New Regs on Earnings Strippings Transactions

On October 13, 2016, the Treasury and IRS issued regulations [T.D. 9790 (Oct. 13, 2016)] finalizing and revising proposed regulations issued earlier in the year that targeted post-inversion earnings strippings transactions, which are certain related-party debt transactions that inverting companies engage in post-inversion to lower their tax liability.

The issuance of the proposed regulations in April was received with a significant amount of commentary from corporations, banks, and tax practitioners, and the new set of final, temporary, and proposed regulations reflect the Treasury and IRS’s efforts to address the comments and concerns. As quoted in the Treasury Department’s press release announcing the new set of regulations [See “Treasury [sic] Issues Final Earning Stripping Regulations to Narrowly Target Corporate Transactions That Erode U.S. Tax Base,” U.S. Department of the Treasury Press Center (Oct. 13, 2016), which can be found at https://www.treasury.gov/press-center/press-releases/Pages/jl0580.aspx],  Secretary Jacob Lew stated with respect to the comments:

Today’s final regulations are an important step in addressing earnings stripping, a commonly used technique to minimize taxes after an inversion. Throughout our rulemaking process, we sought comments to help narrow the rule and avoid any unintended consequences. We engaged extensively with businesses, tax experts, the public, and lawmakers and carefully considered their comments and recommendations. As a result of this process, the final rule effectively addresses stakeholder concerns by more narrowly focusing the regulations on aggressive tax avoidance tactics and providing certain limited exemptions.

The new set of regulations adopt many of the provisions of the proposed regulations, which set forth rules establishing certain threshold documentation requirements that   corporations have to satisfy in order for certain related-party interests in a corporation to qualify as debt for federal tax purposes. [Proposed regulations, 81 FR 20912 (April 8, 2016]. The required documentation enables the IRS Commissioner to determine whether interests are debt or stock pursuant to the Commissioner’s authority under IRC Section 385. [Proposed regulations, 81 FR 20912 (April 8, 2016]. In addition to adopting as final many of the rules in the proposed regulations, the new set of regulations also modify many of the provisions of the proposed regulations. The preamble to the new set of regulations summarizes these changes, and below are some of the major changes highlighted in the preamble:

• The bifurcation rule of the proposed regulations, which allowed the Commissioner to treat a purported debt instrument as in part stock and in part indebtedness, is dropped in the final regulations.

• The final regulations do not apply to foreign issuers debt instruments.

• The final regulations do not apply to S corporations and non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs).

• The final regulations drop the 30-day “timely-preparation” period for a taxpayer to prepare the required documentation under Section 1.385-2 and will now treat the documentation as timely prepared if the issuer of the purported debt instrument prepares the documentation by the time the issuer’s federal income tax return is filed.                                                                                      

• The final regulations provide a rebuttable presumption that a purported debt instrument is stock, rather than a per se recharacterization of the debt as stock, if an expanded group fails to meet the documentation requirements with respect to the purported debt instrument but the expanded group is otherwise generally in compliance with the documentation requirements of Section 1.385-2.

• The final regulations delay the implementation of the documentation regulations in Section 1.385-2 and now will apply to debt instruments issued on or after January 1, 2018.

• The final and temporary regulations in Section 1.385-3 exclude from their application debt instruments issued by certain financial groups and insurance entities whose capital structure is subject to a specified degree of regulatory oversight.

• The final and temporary regulations in Section 1.385-3 do not apply to certain related-party cash management arrangements and other short-term debt instruments used to finance short-term needs.

• The earnings and profits exception in Section 1.385-3 is expanded by the final and temporary regulations to include all the earnings and profits of a corporation that it accumulated while the corporation was a member of the same expanded group and after the day that the proposed regulations were issued.

Additional modifications in response to the numerous comments on the proposed regulations are found in the final and temporary regulations, and the changes (and the significant length of the regulations themselves) evidence the Treasury’s careful study and consideration of the concerns of affected taxpayers and others in the tax community. From a policy perspective, the new set of regulations demonstrates the Treasury and IRS’s continued efforts to curb corporate inversions and, as expressed by Secretary Lew, “to protect the tax base from continued erosion”. [See “Treasury [sic] Issues Final Earning Stripping Regulations to Narrowly Target Corporate Transactions That Erode U.S. Tax Base,” U.S. Department of the Treasury Press Center (Oct. 13, 2016), which can be found at https://www.treasury.gov/press-center/press-releases/Pages/jl0580.aspx]. Considering the robust response to the  proposed regulations issued in April, it will be interesting to see how the new regulations will be received.