On April 4, 2016, in order to discourage corporate inversions and potential earnings stripping, the IRS and the Treasury Department issued proposed regulations under Internal Revenue Code (IRC) section 385 on the treatment of certain interests in corporations as stock or indebtedness; the regulations were finalized on October 13, 2016. According to the Treasury Department, a corporate inversion is a transaction in which a U.S.–domiciled multinational company changes its tax residence to a tax haven country for the purpose of reducing or avoiding federal income taxes. Earnings stripping is a strategy used to minimize federal taxes by paying deductible interest to a new foreign parent or a foreign affiliate in a low-tax country through intercompany debt distributions. As a result of the new regulations, this “related-party debt” will be recharacterized as stock, and no interest expense deduction will be allowed.
The new regulations, however, do not apply only to corporate inversion transactions; any related-party transaction is potentially subject to them, with some exceptions. Because of these significant changes, it is crucial for taxpayers and their advisors to be familiar with the regulations, which apply to taxable years ending on or after January 19, 2017, and to any debt instruments subject to recharacterization issued immediately after January 19, 2017. This article will discuss the background of IRC section 385, describe and analyze the regulations, and provide the tax implications.
In 1969, Congress enacted IRC section 385, giving the Treasury Department the authority to prescribe regulations necessary to determine whether an interest in a corporation should be treated as stock or debt for tax purposes. Absent regulations, the characterization of such interests as debt or equity has mainly been based on judicial decisions. Because of the increasing concerns over corporate inversions and potential earnings stripping through intercompany debt, the IRS and the Treasury Department released Notice 2014-52 on Sept. 22, 2014, and Notice 2015-79 on Nov. 19, 2015, followed by the issuance of the proposed and final regulations.
Analysis of Final Regulations
The final regulations are generally applicable only to expanded group instruments (EGI) in which both the issuer and the holder are the members of the same expanded group. More importantly, final regulations only apply to EGI issued by domestic corporations defined as covered members in Treasury Regulations section 1.385-1(c)(2). In addition, the final regulations do not apply to indebtedness between members of a consolidated group.
Section 1.385-1(c)(4) defines an expanded group as one or more chains of corporations [as defined in IRC section 1504(a), with some exceptions in section 1504(b)(8)] connected through stock ownership with a common parent corporation. The final regulations clearly state, however, that S corporations are not considered to be members of expanded groups. In addition, regulated investment companies (RIC) and real estate investment trusts (REIT) are excluded from memberships as well, unless they are controlled by members of an otherwise existing expanded group. The Exhibit gives an example of an expanded group structure.
The final regulations also contain several rules on addressing the consequences of recharacterization in Treasury Regulations section 1.385-1(d). Specifically, if a debt instrument is treated as equity, then it is deemed to have been exchanged for equity. The holder of the debt is treated as having realized an amount equal to its adjusted basis in that portion of the debt or EGI as of the date of the deemed exchange, and the issuer is treated as having retired the same portion of the relevant debt instrument for an amount equal to its adjusted issue price on that date, without taking into account accrued but unpaid interest.
The final regulations set forth threshold requirements with regard to preparation and maintenance of documentation and information related to the EGI. The purpose of these requirements is 1) to guide the taxpayers to prepare, maintain, and provide the necessary documentation and other information to support the debt treatment; and 2) to enable an analysis of whether an EGI is appropriately being treated as stock or debt for federal tax purposes. The documentation requirements only apply to EGIs if 1) the stock of any member of the expanded group is publicly traded; 2) on the date that an applicable instrument first becomes an EGI, total assets exceed $100 million on any applicable financial statements; or 3) annual total revenue exceeds $50 million on any applicable financial statement on the date that an applicable instrument first becomes an EGI. The documentation and information requirements under the final regulations include the following:
- There must be written documentation showing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.
- The written documentation must prove that the holder has the rights of a creditor to enforce the obligation.
- There must be a reasonable expectation of the issuer’s ability to repay the EGI.
- There must be actions evidencing a debtor-creditor relationship.
The documentation rules only apply to debt instruments issued on or after January 1, 2019, and must be met no later than the time for filing the issuer’s federal income tax return, including extensions, for the taxable year that includes the relevant date for such documentation or information. Furthermore, the documentation must be maintained for all taxable years in which the EGI is outstanding or until the time period limitations expire for any tax returns related to the EGI.
Under the final regulations, any EGI that fails to meet the documentation requirements is treated as stock for federal tax purposes unless the taxpayer clearly substantiates that there are sufficient common law factors to treat the EGI as debt or timely discovers and remedies a ministerial or nonmaterial failure or error.
Debt instruments treated as stock.
Under the general rule, a covered debt instrument is treated as stock for federal tax purposes if it is issued by a covered member to a member of its expanded group in a distribution, in exchange for stock of an expanded group member, or in exchange for property in an asset reorganization.
The funding rule commonly treats a covered debt instrument as stock to the extent that it is issued by a covered member to a member of its expanded group in exchange for property with the principal purpose of funding certain distributions or acquisitions in one or more of the following situations:
- Such a distribution not pursuant to an asset reorganization that is permitted to be received without the recognition of gain or income under IRC section 354(a)(1) or section 356, as applicable
- An acquisition of expanded group stock, other than in an exempt exchange, by the covered member from a member of its expanded group in exchange for property other than expanded group stock
- An acquisition of property by the covered member in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the expanded group immediately receives “other property” or money within the meaning of section 356 with respect to its stock in the transferor corporation.
The determination of whether a covered debt instrument is issued with the principal purpose of funding a distribution or acquisition is determined based upon all of the facts and circumstances. If the covered member issues a debt instrument any time between 36 months before the date of the distribution or acquisition and 36 months after, it is treated as issued with the principal purpose of funding a distribution or acquisition.
In addition to the above two rules, antiabuse rules were implemented to recharacterize a covered debt instrument as stock if it is issued with the principal purpose of avoiding the application of those rules. The application of the anti-abuse rules also depends upon the relevant facts and circumstances.
The final regulations also include several exceptions to the application of the general and funding rules. First, certain debt instruments are excluded from the general and funding rules, namely those issued by regulated financial and insurance companies and certain qualified short-term debt instruments as defined in Treasury Regulations section 1.385-3T(b)(3). In addition, if immediately after the debt instrument is issued, the aggregated adjusted issue price of debt instruments held by all members of the expanded group does not exceed $50 million, the instrument is not subject to the general and funding rules. Note, however, that the rules will still apply to the extent that covered debt instruments exceed $50 million.
Antiabuse rules were implemented to recharacterize a covered debt instrument as stock if it is issued with the principal purpose of avoiding the application of those rules.
Second, there are several exceptions in terms of certain distributions and acquisitions:
- Distributions or acquisitions up to the amount of the covered member’s expanded group earnings account balance are exempt from the general and funding rules. The expanded group earnings account is the earnings and profits accumulated by the covered member in taxable years ended on or after April 5, 2016. Special rules apply if the covered member joins the expanded group during the taxable years. The reduction of the expanded group earnings account is applied based on the order in which the distribution or acquisition occurs.
- After considering the expanded group earnings account exception, the distributions or acquisitions to the extent of the covered member’s qualified contribution account are excluded from the general and funding rules. Qualified contributions generally include any contribution of property [other than expanded group stock, covered debt instruments, and certain other excluded property discussed in Treasury Regulations section 1.385-3(c)(3)(ii)(D)] made within three years before or after the distribution or acquisition.
- Acquisitions of expanded group stock by a covered member (acquirer) from a subsidiary (seller) in which the acquirer does not relinquish control of the seller pursuant to a preexisting plan, other than where the seller ceases to be a member of the group, are not subject to the general and funding rules.
- Acquisitions of expanded group stock delivered to individuals who are employees, directors, or independent contractors in consideration for services are not subject to the general and funding rules.
- Acquisitions of expanded group stock by a dealer in securities in the ordinary course of business are not subject to the general and funding rules.
In general, the recharacterization rules discussed above apply to taxable years ending on or after January 19, 2017, and to covered debt instruments issued immediately after January 19, 2017.
In general, the final regulations recharacterize certain related-party debt instruments as stock for federal tax purposes, with some exceptions; however, it is important to note that the final regulations apply only to debt issued by domestic corporations of an expanded group. In addition, members of large groups are required to substantiate debt treatment between related-party transactions; key information that must be documented includes a binding obligation for the issuer to repay the principal amount borrowed, creditor’s rights, a reasonable expectation of repayment, and evidence of ongoing debtor-creditor relationship. If the documentation and information requirements are not met, the debt instruments are recharacterized as equity for federal tax purposes (with some exceptions). In addition, certain cash pooling arrangements and certain internal banking services are subject to the documentation rules.
For future debt transactions, tax advisors should apply planning strategies based on situations that are not subject to the recharacterization rules discussed above.
Corporate taxpayers still have time to learn and apply the new documentation requirements for planned future debt transactions, as the documentation rules go into effect for tax years beginning on or after January 1, 2019. The compliance burden will, however, be significant and substantial. Taxpayers should familiarize themselves with the documentation rules and gradually adopt them into current and planned future debt transactions.
In order to prevent related-party debt instruments being treated as equity, taxpayers should avoid the following situations:
- Distribution of a covered debt instrument to a member of the expanded group, such as a note issued as a dividend or return of capital on which interest is subsequently paid
- Issuance of a debt instrument in exchange for expanded group stock
- Issuance of a covered debt instrument in exchange for expanded group stock that is then exchanged for stock in a corporation that is not a member of the same expanded group
- Any related-party debt, to the extent that the issuer of the debt either makes a distribution with respect to the issuer’s stock or an acquisition of affiliate stock, if the debt issuance occurs during the 36 months before and 36 months after the date of the distribution or acquisition (any remaining debt above the issuer’s future distribution to other expanded group members will not be recharacterized as equity)
- Distribution of expanded group stock and covered debt instrument in a reorganization that qualifies under IRC section 355
- Distribution and issuance of a covered debt instrument with the principal purpose of avoiding the provisions of Treasury Regulations section 1.385-3.
In addition to the exceptions outlined above, the following related-party debt instruments are not recharacterized as equity under the final regulations:
- Debt instruments issued by foreign corporations of the expanded group
- Debt instruments issued between U.S. members of an expanded group that have elected to file a consolidated return for federal income tax purposes
- Debt instruments issued by S corporations, regulated investment companies (RIC) and real estate investment trusts (REIT), which are generally not considered members of an expanded group
- Debt issued in exchange for expanded group member stock that meets the exempt exchange requirements discussed in Treasury Regulations section 1.385-3(f)(5).
Be Ready for the New Rules
The recharacterization rule applies to taxable years ending on or after January 19, 2017. As a result, it is important for corporate taxpayers to screen their current debt instruments to see whether they are subject to the recharacterization rule based on the conditions discussed above. Once such debt instruments have been identified, steps should be taken to follow the final regulations and make the necessary changes. For future debt transactions, tax advisors should apply planning strategies based on situations that are not subject to the recharacterization rules discussed above.
Finally, although the final regulations made some significant changes from the proposed regulations, which were released on April 4, 2016, the authors expect the Treasury Department and the IRS to make further explanation or changes to the final regulations as they take effect.