Treasury Targets Related-Party Debt with Proposed Regulations to Treat Debt as Equity

Proposed regulations would establish a sweeping framework to treat debt as equity in an effort to curb the use of “excessive” related-party debt.

On April 4, 2016, the US Department of the Treasury (Treasury) and the Internal Revenue Service (the IRS) announced proposed regulations (the Proposed Regulations) under Section 385 to address certain related-party debt transactions perceived as producing significant tax benefits but lacking meaningful non-tax significance. These transactions include “earnings stripping” techniques and repatriation planning that remove certain intragroup payments from the US federal income tax net. Section 385, enacted almost 50 years ago and largely dormant since an amendment in 1992, grants Treasury the authority to prescribe regulations to determine whether an interest in a corporation is properly treated as debt or stock. Regulations were issued in the early 1980s, but their effective date was delayed several times and the regulations were finally withdrawn without ever entering into force. Although the Proposed Regulations were issued as part of a package related to inversion and post-inversion transactions (for more detail regarding those regulations, please see the concurrently published Latham & Watkins Client Alert “Treasury Issues Stringent Inversion Regulations, Proposes Far-Reaching Related-Party Debt Rules”), the Proposed Regulations extend beyond the inversion context, applying generally to taxpayers in both the cross-border and even the purely domestic context.

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Latham & Watkins Tax Practice April 21, 2016 | Number 1955

Treasury Targets Related-Party Debt with Proposed
Regulations to Treat Debt as Equity
Proposed regulations would establish a sweeping framework to treat debt as equity in an
effort to curb the use of “excessive” related-party debt.
On April 4, 2016, the US Department of the Treasury (Treasury) and the Internal Revenue Service (the
IRS) announced proposed regulations (the Proposed Regulations) under Section 3851 to address certain
related-party debt transactions perceived as producing significant tax benefits but lacking meaningful non-
tax significance. These transactions include “earnings stripping” techniques and repatriation planning that
remove certain intragroup payments from the US federal income tax net. Section 385, enacted almost 50
years ago and largely dormant since an amendment in 1992, grants Treasury the authority to prescribe
regulations to determine whether an interest in a corporation is properly treated as debt or stock.
Regulations were issued in the early 1980s, but their effective date was delayed several times and the
regulations were finally withdrawn without ever entering into force. Although the Proposed Regulations
were issued as part of a package related to inversion and post-inversion transactions (for more detail
regarding those regulations, please see the concurrently published Latham & Watkins Client Alert
“Treasury Issues Stringent Inversion Regulations, Proposes Far-Reaching Related-Party Debt Rules”),2
the Proposed Regulations extend beyond the inversion context, applying generally to taxpayers in both
the cross-border and even the purely domestic context.
The Proposed Regulations, as drafted, would attempt to achieve Treasury’s and the IRS’ policy objectives
by treating as stock:
• Certain related-party debt issued in connection with specific types of transactions
• Certain related-party debt for which specific documentation requirements are not met
• Entirely or in part, certain other related-party instruments that, although styled as debt, are perceived
to be more appropriately characterized, at least partially, as stock
In general, the Proposed Regulations would apply to instruments in the form of debt issued (or deemed
issued) and held by members of the same “expanded group,” although in some cases, discussed below,
their scope is broader. An expanded group, which would consist of corporations that are connected
directly or indirectly by 80% ownership (by vote or value) is similar to an affiliated group that files a
consolidated federal income tax return (a consolidated group), but would also include entities ineligible to
be part of a consolidated group. These entities include foreign corporations, real estate investment trusts
(REITs) and corporations held indirectly through partnerships. As described below, however, the
Latham & Watkins April 21, 2016 | Number 1955 | Page 2

Proposed Regulations would generally not apply to instruments issued and held by members of the same
consolidated group.

One clear result of recasting debt as stock in the three circumstances listed above is that deductible
interest payments become non-deductible dividends. In addition, in the cross-border context, dividend
payments may be subject to withholding tax at higher rates than those applicable to interest payments.
Moreover, principal payments on recast debt may be treated as dividends potentially subject to
withholding tax. Unexpected results could also arise under many other circumstances where the
distinction between debt and equity results in materially different US federal income tax consequences.
The Proposed Regulations would also impose significant monitoring and documentation burdens on
multinational and domestic groups with common cash management arrangements, or that regularly
engage in intercompany debt issuances and distributions.
I. Related Party Debt Issued in Connection with Certain Transactions
Subject to certain exceptions, including the exception for transactions among members of a consolidated
group, as described above, the Proposed Regulations would treat as stock a debt instrument issued to a
member of the issuer’s expanded group in connection with specified transactions. Importantly, under
these rules, the terms of the debt instrument itself are irrelevant in determining whether debt treatment
applies, as the instrument would be subject to treatment as stock even if the documentation requirements
described below are satisfied and, under traditional debt-equity analysis, the instrument would otherwise
be treated as debt.
• General Rule: Subject to certain exceptions described below, the “general rule” would treat as stock
a debt instrument issued to a member of the issuer’s expanded group if the debt instrument were
issued (i) in a distribution; (ii) to acquire stock of a member of the issuer’s expanded group (e.g., in a
transaction that would otherwise be subject to Section 304); or (iii) as consideration in certain internal
asset reorganizations (e.g., in a “D” reorganization).
– Example 1:3 US parent (USP) sells one foreign subsidiary (Foreign Sub 2) to another foreign
subsidiary (Foreign Sub 1, which has zero current-year earnings and profits, or E&P) in
exchange for a US$75 million note. In the absence of the Proposed Regulations, this
transaction would be subject to Section 304, and the note would generally be treated as
distributed to USP by Foreign Sub 1. Under the Proposed Regulations’ general rule, following
the transaction, USP would not be treated as holding a note issued by Foreign Sub 1, but
instead be treated as holding additional stock (with features different from Foreign Sub 1’s
stock that USP already held).

Latham & Watkins April 21, 2016 | Number 1955 | Page 3

• Funding Rule: The Proposed Regulations also target multi-step transactions that implicate policy
concerns similar to those that transactions subject to the general rule raise. Subject to certain
exceptions, under the “funding rule,” a debt instrument issued for property, including cash, (a funded
debt instrument) will nonetheless be characterized as stock if a member of the expanded group (a
funded member) issues a funded debt instrument to another member of the expanded group in a
separate transaction with a principal purpose of using the debt proceeds to fund one or more
distributions or acquisitions described in the general rule (a principal purpose debt instrument). The
funding rule generally would not apply to treat debt instruments issued on or after April 4, 2016, as
funding a distribution or acquisition that occurred before such date. Subject to the “per se rule”
described below, whether such principal purpose exists would be determined based on all facts and
circumstances.

– Per se rule: The most significant feature of the funding rule is a non-rebuttable presumption
(the per se rule) that, subject to certain exceptions described below, treats certain funded
debt instruments as principal purpose debt instruments, whether or not a principal purpose
actually exists to fund a general rule transaction. Under the per se rule, a funded debt
instrument would be treated as stock if the instrument were issued during the six-year period
beginning 36 months before, and ending 36 months after, the issuer engages in a distribution
or acquisition described in the general rule. Certain “ordinary course” debt would be exempt
from the per se rule. However, this exception is limited and would not apply to activities many
large multinationals view as ordinary course, including intercompany financings and treasury
activities. Thus, the per se rule would create a significant risk of foot-faults with drastic
consequences: transactions completely unrelated to a funded debt issuance (and
meaningfully separated from the issuance by time) could cause such debt to be treated as
stock. The per se rule would not create a safe harbor by implication. Accordingly, debt issued
outside of the six-year presumption period would remain subject to treatment as stock based
on a facts-and-circumstances determination of whether the debt was a principal purpose debt
instrument.
– Example 2: Loans from a REIT (or in some cases, from an operating partnership in an
UPREIT structure) to a taxable REIT subsidiary (a TRS) could be subject to treatment as
stock under the Proposed Regulations as a result of distributions from the TRS occurring in
the 36 months before or after the loan (even if the distribution and loan occurred in
connection with unrelated transactions). In Year 1, REIT loans TRS US$70 million and
receives a note (TRS Note). In Year 2, TRS distributes US$60 million to REIT, and TRS has
zero current-year E&P in Year 2. Under the per se rule, TRS Note would be treated as a
principal purpose debt instrument because of the US$60 million distribution from TRS to
REIT in Year 2. At the time of the distribution, REIT would be treated as exchanging US$60
million of TRS Note for TRS stock, and the remaining US$10 million would be treated as
debt. The same result would follow if, for example, rather than a REIT, the parent were a
foreign corporation and the subsidiary a domestic corporation.
Latham & Watkins April 21, 2016 | Number 1955 | Page 4

• Exceptions to the General Rule and the Funding Rule: The Proposed Regulations specify certain
exceptions to the general rule and the funding rule. For example, debt would not be subject to these
rules to the extent the debt was issued in distributions or acquisitions not exceeding the issuer’s
current-year E&P. In addition, under the “threshold exception,” a debt instrument that would otherwise
be treated as stock under the general rule or the funding rule would not be treated as such if,
immediately after issuance, the aggregate adjusted issue price of all such debt instruments held by
members of the expanded group did not exceed US$50 million. The threshold exception, however,
might have limited application in practice as all debt instruments that would be recast as stock under
the general rule or the funding rule (even those with both non-US issuers and holders) would count
against the US$50 million threshold. Moreover, a debt instrument that qualified as debt upon
issuance solely by reason of the threshold exception could subsequently be treated as stock if the
expanded group’s applicable debt instruments subsequently exceed the threshold.
– Example 3: Prior to Year 1, an expanded group consisting of foreign parent (FP), a US
subsidiary (US Sub) and a foreign subsidiary (Foreign Sub) have no intragroup debt that
would be treated as stock but for the threshold exception. In Year 1, US Sub distributes a
US$30 million note (US Note) to FP, and US Sub has zero current-year E&P in Year 1. Under
the threshold exception, US Note would be treated as debt. In Year 2, Foreign Sub distributes
a US$30 million note (FS Note) to FP, and Foreign Sub has zero current-year E&P in Year 2.
At the time of Foreign Sub’s distribution, the adjusted issue price of US Note is US$30
million. The threshold exception would no longer apply because the aggregate adjusted issue
price of US Note and FS Note is greater than US$50 million. Thus, in Year 2, FP would be
treated as exchanging US Note for US Sub stock, and FS Note would be treated as stock.

Latham & Watkins April 21, 2016 | Number 1955 | Page 5

• Timing of Recharacterization: A debt instrument recast as stock would generally be treated as
stock as of the debt issuance. Additional rules address circumstances where an instrument’s
character may change because of subsequent transactions or changes with respect to the holder or
issuer of the debt. For example, if a debt instrument would be treated as stock under the funding rule
and the funded transaction occurs in a tax year after the debt issuance, the debt would be treated as
stock when the funded transaction occurs. In addition, if debt treated as stock leaves the expanded
group, the debt would cease to be treated as stock at such time. Importantly, a change in an
instrument’s character would require retesting of other debt instruments issued among members of
the expanded group.
– Example 4: In Year 1, foreign parent (FP) loans its US subsidiary (US Sub) US$75 million and
receives a note (US Sub Note A). In Year 2, US Sub distributes US$60 million, and US Sub has
zero current-year E&P in Year 2. For reasons described in Example 2 above, at the time of the
distribution, FP would be treated as exchanging US$60 million of US Sub Note A for US Sub
stock, and the remaining US$15 million would be treated as debt. Later in Year 2, FP loans US
Sub an additional US$100 million and receives a note (US Sub Note B). US Sub Note B would
not be treated as stock under the per se rule and funding rule because US Sub Note A would be
treated as fully funding the prior Year 2 US$60 million distribution. In Year 3, FP sells US Sub
Note A to a non-expanded group member. As a result, no part of US Sub Note A would continue
to be treated as stock. However, US Sub Note B would be retested to determine whether it would
be required to be treated as stock in whole or part from that time forward. Under the per se rule
and the funding rule, FP would be treated as exchanging US$60 million of US Sub Note B for US
Sub stock, and the remaining US$40 million would be treated as debt.

• Anti-Avoidance Rules and No Affirmative Use: Consistent with the intended broad reach of the
Proposed Regulations, an anti-abuse provision would operate to treat as stock debt instruments
issued with a principal purpose of avoiding the general rule, the funding rule or the rules relating to
consolidated groups (discussed below). The Proposed Regulations provide a non-exhaustive list of
transactions perceived as abusive, such as where a debt instrument is issued to an entity that was
not a member of the expanded group at issuance, but later becomes a member of the group. To
prevent avoidance through the use of partnerships, a partnership that is 80% controlled by members
of an expanded group would be treated as an aggregate of its partners, which would therefore be
treated as owning their proportionate share of partnership assets and as issuing their proportionate
share of partnership debt. In addition, taxpayers would not be able to use these rules affirmatively to
reduce tax liability by treating debt as stock, because the rules would not apply to a transaction if a
principal purpose of the transaction were to have debt treated as stock in order to reduce tax liability.

Latham & Watkins April 21, 2016 | Number 1955 | Page 6

• Effectiveness: The general rule and funding rule would apply, generally, to debt issued (or deemed
issued) on or after April 4, 2016. However, a transition rule would apply to debt instruments that are
issued before the regulations are finalized and would be treated as stock under these rules. Such
debt instruments would continue to be treated as debt until 90 days after final regulations are issued.
At the end of the transition period, a holder of such debt would be deemed to exchange the debt for
stock, if the holder is a member of the issuer’s expanded group at such time.
II. Documentation Requirements
In general, the Proposed Regulations would require contemporaneous documentation and financial
analysis to support the treatment of certain related-party debt as debt. These requirements are intended
to cause related parties to produce, with respect to such debt, the documentation and financial analysis
typical of transactions involving unrelated parties. Compliance with these requirements would be
necessary but not sufficient to treat debt instruments issued and held by members of the same expanded
group (expanded group instruments or EGIs) as debt. Failure to comply with these requirements would,
therefore, generally result in the EGI being treated as stock.
• Scope: In general, the documentation requirements would apply to EGIs issued, or deemed issued,
by large taxpayer groups after the regulations are finalized. Large taxpayer groups are expanded
groups with members whose stock is publicly traded or with “applicable financial statements” showing
US$50 million in annual revenue or US$100 million in assets. Applicable financial statements are,
generally, financial statements prepared for a substantial non-tax purpose that include the assets, a
portion of the assets or the annual total revenue of any member of the expanded group.
• Requirements: The Proposed Regulations would require producing documentary evidence that the
IRS could review to determine whether an EGI was appropriately treated as debt. The documentation
would need to establish that: (i) the issuer was under an unconditional and legally binding obligation
to pay a sum certain on demand or on fixed dates; (ii) the holder had creditor’s rights to enforce the
issuer’s obligations under the EGI; (iii) as of the date of the EGI’s issuance, the issuer’s financial
position supported the reasonable expectation that the issuer intended and would be able to satisfy
its obligations under the EGI; and (iv) the ongoing conduct of the EGI’s issuer and holder was
consistent with an arm’s-length relationship between an unrelated debtor and creditor. The
documentation would need to be maintained for the period during which the EGI remains outstanding
and until the expiration of the period of limitations for any return to which the treatment of the EGI was
relevant.
III. Analysis of the Purported Debt; Potential for Partial Recast
As discussed above, the Proposed Regulations would cause certain related-party debt instruments to be
treated as stock by application of the general rule or the funding rule, or through the issuer or holder’s
failure to satisfy applicable documentation requirements. Such treatment would not, except as specifically
set forth in the documentation requirements, be based on the characteristics of the instrument itself nor
on the issuer’s financial position, which would only become relevant once the rules and requirements
discussed above were satisfied. If these threshold requirements were satisfied, the IRS would still be
empowered to apply general US federal income tax principles to treat certain related-party instruments in
the form of debt as stock, either entirely or in part. For instance, if upon analysis the IRS were to
determine that there was a reasonable expectation that only a portion of an EGI’s principal would be
repaid, the IRS would be able to treat the excess principal as stock. In addition, under the Proposed
Regulations, the IRS’ authority to partially or entirely recast an instrument in the form of debt as stock
would extend beyond EGIs to instruments issued, or deemed issued, in the form of debt to members of
Latham & Watkins April 21, 2016 | Number 1955 | Page 7

the same “modified expanded group” as the issuer. A “modified expanded group” is similar to an
expanded group, but the ownership requirement would be reduced from 80% to 50%.
IV. Consolidated Groups
The Proposed Regulations generally would treat members of a consolidated group as the same
corporation for purposes of applying the rules described above. Therefore, a debt instrument issued and
held by members of the same consolidated group (a consolidated group debt instrument) would,
generally, not be subject to the Proposed Regulations. When the issuer or holder of a consolidated group
debt instrument ceases to be a member of the consolidated group, but remains in the expanded group (or
modified expanded group), the Proposed Regulations’ requirements would apply to the debt instrument.
Similarly, a consolidated group debt instrument that was transferred outside of the consolidated group to
a holder that is a member of the expanded group (or modified expanded group) would be subject to the
Proposed Regulations.
Latham & Watkins April 21, 2016 | Number 1955 | Page 8

If you have questions about this Client Alert, please contact one of the authors listed below or the Latham
lawyer with whom you normally consult:

Michael J. Brody
[email protected]
+1.213.891.8724
Los Angeles

Nicholas J. DeNovio
[email protected]
+1.202.637.1034
Washington, D.C.

Diana S. Doyle
[email protected]
+1.312.876.7679
Chicago

Jiyeon Lee-Lim
[email protected]
+1.212.906.1298
New York
Jocelyn F. Noll
[email protected]
+1.212.906.1616
New York
Laurence J. Stein
[email protected]
+1.213.891.8322
Los Angeles

Kirt Switzer
[email protected]
+1.415.395.8885
San Francisco
Lisa G. Watts
[email protected]
+1.212.906.1200
New York

Katherine M. Baldwin*
[email protected]
+1.212.906.1206
New York
E. Rene de Vera
[email protected]
+1.312.876.7610
Chicago

Sean M. FitzGerald
[email protected]
+1.202.637.2226
Washington, D.C.
Jared W. Grimley
[email protected]
+1.713.546.7403
Houston

Shruti Hazra
[email protected]
+1.212.906.4641
New York
Alan R. Kimball†
[email protected]
+1.212.906.1683
New York
Nicolle Nonken Gibbs
[email protected]
+1.202.637.1031
Washington, D.C.
Thomas H. Halpern
Knowledge Management Lawyer
[email protected]
+1.213.891.8684
Los Angeles

*Admitted to practice in California only
†Admitted to practice in Massachusetts only

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Endnotes

1 All references to “Section” refer to sections of the Internal Revenue Code of 1986, as amended (the Code).
2 For further discussion, please refer to: Latham & Watkins Client Alert No. 1956 (Apr. 21, 2016), Treasury Issues Stringent
Inversion regulations, proposes Far-Reaching Related-Party Debt Rules available at
https://www.lw.com/thoughtLeadership/treasury-issues-stringent-inversion-regulations.
3 For purposes of Examples 1 through 4, each note is assumed to be issued with adequately stated interest.

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