U.S. Taxation of Related Party Debt: New Proposed Debt/Equity Regulations Affecting Debt Held by Related CorporationsSullivan & Cromwell LLP - April 5, 2016
Yesterday evening, the U.S. Treasury Department issued a notice of proposed rulemaking that could significantly affect the debt capitalization of U.S. subsidiary groups owned by foreign corporations (and of foreign subsidiaries owned by U.S. corporations).
The proposed regulations would, among other things, effectively turn debt issued by a U.S. subsidiary group and held by a related foreign parent corporation into preferred equity for U.S. tax purposes, unless the debt was issued for cash that served to increase the capital of the U.S. subsidiary group, after taking any related transactions into account. For example, $1 billion of debt issued by the U.S. group to the foreign parent in exchange for $1 billion of cash would be respected as debt for tax purposes. However, such debt would not be respected as debt if (i) $1 billion of debt was simply distributed by the U.S. group to the foreign parent, (ii) $1 billion of debt was issued by the U.S. group to the foreign parent for cash, but the $1 billion of cash was later (or earlier) distributed to the foreign parent, (iii) the foreign parent sold one U.S. subsidiary to another U.S. subsidiary in exchange for $1 billion of debt in the acquirer, (iv) the foreign parent merged one U.S. subsidiary into another U.S. subsidiary in exchange for stock plus $1 billion of debt, or (v) one foreign affiliate lent $1 billion to a U.S. subsidiary and the U.S. subsidiary distributed the cash to a different foreign affiliate. The proposed regulations are broadly drafted in an effort to cover similar transactions perceived as end-runs or loopholes. These rules would likewise apply to the debt capitalization of foreign subsidiaries by U.S. parent corporations.
The most significant consequences of debt held by a related foreign corporation being treated as preferred equity for U.S. tax purposes include:
- interest paid on such debt would not be deductible for U.S. tax purposes; and
- interest payments on such debt would be treated as dividends subject to outbound U.S. withholding tax, at whatever rate was provided for by an applicable income tax treaty with the foreign parent’s home jurisdiction (or at a 30% rate, if no such treaty was available).
The proposed regulations also include other novel features relating to the tax treatment of inbound debt, including:
- requiring a related parent corporation that wishes the IRS to respect debt characterization to produce and maintain documentation supporting an assertion that the debt is likely to be repaid; and
- authorizing the IRS to treat such debt partly as debt and partly as equity in cases where such substantiation is deemed to be inadequate.
A more detailed memorandum explaining the proposed regulations will be forthcoming. In the meantime, questions regarding the proposed regulations may be directed to David Hariton (212-558-4248), Ron Creamer (212-558-4665), Eric Wang (212-558-3328), Jeff Hochberg (212-558-3266), David Spitzer (212-558-4376), or any other member of the Tax Group.