11 May 2016

New Section 385 regulations treating certain related-party corporate interests as stock, rather than debt, will affect insurance companies

The US Treasury Department (Treasury) and Internal Revenue Service (IRS) recently released proposed regulations (REG-108060-15) under Section 385 (the Proposed Regulations) that would:

— Authorize the commissioner of the IRS (the Commissioner) to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes

— Establish extensive documentation requirements in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes

— Treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes

Background

Section 385(a) authorizes Treasury to issue regulations that may be necessary or appropriate to determine whether an interest in a corporation is treated as stock or indebtedness for federal tax purposes. The Proposed Regulations provide rules for when certain related-party interests in a corporation would be treated, for federal tax purposes, in whole or in part, as stock rather than debt and apply to foreign and domestic related parties. Whether the debt that is now treated as equity would be characterized as common stock or preferred stock would depend on the nature of the debt instrument. The Proposed Regulations would not apply, however, to issuances of debt and related transactions between members of a consolidated group.

The Proposed Regulations generally apply only to debt instruments between members of an "expanded group," which includes US, foreign and tax-exempt corporations in which 80% of the vote or value (not vote and value) is owned by expanded group members.

In contrast to current law, under which an interest is generally treated as either wholly debt or wholly equity, Prop. Reg. Section 1.385-1 would authorize the Commissioner to treat a related-party interest in a corporation as indebtedness in part and as stock in part, consistent with its substance. This proposed rule would apply to debt instruments issued between parties that meet a 50% threshold for relatedness rather than the 80% threshold for expanded group membership otherwise applicable to other rules contained in the Proposed Regulations.

Timelines

In general, the rules allowing the IRS to bifurcate instruments as part-debt and part-equity would apply to certain related-party interests issued on or after the date the Proposed Regulations are issued as final regulations.

New loan documentation requirements — Prop. Reg. Section 1.385-2

Prop. Reg. Section 1.385-2 would establish documentation requirements that must be satisfied for certain related-party interests in a corporation, including surplus notes, to be treated as indebtedness for federal tax purposes. The absence of this documentation would result in the debt being treated as equity for tax purposes. This rule is intended to apply only to "large taxpayer groups," defined as those that are part of an expanded group that includes a member that is publicly traded, where all or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding US$100 million, or all or any portion of the expanded group's financial results are reported on financial statements that reflect annual total revenue exceeding US$50 million.

A taxpayer seeking to establish that a purported debt instrument is indebtedness for federal tax purposes would have to provide documentation establishing:

1. A binding obligation to repay the funds advanced

2. Creditors' rights to enforce the terms of the debt

3. A reasonable expectation that the funds advanced can be repaid (e.g., cash flow projections or other relevant financial data)

4. After the instrument is issued, actions evidencing an ongoing genuine debtor-creditor relationship (i.e., documentation showing the issuer complies with the terms of the debt, including timely prepared documentation of any payments supporting the treatment of the debt instrument as indebtedness for federal tax purposes)

If the issuer fails to comply with the terms of the debt (e.g., fails to make one or more required payments), the documentation would have to include evidence of the holder's reasonable exercise of the diligence and judgment of a creditor, including the parties' efforts to renegotiate the terms of the debt.

Timelines

In general, the newly required loan documentation would need to be prepared no later than 30 calendar days after the date that the debt instrument comes to be held by an expanded group member. In the case of documentation of the debtor-creditor relationship, however, the regulations allow the documentation to be prepared up to 120 calendar days after the payment or relevant event occurred.

These rules would generally apply to related-party interests in a corporation issued on or after the date the Proposed Regulations are issued as final regulations.

Treatment of debt instruments as equity in related-party transactions

Prop. Reg. Section 1.385-3 provides rules that would treat as stock certain related-party debt instruments that otherwise would be treated as indebtedness for federal tax purposes, if the instruments are issued as part of certain related-party transactions. Under these rules, whether a related-party debt instrument is treated as stock for federal tax purposes would turn on the relationship of the holder to the issuer and how the holder acquired the interest, not the terms of the instrument itself. These rules depart significantly from the tests historically applied by the courts.

Treasury and the IRS identified three types of transactions in which, in their view, equity replaces with debt with no significant non-tax effect and which, therefore, can create opportunities for abuse:

1. Distributions of debt instruments by corporations to their related corporate shareholders

2. Issuances of debt instruments by corporations in exchange for stock of an affiliate (e.g., in connection with a Section 304 sale)

3. Certain issuances of debt instruments as consideration in an exchange under an internal asset reorganization

Debt instruments issued in these transactions are treated as equity unless one of these three exceptions applies:

1. Exception for current-year earnings and profits. Distributions or acquisitions that do not exceed current earnings and profits are not treated as distributions or acquisitions.

2. Threshold exception. A related-party debt instrument will not be treated as stock if, when the debt is issued, the aggregate adjusted issue price of all other related-party debt instruments that would be treated as stock does not exceed US$50 million.

3. Exception for funded acquisitions of subsidiary stock by issuance. An acquisition of expanded group stock would not be treated as an acquisition if:

(i) The acquisition results from a transfer of property by the transferor to an issuer in exchange for stock of the issuer
(ii) The transferor holds, directly or indirectly, for the 36 months following the issuance, more than 50% of the total combined voting power of all classes of stock of the issuer entitled to vote and more than 50% of the total value of the stock of the issuer

The Proposed Regulations also contain a "funding rule" that would treat debt as equity when a corporation issues a debt instrument to a related party with a principal purpose of funding a distribution or an acquisition as previously described. The determination of whether a debt instrument is issued with a principal purpose of funding a distribution or an acquisition is based on all the facts and circumstances. The Proposed Regulations would, however, establish a non-rebuttable presumption that the principal purpose is funding a distribution or acquisition if the funded member issued the debt instrument during the six-year period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution or acquisition. An exception to this "funding rule" would apply to debt instruments issued in connection to the purchase of property (e.g., inventory) or the receipt of services between members of the same expanded group or in the ordinary course of the purchaser's or recipient's trade or business. But, significantly, it is not intended to cover intercompany financing or treasury center activities.

Presumably, certain types of financing activity to effect an external acquisition (e.g., a cash loan from a foreign parent corporation to a US subsidiary used to acquire a US target corporation) would not be affected. However, many popular post-acquisition debt "push down" strategies involving a subsidiary's distribution of a note to its parent would likely be subject to Prop. Reg. Section 1.385-3(b).

Timelines

Although the Proposed Regulations only become effective when issued in final form, they would generally apply to debt instruments issued on or after April 4, 2016. Debt instruments implicated by these rules that are issued prior to the date the regulations are finalized, however, will continue to be treated as debt instruments during the 90 days following the adoption of the final regulations. Thus, during this period, taxpayers might avoid the application of these rules by repaying or otherwise eliminating related-party debt instruments that would otherwise be treated as stock.

Insurance company implications

If finalized in their current form, the proposed regulations would affect both a wide range of mergers and acquisition transactions and ordinary course corporate finance and tax operations. In many situations, financing of a subsidiary would need to be documented in accordance with the standards discussed earlier, or the "debt" would not be treated as debt for federal income tax purposes.

For insurance companies, the Proposed Regulations would require what were once considered routine movements of cash between related entities to now be heavily documented and all such transactions entered into after April 4, 2016 (including certain modifications to existing obligations) would need to comply with documentation requirements or potentially be characterized as equity. For example, if finalized in their current form, informal cash funding of an affiliate's day-to-day operations through debt may now require due diligence on the borrower's ability to repay, transfer pricing analysis of the loan documents and regular payment of interest. Furthermore, to maintain their status as debt for US federal income tax purposes, surplus notes used to capitalize insurance companies that are currently treated as debt would need to be documented in accordance with these rules, or risk such debt treatment being challenged for at least some component of the principal and interest on the surplus note. All such transactions entered after April 4, 2016, including certain modifications to existing obligations, would need to comply with these documentation requirements or potentially be characterized as equity.

Insurance companies that issue intercompany notes after April 4, 2016, in a distribution or in exchange for stock or assets of affiliated (i.e., expanded affiliated group) entities would need to be cognizant of the new rules and their timelines, which would turn these debt instruments into equity 90 days after the regulations are finalized, regardless of the documentation on hand. In these cases, companies should consider restructuring or full payment of these notes prior to such date.

Questions on other types of arrangements or contractual obligations will need to be resolved to determine whether they could be treated as debt obligations and therefore must be documented. For example, consider these arrangements:

1. Premiums due and payable, in particular, a funds-withheld arrangement

2. Claim amounts accruing from estimates or reserves that become fixed and determinable (and rise to the level of debt)

3. Contingent obligations in which the contingency resolves

4. Service agreements providing for obligations to compensate other group members (consideration of group underwriting activities)

Another item to consider is the effect of the Proposed Regulations on payments made under certain service agreements, and whether they would be considered an exchange for property (e.g., payment for actuarial study; use of brand name or other intangible property (information database, customer list, etc.)).

The funding rule, and its non-rebuttable presumption to treat debt as equity, coupled with its 36-month look-back and look-forward periods could significantly impair routine movements of cash between insurance companies. For example, if a corporation is considering funding its insurance company affiliate with a surplus note, it would need not only to have all the required documentation to characterize the surplus note as a loan but also to contemplate past and future intercompany transactions in order to avoid the funding rule's application. In many cases, this funding rule could significantly limit an expanded group's ability to react quickly to changes in market conditions through reallocating funds to entities where these funds are needed.

These new rules may highlight the need for insurance companies to consider alternative methods for generating deductible payments, perhaps including an increased interest in the usage of captive insurance.

For a more detailed discussion of the Proposed Regulations, see Tax Alert 2016-632.

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Contact Information
For additional information concerning this Alert, please contact:
 
Insurance Group
Mike Shields(215) 448-5291
Chris Ocasal(202) 327-6868
Norm Hannawa(202) 327-6250
Ted Clabault(202) 327-6839
Revital Gallen(949) 437-0302

Document ID: 2016-0850