On April 4, 2016, the U.S. Treasury Department and the IRS issued proposed regulations which govern whether certain related-party debt instruments will be classified as either debt or equity for U.S. federal income tax purposes. These rules are designed to prevent the excessive shifting of profits between related entities by way of interest charges on related-party debt instruments.
New Rules
These proposed regulations generally introduce the following:
- New debt Documentation Requirements;
- The General Rule, which characterizes a debt as equity if it is issued in a prohibited transaction; and
- The Funding Rule, which characterizes a debt as equity if it is issued to fund a transaction prohibited under the General Rule.
These rules generally apply to indebtedness within an Expanded Group ("EG"), which includes all corporations which are connected by ownership (directly or indirectly) of 80 per cent or more by vote or value. Indebtedness between companies filing as members of the same consolidated group is not covered by these rules as the consolidated group members are considered to be one taxpayer. The proposed regulations should apply to debt instruments issued on or after April 4, 2016, taking effect 90 days after the finalization of these regulations.
Documentation Requirements
The proposed regulations impose a contemporaneous documentation requirement, whereby the essential characteristics of the indebtedness must be documented within 30 days of issuance. These must include:
- Evidence of the issuer's unconditional and legally binding obligation to pay a sum certain;
- Evidence of the creditor's rights, including a superior right to that of shareholders to share in the assets of the issuer in case of dissolution;
- Evidence of a reasonable expectation that the issuer will be able to satisfy its obligations under the instrument; and
- Evidence of a creditor-debtor relationship, including documentation of payment of interest and principal, which must be prepared no later than 120 days after such payment is due.
Failure to satisfy any of these requirements can cause the indebtedness to be classified as a stock.
The Documentation Requirements apply to Expanded Groups:
- In which the stock of any member is publicly traded;
- Which has total assets exceeding $100 million; or
- Has total annual revenue in excess of $50 million.
These Documentation Requirements will apply to debt instruments issued after the proposed regulations are finalized. Those taxpayers not meeting the above-listed requirements to be subject to the Documentation Rules should still consider whether related-party debt instruments issued would satisfy those requirements, as the IRS may still look to those factors when determining whether a debt instrument constitutes a bona fide debt for U.S. tax purposes.
General Rule
A debt instrument will be treated as stock if the instrument is issued:
- As a distribution to an EG member;
- In an exchange for stock of an EG member; or
- In an asset reorganization.
When the General Rule is triggered, the debt instrument will be treated as stock as of the date of issuance.
Funding Rule
A debt instrument will be treated as stock if the instrument is issued with the principal purpose of funding any of the transactions covered by the General Rule. Because cash is fungible, the proposed regulations impose a Per Se Rule, whereby a debt instrument will be deemed to be issued for such forbidden principal purpose if it is issued during the 72-month period beginning 36 months before and ending 36 months after the transaction.
Exceptions to General and Funding Rules
There are exceptions, however, to the General and Funding Rules. The first exception provides that distributions or acquisitions that do not exceed current Earnings and Profits ("E&P") shall not be included for the purposes of these rules. The second exception provides that indebtedness shall not be classified as stock, under either the General or Funding Rules, provided such amounts do not exceed US$50 million in the aggregate. Once the US$50 million threshold is exceeded, all debt instruments which would have otherwise been treated as equity, will be treated as stock as of that date.
Bifurcation Rule
Unlike the all-or-nothing approach historically taken by the IRS when determining whether an instrument was debt or equity, the proposed regulations allow the IRS (but not the taxpayer) to treat an instrument as part debt and part equity. Furthermore, the IRS may also apply the Bifurcation Rule to instruments between corporations which are connected by ownership (directly or indirectly) of 50 per cent or more by vote or value. The Bifurcation Rule will apply to debt instruments issued on or after the date the proposed regulations are finalized.
Deemed Exchange
If, in accordance with these proposed regulations, a debt is recharacterized as equity, in whole or in part, no gain or loss shall be recognized by either the holder or the issuer, other than any gain or loss from foreign exchange, if applicable.
Conclusion
These proposed regulations will increase the amount of diligence required before issuing cross border debt. Those taxpayers subject to the Documentation Requirements will face significant compliance costs and may consider simplifying their instruments to minimize those costs (e.g., go from monthly interest payments to annual). Furthermore, the 72-month period surrounding a debt issuance will be a trap for the unwary as seemingly unrelated transactions can become connected and cause a debt issuance to be treated as equity. The Bifurcation Rule is particularly troublesome as it grants the IRS the power to split an instrument into part debt and part equity, but does not expressly state the factors that the IRS will use in making such determination. This will cause taxpayers to continue to have to rely on varying case law in determining whether an instrument is debt or equity. This uncertainty could have been reduced if the Treasury had issued specific guidance as to the factors to be used in determining whether an instrument is debt or equity, as was Congress' direction. Unfortunately, the proposed regulations only define specific instances in which debt instruments will be treated as equity, per se.
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.
