While the transfer pricing issues associated with tangible goods, services and intangible property have garnered the lion’s share of attention from the IRS, related-party transactions involving financial transactions, such as intercompany loans, have begun to draw increasing interest from the IRS. Due to IRS concerns that foreign multinational enterprises (MNEs) are using intercompany debt transactions to base erode the profits of their U.S. subsidiaries, foreign investors now frequently face greater scrutiny on their loans to their U.S. subsidiaries.
To support their intercompany interest payments’ deductibility, foreign MNEs with U.S. subsidiaries should remain knowledgeable about and compliant with the U.S. rules governing intercompany loans—especially with the new intercompany debt rules.
U.S. Regulatory Framework
The U.S. Internal Revenue Code (IRC) Section 163(j), Interest: Limitation on Deduction for Interest on Certain Indebtedness, IRC §385, Treatment of Certain Interests in Corporations as Stock or Indebtedness, and Treasury Regulation §1.482-2, Determination of Taxable Income in Specific Situations, contain key rules concerning intercompany loans. Section 163(j) contains rules designed to combat thin capitalization and earning stripping. Section 385 contains rules that dictate whether a direct or indirect interest in a related corporation is treated as stock, indebtedness or a combination thereof. Finally, §1.482-2 contains rules that determine the appropriateness of interest rates on the principal amount of bona fide indebtedness between related parties.
Section 163(j) was enacted by the Omnibus Budget Reconciliation Act of 1989. Otherwise known as the “thin cap rules,” §163(j)’s purpose is to limit the deductibility of interest by a thinly capitalized corporation where interest is paid to a related payee totally or partially exempt from U.S. tax on the distribution. These rules were enacted to inhibit perceived erosion of the U.S. tax base through interest expense deductions.
For §163(j) to apply, a U.S. corporation/branch of a foreign corporation must make interest payments to a related person or third party, i.e., third-party bank. If there’s a qualified guarantee of the debt, the payee, i.e., foreign corporation, must be exempt from U.S. tax on some portion of the income, the net interest expense most exceed 50 percent of adjusted taxable income for the tax year and the entity must have a debt-to-equity ratio of greater than 1.5 to 1.0 (determined on the last day of the entity’s taxable year). If these elements are satisfied, disqualified interest paid or accrued in the current tax year by the U.S. corporation/branch will be disallowed to the extent the entity has excess interest expense for the current tax year.
On April 4, 2016, the IRS and Treasury Department issued proposed regulations under §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 thereof. The primary objective of the proposed regulations is to target corporate inversions as well as curb related party attempts to use debt instruments as a method to shift U.S. source earnings, through interest deductions, into low tax jurisdictions outside the United States.
Section 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 thereof. This section generally applies to expanded group indebtedness (EGI), which are instruments where both the issuer and holder are members of the same modified expanded group. For purposes of §385, modified expanded groups are the same as an affiliated group under §1504(d); however, it adopts a more stringent 50 percent ownership test (rather than the 80 percent threshold commonly applied to expanded groups).
The IRS has identified three primary 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 stock of an affiliate, 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.
Proposed Reg. §1.385-1 provides the IRS with the ability to bifurcate debt instruments, which may result in debt partly treated as debt and as stock. A debt instrument being subject to bifurcation treatment is determined by applying a facts and circumstances test.
The proposed regulations also include certain additional documentation requirements as they relate to EGI. Taxpayers 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 are not satisfied, absent reasonable cause, the debt instrument will be treated as stock.
The following written documentation is necessary to establish a debt instrument as indebtedness under §1.385-2(b)(2):
- An unconditional obligation to pay a sum certain on demand or at one or more fixed dates
- Creation of a creditor’s right to enforce the obligation
- Written documentation showing a reasonable expectation of the issuer’s ability to repay the debt
- Actions evident of an ongoing debtor-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-creditor relationship (see the last bullet above) is required no later than 120 calendar days after the payment or relevant event occurred.
The documentation requirements apply to expanded groups where:
- The stock of any member of the expanded group is publicly traded
- Any portion of the expanded group’s financial results are reported on financial statements with total assets exceeding $100 million
- Section 1.385-2(a)(2)(i) requires any portion of the expanded group’s financial results to be reported on financial statements reflecting more than $50 million in total annual revenue
Section 1.385-3 contains a funding rule that treats certain related-party debt instruments as stock issued with a principal purpose of funding a distribution or acquisition (or, in particular, one of the three policy concern transactions provided above).
This section also includes certain exceptions to §385 application, which include:
- Current-year earnings and profits: Distributions or acquisitions that aren’t in excess of current-year exploration and production of the distributing or acquiring corporation are beyond the scope of §385.
- Threshold exception: The aggregate issue price of all expanded group debt instruments does not exceed $50 million.
- Funding acquisitions of subsidiary stock: An acquisition of expanded group stock will not be treated as an acquisition for purposes of the funding rule if the acquisition results from a property transfered by a funded member to an issuer in exchange for stock of the issuer and for a 36-month period following issuance, the transferor holds more than 50 percent of the total vote and value of the issuer stock.
The proposed regulations will not apply until issued in final form. Once in final form, the proposed regulation will apply to debt instruments issued on or after April 4, 2016.
Treasury Regulation §1.482-2 provides the framework for evaluating the arm’s-length nature of intercompany loans, specifically the rate of interest charged on intercompany loans. Section 1.482-2 determines the appropriateness of the rate of interest charged on the principal amount of bona fide indebtedness between related parties. There are three alternatives to documenting intercompany interest rates:
- Applicable Federal Rate (AFR) Safe Haven – Safe haven for bona fide debt between members of a group of controlled entities provided the following conditions are met: the loan must be denominated in U.S. dollars, lender must not be in the trade or business of making loans to unrelated parties at the time the loan is made and the situs of the borrower rule does not apply. Under the safe harbor, an arm’s-length range of interest ranges from 100 percent to 130 percent of the appropriate AFR, i.e., short, medium or long-term.
- Situs of the Borrower Rule – The situs of the borrower rule provides that if the loan represents the proceeds of the loan obtained by the lender at the situs of the borrower, an arm’s-length rate is equal to the rate actually paid by the lender plus an amount that reflects the costs incurred by the lender in borrowing such amounts and making such loans, unless the taxpayer establishes a more appropriate rate.
- Arm’s-Length Market-Based Pricing of Interest – Outside of the AFR safe haven and situs of the borrower rule, there are no specific methods to evaluate an arm’s-length interest rate. The general rule is that an arm’s-length interest rate shall be an interest rate that was charged—or would have been charged–at the time the indebtedness arose, in independent transactions with or between unrelated parties under similar circumstances and that “all relevant factors shall be considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.”
As with the transfer pricing of other types of intercompany transactions, the selection of a transfer pricing method for evaluating the arm’s-length nature of related-party loans should be based on the specific facts and circumstances and the availability of reliable data to benchmark the transactions. Taxpayers should document their intercompany transfer pricing policies in a transfer pricing study.
Practical Implications for Foreign Investors
The abovementioned U.S. regulations create several challenges for foreign investors with respect to intercompany loans:
- Foreign investors with loans to their U.S. affiliates must closely monitor their interest expense to adjusted taxable income and debt-to-equity financial ratios so they don’t run afoul of the intercompany interest expense deduction rules of §163(j). Failure to comply with the §163(j) standards may result in some or all of the taxpayer’s intercompany interest deduction being disallowed.
- As a result of §1.385, foreign investors must certify the bona fide nature of their intercompany debt arrangements through formal documentation. Specifically, taxpayers must provide evidence of the intercompany borrower’s unconditional obligation to repay the borrowed funds at a specified date(s) or on demand, ability to repay the debt and timely principal and interest payments (or default actions, in the case of nonpayment), consistent with third-party financing arrangements. Failure to do so may result in the IRS recharacterizing all or a portion of the debt as equity, which would have the doubly detrimental impact of eliminating interest expense deductions and creating a withholding requirement on the former interest expense payments that have now been recharacterized by the IRS as dividend payments.
- Lastly, foreign investors’ interest rates charged in their intercompany loan agreements must be arm’s-length in nature, as outlined in §1.482. Taxpayers should use one of the methods discussed above to support and document the arm’s-length nature of their intercompany interest payments, i.e., interest safe harbor rates, situs of borrower or market-based interest rate. For intercompany loans with a fixed interest rate, the taxpayer generally only would need to establish the arm’s-length nature of the intercompany interest rate at the loan’s inception. For loans with variable interest rates, however, the interest rates should be evaluated on an annual basis so interest rates charged are consistent with current arm’s-length interest rates under one of the aforementioned. In all cases, we would recommend the preparation of transfer pricing documentation to support the arm’s-length nature of foreign investors’ intercompany financing arrangements.
Given the more robust regulatory environment in the U.S. concerning related-party loans, we would encourage foreign investors with intercompany loans to closely monitor and document their intercompany loan arrangements.
For more information, please contact your BKD advisor.