IRS Issues Final and Temporary Debt-Equity Regulations
October 25, 2016
By Richard Shapiro
Despite the highly controversial content of the April 2016 proposed regulations which engendered significant adverse comment, the Treasury and IRS on October 13 released much anticipated final and temporary regulations (referred to in this alert as the “final regulations”) under IRC Sec. 385, effective October 21. Portions of the April 2016 proposed regulations that were substantially revised as a result of comments received have been issued as temporary and proposed regulations. Also, the Treasury and IRS have “reserved” on certain portions of the April 2016 proposed regulations pending additional study.
The final regulations establish threshold documentation requirements that ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as debt for federal income tax purposes, and treat as stock certain related-party interests that otherwise would be treated as debt for federal income tax purposes. Subject to certain qualifications and exceptions, the final regulations apply to certain “expanded groups” and to interests and debt instruments issued by corporations to members of the same expanded group. In general, an expanded group includes a chain of corporations with a common parent that are connected, directly and indirectly, by ownership of 80% of the vote or value of each member. Once an expanded group has been established, other types of entities as well as individuals can be included in the expanded group through ownership.
The preamble to the final regulations (the “Preamble”) exhaustively reviews the various comments received with respect to the proposed debt-equity regulations, what provisions of the proposed regulations were modified or not modified and why, and addresses the authority to issue these regulations under IRC Sec. 385. In making modifications to the April 2016 proposed regulations, the Treasury and IRS note in the Preamble that the final regulations “… better target the entities and activities that lead to inappropriate interest deductions by limiting the type of businesses affected. In doing so, the final and temporary regulations significantly reduce compliance and administrative burden, while still placing effective limits on the transactions most responsible for inappropriately reducing U.S. tax revenue.”
The following is a summary of key highlights of the final regulations, and the related provision of the April 2016 proposed regulations, where relevant:
- Overall scope of final regulations. The final regulations do not apply to foreign corporations that issue debt, S corporations, non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs). Generally, members of a federal consolidated group are treated as one corporation for purposes of the final regulations.
- Removal of bifurcation rule. Under the April 2016 proposed regulations, the IRS (but not taxpayers) could characterize a single instrument as part debt and part equity for tax purposes if that treatment were deemed to be appropriate. That treatment was dropped in the final regulations.
- Documentation. Under the April 2016 proposed regulations, the absence of timely prepared documentation and financial analysis evidencing four essential characteristics was dispositive in requiring a purported debt instrument to be treated as stock for federal income tax purposes. Specifically, taxpayers need to provide evidence: (i) of an unconditional and binding obligation to make interest and principal payments on certain fixed dates; (ii) that the holder of the loan has the rights of a creditor, including superior rights to shareholders in the case of dissolution; (iii) of a reasonable expectation of the borrower’s ability to repay the loan; and (iv) of conduct consistent with a debtor-creditor relationship. However, being in compliance with the documentation requirements did not establish that an interest was indebtedness but rather served to satisfy the minimum requirement for the possible determination of debt status under general federal tax principles. This remains in the final regulations.
The final regulations eliminated the 30-day timely preparation requirement contained in the April 2016 proposed regulations; documentation and financial analysis is now deemed timely if it is prepared by the time the issuer’s federal income tax return is filed (taking into account all applicable extensions). Further, if an expanded group is otherwise generally compliant with the documentation requirements, the failure to produce such documentation is now a rebuttable presumption -- rather than a per se characterization -- that such instrument is stock. The final regulations maintain the threshold requirement that the documentation rules apply only to related groups of corporations where the stock of at least one member is publicly traded or the group’s financial results show assets exceeding $100 million or annual revenue exceeding $50 million. Finally, the final regulations apply these documentation provisions only to debt instruments issued on or after January 1, 2018.
- Distributions of debt instruments. The April 2016 proposed regulations provided that a debt instrument is treated as stock to the extent that a debt instrument was issued in exchange for property, including cash, with a principal purpose of using the proceeds to fund a distribution to a controlling shareholder or another transaction that achieves an economically similar result (the so-called “Funding Rule”). Also, the April 2016 proposed regulations included a per se application of the Funding Rule if a debt instrument was issued in exchange for property (other than in the ordinary course of purchasing goods or services from an affiliate) during the period beginning 36 months before and ending 36 months after the funded member made the distribution or undertook a transaction with a similar effect. The April 2016 proposed regulations also included exceptions to limit the scope to transactions outside the ordinary course of business by large complex taxpayers.
The final regulations make a number of changes to the proposed rules governing distributions of debt instruments:
- Debt instruments issued by regulated financial groups and insurance entities. The final regulations do not apply to debt instruments issued by certain financial entities, financial groups and insurance companies (other than captive insurers) that are subject to a specified degree of regulatory oversight regarding their regulatory structure. The Preamble notes that, for example, regulated financial services entities are subject to capital or leverage requirements that constrain the ability of such institutions to engage in transactions addressed by the final regulations.
- Cash management arrangements. The final regulations generally exclude deposits pursuant to a cash management arrangement as well as certain advances that finance short-term liquidity needs. As noted in the Preamble, this exception allows companies to efficiently transfer cash around an affiliated group in order to meet the global cash needs of the business without resorting to third-party borrowing to avoid the impact of these regulations.
- Cascading recharacterizations. The final regulations narrow the application of the Funding Rule by preventing in certain circumstances the “cascading” consequences of recharacterizing debt as stock.
- Expanded earnings and profits exception. Under the April 2016 proposed regulations, the aggregate amount of distributions or acquisitions that do not exceed the current year’s earnings and profits of the distributor or the acquiring corporation were not treated as distributions or acquisitions. The final regulations expand the earnings and profits exception to include all of the earnings and profits of a corporation accumulated while it is a member of the same expanded group in taxable years ending after April 4, 2016. This is intended to ensure that companies are not incentivized to make distributions that use up their current earnings and profits before it would have become unusable in the next taxable year.
- Expanded access to $50 million exception. Under the April 2016 proposed regulations, a debt instrument was not treated as stock if, immediately after the debt was issued, the aggregate adjusted issue price of debt instruments held by members of the expanded group did not exceed $50 million. Under the final regulations, in lieu of the “cliff effect” of the April 2016 proposed regulations, all taxpayers can exclude the first $50 million of indebtedness that otherwise would be recharacterized.
- Credit for certain capital contributions. The final regulations allow a taxpayer to reduce the amount of its distributions and acquisitions that otherwise could cause an equal amount of the taxpayer’s debt to be recharacterized as equity by the amount of the contributions to the taxpayer’s capital. The effect of this is to treat distributions and acquisitions as funded by new equity contributions before related-party borrowings.
- Exception for equity compensation. An exception is provided for the acquisition of stock delivered to employees, directors and independent contractors as consideration for the provision of services.
- Expansion of 90-day delay for recharacterization. The 90-day delay in the April 2016 proposed regulations for recharacterization in the case of debt instruments issued on or after April 4, 2016 but prior to publication of final regulations is expanded such that any debt instrument that is subject to recharacterization but issued on or before January 19, 2017 is not recharacterized until immediately after January 19, 2017.
Two final observations should be noted –
- Investment blockers. We note that the preamble to the April 2016 proposed regulations requested comments on whether certain debt instruments used by investment partnerships, including indebtedness issued by certain “blocker” entities, implicated policy considerations similar to those motivating the proposed regulations. The Preamble states that several comments recommended that the scope of the April 2016 proposed regulations not be broadened to apply to such transactions (by, for example, treating a partnership that owns 80% or greater of the stock of a blocker corporation as an expanded group member). The Preamble notes that the final regulations do not apply special rules for debt instruments used by investment partnerships, including indebtedness issued by blocker entities.
- State considerations. The state tax implications of these final regulations need to be carefully evaluated. To what extent will states conform with these new IRC Sec. 385 rules? What about states that do not recognize consolidated returns, or follow federal consolidated return rules? What about states that utilize combined or separate reporting? The response to these final regulations by the various states bears careful watching.