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IRS Limits Application of Debt/Equity Regs, Expands Exceptions for Ordinary Business Transactions

(Parker Tax Publishing November 2016)

The IRS has issued final and temporary regulations under Code Sec. 385 that make substantial changes to controversial proposed regulations that addressed the characterization of debt and equity in an attempt to combat earnings stripping following a corporate inversion. The final regulations, which apply to debt instruments issued on or after January 1, 2018, generally exempt foreign taxpayers, S corporations, and some RICs and REITs from the new rules, relax documentation requirements, and limit the scope of the new rules in order to reduce the impact on ordinary business transactions. T.D. 9790 (10/21/16).


Corporate inversions are seen as a problem for the U.S. tax system because they are generally entered into for tax avoidance purposes. A corporate inversion is a transaction in which a multinational group with a U.S. parent changes its tax residence to reduce or avoid paying U.S. taxes. Specifically, a group with a U.S. parent engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the U.S., typically in a low-tax country. After a corporate inversion, multinational corporations often use a tactic called "earnings stripping" to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country. For example, following an inversion or foreign takeover, a U.S. subsidiary can issue its own debt to its foreign parent as a dividend distribution. The foreign parent, in turn, can transfer this debt to a low-tax foreign affiliate. The U.S. subsidiary can then deduct the resulting interest expense on its U.S. income tax return at a significantly higher tax rate than is paid on the interest received by the related foreign affiliate. The related foreign affiliate can also use various strategies to avoid paying any tax at all on the associated interest income. The IRS stated that, when available, these tax savings incentivize firms with a foreign parent to load up their U.S. subsidiaries with related-party debt.

In April, the IRS issued proposed regulations (REG-108060-15 (4/8/16)) which targeted earnings stripping transactions. The proposed regulations generally made it more difficult for groups with a foreign parent to quickly load up their U.S. subsidiaries with related party debt following an inversion or foreign takeover, by treating as stock instruments issued to a related corporation through dividends or certain economically similar transactions. In addition, the proposed regulations provided that the IRS, on audit, could divide a purported debt instrument into part debt and part stock (bifurcation rule).

The proposed regulations were met with immense backlash from Congressional lawmakers and businesses concerned that the proposed regulations would impose compliance burdens and result in collateral consequences that were not justified by the stated policy objectives. In response to these concerns, the IRS has issued final and temporary regulations that substantially revise the proposed regulations.

Final Regs Exempt Foreign Issuers, S Corps, RICs, and REITs, Remove Bifurcation Rule

The proposed regulations generally applied to "expanded groups," which were defined by reference to Code Sec. 1504(a) "affiliated groups" but broadened to include foreign and tax-exempt corporations, as well as corporations held indirectly, for example, through partnerships. Practitioners expressed concerns regarding the complexity of applying the proposed regulations to foreign borrowers. In addition, practitioners requested that S corporations, regulated investment companies (RICs), and real estate investment trusts (REITs) be excluded from the definition of an expanded group, noting that these entities are similar to non-controlled partnerships (which the proposed regulations would not have included in an expanded group), and that recharacterization of an instrument issued by these entities could affect its tax status.

In response to practitioner concerns, the final regulations apply only to instruments issued by members of an expanded group that are domestic corporations. In addition, the final regulations exempt from the definition of an "expanded group" S corporations and RICs or REITs that are not controlled by members of an expanded group. Thus, the final regulations do not apply to foreign issuers, S corporations, and non-controlled RICs and REITs.

The final regulations also do not include the general bifurcation rule from the proposed regulations. The IRS noted that this rule was broadly applicable and not subject to the same threshold rules as most of the regulations' other provisions. Practitioners had expressed concerns about a lack of specificity in application and corresponding unintended collateral consequences. For example, one concern was that this provision could have unintended and disqualifying effects on an entity's tax status, such as for an S corporation or a REIT. The IRS stated it is continuing to study comments received on the proposed bifurcation rule.

Final Regulations Relax Documentation Requirements

Under the proposed regulations, companies were required to undertake certain due diligence procedures and complete documentation up front to establish that a financial instrument is really debt. Specifically, the proposed regulations required key information be documented, including a binding obligation for an issuer to repay the principal amount borrowed, creditor's rights, a reasonable expectation of repayment, and evidence of an ongoing debtor-creditor relationship. Prop. Reg. Sec. 1.385-2 provided that the absence of timely preparation of documentation and financial analysis evidencing these four essential characteristics of indebtedness would be a dispositive factor requiring a purported debt instrument to be treated as stock for federal tax purposes.

The final regulations eliminate the timely document preparation requirement, and instead treat documentation and financial analysis as timely prepared if it is prepared by the time that the issuer's federal income tax return is filed (taking into account all applicable extensions). The final regulations also provide that, if an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than per se recharacterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument.

In addition, the final regulations apply only to debt instruments issued on or after January 1, 2018.

Final and Temp Regs Make Significant Changes Regarding Distributions of Debt Instruments and Similar Transactions

Under the proposed regulations, if the application of Prop. Reg. Sec. 1.385-2 and general federal income tax principles otherwise would result in treating an interest issued to a related party as indebtedness for federal tax purposes, Prop. Reg. Sec. 1.385-3 provided additional rules that would treat the interest, in whole or in part, as stock for federal tax purposes if it was issued in a distribution or other transaction that was identified as frequently having only limited non-tax effect (the general rule), or was issued to fund such a transaction (the funding rule).

The final and temporary regulations under Reg. Sec. 1.385-3 generally retain these rules that recharacterize purported debt of U.S. issuers as equity if the interest is among highly related parties and does not finance new investment, but make significant modifications and provide various exceptions and exclusions in order to exempt most ordinary course transactions and certain common commercial lending practices from being subject to the rules.

Specifically, the final and temporary regulations provide that, when applying the Reg. Sec. 1.385-3 rules, an expanded earnings and profits (E&P) exception takes into account a corporation's E&P accumulated after April 4, 2016, as opposed to limiting distributions to the amount of E&P generated each year (as under the proposed regulations). However, the accumulated E&P available under this exception to offset distributions or acquisitions for purposes of applying the Reg. Sec. 1.385-3 rules resets to zero when there is a change in control of the issuer due, for example, to the issuer being acquired by an unrelated party.

In addition, Reg. Sec. 1.385-3 does not apply to cash pool borrowing and other short-term debt. The exception for short-term debt allows companies to efficiently transfer cash around an affiliated group in order to meet the day-to-day global cash needs of the business without resorting to third-party borrowing in order to avoid Reg. Sec. 1.385-3.

The final and temporary regulations also provide an exception for the first $50 million of debt that would otherwise be recharacterized as stock. Under the threshold exception in Reg. Sec. 1.385-3(c)(4), immediately after debt would be treated as stock, to the extent that the aggregate adjusted issue price of that debt exceeds $50 million, only the amount of the debt in excess of $50 million will be treated as stock.

In addition, the final and temporary regulations make the following changes:

(1) Exclusion of debt instruments issued by regulated financial groups and insurance entities - The final and temporary regulations do not apply to debt instruments issued by certain specified financial entities, financial groups, and insurance companies that are subject to a specified degree of regulatory oversight regarding their capital structure.

(2) Limiting certain "cascading" recharacterizations - The final and temporary regulations narrow the application of the funding rule by preventing, in certain circumstances, the so-called "cascading" consequence of recharacterizing a debt instrument as stock.

(3) Credit for certain capital contributions - The final and temporary regulations provide an exception pursuant to which certain contributions of property are "netted" against distributions and transactions with similar economic effect.

(4) Exception for equity compensation - The final and temporary regulations provide an exception for the acquisition of stock delivered to employees, directors, and independent contractors as consideration for the provision of services.

The final and temporary regulations also provide that any debt instrument that is subject to recharacterization but that is issued on or before January 19, 2017, will not be recharacterized until immediately after that date.

Effective Date and Transition Rules

The final and temporary regulations generally apply to tax years ending on or after January 19, 2017. In addition, the final regulations under Reg. Sec. 1.385-2 do not apply to interests issued or deemed issued before January 1, 2018. Reg. Sec. 1.385-3 and Reg. Sec. 1.385-3T grandfather debt instruments issued before April 5, 2016.

The final regulations under Reg. Sec. 1.385-3 provide a transition period under which any debt instrument that would be treated as stock by reason of the application of the final and temporary regulations on or before January 19, 2017 (the final transition period) is not treated as stock, but rather the covered debt instrument is deemed to be exchanged for stock immediately after that date, but only to the extent that the debt instrument is held by a member of the issuer's expanded group immediately after that date (final transition period rule). Thus, the final transition period rule addresses both debt instruments that would have been recharacterized before the final and temporary regulations become applicable (that is, because the recharacterization would have occurred during a taxable year ending before January 19, 2017), as well as other debt instruments that would be treated as stock on or before that date.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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