On April 4, 2016, the IRS released proposed regulations under Internal Revenue Code (IRC) Section 385. These regulations are part of the Obama administration’s efforts to reduce the attractiveness of inversion transactions—in which a U.S.-parented corporation changes its tax residence to reduce or avoid paying U.S. taxes. The proposed regulations seek to limit the ability to use intercompany debt to reduce the federal tax liability of U.S. companies owned by an inverted company. However, the proposed regulations, if finalized in their current form, have the potential to negatively impact routine intercompany financing transactions for many taxpayers.
Section 385 grants the Treasury Department authority to issue regulations defining the circumstances in which an investment in a related corporation is treated as stock, indebtedness, or part stock and part indebtedness, for federal income tax purposes. Before the proposed Treasury regulations were issued, taxpayers and the IRS relied on factors set forth in case law such as Estate of Mixon, 464 F.2d 394 (Fifth Cir. 1972) to determine whether an instrument was debt or equity for federal income tax purposes. In practice, instruments in question were generally treated as all debt or all equity (an all-or-nothing approach).
The proposed regulations
Key features include:
- The regulations apply to expanded group indebtedness (EGI). EGI is an instrument in which both the issuer and holder are members of the same expanded group. The definition of expanded group is defined as an affiliated group under Sec. 1504(a) but is expanded in several respects. For example, corporations held through partnerships may be part of an expanded group. While an instrument between members of the same consolidated group is not EGI, there are specific rules involving consolidated groups, which are discussed below.
- The regulations impose very specific documentation requirements for intercompany debt that must be met to avoid re-characterization as equity.
- The IRS permitted to bifurcate an instrument issued between related parties into a combination of part debt and part stock (a departure from the all-or-nothing approach).
- The most significant impacts of the regulations reside in Proposed Regs. 1.385-3 and 1.385-4. Proposed Reg. 1.385-3 broadly identifies two types of transactions that generally treat EGI as stock, rather than debt, for all federal tax purposes: Debt issued to a related party in distribution or as consideration in certain transactions (the General Rule), and debt issued with a principal purpose of funding transactions described in the General Rule (the Funding Rule). Transactions targeted under the General Rule include:
- The issuance of EGI through distribution to its parent;
- The issuance of EGI as consideration to acquire expanded group stock (subject to certain exceptions); and
- The issuance of EGI as consideration in an asset reorganization among members of the same expanded group (subject to certain requirements).
Under the Funding Rule, there is a per se rule that a principal purpose exists if the funding transaction and the relevant distribution or acquisition (by either the funded member or a predecessor or successor of the funded member) under the General Rule occur within 36 months of each other. This means that if the issuer of EGI issues the instrument during the time period beginning 36 months before the acquisition or distribution and ending 36 months after the acquisition or distribution, the instrument is generally treated as debt. There is a limited exception for the extensions of credit for the sales of inventory and receipt of services in the ordinary course of business.
There are limited exceptions to the application of the General Rule and Funding Rule. There is also an anti-abuse rule, which treats debt instruments not subject to the proposed regulations as stock if the debt instruments are issued with a principal purpose of avoiding the application of the General Rule and/or Funding Rule. There is also a rule that prevents the use of Proposed Reg. 1.385-3 to reduce the federal income tax liability of an expanded group member.
Rules under Proposed Reg. 1.385-4 apply the General Rule and Funding Rule concepts to a debt instrument between members of a consolidated group (consolidated group instrument) that becomes EGI, or EGI that becomes a consolidated group instrument.
These regulations apply to debt instruments issued on or after April 4, 2016 and to any debt treated as issued before April 4, 2016 as a result of a “check the box” entity classification election filed on or after April 4, 2016. If the proposed regulations would treat a debt instrument as stock (that is, debt instruments issued or deemed issued in the timeframe discussed above), the debt instrument is treated as indebtedness until the date that is 90 days after the date the Proposed Regulations are issued as final. Finally, a transition rule provides that for purposes of applying the Funding Rule, a distribution or acquisition that occurs before April 4, 2016 is not taken into account, unless the distribution or acquisition is deemed to have occurred before April 4, 2016, as a result of a “check the box” election filed on or after April 4, 2016.
As noted above, a purported debt instrument that is recast as stock under these rules is treated as stock for all federal income tax purposes. Depending on the taxpayer’s facts and circumstances, the implications of stock treatment could be very broad, including but not limited to:
- Treatment of interest payments as dividends, which if paid by a U.S. corporation, are non-deductible for federal income tax purposes. In the case of payments to a foreign related party, treating the interest payments as dividend may result a different withholding tax rate;
- Treatment of repayment of principal as a dividend and/or redemption of equity, which may reduce the availability of foreign tax credits in certain circumstances;
- Triggering of changes in stock ownership which, among other things, can result in deconsolidation of U.S. entities in a consolidated group.
It’s important to note that these rules apply to both inbound (foreign investment in U.S.) and outbound (U.S. investment in foreign) intercompany financing structures, including cash-pooling arrangements. For example, parties to a cash-pool arrangement that pay dividends within the 72-month window of the borrowing would be subject to these rules.
The use of third-party debt from an institutional lender that is guaranteed by a member of the expanded group is not explicitly defined as EGI; however, it is unclear whether such an arrangement would be subject to the anti-abuse rule. Note that IRC Sec. 163(j), which limits the U.S. tax benefits of intercompany debt in certain circumstances, applies to certain third-party debt guaranteed by an affiliate, so it’s not beyond the realm of possibility that third-party debt could be treated as EGI.
Unfortunately, as is often the case, Treasury’s desire to address a specific perceived tax abuse has resulted in a set of rules, which, if finalized, will have far-reaching implications.
Outlook and next steps
It’s impossible to say whether the regulations will be finalized in their current form, or when they will be finalized. Written comments and requests for public hearing on these proposed regulations must be received by July 7, 2016. Depending on the feedback received by the IRS from the public, the availability of resources within the IRS, and the current political environment, it’s likely that the regulations won’t be finalized until later this year at the earliest.
Taxpayers should evaluate the implications of the proposed regulations on current and planned intercompany financing, dividend planning, and planned internal restructurings.
Robert Zielinski is a partner based out of our Rochester, NY office.