On October 13, 2016, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) published final and temporary Treasury regulations on the classification of purported debt instruments as either debt or equity for U.S. federal income tax purposes (Regulations). The Regulations substantially revise and narrow the scope of the proposed Treasury regulations issued by the Treasury and the IRS on April 4, 2016 (Proposed Regulations) that were subject to significant comments. The following includes a summary of the changes made to the Proposed Regulations.
Please see our previous Sidley Update on the Proposed Regulations, available here, which provides additional background information and analysis on these rules.
The Regulations apply only to debt issued (or deemed issued) by domestic corporations to their domestic or foreign corporate or partnership affiliates, requiring an 80 percent vote or value affiliation (Expanded Group). The Regulations have two main parts. The first part requires Expanded Groups that are publicly traded, have assets exceeding US$100 million, or have revenue exceeding US$50 million, to maintain certain documentation to support debt treatment of intercompany debt. Failure by the group to meet such documentation requirements could result in the debt being recharacterized as equity. These documentation rules only apply to debt issued on or after January 1, 2018. The second part of the Regulations (implementing a Recharacterization Rule and a Funding Rule, as defined below) generally deals with certain debt issued or deemed issued by a domestic corporation to its affiliates where there is no new investment in the operations of the issuer or its controlled subsidiaries (e.g., a domestic corporation that distributes a note to its foreign parent). Under the Regulations, such debt may be recharacterized as equity. The second part only applies to debt issued on or after April 5, 2016 and such debt may be recharacterized only after January 19, 2017. Neither part applies to debt between members of a consolidated group.
Summary of Changes to the Proposed Regulations
The Regulations substantially narrow the scope of the Proposed Regulations in several important ways:
Changes in Overall Scope
- The Regulations remove the bifurcation rule that would have permitted the IRS to treat a debt instrument in part as debt and in part as equity.
- The Regulations do not apply to (and reserve on) debt issued by foreign issuers.
- In addition to excluding debt between members of a consolidated group, the Regulations do not apply to S-corporations, or to Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs) that are not 80 percent controlled (by vote or value) by another person.
Changes to the Documentation Requirements
- The documentation requirements apply only to debt issued on or after January 1, 2018.
- Taxpayers have until they file their federal income tax return to prepare the documentation necessary to support treatment as debt, and are no longer required to prepare such documentation within 30 days of the debt being issued.
- Failure to comply with the documentation requirements no longer results in an automatic recharacterization of the debt instrument but instead results in a rebuttable presumption that the instrument is equity.
Changes to the Debt Distribution Recharacterization Rules
- The Regulations do not apply to cash management arrangements and certain short-term debt (note that this exception does not apply to the documentation requirement).
- The Regulations do not apply to debt issued by certain regulated entities, including financial entities (such as banks, bank holding companies, registered broker dealers and certain affiliates) and certain insurance companies.
- The Regulations expand the earnings and profits exception to all earnings and profits accumulated while the issuer was a member of the same expanded group and after the Proposed Regulations were issued.
- The Regulations exclude the first US$50 million of debt that would otherwise be recharacterized as equity even if the recharacterized debt exceeds US$50 million, thus removing the “cliff effect” under the Proposed Regulations.
- The Regulations permit issuers to net certain contributions against distributions, and include an exception for acquired stock delivered to employees and other service providers.
- The debt distribution recharacterization rules, including the Funding Rule (defined below), continue to apply to debt instruments issued on or after, and distributions and acquisitions occurring on or after, April 5, 2016.
- Mergers & Acquisitions. We expect the application of these Regulations to modify the standard due diligence performed by potential acquirers of corporate groups, and be considered by sellers when an Expanded Group member leaves the group. For example, when intercompany debt is no longer held or issued by a member of the Expanded Group (e.g., if the debt of the member that held the debt was sold to a third party), the Expanded Group is required to retest the debt of the remaining members to determine whether it is treated as funding the distributions and required to be recharacterized as equity.
- Investment Funds. With respect to investment funds, the Preamble clarifies that groups of investment funds managed by the same investment advisor may, under the rules described above, be part of an Expanded Group if the investment advisor controls the voting interests in the investment funds. The Regulations were not extended to cover debt issued by subsidiary blocker corporations to a partnership that is not a controlled partnership (e.g., they generally do not treat a partnership that owns 100 percent of a blocker corporation as an Expanded Group member), though the IRS and Treasury continue to study these structures.
- Insurance Industry. The Regulations include important exceptions and clarifications for the insurance industry. Debt issued by a regulated insurance company is considered to meet the documentation requirements if it requires the consent of a regulator to pay interest or principal and, at the time of issuance, is expected to be repaid (although documentation must be maintained that these two requirements are satisfied). The Preamble also clarifies that the new documentation requirements do not apply to reinsurance (including funds-withheld reinsurance) because such contractual agreements are not debt in form. Additionally, the debt distribution recharacterization rules do not apply to debt issued by regulated insurance companies (other than certain captive insurance companies) that are subject to risk-based capital requirements under state law. Industry members had sought a clarification that the rules would not apply to debt issued between affiliated members of a corporate group that are not included in a consolidated group (for instance, debt issued by a life insurance company before the five-year waiting period expires), but the IRS and Treasury explicitly declined to provide for such an exclusion.
Revised General Scope
- Generally, the Regulations target debt between members of an Expanded Group. A partnership is included only if the partnership is 80 percent controlled by corporate members of the Expanded Group.
- In a significant departure from the Proposed Regulations, however, the Regulations do not apply to debt issued by foreign entities (but do apply to debt issued by domestic corporations to their foreign affiliate members of the Expanded Group).
- Unlike the Proposed Regulations, the Regulations do not apply to debt issued to or by S-corporations, or to debt issued to or by non-controlled RICs or REITs. Therefore, groups with REITs or RICs as their common parent are generally not subject to these rules unless their corporate subsidiaries independently form an internal expanded group. However, REITs and RICs that are 80 percent controlled by members of the Expanded Group are subject to the Regulations.
- In a further departure from the Proposed Regulations, the Regulations reserve on the application of the Section 318 “downward” attribution rules for purposes of determining the members of the Expanded Group. The Regulations therefore do not currently apply to brother-sister groups with non-corporate owners. The Regulations also limit the attribution rules with respect to options to situations where the options are reasonably certain to be exercised.
Changes to the Documentation Requirements
- Departing from the Proposed Regulations, with respect to the documentation requirements, the Regulations:
- only apply to debt issued on or after January 1, 2018;
- allow taxpayers until the due date for filing their tax returns (including extensions) to prepare the necessary documentation;
- permit taxpayers to rebut the presumption that debt not meeting the documentation requirements is equity, provided that the Expanded Group demonstrates a “high degree of compliance” (based on certain enumerated tests) with the documentation rules generally;
- clarify that the Regulations do not apply to repos, reinsurance (including funds-withheld reinsurance), mineral production payments, regular interests in REMICs, deemed debt under Section 482 and other instruments specifically treated as debt under the Internal Revenue Code of 1986, as amended (Code);
- do not apply to debt issued by a controlled partnership, although this debt may be subject to an anti-abuse rule (additionally, debt issued by a corporate member of the Expanded Group to a controlled partnership is subject to these rules);
- include a reasonable cause exception and a ministerial non-material failure exception; and
- generally provide that: (i) debt issued by banks and bank holding companies (and certain other regulated financial companies such as registered broker dealers) (including debt issued by certain affiliates of such financial institutions); and (ii) debt issued by certain insurance companies that requires the consent of a regulator to pay principal or interest, are treated as meeting the documentation requirements as long as they are expected to be repaid at the time of issuance and proper documentation that they qualify for the exemption is maintained.
- Cash Pooling. The Regulations provide only limited relief from the documentation requirements for cash pooling, revolving credit and similar arrangements, permitting taxpayers to document such arrangements using a single master agreement and generally requiring only annual updates demonstrating the ability to repay the maximum amount permitted to be borrowed under the agreement.
Changes to the Debt Distribution Recharacterization Rules
The Regulations apply to debt issued on or after April 5, 2016 but will not recharacterize such debt before January 20, 2017.
The Regulations generally adopt the Proposed Regulations by automatically recharacterizing: (i) debt distributed to another member of its Expanded Group; (ii) debt used to purchase equity interests in another member of the Expanded Group; and (iii) debt issued to purchase property from another member of the Expanded Group and then distributed to another member of the Expanded Group by the transferor (Recharacterization Rule). The Recharacterization Rule is backstopped by the “Funding Rule.” Under the Funding Rule, debt is issued by a member of the Expanded Group in return for cash or other property that is then used to fund a distribution to another member of the Expanded Group (or an acquisition of stock from such a member) within a 36-month period before or after the debt was issued, is recharacterized as equity. A more detailed description is available here.
New General Exceptions
The Regulations expand and add additional exceptions that apply both to the Recharacterization Rule and the Funding Rule:
- Exemption for First US$50 Million. The Regulations exempt the first US$50 million of debt that would have otherwise been recharacterized. Unlike the Proposed Regulations, once the US$50 million threshold is reached, only the excess is subject to recharacterization.
- Exemption for Earnings and Profits. The aggregate amount of the issuer’s earnings and profits will reduce the amount of debt that is subject to recharacterization. The Regulations expand the earnings and profits exception in the Proposed Regulations to take into account all accumulated earnings and profits during the issuer’s membership in the Expanded Group, provided they were accumulated in taxable years ending after April 4, 2016. The Proposed Regulations only exempted the current year earnings and profits. Detailed rules are provided on how to calculate the running balance of such earnings and profits and how they are applied to reduce the distributions that are subject to these rules.
- Exemption for Investment in Subsidiary Stock. The Regulations expand the subsidiary stock issuance exemption in the Proposed Regulations to all acquisitions of Expanded Group stock by a domestic member of the Expanded Group if the acquirer controls (measured by 50 percent of vote and value) directly or indirectly the member of the Expanded Group from which the stock was acquired (seller) and does not relinquish control of the seller pursuant to a plan that existed on the date of acquisition other than in a transaction in which the seller leaves the Expanded Group.
- The rationale for this exemption is that the acquirer still has indirect control over the consideration paid for the acquisition, and therefore no distribution has taken place.
- The requirement to retain control for 36 months under the Proposed Regulations has been replaced by a rebuttable presumption that any relinquishment of control within those 36 months was pursuant to a plan to relinquish control.
- Exemption for Stock Paid for Services. The Regulations exempt an acquisition of Expanded Group stock if such stock is delivered to individuals that are employees, directors or independent contractors in return for services.
- Netting Distributions with Contributions. With certain exceptions, the Regulations reduce net distributions by contributions made by members of the Expanded Group in return for stock of the issuing member during the period beginning 36 months before and ending 36 months after the distribution or acquisition. Contributions having a principal purpose of avoiding the application of the Regulations are not netted.
- The rationale for this rule is that the issuer used the cash from such contributions or earnings to make the distributions and not the cash proceeds from the debt.
- Exemption for Debt Issued by Regulated Financial and Insurance Companies. The Regulations do not apply to debt issued by certain regulated entities, including financial entities (such as banks, bank holding companies, registered broker dealers and certain affiliates) and certain regulated insurance companies.
New Exceptions to the Funding Rule
The Funding Rule has several new exceptions that did not appear in the Proposed Regulations or were otherwise expanded in the Regulations:
- Cash Pooling and Short-Term Debt. The temporary Regulations include a new exception for cash pools and qualified short-term debt instruments:
- cash pooling arrangements (generally, demand deposits with an Expanded Group member, controlled partnership or qualified business unit) that have as their principal purpose managing a cash-management arrangement for participating Expanded Group members, and either retaining excess cash on its books or depositing or investing excess cash with third parties (the IRS and Treasury expect that the expenses of the cash pool entity will be paid by income it receives for its services and not from the deposits);
- short-term funding arrangements (generally, debt that does not exceed the issuer’s short-term financing needs (determined with reference to the issuer’s current assets) or that has a maturity of 270 days or less and that meets certain interest rate requirements);
- ordinary course loans (generally, debt for the acquisition of property in the ordinary course of the issuer’s trade or business if reasonably expected to be repaid within 120 days), although, in a departure from the Proposed Regulations, there is no requirement that the debt reflect deductible amounts under Section 162 of the Code; and
- interest-free loans (generally, debt that does not provide for interest, does not have OID, is not required to provide for interest under Section 482 of the Code and is not imputed interest under the Code).
- Limited to Debt Issued for Property. The Regulations limit the scope of the Funding Rule to debt issued in exchange for property. Debt issued for services, royalties and rents is no longer subject to this rule.
- Limited to Same Expanded Group. The Regulations add an exception to the Funding Rule in situations where the distribution or acquisition on the one hand, and the issuance of the debt on the other hand, occurred when the issuer was a member of a different Expanded Group.
- Does Not Apply to Secondary Market Acquisitions. The Preamble clarifies that the Funding Rule only applies to an issuance (or deemed issuance) of a covered debt instrument and does not apply to an acquisition of such debt in the secondary market.
- Exception for Liquidations and Spin-Offs. A distribution in complete liquidation (whether or not taxable) and a distribution of stock that is not treated as “boot” are not treated as distributions of property for purposes of the funding rule.
- Significant Modification of Debt. For purposes of the 36-month period used in the Funding Rule, with certain exceptions, debt instruments that are treated as exchanged as a result of a significant modification are nevertheless treated as issued on their original issue date (the reason is that such modification generally does not generate new proceeds that could fund distributions or acquisitions).
Treatment of Controlled Partnerships
- Aggregate Approach. The temporary Regulations retain the aggregate approach to controlled partnerships. Therefore any property acquired by a controlled partnership is treated as having been acquired by its Expanded Group partners based on their respective liquidation value percentages.
- The exception for qualified short-term debt is applied at the controlled partnership level by treating the partnership as the issuer of the relevant debt instrument (e.g., looking at the current assets/short-term financing needs of the partnership rather than its partners).
- Deemed Transactions. Instead of recharacterizing the debt issued by a controlled partnership under the Recharacterization Rule and the Funding Rule, the temporary Regulations treat the holder of the debt as having transferred the debt to the Expanded Group partners in exchange for stock of such partners based on the partners’ distributive share of the partnership’s reasonably anticipated interest expense (Issuance Percentage). This deemed contribution, however, is disregarded for purposes of allocating the debt under Section 752 of the Code.
- Preferred Equity. The IRS and Treasury continue to study whether it is appropriate to subject preferred equity in controlled partnerships to these rules, and intend to “closely scrutinize, and may challenge” under the anti-abuse rule transactions in which preferred equity is issued in situations that, had the equity been debt, the Regulations would have applied.
- Anti-Abuse Rule Clarified. The Regulations retain the anti-abuse rule under the Proposed Regulations with some clarification. Under the Regulations, the anti-abuse rule applies if a member of an Expanded Group enters into a transaction with a principal purpose of avoiding the purposes of the debt distribution recharacterization rules. This rule may therefore apply even if the taxpayer had other principal purposes for the transaction.
- Affirmative Use Reserved. The Regulations withdrew and reserved on the Proposed Regulation that would have prevented taxpayers from affirmatively using the Regulations to reduce federal tax liabilities.
- Documentation Requirements. The documentation requirements only apply to debt that is issued on or after January 1, 2018 (including debt issued after this date under a credit facility executed before such date).
- Debt Distribution Recharacterization Rules. The debt distribution recharacterization rules are subject to several effective date provisions:
- The rules apply only to debt instruments issued on or after April 5, 2016 (instead of April 4 as in the Proposed Regulations).
- For purposes of the Funding Rule, distributions and acquisitions occurring before April 5, 2016 are disregarded.
- Except as described below, the Regulations only apply to taxable years ending on or after the 90-day period ending after the publication of the Regulations in the Federal Register (i.e., January 19, 2017) (January Effective Date).
- Debt that would have been recharacterized under the Regulations in a taxable year ending on or before the January Effective Date (e.g., debt distributed on June 1, 2016), or debt that would have been recharacterized before the January Effective Date, and in a taxable year ending on or after the January Effective Date (e.g., debt distributed on January 3, 2017), will be treated as equity immediately after the January Effective Date if it is still outstanding and held by a member of the Expanded Group at that time.
- To prevent abuse, the Regulations also provide that if a debt instrument would have been required to be recharacterized after April 4, 2016 and on or before the January Effective Date (e.g., the debt distributed on June 1, 2016 in the above example), but is not recharacterized under the preceding transition rules (e.g., the debt was not outstanding on the January Effective Date because it was repaid on January 2, 2017), then any payment made on such debt instrument (other than stated interest), including pursuant to refinancing (e.g., the repayment of principal on January 2, 2017), will be taken into account as a distribution for purposes on the Funding Rule. Such distribution could therefore potentially cause a recharacterization of other debt instruments issued by the issuer. Absent such repayment, the distribution of the debt itself (in the example) is generally not treated as a distribution for purposes of the Funding Rule.
- Additional transition rules are also provided in situations where the issuer and holder cease to be members of the same group during the transition period.
- Taxpayers have an option to apply the debt distribution recharacterization rules of the Proposed Regulations to debt issued between April 4 and October 13 of this year.
We will continue to monitor these developments closely.