Author: ROBERT RIZZI is a tax partner at Steptoe & Johnson LLP in Washington and New York.
When the “final” debt-equity regulations under Section 385(a)1 were withdrawn in 1982, 2 there were few regrets.3 Indeed, probably only two tax practitioners were truly distraught by the government’s decision to abandon the project-the principal IRS author of the regulations, and your columnist, who had just completed an unpublished article analyzing her work.4 The impracticality of Treasury’s attempt to classify the entire universe of financial instruments as either entirely debt or entirely equity using a bright-line factor analysis, given the fact that “‘debt’ and ‘equity’ are labels for the two edges of a spectrum, between which lie an infinite number of investment instruments,”5 has been widely acknowledged. In fact, the commentary critiquing this early use of Section 385 is almost as extensive as the scholarship on the debt-equity regulatory issue itself.6
The partial resurrection of Section 385 in the new proposed regulations illustrates the fascinating twists of tax policy.7 In a quick strike, Treasury attempted to prevail where the original drafters failed. As described below, one impetus for the rules is the ongoing struggle with so-called “inversion” transactions, that is, restructurings that result in U.S. corporations emigrating to some type of foreign ownership, with the goal of mitigating the U.S. corporate income tax burden, as well as the general concern about “earnings stripping” by historic foreign multinationals. Early steps to constrain inversions with a new Code section8 have not prevented some major transactions, and Treasury has employed new tools, including the proposed regulations under Section 385, as part of this ongoing effort.9 This column highlights the fact that the proposed Section 385 regulations, if adopted, will not be limited to inversion transactions, and could impact both the organization of domestic corporations, and more broadly certain mergers and acquisitions of such corporations, with a range of unintended consequences.
Corporate inversions raise a number of complexities, but many such cross-border strategies involve the use of intercompany indebtedness to reduce U.S. taxes through interest payments. These strategies led one prominent tax academic to suggest limiting the interest deduction in connection with inversions by recharacterizing the intercompany indebtedness as equity under Section 385:
The explicit language of section 385 gives the Treasury secretary direct and powerful regulatory authority to reclassify debt as equity and thereby transform a deductible interest payment into a nondeductible dividend. Under section 385, it is possible and appropriate to identify cases in which the use of related-party debt exceeds thresholds that should be acceptable in a particular case.10
Needless to say, the professor’s innovative suggestion led to controversy, including whether inversion transactions could be regulated in this way under a statute that was designed before inversion transactions existed, or instead would require further action by Congress.11
The Domestic Target
The new proposed regulations expressly state that they are not limited to cross-border transactions, even though a major impetus was inversions into foreign ownership.12Thus, the preamble states that, although 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,” the regulations are also intended to address “inappropriate” reductions of tax liability with “excessive indebtedness between domestic related parties.”13
It should be emphasized that the proposed regulations, unlike the original “final” Section 385 regulations, only address financial instruments issued with respect to related parties (discussed further below). Unrelated party debt is completely excluded from coverage, in part because the government recognized that recharacterization of debt could result in “unnecessary uncertainty in the capital markets.”14 Moreover, only related parties that are not part of a consolidated group are the target of the proposed regulations.15 This is because, as stated in the preamble, the drafters believed that the concerns over classification do not apply when the issuer’s deduction for interest expense and the holder’s corresponding interest income offset each other on the group’s consolidated federal income tax return.16 Foreign corporations are ineligible for inclusion in consolidated returns.17 The subset of domestic transactions addressed by the proposed regulations encompasses related but not consolidated groups of U.S. companies.
The new proposed regulations look to a number of transactional elements to determine whether a particular related-party debt instrument should be converted into equity. The principal “per se” types of instruments that are the subject of particular scrutiny include the following:
- debt instruments distributed by corporations to their related corporate shareholders;
- issuances of debt instruments by corporations in exchange for stock of an affiliate;18
- issuances of debt instruments as consideration as part of an internal asset reorganization; and
- when a related-party debt instrument is issued in a separate transaction to fund (1) a distribution of cash or other property to a related corporate shareholder; (2) an acquisition of affiliate stock from an affiliate; or (3) certain acquisitions of property from an affiliate pursuant to an internal asset reorganization.19
These categories, as explained in the preamble, are the main ones that have come to the attention of Treasury as particularly susceptible to the “earnings stripping” planning that Treasury has come to associate with corporate inversions intended to reduce U.S. corporate tax. Accordingly, the proposed regulations treat related-party debt instruments issued in these categories of transactions as stock, subject to certain exceptions.
The Bifurcation Rules
In 1989, Congress amended Section 385(a) to authorize the issuance of regulations permitting an instrument issued by a corporation to be treated as in part indebtedness and in part stock.20 With some understatement, the legislative history of the amendment noted that “there has been a tendency by the courts to characterize an instrument entirely as debt or entirely as equity.”21 The 1989 amendment opened the way for the “bifurcation” of financial instruments that has been included in the new proposed regulations.
Bifurcation has long been considered a theoretical possibility with respect to debt-equity classification. In one important but infrequently cited decision, Farley Realty Corp.,22 a court developed a bifurcation approach in connection with a real estate loan. That loan provided for fixed interest for ten years, and, at the end of that time, in addition to repayment of the “principal” amount, for the payment to the “lender” of 50% of the increased value of the real property that was related to the loan.23 Only a few commentators have found the Farley Realty approach interesting,24 and instead court decisions, as well as IRS rulings, have followed the traditional path of classifying instruments at the time of issuance, and categorizing them either as entirely debt or entirely equity.
The proposed regulations breathe new life into the bifurcation debate. Finding that the “all-or-nothing approach” is particularly problematic in related-party situations, especially where the circumstances surrounding a purported debt instrument provide only slightly more support for characterizing the entire interest as indebtedness than as equity, and judging that the overwhelming consensus in the debt-equity cases could well fail to reflect the economic substance of related-party interests,25 the proposed regulations provide a remarkably abbreviated (especially given the otherwise bulky nature of the rest of the new rules) approach. The key provision merely states that if the analysis “supports a reasonable expectation” that only “a portion of the principal” of the purported debt will be repaid, the “application of federal tax principles” can support bifurcation.26
The effect of a partial reclassification of debt to equity will have the same economic effect as disallowing a portion of the interest deduction on the original debt instrument, and thus parallels some of the interest-deduction limitations proposed in recent tax reforms.27 To many observers, the bifurcation portion of the proposed regulations is the most significant development of all,28 and appears to be an effort to use the proposed regulations under Section 385 as an opportunity to exercise the statutory power granted in 1989. Moreover, as described in more detail below, the bifurcation rules apply to a potentially much larger set of taxpayers, referred to as a “modified expanded group” or “MEG.”
Expanded Groups and MEGs
Unlike the comprehensive approach to debt-equity issues in the “final” Section 385 regulations, the new proposed regulations focus exclusively on related-party transactions. With the important exception of taxpayers that are members of a MEG, the scope is generally limited to purported indebtedness between members of a brand new category of relationship among various taxpayers, called an “expanded group.”29
The proposed regulations begin the definition of “expanded group” by reference to “affiliated group” in Section 1504(a)(1), and then broaden it, most importantly, by including foreign corporations, as well as corporations held indirectly, for example, through partnerships.30 The proposed regulations also borrow attribution rules from Section 304(c)(3).31 The proposed regulations further deviate from the test for affiliated groups by treating a corporation as a member of an expanded group if 80% of the vote or value of stock is owned by expanded group members, instead of 80% of the vote and value, as generally required under Section 1504(a).32
Finally, as noted above, under the bifurcation rules, the “modified expanded group” definition is used instead of the expanded group. A MEG includes everything covered by the expanded group definition, but uses a 50% rather than 80% threshold. The MEG rules also include certain partnerships and certain other persons.33
Importantly, the 50% test for a MEG uses an “equal to or greater than” threshold, to track the 80% test in Section 1504 for affiliated groups, rather than the “more than 50%” test used in other key related-party provisions of the Code, including Section 267(b), which inexplicably is cited in the proposed regulations as support for its use of the “equal to 50%” test.34 It is these MEG rules that have perhaps the greatest potential for impacting domestic M&A transactions.
Impact on M&A Transactions
Because the expanded group rules apply only to affiliated groups (with slight modifications) and because affiliated groups that file consolidated returns are expressly not covered by the proposed regulations at all, the rules for “80%” domestic corporations may be of limited application.35 Rather, the bifurcation regulations dealing with MEGs could be a far greater concern for domestic M&A transactions. As just noted, these transactions require only a 50% (not “more than” 50%) ownership relationship to trigger the risk of deemed-stock treatment. Moreover, at least as currently drafted, the bifurcation rules do not provide for any explicit tests or categories of instruments that might be subject to bifurcation; the clear implication is that these regulations would be used retrospectively, on audit, long after capital structures are in place, and as a practical matter it is inevitable that the tax authorities may well take into account subsequent events to determine whether an instrument performed like debt or equity or some of both.36
The result of this combination of a reduced relationship threshold and an unstructured test for partial reclassification will be to call into question a range of financing decisions made in connection with the initial formation of companies. The bifurcation regulations will thus serve as a complement to the “earnings stripping” rules of Section 163(j), limiting the ability of newly formed entities to count on certain interest deductions, with the nuance that, as noted above, the proposed regulations under Section 385 use a 50% ownership test, whereas the venerable rules of Section 163(j) incorporate the more-than-50% standard under Section 267 and Section 707(b).37
The constraints on internal restructurings of existing groups also will be impacted by the reclassification risks, at least with respect to debt instruments issued with a “principal purpose” of funding certain related-party transactions. These provisions of the regulations are clearly intended to backstop other, more direct limitations in order to preclude multi-step transactions that might otherwise be used to avoid the application of these proposed regulations, while achieving economically similar outcomes.38 The preamble identifies a number of such indirect arrangements, including a situation in which a wholly owned subsidiary that otherwise would have distributed a debt instrument to its parent corporation could, absent these rules, borrow cash from its parent and later distribute that cash to its parent in a transaction that is purported to be independent from the borrowing.
Another illustration of the possible impact on certain domestic transactions is a special “anti-abuse rule” that addresses the acquisition of debt instruments that were originally issued to third parties, but later become part of an expanded group relationship, in some cases because of independent changes in ownership. For example, the preamble discusses a situation in which the change of control of the issuer group was not foreseeable when the debt instrument was issued to the original non-member. This would not be covered by the anti-abuse rules. On the other hand, the preamble identifies another case in which the issuance of an instrument to a non-member occurs after “discussions” are underway regarding the change-of-control transaction, indicating this situation could fall within the anti-abuse restriction.39 Needless to say, this contrasting treatment of indirectly acquired debt instruments will raise significant due diligence questions in connection with typical M&A financing transactions.
Finally (at least for this column), there is the question of the category of stock (common, preferred, nonqualified preferred, “straight” preferred under Section 1504(a)(4), etc.) created when debt is recharacterized under the proposed regulations. The rules simply state that the category will be “determined by taking into account the terms of the instrument (for example, voting and conversion rights and rights relating to dividends, redemption, liquidation, and other distributions)”;40 however, unless the debt is fairly unusual, it would likely be treated as preferred and not common. This in turn would impact other tests under the Code,41 and will also require special scrutiny in due diligence. Moreover, if the debt is reclassified, presumably it would be counted under the “vote or value” test to determine if a corporation is part of an expanded group or a MEG.42 This will make it more difficult to plan out of such related-party groups by structuring changes in ownership close to the line.43
A substantial part of the proposed regulations addresses requirements for related parties to thoroughly document and provide other information to support the debt classification of related-party indebtedness-either as part of an expanded group or as part of a MEG.44 The proposed regulations expressly provide an intention “to impose discipline,”45 by requiring timely documentation and financial analyses similar to the support ostensibly created when indebtedness is issued to third parties. Four essential terms and characteristics are supposed to be included in this documentation: (1) a legally binding obligation to pay, (2) creditors’ rights to enforce the obligation, (3) a reasonable expectation of repayment at the time the interest is created, and (4) an ongoing relationship during the life of the interest consistent with arms-length relationships between unrelated debtors and creditors.
This sharp focus on paperwork, in addition to imposing additional costs on what are often simply intercompany transactions, is supposed “to help demonstrate whether there was intent” to create a true debtor-creditor relationship that results in bona fide indebtedness and also to help ensure that the documentation necessary to perform an analysis of a purported debt instrument is prepared and maintained.46 In light of the bright-line timing and other requirements in the proposed documentation rules,47 these requirements can also be viewed as additional traps for the unwary.
The most exhaustive analysis of the debt-equity issue, published in 1971, 48 remains a model of tax scholarship, but likely never contemplated that the then-newly enacted Section 385 would be used to police cross-border transactions, much less to bootstrap earnings-stripping restrictions (which in any event were not codified until 1989). The new proposed regulations, if adopted in substantially similar form, promise to change the landscape of tax planning for corporate debt. Of particular concern are the bifurcation rules for 50% related parties, which should be fully explored in the relatively short period that may be available before the proposed regulations become final.
For citations, see full article in WG&L Corporate Taxation Journal.
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