Doing Business in the United States: Financing US operations

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A. Debt vs. equity

1. Section 385 regulations

During 2016, Treasury and the IRS issued final and now-expired temporary regulations under Section 385 addressing whether an interest in a related corporation is treated as equity or indebtedness, or as in part stock and in part indebtedness (the ‘385 Regulations’). The 385 Regulations are intended to limit the effectiveness of certain types of tax planning by characterizing related-party financings as equity, even if they are in form ordinary debt instruments. The types of transactions targeted include debt arising through the distribution of notes or loans, primarily in the inbound context.

Note: Application of the 385 Regulations is not limited to these types of transactions. The 385 Regulations instead apply generally to characterize as equity broad categories of related-party debt transactions that routinely arise in the ordinary course of operations in both the domestic and international context. The 385 Regulations therefore have a profound impact on a range of modern treasury management techniques, including cash pooling.

On November 4, 2019, Treasury issued final regulations that revoke the documentation requirements in the 385 Regulations effective as of that date (the Final Regulations).

Note: The 2016 Proposed Regulations that provided exceptions for certain short-term debt instruments and provided additional rules regarding partnerships and consolidated groups were finalized on May 14, 2020, without any substantive change.


Inbound insight: Because of the deferred effective date of the documentation requirements under Notice 2017-36 and the reliance language in the proposed regulations issued in September 2018, taxpayers effectively were never required to satisfy the now-removed documentation requirements.
 


Inbound insight: A taxpayer’s documentation of related-party loan arrangements (such as a comparability analysis in relation to the conduct of similarly situated unrelated parties) remains important for substantiating the arrangement’s treatment as indebtedness under traditional common law debt/equity analysis.
 

The 385 Regulations generally apply to financial instruments issued after April 4, 2016, or instruments issued before that date that have undergone certain types of significant modifications. Instruments issued after April 4, 2016, but before January 19, 2017, are subject to certain transition rules.The key remaining operational rules in the 385 Regulations are the following:

  • Reg. secs. 1.385-3 and 1.385-4 (the Distribution Rules) characterize as equity (i) notes distributed to a related shareholder, (ii) notes issued to acquire equity of a related entity, and (iii) notes distributed to a related entity as boot in an asset reorganization.
  • The Distribution Rules also treat as stock a debt instrument that is issued as part of a series of transactions that achieves a result similar to the distribution of a debt instrument (the Funding Rule).

  • The rules also generally characterize as an equity investment loans to related entities within a 72-month period centered on the date of the loan that (i) distribute dividends, (ii) acquire equity in related entities, or (iii) distribute boot in asset reorganizations (the per se Funding Rule).
  • Also on November 4, 2019, Treasury and the IRS issued an Advance Notice of Proposed Rulemaking (ANPR) announcing their intent to issue proposed regulations that would streamline the Distribution Rules. The ANPR provides that the per se Funding Rule would be withdrawn and future proposed regulations would treat a debt instrument as funding a distribution or economically similar transaction only if there is a sufficient factual connection between the two.


Inbound insight: Companies and tax practitioners considering any acquisition of a US business entity by a foreign business entity, as well as certain inbound restructuring transactions, need to consider the full scope of the remaining Section 385 regulations, and the possible adverse US consequences arising from their application. Additionally, existing judicial principles still need to be followed, including documenting that there is adequate support for treatment of an instrument as debt or equity for US federal income tax purposes.
 


Inbound insight: Although Treasury and the IRS announced in the ANPR that they intend to make the Distribution Rules more streamlined and targeted, future regulations would apply only prospectively. As a result, the ANPR effectively is a request for comments on how best to streamline and target the Distribution Rules, Thus, the Distribution Rules (including the per se Funding Rule) continue to apply, and taxpayers should continue to evaluate how those regulations apply to their debt instruments.
 

2. IRS Information Document Request (IDR)

Companies often finance the operations of their global business through intercompany loans. In determining whether intercompany loans are truly debt in nature or whether they are, in fact, equity transactions, the IRS has developed a 13-part Information Document Request (IDR), which includes a request for financial data for years outside of the particular audit cycle.

If the IRS finds the transaction to appear more like equity than debt in nature, the interest deduction taken on a company's tax return associated with the ‘debt’ will be denied. For companies that have recently increased their debt level, it is likely that the IRS will focus even more on this issue, potentially auditing future years when the intercompany debt exponentially increases.

The factors the IRS will consider – which are based on relevant case law –  include whether:

  • an arm's-length rate of interest was charged and interest payments were timely made
  • the debt is evidenced by written documents such as notes
  • the debt has a fixed maturity date and scheduled payments
  • there is an expectation that the debt will be repaid with free working capital
  • security is given for the advances
  • the borrower is adequately capitalized
  • the borrower is able to obtain adequate outside financing from third-party sources.

While no one particular factor or set of factors is controlling, case law has established that the objective facts of a taxpayer’s situation must indicate the intention to create an unconditional obligation to repay the advances. Although courts consider both the form and the economic substance of the advance, the economic substance is deemed more important. The more a related-party financing arrangement resembles a loan that an external lender would make to the borrower, the more likely the advance will be considered debt.


Inbound insight: The OECD’s BEPS initiative includes proposed restrictions on the deductibility of related-party debt based on either a group's worldwide debt to equity ratio or a percentage of earnings before interest, taxes, depreciation, and amortization (EBITA). Early versions of the Act included a worldwide leverage test, but such a test was not included in the Act’s interest expense deduction limitation discussed above.

3. Key Tax Court decision

A large body of case law has developed as to whether an instrument is characterized as debt or equity. A US Tax Court memorandum opinion from 2012 in which the court upheld the taxpayer's debt characterization of US intercompany debt – while a ‘memorandum decision’ that does not serve as binding precedent – is important because it indicates the Tax Court’s current approach to debt vs. equity determinations. Note: The Tax Court is the federal trial-level court that hears most federal tax cases.

In particular, at a time when the IRS has been aggressively challenging taxpayers’ intercompany financing arrangements, in this case the Tax Court applied a principled approach based on traditional debt vs. equity factors as established by case law. Note that the debt vs. equity determination is based on a taxpayer's particular facts and circumstances.

The issue in NA General Partnership & Subsidiaries v. Commissioner, T.C. Memo. 2012-172, was whether an advance made by the taxpayer’s non-US parent to its US group constituted debt or equity and, therefore, whether the taxpayer was entitled to interest expense deductions. The court, ruling in favor of the taxpayer, upheld the taxpayer's treatment of the advance as debt.

The Tax Court applied a traditional debt vs. equity analysis, examining a series of factors developed by courts. Because appeal of the case would have been heard by the US Court of Appeals for the Ninth Circuit (the IRS did not appeal the decision), the Tax Court focused on case law developed by that circuit, which considers the following factors relevant to determine whether an advance is debt or equity:

  • the name given to the documents evidencing the indebtedness
  • the presence of a fixed maturity date
  • the source of the payments
  • the right to enforce payments of principal and interest
  • participation in management
  • a status equal or inferior to that of regular corporate creditors
  • the intent of the parties
  • ‘thin’ or adequate capitalization
  • identity of interest between creditor and stockholder
  • payment of interest only out of ‘dividend’ money
  • the corporation's ability to obtain loans from outside lending institutions.

Inbound insight: The Tax Court’s analysis reflects that courts generally look to whether the borrower has the ability to generate sufficient cash flows to service and repay the debt as an important factor. Interestingly, the test is often applied by looking at operating cash flow, i.e., whether the borrower would have the ability to generate sufficient operating cash flows to service the debt without being forced to sell its assets.

4. General approach of courts

a. Source of payments

While each court may not apply precisely the same factors, the courts often consider the source of payments in analyzing whether an instrument is debt or equity. In particular, if repayment depends on earnings or is to come from a restricted source, equity characterization may be indicated.

b. Subordination to creditors

Another factor courts frequently consider is whether the relevant instruments are subordinated to creditors.

c. Intent of the parties

Courts frequently consider objective indications of the parties' intent to determine whether they intended to enter into a debtor-creditor relationship. In the Tax Court case discussed above, the IRS also argued that the parties’ post-transaction conduct did not demonstrate intent to form a genuine debtor-creditor relationship. The IRS focused on the delayed interest payments, and the short-term loan from the foreign parent to the borrower to fund interest payments on the loan.


Inbound insight: The IRS has challenged intercompany debt arrangements by using hindsight evidence to assert that the behavior of the parties subsequent to the arrangement's inception reveals that the parties never truly intended to create a debtor-creditor relationship. In general, existing case law suggests that it is not appropriate to recharacterize debt as equity by using hindsight evidence based on circumstances that the parties reasonably did not anticipate at the onset.

d. Inadequate capitalization

In general, if a corporation is thinly capitalized, advances made to the corporation are more likely to be characterized as equity. Courts generally focus their analysis of a corporation’s capitalization on its debt-to-equity ratio.

e. Ability to obtain outside financing

Courts have held that evidence that a purported debtor could have obtained loans from outside sources on comparable terms points in favor of debt characterization, whereas evidence that a debtor could not have obtained such loans points toward an equity characterization.

B. Cash pooling

Many corporate groups take advantage of so-called cash pooling arrangements (either physical or notional), in which credit and debit positions of multiple members of a group generally are concentrated in a single account (either physically or notionally). US tax consequences should be considered with respect to these cash pooling arrangements.

Specifically, if a US group member is asked to join a cash pool, various US tax issues must be considered. If the US member only deposits funds with (i.e., lends to) the cash pool, the tax issues include:

  • intercompany interest rates must be adequate and at arm’s length (consider the safe harbor rate under Section 482)

  • to the extent funds are denominated in a non-functional currency, foreign currency gains or losses must be accounted for and net foreign currency gain of a CFC borrower could give rise to subpart F income or GILTI

  • requirements for annual withholding tax returns for US-source income of foreign persons and

  • Foreign Bank and Financial Account (FBAR) and FATCA reporting requirements.

If the US member draws on (i.e., borrows from) the cash pool, additional US tax issues that must be considered include:

  • interest deductions, including thin capitalization issues the interest deduction deferral rules, and the interest disallowance rules for payments involving a hybrid entity

  • withholding tax and conduit issues, including requirements for annual withholding tax returns for US-source income of foreign persons and the availability of treaty benefits

  • subpart F and Section 956 issues to the extent there are CFC depositors, even if the cash pool itself is not a CFC or has relatively low earnings. (see Tax readiness insight below with respect to Section 956.)

  • Section 59A (BEAT) issues arising with cross-border payments and

  • Potential recharacterization of debt as equity under Section 385.

If the US member draws on (i.e., borrows from) the cash pool, additional US tax issues that must be considered include:

  • interest deductions, including thin capitalization issues the interest deduction deferral rules, and the interest disallowance rules for payments involving a hybrid entity

  • withholding tax and conduit issues, including requirements for annual withholding tax returns for US-source income of foreign persons and the availability of treaty benefits

  • subpart F and Section 956 issues to the extent there are CFC depositors, even if the cash pool itself is not a CFC or has relatively low earnings. (see Tax readiness insight below with respect to Section 956.)

  • Section 59A (BEAT) issues arising with cross-border payments and

  • Potential recharacterization of debt as equity under Section 385.


Inbound insight: If US subsidiaries of a US group member are required to join the cash pool, these considerations apply to each US participant in the pool. Consider using a subpool to manage the multiplicity of issues, including treaty qualification considerations. (See also the discussion above of the Section 385 regulations.)

Tax readiness insight: The cost of financing likely will increase in light of the Act. All taxpayers (e.g., both inbound and outbound) are subject to new interest deduction limitations for both related-party and third-party debt.

Tax readiness insight: In November 2018, Treasury issued proposed regulations limiting the application of Section 956 for US corporate shareholders. In general (and with certain exceptions), under Section 245A and the proposed Section 956 regulations, respectively, neither an actual dividend to a corporate US shareholder, nor such a shareholder's amount determined under Section 956, will result in additional US tax.On May 23, 2019, Treasury and the IRS published final regulations under Section 956 that largely adopt the 2018 proposed regulations, but with two important substantive changes. First, the final regulations provide a new ordering rule that sources the hypothetical distribution solely from a CFC’s Section 959(c)(2) previously taxed earnings and profits and Section 959(c)(3) earnings and profits. Second, the final regulations reduce the potential Section 956 amount with respect to a US shareholder that is a domestic partnership at the partnership level, to the extent that a domestic corporate partner of the partnership would be entitled to a Section 245A DRD if the partnership received its share of the tentative Section 956 amount directly as a distribution from the CFC.

For more information, please contact:

Oren Penn

Principal, US Inbound Tax and International Tax Services, PwC US

Email

Eileen Scott

Managing Director, International Tax Services, PwC US

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Christopher Kong

Christopher Kong

US inbound tax leader, PwC US

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