Follow-Up Discussion of the Final Section 385 Related-Party Debt Rules: Final and Temporary Regulations Limit and Clarify Proposed Documentation and Recharacterization Rules That Now Apply Mainly to “Inbound” Related-Party Debt Instruments

Sullivan & Cromwell LLP - October 20, 2016
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On October 13, 2016, the Internal Revenue Service (the “IRS”) and the Treasury Department issued widely anticipated final regulations (the “Final Regulations”) and temporary regulations (the “Temporary Regulations,” and, together with the Final Regulations, the “Final and Temporary Regulations”) that in some circumstances treat debt issued by a U.S. corporation and held by a related party outside a U.S. consolidated group as equity for U.S. tax purposes.  This memorandum follows up on our earlier memorandum that provided a summary overview of the Final and Temporary Regulations, and provides a more detailed description of the Final and Temporary Regulations.

These debt/equity regulations were first issued in proposed form on April 4, 2016 (the “Proposed Regulations”), and the new regulations generally retain the structure and general approach of the Proposed Regulations.  Thus, the Final and Temporary Regulations continue to include: (i) rules that would recharacterize applicable related-party debt if it fails to meet certain documentation requirements (the “Documentation Requirements”) and (ii) rules that would recharacterize applicable related-party debt if it is in effect distributed, rather than issued for cash (and therefore effectively replaces equity capital) (the “Inbound Distributed Debt Rules”).  However, the IRS and Treasury Department have significantly narrowed the Final and Temporary Regulations in response to feedback received from taxpayers and commentators.