On April 4, 2016, the U.S. Department of the Treasury announced the release of new temporary and proposed regulations aimed at curbing the practice of inversions by domestic taxpayers to comparatively low-tax foreign jurisdictions. The temporary regulations include rules under section 7874 (Congress’s 2004 response to inversions) and several other sections of the Code to address technical aspects of various techniques taxpayers have used to avoid the purposes of section 7874 and to reduce the U.S. federal income tax liabilities of inverted companies following an inversion.
The proposed regulations (“Proposed Regulations”) were issued under section 385, which authorizes the Secretary to prescribe regulations to determine whether an interest in a corporation is to be treated as stock or indebtedness for tax purposes. Although the Proposed Regulations were issued as part of Treasury’s anti-inversion agenda to prevent earnings stripping, these rules would override the common-law debt/equity framework in a wide range of cross-border and purely domestic settings. The rules would conclusively treat debt instruments as equity for tax purposes when they are issued in certain related-party situations or are held by certain related parties and not supported by specifically required documentation. Treasury has stated its intent to move swiftly to finalize these rules.
The rules generally apply to any debt instrument issued by a member of an “expanded group” and issued to or held by another member of such expanded group. An “expanded group” means an “affiliated group” under section 1504(a) of the Code expanded to include (1) foreign corporations, tax exempt corporations, S corporations, REITs, and other types of corporations otherwise excluded from an “affiliated group” under section 1504(b); (2) includible corporations for which either the 80% total voting power or 80% total value stock ownership test is met (relaxing the requirement that both tests be met); and (3) a common parent corporation that may only indirectly satisfy the stock ownership tests (relaxing the requirement that such ownership be direct in at least one other corporation). Importantly, because all members of a consolidated group (i.e., an affiliated group that files a consolidated return) are treated as a single corporation under the Proposed Regulations, a consolidated group does not constitute an expanded group.
Partnerships in which expanded group members own in the aggregate at least an 80% interest in capital or profits are included in the expanded group for purposes of the documentation requirements, and the assets and liabilities of such a controlled partnership are treated as held proportionately and directly by the relevant expanded group members for purposes of the other debt reclassification rules.
Under the Proposed Regulations, with certain exceptions, a debt instrument may be conclusively treated as stock, regardless of any traditional debt/equity factors, when
- the instrument is issued to an expanded group member (1) as a distribution; (2) as consideration for acquiring the stock of an expanded group member; (3) in exchange for property in a type-A, C, D, F, or G reorganization (an “asset reorganization”), but only to the extent the instrument is distributed to or exchanged with an expanded group member with respect to that member’s stock in the asset-transferor; or (4) in exchange for property with a principal purpose of otherwise funding a distribution, acquisition, or exchange among expanded group members similar to (1), (2), or (3) above (the “Funding Rule”); or
- the instrument is held by a member of the same expanded group as the issuer and a taxpayer that characterizes it as debt fails to provide, upon request by the Commissioner, complete and contemporaneously prepared documentation under several enumerated categories of requirements that correspond to traditional debt/equity factors (e.g., evidence of an unconditional obligation to pay a sum certain, reasonable expectation of repayment, etc.).
A debt instrument is treated as stock if it is issued with a principal purpose of avoiding the application of these rules—for example, when a debt instrument is issued to, and later acquired from, a person that is not a member of the issuer’s expanded group with a principal purpose of avoiding the rules. Conversely, these recharacterization rules do not apply to a transaction entered into with a principal purpose of reducing the federal tax liability of the taxpayer or another person (i.e., by avoiding a debt classification). Additionally, the Commissioner is given power under the Proposed Regulations to bifurcate an instrument subject to these rules and treat the instrument partially as indebtedness and partially as stock in circumstances he deems appropriate—for example, when there is a reasonable expectation of repayment as to only a portion of a principal amount. This bifurcation power extends to instruments issued among members of an even broader group, namely, the expanded group as described above, but using a 50% ownership threshold instead of 80%.
The documentation requirements would apply starting on the date final regulations are published, and the other classification rules would apply to debt instruments issued on or after April 4, 2016, but with classification as stock under such rules delayed until 90 days after publication of final regulations.
Following is a more detailed discussion of the rules that could trigger classification of an instrument as stock under the Proposed Regulations.
A debt instrument is treated as stock to the extent it is issued by a corporation to a member of the corporation’s expanded group in a distribution. “Distribution” means any distribution by a corporation with respect to its stock, including a distribution in exchange for such stock (i.e., a redemption) and regardless of whether the distribution is treated as a dividend for tax purposes.
According to the preamble to the Proposed Regulations, this treatment of instruments issued as distributions is intended to foreclose treatment as debt in situations similar to that in Kraft Foods Co. v. Comm’r, 232 F.2d 118 (2nd Cir. 1956), where a controlled subsidiary effectively directed a portion of its earnings to its loss-generating parent (with which it did not file a consolidated return) by issuing debt to the parent as a distribution. The preamble asserts that treating the instrument as stock rather than debt is justified by the lack of new capital investment in connection with such an issuance, the potential for abuse in the related party context, and the “typical lack of a substantial non-tax business purpose” for such an issuance.
A debt instrument is treated as stock to the extent it is issued by a corporation to a member of the corporation’s expanded group in exchange for expanded group stock, other than in an “exempt exchange” described below. This rule applies regardless of whether the expanded group stock is acquired from a shareholder of the issuer of the acquired stock or directly from such issuer, and it applies in deemed exchanges such as a contribution to a wholly-owned subsidiary where the issuance of additional subsidiary stock would be meaningless. The preamble notes the economic similarity of such purchases of affiliate stock to the distributions addressed above, so Treasury deems this rule necessary to avoid circumvention of the distribution rule.
An exempt exchange is an acquisition of expanded group stock in which the transferor and transferee of the stock are parties to an asset reorganization (i.e., a type-A, C, D, F, or G reorganization) and either (1) section 361(a) or (b) applies to the transferor of the expanded group stock (if the stock is not transferred by issuance) or (2) section 1032 or Treas. Reg. § 1.1032-2 applies to the transferor of the expanded group stock (if the stock is transferred by issuance) and the stock is distributed by the transferee pursuant to the plan of reorganization. Though technical, generally the concept of an exempt exchange exists to funnel analysis of asset reorganizations to the rules discussed below, which include certain further conditions in order to trigger a recharacterization. But not all stock acquisitions in connection with asset reorganizations are exempt exchanges. For example, where a parent contributes a note and parent stock to a subsidiary for use by the subsidiary in a triangular C reorganization among expanded group members, the section 351 exchange of the parent’s note for the subsidiary’s stock is not an exempt exchange.
A debt instrument is treated as stock to the extent it is issued by a corporation to a member of the corporation’s expanded group (1) in exchange for property in an asset reorganization (i.e., a type-A, C, D, F, or G reorganization), but only to the extent (2) the instrument is distributed to or exchanged with an expanded group member (as determined immediately before the reorganization) with respect to that member’s stock in the asset-transferor. The second requirement is intended to cover situations where a shareholder receives boot in either a divisive or an acquisitive asset reorganization.
The preamble notes that internal asset reorganizations can operate in a similar manner to stock acquisitions as a device to convert what otherwise would be a distribution into a sale or exchange transaction without having any meaningful non-tax effect. In particular, the preamble offers the following example of a D reorganization subject to these rules. A foreign parent corporation (Parent) owns all of the stock of two U.S. subsidiaries, S1 and S2. In a transaction qualifying as a D reorganization, Parent transfers its stock in S1 to S2 in exchange for a note issued by S2, and S1 converts to a limited liability company. This transaction has a similar effect as a transaction in which S2 issues a debt instrument to Parent in exchange for S1 stock, with the only difference being that S2 acquired the assets of S1 instead of the S1 stock and Parent received the debt instrument as a result of the liquidation of S1. No new capital is introduced into the group, and ultimate ownership of the assets held by S1 and S2 is unaffected.
When a debt instrument is classified as stock pursuant to this rule, that classification may alter analysis of the taxability of receipt of the debt instrument in the reorganization. For example, an instrument that otherwise would be treated as boot under section 356 might instead be classified as stock upon issuance under this rule; consequently, receipt of the instrument would be tested for qualification under section 355.
The preamble explains that the policy concerns implicated by the transactions described above also arise when a corporation issues a debt instrument to a related party with a principal purpose of funding a distribution or an acquisition similar to those described above. Thus, under the Proposed Regulations a debt instrument is treated as stock to the extent it is issued by a corporation to a member of the corporation’s expanded group with a principal purpose of funding one or more of the following transactions (which generally mirror the distributions and acquisitions discussed above):
- a distribution of property by the funded member to a member of the funded member’s expanded group, other than a distribution of stock pursuant to an asset reorganization that is permitted to be received without the recognition of gain or income under section 354(a)(1) or 355(a)(1) or, when section 356 applies, that is not treated as boot;
- an acquisition of expanded group stock, other than in an exempt exchange (see above under “Stock Acquisition”), by the funded member from a member of the funded member’s expanded group in exchange for property other than expanded group stock; or
- an acquisition of property by the funded member in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the funded member’s expanded group immediately before the reorganization receives boot with respect to its stock in the transferor corporation.
Subject to certain exceptions, references to the funded member for purposes of this rule include references to any predecessor or successor of such member.
Determination of the principal purpose for an issuance generally is based on all the facts and circumstances. However, in what may be their most contentious provisions, the Proposed Regulations set forth rules based on the timing of the relevant transactions to irrebutably deem the principal purpose requirement as met. If an expanded group debt instrument is issued by the funded member in the period beginning 36 months before and ending 36 months after the funded member makes a distribution or acquisition described in the list above, the principal purpose requirement is irrebutably presumed to be met (the “72 Month Rule”). The preamble justifies this per se rule by noting the fungibility of money and the difficulty for the IRS to establish the principal purpose of these types of internal transactions. As a measure of relief, certain ordinary course debt instruments are exempt from the 72 Month Rule, including ordinary course extensions of credit for the sale of inventory and the receipt of services (but not including intercompany financing or treasury center activities). Also, transactions that occurred before April 4, 2016, are not considered under the 72 Month Rule.
Note that, in addition to the exceptions listed below, the second prong of the Funding Rule is subject to an exception for funded acquisitions of subsidiary stock through an issuance. An acquisition of expanded group stock would not be treated as an acquisition under the second prong if (1) the acquisition results from a transfer of property by a funded member (the transferor) to an issuer (of stock) in exchange for stock of the issuer, and (2) for the 36-month period following the issuance, the transferor holds, directly or indirectly, more than 50% of the total combined voting power of all classes of stock of the issuer entitled to vote and more than 50% of the total value of the stock of the issuer.
Exceptions to Stock Classification
There are two rules that operate as exceptions to stock classification under the above provisions (but not the documentation requirements discussed below).
First, a debt instrument is not classified as stock under such rules if, immediately after it is issued, the aggregate adjusted issue price of all debt instruments held by expanded group members that would otherwise be subject to such rules is $50 million or less. However, once this threshold is exceeded, this exception will not apply to any debt instrument issued by members of the expanded group for so long as any debt instrument remains outstanding that was previously treated as debt for tax purposes solely because of this exception.
Second, in determining whether a distribution or acquisition triggers a stock classification, the aggregate amount of distributions and acquisitions of a group member are reduced by that member’s current-year earnings and profits. This reduction is applied to various transactions of a corporation based on the order in which the transactions occur. No reason is given for limiting the E&P exception to current-year amounts, but comments in the preamble suggest that Treasury’s policy concerns are separate and apart from the existence of E&P and that an exception tied to current-year E&P merely serves to accommodate ordinary course distributions and acquisitions.
The Proposed Regulations establish contemporaneous documentation requirements that must be satisfied to support the debt characterization of instruments issued by one expanded group member and held by another. In general, taxpayers would be required to prepare the specified documentation within 30 days from the relevant event dates and would be required to maintain ongoing documentation of specified events throughout the term of the instrument and until the limitations period expires for any return for which the treatment of the instrument is relevant.
If such documentation is not timely prepared, maintained, and delivered to the IRS on request, the instrument would be treated as stock for federal tax purposes. This requirement is a necessary but not sufficient condition in order for an instrument to be respected as debt—even if a taxpayer complies with the documentation requirements, the instrument would still be characterized as either stock or debt under general federal tax principles.
Under the rules, an issuer seeking to characterize an instrument as debt would be required to maintain documentation establishing: (1) an unconditional obligation to pay a sum certain; (2) creditor’s rights to enforce the terms of the debt, including a right senior to equity holders; (3) a reasonable expectation that the issuer can repay advanced funds (e.g., cash flow projections or other relevant financial data); and (4) any actions taken that evidence an ongoing genuine debtor-creditor relationship (e.g., evidence of timely payments and evidence of the creditor acting as a reasonable creditor in the event of a default, such as through enforcement attempts or renegotiation of terms). Additional specific documentation requirements apply for revolving credit agreements and cash pooling agreements. A reasonable cause exception is available for non-compliance with these requirements.
The documentation requirements apply only to expanded groups for which (1) the stock of any member of the expanded group is traded on (or subject to the rules of) an established financial market or (2) on the date an instrument first would otherwise be subject to these documentation requirements, total assets in excess of $100 million or total annual revenue in excess of $50 million have been reported on a financial statement that includes assets or revenues of any member of the expanded group and that is required by the SEC or otherwise within the prior three years.
Timing of Classification and Tax Treatment of Reclassification
Subject to the effective date provisions noted below, a debt instrument treated as stock under the Proposed Regulations because it is issued in a distribution, stock acquisition, or asset reorganization or is subject to the Funding Rule generally will be treated as stock from the time of issuance. Similarly, a debt instrument that upon issuance is held by a member of the same expanded group as the issuer and is treated as stock because of failure of the documentation requirements generally will be treated as stock from the time of issuance.
When the 72 Month Rule applies to treat an instrument initially respected as debt as funding a distribution or acquisition in a year subsequent to issuance, the debt instrument is deemed to be exchanged for stock when such distribution or acquisition occurs. Similarly, when the threshold exception ceases to apply to an instrument initially respected as debt or acceptable documentation of an ongoing debtor-creditor relationship ceases to be produced, a deemed exchange of debt for stock occurs at such time. The holder is treated as having an amount realized equal to the holder’s adjusted basis in the debt instrument as of the date of the deemed exchange (and as having basis in the stock deemed to be received equal to that amount), and the issuer is treated as having retired the debt instrument for an amount equal to its adjusted issue price as of the date of the deemed exchange. Neither party accounts for any accrued but unpaid qualified stated interest on the debt instrument as of the time of the deemed exchange.
If a debt instrument that is treated as stock is transferred outside of the expanded group, the issuer is treated as issuing at such time a new debt instrument to the holder in exchange for the debt treated as stock.
The documentation requirements would apply starting on the date final regulations are published. The other classification rules would apply to debt instruments issued on or after April 4, 2016, with the classification of an instrument as stock under such rules delayed until 90 days after the date final regulations are published. Thus, there would be a transition period during which taxpayers may repay or otherwise eliminate related-party debt instruments that could be treated as stock.
Although the Proposed Regulations are at least partially a response to inversions and redomiciliations, it is clear that the rules as proposed would have a sweeping and severe impact on a much wider range of related-party financing transactions. These rules would apply not only to new issuances but also to existing instruments that become held by parties absorbed in the broad definition of “expanded group.” As a consequence of the draconian 72 Month Rule, any corporate distribution, related-party stock acquisition, or intra-group asset reorganization could automatically preclude a debt characterization for related-party financing transactions over a six-year period unless an exception applies. Large issuers must produce and maintain the specified documentation, which in some cases will require the generation of new types of documents, while being mindful of the time deadlines.
Again, Treasury has stated its intent to swiftly finalize the Proposed Regulations. Due to their aggressive approach and highly technical rules, it is uncertain whether the Proposed Regulations will be finalized and, if so, whether the final rules will be substantially unaltered. Well-advised taxpayers who are planning or have recently engaged in a transaction discussed above should consider the potential effects under the Proposed Regulations on any relevant debt relationships in which the holder and issuer are related but are not members of the same consolidated group. There may be little time to understand the operation of these important rules before they apply.
This update is intended only to provide a general summary of certain tax provisions and not to constitute tax advice for any particular situation. If you have any questions about any of these tax provisions or their applicability to your particular circumstances, please contact any of the authors of this update.