Related-Party Debt / Equity Regulations: IRS Issues Proposed Regulations Intended to Limit Earnings Stripping but Which—if Finalized—Would Broadly Change the U.S. Tax Treatment of Related-Party Indebtedness

Sullivan & Cromwell LLP - April 14, 2016

On April 4, 2016, the IRS and Treasury Department issued proposed regulations (the “Proposed Regulations”) that would—if finalized in their current form—treat related-party debt as equity for U.S. tax purposes in certain circumstances.  Although the Proposed Regulations were issued concurrently with temporary regulations aimed at so-called “inversion” transactions, the Proposed Regulations would have a much broader impact, and would—in cases where a debt instrument is recharacterized—often increase the U.S. tax liability of the affected group.
As discussed further below, the Proposed Regulations introduce three new sets of rules.  The first aspect of the Proposed Regulations (the “Distributed Debt Rules”) is intended to modify the tax treatment of transactions that can create related-party leverage without an investment of new capital, and applies to instruments that are distributed to a related party, issued in exchange for stock of a related party, or issued in other transactions (including certain asset reorganizations and transactions that may fund distributions) that the IRS and Treasury Department believe can be used for similar purposes.  The second element of the Proposed Regulations (the “Documentation Requirements”) introduces new recordkeeping and similar rules for issuers and holders of related-party debt.  The third set of rules within the Proposed Regulations (the “Bifurcation Authority”) permits the IRS to characterize an instrument as partly indebtedness and partly equity for U.S. federal income tax purposes.
The Proposed Regulations would affect both foreign-parented groups that make inbound U.S. investments and U.S.-parented groups that own foreign subsidiaries.  While the Proposed Regulations would not affect debt obligations among members of a group of U.S. corporations that files a consolidated U.S. federal income tax return, several common types of entities—such as regulated investment companies (“RICs”), real estate investment trusts (“REITs”) and certain insurance companies—cannot be included on consolidated returns.  Although the Proposed Regulations are intended to limit certain transactions that the IRS and Treasury Department believe are motivated largely by tax considerations (such as internal restructurings that allow foreign parent corporations to create high levels of related-party leverage within their U.S. groups to “strip” earnings without investing new capital), the Proposed Regulations are drafted broadly, and may be pertinent to routine funding arrangements and other transactions that are not considered tax-driven.
We understand that the IRS and Treasury Department are seeking to finalize the Proposed Regulations before September 5, 2016.  If the Proposed Regulations are finalized in their current form, the Distributed Debt Rules would generally apply (beginning 90 days after final regulations are issued) to instruments issued on or after April 4, 2016.  The Documentation Requirements and Bifurcation Authority are not proposed to take effect until the Proposed Regulations are published in final form, but would take effect immediately on that date and generally must be satisfied within 30 days of the date when an obligation is issued.