Sally Morrison is a partner and leader within the International Tax and Global Strategies practice of Deloitte Tax LLP in Kansas City, Missouri. On November 21, 2016, Ms. Morrison answered the following questions for BEPS Global Currents, regarding the Section 385 final Regulations (T.D. 9790) (“Final Regulations”) published in the Federal Register on October 21, 2016, which generally target related parties that engage in certain specific earnings-stripping transactions:
Q: Due to the fact that the Section 385 Regulations affect companies’ cash pooling transactions, are clients making any changes to how internal cash transfers are being recorded/documented?
A: Yes, companies are considering approaches to recording and documenting cash transfers as a result of their cash pooling arrangements, including implementing tracking procedures to address the exceptions under the rules. The Final Regulations also provide a limited exception for deposits received by a “qualified cash pool header”. Accordingly, companies are ensuring that the cash pooling entity meets the requirements of a qualified cash pool header.
Q: Similar to the above question, will the ways in which clients document short- and long-term intercompany loans change based on the Section 385 Regulations?
A: Companies will likely change documentation for short- and long-term intercompany loans if they believe the current documentation is not in compliance with the requirements of the Final Regulations.
However, and importantly, the number of instruments to which the Final Regulations apply is significantly narrowed in comparison to the Proposed Regulations. For example, Final Regulations only apply to domestic issuers of debt and therefore, the documentation requirements will generally not apply to any foreign issuers of debt. Further, debt between members of a U.S. consolidated group is generally not subject to recharacterization under the rules either. However, U.S. companies with intercompany loans and cash management practices may likewise change documentation and intercompany practices in light of potential state tax ramifications where the consolidated group exception does not apply.
The Final Regulations provide that an annual debt capacity analysis is required for cash pooling, credit facility, revolver and other similar arrangements. Therefore, companies need to start implementing procedures and tools to document each borrower’s debt capacity before the effective date of the Documentation Rules.
Q: How are LLCs, S corporations, and partnerships reacting to the section 385 Regulations?
A: In general, the concerns regarding pass through entities were largely addressed in the Final Regulations. For example, one concern was the potential to invalidate an S corporation’s “S Election” by characterizing debt issued by an S corporation into equity; however, S corporations are excluded from the definition of expanded group, and therefore, debt issued by an S corporation is exempt from the rules.
Certain partnerships are subject to portions of the Section 385 Regulations. For example, while controlled partnerships generally are exempt from the scope of the Documentation Rules, they are still subject to the Recast Rules. The Final Regulations adopt a deemed conduit approach in which if a controlled partnership’s debt instrument would be recharacterized as equity, the expanded group member that holds the receivable is deemed to transfer its recharacterized portion of the receivable to the partner that undertook the distribution or acquisition in exchange for stock in that partner with the deemed stock having the same terms as the receivable.
The Treasury and IRS note in the Preamble that they intend to use the anti-abuse rules to closely scrutinize transactions in which a controlled partnership issues preferred equity and the Recast Rules would have applied had the preferred equity been denominated as a debt instrument issued by the partnership.
LLCs that are treated as disregarded entities of a covered member are still subject to the Documentation Rules and Recast Rules. If debt of the disregarded entity is recharacterized as equity, it will be converted into equity of the covered member and not the disregarded entity, thereby avoiding the possibility of creating new members, which would cause the disregarded entity to become a partnership.
Q: Are multinationals changing their M&A strategies (i.e., acquisitions) as a result of the Section 385 Regulations?
A: Companies pursuing M&A activities are impacted by the Final Regulations in terms of the flow of funds to make acquisitions and approaches to post-merger integration. Since the scope of the Final Regulations excludes debt of foreign issuers, the M&A strategy concerns are limited to domestic issuers.
The Final Regulations prevent the cascading consequences of recharacterizing a debt instrument as stock and excluding subsidy stock acquisitions. M&A due diligence should appropriately identify risks with loans and prohibited transactions undertaken by targets and members of their expanded groups as well as the benefits of maintaining grandfathered debt.
Q: Are your clients evaluating treaty withholding implications for any cross-border financing transactions they may have as a result of the Section 385 Regulations?
A: Companies are evaluating the withholding tax implications of a recharacterization of debt into equity and the resulting requirement to apply withholding tax to dividends instead of interest. The Final Regulations apply only to debt issued by a domestic corporation or a disregarded entity of a domestic corporation, and therefore, the withholding tax implications largely focus on U.S. withholding tax considerations.
Q: Are your clients evaluating any potential foreign tax credit and/or subpart F implications as a result of the Section 385 Regulations?
A: Companies are evaluating possible implications to their foreign tax credit and subpart F positions resulting from a recharacterization of a debt instrument (as well as other consequences of such a recast on tax-free exchanges, etc.). Because loans issued by foreign corporations are no longer subject to the Regulations, the concerns around the loss of foreign tax credits in a situation where a loan is recharacterized as nonvoting equity has largely been alleviated. Section 956 loans, however, are still subject to the rules, and it is necessary to consider the foreign tax credit and subpart F implications of the recast of such a loan.
Q: Are your clients evaluating any of their employee compensation structures as a result of the Section 385 Regulations?
A: The Final Regulations do not apply to stock delivered to employees, directors, and independent contractors, and therefore, the concerns regarding the Section 385 Regulations have been largely alleviated.
Q: While the final Section 385 Regulations are limited to debt instruments issued by U.S. companies, do your clients still intend to evaluate any debt instruments issued by foreign companies to see if they may need to be restructured or documented differently?
A: Treasury’s focus on debt instruments has made companies more cautious of their debt hygiene both in terms of documentation of debt instruments as well as supporting debt capacity. The four factors cited in the Documentation Rules appear to have elevated status over the other historical debt/equity factors. This may change debt/equity analysis for loans that are not subject to the 385 regulations but are nonetheless subject to the general provisions of IRC section 385 and historic case law.
Q: Are your clients evaluating any potential U.S. state and local income tax implications posed by the final Section 385 Regulations?
A: Yes. The Final 385 Regulations’ impact on state and local income tax has become one of the most discussed topics. Each state adopts its own version of IRC conformity and generally requires companies to file separate or on a combined basis. Certain states have additional rules or policies impacting intercompany transactions. Due to the variables involved, the state and local income tax impacts of the Final Regulations may be significant. Each company must evaluate the Final 385 Regulations in relation to their own state and local tax footprint to determine potential implications.
This article does not constitute tax, legal, or other advice from Deloitte LLP, which assumes no responsibility regarding assessing or advising the reader about tax, legal, or other consequences arising from the reader’s particular situation.
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