The final regulations will complicate tax planning for U.S. companies with foreign parent entities. Know how the documentation and transaction rules affect you.
The final regulations under Section 385 of the Internal Revenue Code may have profound effects on United States inbound taxpayers. These new rules can cause debt to be re-characterized as equity, resulting in the treatment of deductible interest expense as a nondeductible dividend. Inbound multinationals should pay particularly close attention to these regulations if you have long-term loans or short-term funding/cash pooling in place.
Inbound multinationals should pay particularly close attention to these regulations if you have long-term loans or short-term funding/cash pooling in place.
You should also consider whether any debt issued after April 4, 2016, is subject to the transaction rules, and plan for future debt issuances to avoid the potential negative consequences of having debt re-characterized as equity. In addition, between now and January 1, 2018, you should understand the requirements of the documentation rule and implement internal procedures to help you comply with this rule prior to any future debt issuances.
Here’s a breakdown of the final Section 385 regulations and the documentation and transaction rules that will affect your tax planning and compliance.
Section 385 overview
Congress originally enacted Section 385 in 1969. It granted the U.S. Treasury authority to issue regulations that help determine whether an interest in a corporation is to be treated as stock or indebtedness for federal income tax purposes. Because the regulations were not actually issued until 2016, the characterization of an instrument as debt or equity under Section 385 is based on several factors embodied in common law (e.g., written note, commercial interest rate, and repayment terms).
On April 4, 2016, the Treasury and the IRS issued proposed regulations under Section 385 addressing when debt may be re-characterized as equity for certain debt instruments in certain circumstances when issued between related corporations. The proposed regulations were highly controversial because of their scope and impact on internal cash management (which is a part of normal business operations), so some favorable modifications were made to the final regulations.
Final Section 385 regulations were issued on October 13, 2016. They were slightly narrower in scope and applied to a smaller pool of debt instruments and additional exceptions for cash management in the normal course of business.
The final regulations primarily affect inbound related-party debt (i.e., loans from foreign related parties to a U.S. corporate related party) and nonconsolidated U.S. related-party debt, thus applying only to debt issued by U.S. corporations and certain U.S. partnerships. They include rules regarding the documentation of related-party debt instruments (the “documentation rule”) and the re-characterization of related-party debt instruments issued in certain restructuring transactions (the “transaction rule”).
Section 385 rules are applied in addition to Sections 267(a) and 163(j), which already contain provisions in U.S. income tax law to limit interest deductions on interest accrued and paid to foreign related parties. Section 267(a)(3) prevents accrued interest to a foreign related party from being deductible for U.S. income tax purposes until the interest is paid. The “earnings stripping” provisions of Section 163(j) can further limit a deduction for interest after it is paid by disallowing interest paid to a related party when it is subject to either no or reduced taxation when net interest expense exceeds 50 percent of adjusted taxable income and the debt-to-equity ratio at close of tax year exceeds 1.5:1.
Type of debt affected by Section 385
The final Section 385 regulations apply to debt issued by U.S. corporations owned by U.S. parent multinationals and foreign-based multinationals. For U.S. parent multinationals, loans to U.S. affiliates made by foreign affiliates can be re-characterized as equity and require compliance with the documentation rules. Trade payables owed to foreign affiliates are within the scope of the re-characterization rules but may be excluded under the “ordinary course” or “interest-free loan” exceptions, and will require compliance with the documentation rules. Other applications of the Section 385 regulations for a U.S. parent multinational include cash pooling for a U.S. parent with multiple consolidated groups.
For a foreign-based multinational, Section 385 regulations can apply to long-term inbound lending and short-term funding/cash pooling. Both types of lending are subject to re-characterization under both the “general rule” and the “funding rule” contained in the transaction rule, and both are subject to the documentation rule. Short-term funding/cash pooling may be excluded from re-characterization under the 270-day, working capital, or interest-free loan exceptions. Trade payables owed by U.S. affiliates to foreign affiliates are also within the scope of both the documentation rule and the transaction rule but can be excluded from re-characterization under either ordinary course or interest-free loan exceptions, although compliance with the documentation rule is still required.
Documentation rules
The documentation rules (Treasury Regulation § 1.385-2) facilitate analysis of related-party debt instruments by establishing documentation and maintenance requirements, operating rules, presumptions, and factors that impact treatment of a debt instrument as debt or equity. Compliance with the documentation rule does not necessarily guarantee debt treatment. The documentation rule can apply to debt instruments or open account debt of U.S. corporations held by a non-consolidated “expanded group” member (generally corporations under common ownership of 80 percent of the vote and value of their outstanding stock). Debt held by an expanded group member under the Section 385 rules is referred to as an “expanded group instrument” (EGI) and only applies to EGIs issued or deemed issued on or after January 1, 2018.
Documentation content
The documentation rule requires that certain factors must be documented and maintained, including:
- Unconditional obligation to pay a sum certain
- Creditor rights
- Reasonable expectation of payment
- Existence of a debtor-creditor relationship
Documentation must include all documents that support material rights and obligations of the issuer and holder of the debt and the associated rights and obligations of other parties (e.g., guarantees). The U.S. corporation, as issuer of the EGI, must comply with the documentation rule no later than the date of its appropriately filed U.S. tax return (including extensions) for the tax year the EGI was issued.
The regulations further discuss the factors required to comply with the documentation rule. For the creditor rights factor, the regulations contain a “market standard” safe harbor under which documentation customarily used for comparable third-party transactions may be applied. Creditor rights documentation may also be satisfied if the issuer’s tax files reference relevant local laws providing such rights (i.e., such rights do not need to be restated in the EGI). Lastly, compliance with the documentation rule is not “re-triggered” if there is a “significant modification” that treats the debt instrument as being exchanged under Section 1001 if the terms of an EGI do not change.
To satisfy the reasonable expectation of repayment factor, nonrecourse EGIs must include information on property serving as security. An issuer with multiple EGIs (e.g., cash pool or revolver) can satisfy this requirement with an annual credit analysis, provided the analysis is updated if there is a “material event” that affects the EGI issuer’s ability to repay, such as bankruptcy or material disposition of assets. For this factor, documentation is “re-triggered” as a result of a Section 1001 “significant modification” that changes the issuer of the EGI.
Cash pooling documentation compliance
The documentation rules contain specific provisions for cash pooling arrangements, revolving credit agreements, and agreements governing payables and receivables.
Notional cash pooling arrangements are subject to these special rules to the extent the EGI would be treated as issued directly between expanded group members. To satisfy the sum certain and creditor rights factors, the EGI’s documentation must include all relevant enabling documents, prepared and maintained in accordance with the documentation rules.
Documentation for cash pooling arrangements or internal banking operations must also be prepared and maintained in accordance with the documentation rules. This includes agreements with entities that are not EG members (such as notional cash pools). Compliance with the documentation rule is triggered if agreements are amended to either increase maximum principal or admit a new borrower.
Failure to comply
Failure to comply with the documentation rules generally results in an EGI being re-characterized as stock (i.e., equity) for all U.S. tax purposes. The 385 regulations do contain exceptions to re-characterization for reasonable cause, a rebuttable presumption, and taxpayer remedy.
The rebuttable presumption exception may be argued if the expanded group is otherwise “highly compliant” and the EGI is respected as debt if the issuer clearly establishes that the EGI is properly treated as debt under common law.
The taxpayer remedy exception may apply where the taxpayer can remedy ministerial or non-material noncompliance or error if the remedy is completed prior to IRS discovery.
Transaction rules
Transaction rules (Treasury Regulation § 1.385-3 and Temporary Regulation § 1.385-3T) re-characterize stock as related-party debt instruments issued in a transaction or series of transactions that do not result in new investment in operations. Re-characterization applies even if the debt instrument satisfies the documentation rules and is treated as debt under common law principles.
A debt instrument treated as equity under the transaction rules generally is treated as such for all U.S. tax purposes. The two primary operating rules contained within the transaction rule are the “general rule” and the “funding rule.”
General rule
Transaction rules apply to “covered debt instruments” (CDI), which generally are debt instruments issued by domestic corporations after April 4, 2016, with limited exceptions. A CDI issued to an expanded group member is treated as equity if it is issued in one of the following transactions:
- Distribution
- Exchange for stock of an expanded group member (EG stock) other than an “exempt exchange,” such as a liquidating distributions (taxable and tax-free)
- Exchange for property in an asset reorganization if the instrument is received as boot (e.g., cash) by an expanded group member
Funding rule
A CDI that is not a qualified short-term debt instrument is treated as equity if it is issued by a domestic corporation (i.e., a “funded member”) to an expanded group member in exchange for property, and treated as funding one of the following “defunding transactions” completed by the funded member after April 4, 2016:
- Distribution of property to an expanded group member other than in an “exempt distribution”
- Acquisition of EG stock from an expanded group member in exchange for EG stock other than in an exempt exchange
- Distribution of boot (e.g., cash) to an expanded group member in an asset reorganization
A CDI is treated as funding a defunding transaction if, based on the facts and circumstances, it was issued for a principal purpose of funding the defunding transaction, or it is issued in the defunding transaction’s “per se period.” The per se period is the 72-month period beginning 36 months before the defunding transaction.
General and funding rule exceptions
There are three primary types of exceptions that apply to the general rule or the funding rule:
- Exceptions that exclude a transaction from being a general rule transaction and/or a defunding transaction (“exclusion exceptions”)
- Rules that reduce the amount of general rule transactions and/or defunding transactions (“reduction exceptions”)
- “Threshold exceptions,” which, under the expanded group earnings exception, general rule transactions and defunding transactions, are decreased by a CDI issuer’s “expanded group earnings.” These are generally the earnings and profits (E&P), with certain modifications, accumulated in taxable years ending after April 4, 2016, during the period the issuer was part of the expanded group computed as of the end of the year without regard to any general rule transactions or defunding transactions. The threshold exception allows the first $50 million of tainted CDIs under the transaction rules to be excluded from re-characterization as equity. Any CDI amount exceeding the $50 million threshold is re-characterized as equity while the first $50 million continues to be treated as debt.
How we can help
Although the final Section 385 regulations incorporate several taxpayer-friendly provisions, they still will have broad tax and financial implications to U.S. inbound taxpayers when debt must be re-characterized as equity. Tax planning for multinationals has become quite a bit more complicated. Our global compliance and tax professionals can help you make sense of the new regulations and navigate their related planning challenges.