On April 4, 2016, the IRS and Treasury Department issued proposed regulations under Internal Revenue Code (IRC) Section 385 addressing whether a direct or indirect interest in a related corporation—for U.S. tax purposes—is treated as stock, indebtedness or a combination.
A primary goal of the proposed regulations is to target related parties attempting to use debt instruments as a method to shift U.S.-source earnings, through interest deductions, into low-tax jurisdictions outside the United States. The proposed regulations address outbound and inbound transactions.
IRC Sec. 385 originally was enacted as part of the Tax Reform Act of 1969 and amended by The Omnibus Budget Reconciliation Act of 1989. Sec. 385 was drafted with the expectation that subsequent regulations would follow, and Sec. 385(a) authorizes the Treasury Department to prescribe regulations to determine whether an interest in a corporation is treated as stock, indebtedness or a combination. A recommended set of factors for determining whether a debtor-and-creditor or a corporation-and-shareholder relationship exists is articulated in §385(b). Regulatory guidance hadn’t been provided by the Treasury Department until the regulations on supplemental guidance in §385(b).
The proposed regulations provide the following guidance:
- §1.385-1 grants the IRS the power to treat a related-party equity interest as indebtedness and stock in part, consistent with its substance
- §1.385-2 establishes new documentation requirements for certain related-party interests to be treated as indebtedness. This section also defines and provides supplemental guidance on expanded group indebtedness (EGI).
- §1.385-3 & 4 provide rules that treat certain related-party debt as stock for federal income tax purposes.
The proposed rules generally only apply to EGIs—an instrument where both the issuer and holder are members of the same modified expanded group. A modified expanded group is an affiliated group under §1504(a) but adopts a more stringent 50 percent ownership test—rather than the 80 percent threshold applied to expanded groups—and includes certain partnerships and other persons.
Prop. Reg. §1.385-1: Bifurcation of Related-Party Indebtedness
Prop. Reg. §1.385-1 allows the IRS to bifurcate debt instruments. The bifurcation process may result in debt partly treated as debt and partly as stock. Whether a debt instrument is subject to bifurcation treatment is determined by the objective substance of the instrument through a facts and circumstances test. For example, if an analysis of a related-party interest documented as a $5 million debt instrument demonstrates the issuer cannot reasonably expect to repay more than $3 million of the principal amount at the interest issuance, the IRS may treat the instrument as part debt and part stock, i.e., $3 million in debt and $2 million in stock. The type of stock—preferred or common—would be determined based upon the terms of the instrument. This is contrary to the original “all or nothing” approach, where a debt instrument had to be treated as fully debt or fully equity.
Prop. Reg. §1.385-2: Documentation Requirements
Pursuant to the preamble of the proposed regulations, §1.385-2 should provide “a degree of discipline in the nature of the necessary documentation, and in the conduct of financial diligence indicative of a true debtor-creditor relationship, that exceeds what is required under current law.” The purpose of these new documentation requirements is to provide the IRS with the ability to effectively analyze the character of the debt.
If the documentation requirements aren’t satisfied, the debt instrument will be treated as stock—unless the taxpayer establishes the failure was due to reasonable cause.
The following written documentation is necessary to establish a debt instrument as indebtedness under Prop. Reg. §1.385-2(b)(2):
- An unconditional obligation to pay a sum certain on demand or at one or more fixed dates
- Establishment of a creditor’s rights to enforce the obligation
- Written documentation showing a reasonable expectation of the issuer’s ability to repay the debt
- Actions evidencing an ongoing debtor-and-creditor relationship, which can include timely interest, principal payments and default actions in the event of nonpayment
The required documentation must be prepared no later than 30 calendar days after the date the debt instrument is considered held by an expanded group member. Documented evidence of a debtor-and-creditor relationship (see the last bullet above) is required no later than 120 calendar days after the payment or relevant event occurred. Documentation of the items above must be maintained for all taxable years the EGI is outstanding and until the period of limitations expires for any return where the EGI is relevant.
In case of a late payment or default, documentation would need to substantiate the creditor’s actions as reasonable, if the relationship between the parties was at arm’s length. An example would be an extension for payments, with interest applied to late payments or an attempt to renegotiate the debt terms after a reasonable exercise of diligence expected of a creditor.
Below are examples of the groups where documentation requirements apply:
- The stock of any member of the expanded group is publicly traded
- Any portion of the expanded group’s financial results is reported on financial statements with total assets exceeding $100 million
- Sec. 1.385-2(a)(2)(i) requires any portion of the expanded group’s financial results be reported on financial statements reflecting more than $50 million in total annual revenue
When an EGI ceases to be held by a member of an expanded group, its treatment will be determined under general tax principles. If general tax principles result in a character change of an instrument treated as equity under §385 to debt under general tax principles, the old instrument will be treated as if it were redeemed or exchanged for a newly issued debt instrument.
Finally, EGIs issued by disregarded entities or partnerships treated as equity under §385 are treated as if they were issued by the disregarded entity or partnership.
Prop. Reg. §1.385-2 also contains anti-abuse and no-affirmative-use rules. If a debt instrument is issued with the principal purpose of avoiding the proposed rules, the instrument will be treated as an EGI and subject to the rules articulated within this proposed regulation. Likewise, these rules wouldn’t apply if there were a failure to satisfy the requirements of this section with a principal purpose of reducing the federal tax liability of any member or members of the expanded affiliated group of the issuer.
Prop. Reg. §1.385-3: Distributions of Debt
Prop. Reg. §1.385-3 provides general rules for treating certain related-party debt instruments as stock. In a significant departure from the multifactor tests commonly used by the courts, the new rules will examine the circumstances surrounding the issuance of the debt, not the terms of the debt itself. According to the Treasury, transactions included within the scope of these new rules are designed to treat debt issuances as equity when there’s no negative nontax effect. Regarding planning, the idea is to prevent foreign-parented groups of companies from using debt to erode the U.S. tax base without a corresponding new capital investment and to limit the ability of U.S.-parented groups from using debt to repatriate low-taxed earnings and profits held by controlled foreign corporations.
The IRS preamble to the regulations has identified three general types of transactions between affiliates that raise significant policy concerns:
- Distributions of debt instruments by corporations to their related corporate shareholders
- Issuances of debt instruments by corporations in exchange for an affiliate's stock, e.g., in connection with a §304 transaction
- Certain issuances of debt instruments as consideration in an exchange pursuant to an internal asset reorganization
If a debt instrument is issued to a related party in any of the above situations, the debt instrument will instead be treated as stock, subject to certain exceptions.
In addition, Prop. Reg. §1.385-3 includes a funding rule that treats stock as an expanded group debt instrument issued with the principal purpose of funding a distribution or acquisition described in the transactions above. Whether or not this funding rule applies is based on facts and circumstances. However, the proposed regulations establish a nonrebuttable presumption whereby an EGI will be considered issued with such a principal purpose if it’s issued by the funded member during the period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution and acquisition (the 72-month period). It should be noted, the 72-month rule isn't a safe harbor. A debt instrument issued outside the 72-month period may be treated as having the principal purpose of funding a distribution or acquisition based on the facts and circumstances surrounding the transaction. There's an exception for indebtedness arising in the ordinary course of business, e.g., where a debt instrument arises in connection with the purchase of inventory or to purchase services between members of the same expanded group. However, the exception doesn’t include intercompany financing transactions.
In addition, the exceptions below also are provided in the general and funding rules of Prop. Reg. §1.385-3:
- Current-year earnings and profits (E&P) – Distributions or acquisitions that aren’t in excess of the current-year E&P of the distributing or acquiring corporation are beyond the scope of the new rules
- Threshold exception – When a debt instrument is not to be treated as stock if—when the debt is issued—the aggregate issue price of all expanded group debt instruments treated as stock doesn't exceed $50 million
- Funded acquisitions of subsidiary stock – An acquisition of expanded group stock won't be treated as an acquisition for purposes of the funding rule if:
- The acquisition results from a transfer of property by a funded member to an issuer in exchange for the issuer's stock
- And for the 36-month period following the issuance, the transferor holds—directly or indirectly—more than 50 percent of the total vote and value of the issuer's stock
A similar anti-abuse provision is provided for purposes of Prop. Reg. §1.385-3 that treats a debt instrument as stock if it’s issued with a principal purpose of avoiding application of this section.
The new regulations provide many examples of applying the rules under Prop. Reg. §1.385-3. We’ve provided a few below to illustrate:
Example 1: In year one, FS1 lends $100 to USS1 (both FS1 and USS1 are members of the same expanded group) in exchange for Note A issued by USS1. In year two, USS1 issues Note B, with a value of $100 to FP in a distribution. Under the new proposed regulations, Note B is a debt instrument that’s issued by USS1 to FP, both of which are members of the same expanded group; thus, Note B is treated as stock of USS1. In year two, the proposed regulations would then treat USS1 as distributing its own stock to FP in a distribution subject to §305. Because Note B is treated as stock under the proposed regulations, it’s not treated as property for purposes of the funding rules as it’s not considered property within §317. Accordingly, Note A isn’t treated as funding the distribution of Note B for purposes of the new rules.
Example 2: In year one, USS1 issues a note to FP in exchange for 40 percent of FS1, which is owned by FP. Since USS1 and FP are members of the expanded group, the note is treated as stock of USS1. Since USS1 and FP are not parties to a reorganization, this exchange isn’t an exempt exchange under the proposed regulations. In addition, because the note is treated as stock, it’s not property for purposes of §304, as it’s not property under §317. Therefore, USS1’s acquisition of FS1 stock isn’t an acquisition as described in §304. The note isn’t treated as indebtedness for purposes of the funding rule since the note is treated as stock for federal tax purposes when issued by USS1.
Example 3: In year one, FP lends $200 to CFC, part of FP’s expanded group, in exchange for Note A from CFC. Later that same year, CFC distributes $400 of cash to its U.S. parent. CFC is not an expatriated foreign entity, as defined in §1.7874-12T(a)(9). Under the new regulations, Note A is treated as issued with a principal purpose of funding the distribution by CFC to its U.S. parent because Note A is issued to a member of the FP expanded group during the 72-month period determined with respect to the CFC’s distribution to its U.S. parent. Accordingly, Note A is treated as stock when issued by CFC to FP in year one.
Prop. Reg. §1.385-4: Consolidated Groups
Prop. Reg. §1.385-4 provides operating rules for applying §1.385-3 where a debt instrument ceases to be a consolidated group debt instrument but continues to be an expanded group debt instrument.
The proposed regulations wouldn’t apply until they are issued in final form—and only then would they apply to all debt instruments issued on or after April 4, 2016.
Prop. Reg. §1.385-3 only would apply from the period 90 days after the adoption of the final regulations, giving taxpayers time to reverse related-party debt instruments. Similar rules apply for §1.385-4.
Concerns about the proposed regulations have been similar to those that motivated the OECD’s base erosion and profit shifting project as well as §163(j) earnings stripping rules. These new regulations promise to reach far beyond their intended targeting of inversion transactions. They would dramatically affect:
- Mergers and acquisitions
- Common corporate financing techniques
- Non-U.S.-based and U.S.-based multinational corporations
- Private equity funds and their portfolio companies
- Real estate investment trusts and their subsidiaries
Further, the documentation requirements alone present a major additional burden for larger companies. In addition, intercompany nonrecognition transactions that included the issuances of debt as “boot” may now be treated as issuances of stock. Not to mention that §304 transactions not considered stock potentially would no longer be considered property under that code section, severely limiting its application. In addition, while the funding of acquisitions of unrelated target companies may not be directly affected by these rules, pre- and post-acquisition debt pushdown strategies may be limited because they typically involve related-party issuances of debt instruments.
For smaller businesses, how will these rules apply to S corporations, limited liability companies, partnerships and foreign disregarded entities?
Due to these issues, combined with the complexity of related-party financing, it may take several years before these rules are streamlined. With broad application and increased documentation and compliance requirements, there certainly will be questions regarding proper record maintenance and the period within which companies will need to comply with those requirements. However, the U.S. government has made it clear it intends to quickly finalize the regulations. It should be assumed that the proposed regulations may be enforced before many of these questions are answered.
For more information, please contact your BKD advisor.