For decades, the determination of whether debt issued between related parties should properly be characterized as equity has provided grounds for frequent disputes between taxpayers and the Treasury Department and the IRS (together, “the government”). Congress attempted to address this issue through the enactment of IRC § 385(a) (as part of the Tax Reform Act of 1969), which authorizes the Treasury Department to prescribe regulations as necessary or appropriate to determine whether an interest in a corporation should be treated as debt or equity. However, the government had not done so – until now.
On April 4, 2016, the government surprised the tax bar and the taxpayer community when it issued a new set of comprehensive regulations under IRC § 385 (“Proposed Regulations”). The Proposed Regulations represent a substantial change from settled law and will, if adopted, have a wide-ranging impact on intercompany debt including requiring certain debt instruments issued between related parties to be recharacterized as equity and establishing minimum documentation requirements that must be satisfied for intercompany debt instruments to be respected. The Proposed Regulations may also have substantial implications for state income tax purposes.
How the Proposed Regulations Will Operate
The Proposed Regulations establish fixed rules for determining whether intercorporate debt will be respected as debt for tax purposes. Specifically, the regulations will generally apply to debt instruments between members of an affiliated group that are issued after April 3, 2016, although certain transactions such as a transfer of debt or a change in entity classification could trigger the deemed issuance of a new note that would be subject to the regulations. Under a transitional rule, old debt instruments will be respected until 90 days after the final regulations are adopted after which they will be treated as equity if they would be so classified under the new regulations.
There are two provisions under the Proposed Regulations that would operate to recharacterize certain debt instruments as equity: the General Rule and the Funding Rule. Under the General Rule, debt between members of an affiliated group will be recharacterized as equity to the extent that it is issued as a distribution, in exchange for stock of an affiliate, or as part of an internal reorganization. Under the Funding Rule, debt that is issued to an affiliate in exchange for property will be recharacterized as equity where the principal purpose of the loan is to allow the issuing entity to fund certain types of distributions or acquisitions.
The Proposed Regulations provide two exceptions to the General Rule and the Funding Rule. First, a debt instrument will not be treated as equity if the aggregate issue price of all such debt instruments that would otherwise be treated as equity under the regulations does not exceed $50 million when it is issued. Second, distributions or acquisitions that do not exceed the current year’s E&P will not be treated as distributions or acquisitions for purposes of determining whether debt instruments should be recharacterized as equity under the General or Funding Rule.
The Proposed Regulations also impose contemporaneous documentation requirements that must be satisfied for certain related-party interests in a corporation to be treated as debt for tax purposes. Such documentation must establish a reasonable expectation of repayment and must be prepared no later than 30 days after the issuance of a related-party debt instrument.
Potential State Tax Implications
The Proposed Regulations may have a wide range of implications for state income tax purposes depending on whether and how states incorporate the final regulations. Even if states do not adopt similar regulations, it is possible that they will apply the underlying principles of the federal regulations when making debt-equity determinations. For instance, the Proposed Regulations do not apply to indebtedness between members of a federal consolidated group. Rather, a consolidated group is treated as a single taxpayer (i.e., one corporation) and is not subject to the General Rule, the Funding Rule, or the documentation requirements. In cases where a corporation files a consolidated federal return but is required for state tax purposes to calculate its taxable income as if a separate federal return had been filed, a state department of revenue might determine that the principles of the federal regulations should apply for state tax purposes even though the regulations would not apply for federal purposes.
It is also reasonable to assume that state auditors might look to the federal regulations for guidance during state and local tax audits rather than conduct their own detailed analysis of the factors historically taken into account when making debt-equity determinations. If this is the case, taxpayers might also be expected to meet the new documentation requirements under the federal regulations in order for existing debt to continue to be respected at the state level.
Further, many separate company states have enacted addback statutes (i.e., statutes that require taxpayers to add back the deduction for interest paid to an affiliated entity) that contain various safe harbors and exceptions. The Proposed Regulations, however, contain no such safe harbors or exceptions and thus, could result in a disallowance of the state-level deduction when applied to recharacterize debt as equity.
The Proposed Regulations, whether finalized in their current or altered form, will likely have far reaching effects that may not be fully grasped by taxpayers or the government for some time to come. Lawmakers have already begun to express concerns regarding the possible adverse administrative and economic consequences of the Proposed Regulations. In fact, the Senate Finance Committee and the House Ways and Means Committee are set to meet with top Treasury Department officials on July 6, 2016, to discuss the Proposed Regulations.
We will continue to monitor the progress of the Proposed Regulations and the potential implications for state and local taxpayers. In the meantime, prudent taxpayers should be aware of the proposed rules and take them into account when consulting with state and local tax counsel about tax planning.