United States: The IRS Plans To Convert Your Debt To Equity – And Create Income Out Of Nothing!

Last Updated: August 15 2016
Article by Stuart Lyons and Stanley Rose

Shakespeare, through Polonius (Hamlet), tells us "Neither a borrower nor a lender be; for loan oft loses both itself and friend..."  Proposed tax rules suggest that it will also soon lose favorable tax treatment.

The IRS has issued some proposed treasury regulations that, if finalized, will have a dramatic impact on related party debt. The rules, REG-108060-15, which amplify Code Section 385, will give the IRS the ability to re-characterize debt between certain related parties as equity. These rules are part of a crackdown on multinational companies, and are designed to remove their ability to shift profits from the U.S. to more tax-friendly nations. But as presently written, the rules will impact many loans between domestic related parties too. These regulations are significant, because if the IRS forces debt to be viewed as equity, the payments that borrowers planned to treat as deductible interest will instead be viewed as nondeductible dividends – still taxable to the recipient, but not deductible by the payer.

These Regulations, then, serve not only as a tool for the IRS to put an end to shifting of profits between related parties, but also to essentially create net income out of nothing.

EXECUTIVE SUMMARY

  • Proposed Regulation REG-108060-15 is not yet law, but may be soon.
  • Once finalized, it will be effective as of April 3, 2016.
  • Intended to curb cross-border profit-shifting and corporate inversions, the impact will be much broader by applying to completely domestic related parties.
  • It allows the IRS to automatically recharacterize certain related-party debt to equity.
  • There is no impact whatsoever on debt between unrelated parties.
  • Debtors may be denied interest deductions, and creditors could be deemed to have received dividends instead of nontaxable principal payments.
  • Publicly traded or large related-party taxpayers are subject to significant, contemporaneous recordkeeping requirements, the omission of which automatically converts debt to equity for tax purposes.
  • Certain uses of debt proceeds by related parties will automatically convert debt to equity, unless total related party debt does not exceed $50 million.
  • Small taxpayers are at risk also. They are not subject to some of the automatic reclassification of debt to equity that can apply to certain large entities, but they are still subject to adjustments at the IRS's discretion.

STATUS OF THIS LAW

What is a "proposed regulation?"

Internal Revenue Code represents the highest authority, and its rules are created by Congress. Congress often authorizes the IRS to write regulations, which supplement specific sections of the Code. Finalized regulations carry the force of law, and represent the second highest source of authoritative tax law. While in proposed form (like REG-108060-15), regulations do not carry the force of law, so while this rule is not a "done deal," in one form or another it may be before long – and we best be ready for it.

What is the existing rule that this proposal modifies?

REG-108060-15 will supplement Internal Revenue Code Section 385 – Treatment of Certain Interest in Corporations as Stock or Indebtedness. This section, unlike most, does not lay out much substantive law of its own, but consists almost entirely of Congressional authorization to the Treasury Department (the IRS) to provide rules addressing how to differentiate debt from equity. It lists a number of factors to be considered, and explains that the issuer (debtor) must follow its own initial characterization of the instrument; the holder (creditor) must follow that treatment unless it formally informs the IRS that it is treating it differently; but that the IRS is not bound at all by anyone's claim that a relationship is that of debt rather than equity. Without more clear guidance in the code or regulations, the IRS has recharacterized taxpayer's loans with great frequency, but using very inconsistent application of a number of vague factors, leading many outcomes to be determined by the courts. The proposed regulations answer Congress's call for more formal guidance. They are designed to remove ambiguity and keep more cases out of the courts, but they will make it far more difficult for many taxpayers to successfully argue debt is in use, rather than equity – regardless of how taxpayers view the relationship, and in many cases, in spite of the underlying documentation.

WHO DOES IT AFFECT? HOW DOES IT WORK?

REG-108060-15 is lengthy and detailed, and not yet finalized. What follows is merely an overview of some of its current features. Note that the information immediately below applies broadly across all parties affected by these rules. It is followed by some documentation requirements that apply only to large taxpayers. Finally, it covers certain types of transactions that, regardless of how well taxpayers follow the rules prescribed for creating true debt, will be treated as equity simply due to the use of the funds (this category does not apply unless total related-party debt exceeds $50 million).

General application

First, the proposed regulations make it clear that taxpayers who meet all the new requirements enumerated in REG-108060-15 are not guaranteed that their instrument will be treated as debt. Instead, a taxpayer must follow the rules merely to preserve the possibility that treatment as debt will be available.

If and when finalized, the proposed regulations will apply to existing loans initiated after April 3, 2016.

The regulations will apply to members of "expanded groups." Generally, overlapping ownership of 80% or more by two corporations will create an expanded group. This new term generally follows the IRC Section 1504(a) definition of "affiliated groups" that applies in many areas of tax law, but in subtle ways the new term is somewhat broader, and many corporations that are not part of an affiliated group will be part of an expanded group. Also, unlike affiliated groups, the definition of expanded groups includes partnerships, S corporations, tax-exempt entities, disregarded entities, and corporations owned indirectly through other entities.

While the code has always specifically allowed for bifurcation of an instrument into part debt, part equity components, the IRS and the courts until now have quite consistently applied an "all or nothing" approach to their debt vs. equity analysis. The proposed regulations formalize an approach that will make partial re-class of debt to equity a common occurrence.

Large taxpayers' documentation requirements

Specific documentation requirements are imposed upon expanded groups that include large taxpayers. Generally, if an entity in the expanded group is publicly traded, or an entity in the group owns total assets that exceed $100 million or generates revenues that exceed $50 million at the time the related party loan is used (or if either of these two numerical thresholds were met within the 3 year period prior to the use of that loan), that entity and all other members of its expanded group are subject to these heightened record-keeping requirements. If applicable, large taxpayers must create written records documenting the following characteristics:

  1. An unconditional obligation to pay a sum certain (on demand or at one or more fixed dates)
  2. Creditor's rights (the ability to enforce the loan, description of triggering events, and evidence that the creditor's rights exceed shareholder's claim to assets)
  3. Written documentation establishing the intention and reasonable expectation of ability to repay the loan, taking into account "all relevant circumstances" and including consideration of other obligations of the debtor (financial statements, asset appraisals, budgets, financial ratios, and third party reports of value are encouraged)
  4. Actions evidencing debtor-creditor relationship (proof of principal and interest payments, or proof of collection or renegotiation efforts)
  5. Other (the IRS reserved a section in the regulations for more requirements to follow)

The documents described above must be complete and (if applicable) executed, and any additional information can supplement, but cannot substitute for, the required material. They must be prepared within 30 days of the loan, or within 30 days of two entities with an existing loan becoming members of the same expanded group. The regulations make it clear that failure to maintain these records automatically results in the loan being re-characterized as equity.

Certain uses of funds will taint their character – even if otherwise qualified as true debt

There are certain uses of funds that will cause them to be treated as equity, regardless of a taxpayer's adherence to all of the other rules described above.

If the instrument itself or cash flow resulting from it are used to fund a distribution to an expanded group member, or to acquire stock of a member, or to accomplish an asset reorganization, an otherwise qualified debt instrument will be automatically re-characterized by the IRS as equity. Any instrument issued in the 3 years preceding, or in the 3 years following one of these transactions will be deemed to have been used for one of these prohibited purposes. Note – this 6 year rule is worded as a "nonrebuttable presumption." This means that even if a taxpayer can prove that the instrument's funds were not used for a prohibited purpose, the law will treat it as if they were.

Three exceptions are provided, and if one of them is met, the taxpayer's characterization as debt can survive if otherwise qualified:

  1. The amounts spent on the prohibited purposes above do not exceed $50 million in total;
  2. The amounts spent on the prohibited purposes do not exceed the entity's current earnings and profits (in other words, the loan could have been funded from that year's income); or
  3. Stock of a corporation is newly-issued to a group member in exchange for debt, and that group member then holds, and for 3 years continues to hold, at least 50% of that corporation's stock.

IMPACT AND ANALYSIS

So what will happen if an entity's debt is treated as equity by the IRS? For starters, interest expense will be denied to the debtor, and the payments instead will be deemed to be nondeductible dividends or a return of capital (the debtor's taxable income will increase). The recipient (who presumably could find itself a party to an IRS audit purely as a result of its shared instrument with the other expanded group member) will see its interest payments treated as dividend income, but what of the principal? Presumably that too will be treated as dividend income.

These rules came from an effort to clamp down on corporate inversions and other profit-shifting arrangements that result from large companies' efforts to limit their exposure to U.S. corporate taxation, which imposes one of the highest rates in the world, and unlike nearly every other developed nation, taxes worldwide income, rather than income earned within its borders. But the rules are more far-reaching than that. Related parties whose activities are limited solely to the U.S. are caught in its grasps.

Also, although some stringent record-keeping requirements are imposed only on large taxpayers, smaller ones are still very much subject to the risk of re-characterization; they only enjoy immunization from automatic re-characterization. The enhanced record-keeping arguably makes no sense to begin with, because unlike nearly any other area of law, in the tax realm the taxpayer carries the burden of proof – not the government. This has characteristics of a rule designed to empower an IRS examiner who during an audit otherwise would have to verify the terms of a debt instrument using a historical facts-and-circumstances analysis. He or she can now blindly make a large adjustment that seemingly defies all logic.

Certain dividend payments between foreign and U.S. taxpayers are subject to withholding. A recharacterization from interest to dividends could cause a taxpayer to have inadvertently violated its withholding requirements.

Domestic and foreign dividends under many circumstances must be reported to the IRS (such as Form 1099-DIV). This represents another opportunity for an inadvertent violation if an adjustment is made.

If these regulations are finalized, they become effective as of April 3 of this year. A literal reading of this means that many companies could immediately be in noncompliance with these rules. Entities that have not created the exhaustive record-keeping requirements applicable to large corporations are especially vulnerable, as are companies with large related-party loans outstanding as of April 3 that innocently funded a group member's asset reorganization, acquisition or distribution. Unfortunately, the 3 year retroactive window that applies could cause legitimate actions taken as far back as April 3 of 2013 to have devastating, irreversible effects on a taxpayer today.

It is difficult to provide advice based solely on proposed legislation, but readers should be aware of the heavy potential consequences of recharacterization of debt to equity. It is hard to see how these rules do not represent a significant overreach of the power given by Congress in this area when it created Code Section 385 in 1969. It authorized the IRS only to write rules to help "determine whether an interest in a corporation is to be treated... as stock or indebtedness." These rules do not merely help determine the status of a financial instrument; they go far beyond that and change the treatment of legitimate debt for no apparent reason other than the IRS does not like the results.

Publicly-traded entities or members of expanded groups that include large taxpayers (or members that were large within the last 3 years) should consider documenting new debts now that follow the criteria in the proposed regulations, to prevent automatic noncompliance if and when the rules are finalized. Group members that issued debt within the last 3 years that were used for any of the prohibited purposes described above should be especially wary, and those that are close to, but have not yet exceeded the $50 million lending threshold, should avoid crossing that threshold if possible. Some related parties, ridiculously, should consider pursuing unrelated third-party loans to avoid running afoul of these rules.

Proposed Regulations REG-108060-15 have undergone vigorous debate as they move through the customary public comment stage en route to finalization or revision.

Just recently, in mid-July, the Treasury Department conducted hearings to allow for public comment and airing of concerns. As a result of those hearings, Treasury is considering four main areas where these proposed regulations "might have over done it".1  These four areas are cash pooling and short-term debt movement around multi-national groups, foreign to foreign intragroup loans, effects on banking and other highly regulated industries, and effects on S corporations and other pass-through entities.

Treasury is looking for a quick finalization of these regulations, perhaps as early as Labor Day 2016. Taxpayers who may be impacted by these new rules should be ready for any outcome.

Footnote

1 Robert Stack, Treasury Deputy Assistant Secretary (international tax affairs), July 16, 2016

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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