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.