Controversial Debt-Equity Regulations Finalized With Limited Fixes, Concessions And Reservations By Government

On October 13, 2016, Treasury and the IRS issued important new final and temporary regulations (the "Regulations") under section 385 of the Internal Revenue Code addressing the treatment of intercompany debt for U.S. federal income tax ("U.S. tax") purposes. The Regulations generally will apply to taxable years ending after January 18, 2017, while the documentation requirements described below will apply to debt instruments issued after December 31, 2017. The proposed version of the Regulations, issued in April 2016, attracted controversy due to its broad reach and strict requirements as well as arguments that the rules exceeded the authority granted to Treasury by Congress.

The overall structure of the Regulations remains largely the same as that of the proposed rules, although significant issues are reserved on, including the application of the Regulations to foreign issuers of intercompany debt, and significant exceptions have been added, including for certain short-term cash pooling arrangements.

Part I below provides an overview of the Regulations, and Part II below highlights important differences between the Regulations and the proposed rules and describes certain other significant issues in the Regulations.

  1. Overview of Regulations

    Under U.S. tax law, interest payments on debt generally are deductible, while the payor of a dividend generally receives no deduction. The government has become increasingly concerned that multinational companies, particularly in connection with an inversion, create debt in their U.S. operations and cause their U.S. subsidiaries to pay interest to foreign affiliates, effectively shifting earnings from the United States to foreign jurisdictions with lower corporate tax rates. The preamble to the Regulations indicates that preventing this "earnings stripping" is the core purpose of the new rules. Nevertheless, the Regulations have a far broader reach and potentially affect transactions having nothing to do with inversions or earnings stripping.

    The Regulations seek to address earnings stripping primarily by making it more difficult to classify many intercompany loans as debt for U.S. tax purposes. The Regulations apply to debt issued to a related entity by a domestic corporation or by certain "flow-through" entities, but exclude debt between members of a consolidated group and adopt threshold asset and other requirements to reduce the Regulations' application to taxpayers other than large corporate groups. For this purpose, two entities are related if they belong to the same "expanded group," which generally means that they are directly, indirectly, or constructively connected through chains of 80% or greater ownership. The Regulations impose two principal restrictions on a taxpayer's ability to classify an instrument as debt for U.S. tax purposes when issued within an expanded group by a domestic corporation or certain flow-through entities.

    First, the Regulations require that taxpayers prepare and maintain documentation (the "Documentation Rules") with respect to debt instruments issued or deemed issued by a U.S. member of an expanded group (or a disregarded entity thereof) to another member of an expanded group (or a disregarded entity thereof or a "controlled partnership" that is 80% owned by that expanded group) ("EGIs"). The required documentation must demonstrate: (i) an unconditional obligation to pay a sum certain, (ii) creditor's rights for the holder, (iii) a reasonable expectation that the issuer would be able to repay the loan and (iv) the existence of a debtor-creditor relationship between the issuer and holder. With some notable exceptions, the Regulations treat EGIs that fail to satisfy the Documentation Rules as equity for U.S. tax purposes.

    Second, the Regulations take aim at transactions in which one member of a corporate group issues debt to another member but arguably does not receive any additional net investment. A "General Rule" automatically recasts debt instruments issued or deemed issued by a U.S. member of an expanded group (or a disregarded entity thereof or a partnership with one or more U.S. partners that is a controlled partnership with respect to that expanded group) ("covered debt instruments") to another member of the expanded group...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT