Much attention in recent months has been deservedly directed at the recently proposed Sec. 385 regulations (REG-108060-15). In addition to introducing prescriptive documentation requirements for financial instruments intended to be treated as debt for U.S. federal income tax purposes, the proposed regulations target three types of transactions formerly considered well-established and routine mechanisms for creating internal leverage within a controlled group's entity structure.
The proposed regulations treat the following transactions as giving rise to "principal purpose debt instruments" that are recast as stock for U.S. federal income tax purposes:
- Distributions of property from one to another member of an expanded group (other than those pursuant to tax-free reorganizations under Sec. 354(a)(1) or 355(a)(1), or, when Sec. 356 applies, those not involving money or "other property" as described in that section);
- Acquisitions of an expanded group member's stock in exchange for property other than stock; and
- Acquisitions of an expanded group member's property in exchange for stock of the acquiring member and "other property" within the meaning of Sec. 356 (Prop. Regs. Sec. 1.385-3(b)(3)).
"Expanded group" in this context is defined as one or more chains of corporations connected through stock ownership with a common parent corporation that owns, directly or indirectly, at least 80% of the voting power or value of the stock of other includible corporations (Prop. Regs. Sec. 1.385-1(b)(3)).
It is worth noting that the proposed regulations provide a maximum expanded group debt level, below which the "principal purpose debt instrument" characterization is inapplicable. A debt instrument will not be recast as stock to the extent the aggregate adjusted issue price of debt instruments held by members of the expanded group does not exceed $50 million. Any debt instrument that is not denominated in U.S. dollars is translated into U.S. dollars at the spot rate (as defined in Regs. Sec. 1.988-1(d)) on the date the debt instrument is issued (Prop. Regs. Sec. 1.385-3(c)(2)).
Chief among the IRS's motivations in promulgating the proposed Sec. 385 regulations is closing a loophole with respect to transactions that lack meaningful nontax significance, such that respecting the instrument as indebtedness for federal tax purposes produces inappropriate results. But could a transaction having nontax significance still produce inappropriate results as deemed by the IRS?
Example: USCo, a domestic corporation, wholly owns FC1, a controlled foreign corporation (CFC). USCo contributes its shares in FC1 to FC2, a newly formed CFC, and complies with all gain recognition agreement filing requirements under Regs. Sec. 1.367(a)-8. FC2 then borrows funds from a third party and distributes the funds toUSCo.
Because USCo receives a carryover basis in FC2 stock (see Sec. 358(a)(1)) that exceeds the amount of the distribution by FC2, and assuming FC2 remains "clean" of earnings and profits, this distribution should qualify as a tax-free return of basis under Sec. 301(c)(2). Since no debt instrument was created in the distribution, it is outside the scope of the proposed Sec. 385 regulations.
Leaving aside the question of business purpose, the transaction described in the above example results in outsized benefits to USCo, which is able to access foreign cash without incurring U.S. tax. The presence of third-party debt at FC2, while adding a nontax business dimension to the transaction, is unlikely to deter those U.S. multinationals with excess, low-tax foreign cash and a proclivity for tax planning from engaging in this type of transaction. Thus, the transaction described above is one example where third-party borrowing can produce the very result that the proposed Sec. 385 regulations aim to prevent, with potentially minor changes in the group economics.
Practitioners familiar with the proposed regulations may recall the associated anti-abuse rule, which treats as stock debt instruments issued with the principal purpose of avoiding application of the proposed regulations (Prop. Regs. Sec. 1.385-3(b)(4)). This provision specifically mentions a scenario in which a debt instrument is issued to, and later acquired from, a person that is not a member of the issuer's expanded group. Of course, this scenario is avoided in the example above, provided FC2 and not one of its affiliates ultimately satisfies the third-party loan. However, assuming USCo at some point acquires the debt instrument issued by FC2 from the third-party holder, the anti-abuse rule would clearly apply to treat this debt instrument as equity.
But consider the application of the so-called CFC netting rule of Regs. Sec. 1.861-10(e) in relation to this USCo-FC2 instrument. The CFC netting rule requires that if a U.S. corporation borrows in the United States and lends to its CFC, a portion of the interest expense incurred by the U.S. corporation must be allocated against the interest income paid by the CFC, thereby reducing foreign-source income and potentially the foreign tax credit. Absent the application of the anti-abuse rule under Prop. Regs. Sec. 1.385-3(b)(3), the nominal debt instrument in place between USCo and FC2 would be respected for tax purposes, despite the possibility that this treatment could result in higher U.S. tax liability via application of the CFC netting rule. Hence, one scenario is uncovered whereby the taxpayer could prefer to use the Sec. 385 proposed regulations affirmatively.
Alas, the authors of the Sec. 385 proposed regulations appear to have preempted an otherwise shrewd ploy here. To the extent USCo's U.S. tax liability is reduced by simultaneous application of the anti-abuse rule under the Sec. 385 proposed regulations and the CFC netting rule, the application of the anti-abuse rule under the Sec. 385 proposed regulations is turned off under the "no affirmative use" provision of Prop. Regs. Sec. 1.385-3(e).
In summary, while the use of third-party lending may effectively substitute for the use of related-party debt in certain transactions where the inception of this debt is an intermediate step rather than a final byproduct, taxpayers and practitioners should carefully consider the combination of the anti-abuse and no-affirmative-use rules of Prop. Regs. Sec. 1.385-3 for transactions designed to create related-party debt from a third-party debt instrument.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.