Why Your Businesses Cannot Ignore the IRS’s Proposed Regulations on Related Party Debt (Even if You Are Not a Multinational)May 2016
The IRS has issued proposed regulations under Section 385 of the Internal Revenue Code (the "Code") that, if finalized, would radically alter and expand the circumstances in which corporate debt issued to a related party could be recharacterized as equity (REG-108060-15). Because related party debt is commonly used in a wide variety of corporate transactions, including mergers and acquisitions, the proposed regulations will have a significant impact on corporate groups and transactions. The IRS has stated that it is committed to finalizing these regulations by the end of the summer. While most of the provisions in the proposed regulations will not be effective until final regulations are issued, businesses need to be aware of a number of important aspects of these proposed rules:
- Although they were released as part of a larger package of rules relating to corporate inversions, they apply to many common transactions between purely domestic entities.
- In addition to denying interest deductions, reclassification of debt as equity under the proposed rules may trigger withholding obligations and could create significant state tax issues for many corporate groups.
- Certain larger businesses may need to prepare to comply with new documentation rules to avoid having related party debt automatically recharacterized as equity.
- Several concerns have been voiced on the potential adverse impact the proposed rules could have on common cash pooling techniques used by corporate groups to manage cash.
The proposed regulations are extremely lengthy and complex; thus, the purpose of this publication is to provide a general overview of issues that could arise. We strongly suggest that all related party debt transactions be reviewed by tax advisors to ensure compliance with the rules. If you would like more information about these new rules, and how they apply to your business, please contact our offices.
For federal income tax purposes, the case law concerning whether purported indebtedness is respected as such or is treated as stock has been inconsistent, which reflects differences in the lists of pertinent factors developed by the various courts. Under existing law, an interest in a related corporation generally is treated as either wholly debt or wholly equity.
The Proposed Regulations
The proposed regulations would apply to indebtedness between members of an "expanded group." An expanded group generally is an affiliated group, as defined in Section 1504(a) of the Code. However, members of an expanded group may include many types of corporations that are not included in affiliated groups, such as foreign and tax-exempt corporations, S corporations, and corporations held indirectly (e.g., through partnerships). Membership in an expanded group generally is determined under an 80% vote or value test rather than the stricter 80% vote and value test applicable to affiliated groups. In addition, indirect ownership of corporations would be determined in accordance with the attribution rules under Section 304(c)(3) of the Code.
The scope of the proposed regulations is subject to a number of important limitations. The proposed regulations do not:
- Alter the rules applicable to debt between unrelated parties;
- Affect the rules applicable to interests characterized by the issuer as equity rather than debt; or
- Apply to issuances of interests and related transactions among members of a consolidated group.
Although interests issued between members of a consolidated group would not be affected, the proposed regulations do provide rules to address the treatment that applies when parties join or leave a consolidated group.
Overview of the Changes Made by the Proposed Regulations
The proposed regulations make three major changes to the rules governing the characterization of corporate debt issued between members of an expanded group (an "applicable instrument"):
- They permit the IRS to recharacterize an applicable instrument as part debt and part equity (the "Partial Recharacterization Rule");
- They impose new documentation and financial analysis requirements as a pre-condition to debt characterization on certain large taxpayers (that is, failure to satisfy the requirements generally results in automatic characterization of the applicable instrument as stock) (the "Documentation Requirements"); and
- Subject to certain exceptions, they automatically characterize as stock, applicable instruments issued in the following types of distributions or similar transactions (the "Per Se Equity Rule"):
- Distributions of applicable instruments by corporations to their members of their expanded group;
- Issuances of applicable instruments by corporations in exchange for stock of a member of the corporation's expanded group;
- Certain issuances of applicable instruments as consideration in an exchange pursuant to an internal asset reorganization; and
- Issuance of applicable instruments to a member of an expanded group in a separate transaction with a principal purpose of funding (i) a distribution of cash or other property to a member of the expanded group; (ii) an acquisition of affiliate stock from an affiliate for an applicable instrument; or (iii) certain acquisitions of property in an internal asset reorganization.
The Partial Recharacterization Rule and the Documentation Requirements would apply to applicable instruments issued or deemed to have been issued (1) on or after the date that the proposed regulations are finalized, or (2) before the date that the proposed regulations are finalized, if and to the extent that the debt instrument was deemed issued as a result of a check-the-box election filed on or after the date final regulations are published.
The Per Se Equity Rule and the rules applicable to consolidated groups generally would apply to applicable instruments issued or deemed to have been issued (1) on or after April 4, 2016, or (2) before April 4, 2016, if and to the extent that the debt instrument was deemed issued as a result of a check-the-box election filed on or after the date final regulations are published. In certain cases, this effective date rule is modified such that the applicable instrument is temporarily treated as debt until the end of the 90-day period following publication of final regulations.
Considerations and Analysis
- Although the proposed regulations were issued in connection with a larger package of guidance intended to halt corporate inversions, they could affect many common corporate transactions that are unrelated to inversions, and they would apply to transactions that involve solely domestic entities.
- The fact that the proposed regulations would not apply to members of a consolidated group would mitigate the adverse impact of the proposed regulations. However, the impact of the rules should be considered when a member is joining or leaving a consolidated group.
- Because the Per Se Equity Rule and the rules applicable to consolidated groups would apply retroactively, the potential application of these rules to current transactions needs to be kept in mind.
- Although the Partial Recharacterization Rule and Documentation Requirements generally would apply only to debt instruments issued after the date that final regulations are published, the grandfathered status of an applicable instrument could be lost if the applicable instrument were deemed to have been reissued as a result of a check-the-box election. In addition, consideration should be given to whether a significant modification under Treasury Regulation Section 1.1001-3 could affect grandfathered status.
- The Documentation Requirements are extensive and similar to the documentation and analysis created when indebtedness is issued to third parties.
- Recharacterization of an applicable instrument as equity under the proposed regulations would affect not only the deductibility of interest, but could have significant adverse consequences on withholding required with respect to payments made on applicable instruments.
- The regulations could have a major impact on state taxation and the ability of states to independently characterize instruments as debt or equity, as noted in McLoughlin, "Treasury’s Debt-Equity Rules May Curtail States’ Authority," BNA Daily Tax Report (April 25, 2015).
- In addition, the rules could cause intercompany debt to be hybrid instruments, treated as equity for U.S. purposes and debt for foreign purposes. Hybrid Instruments have been a major focus of the OECD’s BEPS initiative.
- Practitioners have also expressed significant concern that common cash pooling techniques used by corporate groups to manage cash could be subject to the rules unless a carve-out is created.
- Finally, if the regulations are finalized, careful consideration should be given as to whether representations and warranties should be modified. In addition, due diligence presumably will need to include consideration of whether the Documentation Requirements have been complied with and how the regulations might affect any related party debt.