New Section 385 regulations significantly limit scope

Transcription

1 from PwC Tax Services New Section 385 regulations significantly limit scope October 14, 2016 In brief The Treasury Department and Internal Revenue Service yesterday released final and temporary regulations under Section 385, which address whether certain instruments between related parties are treated as debt or equity. The regulations were announced in a press conference by Treasury Secretary Jack Lew, who stated that we sought comments to help narrow the rule and avoid unintended consequences. The proposed regulations, which were issued on April 4, generated significant Congressional and taxpayer concern, including nearly 200 unique comment letters. [For prior coverage, see PwC s Tax Insight] The preamble to the regulations devotes roughly 370 pages to addressing these comments. The government made significant changes in the final regulations in response to taxpayer comments, dramatically narrowing the application of the rules to better focus on related party financings that have potential to erode the US tax base. Because the regulatory package is 518 pages, it will take time to fully assess the impact of the final and temporary regulations. Below, we provide a high-level summary of some of the major changes from the proposed regulations. In detail Exception for Non-US Issuers The scope of the final and temporary regulations is significantly narrower than the proposed regulations, as the final and temporary regulations apply only to expanded group instruments (EGIs) and debt instruments issued by domestic corporations. The final and temporary regulations reserve on the application of the regulations--in their entirety--to non-us issuers and, therefore, do not apply to debt instruments issued by foreign corporations, including CFCs. Specifically, the regulations apply only to debt issued by covered members, which are defined in Treas. Reg. sec (c)(2) to include a "member of an expanded group that is (i) a domestic corporation; and (ii) [Reserved]." The exception for debt issued by foreign corporations applies both for purposes of the -2 contemporaneous documentation regulations and for purposes of the -3 recharacterization regulations. When combined with the exception for debt between members of a consolidated group, this new exception generally will limit the application of the regulations to debt issued by US corporations to foreign affiliates. This dramatic narrowing of the scope of the regulations will significantly reduce the compliance burden of the contemporaneous documentation rules and narrow the application of the recharacterization rules to inbound lending. Excluding debt issued by foreign corporations from the operation of the recharacterization rules eliminates the issue under the proposed regulations that a recharacterization of debt of controlled foreign corporations could result in the loss of foreign tax credits. Excluding

2 debt of foreign issuers also eliminates the crippling effects that the proposed regulations would have had on the offshore treasury operations of USbased multinational groups. The final regulations potentially will apply to treasury operations of foreign-based multinational groups financing US affiliates. Exceptions for ordinary course transactions, cash pool deposits and borrowings, and other qualified short-term debt instruments As expected, the final regulations include exceptions for debt instruments issued as part of defined cash pooling and related arrangements. Specifically, the funding rule under Treas. Reg. sec (b)(3) does not apply to qualified short-term debt instruments, defined to consist of four separate categories of debt instruments: (A) short-term funding arrangements, which include both (1) debt instruments with short-term interest rates to the extent of the issuer s current assets other than cash and cash equivalents; and (2) debt instruments with short-term interest rates if the issuer is a net borrower from the lender for less than 270 days during a taxable year; (B) ordinary course loans, generally defined as debt instruments issued in the ordinary course of the issuer s trade or business that are reasonably expected to be repaid within 120 days; (C) interestfree loans, generally defined as debt instruments with no stated interest, original issue discount, or imputed interest; and (D) cash pool deposits, generally defined as demand deposits with a qualified cash pool header, generally defined as an expanded group member, controlled partnership, or qualified business unit that has as its principal purpose managing cash for participating expanded group members. The preamble explains that the purpose of these exceptions is to facilitate nontax motivated cash management techniques. The preamble further clarifies that although the ordinary course loans component of this exception does not expressly apply to payables with respect to rents, royalties, and services, the funding rule applies only to debt instruments issued for property and therefore debt instruments issued in exchange for the use of property or the performance of services are always outside the scope of the funding rule. Current year E&P exception The final and temporary regulations provide an exception to the general and funding rule to the extent of the corporation s expanded group earnings account. Generally, the expanded group earnings account includes all earnings and profits of a corporation that were accumulated while it was a member of the same expanded group and accumulated in tax years ending after April 4, For purposes of tracking the expanded group earnings account, special rules apply for the receipt of dividends by the corporation, interest payments made by the corporation, transactions in which the corporation acquires assets in a transaction to which Section 381(a) applies, as well as the allocation of earnings and profits in a Section 355 distribution pursuant to Treas. Reg. sec Further, the temporary regulations provide that a consolidated group has one account and only the earnings and profits of the common parent of the consolidated group are considered in calculating the expanded group earnings for the expanded group period of a consolidated group. A consolidated group succeeds to the expanded group earnings account of a joining member. If an expanded group member leaves a consolidated group as a result of a Section 355 distribution, the expanded group earnings account of the consolidated group is allocated between the consolidated group and the departing member in proportion to the E&P of the consolidated group and the departing member immediately after the distribution. Exclusion for certain acquisitions of subsidiary stock The final and temporary regulations modify the exception to the funding rule for certain acquisitions of controlled subsidiary stock. The exclusion includes a requirement for control not to be relinquished pursuant to a plan that existed on the date of the acquisition. The definition of control and the 36-month period following the date of the acquisition requirement remain the same. The per se rule in the proposed regulations has been replaced by a rebuttable presumption that the acquirer is presumed to have a plan to relinquish control of the seller on the acquisition date upon relinquishment of control of the seller within the 36-month period following the acquisition date. However taxpayers may present facts and circumstances clearly establishing that the loss of control was not contemplated on the acquisition date and that avoidance was not a principal purpose for the subsequent loss of control. The bifurcation rule The final regulations do not include a general bifurcation rule, but the preamble to the regulations indicates that Treasury and the IRS will continue to study this issue. The bifurcation rule set forth in Prop. Treas. Reg. sec (d) appeared to provide the Commissioner with discretion to treat debt instruments between two members of the same modified expanded group as in part debt and in part stock (i.e., to 2 pwc

3 bifurcate the interest) to the extent that an analysis of the relevant facts and circumstances as of the instrument s issuance supported such treatment. Comments submitted to the IRS and Treasury raised concerns as to the validity of the bifurcation rule and called for clear parameters relating to the Commissioner s decision to bifurcate a debt instrument. The removal of the bifurcation rule alleviates these concerns. Changes to documentation rules The documentation rules under Treas. Reg. sec retain the requirements in the proposed regulations requiring enforceable legal documentation, standard creditor rights, demonstration of ability to pay, and ongoing maintenance and controls. The final regulations, however, dramatically limit the scope of the documentation rules by applying them only to debt issued by US corporations, while modifying the filing requirements and the consequences of noncompliance. Debts issued by S corporations, non-controlled real estate investment trusts (REITs) and regulated investment companies (RICs), and controlled partnerships generally are also excluded. Treas. Reg. sec , as finalized, also modifies the weight of certain factors for purposes of common law determinations of whether an instrument constitutes indebtedness or equity. Specifically, Treas. Reg. sec (b)(3) provides that the factors that must be documented under Treas. Reg. sec (c)(2) (i.e., unconditional obligation to pay a sum certain, creditor s rights, reasonable expectation of ability to repay, and actions evidencing a debtor-creditor relationship) constitute significant factors in making a common law determination of whether an instrument constitutes indebtedness or equity, and all other factors are treated as lesser factors. The effective date of the documentation rules has been deferred to January 1, Additional relief has also been provided as to the time when documentation must be completed. Under the final regulations, the documentation must be available as of the date of the tax return filing. This is consistent with current US transfer pricing documentation timing requirements under Section With respect to consequences of non-compliance, the final regulations provide that, if an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than per se recharacterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument (i.e., there is a need to demonstrate a high degree of compliance with the requirements, based on enumerated tests). No general exception from the documentation requirements is provided for cash pools, but the exception for debts issued by foreign corporations will, as a practical matter, effectively exempt offshore cash pooling operations of US-based multinationals. Reorganizations and other subchapter C nonrecognition transactions In response to comments, the final and temporary regulations include a number of exceptions to the funding rule with respect to tax free reorganizations and similar transactions. A distribution in complete liquidation of a funded member pursuant to a plan of liquidation and distributions allowed to be received without the recognition of gain under Section 354, 355, or 356 are exempt distributions which are not distributions of property for the purpose of the funding rule. The final regulations also exempt exchanges of expanded group stock in tax free reorganizations, tax free issuance of stock, and tax free liquidations. A number of commentators expressed concern about the effects of treatment of a nominal debt instrument as stock for all federal income tax purposes. Specifically, the recharacterized debt may cause a transferor to fail to obtain Section 368(c) control required by numerous provisions such as reorganizations, liquidations, and corporate formations and affiliation for consolidated return purposes. The final regulations did not make changes to address these concerns. A number of commentators recommended that general rule and funding rule transactions be reduced by capital contributions to the corporation to the extent that they do not reduce a member s net equity. The final regulations adopt the approach that the amount of a distribution or acquisition under the general rule or the funding rule is reduced by the aggregate fair market value of the stock issued by the member in a qualified contribution so long as the qualified contribution does not reduce another distribution or acquisition and is during the qualified period. A qualified contribution is a contribution of property other than excluded property to a covered member by a member of the covered member s expanded group in exchange for stock. Excluded property includes expanded group stock, property acquired in certain internal asset reorganizations, a covered debt instrument of a group member, property acquired using a covered debt instrument, certain debt instruments of a controlled partnership, and any property acquired with a principal purpose of avoiding the purpose of Treas. Reg. sec T. Certain other contributions have also been excluded 3 pwc

4 as qualified contributions to avoid abuse. The qualified period means, with respect to a covered member, a qualified contribution and distribution or acquisition within 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. Qualified contributions must be allocated or reduced following certain corporate transactions such as Section 381 acquisitions and Section 355 distributions. The Treasury and the IRS also clarified the predecessor and successor rules, when a funded member and either its predecessor or successor are members of different expanded groups. Specifically, the final and temporary regulations provide that the distributing corporation and controlled corporation in a distribution that qualifies under Section 355 cease to have a predecessor and successor relationship as of the date that the corporations cease to be members of the same expanded group. Consolidated groups Prop. Treas. Reg. sec (e) would have treated all members of a consolidated group as a single corporation (the one-corporation rule ) for purposes of the Section 385 regulations. Treas. Reg. sec T(b)(1) modifies the one-corporation rule slightly, in that the rule does not apply for purposes of the documentation requirement of Treas. Reg. sec , and that the determination of whether a debt instrument issued by a member of a consolidated group is a covered debt instrument is made on a separate member basis. Several commenters requested guidance about the scope of the one-corporation rule. In response, Treas. Reg. sec T(b)(5) sets forth an order of operations rule, under which a transaction involving one or more members of a consolidated group is first characterized under federal tax law without regard to the one-corporation rule, and then Treas. Reg. secs T and T apply to the transaction as characterized to determine whether the debt instrument is treated as stock, treating the consolidated group as one corporation, unless otherwise provided. With respect to issues surrounding members entering and leaving consolidated groups, the temporary regulations provide that when a departing member (a member of an expanded group that ceases to be a member of its original consolidated group but continues to be a member of the same expanded group) ceases to be a member of a consolidated group, the departing member s history of transactions with other consolidated group members remains disregarded. When an expanded group member joins a consolidated group, and continues to be a member of the same expanding group (a joining member ) the joining member and the consolidated group it joins are predecessor and successor for purposes of Treas. Reg. sec (b)(3). As to controlled partnerships, the temporary regulations clarify that a partnership all of the partners of which are members of the same consolidated group is treated as a partnership (and not a disregarded entity) for purposes of Treas. Reg. secs , T, and T; a covered debt instrument between a consolidated group member and a controlled partnership is thus treated as a consolidated group debt instrument. S corporations, REITs, and RICs The final regulations alleviate some of the concerns highlighted by the commentators with regards to the consequences of applying the proposed regulations to S corporations (i.e., potential termination of S corporation status), to REITs (i.e., potential loss of REIT status), and to RICs. Specifically, S corporations are expressly excluded from the definition of an expanded group member and therefore are exempt from all aspects of the final regulations. REITs and RICs may still be part of the expanded group, and thus subject to the regulations, to the extent they are controlled by members of an expanded group. Noncontrolled REITs and RICs, however, are excluded from the final regulations to the extent they would otherwise be the parent of an expanded group. Partnerships The Section 385 regulatory package contains temporary regulations treating a controlled partnership as an aggregate of its partners. The proposed regulations had proposed to recharacterize debt issued by a partnership as equity interests issued by the expanded group partners. In response to comments, the temporary regulations instead deem the holder of a debt instrument issued by a partnership to transfer that debt instrument to the expanded group partner or partners in exchange for stock in those entities. This deemed transfer is accomplished in several steps. First, the partnership determines the portion of the debt instrument that is treated as issued by an expanded group partner. Second, the partnership determines whether that portion of the debt instrument would be treated as stock under the aggregate approach, applying the general principles of Treas. Reg. sec (b). Third, the holder-in-form of the debt instrument is treated as transferring a portion of the debt instrument with a principal amount equal to the adjusted issue price of the specified portion to the expanded group partner (deemed holder) in exchange for stock in the expanded group partner (deemed partner 4 pwc

5 stock). This deemed transfer is treated as occurring for all US federal tax purposes. However, the temporary regulations provide that the deemed transfer does not cause the debt to be treated as owed to a partner for purposes of determining economic risk of loss when allocating the debt among the partners pursuant to Section 752. Banks and financial institutions The rule of Treas. Reg. sec (g) allows broad relief to regulated financial institutions through the definition of covered debt instrument. The status of an entity as a regulated financial company is determined through a specific enumeration of regulatory regimes (nearly all of which are identified via citation to the US Code or the Code of Federal Regulations). Omitting these citations, the exempted entities include: bank holding companies; certain savings and loan holding companies; insured depository institutions and any other national banks or state banks that are members of the Federal Reserve System; nonbank financial companies subject to a determination by the Financial Stability Oversight Council; certain US intermediate holding companies formed by foreign banking organizations; Edge Act and agreement corporations; supervised securities holding companies; registered broker-dealers; futures commission merchants; swap dealers; security-based swap dealers; Federal Home Loan Banks; Farm Credit System institutions; and small business investment companies. The use of the modifier certain in the list above is explained at least in part by the non-exempted entity list below. How certain modifies intermediate holding companies is not readily apparent. Of the exempted entity list, the preamble states as follows: "Although the specific requirements vary across the regulatory regimes... in each case the regulatory regime imposes capital or leverage requirements that have the effect of limiting the extent to which a regulated company can increase the amount of its debt." The drafters went on to note that consolidated supervision may apply to an entire group, including consolidated capital or leverage requirements and supervision of all material subsidiaries. There is also a non-exempted entity list consisting of: subsidiaries of a bank holding company or savings and loan holding that are held pursuant to the complementary activities authority, merchant banking authority, or grandfathered commodities activities authority under certain provisions of the Bank Holding Company Act. These, the drafters explain, are no different than any non-financial business. Also carved out are expanded group members that are not direct or indirect subsidiaries of a regulated financial company. Thus, if a regulated financial company is the parent of an expanded group, the entire group constitutes a regulated financial group. If not, only the direct and indirect subsidiaries of the regulated financial company constitute a regulated financial group. In addition to the regulatory regime aspects of the regulations, there are defined terms that carve out specific instruments from the definition of a covered debt instrument. These include a qualified dealer debt instrument and an excluded statutory or regulatory debt instrument. These rules have the effect of carving out debt instruments that form part of dealer inventory and debt instruments described in specific provisions of the Code (e.g., the notional debt that arises in connection with Section 482 adjustments). Insurance companies Like regulated financial institutions, regulated insurance companies are subject to regulatory capital requirements and have limited ability to issue instruments inappropriately characterized as debt. The final regulations accordingly do not apply to interests issued by regulated insurance companies other than captive insurance companies. The final regulations also treat surplus notes of an insurance company as meeting the documentation requirements of the regulations, even though approval or consent of a regulator may be required for payments under the notes. The final regulations make no special provision for life insurance companies that are prevented from joining a consolidated return by the life-nonlife consolidated return limitations, nor do they provide specific guidance on the treatment of a company s obligations under funds withheld reinsurance. Effective date and transition period The final and temporary regulations are effective as of their date of publication in the Federal Register, which is currently scheduled for October 21, 2016, and apply to taxable years ending on or after the date 90 days after the publication date, which would be January 19, 2017 based on the current schedule. The final regulations lengthen the proposed transition period by providing that any covered debt instrument that would be treated as stock by reason of the application of the final and temporary regulations on or before the date 90 days after the publication date (the final transition period ) is not treated as stock during that 90- day period, but rather that the covered debt instrument is deemed to be 5 pwc

6 exchanged for stock immediately after such 90th day, but only to the extent that the covered debt instrument is held by a member of the issuer s expanded group immediately after such 90th day (the final transition period rule ). Taxpayers may elect, however, to apply the proposed regulations to debt instruments issued after April 4, 2016, and before October 13, 2016, provided those rules are consistently applied. The documentation requirements under Treas. Reg. sec do not apply to interests issued or deemed issued before January 1, Let s talk PwC will continue to provide updates as we review the Section 385 regulations. For more information on these rules, please contact your local PwC contact or: Chip Harter (202) chip.harter@pwc.com Pam Olson (202) pam.olson@pwc.com Trent Johnson (202) trent.h.johnson@pwc.com Wade Sutton (202) william.w.sutton@pwc.com David Schenck (202) david.a.schenck@pwc.com Aaron Junge (202) aaron.h.junge@pwc.com Krishnan Chandrasekhar (312) krishnan.chandrasekhar@pwc.com Jeff Maddrey (202) jeffrey.maddrey@pwc.com Jared Hermann (202) jared.a.hermann@pwc.com Stay current and connected. Our timely news insights, periodicals, thought leadership, and webcasts help you anticipate and adapt in today's evolving business environment. Subscribe or manage your subscriptions at: pwc.com/us/subscriptions 2016 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. At PwC, our purpose is to build trust in society and solve important problems. PwC is a network of firms in 157 countries with more than 208,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out more and tell us what matters to you by visiting us at 6 pwc