United States: Proposed Regulations May Disrupt Intercompany Debt Practices

Introduction

The US Department of the Treasury issued proposed regulations on April 4, 2016, addressing the characterization of certain instruments as debt or equity for US federal income tax purposes (Proposed Regulations). The Proposed Regulations have been issued as part of a series of Treasury pronouncements designed to limit the ability of US corporations to undertake so-called “inversion” transactions, whereby a multinational corporate group owned by a US parent moves its tax residence outside of the United States. The Proposed Regulations, however, have wide-reaching implications beyond the world of inversions.

The Proposed Regulations include three key provisions: (1) the grant of authority to the US Internal Revenue Service to treat certain related-party debt as in part debt and in part equity; (2) the creation of contemporaneous documentation requirements to support debt characterization of certain related-party debt; and (3) a default rule treating debt issued to certain related parties in connection with specified (targeted) transactions as equity. As discussed in more detail below, “targeted” transactions generally include cashless transactions interposing intercompany debt into a group structure, as well as multistep transactions designed to achieve the same results.

Scope of the Proposed Regulations

The provisions of the Proposed Regulations generally apply to “expanded group instruments” (EGIs), defined as an interest issued, or deemed issued, in the form of debt between members of an “expanded group.” An “expanded group” is defined to include (a) all corporations (e.g., US and non-US corporations, S corporations, tax-exempt corporations, real estate investment trusts and regulated investment companies) that are at least 80 percent owned (by vote or value) by a common parent, directly or indirectly (including indirectly through partnerships and through the application of certain other ownership attribution rules) and (b) all partnerships, 80 percent or more of the interests in the capital or profits which are owned, directly or indirectly (through application of certain stock ownership attribution rules), by one or more members of the expanded group (a so-called “controlled partnership”). Members of a US consolidated corporate group are treated as a single member of an expanded group, and as such, debt between US consolidated group members is not an EGI. However, such debt will become an EGI if one of the relevant parties leaves the consolidated group.

Provision 1: EGI May Be Treated as in Part Debt and in Part Equity

The Proposed Regulations grant authority to the IRS (but not to the taxpayer) to treat an EGI as in part debt and in part equity for US federal income tax purposes. Historically, when the debt treatment of an instrument for such purposes is challenged, courts have treated such instrument as all debt or all equity. However, the Treasury noted that the so-called “all-or-nothing” approach is problematic in cases where the facts and circumstances surrounding a purported debt instrument provide only slightly more support for treatment of the interest as debt rather than equity.

Unlike the other provisions of the Proposed Regulations, this authority to bifurcate an EGI is applicable to an EGI between members of a “modified expanded group,” generally defined in the same fashion as an expanded group except that (a) the 80 percent ownership threshold is reduced to 50 percent and (b) members of a modified expanded group include individuals, partnerships, trusts or estates that own, directly or indirectly (through application of certain stock ownership attribution rules), at least 50 percent of the value of a modified expanded group member.

Provision 2: Contemporaneous Documentation Requirements

The Proposed Regulations require the preparation of certain contemporaneous written documentation in order for an EGI to be treated as debt for US federal income tax purposes. Failure to meet such requirements automatically (subject to a reasonable cause exception) results in the EGI being treated as equity, regardless of whether such EGI would appropriately otherwise be treated as debt based on the facts and circumstances.

The documentation requirements apply only to an EGI if (a) the issuer or one of its expanded group members is publicly traded; (b) the expanded group has total assets exceeding $100 million; or (c) the expanded group has annual revenues in excess of $50 million. If applicable, the Proposed Regulations require that an EGI be supported by the following four categories of documentation:

  1. Documentation establishing that the EGI issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.
  2. Documentation establishing that the EGI holder has the rights of a creditor to enforce such obligation. The rights of a creditor typically include, but are not limited to, the right to cause or trigger an event of default or acceleration of the EGI under certain circumstance and to enforce payment.
  3. Documentation that contains information establishing that, as of the relevant date, the EGI issuer’s financial position supported a reasonable expectation that the EGI issuer would be able to meet its obligations pursuant to the terms of the applicable instrument. Such requirement may be met by written documentation that may include cash flow projections, financial statements, business forecasts, asset appraisals, determination of a debt-to-equity ratio and other relevant financial ratios.
  4. Documentation that demonstrates the ongoing arm’s-length debtor-creditor relationship during the life of the EGI, including documentation of any required payment of principal and interest, such as wire transfer receipts. In the event that interest and principal is not paid as required, documentation must evidence the creditor’s efforts to assert its rights as creditor or to renegotiate the agreement, or the decision to refrain from pursuing any actions to enforce payment.

The above-noted documentation generally must be prepared within 30 days of the issuance of an EGI (or of any relevant retesting date, such as the date on which an existing intercompany debt between US consolidated group members becomes an EGI as a result of a member leaving the group). Documentation relating specifically to the ongoing debtor-creditor relationship must be prepared up to 120 days after a payment on the EGI, or other relevant event. The documentation must be maintained for all taxable years that the EGI is outstanding and until the statute of limitations expires for any tax return with respect to which the US federal income tax treatment of the EGI is relevant.

Provision 3: Default Equity Treatment for EGIs Issued in Targeted Transactions

Under the Proposed Regulations, an EGI issued in connection with any one of the following three “targeted” transactions, generally, will be treated as equity for US federal income tax purposes:

  1. EGIs distributed by a company to a member of its expanded group;
  2. EGIs issued in exchange for stock of a member of its expanded group, other than in an “exempt exchange” (defined below); and,
  3. EGIs issued by an acquiring company as consideration in an exchange pursuant to an internal asset reorganization where a member of the EGI issuer’s  expanded group receives the EGI as a distribution with respect to its stock pursuant to the plan of reorganization.

The first category of targeted transactions, distributions of EGIs, is the transaction of primary concern to the Treasury. The Treasury noted that a distribution of a receivable by a subsidiary to its parent, particularly where no new capital is introduced, often lacks meaningful non-tax significance such that respecting the instrument as debt for US federal income tax purposes produces inappropriate tax results. Furthermore, the Treasury is concerned that this type of transaction is frequently used to create interest deductions that reduce US taxable income of a US subsidiary or reduce non-US income of a “controlled foreign corporation” that would otherwise be included in a US parent’s taxable income under the so-called “Subpart F” rules.

As to the second category of targeted transactions, the Treasury expressed concern that taxpayers may structure a transaction as a purchase of stock of a member of its expanded group in exchange for an EGI in order to circumvent default equity treatment under the first category. The Treasury explained that the third category of targeted transactions is needed because internal asset reorganizations also can operate as a device to circumvent default equity treatment under the first category. As noted above, the second category does not apply to “exempt exchanges,” generally defined as an acquisition of expanded group stock in which the transferor and transferee of the stock are parties to certain tax-free asset reorganizations. However, transactions including exempt exchanges generally will be captured by the third category of targeted transactions.

Default Equity Treatment of EGIs Under the Funding Rule

Under the so-called “funding rule,” an EGI is treated as equity to the extent it is a “principal purpose debt instrument.” A “principal purpose debt instrument” generally is defined as a debt instrument that is issued by a corporation (the “funded member”) to a member of its expanded group in exchange for property with a principal purpose of funding one of the following transactions:

  1. a distribution of property by the funded member to a member of its expanded group, other than certain tax-free distributions of stock;
  2. an acquisition of expanded group stock, other than in an “exempt exchange” (defined above), by the funded member from a member of its expanded group in exchange for property other than expanded group stock; or
  3. an acquisition of property by the funded member in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of its expanded group immediately before the reorganization receives taxable property (i.e., “boot”) from a distribution with respect to its stock in the transferor corporation.

The Treasury has noted that, without the funding rule, taxpayers that otherwise would have issued an EGI in a one-step transaction would be able to use multistep transactions to avoid the application of the Proposed Regulations while achieving economically similar outcomes. For example, a wholly owned subsidiary that otherwise would have distributed an EGI to its parent corporation in a distribution could, absent these rules, borrow cash from its parent and later distribute that cash to its parent in a transaction that is purported to be independent from the borrowing.

Importantly, there is a non-rebuttable presumption that funding one of the above transactions is a principal purpose of a debt issuance if such debt is issued within 36 months before or after the occurrence of one of the above transactions. The Treasury has noted that this presumption is appropriate because money is fungible and because it is difficult for the IRS to establish the principal purpose of internal transactions.

Exceptions to Equity Treatment Under the Targeted Transactions and Funding Rule

The Proposed Regulations create certain exceptions to the targeted transactions and the funding rule discussed above. First, applicable distributions or acquisitions of an EGI in a given year are not treated by default as equity (1) to the extent of the expanded group member’s current year earnings and profits (E&P), or (2) where the aggregate adjusted issue price of all EGIs held by members of the expanded group does not exceed $50 million. With respect to the latter exception, once the $50 million EGI threshold is exceeded, all EGIs of the expanded group are subject to the default equity treatment rules.

Second, for purposes of the second category of the funding rule (i.e., an acquisition of expanded group member stock), the funding rule does not apply generally if, for the 36-month period immediately following the acquisition, the acquirer of affiliate stock owns, directly or indirectly, more than 50 percent of the stock of the transferor (by vote and value).

Third, the funding rule does not apply to an EGI that arises in the ordinary course of the EGI issuer’s trade or business in connection with the purchase of property or the receipt of services and the principal amount of the EGI is an amount that would be ordinary and necessary to carry on the trade or business of the EGI issuer if it were unrelated to the lender.

Consequences of Treatment as Equity

If an EGI is treated as equity under the Proposed Regulations, such EGI will be treated as equity for all US federal income tax purposes. This means that payments on EGIs will be treated as non-deductible distributions with respect to stock rather than deductible interest payments. Treatment as equity also may impact withholding tax rates on payments to non-US person holding EGIs under applicable income tax treaties.

Effective Dates of the Proposed Regulations

The proposed rules relating to the IRS authority to bifurcate an EGI and the documentation requirements will be effective for applicable EGIs issued on or after the date final regulations are issued. The proposed rules relating to the default treatment as equity in the case of an EGI issued in connection with a targeted transaction will be effective for applicable EGIs issued on or after April 4, 2016 that still are outstanding 90 days after the final regulations are issued. EGIs issued in connection with a targeted transaction between April 4, 2016 and the 90-day period after the regulations are finalized will be deemed to be exchanged for equity at the end of such 90-day period.

Observations

The Treasury has expressed its intent to finalize the Proposed Regulations quickly. However, the Treasury has also requested comments from the public on the Proposed Regulations. We expect that the Proposed Regulations will attract a significant amount of comments. In particular, concern has been expressed regarding the application of the Proposed Regulations to so-called “cash pooling” arrangements of corporate groups. Additionally, there is concern that the definition of the “expanded group” is too broad, including, by virtue of the inclusion of stock that is owned indirectly through partnerships.

The Proposed Regulations were promulgated under Section 385 of the US Internal Revenue Code. Section 385 provides examples of factors created under common law that have been used to determine whether an interest is properly treated as debt or equity, but grants authority to the Treasury to provide official guidance regarding the appropriate factors. The Proposed Regulations, however, fail to provide guidance that relates to the various factors present in common law. Instead, they create default rules, independent of any factors, in which an interest purported to be debt may be treated as equity. As such, the Proposed Regulations may be read to go beyond the authority granted under Section 385 in that certain of the new provisions would treat as equity an EGI that would qualify as debt under common law.

Whereas the Proposed Regulations require EGIs to be treated as equity under certain circumstances, they do not provide clear guidance as to the type of equity (e.g., preferred or common stock). This lack of guidance creates uncertainty for certain entities and groups that are defined by equity ownership thresholds, such as a US consolidated group and a “controlled foreign corporation.” In the case of an EGI that closely resembles a debt instrument but is treated as equity under the Proposed Regulations, it is difficult to see how such instrument may be treated as common equity because debt tends to be more similar to preferred equity than common equity. Guidance to this effect from the Treasury would, however, be welcome.

The Proposed Regulations provide a number of exceptions to the default equity treatment of an EGI under the targeted transactions and the funding rule. However, the rationale behind the limitations of certain of the exceptions is somewhat unclear. For example, the exception from debt characterization only for distributions that do not exceed current year (as opposed to current and accumulated) E&P is somewhat puzzling. Subject to the $50 million EGI threshold, this means that, where there is genuine debt funding of a subsidiary, distributions that exceed current year E&P may run afoul of the funding rule, even where there is significant accumulated E&P. Accordingly, to the extent contemplated distributions will exceed these amounts, it may be advisable to repay EGI principal to the extent of such excess amount prior to making any distributions with respect to equity.

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