If they become final, the IRS and Treasury Department’s proposed regulations on related-party debt and equity transactions, meant to curb what is commonly called “earnings stripping,” could affect a wide swath of ordinary business transactions that involve related-party lending. The regulations, released April 4 as part of a crackdown on inversions, are not limited to inverted companies or cross-border transactions but apply broadly to ordinary-course related-party debt transactions. This means many U.S.-based companies, not just those that changed their legal addresses to low-tax countries, may have to change their internal financing strategies, treasury functions and tax planning.
Here are three key elements of the regulations:
They permit the IRS to bifurcate interests that are indebtedness in part but not in whole into part-debt and part-equity for federal tax purposes. This action is contrary to a long-held practice that treats an instrument as either debt or equity. It applies generally to debt among related legal entities, not bank loans or other third-party borrowing.
They require that certain due diligence and documentation be undertaken to substantiate the treatment of certain interests issued between related parties as indebtedness. If a taxpayer fails to timely prepare and maintain this required documentation, or fails to provide required documentation to the IRS upon request, the debt instrument will be treated as equity. The factors include a binding obligation to repay, reasonable expectation of repayment and other requirements effectively showing evidence that the lender undertook ordinary diligence that would otherwise be present in a third-party lending transaction.
They provide specific rules that treat certain debt instruments as stock that would otherwise be treated as indebtedness for federal income tax purposes. This measure is intended to target related-party leverage without an investment of new capital.
The breadth of the regulations, which could result in a significant loss of interest deductions and possibly initiate a withholding tax obligation for issuers, is sure to ignite lobbying and comments. The comment period is open only until July 7, and Treasury has indicated it will move “swiftly” to make the regulations final.
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