On August 2, 2016, BDO held a webcast on the U.S. Section 385 Proposed Regulations (“Proposed Regulations”), concerning treatment of direct or indirect interests in a related corporation as stock, debt, or as in part stock and in part debt. The panelists included Joseph Calianno, Partner, International Technical Tax Practice Leader in the Washington National Tax Office; Brad Rode, Partner, International Tax Services in the Chicago office; and Douglas Poms, Deputy International Tax Counsel at Treasury.
Background on Corporate Debt/Equity Rules
Pursuant to Section 385(c), a corporate issuer’s characterization at issuance of a corporate instrument as stock or debt is binding on the issuer and all holders (unless the holder discloses inconsistent treatment on its return), but is not binding on the IRS.
If the IRS determines that a corporation’s debt obligations should be treated as equity (stock), it will treat interest paid on the securities as nondeductible dividend income. While no single factor is controlling, the following factors are relevant in determining whether a corporate obligation is debt or equity for federal tax purposes:
- The right to enforce payment of principal and interest.
- Presence or absence of a maturity date.
- Source of payments.
- Status equal to or inferior to that of regular corporate creditors.
- “Thin” or inadequate capitalization.
- Intent of parties.
- Identity of interest between creditor and stockholder.
Background on Proposed Regulations
On April 4, 2016, Treasury and the IRS issued the Proposed Regulations (REG-108060-15) addressing whether a direct or indirect interest in a related corporation is treated as stock, debt, or as in part stock and in part debt, for U.S. federal tax purposes. The Proposed Regulations generally target related parties that engage in certain transactions using U.S. debt to “strip” U.S.-source earnings (through interest deductions) to lower-tax jurisdictions, but may apply without regard to whether the related parties are domestic or foreign. They also require the preparation and maintenance of extensive documentation to substantiate debt treatment between related parties.
Although the Proposed Regulations were released as part of a larger package of anti-inversion measures, they would apply to many routine financial transactions (including cash pooling arrangements) and common Subchapter C transactions of U.S.- and non-U.S.-based multinational enterprises (MNEs), regardless of whether the MNEs in question effected an inversion.
Because there are currently no Regulations in effect under Section 385, the case law that developed before the enactment of Section 385 has continued to evolve and to control the characterization of an interest in a corporation as debt or equity. Courts have historically followed an all-or-nothing approach to treating interest in a corporation as wholly equity or wholly debt. The Proposed Regulations would allow the IRS Commissioner to depart from the all-or-nothing approach (when appropriate) to ensure that the income of related taxpayers are reflected clearly.
If made final, the Proposed Regulations would:
- Bifurcation rule. Provide IRS with the ability treat certain related-party debt as in part equity and in part debt based on relevant facts and circumstances (Prop. Reg. 1.385-1(d)).
- Documentation rule. Impose extensive documentation and information requirements on “large taxpayer groups” in order for a purported debt instrument between members of an expanded group (EG, as defined in Prop. Reg. 1.385-1(b)(3)) to be respected as debt—that is, not recast as equity (Prop. Reg. 1.385-2).
- Per se stock rule. Subject to certain exceptions, recast related-party debt instruments as equity for U.S. federal tax purposes when issued (1) as a distribution; (2) in exchange for related-party stock (e.g., in a Section 304 sale); (3) as consideration in an internal asset reorganization (e.g., boot in a Section 368(a)(1)(D) reorganization); or (4) to fund a distribution, acquisition of related-party stock, or boot in an internal asset reorganization (Prop. Reg. 1.385-3).
In general, the Proposed Regulations would apply to any applicable instrument issued or deemed issued on or after the date that the Proposed Regulations are published as final in the Federal Register and to any applicable instrument treated as indebtedness issued or deemed issued before the date that the Proposed Regulations are issued as final if and to the extent that it was deemed issued as a result of an entity classification election made under Reg. 301.7701-3 that is filed on or after the date that the Proposed Regulations are issued as final in the Federal Register.
The Proposed Regulations would potentially recharacterize as equity debt issued between members of an “expanded group,” which includes (1) foreign and tax-exempt corporations; (2) corporations held indirectly (e.g., through partnerships); and (3) corporations connected by ownership of 80% vote or value, rather than vote and value. Members of a consolidated group should be treated as a single entity and are not subject to these rules. There is no threshold in terms of the size of the issuer.
The Proposed Regulations have significant implications with regard to the OECD BEPS project,
specifically for Action 2 (hybrid mismatch arrangements) and Action 4 (interest deductions). Action 2 applies if the U.S. recharacterizes the debt as equity, as taxpayers will then need to determine how the foreign jurisdiction will treat the relevant instrument.
August 2, 2016, BDO Webcast
The panelists provided an overview of the Proposed Regulations , and the far-reaching effects that these rules have on both inbound foreign companies that have a U.S. business, and outbound (e.g., cash pooling) transactions. The goal is to prevent erosion of the U.S. tax base. Although the Proposed Regulations are packaged with the new Section 7874 Temporary Regulations on inversions, their scope is not limited to inverted companies. The impact is much broader, and will affect companies’ current plans and structures.
Notably, the Treasury official (Douglas Poms) said that the U.S. is evaluating a potential exception for cash-pooling transactions based on comments from various stakeholders. However, any exception would apply to such transactions that are short-term.
Editor’s Note: “Cash pooling” generally refers to a cash management technique that may be used by Treasury centers of MNEs, among others. The arrangement may allow the debit (excess cash) and credit (cash deficit) in the accounts of the members of the MNE to be combined into one account to limit low balances or transaction fees. At the time of the pooling, the positive balances in the accounts may be physically (or notionally) transferred to the pool leader. The pool leader may then physically (or notionally) provide the excess cash to those members that are in an overdraft position.
Also, Poms said that the U.S. prefers bright-line rules due to lower IRS resources, which is why the Proposed Regulations would require IRS consideration of all intercompany financing activities that occur three years before and three years after a loan is issued, to determine whether the transaction should be recast as equity for tax purposes.
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