TRUE ALERT: Final Debt-Equity Regulations More Narrowly Focused on Earnings Stripping

 
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Earlier this year, the Government proposed sweeping regulations to address “earnings stripping”—in which a U.S. company borrows money from a foreign affiliate, thereby shifting income from the United States to a jurisdiction with lower tax rates. The proposed regulations—issued under section 385 of the Internal Revenue Code—were designed to treat certain instruments that were purportedly debt as stock in order to address this perceived erosion of the U.S. tax base.

Specifically, the proposed rules:

  • Allowed the IRS to bifurcate an instrument, treating it part as debt and part as stock for federal income tax purposes;
  • Required timely documentation as a necessary factor for an instrument to be treated as debt and prescribed in detail the nature of the documentation;
  • Identified additional dispositive factors indicating that an instrument should be treated as stock for federal income tax purposes involving—
    • A distribution of a debt instrument to shareholders or similar transactions that achieve economically similar results;
    • A “funding rule” treating an instrument as stock where it is issued as part of a series of transactions that achieve economically similar results;
    • A 72-month per se rule;
  • Contained several exceptions (in particular, for consolidated groups), special rules, and anti-abuse provisions.

Commentators immediately blasted the proposed regulations as creating massive compliance problems and collateral consequences not justified by the Government’s concern for earnings stripping.  The Treasury Department received nearly 30,000 comments from the public on these rules (although many were substantially identical comments from members of lobbying groups), including about 150 detailed, substantive comments from bar associations, accounting firms, and other tax professionals.

On October 13, 2016, the Government issued final, temporary, and proposed regulations replacing the earlier proposed rules. The final regulations modify the proposed rules in significant respects; most of the changes are in response to the comments received by the Government. In general, the changes modify the scope of the rules so that they apply to fewer taxpayers, relax many of the strict rules in the proposed regulations, and provide a better balance between the burdens on taxpayers and the policy objectives of the Government.

Among the most important changes, the final regulations:

  • Do not apply to foreign borrowers, S corporations, RICs, REITs, regulated financial groups, and insurance companies;
  • Eliminate the bifurcation rule;
  • Modify the documentation rules by—
    • Requiring documentation and financial analysis to be in place by the time the issuer’s federal income tax return is filed (including extensions);
    • Making the presumption that failure to meet the documentation requirements a rebuttable presumption that the instrument is stock, rather than the per se recharacterization as stock provided in the proposed regulations;
    • Delaying application of the final rules to debt instruments issued on or after January 1, 2018;
  • Generally exclude cash pooling, cash management arrangements, and other short-term debt instruments from their scope (although the documentation rules apply to these situations);
  • Narrow application of the funding rule by preventing, in some cases, the “cascading” effect of recharacterizing a debt instrument as stock;
  • Expand the earnings and profits exception to include E&P accumulated after April 4, 2016;
  • Eliminate the “cliff effect” of the proposed regulations to allow all taxpayers to exclude the first $50 million of indebtedness from recharacterization;
  • Provide credit for certain capital contributions to be netted against distributions and similar transactions;
  • Provide an exception for equity compensation; and
  • Provide that any instrument subject to recharacterization as stock will not be recharacterized until immediately after January 19, 2017.

On the other hand, the Government kept the controversial funding rule and its 72-month per se rule.

The revised documentation requirements will apply to an expanded group instrument issued by a domestic corporation (other than an S corporation, RIC, or REIT) where any member of its expanded group is publicly traded, the total assets of the group exceed $100 million on any applicable financial statement, or annual total revenue of the group exceeds $50 million on any AFR or combinations of AFRs. The Government estimates that the documentation rules will impact only 6,300 of the roughly 1.6 million C corporations in the United States (0.4%).

Even if the taxpayer is not expressly covered by the documentation requirement, the issue of whether an instrument is debt or equity could still arise on IRS examination of any taxpayer’s tax returns. Moreover, a taxpayer may unknowingly be in a position to exceed the $50 million or $100 million threshold limitations in a given year. As a result, we believe that it is a “best practice” for all taxpayers to create and maintain documentation similar to that required by the final regulations.

One of the major open issues is the extent to which the States may follow the federal rules, particularly with regard to the general exception for instruments between members of a consolidated group.  Some practitioners believe that the states will use these regulations as a tool to disallow interest expense on certain intercompany transactions. 

Taxpayers who may be affected by the final regulations should review all of their existing intercompany debt arrangements (including cash management accounts) to determine their potential exposure under the new rules. They should then develop internal processes and procedures to ensure that they maintain compliance with the regulations. The income tax experts at True Partners Consulting are available to assist in this review.

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Contacts:

Robert M. Gordon
Managing Director
312-235-3321
Robert.Gordon@TPCtax.com

Ron Tambasco
Managing Director
813-434-4001
Ron.Tambasco@TPCtax.com

 

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