Monday, as part of the Obama administration’s announcement of a crackdown on inversions and the release of temporary regulations aimed at tightening the inversion rules (a separate Osler Update on which will be forthcoming), the U.S. Treasury issued proposed regulations that would dramatically change the taxation of corporate debt issued to related corporations having nothing to do with inversions or foreign acquisitions. Most significantly, the regulations impose new rules under which certain purported related-party debt instruments are deemed to be equity for U.S. federal tax purposes. These new rules have evoked a groundswell of both praise and criticism.
In addition, the regulations (i) authorize the IRS to treat certain related-party interests in a corporation as indebtedness in part and stock in part for U.S. federal tax purposes, and (ii) establish documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for U.S. federal tax purposes.
These proposed regulations would be a fundamental shift in how U.S. debt/equity analysis is performed and dramatically increase the risk of having debt re-characterized as equity for U.S. tax purposes. Because certain of these rules have retroactive effect to April 4, 2016, Canadian corporations financing their U.S. subsidiaries with debt (whether that debt is used to finance an acquisition, finance growth or expansion in the U.S. market, or for any other reason) should immediately begin analyzing the potential effect of these rules on their operations.
The proposed regulations apply to related party debt without regard to whether the parties are domestic or foreign, but generally do not apply to transactions among members of a U.S. consolidated group.
Deemed equity treatment for certain related party debt
Under these regulations, debt issued by a corporation is treated as equity for all U.S. federal tax purposes if the debt is not issued for cash or property, but is instead (i) issued in a distribution to a related corporate shareholder, (ii) issued in exchange for stock of a member of the same affiliated group or (iii) issued in an asset reorganization between members of the same affiliated group. An affiliated group for these purposes is generally a group of corporations (including non-U.S. corporations) in which 80 percent of the vote or value of the stock of each member is owned directly or indirectly by other members of the affiliated group. Thus, a note distributed from a U.S. subsidiary to its foreign parent in order to “right-size” the subsidiary’s capital structure will no longer produce the intended tax consequences.
More broadly, corporate debt issued to a related party for cash or property is generally treated as equity if it is issued with a principal purpose of funding (i) a distribution of cash or property on stock held by another member of the affiliated group, (ii) an acquisition of stock of an affiliated group member, or (iii) an acquisition of property from an affiliated group member in an asset reorganization. A debt instrument may be treated as having such a principal purpose regardless of whether it is issued before or after the distribution or acquisition in question.
This “principal purpose” test is subject to an extremely broad, non-rebuttable presumption of a principal purpose to fund a transaction described above if the debt instrument is issued during the period beginning 36 months before a distribution or acquisition described above and ending 36 months after such a distribution or acquisition. There is an exception from the presumption for certain debt instruments that arise in the ordinary course of the issuer’s trade or business in connection with the purchase of property or the receipt of services.
These “deemed equity” rules are not applicable with respect to distributions and acquisitions described above in a given year that do not exceed the corporation’s current year earnings and profits. An exception is also provided where the aggregate issue price of all related party debt instruments issued by a corporation that otherwise would be treated as stock under these proposed regulations does not exceed $50 million. A final exception applies to acquisitions of affiliate stock where debt was issued in a separate transaction if the acquisition results from a transfer of property in exchange for stock, and, for the 36-month period following the issuance, the transferor holds, directly or indirectly, more than 50 percent of the vote and value of the issuer of the debt (e.g., a corporation can invest in its own subsidiary without the acquisition being treated as a described acquisition).
An anti-abuse rule provides a debt instrument or other interest not in form debt is treated as stock if it is issued with a principal purpose of avoiding the application of these proposed regulations.
These rules represent dramatic departures from case law and prior regulations and rules relating to the creation of intra-group debt and are completely different in approach from the proposals to restrict deductions of affiliated debt interest expense that have emerged from the OECD BEPS initiative.
Debt in part/equity in part
Generally, the IRS and courts have tended to characterize an interest in a corporation either entirely as debt or entirely as equity. The Treasury and the IRS expressed frustration that this “all-or-nothing” approach was problematic where the facts and circumstances provide only slightly more support for characterization of the entire interest as indebtedness rather than equity. Under regulatory authority that was granted to the IRS in 1989 but not previously exercised, the new regulations permit but do not require the IRS to treat a purported debt instrument issued between related parties as in part debt and in part equity for U.S. federal tax purposes, consistent with the substance of the instrument. The issuers and related holders of the debt are required to treat the instrument in manner consistent with the issuer’s initial characterization. For purposes of this rule, a 50-percent threshold for relatedness applies.
Required documentation and support for debt characterization
The new proposed regulations prescribe documentation and information that must be prepared and provided to the IRS on request with respect to arrangements that in form are traditional debt instruments issued by a corporation to a related party. These new requirements resemble in many ways the contemporaneous pricing support currently prepared for transfer pricing transactions. The proposed regulations reserve with respect to documentation of interests that are not in form debt. Failure to provide this support to the IRS when requested will result in the IRS treating the purported related party debt instrument as equity for U.S. federal tax purposes. For purposes of these documentation rules, the 80 percent “affiliated group” rule described above is used.
The regulations require timely prepared written documentation that includes a form of debt that evidences legal rights of creditors, support relating to the reasonable expectation of repayment (e.g., cash flow projections, determination of debt-to-equity and other relevant financial ratios of the issuer) and evidence of payments made on the debt or, if the issuer has failed to comply with the terms of the instrument, evidence of the holder’s reasonable exercise of the diligence and judgment of a creditor.
In general, the documentation must be prepared no later than 30 calendar days (120 calendar days in the case of evidence of an ongoing debtor-creditor relationship) after the date of the issuance or deemed issuance of the purported debt instrument or other relevant event and must be maintained until the expiration of the statute of limitations for any U.S. federal income tax return for which the treatment of the instrument is relevant.
These documentation requirements are intended to apply only to large taxpayer groups, and only apply if either (i) the stock of any member of the group is publicly traded, (ii) the group’s financial statements show total assets exceeding $100 million, or (iii) the group’s financial statements show annual total revenue that exceeds $50 million.
The regulations deeming related-party debt to be equity in distributions and similar transactions are generally proposed to be effective for debt instruments issued and distributions or acquisitions occurring on or after April 4, 2016, but, for transactions prior to the finalization of the regulations, any debt treated as equity under these rules would not be treated as debt until 90 days after the finalization of the regulations. The regulations regarding the treatment of interests as part debt and part equity and the regulations requiring documentation and support for debt characterization are proposed to generally be effective for debt issued or deemed issued on or after the date final regulations are published.
For non-U.S.-parented groups, the effect of the “deemed equity” rules on their U.S. subsidiaries that have issued debt to non-U.S. affiliates will be to deny any deduction for U.S. tax purposes for interest paid on related party debt treated as equity under these rules, as well as the imposition of dividend withholding tax on interest paid on such debt. Because of the broad scope of the presumption rules, corporations issuing debt to affiliated group members on or after April 4, 2016 will generally not be able to rely solely on the fact that the proceeds from a related party loan are actually used to invest in the corporation’s operations or to acquire assets from third parties (subject to the “ordinary course” exception). Instead, consideration should be given to whether the corporation has engaged in any described distributions or acquisitions since April 4, 2016 (or may have such transactions in the future) that may taint the new related party loan and whether any exception may apply.
Due to the departure these regulations take from past tax law and practise, substantial comments and criticism are likely. However, the commitment of the U.S. Treasury to these new regulations was made clear in the public statements of Jack Lew, the U.S. Secretary of Treasury, and President Obama over the last two days.