Authored by: Robert Gordon, Managing Director
During the past several years, “inversion” transactions—where a U.S. company is acquired by a smaller, foreign corporation based in a lower-tax jurisdiction—have been attacked by the President, Congress, the U.S. Treasury Department, and the IRS as “unpatriotic” attempts to weaken the U.S. tax base and export jobs overseas. Congress enacted Code section 7874 in 2004, Treasury issued regulations in 2008, and the IRS issued guidance limiting taxpayers’ ability to invert in 2014 and 2015. Nevertheless, the activity has continued, most recently in the proposed merger of Pfizer Inc. with Ireland-based Allergan plc.
On April 4, 2016, the Government brought out the heavy artillery. It blasted the transactions with new temporary and proposed regulations that not only make it even more difficult to invert in the first place, but eviscerate the tax benefits of inversions and, in the case of the proposed regulations that will treat certain intercompany debt as equity for tax purposes, inflict “collateral damage” on standard methods of capitalizing members of corporate groups. (In response, Pfizer and Allergan canceled their proposed merger.)
The temporary regulations (T.D. 9761) incorporate the rules described in Notices 2014-52 and 2015-79 that address certain transactions designed to avoid the anti-inversion purposes of Code section 7874 and to reduce the tax benefits of companies that invert. The temporary regulations also clarify certain definitions and exceptions and introduce new rules addressing issues not discussed in either Notice, including (i) identifying a foreign acquiring corporation in multi-step transactions; (ii) disregarding stock of the foreign acquiring corporation that is attributable to previous acquisitions of domestic entities; (iii) requiring CFCs to recognize gain upon certain asset transfers to a related foreign person that is not a CFC; and (iv) defining group income for purposes of the substantial business activities test.
But the truly explosive change is contained in the proposed regulations, which will treat as stock certain related-party interests that otherwise would be treated as debt for federal income tax purposes. The proposed rules are designed to attack “earnings stripping”—whereby a foreign corporation lends money to its US subsidiary, which can then reduce its US taxable income through interest deductions while including in its foreign income the interest payments (presumably at a lower tax rate). The rules, however, apply not only to cross-border transactions, but also to instruments between two related domestic entities.
In the view of the government, related-party indebtedness is suspect because there is typically little economic incentive for a related-party lender to impose discipline and diligence on the behavior of a related party borrower. The proposed rules therefore contain two major elements: a documentation requirement and recharacterization of certain purported debt as equity, in whole or in part, to reflect its substance.
The documentation requirements address four characteristics of bona fide indebtedness: (i) a legally binding unconditional obligation to pay a sum certain; (ii) the holder must have the rights of a creditor to enforce the obligation; (iii) at the time the instrument is issued, there must be a reasonable expectation that the issuer will be able to repay the debt; and (iv) during the time that the instrument is outstanding, the parties’ actions evidence a bona fide debtor-creditor relationship. Documentation regarding the first three items must be prepared contemporaneously with the issuance of the instrument, while the fourth item must be documented as repayments are made (or not made).
The preparation and maintenance of this documentation is necessary, but not sufficient, to treat the obligation as debt. Thus, if the documentation is not created or maintained, the instrument cannot be treated as debt; but even if it is maintained, the IRS can still examine the substance of the arrangement to reclassify some or all of the purported debt as equity.
The documentation requirements apply to taxpayers that are publicly traded or have an applica-ble financial statement with assets exceeding $100 million or revenues exceeding $50 million. The requirements will be effective when the regulations are finalized.
The second, more substantive, element focusses on three types of transactions between affiliates: (i) a distribution of debt instruments by corporations to their related corporate shareholders; (ii) issuance of debt instruments by a corporation in exchange for stock of an affiliate; and (iii) certain issuances in an exchange pursuant to an internal asset reorganization. The regulations also address situations where a third, related party funds one of these three types of transactions. In each of these situations, the regulations generally treat a purported debt instrument as stock.
There are several exceptions to this general rule, including (i) current year e&p of the issuer reduces the amount of the note that is treated as stock; (ii) if the aggregate adjusted issue price of all debt instruments held by members of the extended group does not exceed $50 million; or (iii) an acquisition of expanded group stock if the acquisition results from a transfer to an issuer in exchange for stock of the issuer and the transferor remains in control of the issuer for the next 36 months. In addition, members of a consolidated group are treated as one corporation, so the proposed rules will have limited applicability in that context. On the other hand, partnerships and disregarded entities are viewed as aggregates, so they (or their owners) are subject to the rules.
These rules will apply to any debt instrument issued on or after April 4, 2016, with certain transition rules.
The proposed rules—issued under Congress’s grant of “necessary and appropriate” authority to Treasury to define the difference between debt and equity—are a radical change to existing law. The Treasury and IRS estimate that the rules could apply to as many as 21,000 taxpayers, and have asked for requests for a hearing and comments on the proposed regulations by July 7, 2016. In particular, they have asked the public to comment on other issues, including additional instruments that should be subject to the proposed regulations; whether special rules are necessary for cash pools, cash sweeps, and similar cash management arrangements; whether certain instruments commonly used by investment partnerships, including debt issued by “blocker” entities, should be subject to the proposed rules; and the treatment of controlled partnerships.
Almost every corporate taxpayer will be impacted in some way by these new rules. Taxpayers should review all of their existing intercompany debt arrangements (including open accounts maintained for cash management purposes) to determine their potential exposure if the proposed regulations become final. The Federal tax experts at True Partners Consulting are available to assist in this review or to help prepare comments on the proposed regulations.
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