Jonathan Galin and Gabriel Ewing from KPMG in the US run through the recently finalised 385 Treasury Regulations released in October 2016, introducing a series of rules that apply to potentially recharacterise certain US company issued debt to certain related parties as equity.
Tax considerations often play a significant role in the structuring of cross-border mergers and acquisitions and intragroup reorganisations. For transactions involving US subsidiaries to multinational groups, a key planning consideration may involve the implementation of intragroup financing. In particular, the use of debt to reduce a taxpayer’s effective tax burden through the deduction of interest expense and financing expenses for US tax purposes has long been a tool of US tax planners.
In the context of related party debt, the recently finalised 385 Treasury Regulations (“385 Regulations” or “Final 385 Regulations”), released in October 2016, introduce a series of rules that apply to potentially recharacterise certain US company issued debt to certain related parties as equity. While the proposed 385 Treasury Regulations (“Proposed 385 Regulations”) were released on the same day as targeted corporate tax inversion regulations and launched as part of the broader US effort to reduce the benefits of offshore corporate tax planning, the Final 385 Regulations will apply in the context of the debt financing of US subsidiaries of non-US parented multinational groups regardless of whether an “inversion” transaction has occurred.
Proposed 385 Regulations were originally issued in April 2016. In the six months prior to finalisation the Proposed 385 Regulations were subject to widespread comment and in certain instances, criticism by businesses and tax professionals. In response, the US Treasury and the IRS have made significant changes to the Proposed 385 Regulations that reduce the potential impact of the new rules on US parented multinational groups, such as excluding foreign company issued debt from the purview of the Final 385 Regulations. Nonetheless, the Final 385 Regulations introduce new compliance requirements and potential changes in the treatment of certain related party debt that will generally apply to non-US parented multinational groups.
The 385 Regulations generally apply to certain related party debt due from domestic (i.e. US) corporations and certain controlled partnerships, unless both borrower and lender are within the same US consolidated tax group. In general, only debt between a borrower and lender within the same “expanded group”, in which there is a common parent with direct or indirect ownership of 80% of the vote or value of each, is subject to the 385 Regulations.
Subject to certain exceptions, the Documentation Rule implements contemporaneous documentation requirements on certain related party loans, including written documentation on four indebtedness factors. Failure to meet such documentation requirements may result in the reclassification of the debt as equity for US tax purposes.
Furthermore, the definition of “contemporaneous” has been relaxed in the Final 385 Regulations as originally proposed such that documentation will be treated as timely if it is prepared by the due date for the issuer’s relevant federal income tax return (taking into account all applicable extensions). However, the Documentation Rule still implements significant administrative requirements on borrowers and concerns remain among certain business and tax professionals in respect of certain types of related party funding, for example, the potential impact on cash pooling and revolving credit arrangements.
The Documentation Rule applies only to debt issued on or after 01 January 2018 rather than the date the regulations became final as initially proposed.
The Recast Rule features two basic operating regimes that can reclassify certain US company issued debt to members of the same expanded group as equity – the “General Recast Rule” and the “Funding Rule”. The “General Recast Rule” identifies three basic types of “suspect transactions” – (1) dividends of self-created instruments of indebtedness, (2) purchase of expanded group member stock in exchange for debt of the purchaser, and (3) debt instruments issued as “boot” in an intra-expanded group reorganization. Subject to certain exceptions, debt to which the 385 Regulations apply could be recharacterised as stock for US tax purposes if issued in one of these suspect transactions.
The Funding Rule generally applies to recharacterise debt as equity when the debt is issued in exchange for property (e.g., cash) and the issuer engages in certain identified transactions (“funded transactions”) (e.g., dividend distributions or purchase of expanded group member stock) within a 72-month time-frame (36 months before until 36 months after the date of the funded transaction), unless certain exceptions apply.
In general, the Recast Rule only applies to debt issued on or after 04 April 2016 – however, pre-04 April 2016 issued debt may be subject to the Recast Rules if the terms of such instruments are “significantly modified” as determined under the applicable US Treasury Regulations concerning modification of debt instruments.
While the introduction of new and expanded exceptions have limited the scope of the Final 385 Regulations as compared to the earlier Proposed 385 Regulations, the potential US tax consequences of the Final 385 Regulations remain substantial for non-US parented multinational groups. In particular, the Funding Rule can be especially relevant for related party debt-funded US sub-group companies engaging in M&A transactions. Close monitoring of the ongoing activities of the US company’s activities will be required to avoid unintended recharacterisation of certain debt as equity.
Early consultation with your tax adviser before engaging in transactions involving related party debt-funded US sub-group companies is highly recommended to mitigate the risk of recharacterisation under the 385 Regulations. If you consider that these new 385 Regulations could apply to your US sub-group, we recommend that you take action now to identify the (potential) impact of the Documentation and Recast Rules, including compiling and maintaining a complete inventory of outstanding intragroup loans between US and non-US expanded group members.
Additionally, although the Documentation Rule will enter into force for debt issued on or after 01 January, 2018, following the Documentation Rule should be considered a “best practice” and thus it is highly recommended that US subsidiaries of foreign groups at risk of falling within the ambit of the Final 385 Regulations follow the Documentation Rule currently and not wait until future tax years.
The US tax landscape features challenging, and unsettled terrain as it concerns the use of acquisition and intragroup financing, therefore it is critical now, more than ever, that clients seek appropriate advice and then follow it carefully so they may emerge unscathed.
To find out how the US Tax practice in Europe can help your business with cross-border US tax issues, please contact one of the following professionals listed below.
Gabriel Ewing - Manager, KPMG in the US
Jonathan Galin - Manager, KPMG in the US