Final U.S. debt-equity treasury regulations released Proposed Treasury regulations released earlier this year addressing the U.S. tax treatment of related-party debt caused widespread alarm across many industries, mainly because of their far-reaching scope. Final regulations released in October, however, significantly narrow and relax the proposed regulations but continue to impose significant compliance burdens and impact many related-party financing transactions. Any investment funds that are considered "related" to a US-debt issuer under the regulations should consider the new 385 regulations in reviewing its current structure and making any future investments.
On April 4, 2016, the U.S. Internal Revenue Service ("IRS") and the U.S. Treasury Department ("Treasury") issued proposed regulations under Section 385 of the Internal Revenue Code (the "Proposed Regulations") that would reclassify certain instruments that are debt in form as equity for U.S. income tax purposes. The Proposed Regulations were part of the IRS’ efforts to curtail perceived benefits of inversion transactions and certain forms of U.S. earnings stripping, such as debt pushdowns that introduce debt through note distributions by U.S. subsidiaries to foreign shareholders in the "inbound" context, and transactions in which U.S.-parented groups use debt to repatriate low-taxed earnings and profits held by foreign corporations in the "outbound" context. The Proposed Regulations would, in certain circumstances, have recharacterized debt instruments issued between members of an "expanded group" as stock or as part stock and part debt for U.S. federal income tax purposes. Debt instruments subject to the regulations are referred to as expanded group instruments ("EGIs").
The Proposed Regulations
The Proposed Regulations contained:
- a "General Rule" that treats as stock (i) debt instruments distributed to a related party, (ii) debt instruments issued to acquire stock of a related party, and (iii) debt instruments distributed to a related entity as "boot" in an asset acquisition;
- a "Funding Rule" that generally characterizes a related-party debt instrument as stock if that instrument is used to fund (i) the distribution of a dividend, (ii) the acquisition of stock in a related entity, or (iii) the distribution of "boot" in an asset reorganization, with debt issued either 36 months before or after the relevant transaction generally being treated as issued with such a principal purpose;
- a "Documentation Rule" that would recharacterize as equity debt if the parties failed to prepare and maintain loan documentation supporting debt treatment — including an unconditional obligation to pay a sum certain, creditor’s rights to enforce the terms of the EGI, reasonable expectation of the borrower’s ability to repay the EGI, and actions evidencing a genuine debtor-creditor relationship — within 30 days of issuance; and
- a "Bifurcation Rule" that allows the IRS to treat related-party debt as in part equity and in part debt in some cases.(See summary of the proposed regulations by Hogan Lovells here.
Industry response to the Proposed Regulations
The Proposed Regulations were heavily criticized as being a departure from existing law, where courts generally have applied a long-standing multifactor analysis to distinguish debt from equity, and instead focused almost exclusively on the relationship of the parties to the instrument, the context in which it was issued, and the relevant documentation to determine whether there is sufficient support for debt treatment. The IRS received an overwhelming number of public comments (a total of 29,780) to the Proposed Regulations.
Final and temporary regulations
On October 13, 2016, final and temporary regulations (the "Final Regulations") were released. Perhaps because of the pervasive opposition to many aspects of the Proposed Regulations, the preamble to the Final Regulations includes detailed responses to many of the public’s comments and an unusually lengthy justification for the new debt-equity rules, explaining that the Final Regulations should affect only 1,200 corporate groups, mostly large taxpayers with closely related affiliates that issue debt instruments.
The final and temporary regulations
Exemptions for foreign issuers
The Final Regulations do not apply to foreign issuers of debt, including foreign holding companies, foreign investment or special purpose subsidiaries, and foreign service company affiliates (but Treasury officials warn that they are reexamining such rules and may issue regulations in the future that apply to foreign issuers). As a result, in their current form the Final Regulations generally are restricted to the domestic and "inbound" contexts involving foreign parented groups. Domestic companies, including domestic holding companies and LLCs treated as domestic corporations for federal income tax purposes, are still subject to the regulations but may benefit from the new carve-outs, as described herein.
Exemptions for short-term loans
The Final Regulations generally exclude short-term loans, including cash pool arrangements.
Partial exemption for regulated financial entities
A similar exemption also exists for regulated financial entities, such as banks, bank holding companies, registered broker dealers and certain affiliates. The rationale is that the regulatory regime imposes capital or leverage requirements that have the effect of limiting the extent to which a regulated company can increase the amount of its debt. Members of regulated financial entity groups that are not themselves treated as regulated financial entities, such as holding companies and service companies, are excluded from the exemption because they are not directly subject to the regulatory regime. An EGI issued by an excepted regulated financial company is considered to meet the Documentation Rule as long as it contains terms required by a regulator of that issuer in order for the EGI to satisfy regulatory capital or similar rules that govern resolution or orderly liquidation.
Partial exemption for regulated insurance companies
While domestic insurance companies are not entirely exempted from the regulations, EGIs issued by "regulated insurance companies" are exempted from the application of the General Rule and Funding Rule. The rationale for the exemption is that such entities are subject to stringent state insurance regulations and therefore have limited ability to issue instruments inappropriately characterized as debt. Certain insurance captives are not considered to be regulated insurance companies qualifying for this exemption because such companies generally are not subject to the same risk-based capital requirements and are otherwise not subject to regulation and oversight to the same degree as other insurance and reinsurance companies. Members of insurance company groups that are not themselves regulated insurance companies, such as holding companies and service companies, are also excluded from the exemption because they are not directly subject to state insurance regulations. A foreign insurance CFC treated as a domestic company under Sec. 953(d) is not exempted as a foreign issuer because it is treated as a domestic company and presumably would not be subject to the partial exemption as a regulated insurance company, assuming it is not subject to state insurance regulations. While EGIs issued by regulated insurance companies are still subject to the Documentation Rule, the Documentation Rule has been relaxed.
Modification of the specific rules
The General Rule and the Funding Rule generally will have effect beginning on January 19, 2017 — 90 days after the official implementation of the Final Regulations. To prevent abuse, payments made on certain debt instruments outstanding after April 4, 2016 but repaid before January 19, 2017 may nonetheless be subject to recharacterization.
The Documentation Rule has been narrowed to apply to an expanded group only if (i) the stock of any member of the expanded group is publicly traded, (ii) all or any portion of the expanded group’s financial results are reported on financial statements with total assets exceeding $100 million, or (iii) the expanded group’s financial results are reported on financial statements that reflect annual total revenue exceeding $50 million. Further, the Documentation Rule has been relaxed in a number of ways. First, the Documentation Rule does not apply until January 1, 2018. Second, an issuer is not required to document debt instruments until the due date of its tax returns (including any applicable extensions) for the year of issuance. Third, the regulations provide that an expanded group that demonstrates a "high degree of compliance" with the documentation requirements will not be subject to automatic equity recharacterization for isolated instances of noncompliance. A noncompliant instrument issued by such an expanded group would be classified using the multi-factor analysis of existing law, but the group will carry the evidentiary burden to rebut a presumption that the instrument is equity. If an expanded group does not demonstrate a high degree of compliance with the Documentation Rule, such noncompliant EGI would be treated as stock for federal tax purposes. Fourth, the regulations provide a "market standard safe harbor," whereby the documentation requirements can be satisfied with documentation of a kind customarily used in comparable third-party transactions.
The Bifurcation Rule was abandoned, but the IRS notes it will continue to study the need for such a rule. It is possible that this will be addressed by the Treasury Department under the next presidential administration.