2016-Issue 13 – As is often the case in practical tax planning, “an ounce of prevention is worth a pound of cure.” On April 4, 2016, the IRS and Treasury issued proposed regulations under the authority of Section 385 of the Internal Revenue Code. Numerous commentators have questioned the IRS and Treasury’s authority to create several of the rules in these regulations. As a result, their validity may or may not be upheld in court, if the regulations are finalized as proposed. Unfortunately, while the possibility of a future court battle between taxpayers and the IRS over these regulations may be of major academic interest, it is of no present or practical help to internal tax departments that are undoubtedly asking the questions, “What do these regulations mean to my company? What should I be doing about them now?”
This edition of Tax Advisor Weekly attempts to answer some of the questions that internal tax departments are currently thinking about. It discusses how to deal with some of the practical aspects of complying with these new regulations — specifically, how to deal with the new documentation requirements for certain related-party debt in a practical manner.
It is important to note that these proposed documentation rules would merely formalize the obligation to document certain key points that we would typically expect to be present for related-party instruments, in order for them to be respected as debt rather than be recast as equity (other rules dealing with certain intercompany debt transactions in the new 385 regulations do more than just formalize documentation requirements; they actually re-characterize certain transactions as equity). Thus, many of our suggestions below are applicable to all related-party debt instruments as a matter of “best practices,” even instruments that are technically not subject to the new documentation regulations.
Overview of the Proposed Related-Party Debt Documentation Rules
Proposed Regulation 1.385-2 requires certain taxpayers to maintain specified types of documentation for purported debt instruments between members of the same “expanded group” and to furnish that documentation upon request by the Commissioner. While that requirement merely formalizes one of the indicia of a debtor-creditor relationship that many court cases have recognized, the penalty for non-compliance that would be imposed by the proposed regulations represents a major departure from prior case law. Under the proposed regulations, failure to comply would require the Commissioner to automatically treat the purported debt instrument as stock (subject to the possibility of reasonable cause relief). Under prior case law, documentation was merely one of several factors to consider in the debt versus equity determination. Less than perfect documentation was never an automatic disqualifier.
Definition of Expanded Group
The term “expanded group” means an affiliated group as defined in Section 1504(a) (dealing with consolidated returns) as modified in the following ways:
- An expanded group includes any of the corporations listed in the exceptions in Section 1504(b) (e.g., foreign corporations, tax exempts, etc.);
- An expanded group includes corporations owned “indirectly” (as defined); and
- The 80 percent of vote and value test in 1504(a) is modified to 80 percent of vote or value.
Small Business Exception
The documentation requirements apply to an instrument only if either:
A. The stock of any member of the expanded group is publicly traded;
B. Total assets exceed $100 million on “any applicable financial statement"; or
C. Annual total revenue exceeds $50 million on “any applicable financial statement.”
The required documentation must be in writing and must establish the following points:
- The issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates;
- The holder has the rights of a creditor to enforce the obligation (e.g., priority over stockholders and acceleration rights upon default);
- The issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations under the instrument; and
- The issuer made all required payments; or, if the issuer did not make a payment, the holder exercised reasonable diligence and judgement in its capacity as a creditor.
The new documentation regulations are generally applicable to debt instruments between members of an expanded group on or after the date that these regulations are finalized. Note that these regulations have not been finalized to date and Treasury and the IRS have indicated that they plan to finalize them quickly. In that regard, the deadline for comments has been set at July 7, 2016.
Please note that some other provisions (unrelated to the new documentation requirements) in the new 385 regulations are effective for instruments issued on or after April 4, 2016, with certain exceptions.
Questions That Internal Tax Departments Are Likely Asking
Below are some questions that internal tax departments are likely dealing with and some practical answers to them.
1. These regulations are not effective until they are finalized, so I don’t need to do anything right now, correct?
These new documentation requirements are based on a long line of court cases and IRS rulings that discuss the various factors that should be taken into account when determining whether an instrument should be considered as debt or equity for U.S. federal income tax purposes. In fact, the points that need to be established by the documentation consist of facts that are commonly indicative of debt treatment under the case law and IRS rulings.
Thus, we would typically expect these points to be present in an intercompany debt arrangement. Additionally, when auditing an instrument to determine if it should be considered debt or equity, the IRS and your attest firm will typically look to see if these points are established.
We have traditionally recommended that most of the points mentioned in the new documentation rules be documented for intercompany debt arrangements. This serves several purposes:
- It provides a roadmap to internal treasury, tax and financial reporting departments, to ensure their proper understanding of, and accounting for, related-party transactions.
- It documents the intent of the parties to enter into a debt instrument, which is one of the key aspects of debt treatment.
- It may serve to document the fact that the parties are acting as unrelated third parties would act when entering into a debtor-creditor relationship.
- It may serve as required documentation for an uncertain tax position regarding the treatment of the instrument as debt for your attest firm.
- It serves as documentation in the case of an IRS audit.
- It can provide certainty as to the various rights and obligations of each of the parties to the loan, should either or both of them become a party to a lawsuit with third-party creditors or minority shareholders.
Thus, we recommend that all intercompany debt be documented in this manner notwithstanding the fact that the new regulations are not yet effective. When the new regulations become effective, they will simply serve to raise the stakes regarding documentation (via per se equity treatment for failure to comply). But a prudent practice is to have this type of documentation in place whenever entering into an intercompany debt agreement.
2. My company has debt instruments between members of my expanded group that have already been entered into and will not be subject to the new documentation regulations. Should I do anything with these instruments?
As discussed above, we recommend that all intercompany debt be documented for the reasons listed above. This includes historical debt that is not subject to the new documentation regulations. If you have intercompany debt that is undocumented, we recommend the following:
- Prepare an intercompany agreement immediately (if none has been prepared).
- Gather information showing that the intent of the parties was to create debt at the time of issuance — for example, emails, board resolutions and other indications that it was intended to treat amounts as debt (as a commercial matter; not just for tax purposes).
- Gather historical information showing that the borrower had the ability to service the debt, as of the date of issuance.
3. Can debt issued prior to finalization of these regulations become subject to the new documentation regulations?
Under Section 1.1001-3 of the Treasury Regulations, when a debt instrument is “significantly modified,” a transaction is deemed to occur by which the old debt is exchanged for new debt. Significant modifications can occur in a variety of ways if a debt instrument is changed in a material manner. The documentation regulations under 1.385-2 indicate that the deemed new debt instrument will be subject to the documentation reporting requirements. Thus, it is possible for debt issued prior to these regulations becoming effective to become subject to them if the debt is significantly modified. Please note that significant modifications of debt instruments can give rise to other tax consequences as well, and we recommend discussing changes to intercompany debt instruments with your tax adviser.
Another way by which debt issued prior to the finalization of these regulations can become subject to the new documentation rules is where an “intercompany obligation” (as defined in Treas. Reg. 1.1502-13) loses its status as an intercompany obligation while remaining due to / from members of an expanded group. Generally, debt between members of a U.S. consolidated group is exempt from the reporting requirements under 1.385-2. However, if one party to the debt instrument deconsolidates, ceasing to be a member of the U.S. consolidated group, but is still considered a member of the expanded group, the documentation requirements will become applicable. Additionally, if a debt instrument between members of a U.S. consolidated group is transferred or assumed by a non-group member that is a member of the expanded group, the documentation requirements become applicable as well. This often happens as part of a restructuring.
In these cases, the documentation under 1.385-2 must be put in place within 30 days of the date that an intercompany obligation loses its status as such.
4. My company often accrues interest, in lieu of making payments, on debt between members of my expanded group. For new debt issued after the regulations are finalized, how should I deal with this under documentation requirement No. 4 of the new documentation regulations once they are finalized?
As discussed above, the fourth documentation requirement under the regulations requires the taxpayer to establish that “the issuer made all required payments; or, if the issuer did not make a payment, the holder exercised reasonable diligence and judgement in its capacity as a creditor.” This requirement seems to make taxpayers play the role of a bank and know and understand what “reasonable diligence and judgment in its capacity as a creditor” would be. Needless to say, many organizations (outside of the banking realm) may not have experience in this area.
In our experience, it is not uncommon for taxpayers to postpone payments under related-party debt instruments. In fact, postponements also occur in the case of unrelated-party debt instruments. Banks don’t always demand immediate repayment of the outstanding principal in situations where some payments are deferred. Treasury Regulations Section 1.1001-3 (commonly referred to as the “Cottage Savings Regulations”) provides a safe harbor for avoiding a deemed exchange when postponing payments under a debt instrument. This safe harbor states that a significant modification of a debt instrument (as discussed above) does not occur if payments under the instrument are postponed so long as the postponement is for a period equal to the lesser of five years or 50 percent of the original term of the instrument.
We recommend being proactive in this area when drafting intercompany debt agreements and modifying existing agreements. Below are some examples of how this requirement may be approached when drafting an intercompany debt agreement after these regulations are finalized and, thus, applicable to the instrument.
- Be thoughtful when drafting the collection terms of your debt instrument. It goes without saying that the more lenient the collection procedure in the agreement is, the easier it is to justify accruing interest in lieu of making payments. On the other hand, the more lenient the collection procedure, the more the arrangements might be viewed as indicative of a corporation-shareholder relationship, rather than a debtor-creditor relationship. If possible, you may even be able to reach out to your bank to get its thoughts on reasonable collection terms permitted by unrelated lenders.
- Consider entering into debt agreements that do not require interest to be paid on specific dates. For example, a paid in kind or “PIK” note allows for payments of interest to be paid in cash or additional principal. There are various tax and business considerations to be made when entering into these types of debt agreements, but they can be used to postpone interest payments if structured correctly. But here again, the more flexibility allowed, the more the arrangements might be viewed as indicative of a corporation-shareholder relationship rather than a debtor-creditor relationship. We recommend discussing these options with your tax advisors.
- If you postpone payments on a debt instrument between members of your expanded group that was entered into prior to these regulations becoming effective, make efforts to address the Cottage Savings Regulations discussed above. As discussed above, a significant modification of a debt instrument may subject the instrument to the new reporting regulations after these regulations are finalized.
5. My company may not always document intercompany trade receivables / payables in the manner required by the proposed regulations. Are those arrangements also subject to the new documentation requirements?
There does not appear to be a clear exception from the documentation requirements that applies to trade payables. The absence of any such exception may require action by taxpayers to prevent the per se recast of trade payables as stock in the absence of written documentation satisfying the requirements of Section 1.385-2. It is not uncommon for the arrangements with respect to related-party trade accounts to not be documented in writing (at least not to the extent required by Section 1.385-2). Perhaps Treasury believed that trade payables were excepted from the scope of Section 1.385-2 because they don’t represent an “interest issued or deemed issued that is in the form of a debt instrument,” as that phrase is used in the definition of “applicable instrument” in Section 1.385-2(a)(4)(i). But unless and until some clarification is received on this point, it would be prudent to review intercompany trade relationships and to formalize agreements and related documentation where appropriate.
6. My company is a U.S.-based multinational and has debt instruments between non-U.S. members of our global expanded group. Will the new documentation requirements under the regulations apply to this type of debt?
The proposed regulations do not contain an exception for transactions between extended group members that are not subject to current U.S. tax, such as foreign subsidiaries that are classified as controlled foreign corporations (CFCs) that are not currently subject to U.S. tax. The preamble requests comments regarding the application of the rules to foreign entities that are not required to file a U.S. return and that are not a CFC or a controlled partnership but in a later year become one of those types of entities. This request would seem to corroborate the notion that transactions between CFCs are clearly covered by the proposed regulations as they presently stand.
7. My company is a U.S. subsidiary of a foreign-based multinational group that has been funded, in part, with one or more so-called “repo transactions,” which we have treated as debt for U.S. tax purposes. Do the proposed new documentation rules apply to “repo transactions?”
At the moment, the documentation rules only address interests that are issued in the form of debt. A “repo,” or repurchase obligation, takes the form of a sale of shares coupled with a binding legal agreement by which the seller promises to repurchase the shares at a specified time for a specified price. The proposed regulations reserve with respect to interests, such as repos, that are not in the form of indebtedness, and Treasury has requested comments on the appropriate documentation of such interests. But even in the absence of a specific regulatory requirement, it would be prudent to maintain documentation of the critical aspects of a repo arrangement that warrant its treatment, under a substance over form analysis, as indebtedness for purposes of U.S. tax law.
Alvarez & Marsal Taxand Says:
A proactive approach to the new documentation requirements under Proposed Treasury Regulations Section 1.385-2 can help relieve some stress in the case that the intercompany debt arrangement is later audited or challenged by the IRS. It can also help to establish the fact that your instrument should be considered debt for U.S. federal income tax purposes by the IRS and your attest firm.
Here are some key takeaways when dealing with related-party debt:
- Document all debt instruments between members of your expanded group even if the instrument is not subject to the new documentation regulations. The regulations require taxpayers to document facts we would typically expect to be present in an intercompany debt arrangement. Additionally, when auditing an instrument to determine if it should be considered debt or equity, the IRS and your attest firm will typically look to see if these points are established, and documenting them is a very good defense in the case of an audit or when supporting debt treatment of the instrument to your auditor.
- When drafting debt instruments between members of your expanded group, anticipate your needs and seek counsel from experts (i.e., banks and tax advisers). There may be creative ways to meet your tax and business needs.
- Avoid triggering significant modifications to debt instruments that were entered into between members of your expanded group prior to these regulations being finalized.
For More Information
Kristina Dautrich Reynolds
Managing Director, Washington DC
+1 202 688 4222
Senior Director, New York
+1 212 759 5532
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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