On October 13, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued final and temporary regulations under section 385 (T.D. 9790). As summarized in our prior update, the scope of the final regulations is reduced in several important and helpful respects as compared to the proposed regulations issued in April 2016. Significantly, while the proposed regulations applied to all debt, whether issued by a US or foreign person, the regulations “reserve on all aspects of their application to foreign issuers,” thus avoiding the significant compliance burdens and numerous negative collateral tax consequences that would have resulted under the broader scope of the proposed regulations.
This alert describes how the foreign issuer exclusion is implemented in the final and temporary regulations, explains Treasury and the IRS’s stated reasoning for reserving on the topic of foreign issuers, and comments on the practical implications of the exclusion in the short-term and the long-term.
Implementation of the Foreign Issuer Exclusion in the Regulations
From a technical standpoint, the foreign issuer exclusion is achieved by creating a new term, “covered member,” which is defined as a member of an “expanded group” that is a domestic corporation (Treas. Reg. § 1.385-1(c)(2)). The final and temporary regulations reserve on the inclusion of foreign corporations within the definition of a covered member. In other words, foreign issuers currently are not treated as covered members. As a result, they are not subject to the documentation rules (Treas. Reg. § 1.385-2), which apply to expanded group instruments (EGIs) issued by a covered member or by a disregarded entity that has a regarded owner that is a covered member. The automatic recharacterization rules (Treas. Reg. § 1.385-3) also only apply to debt instruments issued by a covered member of an expanded group to another member of the same expanded group (where such instrument is issued in a distribution; an exchange for the stock of a member of the expanded group (other than in an exempt exchange); or in exchange for property in an asset reorganization).
Rationale for the Foreign Issuer Exclusion
Treasury and the IRS received numerous comments expressing concern regarding the application of the proposed rules to foreign borrowers, including with respect to compliance burdens and potential negative collateral consequences of recharacterization, such as the loss of foreign tax credits and failure to satisfy treaty limitation on benefits requirements. Some commentators also argued that the proposed regulations ran counter to the goal of Action Item 2 (“Neutralize the effects of hybrid mismatch arrangements”) under the Organization for Economic Cooperation and Development’s (OECD) base erosion and profit shifting (BEPS) action plan. Several commentators recommended a “foreign-to-foreign” exception for debt issued by a foreign person to another foreign person.
As explained in the preamble to the regulations, the final and temporary regulations reserve on their application with respect to debt issued by foreign persons, regardless of whether the debt is issued to a US person or a foreign person, “due to the potential complexity and collateral consequences of applying the regulations in this context where the U.S. tax implications are less direct and of a different nature.” As explained in the preamble, “[n]on-U.S. issuers [of debt] have limited incentives to mischaracterize equity as debt under the U.S. tax system because non-U.S. debt does not generally affect U.S. corporate liability directly either because (i) the issuer is entirely foreign owned (and thus generally outside of the U.S. tax system if it lacks a U.S. presence) or, (ii) in the case of an issuer that is a CFC [controlled foreign corporation], its income is eligible for deferral.” As a result of this carve out for foreign issuers of debt, the final regulations generally target inbound debt, thus more narrowly carrying out a major policy justification set forth by Treasury and the IRS for implementing the rules in the first place—namely, to restrict the practice of “earnings stripping,” particularly in the case of inverted companies.
Even if, for the time being, Treasury and the IRS have decided to reserve on the topic of the application of the final regulations to foreign issuers, there are a number of reasons why foreign issuers could be impacted by the final regulations—both in the short and long terms. In the short term, the documentation rules may be viewed as “best practices” for key debt instruments issued by foreign persons, even if the rules are not technically applicable. Where respecting an instrument as debt is critical to the intended tax consequences of a transaction, taxpayers should strive to document the instrument consistent with the final regulations.
In the long term, there is no guarantee that the foreign issuer exclusion will endure. As the preamble to the regulations states, Treasury and the IRS “continue to consider how the burdens of complying [in the context of foreign issuers] compare to the advantages of limiting potential abuses and how a better balance might be achieved.” In light of Treasury and the IRS’s decision to merely “reserve” on the issue, taxpayers should remain mindful that future administrations could choose to cut back or even eliminate the foreign issuer exception. Taxpayers that could be affected by future guidance should consider submitting comments on the foreign issuer exclusion, including reiterating the compliance burdens that would arise from applying the documentation and automatic recharacterization rules to foreign debt. In the preamble to the regulations, the government specifically requested comments on (i) the application of the final and temporary regulations to foreign issuers and (ii) the application of the recharacterization rules to US branches of foreign issuers. Comments on the proposed regulations are due January 19, 2017. The preamble states that any future guidance to apply the regulations to foreign issuers will apply prospectively.
Further, by reserving on the treatment of foreign issuers, the final regulations do not target certain repatriation strategies using foreign-issued debt that would have been significantly curtailed under the broader scope of the proposed regulations. The preamble to the proposed regulations expressed a concern regarding “distortive results” obtained by US-parented groups by using debt “to create interest deductions that reduce the earnings and profits of CFCs and to facilitate the repatriation of untaxed earnings without recognizing dividend income.” Taxpayers should not interpret the narrower scope of the final regulations as the government’s retreat from challenging repatriation strategies, either under existing law or future guidance, that the government deems abusive.