FinTech in Turkey: Overview
Ekin İnal and Ecem Naz Boyacıoğlu provide an overview of FinTech in Turkey.
New regulations the Internal Revenue Service proposed in early April to try to halt corporate inversions could affect all uses of debt between affiliated companies.
The regulations have a potentially very broad reach.
They are merely proposed.
An example of their potential reach is where a foreign company makes an inbound investment into the United States, sets up a US corporation through which to hold the investment, and capitalizes the US corporation partly with debt and partly with equity. This allows the foreign investor to pull out earnings from the US holding company in the form of interest on the debt. Interest is deductible. Use of debt allows part of the earnings to be returned to the foreign investor without US income taxes at the holding company level. The only tax would be a potential withholding tax at the US border.
Most countries allow this type of “earnings stripping.” Most countries, including the US, impose limits. The US will not allow part of the interest paid to a foreign parent company to be deducted if the debt-to-equity ratio of the US holding company exceeds 1.5 to 1 and the foreign parent company is in a country with a favorable US tax treaty that waives or reduces US withholding taxes on interest rates.
The new rules give the IRS the means to take a tougher approach to earnings stripping, even when it complies with current US limits.
Another area where the new rules might come into play is in purely domestic contexts where a US company makes a loan to an affiliate. However, they will not affect debt instruments issued between two corporations that join in filing a US consolidated income tax return.
The regulations will affect debt instruments issued after the regulations are republished in final form.
It is not clear how quickly the IRS will move to finalize them.
Some critics are accusing Treasury of resorting to a sledgehammer in its effort to stamp out corporate inversions.
In an inversion, a US corporation with substantial foreign operations inverts its ownership structure to put a foreign parent company on top with the aim of keeping future earnings from its overseas businesses outside the US tax net. An inversion is more attractive if the new foreign parent can also drain earnings from the US subsidiary through earnings stripping.
The Treasury looked for ways to limit the new rules to inversion situations. It is hard to do. The mere threat that the regulations may be published in final form before a complicated inversion that is costly to implement can be completed may be enough.
The broad reach of the proposed regulation would affect lots of inbound US investment.
The Treasury turned to issuing regulations after Congress made clear it has little interest in acting. Republicans control both houses of Congress. Republican leaders believe the way to fight inversions is to reduce the corporate income tax rate and believe that narrowly-targeted measures will ultimately prove ineffective. Edward Kleinbard, a law professor at the University of Southern California and former staff chief of the Joint Committee on Taxation, put it differently: “Congress has shown itself unwilling to honor its obligation to invest in the routine maintenance of the tax code . . . .”
The proposed new rules have three parts.
First, they require any company issuing debt to an affiliate to keep written documentation to prove the instrument is debt. The IRS will need this to do its own analysis.
The documentation must prove four things. The instrument is a legally-binding obligation to pay a fixed sum of money on demand or on one or more fixed dates. The affiliated lender has a right to enforce the obligation, including a right to declare a default and accelerate repayment, and it has claim to company assets in a liquidation to satisfy the debt that is superior to any claim that the shareholders have to the assets. Repayment is expected by the maturity date. The parties behave in fact over time like a borrower and an arm’s-length lender.
The documentation must be contemporaneous. Thus, with some exceptions, all but the information relating to actual performance must be compiled within 30 days after the debt instrument is issued. The information must be kept on file for the full period the debt is outstanding plus any additional period until the statute of limitations has expired on a back tax claim.
The documentation must include “complete and (if relevant) executed copies of all instruments, agreements and other documents evidencing the material rights and obligations of other parties such as guarantees and subordination agreements.” Proof that repayment is expected may require cash flow projections given to third parties, financial statements, business forecasts, asset appraisals and debt-equity and other financial ratios and information about sources of cash for repayment.
Such extensive documentation is burdensome to assemble. Therefore, the IRS is only requiring it where any member of the expanded affiliated group has shares that are publicly traded, or the group had more than $100 million in assets or revenue of more than $50 million a year in any of the three prior years.
The documentation is “necessary, but not sufficient” to ensure treatment of the instrument as debt. The IRS remains free to treat a purported debt as equity on substantive grounds.
Two companies will be considered affiliated, so that documentation will be required to validate debt instruments between them, if the companies have at least 80% common ownership by vote or value. It is the same test as for determining whether two corporations can join in filing a US consolidated income tax return, except that foreign corporations are considered part of the affiliated group as are corporations with partnerships in between them. The IRS suggested debt of affiliated partnerships and disregarded entities may also be reclassified under these rules. It is not clear why since these types of entities do not pay income taxes and are not obvious candidates for earnings stripping. The earnings stripped would have to belong to a corporate partner or owner. It is also not clear what metrics will apply to controlled partnerships to treat them as affiliated.
The new proposed rules put companies on notice that the IRS may take action during an audit to treat a debt as part debt and part equity. An example is where the IRS believes that only part of the “debt” is likely to be repaid.
While there have been instances where the IRS or the courts have taken that position in the past, such instances have been rare.
Debts between a broader group of companies may be picked up by this part of the new rules. Two companies will be considered affiliated for this purpose if they have only 50% common ownership by vote or value.
The focus is on instruments that the parties characterize at time of issuance as debt. The agency does not plan to invoke these new powers to recharacterize instruments as debt that the parties start out treating as equity as that “would require more detailed guidance.”
Finally, the proposed rules curb transactions that increase related-party debt without financing any new investment in the United States.
They identify six transactions that the IRS believes are usually undertaken for tax reasons and rarely have a real business purpose. The common thread in the transactions is debt is issued to a related party without receipt of any actual cash.
An example is where a US subsidiary corporation pays a dividend to its parent by issuing the parent a debt instrument. No new investment is made in the parent. In a cross-border context, this gives the foreign parent greater ability to strip earnings.
The same strategy could be used by a US parent company to repatriate earnings from an offshore subsidiary to the US without a US tax on the earnings. For example, the foreign subsidiary could issue debt — essentially an IOU — to its US parent in a year when the foreign subsidiary has no undistributed earnings and the US parent has enough basis in its stock in the subsidiary to treat the distributed debt instrument as a return of capital. In a later year when the subsidiary has earnings, it can use them to repay the debt. The earnings end up not being taxed in the United States.
The IRS said it plans to treat the debt issued in these cases as equity. The key is there is a parent-subsidiary relationship — either inbound or outbound — there is no new capital investment by the parent, and there is no real business purpose. Although the holder of the debt instrument may have different legal rights than a equity participant in theory, the IRS said, those differences have little meaning when the parties are related.
Ekin İnal and Ecem Naz Boyacıoğlu provide an overview of FinTech in Turkey.
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