U.S. Taxation of Related Party Debt: New Proposed Regulations

[On April 4, 2016], the U.S. Treasury Department issued a notice of proposed rulemaking that could significantly affect the debt capitalization of U.S. subsidiary groups owned by foreign corporations (and of foreign subsidiaries owned by U.S. corporations).

The proposed regulations would, among other things, effectively turn debt issued by a U.S. subsidiary group and held by a related foreign parent corporation into preferred equity for U.S. tax purposes, unless the debt was issued for cash that served to increase the capital of the U.S. subsidiary group, after taking any related transactions into account. For example, $1 billion of debt issued by the U.S. group to the foreign parent in exchange for $1 billion of cash would be respected as debt for tax purposes. However, such debt would not be respected as debt if (i) $1 billion of debt was simply distributed by the U.S. group to the foreign parent, (ii) $1 billion of debt was issued by the U.S. group to the foreign parent for cash, but the $1 billion of cash was later (or earlier) distributed to the foreign parent, (iii) the foreign parent sold one U.S. subsidiary to another U.S. subsidiary in exchange for $1 billion of debt in the acquirer, (iv) the foreign parent merged one U.S. subsidiary into another U.S. subsidiary in exchange for stock plus $1 billion of debt, or (v) one foreign affiliate lent $1 billion to a U.S. subsidiary and the U.S. subsidiary distributed the cash to a different foreign affiliate. The proposed regulations are broadly drafted in an effort to cover similar transactions perceived as end-runs or loopholes. These rules would likewise apply to the debt capitalization of foreign subsidiaries by U.S. parent corporations.

The most significant consequences of debt held by a related foreign corporation being treated as preferred equity for U.S. tax purposes include:

• interest paid on such debt would not be deductible for U.S. tax purposes; and
• interest payments on such debt would be treated as dividends subject to outbound U.S. withholding tax, at whatever rate was provided for by an applicable income tax treaty with the foreign parent’s home jurisdiction (or at a 30% rate, if no such treaty was available).

If the proposed regulations are finalized in their current form, they would apply retroactively to debt instruments issued from yesterday onward. If such debt instruments were treated as equity under the terms of the proposed regulations, they would continue to be treated as debt only until 90 days after the issuance of final regulations by the Treasury, and thereafter they would be treated as having been exchanged for preferred equity under the regulations. While it is impossible to predict when or whether the regulations will be finalized as proposed, it does seem reasonable to suppose that finalization (if it does occur) might occur this year on an accelerated basis, given the impending change in administrations.

The proposed regulations also include other novel features relating to the tax treatment of inbound debt, including:

• requiring a related parent corporation that wishes the IRS to respect debt characterization to produce and maintain documentation supporting an assertion that the debt is likely to be repaid; and
• authorizing the IRS to treat such debt partly as debt and partly as equity in cases where such substantiation is deemed to be inadequate.

The proposed regulations are part of a broader package dealing with inversions, although they obviously don’t deal only (or even primarily) with inverting companies. They are being issued under the authority of Section 385 of the Internal Revenue Code, which authorizes the Treasury to prescribe any regulations necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness.