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Tax Law

April ’16 Inversion Regs Impose Anti-Earnings Strippings Rules

On April 8, 2016, the IRS and Treasury took additional action against corporate inversions and issued temporary, proposed, and final regulations targeting inversion transactions. Among the proposed regulations were much anticipated rules that address earnings strippings transactions. This article briefly discusses the new rules.

Earnings Strippings. The goal of the proposed regulations in 81 FR 20912 is to discourage post-inversion, earnings strippings transactions, which attempt to lower a multinational corporation’s U.S. tax liability by using payments of deductible interest to its new foreign parent or one of its foreign affiliates in a tax-friendlier jurisdiction. [See, “Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Strippings Regulations,” 4/4/2016].

As stated in the Treasury’s Fact Sheet, the proposed regulations curb earnings strippings by:

1. Targeting transactions that increase related-party debt that is not used to finance new investment in the U.S.

2. Allowing the IRS on audit to divide a purported debt instrument into part debt and part stock.

3. Requiring documentation for members of large groups to include key information for debt-equity tax analysis.

The proposed regulations in 81 FR 20912 are issued under IRC Section 385, the provision of the Code which allows the Treasury “to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated . . . as stock or indebtedness (or as in part stock and in part indebtedness)”. [IRC § 385(a)].

Under IRC Section 385, the regulations issued by the Treasury are to “. . . set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists.” [IRC § 385(b)]. These recent proposed regulations are the first regulations issued under IRC Section 385.

As noted in the preamble to the proposed regulations, the Treasury and IRS mentioned in the 2014 and 2015 notices that they were considering guidance aimed at “strategies that avoid U.S. tax on U.S. operations by shifting or ‘stripping’ U.S.-source earnings to lower-tax jurisdictions, including through inter-company debt”, and these proposed regulations follow through on that consideration. [Preamble, 81 FR 20912]. Although the proposed regulations in 81 FR 20912 were issued at the same time as the proposed, final, and temporary regulations issued specifically with respect to corporate inversions, the proposed regulations point out that they also apply to excessive debt between two domestic entities. The preamble to 81 FR 20912 states that the proposed regulations under IRC Section 385 apply to “purported indebtedness issued to certain related parties, without regard to whether the parties are domestic or foreign.” [Preamble, 81 FR 20912].

Substantiation and Treatment of Related-Party Interest as Stock. The key provisions of the proposed regulations address:

(1)   the requirements taxpayers must meet to substantiate the treatment of related-party interest as debt for federal tax purposes, and

(2)   the circumstances under which the IRS can treat the related-party interest as stock, in whole or in part, rather than debt for federal tax purposes.

The preamble to 81 FR 20912 states that the proposed regulations provide guidance on the substantiation by a taxpayer of the treatment of:

(1) certain interests issued between related parties as indebtedness for federal tax purposes,

(2) certain interests in a corporation as in part indebtedness and in part stock, and

(3) distributions of debt instruments and similar transactions that frequently have only limited non-tax effects. [Preamble, 81 FR 20912].

Definitions and Operating Rules. Definitions for purposes of the proposed regulations are provided in Proposed Regulations Section 1.385-1. The definitions are for the terms controlled partnership, disregarded entity, expanded group, modified controlled partnership, and modified expanded group. Section 1.385-1 of the proposed regulations also provides operating rules pertaining to the treatment of certain direct and indirect interests in corporations as stock or debt for federal tax purposes, including rules regarding the treatment of a deemed exchange and the treatment of an expanded group instrument as part debt and part stock after an analysis by the Commissioner.

Substantiation for Debt-Equity Analysis by Commissioner. Section 1.385-2 of the proposed regulations provides certain threshold preparation and maintenance requirements that a taxpayer must satisfy with respect to documentation and information in order to substantiate the treatment of an interest between members of an expanded group as debt for federal tax purposes. Per Proposed Regulations Section 1.385-2, the purpose for the requirements is to enable the Commissioner to make an “analysis” as to whether an expanded group instrument is “appropriately treated as stock or indebtedness for federal tax purposes.” [Prop. Treas. Reg. § 1.385-2(a)(1)]. Also, per Section 1.385-2 of the proposed regulations, meeting the threshold requirements is only the beginning of the analysis. Section 1.385-2 states: “Satisfying the requirements of this section does not establish that an interest is indebtedness; such satisfaction serves as a minimum standard that enables this determination to be made under general federal tax principles.” [ Prop. Treas. Reg. § 1.385-2(a)(1) ].

Proposed Regulations Section 1.385-2 provides that nothing in the section prevents the Commissioner from making a substance over form assertion with respect to a transaction involving an EGI or the EGI itself, from disregarding the transaction or the EGI, or from treating the transaction or EGI according to its substance for federal tax purposes. Section 1.385-2 of the proposed regulations further provides that a determination of the federal tax treatment of the EGI can only be made after the threshold requirements are met and that after that point, the Commissioner may analyze “the documentation and information prepared and maintained, other facts and circumstances relating to the EGI, and general federal tax principles”. [Prop. Treas. Reg. § 1.385-2(a)(1)]. Proposed Regulations Section 1.385-2 states that: “If the requirements of [Section 1.385-2] are not satisfied with respect to an EGI the substance of which is regarded for federal tax purposes, the EGI will be treated as stock.” [Prop. Treas. Reg. § 1.385-2(a)(1)].

Stock Treatment for Certain Interests Otherwise Treated as Debt. Under Section 1.385-3 of the proposed regulations, certain interests in a corporation that are held by a member of the corporation’s expanded group and that otherwise would be treated as debt for federal tax purposes can be treated as stock. [Prop. Treas. Reg. § 1.385-3(a)]. Section 1.385-3 of the proposed regulations provides several rules to determine whether such interests can be treated as stock rather than purported debt and also several examples illustrating the application of the rules. Proposed Regulations Section 1.385-3 sets forth scenarios when a debt instrument will be treated as stock under the section and states that if a debt instrument is treated as stock under the section, the debt instrument will be treated as stock for all federal tax purposes. [Prop. Treas. Reg. § 1.385-3(b)].

Under the general rule of Section 1.385-3 of the proposed regulations, a debt instrument generally will be treated as stock to the extent the debt instrument is issued by a corporation to a member of the corporation’s expanded group in:

(1) a distribution,

(2) an exchange for expanded group stock, other than in exchange that is exempt, or

(3) to a certain extent, an exchange for property in an asset reorganization. [Prop. Treas. Reg. § 1.385-3(b)(2)].

In the case of an exchange for property in an asset reorganization, the debt instrument will be treated as stock only to the extent that, pursuant to the reorganization plan, “a shareholder that is a member of the issuer’s expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation.” [Prop. Treas. Reg. § 1.385-3(b)(2)(iii)].

Section 1.385-3 of the proposed regulations further provides that unless an exception applies, a debt instrument will be treated as stock to the extent it is a “principal purpose debt instrument”. [Prop. Treas. Reg. § 1.385-3(b)(3)(i)]. The section states that a “principal purpose debt instrument” is a debt instrument “issued by a corporation (a “funded member”) to a member of the funded member’s expanded group in exchange for property with a principal purpose of funding a distribution or acquisition . . .” described in the section. [Prop. Reg. § 1.385-3(b)(3)(ii)].

An anti-abuse provision is found in Proposed Regulations Section 1.385-3, which provides that a debt instrument, or an interest that is not a debt interest for purposes of Section 1.385-3 or Section 1.385-4 of the proposed regulations, will be treated as stock if it is issued with the principal purpose of avoiding the application of Section 1.385-3 or Section 1.385-4 of the proposed regulations. [Prop. Reg. § 1.385-3(b)(4)].

As referenced above, there are exceptions to the application of the stock treatment rules of Section 1.385-3 of the proposed regulations. Section 1.385-3(c) of the proposed regulations provides the following exceptions:

(1) exception for current year earnings and profits,

(2) threshold exception, and

(3) exception for funded acquisitions of subsidiary stock by issuance. [See Prop. Treas. Reg. § 1.385-3(c)].

Section 1.385-3 of the proposed regulations also provides operating rules for when a debt instrument is treated as stock under Section 1.385-3(b) of the proposed regulations. [See Prop. Treas. Reg. § 1.385-3(d)]. In addition, Section 1.385-3 of the proposed regulation provides definitions for terms used in the section and also several examples, as mentioned. [See Prop. Treas. Reg. § 1.385-3(f) and (g)].

Consolidated Groups.  Special rules on the treatment of transactions involving consolidated groups are provided in Section 1.385-4 of the proposed regulations. Section 1.385-4 states that it provides rules for applying Section 1.385-3 to consolidated groups when an interest ceases to be a consolidated group debt instrument or when an interest becomes a consolidated group debt instrument. [Prop. Treas. Reg. § 1.385-4(a)]. Section 1.385-4 of the proposed regulations states that members of a consolidated group are treated as one corporation for purposes of the regulations under IRC Section 385. [Prop. Treas. Reg. § 1.385-4(a)]. Proposed Regulations Section 1.385-4 states that when a corporation stops being a member of the consolidated group but continues to be a member of the expanded group, a debt instrument issued or held by such corporation, referred to as departing member, will be treated as indebtedness or stock. [Prop. Treas. Reg. § 1.385-4(b)].

Section 1.385-4 of the proposed regulations also provides a rule for when a debt instrument that is treated as stock under Section 1.385-3 enters a consolidated group and becomes a consolidated group debt instrument. Proposed Regulations Section 1.385-4 states that “immediately before that debt instrument becomes a consolidated group debt instrument, the issuer is treated as issuing a new debt instrument to the holder in exchange for the debt instrument that was treated as stock in a transaction that is disregarded for purposes of § 1.385-3(b).”

Examples of the application of the rules of Section 1.385-4 of the proposed regulations are also provided in the section.