Treasury and IRS Propose New Debt/Equity Regulations: Significant for Tax Structures Involving Related Party Debt

On April 4, 2016, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed Treasury regulations concerning the classification of purported related party debt instruments as either debt, equity or partially debt and partially equity for U.S. federal income tax purposes (Proposed Regulations). The Proposed Regulations target various intercompany financing structures and common tax planning techniques that the Treasury and the IRS find objectionable. Although many of these objections relate to inversions, the Proposed Regulations, if finalized in their current form, will also affect a broad range of common tax structures across all industries, including, potentially, structures used by private equity and hedge funds. The Proposed Regulations, if finalized, will generally become effective retroactively for debt issued on or after April 4, 2016. Accordingly, the Proposed Regulations are expected to have an immediate effect on tax planning activities.

Summary of the Proposed Regulations

Purpose.

The Proposed Regulations are intended to prevent taxpayers from aggressively using debt in situations in which debt is hardly distinguishable from equity, but in which significant U.S. tax benefits come with the use of debt rather than equity. The classic example is a foreign parent corporation that funds its wholly owned U.S. subsidiary with a mix of interest-bearing debt and equity to minimize the U.S. corporate tax of the U.S. subsidiary through interest deductions. In many cases, the interest payments are not subject to U.S. interest withholding tax under an applicable income tax treaty. Because of the control that the parent has over the subsidiary, and because the parent is both the sole equity holder and the sole lender, the economic significance of this shareholder debt (when compared with equity) is minimal or non-existent compared to the significant tax benefit of the annual interest deduction. Therefore, the Proposed Regulations, under certain circumstances, recharacterize such debt as equity.

Scope. The Proposed Regulations:

• apply only to financial instruments that are in the form of debt.
• target corporate groups (Expanded Group) consisting of U.S. and non-U.S. corporations, tax-exempt corporations, real estate investment trusts (REITs) and regulated investment companies (RICs), using a 80 percent (by vote or value) test for purposes of defining an Expanded Group; a partnership is included only if the partnership is a controlled partnership of an Expanded Group (80 percent owned by a corporation) and, in that case, is treated as an aggregate of its partners for this purpose.
• target only debt between members of an Expanded Group (Expanded Group Instrument or EGI); accordingly, typical capital market debt of a borrower issued to one or more holders unrelated to the borrower is not covered; such capital market debt continues to be covered solely by long-standing case law.
• target debt of large corporate groups; thus, an EGI is subject to the Proposed Regulations only if:
  
  • either the corporate issuer or one of its Expanded Group members is publicly traded;
  • the Expanded Group has total assets exceeding US$100 million; or
  • the Expanded Group has annual revenues in excess of US$50 million.
• do not apply to debt between members of the same consolidated group for U.S. federal income tax purposes; instead, members of a consolidated group are treated as one corporation for purposes of the Proposed Regulations.

Recharacterization of Debt as Equity. 

• The Proposed Regulations automatically re-characterize certain related party debt as equity, even if such debt would otherwise be respected as debt under general debt/equity principles (the Per Se Equity Rule) if:
  
  • an EGI is created by way of a distribution by an Expanded Group member to its corporate shareholder who is a member of the same Expanded Group;
  • an EGI is issued in exchange for stock of another Expanded Group member, subject to limited exceptions (e.g., intra-group Section 304¹ type of transactions); or
  • an EGI is issued by an Expanded Group member in exchange for property of another Expanded Group member in an asset reorganization (e.g., intra-group D reorganizations).
• The Per Se Equity Rule is backstopped by the important so-called “Funding Rule,” pursuant to which an EGI issued for cash or other property will be treated as equity if the EGI is issued with “a principal purpose” of funding:
  
  • a distribution of property by the Expanded Group member that has issued the EGI (the funded group member) to another member of that Expanded Group;
  • an acquisition of stock of an Expanded Group member by the funded group member in exchange for property other than stock of an Expanded Group member; or
  • an acquisition of property by the funded group member from another Expanded Group member in certain asset reorganization.
• The “principal purpose” test is generally based on all of the facts and circumstances. However, an EGI will be deemed to have been issued with a bad principal purpose if it is issued by the funded group member during the period beginning 36 months after the date of the distribution or acquisition and ending 36 months after the date of the distribution or acquisition (the Non-rebuttable Bad Purpose Presumption). The Non-rebuttable Bad Purpose Presumption will not apply to related party debt issued in the ordinary course of the issuer’s trade or business in connection with the purchase of property or the receipt of services.
• The Funding Rule will not apply:
  • if the aggregate adjusted issue price of all EGIs subject to recharacterization held by members of an Expanded Group does not exceed US$50 million (the Per Se Equity Rule also does not apply);
  • if distributions or acquisitions do not exceed the Expanded Group member’s current year earnings and profits (as determined for U.S. tax purposes) (the Per Se Equity Rule also does not apply); or
  • in the case of certain debt-funded acquisitions of stock of a subsidiary if, for the 36-month period immediately following the acquisition, the buyer holds, directly or indirectly, more than 50 percent (by vote and value) of the stock of the issuer of the EGI.
• If there is a lesser-degree of relatedness based on a 50 percent test (by vote or value) (Modified Expanded Group), then the Per Se Equity Rule and the Funding Rule do not apply, but a related party debt (Modified Expanded Group Instrument or Modified EGI) can be bifurcated into part debt and part equity, something that the long-standing case law generally did not support.
• If related party debt is re-characterized as equity under the Proposed Regulations, then the facts and circumstances and existing tax law principles will determine what kind of equity it will be (e.g., voting stock, non-voting stock, preferred stock, common stock).
• In a major departure from general tax principles, in certain circumstances the debt characterization of an EGI must be retested throughout the term of a purported debt instrument. Specifically, debt status is generally tested or re-tested when:
  • the EGI is issued;
  • the EGI ceases to be an EGI because either it is sold to an unrelated third party or the lending or borrowing member of the Expanded Group ceases to be a member of the Expanded Group;
  • documentation is insufficient to show reasonable exercise of creditor rights in case of defaults;
  • the Funding Rule requires a retesting due to actions taken after the issuance of the EGI (i.e., a subsequent distribution by the issuer of the EGI); or
  • a debt instrument ceases to be a consolidated group debt instrument but still is an EGI.

Documentation Requirements. If the taxpayer does not assemble (generally within 30 days of the issuance date or any relevant retesting date) and maintains documentation that sufficiently supports debt classification in accordance with the recordkeeping requirements of the Proposed Regulations (the Required EGI Documentation), the relevant EGI will automatically be treated as equity, even if such debt would otherwise clearly be debt under general debt/equity principles. The Required EGI Documentation, which needs to be in written form, must demonstrate:

• an unconditional obligation to pay a sum certain (e.g., legally binding obligation);
• creditor’s rights (including the right to trigger acceleration or default for non-payment, the right to sue to enforce payment and seniority over equity holders in liquidation);
• reasonable expectation of repayment using evidence such as cash flow projections, debt/equity ratio, collateral appraisals, comparison to comparable borrowers, business forecasts (no third-party analysis is necessary);
• timely payment of principal and interest (demonstrating that the form is actually respected by the taxpayer); and
• in the case of a non-payment (or another event of default), the holder of the related party debt exercises reasonable diligence and judgment as a creditor.

Anti-Abuse and Ordering Rules.

• A broad general anti-abuse rule provides that if debt is issued with “a principal purpose” of avoiding the application of the Proposed Regulations, then the debt will be treated as an EGI subject to the Proposed Regulations.
• The Proposed Regulations apply before the earning stripping rules of Section 163(j).

Effective Dates. If finalized in their current form, the Proposed Regulations will generally become effective retroactively to April 4, 2016, which means that any related party debt issued (or deemed issued pursuant to a significant modification of pre-April 4, 2016 debt) on or after April 4, 2016 may be re-characterized as equity under the Proposed Regulations. There is no grandfathering rule for related party debt agreed upon but not yet funded prior to April 4, 2016. There is, however, a transition rule pursuant to which an EGI that would otherwise be treated as equity under the Proposed Regulations as of April 4, 2016 will continue to be treated as debt for 90 days following the issuance of final debt/equity regulations. This should give taxpayers a narrow “grace period” during which they can unwind related party debt structures after the issuance of final regulations. Note, however, that the Required EGI Documentation and the bifurcation rules are effective only for debt instruments issued after the date of issuance of final regulations.

Initial Observations

The practical significance of the Proposed Regulations is best illustrated by the following examples.

Industrial Group with a U.S. Loss Subsidiary. French parent is a widget maker. It has a wholly owned U.S. subsidiary that has operated at a small loss in each of its years of existence due to significant start-up costs. It is projected that the U.S. subsidiary will become profitable in 2017. French parent is not an inverted company. To mitigate the future U.S. tax burden, French parent causes its U.S. subsidiary to distribute an intercompany, interest bearing note. Such distribution is not a taxable dividend because the U.S. subsidiary has no earnings and profits, due to its history of losses. Accordingly, the creation of the related party debt is tax-free. Interest payments from the U.S. subsidiary to the French parent under the note will not be subject to U.S. interest withholding tax because of the U.S.-France tax treaty. Accordingly, absent the Proposed Regulations, the deductible interest payments under the new related party debt will reduce the U.S. corporate tax burden of the U.S. subsidiary, assuming the debt is respected under general debt/equity principles. Under the Proposed Regulations, the note will be mandatorily recast as equity because it was issued via a distribution by a member of an Expanded Group to another member of that Expanded Group. The U.S. subsidiary’s ability to service the note does not matter. Thus, no interest deductions will reduce the U.S. corporate tax base and the interest payments on the note will be treated as dividend distributions, subject to 30 percent dividend withholding tax, unless reduced to 0 percent by the U.S.-France tax treaty.

Funding Rule. UK parent owns a wholly owned U.S. subsidiary (U.S. Sub). U.S. Sub, in turn, owns all of the stock of a Dutch subsidiary (Dutch Sub). In year 1, UK parent lends US$100 million to Dutch Sub in exchange for a note for valid non-tax business reasons. In the ordinary course and consistent with past practice during the last decade, Dutch Sub makes a US$5 million distribution to U.S. Sub at the end of year 2. Dutch Sub has no current year earnings and profits in year 2. The note is an EGI because an Expanded Group includes non-U.S. corporations and debt between two non-U.S. corporations can be an EGI. Because the note is issued within the 36-month period prior to the distribution and because the Dutch Sub has no current year earning and profits, the Funding Rule applies and recasts US$5 million of the note of Dutch Sub as stock for U.S. tax purposes.

Multiple Lenders. Solvent and profitable U.S. corporation borrows $100 million from an unrelated U.S. insurance company under a privately placed note with an 8 percent interest coupon. Assume this note is debt for tax purposes under general principles. In addition, the U.S. corporation borrows US$100 million from its 80 percent shareholder based on the same terms as the insurance company note, except that the shareholder debt is senior to the insurance company debt, is secured by a mortgage and has a 4 percent coupon rate. The shareholder neglects to put the Required EGI Documentation in place in a timely fashion and is ineligible for the reasonable cause exception. In the absence of the Proposed Regulations, the shareholder debt would be treated as debt under general debt/equity principles because it is senior to the insurance company debt and it is secured by a mortgage. Under the Proposed Regulations, however, the shareholder debt is an EGI for which no Required EGI Documentation is in place. Accordingly, the shareholder debt is treated as equity for tax purposes, even though the junior insurance company note is treated as debt for tax purposes.

Private Equity Blocker Corporation. A, a Delaware private equity fund limited partnership, invests in a portfolio company organized as a LLC that is treated as a partnership for U.S. tax purposes. To shield its non-U.S. investors from effectively connected income, A forms a Delaware blocker corporation which A funds with 60 percent debt and 40 percent equity. A partnership cannot be a member of an Expanded Group unless a corporation owns 80 percent or more of the partnership. Therefore, the debt of the blocker corporation should not be subject to the Proposed Regulations because there is no Expanded Group. It should be noted that Treasury and the IRS requested comments whether or not this type of debt should be covered by the Proposed Regulations.

Private Equity Acquisition. A Delaware private equity fund limited partnership with U.S. taxable investors forms a UK acquisition corporation (UK Holdco) and such UK Holdco acquires all the shares of a German target corporation (German Target) with numerous German and non-German subsidiaries in exchange for cash. German Target has assets in excess of US$100 million and it has operated, for a decade, a global cash management pool with its subsidiaries. UK Holdco acquires a Mexican subsidiary from the German Target in exchange for an intercompany note. Both the cash pool arrangement and the intercompany note will be EGIs and will, therefore, be subject to the Proposed Regulations, including the Required EGI Documentation rules, and may be recast as equity.

REITs. A publicly traded REIT has a wholly owned taxable REIT subsidiary (TRS) that it funds with an intercompany debt instrument, secured by real estate held by the TRS. Even though this situation was arguably not targeted at all by the Proposed Regulations, it falls under the scope of those rules and the debt may be recast as equity if, for example, the Required EGI Documentation is not prepared.

Surplus Notes. A publicly traded holding company in the insurance industry has a non-consolidated life insurance subsidiary. The non-consolidated life insurance subsidiary issues a surplus note to the holding company in exchange for cash. Again, this established market practice was arguably not the target of the Proposed Regulations, but the surplus note in this example is within the scope of these new rules and the surplus note may be recast as equity if, for example, the Required EGI Documentation is not prepared.

We expect that the Proposed Regulations will attract a large amount of comments. However, given the election year and the short period for comments, it is possible that Treasury and the IRS will attempt to finalize the Proposed Regulations before the new administration takes office at the end of January 2017. We will continue to monitor these complex developments closely. 

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¹References to “Sections” are references are to the Internal Revenue Code of 1986, as amended.

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