Avoid Unintended Results from Complex New Rules for Intercorporate Debt
In April 2016, the Treasury Department and the IRS issued proposed regulations under Sec. 385. If the proposed regulations are finalized, they will change the way that corporate groups treat intercompany debt. Issued along with guidance on corporate inversions, the new proposed Sec. 385 regulations target transactions that increase debt between related parties where there is no new investment in the U.S.
Following a corporate inversion or a foreign takeover of a U.S. company, a U.S. subsidiary can issue debt to its foreign parent which in turn transfers the debt to a foreign affiliate located in a low-tax jurisdiction. The U.S. subsidiary will deduct the interest expense at a higher tax rate than the tax rate paid on the interest income received by the foreign affiliate. The foreign affiliate may even implement tax strategies to avoid paying any tax on the interest income.
The new proposed regulations will make it more difficult for companies to engage in transactions described above as well as impact the U.S. tax treatment of cross-border loans between affiliated members of a multi-national enterprise, loans between commonly controlled U.S. corporations not filing a consolidated tax return, and loans between members of brother-sister U.S. consolidated return groups. The new proposed regulations will not impact loans between members of a single consolidated return group.
The new proposed regulations will do the following:
- Impose new documentation and reporting requirements that must be complied with on a timely basis (defined in the new proposed regulations). If the requirements are not met, the purported debt instrument will be characterized as stock for U.S. tax purposes. A reasonable cause exception applies.
- Allow the IRS to treat a debt instrument issued between members of a modified expanded group as part debt and part stock to the extent dictated by the relevant facts and circumstances. A modified expanded group is based on the affiliated group principles of Sec. 1504(a) modified with a 50% ownership requirement with the common parent and includes domestic and foreign corporations, RICs, REITs, S corporations, partnerships, trusts and estates, and individuals that own at least 50% of the stock or interests in a modified expanded group member.
- Require recharacterization of certain debt instruments to equity. Debt instruments issued in the following situations will be recast as stock:
Debt issued by a corporation to a related corporate shareholder as a distribution
Debt issued in a two-step version of the corporate distribution where a U.S. subsidiary borrows cash from a related company and pays a cash dividend to its foreign parent
Debt issued by a corporation in exchange for stock of an affiliate, e.g. the repurchase of shares for a note or the purchase of affiliate shares for a note in what would otherwise be a Sec. 304 transaction
Certain debt issued as part of an internal asset reorganization if the instrument is received by a corporate transferor that is a modified expanded group member with respect to its transferor corporation stock. The definition of an expanded group member is derived from the affiliated group rules of Sec. 1504(a) and includes foreign and domestic corporations related by at least 80% (vote or value) direct or indirect common parent ownership. Note that an expanded group for these purposes is different than a modified expanded group mentioned above in the “part debt and part stock” rule.
Exceptions to the Rule
There are certain exceptions to the application of the new proposed regulations. The exceptions are provided for small companies that are not publicly traded, groups with less than $50 million of intercompany debt, and for routine distributions such as the distribution of current year earnings and profits.
The new proposed regulations apply to debt instruments issued or deemed issued after April 4, 2016. Intercompany debt instruments that are subject to recharacterization will continue to be treated as debt for 90 days after the issuance of final regulations. Thereafter, these debt instruments will be considered to be equity. Debt instruments issued before April 5, 2016 are grandfathered, but will be subject to the final regulations if they are significantly modified after April 4, 2016.
The new proposed regulations under Sec. 385 are complex and require careful analysis. Taxpayers should make sure they understand the impact of these new rules on all intercorporate debt transactions so that they don’t end up with unintended results. Contact us to discuss your specific situation.View full article
By Joe Burwick, CPA
Crowdfunding is not a new concept, as grassroots fundraising dates back to 1997. But with new platforms, like that of IndieGoGo and Kickstarter, crowdfunding has gained traction in raising revenues for donations, charities, and businesses.
What types are there?
Crowdfunding relies on the concept of asking large groups of organizations and individuals, to contribute to a project. There are three primary types of crowdfunding:
Donation or Reward. When people give money towards a project and receive a gift or promise of one of the finished products in return.
Debt. Receiving funding from people with the expectation they will be paid back with interest in the future.
Equity. This involves getting a large number of people to buy into an idea in return for equity in the project or business.
Depending on the structure of the transaction (Equity, Debt, or Donation/Reward) there are differing tax implications and reporting requirements. For instance, donations/rewards where the investor receives something in return is a taxable event and must be included in gross receipts. However, if deductible business expenses exceed your crowdfunding revenue and other operating revenue, then you won’t owe income tax (but may owe franchise or minimum taxes).
Depending on how the payments are received, the crowdfunding recipient may get Form 1099-K. If payments are made by credit card or if payment in settlement of third party network transactions (i.e. PayPal) where gross payments exceed $20,000 and there are more than 200 transactions, you may receive one of these forms. The IRS will look to match (and analyze) the income on your return to Form 1099-K you receive.
In response to the growing popularity of Crowdfunding, the JOBS act set the Crowdfunding exemption for equity interest offered to the public at a ceiling of $1,000,000 for the aggregate amount sold to all investors in a twelve month period. Prior to this act you had to either register with the SEC or meet another exception before offering securities to the public.
The act further limits the amount sold to any individual investor based upon their annual income or net worth as follows:
If annual income or net worth is less than $100,000; the aggregate amount sold to such investor cannot exceed $2,000 or 5 percent of net worth / annual income.
If annual income or net worth is greater than $100,000 the aggregate amount sold to such investor cannot exceed ten percent of the annual income or net worth of the investor (not to exceed a maximum aggregate amount of $100,000).
You should consult a tax advisor to determine if the amounts received can be excluded from income (i.e. under Internal Revenue Code Section 118 for a Corporation).
What are the Financial Reporting Requirements?
Not only are there potential tax implications to these equity investments, but you must meet various financial reporting requirements as well. Here is what you have to know to meet the financial condition requirements clause of the JOBS act:
Different offering amounts have different SEC financial reporting standards. Congress has set forth the standards as follows:
If the target offering is $100,000 or less, the most recently completed income tax return and financial statements certified by the principal executive officer of the issuer must be provided.
If the target offering is more than $100,000, but not more than $500,000, financial statements reviewed by a public accountant independent of the issuer must be provided.
If the target offering is $500,000 or more, audited financial statements reviewed by a public accountant independent of the issuer must be provided.
As new provisions of the JOBS Act are rolled out, it seems to have raised more questions than answers for entrepreneurs and online start ups. While the bill was designed to help companies tap investors for the early cash they need to get established and hire workers, easing federal requirements for completing private share offerings; a young company would then be bound by SEC rules protecting the rights of their new stockholders, as well as certain state laws.
Don’t expect state security regulators to ease up anytime soon. As crowdfunding gains traction (and the dollars associated with it grow), so too will the scrutinizing of start-ups that issue shares through crowdfunding. Due to the complexities of parts of the JOBS Act and SEC rules toward crowdfunding, entrepreneurs should talk to a tax consultant; to be aware of all the state and federal regulations and the impact it may have at tax time.
Freed Maxick CPAs
Freed Maxick tax auditors will keep you up to date on the most pressing tax issues. If you would like to know how crowdfunding may affect your business at tax time Contact us and connect with our experts.