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When is a Debt Instrument Transformed into Equity? When the US Treasury Proposes So.

Internal Revenue Service|International|Tax

By Michael Leopold

In response to the seemingly public trend of U.S. Corporate inversions and more companies looking for ways to defer paying US taxes on foreign-earned income, the U.S. Treasury issued proposed regulations on how debt and equity should be classified for tax purposes. The proposed REG-108060-15 falls under Section 385, and was enacted as part of the Tax Reform Act of 1969. It gives the Internal Revenue Service (IRS) broad powers in interpreting whether an economic interest in an entity is considered to be debt or equity. The Treasury is investigating ways to better define when something is truly a loan or whether it is equity in disguise (perhaps a parent organization makes a loan and knows the related business cannot repay it with normal cash flow). It also allows the IRS to make the call and potentially bifurcate the above-mentioned debt into a combination of both debt and equity, depending on economic substance.

With globalization, many companies have expanded into new countries and markets. Along with new profits and diversification, U.S. companies have focused on ways in which to decrease taxation. While most countries tax a business at the local country level, the U.S. has a worldwide income taxation policy whereby earnings in every location are taxed. While U.S.-based operations are taxed in the year generated, foreign income from a corporate subsidiary is usually only taxed when the money comes back home. Once here, usually in the form of a dividend, it is then taxed, minus a credit for any past foreign taxes paid. It has been widely reported in the news that many large companies (Apple, Microsoft, and others) have billions in cash that have yet to come back to the states. For most of these companies, the taxes paid overseas are much less than the U.S. taxes are.

So what is a company to do when funds are overseas from legitimate business dealings but money is needed at home? Borrow it. Businesses are choosing to lend funds from one related corporation in an economic group to the other. This gives them the ability to set rates that may be more favorable than through a bank and may give better payment terms as well. The U.S. Company can then deduct the interest paid on the loan as an expense, subject to the payments being made and existing thin capitalization rules followed (when a corporation is financed with too much debt and very little equity), and the foreign corporation will be taxed on the interest income locally. The U.S. corporation can delay paying U.S. taxes on repatriated earnings for the time being and still have access to the funds needed.

With a need for more tax dollars at home and a public feeling of companies needing to pay their fair share, the Treasury’s proposal to combat the loan strategy came this spring.

There are two main parts to the proposed regulations: the General Rule and the Funding Rule. The General Rule has three prongs to it. The first prong potentially treats certain debt instruments as equity to the extant issued by corporations to a member of the corporation’s expanded group, as defined below. From how it has been written, it would seem that the IRS would also be able to determine the character of the stock (common, preferred, etc.) based on the terms the lending company writes in the debt instrument to its affiliate. The second prong treats debt as equity for certain types of assets (say boot given in the form of a note). The third prong would potentially apply to debt issued in exchange for property during asset reorganizations within the same expanded group (most that fall within the subsections of Sec 368). The Funding Rule focuses more on where the funds are coming from. For larger businesses using various treasury cash pooling tools (a common tool whereby one large checking account is jointly used), the IRS may see monetary transactions coming out of it as a loan, rather than the business’ way of centralizing their banking.

The regulations apply to any expanded group. An expanded group broadens the IRS’ concept of an affiliated group to also include foreign corporations, domestic corporations held indirectly through partnerships, and any corporation connected through either 80% of voting shares or 80% of share value. Consolidated C Corporations with domestic operations are considered a single taxpayer and are excluded from these rules.

While the main intended recipients of the proposed regulations were very large multinational corporations, they may apply to many medium-sized businesses as well. There are a few thresholds that give leeway to smaller organizations: less than $50 million in all potential expanded group borrowing, less than $100 million in group assets, if debt instruments are less than the normal earnings and profits for that year, and lastly, debt instruments used in the transfer of property to a related party in exchange for equity and the percentage owned in that company within a 36 month window stays over 50% (the idea being longer term investment in the company and not simply cycling cash in and out).

What this means, is that companies in the U.S. will have to consider from where and how they are funding transactions. For example, one expanded group company may loan $10 million to another. From an actual cash flow perspective, the company may only be able to pay back $3 million in the set timeframe. In that case, the IRS may bifurcate the loan and consider the other $7 million as new equity in the second company. There are also very detailed loan paperwork requirements (essentially requiring the lending company to document transactions like a bank), and there is the potential for the IRS to retroactively classify the transaction based on current performance. Another point of concern would be with the much used S Corporation structure. As S Corporations cannot have C Corporations as shareholders or two classes of voting stock, having an expanded group member lend it money may unintentionally put the S status at risk if the IRS reclassifies the debt as a new type of equity stock.

The Treasury has expressed the desire to finalize the proposal within a year. The open comment period finished at the end of July, and hearings were held the week after. A number of trade groups and affected businesses have come forward with requests for more information. The U.S. Chamber of Commerce has asked for until 2019 to work on this more. House Ways and Means Chairman, Kevin Brady (R-TX), has expressed concern over the economic impact to a number of business types. At a recent event by the Tax Policy Center Mark Mazur, Treasury Department’s assistant secretary for tax policy, shared that, “We've gotten hundreds of comment letters - some incredibly helpful ones that point out some of the possibly unintended consequences, things that we'd like to try and fix.” While not finalized, there are certainly things that should be reviewed in regards to inter-company loans, the necessary paperwork documentation, cash-pooling, and more.

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