On April 4, 2016, the U.S. Treasury Department and the Internal Revenue Service (“IRS”) issued proposed regulations ostensibly aimed at curbing inversions and earnings stripping, by companies located in the U.S. with overseas ties. If finalized, these regulations would become retroactive to April 4, 2016, and would fundamentally shift the way debt and equity are characterized by a broad range of companies doing business in the United States. Far from simply making it more difficult for U.S. companies to relocate their headquarters overseas, the proposed regulations would dramatically alter the tax landscape for most companies’ capital structures, internal financings and cash management.
The inversion regulations will be addressed in a separate post on our Taxes Without Borders blog shortly. Our blog post focuses solely on the intercompany debt regulations, which likely would result in a substantial portion of intercompany debt transactions being recharacterized as equity contributions and distributions thereon.
At the outset, it is important to note that these rules would not apply to debt between members of a U.S. consolidated group, presumably because there is no inversion risk associated with a U.S. consolidated group. Rather, the regulations would apply to debt between U.S. and foreign members of a consolidated tax group and transactions involving foreign-parented groups or U.S.-parented groups with foreign constituencies.
The proposed regulations would provide the IRS with new tools for challenging the tax treatment of intercompany debt. The regulations have three main components:
- (i) rules permitting the IRS to bifurcate an intercompany debt instrument into separate debt and equity instruments;
- (ii) documentation rules, which, if not satisfied, would treat intercompany debt as equity;
- and (iii) rules that would automatically treat certain intercompany debt as equity.
Each of these components is briefly summarized below:
Ability to Bifurcate Debt
Never before has the IRS had the ability to bifurcate a single instrument into both debt and equity. The proposed regulations, however, would permit the IRS to do just that. Unfortunately, the current version of the proposed regulations does not provide clear guidance to when the IRS may exercise this authority. If the issuer was unlikely to repay the entire outstanding principal balance of the loan, the IRS could elect to bifurcate a debt instrument. As you can imagine, if this bifurcation tool were implemented, it would have the potential to create substantial uncertainty regarding the use of intercompany debt instruments within consolidated tax groups.
In addition, the proposed regulations would impose stringent requirements on the documentation of intercompany debt. To be treated by the IRS as debt, rather than equity, would require the following to be documented:
(i) the debt issuer’s unconditional obligation to pay a certain sum on demand or one or more fixed dates;
(ii) the debt holder’s rights as a creditor to enforce the obligation;
(iii) the reasonable likelihood that an issuer would be able to repay the debt in full as of the funding date (through references to projections, appraisals, financial statements and other financial metrics);
and (iv) evidence that a holder’s actions post-issuance would be consistent with those of an unaffiliated creditor (i.e., evidence of a typical debtor-creditor relationship).
Additional documentation requirements would also be required for credit facilities, open accounts and pooling arrangements. Subject to a limited exception for reasonable cause, if any of these documentation requirements were not satisfied, the debt automatically would be treated as equity. Clearly, these regulations introduce significant new compliance burdens on corporate taxpayers.
Debt Treated As Equity in Specified Transactions
Finally, the proposed regulations would automatically treat certain types of intercompany debt as equity with the following characteristics:
(i) debt in the form of a distribution;
(ii) debt that is used to purchase stock of a member of the consolidated group;
or (iii) debt issued in exchange for property in an asset reorganization of a group member. In other words, most intercompany debt transactions in which debt is issued without providing new capital to the issuer would be automatically recharacterized as equity.
If finalized and implemented, the impact of these regulations would be profound. The proposed regulations may change the results of many transactions that have traditionally been viewed as legitimate intercompany financings. Recharacterizing these transactions as equity would deny the issuer interest-expense deductions and require the holder to treat purported interest payments as distributions that would potentially be subject to higher tax rates.
Due to the complete turnaround these regulations make from decades of established tax law and practice, we can assume that substantial commentary and criticism will be forthcoming. That being said, in recent days, both President Obama and Jack Lew (the U.S. Treasury Secretary) have reaffirmed their commitments to these new regulations as a much needed tool in the inversion battle. We will continue to keep readers updated as developments occur.