Final regulations target related-party debt
In October 2016, the IRS issued the final and temporary Section 385 regulations providing for the recharacterization of certain corporate debt as equity. These regulations are designed to prevent companies from using inversions and other strategies to avoid or minimize U.S. federal income taxes. Although the regulations remain controversial — and could change under the new presidential administration — they significantly narrow the scope of earlier proposed regulations.
War on inversions
The new regulations are an important weapon in the IRS’s battle with corporate inversions and earnings-stripping transactions. In a typical inversion, a company in a low-tax foreign jurisdiction acquires a U.S. corporation (or a multinational group with a U.S. parent). The merged group then relocates its tax residence to the foreign jurisdiction. After an inversion, the group may use earnings stripping (see “Earnings stripping: How does it save taxes?”) to shift income from the U.S. corporation to its lower-taxed foreign affiliates.
The regulations combat this practice by re-characterizing certain types of debt between related parties as equity. Converting deductible interest into nondeductible dividends effectively erases the earnings stripping benefits. Plus, dividends paid to foreign companies may be subject to U.S. withholding taxes at substantially higher rates than interest.
The proposed regulations were heavily criticized by commenters for being so broad in scope that they would adversely affect not only earnings stripping, but also legitimate cash management practices. The final and temporary regulations address this concern by substantially narrowing the scope of the rules and introducing several significant exceptions.
Proposed rules widen reach
The proposed regulations sought to require public companies and companies whose audited financial statements report total assets over $100 million or annual revenue over $50 million to maintain documentation that supported the treatment of related-party debt as debt (the “Documentation Rules”). Failure to do so would have resulted in recharacterization of debt as equity. And, the IRS would have had the authority to bifurcate debt into part debt and part equity.
The proposed regulations also contained the “Recast Rules,” which would automatically re-characterize notes or other debt instruments as equity if they were issued:
- As a distribution to a related party,
- To acquire a related party’s equity,
- As consideration in certain types of asset reorganization, or
- With the principal purpose of funding any of the above transactions.
One of the most contentious provisions was the “Funding Rule.” This is an irrebuttable presumption that a debt’s principal purpose is to fund a transaction if it’s issued within the 72-month period surrounding the transaction (with an exception for certain ordinary course debt instruments).
Final rules narrow scope
The final and temporary regulations retained many of the concepts in the proposed regulations — including the Documentation, Recast and Funding Rules. But they rewrote them in an attempt to address earnings stripping more narrowly.
For example, the new rules don’t apply to debt issued by foreign corporations or by certain regulated entities, such as financial and insurance companies. Partnerships are also excluded, although an anti-abuse provision to prevent companies from using controlled partnerships to evade the rules has been included. S corporations, non-controlled regulated investment companies and real estate investment trusts are exempt from most provisions.
As for the Documentation Rules, companies must now prepare required documentation by an issuer’s extended tax return due date, rather than 30 (or, in some cases, 120) days after debt issuance, as originally proposed. In addition, taxpayers that are “highly compliant” with the Documentation Rules may rebut the presumption that an undocumented debt is equity. The final rule also delayed the Documentation Rules’ effective date and will apply to debt instruments issued on or after January 1, 2018.
Another change makes certain routine treasury management techniques, including cash pooling and short-term loans, exempt from the Recast Rules (but not the Documentation Rules). Also, the exception for debt to the extent of an issuer’s current-year earnings and profits (E&P) now includes all E&P accumulated while a member of the expanded group for tax years ending after April 4, 2016. Finally, the IRS will not be authorized to bifurcate related-party debt into part debt and part equity. Other changes narrow the scope of both the Documentation and Recast Rules.
Despite their narrower scope, the final regulations will have significant consequences for many taxpayers. Review your debt and cash management practices and evaluate the new rules’ impact. And keep in mind that Congress or the new administration may modify these rules in the future.
Earnings stripping: How does it save taxes?
Often, after an inversion, corporate groups use earnings stripping as a strategy for minimizing their U.S. tax liability. The concept is simple: A U.S. corporation borrows money from or issues a debt instrument to a parent corporation or other affiliate in a low-tax foreign jurisdiction.
The U.S. corporation pays interest on the debt to its foreign affiliate, deducting the payments from its earnings for U.S. tax purposes. The foreign recipient’s interest income is then taxed at favorable withholding rates or, under some tax treaties, not at all. Essentially, this technique shifts income from the U.S. to jurisdictions with substantially lower tax rates, with little or no withholding tax cost.