U.S. Treasury Releases Update on its Tax Regulatory Review: Section 385 and 367 likely to be Materially Affected

On Wednesday, October 4, 2017, the U.S. Department of the Treasury (“Treasury”) released the "Second Report to the President on Identifying and Reducing Regulatory Burdens" (“Second Report”). The Second Report contains recommendations on actions to eliminate or mitigate burdens imposed on taxpayers by eight recent tax regulations issued during the prior administration. This includes partially revoking and replacing the documentation requirements under the Final 385 Regulations as well as substantially revising the Final 367 Regulations. Treasury’s ultimate revisions to the Final 385 and 367 Regulations could have significant implications for companies engaging in certain intercompany transactions.

Additional detail from the Second Report is provided below. Duff & Phelps will continue to provide updates as Treasury’s regulatory process evolves.

Background

The Second Report was prepared in response to Executive Order 13789, issued on April 21, 2017, which called for Treasury to review significant tax regulations issued after January 1, 2016, and identify and provide recommendations for regulations that impose an undue financial burden on U.S. taxpayers, add undue complexity to the U.S. federal tax laws, and/or exceed the statutory authority of the Internal Revenue Service (“IRS”). As an initial response, in a memo dated June 22, 2017, Treasury identified eight tax regulations for further review. This Second Report expands upon the first with further detail on Treasury’s conclusions, recommendations and additional work to be done with regards to the eight identified tax regulations.

The Final 385 Regulations: Revoke and Replace the Documentation Requirements

The Final 385 Regulations, issued on October 14, 2016, provide restrictions and minimum documentation requirements around the recognition of intercompany financing instruments as debt (and corresponding payments as tax-deductible interest) for U.S. federal income tax purposes. In its review of the Final 385 Regulations, Treasury responded to each of these components separately.

In the Second Report, Treasury emphasized strong public pushback from commenters on these rules and ultimately concluded that, as they stand, the minimum documentation requirements do in fact impose an undue burden, specifically citing that the current requirements could compel corporations to “build expensive new systems to satisfy the numerous tests required by the regulations.” As such, the Second Report states that Treasury and the IRS are “considering a proposal to revoke the documentation regulations as issued,” and replacing the existing rules with ones that are “substantially simplified and streamlined.” Treasury specifically noted that the current documentation requirement regarding how to demonstrate that there is a reasonable expectation that a borrower has the ability to repay was problematic.

Further, Treasury notes in the Second Report that commentators “criticized the complexity and breadth” of the 385 distribution regulations, which Treasury itself referred to as a “blunt instrument for accomplishing their tax policy objectives.” That said, Treasury ultimately concluded against revoking or modifying the rules. Instead, noting that expected tax reform will likely address the problems that these regulations were meant to address and render them obsolete, but that in the meantime revoking the rules “could make existing problems worse.”

See our overview of the Final 385 Regulations contemporaneous to their release in October 2016 for more background on the current version of these regulations.

The Final 367 Regulations: Substantial Revision in the Near Term

The Final 367 Regulations, published on December 16, 2016, eliminated the exception under Section 1.367(d)-1T(b) for outbound transfers of foreign goodwill and going concern value (“FGGCV”) and limited the application of the active foreign trade or business (“ATB”) exception under Section 367(a)(3) to certain specified property (not including FGGCV). For FGGCV, the Final 367 Regulations therefore require the U.S. transferor to either recognize a gain under Section 367(a) or elect into the deemed royalty regime of Section 367(d), thus subjecting to U.S. taxation transfers that had not generally been subject to income or gain recognition under Section 367.

Treasury noted that commenters requested transfers of FGGCV be eligible for exceptions “in circumstances not ripe for abuse.” Upon reviewing Section 367, Treasury agreed with commenters that an exception to the Final 367 Regulations might be justified. This would include circumstances with “limited potential for abuse and administrative difficulties, including those involving valuation.” Treasury expects to propose a formal revision in “the near term.”

See our overview of the Final 367 Regulations for more background on the current version of these regulations.