Is It Debt or Equity? A Survey of the Proposed Section 385 Regulations

By:
James J. Wienclaw, CPA
Published Date:
Jul 1, 2016

The fundamental question investors address when capitalizing a business is how it should be funded—with debt, equity, or a combination of both. Considerations can vary widely depending on the level of risk an investor is willing to take or the desired tax treatment—for example, investor priorities over the business liquidation, priority in bankruptcy, annual cash-flow needs, annual income classification, interest or dividend treatment, and future tax benefits, among others. Generally, the IRC and related Treasury Regulations provide no definitive definition of either debt or equity. Therefore, in determining debt or equity classification, taxpayers and the IRS must look to the facts and circumstances, prior rulings, and case law.  As a result, taxpayers have employed flexibility in determining the optimal capital structure of a business.   

In an effort to provide clarity, the Treasury Department issued proposed regulations in April 2016 under IRC section 385. They drew much criticism: If finalized, they will dramatically change the tax treatment and compliance requirements for intercompany debt transactions. Although the proposed regulations were issued with anti-inversion legislation that drew attention to international restructurings and earnings stripping, the proposed regulations have wide applicability to expanded corporate groups that include domestic and foreign corporate chains, such as exempt entities, domestic affiliated corporate groups, and—in some cases—partnership interests.  The proposed regulations define an expanded group (“EG”) is an affiliated group, as defined in IRC section 1504(a), which has an 80% vote and value test with the inclusion of foreign entities.

At this time, portions of the proposed regulations—if finalized—would retroactively apply to debt instruments issued on or after April 4, 2016. It should be noted that Congress enacted IRC section 385 in 1969, and the Treasury Department issued final regulations in 1980 regarding whether an interest in a corporation would be treated as stock or debt; however, these regulations were subsequently withdrawn over concerns of vagueness and taxpayer manipulation. The new proposed regulations appear to go to the other extreme, and contain three key provisions of which practitioners and taxpayers should be mindful:    

Bifurcation Rule (Proposed Reg. 1.382-1). This gives the IRS authority to classify related party debt as part debt, part equity, or all equity—based on the facts and circumstances. To date, the IRS and the courts have followed a long-standing multifactor approach of “it’s either debt or equity” in ruling on these issues. The proposed regulations, however, provide no definitive guidance in making such determinations. It will be interesting to see how this develops, but we can be sure the existing body of knowledge will remain relevant to these decisions. Those interested might find the Joint Committee on Taxation’s Overview of the Tax Treatment of Corporate Debt and Equity useful in evaluating debt characteristics versus equity characteristics. Prior IRS and court rulings on debt versus equity also consider many of the same characteristics in their rulings. Whatever the means, reallocation can produce costly and unintended consequences—not to mention significantly increased compliance costs.                                  

Documentation Rule (Proposed Reg. 1-385-2). This gives the IRS authority to rely on significant contemporaneous documentation supporting purported debt treatment between affiliated members of an “expanded group instrument” (“EGI”). In general, the EGI rule applies to EG  traded on or subject to the rules of an established financial market, whose total assets exceed $100 million or whose total revenues exceed $50 million. In today’s standards, these are very low thresholds and the documentation requirements will be onerous. Generally, this requirement must be satisfied within 30 days after an EGI is issued or the date the issuer becomes an expanded group member. The proposed regulations contain the following three requirements to establish a genuine debtor-creditor relationship:

-- There must be written documentation showing an unconditional obligation to pay a sum certain on demand or at one or more fixed dates.

-- There must be written documentation supporting creditor rights in enforcing the obligation and providing for event triggers with default or acceleration clauses, waiver exceptions, dissolution provisions, and legal remedies.

-- There must be written documentation that clearly supports a reasonable expectation as to the ability to repay the obligation, including a credit analysis and financial review. 

Per Se Stock Rule (Proposed Reg. 1.385-3). This is targeted at debt issuances relating to transactions the Treasury Department has deemed to have limited non-tax significance. The rule, however, can inadvertently trap a taxpayer engaging in a transaction where tax avoidance is not a principal purpose. (Taxpayers will have 90 days to eliminate existing tainted transactions after the regulations are finalized). Accordingly, the IRS will now have bright line authority to recast related party debt as equity where debt is issued

-- as a distribution with respect to distributing corporations’ stock as a dividend or return of capital, including a redemption;

-- in exchange for affiliate stock;

-- as boot in an internal asset reorganization; or

-- to fund a distribution or acquisition of affiliate stock.  

As a practical matter, the documentation requirements are often handled with less formality than the proposed regulations require. The documentation requirements are not without some rationale, but taxpayers will invariably run afoul of these requirements. Applying the rules to groups that routinely engage in significant intercompany transactions will be a very complex process.   

The per se stock rule creates another level of complexity to work through because taxpayers and practitioners will have to document what the funds were actually used for. Taxpayers that run afoul here will be trapped with a default equity classification even where the documentation requirements are satisfied.      

As with most issues under examination, the IRS has the benefit of hindsight in evaluating the facts and circumstances, overall substance, and performance on any transaction. Therefore, noncompliance  most likely will result in debt automatically recast as equity. As a result, significant demand will be placed on professional resources, with a resulting increase in costs associated with financial audits and tax compliance.

What are some of the ramifications? The simple conclusion leads us to a lost interest deduction where debt is recast as equity.  The issues, however, can go much deeper, as this incomplete list of potential consequences demonstrate:  

-- Both taxpayers and practitioners might have to implement new levels of scrutiny in addressing these issues for purposes of analyzing uncertain tax position disclosures, which can be extremely subjective and costly.

-- There is an uncertain result where a presumed interest payment is characterized as a distribution—is it a dividend, return of capital, or some combination thereof?

-- There might be potential U.S. withholding tax issues, where interest is recast as a dividend income.

-- There will be implications in tracking stock basis.    

-- There will be due diligence costs for related acquisitions where the target engaged in intragroup financing transactions.

-- There will be an impact on group equity or asset reorganizations with the application of the per se stock rule.

The intent of the proposed regulations is to give the IRS tools to combat taxpayers from engineering interest-related tax deductions where EGI are issued. If these regulations are finalized, taxpayers will not only be required to apply them to transactions involving international affiliates, but also affiliated U.S. domestic groups—which could include otherwise exempt federal consolidated groups, where a member with related party debt enters or exits the group. Furthermore, there might be state and local implications due to different filing schemes.  

Critics of these regulations state that the Treasury Department and the IRS have completely underestimated the complexity and hour requirements needed to comply with these regulations. Many claim the requirements are simply not standard corporate practices, which might result in many corporations hiring professional staff dedicated to addressing these regulations. The IRS response to this criticism is that there are a lot of things taxpayers do to gain tax deductions that they normally would not otherwise do.   

This would not be the first time proposed regulations are issued with an overly complicated set of rules that can be impractical to efficiently and adequately implement. The IRS has indicated that comments on the proposed regulations must be submitted prior to July 7, 2016 to receive consideration in framing the final regulations slated for issuance later this year. The IRS has received a significant response to these regulations that request changes or the elimination of controversial provisions that many practitioners believe are impractical.

There is hope that the final regulations will relax the definitional criteria of an EG, along with providing some relief to the documentation and per se stock requirements. Ultimately, taxpayers and practitioners need regulations that can be implemented in a practical manner, which will increase compliance. The IRS also needs the same to effectively address and examine these complex issues. Based on the Treasury Department’s current position on anti-inversion and earnings stripping, it’s a risky proposition to assume the proposed regulations will go the way the final IRC section 385 regulations did in 1982. A more practical approach is for some compromise to be introduced with the final regulations later this year.


James J. Wienclaw, CPA,  is a partner in CohnReznick’s New York office. He is also the immediate past chairman of the NYSSCPA C Corporations Committee. He has almost 20 years of diversified public accounting experience with an extensive background in providing tax services to public and private companies and to the individual owners of closely held businesses. Jim’s expertise spans a variety of industries, including manufacturing and wholesale distribution, technology, commercial real estate, and professional services. Jim handles complex corporate and partnership entity tax structures for businesses operating in a multi-state environment. Services that he provides include tax consulting and compliance, tax minimization and optimization, implementation of tax efficient filing structures, net operating loss (NOL) utilization and limitations consulting, tax accrual services, and consulting on business acquisitions and dispositions. In addition to being a member of the NYSSCPA, Jim is also a member of the AICPA. He can be reached at  646-762-3430 or Jim.Wienclaw@cohnreznick.com

 
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