United States: Impact Of New Tax Regulations On Intercompany Debt Obligations

Last Updated: November 11 2016
Article by Peter M. Daub and Casey August

The final, temporary, and proposed regulations issued by the Internal Revenue Service on October 13 relating to intercompany debt obligations between members of an affiliated group of corporations under Section 385 of the Internal Revenue Code (the "new regulations") should come as a great relief to US-parented multinationals and should bring some cheer to even those that are foreign-parented.

The proposed regulations issued on April 4, 2016 (the "proposed regulations") on which the new regulations are based would, with few exceptions, have treated debt obligations between affiliated corporations at least one of which was not a member of the US consolidated group as stock in certain cases. These include situations in which the obligation did not satisfy onerous documentation requirements, was issued in a distribution or equivalent transaction, or was deemed under the regulations to fund a distribution or acquisition of affiliate stock by the issuer. This characterization could have had very significant adverse tax consequences.

As explained in greater detail below, the new regulations have cut back on the proposed regulations in various ways. Most significantly, the final regulations do not apply to the following:

  • Debt issued by foreign corporations. This means that, for many US-parented groups, the final regulations may have very limited application. The IRS has indicated, however, that this cutback is subject to further study.
  • Many short-term debts, including debts issued in cash pooling debt arrangements.
  • Obligations that the final regulations would otherwise treat as stock because they are deemed under the regulations to fund the distribution or acquisition of affiliate stock by the issuer, where the distribution or acquisition does not exceed the borrower's earnings accumulated in taxable years ending after April 4, 2016 while the borrower was a member of a group with the same parent.
  • Debt issued by S corporations, various financial institutions, and most regulated investment companies (RICs) and real estate investment trusts (REITs).

Additional cutbacks from the proposed regulations relate to documentation and ownership attribution rules:

  • The documentation requirements do not enter into force until 2018. The taxpayer can, moreover, take the actions necessary to comply with them until the due date, with extensions, for filing its tax return (rather than until 30 days after issuance, as required by the proposed regulations).
  • Ownership attribution rules that could have created havoc for the private equity industry have, pending further study, been eliminated.

Background 

By way of background, with some important exceptions, the new regulations have retained the proposed regulations' definition of an affiliated group the members of which are subject to these rules (an "expanded affiliated group" (EAG)) as one or more chains of corporations (whether domestic or foreign) connected through stock ownership with a common parent corporation, but only if the EAG parent owns directly or indirectly at least 80% of the value or vote in at least one of the other corporations and at least 80% of the value or vote of the stock in each of the other corporations is owned directly or indirectly by one or more of the other corporations (except the common parent).

The proposed regulations, if finalized, would have generally treated a debt obligation between such members as stock for US federal income tax purposes if

  • the taxpayer did not satisfy the onerous documentation requirements specified by the proposed regulations (the "documentation rule") with respect to the obligation or
  • if the obligation was (i) issued in a distribution or equivalent transaction (the "distribution rule") or (ii) not issued in such a transaction (for example, if the obligation was issued for money) but, when viewed together, the obligation and another specified transaction (such as the issuer's distribution of property or acquisition of affiliate stock) resembled an obligation issued in a distribution (the "funding rule").  

The proposed regulations, if finalized, would have applied to obligations of both US and foreign issuers and thus could have had a broad and adverse impact on all multinationals. These would have included (a) the denial of deductions for, and imposition of withholding tax on, interest paid by a US subsidiary obligor to the foreign parent or other member of the EAG not in the US subsidiary's US consolidated group, (b) the treatment of repayments of notes issued by a foreign subsidiary to its US parent or other member of the US consolidated group as taxable dividends, and (c) the loss of credits by a US parent or other member of the consolidated group for taxes paid by a foreign subsidiary whose borrowing from a foreign affiliate the regulations treated as stock. If finalized, the proposed regulations could have also had an adverse impact on private equity structures, RICs, REITs, S corporations, and partnership structures.

US-Parented Multinationals

With a few notable exceptions, the new regulations, when implemented, will be irrelevant to US-parented multinationals. The single most important change in this regard is the new regulations' "reservation" with respect to intercompany obligations issued by a foreign member of the EAG. That is, until such time (if ever) as regulations expand the scope of the new regulations, they will not apply to any obligations issued by a foreign corporation. Accordingly, the regulations will not treat as stock a debt issued by a foreign subsidiary to a foreign affiliate or to any member of the consolidated group, which by definition includes only domestic corporations. (In order to be respected as debt, the instrument must, however, still meet case law standards.) Thus, the repatriation and foreign tax credit issues mentioned above have been largely resolved favorably to US-parented multinationals.

One of the most widespread criticisms of the proposed regulations voiced by both US-parented and foreign-parented multinationals was that they had the potential to treat short-term, everyday intercompany financing through cash pools as stock. In the case of US-based multinationals, the application of the regulations to cash pools involving foreign participants could have resulted not only in the adverse foreign tax credit and repatriation consequences mentioned above, but also other miscellaneous untoward effects, such as the transformation of a tax-free reorganization or acquisition of corporate control into a taxable transaction with Subpart F consequences to the US consolidated group. By excluding debt issued by foreign corporations from their scope, the new regulations have eliminated the issues that application of the proposed regulations to foreign participant cash pools maintained by US-parented groups would have created.[1]

Some problems, however, linger for US-parented multinationals. Cash-rich foreign members of a US-parented EAG frequently provide temporary financing to the US parent or other consolidated group member. As indicated, the proposed regulations would have treated as stock an intercompany loan coupled with one of several alternative transactions (such as the obligor's distribution of property). The new regulations, in concept, preserve this treatment. Since an obligation issued by the US parent to a foreign subsidiary in exchange for an advance is not excluded from the new regulations' application on the basis that the issuer is foreign, the new regulations could in theory apply to the US parent's obligation.

As a practical matter, however, this application should be limited. Because of the potential application of Section 956 where a foreign subsidiary holds debt of a US affiliate on its quarter-end, US-parented EAGs generally ensure that a US affiliate obligation held by a foreign subsidiary has a term of less than 90 days.

The new regulations generally provide that the funding rule—one of the three rules whose application can result in stock treatment and the one that might conceivably apply in this situation—will not apply to an obligation with a maturity of 270 days or less, assuming that the issuer is not a "net borrower" with respect to all obligations issued to affiliates (with the notable exception of debt issued as consideration for the acquisition of property other than money in the ordinary course of the issuer's trade or business) on more than 270 days during the taxable year. Because of Section 956, a foreign subsidiary is very unlikely to hold a US affiliate's obligation with a maturity exceeding 270 days and thus, in this respect, the application of the funding rule to obligations with a maturity of more than 270 days is inconsequential.

The "net borrower" restriction, however, does impose some constraints on borrowings from foreign affiliates. If a US affiliate chooses to rely on the 270-day rule to avoid the impact of the funding rule, it will generally not be able to borrow from foreign subsidiaries for one-quarter of the taxable year—conceivably a problem for some US-parented EAGs that continuously borrow from foreign affiliates. The US affiliate, however, conceivably could rely on an alternative short-term debt exclusion of an amount of debt necessary to finance current assets reasonably expected to be reflected on the affiliate's balance sheet as a result of ordinary course transactions during the issuer's normal operating cycle. Or it could ensure that members of the consolidated group do not engage in transactions (such as the acquisition of stock of a non-consolidated affiliate) that, when married up with the US affiliate's borrowing, could trigger application of the funding rule. Whether multinationals' treasury departments can live with the net borrower restriction remains to be seen.

The short-term debt exclusions apply only to the funding rule, not the distribution rule or the documentation rule. Yet, in most cases, these rules may not pose a serious risk of equity treatment. The parent (or any other member of the consolidated group) will obviously not access the foreign subsidiary's funds by distributing a note or engaging in a transaction treated by the new regulations as equivalent to such a distributed note.

If, because of the application of the funding rule, the US parent debt is treated as stock, the US parent will be denied deductions for the interest; the interest may be subject to US withholding tax at a higher rate under a tax treaty than if the debt were respect as such; and, if the foreign subsidiary loans to a member of the consolidated group that does not (like the US parent) directly or indirectly own all the stock in the foreign subsidiary, payments of principal could be treated as dividends subject to withholding and current inclusion by the US group under Subpart F. Yet, for the reasons indicated, these issues should be largely manageable.

While the parent will need to comply with the new regulations' documentation requirements, they are considerably less onerous than those in the proposed regulations. First and foremost, the new regulations generally remove the per se equity re-characterization for debt instruments not complying with the documentation requirements in favor of a rebuttable presumption of equity treatment for inadequately documented debt issued between members of an EAG that is not generally "highly compliant" with the documentation requirements. The new regulations also relax the timely preparation requirement by replacing the proposed regulations' general 30-day after issuance preparation requirement with a requirement that documentation must be prepared by the filing of the issuer's tax return. The new regulations relax the documentation requirement for multiple debt instruments issued under a "master" credit agreement, such as a revolving credit facility or cash pooling agreement, by obliging the issuer to obtain a single documented credit analysis demonstrating its ability to pay interest and principal on all debts issued under the agreement on or after the date of the analysis through the end of the taxable year. In addition, the documentation requirements apply only to debt issued on or after January 1, 2018; presumably these requirements, although issued as final regulations, may yet be amended in response to comments before they become effective.     

There are at least two caveats to the generally favorable assessment of the new regulations' impact on US-parented EAGs. The use of partnerships and disregarded entities may increase the costs of complying with the regulations. Perhaps more important, like the proposed regulations, the new regulations effectively carve out from their application obligations between members of a consolidated group. To the extent that a US state has adopted federal standards for computing taxable income but not the federal consolidation regime, however, debt between such members that would be respected as such for federal income tax purposes may not be respected for state income tax purposes.

Foreign-Parented Multinationals

The impact on foreign-parented EAGs will be much greater than on US-parented EAGs. Just as the exclusion of debt of foreign issuers from the scope of the new regulations renders the new regulations much more manageable than the proposed regulations for US-parented EAGs, the retention of debt of domestic issuers in the scope of the new regulations will make the new regulations problematic for foreign issuers (although, as noted below, some exceptions may considerably lighten the impact). Specifically, the differential impact on US-parented and foreign-parented EAGs confirms as the overriding aim of the project the prevention of the stripping of earnings of a domestic member of a foreign-parented EAG through deductions for interest on a debt owed by the domestic member to the foreign parent or other foreign group member not directly or indirectly owned by the domestic member.

The new regulations' earnings stripping impact on well-advised, foreign-based EAGs with longstanding US operations is likely to be relatively insignificant outside the acquisition context since US members of those groups frequently are obligors to the foreign parent or other foreign affiliate on debts with earnings stripping potential that were issued at a time before the regulations could have affected their treatment. (It is possible, however, that the new regulations may pose challenges to increasing leverage in line with the growth in the US business.) Nor should the regulations have much of an impact on leverage created in a cash acquisition by a foreign-parented EAG of a US target, since the debt obligation to the foreign parent or other foreign EAG member created in connection with such an acquisition is likely issued for the cash used in the acquisition and thus not subject to the new regulations unless combined with a distribution by or acquisition of affiliate stock by the issuer.

The regulations are likely to have their greatest impact on foreign-based EAGs that acquire a domestic target not wholly for cash. In that case, the debt owed by the target or other member of the consolidated group to the foreign parent or other foreign EAG member is typically issued for foreign parent stock, an issuance to which the distribution rule applies. Since these transactions are often "inversion" transactions in which former shareholders of the domestic target acquire between 50%–80% of the foreign parent, the new regulations should perhaps be viewed as the earnings stripping installment in a series of guidance (previously issued under Sections 7874, 956, and 7701(l)) aimed at the purported benefits of such transactions. (Note that, whereas the prior installments applied only to inversions where the former target shareholders acquired at least 60% of the foreign parent, the new regulations do not have such a floor.)

The existence of this overarching goal raises the question of whether the US Department of the Treasury and the IRS have the authority to use Section 385 as a vehicle largely to address earnings stripping in this fairly limited context, especially when the Code has had for almost 30 years a separate provision (Section 163(j)) targeted at earnings stripping. It also raises the question of whether the regulations, in the case where the foreign parent is resident in a US treaty jurisdiction, violate a provision typical in US treaties that mandate the deductibility of interest on debt issued by a US corporation to its treaty jurisdiction parent "on the same conditions" as if the interest had been paid to a US parent.       

If an obligation issued by a domestic member of a foreign-parented EAG to a foreign member is treated as stock under the regulations, then deductions for interest on the instrument will be permanently denied, withholding tax might be imposed on the interest payments at a rate higher than would otherwise apply, and withholding tax might be imposed on principal payments.

The documentation rule, as described above, could very well apply to such a debt. The major change from the proposed regulations—largely relevant to foreign-parented multinationals because the new regulations do not apply to obligations of foreign issuers at all—is the relaxation of the documentation requirements applicable to obligations issued in a cash pooling arrangement. As mentioned above, only a single credit analysis must be prepared on an annual basis for all obligations issued under the cash pooling agreement on or after the date of the analysis and through the end of the year. As noted, the documentation rule will apply only to obligations issued on or after January 1, 2018, and it is possible that, in response to comments, it might be modified before implementation.

The new regulations have introduced several exceptions that apply to the funding rule only or both the funding rule and the distribution rule. Again, apart from their utility in facilitating the financing of a consolidated group by a foreign subsidiary, the exceptions will (because the new regulations do not apply to obligations of foreign issuers at all) largely be relevant to foreign-parented multinationals.

In addition to the exceptions for short-term debt obligations, the most significant new exception that applies only to the funding rule is that for deposits with a "cash pool header." This exception applies to deposits with a member of the EAG principally engaged in a cash-management arrangement for other EAG members that maintains any surplus balance in the cash pool as either cash or investments in obligations of unrelated persons.

The exceptions that apply to both the distribution rule and the funding rule include interests deemed to be debt under statute or regulations (such as a "regular interest" in a real estate mortgage investment conduit or a debt arising from an adjustment under Section 482) and an obligation issued by an "excepted regulated financial company" or a "regulated insurance company." The exception for obligations of excepted regulated financial companies applies to obligations of financial institutions that are subject to nontax regulatory capital or leverage requirements, such as banking or savings and loan holding companies, as well as their affiliated subsidiaries that do not engage in a non-financial business. A similar exception applies to obligations issued by regulated insurance companies conducting a general insurance business with unrelated parties (i.e., not captive insurance companies), but this exception does not extend to the affiliated subsidiaries of a qualifying regulated insurance company.

The newly expanded exception from the application of both the funding rule and the distribution rule that will have the most pervasive effect is that for the earnings of the borrower accumulated in taxable years ending after April 4, 2016 while the borrower was a member of the EAG with the same EAG parent. As indicated by this formulation, while the new regulations greatly expand the earnings exception by counting prior year earnings, a borrower's available earnings for purposes of this exception are generally reset to zero when there is a change in control of the borrower itself or of the EAG ultimate parent. The new regulations, however, do clarify that the earnings of an entire US consolidated group of affiliated corporations may generally be taken into account with respect to an obligation issued by a member of the consolidated group, which is consistent with the approach in the new regulations of treating the entire US consolidated group as a single corporation.

It remains to be seen how useful this expansion of the exception will be for foreign-parented multinationals. The statutory earnings stripping provision (Section 163(j)) generally defers deductions for interest paid by a US subsidiary to the foreign parent to the extent the subsidiary's net interest expense for the year exceeds 50% of its earnings before interest and depreciation for the year. The question is the extent to which the distribution rule or the funding rule—taking into account the exception for accumulated earnings—will, as a practical matter, restrict the deductibility of interest beyond the constraint that the statutory provision already imposes. Given that the funding rule and the distribution rule permanently deny a deduction for interest, whereas Section 163(j) only defers the deduction, the Section 385 rules, in theory, could be very limiting in all cases to which Section 163(j) would in any event apply. Yet since for many taxpayers the Section 163(j) deferral as a practical matter operates as a permanent disallowance, realistically the question is the extent to which the distribution rule and the funding rule—taking into account the accumulated earnings exception—impose an additional restriction on current deductions for interest.

Unquestionably, the inclusion of all accumulated earnings will reduce the portion of a debt treated as stock under either rule. Thus, if a US subsidiary that has $500 million in current earnings and $2 billion in post-affiliation accumulated earnings distributes a $10 billion note to its parent, the new regulations' expansion of the earnings exception will reduce from $9.5 billion to $8 billion the amount of the debt that would be treated as equity and correspondingly the amount of interest on the debt for which a deduction would be permanently denied. This is still a very severe restriction on earnings stripping. The question facing foreign-parented multinationals is the amount of leverage that the US group could have supported in light of Section 163(j) and common law debt-equity rules, and whether that amount sufficiently exceeds accumulated earnings so as to make the new rules a real impediment.

Private Equity Structures, RICs, REITs, Partnerships, and S Corporations

The proposed regulations' stock ownership attribution rules could have resulted in an EAG through relatively minimal common "brother-sister" corporate ownership by a partnership. Specifically, the proposed regulations applied the "downstream" partnership attribution rule of Section 318(a)(3)(A), which treats all of the stock owned by a partner in a partnership as owned by the partnership regardless of the partner's proportionate ownership of the partnership. Under this rule, for example, a partnership would be attributed the ownership of subsidiaries owned by a 1% corporate partner, with the consequence that those subsidiaries and any corporate subsidiaries directly owned by the partnership would be treated as an EAG.

Comments to the proposed regulations, particularly those submitted on behalf of the private equity fund industry, understandably expressed the concern that causing this type of "brother-sister" affiliation among relatively unrelated entities did not align with the stated intent of the proposed regulations to address obligations issued among highly related corporations. The new regulations respond to this concern by reserving on the application of the downward partnership attribution rule pending further study. There remains concern, however, that the IRS could re-propose or adopt some form of this expansive downward partnership attribution rule in the future.

Debt issued by partnerships whose members are members of an EAG is analyzed under the aggregate theory of partnership taxation, creating a deemed conduit approach under the authority of Section 7701(l). Thus, the proportion of the debt that is treated as issued by the EAG partner under the aggregate theory is treated as "deemed partner stock" issued in a "deemed transfer" by the holder-in-form of the debt instrument of a "deemed transferred receivable." When the dust settles, the partnership is deemed to pay interest to the EAG partner, which then makes distributions on the deemed stock. The partnership's interest deduction and the EAG partner's interest income net. The terms of the deemed stock match the terms of the partnership's debt obligation. The entire construct is turned off for purposes of Section 752 (allocation of partnership liabilities) such that unrelated minority partners are unaffected by the Section 385 regulations.

Perhaps the most significant change to the definition of the EAG is the exclusion from its membership of S corporations entirely and RICs and REITS that would be considered members only because one or more EAG members owns at least 80% of the value (as opposed to the vote) of the stock of the RIC or REIT. Thus, none of the new regulations, including the documentation requirements, will apply to such entities.

Effective Date

The distribution rule and the funding rule generally apply to taxable years ending on or after January 19, 2017. To the extent, however, that the new regulations would (without regard to this general effective date rule) have treated as stock a debt instrument issued in a prior taxable year, the debt will not be treated as stock during the 90-day period ending on January 19, 2017, but will be treated as exchanged for stock immediately after that date to the extent it is held by a member of the issuer's EAG immediately after that date. As mentioned above, however, only obligations issued on or after January 1, 2018 will be subject to the documentation requirements.

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

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