The Treasury Department (Treasury) and Internal Revenue Service (IRS) recently issued REG-108060-15, containing proposed regulations under section 385 of the Internal Revenue Code (the Code). These proposed regulations, if finalized in their current form, would dramatically affect the analysis applied when determining whether an interest in a related corporation is treated as stock or indebtedness, or as in part stock and in part indebtedness. In general, the proposed regulations would give the IRS authority to recharacterize certain intercompany debt instruments as stock (most likely, preferred equity) unless the intercompany debt is issued in exchange for cash or other nonstock property that increases the nonstock assets of the issuer.
A recharacterization of debt as equity can lead to harsh or unexpected results for taxpayers as the issuer cannot deduct the interest payments on the recharacterized debt, and the interest payments will be treated as dividends for all US federal income tax purposes. If a foreign counterparty is involved, this recharacterization can also cause an unexpected mismatch. For example, if a loan from a foreign parent to its US subsidiary is recharacterized as equity, what was intended to be a deductible interest payment to the foreign parent will be converted, retroactively, to a nondeductible dividend payment for US tax purposes. However, this payment will still be subject to income tax in the foreign parent’s jurisdiction since the relevant jurisdiction’s participation exemption for dividends will not be applicable as the payment is still treated as taxable interest for foreign tax purposes, resulting in effective double taxation. Potentially worse, this recharacterization could cause the instrument to be treated as a hybrid instrument for foreign tax purposes and thus negatively affect its treatment in the foreign jurisdiction under new laws promulgated under the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) initiative.
As detailed below, while the stated purpose of these proposed regulations as articulated in the Treasury’s recent press release is to “reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping,” the proposed regulations would have significant and far-reaching consequences for any taxpayers that engaged in intercompany financing with their US or foreign affiliates. The issuance of related-party debt may no longer provide the same tax benefits, and for many taxpayers, debt-financed transactions that have no connection whatsoever with inversions or aggressive inbound tax planning may now be affected. Moreover, the proposed contemporaneous documentation requirements would also present a substantial compliance burden on taxpayers using significant amounts of intercompany debt to finance their daily business operations, for example, in cash pooling arrangements or other regular treasury center activities. Furthermore, because the proposed regulations would generally apply to instruments issued after April 4, 2016, taxpayers must consider the potential impact of these proposed regulations on current transactions as well as on any debt instruments that are transferred or significantly modified after that date.
The determination of whether an interest in an entity is debt or equity for US federal income tax purposes is based on all the relevant facts and circumstances under US common law. The jurisprudence on this matter has developed a series of multifactor tests designed to determine whether an instrument is debt or equity in its entirety. Congress codified these common-law tests into the Code in enacting section 385, which also authorizes the Treasury to issue regulations necessary to determine whether an interest in a corporation is treated as stock or indebtedness for US federal income tax purposes. There are no such regulations currently in effect and these proposed regulations are the first set of regulations introduced by the IRS under section 385 since its enactment in 1969.
The proposed regulations
The proposed regulations would apply to “expanded group indebtedness” (EGI), which is defined as an instrument of which both the issuer and holder are members of the same “expanded group.”
An “expanded group” is defined under the proposed regulations the same as an “affiliated group” is defined under section 1504(a) of the Code, but with four key modifications. First, the expanded group includes foreign corporations. Second, the expanded group includes corporations held indirectly through partnerships. Third, the proposed regulations apply the attribution rules of section 304(c)(3) for purposes of determining indirect ownership. Fourth and finally, an expanded group includes corporations connected by ownership of 80 percent of vote or value (instead of vote and value). The proposed regulations do not apply to indebtedness between members of a consolidated group in most circumstances. However, indebtedness between members of a consolidated group could become EGI subject to the proposed regulations if and when the instrument or a party to the instrument ceases to be within a consolidated group. It should be noted, under these rules, the proposed regulations may apply to debt instruments of disregarded entities if their owner is part of an expanded group and debt instruments of a “controlled partnership,” defined as a partnership with respect to which at least 80 percent of the interests in partnership capital or profits are owned, directly or indirectly, by one or more members of an expanded group.
Treatment of certain instruments as debt in part and stock in part
Under common-law principles and current law, an interest in an entity is generally treated as wholly debt or wholly equity. Prop. Reg. section 1.385-1(d)(1) would provide the IRS the exclusive authority (to the exclusion of taxpayers) to treat an EGI as part indebtedness and part stock to the extent justified to reflect the economic substance of the transaction between the issuer and holder. It should be noted that the scope of the IRS’s authority to bifurcate extends to instruments between members of a “modified expanded group,” which is defined the same as an “expanded group” except that the ownership threshold is reduced to 50 percent from 80 percent. This rule would apply to related-party instruments issued on or after the date the proposed regulations are issued as final regulations.
Contemporaneous documentation requirements
Prop. Reg. section 1.385-2 sets forth the contemporaneous documentation requirements that must be satisfied in order for any EGI to be treated as indebtedness for US federal income tax purposes. The aim of these requirements is to put the onus on the taxpayer to provide the IRS with the information required to analyze the instrument under the principles of section 385 and the proposed regulations. While the voluminous details of these contemporaneous documentation requirements are beyond the scope of this alert, these requirements are intended to apply only to large taxpayer groups. Therefore, a related-party debt instrument is not subject to these contemporaneous documentation requirements unless: the stock of any member of the expanded group is publicly traded; the expanded group’s financial statements at any time show total assets exceeding US$100 million; or the expanded group’s financial statements show annual total revenue that exceeds US$50 million.
Certain distributions of debt instruments and related transactions
Prop. Reg. section 1.385-3 and 1.385-4 give the IRS the authority to characterize as equity: notes distributed to a related shareholder, notes issued to acquire equity of a related entity, and notes distributed to a related entity as boot in an asset reorganization. In addition, these rules also contain a non-rebuttable presumption that recharacterizes as equity any investment loans made to a related entity if, within the 36-month period either before or after the loan, the related borrower either distributes dividends, acquires equity in a related entity, or distributes boot in an asset reorganization. In addition, the proposed regulations also contain a broad “funding rule” that would generally treat as stock any debt issued to fund any of the three aforementioned transactions.
Prop. Reg. section 1.385-3(c) lists the three exceptions to the application of these rules to recharacterize any portion of an intercompany debt instrument as equity. First, distributions or acquisitions that do not exceed current earnings and profits are not treated as distributions or acquisitions subject to recharacterization. Second, there is a threshold exception that provides that a debt instrument will not be recharacterized as stock if, when the debt is issued, the issue price of all other debt instruments considered EGI under the proposed regulations does not exceed US$50 million. Third, the proposed regulations provide a specific exception for debt instruments issued in connection with the transfer of property to a related borrower in exchange for equity in the same related borrower, and for the 36-month period following the issuance, the lending entity holds, directly or indirectly, more than 50 percent of the vote and value of the stock of the related borrower. This third exception generally applies to notes issued in certain nontaxable asset reorganizations under the Code.
What about me?
The details of the proposed regulations are complex, and determining exactly how they will apply to specific transactions will require detailed analysis. While these rules are ostensibly aimed at curbing inversions, the fact of the matter is that the only segment of US taxpayers clearly outside the scope of these rules are domestic companies with no foreign affiliates, no related entities outside the consolidated group, and no related-party indebtedness. Among the entities, structures, and transactions that the proposed regulations would affect are US companies undertaking debt-financed reorganizations and restructuring of their foreign operations, foreign multinationals undertaking reorganizations or debt-financed restructurings involving their US businesses, debt-financed mergers and acquisitions, refinancing and repatriations involving private equity portfolio companies, and financing of closely held businesses by related parties.
Most domestic and foreign investors in US corporate entities will need to consider the potential application of these rules to any intercompany debt to be issued after April 4, 2016. Furthermore, even though the proposed regulations should not apply to intercompany debt that was outstanding prior to April 4, 2016, such debt could easily become EGI subject to recharacterization through common transactions such as an entity classification election or a significant modification of the debt instrument. We understand that the Treasury and the IRS intend to move hastily to finalize these proposed regulations and, therefore, recommend you seek professional tax advice with respect to your intercompany borrowings, both current and prospective.
For more information on this topic, or to learn how Baker Tilly international tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.