The IRS has recently released proposed regulations that may significantly change the landscape of the debt vs. equity distinction. The three most troublesome aspects of these rules to taxpayers are that they permit the IRS to –
- Treat certain related-party debt as part equity and part debt;
- Re-characterize certain related-party debt as equity (“Per Se” provision); and
- Impose onerous documentation requirements, which if not met, could result in related-party debt, including trade payables, being treated as equity.
Before going further, it is important to note that these provisions do not apply to intercompany obligations between consolidated group members as long as the obligation remains in the group.
First, under the proposed rules, the IRS will have the authority to treat related-party debt, including interest, as part debt and part equity. While the rules do not provide specific parameters as to the application of this rule, it appears that the IRS will focus on the expectation of payment by the debtor. The impact of recasting of debt to equity could be far-reaching, including: the denial of an interest deduction; the creation of another class of stock, which may impact S Corporation status; and the inability to use foreign tax credits.
Next, the “Per Se” provision identifies the types of related-party debt transactions that will be recast as equity. This provision is most important in the context of loans between foreign based Multi-Nationals and US Subsidiaries. Items that could fall under this treatment include the distribution of related-party debt or the use of related-party debt to fund certain distributions or acquisitions (“funding”).
Contained in the funding provision, is a non-rebuttable timing presumption. In other words, related-party debt issued in connection with the funded party making a distribution or acquisition of the stock of another related-party, within a 72-month period (36 months before and 36 months after the distribution or acquisition) will automatically be considered to be an equity transaction.
Lastly, the documentation requirements would apply to certain related-party debt, including trade payables, if all or any portion of the assets of the related group exceeds $100 million or annual revenue exceeds $50 million. These rules require that formal loan agreements be in place, within 30 days of the advance or trade payable, with the same creditor rights as any third party lender, including the right to accelerate payments and default procedures. Also similar to a third party lender, the borrower’s ability to repay must be documented and include support such as cash flow statements.
At present, it is unclear at what point undocumented related-party loans would be treated as equity – i.e. at the lapse of 30 days or in the event of default. Either way, even if the related-party loans are properly documented, they could still fall under one of the other provisions and thus, turned into equity.
It is important to note that these are only proposed rules. The IRS is currently considering comments on these proposed rules before they are finalized. Due to the complexity and onerous nature of them, many commentators and industry organizations are calling for them to be withdrawn or significantly modified. A public hearing on the proposed rules is set to take place on July 14, 2016. Reach out to us online by clicking here, or call 513-241-8313 to speak with a member of our tax team.