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.