In its continuing attempt to curtail inversions, on April 4, 2016, the Treasury Department issued temporary and final Treasury Regulations (T.D. 9761)1 specifically directed at inversions (the “Inversion Regulations”) and issued proposed Treasury Regulations (REG-108060-15) targeting related party debt and earnings stripping (the “Earnings Stripping Regulations”). This is the Treasury Department’s third round of guidance on inversions since September 22, 2014.
While the Inversion Regulations primarily represent the incorporation of prior inversion guidance into formal regulations, the Earnings Stripping Regulations are new proposed rules that further reduce the potential benefits of inversions by making it more difficult to “strip” United States source earnings to lower-tax jurisdictions through the issuance of related party debt and payment of related party interest. Importantly, although the Earnings Stripping Regulations have been issued with inversions in mind, the Earnings Stripping Regulations do not specifically apply to inversions and, therefore, can potentially apply to common multi-national lending scenarios.
In general, an inversion is a transaction in which a US parent corporation (the “Inverted US Company”) is acquired by and becomes a subsidiary of a foreign parent corporation (the “New Foreign Parent Company”). While an Inverted US Company will continue to be subject to US taxes on its worldwide income, among other things, an inversion transaction could allow the group to reduce the Inverted US Company’s US federal income tax liability on its US source earnings through the issuance of related party debt and payment of related party interest. For example, after an inversion, the Inverted US Company could issue debt and pay interest to the New Foreign Parent Company or one of the New Foreign Parent Company’s non-US affiliates (an “Affiliate”). The Inverted US Company could then deduct such interest from its US federal taxable income, which often provides significant tax savings to the group because the US tax rate could be significantly higher than the non-US jurisdiction’s tax rate applicable to either the New Foreign Parent Company or an Affiliate.
The primary anti-inversion rules are contained in Sections 367 and 7874 of the Internal Revenue Code of 1986, as amended (the “Code,” hereinafter, Section references are to the Code). In general, Section 367 requires US shareholders of an Inverted US Company to recognize gain (but not loss) in an inversion, and Section 7874 will either treat the New Foreign Parent Corporation as a US corporation for US federal income tax purposes or subject it to various tax disadvantages depending on the percentage of stock of the New Foreign Parent Company that is owned by the former shareholders of the Inverted US Company.
On September 22, 2014, the Treasury Department and the Internal Revenue Service (the “IRS”) issued Notice 2014-52 (the “2014 Notice”). The 2014 Notice announced the intention of the Treasury Department and the IRS to issue regulations to address certain transactions structured to avoid the purposes of the anti-inversion rules discussed above. On November 19, 2015, the Treasury Department and the IRS issued Notice 2015-79 (the “2015 Notice,” and collectively with the 2014 Notice, the “Inversion Notices”). The 2015 Notice expanded on the rules previously issued in the 2014 Notice and introduced new rules and announced the intention of the Treasury Department and the IRS to issue regulations to address such expanded and new rules.
The Inversion Regulations
The Inversion Regulations incorporate the guidance contained in the Inversion Notices and generally apply the analogous rules in the 2014 Notice to transactions completed on or after September 22, 2014, and the analogous rules in the 2015 Notice to transactions completed on or after November 19, 2015. The Inversion Regulations, however, do contain a significant new rule (discussed below), and such rule (and any other rules not contained in either of the Inversion Notices) generally apply to transactions completed on or after April 4, 2016.
Prior to the issuance of the Inversion Regulations, the New Foreign Parent Company could acquire numerous US corporations in advance of acquiring a larger Inverted US Company. These prior acquisitions could allow the New Foreign Parent Company to avoid Section 7874 because the value of the New Foreign Parent Company would increase every time its stock is issued in connection with its acquisition of a US corporation, allowing the New Foreign Parent Company to ultimately acquire an even larger US company while remaining below the ownership threshold to avoid the application of Section 7874. The New Foreign Parent Company could continue to acquire larger US companies without the application of Section 7874, and then shortly thereafter, acquire the even larger Inverted US Company while, once again, avoiding Section 7874 of the Code. The Inversion Regulations prevent such avoidance of Section 7874 by excluding certain stock of the New Foreign Parent Company that is attributable to assets acquired from a US corporation during the 36-month period ending on the signing date for the acquisition of the Inverted US Company for purposes of calculating the ownership percentage thresholds under Section 7874.
The Earnings Stripping Regulations
The Earnings Stripping Regulations limit the benefits of inversions (but also potentially apply to any related party lending situation) by (i) treating certain related party debt in a US corporation as stock for US federal income tax purposes if such related party debt does not finance new investment in the United States (the “Debt Treated as Stock Rules”), (ii) certain related party debt in a US corporation as in part debt and in part stock for US federal income tax purposes (the “Bifurcation Rules”), and (iii) requiring certain documentation requirements to be satisfied in order for certain related party debt in a US corporation to be treated as debt for US federal income tax purposes (the “Documentation Rules”). Importantly, such rules do not generally apply to debt issued between members of a US consolidated group. When and if final Treasury Regulations are issued incorporating the Earnings Stripping Regulations, the Debt Treated as Stock Rules will generally apply to debt issued after April 4, 2016, while the Bifurcation Rules and the Documentation Rules will apply to instruments on or after the final Treasury Regulations are published as final Treasury Regulations.
The Debt Treated as Stock Rules – After an inversion, the group is often able to obtain the benefits of earnings stripping through the issuance by the Inverted US Company of its own debt in a scenario that does not finance new business investment in the United States. This can be accomplished by having the Inverted US Company issue its own debt either (i) to the New Foreign Parent Company in the form of a dividend distribution, (ii) to an Affiliate in exchange for cash that is then used to fund a dividend distribution to the New Foreign Parent Company, or (iii) to an Affiliate in exchange for certain stock or assets in a transaction that is economically similar to a dividend. The Earnings Stripping Regulations generally prevent the use of related party debt to “strip” earnings in such situations by treating related party debt that is issued in such situations as stock for US federal income tax purposes so long as the New Foreign Parent Company, the Inverted US Company, and the Affiliates have more than $50 million of total related debt instruments that would otherwise be treated as stock under the this rule.
The Bifurcation Rules – Under current law, the IRS is generally required to characterize an interest in a corporation as either wholly debt or wholly stock for US federal income tax purposes. The Treasury Department believes that this all-or-nothing approach frequently fails to reflect the economic substance of certain related party transactions and, therefore, gives rise to inappropriate US federal income tax consequences in such situations. The Earnings Stripping Regulations would permit the IRS to treat a purported debt instrument issued between related parties as in part debt and in part stock for US federal income tax purposes.
The Documentation Rules – The Treasury Department believes that it can be difficult for the IRS to obtain information to conduct a proper debt-equity analysis with respect to related party debt because of the lack of detail in a taxpayer’s documentation for such debt. The Earnings Stripping Regulations provide rules requiring the timely preparation and maintenance of documentation and financial analysis evidencing each of the four following characteristics of debt: (i) a legally binding obligation to pay, (ii) creditor’s rights, (iii) a reasonable expectation of repayment at the time the instrument is created, and (iv) an ongoing arm’s-length debtor-creditor relationship. Satisfaction of such documentation requirements would not necessarily guarantee that an instrument is respected as debt for US federal income tax purposes, but importantly, if such documentation requirements are not satisfied, then the instrument would not be treated as debt and would instead be characterized as stock for US federal income tax purposes. The Documentation Rules would only apply if the stock of any member of the group is publicly traded, the total assets of the group exceed $100 million on any applicable financial statement, or annual total revenue of the group exceeds $50 million on any applicable financial statement.
Even though the Earnings Stripping Regulations are being issued primarily to address inversions, the Earnings Stripping Regulations have a much broader scope and can apply to any multi-national related party lending situation. Therefore, it is critical for all multi-national groups to review and analyze their related party debt in light of the Earnings Stripping Regulations.
On the same date, the Treasury Department also issued proposed Treasury Regulations (REG-135734-14) that adopt the same text as the temporary Treasury Regulations.