The US Department of the Treasury issued final and temporary regulations this fall, addressing the characterization of certain instruments as debt or equity for US federal income tax purposes (the Final Regulations). The Final Regulations were issued in proposed form in April of this year (the Proposed Regulations) and were summarized in Kaye Scholer’s previous Tax Alert: Proposed Regulations May Disrupt Intercompany Debt Practices. Like the Proposed Regulations, the Final Regulations are intended to restrict the ability of US corporations to use related-party debt to “strip” earnings from the United States.This is achieved through two main sets of rules: (1) Threshold documentation requirements that ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as debt for US federal income tax purposes (the Documentation Requirements) and (2) default rules for treating debt instruments issued to certain related parties in connection with specified transactions as equity for US federal income tax purposes (the Transactional Rules).
The Final Regulations largely adopt the structure of the Proposed Regulations. However, the Final Regulations include revisions intended to limit the scope of the Final Regulations to the transactions of greatest concern to the IRS and minimize the compliance burden on taxpayers. Key revisions are as follows:
- The Final Regulations do not incorporate a rule included in the Proposed Regulations that would have allowed the IRS to bifurcate a debt instrument to be treated as in part equity and in part debt for US federal income tax purposes.
- The Final Regulations generally do not apply to debt instruments issued by non-US corporations. The Final Regulations also do not apply to S corporations, certain real estate investment trusts (REITs) or certain regulated investment companies (RICs), and create special rules of application for certain regulated financial and insurance companies.
- If a taxpayer generally is compliant with the Documentation Requirements, the Final Regulations create a rebuttable, as opposed to a non-rebuttable, presumption that a non-compliant debt instrument is treated as equity for US federal income tax purposes.
- The Final Regulations expand certain exceptions to the Transactional Rules that were included in the Proposed Regulations and create a number of new exceptions.
- The Final Regulations create delayed effective dates for both the Documentation Requirements and Transactional Rules.
Despite the issuance of the Final Regulations, there has been some speculation that, especially in light of the recent US federal government election results, the Final Regulations may be revoked or substantially modified. However, the tax reform agenda of the new administration is not entirely clear at this point. Therefore, we recommend that for the time being investments should be structured on the assumption that the Final Regulations will remain in force.
II. Scope of the Final Regulations
The provisions of the Final Regulations generally apply to debt instruments between members of an “Expanded Group,” defined as one or more groups of US and non-US corporations (excluding S corporations) with a common corporate parent (other than a REIT or RIC), but only if (1) the corporate parent owns, directly or indirectly (applying certain constructive ownership rules), at least 80 percent of the vote or value in at least one corporation in the group, and (2) at least 80 percent of the vote or value in each of the other corporations is owned, directly or indirectly (applying certain constructive ownership rules), by one or more of the other corporations in the group. Additionally, the provisions of the Final Regulations may also apply to debt instruments issued or held by a so-called “Controlled Partnership,” defined as an entity treated as a partnership for US federal income tax purposes with respect to which at least 80 percent of the interests in partnership capital or profits are owned, directly or indirectly, by one or more members of the Expanded Group.
A REIT or RIC, as indicated above, will be excluded from an Expanded Group and exempt from the provisions of the Final Regulations if it is the parent entity of a group of corporations (although a so-called “taxable REIT subsidiary” may be included in an Expanded Group and subject to the Final Regulations). A REIT or RIC may, however, be included in an Expanded Group and subject to the Final Regulations if it is owned at least 80 percent by vote or value, directly or indirectly, by one or more corporations that are members of an Expanded Group.
The Final Regulations generally do not apply to debt instruments issued by a non-US corporation. However, the Final Regulations reserve on non-US issuers of debt instruments, and the Treasury has indicated that the application of similar rules to non-US issuers in the future is a question that remains under study. Debt instruments between members of the same US consolidated group also are not subject to the Final Regulations.
III. Overview of Documentation Requirements
The Documentation Requirements create rules for issuers and holders of so-called “Expanded Group Interests” (EGIs) to maintain written records to support the characterization of such instruments as debt for US federal income tax purposes. In general, an EGI is a debt instrument that is issued by a US corporation and is held by one of the following: (1) A corporation (whether US or non-US) within the issuer’s Expanded Group; (2) a disregarded entity owned by a corporation within the issuer’s Expanded Group; or (3) a Controlled Partnership within the issuer’s Expanded Group. Subject to certain exceptions discussed below, an instrument subject to the Documentation Requirements that does not comply with such requirements is automatically recharacterized as equity for US federal income tax purposes.
The Documentation Requirements apply to an EGI only if the Expanded Group meets any of the following threshold limitations on the date the instrument first becomes an EGI: (1) The stock of any Expanded Group member is publicly traded; (2) the total assets of the Expanded Group exceeds $100 million; or (3) the annual total revenue of the Expanded Group exceeds $50 million.
To satisfy the Documentation Requirements, the Final Regulations list the following four debt factors that must be reflected in written documents:
- Documentation to the effect that the EGI issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.
- Documentation establishing that the EGI holder has the rights of a creditor to enforce such obligation. The rights of a creditor typically include, but are not limited to, the right to cause or trigger an event of default or acceleration of the EGI under certain circumstances and to enforce payment thereof.
- Documentation that contains information establishing that, as of the relevant date, the EGI issuer’s financial position supported a reasonable expectation that the EGI issuer would be able to meet its obligations pursuant to the terms of the applicable instrument. Such requirement may be met by written documentation that includes cash flow projections, financial statements, business forecasts, asset appraisals, determination of a debt-to-equity ratio and other relevant financial ratios.
- Documentation that demonstrates an ongoing arm’s-length, debtor-creditor, relationship during the life of the EGI, including documentation of any required payment of principal and interest, such as wire transfer receipts. In the event that interest and principal is not paid as required, documentation must evidence the creditor’s efforts to assert its rights as creditor or to renegotiate the agreement, or a decision to refrain from pursuing any actions to enforce payment.
An Expanded Group that is “highly compliant” with the Documentation Requirements during a year when an EGI does not meet the Documentation Requirements (an Undocumented EGI), may challenge the treatment of an Undocumented EGI as equity for US federal income tax purposes. An Expanded Group is considered “highly compliant” if it meets certain tests that look to the issue price of the Undocumented EGIs and the proportion of Undocumented EGIs to all EGIs. As an additional exception, the Final Regulations provide that an Undocumented EGI will not automatically be treated as equity if the Undocumented EGI resulted from a situation where the taxpayer had “reasonable cause” for not complying with the Documentation Requirements. Moreover, instruments issued by certain regulated financial and insurance companies are deemed to satisfy the Documentation Requirements if such instruments meet certain regulatory standards specific to such entities.
The items needed to satisfy the above-noted four factors of the Documentation Requirements must be prepared by the time the EGI issuer is required to file its US federal income tax return, taking into account any extensions, for the year in which the “relevant date” (generally, the date on which the EGI is issued for the first three factors, and the date of payment or event of default for the fourth factor). Documentation must be maintained for all years that the relevant EGI is outstanding, and until the statute of limitations expires with respect to the US federal tax returns reflecting any deduction or other relevant item with respect to the EGI.
IV. Recharacterization of Debt as Equity Under The Transactional Rules
The Transactional Rules apply only to a so-called “Covered Debt Instrument” (CDI), generally defined to include a debt instrument issued after April 4, 2016 by a US corporation (excluding certain dealer debt instruments, debt instruments issued by certain regulated financial or insurance companies and certain other excepted debt instruments). Under the general rule, subject to exceptions discussed below, a CDI issued to an Expanded Group member automatically will be recharacterized as equity for US federal income tax purposes if it is issued in a distribution, in exchange for stock of an Expanded Group member or in exchange for property in an internal asset reorganization (the Targeted Transactions Rule). The Treasury has noted that the foregoing “targeted transactions,” where no new capital is introduced, often lack meaningful non-tax significance such that respecting the issued instrument as debt for US federal income tax purposes produces inappropriate tax results.
Under the so-called “Funding Rule,” subject to exceptions discussed below, a CDI also will be recharacterized as equity for US federal income tax purposes to the extent the CDI is issued to an Expanded Group member in exchange for cash or other property that funds a distribution or acquisition similar to those covered by the Targeted Transactions Rule. The Final Regulations include a default rule that treats a CDI as funding a relevant distribution or acquisition if the CDI is issued during the period beginning 36 months before the date of the distribution or acquisition, and ending 36 months after the date of a relevant distribution or acquisition (the Per Se Period). Additionally, a CDI issued to an Expanded Group member outside of the Per Se Period is treated as funding a relevant distribution or acquisition if it is determined, based on an examination of all the facts and circumstances, that the CDI was issued with a principal purpose of funding such distribution or acquisition. The Treasury has noted that, without the Funding Rule, taxpayers that otherwise would have issued a CDI in a one-step transaction would be able to use multistep transactions to avoid the application of the Targeted Transactions Rule while achieving economically similar outcomes.
V. Exceptions to the Transactional Rules
The following is an overview of certain of the key exceptions to the Transactional Rules that prevent a CDI from automatically being recharacterized as equity for US federal income tax purposes.
- Distributions or acquisitions by an Expanded Group member subject to the Transactional Rules may be reduced to the extent of such Expanded Group member’s current and accumulated earnings and profits relating to taxable years ending after April 4, 2016, subject to certain limitations.
- Distributions or acquisitions by an Expanded Group member subject to the Transactional Rules may be reduced by the aggregate fair market value of stock issued by such Expanded Group member to another Expanded Group member in connection with certain contributions of cash or property.
- Acquisitions of stock of an Expanded Group member are excluded from the Transactional Rules if the Expanded Group member that acquires the stock “controls” the seller (i.e., holds, directly or indirectly, more than 50 percent of the vote and value of the seller) immediately after the acquisition and does not lose such control pursuant to a plan for a specified period of time.
- The Transactional Rules do not apply to an acquisition of stock of an Expanded Group member in the ordinary course of the acquiring Expanded Group member in its business as a “securities dealer,” or to a CDI acquired by or issued to an Expanded Group member that is a securities dealer, provided if certain other requirements are met.
- Specific types of debt instruments are excluded from the Funding Rule only, including intercompany loans that are part of a qualifying cash pool arrangement, certain short-term debt instruments, loans made in the ordinary course of the issuer’s trade or business that are reasonably expected to be repaid within 120 days of issuance, and interest-free loans.
- CDIs with a principal amount of up to $50 million that would otherwise be recharacterized under the Transactional Rules are exempted from recharacterization as equity. This exception continues to apply to the first $50 million of applicable CDIs even if such amount is subsequently exceeded.
VI. Consequences of Recharacterization of Debt as Equity
In general, if an instrument is recharacterized as equity under the Final Regulations, that instrument is treated as equity for US federal income tax purposes from the instrument’s original issue date. However, a debt instrument may be recharacterized as equity after the original issue date, for example, if a debt instrument is treated as funding a distribution or acquisition that occurs in a taxable year of the issuer subsequent to the taxable year during which the instrument is issued. In such case, the instrument is initially respected as debt and then deemed exchanged for equity on the date of the acquisition or distribution treated as funded by the instrument. In the case of a deemed exchange of a debt instrument for equity, a holder’s amount realized is deemed to be equal to the holder’s adjusted basis in the instrument (i.e., generally, no gain or loss, other than non-US currency exchange gain or loss, will be recognized).
As a result of an instrument being treated as equity instead of debt for US federal income tax purposes, payments on such instrument should be treated as non-deductible dividends instead of deductible interest payments. The characterization of payments as dividends instead of interest may result in additional withholding tax on such payments.
VII. Effective Dates of the Final Regulations
The Documentation Requirements apply to EGIs issued on or after January 1, 2018. The Transactional Rules apply to CDIs issued after April 4, 2016; however, such CDIs will not be recharacterized as equity until January 19, 2017 (i.e., 90 days after publication of the Final Regulations in the federal register).