United States: IRS Issues Final Debt-Equity Regulations

On October 13th, the Internal Revenue Service ("IRS") followed through on its promise to issue final regulations and temporary regulations under Section1 385 (the "Final Regulations" and "Temporary Regulations," respectively) a little over six months after they were proposed. The Final Regulations generally follow the same structure as the regulations proposed by the IRS on April 4, 2016 (the "Proposed Regulations"), but contain significant exceptions that would exempt many types of instruments, some domestic issuers, and all foreign issuers from their application.

The Proposed Regulations have been the subject of significant controversy and provoked an outcry from practitioners, congressional hearings, and over 29,600 comments. Many commenters warned that, if finalized in a similar form, the Proposed Regulations would severely impair normal business conduct.

The Final Regulations are generally effective for taxable years ending on or after January 19, 2017 (the "Effective Date"), although the Documentation Requirements discussed below only apply to related group debt issued on or after January 1, 2018.

SCOPE

The Proposed Regulations generally addressed instruments (Expanded Group Instruments or "EGIs") labeled as indebtedness between members of the same "Expanded Group," defined as a chain of corporations (including foreign corporations and tax-exempt entities) with a common parent connected by ownership of 80% of the vote or value of each member (rather than the vote and value of each member as in Section 1504(a)). Indirect ownership of corporations was also taken into account by attributing ownership through related entities. Therefore, under the Proposed Regulations, an Expanded Group included not only domestic corporations but also foreign corporations and special status entities such as S corporations, regulated investment companies (RICs), real estate investment trusts (REITs), tax-exempt corporations, life insurance companies and financial entities. In response to comments that the Proposed Regulations were overly broad, the IRS and Treasury Department limited the application of the Final and Temporary Regulations as compared to the Proposed Regulations in several respects.

Most significantly, the application of the Final and Temporary Regulations is generally limited to indebtedness issued by domestic corporations. The Treasury Department and the IRS have reserved on the application to EGIs and debt instruments issued by foreign corporations (including controlled foreign corporations) pending further study. Significantly, this means that purely foreign-to-foreign transactions where both the borrower and the lender are foreign corporations are generally excluded from the application of the Final and Temporary Regulations. The Treasury Department and the IRS achieve this result by adopting a new term of "Covered Member" defined as a member of an Expanded Group that is a domestic corporation. The Final Regulations generally do not apply to entities that are not Covered Members.

In addition, the Treasury Department and the IRS significantly limited the definition of Expanded Group for the Final and Temporary Regulations for certain entities with special tax status. In response to comments to the Proposed Regulations, non-controlled RICs, non-controlled REITs, and S corporations are generally excluded from the application of the Final Regulations. The Treasury Department and the IRS thus agreed with the comparison of S corporations, RICs, and REITs to non-controlled partnerships, which are generally excluded from the definition of an Expanded Group. The Treasury Department and the IRS recognized the similar flow-through characteristics of S corporations, RICs, and REITs as non-controlled partnerships and similarly excluded such entities from the definition of an Expanded Group.

While there is no blanket exception from the application of the Final and Temporary Regulations for insurance companies and financial institutions, the requirements are relaxed for certain specified financial entities, financial groups, and insurance companies that are subject to a specified degree of regulatory oversight regarding their capital structure. There is no special exemption for tax-exempt entities.

The remainder of this alert addresses the requirements for those entities that are within the scope of these regulations.

PARTIAL DEBT/EQUITY TREATMENT

The Proposed Regulations authorized the IRS to recharacterize a single instrument as equity in part and indebtedness in part, if warranted by the facts and circumstances. This rule has been removed from the Final Regulations, although the Treasury Department and the IRS are continuing to study the issue.

Although no general power to bifurcate an instrument exists, it is possible that an instrument may be bifurcated under the Automatic Equity Rules discussed below. For example, if the member of an Expanded Group borrows $100 from another member of the Expanded Group to fund a $50 distribution, under the Automatic Equity Rules half of the $100 issuance would be treated as stock. "Principal" payments on the instruments may be designated by the issuer as being with respect to the recharacterized portion or the portion that remains treated as indebtedness. "Interest" payments are treated as paid on pro rata with respect to each portion.

DOCUMENTATION REQUIREMENTS

The Proposed Regulations had established new documentation requirements that must be met to keep the IRS from automatically recharacterizing an instrument as equity. While the Final Regulations retain the basic premise of recharacterization for EGIs that fail to meet the documentations requirements, they provide significant modifications, exceptions, and clarifications to the documentation requirements.

Scope of Documentation Requirements

The Final Regulations narrow the scope of the documentation requirements by excluding certain EGIs. By virtue of their broader exclusion from the Final Regulations, EGIs issued by a foreign issuer, an S corporation, and generally interests issued by non-controlled REITs and non-controlled RICs are excluded from the documentation requirements. Instruments issued by controlled partnerships are also generally excluded from the documentation requirements, although they are still subject to an anti-abuse rule. Obligations between members of a consolidated group are also excluded, as the consolidated return regulations already provide a comprehensive regime governing substantially all obligations between members. In addition, the Treasury Department and the IRS recognized that certain regulated entities may be required in some cases to issue an instrument that would be debt under federal tax principles but for certain terms or conditions imposed by a regulator. Therefore, the Final Regulations clarify that EGIs issued by certain regulated financial and insurance companies that are required by regulators to include particular terms or conditions in the relevant instrument are treated as meeting the documentation requirements.

The Final Regulations retain the threshold limitation contained in the Proposed Regulations. As a result, the documentation requirements only apply if a member of the relevant Expanded Group is publicly traded, or if on the date the instrument first becomes an EGI, the group's total assets or total annual revenues exceed $100 million or $50 million, respectively.

Rebuttable Presumption for Highly Compliant Taxpayers

As in the Proposed Regulations, the Final Regulations establish the documentation requirements only as a minimum standard that must be met in order for an EGI to be treated as debt based on an application of the federal tax principles developed under applicable case law. Thus, only if the documentation requirements are satisfied would the determination of whether an EGI is properly treated as indebtedness for federal tax purposes be made under general federal tax principles.

Under the Proposed Regulations, failure to prepare and maintain the required documentation resulted in automatic equity characterization of the EGI, subject to a reasonable cause exception. As a welcome relaxation of this per se treatment, the Final Regulations provide a rebuttable presumption for highly compliant taxpayers. For members of an Expanded Group that is "highly compliant" with the documentation rules, an undocumented EGI (i.e., an EGI that fails to meet the documentation requirements) is not automatically treated as stock but is presumed, subject to rebuttal, to be stock for federal tax purposes. A taxpayer can overcome this presumption by clearly establishing that there are sufficient common law factors to treat the EGI as indebtedness. To demonstrate a high degree of compliance, the Expanded Group must meet one of the following tests during the calendar year in which an EGI fails the documentation requirements: (1) the quarterly average of the aggregate adjusted issue price of all undocumented EGIs is less than 10% of the quarterly average of the aggregate adjusted issue price of all outstanding EGIs; (2) no undocumented EGI has an issue price in excess of $100 million, and the quarterly average of the total number of undocumented EGIs is less than 5% of the quarterly average of the total number of all outstanding EGIs; or (3) no undocumented EGI has an issue price in excess of $25 million, and the quarterly average of the total number of undocumented EGIs is less than 10% of the quarterly average of the total number of all outstanding EGIs.

The Final Regulations retain the reasonable cause exception to the documentation requirements and add relief for ministerial or non-material failures or errors that are discovered and corrected prior to the IRS's discovery of such failure or error.

Documentation and Information to Be Prepared and Maintained

The Final Regulations retain the four categories of documentation and information to be prepared and maintained for each EGI that were introduced in the Proposed Regulations, with some exceptions and clarifications. Each of the four requirements described below is meant to reflect an essential characteristic of indebtedness for federal tax purposes.

1. Unconditional Obligation to Pay a Sum Certain

Written documentation must establish that the issuer has entered into an unconditional and legally binding obligation to pay a fixed or determinable sum certain on demand or at one or more fixed dates. The Final Regulations add a market standard safe harbor for this factor; that is, documentation of a kind customarily used in comparable third-party transactions (e.g., trade payables with third parties) may be used to satisfy this requirement.

2. Creditor's Rights to Enforce Terms

The documents must establish that the holder has the legal rights of a creditor to enforce the terms of the EGI. At a minimum, the rights of a creditor must include a superior right to shareholders to share in the assets of the issuer in the case of dissolution. In recognition of the fact that creditor's rights are often established by law and not necessarily included in the loan documentations, the Final Regulations provide that creditor's rights may be provided under local law, as long as the legal agreement contains a reference to the provisions of local law providing such rights. The Final Regulations also adopt the market standard safe harbor for this requirement.

3. Reasonable Expectation of Repayment

The documents must evidence a reasonable expectation that, as of the date of issuance of the EGI, the issuer could in fact repay the amount of the proposed loan. The documentation might include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity, and other relevant financial ratios of the issuer. A number of clarifications are made in the Final Regulations relating to this documentation requirement. If an EGI is nonrecourse, the documentation to support such indebtedness must include the value of property available to support repayment of the nonrecourse EGI. Additionally, the Final Regulations clarify that documentation may include cash flow projections and similar economic analyses prepared by either the members of the Expanded Group of the issuer or third parties. The Final Regulations also add that the documentation may assume that the principal amount of an EGI may be satisfied with the proceeds of another borrowing by the issuer, provided that such assumption is reasonable. A new rule regarding multiple EGIs issued by the same issuer is adopted in the Final Regulations. Under the new rule, a single annual credit analysis may be prepared with respect to multiple EGIs issued by the same issuer, up to an overall amount of indebtedness set forth in the annual credit analysis, provided that any such EGIs are issued on any day within the 12-month period beginning on the date on which the analysis in the annual credit analysis is based.

4. Genuine Debtor-Creditor Relationship

The documents must evidence an ongoing debtor-creditor relationship, which can come in two forms. First, in the case of an issuer that complied with the terms of the EGI, documentation must include evidence of any payments on which the taxpayer relies to establish debt treatment under general federal tax principles. In the alternative, if the issuer did not comply with the terms of the EGI (by not making required payments or otherwise suffering an event of default under the EGI), to show a genuine debtor-creditor relationship there must be documentation showing the holder's reasonable exercise of the diligence and judgment of a creditor. Recognizing the practice of many lenders that choose not to enforce creditor's rights for sound business reasons, the Final Regulations provide that, if a holder does not enforce its creditor's rights, there must be documentation that supports the holder's decision to refrain from pursuing any enforcement actions as being consistent with the reasonable exercise of the diligence and judgment of a creditor.

Revolving Credit Agreements, Cash Pooling and Similar Arrangements

With respect to revolving credit agreements, cash pooling arrangements and similar arrangements under a master agreement, the Proposed Regulations had provided that the documentation requirements apply to the master agreement as a whole (rather than for each individual transaction). The Final Regulations continue with this approach with the following clarification: with respect to EGIs governed by a master agreement, a single credit analysis may be prepared and used on an annual basis up to an overall amount of indebtedness set forth in the annual credit analysis, and the first such annual credit analysis must be performed upon the execution of the master agreement.

Obligations of Disregarded Entities

The Final Regulations provide that, if an EGI issued by a disregarded entity that is owned by a regarded member of an Expanded Group is treated as stock as a result of failing the documentation requirements, the stock is treated as having been issued by the regarded owner of the disregarded entity. Thus, the regarded owner of the disregarded entity will be treated as the holder of the EGI issued by the disregarded entity, and the actual holder will be treated as the holder of the stock deemed issued by the regarded owner. This new rule is a departure from the Proposed Regulations, which would have caused the disregarded entity to become a partnership for tax purposes.

Timely Preparation Requirement

The Proposed Regulations generally required that the documentation be prepared no later than 30 calendar days after the date of a relevant event, which was generally the date the EGI was issued or the date the issuer became an Expanded Group member; in the case of documentation of the debtor-creditor relationship (the fourth requirement above), the Proposed Regulations allowed documentation to be prepared up to 120 calendar days after a payment or relevant event occurred. In response to comments, the Final Regulations replace these 30- and 120-day timely preparation requirements with a requirement that documentation and financial analysis be prepared by the time that the issuer's federal income tax return is filed (taking into account all applicable extensions).

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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Michelle M. Jewett
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