While the primary target might have initially been large multinational companies, the proposed regulations met wide-spread criticism for their severe impact on businesses of all sizes.
Now, the final regulations under Section 385 have been issued, with a scaled back scope in an attempt to alleviate some of the affects on businesses.
Guidance on the Significance of the New Regulations
The IRS recently issued the much-anticipated final regulations intended to keep multinational companies from moving their profits offshore to avoid paying U.S. income taxes. The regulations are part of a larger campaign against corporate inversions, whereby a U.S. company merges with a foreign firm and then changes its tax address (domicile) to the foreign country. In particular, these regulations address “earnings stripping,” a practice commonly used to minimize U.S. taxes after an inversion by injecting debt into what is left of the U.S. business.
The finalized regulations (outlined below, and also referred as the “debt-equity” or “Section 385” regulations) contain numerous changes in response to extensive feedback from the proposed regulations released earlier this year. The proposed regulations drew much criticism and would have impacted many more related party lending arrangements, even if no earnings stripping situation existed. Due, in part to comments from many parties, including members of Congress, the final regulations greatly reduced the scope of the proposed regulations.
The primary focus of these regulations is to limit the ability of corporations to pursue earnings stripping and perhaps other tax objectives by allowing the IRS to treat certain debt transactions among related parties (for example, a foreign parent company and a U.S. affiliate) as equity transactions. In other words, if certain documentation requirements for the intercompany debt are not met or the debt is issued in specified “tainted transaction,” the IRS will then be able to re-characterize intercompany notes as stock and deny deductibility of interest payments.
Overview of the Regulations
These regulations (both the proposed and final formats) are complicated, but they can be broken down into three main areas. The first part of the regulations focuses on the members of affiliated group of related entities that are subject to these rules. Second, the regulations address the documentation requirements of any related party instrument. Finally, the regulations address what happens if the group has a “tainted transaction,” and is thus, subject to the instrument being re-cast as stock instead of debt.
A. Related Party Groups
The IRS issued proposed regulations to tackle the so-called “earnings stripping” approach by tightening the tax rules that distinguish between debt and equity instruments. According to the IRS, multinational corporations often use earnings stripping after a corporate inversion to minimize their U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country, such as Ireland. The technique can generate significant interest deductions without any corresponding new investment in the United States.
One of the more significant changes made by the IRS in the final regulations was that these rules only apply to instruments issued by U.S. (or domestic) corporations; they do not apply to foreign issued instruments. Any instruments issued by U.S. corporations that are held by other members of the affiliated group (including any foreign members), however, will be impacted by these new rules.
Another key change with instruments issued between affiliated members was that the proposed regulations would have provided the IRS the ability to treat an instrument as “part debt” and “part equity” (the “bifurcation rule”). This bifurcation rule included in the proposed regulations has been eliminated in the final regulations.
Further, one of the other major changes dealing with members of expanded group of related parties is that the final regulations now exempt S Corporations, RICs and REITs from the impact of these regulations.
B. Documentation Requirements Apply (Documentation Rule)
The final regulations also require corporations claiming interest deductions on related-party loans to provide documentation for the loans, for example, a note, a loan agreement, an annual credit analysis evidencing the following factors:
• An unconditional and binding obligation to make interest and principal payments on certain fixed dates;
• The debt holder’s rights as a creditor, including superior rights to shareholders in the case of dissolution;
• A reasonable expectation of the borrower’s ability to repay the loan; and
• Conduct consistent with a debtor-creditor relationship.
In addition, the regulations indicate that the Documentation Rule must be met if the financial statements of the expanded group have assets over $100,000,000; or annual revenue that exceeds $50,000,000.
The documentation rules in the proposed regulations were very harsh, but have been softened somewhat in the final regulations. An existence of a “rebuttable presumption” may save the taxpayer from than an automatic re-characterization of the instrument as stock for lack of documentation (as was spelled out in the proposed regulations). Impacted taxpayers, however, must still review and adhere to these regulations. If they fail to meet the provisions of the “Documentation Rule,” then the instrument will be treated as stock for all U.S. tax purposes.
C. Recharacterization Rule: Exceptions Expanded for Ordinary Business or Course Transactions
As noted above, the most significant change in the final regulations is that the Recharacterization Rule only applies to debt issued by covered members that are domestic corporations (which excludes foreign borrowers). In addition, there were several other changes in the Recharacterization Rule. There is an exception for distributions (payments made to affiliates) to now generally include future earnings and allow corporations to net their distributions against capital contributions. The exceptions for ordinary course transactions have been expanded to include acquisitions of stock associated with employee compensation plans, among others.
Possible State Tax Impact
A recharacterization of debt under the final and temporary regulations could also result in several potential state tax impacts. Companies will need to consider the possible state tax treatments of distributions associated with an instrument that is converted from debt into stock. For instance, this could involve principal and interest payments being re-cast to dividends, return of basis, and distributions in excess of basis for states tax purposes.
Effective Dates of the Regulations
The proposed regulations indicated that the regulations (other than the documentation requirements) would generally be effective when made final. The final regulations, however, provide that Recharacterization Rules apply as of April 4, 2016, while the Documentation Rules apply to debt issued on or after January 1, 2018.
What a Business Can Do Now
A business could undertake the following steps now in light of these final regulations.
First, identify all debt instruments a group has in place and determine if any of these are subject to the new Recharacterization Rules.
Fix any debt instruments and adopt policies to ensure sure the instruments adhere to the Recharacterization Rules.
Adopt polices to make certain any debt instruments adhere to the Documentation Rule.
Other changes and further review may be needed depending on your particular situation, but this is a good start.
Finally, these controversial regulations received much attention this year, but the final regulations backed off in a number of areas. It is uncertain what the new administration and Congress will do with these regulations next year. So keep an eye on this. As these regulations are now final, however, impacted businesses should evaluate these closely. For more information on specifically how the new guidance applies to your business and its related-party debt transactions, please contact a Sikich tax advisor.