Proposed Regulations Will Greatly Affect Intra-Group Financing (article)
The IRS in April issued proposed regulations under Internal Revenue Code Section 385 relating to the classification of financial instruments as debt or equity. Although the proposed regulations were primarily intended to address post-inversion earnings-stripping of U.S. subsidiaries of inverted companies, they reach far beyond that narrow category of transactions and have the potential to fundamentally change how multinational groups finance their operations.
The proposed regulations supplement, rather than supersede, existing limitations on the deductibility of interest on related-party debt instruments under Code Sections 163(j) and 267.They give the IRS broad discretion to treat instruments that appear to be debt as though they are stock—in whole or in part.Such a recharacterization is applicable for all purposes under the Code.
The proposed regulations take a two-pronged approach to addressing what Treasury and the IRS apparently perceive as abusive uses of inter-company debt. First, in order to treat an inter-company debt instrument in accordance with its terms, taxpayers must compile, keep and make available to the IRS upon request extensive contemporaneous documentation supporting the characterization of the instrument as debt. Second, issuances of purported debt in connection with, or that are used to fund, certain kinds of distributions, acquisitions or restructurings are subject to a per se recharacterization rule.
The proposed regulations generally will go into effect when they are finalized. Certain aspects of the rules, however, are proposed to be effective for instruments issued or transactions entered into on or after April 4, 2016.IRS Commissioner John Koskinen has said that the agency hopes to finalize the proposed rules by Labor Day.
Who (and What) Is Affected?
In order to be subject to the new regulations, a purported debt instrument must be an “expanded group instrument,” or “EGI.” An EGI is any “applicable instrument” (any instrument that is in the form a debt instrument) issued by a member of an “expanded group” and held by another member of the same expanded group. An expanded group is defined by reference to the definition of “affiliated group” (groups that are permitted to elect to file consolidated returns), but with two significant differences. First, an entity is part of the group if it is owned 80 percent or more, by vote or value, by another group member (the affiliated group rules normally require that a member be owned 80 percent or more by vote and value). Second, entities that are normally not permitted to be included in a consolidated return—tax-exempt entities, insurance companies, foreign corporations, DISCs, and S corporations—can be part of an expanded group if the ownership requirements are met.
The Documentation Rules
The documentation rules set forth in Proposed Regulations Section 1.385-2 provide relief for smaller companies. The documentation rules apply to EGIs only if, as of the date the instrument becomes an EGI:
- the stock of a member of the expanded group is publicly traded, or
- there is an “applicable financial statement” that shows either more than $100 million of total assets or more than $50 million of annual revenue.
An applicable financial statement is any separate-company financial statement of any member of the expanded group, or any consolidated financial statement that includes assets or revenue of any member of the expanded group, if:
- It is required to be filed with the SEC;
- It is an audited statement that is used for credit purposes, reporting to shareholders, or any other substantial non-tax purpose; or
- It is a statement other than a tax return that it is required to be provided to any Federal, state, or foreign government agency.
For those entities not exempt from the documentation rules, any EGI is automatically treated as stock unless specified documentation is prepared and maintained. This documentation requirement notwithstanding, an EGI may still be recharacterized as stock if the IRS determines, using the facts-and-circumstances approach outlined in the case law, that it is more appropriately treated as stock. Thus, compliance with the documentation rules is not a safe harbor.
In general, within 30 days after a member of the expanded group becomes an issuer of an EGI, the following documents must be created:
- A written and executed instrument evidencing the issuer’s “unconditional and legally binding obligation to pay a sum certain on demand or on one or more fixed dates,” and also establishing “that the holder has the rights of a creditor to enforce the obligation;” and
- Documents establishing that, given the issuer’s financial condition, there is a reasonable expectation that the issuer would be able to, and would, meet its obligations pursuant to the instrument, which “may include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity and other relevant financial ratios … and other information regarding the sources of funds enabling the issuer to meet its obligations ….”
If the taxpayer relies on payments of interest or principal to establish that the instrument is properly treated as debt, those payments must be documented. Finally, if there is an event of default under the instrument, the holder must document its “reasonable exercise of the diligence and judgment of a creditor.” It is not an overstatement to say that holders of EGIs will be required to behave like commercial lenders and keep files demonstrating that they have done so. This documentation must be kept for as long as the instrument is outstanding and until the statute of limitation expires for any year in which the classification of the instrument as debt or equity is relevant. The documentation must be provided to the IRS upon request.
Per Se Recharacterization
Proposed Regulations Section 1.385-3 automatically treats as stock “certain interests” in a corporation that are held by a member of the expanded group that would otherwise be treated as debt. Subject to certain transition rules, these rules apply to instruments issued on or after April 4, 2016. The proposed regulations provide for both a “general rule” and a “funding rule.”
Under the general rule, purported debt is treated as stock in three specific circumstances:
- It is issued as a distribution (with respect to the issuer’s stock);
- It is issued in exchange for stock of another member of the expanded group (except in a small category of exempted transactions); or
- It is issued in an asset reorganization and received by a member of the expanded group with respect to its stock in another member of the expanded group.
The funding rule treats as stock purported debt of an expanded group member issued with a principal purpose of funding a transaction described in any of the three prongs of the general rule. The proposed regulations state that whether a principal purpose exists is determined based on all facts and circumstances; however, there is a non-rebuttable presumption that instruments issued within 36 months before or 36 months after a distribution or acquisition have the prohibited principal purpose. There is an exception to the presumption for ordinary-course trade receivables for goods or services.
A so-called “threshold exception” limits the application of both the general and the funding rules. Purported debt that would otherwise be recharacterized as stock under these rules will not be recharacterized if the aggregate adjusted issue price of all such instruments held by members of the expanded group is $50 million or less. Distributions or acquisitions under either the general rule or the funding rule that do not exceed current year earnings and profits (E&P) are also exempt from these rules.
Treatment of Recharacterized Debt
As noted above, debt recharacterized as stock, in whole or in part, under the proposed regulations is treated as stock for all purposes under the Code. The consequences of such recharacterization can be far-reaching. At a minimum, amounts previously characterized as interest would be treated as distributions with respect to the issuers stock. This can affect the issuer’s earnings and profits (E&P), the previously taxed income of an issuer that is a controlled foreign corporation, U.S. withholding taxes and a potentially vast number of other collateral effects. Recharacterization of debt as stock could also require revision of Section 163(j) calculations.
The proposed regulations, however, grant some limited relief to both issuers and holders when debt is recharacterized. The debt is deemed to have been exchanged by the holder for stock with a fair market value equal to the holder’s adjusted basis in the debt, so that the holder does not recognize gain or loss on the deemed exchange; similarly, the issuer is deemed to have retired the recharacterized debt for an amount equal to its adjusted issue price, so that the issuer does not recognize gain or loss. Any foreign exchange gain or loss that arises in a deemed exchange of debt, however, must be recognized.
If the proposed regulations are finalized in their present form, they will substantially affect the way all but the smallest multinational groups fund their operations. Informal, poorly documented inter-company financings will no longer be treated as debt. Some well-known repatriation strategies will be precluded. Moreover, the six-year window under the funding rule could adversely impact ordinary course financing operations of multinational groups. Yet another set of burdensome documentation rules will be put in place, resulting in substantially increased compliance costs. Given the political pressure on Treasury and the IRS to “do something” about inversions, it seems likely that these rules will be fast-tracked to final adoption with minimal changes. Accordingly, corporate groups that are potentially affected would be well advised to assess their readiness to comply with the new regulations, and be prepared to move forward under the new regime. To discuss how these proposed rules could affect your intercompany financing arrangements, contact us.
Copyright © 2016, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).