On Oct. 13, 2016, the Treasury Department and the IRS released final and temporary regulations that address earnings stripping and deter multinational corporations (MNCs) from shifting income out of the United States to lower-tax jurisdictions. These final regulations describe requirements that intercompany advances must meet to be considered debt instruments rather than stock. The rules also identify certain types of transactions in connection with an instrument that will be considered stock. The impact of these rules on MNCs with operations in the United States will be significant, and companies should develop plans to ensure both tax and financial reporting compliance.
In general, corporations can raise capital by issuing either debt or stock. U.S. tax rules provide an incentive for corporations to issue debt because the interest expense is deductible for U.S. tax purposes while dividends are not. When corporations deal with unrelated parties in the marketplace, they face economic and legal constraints that limit their ability to issue debt. When the parties to the transaction are closely related, however, these constraints do not exist. In the view of the U.S. government, this can lead to over-leveraging, tax arbitrage, and a negative impact on the U.S. tax base. In recent years, an increase in debt issued by U.S. corporations to foreign MNCs has created significant economic and revenue costs to the United States, which the government has decided to address.
On April 4, 2016, Treasury proposed regulations under Sec. 385 to address this problem by creating rules that would treat certain instruments issued to related parties as stock. Most of the 30,000 comments received by the government objected to the proposed regulations on the grounds that they would have a negative impact on transactions entered into in the ordinary course of business, would be costly for corporations to implement, and would create unintended consequences in the tax law.
The final regulations—which are extremely complex and detailed—narrow the impact on corporations and provide significant relief compared to the proposed regulations. In particular, they now apply only to debt issued by members of an expanded group that are domestic C corporations that are either (1) publicly traded; (2) have revenue greater than $50 million; or (3) have assets over $100 million.
Although the regulations were finalized in October, their fate under the Donald Trump Administration remains unknown as of the time of this writing. Because of the controversy surrounding them, 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.
2 major substantive rules
The final regulations contain two major substantive rules: (1) the recharacterization rules dealing with certain types of "tainted" transactions that the government considers abusive and (2) the rules requiring documentation of related-party instruments.
The final regulations generally retain the recharacterization rules contained in the proposed regulations, targeting transactions with earnings-stripping potential. Under the general rule, a debt instrument issued by a U.S. issuer that is not exempt from the final regulations will be recharacterized as equity if the instrument is issued in (1) a distribution to another member of the group; (2) an acquisition of stock of another member of the group; or (3) an acquisition of property in an asset reorganization pursuant to the reorganization by a member of the group. Under the funding rule, a debt instrument issued by a member of the expanded group to another member of the group is recharacterized as equity to the extent that it is treated as funding a prohibited distribution or acquisition.
The six-year per se funding rule treats a debt instrument as funding any distribution or acquisition that occurs within the period that begins 36 months before the issuance of a debt instrument and that ends 36 months after its issuance. The rule generally cannot be rebutted, with two noteworthy exceptions: (1) A debt instrument is exempt to the extent of the earnings and profits (E&P) accumulated by the issuing corporation in tax years ending on or after April 5, 2016, and derived while the entity was a member of the same group, and (2) a new exception that permits the MNC to net certain capital contributions (made to the issuing corporation within the 36-month period before the distribution or acquisition) against the amount of the distribution, resulting in only the net amount of the distribution or acquisition counting toward the application of the recharacterization rules.
Another notable exception to the funding rule is an exception for certain instruments, such as instruments issued by regulated financial institutions, statutory instruments such as production payments, qualified dealer securities, and qualified short-term debt instruments that fall within one of four defined categories: (1) short-term funding arrangements for working capital borrowings or 270-day borrowings; (2) ordinary course payables generally defined as debt instruments issued in the ordinary course of the issuer's trade or business that are expected to be repaid within 120 days; (3) interest-free loans that do not provide for stated interest, original issue discount, or imputed interest; or (4) cash pool deposits generally defined as demand deposits with a qualified cash pool header under a cash management arrangement.
The final regulations retain the general rule that an expanded group instrument (EGI) is treated as stock if the taxpayer fails to comply with certain documentation and recordkeeping requirements. These rules generally apply to all types of "in-form" debt, including debt that is evidenced only through journal entries or trade accounts and provide details on using an "umbrella" or "master" credit agreement to serve as the documentation platform for cash pooling, credit facilities, or similar intercompany arrangements. The rule for an undocumented EGI has been relaxed somewhat, in that an MNC that has a high degree of compliance may rebut the presumption of equity treatment by establishing sufficient common law factors to support the debt treatment.
Under the final regulations, any instrument issued by a domestic C corporation to a related party can be considered debt for U.S. federal income purposes only if there is written documentation establishing:
- A written promissory note: A binding legal obligation to repay a fixed or determinable sum certain on demand or at one or more fixed dates;
- Creditor's rights: The creditor/holder has the legal rights of a creditor to enforce the terms of the instrument;
- Creditworthiness: As of the issue date and taking into account all relevant circumstances, the issuer's financial position supports a reasonable expectation that the issuer intended to, and would be able to, meet its obligations under the terms of the interest; and
- Payment or exercise of remedies: That the debtor-creditor relationship is ongoing, with written proof that either:
- All payments required by the instrument are being made under the terms of the instrument, or
- In the event of a default, the holder takes actions that an ordinary, reasonable third-party lender would take (e.g., acceleration of the debt, foreclosure on security, renegotiation, or a reasoned decision to forgo exercise of its rights at that time).
Meeting the documentation requirements
As an initial matter, while application of the final regulations is generally limited to U.S. C corporation issuers, the documentation rules illustrate best practices for all taxpayers. Because adequate documentation is a critical determining factor for making debt-equity determinations under the common law—which still applies to all issuers—taxpayers should be prepared to follow the documentation rules for all intercompany advances.
To meet the documentation requirements, all MNCs with activities in the United States should develop a detailed action plan to ensure compliance both for existing instruments and for those issued in the future. In general, an implementation plan should include three major components: risk analysis, process and procedures development, and monitoring and reassessment.
Risk analysis. Every company that may be subject to the new rules should perform an immediate risk analysis for all related-party loans within its multinational group, as well as examine its existing processes to understand its potential exposures. The MNC should create a complete inventory of its related-party loans (including intercompany accounts), followed by a review of all current documentation supporting those transactions and any policies and procedures already in place.
If an MNC conducted a risk analysis previously under the proposed regulations, it should reassess the conclusions in light of the final regulations. In any event, a company should identify and remedy gaps between current documentation and the requirements of the regulations, as well as consider potential impacts to its tax provision and FASB Accounting Standards Codification Topic 740, Income Taxes. Steps that can be taken immediately may include eliminating or reducing intercompany balances or converting problematic entities into disregarded entities.
Debt capacity analysis. To demonstrate the issuer's creditworthiness, companies should conduct a debt capacity analysis, which includes (1) a lender-oriented analysis of current debt market conditions, including any third-party reports or analyses; (2) a search for comparable peers and an evaluation of the borrowers against comparable peers across a range of relevant financial ratios; and (3) an evaluation of the projected cash flows of the borrower to address serviceability of the debt over the lending horizon, given specific terms and conditions.
Processes and procedures. Once a risk analysis and debt capacity analysis have been completed and the immediate issues have been identified, the MNC should develop and test processes and procedures regarding creation, documentation, and management of all future related-party advances (including cash management methods, trade receivables and payables, transfer-pricing adjustments, and other situations).
The MNC should identify and designate a "process owner" as part of the design process. The process owner provides accountability to the parties and to management and can serve as the direct point of contact within the organization for all matters connected to documentation. The design process should involve all internal and external stakeholders with both direct (senior management, legal, treasury, and tax) and indirect (IT, accounts payable/receivable, internal and external audit, and/or outside advisers) involvement to minimize its impact on the business. Only after understanding the impact to the various stakeholders should the MNC design, test, and implement new debt policies and repeatable processes and procedures to mitigate risk and comply with the regulations.
Each step in the documentation process should be clearly identified so that there is no ambiguity or confusion about what needs to be done and who is responsible for the task. Specific control and review procedures should be designed to ensure that the process is performed accurately. The process owner should maintain all documentation in a central location to help encourage uniformity and completeness in reporting and simplify monitoring activities.
Implementation is often the most challenging aspect of the action plan. Training is a critical element of any successful implementation. Procedures may be designed with the best intentions, but if they are not implemented uniformly, directions are not clear, or the correct stakeholders are not involved, there is a risk of noncompliance and recharacterization of debt to equity.
All stakeholders must be aware of the designated process owner so that they receive a clear and consistent message and know where to turn if they have questions. Throughout this phase, the MNC should give careful consideration to communication and the accessibility of timely and accurate information. Periodic meetings, creation of a distribution list, and the use of a dedicated loan-tracking and storage system can ensure that all stakeholders can successfully participate in and own the entire process.
Monitoring and reassessment. After implementation, the MNC should perform monitoring activities—including periodic assessment of the processes and procedures—at least annually. While this review should focus on compliance with and performance by the stakeholders of the processes, it is also important for understanding where improvements can be made or where law changes may need to be incorporated. As always, timely communication will be critical.
Compliance with the new regulations will be challenging and require involvement from multiple parties both within and outside the organization. Nevertheless, a clearly defined action plan and a strategy focusing on both the immediate and future needs of the business will prepare the organization to overcome this challenge successfully.
Timely preparation of documentation. The effective date of the documentation rules has been extended and applies only to debt issued on or after Jan. 1, 2018. The documentation must be completed no later than the due date of the issuer's tax return (including extensions) for the relevant tax year in which the debt instrument is issued. Failure to timely prepare the documentation creates a presumption (which the company may overcome) that the instrument is stock.
It is too early to know the full impact of these regulations on intercompany activities of MNCs, and, in fact, the incoming Donald Trump administration or Congress may revise or even withdraw the final regulations. Nevertheless, as a matter of good housekeeping, MNCs should focus on their documentation and compliance efforts. Additionally, MNCs should consider separating the cash pooling and treasury operations of their U.S. subsidiaries from their foreign subsidiaries to mitigate application of the final regulations. Lastly, MNCs should consider carefully tracking and documenting E&P of their group members and tracking contributions and distributions to mitigate the application of the recharacterization rules.
Failure to comply with the documentation and recharacterization rules may result in unintended tax consequences. In the most basic case, issuers of instruments that are recharacterized as stock potentially will face (1) loss of interest deductions; (2) loss of Sec. 902 foreign tax credits; (3) taxable reorganization transactions for failure to meet ownership requirements under the corporate reorganization rules; (4) deconsolidation for failure to meet the consolidated group ownership rules; (5) loss of entitlement to benefits provided by the U.S. income tax treaties due to unmet ownership tests; (6) state income tax consequences; and (7) impacts to an MNC's tax provision and Topic 740 reporting.
Robert M. Gordon, the managing director of True Partners Consulting LLC, specializes in the taxation of complex domestic and international transactions, M&A, joint ventures, and general federal tax planning in the firm's Chicago office. Alexis Bergman, a director with True Partners, specializes in the taxation of domestic and international transactions and advises multinational corporations on their most complex business transactions, also in the Chicago office. Jennifer Crawford is a director with True Partners in its Tampa, Fla., office, where she helps clients improve their tax functions by evaluating current processes, determining best practices, and implementing effective control procedures.