The Final Debt-Equity Regulations: The Sky Is Not Falling

Transcription

1 taxnotes The Final Debt-Equity Regulations: The Sky Is Not Falling By Devon M. Bodoh, Greg W. Featherman, Stephen M. Massed, Andrew D. Simmons, and Alfonso J. Dulcey Reprinted from Tax Notes, February 20, 2017, p. 979 Volume 154, Number 8 February 20, 2017 (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

2 The Final Debt-Equity Regulations: The Sky Is Not Falling by Devon M. Bodoh, Greg W. Featherman, Stephen M. Massed, Andrew D. Simmons, and Alfonso J. Dulcey Devon M. Bodoh Greg W. Featherman Stephen M. Massed Andrew D. Simmons and Alfonso J. Dulcey are all members of KPMG LLP s Washington National Tax (WNT) practice. Bodoh is the leader of KPMG s complex transactions group and the principal in charge of KPMG s WNT international mergers and acquisitions group. Featherman is a principal and a member of the international M&A group and the complex transactions group. Massed is a managing director and a member of the international M&A group and the complex transactions group. Simmons is a senior manager and Dulcey is a manager in the international M&A group. In this report, the authors review the final and temporary section 385 regulations and highlight the key differences between those regulations and the proposed section 385 regulations. The final and temporary regulations change the way relatedparty instruments are characterized for federal tax purposes, and multinational corporate groups should consider the regs potential application to their intragroup debtor-creditor relationships. This report represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG. The information herein is of a general nature and based on authorities that are subject to change. Its applicability to specific situations should be determined through consultation with your tax adviser. Table of Contents I. Introduction II. Debt Versus Equity: In General III. General Scope and Operating Rules IV. The Documentation Rules A. In General B. The Requirements C. Exceptions D. Timing Rules for Recharacterization SPECIAL REPORT tax notes V. The Recast Rules A. In General B. The General Rule C. The Funding Rule D. Recast Rule Exceptions and Reductions E. Timing and Operating Rules F. Transition Rules G. The Consolidated Group Rules VI. Conclusion I. Introduction On October 21, 2016, Treasury and the IRS published final and temporary regulations under section 385 that address the characterization of specific related-party instruments as debt or stock for federal tax purposes. 1 The final and temporary regulations follow up on the proposed regulations issued under section 385 on April 4, 2016, 2 retaining the general framework of the proposed rules but with a much narrower scope. For example, the final and temporary regulations do not include a rule that permits the IRS to bifurcate an instrument as part debt and part stock, and they do not apply to foreign-issued instruments. The reduced scope of the final and temporary regulations is a welcome change because the breadth of the proposed regulations would have made their application a challenge for taxpayers, with the potential to lead to frequently adverse, and sometimes unintended consequences. The final and temporary regulations have three primary parts: (1) reg. section , which provides documentation requirements that must be satisfied for related-party instruments to be characterized as debt for federal tax purposes (the documentation rules); (2) reg. sections and -3T, which provide rules that recharacterize relatedparty debt instruments as stock if the instruments are issued in, or fund, specified distributions or acquisitions (the recast rules); and (3) reg. section T, which provides rules regarding the application of the recast rules to U.S. consolidated groups (the consolidated group rules). 1 T.D REG TAX NOTES, February 20,

3 COMMENTARY / SPECIAL REPORT II. Debt Versus Equity: In General 3 See, e.g., Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); Hardman v. United States, 827 F.2d 1409, 1412 (9th Cir. 1987); and Commissioner v. O.P.P. Holding Corp.,76F.2d11,13(2d Cir. 1935). 4 See, e.g., Busch v. Commissioner, 728 F.2d 945, 950 (7th Cir. 1984); and Raymond v. United States, 511 F.2d 185, 190 (6th Cir. 1975). 5 See, e.g., Estate of Mixon, 464 F.2d at 402; Nassau Lens Co. v. Commissioner, 308 F.2d 39, 47 (2d Cir. 1962); and Farley Realty Corp. v. Commissioner, 279 F.2d 701, 705 (2d Cir. 1960). 6 See, e.g., Estate of Mixon, 464 F.2d at 402; Wortham Machinery Co. v. Commissioner, 521 F.2d 160, 164 (10th Cir. 1975); and Commissioner v. Page Oil Co., 129 F.2d 748, 750 (2d Cir. 1942). 7 See, e.g., Estate of Mixon, 464 F.2d at 402; Nassau Lens, 308 F.2d at 47; and Farley Realty, 279 F.2d at See, e.g., Commissioner v. Meridian and Thirteenth Realty Co., 132 F.2d 182, (7th Cir. 1942); Slappey Drive Industrial Park v. United States, 561 F.2d 572, 582 (5th Cir. 1977); and Gilbert v. Commissioner, 262 F.2d 512, 513 (2d Cir. 1959). 9 See, e.g., In re Lane, 742 F.2d 1311, 1314 (11th Cir. 1984); and Burr Oaks Corp. v. Commissioner, 365 F.2d 24, 27 (7th Cir. 1966). 10 See, e.g., P.M. Finance Corp. v. Commissioner, 302 F.2d 786, (3d Cir. 1962); Arlington Park Jockey Club v. Sauber, 262 F.2d 902, 906 (7th Cir. 1959); and Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 630 (6th Cir. 1986). 11 See, e.g., Roth Steel, 800 F.2d at ; Creston Corp. v. Commissioner, 40 T.C. 932, 938 (1963); and Piedmont Corp. v. Commissioner, 388 F.2d 886, (4th Cir. 1968). 12 See, e.g., Bauer v. Commissioner, 748 F.2d 1365, (9th Cir. 1984); Charter Wire Inc. v. United States, 309 F.2d 878, (7th Cir. 1962); and Kraft Foods Co. v. Commissioner, 232 F.2d 118, 123, 127 (2d Cir. 1956). Historically, the determination of whether an instrument is debt or equity for federal tax purposes has been made under common law by examining the facts and circumstances surrounding the instrument s issuance, terms, and repayment, and the relationship between the instrument s issuer and the holder, in light of several objective factors. The list of objective factors commonly used by the courts includes (1) the name given to the instrument by the parties; 3 (2) whether the instrument includes a fixed maturity date; 4 (3) whether the issuer is obligated to pay a sum certain and interest; 5 (4) the extent to which the instrument is subordinated; 6 (5) whether the parties intended to create a debtorcreditor relationship; 7 (6) whether the instrument gives the holder creditor s rights (for example, the right to sue in the case of default and whether the parties attempt to enforce those rights); 8 (7) whether the instrument provides the holder management rights regarding the issuer; 9 (8) whether the issuer s shareholders own the instrument in proportion to their equity interests in the issuer; 10 (9) the source of the issuer s payments on the instrument; 11 and (10) whether the issuer is adequately capitalized. 12 No single factor is dispositive of a genuine debtorcreditor relationship, and the weight given to any single factor depends on the facts and circumstances at hand. 13 Although each federal appellate circuit has developed its own set of objective factors to use in determining whether an instrument is debt or stock for federal tax purposes, there is some commonality between the factors used by the circuits. Section 385(a) authorizes the Treasury secretary to prescribe regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated...asstock or indebtedness (or as in part stock and in part indebtedness). Section 385(b) provides that the Treasury regulations prescribed under section 385 shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. Section 385(b) also provides that the factors that may be taken into account are (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain and fixed rate of interest; (2) whether there is subordination to or preference over any indebtedness of the corporation; (3) the debt-to-equity ratio of the corporation; (4) whether the instrument is convertible into stock of the corporation; and (5) the relationship between holding stock in the corporation and holding of the instrument. Before the issuance of the final and temporary regulations, no final or temporary regulations under section 385 were outstanding. 14 The characterization of an instrument as debt or equity for federal tax purposes carries significance for both taxpayers and the government because debt characterization generally gives the issuer or the holder specific tax advantages as compared with equity characterization. For example, subject to some limitations, 15 a corporation can deduct interest payments in computing its taxable income; 16 a corporation cannot deduct dividends. Also, U.S. income tax treaties generally exempt 13 See John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946); and J.S. Biritz Construction Co. v. Commissioner, 387 F.2d 451, 457 (8th Cir. 1967). 14 Treasury and the IRS have previously issued regulations under section 385. T.D However, those regulations were later withdrawn. T.D See, e.g., section 163(j) (limiting the deductibility of interest paid by a domestic corporation to specified related persons that are not subject to federal tax on the receipt of that interest (or subject to a reduced rate of taxation) when the domestic corporation meets particular thin capitalization standards); section 267(a)(2) and (3) (limiting the deductibility of interest paid to a foreign person until either (1) interest income is taken into account as income by the recipient, or (2) actual payment); section 279 (limiting the deductibility of interest by a corporation on indebtedness incurred to acquire the stock or assets of another corporation). 16 Section 163(a). 980 TAX NOTES, February 20, 2017

4 U.S.-source interest payments from federal withholding tax but subject U.S.-source dividends to federal withholding tax albeit at a rate lower than the 30 percent statutory rate. 17 III. General Scope and Operating Rules As a threshold matter, satisfying the final and temporary regulations does not guarantee that an instrument will be treated as debt for federal tax purposes. Rather, the regulations provide minimum standards that must be satisfied for an instrument to be treated as debt for federal tax purposes. Thus, if an instrument satisfies the regulations, it must still be analyzed under common law to determine whether it is treated as debt or stock for federal tax purposes. 18 Accordingly, a common law debt-equity analysis remains essential in determining whether an instrument is characterized as debt or stock for federal tax purposes. However, failure to satisfy the regulations generally results in an instrument being characterized as stock for federal tax purposes. 19 The final and temporary regulations apply only to related-party instruments issued, or treated as issued, by a covered member, which is defined as a domestic corporation. 20 The regulations reserve on their application to foreign-issued instruments. 21 This is a significant departure from the proposed regulations, which applied to both domestic- and 17 See, e.g., Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital (1980), as amended through the fifth protocol, signed on September 21, 2007, Art. XI, para. 1 (providing that interest is not taxed in the source state) and Art. X, para. 2 (generally providing that dividends are subject to source-state taxation at a 15 percent rate unless the recipient owns at least 10 percent of the voting stock of the payer corporation, in which case the rate is 5 percent). A limited number of U.S. income tax treaties subject U.S.-source dividends to a 0 percent U.S. federal withholding tax rate. See, e.g., Convention Between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and Capital Gains (2001), as amended by the protocol, signed on July 19, 2002, art. 10, para. 3 (providing that dividends are not taxed in the source state if requirements are satisfied). 18 Reg. section (b). 19 Thus, the regulations generally will create hybrid instruments (i.e., an instrument characterized as stock for federal tax purposes but as debt for foreign law purposes). Compare OECD, Base Erosion and Profit Shifting Project: Neutralising the Effects of Hybrid Mismatch Arrangements, Action Final Report (Oct. 15, 2015) (addressing specific hybrid instruments and the benefits arising from a mismatch created by these instruments). 20 Reg. section (c)(2)(i). 21 Reg. section (c)(2)(ii). Treasury and the IRS continue to study the application of the regulations to foreign-issued instruments. See preamble to T.D. 9790, 81 F.R , at (Oct. 21, 2016). COMMENTARY / SPECIAL REPORT foreign-issued instruments. The elimination of foreign-issued instruments from the scope of the final and temporary regulations is a reasonable change because their inclusion in the proposed regulations had various collateral consequences (for example, the proposed regulations potentially affected controlled foreign corporation status, the availability of section 902 foreign tax credits, qualification for U.S. income tax treaty benefits, and the tax due diligence associated with the acquisition of foreign target companies). A related-party instrument is within the scope of the final and temporary regulations if it is issued to, or held by, a member of the covered member s expanded group. An expanded group generally is one or more chains of corporations, other than S corporations, connected through direct or indirect common stock ownership of at least 80 percent (vote or value) with a common parent corporation that is not a regulated investment company, a real estate investment trust, or an S corporation. 22 For these purposes, indirect ownership is determined using the section 318(a) constructive ownership rules, with the following modifications: (1) family attribution is reserved; (2) downward attribution to partnerships, trusts, estates, and corporations is reserved; (3) the threshold for upward corporate attribution is reduced to 5 percent; and (4) stock represented by an option is considered owned only if it is reasonably certain to be exercised. 23 The final regulations definition of expanded group is different from the term s definition in the proposed regulations in several important respects. First, S corporations are entirely removed from the definition, and a RIC and a REIT cannot be the common parent of an expanded group that is, RICs and REITs are included in an expanded group only if they are captive companies. 24 Second, the final regulations reservation on downward section 318 attribution for determining indirect ownership prohibits brother-sister affiliated corporations from being members of the same expanded group on account of common noncorporate ownership. 25 This is particularly relevant to private equity and other investment funds, which typically own interests in multiple corporate groups through tiered partnership structures Reg. section (c)(4)(i). 23 Reg. section (c)(4)(iii). 24 Reg. section (c)(4)(i). 25 Id.; reg. section (c)(4)(v). 26 For example, Individual A owns all the stock in Corp. X and a 1 percent interest in partnership PRS. PRS owns all the stock in Corp. Y, and Y owns all the stock of Corp. Z. Under section 318(a)(3)(A), PRS is treated as owning all the stock owned by A and thus is treated as owning all the stock in X. (Footnote continued on next page.) TAX NOTES, February 20,

5 COMMENTARY / SPECIAL REPORT If the final and temporary regulations recharacterize a related-party instrument that purports to be indebtedness (or portion thereof) as stock, the holder may be treated as exchanging the instrument for stock (as opposed to the instrument being treated as issued as stock). If the recharacterization results in a deemed exchange, the following federal tax consequences occur with respect to the holder: (1) the holder realizes an amount equal to its adjusted basis in the instrument (or a portion thereof) on the date of the exchange, and (2) the holder receives a basis in the stock received equal to the amount realized. 27 Also, the issuer is treated as retiring the instrument (or a portion thereof) for an amount equal to the instrument s adjusted issue price as of the date of the exchange. 28 Finally, neither the holder nor the issuer accounts for any accrued but unpaid qualified stated interest or any foreign exchange gain or loss on accrued but unpaid qualified stated interest on the instrument. 29 IV. The Documentation Rules A. In General The documentation rules are intended to assist the IRS in determining whether a related-party instrument should be characterized as debt or stock for federal tax purposes. The rules, like their counterparts in the proposed regulations, focus on substantiating four factors that are essential for treating an instrument as debt for federal tax purposes: (1) the instrument obligates the issuer to pay a sum certain; (2) the instrument gives the holder creditor s rights; (3) the issuer has the ability to repay instrument; and (4) the issuer and holder maintain a debtor-creditor relationship. 30 Courts commonly emphasize these factors in common law debt-equity analyses. Thus, the documentation rules can be Under section 318(a)(5)(A), PRS is treated as actually owning all the stock in X for purposes of applying section 318(a)(3). Under section 318(a)(3)(C), X and Y are each treated as owning all the stock owned by PRS. Thus, X is treated as owning all the stock in Y, and Y is treated as owning all the stock in X. Under the proposed regulations, by virtue of A s 1 percent interest in PRS, X and Y are treated as members of the same expanded group. The reservation on downward section 318(a) attribution prevents PRS from owning A s X stock, and thus X and Y are not members of the same expanded group under the regulations. 27 Reg. section (d)(1)(i). 28 Id. For purposes of section 108(e)(8), the stock deemed issued in exchange for the instrument is treated as having a fair market value equal to the adjusted issue price of the instrument (or a portion thereof) deemed exchanged. Reg. section (d)(1)(iii). 29 Reg. section (d)(1)(i). Note, however, that the rules of reg. section (b)(13) still apply to a deemed exchange instrument under the final regulations. Reg. section (d)(1)(ii). 30 See reg. section (c)(2). viewed as establishing existing best practices as requirements for debt treatment. The documentation rules apply to an expanded group interest (EGI) issued (or deemed issued) on or after January 1, An EGI generally is an interest that is (1) issued (or deemed issued) in the legal form of a debt instrument (including a draw or separate amount borrowed under an open draw facility (defined below), regardless of whether a separate legal document is issued); or an intercompany payable and receivable documented as debt in a general ledger, accounting system, an open account ledger, or similar arrangement (each, an applicable interest); and (2) issued by a covered member (or its disregarded entity) and held by an expanded group member (or its disregarded entity) or a controlled partnership (that is, a partnership at least 80 percent of the capital and profits of which are directly or indirectly owned by expanded group members). 31 The final regulations inclusion of open account arrangements within the definition of EGI makes it clear that these types of arrangements are subject to the documentation rules that point was unclear in the proposed regulations. However, the definition of applicable interest specifically excludes some arrangements, such as sale-repurchase agreements, which are not in the legal form of a debt instrument but are treated as indebtedness for federal tax purposes. 32 Intercompany obligations (as defined in reg. section (g)(2)(ii)) or an interest issued and held by members of the same U.S. consolidated group are not EGIs. 33 Accordingly, an applicable interest between members of the same U.S. consolidated group is exempt from the documentation rules as long as the interest remains within the group. Note that because a partnership cannot be a member of a U.S. consolidated group and an applicable interest held by a controlled partnership is an EGI, it appears that an EGI held by a controlled partnership that is wholly owned by members of the issuer s U.S. consolidated group is subject to the documentation rules even though this would not be the case if the partners directly held the EGI. 34 That 31 Reg. section (c)(1), -2(d)(2), and -2(d)(3). The indirect ownership principles applicable to the expanded group determination apply in determining whether a partnership is a controlled partnership. Reg. section (c)(1). See supra for a description of the indirect ownership rules. 32 Reg. section (d)(2)(i)(A). 33 Reg. section (d)(2)(ii). 34 Note that for purposes of the recast rules, a debt instrument issued by a controlled partnership that is wholly owned by members of a U.S. consolidated group is treated as issued by a member of the U.S. consolidated group and thus is generally not subject to the recast rules. See reg. section T(b)(6) and (e)(1). 982 TAX NOTES, February 20, 2017

6 result is a deviation from the regulations general adoption of the aggregate theory of partnerships. Also, because a partnership is not a covered member, the documentation rules do not apply to partnership-issued interests even if the partnership is wholly owned by covered members a significant departure from the proposed regulations, which applied their documentation provisions to interests issued by controlled partnerships. 35 The documentation rules application to EGIs issued on or after January 1, 2018, is a significant change from the proposed regulations, which would have applied to EGIs issued after the regulations were published as final. This delayed application, coupled with the documentation rules revised timing requirements (discussed below), means that the earliest date by which taxpayers will have to comply with the documentation rules is the due date (including extensions) of their 2018 federal tax return (for example, September 15, 2019, for calendar-year taxpayers that have filed 6 month extensions). Accordingly, the final regulations give taxpayers much more time than the proposed regulations to establish their internal systems and controls for complying with the documentation rules. The final regulations, like the proposed regulations, generally limit the application of the documentation rules to large taxpayers. The documentation rules do not apply unless (1) the stock of any member of the expanded group is traded on an established financial market, (2) the expanded group s assets exceed $100 million on any one applicable financial statement or combination of applicable financial statements, or (3) the expanded group s annual total revenue exceeds $50 million on any applicable financial statement or combination of applicable financial statements The proposed regulations imposed the documentation requirements on controlled partnerships, which treated an EGI issued by a controlled partnership as equity of the partnership if the requirements were not satisfied. However, the antiabuse rule of reg. section (f) may apply to subject an instrument issued by a partnership to the documentation rules if the principal purpose for issuing the instrument was to avoid the application of the documentation rules. 36 Reg. section (a)(3)(ii). An applicable financial statement is the financial statement of any member of the expanded group (including a consolidated financial statement) that includes the assets, portion of the assets, or annual total revenue and is prepared within three years before the date the applicable instrument first becomes an EGI. See reg. section (d)(1). The final regulations clarify that applicable financial statements that do not duplicate the assets or income of an expanded group must be combined when determining whether the expanded group meets the above thresholds. See reg. section (a)(3)(ii)(C)(1). To avoid double counting, but without reducing the applicability of the rules, the documentation rules provide that to the extent there are overlapping financial statements, (Footnote continued in next column.) COMMENTARY / SPECIAL REPORT If a taxpayer fails to satisfy the documentation rules for an EGI and an exception doesn t apply, the EGI is treated as stock for all federal tax purposes. 37 In contrast, a debt instrument treated as stock under the recast rules is not treated as stock for section 1504 purposes. 38 Thus, if an EGI is treated as stock under the documentation rules, the covered member that issued the EGI could become deconsolidated from a U.S. consolidated group. Finally, the final regulations reserve on the no affirmative use rule included in the proposed regulations. 39 That rule would have prevented the documentation rules from applying if there was an intentional failure to satisfy them in order to reduce the federal tax liability of any person. Treasury and the IRS continue to study the issue. 40 B. The Requirements The documentation rules require taxpayers to prepare and maintain specific records demonstrating that (1) an EGI obligates the issuer to pay a sum certain, (2) the EGI gives the holder creditor s rights, (3) the issuer has the ability to repay the EGI, and (4) the issuer and holder maintain a debtorcreditor relationship. 41 The documentation rules are applied on an EGI-by-EGI basis, but the same documentation can be used to satisfy the requirements for multiple EGIs. 42 Taxpayers must maintain the documents required by the documentation rules for all tax years that the EGI is outstanding and until the period of limitations expires for any federal tax return to which the treatment of the EGI is relevant. 43 EGIs issued by specified financial companies and insurance companies are deemed to satisfy the documentation rules if the EGI s terms comply with the regulatory requirements applicable to those companies and, at the time of issuance, it is expected that the EGI will be paid in accordance with its terms. 44 taxpayers must use the financial statement with the higher amount of total assets. Reg. section (a)(3)(ii)(C)(2). 37 Reg. section (b)(1). 38 Reg. section (d)(7). 39 Reg. section (g). 40 Preamble to T.D. 9790, 81 F.R. at See reg. section (c)(2). 42 Reg. section (c)(1)(i). 43 Reg. section (c)(5). 44 Reg. section (c)(1)(iii). An EGI issued by an excepted regulated financial company satisfies the documentation rules if the EGI contains terms required by a regulator of that company in order for the EGI to satisfy regulatory capital or similar requirements, if at the time of issuance it is expected that the EGI will be paid in accordance with its terms. Reg. section (c)(1)(iii)(A). An EGI issued by a regulated insurance company satisfies the documentation rules if the issuer must receive regulatory approval or consent before making payments of principal or interests on the EGI, if at the time of issuance it (Footnote continued on next page.) TAX NOTES, February 20,

7 COMMENTARY / SPECIAL REPORT 1. Intrinsic factors: Documenting sum certain and creditor s rights. The documentation of an issuer s obligation to pay a sum certain and a holder s creditor s rights are related in that both requirements are intrinsic qualities of an EGI. Regarding the sum certain documentation requirement, taxpayers must have written documentation that establishes that the issuer of an EGI has entered into an unconditional and legally binding obligation to pay a fixed or determinable sum certain on demand or at one or more fixed dates. 45 Regarding the creditor s rights documentation requirement, taxpayers must have written documentation that establishes that the holder has the rights of a creditor to enforce the EGI. 46 Creditor s rights must include superior liquidation rights to the issuer s shareholders and also typically include (1) the right to cause or trigger an event of default or acceleration of the EGI if the issuer does not repay the EGI in accordance with its terms, and (2) the right to sue to enforce payment of the EGI. 47 The sum certain and creditor s rights documentation requirements can be satisfied with the type of documentation customarily used in comparable third-party transactions treated as debt for federal tax purposes (for example, a taxpayer can satisfy those requirements for trade payables by using the same documentation it uses for third-party trade payables). 48 The final regulations include special rules for satisfying the sum certain and creditor s rights documentation requirements for an EGI that is not is expected that the EGI will be paid in accordance with its terms. Reg. section (c)(1)(iii)(B). An excepted regulated financial company generally is a domestic corporation that is a regulated financial company (e.g., a bank, a covered savings and loan holding company, or a SEC-registered broker-dealer) or a member of a regulated financial group. Reg. section (g)(3)(iv). A regulated financial group generally is any expanded group of which a covered member that is a regulated financial company would be the common parent if no person directly or indirectly owned that regulated financial company. See reg. section (g)(3)(iv). A regulated insurance company generally is a domestic insurance company licensed, authorized, or regulated to sell, and regularly engaged in issuing, insurance, reinsurance, or annuity contracts to third parties. See reg. section (g)(3)(v). 45 Reg. section (c)(2)(i). 46 Reg. section (c)(2)(ii). 47 Id. The final regulations clarify that creditor s rights can be provided in the EGI itself or by local law. Id. In the latter case, the creditor s rights do not need to be included in the EGI itself. Rather, the documentation need only refer to the local law providing the creditor s rights. Id. A nonrecourse EGI gives the holder creditor s rights if it provides sufficient remedies regarding a specific subset of the covered member s assets. Id. For these purposes, in determining if an EGI is considered subordinate or pari passu to the issuer s shareholders, debt instruments recharacterized as stock under the recast rules are not taken into account. Id. 48 See reg. section (c)(1)(ii). evidenced by a separate note or other writing regarding the principal balance for example, a revolving credit facility, a cash pool agreement, or an omnibus or umbrella agreement that governs open account obligations (an open draw facility). In this case, the requirements are satisfied only if the material documentation associated with the EGI, including all relevant enabling documents, is prepared and maintained in accordance with the documentation rules. 49 The final regulations note that relevant enabling documents may include items such as board resolutions, credit agreements, omnibus agreements, security agreements, and any other relevant agreement showing the initial, or increase in, the EGI s principal balance. 50 Further, if the EGI is issued under an open draw facility that is a cash pool agreement or internal banking service that involves account sweeps, revolving cash advances, overdraft setoff, or similar features, the sum certain and creditor s rights documentation requirements are satisfied only if the material documentation that governs the ongoing operations of the open draw facility, including agreements with third parties, is prepared and maintained in accordance with the documentation rules. 51 This documentation must include the legal rights and obligations of expanded group members and non-expanded-group members regarding the open draw facility. 52 The sum certain and creditor s rights documentation generally must be in place by the due date (including extensions) for the federal tax return for the year that includes the date on which a covered member becomes an issuer of an EGI. 53 However, if an EGI is deemed reissued under reg. section as a result of the modification or alteration of its terms reflected by an express written agreement or amendment, the sum certain and creditor s rights documentation must be in place by the due date (including extensions) for the federal tax return year that includes the date of the deemed reissuance. 54 In contrast, under the proposed regulations, the documentation had to be in place no later than 30 days after the date on which an expanded group member became an issuer of an EGI, without regard to any deemed reissuance under reg. section Regarding an open draw facility, the sum certain and creditor s rights documentation generally must be in place by the due date (including extensions) 49 Reg. section (c)(3)(i)(A)(2). 50 Id. 51 Reg. section (c)(3)(i)(B). 52 Id. 53 Reg. section (c)(4)(ii)(A). 54 Id. 55 Prop. reg. section (b)(3)(i) and (ii)(a). 984 TAX NOTES, February 20, 2017

8 for the federal tax return for the year that includes (1) the date of execution of the legal documents governing the open draw facility, and (2) any date on which those legal documents are amended to either provide an increase in the maximum amount of principal or admit an additional borrower Ability to repay. The ability to repay documentation requirement requires that taxpayers have written documentation that as of the date of issuance, the issuer was reasonably expected to meet its obligations under an EGI. 57 The documentation that can be used to satisfy this requirement includes financial statements, cash flow projections, business forecasts, third-party analyses, comparable thirdparty credit, or other documentation showing that the issuer s financial position will allow it to meet its obligations under an EGI. 58 This documentation may assume that the issuer could satisfy the EGI through refinancing the instrument. 59 If a disregarded entity of a covered member issues an EGI and the covered member has limited liability regarding the entity, the ability to repay documentation requirement can be satisfied only by looking to the disregarded entity s financial position. 60 However, if the covered member does not have limited liability regarding the disregarded entity, including because of a guarantee or similar arrangement, the covered member s financial position (taking into account the assets, liabilities, and financial position of the disregarded entity) is considered in determining whether the ability to repay documentation requirement is satisfied. 61 The final regulations provide much-needed rules regarding the satisfaction of the ability to repay documentation requirement when a single issuer issues multiple EGIs or participates in an open draw facility. In the former case, written documentation can be prepared annually (an annual credit analysis) to support the issuer s ability to repay 56 Reg. section (c)(4)(ii)(E)(1). 57 Reg. section (c)(2)(iii)(A). 58 Reg. section (c)(2)(iii)(A) and (C). Other acceptable documentation includes asset appraisals and relevant financial ratios. Reg. section (c)(2)(iii)(E). Regarding nonrecourse EGIs, the documentation must include information regarding any cash or property securing the EGI, including (1) the FMV of publicly traded property that secures the EGI, and (2) an appraisal, if any, of property securing the EGI that was prepared in accordance with the issuance of the EGI or within the three-year period preceding the issuance of the EGI. Reg. section (c)(3)(iii)(A). 59 Reg. section (c)(2)(iii)(E). 60 Reg. section (c)(2)(iii)(D). For these purposes, a covered member has limited liability regarding a disregarded entity if the member has no personal liability for the debts of or claims against the entity by reason of being a member. Id.; reg. section (b)(2)(ii). 61 Reg. section (c)(2)(iii)(D). multiple EGIs or an aggregate amount of debt, if the EGIs are issued during the 12-month period that begins on the date the annual credit analysis is based. 62 However, if the issuer experiences a material event (for example, bankruptcy, a material change in its line of business, or a disposition, sale, or distribution of 50 percent of its assets) within that 12-month period, the annual credit analysis cannot be used for a later-issued EGI. 63 Rather, a new annual credit analysis can be performed to satisfy the ability to repay requirement for any later-issued EGIs. 64 If an issuer issues an EGI through its participation in an open draw facility, the written documentation establishing the issuer s ability to repay must be established with an annual credit analysis, which is then refreshed at least annually or earlier if the issuer experiences a material event. 65 The annual credit analysis must establish that the issuer has the ability to repay the maximum principal amount available under the open draw facility. 66 The proposed regulations did not include an annual credit analysis concept. Thus, they required that an issuer s creditworthiness be documented each time it issued an EGI. 67 Also, the proposed regulations did not provide guidance on whether each draw on an open draw facility was a separate EGI. Therefore, the proposed regulations could have applied to require taxpayers to satisfy the ability to repay documentation requirement each time a borrower drew down on an open draw facility. That requirement would have been particularly burdensome for corporate groups that use open draw facilities as part of their internal cash management systems. The final regulations annual credit analysis concept greatly reduces the burden of satisfying the ability to repay documentation requirement for open draw facilities because the analysis can be used for multiple draws, regardless of whether each draw is a separate EGI. The ability to repay documentation generally must be in place by the due date (including extensions) for the federal tax return for the year that includes the date on which a covered member becomes an issuer of an EGI. 68 However, if an EGI is deemed reissued under reg. section , the documentation must be in place by the due date (including extensions) for the federal tax return for the year that includes the date of the deemed 62 Reg. section (c)(2)(iii)(B)(1). 63 Reg. section (c)(2)(iii)(B)(2). 64 Id. 65 Reg. section (c)(3)(i)(A)(3). COMMENTARY / SPECIAL REPORT 66 Id. 67 See prop. reg. section (b)(2)(iii). 68 Reg. section (c)(4)(ii)(B)(1). TAX NOTES, February 20,

9 COMMENTARY / SPECIAL REPORT reissuance. 69 Under the proposed regulations, the documentation had to be in place no later than 30 days after the date on which an expanded group member became an issuer of an EGI and the date of any deemed reissuance under reg. section If an annual credit analysis is used to satisfy the ability to repay documentation requirement, the documentation must be in place by the due date (including extensions) for the federal tax return for the year that includes the date on which the initial analysis is based, for each year that includes the annual anniversary of that date (unless a material event occurs) and each year that includes the date of any material event. 71 Regarding an open draw facility, the ability to repay documentation generally must be in place by the due date (including extensions) for the federal tax return for the year that includes (1) each anniversary of the date of execution of the legal documents governing the open draw facility for the life of those documents, and (2) the date, if any, on which a material event occurred for an issuer Debtor-creditor relationship. The debtorcreditor relationship documentation requirement has two parts. First, the issuer must have written documentation (for example, wire transfer or bank statement) of its principal and interest payments. 73 This requirement also can be satisfied by netting payables and receivables between the issuer and the holder or through journal entries in the expanded group s accounting system. 74 Treasury and the IRS have tried to make clear that it is the payment of interest and principal and its documentation that matters, rather than the manner or form of payment. 75 Second, in the event of default, the holder must have written documentation demonstrating that it reasonably exercised the diligence and judgment of a creditor in assessing whether to assert its creditor rights. 76 For example, the holder could document its assertion of its creditor rights, the parties efforts to renegotiate the breach, or any change in the EGI s material terms. 77 Alternatively, the holder could provide documentation supporting its decision to refrain from asserting its creditor rights for example, the holder s reasonable belief that the 69 Id. 70 Prop. reg. section (b)(3)(i) and (ii)(b). 71 Reg. section (c)(4)(ii)(B)(2)(i). 72 Reg. section (c)(4)(ii)(E)(2). 73 Reg. section (c)(2)(iv)(A). 74 Id. 75 Preamble to T.D. 9790, 81 F.R. at Reg. section (c)(2)(iv)(B). 77 Reg. section (c)(2)(iv)(B)(1). issuer s nonpayment was the result of short-lived economic hardship and the issuer otherwise had favorable long-term prospects for repaying the EGI. 78 For the requirement that there be documentation of payments of principal and interest, the documentation generally must be in place by the due date (including extensions) for the federal tax return for each year that includes a date on which those payments are made. 79 For the requirement that the holder document its reasons for asserting or failing to assert its rights in the event of default, the documentation generally must be in place by the due date (including extensions) for the federal tax return for the year that includes the date on which the default occurs. 80 In contrast, under the proposed regulations, the documentation had to be in place no later than 120 days after the date on which payments of principal or interest were made and the date on which a default occurred. 81 C. Exceptions There are three exceptions to the documentation rules. First, the final regulations retain the proposed regulations reasonable cause exception. 82 If reasonable cause for failure to comply with the documentation rules regarding an EGI is established, the taxpayer must prepare the necessary documentation within a reasonable time of establishing reasonable cause and maintain that documentation in accordance with the documentation rules. 83 Second, the final regulations add a new exception for highly compliant taxpayers. 84 If that requirement is satisfied, the noncompliant EGI is not automatically recharacterized as stock but is instead presumed to be stock. 85 A taxpayer can rebut that presumption if 78 Reg. section (c)(2)(iv)(B)(2). 79 Reg. section (c)(4)(ii)(C)(1). 80 Reg. section (c)(4)(ii)(C)(2). 81 Prop. reg. section (b)(3)(i), (ii)(c), and (ii)(d). 82 Reg. section (b)(2)(ii). A taxpayer may establish a reasonable cause for failure to comply with the documentation rules under the principles of reg. section Reg. section (b)(2)(ii)(A). 83 Reg. section (b)(2)(ii)(B). 84 Reg. section (b)(2)(i)(A). A taxpayer is highly compliant if (1) the average total adjusted issue price of all EGIs that are undocumented and outstanding as of the close of each calendar quarter is less than 10 percent of the average amount of total adjusted issue price of all EGIs outstanding at that time, or (2) no undocumented EGI during the calendar year has an issue price exceeding (A) $100 million and the average total number of undocumented EGIs is less than 5 percent of the total number of EGIs outstanding at the close of each calendar quarter, or (B) $25 million and the average total number of undocumented EGIs is less than 10 percent of the total number of EGIs outstanding at the close of each calendar quarter. Reg. section (b)(2)(i)(B). 85 Reg. section (b)(2)(i)(A). 986 TAX NOTES, February 20, 2017

10 it clearly establishes that the EGI should be characterized as debt under common law. 86 The final regulations do not provide any detail regarding how a taxpayer can clearly establish that an EGI is debt under common law. In many cases this ambiguity will be moot, because it may be difficult for taxpayers to satisfy the standards to be considered highly compliant in the first instance. If the presumption is rebutted, the characterization of the EGI as debt or stock is made by reference to common law factors, with significant weight attached to the four factors described in the documentation rules. 87 Third, the final regulations add a new scrivener s error exception that allows a taxpayer to self-correct ministerial or nonmaterial failure or error before IRS discovery. 88 The new exceptions soften what many commentators believed was an unnecessarily narrow reasonable cause exception in the proposed regulations Id. 87 Reg. section (b)(2)(i)(C) and (b)(3). 88 Reg. section (b)(2)(iii). 89 Preamble to T.D. 9790, 81 F.R. at Reg. section (e)(3)(i). 91 Id.; reg. section (e)(1). 92 Reg. section (e)(3)(ii). 93 Reg. section (e)(2). 94 Reg. section (e)(4). D. Timing Rules for Recharacterization The final regulations include rules that govern the timing of when an EGI is treated as stock under the documentation rules. First, an EGI is treated as stock ab initio if the applicable interest was an EGI when issued. 90 Second, if an applicable interest was not an EGI when issued, the documentation rules apply once the interest becomes an EGI and, if treated as stock under the documentation rules, the applicable interest is treated as stock when it becomes an EGI. 91 Third, notwithstanding the above, if the EGI is treated as stock from a post-issuance failure to comply with the debtor-creditor relationship documentation requirement, it is treated as stock when the facts and circumstances indicate that the behavior of the issuer and holder ceased to demonstrate a debtor-creditor relationship. 92 In contrast, if an EGI treated as stock under the documentation rules ceases to be an EGI, it is characterized as debt or stock under general federal tax principles when the instrument ceases to be an EGI. 93 Similar timing rules apply when an EGI issued by a disregarded entity is determined to be stock, except that the owner of the disregarded entity, not the entity itself, is treated as issuing the stock (either ab initio or in exchange for the EGI). 94 The proposed regulations provided that an EGI issued by a disregarded entity that was treated as stock under the documentation rules was equity of the entity. Thus, if the proposed regulations documentation rules were not satisfied regarding the disregarded entityissued EGI, the disregarded entity became a partnership for federal tax purposes. 95 The removal of this springing partnership issue is a reasonable change because it caused unnecessary complexity and could have resulted in adverse results (for example, a springing partnership could cause deconsolidation of a domestic corporation legally owned by the disregarded entity). A. In General COMMENTARY / SPECIAL REPORT V. The Recast Rules The recast rules reflect Treasury and the IRS s position that a related-party debt instrument issued in a transaction in which there is not a new capital investment in the issuer lacks sufficient nontax purpose and thus should not be respected as debt for federal tax purposes. 96 To this end, the recast rules treat a related-party debt instrument as stock if it is issued in a distribution or a transaction that is economically similar to a distribution that does not result in new investment in, or a significant change in the ownership of, the issuer. The recast rules apply to a covered debt instrument (CDI), which generally is a debt instrument issued after April 4, 2016, by a covered member. 97 The regulations include several exceptions to the CDI definition that were not in the proposed regulations. First, a debt instrument is not a CDI if it is (1) issued to, or acquired by, a securities dealer in its ordinary course of business and held by the dealer for resale to customers, or (2) specifically characterized as debt under particular code provisions (for example, a regular interest in a real estate mortgage investment conduit or a debt instrument that arises under a transfer pricing adjustment). 98 Second, a debt instrument is not a CDI if it is issued by specified regulated financial or insurance companies Prop. reg. section (c)(5). 96 Preamble to T.D. 9790, 81 F.R. at ; preamble to REG , 81 F.R , at (Apr. 8, 2016). 97 Reg. section (g)(3)(i). 98 Reg. section (g)(3)(ii) and (iii). Other instruments that are specifically characterized as debt under the code and not considered CDIs are production payments treated as loans under section 636(a) or (b), stripped bonds and coupons described in section 1286, and leases treated as loans under section 467. Reg. section (g)(3)(ii). 99 Reg. section (g)(3)(i). A debt instrument is not a CDI if it is issued by an excepted regulated financial company or a regulated insurance company. Id. TAX NOTES, February 20,