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Major U.S. tax debt/equity rules finalized

Author(s): Paul Seraganian, Jennifer Lee, William Corcoran, Adam Wallwork, Ramin Wright, David R. Hardy

Oct 14, 2016

On Thursday, October 13, the Internal Revenue Service and Treasury Department issued their much anticipated final and temporary regulations under Section 385 of the Internal Revenue Code, which are expected to permanently reshape the way multinationals do business. These “debt/equity” regulations provide rules that recharacterize certain cross-border intercompany debt instruments as equity for U.S. tax purposes. When the IRS and Treasury first published proposed regulations under Section 385 on April 4, 2016, these rules sent shockwaves through U.S. tax circles and, more broadly, the international business community, by radically changing their calculus for determining when debt instruments would be respected as debt for U.S. tax purposes.

The final and temporary Section 385 regulations come in the wake of an unprecedented volume of taxpayer comments and an unsuccessful congressional effort to block their issuance. While retaining much of the basic framework of the proposed regulations issued on April 4, 2016 of this year (including the retroactive effective date, now as of April 5, 2016), Treasury implemented significant carve-outs and limitations to the rules, including a sweeping exclusion for non-U.S. issuers of debt and an important exception for financial institutions.  Despite these broad exclusions, the final rules retain their enormous scope and will be highly disruptive to financing transactions into and out of the United States. 

Importance to Canadian taxpayers

Given the level of economic integration and cross-border transactional flow between Canada and the United States (see our latest Cross-Border Quarterly Update), these rules are uniquely important to Canadian taxpayers.  For those Canadian companies not directly benefiting from an exclusion, the final regulations are a game-changer in cross-border tax planning, especially for Canadian companies with significant U.S. subsidiaries or investments. We expect that these rules will create the need for new operating guidelines on several forms of (until now) benign intercompany transactions.

This Update will provide a brief overview of the final and temporary regulations (including a punch-list of the key areas of change) so that our clients and readers have up-to-the-minute knowledge of this important and changing landscape. In the coming days, we will also share further insights on how these rules will impact Canadian companies and what taxpayers can be doing to prepare and plan for their impact.

Scope of the final and temporary section 385 regulations 

Readers will recall that the proposed Section 385 rules had three main components:

  1. Bifurcation Rule: Allowing the IRS to treat a debt instrument as part-debt and part-equity.
  2. Documentation Rule: Under which a debt instrument would automatically be treated as equity if certain documentation requirements were not satisfied by the taxpayer in a timely manner.
  3. The Per Se Rule: Under which debt instruments issued in certain prescribed transactions and within certain prescribed time periods, would be automatically recharacterized as equity.

The rules issued yesterday remove the bifurcation rule and modify each of the Documentation and “Per Se” Rules. 

Even more importantly, the rules exclude non-U.S. issuers from their scope entirely (as a technical matter, the regulations “reserve” on this matter so it is possible that the IRS could decide to subsequently release rules addressing non-U.S. issuers). This means, among other things, that Canadian corporations, including Canadian securitization vehicles, that issue debt instruments will generally not be subject to these rules. However, the rules will affect the internal operations of Canadian companies with U.S. subsidiaries and operations.

Modifications to the Per Se Rule

The main structure of the Per Se Rule in the proposed regulations was retained. For a description of how this rule works, please see our related Osler Update. Importantly, the final Per Se rule continues to apply to debt instruments issued after April 4, 2016, and distributions and acquisitions after this date continue to be taken into account under these rules. The Per Se rule will have effect (i.e., it may recharacterize debt instruments issued after April 4, 2016) beginning 90 days after the official implementation of the final regulations. This 90-day period should end in mid-January of 2017, depending on the date the final regulations are officially published in the Federal Register in the U.S.

The principal modifications made by the final rules are:

  1. Exclusion for financial institutions: The Per Se rule will not apply to debt instruments issued by certain highly regulated financial companies, on the basis that these companies are already subject to significant scrutiny of their operations. For these purposes, regulated financial companies include 17 categories of entities, including bank holding companies, national banks, insured depository institutions, and certain subsidiaries of these entities. Other excluded financial institutions include regulated swap dealers, futures commission merchants, and brokers or dealers, but not subsidiaries of such entities.

  2. Cash pool exception: The temporary rules contain an exclusion for “cash-management” arrangements and certain short-term intercompany financings. A cash-management arrangement is similar to the functions of cash pooling activities commonly used by large corporate enterprises to manage cash for their relevant subsidiaries, and includes activities such as borrowing excess cash from group members prior to lending funds to other group members, foreign exchange management, clearing payments, investing excess cash with third parties, and settling intercompany accounts. We note that Treasury has reserved portions of its guidance on this exception. We expect to issue a future Osler Update including additional detail on the operation of this exception, as it is likely to be heavily relied upon by many corporate groups.

  3. E&P exclusion broadened: The current year earnings and profits (E&P) exception has been expanded to apply to all E&P that a corporation generates after April 4, 2016 (with certain exceptions and limitations that apply in the case of a change of control of the corporation). As well, certain qualified capital contributions of property offset distributions and other similar transactions for the purposes of these rules.

  4. Cascading potential reduced: The “cascading effects” of the proposed Per Se rule (which refers to the ability of the proposed regulations to result in a “chain-reaction” of multiple equity recharacterizations of related party debt) have been mitigated, but not eliminated, in the final rules. The IRS feels that eliminating foreign issuers from the scope of the rule, together with the exclusion for certain cash management arrangements, will operate to neutralize much of the threat of cascading results.

  5. $50 -million exclusion modified:  The $50-million exception was changed so that it is no longer a “tipping basket” having a cliff effect. Under the new rule, taxpayers can exclude the first $50 million of indebtedness, that would otherwise be recharacterized as equity, from the scope of the Per Se rule.

Modifications to the Documentation Rule

As with the Per Se rule, much of the content of the proposed Documentation Rule was retained in the final regulations. For a description of the proposed Documentation rule, please see our related Osler Update. The final regulations will apply to debt issued on or after January 1, 2018.

The main changes to the Documentation Rule are:

  1. Deadlines significantly eased:  The proposed rule generally required documentation requirements to be satisfied within 30 days (or in certain cases, 120 days) of the issuance of the debt instrument (or certain other prescribed events). The final Documentation rule requires documentation requirements to be satisfied by the time the taxpayer’s U.S. federal income tax return for that year is filed (including extensions).

  2. Reducing Effects of Footfaults:  One of the most troubling aspects of the proposed Documentation Rule was that small compliance footfaults resulted in draconian consequences (automatic recharacterization as equity, subject only to a reasonable cause exception). The final regulations take a more measured approach and generally provide that for taxpayers that demonstrate a “high degree of compliance” with the documentation requirements, isolated instances of noncompliance will not be subject to automatic equity recharacterization. Instead, the noncompliant debt instrument would be made subject to a rebuttable presumption that it is equity. The taxpayer would then carry an evidentiary burden to show that, on its merits, the instruments should be treated as debt for U.S. tax purposes.

The regulations continue to apply to a broad range of investments made in the U.S. by Canadian persons. For example, Canadians investing in the U.S. may form U.S. corporations to hold U.S. assets, and finance these investments in part with debt. These U.S. corporations (commonly referred to as “leveraged blockers”) can be subject to these newly finalized rules. Canadian entities, including Canadian private equity funds, should consider revisiting structures using such blockers. Under the final regulations, it may be possible to instead use non-U.S. corporations as blockers to minimize the impact of the new rules, but there are other considerations to weigh, such as the potential application of the U.S. branch profits tax rules.