November 9, 2016

Implications of the New Section 385 Regulations on Insurance Company Groups

By Thomas Gray

The United States Treasury issued final and temporary regulations regarding the classification of debt and equity under Section 385 of the Internal Revenue Code (the “Final Regulations”) on Oct. 13, 2016. The Final Regulations are another attempt by the Treasury to stop multinational companies from “stripping” income out of the U.S. following a corporate inversion.

The application of the Final Regulations is subject to many limitations and exclusions, including exclusions for most insurance companies and the normal business transactions they enter into. As such, the Final Regulations are a welcomed relief from the proposed regulations (the “Proposed Regulations”) that were so broad that they could have affected many ordinary business transactions of insurers that had no connection to inversions. Caution still must be exercised to ensure that the comprehensive requirements of the Final Regulations are followed to the extent that they do apply.

The Final Regulations

The Final Regulations impose two general rules: (i) the minimum documentation required to determine whether an instrument is to be treated as debt or equity under general federal income tax principles (the “Documentation Rules”) and (ii) recharacterizing debt as stock where that debt has been issued to a highly related party and does not finance new investments (the “Recharacterization Rules”). Both the Documentation Rules and the Recharacterization Rules potentially affect insurance companies, but in response to many comments, the Treasury has significantly curtailed their application.

The Final Regulations:

  • Reserve on their application with respect to foreign issuers;
  • Exclude certain debt issued by “regulated insurance companies” from the Documentation Rules;
  • Exclude “regulated insurance companies” from the Recharacterization Rules;
  • Provide threshold limitations for the application of both the Documentations Rules and the Recharacterization Rules; and
  • Clarify that certain transactions typically entered into by insurance companies, such as insurance and reinsurance transactions, generally do not constitute the issuance of indebtedness and, if not treated as the issuance of indebtedness, would not be subject to the Final Regulations.

Covered Member and Expanded Groups

The Final Regulations have first limited the regulations application by reserving on all aspects of their application to foreign issuers and, as a result, the Final Regulations do not apply to foreign issuers. The exemption is accomplished by creating a new term “covered member”, which as of now, only includes domestic corporations. Domestic corporations, however, do include foreign insurance corporations that have made elections under Section 953(d) of the Internal Revenue Code to be treated as domestic corporations. Treasury officials during separate tax conferences noted that these regulations may become applicable to foreign issuers in the future, but the Treasury Department will leave further consideration of their application to foreign issuers to the incoming administration.

The Final Regulations also only apply where debt is held by a member of the issuer’s “expanded group”. An expanded group generally means one or more chain of corporations where a common parent corporation (other than a common parent corporation that is a regulated investment company, a real estate investment trust or an S corporation) owns directly or indirectly 80% or more of the stock of at least one of the other corporations in the chain and such other corporations own directly or indirectly 80% or more of the stock of the other corporations in the chain. So unlike a consolidated group, an expanded group can include foreign corporations and certain corporations that would otherwise be excluded from a consolidated group.

As discussed below, the terms covered member and expanded group are used throughout the Final Regulations to help limit the application of Documentation Rules and the Recharacterization Rules.

Documentation Rules

Expanded Group Interest

The Documentation Rules provide rules for the preparation and maintenance of the documents and information necessary to the determination of whether certain instruments will be treated as indebtedness for federal tax purposes. The Documentation Rules require four factors that must be documented to establish that an expanded group interest is indebtedness. The four factors are: (1) the issuer’s binding obligation to pay a sum certain; (2) the holder’s rights to enforce payment; (3) a reasonable expectation of repayment; and (4) a course of conduct that is generally consistent with a debtor-creditor relationship.

The Documentation Rules only apply where a covered member issues an “expanded group interest” (an “EGI”). The Documentation Rules also apply where a disregarded entity owned by a covered member issues an EGI. An EGI is an applicable interest (such as an interest issued in the legal form of debt or an intercompany payable/receivable entered into in journal entry form) issued by a member of an expanded group and which is held by a member of the same expanded group. The holder can also be a disregarded entity owned by a covered member or a controlled partnership.

The Documentations Rules provide various exceptions to what interests are excluded from the term “applicable interests,” including interests issued between members of the same consolidated group and interests issued or deemed issued before Jan. 1, 2018. Therefore, the Documentation Rules will not apply if a member of a consolidated group issues an interest to another member of the same consolidated group, and the Documentation Rules will not become operative until Jan. 1, 2018.

Regulated Insurance Company EGIs

Although the Final Regulations do not exclude insurance companies from the Documentation Rules, the Final Regulations generally provide that a “regulated insurance company” (as such term is defined below) will be treated as meeting the Documentation Rules when issuing an EGI if the issuer is required to receive approval or consent of an insurance regulatory body prior to making payments of principal or interest, provided that at issuance it is expected that the EGI will be paid in accordance with its terms. If approval and consent is not required then the regulated insurance company would have to meet the requirements of the Documentation Rules.

Threshold Limitations

In order to limit the reach of the Documentation Rules, the Final Regulations impose a threshold limitation as of the date an applicable interest becomes an EGI. On that date, the Documentation Rules will only apply if (i) the stock of any member of the expanded group is traded on (or subject to the rules of) and established financial market, (ii) the total assets exceed $100 million on any applicable financial statement or combination of applicable financial statements, or (iii) annual total revenue exceeds $50 million on any applicable financial statement or combination of applicable financial statements. The Final Regulations provide complicated rules with respect to financial statements that are non-U.S. dollar denominated or where financial statements must be combined.


If the documentation and information described under the Documentation Rules is not prepared and maintained in the manner as described under the Documentation Rules with respect to an EGI and no exception applies, then the EGI will be treated as stock for all federal tax purposes. In addition, if such documentation is not provided to the IRS when requested, then the IRS will treat such documentation as not prepared or maintained. Although most debt typically issued by an insurance company is likely to be excluded from the Documentation Rules, there is no blanket exception and insurance companies should be careful to follow the requirements of these rules.

Recharacterization Rules

The Recharacterization Rules generally provide that a “covered debt instrument” is treated as stock to the extent the covered debt instrument is issued by a covered member to a member of the covered member’s expanded group in one or more of the following transactions: (i) in a distribution; (ii) in certain exchanges for expanded group stock; and (iii) in certain exchanges for property in an asset reorganization.

Regulated Insurance Companies

As noted above, the new term covered member includes only domestic corporations and therefore the Recharacterization Rules do not currently apply to foreign issuers. In addition, the Treasury has determined that debt instruments issued by insurance companies that are subject to risk-based capital requirements under state law should be excluded from the definition of a “covered debt instrument” (generally a debt instrument issued by a domestic corporation after April 4, 2016). The Treasury has taken the view that these insurance companies, each a regulated insurance company, are subject to requirements and other regulation that mitigate the risk that they would engage in the types of transactions addressed by the Final Regulations.

The Final Regulations define a “regulated insurance company” as a covered member that is: (i) subject to tax under subchapter L of chapter 1 of the Internal Revenue Code; (ii) domiciled or organized under the laws of a state or the District of Columbia; (iii) licensed, authorized, or regulated by one or more states or the District of Columbia to sell insurance, reinsurance, or annuity contracts to persons other than related persons (as such term is defined in the Internal Revenue Code); and (iv) engaged in regular issuances of (or subject to ongoing liability with respect to) insurance, reinsurance, or annuity contracts with persons that are not related persons. In order to prevent a company from inappropriately qualifying as a regulated insurance company, the Final Regulations also provide that in no case will a corporation satisfy the licensing, authorization, or regulation requirements if a principal purpose for obtaining such license, authorization, or regulation was to qualify as a “regulated insurance company” under the Final Regulations.

The last prong of the definition of “regulated insurance company” has the effect of not including within the exclusion certain captive insurance and reinsurance captive companies. Covered debt instruments issued by such companies are not excluded under the Final Regulations because captive insurers are not subject to risk-based capital requirements and are otherwise not subject to regulation and oversight to the same degree as other insurance and reinsurance companies.

Insurance and Reinsurance Transactions

The Preamble to the Final Regulations notes that commentators requested that the Final Regulations should not apply to (i) insurance or reinsurance transactions entered into in the ordinary course of an insurer’s or reinsurer’s trade or business or (ii) reinsurance arrangements where funds otherwise due to the reinsurance company are withheld by the insurance company ceding risk to a reinsurance company. In its discussion, the Preamble provides that the Recharacterization Rules only apply to debt instruments and the transactions described in the preceding sentence are not ordinarily treated as debt. Because the above transactions generally would not be considered debt, the Recharacterization Rules would not apply to such insurance or reinsurance transactions. To the extent the transactions could be treated as debt, but the issuer is a regulated insurance company, then the issuance would also be excluded from the Recharacterization Rules. Although not specifically excluded in the Final Regulations, the discussion in the Preamble should give comfort that the Final Regulations do not cover the above described insurance transactions.

Expanded Group and Threshold Exception

If a domestic insurance company finds that it is not a regulated insurance company under the Final Regulations and it issues a covered debt instrument to a member of its expanded group, the issuance may still be excluded from the Recharacterization Rules. The Final Regulations provide threshold exception that if, but for this exception, at the time such debt would have been treated as stock under the Recharacterization Rules, the aggregate adjusted issue price of the debt instruments held by members of the issuer’s expanded group does not exceed $50 million, then the debt will not be recharacterized as stock. This exception is intended to provide relief to smaller issuers of debt that otherwise would have been caught up in the Recharacterization Rules. The Recharacterization Rules also provide exceptions for certain acquisitions for expanded group stock and funding certain distributions.

Consolidated Groups

The Final Regulations also address how the Recharacterization Rules interact with covered debt instruments issued by a member of a consolidated group (the “Consolidated Rules”). Generally, the Consolidated Rules provide that a consolidated group is treated as one corporation for purposes of the Recharacterization Rules so that where one member of a consolidated group issues a covered debt instrument to a member of its expanded group, but not a member of its consolidated group, the Consolidated Rules treat the covered debt instrument as issued by the consolidated group. The Treasury provides the consolidated group exclusion because the income stripping concerns addressed in the Final Regulations are not necessarily present where the interest income and corresponding deductions are reported on one federal tax return.

Some commentators to the Proposed Regulations requested that newly acquired life insurance companies be included in the group that would be considered one corporation under the Consolidated Rules, but the Treasury declined to follow the request. The Preamble to the Final Regulations noted that since there would be more than one federal tax return involved, such inclusion would not be within the one corporation concept. In addition, since there is the regulated insurance company exception to the Recharacterization Rules, most life insurance companies would be excluded in any case.

Effective Date

The Final Regulations apply to taxable years ending on or after Jan. 19, 2017 with respect to debt instruments issued after April 4, 2016. Transition rules also apply. Taxpayers may elect to consistently apply the rules of the Proposed Regulations for instruments after April 4 and before Oct. 13, 2016.


The Final Regulations offer welcome relief to insurance companies. Most debt issuances and ordinary activities entered into by insurance companies will be excluded from the Final Regulations. A domestic insurance company, however, still needs to be mindful of whether it qualifies as a regulated insurance company and whether any interest issued qualifies for an exception to the Documentation Rules. Furthermore, as indicated above, the Treasury is still reviewing the application of the above rules to foreign issuers so it is possible that in the future we could see guidance that applies the above rules to foreign issuers.

For more information on the application of these rules or federal income taxes in general, please contact the author listed above or the Drinker Biddle lawyer with whom you regularly work.

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