United States: Proposed Regulations Threaten Routine Capitalization Strategies And Related-Party Lending Transactions

New Treasury guidance provides sweeping new proposed regulations that could greatly affect tax-advantaged capitalization strategies and various ordinary business transactions that involve related-party lending.

The IRS and Treasury continued their multiyear assault on inversion transactions with a guidance package released on April 4. The guidance included not only temporary regulations on inversion rules themselves (T.D. 9761), but also proposed regulations (REG-108060-15) intended to deter certain "earnings stripping transactions" that are often used as domestic, international, or state and local tax planning strategies. The proposed regs authorize the IRS to bifurcate certain related-party corporate debt into part debt and part stock. They also establish threshold documentation requirements that must be satisfied for certain related-party corporate debt to be respected as debt for U.S. federal tax purposes.

Although the proposed regs were presumably intended to address earnings stripping after international inversions, they would have a much broader effect. In their current form, they would affect certain tax-advantaged capitalization strategies and related-party business transactions between domestic entities. Because the proposed regs have a retroactive effective date, taxpayers should carefully consider the potential impact on all related-party lending transactions after April 4, 2016.

The temporary regulations under T.D. 9761 address transactions that are structured to avoid the purposes of Sections 7874 and 367. Those regulations are not the subject of this Tax Flash.

BACKGROUND

In 1969, Congress enacted Section 385 to authorize the IRS and Treasury to issue regulations addressing the characterization of an interest in a corporation as debt versus equity. However, no regulations are currently in effect under Section 385. As a result, a large body of case law developed to determine whether an interest in a corporation is characterized as debt or equity.

The IRS is now proposing regulations under Section 385 for the first time as part of their anti-inversion efforts. But instead of narrowly focusing on earnings stripping transactions in the international tax planning context, the IRS chose to use the significant authority provided by Section 385 to combat earnings stripping transactions broadly — whether enacted as part of a domestic, international, or state and local planning strategy. Accordingly, the IRS noted in the preamble to the proposed regs that although the regulations are motivated in part by transactions that result in excessive indebtedness in cross-border transactions, federal income tax liabilities can also be reduced or eliminated with excessive indebtedness between domestic related parties.

PROPOSED REGS

Part stock, part debt

Current law generally provides an all-or-nothing approach for debt-versus-equity determinations. Thus, such an approach treats an instrument as constituting either debt or equity — but not both — based on the application of relevant case law to the facts and circumstances. The preamble noted that this approach was problematic in cases in which purported debt instruments "provide only slightly more support for characterization of the entire interest as indebtedness than for equity characterization. ..."

To address this concern, the proposed regs permit the IRS to depart from the all-or-nothing approach when appropriate in characterizing indebtedness as either debt or equity.  Accordingly, the proposed regs authorize the IRS to bifurcate an instrument between debt and equity if an analysis, conducted under general federal tax principles, indicates the instrument should be treated as part equity and part debt.

This proposed rule would apply to instruments in place between parties meeting a 50% vote or value threshold for relatedness (a modified expanded group), as opposed to an 80% vote or value threshold applicable with respect to other rules (an expanded group) in the proposed regs.  

In addition, the proposed regs require all parties relying on the characterization of an instrument as debt  to treat the instrument consistent with the issuer's characterization. Thus, for example, a holder may not disclose on its return under Section 385(c)(2) that it is treating an instrument as part stock and part debt if the issuer of the instrument treats it as indebtedness.

Documentation and Information

The proposed regs require the timely preparation and maintenance of documentation for instruments characterized as debt. If a taxpayer fails to prepare and maintain required documentation in a timely way, or fails to provide required documentation to the IRS upon request, the debt instrument will be treated as stock.

The proposed regs require taxpayers to prepare and maintain four general categories of written documentation to avoid de facto stock treatment. These categories reflect critical characteristics of indebtedness for U.S. federal tax purposes and include:   

  1. Binding legal obligation to repay, either on demand or on one or more fixed dates
  2. Creditor's rights to enforce the obligation
  3. Resonable expectation of ability to repay the debt
  4. Actions evidencing debtor-creditor relationship

This Tax Flash doesn't attempt to discuss the important details underlying each of these four categories.  

These documentation requirements apply only to expanded group instruments (EGIs, as discussed later) held by large taxpayer groups. A large taxpayer group includes any group that satisfies one or more of the following requirements:

  • The stock of any member of the expanded group is traded on an established financial market.
  • Total assets of the expanded group exceed $100 million as reported on any applicable financial statements on the date an instrument becomes an EGI.
  • The expanded group's annual total revenue exceeds $50 million, as reported on any applicable financial statements on the date an instrument becomes an EGI.

Documentation is considered timely for the first three categories if prepared no later than 30 calendar days after the relevant event. For the fourth category, documentation is timely if prepared no later than 120 days after the relevant event.

TRANSACTION RULES

To deter earnings stripping and other transactions, the proposed regs provide various rules (transaction rules) that characterize an otherwise valid debt instrument as stock for all federal tax purposes. Specifically, the proposed regs provide three transactions rules that cause debt to be treated as stock: the general rule, the funding rule and the anti-abuse rule. The regulations also include three general exceptions to these rules.

  • General rule: The general rule treats a debt instrument as stock if the debt instrument is issued: (i) in a distribution, (ii) in exchange for expanded group stock (other than in certain exempt exchanges) or (iii) in exchange for property in an 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. The preamble notes that these transactions lack substantial nontax purposes and do not introduce "new capital."
  • Funding rule: The funding rule treats a debt instrument as stock if the debt is issued by a corporation (funded member) to a member of the expanded group in exchange for property and the debt constitutes a principal purpose debt instrument. A principal purpose debt instrument is a debt issued with the principal purpose of funding a distribution or an acquisition in various circumstances set forth in the proposed regs. The IRS believes the funding rule addresses transactions that, when viewed together, present similar policy concerns as the transactions that are subject to the general rule.   
  • Anti-abuse rule: Under this rule, a debt instrument is treated as stock if it is issued with a principal purpose of avoiding the application of the proposed regs. The Proposed Regs provide a significant non-exhaustive list of examples in which the anti-abuse rule applies.

The proposed regs include three exceptions from the transaction rules that otherwise characterize a debt instrument as stock. These exceptions include:

  1. Certain distributions and acquisitions that do not exceed current year earnings and profits
  2. The aggregate adjusted issue price of all expanded group debt that would otherwise be treated as stock under the transaction rules does not exceed $50 million
  3. An exception for certain funded acquisitions of subsidiary stock by issuance

Consolidated groups

For all purposes of the proposed regs, members of a consolidated group are treated as one corporation. For example, the proposed regs do not apply to debt instruments between members of a consolidated group (intercompany debt).  The IRS believes that the issues of concern regarding related-party debt don't exist when the issuer's deduction for interest expense and the holder's corresponding interest income offset on a consolidated federal income tax return.   

EFFECTIVE DATES

The proposed regs have varying effective dates, which are specific to respective operating provisions. The regulations permitting the IRS to depart from the all-or-nothing approach and the regulations pertaining to timely documentation requirements are effective for applicable instruments issued on or after the publication of the final regulations. However, the transaction rules apply to debt instruments issued on or after April 4, 2016, but would not treat interests as stock until the date that is 90 days after the final regulations were published.  

PRELIMINARY OBSERVATIONS

The breadth of the proposed regs will likely capture many ordinary course transactions and business operations occurring between related parties — whether foreign or domestic. For example, the proposed regs will affect inverted companies and cross-border transactions. In addition, they will influence ordinary related-party debt funding of portfolio investments by private equity vehicles and certain ordinary related-party treasury functions.

The proposed regs will also affect reorganization transactions. Many restructuring transactions previously characterized according to form should be carefully analyzed in light of these proposed regs. These rules, in combination with the strict documentation requirements, will influence many related-party financing transactions.  

Taxpayers should carefully analyze the proposed regs regarding any instruments issued on or after April 4, 2016. As noted, the regulations may apply retroactively to certain obligations issued before the regulations are finalized, and Treasury intends to move swiftly to finalize the rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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