Background

The US Department of Treasury (Treasury) has released final regulations under section 385 of the Internal Revenue Code dealing with the circumstances under which related company debt will be classified as equity for income tax purposes. Regulations under this provision had been proposed in April. (For prior coverage of the proposed regulations click here.) The proposed regulations caused a considerable amount of consternation in the corporate taxpayer community. Although section 385 (enacted in the Tax Reform Act of 1969) was arguably intended merely to require Treasury to list factors that would be taken into account in determining when purported debt should be reclassified as equity, the proposed regulations prescribed absolute rules, not just factors. If a debt instrument failed to meet the requirements of the proposed regulations, in many cases it was automatically reclassified as equity regardless of whether it would have been respected as debt under the well-accepted rules that had been laid down in dozens of federal court cases.

Treasury’s principal concern was with preventing US corporations from diverting income to foreign affiliates via payments on debts owed to the foreign affiliates. This was, in turn, an offshoot of Treasury’s concern about inversions, under which US corporations moved abroad, by merger or otherwise, in manners that reduced their federal tax liability.

Although designed to address an international tax issue (one that has been of concern to foreign governments as well as to Treasury), the proposed regulations were not limited to the diversion of income offshore and applied to purely domestic transactions as well. They had implications for state and local taxation, although, obviously, Treasury had not focused on that. These implications were discussed in an earlier article that can be found here. This article is a follow-up to that article and will comment on the final regulations with particular emphasis on the changes from the proposed regulations. The proposed regulations were controversial and reportedly generated roughly 29,600 comments. Treasury, to its credit, seriously considered those comments and addressed many of them in the final regulations. The final regulations significantly narrow the scope of the proposed regulations in many respects. Still, they are sweeping and are likely to have many unintended consequences, including in the state and local tax area.

Final Regulations

The final regulations, like the proposed regulations, set forth certain rules under which debt will automatically be reclassified as equity or will be presumed to be equity. An important point to keep in mind is that satisfying the rules of the final regulations does not mean that a particular debt instrument gets a free pass and will necessarily be respected as debt for income tax purposes. It only means that the debt will not automatically be reclassified as equity under the regulations. It still must pass the traditional tests that have been laid down in the federal case law. For example, although the final regulations except from their scope debt issued by certain regulated financial corporations and insurance companies, that debt will still have to pass muster under the criteria specified in the federal case law.

The final regulations generally apply only to debt between related corporations (albeit they also apply in the case of certain corporate “controlled partnerships” (not discussed here)). The universe that is subject to these rules is defined as the “expanded group” of corporations, which generally is similar to the definition of “affiliated group” in section 1504(a), dealing with eligibility to file consolidated federal returns, except that the 80 percent test is measured by vote or value. The definition of “expanded group” is modified in the final regulations by excluding S corporations, non-controlled regulated investment companies and non-controlled real estate investment trusts. 

A major change from the proposed regulations is that foreign issuers of debt also are excluded from the definition. Treasury has reserved on this issue and may address it later, but for now, debt issued by foreign corporations will not be subject to the final regulations. This is consistent with Treasury’s principal concern about preventing US corporations from deducting interest paid to their foreign affiliates. The problem does not arise with respect to interest paid by a foreign corporation to a US affiliate.

Section 385(a) specifically provides that the regulations can prescribe circumstances under which a debt instrument will be treated as part debt and part equity and the proposed regulations contained detailed bifurcation rules. The bifurcation rules of the proposed regulations were subject to significant criticisms and the concept has been dropped from the final regulations. Once again, however, it is certainly possible that the Internal Revenue Service in an audit could treat a particular instrument as being part debt and part equity under traditional common law principles.

The proposed regulations contained detailed documentation rules that had to be complied with for an instrument to be respected as debt. These rules applied only to large corporate groups. They applied only if the stock of any expanded group member was publicly traded, the expanded group had total assets exceeding $100 million or the expanded group had total annual revenue that exceeded $50 million.   

The final regulations retain the documentation rules, but with some significant changes. Noncompliance with these rules with respect to an instrument generally results in the instrument being treated as equity for federal tax purposes; however, noncompliance results only in a rebuttable presumption that the instrument in question is equity for federal tax purposes if the taxpayer can show it is otherwise “highly compliant” with the documentation rules. This can be done by showing either that at least 90 percent of expanded group debt instruments meet the requirements or that the non-compliant debt instruments are not material, as specified in detailed rules included in the regulations. The presumption then can be overcome if the taxpayer can demonstrate that the instrument should be treated as debt under the traditional common law rules.   

Among the documentation requirements is one that requires an analysis of the issuer’s ability to repay the debt in accordance with its terms. This means that corporations will have to produce and maintain studies showing that the issuer’s financial circumstances and prospects were such as to justify a reasonable expectation that the debt would be repaid. Although obviously banks and other professional lenders do this as a matter of course with respect to loans made to customers in the ordinary course of business, they do not do so with respect to related party debt and regular business corporations typically do not do this with respect to inter-company debt. Affected taxpayers will have to change their practices.  

Fortunately for taxpayers, the effective date of the documentation rules has been delayed. The rules will only apply to debt instruments that are issued after December 31, 2017. This will give corporations time to develop systems to comply with the new rules.  

Among the most controversial rules of the proposed regulations were the funding rules. These generally provided that debt issued in connection with a distribution, in exchange for the stock of a member of the expanded group, or as “boot” in an internal asset reorganization was automatically reclassified as equity if it was issued within three years before or three years after the transaction. The concept of the funding rule and, in particular, its application to all transactions within a six-year period, were criticized by many commenters. The final regulations retain the basic concept, but they soften it in a number of respects.  

The proposed regulations contained an exception for certain transactions that occurred in the ordinary course of business. These were designed primarily to apply to routine purchases of goods and services within the expanded group that were not paid for immediately, but were funded by inter-company debt. The final regulations expand the scope of the ordinary course exemption to include traditional cash pooling arrangements and short-term debt instruments. Under the final regulations, the funding rule does not apply to “qualified short-term debt instruments,” which are defined to include short-term funding arrangements, ordinary course loans, interest-free loans and cash pool arrangements.  

The proposed regulations provided that the amount of transactions subject to the funding rules was reduced by the amount of the issuer’s current-year earnings and profits. The current year limitation was criticized for a number of reasons, including that it was typically impossible to determine them before the end of the year, and that it would create an artificial incentive to “use” current year earnings and profits by making premature distributions. The final regulations expand the earnings and profits limitation to include all earnings and profits of a corporation accumulated during its membership in an expanded group provided they were accumulated in taxable years ending after April 4, 2016 (the date when the proposed regulations were issued).  

The proposed regulations provided that debt would not be reclassified as stock if at the time of issuance the aggregate issue price of all instruments that would otherwise be treated as stock under the proposed regulations did not exceed $50 million. The final regulations modified this rule by eliminating the “cliff” effect and allowing the exclusion of the first $50 million of expanded group debt even if the aggregate amount of expanded group debt exceeded $50 million.  

In a major change, the final regulations except from their requirements debt issued by certain regulated entities such as insurance companies or financial institutions. Covered debt instruments do not include instruments issued by regulated insurance companies that are subject to risk-based capital requirements under state law. The preamble states that the regulatory requirements mitigate the risk that tax avoidance transactions would be done. The exception is limited to insurance companies that engage in regular issuances of insurance to unrelated persons. Captive insurance companies are not included in the exception. Further, the exception does not apply to members of an expanded group that includes an insurance company that are not themselves insurance companies. The same principles apply to debt issued by regulated financial institutions, including those with specific regulatory or capital requirements such as bank holding companies, members of the Federal Reserve System, registered broker-dealers, companies subject to a determination by the Financial Stability Oversight Council and Federal Home Loan banks.  

Instruments issued by regulated insurance companies and financial institutions are treated as meeting the documentation rules if they contain terms that satisfy regulatory requirements.  

The proposed regulations treated members of a consolidated return group as a single corporation, which in effect meant that debt instruments issued by one consolidated return group member to another were not subject to the rules. This general concept has been retained, with slight modifications. Under the final regulations, members of a consolidated group are treated as one corporation but only for purposes of the general and funding rules. With respect to the documentation rules, the final regulations do not treat the members as a single corporation, but they provide that obligations between consolidated group members are not subject to the documentation rules. As a practical matter, this may not be a significant change. An important point to remember is that the exception for intra-group debt does not apply to debt issued to related corporations that do not join in the consolidated federal return.

SALT Implications

A basic issue that will be of concern to SALT practitioners is whether, and the extent to which, the principles of the final regulations will apply for state and local tax purposes. State statutes typically base state taxable income on federal taxable income with changes to reflect differences between federal and state tax policies. Will states that generally conform to the Internal Revenue Code be required to adopt the final regulations or their principles? In my article on the proposed regulations, I argued that this was not the case. Although the final regulations have been adopted pursuant to a statutory mandate, they are not part of the Internal Revenue Code. While regulations adopted pursuant to a statutory authorization are entitled to greater deference than normal interpretative regulations, they are not part of the law and are subject to judicial review. Even provisions of the consolidated return regulations, where it is clear that Congress has delegated rule-making authority to Treasury, have been declared invalid by the courts on occasion. State revenue departments have made it clear that they believe that they are not bound by IRS determinations or interpretations of other Code provisions. In fact, most states do not automatically conform to the consolidated return regulations, even though, as indicated above, they represent an express delegation of rule-making authority by Congress to Treasury. Some state revenue departments follow the consolidated return regulations with respect to corporations filing combined returns, but most do not address the issue.  

In my view, the states will not be required to adopt the final regulations or their principles and will be free to reject them entirely, to accept parts of them and not others and to modify them as applied to their own laws. I should mention, however, that this view is not universally shared. In an exchange at the meeting of the American Bar Association Section of Taxation’s Committee on State and Local Taxes in Boston on September 30, Michael Fatale of the Massachusetts Department of Revenue, disagreed with this view and voiced that he thought that the states would be required to adopt the regulations when ultimately issued under section 385 (the final regulations had not been yet released). We will see how the states come down on this.

Even if state revenue departments do not consider themselves to be bound by the terms of the final regulations, they may look to them for guidance, and it can be expected that they will be a factor in state and local tax audits. As pointed out in my article on the proposed regulations, I have had cases in which state auditors agreed to be bound by the results of an IRS audit of a debt-equity issue, even though this meant keeping the statute of limitations open only for that issue. Further, relying on federal regulations would be an easy way for state revenue departments to avoid having to make their own detailed examinations of the many factors that the courts have taken into account in making debt-equity determinations. I have been advising clients that it would be prudent to meet the requirements of the final regulations, even with respect to debt that is not literally subject to those regulations (for example, because the companies are too small or because they are filing consolidated federal income tax returns).  

One option open to the states would be to adopt comparable regulations that conform to the basic principles of the final regulations, but that part company with them with respect to certain details. For example, comparable state regulations might have lower thresholds for the size of affected corporations or debt or have no thresholds at all. A state revenue department could also retain the minimum size threshold concept but reduce the thresholds so as to apply the state’s regulations to more corporations.  

A fundamental question discussed in my earlier article was whether state revenue departments will apply the regulations or their principles to corporations that are not subject to the federal regulations because they are members of a federal consolidated return group but that file separate state returns. This is a common situation because many corporations that file consolidated federal returns are not engaged in a common unitary business and hence file separate returns in one or more states. It is possible that a state revenue department could assert that the principles of the federal regulations should apply for state tax purposes in those situations even though the federal regulations do not apply. Presumably, the potential for tax avoidance that Treasury has concluded is present when related corporations file separate federal returns would be present for state purposes in those situations. In some states, this is required by statute. For example, the Louisiana and Maryland statutes specifically provide that corporations that file consolidated federal income tax returns must be treated for state income tax purposes as if they had filed separate federal income tax returns. (See LA. Rev. Stat. Ann. Section 47:287.733.A; and Md. Code Ann. Section 10-811.)  

Conversely, some corporations file state combined returns even though they file separate federal returns. For example, in New York, corporations can file combined returns even though the stock of both corporations is owned by an individual. These corporations could not file consolidated federal returns because a federal consolidated return group must have a common corporate parent. Further, In New York, combined returns can be required or permitted if the common ownership exceeds 50 percent, whereas the federal common ownership level is 80 percent. In those situations, could taxpayers argue that, even though the federal regulations literally apply and require a certain debt instrument to be treated as equity, a similar determination should not be made for state purposes because they are filing combined state returns and if the same filing profile had existed for federal purposes the regulations would not have applied? Such an argument would be strengthened if the state adopted the federal rules on elimination in intra-group transactions under the federal consolidated return regulations.  

In my article on the proposed regulations, I pointed out that the exception for distributions from earnings and profits could be applied differently for state and local tax purposes than for federal tax purposes because state and local earnings and profits are not necessarily the same as federal earnings and profits. If state revenue departments apply this rule, will they apply it to federal earnings and profits or to state earnings and profits? The right approach would seem to be to use state earnings and profits as the measure, even though that could result in an instrument being treated differently for federal and state purposes.

Another implication of the regulations is that corporations that are paying franchise taxes based on the amount of their capital, and not on the amount of their net income, may find that their capital-based taxes increase if debt is reclassified as equity.  

As indicated above, the final regulations exclude debt issued by S corporations from their scope. How will the states treat corporations that are S corporations for federal income tax purposes but that are C corporations for state income tax purposes? In New York, a federal S corporation must elect to be treated as an S corporation for state tax purposes. If it fails to do so, it will be treated as a C corporation. Under the New York City general corporation tax, S corporations are mandatorily treated as C corporations. The New York tax authorities will have to decide how they are going to treat these entities.  

Conclusion

The proposed regulations were controversial and gave rise to much criticism. Indeed, the concept was attacked by many members of Congress. Nevertheless, Treasury has issued them in final form and they are now part of the tax landscape. State and local tax practitioners, both in-house and in professional firms, will have to address the implications of the regulations and, more importantly, will have to make their business and federal tax colleagues aware that these regulations have state and local tax consequences that must be taken into account.