IRS Releases New Earnings Stripping Regulations
Corporate & Finance Alert
On April 4, 2016, the United States Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) released proposed regulations (“Proposed Regulations”) under Section 385 of the Internal Revenue Code of 1986, as amended (the “Code”). The Proposed Regulations, issued as part of a package of proposed and temporary regulations addressing corporate inversions, establish new rules to determine in particular fact situations whether an interest in a corporation should be treated as stock or indebtedness for federal tax purposes.
Previously, in IRS Notices 2014-52 and 2015-79, Treasury and the IRS expressed their concerns about transactions involving the use of indebtedness in order to facilitate the stripping of the U.S. tax base of a corporate group following an inversion transaction. For example, under current law, following an inversion or a foreign takeover, a U.S. corporation may erode its U.S. tax base by issuing its own debt to its foreign parent and making deductible interest payments to the inverted parent, which may be subject to little or no tax. In the alternative, the parent could also transfer the debt instrument to a foreign affiliate in a low-tax jurisdiction. A U.S. corporation may also be able to repatriate untaxed earnings & profits from controlled foreign corporations in the form of a non-taxable return of capital by having the controlled foreign corporation distribute a note to the U.S. corporation in a year in which the controlled foreign corporation has no earnings and profits, and making deductible interest payments thereon in subsequent years.
Until now, the IRS dealt with earnings stripping primarily by means of Section 163(j) of the Code. In addition, the determination of whether an instrument was debt or equity for federal tax purposes depended on a list of judicially developed factors. The Proposed Regulations introduce specific rules that would affect the classification of instruments in related-party transactions.
The Proposed Regulations
Fundamentally, the Proposed Regulations:
- Allow the IRS to treat certain instruments issued between members of an expanded group (as that term is defined in Proposed Regulation Section 1.385-1(b)(3)) as debt in part and stock in part for federal tax purposes;
- Establish extensive documentation requirements for members of an expanded group for purposes of the debt-equity analysis; and
- Treat as stock certain interests in a corporation issued between members of an expanded group that would otherwise be treated as debt for federal tax purposes.
1. Treatment of a Debt Instrument as Debt in Part and Stock in Part under Prop. Treas. Reg. Section 1.385-1
Under current law, instruments are generally treated as entirely debt or entirely stock for federal tax purposes. Proposed Regulation Section 1.385-1(d) would authorize the IRS to treat any “expanded group instrument” or “EGI” as debt in part and stock in part, consistent with the substance of the instrument. For example, under Proposed Regulation Section 1.385-1, if the IRS determined that the issuer of an EGI with a face amount of $1,000,000 cannot reasonably be expected to repay more than $800,000 of the principal amount as of the instrument’s issuance date, the IRS may bifurcate the interest into an $800,000 debt instrument and a $200,000 stock instrument.
For purposes of this Proposed Regulation Section 1.385-1(d) only, the term “expanded group” includes a relatedness threshold of 50% between the group members (as opposed to the 80% relatedness threshold for expanded group members which applies for other rules in the Proposed Regulations).
2. Documentation Requirements for Purposes of Debt-Equity Analysis under Prop. Treas. Reg. Section 1.385-2
Under current law, it can often be difficult for the IRS to obtain all the information needed to properly analyze whether a related-party instrument is debt or equity for federal tax purposes. This is particularly so with respect to the parties’ intent to create a debtor-creditor relationship, which is one of the more important factors in the debt-equity analysis.
Proposed Regulation Section 1.385-2 would impose documentation requirements that would need to be satisfied in order for certain EGIs to be treated as debt for federal tax purposes. This rule would apply to EGIs only if (1) the stock of any member of the expanded group is publicly traded; (2) on the date that an applicable instrument first becomes an EGI, total assets on any applicable financial statement that includes any member of the expanded group exceed $100 million, or (3) on the date that an applicable instrument first becomes an EGI, the annual total revenue on any applicable financial statement that includes any member of the expanded group exceeds $50 million.
Under Proposed Regulation Section 1.385-2, a taxpayer seeking to establish that a purported EGI is indebtedness for federal tax purposes would need to provide written documentation establishing: (1) an unconditional and binding obligation to pay a sum certain on demand or at a specified time; (2) that the holder has the rights of a creditor to enforce the terms of the debt; (3) a reasonable expectation that the debt will be repaid; and (4) ongoing actions or behavior evidencing a true debtor-creditor relationship between the parties. With respect to the third category, the documentation could be in the form of future cash projections or other financial data of the debtor evidencing sufficient funds to meets its obligations under the instrument. With respect to the fourth category, the form of documentation would depend on whether the debtor complies with the terms of the debt. If so, the documentation should include proof of any payments of principal and interest with respect to the instrument. If not, the documentation should include evidence of the holder’s reasonable exercise of the diligence and judgment of a creditor, including the parties’ arms-length efforts to renegotiate the terms of the debt or the charging of appropriate interest on any deferred payments.
The documentation required under Proposed Regulation Section 1.385-2 will generally need to be prepared within 30 calendar days after the date that the debt instrument comes to be held by a member of the expanded group. With respect to documentation evidencing a genuine ongoing debtor-creditor relationship, however, the parties will generally have 120 days after the relevant event occurred to prepare the required documents. An exception may be available if the person characterizing an EGI as indebtedness for federal tax purposes establishes that a failure to satisfy the requirements of Proposed Regulation Section 1.385-2 is due to reasonable cause, applying the principles of Treasury Regulation Section 301.6724-1.
Proposed Regulation Section 1.385-2 would generally apply to an EGI at the time it becomes held by an expanded group member, and would cease to apply to the instrument when the instrument is no longer held by an expanded group member. An instrument characterized as stock under Proposed Regulation Section 1.385-2 will be recharacterized in accordance with general tax principles once it ceases to be subject to the proposed regulations, with the issuer being treated as issuing a new debt instrument in exchange for the old EGI.
Proposed Regulation Section 1.385-2 applies to any applicable instrument issued (or deemed issued) on or after the date that the Proposed Regulations are published as final in the Federal Register.
3. Distributions of Debt Instruments and Related Transactions under Prop. Treas. Reg. 1.385-3
Proposed Regulation Section 1.385-3(b)(2) would treat as stock certain interests in a corporation that are held by a member of the corporation’s expanded group if such instruments are issued (1) by a subsidiary to its foreign parent or other member of its expanded group in a distribution with no cash received in exchange therefor; (2) in exchange for stock of an affiliate (e.g., in connection with a Section 304 transaction), other than in an exempt exchange; or (3) in exchange for the assets of an affiliate (e.g., in connection with an internal asset reorganization), but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the issuer’s expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation. This rule is known as the “general rule.”
Proposed Regulation Section 1.385-3(b)(3) would treat a debt instrument as stock to the extent the instrument is issued by a corporation to a member of the corporation’s expanded group in exchange for property with a principal purpose of funding a distribution or an acquisition described in (1) through (3) above. This rule is known as the “funding rule.”
In addition, Proposed Regulation Section 1.385-3(b)(4) would treat a debt instrument as stock if the instrument is issued with a principal purpose of avoiding the application of the Proposed Regulations.
Whether a debt instrument is issued with a principal purpose of funding a distribution or an acquisition described in (1) through (3) above is based on all the facts and circumstances, subject, however, to a non-rebuttable presumption that an expanded group debt instrument is issued with such a principal purpose if it is issued by the funded member during the period beginning 36 months before and ending 36 months after the funded member makes a distribution or acquisition. An exception to this non-rebuttable presumption would be available for debt instruments that arise in the ordinary course of the issuer’s trade or business, i.e. debt instruments issued in connection with the purchase of property or the receipt of services to the extent that the amounts payable thereunder would be currently deductible by the issuer under Section 162 or currently included in the issuer’s cost of goods sold or inventory, provided that it does not exceed the amount that would be ordinary and necessary to carry on the issuer’s trade or business.
Proposed Regulation Section 1.385-3 provides for three exceptions to the rules set forth therein:
a. To the extent that the distributions or acquisitions under the general rule or the funding rule described above do not exceed the current earnings and profits of the distributing or the acquiring corporation, as the case may be, they are not treated as distributions or acquisitions for purposes of the general rule or the funding rule;
b. If, immediately after the EGI is issued, the aggregate adjusted issue price of all other expanded group debt instruments that would otherwise be treated as stock under the Proposed Regulations does not exceed $50 million, the debt instrument will not be treated as stock; and
c. An acquisition of expanded group stock by issuance of an EGI would not be treated as an acquisition falling within the ambit of the funding rule described above if (i) the acquisition results from a transfer of property by a funded member (the transferor) to an issuer in exchange for stock of the issuer, and (ii) for the 36-month period following the issuance, the transferor holds, directly or indirectly, more than 50% of the total combined voting power of all classes of stock of the issuer entitled to vote and more than 50% of the total value of the stock of the issuer.
4. Application to a Consolidated Group under Prop. Reg. Section 1.385-4
Proposed Regulation Section 1.385-1(e) protects members of a consolidated group from the Section 385 rules by treating such members as one corporation for purposes of those rules.
Proposed Regulation Section 1.385-4 then provides rules for applying Proposed Regulation Section 1.385-3 to a consolidated group when an interest ceases to be a consolidated group debt instrument or becomes a consolidated group debt instrument. In general, when a corporation ceases to be a member of the consolidated group but continues to be a member of an expanded group, a debt instrument that is issued or held by that member may be treated as stock if the instrument was not treated as stock solely because all members of the consolidated group were treated as a single taxpayer. Similarly, when a debt instrument that is treated as stock under Proposed Regulation Section 1.385-3 becomes a consolidated group debt instrument, the issuer would be treated as issuing a new debt instrument to the holder in exchange for the debt instrument that was treated as stock in a transaction disregarded for purposes of Proposed Regulation Section 1.385-3(b).
5. Effective Date
Proposed Regulations Sections 1.385-3 and 1.385-4 apply to debt instruments issued (or deemed issued) on or after April 4, 2016; however, such debt instruments will retain their characterization as debt until 90 days after the final regulations are published in the Federal Register.
If finalized in their current form, the Proposed Regulations will cause significant changes in the structuring of debt capitalization of U.S. subsidiary groups owned by foreign corporations and of foreign subsidiaries owned by U.S. corporations, and even domestic groups not filing consolidated returns. Although the Proposed Regulations were issued at the same time as the anti-inversion regulations targeting the tax benefits of inversion transactions, the regulations are likely to have an impact far beyond the context of inversions, mandating that routine corporate financing transactions involving subsidiaries be documented in accordance with the standards set forth therein or risk not being afforded treatment as debt for federal tax purposes.
If related-party debt that is issued, distributed or exchanged is characterized (or recharacterized) as equity for federal tax purposes, interest deductions to the issuer will be disallowed, and withholding obligations on the part of the holder will likely increase (generally, at a rate of 30% or a lower rate if a tax treaty applies).
Moreover, although the Proposed Regulations would not apply to debt instruments issued prior to April 4, 2016, such instruments could become subject to the regulations by virtue of an entity classification election or a significant modification of the instrument, or even a transfer of the debt instrument to an unaffiliated holder. It is therefore important that taxpayers that could be potentially affected by these rules take steps now to minimize the impact of the Proposed Regulations.
The IRS has indicated that it will move quickly to make the proposed regulations final.
This summary is for informational purposes only and not provided as legal advice. If you wish to discuss existing or potential debt transactions with a related non-U.S. entity, we would be pleased to speak with you.