The U.S. Treasury Department has very recently and unexpectedly released significant guidance that promises, if finalized, to fundamentally limit the circumstances under which related corporations (and, in some cases, partnerships) can issue debt to each other (“Proposed Debt Regulations”). The proposed rules would apply in both wholly domestic and U.S.-to-foreign circumstances, and must be carefully considered by all corporate groups that fall within their expansive reach. The Treasury has announced that it intends to move swiftly to finalize the Proposed Debt Regulations that, in many cases, would have a retroactive effective date of April 4, 2016.
By way of background, capitalization structures using debt can provide important tax benefits, as they can reduce the debtor entity’s tax burden through the creation of deductions, avoid dividend withholding taxes on transfers of principal that might otherwise be deemed dividends, and generally facilitate the movement of cash, stock, and assets. The Treasury has had a perennial concern that purported debt is actually disguised equity. While the United States has “earnings stripping rules” (and the Organization of Economic Cooperation and Development’s Final Reports on “Base Erosion and Profit Shifting,” issued in October 2015, proposed significant enhancements to those rules – both in the United States and around the world), it has also historically tried to argue for recharacterization of debt as equity under an array of sometimes inconsistent judicial rulings and multi-factored tests. The U.S. tax authorities have suffered some significant litigation losses in this area in recent years.
Given this background, the Proposed Debt Regulations will, if finalized, dramatically change the playing field in favor of the Treasury by enhancing and increasing the circumstances wherein the U.S. tax authorities will successfully be able to recast debt as equity. Where such recasts occur, interest deductions will be denied, withholding tax results may change, and the equity composition of purported issuers of debt will change (which may have significant results under various other U.S. tax rules contingent upon ownership tests, such as the U.S. anti-deferral rules). The effects will be particularly dramatic for foreign investors in the United States, because the resulting recharacterization will produce conflicts and potential double taxation vis-a-vis the tax laws of their jurisdictions of residence.
The Proposed Debt Regulations would introduce three categories of new rules:
Rule 1 – Automatic Equity Characterization Rule
- What it is. Under this rule, debt would be automatically recharacterized as equity for U.S. federal income tax purposes in four circumstances:
- A corporation’s distribution of a debt instrument to a related corporate shareholder
- A corporation’s issuance of a debt instrument to a related corporate shareholder in exchange for affiliate stock
- A corporation’s issuance of a debt instrument to a related corporate shareholder as consideration in an exchange pursuant to an internal asset reorganization
- A corporation’s issuance of a debt instrument to a related corporate shareholder in a transaction engaged in with “a principal purpose” to “fund” (i) a distribution of cash or other property to a related corporate shareholder; (ii) an acquisition of affiliate stock from an affiliate; or (iii) acquisitions of property from an affiliate pursuant to an internal asset reorganization. Any debt instrument issued during the period beginning 36 months before the relevant corporation makes a distribution or acquisition, and ending 36 months after the distribution or acquisition, would be treated as per se equity.
Certain narrow exceptions to the Automatic Equity Characterization Rule have been proposed, but taxpayers can anticipate limited relief from such exceptions. Broad anti-abuse rules are also embedded in the rule.
- Who it affects. This rule, it must be stressed, only would apply to related parties that are members of an “expanded group.” An “expanded group” would include U.S. and foreign corporations, tax-exempt corporations, life insurance companies, and corporations held through partnerships so long as 80 percent of the vote or value of the relevant entities’ stock (rather than vote and value) is owned by expanded group members. Complex attribution rules would apply. Importantly, U.S. corporate groups (which do not include foreign affiliates, among other entities) that file consolidated federal income tax returns would be exempt from these rules, but might become subject to the rules as members join or leave the consolidated group.
- When it is applicable. The Automatic Equity Characterization Rule would apply to any debt instrument issued on or after April 4, 2016. Additionally, the Automatic Equity Characterization Rule would apply to any applicable instrument treated as issued as a result of an entity classification election under, e.g., a “check-the-box election,” made on or after April 4, 2016. A transition rule, however, would provide affected taxpayers with 90 days following finalization of the rule during which they might eliminate the debt instrument prior to its permanent recast as equity.
- Observations. The potential impact of the Automatic Equity Characterization Rule cannot be overstated. If finalized, it will eliminate numerous commonplace related party lending transactions. It will also severely inhibit standard intercompany stock and corporate reorganizations, at least those in which debt would have typically been utilized. The rule can apply in wholly domestic circumstances, but will certainly have dramatic, negative effects upon foreign corporate investors into the United States.
Rule 2 – New Documentation Requirements
- What it is. In order to enhance its ability to audit and analyze purported debt issuances, the Treasury has proposed that a member of an expanded group that issues an instrument to another member must timely prepare and maintain written documentation and information establishing:
- A legally binding obligation to pay a sum certain on demand or at one or more fixed dates,
- That the instrument’s holder has typical creditor’s rights to enforce payment;
- A reasonable expectation of repayment at the time that the debt instrument is created, the documentation for which may include cash flow projections, financial statements, business forecasts, asset appraisals, and determinations of debt-to-equity and other relevant financial ratios of the issuer (compared with industry averages), and other information regarding the sources of funds that would enable the issuer to meet its obligations under the instrument; and
- Post-issuance, evidence of an ongoing relationship during the life of the debt instrument consistent with arm’s-length relationships between unrelated debtors and creditors (e.g., evidence of timely payments of principal and interest or, conversely, evidence of the holder’s reasonable exercise of the diligence and judgment of a creditor where one or more defaults or similar events occur).
- Who it affects. Importantly, the New Documentation Requirements would apply only to expanded groups where:
- The stock of any member of the expanded group is publicly traded
- All or any portion of the expanded group’s financial results are reported on financial statements with total assets exceeding $100 million, or
- The expanded group’s financial results are reported on financial statements that reflect annual total revenue exceeding $50 million
It should be observed that, for the purposes of the document requirements, a person can be an issuer if that person is expected to satisfy a material obligation under an instrument, even if that person is not the primary obligor. A guarantor, however, is not an issuer unless the guarantor is expected to be the primary obligor.
- When it is applicable. The New Documentation Requirements have been proposed to be effective only for debt instruments issued on or after the date that the regulations are published in final form, as well as to any applicable instrument treated as indebtedness issued or deemed issued before the date of finalization, if and to the extent it was deemed issued as a result of an entity classification election that is filed on or after the date of finalization.
- Observations. The New Documentation Requirements would impose significant documentation and compliance burdens on large expanded groups. The Treasury itself acknowledges this in its Preamble to the Proposed Debt Regulations. Very importantly, however, compliance with the New Documentation Requirements is not sufficient to guarantee debt treatment of an instrument; compliance is merely a threshold requirement and taxpayers must still be prepared to validate debt characterization through the application of the traditional judicial multi-factored tests (which the Treasury has taken no steps to rationalize or clarify).
Rule 3 – Instrument Bifurcation Rule
- What it is. The Instrument Bifurcation Rule empowers the Treasury to treat an instrument as indebtedness in part and as stock in part, based on the “relevant facts and circumstances.”
- Who it affects. Importantly, while this rule, too, applies only to instruments issued among members of an “expanded group,” the threshold for relatedness for the purposes of this rule is reduced from 80 percent to merely 50 percent.
- When it is applicable. The Instrument Bifurcation Rule have been proposed to be effective only for debt instruments issued on or after the date that the regulations are published in final form, as well as to any applicable instrument treated as indebtedness issued or deemed issued before the date of finalization, if and to the extent it was deemed issued as a result of an entity classification election that is filed on or after the date of finalization.
- Observations. This rule, while simple on its face, should enhance the Treasury’s ability to successfully characterize at least a portion of certain instruments as equity, rather than debt. This, in turn, may improve the Treasury’s success rate in challenging instruments in the courts (which have traditionally taken an “all or nothing” approach) and, thus, correspondingly embolden the Treasury on audit.