State Tax Implications of New (and Pending) Federal Rules

Transcription

1 Todd A. Lard Andrew D. Appleby NESTOA September 27, 2016 State Tax Implications of New (and Pending) Federal Rules 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 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 nonvoting 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 was instead 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 for 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 PARTNERSHIP RULES 22

23 Federal Partnership Audit Reform Bipartisan Budget Act of 2015 Includes federal partnership audit reform Generally applies to tax years beginning after 12/31/17 But certain elections can make it applicable RIGHT NOW Meant to simplify auditing partnerships and assessing liabilities expected to raise $9.3 billion (over 10 years) 23

24 IRS Audit/Adjustment Rates by Entity Type Figure 5: Fiscal Year 2012 Examination and Adjustment Rates for Different Types of Tax Returns Source: US Government Accountability Office Partnerships and S corporations: IRS Needs to Improve Information to Address Tax Noncompliance (May 2014) (available on the Internet at (last accessed Mar. 22, 2016)) 24

25 IRS Returns by Entity Type Figure 4: Number of Returns by Form of Business, Tax Years 2002 to 2011 Source: US Government Accountability Office Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (Sept. 2014) (GAO ) available on the Internet at (last accessed Mar. 22, 2016)) 25

26 Growth of Large Partnerships Table 16: Number of Large Partnerships by Industry Group, Tax Years 2002 to 2011 Tax Year Industry Group Mining Manufacturing Transportation and Warehousing Transportation and Warehousing Finance and insurance 1,799 2,195 2,715 3,190 4,731 5,707 5,530 6,124 5,955 7,333 Real Estate, Rental and Leasing Professional, Scientific, and Technical Services ,081 1,275 1,486 1,401 1,287 1, Holding companies Other Source: GAO analysis of IRS data from the Enhanced Large Partnership Indicator (ELPI) File and Business Returns Transaction File, Compliance Data Warehouse. I GAO

27 Other Statistics Richard Prisinzano, U.S. Treasury Department; Danny Yagan, University of California, at Berkeley Economics Department, Draft Paper for NYU Spring Colloquium on Tax Policy and Public Finance 2016, Business in the United States Who Owns It and How Much Tax Do They Pay? 27

28 Other Statistics Richard Prisinzano, U.S. Treasury Department; Danny Yagan, University of California, at Berkeley Economics Department, Draft Paper for NYU Spring Colloquium on Tax Policy and Public Finance 2016, Business in the United States Who Owns It and How Much Tax Do They Pay? 28

29 Other Statistics 15%-20% of income cannot be traced to partners (or back to partnerships) because of the nature of the partners or circular partnership holdings Almost 70% of partnership income accrues to the top 1% income earners 29

30 Multi-Tiered Partnership Structure Figure 7: Example of Partnership Structure Source: US Government Accountability Office Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (Sept. 2014) (pg. 17) (GAO ) available on the Internet at (last accessed Mar. 22, 2016)) 30

31 Implications for the States Large financial market and production states (and venture capital markets) are likely to see the greatest impact Smaller and more rural states partnerships are likely to be simpler, more closely held, investment partnerships (with real estate predominating) and less likely to have multistate implications 31

32 New Regime Basic Rules IRS may assess and collect from partnerships at the entity level for 1065 and Schedule K-1 issues Collection from partnership (not partners) in year of adjustment rather than year of review Option to elect out for partnerships with 100 or fewer partners Partners cannot be other partnerships, LLCs (including SMLLCs), trusts or tax-exempt organizations Audit, assessment and collection at partner level Back to the Future Pre-TEFRA Election is the PARTNERSHIP s (not the partners individually) Who s going to decide? 32

33 New Regime Basic Rules Partnership representative (f/k/a Tax Matters Partner ) makes binding decisions for the partners and the partnership Doesn t even have to be a partner If one has not been appointed, the IRS will appoint one for you How will partnership representative be: Controlled? Compensated and indemnified? Does this mean that EVERY PARTNERSHIP/LLC AGREEMENT in America has to be revised to cover this point? 33

34 New Regime Basic Rules After assessment, partnerships (that can t elect out) can: Modify the proposed entity level assessment by presenting information specific to partners taxes including amended returns Push out the entity level tax liability by providing Schedule K type reports to partners for their share of the tax imposed at the partnership level - current year Cost: 2% higher interest rate 34

35 State Issues Will state law conform to the new federal changes? Not automatically New federal rules are primarily in IRC secs to 6241 (administrative procedures) States use the IRC only to compute taxable income and do not incorporate IRC administrative procedures States usually have their own procedures Practitioners need guidance for dealing with partnership and operating agreements 35

36 State Issues Without automatic adoption, where does that leave states? For partnerships assessed by the IRS at the entity level, how will states impose related state tax? How are states to deal with the liability being assessed in year of adjustment rather than year of review? Most states never conformed to TEFRA 36

37 Existing State Enforcement Mechanisms Many states already use two types of enforcement mechanisms for nonresident partners: Impose withholding requirement on partnership for income passed through to nonresident partners (or nonresident partner consents to state taxation) Impose a composite filing requirement Could states modify/expand these to require entity level audit liability remittance? 37

38 Procedural Issues for States Statutes of limitations and notices to partners Start date of audit (as relates to each partner) Adjustments that affect one partner Adjustments that affect multiple partners Adjustments that affect past years or future years Adjustments resulting in refunds Who represents the partnership with respect to appealing or settling issues? Penalties and interest Collection of liabilities 38

39 Procedural Issues for States Assessment in year of adjustment rather than reviewed tax year Partners in adjustment year could be different than partners in reviewed year Partners move change state of residence Paying for other people s taxes Will states conform to federal elections? Allow separate state elections? Post-federal audit information sharing Is state s receipt of partnership-level tax liability enough information to assess partners? How will states obtain information they need for state purposes (e.g., apportionment data? Business/nonbusiness income? Unitary determinations?) 39

40 Arizona The First Adopter Faced a minor problem: No statutory authority to even audit a partnership Largely adopts federal procedures, with some revisions New law amended RAR statute and added new statute. Ariz. Laws 2016, ch. 155 (S.B. 1288) (signed May 11, 2016) If partnership is assessed by IRS: For increases to AZ taxable income, partnership must file AZ return and pay tax within 90 days after final IRS determination For decreases to AZ taxable income, or if partnership makes federal push out election: Partnership must provide reviewed year partners (and DOR) an adjusted K-1 within 90 days after final IRS determination Partnership must pay tax if it fails to timely issue adjusted K-1s Partnership must pay tax on any RAR adjustments that it does not properly include on the adjusted K-1s Partners receiving adjusted K-1 must file an amended AZ return and pay tax within 150 days after final IRS determination reporting the changes 40

41 Nexus of Partners and Partnerships Type matters Individuals or corporations General or limited Active or passive Operational or investment Nexus over the partnership may be essential for a state that needs information from that entity to audit a resident partner Loss of revenue if state adopts entity level partnership assessment and resident partner has interest in out-of-state audited partnership? 41

42 State Cases Are Mixed Alabama In Lanzi, state appeals court ruled that an individual s interest in an LLC was not sufficient to create nexus over that individual Pennsylvania In Marshall Jr. v. Commonwealth, the state Commonwealth Court held that a Texas resident s holding of a limited partnership interest was sufficient to subject him to income tax in PA because the partnership had substantial commercial assets in the state, which the limited partner was well aware of. (Affirmed in Wirth v. Commonwealth) 42

43 State Cases Are Mixed In Kentucky An out-of-state corporate limited partner was held to have nexus in the state. Asworth Corp. v. Revenue Cabinet In New Jersey The state appellate court ruled that a corporate limited partner which had no control of the business in NJ and had no unitary relationship with the limited partnership did not have nexus in the state. BIS LP, Inc. v. Director, Division of Taxation 43

44 Apportionment Individuals Resident individuals taxed on 100% with credit for taxes paid on partnership income to other states on a source basis Nonresident individuals taxed on a source basis (partnership items allocated or apportioned at partnership level) 44

45 Apportionment Corporations Three general possibilities: Include partnership tax items but no apportionment factors or other source information (use corporate factors only) Include proportional share of factors with corporate factors Allocate or apportion partnership items at the partnership level and flow through source information to corporate partner 45

46 Apportionment Generally For unitary partnerships distributing business income include proportional share of partnership factors For non-unitary partnerships distributing operational items apportion using corporation s factors For non-unitary partnerships distributing investment items allocate at the partnership level and flowthrough the sourcing information 46

47 Questions? Todd A. Lard Sutherland Asbill & Brennan LLP Andrew D. Appleby Sutherland Asbill & Brennan LLP

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