On October 13, 2016, the U.S. Treasury Department and IRS issued final and temporary regulations within Internal Revenue Code (IRC) Section 385. These regulations are the most recent in a series of actions taken by the Treasury and IRS to curb earnings stripping and inversion transactions by U.S. multinational corporations. After considerable commentary attacking the proposed regulations, the Treasury and IRS made a number of significant changes. These changes minimize complexity, reduce administrative burdens and significantly narrow the scope of targeted transactions.
Removal of the Bifurcation Rule
One of the most notable differences to the final and temporary regulations is the elimination of the bifurcation rule. The proposed regulations would have permitted the IRS to bifurcate a debt instrument into a combination of debt and equity, depending upon each case’s facts. Removal of the bifurcation rule will result in a reversal of the debt versus equity classification as an “all or nothing” analysis that will adhere to the common law traditions previously relied upon by both the IRS and taxpayers. However, the preamble states the IRS will continue to study this issue.
Exception for Debt Issued by Foreign Corporations, S Corporations, Noncontrolled Regulated Investment Companies & Real Estate Investment Trusts
The final and temporary regulations apply only to debt issued by domestic corporations to foreign corporations that are part of the domestic corporation’s expanded group. This more narrow scope significantly reduces the effect of these regulations. The definition of expanded group (EG) for purposes of the regulations continues to be based on concepts similar to those outlined in §1504(a). These changes mean that debt issued by foreign corporations, S corps, most regulated investment companies and partnerships where at least 80 percent of the capital/profits interests are owned directly or indirectly by EG members isn’t subject to the final and temporary regulations. Direct or indirect ownership is generally determined pursuant to the attribution rules set forth in §318. Consistent with the proposed regulations, all members of a consolidated group are treated as a single corporation.
Relaxation of Burden of Proof & Extension of the Due Dates for the Documentation Rules
The documentation rules contained within the final and temporary regulations require a covered member to have created written documentation evidencing a binding obligation to pay; the holder has creditor’s rights to enforce the obligation, reasonable expectation or repayment and evidence consistent with a true debtor-creditor relationship. While the final and temporary regulations retain the general rule that an expanded group instrument (EGI) is treated as stock if certain documentation requirements aren’t met, such documentation requirements have been significantly liberalized within Treasury Regulation §§1.385-2.
The final and temporary rules altered the timing and implementation of the documentation rules contained within the proposed §385 regulations. Treas. Reg. §§1.385-2 requires documentation of an EGI to be completed no later than the issuer’s timely filed U.S. tax return (including extensions) for the year the EGI was issued or in which a “relevant date” occurs. This replaces the 30- and 120-day compliance periods under the proposed regulations. The implementation period also has been delayed for EGIs issued on or after January 1, 2018.
The final and temporary regulations also relax the rebuttable presumption rule. The proposed regulations provide that an EGI failing to meet the documentation requirements (that was considered an undocumented EGI) would be automatically treated as stock. The final and temporary regulations narrowed this rule, providing that members of an EG with a high degree of compliance will have the opportunity to rebut the presumption that the EGI will be presumed as stock by clearly establishing sufficient common law factors to treat the EGI as indebtedness. To demonstrate a high degree of compliance, the EG must meet one of these tests:
- The aggregate adjusted issue price of undocumented EGIs at the end of each quarter is less than 10 percent of the aggregate adjusted issue price of all outstanding EGIs
- No undocumented EGI has an issue price greater than $100 million, and at the end of each quarter, less than 5 percent of all EGIs are undocumented
- No undocumented EGI has an issue price greater than $25 million, and at the end of each quarter, less than 10 percent of all EGIs are undocumented
Treatment of Debt Issued by a Disregarded Entity
As it relates to disregarded entities, the final and temporary regulations provide that if an obligation of a disregarded entity owned by a corporate member of an expanded group is treated as stock due to failure to comply with the documentation requirements, the stock is treated as having been issued by the corporate owner—a result that contrasts with the proposed regulations, where the disregarded entity would have become a partnership for tax purposes. The result contrasting with the proposed regulations is undesirable due to potential gain triggering and other adverse tax consequences. Under the final and temporary regulations, the stock deemed as owner-issued will be treated as having identical terms to the EGI issued to the disregarded entity. As it relates to the per se rules, to the extent the owner of the disregarded entity is a controlled partnership, the controlled partnership rules will apply as if the partnership were the debt instrument issuer.
Exception for Cash Management Arrangements & Short-Term Financing
One of the primary concerns raised by taxpayers regarding the proposed regulations was their potential effect on cash pooling and other short-term financing arrangements. In response, the final and temporary regulations provide exemptions whereby a debt instrument will be excluded from the funding rule as a qualified short-term debt instrument if one of these exceptions applies:
- Cash pooling: These are demand deposits received by a qualified cash pool header pursuant to a cash management arrangement. A qualified cash pool header includes any expanded group member, controlled partnership or qualified business unit (QBU)—described in §1.989(a)-1(b)(2)(ii)—that has its principal purpose as managing cash-management arrangements for participating expanded group members, provided that the excess of funds on deposit with such expanded group member, controlled partnership or QBU (header) over the outstanding balance of loans made by the header is maintained on the books and records of the header in the form of cash or cash equivalents, or invested through deposits with, or the acquisition of obligations or portfolio securities of, persons that don’t have a relationship with the header. The term cash management means an arrangement whose principal purpose is to manage cash for participating expanded group members.
- Current Assets Test: This is when debt instruments having interest rates less than or equal to the typical arm’s-length rate and, after issuance, the issuer’s outstanding balance of expanded group debt doesn’t exceed the noncash current assets reasonably expected to be reflected on the issuer’s balance sheet, which result from ordinary-course business transactions during the 90-day period or the issuer’s normal operating cycle, whichever is longer.
- 270-Day Test: This is when debt instruments have a term of 270 days or less, bearing an arm’s-length interest rate, and the issuer isn’t a net borrower (1) for more than 270 days during its taxable year or consecutive days during consecutive tax years or (2) from any other expanded group member that would otherwise meet the other requirements of the 270-day test.
- Ordinary Course Loans: Debt instruments issued to acquire property (other than money) in the ordinary course of the issuer’s trade or business, which is reasonably expected to be repaid within 120 days of issuance.
- Interest-Free Loans: These are debt instruments that don’t provide for stated interest or don’t have interest charged on the instrument, original issue discount or imputed interest under §§483 or 7872 or the interest isn’t required to be charged with §482.
Exceptions to the E&P Shield, Funding & Per Se Rules
Within the general rule, a debt instrument issued between EG members is treated as equity if issued in a distribution either:
- In exchange for stock of an EG member, or
- In exchange for property in an asset reorganization (subject to various exceptions)
Transactions addressed pursuant to the general rule are commonly used by inverted companies as interest-stripping mechanisms. The funding rule expands on the general rule by treating covered debt instruments issued to an EG member as equity to the extent it funds a distribution or acquisition. The final and temporary regulations kept the per se funding rule intact, thus any debt instrument issued by a funded member within a 72-month period, i.e., the period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution and acquisition, is treated as having been issued to fund a distribution or acquisition and therefore treated as equity. The per se rule continues not to be considered a safe harbor, since 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.
To reduce the per se rule’s harshness, the final and temporary regulations expanded the original exceptions contained within the proposed regulations, i.e., current-year earnings and profits (E&P), funded acquisition and threshold exceptions, and introduced these new exceptions:
- Current-Year E&P Exception: The final and temporary regulations take into account a corporation’s E&P accumulated after April 4, 2016, as opposed to limiting distributions to the E&P amount generated in the current year.
- Funded Acquisition Exception: The final and temporary regulations don’t consider qualified short-term debt to be a covered debt instrument. Qualified short-term debt generally includes short-term funding arrangements that meet:
- Either a specified current asset or 270-day test
- Ordinary course loans issued as consideration for property acquisition in the ordinary course of the issuer’s trade or business that are expected to be repaid within 120 days of issuance
- Interest-free loans that don’t provide for stated interest, original issue discount, imputed interest or subject to a required interest charge within §482
- Deposits with a qualified cash pool header
- Threshold Exception: The final and temporary regulations removed the cliff effect—all taxpayers can exclude the first $50 million of indebtedness that otherwise would have been recharacterized.
The newly adopted exceptions to the per se rule found within the final and temporary regulations include:
- Debt issued to/acquired by securities dealers (in their ordinary course of business), banks and insurance companies
- Debt instruments won’t be recharacterized to the extent an EG member has contributed qualified property to the issuer within three years before and three years after the date of any distribution or acquisition. Qualified property commonly includes any property (other than EG stock), covered debt instruments and certain other excluded property provided in Treas. Reg. 1.385-3(c)(3)(ii)(D).
- Distributions of EG stock to compensate service providers, including employees, directors or independent contractors
The final and temporary regulations have updated the effective dates of the §385 requirements. In general, the final and proposed regulations apply to taxable years ending on or after January 19, 2017, with respect to debt instruments issued after April 4, 2016. Additional updates include:
- Per se stock rules only apply to debt instruments issued after April 4, 2016, and only as it relates to taxable years ending on or after January 19, 2017.
- The 72-month testing period as it relates to the per se funding rule only applies to distributions and acquisitions occurring after April 4, 2016.
- Documentation rules only apply to EGIs issued beginning after January 1, 2018 (as mentioned above).
- Taxpayers may elect to apply the proposed regulations to debt instruments after April 4, 2016 (but before October 13, 2016) only as it relates to determining whether a debt instrument is treated as stock. For this to apply, it’s necessary that the proposed regulations consistently apply.
Contact your BKD advisor if you have questions.