Treasury officials offer insights on proposed debt/equity regulations
TAX ALERT |
Treasury officials speaking at a recent forum hosted by the D.C. Bar Association Tax Section offered insights on some unresolved issues arising from recently proposed regulations under section 385. The proposed regulations, issued on April 4, 2016, grant the IRS broad authority to determine whether certain interests in related entities should be treated, in whole or in part, as stock or indebtedness. While intended to limit certain tax planning techniques involving related party financing arrangements, the impact of the new rules reach much further. As practitioners continue to digest the full impact of the proposed regulations, several unexpected issues have arisen. Treasury officials commented on some of these issues summarized below:
- The Treasury intends the definition of an expanded group (EG) to include brother/sister corporations having a single partnership or individual as their common owner. The EG is an important concept because the proposed regulations generally apply only to debt instruments issued between members of an EG. As the rules are currently written, brother/sister corporations are not in the same EG if they are owned by a single partnership or individual (unless they are owned by a partnership that is also owned by affiliated companies). However, Treasury officials stated that future guidance will likely provide that such entities are in the same EG.
- Future guidance may ease documentation requirements for centralized financing arrangements generally known as cash pooling. Under the proposed regulations, taxpayers must conduct an ‘ability to pay’ analysis in order to classify an instrument as debt and taxpayers with a cash pooling arrangement may be required to conduct such analysis each time a member of the group draws cash from the pool. Practitioners have suggested that it would be sufficient to perform an ability to pay analysis covering advances from the cash pool up to a certain limit–the sort of analysis generally performed in connection with revolving credit agreements. Government officials appear receptive to the idea of the requiring analysis only at the creation of the facility and upon any modification increasing the credit line. However, cash pooling arrangements may still raise issues under the documentation rules; for example, an ability to pay analysis performed in advance may not suffice with respect to borrowings payable on demand (i.e., with no fixed maturity date).
- The Treasury is reviewing comments on, and is considering the impact of, the collateral consequences of reclassified debt issued by disregarded entities, S corporations and real estate mortgage investment conduits. Specifically, Treasury is currently considering how the new rules should work with existing safe harbor debt provisions and entity classifications. Officials have indicated that some entity statutory debt-equity rules may not be affected by the new regulations. However, reclassifications of debt as equity under the regulations generally would have tax consequences, as the holder of the reclassified debt generally would be treated as an equity holder for tax purposes.
During the course of the forum Treasury officials indicated that the proposed regulations were not intended to apply to small businesses, noting that aspects of the proposal exclude EGs that do not meet certain thresholds. These thresholds include, for example, one that can be triggered by $50 million in revenue or $100 million in assets, and, for a separate aspect of the proposal, one triggered by an aggregate of $50 million of certain intra-group debt outstanding. Many middle market companies may exceed these thresholds. Thus, companies with related party debt should not delay in evaluating the potential impact the proposed regulations may have on their existing debt/equity structure and their future plans.