Determining the Treatment of Certain Interests in Corporations as Stock or Indebtedness

General provisions.

The final regulations are generally applicable only to expanded group instruments (EGI) in which both the issuer and the holder are the members of the same expanded group. More importantly, final regulations only apply to EGI issued by domestic corporations defined as covered members in Treasury Regulations section 1.385-1(c)(2). In addition, the final regulations do not apply to indebtedness between members of a consolidated group.

Section 1.385-1(c)(4) defines an expanded group as one or more chains of corporations [as defined in IRC section 1504(a), with some exceptions in section 1504(b)(8)] connected through stock ownership with a common parent corporation. The final regulations clearly state, however, that S corporations are not considered to be members of expanded groups. In addition, regulated investment companies (RIC) and real estate investment trusts (REIT) are excluded from memberships as well, unless they are controlled by members of an otherwise existing expanded group. The Exhibit gives an example of an expanded group structure.

The final regulations also contain several rules on addressing the consequences of recharacterization in Treasury Regulations section 1.385-1(d). Specifically, if a debt instrument is treated as equity, then it is deemed to have been exchanged for equity. The holder of the debt is treated as having realized an amount equal to its adjusted basis in that portion of the debt or EGI as of the date of the deemed exchange, and the issuer is treated as having retired the same portion of the relevant debt instrument for an amount equal to its adjusted issue price on that date, without taking into account accrued but unpaid interest.

Documentation requirements.

The final regulations set forth threshold requirements with regard to preparation and maintenance of documentation and information related to the EGI. The purpose of these requirements is 1) to guide the taxpayers to prepare, maintain, and provide the necessary documentation and other information to support the debt treatment; and 2) to enable an analysis of whether an EGI is appropriately being treated as stock or debt for federal tax purposes. The documentation requirements only apply to EGIs if 1) the stock of any member of the expanded group is publicly traded; 2) on the date that an applicable instrument first becomes an EGI, total assets exceed $100 million on any applicable financial statements; or 3) annual total revenue exceeds $50 million on any applicable financial statement on the date that an applicable instrument first becomes an EGI. The documentation and information requirements under the final regulations include the following:

• There must be written documentation showing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.
• The written documentation must prove that the holder has the rights of a creditor to enforce the obligation.
• There must be a reasonable expectation of the issuer’s ability to repay the EGI.
• There must be actions evidencing a debtor-creditor relationship.

The documentation rules only apply to debt instruments issued on or after January 1, 2019, and must be met no later than the time for filing the issuer’s federal income tax return, including extensions, for the taxable year that includes the relevant date for such documentation or information. Furthermore, the documentation must be maintained for all taxable years in which the EGI is outstanding or until the time period limitations expire for any tax returns related to the EGI.

Under the final regulations, any EGI that fails to meet the documentation requirements is treated as stock for federal tax purposes unless the taxpayer clearly substantiates that there are sufficient common law factors to treat the EGI as debt or timely discovers and remedies a ministerial or nonmaterial failure or error.

Debt instruments treated as stock.

Under the general rule, a covered debt instrument is treated as stock for federal tax purposes if it is issued by a covered member to a member of its expanded group in a distribution, in exchange for stock of an expanded group member, or in exchange for property in an asset reorganization.

The funding rule commonly treats a covered debt instrument as stock to the extent that it is issued by a covered member to a member of its expanded group in exchange for property with the principal purpose of funding certain distributions or acquisitions in one or more of the following situations:

• Such a distribution not pursuant to an asset reorganization that is permitted to be received without the recognition of gain or income under IRC section 354(a)(1) or section 356, as applicable
• An acquisition of expanded group stock, other than in an exempt exchange, by the covered member from a member of its expanded group in exchange for property other than expanded group stock
• An acquisition of property by the covered member in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the expanded group immediately receives “other property” or money within the meaning of section 356 with respect to its stock in the transferor corporation.

The determination of whether a covered debt instrument is issued with the principal purpose of funding a distribution or acquisition is determined based upon all of the facts and circumstances. If the covered member issues a debt instrument any time between 36 months before the date of the distribution or acquisition and 36 months after, it is treated as issued with the principal purpose of funding a distribution or acquisition.

In addition to the above two rules, antiabuse rules were implemented to recharacterize a covered debt instrument as stock if it is issued with the principal purpose of avoiding the application of those rules. The application of the anti-abuse rules also depends upon the relevant facts and circumstances.

The final regulations also include several exceptions to the application of the general and funding rules. First, certain debt instruments are excluded from the general and funding rules, namely those issued by regulated financial and insurance companies and certain qualified short-term debt instruments as defined in Treasury Regulations section 1.385-3T(b)(3). In addition, if immediately after the debt instrument is issued, the aggregated adjusted issue price of debt instruments held by all members of the expanded group does not exceed $50 million, the instrument is not subject to the general and funding rules. Note, however, that the rules will still apply to the extent that covered debt instruments exceed $50 million.

Second, there are several exceptions in terms of certain distributions and acquisitions:

• Distributions or acquisitions up to the amount of the covered member’s expanded group earnings account balance are exempt from the general and funding rules. The expanded group earnings account is the earnings and profits accumulated by the covered member in taxable years ended on or after April 5, 2016. Special rules apply if the covered member joins the expanded group during the taxable years. The reduction of the expanded group earnings account is applied based on the order in which the distribution or acquisition occurs.
• After considering the expanded group earnings account exception, the distributions or acquisitions to the extent of the covered member’s qualified contribution account are excluded from the general and funding rules. Qualified contributions generally include any contribution of property [other than expanded group stock, covered debt instruments, and certain other excluded property discussed in Treasury Regulations section 1.385-3(c)(3)(ii)(D)] made within three years before or after the distribution or acquisition.
• Acquisitions of expanded group stock by a covered member (acquirer) from a subsidiary (seller) in which the acquirer does not relinquish control of the seller pursuant to a preexisting plan, other than where the seller ceases to be a member of the group, are not subject to the general and funding rules.
• Acquisitions of expanded group stock delivered to individuals who are employees, directors, or independent contractors in consideration for services are not subject to the general and funding rules.
• Acquisitions of expanded group stock by a dealer in securities in the ordinary course of business are not subject to the general and funding rules.

In general, the recharacterization rules discussed above apply to taxable years ending on or after January 19, 2017, and to covered debt instruments issued immediately after January 19, 2017.