Tax Insights Proposed Regulations:
Debt vs. Equity
Proposed regulations re-characterizing related party debt as equity may yield unanticipated tax consequences THE UNITED STATES TREASURY DEPARTMENT (Treasury) proposed regulations on April 4, 2016, that re-characterize some related-party debt as equity. The re-characterization of debt as equity will tend to increase tax costs. The proposed regulations are slated to take effect Sept. 5, 2016, and apply to any related party debt issued on or after April 4, 2016. At their simplest, these rules will greatly increase the burden on companies whose intercompany debt is for sound business reasons with no tax motivation. At the most invasive, debt will effectively be prohibited in certain types of transactions without regard to purpose or validity.
Expanded Group Instrument Criteria is Crucial THE PROPOSED REGULATIONS APPLY to what is deemed an Expanded Group (EG). An EG consists of a parent corporation and any corporation that is at least 80 percent owned – either through vote or value – by the parent corporation. The following provisions apply: • • • •
Foreign corporations are included. A foreign corporation can be the parent corporation. Ownership chains that are broken by partnerships are included. U.S. companies not allowed to consolidate (REITs, RICs, insurance companies, etc.) are included. • U.S. corporations that file a consolidated return are treated as a single entity; therefore, debt within the consolidated group is not affected. A debt instrument used among EG members is regarded as an Expanded Group Instrument (EGI).
Prohibited Leveraging Transactions Defined THE PROPOSED REGULATIONS DEFINE prohibited leveraging transactions based on two rules. Under the General Rule, related party debt is automatically re-characterized as equity if it is issued in: • A distribution. • Certain exchanges for related-party stock. • Exchange for property in certain asset reorganizations. A Funding Rule also applies to related party funding of similar transactions. With that rule, debt is regarded as equity if it is issued 36 months before or after a distribution or asset acquisition.
Tax Insights: Proposed Regulations on Debt vs. Equity Documentation is Crucial for Resolving Debt-Equity Questions DEBT ISSUED AMONG EG MEMBERS will automatically be regarded as equity – and therefore subject to applicable income tax provisions – if the taxpayer cannot produce documentation that supports classifying the EGI as debt. Documentation requirements include: • An unconditional obligation to pay a certain sum. • Creditor’s rights, which may include triggered acceleration or default for non-payment, the right to sue for non-payment, and priority over equity holders in the event of a liquidation. • Reasonable expectation of repayment, based on factors such as cash flow projections, debt-equity ratios, collateral appraisals, business forecasts, and comparisons to similar borrowers. The proposed rules do not require third-party analysis. • Timely principal and interest payments. • Exercise of reasonable diligence and judgement as a creditor in the event of non-payment. The documentation requirements within the proposed regulations apply to any EGI issued on or after April 4, 2016.
Potentially Complicated Consequences Abound THE PROPOSED REGULATION’S IMPACTS need to be considered now because so many business relationships and transactions could be affected by these regulations. EGIs allowed as debt by tax treaties between the U.S. and other nations could be regarded as equity under the proposed regulations. Interest payments could be regarded as dividends by the proposed regulations, thereby generating income tax obligations. A surplus note issued by a subsidiary to a holding company in exchange for cash could be regarded as equity issued, even if the intent was not to attain tax benefits. Instances involving multiple lenders could likewise be regarded as EGI in the absence of supporting documentation. The proposed regulations present these and other potential consequences
Prepare Now THE PROPOSED REGULATIONS will have a substantial impact on companies with EG relationships. While implementation of the proposed regulations may be delayed, the potential impact requires that companies evaluate possible consequences now. Examine EG relationships and any related party debt issued on or after April 4, 2016. Review the proposed regulations and documentation requirements. Consider what actions must be recorded and what related processes must be established to capture and retain crucial information. If needed, consult a tax professional for direction in adhering to the proposed regulations’ requirements.
CONTACT US Vince Houk, CPA Partner-in-Charge, International Tax vince.houk@weaver.com Annick Nguessan, CPA, MBA Director, International Tax annick.nguessan@weaver.com Weaver offers a variety of international consulting and compliance services that cater specifically to the tax needs of international companies, as well as those that desire to operate internationally. For individuals, we can help with tax planning and secondment arrangements, as well as address work permit and visa issues. And, if you or your company is ever audited, whether in the U.S. or abroad, Weaver can help defend you. Some services include: • Business modeling • Cross-border transaction planning, structuring and management • Expatriate tax compliance/planning • E&P computations and interest expense allocations • Foreign tax credit planning and compliance • Global structuring, M&A and refinancing strategies • Off-shore asset protection strategy • Supply-chain and shared services review • Transfer pricing compliance documentation • U.S. and foreign tax audit defense
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