Modified intercompany debt: is it still recognized as debt?

In the context of multinational companies using intercompany debt instruments to fund domestic subsidiaries, the economic crisis has created insolvency issues and liquidity concerns that has prompted companies to consider modifying these instruments. These modifications, however, raise the potential application of section 385 and the regulations thereunder issued in 2016, which can potentially reclassify debt as equity for U.S. tax purposes, and carries significant tax implications.

Below we will shed light on the risks of modifying intercompany debt instruments and the potential application of section 385. The case study presented reflects how debt restructuring and cross-border intercompany funding can lead to the reclassification of debt as equity for U.S. tax purposes. This highlights the need for careful compliance and risk management in such scenarios.

Background

Section 385¹, provides broad authority to Treasury to issue regulations to determine whether an interest in a corporation is treated as stock or indebtedness. In April of 2016, Treasury ultimately used this authority to issue regulations² that govern how certain debt instruments are treated for tax purposes when they are issued by a U.S. corporation to a related party. While the regulations were originally intended to prevent excessive borrowing by related parties in cross-border transactions, they also broadly apply to debt issued by U.S. corporations to related parties, regardless of whether the related party is domestic or foreign.³ These regulations apply when “covered debt instruments”, generally defined as certain⁴ debt instruments issued after April 4th, 2016, by certain⁵ “covered members”, are issued to a member of the “expanded group.”⁶

The general rule⁷ (“General Rule”) reclassifies a covered debt instrument as stock, in the following three transactions:

• If the note is distributed, generally from a U.S. issuer to a foreign related party;
• If the note is issued in exchange for “expanded group stock” (such as a section 304 cross-chain sale), other than in an “exempt exchange”; or
• If the note is issued in an exchange for property in an asset reorganization, to the extent that, an expanded group shareholder receives the debt instrument with respect to its stock in the transferor corporation.

The regulations also apply to debt instruments issued in exchange for property that is treated as “funding” any of the three transactions described above, regardless of when issued (the “Funding Rule”). Another rule further expands application to covered debt instruments issued by a “funded member”⁸ during the period (“Per Se Period”) beginning 36 months before and ending 36 months after, the date of certain distributions or acquisitions (“Per Se Funding Rule”).⁹ Said differently, if a debt instrument is issued by a U.S. corporation to a related party, and then that related party makes a distribution within the Per Se Period, the debt instrument is subject to recharacterization.

For purposes of section 385, when a covered debt instrument is deemed exchanged for a modified covered debt instrument¹⁰, the modified covered debt instrument is treated as issued on the original issue date of the covered debt instrument. If, however, the modifications include: the substitution of an obligor, the addition or deletion of a co-obligor, or the material deferral of scheduled payments due; then the modified covered debt instrument is treated as issued on the date of the deemed exchange (i.e., the date of the modification).¹¹ Notably, a material deferral of scheduled payments is generally understood to be a deferral of at least one payment outside of a “safe-harbor period.”¹²

In determining which amounts of a covered debt instrument are subject to recharacterization, there are various exclusions, exceptions and reductions available.¹³ The aggregate amount of any distributions or acquisitions made by a covered member is reduced by the covered member's expanded group earnings account (“E&P Reduction”).¹⁴ This E&P Reduction does not apply to distributions or acquisitions that were made by a predecessor of the covered member.¹⁵ There is also an exception that applies to the first $50M¹⁶ of covered debt instruments issued by members of the issuer's expanded group, meaning thatfirst $50M is not subject to recharacterization (the “Threshold Exception”).¹⁷

The following case study analyzes a series of transactions that illustrate the application of the rules described above.

Facts

Original Structure

Prior to the effective date of the regulations, a foreign parent corporation (Foreign Parent) wholly owned another foreign corporation (Foreign Sub 1) and a U.S. corporation (US Parent). US Parent filed a consolidated return with its wholly owned domestic subsidiary (US Sub). Foreign Sub 1 owned 55% of a foreign corporation (Foreign Sub 2). US Sub owned the remaining 45% of Foreign Sub 2 (all entities collectively are referred to as the “Group”).

Prior to the effective date of the Regulations, debt existed between US Parent, as the issuer, and Foreign Parent, as the holder, and consisted of two tranches of bona fide debt. Whether there is a non-tax business purpose for the lending or distributions is irrelevant for section 385 purposes and is thus not discussed here.

Tranche 1 has a principal amount of $100 million and was issued by US Parent to Foreign Parent on Jan. 1, 2016, for cash, with a maturity date of Jan. 1, 2021. Tranche 2 has a principal amount of $20 million and was issued by US Parent to Foreign Parent for cash on Jan. 1, 2017, with a maturity date of Jan. 1, 2022. US Parent has $100 million of earnings and profits (E&P) and Foreign Sub 2 has $150 million of E&P.

US Parent deducts the associated interest expense in the U.S., and Foreign Parent recognizes interest income in the relevant foreign tax jurisdiction. As Tranche 1 was issued prior to the effective date of the Regulations, it was respected as debt for U.S. federal income tax purposes.

Redemption Transaction

On Jan. 1, 2018, Foreign Sub 2 distributed $150 million to Foreign Sub 1 in complete redemption of its stock. Immediately after, Foreign Sub 2 made a check-the-box election to be treated as disregarded for U.S. federal income tax purposes (collectively, the Redemption Transaction). 

Debt Restructuring

On Jan. 1, 2019, US Parent and Foreign Parent restructured the two tranches of debt into a single debt instrument (Restructured Debt) with a principal amount of $120 million and a maturity date of Jan. 1, 2026.

Analysis

Original Structure

As of Dec. 31, 2017, prior to the Redemption Transaction, the Group had $20 million of “covered debt instruments” as Tranche 2 was issued after April 4, 2016. At this point, there is no reclassification of any debt into stock.

Based on the ownership, US Parent is a “covered member” and the Group is an “expanded group” with each entity being a member. Interest payments are made by US Parent to Foreign Parent, which are deductible in the U.S. and included as income in the foreign country.

Redemption Transaction

The wide net of the Per Se Funding Rule likely treats the distribution of $150 million in redemption of Foreign Sub 2’s stock, as having been funded by US Parent with the covered debt instrument.

Mechanically, the Per Se Funding Rule applies because the covered debt instrument was issued within 36 months of the distribution, and Foreign Sub 2 made the distribution within 36 months of US Parent becoming the successor. Therefore, US Parent is treated as having funded the distribution in part, by the $20 million Tranche 2.

The $100 million Tranche 1, even though issued within 36 months, is not a covered debt instrument because it was issued prior to April 4, 2016.

Through the application of the Per Se Funding Rule, Tranche 2 is potentially subject to the application of the recharacterization rules under  Reg. Sec. 1.368-3. However, as discussed above, the first $50 million is not subject to recharacterization and as such Tranche 2 will not be treated as stock by way of 385.

Debt Restructuring

Assuming the two tranches were combined, and the term extended via modifications of the original debt instruments, this would likely represent a significant modification for purposes of  Reg. Sec. 1.1001-3. The extended term would constitute a “material deferral” in that the term is extended beyond the safe harbor period discussed above.¹⁸ Since there was a “material deferral”, Reg. sec. 1.385-3(b)(3)(iii)(E)(2) treats the Restructured Debt as having been reissued on the date of the modification (i.e., Jan. 1, 2019).

Therefore, the Restructured Debt is treated as having been issued within 36 months of the Redemption Transaction and is now subject to reclassification under the Per Se Funding Rule.

The aggregate adjusted issue price of the covered debt instruments held by all the members of the expanded group is $120M. However, under Reg. sec. 1.385-3(c)(4), the first $50 million is excluded from recharacterization. Therefore, as a result of the deemed reissuance, $70 million of the Restructured Debt is treated as stock for U.S. federal tax purposes.

As mentioned above, utilizing the E&P Reduction, the aggregate amount of any distributions or acquisitions made by a covered member is generally reduced by the covered member's expanded group earnings account. In this instance, US Parent has $100 million in its expanded group earnings account. However, since the distribution was made prior to Foreign Sub 2’s joining of the U.S. consolidated group, that amount is unavailable to offset any amount of the distribution.

Conclusion

As a result of the Redemption Transaction and the Debt Restructuring, $70 million of the outstanding Restructured Debt amount is treated as stock for U.S. federal tax purposes. One result is that interest payments that relate to the reclassified $70 million are no longer deductible as interest expense for U.S. federal tax purposes.

Additionally, since payments made under the reclassified amount are treated as distributions on stock (and potentially dividends) for U.S. federal tax purposes, there may be withholding tax consequences that were not present prior to recharacterization. Moreover, since the recharacterization is solely for U.S. federal tax purposes, Foreign Parent will continue to have interest income in its home country without any offsetting interest expense in the U.S.

In terms of alleviating the disconformity between interest income and interest expense, the simplest solution, from a U.S. federal tax perspective, is likely a capitalization of the reclassified debt obligation into the US Parent. For U.S. federal tax purposes, this capitalization would potentially be a tax-deferred recapitalization transaction. However, for foreign purposes the contribution would be treated as a contribution of the note receivable into the US Parent, thus tying out the interest disconformity.

As demonstrated in the case study, practitioners need to be cautious when restructuring debt, particularly in the international context as a seemingly simple modification of an intercompany debt instrument could have major tax consequences.

_{¹ All section references are to the Internal Revenue Code of 1986, as amended, or to underlying regulations.}

_{² See generally, Reg. Sec. 1.385-3; there are numerous important defined terms within these regulations and while this article refers to a few of them, readers should be aware that some definitions have been simplified herein for readability.}

_{³ See 81 FR 20912.}

_{⁴ Debt instruments that are not a qualified dealer debt instrument (as defined in paragraph Reg. Sec. 1.385-3(g)(3)(ii)) or an excluded statutory or regulatory debt instrument (as defined in paragraph (g)(3)(iii)).}

_{⁵ Domestic members that are not an excepted regulated financial company (as defined in Reg. Sec. 1.385-3(g)(3)(iv)) or a regulated insurance company (as defined in paragraph (g)(3)(v)).}

_{⁶ Generally, a group of corporations connected by 80% common ownership.}

_{⁷ Reg. Sec. 1.385-3(b)(2).}

_{⁸ A covered member that makes a distribution or acquisition under the Funding Rule.} 

_{⁹ Reg. Sec. 1.385-3(b)(3)(iii)(A).}

_{¹⁰ See generally, Reg. Sec. 1.1001-3.}

_{¹¹ Reg. Sec. 1.385-3(b)(3)(iii)(E).}

_{¹² Reg. Sec. 1.1001-3(e)(3)(ii); The safe harbor period is either: five years for debt instruments with an original term of at least 10 years, or 50% of the term of debt instruments with an original term of less than ten years.}

_{¹³ Note: for the limited illustrative purposes of this article, only the E&P Reduction and Threshold Exception are discussed.}

_{¹⁴ Reg. Sec. 1.385-3(c)(3)(i)(A).}

_{^{1 5}Reg. Sec. 1.385-3(c)(3)(iii).} 

_{¹⁶ That is, the aggregate adjusted issue price of the debts.}

_{¹⁷ Reg. Sec. 1.385-3(c)(4).}

_{¹⁸ In this case, the original terms of both instruments was five years, and combined the term is extended by at least 4 years. The safe harbor in this case, is 50% of five years so 2.5 years.}