Tax Law Update - IRS Issues Proposed Regulations That Would Recast Certain Debt Instruments as Equity

04.28.16

On April 4, 2016, the IRS and U.S. Treasury Department, in connection with a package of regulations prompted by news of the recent spate of corporate inversions (particularly the $160 billion Pfizer-Allergan merger), issued proposed regulations which are designed to attack corporate "earnings stripping" practices, and which have application far beyond the inversion context (the "Proposed Regulations").

One common technique used for U.S. earnings stripping is for a foreign company to lend to a profitable related U.S. company.  This permits the U.S. company to reduce its U.S. tax liability by making deductible interest payments to the foreign lender, who is subject to tax on the interest income at a lower rate.  The Proposed Regulations would recast certain loans to U.S. affiliates as equity investments, rather than debt, so that interest paid thereon would be viewed as nondeductible dividend distributions.  If finalized in their current form, the Proposed Regulations would represent some of the most aggressive anti-taxpayer provisions ever promulgated, and would significantly impede several tax-planning options available to both U.S. and foreign-parented multinationals.
The Proposed Regulations provide that a related-party debt instrument must run a gauntlet of three requirements in order to avoid being recast, either in full or in part, as equity: (1) new documentation requirements, (2) new transactional requirements recasting debt as equity, and (3) traditional debt vs. equity principles.  A failure to satisfy any one of the three separate tests will result in the debt instrument being recast as equity.

The Proposed Regulations do, however, have some limits.  First, they apply only to related-party debt.  Second, the new documentation requirements apply only to expanded groups with total assets exceeding $100 million, annual total revenue exceeding $50 million, or publicly traded members; and the re-characterization rules for debt instruments issued in specified related-party transactions apply only after an aggregate $50 million debt threshold is exceeded.  Therefore, these particular rules should impact only large taxpayer groups.  Third, the Proposed Regulations do not yet have the force of law and generally are not proposed to apply to debt instruments issued before they are finalized, although the re-characterization rules for specified related-party transactions are proposed to apply to debt instruments issued on or after April 4, 2016 (with such instruments continuing to be treated as indebtedness during an additional 90-day grace period after the proposed Regulations are ultimately finalized).

While it remains to be seen whether the Proposed Regulations will ultimately be finalized in their current form, the administration appears hopeful that not only will this happen, but that it will happen before Labor Day. 

To read the full text of Orrick's client alert click here.

For more information on any of the issues discussed herein, please contact Peter Connors, Barbara Spudis de Marigny or Michael Rodgers.