The U.S. Treasury Department issued new proposed tax regulations that would re-characterize certain related party debt as equity, resulting in dividend payments rather than tax deductible interest payments. If finalized in their current form, in some circumstances retroactively to April 4, 2016, the regulations will affect a wide range of related party transactions including common corporate finance operations such as ordinary course type cash pooling arrangements, group structuring transactions as simple as dividends and as complex as mergers and spin-offs, and even certain routine third party financing transactions. These rules also contain strict new documentation requirements for related party debt.
Under the proposed new rules, related party debt issued on or after April 4 to members of an “expanded group” (companies connected by a common parent that directly or indirectly owns at least 80% of the vote or value of each member of the expanded group) will be re-characterized as equity in the following situations:
- Debt is issued in a distribution with respect to stock;
- Debt is exchanged for stock of an expanded group member, with certain exceptions;
- Debt is exchanged for property in an asset reorganization, with certain exceptions;
- Debt is issued within the 36-month period before, or the 36-month period after, any of the foregoing transactions to any other member of the expanded group.
After the regulations are finalized, related party debt must be timely documented and substantiated. Among other things, (i) the debt must be evidenced by a written unconditional obligation to pay sum certain; (ii) the holder must have rights to enforce the debt; and (iii) there must be documentary evidence of a reasonable expectation of the debtor’s ability to repay the debt. Without such documentation, these related party debts described by the regulations generally will be re-characterized as equity, resulting in denied interest expense deductions and potential dividend income.
There are certain safe harbors that may allow a company to avoid the application of these regulations to these related party debt obligations:
- Total amount of intercompany debt subject to re-characterization under these regulations does not exceed $50 million;
- Any debt subject to re-characterization is paid off within 90 days after the regulations are finalized;
- Distributions triggering a re-characterization do not exceed current year earnings and profits;
- Debt is issued in the ordinary course of business in connection with a purchase of property or services and does not exceed balances ordinary and necessary for the business.