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Introduction
On April 4, 2016, the United States Treasury and the Internal Revenue
Service (“IRS”) issued proposed regulations under §385 of the Internal
Revenue Code (the “Code”). The §385 regulations were issued in
tandem with new inversion regulations, but are much broader in their
application (for example, they apply to all U.S. multinationals) and
would have a significant negative impact on multinational companies
that desire to issue intercompany debt. The proposed regulations extend
beyond prescribing rules to determine whether an interest
should be treated as stock or indebtedness. As described below, some
aspects of the new rules are applicable beginning on April 4, 2016.
Documentation Requirements
Proposed Treasury Regulation §1.385-2 imposes new threshold documentation
requirements to treat an instrument between members of
the same expanded group (“EGI”) as debt. Once the threshold documentation
requirements are satisfied, the instrument is still subject to
the debt-equity factors set out in case law. If the contemporaneous
documentation requirements are not satisfied, the instrument is
treated as stock. There is a reasonable cause exception.
An “expanded group” is based on an 80% vote or value relatedness standard. A consolidated group is treated as one corporation for purposes of these rules. The Treasury has stated that the definition of expanded group may get narrower, among other possible modifications to these new proposed regulations.
Additionally, the documentation requirements only apply to expanded groups if the stock of any member is publicly traded, or financial statements of all or any portion of the expanded group show total assets exceeding $100 million or annual total revenue exceeding $50 million.
There are four documentation requirements—the first three must be in place within 30 days of issuance of the instrument and the fourth must be in place within 120 days of the payment due date or an event of default.
First, the parties must have written documentation establishing that the issuer entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates. Second, the written documentation needs to establish that the holder has the rights of a creditor to enforce the obligation. Typically, a creditor’s rights include, but are not limited to, the right to trigger an event of default or acceleration and the right to sue to enforce payment. Creditor’s rights must include a superior right to shareholders to share in the issuer’s assets upon dissolution. For cash pooling and revolving credit arrangements, these first two requirements could be satisfied with a master agreement.
Third, written documentation must be prepared, as of the date of issuance, containing information establishing that the issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations under the instrument. The documentation could include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity and other relevant financial ratios, and other relevant information.
Fourth, ongoing written documentation must be prepared evidencing the issuer’s payments or, in the case of non-payment, the holder’s exercise of a creditor’s diligence and judgment. The Treasury is considering modifying these rules as they relate to cash pooling.
Notably, the four substantiation requirements do not contain an ordinary trade or business exception. Thus, the day-to-day operations of U.S.-based multinational companies and U.S. subsidiaries of foreign based multinational companies would be significantly impacted, resulting in possible delays of funding and the potential need for restructuring of current business operations.
The documentation requirements will apply to any applicable instrument issued or deemed issued on or after the date the regulations are published as final, which is expected to be sometime this year, and to any applicable instrument treated as indebtedness issued or deemed issued before the date these regulations are published as final if and to the extent it was deemed issued as a result of an entity classification election filed on or after these regulations are published as final.
Certain Blacklisted Debt Instrument
Transactions and the Funding Rule
Under the “general rule” of Proposed Treasury
Regulation §1.385-3, a debt instrument
would automatically be treated as stock to the
extent it was issued by a corporation to a
member of the corporation’s expanded group
in any of the following blacklisted transactions: (1) a distribution; (2) in exchange for stock of an expanded
group member; and (3) in exchange for property pursuant to an asset
reorganization within the expanded group.
Under the “funding rule” of Proposed Treasury Regulation §1.385- 3, a debt instrument would be treated as stock to the extent it were issued by a corporation to a member of its expanded group in exchange for property with a principal purpose of funding any of the three blacklisted transactions from the general rule. However, a per se rule establishes a nonrebuttable presumption of failing the principal purpose test. Under the per se rule, a debt instrument issued beginning three years before a blacklisted transaction and ending three years after a blacklisted transaction is automatically treated as stock. Thus, a dividend generally cannot be paid within three years of a blacklisted note issuance.
A few exceptions are available, including an exception for debt that arose in the ordinary course of the issuer’s trade or business in connection with purchase of property or receipt of services to the extent it is reflected as an obligation to pay an amount currently deductible under §162 or included in the issuer’s cost of goods sold or inventory. Additionally, the aggregate amount of any distributions or acquisitions are reduced by an amount equal to the member’s current year earnings and profits and a debt instrument is not treated as stock under the general rule or the funding rule if immediately after it is issued the aggregate adjusted issue price of debt instruments held by all members of the expanded group do not exceed $50 million. Certain anti-abuse rules would apply.
These rules are applicable to any debt instruments issued or reissued (consider Treas. Reg. §1.1001-3) on or after April 4, 2016 and to any debt instrument treated as issued before April 4, 2016 as a result of an entity classification election that is filed on or after April 4, 2016. However, if a debt instrument issued before the regulations are finalized were recharacterized under the general rule or funding rule as stock, it would be treated as debt until 90 days after the regulations are issued as final.
Part Debt-Part Equity
Proposed Treasury Regulation §1.385-1 allows the IRS to treat a
modified expanded group related party debt instrument as partly debt
and partly stock. For this purposes, a modified expanded group is defined
as an expanded group, except 80% is substituted with 50%. The
proposed regulations provide no objective standards for the partly
debt-partly equity recharacterization. IRS examining agents would be
able to subjectively recharacterize debt based on “the relevant facts
and circumstances … under general tax principles.” The ability for
IRS examining agents to subjectively recharacterize debt creates uncertainty
for taxpayers.
Originally published in the 2nd edition of Euromoney Legal Media Group’s Expert Guides for the LMG Rising Stars 2016.
