On April 4, 2016, the Treasury Department issued proposed regulations under Section 385 of the Internal Revenue Code (Proposed Regulations). These regulations prescribe rules and minimum threshold documentation to determine “whether an interest in a related corporation is treated as stock or indebtedness, or as in part stock or in part indebtedness.” Comments to the Proposed Regulations were due July 7, 2016, and the IRS conducted hearings about the comments on July 14, 2016. Final regulations are expected by the end of 2016.
As the proposed related–party debt regulations are finalized, tax leaders are debating how best to address the likely burden of new financial analysis, benchmarking and compliance documentation demands. Planning to assemble large volumes of detailed accounting data, designing efficient and timely processes to evaluate early-stage and ongoing exposure and identifying relevant skills within the tax and treasury departments should be key priorities for tax leaders.
The Proposed Regulations discuss comprise the following for taxpayers with related-party indebtedness:
- Specificity and Timing of Compliance Documentation: The Proposed Regulations mandate “timely preparation of documentation and financial analysis” to substantiate the proper characterization of related-party debt. In general, the documentation must be prepared no later than 30 calendar days after debt was issued.
- Consequences for Insufficient Documentation: The Proposed Regulations provide for the automatic recharacterization of related-party indebtedness to stock if the taxpayer fails to comply with threshold documentation requirements. If the documentation is deemed insufficient, “any federal tax benefit claimed by the taxpayer with respect to the treatment of the interest as indebtedness will be disallowed.”
- Part Debt/Part Equity: The Proposed Regulations move away from an “all or nothing” approach and allow an instrument to be characterized as part debt and part equity.
- Prohibited Transactions: Certain transactions between related-party entities are now considered prohibited transactions and are characterized as stock.
What’s the Impact?
The potential impact of the Proposed Regulations are significant, including new procedures to assemble disparate data resources, burdensome compliance costs, potential need for new skills, increased IRS audit costs, and serious consequences for failing to adhere to the rigorous documentation requirements.
- Evaluating early-stage and ongoing exposure will require assembling and assessing large volumes of accounting data. It is important to design efficient processes to collect relevant accounting data and conduct exposure analysis on a timely basis. If the process is not properly architected, the acquisition, assembly and financial analysis can be time consuming, lead to unreliable conclusions or result in delayed identification of risks.
- The Proposed Regulations also call for substantial compliance reporting, including: debt capacity and industry capital structure analyses, cash flow analysis supporting the taxpayer’s debt servicing capacity, credit ratings determination and interest rate benchmarking, and payment performance analysis.
- In order to adhere to the compliance reporting requirements, taxpayers will need to identify a narrow group of resources with relevant skills to efficiently evaluate new exposures and perform financial analysis. The new analyses may require a combination of tax department and treasury department skills.
- Poor documentation can lead to complicated, and potentially costly, IRS exam discussions. In addition, failure to provide adequate analysis and timely documentation can result in a complete recharacterization of the intended debt to stock, eliminating any benefit from interest deductions.