GW/IRS 29 th Annual Institute on Current Issues in International Taxation Final and Temporary Section 385 Regulations

Transcription

1 GW/IRS 29 th Annual Institute on Current Issues in International Taxation Final and Temporary Section 385 Regulations L.G. Chip Harter, PwC, Chair Bruce Lassman, VP-International Tax, IBM Corp. Kevin Nichols, Senior Counsel, Office of International Tax Counsel, U.S. Treasury Danielle Rolfes, International Tax Counsel, U.S. Treasury Moshe Spinowitz, Skadden Arps, Slate, Meagher & Flom LLC Raymond Stahl, Special Counsel, Associate Chief Counsel International December 15, 2016 Section 385 Congress enacted section 385 in 1969 to provide the Treasury with authority to issue regulations to: determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness, or as in part stock and in part indebtedness. The regulations... shall set forth factors... to be taken into account... in a particular factual situation.... The factors so set forth... may include, among other factors: A written unconditional promise to pay a sum certain and fixed interest. Preferred or subordinated status. Debt-to-equity ratio. Convertibility into stock of issuer. The relationship between holdings of stock in the corporation and the holdings of the instrument. 2 1

2 Proposed Section 385 Regulations 3 Proposed Section 385 Regulations On April 4, 2016, the Treasury and IRS proposed to exercise their authority under section 385 to write regulations distinguishing debt from equity. Notice of Proposed Rulemaking Reg contained Proposed Treas. Reg through -4 (the Proposed Regulations ). The Proposed Regulations would recharacterize as equity for all U.S. federal income tax purposes certain debt instruments issued between highly related corporations issued in defined circumstances. 4 2

3 Proposed Regulations -Stated Policy Objectives The preamble to the Proposed Regulations described several policy objectives: - Debt issued between highly related parties under circumstances that do not increase the issuer s asset base is stated to be inherently more equity like than other debts. - Related party debt is commonly used to engage in tax planning that was viewed as objectionable as a matter of tax policy. The Proposed Regulations were released simultaneously with section 7874 antiinversion regulations. The preamble expressed concern that inverted groups and other foreign-parented groups... create interest deductions that reduce U.S. source income without investing any new capital into the U.S. operations. The preamble also noted that related party debt is used by U.S.-parented groups to obtain distortive results, including reducing earnings of s and facilitating the repatriation of untaxed earnings without recognizing dividend income. 5 Proposed Regulations -Key Elements Contemporaneous Documentation Requirement. Prop. Treas. Reg required documentation of debt issued between members of an Extended Group ( EG ), i.e., Extended Group Instruments ( EGI s ). Documentation includes enforceable legal documentation with creditor s remedies, as well as evidence of reasonable expectation of repayment and of behavior consistent with bona fide debtor-creditor relationship. General Rule. Recharacterized as equity for all federal income tax purposes EGI s issued in circumstances that may not increase the asset base of the issuer. Funding Rule. Designed to prevent the circumvention of the General Rule. 6 3

4 Prop. Treas. Reg. Secs and -4 - General Rule An Expanded Group Instrument is treated as stock if it is issued in any of the following situations: in a distribution, to acquire Expanded Group stock, other than to acquire stock of an acquiring corporation in an asset reorganization, or to acquire property in an asset reorganization, to the extent a shareholder that is a member of the issuer's expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation. 7 Prop. Treas. Reg. Secs and -4 - Funding Rule EGIs are also treated as stock if issued with a principal purpose of funding a distribution or acquisition described above. Therefore an EGI issued to fund any of the following is equity: a distribution a purchase of equity in an affiliate, or payment of boot in an asset reorganization. If the EGI is issued within 36 months of the transaction, the EGI was irrebbuttably presumed to have been issued with a principal purpose of funding the transaction (the Per se Rule ). 8 4

5 Comments on the Proposed Regulations The period for public comments on the Proposed Regulations ran through July 7, Major themes of commentators included: The impact of the global application of the Funding Rule on routine intercompany funding and treasury operations not involving tax planning. The cascading effect of successive applications of the General Rule and the Funding Rule. The collateral consequences of recharacterizing debt as equity for all purposes of the Code. Deemed dividends on repayment, loss of section 902 credits, loss of section 368(c) control. The compliance burden of the contemporaneous documentation requirement and the harshness of the recharacterization sanction. Need for time to get systems in place to comply. 9 Comments on Proposed Regulations -Effect on Treasury Operation CF C dividend Year 1 Application of the Funding Rule would place very significant constraints on ability of based groups to use internal liquidity to fund investments and operations. CF C loan Year 3 CF C The alternative of relying on external funding would impose unnecessary financing costs. T 10 5

6 Comments on Proposed Regulations - Cash Pooling and Iterative Effects P Global Application of Funding Rule would bring within its scope the world-wide routine treasury operations of U.S. based multinationals. Sequential Application of Funding Rule produced iterative effect. 1 2 Cash Pool 3 If 3 pays a dividend within 36 months of borrowing from cash pool, its borrowing is recharacterized as an issuance of stock. Repayment of borrowing is a section 302(d) redemption tainting future borrowings by 3. Cash pool s acquisition of 3 s recharacterized receivable is an acquisition of EG stock, tainting deposits in cash pool. Repayment of one deposit can taint other deposits. 11 Final and Temporary Section 385 Regulations Scope 12 6

7 Final and Temporary Section 385 Regulations Scope of both -2 Documentation Rules and -3 Recharacterization Rules narrowed to apply only to debt issued by U.S. Corporations. Regulations apply to debt of covered member of EG. Covered member defined as: (i) a domestic corporation and (ii) [Reserved]. Because the application of the regulations is limited to debt issued only by U.S. corporations to holders other than consolidated group members, the final and temporary regulations apply to only a small fraction of the debt instruments the Proposed Regulations would have applied to. Reduces the pressure on key technical issues. 13 Comparison of Final with Proposed Regulations Revised scope for U.S.-parented multinationals U.S. Trade Payables U.S. U.S. Trade Payables Cash Pool Creditor Debtor Subject to the Final Regs. Was subject to the Prop. Regs. Not subject to Final or Prop. Regs. U.S. corporations file a consolidated return 14 7

8 Final and Temporary Section 385 Regulations Revised scope for U.S.-parented multinationals Loans to U.S. Affiliates Made by Foreign Affiliates Generally section 956 loans. Subject to the recharacterization rules under Treas. Reg , but would require unusual circumstances. Documentation required under Treas. Reg regulations. Trade Payables Owed to Foreign Affiliates Within the scope of the recharacterization rules under Treas. Reg , but can fall within specific exceptions: - Ordinary course exception - Interest-free loan exception Documentation required under Treas. Reg regulations Most U.S.-based groups have good controls around trade payables owed to foreign affiliates already because of section 956 issues. 15 Comparison of Final with Proposed Regulations Revised scope for foreign-based multinationals Cash Pool FS FS FS Trade Payable Creditor Debtor Subject to the Final Regs. Was subject to the Prop. Regs. Not subject to Final or Prop. Regs. U.S. Corporations file a consolidated return 16 8

9 Final and Temporary Section 385 Regulations Revised scope for foreign-based multinationals Long-Term Inbound Lending - Fully covered to combat base erosion. - Subject to recharacterization under both the general rule and the funding rule under Treas. Reg Documentation required under Treas. Reg regulations. Short-Term Funding/Cash Pooling - Within the scope of the recharacterization rules under Treas. Reg , but can fall within specific exceptions: 270-day exception Working capital exception Interest-free loan exception - Documentation required under Treas. Reg regulations. Trade Payables Owed By U.S. Affiliates to Foreign Affiliates - Within the scope of the recharacterization rules under Treas. Reg , but can fall within specific exceptions: Ordinary course exception Interest-free loan exception - Documentation required under Treas. Reg regulations. 17 Final and Temporary Section 385 Regulations Documentation Requirements 18 9

10 Documentation Requirements In General Treas. Reg provides documentation requirements for expanded group debt, identifying the nature of the documentation needed to substantiate debt treatment and requiring contemporaneous documentation and maintenance. In general, the issuer must document in writing: - an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates; - that the holder has creditor s rights, superior to shareholders (common and preferred) in case of dissolution; - a reasonable expectation of issuer's ability to repay the debt; and - timely interest and principal payments or, in case of failure to make required payments or an event of default, the holder's reasonable exercise of a creditor s diligence and judgment. If not properly documented, the purported debt is treated as stock, unless the highly-compliant taxpayer exception or the reasonable cause exception applies. If properly documented, the purported debt is analyzed as debt or stock under general U.S. federal tax law principles, as modified by Treas. Reg Documentation Requirements Scope The documentation requirements apply to expanded group interests ( EGIs ) issued by a covered member. They generally do not apply to: Debt issued by a foreign person Debt issued by a partnership Debt issued by an S corporation Debt issued between members of a U.S. consolidated group Debt not issued in the legal form of debt, such as a deemed debt instrument (e.g., under section 636 or Rev. Proc ) or a stock-repurchase ( repo ) transaction In addition, the documentation requirements apply only to large taxpayer groups, meaning: - The stock of any member of the expanded group is publicly traded; - Total expanded group assets exceed $100 million; or - Annual total expanded group revenue exceeds $50 million

11 Documentation Requirements Timing The documentation requirements apply only to debt instruments issued on or after January 1, Documentation generally is not required until the extended filing date of the taxable year in which the debt instrument is issued (or in the case of periodic payments and events, in the taxable year of such payment or event). - This means that, for most taxpayers, documentation will not be required until Fall Documentation Requirements Reoccurring Transactions Special documentation rules apply to certain reoccurring, standard transactions (e.g., revolving credit facilities, umbrella agreements for trade payables, cash pools, etc.). Written documentation requirements applicable to relevant enabling documents. A reasonable expectation to repay analysis is required with respect to all times at which an EGI is issued pursuant to a master agreement. o The reasonable expectation to repay analysis must be prepared at least annually, as well as whenever there is a material event with respect to the issuer. o The analysis should document the issuer s ability to repay up to the maximum borrowing amount under the master agreement. With respect to cash pools, taxpayers must also maintain all documentation governing the ongoing operations of cash pooling arrangement, including agreements with entities not members of the expanded group. Notional cash pools are subject to these rules to the extent they result in a deemed loan between members of the expanded group. No guidance is provided with respect to making this determination

12 Documentation Requirements Highly Compliant Taxpayers Although a documentation failure generally results in an instrument automatically being treated as stock, for highly compliant taxpayers the undocumented EGI instead will be presumed to be stock and the taxpayer may rebut that presumption. An expanded group is highly compliant if: - More than 90% of the average adjusted issue price of its debt instruments subject to the documentation requirements are properly documented each quarter, or - More than 90%, if no debt instrument during the calendar year subject to the documentation requirements has an issue price in excess of $25 million, or 95%, if no debt instrument during the calendar year subject to the documentation requirements has an issue price in excess of $100 million, of the quarterly average number of instruments subject to the documentation requirements are properly documented each quarter. Anti-stuffing and anti-abuse rules apply to prevent taxpayers from inappropriately availing themselves of this exception. 23 Changes to Common Law Debt-Equity Analysis Under Treas. Reg (b)(3), the indebtedness factors in the documentation rules are the most significant factors taken into account in determining whether an EGI is debt or equity under common law principles. Other common law factors are taken into account in the determination as lesser factors, with the relative weighting of each lesser factor based on facts and circumstances

13 Exception Framework 1 Issuer Exceptions 2 Instrument Exceptions 3 Transaction Exceptions 4 Attribute Exceptions 5 Threshold Exception 25 Exception Framework Issuer Exceptions Foreign corporation S corporation Regulated financial institution Regulated insurance company Non-controlled RICs & REITs Instrument Exceptions Transaction Exceptions Attribute Exceptions Threshold Exception 26 13

14 Exception Framework Issuer Exceptions Instrument Exceptions Qualified dealer security Regulated or statutory instrument Qualified short-term debt instrument 270-day borrowing Working capital borrowing Ordinary course borrowing Interest-free loan Cash pool deposit Transaction Exceptions Attribute Exceptions Threshold Exception 27 Qualified Short-Term Debt Instruments The funding rule does not apply to certain qualified short-term debt instruments, generally defined as short-term debt instruments falling within one of the following defined categories: Short-term funding arrangements. An issuer can claim only one of the following two exceptions during a taxable year: Working capital borrowings: Generally defined as debt instruments with short-term interest rates to the extent of the issuer s current assets other than cash and cash equivalents, or 270-day borrowings: Generally defined as debt instruments with short-term interest rates and a term of 270 days or less, provided that the issuer is relying on the exception with respect to all lenders for less than 270 days during the taxable year. Ordinary course payables: Generally defined as debt instruments issued in the ordinary course of the issuer s trade or business that are reasonably expected to be repaid within 120 days. Interest-free loans: Generally defined as debt instruments that do not provide for stated interest, original issue discount, or imputed interest. Cash pool deposits: Generally defined as demand deposits with a qualified cash pool header (generally defined as an expanded group member, controlled partnership, or qualified business unit that has as its principal purpose managing cash for participating expanded group members) pursuant to a cash-management arrangement

15 - Cash Pooling Issues Deposits F Cash Pool F F Short-term funding exceptions would allow U.S. affiliates to borrow from foreign cash pool without potential recharacterization 29 - Cash Pooling Issues Cash Pool loans F1 F Short-term funding exceptions also facilitate borrowings by U.S. affiliates from U.S. cash pool in different consolidated group. Qualified cash pool deposit exception facilitates deposits with U.S. cash pool by foreign affiliates and U.S. affiliates in different consolidated groups. Investment Portfolio 30 15

16 - Cash Pooling Issues Treatment of Notional Cash Pools Dutch Germa n French UK loans deposits deposits deposits loans Branc h Dutch Branc h Dutch Bank Germa n Branch Frenc h Branc h Under notional cash pooling arrangements, borrowings by one affiliate are generally secured by deposits of other affiliates. Can be characterized as conduit loans from depositors to borrowers. See, Rev. Rul Notional cash pool borrowings treated as conduit loans from affiliates would need to fall within a short-term funding exception to avoid potential recharacterization. 31 Exception Framework Issuer Exceptions Instrument Exceptions Transaction Exceptions Exempt exchange Exempt distribution Expanded group member stock exchange Subsidiary stock acquisition Compensatory stock acquisition Transfer pricing adjustment Securities dealer acquisition Cascading application for holders Attribute Exceptions Threshold Exception 32 16

17 Subsidiary Stock Acquisitions (c)(2) Transaction: 2 stock P 1 2 Note P Loan - + P acquires 2 stock from 1 in exchange for a Note. This transaction is expected to be treated as an upstream sale pursuant to Rev. Rul , unless recharacterized under section 385. Result: Because P owns more than 50 percent of the vote and value of 1 immediately after the transaction, the exception under Treas. Reg (c)(2)(i) applies and the Note should not be recharacterized as a result of this transaction. 33 Subsidiary Stock Acquisitions (cont d) Transaction: 956 Loan + - P Contributes property Same facts as before, and, in addition, in the following year P contributes property other than EG stock to 2, either in exchange for stock or for no consideration, in a transaction described in section 351(a). 1 2 Result: Because P owns more than 50 percent of the vote and value of 2 immediately after the transaction, the exception under Treas. Reg (c)(2)(i) applies and the 956 Loan should not be recharacterized as a result of this transaction

18 Expanded Group Member Stock Acquisitions 40% of FS stock Note FS % 60% Transaction: acquires 40% of FS s stock from in exchange for a Note. This transaction is expected to be described in section 304(a)(1), unless recharacterized under section 385. FS Result: The Note is recharacterized as stock, unless an exception, such as the expanded earnings exception or the qualified contributions exception, applies. 35 Expanded Group Member Stock Acquisitions (cont d) + - Other property 60% stock 40% FS % 60% FS Transaction: Same facts as before, but assume that an exception applies to the acquisition of FS stock in exchange for the Note such that the Note is not recharacterized. In the following year, contributes to FS all of its stock, and contributes a proportionate amount of additional property to FS in an exchange described in section 351(a). Result: Even though the subsidiary stock acquisition exception under Treas. Reg (c)(2)(i) does not apply because does not own more than 50% of the vote and value of FS, s acquisition of FS stock is not described in Treas. Reg (b)(3)(i)(B) because it is an acquisition of EG stock in exchange for EG stock. Therefore, the Note is not recharacterized under the funding rule

19 Exception Framework Issuer Exceptions Instrument Exceptions Transaction Exceptions Attribute Exceptions Expanded group earnings account Qualified contributions Threshold Exception 37 - Change from Current-Year E&P Exception to Expanded Group Earnings Account Exception (c)(3)(i) Note Distribution Cash Dividend Transaction: distributes a cash dividend to during Also in 2017, issues a Note to in a distribution. Result: The Note is recharacterized as stock under the General Rule, unless an exception applies. s expanded group earnings will be considered in determining whether the E&P exception applies, and the look-thru rule under Treas. Reg (c)(3)(i)(C)(3) will apply to the dividend, adding to s expanded group earnings to the extent paid out of post-2015 E&P of earned while an EG member under the same parent

20 - Qualified Contributions Exception (c)(3)(ii) Transaction: Year 1 Cash Distribution Year 2 Cash Contribution Year 2 Cash Loan FS In Year 1, distributes cash to. In Year 2, FS loans cash to in exchange for a Note. Also in Year 2, contributes cash to. Result: Absent an exception, the Year 2 Note is recharacterized when issued pursuant to the funding rule (Treas. Reg (b)(3)(i)(A) and (iii)), as it is issued within 36 months of the Year 1 cash distribution. Pursuant to Treas. Reg (c)(3)(ii)(A), the Year 2 cash contribution is a qualified contribution that reduces the amount of the Year 1 cash distribution that is treated as a distribution for purposes of the funding rule. If the amount of the Year 2 cash contribution equals or exceeds the Year 1 cash distribution, none of the Year 2 Note will be treated as funding the Year 1 cash distribution. 39 Exception Framework Issuer Exceptions Instrument Exceptions Transaction Exceptions Attribute Exceptions Threshold Exception 40 20

21 - Threshold Exception (c)(4) Exception - Covered debt instruments not treated as stock if immediately after issuance it would be treated as stock, but the aggregate adjusted issue price of recharacterized covered debt instruments held by members of the issuer s expanded group does not exceed $50 million. Removal of Cliff Effect - To the extent that, immediately after a covered debt instrument would be treated as stock, the aggregate adjusted issue price of covered debt instruments held by members of the issuer s expanded group that would be treated as stock exceeds $50 million, only the amount of the covered debt instrument in excess of $50 million is treated as stock Coordination of General and Funding Rules (b)(5) Transaction: In Year 1, issues a Note to in a distribution. In Year 2, FS loans cash to in exchange for a Note. Year 1 Note Distribution FS Year 2 Cash Loan Result: The Year 1 Note is recharacterized when distributed pursuant to the general rule under Treas. Reg (b)(2), unless an exception applies. If an exception applies, the Year 1 distribution is not treated as a distribution for purposes of the funding rule pursuant to Treas. Reg (b)(5). Consequently, the Year 2 Note will not be treated as funding the Year 1 distribution. By operation of Treas. Reg (d)(6), however, both the Year 1 Note and the Year 2 Loan are subject to recharacterization under the funding rule if makes a tainting distribution or acquisition within 36 months. See, discussion of Funded Member Rule below

22 - Funded Member Rule (aka the Double Jeopardy Rule ) (d)(6) Transaction: Year 1 Note Distribution In Year 1, issues a Note to in a distribution. In Year 2, distributes cash to. Result: The Note is recharacterized when distributed pursuant to the general Year 2 Cash rule under Treas. Reg (b)(2), unless the expanded group Distribution earnings exception or the qualified contribution exception applies. If an exception applies, the Note is treated as issued in exchange for property under Treas. Reg (d)(6) and, therefore, may be deemed to fund the Year 2 distribution for purposes of the funding rule under Treas. Reg (b)(3). The Proposed Regulations did not have an analogue to Treas. Reg (d)(6). 43 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Recently inverted companies annual note distributions Leverage can be introduced into a recently inverted U.S. company through distributions of notes up to post- 15 earnings and profits. Trade off between introducing leverage and distributing cash. Amount of leverage that can be introduced using the earnings exception is relatively modest. Modeling suggests that an inverted company that earns a 10% return on assets and annually distributes notes equal to earnings bearing 7% interest would take 10 years to reach a 0.5-to-1 debt-to-equity ratio, and 17 years to reach a 1-to-1 debt-to-equity ratio

23 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Recently inverted companies, cont d T $1 B loan $1 B Seller T Leverage can be introduced more quickly by lending to U.S. sub to fund new acquisitions or expansion. For example, if Sub has no pre-existing debt and is worth $1 billion, it could borrow the $1 billion purchase price for a target from its foreign parent. Would immediately achieve a 1-to-1 debt-toequity ratio. Debt would be subject to recharacterization under the Funding Rule to the extent that Sub made distributions in excess of its expanded group earnings account in the following 36 months. 45 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Established Foreign Owned Subsidiaries Grandfathered Notes If an established Sub of a foreign group has pre-april 5 th inbound debt ( grandfathered debt ), it can maintain that leverage while distributing its current earnings. The grandfathered debt can be refinanced at maturity, and the refinanced debt is subject to the Funding Rule if excess distributions are not made 36 months before or after the refinancing. If Sub does not distribute all of its post- 15 earnings, the balance in its expanded group earnings account can be used to support distributions of notes to increase leverage. Leverage can also be increased by using related party debt to fully fund new investments

24 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Cash Purchases of Targets by Foreign Investors FC Acquisition Co Target Seller Target A foreign purchaser of a Target for cash can fully leverage a domestic acquisition structure. Initial debt is subject to Funding Rule recharacterization if distribution is made in excess of expanded group earnings account in the following 36 months. Initial debt can be refinanced at maturity provided that no distributions made in excess of expanded group earnings account within 36 months before or after the maturity date of initial debt. Leverage can be increased through note distributions to the extent expanded earnings account is not fully distributed or through debt funding new investments. 47 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Cash Purchase of Targets by Foreign Investors cont d Note 2 Sub 2 1 Selle r T If instead itself purchases a Target then sells it down to Sub for a note, the note is recharacterized under the General Rule. Different treatment from debt funding Sub to make the acquisition, even though the economic result is the same. T 48 24

25 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Leveraged Purchases of Depreciable Assets Toll Road Debt The regulations produce a harsher result where a foreign investor is debt financing a U.S. subsidiary which purchases depreciable assets, e.g. infrastructure investments. The Sub may have little or no earnings because of amortization or depreciation deductions but significant cash flow. No capacity to distribute cash flow for next 36 months without producing recharacterization of debt funding. Rely on long-term debt and distribute cash flow during period beginning 3 years after funding and ending 3 years before debt needs to be refinanced? 49 Contrast with Alternative Earnings Stripping Proposals Administration Proposals Interest deduction limited to corporation s proportionate share of worldwide group s external interest expense. OECD Interest Stripping Proposal Limit deduction for net interest expense to 10% to 30% of EBITDA. If higher, up to world-wide group external net interest to EBITDA ratio. House Ways & Means Blueprint. No deduction for net interest expense