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
Important Opportunity for U.S. Employers with Employees in Canada
Some employers may benefit by acting before March 1.
(Extended from previous deadline of February 1.)
Under current Canadian law, U.S. employers are required to withhold and remit Canadian income tax for employees who work in Canada, no matter how short the assignment. Withholding is required even though there may be an exemption under the Canada-U.S. Tax Treaty.
There’s good news, though. The Canadian Government has proposed legislation in place (expected to become law in 2016) for a new exception to its withholding rules. Here are the qualifications for the exception:
- The employee working in Canada has to meet the criteria of a tax treaty with Canada to be exempt from income tax in Canada.
- The employee works in Canada for less than 45 days in the calendar year of the payment or for less than 90 days in any 12-month period that includes the time of the payment.
- The employee is employed by a non-resident Canadian employer, e.g. a U.S. employer.
- The employee is not seconded to Canada to work for a Canadian employer.
- The employee is not an economic employee of a Canadian employer.
- The U.S. employer must not carry on business in Canada through a permanent establishment.
- The U.S. employer must be certified by the Canada Revenue Agency (CRA) at the time that the payment is made.
Even though the new rule is not officially law yet, the Canadian Revenue Agency (CRA) released a form, RC 473, that nonresident (U.S.) employers can use to obtain certification. Nonresident (U.S.) employers should file the form with the CRA at least 30 days before the employee begins working in Canada. To be certified effective January 1, 2016, a nonresident employer should file form RC 473 by March 1, 2016. (This is an extension of the February 1 deadline that CRA had previously announced for certification effective January 1, 2016.) If approved, the CRA will inform the nonresident employer by letter. The approval may be granted for up to two years.
The CRA has indicated that if approved, a qualifying nonresident (U.S.) employer must:
- Track and record the number of days a qualifying employee is either working or present in Canada.
- Determine whether the employee is resident in a country with which Canada has a tax treaty (For U.S. employers, a U.S. resident employee is a resident of a country with which Canada has a tax treaty).
- File a Form T4 Summary and Information Return for employees working in Canada (not required for those earning less than C$10,000).
- Obtain a Canadian business number and a program account number if required to remit amounts to the Canadian Government.
- File all applicable Canadian income tax returns for the calendar years in which the employer is certified by CRA.