The IRS has issued much-anticipated final regulations intended to keep multinational companies from moving their profits offshore to avoid paying U.S. income taxes. The regulations are part of a larger Obama administration campaign against corporate inversions, whereby a U.S. company merges with a foreign firm and then changes its tax address (domicile) to the foreign country. In particular, the regs address earnings stripping, a practice commonly used to minimize taxes after an inversion.
Genesis of the regulations
Since 2014, the Treasury Department has taken several steps to limit the recent wave of corporate inversions. For example, earlier this year, the IRS issued temporary regulations to prevent “serial” inversions. These regs disregard foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. Specifically, the regs prevent a foreign company that acquires multiple U.S. companies in stock-based transactions within a three-year period from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition. The temporary regs have yet to be finalized, but are in effect. Their release in April led almost immediately to the collapse of a pending $160 billion merger between U.S.-based Pfizer and the much smaller Ireland-based company Allergan.
At the same time it released the temporary regs, the IRS issued proposed regulations to tackle so-called “earnings stripping” by tightening the tax rules that distinguish between debt and equity. According to the IRS, multinational corporations often use earnings stripping after a corporate inversion to minimize their U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country, such as Ireland. The technique can generate significant interest deductions without any corresponding new investment in the United States. Unfortunately, the final regulations are not just limited to foreign debt versus equity issues which has caused significant consternation among tax practioners.
The finalized regs contain numerous changes that expand and modify the proposed regs — many of these changes respond to the extensive feedback generated by the temporary regs. The IRS asserts that the final regs will apply to only 6,300 companies. Those companies, it says, make up 0.1% of U.S. corporations but report more than half of corporate net income and almost two-thirds of corporate interest deductions.
New restrictions and requirements
The final regs limit the ability of corporations to pursue earnings stripping by allowing the IRS to treat certain debt transactions among related parties (for example, a parent company and an affiliate) as equity transactions. In other words, the IRS can now convert deductible interest payments into taxable dividends for certain transactions.
The final regs also require corporations claiming interest deductions on related-party loans to provide documentation for the loans, as businesses usually do for loans from unrelated parties. Generally, corporations will need to provide documentation of:
- An unconditional and binding obligation to make interest and principal payments on certain fixed dates,
- The debt holder’s rights as a creditor, including superior rights to shareholders in the case of dissolution,
- A reasonable expectation of the borrower’s ability to repay the loan, and
- Conduct consistent with a debtor-creditor relationship.
Because the ability to minimize income taxes through the issuance of related-party financial instruments isn’t limited to the related companies in different countries, the documentation rules also apply to related U.S. affiliates of a corporate group. This is a point of contention for many U.S. businesses that engage in related-party transactions.
On a more taxpayer-friendly note, the final regulations somewhat relax the intercompany loan documentation rules. They provide that, if an expanded group is otherwise generally compliant with the documentation requirements but doesn’t comply for a certain purported debt instrument, a rebuttable presumption will apply, rather than an automatic recharacterization of the instrument as stock. The regs also move the deadline for submitting the required documentation from within 30 days of the loan to the date the lender’s federal income tax return is due (taking into account extensions).
The final regulations on documentation also provide a significant limitation to their applicability. According the final regulations, they only apply if (1) the stock of any member of the group is publicly traded, (2) the total assets of the group exceed $100 million or (3) the annual revenue for the group exceeds $50 million. This limitation will prevent many smaller groups from needing to comply with the newly imposed documentation requirements.
In addition, the final regs eliminate the bifurcation rule that was included in the proposed regulations. That rule would have allowed the IRS to treat certain debt instruments as part debt and part equity. The IRS has stated, however, that it will continue to study the need for such a rule.
Exceptions to the final regs
Even though the release of the new regs has led to criticism from certain business groups, the Treasury has received praise from some quarters for including several limited exceptions. The exceptions reflect comments the Treasury received on the proposed regs from businesses, tax experts, the public and legislators.
For example, the regs include a broad exemption for cash pools and other loans that are short term in both form and substance. Many companies use such tools to manage cash among their affiliates on a day-to-day basis, sweeping their daily excess cash into a single account. Companies will be allowed to continue to treat as debt short-term instruments issued among related entities in the ordinary course of a group’s business.
The regs also include the following exemptions for certain entities where the risk of earnings stripping is low:
- Transactions between foreign subsidiaries of S. multinational corporations,
- Transactions between S corporations,
- Transactions between regulated financial companies,
- Transactions between regulated insurance companies, and
- Transactions between mutual funds that are regulated investment companies and real estate investment trusts, other than those owned by affiliated groups of companies.
The final regs expand the exceptions for ordinary business or course transactions. The exceptions for distributions (payments made to affiliates) now generally include future earnings and allow corporations to net their distributions against capital contributions. The exceptions for ordinary course transactions have been expanded to include acquisitions of stock associated with employee compensation plans, among others.
Effective date looms
The proposed regs indicated that the regulations (other than the documentation requirements) would generally be effective when made final. The final regs, though, provide a 90-day delay, making the rules that will recharacterize debt as equity effective on or after January 19, 2017. For more information on how the new guidance applies to your business and its related-party debt transactions, please contact us.