Debt/equity & proposed 382(h) regulations
Debt/equity & proposed 382(h) regulations
This article briefly discusses the recent section 385 and 382(h) regulations proposed by the treasury and the IRS that will have a large impact on M&A activity, as well as an anecdote of how not-so-new final regulations under section 6038A could create a potential trap for the unwary.
Section 385 documentation requirements withdrawn
In 2016, the treasury released final regulations for section 385 that substantially altered the traditional rules of determining whether or not instruments were treated as debt or equity for U.S. federal income tax purposes. The final regulations narrowly focused on intercompany debt issued by U.S. companies, which treasury viewed as potentially abusive because the intercompany debt could facilitate earnings stripping and certain tax-free repatriations. The final regulations attacked these potential abuses through provisions that would “recast” certain intercompany debt as equity for U.S. federal income tax purposes in certain situations, including domestically issued instruments with insufficient documentation (the “enhanced documentation” requirements).
But on 4th November 2019, the treasury and Internal Revenue Service (IRS) published proposed regulations in the Federal Register which withdrew and removed the final regulations under section 385 that set forth the enhanced documentation requirements for certain related-party interests in a corporation to be treated as indebtedness. In September 2018, treasury and the IRS released proposed regulations to remove the documentation requirements from the final section 385 regulations, which ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. Comments were requested in connection with the publication of the proposed regulations.
The treasury and the IRS considered the comments received in response to the proposed regulations and “…determined that the burdens imposed on taxpayers by the documentation regulations outweigh the regulations’ intended benefits.” Thus, the proposed regulations were adopted “with no change” as final regulations. The preamble states that treasury and the IRS “continue to consider the issues” raised by the documentation regulations. Simultaneously, treasury and the IRS also released an advance notice of proposed rulemaking announcing their intention to issue proposed regulations regarding the treatment of certain interests in corporations as stock or indebtedness. This release requests comments about the contemplated rules. In addition, the advance notice of proposed rulemaking announces that taxpayers may rely on the 2016 proposed regulations until further notice, provided that the taxpayer “consistently applies the rules” in the 2016 proposed regulations in their entirety.
Proposed Section 382(h) regulations dramatically alter the treatment of loss corporations with built-in gains and losses
Section 382 seeks to prevent loss trafficking by imposing a limitation on the use of pre-change losses to offset post-change income after a US loss corporation undergoes a section 382 ownership change, i.e., an increase of more than 50 percentage points by one or more 5-percent shareholders over a three-year period (an “ownership change”). In general, a section 382 limitation is equal to the value of the stock of the loss corporation immediately before the ownership change, multiplied by the long-term tax-exempt rate in effect on the change date, with certain potentially significant adjustments.
One such adjustment is contained in section 382(h). Section 382(h) provides rules for the treatment of built-in gain or loss recognized during the five-year period beginning on the change date with respect to assets owned by the loss corporation immediately before ownership change. Generally, if an old loss corporation has a net unrealized built-in gain (“NUBIG”) in its assets immediately before the ownership change, the section 382 limitation for any of the first five tax years following the ownership change is increased by the recognized built-in gain (“RBIG”) for such tax year, up to the amount of the NUBIG (reduced by NUBIG absorbed in prior years). If, on the other hand, an old loss corporation has net unrealized built-in loss (“NUBIL”) in its assets immediately before the ownership change, any recognized built-in losses (“RBILs”) for the first five tax years are treated as a pre-change losses for purposes of the section 382 limitation, up to the amount of the NUBIL (reduced by NUBIL absorbed in prior years). These rules reflect a neutrality principle, which aim to treat built-in gains and losses of a loss corporation recognized during the recognition period in the same manner as if they had been recognized before the ownership change.
In 2003, the IRS issued Notice 2003-65 to provide interim guidance regarding the identification of built-in items for purposes of section 382(h). Notice 2003-65 provides two alternative approaches on which taxpayers can rely in making such determinations.
- The first approach generally adopts the methodology used under section 1374(d) and the teasury regulations sections promulgated thereunder, which apply accrual accounting concepts (the “1374 approach”).
- The second approach generally compares a loss corporation’s actual items of income, gain, deduction, and loss against those that would have resulted had the loss corporation made a section 338 election with respect to a hypothetical sale of all its stock on the change date (the “338 approach”).
Generally, the 338 approach provided taxpayer-favorable rules for taxpayers in a NUBIG position, whereas the 1374 approach provided taxpayer-favorable rules for taxpayers in a NUBIL position.
The proposed regulations would require taxpayers to apply a modified version of the 1374 approach, but would eliminate a number of taxpayer-favorable provisions set forth in Notice 2003-65, including the entire 338 approach and many of the favorable components of the 1374 approach. One way to think of the method prescribed by the proposed regulations is as a combination of the least taxpayer-favorable provisions of each of the two Notice 2003-65 approaches. The proposed Regulations treat many built-in loss or deduction items as RBIL that would not have otherwise been taken into account as RBILs under the 1374 approach, but which might have been taken into account under the 338 approach, while adhering to a fairly strict accrual method with respect to built-in gain items.
The proposed Regulations would apply to any ownership change occurring after date of publication of the treasury decision adopting the proposed regulations as final in the federal register. However, taxpayers may choose to apply the proposed regulations to ownership changes occurring in a year which respect to which section 6511(a) has not expired, so long as the rules are applied consistently to such ownership change and all subsequent ownership changes before the applicability of the final regulations.
Reporting requirements for foreign-owned domestic disregarded entities
Generally, domestic entities which are disregarded for US federal income tax purposes Disregarded Entity (“DREs”) have not historically been required to file any US federal income tax or information tax returns.
However, on 17th January 2017, treasury and the IRS published final regulations that treat a domestic DRE wholly owned by a foreign person, as a domestic corporation for the limited purposes of the reporting and recordkeeping requirements under section 6038A of the internal revenue code. The recordkeeping requirements include:
- Filing form 5472, information return of a 25% foreign-owned U.S. corporation or a foreign corporation engaged in a U.S. trade or business (Under sections 6038A and 6038C of the internal revenue code), and identify an expanded number of “reportable transactions” between the entity and its foreign owner or other foreign related parties;
- Maintaining records establishing the accuracy of the information return and the correct U.S. tax treatment of the transactions; and,
- Obtaining an employer identification number (“EIN”) by filing form SS-4, and reporting responsible party information to the U.S. government.
The treasury department, in a related release, included the following statement about the final regulations:
… there is a narrow class of foreign-owned U.S. entities—typically single member Limited Liability Company (LLCs)—that have no obligation to report information to the IRS or to get a tax identification number. These "disregarded entities” can be used to shield the foreign owners of non-U.S. assets or non-U.S. bank accounts. (The new regulations) will allow the IRS to determine whether there is any tax liability, and if so, how much, and to share information with other tax authorities. This will strengthen the IRS’s ability to prevent the use of these entities for tax avoidance purposes, and will build on the success of other efforts to curb the use of foreign entities and accounts to evade U.S. tax.
On a recent engagement, we advised a transaction where a non-U.S. entity (“buyer”) acquired 100 percent of the interests in a U.S. partnership from the only other partner, thereby terminating the partnership. This partnership had no U.S. partners, was not engaged in a U.S. trade or business, and its sole asset consisted of stock of a non-U.S. corporation. In the course of structuring this transaction, we learned the sellers had never filed any information returns for the partnership, and 'buyer' wanted to know if it would inherit this specific liability.
We concluded 'buyer' was deemed to acquire assets that are held in a disregarded entity, and as an asset purchase, 'buyer' would generally not inherit the partnership’s historic tax liabilities. However, in light of the final regulations under section 6038A, we advised 'buyer' that these specific facts triggered application of the section 6038A regulations, and buyerwould be required to file an information based return on behalf of the DRE in order to avoid failure to file penalties. As these final regulations subvert the normal treatment of DREs, it is easy to see how this rule could be overlooked and cause potential problems on subsequent due diligences.
For any tax professionals serving multinational clients, the repeal of the enhanced documentation requirements will bring a collective sigh of relief; however, the stricter rules for corporations undergoing an ownership change, as well as additional reporting requirements for multinational clients with US DREs will require additional vigilance. Now more than ever, clients will be looking to us to advise them, from keeping abreast of the ever-evolving section 385 regulations, to planning into or around future ownership changes, to ensuring our clients are up-to-date and in compliance with all reporting requirements. Our work is far from over.
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