On April 4, 2016, as part of a new guidance package addressing "inversion" transactions, the United States Department of the Treasury ("Treasury") unexpectedly released new proposed regulations (the "385 Regulations") that would fundamentally alter the U.S. tax treatment of intercompany financing within multinational groups.
Despite the purported focus on inversions the 385 Regulations are not limited to companies that have engaged in inversion transactions. The rules will significantly affect most of all U.S. companies and groups that are part of a multinational group that is headquartered outside the U.S. The rules in particular are also designed to restrict the ability of foreign-owned U.S. groups to engage in "earnings stripping," or the use of intercompany debt to reduce the U.S. tax due on the profit arising from the U.S. business operations.
The U.S. tax system already contains several restrictions against "earnings stripping," such as the 50% EBITDA deduction limitation in Code Section 163(j); imposing withholding tax on payments of interest to related non-U.S. taxpayers, unless relieved by Tax Treaty; and special tax accounting rules that require actual payments of interest, instead of mere accruals, for such interest amounts to be deductible. Unlike these rules, the 385 Regulations do not change the tax treatment of the interest amounts. The 385 Regulations instead would treat the underlying debt instrument as equity for U.S. tax purposes, such that the yield on the instrument is not considered deductible interest. In doing so the 385 Regulations will significantly restrict (particularly in the context of internal group restructurings) the opportunities for foreign shareholders to make debt investments in their U.S. subsidiaries.
The 385 Regulations contain three primary areas of focus—Documentation Rules, Recast Rules, and the Bifurcation Rule. These rules apply to a corporate expanded group ("EG"), which is generally a section 1504(a) affiliated group (generally corporations connected by 80% ownership of vote and value except that (1) the nonincludable corporations listed in section 1504(b) including non-US corporations, and (2) the common parent need not own 80% of another member directly, but it can own it indirectly as well, and (3) the group need be connected by ownership of stock constituting 80% of vote or value of a member, rather than vote and value).
Although the question of whether a distribution or acquisition of stock is related to the intercompany debt issuance is a "facts and circumstances" test, the proposed regulations provide a "per se" rule by which a debt instrument is automatically recharacterized as equity to the extent of distributions or acquisitions of stock of affiliates by the issuer during the 36-month period before and after the date of distribution or acquisition (the 72-month period).
Intergroup financing arrangements are a common feature of modern multinational tax and treasury functions. Every multinational organization will, at a minimum, be required to evaluate its internal financing functions (with respect to cash pooling loans, intercompany trade-related debt, term funding, etc.) for compliance with the Documentation Rules and to identify when newly issued debt is subject to the Recast Rules.
All instruments or contractual arrangements that (1) constitute indebtedness for U.S. federal income tax purposes, (2) are issued between members of an expanded group, (3) pursuant to certain transactions are subject to recharacterization under these rules. For example, a sale-leaseback or sale-repurchase agreement that is treated as debt for U.S. federal income tax purposes would be subject to recharacterization under these rules if the other conditions are met.
The Documentation Rules require contemporaneous and ongoing documentation for certain debt instruments issued between EG members ("Expanded Group Instruments" or "EGIs"). Failure to comply with the Documentation Rules can result in the EGI being treated as equity. The Documentation Rules apply to EGIs issued after finalization of the 385 Regulations. Importantly, the 385 Regulations generally do not apply to debt issued between members of a U.S. consolidated group. Thus, intercompany debt between U.S. consolidated group members is exempt from the Documentations Rules.
The Documentation Rules require taxpayers to document (within 30 days of the debt's issuance) the parties' satisfaction of traditional debt indicia, including:
Taxpayers must also document the parties' ongoing performance under the instrument. Such documentation must be in place within 120 days of the relevant date. It would include showing that the issuer has timely made payments of interest and principal according to the loan's terms, and conversely, if a payment has been missed, showing the holder's resulting enforcement actions.
Under the Recast Rules, any debt issued between EG members can be re-characterized as stock for all U.S. federal tax purposes if the debt is issued in certain specified situations. The Recast Rules are proposed to apply to debt issued on or after April 4, 2016. Under a transition rule, debt issued on or after April 4, 2016—that would be recast before finalization of the 385 Regulations—is not recast 90 days after finalization.
The Recast Rules contain two components—a General Rule and a Funding Rule. The General Rule applies when a debt instrument is issued in one of the following situations:
If the General Rule does not apply to a debt, the Funding Rule serves as a broad anti-abuse rule to prevent taxpayers from replicating the effects of the General Rule transactions over time. The Funding Rule applies when:
Corresponding to the General Rule, de-funding transactions occur when a Funded Member does one of the following:
As currently written, there are no intent-based exceptions to the 36 month look-back and look-forward periods.
When one of the Recast Rules applies, the recast debt is generally treated as stock as of the time of its issuance. If, however, the Funding Rule applies and the de-funding leg occurs in a tax year following the year of the borrowing, the recast debt is treated as stock as of the time of the de-funding transaction.
Several exceptions apply to the Recast Rules, as follows:
In addition, the Recast Rules do not apply to acquisitions of stock or assets from unrelated parties or to leveraged asset acquisitions within a group, including borrowing to acquire the stock of a disregarded entity that holds only non-stock assets.
The primary effect of recasting debt as stock is that interest payments will be classified as non-deductible dividends, and the repayment of principal will no longer be a tax-neutral event. More broadly, however, there are many open and unanswered questions regarding the collateral consequences (e.g., foreign tax credit, withholding tax, etc.) arising from the recast debt's equity classification.
Lastly, the 385 Regulations contain another substantive rule that allows the Internal Revenue Service ("IRS") to re-characterize an instrument as part-debt and part-equity instead of the traditional all-or-nothing approach (the "Bifurcation Rule"). The 385 Regulations contain no meaningful guidance on how the Bifurcation Rule is to be applied. Accordingly, its impact is unclear. The Bifurcation Rule would apply to instruments issued after the date of finalization.
It also is far from clear how the new rules will trickle down to the state tax level. For example, separate filing states that do not follow the consolidated return rules may not follow the "consolidated group as one taxpayer" provision, which could greatly expand the rules' scope. The re-characterization results could also percolate into a variety of other state tax issues, such as the creditor's apportionment factor (if interest and dividends are sourced differently); thin cap and related party expense rules; and franchise tax determinations that are based on the federal tax balance sheet.
Taxpayers, trade groups, and other commentators have been very critical of the 385 Regulations. By July 7, 2016, Treasury and the IRS received in excess of 150 comment letters about the proposed regulations under section 385. The government is obligated to review and consider these comments as part of the administrative process to finalize the proposed rules.
Treasury officials met with members of the Senate Finance and House Ways and Means committees regarding the 385 Regulations. A release from the Ways and Means Committee includes a comment from Chairman Kevin Brady (R-TX) about the "negative consequences of the proposed regulations."
Prior to a mid-July meeting about these concerns (organized by the Joint Committee on Taxation), members of Congress had written to Treasury Secretary Lew to express concerns about the proposed regulations. For example, a letter from Republican members of the Senate Finance Committee on July 1, 2016, followed two other letters to Secretary Lew expressing concerns regarding the section 385 proposed regulations—letters previously sent by both Republican and Democratic members of the House Ways and Means Committee.
So far, Treasury officials have broadly indicated that they are receptive to fixing some aspects of the proposed rules that may have been overbroad (by exempting some additional types of debt instruments) or produced unintended consequences. By all accounts, however, the government intends to finalize the 385 Regulations in largely their proposed form (at least in terms of function, if not scope) by the end of 2016 and before a new U.S. presidential administration takes office. Taxpayers should expect the rules to be finalized later this year and must begin reviewing their current capital structures, treasury and internal controls, and corporate development/M&A pipeline to assess potential traps and opportunities under the forthcoming new rules.
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Mie Igarashi | +1 404 222 3212 | firstname.lastname@example.org
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and do not necessarily represent the views or professional advice of KPMG.