The Internal Revenue Service has proposed new regulations that
would generally treat intercompany indebtedness in corporate groups
with 80% common ownership as equity for U.S. tax purposes. The new
restrictions are proposed to be effective for any indebtedness
issued on or after April 4, 2016, with limited exceptions; however,
equity treatment would not be required for such debt before final
regulations are issued. It is likely that the regulations will be
finalized this year or not at all. Although intended primarily to
reduce earnings-stripping opportunities in the cross-border
context, including by inverted companies, the rules would apply
much more broadly.
The proposed regulations seek to overturn the long-standing rule
enunciated by the Second Circuit Court of Appeals in Kraft v.
Commissioner1 that permits a corporation to make a
distribution in the form of its own promissory notes to create an
indebtedness to its sole shareholder. The proposed regulations
would generally treat such indebtedness as stock of the issuer.
Debt issued in consideration for stock of an affiliate or in
exchange for assets in connection with an asset reorganization
would also be recharacterized as stock.
In addition, a true borrowing of funds may also be subject to
equity recharacterization if the borrowing is, or considered to be,
for a principal purpose of funding a distribution or acquisition of
stock of an affiliate by the borrower. The regulations also include
a broad anti-abuse rule and provide a non-rebuttable presumption
that borrowings within three years before or three years after a
distribution or acquisition was made with a bad principal purpose.
This rule is so broad that it will likely prove unworkable in its
current proposed form.
The proposed regulations contain some narrow exceptions for
loans between members of a consolidated group, loans falling below
an aggregate $50-million threshold and loans used to fund
subsidiary capital contributions.
The proposed regulations also include new due diligence and
documentation requirements for related party loans in large
corporate groups with an applicable financial statement. The rules
would disallow interest deductions and treat any loan made to an
affiliated borrower as equity if the parties fail to
contemporaneously document the existence of the debt, the
lender's legal right to enforce the debt, the issuer's
ability to repay the debt and the holder's reasonable exercise
of diligence to collect on the debt.
The proposed regulations would expressly authorize the IRS to
bifurcate a single loan to treat a portion of a related party loan
as equity. This would potentially make it easier for the IRS to
disallow interest deductions if a borrower were thinly capitalized,
but not to a degree that would support recharacterizing the whole
debt as equity. For this purpose, related party loans would include
those between 50% commonly controlled corporate groups.
The proposed rules could adversely affect common "tower
financing" structures used to fund U.S. operations of Canadian
multinationals and would greatly increase the prevalence of hybrid
instruments (treated as debt for foreign tax purposes but as equity
for U.S. tax purposes). This in turn may cause conflicts with
anti-hybrid rules that apply in other jurisdictions or that may be
enacted in the future in the United States or other jurisdictions
in accordance with the BEPS Action Plan Item 2, which targets such
hybrids. Perhaps anticipating the opportunities in this regard
created by the new recharacterization rules, the regulations
provide that recharacterization of debt as equity under the
regulations will not occur if the taxpayer entered into the
transaction with a principal purpose of obtaining a U.S. tax
benefit from recharacterization. However, this limitation might
prove to be impossible to apply in practice, given the broad scope
of the proposed rules.
1 232 F.2d 118 (1956).
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