On Oct. 13, 2016, the Department of the Treasury issued new final and temporary regulations (T.D. 9790) under Sec. 385. The new regulation package contains some of the most complex and detailed rules that Treasury has issued in decades. The density and intricacy of the new regulations left many tax professionals, tax directors, and C-suite executives scrambling to assess the impact on their organizations. To further complicate matters, the new regulations were ushered in by much broader and controversial proposed regulations (REG-108060-15). After considering numerous comments from the public, and painstakingly addressing each one in the preamble to the final and temporary regulations, Treasury issued the final rules on debt vs. equity classification.
Although the new regulations are daunting in their complexity, certain key issues exist that every company and tax adviser should focus on when considering the regulations' potential impact. While there are no substitutes for a thorough review by a qualified tax professional, the main themes of these regulations can be distilled down, and navigated effectively, by focusing on several critical parts. The intent of this item is to outline some of the more common themes that came out of the final and temporary regulations.
Although the regulations were finalized in October, their fate under the Donald Trump Administration remains unknown as of this writing. Because the regulations have been controversial, it is possible that they will be withdrawn, or Congress could use the Congressional Review Act, 5 U.S.C. §§801-808, to remove them.
Editor's note: These regulations were identified as burdensome by the Treasury Department in July 2017 and are being reviewed for possible modification or withdrawal. See "Treasury Identifies 8 Regulations as Burdensome."
Brief History of Sec. 385
Sec. 385 was originally enacted as part of the Tax Reform Act of 1969, P.L. 91-172. Sec. 385(a) authorizes the secretary of the Treasury to issue regulations "as may be necessary or appropriate to determine whether an interest in a corporation is to be treated . . . as stock or indebtedness (or as in part stock and in part indebtedness)." In addition, Congress recommended certain factors to be taken into account when determining whether a debtor-creditor relationship or a corporation-shareholder relationship exists (see Secs. 385(b)(1) through (5)). Congress added Sec. 385(c) in 1992, which provided that the characterization, determined as of the time of the issuance, by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on the issuer and on all holders of the interest but shall not be binding on the secretary. Prior to the new regulations, and absent a period in the early 1980s when a set of regulations were issued but later withdrawn, Treasury had not issued regulations under Sec. 385 to implement the intent of Congress.
On April 4, 2016, Treasury proposed regulations under Sec. 385 in an effort to combat earnings-stripping transactions. According to Treasury, the proposed regulations were intended to further limit the benefits of post-inversion tax-avoidance transactions and were issued in conjunction with other anti-inversion regulations. Those proposed regulations were touted as a measure to combat perceived inversion-related tax planning. However, the proposed regulations created significant controversy, in part because their reach extended far beyond taxpayers engaged in inversion transactions or earnings stripping. After six months of eager anticipation, Treasury issued final and temporary regulations under Sec. 385.
Final and Temporary Sec. 385 Regs.
Officially published in the Federal Register on Oct. 21, 2016, the final and temporary regulations contain a scaled-back version of what was included in the proposed regulations. Notwithstanding the changes made between the proposed and final package, the new regulations remain a complex and challenging set of standards for taxpayers to grapple with.
The new regulations are organized into four main sections. The first section contains general rules and definitions (Regs. Sec. 1.385-1); the second section contains the "documentation rules" (Regs. Sec. 1.385-2); the third section contains a set of transaction-driven rules that operate to recast certain purported lending transactions as equity for U.S. federal income tax purposes (the recast rules) (Regs. Sec. 1.385-3); and the fourth section addresses consolidated groups and their treatment under the recast rules (Regs. Sec. 1.385-4).
Scope of the Regulations
The new regulations contain several significant scope limitations compared to the proposed regulations. The new regulations generally only apply to certain debt instruments issued by U.S. domestic corporations (i.e., domestic issuers) (see Regs. Sec. 1.385-1(c)(2)). That means debt instruments issued by non-U.S. persons (i.e., foreign issuers) are excluded from the scope of the new regulations. Regs. Sec. 1.385-1(c)(4) also excludes S corporations as members of the defined group of related corporations to which the regulations otherwise apply. These limitations provide welcome relief and significantly reduce the burden on taxpayers introduced by the proposed regulations.
The new regulations contain numerous important defined terms but none more so than the concept of an "expanded group." An expanded group is one or more chains of corporations connected through stock ownership with a common corporate parent possessing stock ownership constituting either 80% of the total outstanding vote or 80% of the total value of each corporation in the chain (see Regs. Sec. 1.385-1(c)(4)). Defining the expanded group is extremely important because, as a general matter, both the documentation rules and the recast rules turn on whether purported debt is issued between members of the same expanded group. The definition of an expanded group limits the scope of companies affected by the new regulations.
What Is Required and How Does It Work?
As previously mentioned, the new regulations generally turn on two main sets of rules—the documentation rules and the recast rules. These rules are briefly discussed below.
The documentation rules: The documentation rules contained in Regs. Sec. 1.385-2 require specified documentation for all "in-form" debt instruments issued by domestic corporations (1) that are members of an expanded group, (2) that issue an in-form debt instrument to an expanded group member, and (3) where the issuer and the holder are not members of the same consolidated group.
The documentation rules require that certain indebtedness factors, and information that evidences those factors, be documented by taxpayers in connection with any applicable lending arrangement. The factors required to be documented include (1) an unconditional obligation to pay a sum certain, (2) documentation of the creditor's rights, (3) documentation of a reasonable expectation of an issuer's ability to repay an expanded group instrument, and (4) documentation evidencing actions indicative of an ongoing debtor-creditor relationship (see Regs. Secs. 1.385-2(c)(2)(i) through (iv)).
Regs. Sec. 1.385-2(d)(2)(iii) contains a transition rule that provides that the documentation rules only apply to debt instruments issued on or after Jan. 1, 2018.
The recast rules: The recast rules contained in Regs. Sec. 1.385-3 generally seek to recast debt resulting from certain enumerated transactions between members of an expanded group. The recast rules are separated into two primary sets of rules: the general rule and the funding rule. Under the general rules, debt instruments issued in connection with a distribution, certain acquisitions of extended group stock, or certain acquisitions of expanded group assets in a reorganization transaction result in the debt being recast as equity. The funding rules are similar to the general rules in that they seek to recast debt instruments where transactions between expanded group members are undertaken using cash or other property when the acquiring or distributing entity has been funded with debt proceeds from another expanded group member.
By way of example, if a foreign parent owns two subsidiaries, one being a U.S. corporation and the other being a non-U.S. corporation, a distribution of a debt instrument by the U.S. corporation to the foreign parent may be recast as equity under the general rule, subject to the exceptions discussed below. Similarly, a distribution of cash or property by the U.S. corporation that was funded by issuance of a debt instrument to the brother-sister non-U.S. corporation may be recast as equity under the funding rule, again subject to the exceptions discussed below.
Perhaps the most controversial aspect of the recast rules is the application of the funding rules within a six-year per se period (see Regs. Sec. 1.385-3(b)(3)(iii)(A)). The per se period provides a nonrebuttable presumption that the debt instrument is equity if a debt issuance occurs during the period extending three years before and three years after the acquisition or distribution (funded transaction). The new regulations require no actual connection between the debt instrument and the funded transaction.
The recast rules apply to transactions occurring after the date of the proposed regulation but defer the actual recharacterization of the debt instrument until Jan. 19, 2017 (the date 90 days after the new regulations were published in the Federal Register).
The above is a high-level overview of the new regulations. As noted, the rules are very complex and are not to be taken lightly. Many troubling issues can arise under the regulations when entering into related-party debt transactions. Although complex, many of the most common issues can be distilled to five general themes every company needs to know when addressing the new regulations. The balance of this item focuses on these five themes.
1. The Regulations Have Many Exceptions, Permitted Reductions, and Permitted Exclusions
Certain exceptions may entirely exclude many smaller to midsize corporations from the documentation and recast rules. The first step to evaluating the impact of these rules on a corporation is determining whether the corporation exceeds two important threshold exceptions under the recast and documentation rules.
A threshold requirement must be met for the documentation rules to apply to a domestic issuer. This limitation is intended to limit the scope of the rules to larger corporations. Specifically, the threshold limitation exempts a domestic issuer from the documentation rules unless it satisfies one of the following three predicates: (1) Any member of the issuer's expanded group is publicly traded; (2) total assets exceed $100 million on any applicable financial statement; or (3) annual total revenue exceeds $50 million on any applicable financial statement (see Regs. Sec. 1.385-2(a)(3)(ii)). Falling outside the scope of the documentation rules is not an excuse for poor documentation. The characterization of an instrument will still turn on the judicial principles regarding documentation and financial wherewithal, so discipline in documentation and factor analysis is highly recommended.
For purposes of the recast rules, taxpayers can exclude the first $50 million in indebtedness that would otherwise be subject to those rules. This exclusion effectively creates a $50 million buffer from recast under the new regulations. Such a buffer could be significant for certain taxpayers in alleviating the impact of an inadvertent recharacterization or in outright exempting their lending from the rules. For example, if a foreign parent intends to lend to a U.S. corporate subsidiary, it can generally do so without repercussions under the recast rules so long as the total expanded group debt subject to the rules is less than the $50 million threshold. For many smaller or midsize companies, limiting applicable debt to $50 million should be an easily obtainable goal.
If taxpayers exceed the above threshold, the recast rules contain numerous other exceptions, permitted exclusions, and permitted reductions. The new regulations include fairly complex operating rules regarding qualified contributions and earnings of the funded subsidiary for certain periods after the finalization of the new regulations. The new regulations also include exceptions to the recast rules for certain qualified short-term debt instruments, transfer-pricing adjustments, compensatory equity, and numerous other exceptions generally centered on certain types of transactions perceived to provide limited potential for abuse. Taxpayers should carefully evaluate the applicability of these exceptions when assessing the impact of the new regulations on their organizations.
2. Foreign Corporate Investees Need to Diligently Review Intercompany Trade Payables
Before the new regulations were issued, as a practical matter, most U.S. companies' trade payable with a foreign parent corporation or foreign brother-sister corporation did not receive significant scrutiny. This was due, in part, to the limited risk associated with these types of arrangements (assuming the payable was not outstanding for an excessive period of time). The new regulations have significantly increased this risk surrounding these related-party borrowings.
These new regulations require domestic corporations to evaluate related-party trade payables, barring the applicability of the threshold exceptions discussed above. This includes, for example, testing to see if the trade payable meets a short-term or ordinary-course exception under the new regulations. It also includes a review under the documentation rules, which requires testing the U.S. issuer for financial wherewithal and creditworthiness. While the documentation rules provide streamlined approaches for these recurring debts, attention will still be required in this area to avoid unintended consequences.
By way of example, if a U.S. issuer fails to document its related-party trade payables, and the trade payables are recast as equity under the documentation rules, payments may be viewed as dividends. Dividend payments could attract withholding taxes and would also prevent a deduction otherwise permitted for an interest payment. A recast could also create numerous income tax treaty issues. For instance, an interest payment recast as a dividend made to a brother-sister entity may circumvent tax planning undertaken to locate the parent in a treaty-favorable jurisdiction. Thus, the payment is subjected to a withholding tax rate as high as 30%. Although all of these were risks before the new regulations were issued, these consequences are significantly heightened by the per se nature of the new rules. However, those consequences can generally be avoided by instituting company policies on documentation, payment terms, and certain other contractual terms included in related-party payable arrangements.
3. U.S.-Based Multinationals Will Still Be Affected
One common misconception is that U.S.-based multinationals (i.e., U.S.-based companies owning foreign subsidiaries) are excluded from the scope of the new regulations. While the definition of "covered member" certainly limits the applicability of the new regulations to U.S.-based multinationals, U.S.-based multinationals should still be aware that the rules (particularly the documentation rules) still apply. The new rules impose a burden on U.S. multinationals to the extent the U.S. parent or any related U.S. entity in the structure makes any intercompany debt issuances.
The most commonly overlooked transactions are ordinary business transactions involving the acquisition of goods or services by a U.S. company paid for with the issuance of a trade payable. Failure to document the issuance of the trade payable could result in a deemed issuance of equity and a related redemption of that equity when the intercompany debt is paid. This recast could also result in deemed U.S. income tax inclusions under Sec. 956 because the deemed issuance may be considered an investment in U.S. property (i.e., stock of the U.S. parent). Generally, the documentation rules will likely impose a higher bar even for companies maintaining excellent "hygiene" related to their intercompany transactions. However, as noted above, these consequences can generally be avoided by instituting specific company policies on documentation, payment terms, and other contractual terms included in related-party payable arrangements. Proper prior planning may prevent suboptimal outcomes.
4. Cash Pooling and Complex Treasury Arrangements
When Treasury issued the proposed regulations, cash pooling and other complex treasury arrangements were the focus of numerous comments from the public requesting leniency for or outright exceptions to these arrangements. Despite the many requests, the new regulations do not contain a provision specifically exempting cash pooling arrangements. Treasury, however, does seem to comport with the notion that cash pooling is a necessary day-to-day business need. As a result, the new regulations provide indirect relief from many of the perceived roadblocks faced by cash pooling under the proposed regulations.
For example, the scope limitation excluding foreign issuers under the new regulations significantly reduces the burden placed on taxpayers engaging in foreign cash pooling arrangements. The new regulations also contain certain "special" documentation rules that may help alleviate some of the compliance burdens contained in the proposed regulations for cash pooling and similar arrangements. Finally, the recast rules provide exceptions for certain cash pool deposits and borrowings, and other qualified short-term debt instruments. Taxpayers should take great care when evaluating their intercompany treasury functions and determine what documentation requirements may be implicated and whether the recast rules apply.
5. Foreign Investors Into the U.S. Must Reevaluate Traditional Funding Structures
As previously discussed, the new regulations are generally limited to debt instruments issued by U.S. corporations. As a result, the most significant application of the rules occurs in the context of foreign direct investment into the United States. A foreign corporate parent would generally constitute a member of an expanded group, which would include its U.S. corporate subsidiaries where an 80% vote or value ownership chain exists. Therefore, debt issuances by the U.S. subsidiary fall squarely within the scope of the new regulations. Consequently, intercompany issuances of debt in certain ordinary financing transactions may require documentation and evaluation under the recast rules.
Traditionally, foreign investment into the United States came with an incentive to structure U.S. subsidiaries with leverage, as opposed to equity, to maximize interest deductions in the United States. Often, the process of introducing leverage into the U.S. group comes after the initial acquisition of a U.S. company and is accomplished through related-party transactions. Many of these "inbound financing" transactions were intended to optimize the tax positions of both the borrower and the lender. The application of the new regulations will upset a number of these debt planning strategies used in the past.
Foreign investors should carefully evaluate the broad scope and impact of these new regulations on existing financing arrangements with U.S. issuers. Foreign investors that are planning to undertake future financing transactions will now need to evaluate potential benefits of those transactions through the lens of the new regulations. Entirely new approaches may be required, or limits may be necessary to stay within safe harbors, when inserting additional leverage into the United States.
The various exceptions or scope limitations described in this item may exclude many taxpayers from the reach of the new regulations. For those not excluded, the new regulations can be daunting. While tax professionals working with these regulations should be cautious of the unexpected traps and nuances, the new regulations are manageable with foresight and proper planning. Those tax professionals should be able to navigate the rules effectively if they proactively and appropriately consider the five general themes identified in this item.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.