United States

Final debt-equity regulations released

Final debt-equity rules add significant documentation rules

TAX ALERT  | 

Treasury and the IRS have released final and temporary regulations that generally govern whether certain related-party loans will be classified as debt or equity for tax purposes and that impose significant documentation requirements. The documentation requirements are effective for debt instruments issued on or after Jan. 1, 2018. The equity recharacterization rule generally applies to debt issued and transactions occurring after April 4, 2016; however, special transition rules may apply. 

Taxpayers should carefully examine intercompany loan arrangements to avoid undesired tax results under the new regulations. The good news, however, is that the final regulations provide exceptions for many types of companies and transactions. Companies that qualify for exceptions can thus enter into loan arrangements with greater flexibility. 

What do the regulations do?

The regulations provide two types of rules:

  1. Documentation rule – requiring taxpayers to maintain documentation with respect to certain related company debt
  2. Equity recharacterization rule – requiring equity treatment of debt issued to related companies in specified distribution, asset acquisition and stock acquisition contexts

Corporate groups generally subject to the regulations 

The regulations generally apply to groups of corporations connected by ownership of 80 percent or more.  Non-corporate owners of 80 percent of the group’s parent corporation, however, are not covered.

Some companies and debt instruments are excepted

The regulations do not apply to:

  • S corporations
  • Foreign debt issuers, including foreign corporations owned by U.S. corporations
  • Real estate investment trusts (REITs) and regulated investment companies (RICs) that are not controlled by a corporation or corporate group 
  • Debt instruments between members of a group of corporations that files consolidated federal income tax returns

The final regulations added the first three exceptions listed above and show that Treasury and the IRS have limited the extremely broad scope of the proposed regulations. The proposed regulations also included a consolidated group exception.

Where the documentation requirement applies and what it does

The documentation requirement generally applies to covered debt issued within covered corporate groups if the group either:

  • Has annual revenue exceeding $50 million
  • Has assets exceeding $100 million
  • Has at least one group member with publicly traded stock

The required documentation should evidence the debtor’s obligation to pay, the existence of creditor’s rights and a reasonable expectation of repayment at issuance of the debt, as well as actions evidencing a debtor-creditor relationship after issuance (such as payment of interest).  The documentation must be in place by the due date for the debtor’s federal income tax return for the year (including extensions). The proposed regulations would have required preparation of documents within 30 or 120 days; the final regulations rule allowing use of the tax return filing deadline will help many taxpayers comply with the rules. 

If a taxpayer does not comply with the documentation requirement with respect to a debt instrument, a rebuttable presumption will apply. The debt will be presumed to be equity unless the taxpayer can demonstrate it should be treated as debt under general federal tax principles, modified by some special rules provided in the regulations. This rule is an improvement over the proposed regulations, which would have required equity characterization where the documentation requirement was not met.

The documentation requirement is effective for debt instruments issued on or after Jan. 1, 2018.

Exceptions to the equity recharacterization rule 

As noted above, the equity recharacterization rule generally applies to debt issued to related companies in specified distribution, asset acquisition and stock acquisition contexts. For example, a U.S. subsidiary’s distribution of a debt instrument to a foreign parent corporation generally would be subject to the recharacterization rule. The U.S. subsidiary’s distribution to the foreign parent of cash lent to it from the foreign parent would generally subject the loan to the recharacterization rule. 

There are a number of exceptions to the equity recharacterization rule provided by the final and temporary regulations: 

  • Certain cash management, cash pooling and short-term financing arrangements are excepted. There are alternative ways of qualifying for this exception that involve, among other things, either actual repayments of debt, reasonable expectation of repayment, or non-interest bearing loans. 
  • Certain bank and financial entity groups and certain insurance companies are excepted based on the regulatory oversight of their capital structure.
  • Debt instruments are excepted if they do not exceed the debtor’s earnings and profits accumulated while the debt was a member of the group and during years ending after April 4, 2016.
  • A corporate group’s first $50 million of debt that otherwise would be subject to the equity recharacterization rule is also excepted. 

The equity recharacterization rule generally applies to debt issued and transactions occurring after April 4, 2016. Complex transition period rules provide, however, that the equity recharacterization generally will not apply to debt that is settled within 90 days of the date that the regulations are published in the Federal Register. At the end of the transition period, a debt will be recharacterized as equity if it (1) was issued before this date and after April 4, 2016, and (2) is subject to the equity recharacterization rule.

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