The proposed regulations ignore the commercial realities of doing business in a global economy. They create a bias toward third-party borrowing and equity investments in lieu of intercompany debt. If finalized in their current form, the proposed regulations will force companies to choose inefficient mechanisms for financing their operations and growth strategies. This could have a detrimental impact on everything from earnings-per-share to the ability to access cash outside the United States. In addition, the proposed regulations will cause significant reporting and compliance obligations, which are more onerous than what is common in third-party lending transactions.The U.S. Department of the Treasury and the Internal Revenue Service issued proposed regulations under Section 385 (proposed regulations) that dramatically change decades of jurisprudence on how debt and equity are characterized for U.S. federal income tax purposes.
Issued in tandem with temporary regulations under Sections 7874 and 367, it was made known that this package of regulations was intended to launch an attack against both inversions and post-inversion financing strategies such as earnings stripping. However, the proposed regulations extend far beyond the inversion context, significantly impacting even the most ordinary business and intercompany financing transactions. The broad reach of the proposed regulations would affect related-party debt for both domestic and foreign corporations, S corporations, disregarded entities, and even some partnerships.
The proposed regulations were released on April 4, 2016, and could become final as soon as Labor Day 2016. Given the breadth and anticipated effective date for finalizing the proposed regulations, many companies have taken a bifurcated approach. Companies have been preparing comments in their own names or as part of a professional association or coalition. The comments have been designed to help narrow the scope and delay the effective date of these rules. At the same time, many companies have begun the early stages of building an infrastructure to comply with the documentation requirements and to avoid application of the per se equity rules in the proposed regulations.
However, the proposed regulations extend far beyond the inversion context, significantly impacting even the most ordinary business and intercompany financing transactions.
An Overview of the Proposed Regulations Under Section 385
Section 385, which was enacted in 1969, authorizes the Treasury Department to issue regulations as may be “necessary or appropriate” to determine whether an instrument would be characterized as debt or equity for federal income tax purposes. After prior failed attempts to issue regulations, however, this regulatory authority has lain dormant for decades. Instead, the case law for determining the debt-equity analysis has continued to develop over the years. The various circuit courts of appeals have established multifactor balancing tests to distinguish between debt and equity; although these tests are generally similar, neither the number nor the weight given to the various factors is the same across all circuits.
Under the proposed regulations, the multifactor tests developed by case law would continue to apply if the threshold rules set forth are satisfied. However, some of these rules deviate sharply from current law because they, among other things, recast debt to equity for certain transactions and for mere foot faults that may occur after the debt is issued (typically an investment is characterized at the time of issuance and not recast later, absent extreme circumstances), ignoring the balancing tests and factors altogether.
The proposed regulations contain three main rules. First, they establish extensive documentation and maintenance requirements that must be met for certain related-party instruments to be respected as debt for federal income tax purposes (documentation requirements). Second, they identify several categories of transactions where intercompany debt instruments will no longer be respected; these rules would take the resulting financial instrument that would otherwise qualify as debt and recharacterize it automatically as equity (per se stock rules). Finally, they provide the IRS Commissioner with the authority to bifurcate a debt instrument between certain related parties into part debt and part equity (part stock rule).
The documentation requirements and per se stock rules would affect debt instruments issued between related parties, otherwise defined in the proposed regulations as expanded group instruments (EGI), or instruments issued among an eighty-percent-related “expanded group.”1 The part stock rule would apply to a “modified expanded group,” which includes a broader group of potential debtors, both in terms of the inclusion of the term “person” as defined in Section 7701 and because the definition lowers the eighty-percent relatedness threshold to fifty percent. If finalized in current form, the per se stock rules apply to debt issued on or after April 4, 2016, with a limited cure period for debt issued before the regulations are finalized. In contrast, the part stock rule and documentation requirements apply to debt instruments issued on or after the date the final regulations are published. Note that debt issued before the effective dates could still get caught in these rules if there is a significant modification of the debt instrument after the effective date of the applicable provision.
The proposed regulations would affect almost all large U.S. corporations and some partnerships, as well as some foreign-based multinational corporations. They also would affect some majority-owned subsidiaries, private equity funds, and taxable REIT subsidiaries. Even partnerships can be caught up in these rules under the special controlled partnership rules in the proposed regulations. It should be noted, however, that pass-through businesses that are wholly owned and financed by individuals or trusts generally will be outside the scope of the regulations.
Although the proposed regulations apply to a wide variety of entities, they also generally would not apply to indebtedness between members of a consolidated group—the preamble notes that the policy concerns addressed in the proposed regulations are not present in consolidated group cases because the issuer’s interest expense is often offset by the holder’s interest income. If the debt is transferred outside of the consolidated group or a member ceases to be a member of the consolidated group, however, special rules may apply.
The practical implications of the newly proposed regulations cannot be overstated. The documentation requirements would impose significant burdens for related-party debt instruments, and companies must quickly become familiar with these rules and put proper systems in place to ensure that the intended characterization will be allowed. Failure to comply with the proposed regulations would result in a number of common transactions being subject to previously unforeseen tax consequences by applying an equity recast for all tax purposes rather than, say, merely disallowing or deferring interest deductions. For example, indebtedness that is recast as equity under the proposed regulations may result in payments of interest and principal recast as potentially taxable dividend distributions to the extent of earnings and profits. Many common transactions that were previously tax-free (and approved by courts) would now be taxable. Previously disregarded entities may become regarded, causing previously disregarded debt to spring into existence, resulting in taxable capital shifts.
Documentation Requirements —Building the Right Infrastructure
Perhaps the most obvious and tangible burdens of the proposed regulations are the documentation requirements set forth in Prop. Treas. Reg. Section 1.385-2. These requirements would increase the cost of large companies doing business in the United States by adding to their required paperwork, recordkeeping, and due diligence, far beyond what is already required under Section 482. The documentation requirements would require taxpayers to put new systems and processes in place that purportedly seek to treat intercompany debt similarly to debt that would be issued between unrelated parties. The time and cost associated with this process of documenting the related-party debt at the level demanded by the documentation requirements would require a centralized system to track all issued and outstanding intercompany debt (including trade payables), something most companies do not currently have in place.
Applying the per se stock rule to cash pooling, however, is even more impractical and broad sweeping.
The Mechanics — What’s Required?
The documentation requirements create a threshold set of materials that must be prepared and maintained in order for a related-party debt instrument to be respected as debt for federal income tax purposes. Failure to satisfy the documentation requirements leads to the imposition of an outsized “penalty” for taxpayers—if the documentation requirements are not satisfied, the debt in question is automatically recast as equity unless a reasonable-cause exception applies. Conversely, merely meeting the requirements does not automatically ensure the debt will be respected as debt because common law debt-equity principles will continue to apply.
Within the first thirty days after related-party debt is issued, the company must have written documentation in place that memorializes: (1) a binding obligation to repay the advanced funds on demand or on one or more future dates; (2) the creditor’s rights to enforce the terms of the debt; and (3) a reasonable expectation that the advanced funds can be repaid. Evidence that this third prong is satisfied includes financial projections, debt-to-equity ratios, and asset valuations. Compliance with this last prong will be especially difficult and costly for businesses and is more stringent than what is required in many third-party financing arrangements.
In addition to the first three requirements at issuance, within 120 days after a payment is due or a default, acceleration, or other similar event occurs, the company must document any payments made and the actions taken that evidence a debtor-creditor relationship.2 Note that these requirements apply to in-form debt, which may include short-term non-interest-bearing loans, cash pooling arrangements, and revolvers.
In the case of cash pooling and revolving credit arrangements, the proposed regulations require a different standard for the documents required; the proposed regulations require only that the parties maintain “material documentation” governing these arrangements. In the case of revolving credit arrangements, this documentation might include things like the directors’ resolutions, credit agreements, omnibus agreements, and security agreements, as well as any documentation showing initial and ongoing principal balances. With regard to cash pooling, the “material documentation” standard includes both the initial cash pooling agreement itself, as well as any other agreements or arrangements between expanded group and nonexpanded group members. The nature of this documentation (along with comments made in the preamble) suggests that the service may be using these collateral agreements to treat another entity as the debtor under Plantation Patterns v. Commissioner3 and its progeny.
A limited modifier provides some flexibility in these stringent rules if a taxpayer can show that its failure to comply with the requirements is attributable to reasonable cause. Unintentional infractions of the rules are inevitable and so access to the reasonable-cause exception will be important. Chances of satisfying the reasonable-
cause exception are improved if companies have comprehensive systems in place to comply with the regulations.
These documentation requirements generally would apply to all intercompany or related-party debt between large companies, which must be publicly traded, have assets in excess of $100 million, or have income in excess of $50 million as a group. These requirements are purely prospective and would apply only to debt issued on or after the proposed regulations are finalized. Before assuming that all existing debt will be grandfathered in, however, companies should note the various events that can cause debt to be deemed reissued for tax purposes, such as significant modifications or events triggered by entity classification elections. Debt that is deemed reissued for tax purposes would generally forfeit its grandfathered status and become subject to the documentation requirements.
How Much Will This Cost?
The proposed regulations would impose requirements for related-party financings that equal, and often exceed, the amount of documentation costs associated with third-party borrowings. Outside of the consolidated return context, companies would no longer have the practical benefit of “negotiating” with a familiar party; they would have to document evidence of the borrower’s ability to repay, along with every payment or nonpayment made and actions taken to collect. This rule would require systems in place to provide for the necessary bank-like requirements of start-up documentation, but it would also require a centralized management system that tracks every payment or nonpayment made and documents those events, presumably in more detail than a ledger adjustment or book entry.
The very short deadlines required by the documentation requirements are particularly burdensome and can create a trap for the unwary. The preamble to the proposed regulations does not address why the one-month deadline for newly issued debt and the three-month window set up for all future payments and defaults were selected. In comparison, the cost-sharing rules under Section 482, which require a contemporaneous written agreement, are far more liberal. They allow taxpayers sixty days to finalize the written agreement and allow the taxpayer much more time to put the rest of the documentation in place.
To maintain debt treatment, companies will need to set aside even more of their precious resources for implementation, requiring a coordinated effort among their global and local tax, legal, and treasury functions to draft the reports, contracts, evidence of repayments, and financial landscape of the parties related to financing transactions. Given both the substantial amount of documentation mandated by the documentation requirements and the limited time frame companies would have to produce the written evidence of all relevant events for debt instruments, the likelihood that companies would inadvertently, perhaps inevitably, fail to satisfy documentation requirements for some of their intercompany indebtedness is quite high. Unless the requirements are liberalized, it seems likely that these provisions could trip up many taxpayers on at least some of their intercompany indebtedness, leaving them recourse only under the reasonable-cause relief provisions.
What Should Companies Do Now to Prepare?
As an initial matter, U.S. multinationals and other affected companies will first need to take an inventory of all their currently outstanding intercompany indebtedness, other than debt that is between members of the same U.S. consolidated group. Note for this purpose that debt generally includes any amounts that are viewed as indebtedness for tax purposes, irrespective of whether the debt is evidenced by a note or appears on a balance sheet. Companies are cautioned not to limit this fact-gathering and cataloging exercise to only “new” (post–April 4) indebtedness. Although the proposed regulations generally apply prospectively, as noted earlier, any significant modifications to current related-party debt could trigger the documentation requirements.
All companies then will want to create an infrastructure to track this outstanding debt along with newly created debt to categorize it under the various triggers of the proposed regulations, as discussed further below. This process should be used to generate reports on various types of debts outstanding, to be aware of threshold amounts that could be triggered. These internal systems will also need to have procedures for generating the necessary information and documentation as of the issuance of the debt for future instruments (i.e., ability to repay, creditor rights for the holder, and an unconditional or legally binding obligation to repay a sum certain on demand or on one or more fixed dates). This information would include things like projections and reports to show “reasonable” certainty of ability to repay at issuance, as well as financial stability and loan terms in writing. Internal procedures also must be established to track all future repayments and to produce the necessary documentation within 120 days of each payment or event of default. One can only hope that further guidance will be issued on just what kind of additional documentation is required. For now, practitioners should assume the need to have all of the documentation required to satisfy third-party lenders, such as schedules of all principal and interest payments, as well as creditor rights at missed payments and default, steps taken to collect, and amendments to agreements.
One of the biggest uncertainties in planning for the proposed regulations is in the area of cash pooling. Treasury and the IRS have acknowledged that the documentation requirements may be impractical for cash pooling arrangements. They have repeatedly requested comments on whether special rules are warranted for cash pools, cash sweeps, and similar arrangements for managing cash of an expanded group. As of now, there is no general carve-out in the proposed regulations for such arrangements. Companies should be aware of how impractical these requirements are for cash pooling and revolving credit arrangements—the proposed regulations provide some limited guidance for documentation, but the requirements remain vague at best. In addition, it is not yet clear how the rules apply to notional cash pooling arrangements involving a third-party financial institution.
The Per Se Stock Rules —Transactional and Planning Costs
The per se stock rules in the proposed regulations also contain a set of automatic recast rules in Prop. Treas. Reg. Section 1.385-3 that can be particularly troubling. Like the documentation requirements, the per se stock rules present a number of opportunities for potential triggers of the proposed regulations by multinationals and other traps for the unsuspecting.
The Mechanics — What Do the Rules Say?
The per se stock rules characterize intercompany debt as equity if the debt was issued in certain identified transactions. This recharacterization occurs regardless of whether the debt would otherwise be respected as such under the documentation requirements and common law. The per se stock rules in the proposed regulations have two main recast provisions, referred to as the general rule and the funding rule. These rules in particular constitute a significant departure from the multifactor balancing tests that the courts have traditionally applied to determine whether an instrument should be characterized as debt or equity. Instead of analyzing the characteristics of a debt instrument, the recharacterization of the debt generally turns on the relationship of the holder to the issuer and how the interest was acquired by the holder.
The general rule identifies three broad categories of transactions that would result in the debt issued in the transactions being recharacterized automatically as equity: (1) debt issued in a distribution between members of an expanded group; (2) debt issued in exchange for expanded group stock, with some exceptions; and (3) debt issued in exchange for property in an asset reorganization that is received by a shareholder that is a member of the issuer’s expanded group.
The same policy concerns implicated by the transactions described in the general rule also carry through to the funding rule. The funding rule generally extends the per se rule to include transactions completed with a principal purpose of funding one of the three types of transactions (the funding transactions). This principal purpose standard is determined by evaluating all of the facts and circumstances.
Despite the facts and circumstances test associated with the funding rule, a very broad and irrebuttable timing presumption applies to these funding transactions. The rule provides that debt that runs between members of an expanded group is presumed to have been issued with a principal purpose of funding a transaction described under the general rule if it is issued within a seventy-two-month window. The seventy-two-month window generally begins the thirty-six months before the relevant distribution or acquisition is made and ends thirty-six months after. A limited exception to the funding rule exempts certain debt instruments issued in the ordinary course of business that either result in ordinary and necessary business expense deductions or are included in the basis of inventory.
The per se stock rules generally would apply to debt instruments created on or after April 4, 2016, although the recast of the debt into equity takes effect on the ninetieth day after the date the final regulations are issued. The funding rule in particular includes a transitional rule that provides that a distribution or acquisition described in a funding transaction that occurs before April 4, 2016, other than a distribution or acquisition that is treated as occurring before April 4, 2016, as a result of an entity classification election, is not taken into account. For purposes of the funding rule, companies at least will generally not have to look back to transactions that took place before April 4, 2016. Companies that enter into a targeted transaction after April 4, 2016, and before the regulations are finalized should structure them in such a way that they can be unwound or paid off within the ninety-
day cure period if needed.
Several events could potentially result in the per se stock rules being triggered for already outstanding debt, including the significant modification of the debt.
A few limited exceptions to the per se stock rule exist. Under what is known as the current earnings and profits (E&P) exception, the aggregate amount of any distributions or acquisitions made by an expanded group member under either the general or funding rule is reduced by an amount equal to the member’s current-year E&P. In addition, a threshold rule has been established, stating that a debt instrument would not be treated as equity under the general or funding rules if immediately after the instrument is issued, the aggregate adjusted issue price of all instruments held by all members of the expanded group that are subject to the per se stock rules does not exceed $50 million. Nevertheless, once that relatively low (for most multinationals) $50 million threshold is crossed, it acts like a cliff—all subsequently issued debt instruments are subject to the recharacterization of the general and funding rules, for so long as the instruments benefiting from the threshold exception remain outstanding.
Affected Transactions
It would be impossible to lay out all of the transactions that can be caught up in the exceedingly broad net that is cast by the per se stock rules without completely losing all readership in the process. Instead, we have focused on a few of the primary transactions that would be swept up in the proposed regulations to highlight the breadth of their application.
Debt Issued in Section 304 Transactions and Certain Triangular B Reorganizations
One of the primary transactions identified in the general rule is debt that is issued by a corporation to a member of the corporation’s expanded group in exchange for expanded group stock. This portion of the general rule appears to be aimed in part at triangular reorganizations where an acquiring corporation purchases stock of its parent to use as consideration in the reorganization. The rule, however, would apply broadly to any note issued to acquire stock in an affiliate, including an issuer contributing its own note to the capital of an affiliate or issuing a note to purchase stock of an affiliate in what would otherwise be a Section 304 transaction. Section 304 recharacterizes certain related-party stock sales as redemptions, which could result in dividend income (i.e., ordinary income) to the selling corporation as opposed to capital gain or loss. An example of this type of transaction would be a Section 304 purchase of a controlled corporation for a note. It could also include the purchase of a parent corporation’s stock for a note to be used in a triangular B reorganization. In this case, the note, which would otherwise have been treated as debt under judicially established debt-equity principles, would automatically be recast as stock under the per se stock rules.
It has become common practice for Section 304 transactions to be effectuated with notes in lieu of cash. These transactions are often undertaken for valid business reasons in post-acquisition integration transactions involving controlled foreign corporations (CFCs). They are typically motivated by nontax reasons, just as are the type D reorganizations. Although they are not typically motivated by any intention to base erode the U.S. group or to repatriate earnings, they are still swept up by the expansiveness of the per se stock rules, thus foreclosing a common related-party business transaction. This result becomes even more pronounced when the funding rule is taken into consideration. When these results are coupled with the irrebuttable timing presumption of the funding rule such that a distribution in excess of E&P either in the thirty-six months before a distribution or the thirty-six months after would automatically recast the debt issued as stock in the amount of the distribution, the rule becomes extremely broad.
Stockless D Reorganizations
Another example of a common transaction that would be caught by the general rule is debt issued by a corporation to a member of the corporation’s expanded group as consideration in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the issuer’s expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation. An asset reorganization could include transactions described in Sections 368(a)(1)(A), (C), (D), (F), or (G).
Section 368(a)(1)(D) defines a nondivisive D reorganization as a transaction in which the target corporation transfers substantially all its assets to the acquiring corporation, if (1) immediately after the transfer, either or both the transferor and one or more of its shareholders are in “control” of the acquiring corporation, and (2) stock or securities of the acquiring corporation are distributed to the shareholders of the target. While the distribution requirement would seem to require that the target’s shareholders receive at least some equity in the acquiring company, a “nominal share” concept has been developed in certain cases, applying modified constructive ownership rules under Section 318. In such cases, the transfer of the target’s assets to the acquiring company solely for cash or other nonstock property is deemed to satisfy the distribution requirement. Thus, when there is one-hundred-percent common ownership, it is possible to undertake a D reorganization in exchange for all-boot consideration. This transaction may occur in a sale of stock in the target, followed by an integrated liquidation of the target into the acquiring company by means of a check-the-box election. This integrated transaction may be treated as a Section 368(a)(1)(D) reorganization with one-hundred-percent boot consideration, plus a nominal share. If debt is issued instead of cash in an all-cash D reorganization, that debt would be immediately recharacterized as equity.
Cash Pooling
As noted previously, cash pooling has been identified by the Treasury Department and the IRS as an area in which the documentation requirements may be challenging. Applying the per se stock rule to cash pooling, however, is even more impractical and broad sweeping. Under the funding rule, if a member of the expanded group receives funding from another member of the group through a loan and then within three years makes a distribution or an acquisition, there is an irrebuttable presumption that the loan was made with the principal purpose of funding the distribution or acquisition. The debt, in the amount of the distribution or acquisition, is then immediately recast as stock. Payments of interest and principal on this recast “stock” often will be characterized as distributions for tax purposes. These deemed distributions can in turn place even more indebtedness at risk of being recast as equity under the funding rule, leading to a downward spiral of debt recasts.
These recasts present a substantial number of problems in the context of cash pooling, as this situation occurs constantly in such an arrangement. Beyond the broad application and the sheer number of transactions that would result in the recast of debt under these rules, there are also other practical complications. First, although the per se stock rule contains a set of ordering rules, trying to apply these to nearly constant flows of cash would be seemingly impractical. Second, in the same vein, attempting to match up “funding” and corresponding distributions or acquisitions would prove practically impossible in the cash pool context. Finally, with the constant movement of cash around the pool, trying to determine at any one time what the equity structure looks like under the per se stock rule presents huge challenges.
‘Significant Changes’ to Outstanding Debt: Refinancing
As previously explained, the effective date provision of the per se stock rule states that these rules would apply only to debt instruments issued on or after April 4, 2016, and would only become effective ninety days after the proposed regulations are finalized. It must be re-emphasized, however, that the effective date also implicates deemed issuances as a result of an entity classification election under Treas. Reg. Section 301.7701 and also includes a deemed reissuance under Treas. Reg. Section 1.1001-3. Thus, even if the per se stock rules, on their face, do not seem to apply to debt instruments issued before April 4, 2016, they once again may become applicable if a current debt instrument changes significantly after the regulations become final or by way of an entity classification election implicating an existing debt instrument.
Several events could potentially result in the per se stock rules being triggered for already outstanding debt, including the significant modification of the debt. One of the common mechanisms that could create a significant modification and subsequently trigger these rules is the refinancing of outstanding debt. When a company refinances its debt, it essentially reorganizes its debt obligations by either replacing or restructuring its existing debt instruments. This refinancing can involve changing the terms of the debt instrument, altering the funding sources of the repaying entity, or even changing obligors.
Although the per se stock rules themselves determine the recast of a debt instrument based on the relationship of the issuer and holder of the loan, presumably the same would not apply for determining “significant changes” to the debt, which without changes to the proposed regulations when they are finalized would refer to the regulations under Section 1001 that determine whether a significant change had occurred. This determination has historically been made on the basis of the terms of the instrument. If this standard is the case, refinancing a debt instrument could trigger the per se stock rules, causing debt that would otherwise be grandfathered under these proposed regulations to be recast suddenly as equity instead.
The Part Stock Rule — Uncertainties
If applicable, the part stock rule in Prop. Treas. Reg. Section 1.385-1 would recast debt as part debt and part equity. This rule applies to a so-called modified expanded group, which applies a lower fifty-percent relatedness test. The proposed regulations contain few (if any) limitations on the IRS’ ability to bifurcate related-party debt instruments. There is no guidance on how the IRS will make that determination. The analysis must merely support a reasonable determination that only a portion of the principal amount will be repaid. Outside of the consolidated return context, companies should consider major intercompany financings using tranches of debt instruments, with the goal being to achieve certainty that the senior tranche would be respected as debt whereas only the more junior tranches are at risk of being recast as equity.
Bottom Line: Detrimental Impact
If finalized as currently drafted, the proposed regulations will change the behavior of large companies by creating a bias toward third-party debt and equity. This bias will have a detrimental impact on businesses by forcing them to choose inefficient mechanisms to finance their operations and growth strategies. In addition, these rules would increase the cost of third-party acquisitions by making integration transactions more complex and expensive. The rules will also increase cross-border controversy and create hybrid instruments from otherwise normal, garden-variety debt obligations.
There are steps that companies can take to mitigate the impact of the proposed regulations, as outlined above. However, the best step companies can take at the moment is to understand how these rules change the landscape of how they will do business and to prepare accordingly.
Jeffrey P. Maydew and Christine A. Sloan are partners and Kensington A. Wolgamott is an associate at Baker & McKenzie LLP.
Endnotes
- An expanded group is defined by reference to an affiliate group in Section 1504 of the Code, with the following alterations: (1) the common parent must own directly or indirectly eighty percent of the corporation’s stock (by vote or value); (2) an expanded group can include foreign corporations, tax-exempt organizations, some partnerships (controlled partnerships), regulated investment companies, REITs, and S corporations; and (3) the attribution rules of Section 304 apply to determine the “relatedness” standard. An expanded group instrument (EGI) is a debt instrument issued between members of an expanded group but not between members of consolidated groups.
- Note that it is presently unclear whether internal financial journal entries would be sufficient for this purpose or whether further steps are necessary.
- 462 F.2d 712 (5th Cir. 1972).
