US Inbound: US Treasury issues final regulations on tax treatment of corporate debt
The US Treasury and the IRS have released final regulations under Internal Revenue Code, section 385. They are an improvement over the regulations proposed in April 2016, but still contain many developments that should be noted by inbound organisations.
Debt issued by non-US taxpayers
The final regulations do not apply to debt issued by non-US taxpayers – a large and important carve-out. The regulations, instead, are reserved on foreign issued debt, stating that this topic requires further study. The regulations, therefore, still apply in general to debt issued by US taxpayers. For example, in the inbound context, to foreign parent loans from US subsidiaries.
The final regulations do, however, remove a provision in the proposed regulations that a debt instrument could be split into part debt and part equity depending on the facts and circumstances. If this provision had remained in the final regulations, it would have been a major departure from existing rules and created tremendous uncertainty. Instead, the Treasury said it will continue to study the issue.
The documentation requirements proposed in April largely remain in the final regulations, but have been somewhat softened. They apply in general to domestic corporations if:
The stock of a member of the corporation's expanded affiliated group is publicly traded;
Total assets of the group exceed $100 million; and
Annual total revenues exceed $50 million.
The same documentation can satisfy the requirements for multiple issuances of debt.
The indebtedness factors to be documented are generally the same as in the proposed regulations:
Written documentation establishing that the issuer has entered into an unconditional and legally binding obligation;
Written documentation of the issuer's financial position establishing a reasonable expectation that the issuer intended to, and could, meet its payment obligations; and
Ongoing written documentation evidencing the issuer's payments or, in the case of non-payment, the holder's exercise of a creditor's diligence and judgment.
An important change is that the documentation is treated as timely if it is prepared by the time the issuer's tax return is filed (rather than 30 days after issuing the debt, as per the proposed regulations).
The effective date of the final regulations has been postponed, and now the rules discussed above will apply to debt instruments issued on or after January 1 2018.
Debt issued by domestic corporations
The rules that automatically treat certain debt instruments as equity are generally the same as in the proposed regulations, with the carve-out that they apply only to debt issued by domestic corporations. These per se equity instruments include:
Distributions of debt instruments by domestic corporations to their related corporate shareholders;
Issuances of debt instruments by domestic corporations in exchange for stock of an affiliate; and
Certain issuances of debt instruments as consideration in exchange of an internal asset reorganisation.
In addition, the per se rule applies to debt issued by a domestic corporation to a member of its expanded group in exchange for property treated as funding the transactions described in the paragraph above. Some exceptions to the funding rule now include:
Deposits pursuant to cash management arrangements and certain advances that finance short-term liquidity needs;
Stock that is acquired and used as equity compensation; and
Distributions or acquisitions resulting from transfer pricing adjustments.
The aggregate amount of any distributions or acquisitions by a domestic corporation during a year is reduced, generally, by the earnings and profits accumulated by the domestic corporation while the entity was a member of the expanded group and after April 4 2016 (the day the proposed regulations were issued). All taxpayers also can exclude the first $50 million of debt that would otherwise be characterised as equity.
Fenwick & West