New final and temporary regulations under Section 385, addressing the treatment of related-party debt, significantly narrow parts of the controversial proposed regulations released in April. Because the regulatory package is more than 500 pages long, it will take time to fully evaluate the impact of the new regulations. Grant Thornton LLP nonetheless provides some preliminary FAQs and initial reactions regarding some of the major changes from the proposed regulations.
FAQ No. 1: What is the effective date of the new regulations?
The new regulations are effective as of the date of publication in the Federal Register. This is expected to be on or around Oct. 21, 2016.
The application of the rules under Treas. Reg. Sec. 1.385-2, which requires certain levels of substantiation for treating related-party instruments as indebtedness — the so-called documentation rules — however, have been delayed. These rules are not effective for debt instruments issued prior to Jan. 1, 2018. Therefore, documentation generally won’t be required for calendar-year taxpayers until 2019. See FAQ No. 4 for additional discussion on the timing requirements provided under the documentation rules.
The retroactive effective date for the so-called recast rules under Treas. Reg. Sec. 1.385-3 was retained in the newly issued final regulations. Therefore, many transactions occurring, and debts issued, on or after April 4, 2016, will be subject to the recast rules in most circumstances. The rules would defer the recast until 90 days after the publication date of the regulations (the transition period). The new regulations lengthen the proposed transition period by providing that any covered debt instrument that would be treated as stock by reason of the application of the new regulations on or before the date 90 days after the publication date is not treated as stock during such 90-day transition period, but rather that the covered debt instrument is deemed to be recast immediately after the 90th day (but only to the extent that the covered debt instrument is held by a member of the issuer’s expanded group immediately after such 90th day).
FAQ No. 2: What new requirements do the final and temporary regulations impose?
The new regulations provide mechanical and qualitative rules to address whether a purported debt instrument issued to a related party is treated as stock or debt for U.S. federal tax purposes. This objective is accomplished by applying three general themes: (1) evaluating purported debt under common law principles and factors, (2) imposing strict documentation requirements on purported debt (documentation rules, as described above), and (3) by targeting transactions involving purported debt that insert leverage without additional capital (the recast rules, as described above).
Going forward, domestic corporations included in the scope of the new regulations may be required to maintain documentation and financial analysis pertaining to related-party lending transactions (including most related-party payable accounts). Additionally, those entities included in the scope of the regulations may also be required to monitor their operations, beyond just lending, to ensure that ancillary capital transactions, restructuring or other similar events do not result in a recast of the entities’ purported related-party debt instruments as equity.
FAQ No. 3: Do the regulations apply to Subchapter S corporations?
No, the regulations exclude S corporations from the definition of an expanded group member. Therefore, debt issued by S corporations is now outside the scope of the new regulations. This should provide welcome relief for S corporations and their shareholders.
FAQ No. 4: Do the new regulations change the documentation rules?
The final and temporary regulations retain the documentation rules but with significant modifications from those included in the proposed regulations.
The new regulations require documentation for all “in form” debt instruments issued by domestic corporations that are members of an expanded group, where the instrument is issued to an expanded group member, unless that member is included in the domestic issuers consolidated group. Limiting the scope of the new regulations to issuers that are domestic corporations means the new rules do not apply to debt issued by foreign corporations (i.e., a foreign issuer).
The rules were also modified to provide taxpayers additional time to prepare required documentation. Taxpayers now have until the time they file their federal income tax return (including extensions) to satisfy the documentation requirements. This is a significant extension from the 30- and 120-day requirement provided in the proposed regulations. See FAQ No. 9 for additional discussion on the applicable exceptions.
FAQ No. 5: Do the new regulations exempt U.S. multinationals from the documentation?
No. Although the final and temporary regulations primarily target inbound structures (i.e., foreign-parented enterprises), the rules still apply to U.S. multinationals. For example, a U.S. multinational’s debt created by trade payables with a controlled foreign corporation (CFC) may be subject to the documentation rules. A documentation failure with respect to debts owed to a CFC may result in the CFC’s holding U.S. stock. As stock of a domestic corporation is considered an investment in U.S. property under Section 956, a recast of the debt as stock under the documentation rules could subject the U.S. multinational to deemed U.S. income inclusions of the CFC’s earnings.
FAQ No. 6: Do the regulations apply to debt instruments issued by non-U.S. persons?
In a significant departure from the proposed regulations, only debt instruments issued by domestic corporations (and disregarded entities of domestic corporations) are within the scope of the new regulations. This significant scope limitation applies for purposes of both the documentation rules and the recast rules. This change represents a substantial reduction in the compliance burden imposed under the proposed regulations and also potentially revives certain tax planning strategies that were otherwise nullified under the proposed regulations.
FAQ No. 7: Do the new regulations retain the bifurcation rule?
The new regulations do not include the bifurcation rule that was included in the proposed regulations. However, the government has said it will continue to study this issue. The removal of the bifurcation rule alleviates ambiguity about how the IRS would apply the provisions to taxpayers in the event of an audit. The removal is favorable to taxpayers.
FAQ No. 8: Do the new regulations contain an exception for cash pooling arrangements?
The final and temporary regulations do not contain a provision specifically exempting cash pooling arrangements, as had been requested by many taxpayers in the business community. The IRS and Treasury do, however, seem to comport with the notion that cash pooling is a necessary day-to-day business need. Accordingly, the regulations provide indirect relief from many of the roadblocks faced by cash pooling under the proposed regulations.
First, the exclusion of foreign issuers (see FAQ No. 4) under the regulations significantly reduces burdens that would have been placed on taxpayers engaging in foreign cash pooling arrangements. Second, the regulations contain certain special documentation rules that may help alleviate some of the compliance burdens contained in the proposed regulations for cash pooling and similar arrangements. Finally, the recast rules provide exceptions for certain cash pool deposits and borrowings, and other qualified short-term debt instruments. See FAQ No. 11 for additional discussion on these exceptions.
FAQ No. 9: Do the new regulations provide exceptions to the documentation rules?
Covered Members. The documentation rules generally apply to applicable instruments issued between members of an expanded group, but only if the instrument is issued by a covered member to another member of the expanded group. A covered member is defined as a domestic corporation or a disregarded entity of a domestic corporation. Therefore instruments issued by expanded group members that are not domestic corporations, or instruments issued to persons that are not included in the expanded group of the issuer, appear to be exempt from the documentation rules. For example, debts issued by S corporations, noncontrolled real estate investment trusts and regulated investment companies, and controlled partnerships are generally not subject to the documentation rules.
Threshold Limitations. The documentation rules generally apply only if, as of the date that the instrument becomes an expanded group instrument, one of the following three rules apply: (1) any member of the expanded group is publicly traded; (2) total assets exceed $100 million on any applicable financial statement; or (3) annual total revenue exceeds $50 million on any applicable financial statement. The regulations contain detailed rules regarding the prescribed measurement of revenue and assets for purposes of the financial statement-based tests.
FAQ No. 10: Does a documentation failure result in per se equity characterization under the new regulations?
Under the proposed regulations, a documentation failure with respect to a debt instrument resulted in per se equity treatment. The final and temporary regulations allow limited relief from this rule, and provide that if an expanded group is otherwise highly compliant with the documentation rules, then a rebuttable presumption, rather than per se recharacterization as equity, applies in the event of a documentation failure with respect to a purported debt instrument. To rebut the equity presumption, taxpayers must demonstrate a high percentage of compliance with the documentation rules based on specific enumerated tests.
FAQ No. 11: Do the regulations provide any exceptions to the recast rules?
The final regulations modify the proposed recast rules to contain even more complex operating rules, exceptions and definitional limitations. The following is not intended to cover all exceptions, but rather highlights the major exceptions.
Covered debt instruments. The recast rules generally apply to covered debt instruments issued by covered members to other members of the covered member’s expanded group. A covered debt instrument is any debt instrument issued on or after April 4, 2016, unless the debt instrument is: (1) a qualified dealer debt instrument, (2) an excluded regulatory or statutory debt instrument, (3) issued by a regulated financial company, or (4) issued by a regulated insurance company.
Earnings and profits (E&P) and qualified contribution exceptions. In very general terms, the new regulations contain an exception for distributions or acquisitions otherwise falling within the recast rules if the covered member has cumulative positive E&P beginning with the first tax year ending after April 4, 2016. This expands the E&P exception included in the proposed regulations, which was limited to current-year E&P only.
In addition, the new regulations permit a reduction for qualified contributions to the capital of the distributing or acquiring company. This exception for qualified contributions provides that the amount of a distribution or acquisition under the general rule or the funding rule is reduced by the aggregate fair market value of the stock issued by the member in a qualified contribution so long as the qualified contribution does not reduce another distribution or acquisition and is during the qualified period.
The import of both these rules is that an amount transferred in a transaction that may otherwise result in the recast of a debt issuance may be reduced to the extent a taxpayer can demonstrate that it has sufficient E&P and/or qualified contributions during the designated qualified periods. This represents a potentially significant exception to the recast rules.
Qualified short-term debt exception. For purposes of determining whether a debt instrument will be treated as funding a transaction, a qualified short-term debt will not be considered a covered debt instrument and therefore is not subject to the funding rule portion of the transaction rules. The term qualified short-term debt generally includes short-term funding arrangements, ordinary course loans issued as consideration for the acquisition of property in connection with a taxpayer’s trade or business (provided it is reasonably expected to be repaid within 120 days), certain interest-free loans, and deposits with a qualified cash pool header.
Threshold exception. The new regulations retain and expand the $50 million threshold exception. Under the proposed regulations, a debt instrument was not treated as stock if immediately after issuance the aggregate adjusted issue price of all expanded group debt that otherwise would have been treated as stock under the recast rules did not exceed $50 million. The final rules remove the cliff effect of the threshold exception under the proposed regulations such that all taxpayers can exclude the first $50 million of indebtedness that otherwise would be recast.
Other exceptions. Other exceptions apply that are generally centered on certain types of transactions perceived to provide limited potential for abuse. Those include transactions for certain acquisitions of subsidiary stock, acquisitions of compensatory stock, distributions or acquisitions resulting from transfer pricing adjustments, certain acquisitions of expanded group stock by a dealer in securities, etc.
FAQ No. 12: Do the regulations apply to banks and insurance companies?
Yes. However, broad relief from the recast rules was provided to certain highly regulated industries such as banks, financial institutions and insurance companies. In addition, the new regulations ease the documentation requirements in certain areas for insurance companies and regulated industries. For example, the regulations treat certain instruments with terms required by certain regulators as meeting the documentation and information requirements.
FAQ No. 13: Do the regulations apply to partnerships?
The new scope limitations imposed by the regulations exempt debt issued by partnerships from the documentation rules. However, debt of a covered member that is held by a controlled partnership may still be subject to the rules.
As for the recast rules, the regulations generally retain, with certain modifications, the aggregate approach to debt issued by or to a partnership that has partners that are members of an expanded group.
FAQ No. 14: What are the potential consequences imposed by the final and temporary regulations?
The regulations provide rules that operate to recharacterize internal debt funding transactions as equity. Such equity recharacterization may cause other unintended adverse tax consequences. For example, equity treatment may affect repatriation planning, reduce or eliminate U.S. interest deductions, or have other significant U.S. federal income tax consequences.
The final and temporary regulations substantially narrow the scope incorporated in the proposed regulations and are intended to more precisely target inbound earnings stripping transactions. However, despite the many taxpayer-favorable amendments discussed above, significant consequences remain under the new regime. Although exceptions were added, many came with complex operating rules that should be carefully considered to avoid the daunting traps set by the regulations. Accordingly, taxpayers should carefully evaluate and navigate the new regulations when entering into most related-party lending transactions.
Partner, International Tax Services
Washington National Tax Office
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Manager, International Tax Services
Washington National Tax Office
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