On Oct. 13, 2016, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final and temporary regulations under Section 385 governing the treatment of certain instruments as debt or equity for tax purposes. These regulations reflect major changes to the proposed regulations that were issued in April 2016. The changes will significantly reduce the adverse collateral consequences and traps with which the proposed regulations were fraught. The final regulations are much better tailored to the underlying policy goal of limiting stripping of the U.S. federal corporate income tax base through debt instruments between related parties. In large part – subject to future guidance, as many of the changes were “reserved” – the regulations will only impact domestic corporate issuers of debt to related holders that are outside the consolidated group.
Several of the most important changes under, or aspects of, the final and temporary regulations include:
- The exemption of debt instruments issued by foreign persons from the documentation rules and the transactional rules;
- The deferral of the implementation of the documentation rules and relaxation of the timing for documentation to the due date of the tax return for the year;
- The elimination of the bifurcation rule;
- The retention of the framework of the documentation rules and the transactional rules from the proposed regulations, including the application of the rules to only large corporate taxpayers;
- The retention of the exemption of debt instruments between members of a consolidated group from the documentations rules and the transactional rules; and
- The exceptions to the so-called funding rule for certain debt instruments that are short term, issued in the ordinary course of business, or issued pursuant to cash pooling arrangements.
Although the final and temporary regulations are much narrower in scope than the proposed regulations, they retain the general framework of the documentation rules and transactional rules from the proposed regulations. Many large corporate taxpayers will need to understand and comply with these rules. Despite the fact that the final and temporary regulations target earnings stripping by foreign-parented multinational companies, they apply neutrally and can apply to U.S.-parented multinational companies as well.
For taxpayers that are covered, the additional compliance burden of the documentation rules, and potential consequences of noncompliance, could be significant. Failure to comply with the documentation rules, subject to certain exceptions for foot faults, will result in equity characterization; compliance with the documentation rules alone, however, will not ensure that a debt instrument will be respected as debt. Common law factors and the potential application of the transactional rules still must be considered.
The transactional rules remain exceedingly complex and unforgiving if they apply. They must be added to the checklist of potential tax issues in any transactions involving debt instruments between related parties.
Background: Proposed Regulations
The proposed regulations included a bifurcation rule, documentation rules, and transactional rules. The documentation rules and transactional rules apply only to large corporate taxpayers, whereas the bifurcation rule would have applied more broadly, including to certain small or non-corporate taxpayers.
Bifurcation rule. The bifurcation rule would have granted the IRS the right to bifurcate a debt instrument as part-debt and part-equity in certain circumstances.
Documentation rules. The documentation rules establish certain documentation and procedural requirements relating to debt instruments between related parties, and allow the IRS to treat debt instruments as equity if the requirements are not satisfied. They also clarify the factors to be considered in distinguishing between debt and equity in certain circumstances.
Transactional rules. The transactional rules automatically treat debt instruments between related parties as equity in specified circumstances. The rules are aimed at situations in which, viewed economically, the capital of the issuer of a debt instrument is not increased. The paradigmatic covered transaction is a distribution by the corporate issuer of a debt instrument to a shareholder. The other covered transactions are economically comparable to that basic transaction. The transactional rules also include broad anti-abuse rules.
Overall Changes in Final and Temporary Regulations
The most significant overall changes in the final regulations are:
Exemption of Foreign Issuers. The final regulations, including the documentation rules and the transactional rules, do not cover debt instruments issued by foreign persons. This exemption applies exclusively based on whether the issuer is a foreign person and does not depend on the identity of the holder. Thus, as an example, a debt instrument issued by a controlled foreign corporation (CFC) to a related CFC or related domestic corporation will not be subject to the final regulations. This carve-out is extraordinarily important – it drastically will reduce the number of debt instruments covered and will obviate some of the most troubling aspects of the transactional rules as they had been proposed. This exception, combined with the general exemption of debt instruments between members of a consolidated group, means that the final regulations will apply primarily to debt instruments issued by domestic corporations to related foreign corporations, or between related domestic corporations outside of the consolidated group context. The change also limits the additional compliance burden of tax due diligence in acquisitions of groups with foreign corporations.
Elimination of Bifurcation Rule. The final regulations do not include the bifurcation rule. The bifurcation rule in the proposed regulations would have applied to debt instruments between members of a modified expanded group, a concept that was more expansive than that of an expanded group, on which the documentation rules and transactional rules were based. The bifurcation rule was vexing because, among other reasons, the proposed regulations provided minimal guidance on the circumstances in which it would have been applied, and how it would have been applied. Treasury and the IRS did not include the bifurcation rule in the final regulations, indicating that they will continue to study it.
Exemption of S Corps and certain RICs and REITs. The final regulations exempt S corporations and certain regulated investment companies (RICs) and real estate investment trusts (REITs) (if the RIC or REIT is the parent of the group) from both the documentation rules and the transactional rules.
Changes to Documentation Rules
The most significant changes to the documentation rules in the final regulations are:
Deferral of date by which documentation must be completed. The proposed regulations would have required a taxpayer to satisfy certain of the documentation requirements within 30 days of the issuance or other relevant event. This would have imposed a highly challenging ongoing compliance burden. Under the final regulations, the documentation and financial analysis for a year must be completed by the due date for the tax return for that year, taking into account any extensions. This change accords with the timing requirements for preparing transfer pricing documentation and will reduce the risk of unintentional failures to comply.
Deferral of effective date of documentation rules. Under the proposed regulations, the documentation rules would have been effective for debt instruments issued on or after the date that the final regulations were published. The final regulations, however, defer the effective date, so that the documentation rules will apply to debt instruments issued on or after Jan. 1, 2018. This deferral, combined with the deferral of the date by which the documentation must be prepared, means that a taxpayer will first need to complete documentation by the due date for its tax return for its taxable year that includes Jan. 1, 2018. This change affords taxpayers more time to establish the necessary documentation processes and systems.
Provision of substantial compliance exception for failures to satisfy documentation requirements. The proposed regulations would have included only a limited exception for reasonable cause; otherwise, the IRS automatically would have treated a debt instrument as equity if the documentation requirements were not satisfied. The final regulations retain a reasonable cause exception and introduce a new rebuttable presumption if the expanded group substantially complies with the documentation requirements. If the expanded group satisfies certain objective tests demonstrating substantial compliance, a documentation failure with respect to a debt instrument will not automatically cause it to be treated as equity. Rather, the debt instrument will be presumed to be equity, and the presumption may be rebutted with clear evidence that the instrument is debt under traditional debt-equity factors.
Avoidance of “springing” partnerships. Under the proposed regulations, if a debt instrument issued by a disregarded entity were treated as equity, the disregarded entity could have become classified as a partnership – the existence of a second regarded equity owner would have caused the partnership to spring into being. The final regulations avoid this result, deeming the equity to be issued by the owner of the disregarded entity.
Changes to Transactional Rules
The most significant changes to the transactional rules in the final and temporary regulations are:
Exceptions to funding rule for certain debt instruments that are short term, issued in ordinary course of business, or issued pursuant to cash pooling arrangements. The proposed regulations did not include an exception for cash pooling arrangements, an aspect that was heavily criticized, instead providing only an exception for certain debt instruments issued in the ordinary course of business. The temporary regulations fold the proposed regulations’ exception for debt issued in the ordinary course of business into a new, broader exception to the funding rule (not to the general rule and not to the documentation rules). The new exception covers:
- certain short-term funding arrangements satisfying one of two alternative objective tests between which a corporation must elect, one of which is based on the corporation’s need for short-term financing, and the other of which is based on certain day-counts;
- debt instruments issued as consideration for purchases of property in the ordinary course of business;
- certain interest-free loans; and
- deposits made pursuant to certain cash pooling arrangements.
The final regulations also exempt certain debt instruments issued for stock of members of the expanded group used as compensation for employees or contractors and certain debt instruments established in connection with transfer pricing adjustments. The exception for cash pooling arrangements involves technical requirements – as a practical matter, however, the exemption for debt instruments issued by foreign persons and the general exemption for debt instruments between members of a consolidated group might exempt some cash pooling arrangements completely. This is because a cash pooling arrangement involving only foreign persons or only members of a consolidated group likely will not trigger the documentation rules or transactional rules, and it is common for multinational companies to use separate cash pooling arrangements for domestic and foreign affiliates for other tax reasons, particularly avoiding Subpart F inclusions under Section 956.
Exemption of certain regulated financial institutions and insurance companies from the transactional rules. The final regulations provide a new exception to the transactional rules for debt instruments issued by certain regulated financial institutions, members of regulated financial groups, and regulated insurance companies.
Expansion of exception based on earnings and profits (E&P). The proposed regulations would have provided an annual exception under the transactional rules up to the current-year E&P of the relevant corporation. The final regulations expand the exception to apply in any year up to the E&P of the corporation accumulated in taxable years ending on or after April 5, 2016. This benefit comes at the cost of added complexity in tracking the eligible E&P.
Elimination of "cliff effect" for under $50 million threshold exception. Under the proposed regulations, the transactional rules would not have applied if the aggregate amount of the debt instruments that otherwise would have been recast as equity under the transactional rules did not exceed $50 million. If, however, the $50 million threshold would have been exceeded, the exception would not have applied at all. The final regulations eliminate this cliff effect, providing that the exception will apply up to the first $50 million of debt instruments that otherwise would be recast as equity, regardless of whether the threshold is exceeded.
Expansion of 90-day deferral. Under the proposed regulations, any debt instruments issued on or after the date the proposed regulations were issued but before the publication of final regulations would not have been recast as equity under the transactional rules until 90 days after the publication of the final regulations. This would have provided a limited period during which taxpayers could have cleaned up problematic debt instruments. The final regulations retain the 90-day grace period, and expand its scope to apply to any debt instrument that is issued within 90 days after the date that the final regulations are published.
In the aggregate, these changes better align the documentation rules and transactional rules with the policy behind the regulations. They make it far less likely that taxpayers will inadvertently trip into the rules, and the potential adverse collateral consequences are mitigated.
Nonetheless, the final and temporary regulations will apply to many corporate groups, and it will be necessary for taxpayers to determine whether any of their debt instruments or practices will be covered. Taxpayers should first clean up any problematic debt instruments and then put in place policies to comply with or, if possible, avoid the final and temporary regulations.
Several of the new carve-outs, including the elimination of the bifurcation rule and the exemption of debt instruments issued by foreign persons, are “reserved.” Treasury and the IRS continue to study these issues. They have indicated, however, that any additional rules on these issues will apply prospectively.