On April 4, 2016, the U.S. Department of the Treasury and Internal Revenue Service (IRS) issued two sets of regulations, temporary regulations addressing “inversion” transactions and proposed regulations regarding the treatment of intra-group debt.
The temporary inversion regulations generally are consistent with prior anti-inversion guidance in Notice 2014-52 and Notice 2015-79, although several new provisions were added, including a three-year look-back rule addressing “serial” inversions, which appears to have derailed the previously announced Pfizer/Allergan inversion transaction. The temporary inversion regulations and anti-earnings-stripping aspect of the proposed intra-group debt regulations reflect an aggressive move by Treasury and the IRS to quell the inversion phenomenon—it is hard to imagine a bolder regulatory response, absent legislation.
This remainder of this alert focuses exclusively on the proposed intra-group debt regulations, which if finalized would represent a sea change in the taxation of debt and equity, would fundamentally alter “inbound” international tax planning, and would change the tax treatment of common intra-group transactions.
Simply put, the proposed regulations are of extraordinary importance and would profoundly alter the tax-planning landscape. Related-party debt and unrelated-party debt would become governed by two completely different tax regimes, and it would be far more likely that intra-group debt would be treated as equity for tax purposes.
The proposed regulations would be broadly applicable. Although one of the purposes of the proposed regulations is to limit the ability of inverted U.S. corporations and other foreign-parented groups to strip earnings out of the United States, the proposed regulations are not limited to inversion transactions. They would provide the IRS new tools for challenging the tax treatment of intra-group debt and would impose strict documentation requirements on taxpayers, which would carry substantive consequences if they were not satisfied.
If a debt instrument were to be treated as stock under the proposed regulations, the direct and collateral tax consequences of the transaction would be completely changed. The issuer would be denied interest expense deductions, the holder would be treated as having an equity interest in the issuer for all tax purposes, and the purported interest payments potentially would be treated as dividends (and therefore potentially subject to higher withholding taxes). These are just a few of the potential adverse tax results—the proposed regulations present innumerable potential traps for the unadvised.
The proposed regulations have three main parts: (i) rules permitting the IRS to bifurcate an intra-group debt instrument into a part-debt, part-equity instrument, (ii) documentation rules which, if not satisfied by a taxpayer, would treat intra-group debt as equity, and (iii) rules that would automatically treat intra-group debt as equity in specified transactions. Each of these component parts is summarized below.
As an important exception, these rules would not apply to debt between members of a U.S. consolidated group, presumably because such debt does not raise tax policy concerns. The rules would apply, however, to debt between U.S. and foreign group members, and would apply to both foreign-parented and U.S.-parented groups.
IRS Ability to Bifurcate Debt Instruments
The proposed regulations would permit the IRS to treat an intra-group debt partially as debt and partially as equity. This would reverse existing case law, which generally precludes bifurcation and requires an instrument to be treated as all-debt or all-equity.
The proposed regulations provide minimal guidance regarding the circumstances in which the IRS may exercise this authority. They include an example in which the IRS is permitted to bifurcate a debt instrument because the issuer is expected to be able to repay only a portion of the principal amount of the debt. The proposed regulations do not grant taxpayers authority to bifurcate an instrument affirmatively, although this is not fully clear.
If this bifurcation rule were implemented, it would create uncertainty as to the treatment of instruments within its scope. Given the lack of case law on bifurcation, additional guidance regarding the circumstances in which bifurcation would be permitted and how the analysis would be performed would be needed. The bifurcation rule would apply prospectively to debt issued on or after the date that Treasury and the IRS promulgated final regulations.
The proposed regulations would introduce stringent contemporaneous documentation requirements (and corresponding compliance costs) for intra-group debt. Subject to a limited exception for reasonable cause, if the documentation requirements were not satisfied, the debt automatically would be treated as equity. A taxpayer would be required to provide the documentation to the IRS upon request—thus, these rules would introduce significant new compliance burdens.
The required documentation would relate to four areas that are relevant to the characterization of the instrument as debt or equity. The required documentation would include copies of all relevant instruments and related agreements, as well as written documentation establishing that:
- The issuer had an unconditional and legally binding obligation to pay a sum certain on demand or on one or more fixed dates.
- The holder had the rights of a creditor to enforce the obligation, typically including, but not limited to, the right to accelerate the repayment obligation if the issuer failed to make a payment, the right to sue to enforce payment, and rights to the assets of the issuer that are superior to those of the issuer’s shareholders.
- As of the date of issuance, based on the issuer’s financial position, it was reasonable to expect that the issuer would be able to satisfy its obligations under the debt instrument.
- If the issuer failed to make any payments, the holder’s actions were consistent with it being a creditor, including asserting its rights, renegotiating the terms of the debt, mitigating the default, and enforcing the payments.
Additional documentation would be required for revolving credit facilities, open accounts, and cash pooling arrangements.
The required documentation would need to be prepared close in time to the issuance (or when the debt first became subject to the documentation rules) and would need to be updated, if necessary, over the term of the debt. Note that this timing requirement is more stringent that the timing requirement for transfer pricing documentation, which generally must be prepared by the time the relevant tax return is filed. The documentation would need to be maintained during the term of the debt and until the period of assessment expired for any tax return for which the treatment of the debt was relevant.
There would be some limitations on the scope of the documentation rules, as they would apply to a debt instrument only if the stock of any member of the group was publicly traded or the total assets or revenue of the group on any applicable financial statement for the preceding three years exceeded $100 million or $50 million, respectively. Thus, the rules are aimed at relatively large taxpayers. Like the bifurcation rule, the documentation rules would apply prospectively to debt issued on or after the date that Treasury and the IRS issued final regulations.
Debt Treated as Equity in Specified Transaction
Finally, the proposed regulations would automatically treat intra-group debt issued in specified transactions as equity, regardless of whether the terms of the instrument indicated that it should be respected as debt under a traditional debt-equity analysis. These per se stock rules are the most far reaching in the proposed regulations: they have the feel of anti-abuse rules but apply broadly. This automatic treatment as equity under the proposed regulations would supplant decades of case law that has distinguished between debt and equity based on specified factors, albeit applying heightened scrutiny to instruments between related parties.
The per se stock rules would limit the ability of inverted U.S. corporations and other foreign-parented groups to strip earnings out of the United States and would also change the tax treatment of common intra-group transactions. If the rules are finalized, it will be essential that taxpayers understand these rules inside and out and add them to the tax-checklist for any significant internal transactions that in any way involve debt. Arguably, they are the most important regulatory tax rules for internal transactions to be proposed since the check-the-box entity classification rules.
The proposed regulations generally would treat intra-group debt as equity if the debt was issued:
- In a distribution, such as a dividend.
- To purchase stock of a member of the group.
- In exchange for property in an asset reorganization if a member of the group received the debt in a distribution pursuant to the reorganization.
In effect, the proposed regulations target intra-group transactions in which debt is issued without providing new capital to the purported borrower.
Broad anti-abuse rules would apply, including a rule that automatically would treat any debt issued within three years, either before or after, of a specified transaction as equity. These anti-abuse rules would introduce extraordinary complexity and would necessitate close monitoring of all intra-group transactions, even those that do not involve debt.
There would be several important exceptions. First, as noted above, the per se stock rules would not apply to debt between members of a U.S. consolidated group. Second, they would not apply to certain debt issued for property or services in the ordinary course of business. Third, they would not apply to distributions or acquisitions by a group member to the extent of the group member’s current-year earnings and profits. Finally, they would not apply if the aggregate intra-group debt that otherwise would be treated as equity under the per se stock rules did not exceed $50 million.
The nuances of the per se stock rules are beyond the scope of this alert. It suffices to say, however, they would cover common intra-group transactions such as transactions that otherwise would be subject to section 304 or otherwise would be “cash D reorganizations,” and would recast distributions of notes as stock distributions subject to section 305. If the per se stock rules applied to a debt instrument, the nature of the deemed equity would depend on the terms of the debt. Presumably, most debt would be treated as preferred stock, and potentially “nonqualified preferred stock,” which could give rise to unexpected and adverse tax consequences.
If finalized, the per se stock rules, unlike the bifurcation rule and documentation rules, would have a retroactive aspect. They would apply to debt issued, and transactions entered into, on or after April 4, 2016, the date the proposed regulations were filed for public inspection in the federal register. A taxpayer-friendly transition rule would be provided, however, such that even though the per se stock rules would apply to debt issued and transactions entered into before Treasury and the IRS issue final regulations, they would not actually treat such debt as converting into equity until 90 days after the final regulations are issued. This would give taxpayers a small window of time in which they could restructure such debt to avoid adverse tax consequences of its conversion into stock.