On April 4, 2016, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed Treasury regulations concerning the classification of purported related party debt instruments as either debt, equity or partially debt and partially equity for U.S. federal income tax purposes (Proposed Regulations). The Proposed Regulations target various intercompany financing structures and common tax planning techniques that the Treasury and the IRS find objectionable. Although many of these objections relate to inversions, the Proposed Regulations, if finalized in their current form, will also affect a broad range of common tax structures across all industries, including, potentially, structures used by private equity and hedge funds. The Proposed Regulations, if finalized, will generally become effective retroactively for debt issued on or after April 4, 2016. Accordingly, the Proposed Regulations are expected to have an immediate effect on tax planning activities.
Summary of the Proposed Regulations
The Proposed Regulations are intended to prevent taxpayers from aggressively using debt in situations in which debt is hardly distinguishable from equity, but in which significant U.S. tax benefits come with the use of debt rather than equity. The classic example is a foreign parent corporation that funds its wholly owned U.S. subsidiary with a mix of interest-bearing debt and equity to minimize the U.S. corporate tax of the U.S. subsidiary through interest deductions. In many cases, the interest payments are not subject to U.S. interest withholding tax under an applicable income tax treaty. Because of the control that the parent has over the subsidiary, and because the parent is both the sole equity holder and the sole lender, the economic significance of this shareholder debt (when compared with equity) is minimal or non-existent compared to the significant tax benefit of the annual interest deduction. Therefore, the Proposed Regulations, under certain circumstances, recharacterize such debt as equity.
Scope. The Proposed Regulations:
- apply only to financial instruments that are in the form of debt.
- target corporate groups (Expanded Group) consisting of U.S. and non-U.S. corporations, tax-exempt corporations, real estate investment trusts (REITs) and regulated investment companies (RICs), using a 80 percent (by vote or value) test for purposes of defining an Expanded Group; a partnership is included only if the partnership is a controlled partnership of an Expanded Group (80 percent owned by a corporation) and, in that case, is treated as an aggregate of its partners for this purpose.
- target only debt between members of an Expanded Group (Expanded Group Instrument or EGI); accordingly, typical capital market debt of a borrower issued to one or more holders unrelated to the borrower is not covered; such capital market debt continues to be covered solely by long-standing case law.
- target debt of large corporate groups; thus, an EGI is subject to the Proposed Regulations only if:
- either the corporate issuer or one of its Expanded Group members is publicly traded;the Expanded Group has total assets exceeding US$100 million; orthe Expanded Group has annual revenues in excess of US$50 million.
- do not apply to debt between members of the same consolidated group for U.S. federal income tax purposes; instead, members of a consolidated group are treated as one corporation for purposes of the Proposed Regulations.
Recharacterization of Debt as Equity.
- The Proposed Regulations automatically re-characterize certain related party debt as equity, even if such debt would otherwise be respected as debt under general debt/equity principles (the Per Se Equity Rule) if:
- an EGI is created by way of a distribution by an Expanded Group member to its corporate shareholder who is a member of the same Expanded Group;an EGI is issued in exchange for stock of another Expanded Group member, subject to limited exceptions (e.g., intra-group Section 3041 type of transactions); oran EGI is issued by an Expanded Group member in exchange for property of another Expanded Group member in an asset reorganization (e.g., intra-group D reorganizations).
- The Per Se Equity Rule is backstopped by the important so-called “Funding Rule,” pursuant to which an EGI issued for cash or other property will be treated as equity if the EGI is issued with “a principal purpose” of funding:
- a distribution of property by the Expanded Group member that has issued the EGI (the funded group member) to another member of that Expanded Group;an acquisition of stock of an Expanded Group member by the funded group member in exchange for property other than stock of an Expanded Group member; oran acquisition of property by the funded group member from another Expanded Group member in certain asset reorganization.
- The “principal purpose” test is generally based on all of the facts and circumstances. However, an EGI will be deemed to have been issued with a bad principal purpose if it is issued by the funded group member during the period beginning 36 months after the date of the distribution or acquisition and ending 36 months after the date of the distribution or acquisition (the Non-rebuttable Bad Purpose Presumption). The Non-rebuttable Bad Purpose Presumption will not apply to related party debt issued in the ordinary course of the issuer’s trade or business in connection with the purchase of property or the receipt of services.
- The Funding Rule will not apply:
- if the aggregate adjusted issue price of all EGIs subject to recharacterization held by members of an Expanded Group does not exceed US$50 million (the Per Se Equity Rule also does not apply);
- if distributions or acquisitions do not exceed the Expanded Group member’s current year earnings and profits (as determined for U.S. tax purposes) (the Per Se Equity Rule also does not apply); or
- in the case of certain debt-funded acquisitions of stock of a subsidiary if, for the 36-month period immediately following the acquisition, the buyer holds, directly or indirectly, more than 50 percent (by vote and value) of the stock of the issuer of the EGI.
- If there is a lesser-degree of relatedness based on a 50 percent test (by vote or value) (Modified Expanded Group), then the Per Se Equity Rule and the Funding Rule do not apply, but a related party debt (Modified Expanded Group Instrument or Modified EGI) can be bifurcated into part debt and part equity, something that the long-standing case law generally did not support.
- If related party debt is re-characterized as equity under the Proposed Regulations, then the facts and circumstances and existing tax law principles will determine what kind of equity it will be (e.g., voting stock, non-voting stock, preferred stock, common stock).
- In a major departure from general tax principles, in certain circumstances the debt characterization of an EGI must be retested throughout the term of a purported debt instrument. Specifically, debt status is generally tested or re-tested when:
- the EGI is issued;
- the EGI ceases to be an EGI because either it is sold to an unrelated third party or the lending or borrowing member of the Expanded Group ceases to be a member of the Expanded Group;
- documentation is insufficient to show reasonable exercise of creditor rights in case of defaults;
- the Funding Rule requires a retesting due to actions taken after the issuance of the EGI (i.e., a subsequent distribution by the issuer of the EGI); or
- a debt instrument ceases to be a consolidated group debt instrument but still is an EGI.