEI requested greater exceptions for these kinds of transactions, and the final (and temporary) regulations carve out much greater exceptions for ordinary-course lending. Specifically, the new regulations offer exceptions for lending arrangements that (1) have short-term interest rates to the extent of the debtor’s noncash assets; (2) have short-term interest rates if a debtor is a net borrower for fewer than 270 days per year; (3) are ordinary-course loans and are expected to be repaid within 120 days; (4) do not charge interest; and (5) involve certain cash pools.
Between April 4, when Treasury released the proposed regulations, and July 6, when TEI filed its comments with Treasury and the IRS, over forty TEI members contributed their time and effort to comment on the proposal. We are grateful to each of them.