Tax News Update    Email this document    Print this document  

On April 4, 2016, as part of a broader package of regulations targeting corporate inversion transactions in the international tax arena, including the practice of earnings stripping,¹ the Treasury Department and the Internal Revenue Service (IRS) released proposed regulations (REG-108060-15) under IRC Section 385 (the Proposed Regulations).² The Proposed Regulations would establish rules treating certain related-party interests in a corporation as stock, in whole or in part, rather than debt. Not only do the Proposed Regulations signal a significant change in federal tax policy, they also would affect the realm of state income tax because they affect the determination of the tax base. Treasury Department and IRS officials have publicly indicated that the Proposed Regulations could be finalized as early as Labor Day 2016. Consequently, it is important for taxpayers to understand the Proposed Regulations and quickly consider their possible state income tax implications.

Overview of the Proposed Regulations

Policy rationale and consolidated group exception

According to its preamble (the Preamble), the Proposed Regulations arose in response to excessive cross-border debt between related-parties. The Preamble also states that the Proposed Regulations would apply not only to international transactions but also to domestic transfers of debt between related-parties, as those transfers can artificially reduce federal income tax liabilities and create policy concerns similar to those in cross-border transactions. A critical exception to the application of these rules, however, is that the Proposed Regulations would not apply to related-party debt when the parties are members of the same federal consolidated group since the corresponding interest income and interest expense offset in the consolidated federal income tax return.³

Departure from existing law

Currently, no temporary or final regulations are in effect under Section 385. Prior to the issuance of the Proposed Regulations, the evaluation and ultimate characterization of related-party debt was the object of a complicated body of case law and generally followed an "all-or-nothing" approach (i.e., the related-party interest in a corporation was characterized as either all debt or all stock). The Proposed Regulations would change existing law by:

— Creating a general operating rule under which the IRS (but not taxpayers) may treat certain purported related-party debt instruments partially as debt and partially as stock, based on the substance of those instruments under general federal tax principles (Prop. Treas. Reg. Section 1.385-1)⁴

— Establishing extensive new rules for "large taxpayer groups"⁵ that mandate the preparation and maintenance of specific contemporaneous documentation and information to support certain related-party debt instruments (e.g., loan documents, analyses of the debtor's ability to repay the debt, ongoing payments), and automatically recharacterize those instruments as stock for federal tax purposes if the rules are not satisfied (Prop. Treas. Reg. Section 1.385-2)

— Treating certain related-party debt instruments as stock, even if the debt documentation and information requirements are satisfied, if the instruments are issued as part of specified related-party transactions, including: a) distributions (such as the payment of a dividend in the form of a note payable); b) internal asset reorganizations under Sections 368(a)(1)(A), (C), (D), (F) or (G), and c) stock sales (Prop. Treas. Reg. Section 1.385-3 and -4)

New definitions

Three new tax law definitions in the Proposed Regulations are essential to understanding the application of the rules:

— The Proposed Regulations would apply only to an expanded group instrument (EGI),⁶ which is generally defined as a debt instrument (called an "applicable instrument" in the Proposed Regulations) in which the issuer and holder are members of the same expanded group.

— An expanded group (EG)⁷ includes the members of an "affiliated group" under Section 1504(a) with three key modifications:

1) An EG includes foreign corporations, tax-exempt corporations, insurance corporations, partnerships and S corporations (essentially, any entity that is excluded from the definition of an "includible corporation" under Section 1504(b))⁸

2) The constructive ownership rules of Section 318(a), as modified by Section 304(c)(3), apply for purposes of determining relatedness

3) An EG includes any of the aforementioned entities if 80% of the vote OR value is owned directly or indirectly by other members of the EG (far more expansive than the definition of an "affiliated group," which requires 80% of vote AND value).

— A modified expanded group (MEG),⁹ which appears to apply only to the part debt / part stock determination under Prop. Treas. Reg. Section 1.385-1(d)(1), is an EG that is determined by reducing the requisite ownership percentage described previously from 80% to 50%, and also includes any partnership in which at least 50% of the interests in partnership capital or profits are owned directly or indirectly by one or more members of the MEG (referred to as a "modified controlled partnership"¹⁰).¹¹ Based on the broad definition of a MEG, an EG may be included therein (e.g., a non-consolidated EG, which necessarily meets the definition of a MEG, is similarly subject to Prop. Treas. Reg. Section 1.385-1(d)(1)).

Effective dates

The documentation and information requirements under Prop. Treas. Reg. Section 1.385-2, as well as the general operating rule under Prop. Treas. Reg. Section 1.385-1, would generally apply to:

— Relevant debt instruments issued (or deemed issued) on or after the date that the Proposed Regulations are issued as final

— Debt instruments deemed issued prior to that date, as a result of an entity classification election filed on or after that date.

Subject to a transition rule, Prop. Treas. Reg. Section 1.385-3 would generally apply to debt instruments issued on or after April 4, 2016, and to any debt instruments deemed issued prior to that date as a result of an entity classification election filed on or after that date.¹²

In addition, relevant transactions that could be characterized as debt instruments could easily become subject to the requirements of the Proposed Regulations in the future through, for example, an entity classification election, a significant modification of the instrument or simply a change in the consolidated group affecting an EG (or MEG) member.

Potential state income tax implications

According to the Council of State Governments April 18 release "New Treasury Rules Could Affect Federal and State Tax Revenue," the federal government views corporate inversions and the practice of earnings stripping as transactions that deprive the US of taxable income, which makes it likely that state governments will view them as reducing state government revenue. When income is stripped out of the US federal tax base, it is also stripped out of the state tax base (how much generally depends on the structure and nuances of each state's income tax law). Since the determination of state taxable income in virtually every state depends, either directly or indirectly, upon the determination of federal taxable income, the Proposed Regulations will likely affect state income taxation.

Since the determination of state taxable income in virtually every state depends, either directly or indirectly, upon the determination of federal taxable income, the Proposed Regulations will likely affect state income taxation (as would any federal or international change that affects the consolidated federal income tax return). HOWEVER, if a state does not strictly apply the consolidated group exception under Prop. Treas. Reg. Section 1.385-1(e) or if there is a reasonable risk of non-conformity, and these states attempt to apply these rules to purely domestic transactions, the state income tax effect may be much more significant. Specifically, taxpayers may be obligated to document debt transactions solely for state purposes when they would have no reason to do so for federal purposes under the consolidated group exception. Although most separate company reporting states (and some unitary combined reporting states) make it clear that they do not follow the federal consolidated return regulations, it is unclear whether the consolidated group exception relies upon the federal consolidated return regulations or merely references these regulations for definitional purposes and should be followed by the states. If the Proposed Regulations apply to transactions among members of a federal consolidated group, a variety of potential unintended state consequences may arise, as further described below.

Conformity to the Proposed Regulations and the consolidated group exception

All states generally conform to Section 385 directly or indirectly by either using federal taxable income as the starting point for determining state taxable income or by incorporating by specific reference sections of the Internal Revenue Code. California is an example of the latter (incorporating all of Subchapter C of the Internal Revenue Code into its corporation tax law, as well as final and temporary regulations), although it is in the distinct minority of states that incorporate by direct reference. Since most states simply use the federal determination of taxable income as their starting point for determining state taxable income or adopt the Internal Revenue Code as of a specific or rolling conformity date, determinations by the IRS under Section 385 and the Proposed Regulations will generally be "baked into" these states' determination of state taxable income. Of course, these are broad generalizations with many variations among the states. Accordingly, the central issue surrounding the topic of conformity is whether states that do not follow the federal consolidated group concept will read the consolidated group exception under Prop. Treas. Reg. Section 1.385-1(e) as subjecting transactions among members of a federal consolidated group to the full application of the Proposed Regulations for state (but not federal) income tax purposes. Given the differences in the makeup of members included in federal and state income tax return groups, this conformity topic creates a variety of interesting questions, including the following:

— If a state follows the literal reading of the consolidated group exception under Prop. Treas. Reg. Section 1.385-1(e), does that mean the state will follow the federal rule and not require compliance with the documentation and information requirements under Prop. Treas. Reg. Section 1.385-2 even if it does not necessarily adopt the federal consolidated group concept?

— Moreover, even if a state determines that it will comply with the consolidated group exception, would it affirmatively take steps to decouple from the provisions through statutory, regulatory or related administrative means?

— Alternatively, what if a state determines that the consolidated group exception under Prop. Treas. Reg. Section 1.385-1(e) does not apply at all and it is free to apply the rules to all EGIs (within either the EG or MEG) since it doesn't recognize a federal consolidated group?

— Since each state's taxing statute is unique and each state is sovereign, does this mean every state could approach this question differently so results could vary widely from state to state?

— Does non-recognition of the consolidated group exception by a state mean that taxpayers in those states would have to comply with all of the documentation and information requirements for all intercompany transactions intended to be characterized as debt even though they are not required to do so for federal tax purposes since they are covered by the consolidated group exception?

— Does non-recognition of the consolidated group exception by a state mean that taxpayers in those states would have to recharacterize certain transactions identified in Prop. Treas. Reg. Section 1.385-3 and -4 as equity even though they would not be characterized as such for federal tax purposes because of the exception?

— Most importantly, do the states have the ability, independent of the IRS, to require taxpayers to comply with the Proposed Regulations given the exception's definitional reference to Treas. Reg. Section 1.1502-1(h)? Can states administer and determine matters independently of the IRS?

— Might transactions among members of a unitary combined group be excluded for state income tax purposes even though all of those members are not members of the same federal consolidated group?

Unintended consequences?

If the states don't conform to the consolidated group exception or attempt to independently apply the Proposed Regulations, it could create a myriad of very disconcerting state income tax issues, including the following:

— It could create significant cross-equity ownership issues within a federal consolidated group and possibly dilute stock ownership in some members below the 80% threshold for state income tax purposes, thereby creating non-conformity problems in M&A transactions, subsidiary liquidations, distributions (including ineligibility for state dividends received deductions) and internal reorganizations. For example, dilution of direct ownership by one corporation because of the recharacterization of debt as stock in the hands of another might result in a limited liability company conversion transaction being disqualified for tax-free treatment under the subsidiary liquidation rules of Section 332 and instead being treated as a taxable liquidation solely for state income tax purposes, thereby resulting in the creation of a partnership instead of a disregarded entity under the federal entity classification rules.

— A disregarded limited liability company for federal tax purposes, with deemed cross-equity ownership that could technically be a partnership solely for state income tax purposes, might also be ineligible for entity classification elections. Moreover, would states require such a "partnership" to file a partnership return for state income tax purposes even though it doesn't file a federal partnership return? If it isn't a partnership for federal tax purposes, how is it supposed to obtain the necessary tax return data to file a state-only partnership return?

— Certain intercompany interest deductions could be disallowed even if they might otherwise qualify for an exception from a state's related-party interest expense addback statute.

— If purported related-party debt instruments are recharacterized as stock, a parent company may no longer have the requisite direct percentage of ownership in a subsidiary to qualify for: a) a state's dividends received deduction (remember that principal and interest payments are recharacterized as distributions that could be dividends to the extent of earnings and profits of the distributing corporation); b) an exception from a state's related-party interest expense addback statute; and/or c) special entity classification rules.

— In assessing whether indebtedness is in part debt and in part stock, could each state independently, separate and apart from the IRS, make different determinations of the percentage of debt or stock? For example, if the IRS recharacterizes an instrument as 80% debt and 20% stock, can New Jersey come in and assert for its purposes that it is 70% equity and 30% stock while California asserts it should be 50-50? What kind of issues would that create in not only determining deductions but also satisfying on a state-by-state basis ordinary qualifications for ownership eligibility under all of the provisions in the Internal Revenue Code?

— Could there be an impact on traditional cash management/pooling/sweep arrangements, as well as non-interest bearing intercompany accounts?

Practical implications

The Preamble to the Proposed Regulations indicates that their purpose is to address concerns over the use of intercompany debt. Arguably, many states have already addressed this issue, as evidenced by related-party interest expense addback legislation, tax haven legislation, transfer pricing and unitary combined reporting. In addition, some states have already started to react to inversion transactions by proposing punitive non-income tax legislation, such as placing a ban on awarding incentives to inverted companies and prohibiting state pension funds from investing in inverted corporations. Moreover, the states have important policy goals that are furthered by conformity to the federal tax base, including administrative simplification and judicial requirements of fair apportionment and due process.

However, regardless of the tax technical merits supporting the argument for or against conformity to the Proposed Regulations, affected taxpayers are encouraged to consider the following:

— It seems unlikely that states will formally announce their views on how they intend to apply the Proposed Regulations before they are finalized. In some cases, it could be years before taxpayers find out, or they may not know until they are audited, or they may never know with any high degree of certainty. In addition, each state may make its own determination, which could lead to significant variations in the treatment of an instrument across the states.

— Taxpayers should consider the risks and associated consequences with any potential recharacterizations as stock rather than debt for purported debt instruments that are otherwise exempt from the Proposed Regulations for federal tax purposes but may not be for state income tax purposes.

— As a best practice, taxpayers should consider meeting the documentation and information requirements under Prop. Treas. Reg. Section 1.385-2 for purported debt instruments between members of the federal consolidated group, even if they are not required to do so for federal tax purposes, to avoid risks of states (or the IRS) challenging the debt characterization in the future.

— Taxpayers might want to avoid future domestic transactions that would be recharacterized as per se equity under Prop. Treas. Reg. Section 1.385-3 and -4 if they applied. Consideration should be given to alternative transactions or, at a minimum, the increased risk profile of such transactions should be appreciated.

— Taxpayers should consider making more domestic entities co-obligated on third-party debt in an effort to reduce reliance on intercompany debt in the future.

———————————————

———————————————
ENDNOTES

¹ Inversion transactions involve the redomestication of US corporations to foreign taxing jurisdictions (i.e., a US-parented multinational group acquires a smaller foreign company and relocates the tax residence of the merged group to a lower-tax jurisdiction). The practice of earnings stripping involves the multinational reducing its federal income taxes by paying deductible interest to the new foreign parent or its affiliates.

² Please see Tax Alert 2016-632 {}, for a more detailed federal tax analysis of the Proposed Regulations.

³ Prop. Treas. Reg. Section 1.385-1(e) specifically provides: "Treatment of consolidated groups. For purposes of the regulations under section 385, all members of a consolidated group (as defined in Section1.1502-1(h)) are treated as one corporation." See also the Preamble ("Nonetheless, the Treasury Department and the IRS also have determined that the [P]roposed [R]egulations should not apply to issuances of interests and related transactions among members of a consolidated group because the concerns addressed in the [P]roposed [R]egulations generally are not present when the issuer's deduction for interest expense and the holder's corresponding interest income offset on the group's consolidated federal income tax return.").

⁴ Specifically found in Prop. Treas. Reg. Section 1.385-1(d)(1).

⁵ The documentation and information requirements under Prop. Treas. Reg. Section 1.385-2 would not apply unless: a) the stock of any member of the expanded group (as defined herein) is publicly traded; b) all or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding $100 million; or c) the expanded group's financial results are reported on financial statements that reflect annual total revenue over $50 million.

⁶ Prop. Treas. Reg. Section 1.385-2(a)(4)(ii) (defining "expanded group instrument" or "EGI"); Id. Section 1.385-2(4)(i) (defining "applicable instrument" as "any interest issued or deemed issued that is in the form of a debt instrument").

⁷ Prop. Treas. Reg. Section 1.385-1(b)(3) (defining "expanded group").

⁸ This is accomplished by reference to the definition of "includible corporation" in Section 1504(b) which is generally corporations that are NOT allowed to be included in the federal consolidated group. See Prop. Treas. Reg. Section 1.385-1(b)(3)(A).

⁹ Prop. Treas. Reg. Section 1.385-1(b)(5) (defining "modified expanded group").

¹⁰ Id.; Prop. Treas. Reg. Section 1.385-1(b)(4) (defining "modified controlled partnership").

¹¹ Id.; Prop. Treas. Reg. Section 1.385-1(d)(1)-(2). The Preamble to the Proposed Regulations states that this lower threshold applies because the federal income tax liability can be reduced or eliminated by the introduction of excessive indebtedness between related parties, and this can be accomplished without special cooperation among the related parties, regardless of other transactions undertaken by the issuer or holder after issuance. In addition, a 50% relatedness threshold is consistent with other provisions used in subchapter C of the Internal Revenue Code to identify a level of control or ownership that can warrant different federal tax consequences than those for less-related parties.

¹² Any debt instrument treated as stock under the Proposed Regulations that is issued prior to the date on which final regulations are published would be treated as debt until the 90th day after the date on which final regulations are published. In addition, any debt instrument treated as stock under the Proposed Regulations that is held by a member of the issuer's EG on the 90th day after the date on which final regulations are published shall be deemed exchanged for stock of the issuer of the debt instrument on the 90th day.