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Jim Fuller |
David Forst |
The IRS released far-reaching proposed regulations on determining whether an interest in a corporation is debt or equity. The earnings stripping rules (Code section 163(j)), with which inbound taxpayers are certainly familiar, are not affected by the proposed regulations. Rather the proposed regulations provide a separate set of rules which taxpayers must consider.
The proposed regulations, subject to certain exceptions, treat debt between members of an expanded group (generally meaning related parties) as stock if the debt is issued: (i) as a distribution; (ii) in exchange for stock of a member of the expanded group; or (iii) in exchange for property in an asset reorganisation if a shareholder that is a member of the issuer's expanded group immediately before the reorganisation receives the debt instrument with respect to stock in the transferor corporation.
Debt is also treated as stock if it is issued by a corporation (funded member) to a member of the funded member's expanded group in exchange for property with a principal purpose of funding certain distributions or acquisitions. Subject to certain exception, any debt is treated as issued with a principal purpose of funding a distribution or acquisition if it is issued by the funded member during the period beginning 36 months before the date of the distribution or acquisition, and ending 36 months after the date of the distribution or acquisition.
Thus, for example, a note distributed by a US subsidiary to its foreign parent corporation will be treated as stock under the new rules. Payments in respect of the note, therefore, will be treated as distributions for US tax purposes and not as payments of interest and principal. Additionally, if a foreign subsidiary of the foreign parent loans money to the US subsidiary, and the US subsidiary subsequently distributes the borrowed amount to the foreign parent, the cross-chain loan is treated as an equity investment.
The rules described above are effective for debt instruments issued on or after April 4 2016. However, a transition rule provides that a debt instrument that otherwise would be treated as stock will not be so treated (and will continue to be treated as debt) until 90 days after the rules are published as final regulations.
Other rules provide that the IRS has the authority to treat debt between expanded group members as part debt and part stock to the extent that such split treatment is supported by general federal tax principles. For example, if the IRS determines there is a reasonable expectation that, as of the issuance of the debt, only a portion of the principal amount will be repaid, the debt may be treated as indebtedness in part and stock in part in accordance with such determination. The proposed regulations also mandate a series of documentation requirements on debt between expanded group members that must be completed more or less contemporaneously with the issuance of the debt. The rules described in this paragraph are effective for instruments issued on or after the date the regulations are finalised.
Jim Fuller (jpfuller@fenwick.com) and David Forst (dforst@fenwick.com)
Fenwick & West
Website: www.fenwick.com
