New Proposed Regulations Increase Scrutiny on Related-Party Debt
The U.S. Treasury Department (“Treasury”) and Internal Revenue Service (“IRS”) recently issued proposed regulations (the “New Proposed Regulations”) governing the federal income tax treatment of debt between certain related parties. Part of the Treasury’s continued struggle with so-called “inversion” transactions, these proposed rules apply well beyond inversion transactions and may call into question the tax treatment of common, non-abusive transactions. The proposed regulations, if finalized, could cause debt between members who are part of an “expanded group” (as defined below) to be treated (in whole or in part) as equity for federal income tax purposes and would impose documentation requirements in order for a purported debt instrument to be treated as debt.
If finalized, the new rules regarding classification of certain debt as equity generally would apply to any purported debt instrument issued on or after April 4, 2016, but will not take into account distribution or acquisition transactions (which, as described below, are relevant under the new rules in determining debt/equity status) occurring prior to April 4, 2016. There is a grandfathering rule for debt instruments treated as equity, in whole or in part, under the New Proposed Regulations, whereby equity treatment will not be effective until the day that is 90 days after finalization of the rules. The new documentation requirements will apply to debt instruments issued on or after the date the New Proposed Regulations are finalized.
The Treasury and IRS previously published Notice 2014-52, 2014-42 IRB 712 (October 14, 2014) and Notice 2015-79, 2015-49 IRB 775, which indicated an intention to issue regulations limiting the benefits of certain post-inversion tax avoidance transactions. Specifically, the Treasury and IRS considered guidance addressing strategies that avoid U.S. tax on U.S. operations by shifting or “stripping” U.S. source earnings to lower-tax jurisdictions, including through use of intercompany debt. Such transactions became common tax planning following an inversion transaction.
Debt and Transactions Subject to the New Rules
The New Proposed Regulations are surprising in that they go well beyond the previously cited inversion transactions. The New Proposed Regulations largely apply to debt instruments issued between members of an “expanded group”, which generally is defined as an affiliated group of corporations within the meaning of Section 1504 of the Internal Revenue Code of 1986, as amended (“Code”), which generally requires 80% ownership. The New Proposed Regulations greatly expand the statutory definition of affiliated group, for example by including foreign and tax-exempt corporations. However, it is worth noting that these new rules do not apply to debt between companies that are part of the same consolidated group for U.S. federal income tax purposes.
The New Proposed Regulations provide that purported debt between members of an expanded group is subject to reclassification as equity if issued in any of the following situations (each a “Subject Transaction”):
- as a distribution of the debt by an issuer with respect to its stock (e.g., a dividend or return of capital distribution in the form of notes);
- in exchange for stock of another member of the expanded group (e.g., member acquires stock of another member in exchange for issuing a note to the selling member); or
- in exchange for property in certain tax-free reorganizations.
Subject Transactions also include any issuance of debt with a principal purpose of funding one of the transactions described above. For example, the rules would apply if Subsidiary A borrowed funds from Subsidiary B to fund a distribution from Subsidiary A to its parent corporation. Subject transactions also include any other issuance with a principal purpose of avoiding the application of the New Proposed Regulations.
Whether debt is issued with a principal purpose of funding a Subject Transaction or avoiding application of the New Proposed Regulation is determined based on facts and circumstances. However, the New Regulations contain a non-rebuttable presumption whereby a debt instrument is deemed to have a principal purpose of funding a Subject Transaction if the debt is issued at any time during the 72-month period beginning 36 months before and ending 36 months after the issuing member makes a distribution or acquisition that is considered a Subject Transaction (the “Per Se Rule”).
Helpfully, however, certain transactions are excepted from the rules in the New Proposed Regulations. For instance, debt issued by a member of an expanded group will not be subject to potential treatment as equity if the related Subject Transaction(s) do not involve distributions and acquisitions in excess of the member’s current year earnings and profits. There is another general exception for such debt if, immediately after the debt is issued, the aggregate adjusted issue price of all such expanded group debt held by members of the expanded group does not exceed US$50 million.
Finally, there is a separate exception from the Per Se Rule for debt instruments arising in the ordinary course of the issuing member’s trade or business (e.g., accounts payable). Finally, the New Proposed Regulations give the IRS authority to recast only a portion of a subject debt instrument as equity and treat the remaining portion as debt for U.S. federal income tax purposes (the “Bifurcation Approach”), instead of taking an “all-or-nothing” approach under current law. According to the Treasury and IRS, the existing “all-or-nothing” approach frequently does not reflect the economic substance of related-party debt. If finalized, the new Bifurcation Approach would give the IRS greater flexibility and ability to recharacterize related party transactions.
Additionally, the New Proposed Regulations impose contemporaneous documentation requirements with respect to debt issued between members of an expanded group. Failure to satisfy these reporting requirements will result in such debt being treated as equity under the New Proposed Regulations. The required written documentation must satisfy the following:
- establish the issuer has entered into an unconditional and legally binding obligation to pay a sum certain either on demand or at one or more fixed dates;
- establish that the holder of the debt has the rights of a creditor to enforce the obligation (including the right to cause or trigger and event of default for non-payment);
- contain information establishing a reasonable expectation for issuer to be able to repay the debt at the time of issuance (including cash flow projections, financial statements, business forecasts, asset appraisals, debt-to-equity and other relevant financial ratios);
- documentation of payments of interest and principal (for example, wire transfer records or bank statements reflecting payment); and
- enforcement of lender remedies in the event of non-payment or other default.
Observation: These documentation requirements are intended to mirror requirements that the Treasury and IRS believe would typically be requested and maintained by unrelated lenders. Of note, compliance with these requirements will be necessary, but not sufficient, under the New Proposed Regulations for debt to be respected as debt for U.S. federal income tax purposes. As a practical matter, taxpayers should consider preparing now in order to be able to meet these new requirements in the event the New Proposed Regulations are finalized.