The New Debt-Equity Proposed Regulations "Invert" Existing Law for Related Party Debt
On April 4, 2016, proposed regulations ("Proposed Regulations") under Internal Revenue Code section 3851 were issued that generally recharacterize related party debt as equity in whole or in part for all tax purposes unless the debt represents a new capital investment or certain other exceptions apply. This approach deviates from reliance on the factors listed in section 385(b), which Congress indicated may be included in regulations under section 3852 and on the case law that has developed over the last 50 years to distinguish debt from equity.3 While the U.S. Department of the Treasury's authority to interpret section 385 in this manner may be questioned, if finalized in line with their current form, the Proposed Regulations would disrupt routine financing arrangements, including cash pooling arrangements, requiring taxpayers to undertake significant time and expense to support debt characterization and creating significant uncertainty.4 Although the Proposed Regulations were issued at the same time as proposed and temporary regulations dealing with inversions under section 7874, the Proposed Regulations are not limited to inversion transactions and will impact cross-border related party borrowings as well as purely domestic refinancings.
The Proposed Regulations are divided into four sections:
- Prop. Reg. § 1.385-1 sets forth definitions and gives the Internal Revenue Service (IRS) the authority to bifurcate a debt instrument into debt and equity components based upon "the relevant facts and circumstances";
- Prop. Reg. § 1.385-2 requires that contemporaneous documentation be prepared and maintained to substantiate related party debt;
- Prop. Reg. § 1.385-3 provides rules for treating related party debt as stock if the debt is issued in a transaction, which the Proposed Regulations list as "having only limited non-tax effect" or is used to fund such a transactions; and
- Prop. Reg. § 1.385-4 provides rules for related party debt that ceases to be between members of a consolidated group or becomes a debt between members of a consolidated group.
The scope of the Proposed Regulation is generally limited to debt instruments between members of an "expanded group" (expanded group instruments or "EGIs"). An "expanded group" means an affiliated group, as defined in section 1504, owned directly or indirectly by 80 percent vote or value, but including tax-exempt corporations, insurance companies, foreign corporations, section 936 corporations, regulated investment companies (RICs), real estate investment trusts (REITs), domestic international sales corporations (DISCs), S corporations, disregarded entities and "controlled partnerships."5 A "controlled partnership" is a partnership with respect to which at least 80 percent of the interests in partnership capital or profits are owned directly or indirectly by one or more members of an expanded group.6 The bifurcation rule, however, applies to debt instruments between members of a "modified expanded group," which is an expanded group determined by substituting 50 percent for 80 percent direct or indirect ownership.7 All members of a consolidated group are treated as one corporation, which means that the Proposed Regulations generally do not apply to these instruments between such members.8
Once an EGI is recharacterized as equity, the terms of the instrument will dictate whether the stock will be considered to be common or preferred. It seems unlikely that any purported EGI would be recharacterized as common stock of the issuer.
The Proposed Regulations provide the IRS with the authority to bifurcate a debt instruments into debt and equity components based upon "the relevant facts and circumstances concerning the EGI ... under general federal tax principles."9 As an example, the Proposed Regulations posit that a determination that only a portion of the principal amount of an EGI will be repaid would support bifurcating the instrument into debt and equity. These rules apply to instruments issued or deemed issued on or after the date the regulations are finalized.10
As a threshold matter, the Proposed Regulations generally require documentation within 30 days of the date of issuance of an EGI evidencing (1) an unconditional right to pay a sum certain, (2) creditor's rights to enforce the obligation, (3) a reasonable expectation of repayment at the time the EGI is issued and (4) actions over the term of the EGI evidencing a debtor/creditor relationship (e.g., payments of principal and interest).11 The contemporaneous documentation rules also apply to revolving credit agreements and to pooling arrangements, which are not evidenced by separate notes.12
If complete contemporaneous documentation is not kept, the EGI will be treated as stock.13 If a disregarded entity issues an EGI and contemporaneous documentation is not kept, the EGI will be treated as equity of the disregarded entity. As a result of this recharacterization, the entity would have two owners and would "spring" into classification as a partnership for U.S. federal tax purposes.14 Similarly, if a partnership issues an EGI and contemporaneous documentation is not kept, the EGI will be treated as equity in the partnership.15
Contemporaneous documentation, however, is not determinative of debt status because the IRS Commissioner may determine that an instrument is equity under general federal tax principles or other parts of the Proposed Regulations.16 In addition, the contemporaneous documentation rules cannot be used affirmatively by a taxpayer to recharacterize debt as stock.17
The contemporaneous documentation requirements apply if the stock of any member of the expanded group is publicly traded, total assets of the group exceed $100 million or annual total revenue exceeds $50 million.18 The documentation requirements are effective for EGIs issued or deemed issued on or after the date the regulations are finalized.19
Related Party Debt Characterized as Stock
Prop. Reg. § 1.385-3 generally characterizes an EGI as stock if it is issued:
- in a distribution to a related corporation;
- in exchange for expanded group stock; or
- as consideration to an acquiring corporation in an asset reorganization within the meaning of section 368(a), (c), (d), (f) or (g).
In addition, the Proposed Regulations treat an EGI as stock if it is issued with "a" principal purpose of funding a distribution or acquisition described in the general rule (a "principal purpose debt instrument").20 Unless an EGI is issued in the ordinary course of the issuer's trade or business to purchase property or services and does not exceed the amount ordinary and necessary to carry on the issuer's trade or business, a principal purpose is deemed to exist if the EGI is issued during the 36-month period before or after the issuer makes a distribution or acquisition (i.e., a six-year period).21
In contrast to the contemporaneous documentation rules under Prop. Reg. § 1.358-2, if a disregarded entity issues an EGI in a distribution, acquisition or principal purpose transaction, the instrument will be treated as stock of the owner of the disregarded entity.22 As a result, a recharacterization under Prop. Reg. § 1.358-3 does not give rise to the "springing" partnerships that can occur under the contemporaneous documentation rules. Similarly, debt of a controlled partnership that is recharacterized as equity in a distribution, acquisition or principal purpose transaction will be treated as stock of the expanded group partners.23
Although the Proposed Regulations generally apply only to instruments that are "in form" debt instruments, they also include an anti-abuse rule with a broader potential application. In particular, the Proposed Regulations provide that an instrument other than an "in form" debt instrument will be treated as an EGI if it was issued with a principal purpose of avoiding the acquisition/distribution rules.24 This anti-abuse rule also may apply to debt instruments issued to third parties who later become members of the expanded group and to entities that are not taxed as corporations.
The Proposed Regulations provide an exception for acquisitions and distributions that do not exceed current year earnings and profits.25 However, because this exception only applies to current, and not accumulated, earnings and profits, a taxpayer may not know at the time of a distribution whether EGIs issued within 36 months of the distribution would be recharacterized as equity.
A second exemption is provided for acquisitions and distributions if the total amount of EGIs does not exceed $50 million.26 Once the $50 million threshold is exceeded, the first $50 million EGI, however, may be recharacterized as equity on the date the threshold is exceeded.27
A final exception applies to an acquisition of expanded group stock if the acquisition results from a transfer of property by the funded member to the issuer of an EGI in exchange for stock of the issuer and for 36 months after the issuance, the funded member owns directly or indirectly more than 50 percent of the vote and value of the issuer.28 This exception is intended to permit transfers of property in exchange for stock in the transferee.
Unlike the other parts of the Proposed Regulations, Prop. Reg. § 1.385-3 applies to any EGI issued or deemed issued on or after April 4, 2016, although a transition rule applies for interests issued prior to the finalization date that would be treated as stock under Prop. Reg. § 1.385-3.29 Under the transition rule, such interests will be treated as indebtedness until 90 days after the finalization date, and then treated as exchanged for stock on the 90th day.30
The definition of an expanded group includes both direct and indirect 80 percent ownership of affiliates and the bifurcation rule can be applied where the issuer and holder are members of a 50 percent by vote or value controlled group with broad attribution rules. Because of the potential retroactive application of parts of the Proposed Regulations to interests issued on or after April 4 and the attribution rules for indirect ownership determinations, taxpayers should analyze all new borrowings and modifications of existing borrowings with the Proposed Regulations in mind.
The equity for all purposes rule has many collateral consequences. For example, instruments recharacterized as equity in the United States will remain debt for non-U.S. tax purposes (provided that they were debt for such purposes to begin with), creating hybrid instruments and foreign tax credit mismatches. Foreign tax credits could be lost altogether to the extent a U.S. lender is treated as owning non-voting preferred stock in a foreign subsidiary. Recharacterizing debt issued by a disregarded entity as stock under the documentation rule would result in "springing" partnerships, while recharacterizing debt issued by a disregarded entity as stock under the funding rule would result in a new and unique category of hybrid instrument. Recharacterizing debt as stock could also result in section 355(d) or (e) applying to cause gain recognition after a spin-off. In addition, a loan to a foreign corporation could cause the foreign corporation to be treated as a controlled foreign corporation during the period the loan is outstanding. The IRS is requesting comments on the Proposed Regulations by July 7, 2016, which gives taxpayers little time to analyze how the rules would impact their financing and other cash-management arrangements. Numerous comments are expected for needed clarification to the rules. For example, if an EGI is bifurcated into debt and equity, how are "interest" payments on the debt treated? If a bifurcated EGI is sold to a third party, how is the basis determined? If an EGI is recharacterized as equity, must contemporaneous documentation still be required in the event the EGI reverts back to debt?
The Proposed Regulations will likely result in the replacement of intercompany debt with third-party borrowings, thereby increasing the cost of capital for U.S. investments. This may, on the margin, impact the amount of foreign investments in the United States and invite congressional scrutiny, particularly in an election year. For U.S. based multinationals, the Proposed Regulations may complicate cash-management objectives and result in substantial inefficiencies.
The Proposed Regulations are a paradigm shift that essentially ignores related party debt unless such debt can be traced to new capital. Administration officials have stated that they intend to finalize the Proposed Regulations swiftly, and it will be interesting to see if that can be done before the upcoming election.
Please let us know if you have any questions.
1. All "section" references are to the Internal Revenue Code of 1986, as amended, (the "Code") and to the regulations (Reg. § ___) promulgated thereunder.
2. §385(b) provides:
The regulations prescribed under this section shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. The factors so set forth in the regulations may include among other factors:
(1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,
(2) whether there is subordination to or preference over any indebtedness of the corporation.
(3) the ratio of debt to equity of the corporation,
(4) whether there is convertibility into the stock of the corporation, and
(5) the relationship between holdings of stock in the corporation and holdings of the interest in question.
3. See, e.g., Fin Hay Realty Co. v. United States, 398 F.2d 694 (694) (3d Cir. 1968); Est. of Mixon v. United States, 464 F. 2d 394 (5th Cir. 1972).
4. The IRS Commissioner has suggested that the Proposed Regulations would be finalized by Labor Day 2016, stating on April 12 that "usually when there is a change of administration, major regulations aren't issued after Labor Day, so we're going to complete as much of the guidance plan as we can between now and August" and adding that "It's going to be a race to get as much of that done before" Labor Day. Brian Faler, Don't Expect any Big Tax Regulations After Labor Day, Politico Pro (April 12, 2016) [paywall].
5. Prop. Reg. § 1.385-1(b)(3).
6. Prop. Reg. § 1.385-1(b)(1).
7. Prop. Reg. § 1.385-1(b)(4), (d)(2).
8. Prop. Reg. § 1.385-1(e). Prop. Reg. § 1.385-4 provides special rules for applying Prop. Reg. § 1.385-3 when an interest ceases to be between two members of the consolidated group or becomes an interest between two members of the consolidated group.
9. Prop. Reg. § 1.385-1(d).
10. Prop. Reg. § 1.385-1(f).
11. Prop. Reg. § 1.385-2(b)(2).
12. Prop. Reg. § 1.385-2(b)(3)(iii).
13. Prop. Reg. § 1.385-2(b)(1).
14. Prop. Reg. § 1.385-2(c)(5).
15. Prop. Reg. § 1.385-2(c)(6).
16. Prop. Reg. § 1.385-2(b)(i).
17. Prop. Reg. § 1.385-2(d).
18. Prop. Reg. § 1.385-2(a)(2).
19. Prop. Reg. § 1.385-2(f).
20. Prop. Reg. § 1.385-3(b)(3).
21. Prop. Reg. § 1.385-3(b)(3)(iv)(A).
22. Prop. Reg. § 1.385-3(d)(6).
23. Prop. Reg. § 1.385-3(d)(5).
24. Prop. Reg. § 1.385-3(b)(4).
25. Prop. Reg. § 1.385-3(c)(1).
26. Prop. Reg. § 1.385-3(c)(2).
27. Prop. Reg. § 1.385-3(d)(1)(iii)
28. Prop. Reg. § 1.385-3(c)(3).
29. Prop. Reg. § 1.385-3(h)(1).
30. Prop. Reg. § 1.385-3(h)(3).
For more information, please contact the following authors:
Linda E. Carlisle, former Member
Andrew L. Howlett, firstname.lastname@example.org, 202-626-5821
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