The State of Debt Under the Proposed Section 385 Regulations

Transcription

1 Robb Chase Andrew Appleby TEI Denver May 11, 2016 The State of Debt Under the Proposed Section 385 Regulations All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient.

2 FEDERAL TAX OVERVIEW 2

3 Overview On April 4, proposed regulations were issued under IRC 385 (the Proposed Regulations) to address concerns associated with related-party debt IRC 385, initially enacted in 1969, provides broad authority for regulations to determine whether an interest in a corporation is debt or equity for U.S. federal tax purposes Although issued as part of an inversion package, the Proposed Regulations apply to all corporate taxpayers, not just taxpayers that have engaged in inversion transactions The Proposed Regulations would treat certain related-party debt, in whole or in part, as equity for U.S. federal tax purposes Generally apply to debt among members of an expanded corporate group, which includes certain controlled partnerships Consolidated group members are treated as a single taxpayer for purposes of applying the rules 3

4 Overview The common law multi-factor debt-equity analysis still applies, but under the Proposed Regulations instruments treated as debt under the common law analysis will nonetheless be treated as equity for U.S. federal tax purposes if: Certain documentation requirements are not satisfied; or If the debt is per se equity that is issued in connection with certain transactions, generally distributions, stock sales and asset reorganizations Although generally proposed to be effective when finalized, the per se equity rules would apply to debt issued on or after April 4 that is still outstanding 90 days after the date the regulations are finalized 4

5 Documentation Requirements The Proposed Regulations introduce documentation and information retention requirements that must be satisfied in order for debt issued to a related party to be respected as debt for U.S. federal tax purposes Related-party debt that does not satisfy these requirements is treated as equity for U.S. federal tax purposes The documentation must: Be contemporaneous (i.e., prepared within 30 days of the debt issuance); and Demonstrate the existence of what Treasury and the IRS describe as the essential characteristics of debt 5

6 Documentation Requirements The essential characteristics of debt that must be demonstrated through documentation are: Legally binding obligation to pay; Creditor s rights to enforce the obligation; Reasonable expectation of payment at the time of creation, demonstrated by cash flow projections, financial statements, business forecasts, asset appraisals and other relevant financial ratios (compared to industry averages); and An ongoing relationship during the life of the instrument consistent with arm s-length relationships Satisfaction of these documentation requirements does not itself establish that an instrument will be respected as debt the existing common law multi-factor debt-equity analysis must still be satisfied 6

7 Per Se Equity Certain related-party debt instruments issued in connection with certain transactions would be treated as equity for U.S. federal tax purposes under the Proposed Regulations Per se equity treatment applies even if the common law debtequity factors and documentation requirements are otherwise satisfied Per se equity treatment applies generally to debt instruments: Distributed (as a dividend or return of capital) by a company to a related shareholder; Issued in exchange for stock of an affiliate (including hook stock issued by a related shareholder); and Issued by an acquiring company as consideration in an internal asset reorganization (i.e., a reorganization within the meaning of IRC 368(a)(1)(A), (C), (D), (F), or (G)) 7

8 Per Se Equity A funding rule also would treat related-party debt that is issued with a principal purpose of funding one of the above transactions (i.e., a distribution of cash or other property, an acquisition of stock of an affiliate or an internal asset reorganization) as equity for U.S. federal tax purposes Non-rebuttable presumption that related-party debt issued within 36 months before or after one of the above transactions is treated as equity for U.S. tax purposes The Proposed Regulations include very limited exceptions from these rules The per se equity rules are proposed to apply to debt instruments issued on or after April 4 that are still outstanding 90 days after the regulations are finalized Commissioner has indicated the intent to finalize the rules by Labor Day 8

9 Consolidated Group Exception The Proposed Regulations do not apply to debt instruments between members of a consolidated group, although the existing common law multi-factor debt-equity analysis continues to apply to these transactions To achieve this result, a consolidated group of corporations is treated as one corporation Transactions between different consolidated groups, or between a consolidated group member and a related foreign affiliate, could have unanticipated results How, or even if, the consolidated group rule will be adopted and applied for state tax purposes is an open question 9

10 Consequences of Equity Characterization Related-party debt that is treated as equity under the Proposed Regulations would be treated as equity for all U.S. federal tax purposes, including for example, sections 302, 304, and 305 Under the preamble to the Proposed Regulations, determination of whether equity is common or preferred depends on the terms of the instrument Special rules apply to related-party debt issued by disregarded entities: Debt recast as equity under the documentation rules is treated as equity in the disregarded entity can result in partnership treatment Debt recast as equity under the per se equity rules is treated as equity in the regarded parent of the disregarded entity 10

11 Consequences of Equity Characterization Equity characterization is expected to have consequences for the initial transaction, and for future transactions (e.g., repayment or exchange of instruments) Generally results in loss of interest expense deductions Payments generally treated as dividends, potentially subject to different withholding tax treatment Could impact CFC treatment and cause U.S. entities to cease to be members of consolidated group No foreign tax credits on dividends or subpart F inclusions attributable to the recharacterized instrument if treated as non-voting equity and holder does not also hold sufficient voting equity 11

12 What the Proposed Regulations Mean Now? The Proposed Regulations are not currently effective, but they can implicate existing debt transactions. Companies should: Determine who is related for purposes of the Proposed Regulations Review intercompany debt policies and update as necessary to ensure compliance with documentation requirements With respect to per se equity transactions, review current intercompany financing structure and planning transactions for potential implications under the Proposed Regulations Consider application of the Proposed Regulations in diligence of acquisition targets and in structuring acquisition financing 12

13 STATE TAX IMPLICATIONS 13

14 State Tax General The Proposed Regulations are likely to impact state income taxes, particularly over the long term Any increase in a taxpayer s federal taxable income resulting from the IRS s application of the Proposed Regulations (e.g., reduced interest expense deductions on debt to foreign affiliates, or increased income from characterization of principal repayments as dividends) may have an associated state tax cost, because states generally adopt federal taxable income as the starting point for calculating the state tax Additionally, state tax authorities might follow the path taken by the IRS in the Proposed Regulations by seeking to adopt their own comparable regulations under other state law authority 14

15 State Tax Separate Reporting States Separate company reporting states could seek to apply the Proposed Regulations as a tool to disallow interest deductions on intercompany debt Publicly-traded taxpayers often put in place intercompany debt obligations between related parties to distribute third-party debt among those companies that benefit from it States could seek to use their IRC conformity laws to argue that the Proposed Regulations also apply for state income tax purposes, as many states adopt most or all of the IRC through varying mechanisms States often conform to IRS regulations, either explicitly or implicitly, that are issued under IRC provisions to which they conform Some states (e.g., Massachusetts) have sought to apply debt-equity principles from federal case law to challenge intercompany interest expenses, but such challenges have not been widespread 15

16 State Tax Separate Reporting States The Proposed Regulations do not apply, on their face, to debt between members of a single federal consolidated group However, separate company reporting states routinely apply the IRC and relevant IRS regulations as if each corporation had filed a separate federal tax return (each entity must prepare a separate pro forma return) If states were to apply this approach to the Proposed Regulations, states could potentially attempt to reclassify intercompany debt as equity and thereby deny the related interest expense deductions 16

17 State Tax Separate Reporting States Taxpayers may question a state s authority to apply the Proposed Regulations, or the principles underlying them, to seek to deny a taxpayer s interest expense incurred on intercompany debt Even if state tax law technically incorporated the IRC provision under which the Proposed Regulations were issued (IRC 385), states do not universally adopt IRS regulations This is particularly true for IRS regulations issued under provisions of the IRC that authorize the issuance of Treasury regulations rather than provide substantive rules (e.g., federal consolidated return regulations issued under IRC 1502 are not wholly adopted in many states, such as Georgia) 17

18 State Tax Combined Reporting States Characterization of debt as equity could change the composition of the combined/consolidated group by changing the ownership percentages of subsidiaries For example, a domestic subsidiary that has debt with a foreign affiliate may have its foreign ownership increased as a result of the characterization of debt as equity to a point where the subsidiary no longer satisfies the common ownership requirements for filing a combined/consolidated return In addition, many of the same issues that could arise in the context of the separate reporting states (see above, e.g., interest expense disallowance) could also arise in combined/consolidated reporting states where either the debtor or creditor entity is not included in a state s combined/consolidated group 18

19 State Tax Add Back Statutes Many state legislatures already addressed the circumstances in which intercompany interest expenses should be deductible for state income tax purposes using related-party interest expense add back statutes These statutes generally require interest deductions to be added back if the interest is paid to a related party, unless the taxpayer qualifies for an exception to the add back statute Even where the add back statute does not apply, states could attempt to deny an interest expense deduction by applying the Proposed Regulations For example, states with an add back statute that applies only to interest related to intangible assets (e.g., Tennessee) could assert that the Proposed Regulations authorize them to deny non-intangible-related interest deductions that are otherwise not subject to add back Even in states with broad related-party interest expense add back statutes (e.g., New Jersey), the state could try and use the Proposed Regulations to deny an interest deduction where an exception to the add back statute otherwise applies 19

20 State Tax Add Back Statutes Any potential application of the Proposed Regulations by a state that has adopted an add back statute will be met with a compelling argument that the state s legislature has selected its statutory treatment of related-party interest, and such treatment should trump conformity to a federal tax regulation If the Proposed Regulations did apply, the consequences of reclassifying debt as equity may be similar to, but different than, expense disallowance under an add back statute or under a state s IRC 482-like powers The interest expense may be lost in both scenarios, but if the debt is recast as equity, the interest payments may be considered a dividend, which could be eligible for a dividend-received deduction for the recipient There could also be differences in the apportionment consequences, such as if the interest income were removed from the recipient s sales factor in an expense disallowance scenario but included where the debt wasinstead treated as equity 20

21 State Tax Franchise Tax If a state that imposes a net-worth-based franchise tax (e.g., Louisiana) reclassified debt as equity for state income tax purposes, an issue could also arise regarding whether the reclassification carries over from income to franchise tax purposes Net-worth-based franchise taxes generally include equity in the tax base but exclude debt It is unclear whether a reclassification for income tax purposes would affect a franchise tax based on GAAP book values Some states also have separate statutory or regulatory franchise tax rules that specify bright-line circumstances under which intercompany debt is reclassified for purposes of the state s franchise tax base (e.g., Louisiana, Tennessee) 21

22 MOVING FORWARD 22

23 Comments to Proposed Regulations Consider issues to be raised in comments: The IRS and Treasury have requested comments generally and on a number of specific topics, including: Whether special rules are warranted for cash pools, cash sweeps, and similar arrangements for managing the cash of a group of companies; Application to non-u.s. persons; and Potential extension of the rules to debt issued by blocker entities Comments and requests for a public hearing must be received by the IRS by July 7 23

24 Questions? Robb Chase Andrew Appleby

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