United States: IRS Issues Final Debt-Equity Rules

On October 13, 2016, the US Internal Revenue Service (IRS) released final and temporary regulations that recharacterize certain debt between related corporations as stock. These "debt-equity" regulations generally adopt in final, and in some cases temporary, form the controversial proposed regulations issued in April of this year, with some modifications in response to the hundreds of comments received from affected parties.

Modification to the rules of the proposed regulations

The proposed regulations released in April were detailed, but they fundamentally included three different (but interacting) sets of rules that would cause debt between related corporations to be treated instead as equity.

  • The Bifurcation Rule would generally permit the IRS not just to recharacterize debt of a corporation as stock of a corporation, but also to treat an interest in a corporation as in part stock and in part debt
  • The Documentation Rule would impose extensive substantiation and documentation requirements on corporate groups that are publicly traded or whose total assets or revenues exceeded certain thresholds
  • The Distributions Rule would treat as stock certain debt that is distributed to or received by another group member or exchanged for stock or assets in another group member, or that is treated as "funding" a distribution covered by the "funding rule"

Many commenters expressed alarm that their day-to-day transactions would be significantly impacted by the proposed regulations, and urged that the final regulations be more narrowly tailored to address perceived abuses.

The final regulations issued on October 13 do respond to certain criticisms of the proposed regulations. In particular, the final regulations

  • Omit the Bifurcation Rule
  • Generally limit the Documentation Rule and Distributions Rule to domestic borrowers
  • Generally exempt S corporations and non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs) from the new rules
  • Clarify that a "snapshot" approach is taken when determining the status of a corporation as a member of an expanded group
  • Relax the timing requirements set forth in the Documentation Rule and replace its "per se" characterization rule for failures to meet the documentation and substantiation requirements with a "rebuttable presumption" recharacterization rule
  • Alter the treatment under the Documentation Rule of an "expanded group instrument" issued by certain disregarded entities and partnerships, treating the recharacterized expanded group instrument as stock in the "regarded" corporate owner of the disregarded entity or a partnership interest
  • Provide exemptions from the Distributions Rule for cash pooling and other short-term loans and generally for regulated financial entities, financial groups, and insurance entities
  • Make substantial modifications to the Distributions Rule by expanding the exception for distributions of earnings and profits, exempting the first US$50 million of debt (i.e., not treating the US$50 million threshold as a "cliff"), permitting netting of distributions and contributions in certain cases, and providing an exception for stock issued as equity compensation to employees, directors and independent contractors

Of particular note to multinational groups, the IRS has postponed indefinitely the application of the final regulations to instruments issued by foreign corporations, which for this purpose includes US branches of foreign issuers. By electing to "reserve" for the time being, the final regulations as drafted generally do not apply to foreign issuers.

Welcome changes were made to the Documentation Rule. This rule generally imposes extensive substantiation and documentation requirements on corporate groups that are publicly traded or whose total assets exceed US$100 million or whose total revenues exceed US$50 million. While generally retaining the substance of the documentation and substantiation requirements, the final regulations eliminate the 30-day preparation requirement that was contained in the proposed regulations and instead impose a deadline that such documentation must be prepared by the time the issuer files its federal income tax return (which includes all applicable extensions). Further, the final regulations provide for a rebuttable presumption in instances in which the taxpayer evidenced substantial compliance with the documentation requirements.

As noted above, extensive changes were made to the Distributions Rule. One feature of the proposed regulations that was a common target of commenters' criticism was the "per se funding rule." Under this rule, certain distributions were per se considered to be within the scope of the funding rule if such distribution is made either 36 months following, or was made 36 months prior to, the issuance of the expanded group instrument. While several potential alternatives were suggested by commenters, such as the inclusion of a rebuttable presumption, the IRS decided that it was appropriate to retain the per se funding rule largely as originally proposed.

Finally, the omission of the Bifurcation Rule significantly shrinks the pool of taxpayers subject to the final regulations, as the omission takes with it the concept of a "modified expanded group" that was, in essence, an expanded version of the "expanded group."

Who is affected by the regulations

Section 385 of Internal Revenue Code, the main authority under which the regulations were promulgated, addresses when stock should be treated as debt and vice versa. It, and the regulations, generally do not cause debt to be treated as another kind of equity, such as an interest in a partnership. As such, the regulations primarily apply to corporations that have other corporate affiliates.

Nonetheless, the rules include special rules to deal with partnerships and disregarded entities that have corporate owners, or that own corporations and therefore are included in the corporation's expanded group. Importantly, the final regulations reduce the scope of the expanded group as compared to the proposed regulations, in part by narrowing certain attribution rules and choosing to "reserve" as to the application of the attribution rules to brother-sister groups. However, while the final and temporary regulations certainly will apply to fewer taxpayers and instruments than the proposed regulations would have, the scope of the final and temporary regulations is still significantly broad.

Effective date

The final regulations generally apply to taxable years ending on or after 90 days after October 21, 2016 (i.e., January 19, 2017). For taxpayers with a calendar year fiscal year, the new rules will be effective beginning in 2017. Further, the new Documentation Rule applies only to interests issued (or deemed issued) on or after January 1, 2018. The Distributions Rule will apply to debt instruments issued on or after April 5, 2016, subject to a detailed transition rule, but the 90-day delay in the effective date is intended to give affected taxpayers time to readjust their funding structure before becoming subject to the new rules.

Conclusion

The final regulations require corporate groups with significant operations and US members of the group to review and likely change their practices regarding transfer of funds between affiliates. Even though the regulations include exceptions and special rules that exempt many corporations and issuances of debt from the new rules, corporations must document—and show that they continue to maintain—eligibility for any such exemption or special rule.

Those corporations fully subject to the new regulations will need to adopt new procedures and mechanisms to meet the new documentation and compliance requirements. Yet that will be only the start; corporate transactions must be carefully monitored to ensure that a distribution or other transaction does not inadvertently trigger the new rules. Also, there will inevitably be transactions that cause what was thought to be debt to be treated instead as stock. For this reason, before undertaking transactions in which stock ownership thresholds are relevant, corporations must analyze prior transactions to determine whether those prior transactions have inadvertently triggered the new regulations, thereby changing the ownership and relationship of the parties engaged in the planned transaction.

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