Synopsis

Since the advent of the US Income Tax Code, the question of whether an interest constitutes debt or equity for US tax purposes has been the source of debate. Amid great concern and criticism, the Treasury Department published final regulations under Section 385 on October 21, 2016. These final regulations create additional guidance to consider when answering this timeless question. This Alert provides historical context for the debt/equity analysis together with a brief summary of the final regulations.

Debt vs. Equity

Historically, the question of whether an interest constitutes debt or equity for US tax purposes has been determined by reference to a multifactor test established by the US courts.[1] US courts have recognized that although “classic debt is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income” there are some variations. “Too great a variation,” however, will preclude classification as debt.[2]

Tax consequences of reclassification may include:

• Loss of interest deductions for the issuer;
• Repayments of interest and principal may be recharacterized as dividends;
• Dividends are often taxed at higher rates than interest; and
• Disruption of ownership thresholds under the Code,[3] including Section 382 (net operating loss limitations), Subpart F (controlled foreign corporations), and Section 1504 (consolidated return rules).

Multifactor Test

When evaluating whether an interest is debt or equity, the courts have focused on a number of factors including:

• Whether there is a written unconditional promise to pay a fixed amount;
• Whether repayment must be made on a specified date (or on demand);
• The priority of the obligation in relation to borrower’s other indebtedness;
• Capitalization of the borrower and its ability to repay;
• Availability of third party credit on similar terms; and
• Whether the borrower and lender are related parties.[4]

This multifactor test has been referred to as “an amorphous and highly unsatisfactory ‘smell test.’” [5]It fosters uncertainty as taxpayers and their advisors attempt to predict the results that could emanate from the patchwork of existing case law.[6] Nevertheless, this test has not stopped taxpayers from adopting their preferred classifications, or the IRS from challenging those classifications.[7]

New Regulations

Section 385 was enacted in 1969 authorizing the Treasury Department to promulgate regulations “as may be necessary or appropriate to determine whether an interest in a corporation is to be treated… as stock or indebtedness.”[8] Initial attempts at creating regulations were highly controversial, and the Treasury Department finally gave up in 1983, leaving Section 385 with little impact.[9]

Until 2016. In light of the Treasury Department’s efforts against “corporate inversions”[10] and with the larger backdrop of global coordination to combat base erosion and profit shifting (BEPS), on April 8, 2016, Treasury Department published proposed regulations under Section 385.[11] After public comments, the regulations were revised and published as final regulations on October 21, 2016.[12]

Although ostensibly issued to discourage corporate inversions, in reality, these new regulations are a general anti-earnings-stripping measure.[13] The regulations target related party loans between a US borrower and a non-US lender. Such loans may arise in the ordinary course of business[14] or as the result of reorganizations or other structuring.

As an opening principle, the regulations reinforce the existing multifactor test by providing that, in general, “whether an interest in a corporation is treated for purposes of the Internal Revenue Code as stock or indebtedness… is determined based on common law, including the factors prescribed under such common law.”[15] The regulations proceed to provide two sets of rules under which an instrument that is classified as debt under the multifactor test will nevertheless be treated as equity for federal income tax purposes. Those rules are:

1. Documentation Rule

For interests issued on or after January 1, 2018, the parties are required to have appropriate documentation in place before the due date for the US tax return (including extensions).[16] This includes copies of all documents evidencing material rights and obligations of the borrower and lender.[17] Documentation of a kind that the taxpayer uses with unrelated third parties in similar transactions (e.g., evidence of trade payables) will generally suffice, as will documentation that is required by regulators for certain financial and insurance companies.

The regulations require that specific factors be documented such as:[18]

• Unconditional legally-binding obligation to pay a sum certain;
• Holder’s rights of creditor to enforce the obligation;
• Reasonable expectation of repayment; and
• Analysis of collateral value, particularly with respect to non-recourse debt.

These rules only apply to expanded groups that include a public company; have total assets in excess of $100 million; or have total revenue in excess of $50 million.[19] There are limited exceptions for noncompliance (i) that is de minimis; (ii) when the taxpayer has reasonable cause; or (ii) that is ministerial in nature if remedied by the taxpayer before discovered by the IRS.[20]

2. Distribution Rules

If an instrument is considered debt under the multifactor test and otherwise complies with the documentation rules, it will nevertheless be considered equity if the distribution rules apply. Broadly speaking, the distribution rules seek to recharacterize instruments that are issued to a related party in a situation that does not result in any new investment in the operations of the issuer. In general, these rules apply to debt issued after April 4, 2016 by a US domestic corporation to a related party if the issuer is not an excepted financial or insurance company.[21]

Under these rules, the covered debt is reclassified as stock to the extent issued in connection with a distribution, in exchange for stock of a group member, or in exchange for property in certain asset reorganizations.[22] There is also a “funding rule” which attempts to reclassify debt that is issued to a related party in exchange for property if treated as funding an acquisition or distribution during a six year “per se” period.[23]

These rules do not apply if the aggregate adjusted issue price of covered debt instruments is less than $50 million.[24] There are also exceptions for compensatory stock acquisitions, transfer pricing adjustments, and acquisitions in ordinary course of business by dealer in securities.[25]

Government Opposition and Impact on Businesses

With the recent issuance of these regulations, the future of debt/equity determinations in the US is in a state of flux. Affected businesses are expected to expend considerable effort and funds in compliance costs and restructuring. Furthermore, members of the US Congress and various commentators have questioned the validity of the regulations,[26] including Senate Finance Committee member Dean Heller. Other congressional Republicans, who have generally complained about the scope of the rules as well as the administration’s speed in proposing and finalizing them, have suggested they might invoke the Congressional Review Act to overturn Treasury’s action.

In the meantime, we can expect to see businesses spending several years updating their compliance protocols, while the courts determine the lasting effects of these new regulations. As of the date of this Alert, all we can say for certain is that this story is to be continued…

[1] E.g., Gilbert v. Comm’r, 248 F.2d 399 (52 AFTR 634) (2d Cir 1957); American Metallurgical Co v. Comm’r, TC Memo. 2016-139 (2016).

[2] Gilbert at 637-638 (internal citations omitted).

[3] Unless otherwise indicated, all section references are to the US Internal Revenue Code of 1986, as amended (“Code”) and Treasury Regulations promulgated thereunder.

[4] Estate of Mixon v. U.S., 464 F.2d 394 (30 AFTR 2d 72-5094) (5thCir 1972).

[5] Stephen A. Lind et al., Fundamentals of Corporate Taxation 140 (7th Ed. 2008).

[6] E.g., Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders (WG&L) at ¶4.05.

[7] E.g., American Metallurgical, supra.

[8] Public Law 91-172, § 415(a) (1969)

[9] See e.g., T.D. 7920, 1983-2 C.B. 69 (1983) and Full Service Beverage Co., et al v. Comm’r, TC Memo 1995-126 (1995) (explaining history of the Section 385 regulations).

[10] Corporate inversions are transactions undertaken by US-based multinationals that result in redomestication of the parent company outside of the US. Although there can be non-tax reasons for an inversion, significant tax benefits can often be achieved.

[11] REG-108060-15, 81 FR 20912 (April 8, 2016). See also Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations (April 4, 2016) available at https://www.treasury.gov/press-center/press-releases/Pages/jl0404.aspx.

[12] TD 9790, 81 FR 72858 (October 21, 2016). See also Treasury Issues Final Earnings Stripping Regulations to Narrowly Target Corporate Transactions That Erode U.S. Tax Base (October 13, 2016) available at https://www.treasury.gov/press-center/press-releases/Pages/jl0580.aspx.

[13] The US already has earnings-stripping rules under Section 163(j).

[14] The Treasury Department included exceptions to help reduce the effect on some ordinary course transactions, such as short-term cash pooling arrangements.

[15] Treas. Reg. § 1.385-1(b).

[16] Treas. Reg. § 1.385-2.

[17] Treas. Reg. § 1.385-2(c)(1).

[18] Treas. Reg. § 1.385-2(c)(2).

[19] Treas. Reg. § 1.385-2(a)(3)(ii).

[20] Treas. Reg. § 1.385-2(b)(2)(i)-(iii).

[21] See Treas. Reg. § 1.385-3(g)(3) (covered debt instrument).

[22] Treas. Reg. § 1.385-3(b)(2) (general rule).

[23] Treas. Reg. § 1.385-3(b)(3) (funding rule); -3(b)(3)(iii)(A) (per se period).

[24] Treas. Reg. § 1.385-3(c)(4).

[25] Treas. Reg. § 1.385-3(c) (exceptions).

[26] E.g., House of Representatives, Committee on Ways and Means, Letter to Treasury Secretary Jacob Lew (June 28, 2016) (expressing “surprise” and stating that the proposed regulations are beyond Congressional intent for Section 385). Available at: http://waysandmeans.house.gov/wp-content/uploads/2016/06/20160628_WM-Reps_Lew_385-Regs.pdf.