University of Chicago Federal Tax Conference. Final and Temporary Section 385 Regulations

Transcription

1 University of Chicago Federal Tax Conference Final and Temporary Section 385 Regulations Julie A. Roin, Moderator L.G. Chip Harter Kevin C. Nichols Deborah L. Paul November 11, 2016

2 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

3 Proposed Section 385 Regulations 3

4 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

5 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 CFC s and facilitating the repatriation of untaxed earnings without recognizing dividend income. 5

6 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

7 Prop. Treas. Reg. Secs and -4 -Recharacterization Rules 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

8 Prop. Treas. Reg. Secs and -4 -Recharacterization Rules 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

9 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

10 Comments on Proposed Regulations -Effect on Treasury Operation CFC 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. CFC loan Year 3 CFC The alternative of relying on external funding would impose unnecessary financing costs. T 10

11 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. CFC 1 CFC 2 CFC Cash Pool CFC 3 If CFC 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 CFC 3. Cash pool s acquisition of CFC 3 s recharacterized receivable is an acquisition of EG stock, tainting deposits in cash pool. Repayment of one deposit can taint other deposits. 11

12 Final and Temporary Section 385 Regulations Scope 12

13 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

14 Comparison of Final with Proposed Regulations Revised scope for U.S.-parented multinationals U.S. Trade Payables U.S. U.S. Trade Payables CFC CFC CFC CFC CFC CFC 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

15 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

16 Comparison of Final with Proposed Regulations Revised scope for foreign-based multinationals FP Cash Pool FS FS FS Trade Payable Creditor Debtor CFC CFC 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

17 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

18 Recharacterization Rules Exception Framework 1 Issuer Exceptions 2 Instrument Exceptions 3 Transaction Exceptions 4 Attribute Exceptions 5 Threshold Exception 18

19 Recharacterization Rules 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 19

20 Recharacterization Rules Exception Framework 1 2 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 20

21 Recharacterization Rules 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. 21

22 Recharacterization Rules 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 4 5 Attribute Exceptions Threshold Exception 22

23 Recharacterization Rules Subsidiary Stock Acquisitions (c)(2) Transaction: CFC2 stock P CFC1 Note 956 Loan - + CFC1 P CFC2 P acquires CFC2 stock from CFC1 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. CFC2 Result: Because P owns more than 50 percent of the vote and value of CFC1 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. 23

24 Recharacterization Rules 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 CFC2, either in exchange for stock or for no consideration, in a transaction described in section 351(a). CFC1 CFC2 Result: Because P owns more than 50 percent of the vote and value of CFC2 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. 24

25 Recharacterization Rules Expanded Group Member Stock Acquisitions 40% of FS stock FP Note FS + - FP 40% 60% Transaction: acquires 40% of FS s stock from FP in exchange for a Note. This transaction is expected to be described in section 304(a)(1), unless recharacterized under section 385. CFC CFC FS Result: The Note is recharacterized as stock, unless an exception, such as the expanded earnings exception or the qualified contributions exception, applies. 25

26 Recharacterization Rules Expanded Group Member Stock Acquisitions (cont d) + - FP Other property 60% CFC stock 40% + - FP 40% 60% 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 CFC stock, and FP contributes a proportionate amount of additional property to FS in an exchange described in section 351(a). CFC FS FS CFC 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. 26

27 Recharacterization Rules Exception Framework Issuer Exceptions Instrument Exceptions Transaction Exceptions Attribute Exceptions Expanded group earnings account Qualified contributions 5 Threshold Exception 27

28 Recharacterization Rules - Change from Current-Year E&P Exception to Expanded Group Earnings Account Exception (c)(3)(i) FP CFC Note Distribution Cash Dividend Transaction: CFC distributes a cash dividend to during Also in 2017, issues a Note to FP 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 CFC dividend, adding to s expanded group earnings to the extent paid out of post-2015 E&P of CFC earned while an EG member under the same parent. 28

29 Recharacterization Rules - Qualified Contributions Exception (c)(3)(ii) Transaction: Year 1 Cash Distribution FP Year 2 Cash Contribution FS In Year 1, distributes cash to FP. In Year 2, FS loans cash to in exchange for a Note. Also in Year 2, FP 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. Year 2 Cash Loan 29

30 Recharacterization Rules Exception Framework Issuer Exceptions Instrument Exceptions Transaction Exceptions Attribute Exceptions Threshold Exception 30

31 Recharacterization Rules - 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. 31

32 Recharacterization Rules - Coordination of General and Funding Rules (b)(5) Transaction: Year 1 Note Distribution FP FS In Year 1, issues a Note to FP in a distribution. In Year 2, FS loans cash to in exchange for a Note. 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. Year 2 Cash Loan 32

33 Recharacterization Rules - Funded Member Rule (aka the Double Jeopardy Rule ) (d)(6) Year 1 Note Distribution FP Year 2 Cash Distribution Transaction: In Year 1, issues a Note to FP in a distribution. In Year 2, distributes cash to FP. Result: The Note is recharacterized when distributed pursuant to the general rule under Treas. Reg (b)(2), unless the expanded group 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). 33

34 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Recently inverted companies FP 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. 34

35 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Recently inverted companies, cont d FP 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. 35

36 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Established Foreign Owned Subsidiaries Grandfathered Notes FP 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. 36

37 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. 37

38 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Cash Purchase of Targets by Foreign Investors cont d Note 2 FP Sub 2 1 Seller T If FP 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 38

39 Operation and Effectiveness as an Anti-Earnings Stripping Regime -Leveraged Purchases of Depreciable Assets FP 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? 39

40 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. 40