Treasury Issues Regulations that Discourage Tax Inversions
October 26, 2016
Controversial regulations restrict earnings stripping
REGULATIONS DISTINGUISH BETWEEN DEBT AND EQUITY
On Oct. 13, 2016, the U.S. Department of Treasury and the Internal Revenue Service (IRS) issued controversial final regulations to address earnings stripping. This action will further reduce the benefits of corporate tax inversions, level the playing field between U.S. and non-U.S. businesses and limit the ability of companies to lower their tax bills through transactions involving debt that do not support new investment in the United States. These regulations also require large corporations claiming interest deductions to document loans to and from their affiliates, just as businesses of all sizes do when they borrow from unrelated lenders. The rules were proposed in April along with temporary anti-inversion regulations.
The final regulations were in large part adopted to curtail the perceived abuses related to corporate inversions. In an inversion, a U.S. company takes a foreign address, typically through a merger with a smaller firm, giving it new opportunities to use internal corporate debt as a tax-avoidance technique. After a corporate inversion, multinational corporations often use a technique called earnings stripping to minimize U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country. This commonly-used technique can generate large interest deductions without requiring a company to finance new investment in the United States.
The new regulations restrict the ability of corporations to engage in earnings stripping by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances. They also require that corporations claiming interest deductions on related-party loans provide documentation for the loans, similar to the common practice for third-party loans. The ability to minimize income tax liabilities through the issuance of related-party financial instruments is not, however, limited to the cross-border context, so these rules also apply to related U.S. affiliates of a corporate group.
REGULATIONS IN GENERAL
Section 385 provides the Treasury with the authority to prescribe regulations necessary or appropriate to determine whether an interest in a corporation is to be treated for U.S. federal tax purposes as stock or indebtedness, in whole or in part. The regulations provide factors to be taken into account in determining whether a debtor-creditor or corporation-shareholder relationship exists.
The final and temporary regulations under Code Sec. 385 establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as debt (the “Documentation Rule”) and treat as stock certain related-party instruments that otherwise would be treated as debt (the “Recharacterization Rule”). Specifically, the final regulations generally provide for the following:
- Documentation Rule. The final rules in Reg. § 1.385-2 prescribe the nature of the documentation necessary to substantiate the tax treatment of related-party instruments as indebtedness, including documentation of factors analogous to those found in third-party loans. This generally means that taxpayers must be able to provide such things as: evidence of an unconditional and binding obligation to make interest and principal payments on certain fixed dates; evidence that the holder of the loan has the rights of a creditor, including superior rights to shareholders in the case of dissolution; a reasonable expectation of the borrower’s ability to repay the loan and evidence of conduct consistent with a debtor-creditor relationship.
- Recharacterization Rule. Reg. § 1.385-3 and Temporary Reg. §1.385-3T provide rules that can recharacterize purported debt of U.S. issuers as equity if the interest is among highly-related parties and does not finance new investment. These rules are intended to address transactions that create significant U.S. federal tax benefits while lacking meaningful legal or economic significance.
The final regulations provide a number of exceptions to the general rules, including:
- Exempting cash pools and short-term loans: A broad exemption exists for cash pools, which are essentially common funding accounts for related businesses. The Treasury is also providing an exemption for loans that are short-term in both form and substance.
- Providing limited exemptions for certain entities where the risk of earnings stripping is low: Transactions between foreign subsidiaries of U.S. multinational corporations and transactions between pass-through businesses are exempt from the final regulations. Financial institutions and insurance companies that are subject to regulatory oversight regarding their capital structure are also excluded from certain aspects of the rules.
- Expanding exceptions for ordinary business transactions: The Treasury has significantly expanded the exceptions for distributions to generally include all future earnings and allow corporations to net distributions against capital contributions. The Treasury is also including additional exceptions for ordinary course transactions, such as acquisitions of stock associated with employee compensation plans.
- $50 million of indebtedness: Up to $50 million in debt instruments that would otherwise be recharacterized is exempted from the general and funding rules. Although the $50 million threshold amount remains the same as in the proposed regulations, it no longer has a cliff effect.
- Even though the final section 385 regulations will not apply if the above threshold is not met, taxpayers are still required to document their related-party loans and ensure the terms and conditions of such loans are considered to be made at arm’s length.
- Easing documentation requirements: The Treasury has relaxed the intercompany loan documentation rules for U.S. borrowers. The regulations also extend the deadline by one year until Jan. 1, 2018.
These far-reaching regulations will have a significant negative impact on the tax benefits of certain corporate inversion transactions. In addition, these regulations may require companies to significantly modify the terms and documentation of related-party loans.
If you believe these regulations may apply to your business, please contact Robert Verzi, partner, at [email protected] or your HA&W tax professional to develop a plan for compliance.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.
About the Author
Robert is an international tax partner with more than 27 years of experience providing international tax solutions to publicly and privately-held corporations on an array of international tax matters, such as foreign tax credit management and utilization, structuring foreign and domestic operations, international mergers and acquisitions, and export tax incentives. He also has many years of experience serving foreign-owned U.S. businesses.