During 2016, Treasury and the IRS issued final and temporary regulations under Section 385 addressing whether an interest in a related corporation is treated as stock or indebtedness, or as in part stock and in part indebtedness (the ‘385 Regulations’). The 385 Regulations appear 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 appear to 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 would 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 could have a profound impact on a range of modern treasury management techniques, including cash pooling.
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 operational rules in the 385 Regulations are the following:
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:
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.
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:
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.
Another factor courts frequently consider is whether the relevant instruments are subordinated to creditors.
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.
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.
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.
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:
If the US member draws on (i.e., borrows from) the cash pool, additional US tax issues that must be considered include: