Based on how states conform (or not) to IRS regulations for purposes of state income tax, the recently issued regulations under Sec. 385 could have material consequences for state corporate income tax (and possibly other state and local taxes), even if an exception applies for federal tax purposes. The IRS issued final and temporary regulations (T.D. 9790) on Oct. 13, 2016.
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."
What follows is a high-level overview of certain provisions in the regulations that could have state corporate income tax consequences. It is important to understand that the regulations consist of a number of complex provisions and exceptions, including ordering, transition, and operating rules.
Highlights of the Sec. 385 regulations
In general, the regulations, in certain situations, reclassify intercompany financing arrangements as stock, not debt, and thereby recharacterize any corresponding interest payments as nondeductible distributions for federal income tax purposes. The regulations will apply to debt instruments issued by a "covered member" (defined to include only a domestic U.S. corporation) to another member of the covered member's "expanded group." An expanded group generally means a group of related U.S. and non-U.S. corporations that satisfy an 80% vote or value test, as long as the common parent is not an S corporation, a real estate investment trust, or a regulated investment company. The regulations currently do not apply to foreign (non-U.S.) issuers of intercompany debt instruments, including a controlled foreign corporation.
Under Regs. Sec. 1.385-2, a debt instrument issued by a covered member to another member of the expanded group generally will have to satisfy contemporaneous documentation requirements for it to be treated as debt and not as stock, subject to certain exceptions. One such exception is for an "intercompany obligation," as defined in Regs. Sec. 1.1502-13(g)(2)(ii), or to intercompany debt issued by one member of a federal consolidated group to another member, but only for the period during which both parties are members of the same consolidated group.
The recast rules under Regs. Sec. 1.385-3 and Temp. Regs. Sec. 1.385-3T treat the following intercompany debt instruments as stock, and not debt, regardless of satisfying the documentation requirements and the federal debt or equity case law: (1) a debt instrument issued by a distribution from the covered member to another member of the expanded group; (2) a debt instrument issued by a covered member to another member of the expanded group to acquire another expanded group member's stock (a Sec. 304 transaction); and (3) a debt instrument issued by a covered member to another member of the expanded group to acquire another expanded group member's assets. Certain exceptions may apply.
A funding rule under Regs. Sec. 1.385-3(b)(3) treats an intercompany debt instrument as stock if it is issued by a covered member to another member of the expanded group in exchange for property and it is used to fund certain distributions or acquisitions of stock or assets. A per se funding rule applies if the issuance of the debt instrument occurs 36 months before or 36 months after the distribution or acquisition. As with the recast rules, certain exceptions may apply.
Under Regs. Sec. 1.385-3(b)(4), there is also an anti-abuse rule aimed at transactions with a "principal purpose of avoiding the purposes of" Regs. Sec. 1.385-3 or Temp. Regs. Sec. 1.385-3T. For example, the addition of a co-obligor on an intercompany debt instrument may come within the anti-abuse rule.
The regulations contain three exceptions that could have state corporate income tax consequences. First, a "one corporation" exception operates to exclude debt issued between members of a federal consolidated return group from the recast and funding rules. Next, certain "qualified short-term debt instruments" issued as part of cash-pooling and similar arrangements that satisfy a number of specific requirements are also excluded from the recast and funding rules, although the documentation requirements may still apply. Last, the aggregate amount of intercompany debt instruments issued by a covered member that are treated as stock under the recast and funding rules is reduced by an "expanded group earnings account" of the covered member.
The regulations are effective Oct. 21, 2016, the publication date, and apply to tax years ending on or after Jan. 19, 2017 (the date 90 days after the new regulations were published in the Federal Register). However, the documentation requirements of the regulations do not apply to debt instruments issued (or deemed issued) before Jan. 1, 2018. Nonetheless, several transition rules and grandfather rules also need to be considered.
The potential state tax consequences
Almost every state that has a corporate income tax begins the calculation of state taxable income with federal taxable income, either before or after federal net operating losses and special deductions. The state will then apply addition and subtraction modifications to federal taxable income related to various items of federal income, gain, loss, and deductions. A state may conform to the Internal Revenue Code as of a specific date (or as in effect) or on a moving date basis (or as amended), or may only conform to specifically adopted Code sections. A state may or may not explicitly include Treasury regulations as part of its conformity with the Code. The method of a state's conformity to the Code is an important consideration, as a threshold matter, when considering whether and how a state conforms to the regulations.
More importantly, and especially for separate return states (but also for some unitary combined reporting states), whether a state conforms to the federal consolidated return rules is critical. For example, a number of separate return states specifically provide that an affiliate of a federal consolidated group filing a separate state return must determine its federal taxable income starting point as if the affiliate had filed a separate federal return. As discussed above, the "one corporation" exception does not apply if a federal consolidated return is not filed or if a covered member is not an affiliated member of a federal consolidated return group. As a result, if a state adopts or conforms to the regulations, but is an "as if" state, the "one corporation" exception may apply for federal tax purposes but may not for state corporate income tax purposes.
Likewise, the documentation requirements of the regulations do not apply to an intercompany obligation, as defined in Regs. Sec. 1.1502-13(g)(2)(ii) (or, based on the "one corporation" exception, intercompany debt issued by one member of the federal consolidated return group to another member). As a result, if a state does conform to the Sec. 385 regulations but not to the federal consolidated return regulations, taxpayers may be in a situation where they do not have to follow the documentation requirements for federal tax purposes but will have to apply them for state tax purposes.
Moreover, the "expanded group earnings account" that reduces the aggregate intercompany debt of a covered member subject to recast as stock may be limited in application in these separate return and other states. For a separate return state (and certain unitary combined reporting states, such as California), if they conform to the regulations, the current and accumulated earnings eligible to reduce intercompany debt subject to recast may have to be calculated on a separate entity basis.
The exclusion of S corporations from the regulations may have to be reconsidered for certain state purposes. For example, some tax jurisdictions, such as Tennessee, do not conform to the federal income tax treatment of S corporations (including qualified subchapter S subsidiaries) as passthrough entities (or disregarded entities). Tennessee requires an S corporation to determine net earnings "as if" it was a C corporation for federal tax purposes. It is unclear whether Tennessee or a similar state, if it conforms to the regulations, would exclude an S corporation from its application of the regulations.
Should a state independently apply the regulations to recast intercompany debt as stock, the covered member payer's interest expense deduction is disallowed for state income tax purposes. Application of the regulations by a state could subject a much broader array of intercompany debt arrangements to deduction disallowance than do even a state's existing related-party interest expense "add-back" statutes. Recasting the payment of principal and interest as dividends could have consequences for both the payer and the recipient of the recast dividend, including for the sales factor of a state's apportionment formula, depending upon whether and how dividends and interest are included in, and sourced to, the state's sales factor. For example, as more states adopt market-based sourcing and apply it to interest and/or dividends, it is possible that a state's market-based sourcing regulations, or provisions applicable to "methods of reasonable approximation," could result in the sourcing of interest receipts recast as dividends to the payer's state of commercial domicile or some other "reasonable approximation" of the source of the dividends receipts.
If a state recasts intercompany debt as stock by conforming to the regulations, the recast could also have net worth franchise tax implications. See, e.g., National Grid Holdings, Inc., No. 14-P-1662 (Mass. App. Ct. 6/8/16) (effect of recast of intercompany debt under federal and state common law on the nonincome measure of the Massachusetts excise tax).
State tax consequences must be evaluated
Affiliated groups of corporations, as well as passthrough entity structures operating in certain states, with intercompany debt financing in place, need to evaluate the potential state corporate income and franchise tax consequences of the regulations, even if those regulations do not apply to them for federal income tax purposes.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.