Frustrated by a lack of U.S. corporate tax legislation that would help U.S. companies better compete with the rest of the world, some taxpayers have undertaken “inversion” transactions to lower their tax rate. The government has responded by issuing notices and regulations intended to curb these transactions.
An inversion, in and of itself, does not create a tax savings; rather it is a mechanism for U.S. tax base erosion through the introduction of related-party debt (deductible interest expense on the debt in the United States – a high corporate tax rate jurisdiction – with interest income in a low-rate jurisdiction, creating a positive tax arbitrage). In the latest round of anti-inversion guidance, on April 4, 2016, the U.S. Treasury Department issued proposed related-party debt/equity regulations (proposed regulations to Section 385). However, the proposed regulations are much broader than just applying to inversion transactions, and can apply to more common cross-border transactions.
The check-the-box regulations of 1998 may be considered the most important regulations issued in the international tax context, but the current proposed regulations are arguably a close second.
Congress enacted Section 385 in 1969 which gave authority to Treasury to issue regulations defining what constitutes debt or equity. Treasury has previously proposed regulations, but withdrew them. Case law has created the factors in determining what constitutes debt vs. equity. In addition, the courts have taken an all-or-nothing approach to debt vs. equity, and have not historically bifurcated an instrument into part-debt and part-equity.
The proposed regulations do not change or obviate these debt vs. equity rules. They do provide additional hoops that taxpayers have to go through to get debt treatment for related-party transactions, and create a bifurcation rule. Taxpayers cannot affirmatively apply the regulations.
Part-Debt and Part-Equity
Treasury’s bifurcation rule applies to what is called a modified expanded affiliated group – generally 50 percent or greater common ownership. The recharacterization rules apply to an expanded affiliated group – requiring 80 percent or greater common ownership. The IRS is authorized to bifurcate related-party debt to treat a portion as debt and a portion as equity if it determines that after analyzing a taxpayer’s related-party debt obligations only a portion of the principal amount will be repaid. The bifurcation rule appears to be designed to settle cases more quickly and to provide more favorable settlements in favor of the government.
Taxpayers that enter into the following types of transactions among their expanded group will have their related-party debt recharacterized as equity:
- A related-party asset purchase
- A related-party share purchase
- A recapitalization where the distribution occurs 36 months prior to or after the introduction of the related-party debt
- A reorganization aimed at shutting down so-called inbound “all cash D” transactions
The proposed regulations formalize and align related-party debt documentation requirements too. Expanded groups are subject to contemporaneous documentation and maintenance requirements if the stock of any member of the expanded group is publicly traded or either the total assets of the expanded group exceeds $100 million or annual revenue of the expanded group exceeds $50 million on any applicable financial statement. The four key elements that must be in place (within 30 or 120 days of issuance) for related-party debt instruments to be respected as debt for federal tax purposes are as follows:
A legally binding obligation to pay
- Creditor’s rights to enforce the obligation
- A reasonable expectation of repayment at the time the interest is created
- An ongoing relationship during the life of the interest consistent with arms-length relationships between unrelated debtors and creditors
There are exceptions. Debt between corporations within a consolidated group is not subject to the proposed regulations. However, there may be state tax implications, depending upon whether the state conforms to the U.S. consolidated group rules. Current earnings and profits can be distributed and avoid the pro-posed regulations. Although there is a $50 million exception, it can become largely moot because all related-party debt of the expanded group (including cash-pooling arrangements) must be factored in to determine if this exception is available.
There are numerous and complex effective dates in the proposed regulations. Transactions before April 4, 2016, are unaffected. Treasury has indicated that it intends to move swiftly to finalize the regulations and had been aiming for Labor Day 2016.
Due to its broad application, there may be a number of unexpected consequences. The loss of interest deductions may increase taxable income, create a second class of stock for S corporation taxpayers, or create nonvoting stock that may not produce foreign tax credits.
Taxpayers with related-party debt obligations should assess whether they are part of an expanded or modified expanded group, and determine which aspects of the proposed regulations (if any) to which they are subject. For those taxpayers subject to the new documentation requirements, processes and controls should be implemented now to standardize related-party debt documentation.
Andrew M. Bernard Jr., CPA, is managing director of Andersen Tax in Philadelphia and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
William Long is a senior manager with Andersen Tax in Boston. He can be reached at email@example.com.