Recently proposed Treasury regulations under IRC § 385 (the Proposed Regulations) would create sweeping changes to the federal income tax treatment of related-party debt. The Proposed Regulations could also have far-reaching effects for state income tax purposes, particularly on the deductibility of intercompany interest expenses in separate company reporting states.
Background: Proposed Federal Tax Changes
The Proposed Regulations would reclassify certain debt between related corporations as equity for federal income tax purposes in a manner that reflects a significant departure from the existing federal debt-equity rules. Treatment of related-party debt as equity could result in adverse U.S. income tax consequences, including the loss of interest deductions.
The Proposed Regulations reaffirm the application of existing debt-equity principles in the U.S. federal income tax context, and impose additional requirements for related party debt:
- New documentation rules require that taxpayers prepare and maintain certain contemporaneous documents to support related-party debt (e.g., loan documents, analyses of the debtor’s ability to repay the debt, ongoing payments), and if these rules are not met, the debt is reclassified as equity;
- Even where documentation requirements are satisfied, related-party debt nonetheless will be classified as equity if it is issued in connection with certain transactions, including distributions (e.g., note dividends), internal asset reorganizations under IRC §§ 368 (a)(1)(A), (C), (D), (F) or (G), and stock sales; and
- The IRS has the authority to bifurcate related-party debt so that it is classified as part equity and part debt, a departure from the “all-or-nothing” rule that generally has applied in this area.
The first and third rules would apply prospectively after the Proposed Regulations are finalized. The second rule, which characterizes debt instruments issued in connection with certain specific transactions as equity for U.S. federal income tax purposes, would apply to debt issued on or after April 4, 2016 that is still outstanding 90 days after the Proposed Regulations are finalized. Treasury officials have publicly stated that this rule was intended to prevent taxpayers from making a race to the exit on the targeted transactions.
The Proposed Regulations apply to all debt between related parties, whether the parties are U.S. or foreign. However, the Proposed Regulations treat all members of a U.S. federal income tax consolidated group as a single person, thereby effectively excluding related-party debt between members of a single federal consolidated group from the scope of the rules.
For additional details regarding Proposed Regulations, see Sutherland’s prior Legal Alert.
Potential Implications for State Income Taxes
The Proposed Regulations are likely to impact state income taxes, particularly over the long term. Any increase in a taxpayer’s federal taxable income resulting from the IRS’s application of the Proposed Regulations (e.g., reduced interest expense deductions on debt to foreign affiliates, or increased income from characterization of principal repayments as dividends) may have an associated state tax cost, because states generally adopt federal taxable income as the starting point for calculating the state tax base.
Separate Reporting States
Perhaps more concerning, however, is the potential that separate company reporting states (i.e., states that do not adopt consolidated returns or similar rules) might seek to apply the Proposed Regulations as a tool to disallow interest deductions on intercompany debt. Publicly-traded taxpayers often put in place intercompany debt obligations between related parties to distribute third-party debt among those companies that benefit from it. States could seek to use their IRC conformity laws to argue that the Proposed Regulations also apply for state income tax purposes, as many states adopt most or all of the IRC through varying mechanisms. States often conform to IRS regulations, either explicitly or implicitly, that are issued under IRC provisions to which they conform.
The Proposed Regulations do not apply, on their face, to debt between members of a single federal consolidated group. However, separate company reporting states routinely apply the IRC and relevant IRS regulations “as if” each corporation had filed a separate federal tax return. If states were to apply this approach to the Proposed Regulations, states could potentially argue that the Proposed Regulations provide authority to reclassify intercompany debt as equity and thereby deny the related interest expense deductions.
Sutherland Observation: Taxpayers may question a state’s authority to apply the Proposed Regulations, or the principles underlying them, to seek to deny a taxpayer’s interest expense incurred on intercompany debt. Even if state tax law technically incorporated the IRC provision under which the Proposed Regulations were issued (IRC § 385), states do not universally adopt IRS regulations. This is particularly true for IRS regulations issued under provisions of the IRC that authorize the issuance of Treasury regulations rather than provide substantive rules (e.g., federal consolidated return regulations issued under IRC § 1502 are not wholly adopted in many states, such as Georgia).
Regardless of the IRC conformity issues raised by the Proposed Regulations, the IRS’s action may have other effects on state income taxes. State taxing authorities, for example, might follow the path taken by the IRS in the Proposed Regulations by seeking to adopt their own comparable regulations under other state law authority.
Sutherland Observation: While some states (e.g., Massachusetts) have sought to apply debt-equity principles from federal case law to challenge intercompany interest expenses, such challenges have not been widespread. It remains to be seen whether the Proposed Regulations will generate a renewed interest in these types of challenges at the state level.
Add Back Statutes
Many state legislatures have addressed the circumstances under which intercompany interest expenses should be deductible for state income tax purposes through the adoption of related party interest expense add back statutes. These statutes generally requires interest deductions to be “added back” if the interest is paid to a related party, unless the taxpayer qualifies for an exception to the add back statute.
In theory, even where the add back statute does not apply, states could attempt to deny an interest expense deduction by applying the Proposed Regulations to treat the debt as equity. For example, states with an add back statute that only applies to interest related to intangible assets (e.g., Tennessee) could assert that the Proposed Regulations authorize them to deny non-intangible-related interest deductions that are otherwise not subject to add back. Even in states with broad related party interest expense add back statutes (e.g., New Jersey), the state could try and use the Proposed Regulations to deny an interest deduction where an exception to the add back statute otherwise applies.
Any potential application of the Proposed Regulations by a state that has adopted an add back statute will be met with a compelling argument that the state’s legislature has selected its statutory treatment of related-party interest, and such treatment should trump conformity to a federal tax regulation.
Sutherland Observation: If the Proposed Regulations did apply, the consequences of reclassifying debt as equity may be similar but different than expense disallowance under an add back statute or under a state’s IRC § 482-like powers. The interest expense may be lost in both scenarios, but if the debt is recast as equity, the interest payments may be considered a dividend, which could be eligible for a dividend-received deduction for the recipient. There could also be differences in the apportionment consequences, such as if the interest income were removed from the recipient’s sales factor in an expense disallowance scenario but included where the debt were instead treated as equity.
Combined/Consolidated Reporting States
While the Proposed Regulations have the greatest potential impact in separate company reporting states, they could also impact taxpayers in states that require combined or consolidated reporting. Characterization of debt as equity could change the composition of the combined/consolidated group by changing the ownership percentages of subsidiaries. For example, a domestic subsidiary that has debt with a foreign affiliate may have its foreign ownership increased as a result of the characterization of debt as equity to a point where the subsidiary no longer satisfies the common ownership requirements for filing a combined/consolidated return. In addition, many of the same issues that could arise in the context of the separate reporting states (see above, e.g., interest expense disallowance) could also arise in combined/consolidated reporting states where either the debtor or creditor entity is not included in a state’s combined/consolidated group.
If a state that imposes a net-worth-based franchise tax (e.g., Louisiana) reclassified debt as equity for state income tax purposes, an issue could also arise regarding whether the reclassification carries over from income to franchise tax purposes. Net-worth-based franchise taxes generally include equity in the tax base but exclude debt.
Sutherland Observation: It may be unclear whether a reclassification for income tax purposes would affect a franchise tax based on GAAP book values. Some states also have separate statutory or regulatory franchise tax rules that specify bright-line circumstances under which intercompany debt is reclassified for purposes of the state’s franchise tax base (e.g., Louisiana, Tennessee).