The State of Debt Under the Proposed Section 385 Regulations

Transcription

1 Todd A. Lard Daniel R.B. Nicholas May 5, 2016 The State of Debt Under the Proposed Section 385 Regulations

2 Overview On April 4, proposed regulations were issued under IRC 385 (the Proposed Regulations) to address concerns associated with relatedparty debt. The Proposed Regulations would treat certain related-party debt, in whole or in part, as equity for U.S. 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. Proposed Regulations could also have far-reaching effects for state income tax purposes, particularly on the deductibility of intercompany interest expenses in separate company reporting states. 2

3 Overview Proposed Regulations reaffirm the application of existing debt-equity principles in the U.S. federal income tax context, and impose additional rules for related-party debt: - New documentation rules; - Equity recast rules for related-party debt issued in connection with certain transactions; and - Bifurcation rule allows recast as part equity and part debt. Proposed Regulations prohibit affirmative use of these rules to support a particular characterization. 3

4 Documentation New documentation rules require that taxpayers prepare and maintain certain contemporaneous documents to support relatedparty debt (e.g., loan documents, analyses of the debtor s ability to repay the debt, ongoing payments), and if these rules are not met, the debt may be reclassified as equity by the IRS. Documentation must demonstrate the essential characteristics of debt: - 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. 4

5 Equity Recast Based on Specific Transactions The Proposed Regulations allow the IRS to treat certain related-party debt instruments issued in connection with certain transactions as equity for U.S. tax purposes. - Designed to target specific transactions (e.g., intragroup note distributions and economically similar transactions). - A funding rule also would treat related-party debt that is issued with a principal purpose of funding one of the specified transactions Year 1 Year 2 Year 3 CFC 1 distributes a note to U.S. Parent treated as a return of capital U.S. Parent CFC 1 CFC 2 U.S. Parent CFC 1 CFC 2 CFC 2 distributes cash to CFC 1 treated as a dividend U.S. Parent CFC 1 CFC 2 CFC 1 repays the note to U.S. Parent 5

6 Bifurcation Proposed Regulations allow the IRS to recast a related-party instrument that is in form a debt instrument as equity in part and debt in part. - IRS may bifurcate based on the facts and circumstances at the time of the instrument s issuance based on general U.S. tax principles. 6

7 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. 7

8 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. tax purposes. 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. 8

9 Potential Implications for State Income Taxes 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 base. 9

10 Separate Reporting States Separate company reporting states (i.e., states that do not adopt consolidated returns or similar rules) might seek to apply the Proposed Regulations as a tool to disallow interest deductions on intercompany debt. - 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. Separate company reporting states routinely apply the IRC and relevant IRS regulations as if each corporation had filed a separate federal tax return. - If states were to apply this approach to the Proposed Regulations, states could potentially argue that the Proposed Regulations provide authority to reclassify intercompany debt as equity and thereby deny the related interest expense deductions. Separate company reporting states may seek to adopt their own comparable regulations under other state law authority. 10

11 Add Back Statutes Many state legislatures have adopted statutes that 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, state s could attempt to deny an interest expense deduction by applying the Proposed Regulations to treat the debt as equity. - This would be particularly relevant where a states add back statute applies narrowly (e.g., only to interest related to intangible assets). 11

12 Combined/Consolidated Reporting States Proposed Regulations could impact taxpayers in states that require combined or consolidated reporting by changing the ownership percentages of subsidiaries and resulting in a different composition of the combined/consolidated group. 12

13 Franchise Taxes Net-worth-based franchise taxes generally include equity in the tax base but exclude debt. - A recast from debt to equity for state income tax purposes may carry over from income to franchise tax purposes. 13

14 Questions? Todd A. Lard Partner Sutherland Asbill & Brennan LLP T: Daniel R.B. Nicholas Counsel Sutherland Asbill & Brennan LLP T:

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