The IRS is currently seeking comments on whether the Section 385 rules on related-party financing should be changed or eliminated.
Section 385 was recently included on an advance, interim list of tax regulations prepared by the IRS in response to President Trump's April 2017 executive order to eliminate burdensome regulations. This list of tax regulations, which includes Section 385, are rules that the IRS believes may cause an undue tax burden or excess complexity. Canadian multinationals may stand to benefit from any changes to the Section 385 rules.
The Section 385 Regulations, which apply to certain related-party indebtedness issued by U.S. corporations, were issued on October 13, 2016 (see TaxNewsFlash-Canada 2016-47, "U.S. Issues Final Rules on Related-Party Financing"). The Section 385 Regulations contain certain documentation rules, and rules that can possibly recast such debt to equity in certain situations. Both of these rules have sweeping implications, particularly for non-U.S.-parented (e.g., Canadian) multinationals.
As a threshold matter, before a U.S. debt may be respected as debt under the Section 385 Regulations, the issuing corporation must satisfy numerous documentation requirements. Subject to certain limited exceptions, if these requirements are not met, the instrument is automatically recharacterized as equity. This can lead to adverse U.S. tax consequences in many circumstances.
For example, if a debt instrument is recharacterized as equity, associated interest and/or principal payments are recharacterized as dividends to the extent of the debtor's earnings and profits. As such, a U.S. debtor would receive no interest deduction for U.S. tax purposes. Additionally, if a U.S. corporation owes the applicable debt to a corporation resident in a treaty jurisdiction, such dividends are often subject to a higher rate of withholding tax than applies to interest (for example, generally, 5% versus 0% under the Canada-U.S. treaty).
Even if all the documentation requirements are satisfied, such a U.S. debt continues to be subject to a traditional debt versus equity analysis, established by U.S. case law and IRS rulings, which applies to all related-party debts. Ultimately, such an analysis is based on the relevant facts and circumstances. Additionally, this U.S. debt remains subject to certain recharacterization rules under the Section 385 Regulations known as the "Recast Rules".
Broadly speaking, under the Recast Rules, such U.S. debt is recharacterized as stock to the extent that it is issued to certain related parties:
Collectively, these are referred to as "Tainted Transactions". The Recast Rules also apply to recharacterize as stock a U.S. debt that is issued to certain related parties in exchange for property that is treated as funding one or more Tainted Transactions in certain circumstances (to the extent of the funding).
For example, leveraged cross-border distributions made by U.S. subsidiaries in excess of their earnings and profits accumulated over a certain period are Tainted Transactions under the Recast Rules, with such excess being automatically recast as equity. Cash distributions in excess of the earnings and profits accumulated over this period may also invoke the Recast Rules if such distributions are considered to be funded by debts associated with certain other Tainted Transactions that occur within 36 months before or after such distributions. In this case, the associated debts may be automatically recast as equity, in whole or in part.
IRS seeking comments
The IRS is asking for comments on potential changes to the regulations identified, including the Section 385 regulations. Specifically, the IRS requests comments by August 7, 2017 regarding whether the identified regulations should be rescinded or how any changes could help reduce their tax burden and complexity. The IRS is also requesting comments by July 31, 2017 on whether any other regulations warrant "a broader review". Because the IRS Notice does not specify what action Treasury will take, or when any recommended changes would be effective, taxpayers should generally continue to apply the relevant regulations in their current form.
Although any characterization of an applicable U.S. debt as debt or equity must still consider the factors established by U.S. case law and IRS rulings, a pro-taxpayer change to, or a complete elimination of, the Section 385 Regulations should, in most cases, greatly simplify matters for Canadian multinationals. The automatic nature of recharacterizations under the Section 385 Regulations can be particularly problematic. For example, the character of a purported debt for U.S. tax purposes can switch from year to year, depending on whether the documentation rules of the Section 385 Regulations have been satisfied in a particular year. The resulting deemed exchanges of debt for equity, and vice versa, can have substantially adverse U.S. tax consequences.
For more information, contact your KPMG adviser.
Information is current to July 13, 2017. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's National Tax Centre at 416.777.8500