On October 13, 2016, the Treasury Department finalized highly controversial regulations under Section 385 of the Internal Revenue Code that recharacterize certain debt between related parties as equity for federal income tax purposes. The final regulations retain the same basic architecture as they were proposed in April, but add several exceptions that significantly scale back their scope, at the cost of increased complexity. The final regulations also eliminate one of the proposed regulations’ three recharacterization rules and delay the effective date of another. Given the strong resistance to the Regulations from the tax and business communities, it would not be surprising if they were rescinded under the incoming administration.
The regulations apply to debt between members of an “expanded group,” which generally is a group of corporations at least 80% (by vote or value) of whose interests (other than equity of the parent member) is owned, directly or through attribution, by other group members. In an effort to reduce the potential overbreadth of expanded groups, the final regulations modify the attribution rules as originally proposed such that (i) an entity will not be attributed stock owned by its equity holders, (ii) there is no attribution between family members and (iii) stock is attributed to an option holder only if exercise is reasonably certain.
The regulations do not apply to debt between members of a group that file a consolidated tax return. The final regulations also exclude from their scope debt issued by foreign persons and S corporations, and by regulated investment companies (RICs) and real estate investment trusts (REITs) that are not controlled by expanded group members.
The Bifurcation Rule
The characterization of an instrument as debt or equity is based on a multitude of common law factors. Courts and the IRS have historically treated the instrument as one or the other based on such factors, but not as a hybrid. The proposed regulations granted the IRS the ability to bifurcate a debt instrument and treat it as part debt and part equity if warranted under general federal tax principles. The final regulations deleted this rule, which had attracted much criticism, in large part due to the uncertainty it created.
The Documentation Rule
The regulations set forth documentation requirements that must be met in order for a debt instrument between members of an expanded group to be treated as debt for federal income tax purposes (subject to reasonable cause and ministerial error exceptions, as well as an anti-avoidance rule).
The documentation requirements apply if (i) the stock of any member of the expanded group is publicly traded or (ii) all or any portion of the financial results of an expanded group member is reported on (a) financial statements filed with the SEC or provided to another governmental agency, or (b) certified audited financial statements prepared for a substantial non-tax purpose (such as reporting to shareholders or creditors), in each case showing total assets exceeding $100 million or total revenue exceeding $50 million.
The taxpayer must document the following (special rules apply with respect to documentation of revolvers, master agreements and cash pooling or similar agreements):
- a binding obligation to repay the funds advanced;
- creditors’ rights to enforce the terms of the debt;
- a reasonable expectation that the debt will be repaid; and
- actions evidencing an ongoing genuine debtor-creditor relationship (e.g., (i) timely payment, or (ii) the holder’s reasonable exercise of the diligence and judgment of a creditor following a default).
The required documentation must be prepared prior to the due date of the tax return (with extensions) for (i) the year in which the instrument is issued (or, if later, in which it becomes subject to the documentation requirements), with respect to the first three items (the proposed regulations had required that such documentation be prepared within 30 days of the instrument’s issuance) and (ii) the year of a payment or the occurrence of a relevant event, with respect to the fourth item (the proposed regulations had required documentation of this factor within 120 days of the payment or relevant event).
The regulations do not require that the taxpayer furnish the documents to anyone once they are prepared. Furthermore, meeting these documentation requirements does not guarantee that the instrument will be respected as debt, though the four factors that must be documented are given greater weight than other factors in analyzing the instrument’s proper tax characterization. However, if the documentation is not properly maintained or is not provided to the IRS upon request, the instrument automatically will be treated as equity unless the taxpayer can establish that it is otherwise “highly compliant” (as defined) with the documentation requirements. In that event, a failure to comply creates only a rebuttable presumption of equity treatment.
The documentation rule applies to debt instruments issued on or after January 1, 2018 (as opposed to the date the regulations were finalized, as was proposed). The delayed effective date and the extended date by which the documentation must be prepared mean that taxpayers generally will not be required to first document applicable debt instruments until the latter part of 2019, rather than, in effect, immediately, as had been proposed.
The Distribution Rule
The regulations provide that debt held by a member of an expanded group will be treated as equity if the debt is issued by a group member as follows:
- in a distribution;
- in exchange for stock of an expanded group member (other than in an exempt exchange);
- in exchange for property in certain asset reorganizations.
Debt issued or held by a partnership controlled by a group member generally is treated for these purposes as proportionately issued or held by such group member, and any resulting recharacterized debt instrument issued by such a controlled partnership is treated as an equity interest in such group member, rather than in the partnership.
In addition to the basic distribution rule, debt issued to an expanded group member in exchange for cash or other property is recharacterized as equity if it is issued for the principal purpose of funding a distribution or acquisition of the types described above (the funding rule). Although the determination of whether the debt was issued with such a principal purpose is based on all of the facts and circumstances, under a per se rule a debt instrument will be so treated if it is issued within 36 months before or after the date of the acquisition or distribution and does not arise in the ordinary course of the issuer’s trade or business.
The per se funding rule is without doubt the most controversial aspect of the regulations. In response to strong criticism by the tax and business communities, Treasury expanded certain exceptions provided in the proposed regulations and established several others, including the following:
- Earnings and profits. The rule does not apply to the extent the applicable debt instrument does not exceed earnings and profits accumulated in years ending on or after April 5, 2016. (In the proposed form, the exception would have been limited to current year earnings and profits, not accumulated earnings and profits.)
- Dollar threshold. A debt instrument will not be treated as equity under this rule to the extent that, when the debt is issued, the aggregate adjusted issue price of all expanded group debt instruments that would be treated as equity under this rule, including the newly issued debt, does not exceed $50 million. Once the $50 million threshold is surpassed, only the amount by which such debt exceeds $50 million is recharacterized (unlike the proposed regulations, which applied a cliff rule).
- Funded acquisitions of subsidiary stock. An acquisition of expanded group stock will not be subject to this rule if the acquirer member (i) immediately after the transfer owns more than 50% by vote and value of the group member that sold such stock and (ii) does not relinquish such control pursuant to a plan that existed on the acquisition date (a rebuttable presumption of such a plan exists if control is relinquished within 36 months of the acquisition date).
- Netting. Distributions (and acquisitions) by an expanded group member are not subject to the rule to the extent of the fair market value of stock issued by such member to other group members (or to partnerships controlled by a group member) in exchange for the contribution of cash or property (other than stock of a member and certain other excluded property).
- Other exceptions. The regulations also provide exceptions for, inter alia, (i) debt held or issued by a securities dealer in the ordinary course of business, (ii) short-term debt instruments, (iii) cash pooling arrangements and (iv) debt issued by certain regulated financial companies and regulated insurance companies.
The distribution (and funding) rule applies to debt issued on or after April 4, 2016, but (absent a taxpayer election to the contrary) will not result in such debt being treated as equity until January 20, 2017 (at which time the debt instrument will be deemed exchanged for equity with the consequences described below).
Effect of recharacterization. If a debt instrument that upon initial issuance is treated as debt but is subsequently recharacterized as equity under the regulations (for example, a debt instrument that is issued to an unrelated person is acquired by an expanded group member), then (i) the holder is treated as receiving in satisfaction of the debt an amount equal to the holder’s adjusted tax basis and (ii) the issuer is treated as satisfying the debt for an amount equal to the instrument’s adjusted issue price. A debt instrument that is recharacterized as equity under the regulations that is then transferred outside of the expanded group is treated as newly issued with an issue price equal to its stated redemption price at maturity (or discounted by the applicable federal rate if the instrument does not provide for adequate stated interest). As a result of the deemed new issuance rule, the debt instrument may not be fungible with other debt that would otherwise be of the same issue.
Consistency. While a holder of an instrument generally need not conform to the issuer’s treatment of the instrument as either debt or equity (provided the holder discloses the inconsistent treatment on its tax return), if the holder and issuer are members of an expanded group, the holder must treat as debt any instrument that is in form debt or that is treated as debt by the issuer (and not otherwise recharacterized as stock).
State tax implications. One area of continuing uncertainty is how states will apply the documentation and distribution rules, though the final regulations attempted to address this to some extent. In particular, while the regulations do not apply to debt between members of a consolidated group, it is not clear whether states will apply the rules to such members if they do not file on a combined or similar basis for state purposes. Conversely, it is not clear how states would apply the rules to debt between corporations that file on a combined or similar basis for state purposes but are not part of a federal consolidated group.
The regulations are complex and taxpayers will need to be mindful of them when dealing with intercompany debt. In particular, the per se funding rule, as well as the potential broad reach of corporations included in an expanded group, could cause inadvertent recharacterizations without the taxpayer’s knowledge.