On October 13, 2016, the U.S. Department of the Treasury (“Treasury”) released final and temporary regulations under section 385, which authorizes the Secretary to prescribe regulations that set forth factors to be taken into account in determining whether an interest in a corporation is to be treated as stock or indebtedness for tax purposes.
These regulations (referred to below as the “Final Regulations” or “rules”) in large part put into effect the controversial proposed regulations that Treasury released on April 4, 2016 (the “Proposed Regulations”). As we previously discussed here, though the Proposed Regulations were part of Treasury’s anti-inversion agenda, they reached well beyond that realm to potentially override the common-law debt/equity classification framework in a wide range of cross-border and purely domestic settings. In general, the Proposed Regulations conclusively treated purported indebtedness (“debt instruments”) as stock for tax purposes when the instruments were issued in certain related-party situations or held by certain related parties and not supported by specific documentation.
In response to numerous critical comments received on the Proposed Regulations (both in writing and at a July public hearing), Treasury made a number of changes in the Final Regulations that should substantially reduce the volume of taxpayers and transactions affected by these rules as well as the compliance burdens for those subject to the documentation requirements. Although the Final Regulations continue to treat debt instruments as stock in a wide range of cross-border and purely domestic transactions involving related parties, the result is a more focused and moderated set of rules. Yet these rules remain complex and, because of the high stakes of reclassification, will often be worthy of close analysis in cases of related-party debt.
The discussion that follows is divided into four main parts:
- The first part lists the most significant changes to the Proposed Regulations.
- The second part provides an overview of the significant rules and exceptions in the Final Regulations.
- The third part briefly discusses potential state, local, and foreign income tax implications of the Final Regulations.
- The fourth part offers some concluding thoughts on the effects of the Final Regulations.
All “section” references in this article are to the Internal Revenue Code of 1986, as amended (the “Code”) or the regulations thereunder. All “tax” references are to U.S. federal taxes unless otherwise indicated.
I. Significant Changes to the Proposed Regulations
A. Overall Scope
- No longer applicable to instruments issued by foreign issuers. The Final Regulations reserve on the treatment of debt instruments issued by foreign issuers, other than foreign disregarded entities of domestic corporations. As a result, such debt instruments are completely exempt from the rules. However, debt instruments issued by domestic issuers to foreign holders may still be subject to the rules.
- No longer applicable to instruments issued by/to S corporations. Debt instruments issued by or to S corporations are completely exempt from the rules.
- No longer applicable to instruments issued by/to non-controlled REITs and RICs. Debt instruments issued by or to real estate investment trusts (REITs) and regulated investment companies (RICs), other than REITs or RICs controlled by members of an “expanded group” (essentially, an expanded affiliated group as defined in Part II below), are completely exempt from the rules.
- General bifurcation rule removed. The Final Regulations abandon the general bifurcation rule under the Proposed Regulations that would have permitted the treatment of certain debt instruments as in part indebtedness and in part stock for tax purposes.
B. Documentation Requirements
- All pre-2018 instruments now grandfathered. The documentation requirements do not apply to any debt instrument issued (or deemed issued) before January 1, 2018.
- Timely preparation deadline extended to tax return filing date. Documentation will be treated as timely prepared if it is prepared by the time for filing the issuer’s income tax return (taking into account all applicable extensions). The effect of this change, along with the grandfathering of pre-2018 instruments, is that a calendar year taxpayer will have until the filing date for its 2018 income tax return to complete the required documentation.
- No longer applicable to instruments issued by partnerships. Debt instruments issued by entities treated as partnerships for tax purposes are generally exempt from the documentation requirements. However, debt instruments held by partnerships controlled by expanded group members may still be subject to the rules.
- Documentation of ability to repay is now generally required only annually. A single credit analysis of an issuer’s maximum potential borrowing amount may suffice to document the ability to repay all of the issuer’s new debt instruments issued during the following year until such maximum borrowing amount is reached. This treatment applies not only for multiple borrowings under a single master agreement, such as cash pooling activity and line of credit advances, but also for an issuer’s aggregate borrowings from separate lenders under separate agreements.
- Upon documentation failure, presumption of equity classification may now be rebuttable. If an expanded group is otherwise highly compliant with the documentation requirements, a rebuttable (rather than per se) presumption of stock classification applies upon a documentation failure for a debt instrument.
C. Special Issuances and Funding Rule
- Expanded E&P exception. The E&P exception generally includes all the E&P of a corporation accumulated in tax years ending after April 4, 2016, while the corporation is a member of a group subject to these rules, with certain adjustments.
- Expanded access to $50 million threshold exception. The threshold exception excludes the first $50 million of indebtedness that otherwise would be reclassified regardless of whether that threshold is exceeded (i.e., without a “cliff effect” that would eliminate the entire exception).
- New offset for certain capital contributions. Certain contributions by an expanded group member to an issuer are “netted” against distributions and transactions with similar economic effect.
- New exception for equity compensation. An acquisition of stock is disregarded if the stock is delivered to employees, directors, or independent contractors as consideration for the provision of services.
- New exception for cash management arrangements and other short-term debt instruments. Deposits pursuant to a cash management arrangement as well as certain advances that finance short-term liquidity needs are exempt if certain conditions are met.
- Debt instruments issued by regulated financial groups and insurance entities now excluded. Debt instruments are exempt if issued by certain specified financial entities, financial groups, and insurance companies that are subject to a specified degree of regulatory oversight regarding their capital structure.
- Clarification that certain deemed transactions will not cause “cascading” reclassifications. The rules clarify that certain deemed stock transactions under the funding rule will not result in cascading reapplication of the funding rule to other debt instruments.
II. Overview of Final Regulations
A. Scope and Effect in General
The rules generally apply to a debt instrument issued by a domestic corporation (other than an S corporation) to a holder that is a member of the issuer’s “expanded group,” including an instrument issued or held through a disregarded subsidiary.
An “expanded group” is defined by reference to an “affiliated group” of corporations under section 1504(a), but expanded to include
- foreign corporations, tax exempt corporations, REITs and RICs (other than a REIT or RIC that would be the common parent of the expanded group), and certain other types of corporations otherwise excluded from an “affiliated group” under section 1504(b) (but not including S corporations);
- 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
- a common parent corporation that only indirectly satisfies the stock ownership tests (relaxing the requirement that such ownership be direct in at least one other corporation).
Additionally, where members of an expanded group own, directly or indirectly, at least an 80% aggregate capital or profits interest in a partnership, (1) for purposes only of the documentation requirements, such a controlled partnership is treated as part of the expanded group if it is the holder of a debt instrument issued by a member of the expanded group and (2) for purposes only of the special issuance and funding rules described below, any debt issuances or property acquisitions by such a controlled partnership generally are attributed proportionately under the aggregate theory to the expanded group members that own the partnership.
Importantly, a debt instrument issued to a member of the same consolidated group as the issuer is exempt from the rules — unless and until the instrument is transferred outside of the consolidated group (or the holder leaves the consolidated group).
The rules are extraordinarily detailed and subject to numerous exceptions, but in general a debt instrument may be conclusively treated as stock for tax purposes, regardless of any traditional debt/equity factors, in any of the following circumstances:
- Documentation failure. The instrument is held by a member of the same expanded group as the issuer, and a taxpayer that characterizes the instrument as debt fails to provide, upon request by the Commissioner, complete and timely prepared documentation under several enumerated categories of requirements which generally correspond to traditional debt/equity factors (e.g., evidence of an unconditional obligation to pay a sum certain, reasonable expectation of repayment, etc.);
- Special issuances. The instrument is issued to an expanded group member in one of the following “special issuances”:
- a distribution;
- an acquisition of stock of an expanded group member; or
- an acquisition of property in a type-A, C, D, F, or G reorganization (an “asset reorganization”), but only if, pursuant to the plan of reorganization, an expanded group member receives the instrument with respect to stock it holds in the asset-transferor; or
- Funding rule. The instrument is issued to an expanded group member in exchange for property with a principal purpose of otherwise funding a distribution, acquisition, or exchange among expanded group members similar to the special issuances described above (the “funding rule”).
As a consequence of these rules, evaluating the tax classification of a debt instrument essentially becomes a four-stage process, with an equity classification at any stage mooting the others. Listed in no particular order, the stages are
(1) analysis of the applicability and satisfaction of the documentation requirements;
(2) analysis of the applicability of the special issuance rules;
(3) analysis of the applicability of the funding rule; and
(4) analysis under the common law.
Logically these stages of analysis should be addressed in order of perceived difficulty, easiest to hardest, but that order will likely vary from case to case.
Following is a more detailed discussion of the documentation requirements, special issuance rules, funding rule, and certain operating rules in the Final Regulations.
B. Documentation Requirements
1. Delayed effective date
The documentation requirements apply only to a debt instrument issued on or after January 1, 2018. However, an instrument issued before that date could be deemed issued on or after that date if the instrument is initially held by a member of the same consolidated group as the issuer but is later assigned outside the consolidated group to an expanded group member, or the issuer or holder leaves the consolidated group but remains in the expanded group.
2. Debt instruments subject to the requirements
The documentation requirements apply only to an expanded group interest (or “EGI”), which the Final Regulations define as an interest that is either
- issued in the legal form of a debt instrument; or
- an intercompany payable and receivable documented as debt in a ledger, accounting system, open account intercompany debt ledger, trade payable, journal entry or similar arrangement if no written legal instrument or written legal arrangement governs the legal treatment of such payable and receivable;
in each case issued by a domestic corporation that is not an S corporation to a holder that is a member of the issuer’s expanded group (as defined above), including an instrument issued or held through a disregarded subsidiary or an instrument held (but generally not one issued) by a partnership that is 80% or more controlled by members of the expanded group. The Final Regulations reserve on the application of these rules to debt instruments issued by a foreign issuer.
For this purpose, an issuer is any person that is obligated to satisfy any material obligation created under the terms of the instrument, even if such person is not the primary obligor or has assumed the debt from the original issuer.
Under these rules, any debt that is not in the legal form of debt and is not an intercompany debt documented as described above is exempt from the documentation requirements. Such excluded debt includes, for example, arrangements that may be characterized as debt solely for tax purposes such as a sale-repurchase agreement or a production payment arrangement under section 636. An instrument is also exempt from the documentation requirements during the time it is held by a member of the same consolidated group as the issuer. Additionally, any instrument or interest that is specifically treated as indebtedness for tax purposes under any provision of the Code or the regulations is excluded from the documentation requirements.
The Final Regulations reserve on whether any documentation requirements apply to debt that is not in the form of a debt instrument.
3. Threshold limitation
The documentation requirements only apply to a debt instrument if, as of the date the instrument first becomes held by a member of the same expanded group as the issuer, either
- the stock of any member of the expanded group is traded on (or subject to the rules of) an established financial market; or
- total assets in excess of $100 million or total annual revenue in excess of $50 million has been reported on one or more financial statements of expanded group members within the prior three years, taking into account (without duplication) the aggregate amounts for all expanded group members reported on all financial statements required by the SEC or otherwise used for any substantial non-tax business purpose.
4. Required documentation
If, in accordance with the rules above, a debt instrument becomes subject to the documentation requirements, the instrument will be irrebuttably classified as stock for tax purposes (subject to the exceptions noted below) unless the issuer “timely” prepares, maintains, and delivers to the IRS upon request evidence of the following indications of genuine indebtedness:
- An unconditional obligation to pay a sum certain. This is established by written documentation that the issuer has entered into an unconditional and legally binding obligation to pay a fixed or determinable sum certain on demand or at one or more fixed dates. Documentation of a kind customarily used in comparable third-party transactions that are respected as debt for tax purposes (e.g., accounts payable to third-party vendors) may be used to fulfill this requirement.
- Creditor’s rights. This is established by written documentation that the holder has the rights of a creditor to enforce the terms of the obligation, including rights superior to those of shareholders to receive assets of the issuer upon dissolution. Documentation of a kind customarily used in comparable third-party transactions that are respected as debt for tax purposes may be used to fulfill this requirement. Such rights may also be provided under local law, in which case the documentation should simply reference the relevant provisions of local law.
- A reasonable expectation of the issuer’s ability to repay. This is established by written documentation that, as of the date the instrument is issued and taking into account all relevant circumstances (including all other existing and reasonably anticipated obligations), the issuer’s financial position supported a reasonable expectation that the issuer intended and would be able to meet its obligations under the instrument.
- Any actions evidencing an ongoing debtor-creditor relationship. This is established by written evidence of any payments with respect to the instrument, such as bank statements or journal entries. In the event of a missed payment or other event of default, there must be documentation of the holder’s reasonable exercise of diligence and judgment as a creditor, such as enforcement attempts, renegotiation of terms, and the reasons for any non-enforcement of rights.
Such documentation may include cash flow projections, third-party reports, evidence that a third-party lender would advance funds on similar terms, or other relevant financial documents. For a nonrecourse instrument, the documentation must include information on any cash and property that secures the instrument.
Helpfully, a single annual credit analysis of an issuer’s maximum potential borrowing amount (inclusive of existing obligations) may fulfill this documentation requirement for all of the issuer’s new obligations during the following 12-month period to the extent the maximum borrowing amount is not exceeded. However, if the issuer experiences a “material event” (e.g., a bankruptcy, change in line of business, merger, or sale of a substantial portion of certain enumerated types of assets) after the analysis date, it may not rely on such analysis to satisfy the documentation requirement for a debt instrument issued after such material event.
For cash pooling, revolving credit lines, and similar arrangements for issuing multiple debt instruments without separate documentation, additional rules apply. First, the material documentation associated with the arrangement, including all relevant enabling documents (and in the case of cash pooling, all governing documents), must be prepared and maintained. Relevant enabling documents may include director resolutions, omnibus agreements, and any documentation of initial or increased principal balances. Second, an annual credit analysis of the issuer’s maximum potential borrowing amount under the arrangement must be prepared to support a reasonable expectation of ability to repay.
Timely preparation and period of maintenance
Documentation will be treated as timely prepared if it is prepared no later than the time for filing the issuer’s income tax return (taking into account all applicable extensions) for the tax year that includes the date of the relevant transaction or credit analysis. The documentation must be maintained and updated as required throughout the period that the instrument is subject to these rules and further until the limitations period expires for all tax returns for which the tax classification of the instrument is relevant.
Ministerial or immaterial compliance errors that are corrected before they are discovered by the IRS are disregarded, and a reasonable cause exception is also available for non-compliance. Additionally, if an expanded group is otherwise highly compliant with the documentation requirements according to certain specified criteria, the classification of an instrument as stock under these rules is rebuttable.
Finally, if an issuer characterizes an instrument that is subject to the documentation requirements as indebtedness (e.g., by issuing the instrument in legal form as debt or by claiming a deduction for interest), the issuer and the holder are each required to treat the instrument as indebtedness for all tax purposes.
C. Special Issuance and Funding Rules
1. Debt instruments subject to the rules; transition period
The special issuance and funding rules described below apply only to a “covered debt instrument” issued to a holder that is a member of the issuer’s expanded group (as defined above), including an instrument issued or held through a disregarded subsidiary or by applying the aggregate theory to any partnership that is 80% or more controlled by members of the expanded group (with certain exceptions). The Final Regulations define a covered debt instrument as an interest satisfying both of the following requirements:
- such interest would, but for the application of these reclassification rules, be treated as a “debt instrument” as defined in section 1275(a) and Treas. Reg. § 1.1275-1(d) (i.e., a bond, debenture, note, certificate, or any other instrument or contractual arrangement that constitutes indebtedness under general principles of federal income tax law); and
- such interest is issued (or deemed issued) after April 4, 2016, by a domestic corporation that is not an S corporation.
However, an instrument issued to a member of the same consolidated group as the issuer is excluded — unless and until the instrument is transferred outside of the consolidated group or the holder leaves the consolidated group. Also excluded are certain dealer instruments, production payments under section 636 and other specified arrangements treated as debt under the Code or regulations, and instruments issued by certain regulated financial or insurance companies. The Final Regulations reserve on the application of these rules to debt instruments issued by a foreign issuer.
Thus, in contrast with the documentation requirements, arrangements that are not in the legal form of a debt instrument or a booked intercompany payable could trigger these rules.
Importantly, transition rules delay the reclassification of any instrument that would otherwise be treated as stock under these rules until after January 19, 2017, and such a pre-existing instrument will only then be treated as stock under these rules (subject to certain exceptions under the funding rule) if it is held immediately after January 19, 2017, by a member of the same expanded group as the issuer. This transition period gives taxpayers the opportunity to repay or otherwise eliminate instruments that could be treated as stock under the rules.
2. Special issuance rules
Subject to the exceptions noted below (including the exceptions applicable to both special issuances and the funding rule noted in part 4), a covered debt instrument will be irrebuttably classified as stock for tax purposes if it is issued in one of three types of special issuances: (1) a distribution, (2) an acquisition of stock of an expanded group member, or (3) an acquisition of property in an asset reorganization.
A covered debt instrument will be classified as stock if it is issued as a distribution. “Distribution” means any distribution by a corporation with respect to its stock and thus includes a redemption as well as a taxable or non-taxable dividend and a distribution that is treated as a return of capital or capital gain.
A covered debt instrument is treated as stock if it is issued as consideration for acquiring expanded group stock, other than in an “exempt exchange” described below. This rule could apply where the expanded group stock is acquired from the issuer of such stock or where the stock is acquired from a shareholder of such issuer.
For example, this rule could apply where a subsidiary issues a note to its parent to acquire stock owned by the parent in a sister corporation. Treasury believes that such an internal stock acquisition is economically similar to a distribution discussed above and can function as a device to convert what otherwise would be a distribution into a sale or exchange without any meaningful non-tax effect (i.e., no new capital is introduced into the group and the beneficial ownership of the transferred stock does not change). Accordingly, Treasury deems this rule necessary to avoid circumvention of the distribution rule.
An exempt exchange is an acquisition of expanded group stock in which either
- in the case where the transferor and transferee of the expanded group stock are parties to an asset reorganization, either (1) if the stock is transferred by issuance, nonrecognition under section 1032 or Treas. Reg. § 1.1032-2 applies to the transferor/issuer and the stock is distributed by the transferee pursuant to the plan of reorganization or (2) if the stock is not transferred by issuance, nonrecognition under section 361(a) or (b) applies to the transferor;
- the transferor of the expanded group stock is a shareholder that receives property in a complete liquidation to which section 331 or 332 applies; or
- the transferor of the expanded group stock is deemed to issue the stock in a transaction described in Treas. Reg. § 1.1032-3(b) (i.e., a corporation’s acquisition of stock in its controlling parent for use by the subsidiary as consideration for acquiring property, where the subsidiary makes no payment for the parent stock or pays less than fair market value for the parent stock).
Though the definition of “exempt exchange” is technical, generally this concept exists both to funnel analysis of asset reorganizations to the rules discussed below, which include certain further conditions in order to trigger a reclassification, and to exempt other transactions Treasury considers beyond the policy concerns of the Final Regulations.
A covered debt instrument is treated as stock if it is issued as consideration for acquiring property in an asset reorganization (i.e., a type-A, C, D, F, or G reorganization), but only if pursuant to the plan of reorganization, an expanded group member (as of immediately before the reorganization) receives the instrument with respect to stock it holds in the asset-transferor.
For example, this rule could apply to a D reorganization where (1) a subsidiary contributes its assets to a new corporation in exchange for all the stock and a note from the new corporation and (2) the subsidiary distributes the new stock and note to its parent in a transaction that qualifies under section 355. Treasury believes that such an internal asset reorganization can be economically similar to an internal stock acquisition and function as a device to convert what otherwise would be a distribution into a reorganization without any meaningful non-tax effect (i.e., no new capital is introduced into the group and the beneficial ownership of the transferred assets does not change). Accordingly, Treasury deems this rule necessary to avoid circumvention of the distribution rule.
3. Funding rule
Treasury believes that the policy concerns implicated by the special issuance transactions described above also arise when a corporation issues a covered debt instrument with a purpose of funding a transaction similar to a special issuance.
Accordingly, the funding rule provides that, subject to the exceptions noted below (including the exceptions applicable to both special issuances and the funding rule noted in part 4), a covered debt instrument issued in exchange for property will be irrebuttably classified as stock for tax purposes to the extent the instrument is deemed to fund (under the rules described below) one or more of the following transactions by the issuer (the “funded member”):
- a distribution of property by the funded member to an expanded group member, other than (1) a distribution of property in a complete liquidation under section 336(a) or 337(a) or (2) a distribution of stock permitted to be received without the recognition of income under section 354(a)(1) or 355(a)(1) (or that is not treated as boot if section 356 applies);
- an acquisition of expanded group stock by the funded member from an expanded group member in exchange for property of the funded member (excluding expanded group stock), other than in an exempt exchange (see above under “Special issuance rules—Stock acquisitions”); 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 (as of immediately before the reorganization) receives boot with respect to its stock in the transferor corporation.
No transactions that occurred before April 5, 2016, are taken into account for purposes of applying the funding rule. A transaction that is described in more than one of these categories is counted only once, and to the extent the amount of a transaction is treated as funded by a covered debt instrument under the funding rule, (1) that amount of the transaction is not treated as funded by another covered debt instrument and (2) that amount of the covered debt instrument is not treated as funding another transaction under the funding rule. Transactions by a funded member generally include any transactions by predecessors or successors of such funded member.
When the funding rule applies, the debt instrument is only reclassified as stock to the extent of the amount of the transaction(s) it is treated as funding. For example, if a $300 note is treated as funding a $200 distribution, $200 of the principal amount would be classified as stock and the remaining $100 of principal amount would be classified as indebtedness (subject to satisfaction of the remaining requirements to establish indebtedness).
Reclassification of a covered debt instrument as stock under the funding rule does not result in recharacterization of the funded transaction.
Per se rule. Any covered debt instrument issued by the funded member within the period beginning 36 months before and ending 36 months after the funded member engages in a transaction described in the list above will be irrebuttably deemed to fund such transaction, to the extent the transaction has not already been deemed funded by another debt instrument and the debt instrument has not already been deemed to fund another transaction (the “Per Se Rule”).
Treasury believes the Per Se Rule is justified because money is fungible, any loan proceeds free up other funds for other uses, and requiring actual tracing would present opportunities for abuse and substantial administrative challenges for the IRS.
In the case of multiple covered debt instruments or multiple transactions that could be funded, funding under the Per Se Rule is deemed to occur in the order of issuance and/or in the order of the transactions, as applicable. Additionally, subject to certain exceptions, if a covered debt instrument is treated as exchanged for a modified covered debt instrument pursuant to Treas. Reg. § 1.1001-3(b), the modified covered debt instrument is treated as issued on the original issue date of the covered debt instrument.
Principal purpose catch-all. A covered instrument issued outside of the 72-month per se period will be irrebuttably deemed to fund a transaction described in the list above if it is issued with a principal purpose of funding such transaction, but only to the extent the transaction has not already been deemed funded by another debt instrument and the debt instrument has not already been deemed to fund another transaction. Whether such a principal purpose existed is determined based on all the facts and circumstances, and a principal purpose of funding a transaction can exist regardless of whether the debt issuance occurs before or after the subject transaction.
Exception to funding rule for qualified short-term debt instruments
The funding rule does not apply to any covered debt instrument that is a qualified short-term debt instrument, defined as any of the following (in each case subject to certain additional rules):
Short-term funding arrangement. An instrument for which either
- interest charges do not exceed an arm’s length rate for a similar short-term borrowing and the maximum balance does not exceed the maximum amount of current assets of the issuer expected during a short-term period; or
- the term does not exceed 270 days (or the instrument is an advance under a revolving credit or similar arrangement) and interest charges do not exceed an arm’s length rate for a similar borrowing with a term that does not exceed 270 days.
Ordinary course loan. An instrument issued as consideration for the acquisition of property, other than money, in the ordinary course of the issuer’s trade or business, provided that the obligation is reasonably expected to be repaid within 120 days of issuance.
Interest-free loan. An instrument that does not provide for stated interest (or for which no interest is charged), does not have original issue discount, does not have imputed interest under section 483 or section 7872, and does not require interest to be charged under section 482.
Deposit with a qualified cash-pool header. An instrument that is a demand deposit pursuant to a cash-management arrangement (i.e., an arrangement for borrowing and lending excess funds among expanded group members) with an expanded group member whose principal purpose is managing such cash-management arrangement.
4. Exceptions to stock classification under the special issuance and funding rules
In addition to the exceptions noted above, there are three categories of exceptions that may apply to prevent a stock classification under the special issuance and funding rules. These are (1) exclusions, (2) reductions, and (3) the threshold exception. The exceptions in each category (in the order the categories are listed) are applied before any exceptions in the next category. In each case, these exceptions are subject to certain additional rules not detailed below.
Stock acquisition from controlled subsidiary. An acquisition of expanded group stock is not treated as a stock acquisition under the special issuance rules or funding rule if, immediately after the acquisition, the acquirer controls the member of the group from which such stock is acquired (the seller) and does not relinquish such control pursuant to a pre-existing plan (except where the seller leaves the expanded group). “Control” for this purpose means direct or indirect ownership of more than 50% of total voting power and more than 50% of total value of all classes of stock. If the acquirer relinquishes control of the seller within 36 months after the acquisition, there is a rebuttable presumption of a pre-existing plan to relinquish control.
Stock acquisition for equity compensation. An acquisition of expanded group stock is not treated as a stock acquisition under the special issuance rules or funding rule if the expanded group stock is delivered to individuals that are employees, directors, or independent contractors in consideration for services rendered by such individuals to an expanded group member or a controlled partnership.
Deemed distribution or stock acquisition under section 482. A distribution or acquisition deemed to occur under Treas. Reg. § 1.482-1(g) (relating to transfer pricing adjustments) is not treated as a distribution or stock acquisition under the funding rule.
Stock acquisition by dealer. An acquisition of expanded group stock by a securities dealer in the ordinary course of business is not treated as a stock acquisition under the special issuance rules or funding rule.
Limitation on cascading consequences under funding rule. A deemed acquisition of expanded group stock as a result of reclassification of a debt instrument as stock under the funding rule is not treated as a stock acquisition for purposes of again applying the funding rule, provided that such deemed acquisition is not part of a plan or arrangement to prevent application of the funding rule to a covered debt instrument.
Reduction for accumulated E&P. The aggregate amount of any distributions or acquisitions by an expanded group member described in the special issuance and funding rules in a taxable year is reduced by the member’s “expanded group earnings account.” A member’s expanded group earnings account generally equals the excess of (1) the member’s E&P accumulated through the close of the taxable year, but only for tax years ending after April 4, 2016, and during the period of its membership in the expanded group, with certain adjustments for expanded group items and transactions subject to the special issuance and funding rules, over (2) the cumulative amount of prior year reductions of distributions and acquisitions by such member under this exception during its membership in the expanded group. This reduction is applied to multiple transactions during the year based on the order in which the transactions occur.
Reduction for qualified contributions. The amount of any distribution or acquisition by an expanded group member described in the special issuance or funding rules is reduced by the aggregate fair market value of any stock issued by such member in exchange for contributions by other expanded group members during a period generally beginning 36 months before and ending 36 months after the distribution or acquisition, but only to the extent the contributions have not already reduced any distributions or acquisitions under this exception. Contributions of expanded group stock or certain other tainted assets or debt instruments are excluded, as are contributions from certain parties or that have certain results. This reduction is applied to multiple transactions during the year based on the order in which the transactions occur.
A covered debt instrument is not treated as stock under the special issuance or funding rules if, as of the time immediately after the covered debt instrument would be treated as stock but for this exception, the aggregate adjusted issue price of covered debt instruments held by members of the expanded group that would be treated as stock but for this exception does not exceed $50 million. Only the amount of the covered debt instruments in excess of $50 million is treated as stock after application of this exception.
D. Anti-Abuse Rules
Documentation requirements. A debt instrument that would be an EGI but for the fact that it is not held by a member of the same expanded group as the issuer will be treated as an EGI subject to the documentation requirements if a principal purpose of issuing such instrument is to avoid application of the documentation requirements. This rule could apply, for example, to a debt instrument issued through a non-corporate entity or a slightly less-related corporation in order to circumvent the requirements.
Special issuances and funding rule. A debt instrument not otherwise treated as stock under the special issuance or funding rules will be treated as stock if (1) it is issued with a principal purpose of avoiding the purposes of such rules or (2) the funded member or any expanded group member engages in a transaction (including a distribution or acquisition) with a principal purpose of avoiding the purposes of such rules. This rule could apply, for example, to a debt instrument issued to non-member of the expanded group if the instrument is later acquired by an expanded group member.
E. Other Operating Rules
1. Timing of stock classification
Subject to the respective effective date and transition period rules discussed above:
Failure of documentation requirements. In general, if there is a documentation failure for a debt instrument that has been an EGI from issuance, the instrument will be treated as stock from issuance. If there is a documentation failure for a debt instrument that was not initially an EGI but later became an EGI, the instrument will be treated as stock from the date it became an EGI.
However, if an EGI that initially satisfies the documentation requirements is reclassified as stock as a result of a failure to document actions evidencing an ongoing debtor-creditor relationship, the instrument will be treated as stock from the time the facts and circumstances regarding the behavior of the issuer or holder with respect to the EGI cease to evidence a debtor-creditor relationship.
Special issuance or funding rule. In general, a covered debt instrument treated as stock under the special issuance or funding rules will be treated as stock from issuance. However, if the funding rule applies to treat a covered debt instrument initially respected as debt as funding a distribution or acquisition on a date after issuance, the instrument is deemed to be exchanged for a new issuance of stock on the date such distribution or acquisition occurs.
2. Treatment of deemed exchange upon a post-issuance stock classification
When an instrument initially classified as debt is deemed to be exchanged for stock, the holder of the instrument 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 (or any foreign exchange gain or loss related to accrued but unpaid qualified stated interest) on the debt instrument as of the time of the deemed exchange.
3. Transfer outside of expanded group
If a debt instrument that is treated as stock under the rules is transferred outside of the expanded group (e.g., because the holder leaves the expanded group or the new holder is not a member of the expanded group), the issuer is treated as issuing a new debt instrument at such time to the holder in exchange for the instrument treated as stock. Additionally, if the transferred instrument was classified as stock due to application of the funding rule, all remaining covered debt instruments that are not already treated as stock at such time must be retested for deemed funding of the relevant distribution or acquisition that the transferred instrument was previously treated as funding.
4. Instruments issued by disregarded entities or controlled partnerships
If an instrument that was issued by a disregarded entity (or a controlled partnership, in a case of application of the special issuance rules or funding rule) is treated as stock under the rules, the tax owner of the disregarded entity is (or the expanded group members that own the controlled partnership are) instead treated as the issuer of the stock for tax purposes.
III. Potential State, Local, and Foreign Income Tax Implications
The Final Regulations will likely have significant state, local, and foreign tax implications, but at this early point it is not entirely clear what those implications will be.
In the state tax context, this is due largely to uncertainty as to the extent to which state law will incorporate the Final Regulations. For example, most states have incorporated the Code—with adjustments to reflect state policies—to determine taxable income. But in these states, it is not always clear whether they are bound by Treasury Regulations.
States take a number of approaches with regard to incorporating the Treasury Regulations: some explicitly adopt the Treasury Regulations (in whole or in part), some implicitly adopt the Treasury Regulations by referencing federal taxable income as the starting point for determining state taxable income, and some states simply give deference to the Treasury Regulations in interpreting the Code. But many states simply have not provided a clear answer to this question—a question that is going to become increasingly important to taxpayers and policymakers alike as state tax compliance collides with the Final Regulations. In the lead up to implementation of the Final Regulation, expect to see some states explicitly address the extent to which they will apply the Final Regulations.
If states incorporate the Final Regulations without adjustment, it will present several difficult issues. For example, it is unclear whether states will apply principles of the Final Regulations to taxpayers that are members of a federal consolidated return group but that are required to file separate state income tax returns. Several states specifically require corporations that file a consolidated federal income tax return to prepare their state tax returns “as if they had filed separate federal income tax returns.”
On the other hand, states often require related taxpayers that are not eligible to file a federal consolidated return to file a combined state return if they are engaged in a unitary business. This happens because ownership requirements that trigger combined reporting are often much lower than the 80-percent ownership level required for federal consolidation and because state combined returns often include entities without a common corporate parent. In these circumstances, it is not clear whether states will apply principles similar to the exceptions in the Final Regulations for consolidated groups to members of a state unitary combined group.
It is also unclear how states might apply the exceptions for distributions from E&P. State E&P often differs—sometimes significantly—from federal E&P. States that apply the Final Regulations will have to decide whether to use federal E&P or state E&P in implementing this exception. If states use state E&P this could cause the bizarre result of an instrument being treated differently for federal and state income tax purposes.
In the foreign tax context, reclassification of a debt instrument as stock under the Final Regulations could result in a “hybrid” instrument (i.e., an instrument classified as stock for U.S. tax purposes but classified as debt under the tax laws of one or more foreign jurisdictions). Such a hybrid instrument could trigger negative tax treatment in a foreign jurisdiction that has adopted the Base Erosion and Profit Shifting (BEPS) Action 2 recommendations of the Organisation for Economic Co-operation and Development (OECD), which aim to neutralize the benefits derived from disparate tax treatment of hybrid instruments. The preamble to the Final Regulations notes that exclusion of foreign issuers from the rules mitigates this concern because the BEPS Action 2 recommendations generally apply only to instruments giving rise to a deduction in the issuer’s jurisdiction (i.e., debt instruments of foreign issuers). Nevertheless, there remains some uncertainty regarding the impact the Final Regulations may have on the application of anti-hybrid instrument rules that foreign jurisdictions may adopt in response to the OECD’s BEPS Action 2 recommendations.
The Final Regulations are an ambitious and groundbreaking exercise of Treasury’s regulatory authority and could impact a wide range of related-party financing transactions. They reflect not only extensive consideration by the drafters but also extensive public feedback. Accordingly, the rules are highly complex.
For related-party indebtedness, the Final Regulations constitute a paradigm shift. Achieving a debt classification for tax purposes now requires essentially a four-stage analysis instead of simply an analysis under the common law. The per se rules threaten to nullify a debt classification even where an instrument easily passes the common law tests. And although the effectiveness of the rules has been briefly delayed, taxpayers may have already engaged in transactions that will trigger the special issuance rules or funding rule.
Now is the time for taxpayers to plan their compliance procedures for the documentation requirements and any restructuring or retirements necessary to avoid a detrimental stock classification under the special issuance or funding rules. Even taxpayers who will not initially be subject to these rules may be well-advised to document debt instruments and plan transactions to permit a future debt classification under these rules.