Treasury Dept. Announces Rollback of Sec. 385 Regulations on Offshoring Profits

Chris Gaetano
Published Date:
Nov 4, 2019

The U.S. Treasury Department announced that it is removing certain provisions meant to discourage corporations from moving profits offshore to avoid taxes, saying that the old regulations are redundant in light of changes from the recent Tax Cuts and Jobs Act. The Treasury Department issued final regulations that formally revoke the documentation rules under Section 385.

The previous regulations, which went into effect in 2016, were meant to discourage corporate inversions: the processes by which U.S.-based companies move to lower-tax jurisdictions to reduce the tax burden on their income. The regulations did so by targeting a practice called "earnings stripping," which is paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country. This technique can generate large interest deductions without requiring a company to finance new investment in the United States. The 2016 rules, among other things, restricted the ability of corporations to engage in the practice by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances. Firms claiming interest deductions on related-party loans must also provide documentation for the loans, similar to the common practice for third-party loans. 

Treasury Secretary Tim Mnuchin, however, said that these regulations are no longer necessary because the U.S. business environment is much more competitive due to the TCJA, such as through a lower corporate tax rate, interest expense limitations and the shift to a territorial system. The Treasury Department's new regulations also cited the TCJA’s Base Erosion Anti-abuse Tax (BEAT tax) as another reason why the 2016 rules weren't necessary. 

“The Tax Cuts and Jobs Act leveled the playing field for American businesses and finally allowed the U.S. to shift from a worldwide to a territorial system of taxation,” said Mnuchin. “Because tax cuts made our business environment more competitive, we are now able to remove regulatory burdens that have been rendered obsolete, further reduce costs for job creators and hardworking Americans, and protect the U.S. tax base.”

The Treasury, in the new regulations, has withdrawn the documentation requirement, saying that it placed too much of a burden on taxpayers for little actual benefit. It has thereby removed the requirements set forth in those regulations on taxpayers with respect to certain transactions related to debt issuance. It noted that a comment letter expressed concern that the change would hamper the ability of the IRS to counter earnings stripping,and result in significant decreases in federal revenue. In addition, the commenter asserted that the removal likely would reduce the overall perceived legitimacy of the U.S. tax system, and consequently reduce voluntary compliance. In response to these concerns, the Treasury did leave open the possibility for a modified version of the requirements in the future, which it said would be "substantially" streamlined and simplified in order to minimize taxpayer burden. 

The Treasury Department has also published proposed regulations that would further strip down the 2016 anti-inversion rules by applying the rules only in the event the issuance of a debt instrument has a "sufficient factual connection to a distribution to a member of the taxpayer's expanded group or an economically similar transaction (for example, when the funding transaction and distribution or economically similar transaction are pursuant to an integrated plan)." Those debt instruments issued without such a connection would not be treated as stock. The Treasury Department believes this would be more streamlined and targeted while continuing to deter tax-motivated uneconomic activity.

Written or electronic comments on the proposed regulations must be received by Feb. 3, 2020.

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