June 13, 2016
Reclassification of Related Party Corporate Debt – Treasury Proposes New Section 385 Regulations
By Douglas Nakajima, Director, Tax & Business
On April 4, 2016, The US Treasury and the IRS proposed new regulations pursuant to IRSr Section 385. Although announced as part of the ongoing effort to curb corporate inversions, the proposed regulations focus on related-party corporate indebtedness and, if made effective without significant changes, will have far-ranging impact on corporate ownership and capital structures well beyond the inversion-focused motivation. The new rules will have implications for the treatment of corporate interests in the targeted cross-border environment, but also in a number of purely domestic situations.
Under Section 385's grant of statutory authority to regulate whether an interest in a corporation is to be treated as stock or indebtedness, Treasury crafted a "game-changing" rule-set that would:
- Treat as stock certain related-party interests that would otherwise be treated as indebtedness for federal tax purposes;
- Authorize the Commissioner to treat certain related party interests in a corporation as part-stock and part-indebtedness for federal tax purposes; and
- Require extensive, contemporaneous documentation for the related-party corporate interests to be treated as indebtedness for federal tax purposes.
In contrast to prior regulatory and judicial approaches to determining the character of a corporate interest that relied on a facts and circumstances analysis of certain listed factors, the proposed regulations employ fixed standards, "irrefutable" presumptions, and "conclusive" treatment, to define the federal tax treatment. At least at the outset, the proposed rules target only large corporations; debt instruments are not considered under these proposed regulations if, at the time of issuance, the aggregate issue price of all such debt instruments does not exceed $50 million. However, it should be well-noted that the statutory directive of Section 385 did not limit its coverage to large dollar corporate interests.
Businesses new and old are faced with the foundational question of how best to fund their operations. Equity financing provides a level of certainty, although practically limited in scope and duration; debt financing expands the availability of funding sources, albeit at a cost for the borrowed funds as well as a de facto shared interest in the business. Moreover, debt financing affords distinct tax advantages in the deductibility of interest and the nontaxable repayment of principal. IRS and state tax authorities have been challenged with the determination of the tax treatment of the corporate interest and how to establish the parties' intentions and, where possible, to overturn the legal form of the interest.
Congress enacted Section 385 as part of the Tax Reform Act of 1969, to define the federal tax treatment of a corporate interest as stock or indebtedness. However, Congress essentially delegated its rule-making authority to the Treasury Department, authorizing Treasury to prescribe regulations "necessary or appropriate to determine whether an interest in a corporation is to be treated… as stock or indebtedness (or in part stock and part indebtedness)." The Congressional mandate to establish factors to indicate whether a debtor-creditor relationship or a corporate-shareholder relationship exists remains unfulfilled. Despite attempts at fashioning factors based on prescribed debt-to-equity standards, earlier regulatory proposals met with heavy criticism and were eventually withdrawn. No subsequent attempts have been made and there are no current regulations in effect under Sections 385.
The proposed regulations apply to related-party corporate interests, with their target being excessive related-party intercompany debt in a multinational setting. Presumably, this provides the necessary connection to (and draws popular support from) the anti-inversion frenzy in Washington. However, the preamble to the regulations specifically states that as the potential for similar abuse in domestic related-party situations exists, domestic debt instruments would be included within the scope of the proposed rules. Furthermore, consistent with the authorizing Section 385 statutory language, the proposed regulations provide for the bifurcation of related-party corporate interests between debt and equity or portions of both. For purposes of the bifurcation rule, a lower 50% threshold for determining related status applies. The bifurcation authority would generally apply to certain related-party interests issued on or after the date the proposed regulations are issued as final.
Implications, Reactions and Next Steps
The proposed regulations propose changes to the long-standing approach to characterizing debt instruments that rely on a facts and circumstances review of the debt instrument under judicially evolved factors. The relationship of the parties to the debt instrument now assume primary importance, along with the transactions and context surrounding their issuance. The consequences of reclassifying debt instruments to stock under the proposed rules may significantly increase the tax expense under a proposed financing structure and make the economics of leveraged merger and acquisition structures less viable. On a more basic level, the loss of interest deductions at the borrower level would increase their tax burden, while the potentially taxable receipt of principal repayments to the funding corporation could be create a significant added expense. Moreover, the dividend distributions received on the re-characterized equity could raise withholding tax obligations with respect to the payments.
With the potential for the effective date of April 4, 2016, for certain debt instruments, a significant chilling effect on tax planning involving any use of debt instruments will be suffered. The threat of an automatic reclassification to equity is too onerous. One significant exception is provided to exempt corporations that are members of consolidated groups from these rules.
The proposed regulations are limited to prospective application, and accordingly, should exempt most existing debt instruments/structures. However, exposures to existing interests could yet arise as the result of the modification of existing debt terms and restructuring of legal entity structures, including check-the-box elections.
The reach of these supposedly international regulations to state and local taxation is open to debate. Whether state legislatures will follow the federal lead in the characterization of the corporate interests is not assured and would likely require the adoption of the federal regulations as part of the state's tax laws, or passage of state tax provisions comparable to the proposed federal rules. The state provisions may opt to apply the reclassification rules to a threshold lower than $50 million. The differences between federal and state treatment could be significant.
Treasury and IRS have stated that they expect the proposed regulations under Section 385 to be finalized on an expedited timeframe. To prepare for their implementation, current debt held or issued with related parties that are part of the new "expanded group" should be inventoried to identify the potential scope of exposure created by the proposed regulations. Additionally, the documentation supporting the debt arrangements must be reviewed to determine whether the new documentation requirements can be satisfied; where viewed as deficient, the documentation needs to be supplemented and strengthened. The commercial viability of the debt arrangements and the capacity of the debtors to make timely payment on interest and principal should be assessed. Financial support should be gathered to address any potential challenges.
The previous history of failed Section 385 regulatory efforts and the inevitable critical frenzy that these proposed regulations have generated suggests at least the possibility that the current proposals may yet fail. However, given the "conclusive" mechanics of the new regime, replete with irrefutable presumptions and automatic equity treatment, taxpayers would be well-advised to anticipate that the new requirements and potential reclassifications will become effective in part or in whole in the relatively near-term. The time to prepare is upon us.