Summary

The recently released final regulations under Internal Revenue Code Section 385, addressing the circumstances under which related company debt will be classified as equity for federal income tax purposes, will have a significant impact on state and local taxes. Federal tax practitioners, as well as state and local tax practitioners, must address their implications.

In Depth

The US Department of the Treasury has just released final regulations under Section 385 of the Internal Revenue Code dealing with the circumstances under which related company debt will be classified as equity for income tax purposes. Regulations under this provision had been proposed in April 2016. The proposed regulations caused considerable consternation in the corporate taxpayer community. Although Section 385, which was enacted in the Tax Reform Act of 1969, arguably was intended merely to require Treasury to list factors that would be taken into account in determining when purported debt should be reclassified as equity, the proposed regulations prescribed absolute rules, not just factors. If a debt instrument failed to meet the requirements of the proposed regulations, in many cases it was automatically reclassified as equity regardless of whether it would have been respected as debt under the well-accepted rules that had been laid down in dozens of federal court cases.

Treasury’s principal concern was preventing US corporations from diverting income to foreign affiliates by deducting interest on loans to them from the affiliates. This was, in turn, an offshoot of Treasury’s concern about inversions, under which US corporations moved abroad, by merger or otherwise, in manners that reduced their federal tax liability.

Although designed to address an international tax issue (one that has been of concern to foreign governments as well as to Treasury), the proposed regulations were not limited to the diversion of income offshore and applied to purely domestic transactions as well. They had implications for state and local taxation, although obviously Treasury had not focused on this aspect of the situation. 

Final Regulations

The final regulations, like the proposed regulations, set forth certain rules under which debt will automatically be reclassified as equity or will be presumed to be equity. Satisfying the rules of the final regulations does not mean that a particular debt instrument gets a free pass and will necessarily be respected as debt for income tax purposes. It only means that the debt will not automatically be reclassified as equity under the regulations. The debt still must pass the traditional tests that have been laid down in the federal case law. For example, although the final regulations except from their scope debt issued by certain regulated financial corporations and insurance companies, that debt will still have to pass muster under the criteria specified in the federal case law.

The final regulations apply only to debt issued to related corporations. The universe that is subject to these rules is defined as the “expanded group” of corporations, which generally tracks the definition of “affiliated group” in Internal Revenue Code Section 1504(a), dealing with eligibility to file consolidated federal returns. The definition of “expanded group” is modified by excluding S corporations, non-controlled regulated investment companies and non-controlled real estate investment trusts. A major change from the proposed regulations is that foreign issuers of debt are excluded from the definition. 

The proposed regulations contained detailed documentation rules that had to be followed in order for an instrument to be respected as debt. These rules applied only to large corporate groups. They applied only if the stock of any expanded group member was publicly traded, the expanded group had total assets exceeding $100 million, or the expanded group had total annual revenue that exceeded $50 million. 

The final regulations retain the documentation rules, but with some significant changes. Non-compliance with respect to a debt instrument generally results in it being treated as equity, but non-compliance results only in a rebuttable presumption that the debt is equity if the taxpayer can show that it is otherwise “highly compliant” with the documentation rules. High compliance is based on some mathematical tests. The taxpayer can overcome the presumption by demonstrating that the instrument should be treated as debt under the traditional common law rules.

Among the documentation requirements is an analysis of the issuer’s ability to repay the debt in accordance with its terms. This means that corporations will have to produce and maintain studies showing that the issuer’s financial circumstances and prospects justified a reasonable expectation that the debt would be repaid. Although obviously banks and other professional lenders do this as a matter of course with respect to loans made to customers in the ordinary course of business, they do not do so with respect to related party debt, and regular business corporations typically do not do this with respect to inter-company debt. They will have to change their practices.

Fortunately for taxpayers, the effective date of the documentation rules has been delayed. The rules will only apply to debt instruments issued after December 31, 2017. This will give corporations time to develop systems to comply with the new rules.

Among the most controversial rules of the proposed regulations were the funding rules. These generally provided that debt issued in connection with a distribution, in exchange for the stock of a member of the expanded group, or as “boot” in an internal asset reorganization, was automatically reclassified as equity if it was issued within three years before or after the transaction. Many commenters criticized the concept of the funding rule and, in particular, its application to all transactions within a six-year period. The final regulations retain the basic concept, but they soften it in a number of respects.

The proposed regulations contained an exception for certain transactions that occurred in the ordinary course of business. These were designed primarily to apply to routine purchases of goods and services within the expanded group that were not paid for immediately but were funded by inter-company debt.

The final regulations expand the scope of the ordinary course exemption to include traditional cash pooling arrangements and short-term debt instruments. Under the final regulations, the funding rule does not apply to “qualified short-term debt instruments,” which are defined to include short-term funding arrangements, ordinary course loans, interest-free loans and cash pool arrangements.

The proposed regulations provided that the amount of transactions subject to the funding rules was reduced by the amount of the issuer’s current-year earnings and profits. The current year limitation was criticized for a number of reasons, including that it was typically impossible to determine them before the end of the year, and that it would create an artificial incentive to “use” current-year earnings and profits by making premature distributions. The final regulations expand the earnings and profits limitation to include accumulated earnings and profits, but only those accumulated in taxable years ending after April 4, 2016 (the date when the proposed regulations were issued).

In a major change, the final regulations except from their requirements debt issued by certain regulated entities, such as insurance companies or financial institutions. Covered debt instruments do not include instruments issued by regulated insurance companies that are subject to risk-based capital requirements under state law. The preamble states that the regulatory requirements mitigate the risk that tax-avoidance transactions would be done. The exception is limited to insurance companies that engage in regular issuances of insurance to unrelated persons. Captive insurance companies are not included in the exception. Further, the exception does not apply to members of an expanded group that includes an insurance company, that are not themselves insurance companies. The same principles apply to debt issued by regulated financial institutions, including those with specific regulatory or capital requirements, such as bank holding companies, members of the Federal Reserve System, registered broker-dealers, companies subject to a determination by the Financial Stability Oversight Council, and Federal Home Loan banks.

Instruments issued by regulated insurance companies and financial institutions are treated as meeting the documentation rules if they contain terms that satisfy regulatory requirements.

The proposed regulations treated members of a consolidated return group as a single corporation, which in effect meant that debt instruments issued by one consolidated return group member to another were not subject to the rules. This general concept has been retained, with slight modifications. Under the final regulations, members of a consolidated group are treated as one corporation, but only for purposes of the general and funding rules. With respect to the documentation rules, the final regulations do not treat the members as a single corporation, but provide that obligations between consolidated group members are not subject to the documentation rules. As a practical matter, this may not be a significant change. An important point to remember is that the exception for intra-group debt does not apply to debt issued to related corporations that do not join in the consolidated return.

SALT Implications

A basic issue that will be of concern to SALT practitioners is whether, and the extent to which, the principles of the final regulations will apply for state and local tax purposes. State statutes typically base state taxable income on federal taxable income with changes to reflect differences between federal and state tax policies. Will states that generally conform to the Internal Revenue Code be required to adopt the final regulations or their principles? Although the final regulations have been adopted pursuant to a statutory mandate, they are not part of the Internal Revenue Code. While regulations adopted pursuant to a statutory authorization are entitled to greater deference than normal interpretative regulations, they are not part of the law and are subject to judicial review. Even provisions of the consolidated return regulations, where it is clear that Congress has delegated rule-making authority to Treasury, have been declared invalid by the courts on occasion. (See, e.g., American Standard, Inc. v. United States., 602 F.2d 256 (Cl. Ct. 1979)). State revenue departments have made it clear that they believe that they are not bound by IRS determinations or interpretations of other Code provisions. In fact, most states do not automatically conform to the consolidated return regulations, even though, as indicated above, they represent an express delegation of rule-making authority by Congress to Treasury. Some state revenue departments follow the consolidated return regulations with respect to corporations filing combined returns, but most do not address the issue.

We believe that the states will not be required to adopt the final regulations or their principles and will be free to reject them entirely, to accept parts of them and not others, and to modify them as applied to their own laws. Some revenue department officials disagree, however, and believe that the states will be required to adopt the regulations.

Even if state revenue departments do not consider themselves to be bound by the terms of the final regulations, they may look to them for guidance, and it can be expected that the final regulations will be a factor in state and local tax audits. We have had cases in which state auditors agreed to be bound by the results of an IRS audit of a debt-equity issue, even though this meant keeping the statute of limitations open only for that issue. Further, relying on federal regulations would be an easy way for state revenue departments to avoid having to make their own detailed examinations of the many factors that the courts have taken into account in making debt-equity determinations. It would be prudent to meet the requirements of the final regulations, even with respect to debt that is not literally subject to those regulations (for example, because the companies are too small or because they are filing consolidated federal income tax returns).

One option open to the states would be to adopt comparable regulations that conform to the basic principles of the final regulations but that part company with them with respect to certain details. For example, comparable state regulations might have lower thresholds for the size of affected corporations or debt or have no thresholds at all. A state revenue department could also retain the minimum size threshold concept but reduce the thresholds so as to apply the state’s regulations to more corporations.

A fundamental question is whether state revenue departments will apply the regulations or their principles to corporations that are not subject to the federal regulations because they are members of a federal consolidated return group but file separate state returns. This is a common situation because many corporations that file consolidated federal returns are not engaged in a common unitary business and, hence, file separate returns in one or more states. It is possible that a state revenue department could assert that the principles of the federal regulations should apply for state tax purposes in those situations even though the federal regulations do not apply. Presumably, the potential for tax avoidance that Treasury has concluded is present when related corporations file separate federal returns would be present for state purposes in those situations. In some states, this is required by statute. For example, the Louisiana and Maryland statutes specifically provide that corporations that file consolidated federal income tax returns must be treated for state income tax purposes as if they had filed separate federal income tax returns (LA. Rev. Stat. Ann. Section 47:287.733.A; Md. Code Ann. Section 10-811).

Conversely, some corporations file state combined returns even though they file separate federal returns. For example, in New York State, two corporations can file combined returns even though the stock of both corporations is owned by an individual. These corporations could not file consolidated federal returns because a federal consolidated return group must have a common corporate parent. Further, In New York, combined returns can be required or permitted if the common ownership exceeds 50 percent, whereas the federal common ownership level is 80 percent. In those situations, could taxpayers argue that, even though the federal regulations literally apply and require a certain debt instrument to be treated as equity, a similar determination should not be made for state purposes because they are filing combined state returns and if the same filing profile had existed for federal purposes the regulations would not have applied? Such an argument would be strengthened if the state adopted the federal rules on elimination in intra-group transactions under the federal consolidated return regulations.

The exception for distributions from earnings and profits could be applied differently for state and local tax purposes than for federal tax purposes because state and local earnings and profits are not necessarily the same as federal earnings and profits. If state revenue departments apply this rule, will they apply it to federal earnings and profits or to state earnings and profits? The right approach would seem to be to use state earnings and profits as the measure, even though that could result in an instrument being treated differently for federal and state purposes.

Another implication of the regulations is that corporations that pay franchise taxes based on the amount of their capital and not on the amount of their net income may find that their capital-based taxes increase if debt is reclassified as equity.

As indicated above, the final regulations exclude debt issued by S corporations from their scope. How will the states treat corporations that are S corporations for federal income tax purposes but that are C corporations for state income tax purposes? In New York State, a federal S corporation must elect to be treated as an S corporation for state tax purposes. If it fails to do so, it will be treated as a C corporation. Under the New York City general corporation tax, S corporations are necessarily treated as C corporations. Unlike the New York State rules, the New York City rules do not give corporations a choice. The New York tax authorities will have to decide how they are going to treat these entities.

Conclusion

The proposed regulations were controversial and gave rise to much criticism. Indeed, many members of Congress attacked the concept. Nevertheless, Treasury has issued the regulations in final form, and they are now part of the tax landscape. State and local tax practitioners, both in-house and in professional firms, will have to address the regulations’ implications and, more importantly, will have to make their business and federal tax colleagues aware that these regulations have state and local tax consequences that must be taken into account.