26th Annual Health Sciences Tax Conference

Transcription

1 26th Annual Health Sciences Tax Conference Cross-border financing and impact of Section 385 December 5, 2016

2 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2016 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2 Cross-border financing and impact of Section 385

3 Presenters Lillian Kessler Pfizer Inc. Peapack, NJ Damon Kellar Eli Lilly and Company Indianapolis, IN Lee Cleland Ernst & Young LLP New York, NY Alastair Campbell Ernst & Young LLP New York, NY Page 3 Cross-border financing and impact of Section 385

4 Agenda 1 Overview Documentation and operational considerations Reg Transactional considerations Reg Impact on Life Sciences companies 5 Consolidated return considerations 6 State income tax considerations 7 What you should do now Page 4 Cross-border financing and impact of Section 385

5 Overview Page 5 Cross-border financing and impact of Section 385

6 Section 385 and the proposed regulations Section 385: regulatory authority on treatment of interests in corporations as stock or indebtedness Proposed regulations issued April 4, comment letters filed Bifurcation Rule Prop. Reg (d) Documentation Rule Prop. Reg Transaction Recharacterization Rule Prop. Reg (b)(2) Funding Recharacterization Rule Prop. Reg (b)(3) Provided IRS Commissioner with discretion to treat debt instruments between two members of the same modified expanded group as part debt and part stock Contemporaneous documentation meeting four requirements, aimed at identifying the rights, obligations and intent of the parties to a debt instrument Treated an expanded group debt instrument as stock to the extent that it was issued by a corporation to another member in connection with certain corporate transactions Treated as stock an expanded group instrument that was issued with a principal purpose (with a 36-month per se period) of funding a transaction described in the general rule Page 6 Cross-border financing and impact of Section 385

7 What happened? Final and temporary related-party debt-equity regulations under Section 385 were released on October 13, Regulations were published in the Federal Register on October 21, The Documentation Rule generally applies to debt instruments issued on or after January 1, Recharacterization Rules generally apply to debt instruments issued on or after April 5, 2016; a transition rule generally exempts debt settled within 90 days of the publication of the final regulations. Page 7 Cross-border financing and impact of Section 385

8 Section 385 and the proposed regulations Apply to interests issued by domestic corporations Exclude (reserve on) interests issued by foreign corporations Exclude interests issued by non-captive real estate investment trusts (REITs) and regulated investment companies (RICs) Do not apply to instruments issued within US consolidated group Bifurcation Rule Prop. Reg (d) Documentation Rule Prop. Reg Eliminated Documentation due on return filing date Disregarded entity (DRE) debt recast into equity of regarded owner Exclusion of debt issued by partnership Master agreements blessed Annual debt capacity study allowed Reservation on no affirmative use Transaction Recharacterization Rule Prop. Reg (b)(2) New/expanded emptions and exclusions (e.g., first $50 million of recast debt, compensatory stock, post-april 4, 2016 E&P) Exclusion for certain regulated industries Funding Recharacterization Rule Prop. Reg (b)(3) Numerous exemptions and exclusions (e.g., qualified short-term debt instruments, certain acquisitions of subsidiary stock) Exclusion for certain regulated industries Page 8 Cross-border financing and impact of Section 385

9 Documentation and operational considerations Page 9 Cross-border financing and impact of Section 385

10 Documentation overview Impact Applies to smaller universe of related-party instruments Still contains four categories of documentation requirements for related-party instruments to be respected as debt Failure to satisfy any requirement will result in debt being treated as stock for all US federal tax purposes (unless an exception applies) Satisfaction of documentation requirements does not ensure debt treatment Effective for instruments issued on or after January 1, 2018 Documentation must be completed by due date of issuer s federal income tax return (taking into account extensions) Page 10 Cross-border financing and impact of Section 385

11 Documentation overview Scope Applicable instrument Instrument issued in debt form Excludes instruments issued within US consolidated group Regulations reserve on debt issued in other forms Debt created by revolving credit agreements, cash pools (including certain notional pools), open accounts and trade payables Issued within an expanded group Affiliated group Special attribution rules 80% vote or value Public trading/asset value/revenue threshold Issued by a covered member of an expanded group A domestic corporation (inclusion of foreign corporations reserved) A disregarded entity with covered member as regarded parent Page 11 Cross-border financing and impact of Section 385

12 Indebtedness factors Binding obligation to repay and creditor s rights Indebtedness factors 1 and 2 require, consistent with the proposed regulations, evidence of: Binding obligation to repay (factor 1) Clear, binding agreement There must be written documentation prepared... establishing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates. Creditor s rights to enforce terms (factor 2) Terms of loan must include typical lender protections in event of default or financial distress The written documentation... must establish that the holder has the rights of a creditor to enforce the obligation. Changes/clarifications in final regulations Market standard, regulatory terms safe harbors for indebtedness factors 1 and 2 Use of master agreement for expanded group instrument (EGI) issued under revolving credit agreements, cash pooling and similar arrangements Page 12 Cross-border financing and impact of Section 385

13 Indebtedness factors Reasonable expectation of repayment Reasonable expectation of repayment (factor 3) Consistent with proposed regulations Analysis of financial condition of borrower at issuance Written documentation establishing financial condition as of date of issuance Based on all relevant circumstances Issuer s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations under the terms of the debt Changes in final regulations Refinancing assumptions may be used to support ability to repay. A single, annual credit analysis may cover multiple EGIs issued by the same borrower and no material event. Evidence that a third-party lender would have made a loan with same or similar terms as EGI may be included as documentation supporting this factor. Page 13 Cross-border financing and impact of Section 385

14 Indebtedness factors Genuine debtor-creditor relationship Genuine debtor-creditor relationship (factor 4) Consistent with proposed regulations Ongoing documentation after issuance If an issuer made any payment of interest or principal... documentation must include written evidence of such payment Wire transfer record Bank statements Must document action taken to mitigate any events of default Final regulations provide that evidence of payment may include: Netting of payables or receivables between issuer and holder Payments of interest evidenced by journal entries in a cash management or accounting system of expanded group Considerations Abide by terms of debt May require enhancements to internal treasury system(s) Page 14 Cross-border financing and impact of Section 385

15 Exceptions to documentation requirements Rebuttable presumption High percentage of EGIs compliant Sufficient common law debt factors Reasonable cause Ministerial or non-material failure or error Page 15 Cross-border financing and impact of Section 385

16 Transactional considerations Page 16 Cross-border financing and impact of Section 385

17 Essential framework retained Under Reg , certain categories of corporate debt issuances will be treated as equity of the issuer, either at the time of issuance, or in a subsequent taxable year Overall framework is consistent with the April proposed regulations Issuances include: Distributions on stock Acquisitions of expanded group stock Acquisitions of expanded group assets in a reorganization Covered instruments are generally those issued to members of the issuer s expanded group Broad range of effects on: Deductibility of interest payments and withholding tax implications Foreign currency gain or loss Other nonrecognition transactions Page 17 Cross-border financing and impact of Section 385

18 Significant exceptions Aggregate distributions and acquisitions are reduced by: Covered member s expanded group earnings account (which expands the proposed regulations current-year E&P exception) Qualified contributions $50 million threshold exception No cliff: first $50 million remains debt Debt recharacterized as equity will not affect Section 1504(a) affiliation (e.g., for a consolidated return group) Acquisition of subsidiary stock where covered member acquires and does not relinquish control of seller of stock Control equals more than 50% voting power and value Other exceptions (e.g., compensatory stock) Page 18 Cross-border financing and impact of Section 385

19 Distribution of a debt instrument Indebtedness recharacterized as stock* Indebtedness not recharacterized FP USP Distribution of $500m USP Note USP See Reg (b)(2)(i) * Assumes that exceptions do not apply (e.g., E&P, contribution netting) Distribution of $500m CFC2 Note CFC1 CFC2 Page 19 Cross-border financing and impact of Section 385

20 Acquisitions of stock with a debt instrument Indebtedness recharacterized as stock* Indebtedness not recharacterized FP USP US2 $200m US2 Note US1 CFC2 $200m CFC2 Note CFC1 Sale of US3 stock to US2 US3 See Reg (b)(2)(ii) * Assumes that exceptions do not apply (e.g., E&P, contribution netting) Page 20 Cross-border financing and impact of Section 385 Sale of CFC3 stock to CFC2 CFC3

21 Asset reorganizations with a debt instrument Indebtedness recharacterized as stock* Indebtedness not recharacterized FP $60m US2 Note + $140m US2 stock USP $60m CFC2 Note + $140m CFC2 stock US2 US1 CFC2 CFC1 merger merger See Reg (b)(2)(iii) * Assumes that exceptions do not apply (e.g., E&P, contribution netting) Page 21 Cross-border financing and impact of Section 385

22 Funding rule Subject to certain exceptions (including a qualified shortterm debt instrument ), a debt instrument is also treated as stock to the extent that it is issued by a corporation (funded member) and treated as funding a distribution or acquisition. Typical scenarios are those subject to the per se funding rule. The distributions or acquisitions include (with exceptions for each category): A distribution of property by the funded member to a member of its expanded group An acquisition of expanded group stock An acquisition of property by the funded member that is distributed as boot in an asset reorganization Page 22 Cross-border financing and impact of Section 385

23 Per se funding rule The funding rules have non-rebuttable presumptions, under which a covered debt instrument is treated as stock if it is issued within three years before the date of the distribution or acquisition by the covered member or within three years after the date of the distribution or acquisition (i.e., a six-year period in total). This presumption is non-rebuttable; motive is irrelevant (i.e., the debt is stock under this per se rule). Page 23 Cross-border financing and impact of Section 385

24 Funding a distribution (per se stock) Year 1 FP $200m distribution from USP operations Year 3 Indebtedness recharacterized as stock* FP Finco USP Finco USP US Sub $200m US Sub Note $200m US Sub = Consolidated group See. Reg (b)(3)(iii) * Assumes that exceptions do not apply. Page 24 Cross-border financing and impact of Section 385

25 Funding a reorganization (per se stock) Year 1 FP $100m cash + $100m US2 stock Year 3 Indebtedness recharacterized as stock* FP US1 US2 US3 US1 US2 merger $100m US2 Note $100m Borrowing to finance US2 expansion See. Reg (b)(3)(iii) * Assumes that exceptions do not apply. Page 25 Cross-border financing and impact of Section 385

26 Temporary regulations Qualified short-term funding debt instrument: Short-term funding arrangement Ordinary course loan Interest-free loan Deposits with a qualified cash pool header Disregarded entities Controlled partnerships Page 26 Cross-border financing and impact of Section 385

27 Effective date considerations Reg applies to taxable years ending on or after January 19, Technically, effective on October 21, 2016, with a 90-day delay Does not apply to instruments issued on or before April 4, 2016 Transition rules Option to apply proposed regulations for instruments issued after April 4, 2016, and before October 13, 2016 Page 27 Cross-border financing and impact of Section 385

28 Impact on Life Sciences companies Page 28 Cross-border financing and impact of Section 385

29 Impact on Life Sciences companies Of particular relevance to Life Sciences companies is the requirement under Reg to document the creditworthiness of US companies purchasing product from offshore entities, and the need to implement a debtor/creditor relationship process and credit limits for the US companies purchasing product from offshore affiliates. Life Sciences companies have more inbound US intercompany sales than other industries. Further, although foreign-to-foreign transactions are excepted from the Regulations, foreign-to-foreign transactions are subject to general 385 case law and may be a focus of IRS audit activity for Life Sciences companies. Page 29 Cross-border financing and impact of Section 385

30 Consolidated return considerations Page 30 Cross-border financing and impact of Section 385

31 Treatment of consolidated groups Members of a consolidated group are generally treated as one corporation. Temporary Reg provides rules addressing when an interest: Ceases to be a consolidated group debt instrument Or Becomes a consolidated group debt instrument Among other things, these rules establish the circumstances in which an intercompany obligation becomes stock of the issuer where, e.g., the issuer becomes a nonmember. Coordination of three transactional rules: Including expanded group earnings account Page 31 Cross-border financing and impact of Section 385

32 State income tax considerations Page 32 Cross-border financing and impact of Section 385

33 Key state income tax questions surrounding final and temporary regulations Will the states conform to the final and temporary regulations? The documentation consolidated group exclusion in Reg (d)(2)(ii)(A)? The recharacterization consolidated group exception in Temp. Reg T(b)(1)? Will the states have powers independent of the IRS to police these rules? Can states make debt-equity determinations that are different from those made by the IRS? Page 33 Cross-border financing and impact of Section 385

34 State conformity to Section 385 itself and final and temporary regulations generally All states generally conform to Section 385, directly or indirectly, by either: Using federal taxable income as the starting point for determining state taxable income (e.g., Illinois) Or Incorporating by specific reference sections of the Internal Revenue Code (e.g., California) Thus, determinations by the IRS under the statute and the final and temporary regulations will generally be baked into these states determination of state taxable income. Of course, these are broad generalizations with many variations among the states. Page 34 Cross-border financing and impact of Section 385

35 Consolidated group exception under proposed regulations Under the proposed regulations, the key state income tax issue was whether states would strictly conform to the consolidated group exception found in Prop. Reg (e), which reads as follows: Treatment of consolidated groups. For purposes of the regulations under [S]ection 385, all members of a consolidated group (as defined in [Reg.] (h)) are treated as one corporation. This is applied for all purposes of the proposed regulations. The IRS described this as the one-corporation approach. Our State Income Tax practice had concluded, and some state tax officials had suggested, that the consolidated group exception may not have applied for income tax purposes in certain states because: Most states don t follow the federal consolidated return regulations. Even in states that do, the state income tax filing group sometimes doesn t match the federal consolidated group. In effect, related-party debt transactions that were not subject to the debt-equity rules for federal income tax purposes might still have had to comply with all of the Section 385 regulatory requirements for state income tax purposes. Page 35 Cross-border financing and impact of Section 385

36 Changes to consolidated group exception under final and temporary regulations In the final regulations, Treasury eliminated the consolidated group exception in Prop. Reg (e) but has retained the concept, although in different ways for both the Documentation Rule and the Recharacterization Rules. These changes do not appear to resolve the state income tax concerns. Documentation Rule consolidated group exclusion: Excludes from the crucial term applicable interest (defined in Reg (d)(2)(ii)(A) and which is a foundational element for whether an instrument is an EGI)... an intercompany obligation as defined in [Reg.] (g)(2)(ii) or an interest issued by a member of a consolidated group and held by another member of the same consolidated group, but only for the period during which both parties are members of the same consolidated group This means that intercompany debt between members of the same federal consolidated group continues to fall outside the scope of the Documentation Rule for federal income tax purposes (same as before). But for state income tax purposes, certain states, whether requiring separate or combined filing methodologies, may not recognize that the definitional exclusion applies to applicable instruments. Page 36 Cross-border financing and impact of Section 385

37 Changes to consolidated group exception under final and temporary regulations Recharacterization Rules consolidated group exception: Modified and narrowly applies only to the Recharacterization Rules and is now set forth in Temp. Reg T(b)(1), which specifically provides: [A]ll members of a consolidated group (as defined in [Reg.] (h)) that file (or that are required to file) a consolidated U.S. federal income tax return are treated as one corporation [added language emphasized]. In the preamble, Treasury said that this modification was made in response to a specific request by a commenter of the state income tax implications of the proposed regulations: [T]he comment suggested that this concern could be mitigated in states that adhere to the literal language of the section 385 regulations by modifying [Prop. Reg.] (e) to [add the new language]. The temporary regulations adopt this recommendation. Despite these changes, there remains great uncertainty as to how states will treat intercompany debt under these rules. Instruments excluded for federal income tax purposes could still be subject to the rules for income tax purposes in certain states, particularly states that: Don t align with the federal consolidated filing group And/or Don t follow the federal consolidated return regulations Page 37 Cross-border financing and impact of Section 385

38 What you should do now Page 38 Cross-border financing and impact of Section 385

39 What you should do now 1 Inventory the impacted debt instruments and assess instruments subject to the Recharacterization Rules 2 Remediate impacted instruments while establishing policies and procedures to track and comply with the Recharacterization Rules 3 Determine and, as appropriate, institute systems and procedures to comply with the Documentation Rule 4 Assess alternative strategies (legal entity, lending and pooling structures) with planned transactions, Base Erosion and Profit Shifting (BEPS) and other provisions (e.g., UK anti-hybrid) 5 Drive multifunctional involvement (Tax, Treasury, Accounting, IT, M&A and Operations) to coordinate procedures in complying with the new requirements Page 39 Cross-border financing and impact of Section 385

40 Questions? Page 40 Cross-border financing and impact of Section 385

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