Source: https://www.washingtontaxlaw.com/Washington-Tax-Alerts/Washington-Tax-Alert-June-23-2016-proposed-IRC-385-regulations.shtml
Timestamp: 2019-04-25 00:21:23+00:00

Document:
Set forth below is a comment letter I submitted to Treasury regarding the proposed IRC § 385 regulations.
An article in Tax Notes Today on the proposed IRC § 385 regulations published on May 25, 2016 (2016 TNT 101-2) quotes Mr. Robert Stack, Treasury deputy assistant secretary (international tax affairs), as saying he is surprised that some have called into question the validity of the proposed regulations.
The proposed regulations are invalid for several reasons.
First, IRC § 385(a) authorizes Treasury to prescribe regulations "to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness." The statute is clear that regulations under IRC § 385 should make determinations whether interests in corporations are stock or indebtedness for tax purposes.
Prop. Reg. § 1.385-2, by its own terms, fails to follow this directive. Prop. Reg. § 1.385-2(a)(1) makes no determination whether "expanded group instruments" are stock or indebtedness if certain documentation requirements are satisfied. The proposed regulation provides that satisfying the documentation requirements leaves the classification of the instruments to be determined. Thus, Prop. Reg. § 1.385-2 imposes a requirement, but fails to make the determination that IRC § 385 directs Treasury to make in regulations.
Second, Prop. Reg. §§ 1.385-2 and 1.385-3 make no determinations whether an interest in a corporation is indebtedness. The proposed regulations provide only one-sided guidance that certain debt instruments should be treated as stock. Any inference that a debt instrument would be treated as indebtedness for tax purposes is specifically disavowed. Prop. Reg. § 1.385-3(g)(2). Such one-sided guidance is not consistent with the statute which directs Treasury to "set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists." IRC § 385(b). Such one-sided guidance is also contrary to the legislative history, which directs Treasury to "provide rules for distinguishing debt from equity in the variety of contexts in which this problem can arise."
Third, the proposed regulations are invalid because the regulations classify certain interests issued between members of an expanded group as stock based on criteria that have nothing to do with whether an interest in a corporation should be treated as stock or indebtedness. The provisions in Prop. Reg. § 1.385-2 imposing documentation requirements apply only if the stock of a member of the expanded group is traded on an established financial market or a member has applicable financial statements with a certain amount of revenues or assets. Prop. Reg. § 1.385-2 does not impose documentation requirements if the stock of members of the expanded group are not traded on an established financial market and no group member has applicable financial statements. These parameters in Prop. Reg. § 1.385-2 have no rational connection to any determination whether an interest in a corporation should be treated as stock or indebtedness.
Prop. Reg. § 1.385-3 treats certain debt instruments as stock if the aggregate adjusted issue price of such debt instruments held by members of the taxpayer's expanded group exceeds $50 million, but makes no determination with regard to identical debt instruments if the debt instruments held by members of the expanded group total $50 million or less. This distinction has no basis in IRC § 385 or the tax law generally, and is completely arbitrary.
Congress has enacted provisions in the Internal Revenue Code that apply different substantive rules to taxpayers based on the amount of their revenues or other characteristics. One example is IRC § 263A(b)(2). However, there is nothing in IRC § 385 or the legislative history that allows Treasury to prescribe regulations providing different substantive tax rules based on whether the stock of the corporation or a related party is publicly traded, the corporation or related party has applicable financial statements, or simply because the corporation and related parties have debt instruments exceeding a certain amount. None of that has any rational connection to whether an interest in a corporation should be treated as stock or indebtedness for tax purposes.

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