Final Debt-Equity Tax Regulations Significantly Narrow the Scope of the Proposed Regulations

Transcription

1 OCTOBER 17, 2016 SIDLEY UPDATE Final Debt-Equity Tax Regulatins Significantly Narrw the Scpe f the Prpsed Regulatins On Octber 13, 2016, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) published final and temprary Treasury regulatins n the classificatin f purprted debt instruments as either debt r equity fr U.S. federal incme tax purpses (Regulatins). The Regulatins substantially revise and narrw the scpe f the prpsed Treasury regulatins issued by the Treasury and the IRS n April 4, 2016 (Prpsed Regulatins) that were subject t significant cmments. The fllwing includes a summary f the changes made t the Prpsed Regulatins. Please see ur previus Sidley Update n the Prpsed Regulatins, available here, which prvides additinal backgrund infrmatin and analysis n these rules. General Purpse The Regulatins apply nly t debt issued (r deemed issued) by dmestic crpratins t their dmestic r freign crprate r partnership affiliates, requiring an 80 percent vte r value affiliatin (Expanded Grup). The Regulatins have tw main parts. The first part requires Expanded Grups that are publicly traded, have assets exceeding US$100 millin, r have revenue exceeding US$50 millin, t maintain certain dcumentatin t supprt debt treatment f intercmpany debt. Failure by the grup t meet such dcumentatin requirements culd result in the debt being recharacterized as equity. These dcumentatin rules nly apply t debt issued n r after January 1, The secnd part f the Regulatins (implementing a Recharacterizatin Rule and a Funding Rule, as defined belw) generally deals with certain debt issued r deemed issued by a dmestic crpratin t its affiliates where there is n new investment in the peratins f the issuer r its cntrlled subsidiaries (e.g., a dmestic crpratin that distributes a nte t its freign parent). Under the Regulatins, such debt may be recharacterized as equity. The secnd part nly applies t debt issued n r after April 5, 2016 and such debt may be recharacterized nly after January 19, Neither part applies t debt between members f a cnslidated grup. Sidley Austin prvides this infrmatin as a service t clients and ther friends fr educatinal purpses nly. It shuld nt be cnstrued r relied n as legal advice r t create a lawyer-client relatinship. Furthermre, this Tax update was nt intended r written t be used, and cannt be used, by any persn fr the purpse f aviding any U.S. federal, state r lcal tax penalties that may be impsed n such persn. Attrney Advertising - Fr purpses f cmpliance with New Yrk State Bar rules, ur headquarters are Sidley Austin LLP, 787 Seventh Avenue, New Yrk, NY 10019, ; One Suth Dearbrn, Chicag, IL 60603, ; and 1501 K Street, N.W., Washingtn, D.C ,

2 Page 2 Summary f Changes t the Prpsed Regulatins The Regulatins substantially narrw the scpe f the Prpsed Regulatins in several imprtant ways: Changes in Overall Scpe The Regulatins remve the bifurcatin rule that wuld have permitted the IRS t treat a debt instrument in part as debt and in part as equity. The Regulatins d nt apply t (and reserve n) debt issued by freign issuers. In additin t excluding debt between members f a cnslidated grup, the Regulatins d nt apply t S-crpratins, r t Real Estate Investment Trusts (REITs) and Regulated Investment Cmpanies (RICs) that are nt 80 percent cntrlled (by vte r value) by anther persn. Changes t the Dcumentatin Requirements The dcumentatin requirements apply nly t debt issued n r after January 1, Taxpayers have until they file their federal incme tax return t prepare the dcumentatin necessary t supprt treatment as debt, and are n lnger required t prepare such dcumentatin within 30 days f the debt being issued. Failure t cmply with the dcumentatin requirements n lnger results in an autmatic recharacterizatin f the debt instrument but instead results in a rebuttable presumptin that the instrument is equity. Changes t the Debt Distributin Recharacterizatin Rules The Regulatins d nt apply t cash management arrangements and certain shrt-term debt (nte that this exceptin des nt apply t the dcumentatin requirement). The Regulatins d nt apply t debt issued by certain regulated entities, including financial entities (such as banks, bank hlding cmpanies, registered brker dealers and certain affiliates) and certain insurance cmpanies. The Regulatins expand the earnings and prfits exceptin t all earnings and prfits accumulated while the issuer was a member f the same expanded grup and after the Prpsed Regulatins were issued. The Regulatins exclude the first US$50 millin f debt that wuld therwise be recharacterized as equity even if the recharacterized debt exceeds US$50 millin, thus remving the cliff effect under the Prpsed Regulatins. The Regulatins permit issuers t net certain cntributins against distributins, and include an exceptin fr acquired stck delivered t emplyees and ther service prviders. The debt distributin recharacterizatin rules, including the Funding Rule (defined belw), cntinue t apply t debt instruments issued n r after, and distributins and acquisitins ccurring n r after, April 5, Observatins Mergers & Acquisitins. We expect the applicatin f these Regulatins t mdify the standard due diligence perfrmed by ptential acquirers f crprate grups, and be cnsidered by sellers when an

3 Page 3 Expanded Grup member leaves the grup. Fr example, when intercmpany debt is n lnger held r issued by a member f the Expanded Grup (e.g., if the debt f the member that held the debt was sld t a third party), the Expanded Grup is required t retest the debt f the remaining members t determine whether it is treated as funding the distributins and required t be recharacterized as equity. Investment Funds. With respect t investment funds, the Preamble clarifies that grups f investment funds managed by the same investment advisr may, under the rules described abve, be part f an Expanded Grup if the investment advisr cntrls the vting interests in the investment funds. The Regulatins were nt extended t cver debt issued by subsidiary blcker crpratins t a partnership that is nt a cntrlled partnership (e.g., they generally d nt treat a partnership that wns 100 percent f a blcker crpratin as an Expanded Grup member), thugh the IRS and Treasury cntinue t study these structures. Insurance Industry. The Regulatins include imprtant exceptins and clarificatins fr the insurance industry. Debt issued by a regulated insurance cmpany is cnsidered t meet the dcumentatin requirements if it requires the cnsent f a regulatr t pay interest r principal and, at the time f issuance, is expected t be repaid (althugh dcumentatin must be maintained that these tw requirements are satisfied). The Preamble als clarifies that the new dcumentatin requirements d nt apply t reinsurance (including funds-withheld reinsurance) because such cntractual agreements are nt debt in frm. Additinally, the debt distributin recharacterizatin rules d nt apply t debt issued by regulated insurance cmpanies (ther than certain captive insurance cmpanies) that are subject t risk-based capital requirements under state law. Industry members had sught a clarificatin that the rules wuld nt apply t debt issued between affiliated members f a crprate grup that are nt included in a cnslidated grup (fr instance, debt issued by a life insurance cmpany befre the five-year waiting perid expires), but the IRS and Treasury explicitly declined t prvide fr such an exclusin. Revised General Scpe Generally, the Regulatins target debt between members f an Expanded Grup. A partnership is included nly if the partnership is 80 percent cntrlled by crprate members f the Expanded Grup. In a significant departure frm the Prpsed Regulatins, hwever, the Regulatins d nt apply t debt issued by freign entities (but d apply t debt issued by dmestic crpratins t their freign affiliate members f the Expanded Grup). Unlike the Prpsed Regulatins, the Regulatins d nt apply t debt issued t r by S-crpratins, r t debt issued t r by nn-cntrlled RICs r REITs. Therefre, grups with REITs r RICs as their cmmn parent are generally nt subject t these rules unless their crprate subsidiaries independently frm an internal expanded grup. Hwever, REITs and RICs that are 80 percent cntrlled by members f the Expanded Grup are subject t the Regulatins. In a further departure frm the Prpsed Regulatins, the Regulatins reserve n the applicatin f the Sectin 318 dwnward attributin rules fr purpses f determining the members f the Expanded Grup. The Regulatins therefre d nt currently apply t brther-sister grups with nn-crprate wners. The

4 Page 4 Regulatins als limit the attributin rules with respect t ptins t situatins where the ptins are reasnably certain t be exercised. Changes t the Dcumentatin Requirements Departing frm the Prpsed Regulatins, with respect t the dcumentatin requirements, the Regulatins: nly apply t debt issued n r after January 1, 2018; allw taxpayers until the due date fr filing their tax returns (including extensins) t prepare the necessary dcumentatin; permit taxpayers t rebut the presumptin that debt nt meeting the dcumentatin requirements is equity, prvided that the Expanded Grup demnstrates a high degree f cmpliance (based n certain enumerated tests) with the dcumentatin rules generally; clarify that the Regulatins d nt apply t reps, reinsurance (including funds-withheld reinsurance), mineral prductin payments, regular interests in REMICs, deemed debt under Sectin 482 and ther instruments specifically treated as debt under the Internal Revenue Cde f 1986, as amended (Cde); d nt apply t debt issued by a cntrlled partnership, althugh this debt may be subject t an antiabuse rule (additinally, debt issued by a crprate member f the Expanded Grup t a cntrlled partnership is subject t these rules); include a reasnable cause exceptin and a ministerial nn-material failure exceptin; and generally prvide that: (i) debt issued by banks and bank hlding cmpanies (and certain ther regulated financial cmpanies such as registered brker dealers) (including debt issued by certain affiliates f such financial institutins); and (ii) debt issued by certain insurance cmpanies that requires the cnsent f a regulatr t pay principal r interest, are treated as meeting the dcumentatin requirements as lng as they are expected t be repaid at the time f issuance and prper dcumentatin that they qualify fr the exemptin is maintained. Cash Pling. The Regulatins prvide nly limited relief frm the dcumentatin requirements fr cash pling, revlving credit and similar arrangements, permitting taxpayers t dcument such arrangements using a single master agreement and generally requiring nly annual updates demnstrating the ability t repay the maximum amunt permitted t be brrwed under the agreement. Changes t the Debt Distributin Recharacterizatin Rules The Regulatins apply t debt issued n r after April 5, 2016 but will nt recharacterize such debt befre January 20, The Regulatins generally adpt the Prpsed Regulatins by autmatically recharacterizing: (i) debt distributed t anther member f its Expanded Grup; (ii) debt used t purchase equity interests in anther member f the Expanded Grup; and (iii) debt issued t purchase prperty frm anther member f the Expanded Grup and then distributed t anther member f the Expanded Grup by the transferr (Recharacterizatin Rule). The Recharacterizatin Rule is backstpped by the Funding Rule. Under the Funding Rule, debt is issued by a member f the Expanded Grup in return fr cash r ther prperty that is then used t fund a distributin t

5 Page 5 anther member f the Expanded Grup (r an acquisitin f stck frm such a member) within a 36-mnth perid befre r after the debt was issued, is recharacterized as equity. A mre detailed descriptin is available here. New General Exceptins The Regulatins expand and add additinal exceptins that apply bth t the Recharacterizatin Rule and the Funding Rule: Exemptin fr First US$50 Millin. The Regulatins exempt the first US$50 millin f debt that wuld have therwise been recharacterized. Unlike the Prpsed Regulatins, nce the US$50 millin threshld is reached, nly the excess is subject t recharacterizatin. Exemptin fr Earnings and Prfits. The aggregate amunt f the issuer s earnings and prfits will reduce the amunt f debt that is subject t recharacterizatin. The Regulatins expand the earnings and prfits exceptin in the Prpsed Regulatins t take int accunt all accumulated earnings and prfits during the issuer s membership in the Expanded Grup, prvided they were accumulated in taxable years ending after April 4, The Prpsed Regulatins nly exempted the current year earnings and prfits. Detailed rules are prvided n hw t calculate the running balance f such earnings and prfits and hw they are applied t reduce the distributins that are subject t these rules. Exemptin fr Investment in Subsidiary Stck. The Regulatins expand the subsidiary stck issuance exemptin in the Prpsed Regulatins t all acquisitins f Expanded Grup stck by a dmestic member f the Expanded Grup if the acquirer cntrls (measured by 50 percent f vte and value) directly r indirectly the member f the Expanded Grup frm which the stck was acquired (seller) and des nt relinquish cntrl f the seller pursuant t a plan that existed n the date f acquisitin ther than in a transactin in which the seller leaves the Expanded Grup. The ratinale fr this exemptin is that the acquirer still has indirect cntrl ver the cnsideratin paid fr the acquisitin, and therefre n distributin has taken place. The requirement t retain cntrl fr 36 mnths under the Prpsed Regulatins has been replaced by a rebuttable presumptin that any relinquishment f cntrl within thse 36 mnths was pursuant t a plan t relinquish cntrl. Exemptin fr Stck Paid fr Services. The Regulatins exempt an acquisitin f Expanded Grup stck if such stck is delivered t individuals that are emplyees, directrs r independent cntractrs in return fr services. Netting Distributins with Cntributins. With certain exceptins, the Regulatins reduce net distributins by cntributins made by members f the Expanded Grup in return fr stck f the issuing member during the perid beginning 36 mnths befre and ending 36 mnths after the distributin r acquisitin. Cntributins having a principal purpse f aviding the applicatin f the Regulatins are nt netted. The ratinale fr this rule is that the issuer used the cash frm such cntributins r earnings t make the distributins and nt the cash prceeds frm the debt.

6 Page 6 Exemptin fr Debt Issued by Regulated Financial and Insurance Cmpanies. The Regulatins d nt apply t debt issued by certain regulated entities, including financial entities (such as banks, bank hlding cmpanies, registered brker dealers and certain affiliates) and certain regulated insurance cmpanies. New Exceptins t the Funding Rule The Funding Rule has several new exceptins that did nt appear in the Prpsed Regulatins r were therwise expanded in the Regulatins: Cash Pling and Shrt-Term Debt. The temprary Regulatins include a new exceptin fr cash pls and qualified shrt-term debt instruments: cash pling arrangements (generally, demand depsits with an Expanded Grup member, cntrlled partnership r qualified business unit) that have as their principal purpse managing a cashmanagement arrangement fr participating Expanded Grup members, and either retaining excess cash n its bks r depsiting r investing excess cash with third parties (the IRS and Treasury expect that the expenses f the cash pl entity will be paid by incme it receives fr its services and nt frm the depsits); shrt-term funding arrangements (generally, debt that des nt exceed the issuer s shrt-term financing needs (determined with reference t the issuer s current assets) r that has a maturity f 270 days r less and that meets certain interest rate requirements); rdinary curse lans (generally, debt fr the acquisitin f prperty in the rdinary curse f the issuer s trade r business if reasnably expected t be repaid within 120 days), althugh, in a departure frm the Prpsed Regulatins, there is n requirement that the debt reflect deductible amunts under Sectin 162 f the Cde; and interest-free lans (generally, debt that des nt prvide fr interest, des nt have OID, is nt required t prvide fr interest under Sectin 482 f the Cde and is nt imputed interest under the Cde). Limited t Debt Issued fr Prperty. The Regulatins limit the scpe f the Funding Rule t debt issued in exchange fr prperty. Debt issued fr services, ryalties and rents is n lnger subject t this rule. Limited t Same Expanded Grup. The Regulatins add an exceptin t the Funding Rule in situatins where the distributin r acquisitin n the ne hand, and the issuance f the debt n the ther hand, ccurred when the issuer was a member f a different Expanded Grup. Des Nt Apply t Secndary Market Acquisitins. The Preamble clarifies that the Funding Rule nly applies t an issuance (r deemed issuance) f a cvered debt instrument and des nt apply t an acquisitin f such debt in the secndary market. Exceptin fr Liquidatins and Spin-Offs. A distributin in cmplete liquidatin (whether r nt taxable) and a distributin f stck that is nt treated as bt are nt treated as distributins f prperty fr purpses f the funding rule. Significant Mdificatin f Debt. Fr purpses f the 36-mnth perid used in the Funding Rule, with certain exceptins, debt instruments that are treated as exchanged as a result f a significant mdificatin

7 Page 7 are nevertheless treated as issued n their riginal issue date (the reasn is that such mdificatin generally des nt generate new prceeds that culd fund distributins r acquisitins). Treatment f Cntrlled ships Aggregate Apprach. The temprary Regulatins retain the aggregate apprach t cntrlled partnerships. Therefre any prperty acquired by a cntrlled partnership is treated as having been acquired by its Expanded Grup partners based n their respective liquidatin value percentages. The exceptin fr qualified shrt-term debt is applied at the cntrlled partnership level by treating the partnership as the issuer f the relevant debt instrument (e.g., lking at the current assets/shrt-term financing needs f the partnership rather than its partners). Deemed Transactins. Instead f recharacterizing the debt issued by a cntrlled partnership under the Recharacterizatin Rule and the Funding Rule, the temprary Regulatins treat the hlder f the debt as having transferred the debt t the Expanded Grup partners in exchange fr stck f such partners based n the partners distributive share f the partnership s reasnably anticipated interest expense (Issuance Percentage). This deemed cntributin, hwever, is disregarded fr purpses f allcating the debt under Sectin 752 f the Cde. Preferred Equity. The IRS and Treasury cntinue t study whether it is apprpriate t subject preferred equity in cntrlled partnerships t these rules, and intend t clsely scrutinize, and may challenge under the anti-abuse rule transactins in which preferred equity is issued in situatins that, had the equity been debt, the Regulatins wuld have applied. Anti-Abuse Rules Anti-Abuse Rule Clarified. The Regulatins retain the anti-abuse rule under the Prpsed Regulatins with sme clarificatin. Under the Regulatins, the anti-abuse rule applies if a member f an Expanded Grup enters int a transactin with a principal purpse f aviding the purpses f the debt distributin recharacterizatin rules. This rule may therefre apply even if the taxpayer had ther principal purpses fr the transactin. Affirmative Use Reserved. The Regulatins withdrew and reserved n the Prpsed Regulatin that wuld have prevented taxpayers frm affirmatively using the Regulatins t reduce federal tax liabilities. Effective Dates Dcumentatin Requirements. The dcumentatin requirements nly apply t debt that is issued n r after January 1, 2018 (including debt issued after this date under a credit facility executed befre such date). Debt Distributin Recharacterizatin Rules. The debt distributin recharacterizatin rules are subject t several effective date prvisins: The rules apply nly t debt instruments issued n r after April 5, 2016 (instead f April 4 as in the Prpsed Regulatins). Fr purpses f the Funding Rule, distributins and acquisitins ccurring befre April 5, 2016 are disregarded.

8 Page 8 Except as described belw, the Regulatins nly apply t taxable years ending n r after the 90-day perid ending after the publicatin f the Regulatins in the Federal Register (i.e., January 19, 2017) (January Effective Date). Debt that wuld have been recharacterized under the Regulatins in a taxable year ending n r befre the January Effective Date (e.g., debt distributed n June 1, 2016), r debt that wuld have been recharacterized befre the January Effective Date, and in a taxable year ending n r after the January Effective Date (e.g., debt distributed n January 3, 2017), will be treated as equity immediately after the January Effective Date if it is still utstanding and held by a member f the Expanded Grup at that time. T prevent abuse, the Regulatins als prvide that if a debt instrument wuld have been required t be recharacterized after April 4, 2016 and n r befre the January Effective Date (e.g., the debt distributed n June 1, 2016 in the abve example), but is nt recharacterized under the preceding transitin rules (e.g., the debt was nt utstanding n the January Effective Date because it was repaid n January 2, 2017), then any payment made n such debt instrument (ther than stated interest), including pursuant t refinancing (e.g., the repayment f principal n January 2, 2017), will be taken int accunt as a distributin fr purpses n the Funding Rule. Such distributin culd therefre ptentially cause a recharacterizatin f ther debt instruments issued by the issuer. Absent such repayment, the distributin f the debt itself (in the example) is generally nt treated as a distributin fr purpses f the Funding Rule. Additinal transitin rules are als prvided in situatins where the issuer and hlder cease t be members f the same grup during the transitin perid. Taxpayers have an ptin t apply the debt distributin recharacterizatin rules f the Prpsed Regulatins t debt issued between April 4 and Octber 13 f this year. We will cntinue t mnitr these develpments clsely.

9 Page 9 If yu have any questins regarding this Sidley Update, please cntact the Sidley lawyer with whm yu usually wrk, r Suresh T. Advani sadvani@sidley.cm Laura M. Barzilai lbarzilai@sidley.cm Christian Brause cbrause@sidley.cm Sharp Srensen ssrensen@sidley.cm Tracy D. Williams tdwilliams@sidley.cm Daniel Altman Cunsel daltman@sidley.cm Tax Practice Our Tax Practice prvides legal services in transactins, planning and cntrversy related t United States federal, state and lcal and United Kingdm tax laws. Our lawyers wrk clsely with ur clients and with lawyers in the firm s ther practice grups t develp timely, cst-effective tax strategies and t identify and slve ptential tax-related prblems. T receive Sidley Updates, please subscribe at BEIJING BOSTON BRUSSELS CENTURY CITY CHICAGO DALLAS GENEVA HONG KONG HOUSTON LONDON LOS ANGELES MUNICH NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley and Sidley Austin refer t Sidley Austin LLP and affiliated partnerships as explained at