2016-Issue 12 – On April 4, 2016, the IRS and Treasury released two sets of proposed and temporary regulations that caused various taxpayers, investment bankers and large sectors of the investment community, particularly in the pharmaceutical and biomed sectors, to sound alarm bells. Much of the consternation was focused on the first set, aimed at curbing inversion transactions and, given that Pfizer pulled the plug on its Allergan deal two days after the anti-inversion proposed regulations were announced, the IRS and Treasury clearly hit their intended mark. While there is much to discuss regarding the new anti-inversion proposed regulations (which I will do in an upcoming edition of Tax Advisor Weekly, entitled “Ready, Aim, Fire – IRS and Treasury Successfully Sink the Pfizer Inversion”), the second set of proposed regulations issued on April 4 arguably has a much greater impact on corporate taxpayers across industry sectors as well as on private equity investors and thus merits time and attention.
Notice 2014-52 and Notice 2015-79 described regulations that the Treasury Department and IRS intended to issue to quell the recent tide of inversion transactions and certain post-inversion U.S. source earnings stripping transactions effectuated through intercompany debt. The preamble to the Section 385 proposed regulations provides that while the proposed regulations are “motivated in part by the enhanced incentives for related parties to engage in transactions that result in excessive indebtedness in the cross-border context, federal income tax liability can also be reduced or eliminated with excessive indebtedness between domestic related parties.” The preamble goes on to conclude that due to such perceived abuses, the proposed rules apply to certain related parties without regard to whether the parties are domestic or foreign. Thus, while much of the focus has been on the impact of the anti-inversion proposed rules, the 800-pound gorilla in the room seems to be going unnoticed. So, what is this gorilla all about, and is it friendly?
First, a bit of history: Congress enacted Section 385 in 1969. At that time, Section 385(a) authorized the Treasury Department to issue regulations as necessary or appropriate to determine whether an interest in a corporation is treated as stock or debt. Regulations were issued in 1980 but withdrawn by Treasury and the IRS in 1982. As a result, the determination as to whether an instrument issued by a corporation constitutes debt or equity has largely been left to the courts. As one can imagine, a mosaic of factors developed over time, and now anywhere from 13 to 16 factors (depending on what case law you look to) are considered when analyzing whether a purported debt instrument issued by a corporation to a related party should be respected as debt or recast as equity. This does not make for a quick or easy analysis and certainly not one that tax departments welcome taking on in the heat of an IRS audit.
The proposed regulations provide some helpful guidance to taxpayers, but largely the proposed rules list types of lending transactions the IRS and Treasury find offensive and will recast as equity, full stop. In short, not a very friendly gorilla. Below is a summary of highpoints of the proposed regulations, together with some road hazards taxpayers should be mindful of.
Framework of the Proposed Regulations
The proposed regulations are divided into four sections:
- 1.385-1 contains definitions and operating rules;
- 1.385-2 contains contemporaneous documentation requirements that apply to instruments issued between members of an expanded group (as defined);
- 1.385-3 contains rules that recast as stock certain instruments issued between members of an expanded group that would otherwise be properly treated as debt instruments; and
- 1.385-4 provides special rules regarding transactions described in 1.385-3 as they relate to consolidated groups.
Operating Rules: Part Debt, Part Equity
Perhaps the most “helpful” (and this term is used loosely) aspect of the proposed regulations is that Treasury and the IRS determined that in certain circumstances an instrument issued between related parties may be treated as part debt and part equity rather than imposing an “all or nothing” approach. In the past, where the IRS would challenge the treatment of an instrument as bona fide debt, it was either ultimately respected as debt (either due to settlement on audit or in appeals or through court ruling) or recast entirely as equity. The IRS now has a middle-ground option.
Note that the proposed regulations apply to debt instruments issued to a member of the debtor’s expanded group (EG). The term “expanded group” means an affiliated group as defined in Section 1504(a) but 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.
Importantly, the operating rules allow for the application of part debt, part equity treatment for instruments issued among members of a modified EG that applies a 50 percent ownership threshold. History will tell whether this is ultimately helpful or hurtful to taxpayers, but the optimist view is that this option could facilitate quicker audit settlements by allowing the IRS to respect an instrument as debt in part. That said, the proposed regulations make clear that, consistent with Section 385(c), the issuer must treat the instrument as debt or equity in its entirety from the point of issuance onward. That is, taxpayers must maintain an “all or nothing” approach, while the IRS now has flexibility to choose partial or full debt treatment.
The proposed regulations introduce documentation requirements that are intended to impose discipline on related-party lending transactions by requiring timely documentation and financial analysis similar to the documentation and analysis that is created when debt is issued to third parties. The proposed rules require documentation of the following:
- An unconditional obligation to pay a sum certain on demand or at one or more fixed dates;
- Creditor rights of the holder to enforce the obligation;
- The issuer’s financial position supporting a reasonable expectation that it intends to and has the ability to satisfy its obligations; and
- Actions evidencing a debtor-creditor relationship, such as payments or events of default.
Taxpayers subject to the documentation rules must prepare documentation for items (i)-(iii) above within 30 days of the initial issuance date or date the instrument becomes an expanded group instrument (EGI) and prepare documentation for item (iv) no later than 120 days after the date of payment or event of default. Documentation must be maintained for all years the obligation is outstanding and until the statute of limitations expires for the tax return year in which the instrument is relevant.
The documentation requirements apply to any purported debt instrument issued by a member (including a disregarded entity) of an expanded group as defined above if:
- The stock of any member of the expanded group is traded on (or subject to the rules of) an established financial market;
- On the date the instrument is issued or otherwise becomes an EGI, total assets exceed $100 million on any applicable financial statement; or
- On the date the instrument is issued or otherwise becomes an EGI, annual revenue exceeds $50 million.
Importantly, the documentation rules do not apply to instruments that are treated as intercompany obligations under Treas. Reg. 1.1502-13(g)(2)(ii). But if an instrument ceases to become an intercompany obligation (i.e., because either the issuer or holder leaves the group or the instrument is transferred to an affiliate outside the consolidated return group) then the instrument becomes an EGI subject to the documentation rules.
Impact on Taxpayers: Many taxpayers such as private equity portfolio companies, non-public companies or small public companies will not be affected by these documentation rules. For those taxpayers that are affected, the documentation rules above may not pose any further burden on internal finance, treasury or tax teams, as such documentation is already on file. However, for many taxpayers, these rules will likely pose a significant burden, particularly for companies that routinely move money around group companies through a central treasury system — such as cash sweeps or revolving credit — where robust documentation may be lacking. Importantly, irrespective of whether these new rules set your hair on fire, the documentation rules represent the “minimum standard” for the initial analysis the IRS will undertake to determine if a debt instrument should be respected as debt. If the requirements are not satisfied, the IRS will recast the debt as equity, but even if the requirements are satisfied, the IRS may still recast the debt as equity if the substance of the transaction is different from the form. The proposed documentation requirements generally become effective when the regulations are published as final.
Auto-Recast Transactions – Debt Treated as Equity
For those of you thinking these rules aren’t that bad, keep reading. The IRS and Treasury have identified three types of lending transactions between affiliates that will be recast as equity and a fourth catchall category of transactions that will also be recast as equity. The proposed regulations provide that an EGI is treated as stock to the extent it is issued by a corporation to a member of the expanded group:
- In a distribution;
- In exchange for expanded group stock; or
- In exchange for property in an asset reorganization (e.g., a type “C” or “D” reorganization) but only to the extent the target shareholder is a member of the issuer’s expanded group before the reorganization and such shareholder receives the debt instrument with respect to its stock in the transferor corporation; and
- In a transaction with a principal purpose of funding certain distributions or acquisitions.
A debt instrument is treated as issued with a principal purpose of funding a distribution or acquisition if it is issued during the 36-month period beginning before the date of the distribution or acquisition and ending 36 months after the date of the distribution or acquisition (72-month rule). While there are some exceptions to this per se principal purpose rule, it poses significant road hazards for internal restructurings and certain acquisitions and dispositions.
For example, suppose FP lends $200 to CFC in exchange for Note A on January 1, Year 1, and on June 1, Year 1, CFC distributes $400 to its shareholder USCo. CFC is a member of FP’s expanded group. Result: Note A is treated as issued with a principal purpose of funding a distribution because it was issued within 36 months of CFC’s distribution to USCo. Therefore, Note A is treated as stock from the date of issuance.
Now, assume the same facts as above except that, in addition, on January 1 of Year 2, FP lends an additional $300 to CFC in exchange for Note B. Because Note B was issued within 36 months after CFC’s $400 distribution to USCo, Note B is also treated as issued with a principal purpose of funding CFC’s Year 1 distribution to USCo. Therefore, a portion of Note B, in this case $200 of the $300 principal, is treated as stock. Specifically, $200 of Note B is deemed to be exchanged for stock on January 1, Year 2.
Impact to Taxpayers: The recast transactions set forth in Proposed Regulations Section 1.385-3 and -4 cast a wide net that will likely have a significant impact on certain internal restructuring transactions such as Section 304 transactions, reorganizations and intercompany lending transactions aimed at moving money around a group or returning funds to investors. Private equity funds, U.S. multinational groups and foreign multinational groups need to carefully plan future transactions to avoid pitfalls. Further, these rules generally apply to instruments issued after April 4, 2016. However, instruments issued prior to the final regulations that would be treated as stock under the final regulations are treated as debt until 90 days after the date the final regulations are published in the Federal Register. What does all that gobbledygook mean? In short, if a taxpayer issues a “tainted” debt instrument that would be recast as equity, the taint can be fixed as long as the debt instrument is repaid or eliminated during this 90-day period. That said, a potential escape hatch is no substitute for careful planning upfront — the hatch may fail.
Alvarez & Marsal Taxand Says:
While all the sound bites and snippets over the new anti-inversion proposed regulations may be capturing the attention of many, taxpayers should keep a much closer eye on the gorilla in the corner: It is surly and carries a big stick. The proposed regulations under Section 385 are complicated, impose onerous documentation requirements on many taxpayers and, without proper planning, will create many road hazards and traps for the unwary.
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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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