IRS Issues Final and Temporary Regulations That Significantly Narrow the Scope of Proposed Regulations Recharacterizing Certain Related-Party Debt as Equity for U.S. Income Tax Purposes
Earlier this evening, the Internal Revenue Service (the "IRS") and the Treasury Department issued widely anticipated final regulations (the "Final Regulations") and temporary regulations (the "Temporary Regulations") that treat related-party debt as equity for U.S. tax purposes in certain circumstances. While the Final and Temporary Regulations broadly take the same approach as the debt/equity regulations that were proposed on April 4, 2016 (the "Proposed Regulations"), they have a much narrower scope.
More specifically, Treasury and the IRS issued Proposed Regulations that would in some cases recharacterize debt as equity for U.S. federal income tax purposes if such debt was held by a related party (other than a member of the issuer's consolidated group). These included (i) rules that would recharacterize such debt if it failed to meet certain documentation requirements (the "Documentation Requirements") and (ii) rules that would recharacterize such debt if it was in effect distributed, rather than issued for cash (and therefore effectively replaced equity capital) (the "Distributed Debt Rules"). The Distributed Debt Rules included a broad per se "Funding Rule" that automatically aggregated transactions, over up to a six-year period, for purposes of determining whether such a distribution had in effect occurred.
Treasury and the IRS received a large number of comments from affected taxpayers, many of which have been reflected in the Final and Temporary Regulations. As a result, the scope of the regulations has been significantly narrowed. More specifically:
- Exclusion of Foreign Issuers (Including Subsidiaries). The Documentation Requirements and Distributed Debt Rules do not apply to debt instruments issued by foreign corporations, including subsidiaries of U.S. multinationals. Instead, the Final and Temporary Regulations reserve on such instruments, and the preamble to the regulations states that Treasury and the IRS determined that the application of the regulations to foreign issuers requires further study.
Comment: This change should significantly reduce the risk and complexity of the debt-equity regulations to U.S. multinationals. Since the Final and Temporary Regulations also do not apply to indebtedness between members of a consolidated group, the Distributed Debt Rules now appear to be primarily focused on "inbound debt"--i.e., debt issued by a U.S. subsidiary to a foreign parent corporation or one of its affiliates.
- Postponement & Relaxation of Documentation Requirements. Among other changes to the Documentation Requirements in the Final Regulations, the Documentation Requirements will not apply to debt instruments issued before January 1, 2018. In addition, the required documentation generally may be prepared prior to the timely filing (including extensions) of the issuer's tax return for the relevant taxable year -- in contrast to the Proposed Regulations, which generally required compliance within 30 days of issuance. Moreover, failure to satisfy the Documentation Requirements with respect to a debt instrument will merely create a presumption that the indebtedness is equity for U.S. federal income tax purposes, rather than causing the debt to be treated as equity per se, so long as the issuer's group is otherwise "highly" compliant with the Documentation Requirements. Further, the Documentation Requirements generally will not apply to debt issued by partnerships.
- Elimination of Bifurcation Authority. The Proposed Regulations would have expressly permitted the IRS to bifurcate an instrument by treating it as partly indebtedness and partly equity for U.S. federal income tax purposes. However, the Final and Temporary Regulations eliminate such bifurcation authority. The preamble to the Final and Temporary Regulations states that bifurcation continues to be an area of further study.
- Short-Term/Cash Pooling Exception. The Temporary Regulations provide an exception to the per se Funding Rule for short-term loans among affiliates to cover cash pooling, cash sweeping and similar arrangements. In particular, the Temporary Regulations provide that certain demand deposits made with a "qualified cash pool header" (i.e., an entity principally serving a cash management function for the depositor's group) are not subject to the Funding Rule. In addition, subject to certain detailed tests in the Temporary Regulations, qualifying short-term borrowings are exempted from the Funding Rule to the extent that the issuer is not a "net borrower" from related parties for more than 270 days of the taxable year (or, alternatively, to the extent that the interest rate and aggregate outstanding balance meets certain tests reflecting that such borrowings are consistent with the funding needs of the issuer for its "normal operating cycle"). Moreover, the Temporary Regulations also exempt interest-free loans without original issue discount from the Funding Rule. Finally, under the Documentation Requirements in the Final Regulations, revolving, cash pooling and similar arrangements generally must be documented at least annually.
- Exception for Regulated Financial & Insurance Companies. The Distributed Debt Rules do not apply to debt instruments issued by "regulated financial companies" or their direct or indirect subsidiaries (other than subsidiaries engaged in a non-financial business). "Regulated financial companies" is broadly defined to include (among other things) banks and bank holding companies, U.S. intermediate holding companies of foreign banking organizations, nonbank financial companies designated by FSOC for enhanced supervision by the Federal Reserve, brokers and dealers registered under the Securities Exchange Act of 1934, futures commissions merchants and swap dealers. The Distributed Debt Rules also do not apply to debt instruments issued by qualifying "regulated insurance companies" domiciled or organized in any U.S. state or the District of Columbia.
These companies continue to be subject to the Documentation Requirements in the Final Regulations. However, the Documentation Requirements provide special rules for debt instruments issued by regulated financial companies with terms required by a regulator to satisfy regulatory capital or similar requirements. Such instruments generally will be deemed to meet the Documentation Requirements notwithstanding the special terms.
Comment: Because the Documentation Requirements appear to include strict requirements for documenting the right to an unconditional return of principal and other so-called creditors' rights, this provision appears to indicate some willingness to respect the characterization of such instruments as debt for tax purposes notwithstanding the required presence of terms that could be viewed as "equity features." The preamble to the Final and Temporary Regulations states that additional guidance addressing such instruments is under consideration.
- RICs, REITs & S Corporations. The Final and Temporary Regulations do not apply to groups parented by RICs or REITs. However, RICs and REITs may continue to be subject to the Final and Temporary Regulations if they are subsidiaries of a common parent that is not a RIC or a REIT. S corporations are exempted from the Final and Temporary Regulations entirely.
- Modifications to Six-Year Per Se Rule. The Final and Temporary Regulations generally retain the per se rule. However, the regulations generally broaden relevant exceptions particularly by:
- Netting of Distributions and Contributions- Allowing distributions to be netted against capital contributions;
- Post-April 4, 2016 Accumulated Earnings Exception - Replacing an exception for distributions and acquisitions not in excess of current earnings with an exception generally based on earnings accumulated from taxable years including April 4, 2016 and thereafter; and
- Ordinary Course/Employee Compensation Plan Exceptions- Expanding exceptions for ordinary course transactions, including certain acquisitions of stock in connection with employee compensation plans.
- Effective Date of Distributed Debt Rules. The Distributed Debt Rules generally will still apply to debt instruments issued after April 4, 2016, except that a debt instrument generally will not be recharacterized as equity under the Distributed Debt Rules until 90 days after October 21, 2016 (when the Final and Temporary Regulations are intended to be published in the Federal Register). For debt instruments issued on or before October 12, 2016, the Final Regulations contain a grandfathering rule generally permitting the Distributed Debt Rules in the Proposed Regulations to be applied in lieu of those in the Final and Temporary Regulations, subject to certain consistency requirements.
A more detailed memorandum explaining the Final and Temporary Regulations will be forthcoming. In the meantime, questions regarding the Final Regulations may be directed to any member of the Tax Group. Contact information is available on the final page of this memorandum.