On April 4, 2016, the U.S. Government blasted "inversion" transactions. We explain, what recommended action steps should be taken.
This update is provided by True Partners Consulting LLC.
On April 4, 2016, the U.S. Treasury Department and the IRS issued proposed regulations (REG-108060-15) under section 385 of the Internal Revenue Code that will impact any corporation that issues a purported debt instrument to related corporations or partnerships. Specifically, the proposed rules contain three major elements:
- They treat certain related party interests in a corporation as indebtedness in part and stock in part for federal tax purposes;
- They establish threshold documentation requirements, without which the instrument will be treated as stock for federal tax purposes; and
- They treat as stock certain instruments issued to related parties as distributions, in connection with the acquisition of related-party stock or assets, or used to fund such distributions or acquisitions.
Almost every corporate taxpayer (including partnerships owning or owned by corporations) will be impacted in some way by these rules. While the proposed rules generally will become effective upon the issuance of final regulations, certain aspects will be retroactive to April 4, 2016. Taxpayers will have only 90 days after the issuance of final regulations to ensure that instruments issued after April 4 comply. The Government continues to insist that they will release the final regulations around Labor Day.
Recommended Action Steps
In light of the apparent imminence of the fi rules and the limited transition period, we recommend that companies should begin the compliance process immediately by taking the following steps:
- Inventory all existing intercompany advances and analyze them under the proposed regulations.
- Address any transactions that either lack documentation or could be affected by the per se recharacterization rule or the funding rule.
- Begin developing and documenting policies and procedures for Tax, Treasury, Accounting, Legal, IT, Internal Audit, and other functions to comply with the final regulations going forward.
Frequently Asked Questions About the Proposed Section 385 Regulations
Here are just a few of the questions we have been asked regarding these regulations. Many of them currently have no answers, so we will need to wait for the final regulations. In the meantime, smart taxpayers are preparing now!
Q: What documentation will be sufficient to meet the requirement that a lender must have a “reasonable expectation of repayment”?
A: Generally, the same type of documentation that a third-party lender would rely on in deciding whether to make a loan. In particular, cash flow projections, financial statements, business forecasts, asset appraisals, balance sheet information, debt-to-equity ratios, and credit ratings are among the items that have been suggested.
Q: Will the documentation requirements apply to trade payables? What about cash pools?
A: The proposed regulations as currently drafted would apply to trade payables. The Government recognizes that cash pools and similar arrangements will require special rules and has asked for comments on what those rules might be.
Q: What is the nature of the stock deemed issued in the event of recharacterization?
A: In general, they would likely be treated as non-voting preferred stock. This would create immense problems if the issuer were a subchapter S corporation.
Q: Will loans between CFCs be subject to these regulations?
A: There is currently no exception for loans between CFCs.
Q: What are the standards by which the IRS can bifurcate a debt instrument into part-debt and part-stock?
A: The proposed regulations do not contain any standards other than the judgment of the IRS under “general federal tax principles.”
Q: Is it true that the combination of the per se recharacterization rule for tainted transactions and the 72-month testing period for the funding rule may result in the disqualification of otherwise tax-free reorganizations; disqualification of a member of the consolidated group; disqualification of S corporations, REITs, RICs or hedges; loss of a DRD, foreign tax credits, or treaty benefits; creation of fast-pay preferred stock; or other unpleasant results?
Q: Can I avoid the funding rule by repaying the debt within the same year it is issued?
Q: Will the taint of related-party instruments be removed if the group is acquired by a third party?
A: Generally, no. A funding rule taint may carry over to a new group if the issuer changes groups within 36 months after issuance.
Q: How can a taxpayer know whether they can use the current year E&P exception before having calculated current-year E&P?
A: Not without significant risk.
Q: Shouldn’t the distribution of PTI be an ordinary course exception to the funding rule since it has already been taxed in the United States?
A: It should, but the proposed regulations do not address this question.
Q: To what extent will the States adopt these regulations?
A: So far, no States have publicly announced whether they will adopt these rules. Separate return states will have an incentive to do so, while States that allow combined or consolidated returns may follow some or all of these rules.