Proposed Debt-Equity Regulations Have Dramatic Implications for Corporate Tax Planning and Compliance
On April 4, 2016, the Internal Revenue Service (IRS) and US Department of the Treasury (Treasury)—without advance warning—released proposed regulations under section 385 (the Proposed Regulations) that will, if finalized in their current form, have dramatic implications for US corporate tax planning and compliance. Certain aspects of the rules when finalized are intended to apply retroactively to corporate debt issued in specified circumstances on or after April 4, 2016. US government officials have indicated they intend to finalize the Proposed Regulations as early as the end of August, and many large corporate taxpayers are acting now, rather than waiting, to evaluate the Proposed Regulations’ potential effects on their existing and future US tax planning strategies and compliance regimes.
The Proposed Regulations impact the US federal tax treatment of many cross-border intercompany loans among affiliated members of a multi-national enterprise (MNE), as well as loans between US corporations under common ownership not filing a consolidated return and loans between members of brother-sister US consolidated return groups. However, the Proposed Regulations generally do not affect loans between members of a single consolidated return group (the Proposed Regulations treat the members of a consolidated group as a single taxpayer).
In broad terms, where applicable, the Proposed Regulations (1) impose new documentation and information requirements for intercompany debt which, if not complied with, will automatically result in the purported debt instrument being characterized as stock for federal income tax purposes; (2) authorize the IRS to characterize a debt instrument as in part debt, and in part stock under certain circumstances (an example is provided focused on expected ability to pay); and (3) mandate recharacterization of an instrument otherwise qualifying as debt for federal income tax purposes as stock if issued in a distribution or certain other circumstances specified in the Proposed Regulations (targeting, among other things, note distributions, exchanges of related party stock for debt instruments, and similar debt-funded distributions or other transactions often used in cross-border tax planning to optimize the capitalization of a US member of a MNE, manage the global effective tax rate (via US interest deductions) or mitigate potential withholding taxes associated with repatriation). Certain exceptions are provided for small non-publicly traded groups, groups without significant amounts of proscribed intercompany debt (i.e., less than $50 million), and certain routine distributions (e.g., distributions of current year earnings and profits), but these exceptions are narrowly drawn. Therefore, if the Proposed Regulations are finalized, they will significantly impact the tax planning of virtually every publicly-traded MNE and many privately held enterprises as well.
Following is an overview of the most significant rules in the Proposed Regulations. A flow chart on page 7 illustrates the basic application of these rules.
Section 1.385-2 Documentation and Information Requirements
In General. Section 1.385-2 of the Proposed Regulations sets forth minimum (necessary, but not sufficient) documentation and information requirements for an Expanded Group Instrument or “EGI” (generally a debt instrument (applicable instrument) between parties directly or indirectly at least 80 percent related by vote or value) to be respected as debt for federal income tax purposes, failing which the Proposed Regulations mandate the EGI will be treated as stock. Excepted from the application of the rules is the case of an EGI where no member of the Expanded Group has publicly traded stock and, on the date the instrument first becomes an EGI, (1) total assets do not exceed $100 million on any applicable financial statement and (2) annual total revenues do not exceed $50 million on any applicable financial statement. In addition, the provisions of section 1.385-2 do not extend to instruments not cast in the form of debt, such as sale-repurchase agreements (repos), leases treated as debt and preferred equity certificates.
Section 1.385-2 is proposed to be effective in respect of applicable instruments issued (or deemed issued) after the regulations are finalized (the General Effective Date). Thus, debt instruments issued before the General Effective Date are grandfathered, but such grandfathered instruments can become subject to the final regulations if they are significantly modified and deemed reissued under section 1001 after the General Effective Date.
The Proposed Regulations mandate the timely preparation and maintenance of the following documentation and information:
- Written documentation evidencing an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.
- Written documentation establishing that the holder has the rights of a creditor to enforce the obligation.
- Written documentation (e.g., cash flow projections, business forecasts, asset appraisals, determination of financial ratios) containing information establishing the issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the terms of the applicable instrument.
- If an issuer made any payment of interest or principal with respect to the EGI and such payment is claimed to support the treatment of the EGI as indebtedness under general federal tax principles, documentation must include written evidence of such payment.
- If the issuer did not make a payment of interest or principal that was due and payable under the terms and conditions of the EGI, or if any other event of default or similar event has occurred, there must be written documentation evidencing the holder’s reasonable exercise of the diligence and judgment of a creditor (e.g., documentation of the holder’s efforts to assert its rights under the terms of the EGI or any documentation detailing the holder’s decision to refrain from pursuing any actions to enforce payment).
The Proposed Regulations contain detailed rules as to what constitutes “timely” preparation and specify the records required to be maintained and period for which they must be maintained.
In the case of revolving credit and similar agreements, the documentation requirement may be satisfied by relevant enabling documents such as board of directors’ resolutions, credit agreements, security agreements, as well as any relevant documentation executed with respect to an initial principal balance or increase in the principal balance of the EGI. If an EGI is issued pursuant to a cash pooling arrangement or internal banking service that involves cash sweeps, set-off facilities or similar features, the EGI satisfies the documentation requirements only if the material documentation governing the ongoing operations of the cash pooling arrangement or internal banking service—including any agreements with entities that are not members of the expanded group—conforms to the requirements of section 1.385-2 and contains the relevant legal rights and responsibilities of the parties to the arrangements in conducting the operation of the cash pooling arrangement or internal banking service.
Section 1.385-2 Operating Rules. The operating rules under section 1.385-2 include a “reasonable cause” exception (with reference to the principles set forth in the regulations under section 6724), for instances where the taxpayer is able to establish that a failure to satisfy the documentation and information requirements of section 1.385-2 is due to reasonable cause. In such cases, the Proposed Regulations provide that “appropriate modifications may be made” in determining whether the requirements of this section have been satisfied.
The operating rules also (1) address the application of section 1.385-2 to an applicable instrument becoming or ceasing to be an EGI, including in the case of an applicable instrument ceasing to be between members of a consolidated return group, (2) specify that an EGI issued by a disregarded entity (DRE) that is treated as equity under section 1.385-2 will be treated as an equity interest in the DRE (converting it to a partnership) for federal tax purposes rather than stock in the DRE’s owner and (3) provide that a “controlled partnership” is treated as a member of an expanded group if one or more members of the expanded group own, directly or indirectly, 80 percent of the interests in partnership capital or profits of the controlled partnership and specify that an EGI issued by a controlled partnership that is recharacterized as stock under section 1.385-2 is treated as an equity interest in the controlled partnership.
Finally, section 1.385-2(d) provides that taxpayers may not make affirmative use of the rules of section 1.385-2 to reduce federal tax liability and section 1.385-2(e) provides that if an applicable instrument that is not an EGI is issued with a principal purpose of avoiding the purposes of the section, the applicable instrument will be treated as an EGI subject to the section.
Bifurcation of Debt between Modified Expanded Group Members: Section 1.385-1(d)
Section 1.385-1(d) provides that the IRS may treat an EGI between members of a “Modified Expanded Group” (an Expanded Group but substituting 50 percent for 80 percent as the relationship threshold) as in part indebtedness and in part stock “to the extent that an analysis, as of the issuance of the EGI, of the relevant facts and circumstances concerning the EGI (taking into account any application of section 1.385-2) under general federal tax principles results in a determination that the EGI is properly treated for federal tax purposes as indebtedness in part and stock in part.” The sole example provided involves a case where the IRS’s analysis supports a reasonable expectation that, as of the issuance of the EGI, only a portion of the principal amount of an EGI will be repaid. The issuer of an EGI, the holder of an EGI, and any other person relying on the characterization of an EGI as indebtedness for federal tax purposes would continue to be bound by the issuer’s initial characterization (i.e., no affirmative use of bifurcation by taxpayers is permitted).
The debt bifurcation provision applies to all corporate instruments issued in form as debt, without exception, effective as of the General Effective Date but, for purposes of sections 1.385-3 and 1.385-4, as of the accelerated effective date provided for in those sections (see discussion below). Like the provisions of section 1.385-2, this bifurcated debt provision does not extend to instruments not issued in the form of debt.
Debt Recharacterization Rules of Section 1.385-3
Subject to certain exceptions discussed below, section 1.385-3 provides rules for recasting debt instruments as stock when the instruments are issued in certain transactions. The term “debt instrument” is defined as an interest that would, but for the application of section 1.385-3, be treated as debt under general federal income tax principles (and, unlike section 1.385-1(d) and section 1.385-2, section 1.385-3 can apply to repos, leases treated as debt, preferred equity certificates and other instruments that in substance, but not form, constitute debt for federal tax purposes).
Recasts under General Rule. Under the “General Rule” in section 1.385-3(b)(2)), debt instruments issued under the following circumstances will be recast as stock: (1) debt issued by a corporation to a related corporate shareholder as a distribution, (2) certain debt issued by a corporation in exchange for stock of an affiliate (for example, a share repurchase for a note or a purchase of affiliate shares for a note in what otherwise would be a section 304 transaction) and (3) certain debt issued as part of an internal asset reorganization (e.g., a cross chain transfer of assets in exchange for a note distributed to parent company in a “D” reorganization).
The Proposed Regulations are aimed at effectively overturning the result in Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956), a case in which the Second Circuit Court of Appeals determined that debentures issued by a corporate subsidiary to its sole corporate shareholder as a dividend should be respected as indebtedness for federal income tax purposes. In the preamble to the Proposed Regulations, the IRS and the Treasury note that the factors in cases like Kraft, “including the parent-subsidiary relationship, the fact that no new capital is introduced in connection with a distribution of debentures, and the typical lack of a substantial non-tax business purpose,” support the conclusion that “the issuance of a debt instrument in a distribution is a transaction that frequently has minimal or nonexistent non-tax effects . . . allowing the related parties to obtain significant federal tax benefits at little or no cost.” The IRS and Treasury have determined that in such cases it is appropriate to treat a debt instrument as stock.
Under the “Funding Rule” in section 1.385-3(b)(3), the provisions of section 1.385-3 also apply to any debt instrument that is a “principal purpose debt instrument”—a debt instrument “to the extent it is issued by a corporation (funded member) to a member of the funded member’s expanded group in exchange for property with a principal purpose of funding [certain specified types of a] distribution or acquisition” (paralleling the transactions addressed by the General Rule). The reference to “to the extent” signifies that the treatment of an instrument can be bifurcated under the recharacterization rules of section 1.385-3 as well as under section 1.385-1(d). For example, if a corporation with no earnings and profits borrows $100 from an affiliate and then distributes $80 of cash to its parent corporation, $80 of the loan will be recast as stock and $20 of the loan will continue to be treated as debt. No further rules are provided for how to treat the bifurcated instrument (e.g., how to allocate future interest and principal payments between the stock and debt portions of the instrument).
Under a non-rebuttable per se rule, a debt instrument is treated as issued with a principal purpose of funding a proscribed distribution or acquisition if it is issued by the funded member during the 72 month period beginning 36 months before the date of the distribution or acquisition, and ending 36 months after the date of the distribution or acquisition. This per se rule is subject to a very narrow “ordinary course exception” for a debt instrument that arises in the issuer’s trade or business in connection with the purchase of property or the receipt of services, as well certain other narrow exceptions (that also apply to the General Rule and which are described below). There is currently no general exception for cash sweeps or similar arrangements, although the government is willing to further consider whether some exceptions for these arrangements would be appropriate.
Recasts under Anti-Abuse Rule. Finally, under an anti-abuse rule set forth in section 1.385-3(b)(4), a debt instrument is treated as stock if it is issued with a principal purpose of avoiding the application of section 1.385-3 or section 1.385-4 (not otherwise discussed in this article, section 1.385-4 provides rules for applying section 1.385-3 to consolidated groups when an interest ceases to be a consolidated group debt instrument or becomes a consolidated group debt instrument). In addition, an interest that is not a debt instrument (for example, a contract to which section 483 applies or a non-periodic swap payment) is treated as stock if issued with a principal purpose of avoiding the application of the rules. The anti-avoidance rule may apply, for example, if a debt instrument is issued to, and later acquired from, a person who is not a member of the issuer’s Expanded Group with a principal purpose of avoiding the application of the rules. A number of additional examples are provided.
Exceptions to Application of Section 1.385-3
Section 1.385-3(c) contains a number of important exceptions:
- Exception for Current Earnings and Profits. Section 1.385-3(c) provides that, for purposes of the application of the General Rule (section 1.385-2(b)(2)) and the Funding Rule (section 1.385-2(b)(3)) to a member of an Expanded Group with respect to a taxable year, the aggregate amount of any distributions or acquisitions that are described in the General Rule or the Funding Rule are reduced by an amount equal to the member’s current year earnings and profits. This reduction is applied to the transactions based on the order in which the distributions and acquisitions occur. It is not clear from the preamble why the exception is provided solely for distributions from current (as opposed to current and accumulated earnings and profits), but the government has since stated that the exception is intended only to protect ordinary course distributions and not all dividend distributions.
- Threshold Exception. A debt instrument is not treated as stock under section 1.385-3 if, immediately after the debt instrument is issued, the aggregate adjusted issue price of debt instruments held by members of the Expanded Group otherwise caught by the rules does not exceed $50 million. Once this threshold is exceeded, the Threshold Exception will not apply to any debt instrument issued by members of the Expanded Group for so long as any debt instrument that previously was treated as indebtedness solely because of the Threshold Exception remains outstanding.
- Exception for Funded Acquisitions of Subsidiary Stock by Issuance. An acquisition of Expanded Group stock will not be treated as described in the Funding Rule if the acquisition results from a transfer of property by a funded member (the transferor) to an Expanded Group member (the issuer) in exchange for stock of the issuer, provided that, for the 36-month period immediately following the issuance, the transferor holds, directly or indirectly, more than 50 percent of the total combined voting power of all classes of stock of the issuer entitled to vote and more than 50 percent of the total value of the stock of the issuer.
Section 1.385-3 Operating Rules
Section 1.385-3(d) sets forth various operating rules for the application of the section, including rules addressing excepted debt that that then ceases to qualify for an exception and debt treated as stock which then ceases to be between members of an Expanded Group. A comprehensive discussion of these rules is beyond the scope of this article. A few highlights are as follows:
- Treatment of Partnerships. A controlled partnership is treated as an aggregate of its partners. Thus, for example, when a corporation that is a member of an Expanded Group becomes a partner in a partnership that is a controlled partnership with respect to that Expanded Group, the corporation is treated as acquiring its proportionate share of the controlled partnership’s assets. In addition, each Expanded Group partner in a controlled partnership is treated as issuing its proportionate share (based on its share of partnership profits) of any debt instrument issued by the controlled partnership. To the extent that this application of the aggregate approach causes a debt instrument issued by a controlled partnership to be recharacterized under section 1.385-3(b), then the holder of the recharacterized debt instrument is treated as holding stock in the Expanded Group partners. The controlled partnership rules do not provide guidance regarding all the collateral recasts that result from the aggregate approach, the additional recasts that will be required when the recharacterized debt is later repaid, or any implications under the existing partnership rules (e.g., under section 752).
- Treatment of Disregarded Entities. If a debt instrument of a disregarded entity is treated as stock under section 1.385-3, the debt instrument is treated as stock in the entity’s owner rather than as an equity interest in the entity, which prevents the disregarded entity from becoming a partnership with two equity owners. (This is the opposite of the rule in section 1.385-2, which (as described above) causes a disregarded entity that issues debt without sufficient documentation to become a partnership when the debt is recharacterized as stock.)
- No Affirmative Use. The rules of section 1.385-3 and section 1.385-4 do not apply to the extent a person enters into a transaction that otherwise would be subject to the rules with a principal purpose of reducing the federal tax liability of any member of the Expanded Group that includes the issuer and the holder of the debt instrument by disregarding the treatment of the debt instrument that would occur without regard to this section. (Some have referred to this as “the government always wins rule,” and they have expressed the view that the existence of this rule (among others) makes the Proposed Regulations especially vulnerable to a validity challenge.)
Section 1.385-3 Effective Date
Section 1.385-3 applies to any debt instrument issued on or after April 4, 2016, and to any debt instrument treated as issued before that date as a result of an entity classification election made under section 301.7701-3 that is filed on or after this date. For purposes of the principal purpose test set forth in section 1.385-3(b)(3)(iv), a distribution or acquisition described in the Funding Rule that occurs before April 4 (other than a distribution or acquisition that is treated as occurring before that date as a result of an entity classification election made under section 301.7701-3 that is filed on or after that date) is not taken into account. Once again, care should be exercised to ensure that grandfathered debt instruments issued before April 4, 2016 do not inadvertently become subject to the rules through a significant modification occurring after April 4, 2016.
For instruments that otherwise would be treated as stock pursuant to section 1.385-3 prior to issuance of the section 385 regulations in final form, the debt instrument is treated as indebtedness until the date that is 90 days after the date of publication in the Federal Register of the Treasury decision adopting the rule as a final regulation. To the extent that the debt instrument is held by a member of the issuer’s Expanded Group on the date that is 90 days after the date of publication in the Federal Register of the Treasury decision adopting the rule as a final regulation, the debt instrument is deemed to be exchanged for stock on that date. Although this 90 day rule provides flexibility to unwind debt instruments issued after April 4, 2016, close attention should be paid to both the transaction in which the instrument was issued and the unwind transaction, because such transactions may still be subject to the Funding Rule.
The Proposed Regulations are an ambitious undertaking. Satisfaction of what historically have been factors to take into account as part of a debt-equity analysis will become necessary (but not sufficient) conditions for treatment of an instrument as debt for federal tax purposes if the Proposed Regulations are finalized. The IRS is also given license to bifurcate an instrument into part debt and part stock on audit. Moreover, an instrument qualifying as debt, both under general federal income tax principles and the provisions of section 1.385-1 and section 1.385-2, can still be automatically recharacterized as stock under section 1.385-3 if the debt is issued in certain contexts. Particularly troubling is the vague and uncertain reach of section 1.385-3, covering as it does not only easily discernible fact patterns like the distribution of debentures in Kraft Foods, but also highly ambiguous and complex scenarios such as those addressed by the Funding Rule (particularly under the 72 month per se rule). The routine recharacterization of intercompany debt as stock under these rules can trigger, among many other surprising and adverse consequences, a de-consolidation of a subsidiary, a break in section 368(c) control, disqualification of a REIT, inadvertent hook stock, section 304 transactions and subpart F income, to name only a few examples. It also, of course, would create a proliferation of cross-border hybrid instruments (since the instrument in question may satisfy normal conventions for debt characterization). Moreover, it remains to be seen whether (and how) states will implement the rules once finalized (keeping in mind that members of a consolidated return group may file separate state tax returns). Consequently, taxpayers are well-advised to take stock (no pun intended) of their intercompany debt regimes.
Government officials have expressed an active interest in receiving comments on the Proposed Regulations as quickly as possible. Given the scope and complexity of these new rules, it can be anticipated that extensive comments will be forthcoming.
The 2016 UK Budget – BEPS Measures and Tax Cuts
The 2016 UK Budget (Budget), announced on March 16, 2016, has generally been seen as good news for corporates, but is not without some stings in the tail, particularly for multinationals. Notably, it reaffirms the UK’s desire to lead the way in implementing the recommendations from the Base Erosion and Profit Shifting (BEPS) action plan prepared by the Organisation for Economic Co-operation and Development (OECD), and in some respects to go beyond what the OECD has recommended.
The main headline-grabber is a further reduction in the rate of corporation tax to 17 percent from April 2020, which takes the rate significantly lower than many of the United Kingdom’s international competitors. This demonstrates the government’s desire to use a low corporate tax rate as a calling card to attract businesses (and taxable profits) to the United Kingdom. Clearly it will be welcomed by businesses already in the United Kingdom, and may attract others to locate more functions in the United Kingdom: though multinationals located in higher-taxed countries may need to consider whether the UK rate has now dropped so low that their UK subsidiaries are at risk of being caught by controlled foreign company (CFC) rules that were aimed primarily at tax haven subsidiaries.
The government also confirmed its intention to introduce comprehensive rules to eliminate hybrid mismatches with effect from January 1, 2017, in line with the proposals in the BEPS Action 2 report. In particular, these should remove the benefits from check-the-box planning frequently used by US-based multinationals and from typical Luxembourg fund structuring using hybrid instruments. The government has also announced that the rules will be extended to cover arrangements involving permanent establishments which give rise to a mismatch. This will counteract the benefits from structures whereby payments are made from a permanent establishment to the territory of residence which give rise to a deduction in the territory of the permanent establishment but are not taxed in the territory of residence. It will also counteract “finance branch” structuring of the type undertaken by many multinationals in recent years. All hybrid structures should be reviewed as a matter of urgency.
The hybrid rules will be followed swiftly in April 2017 by a restriction on interest deductibility in line with the BEPS Action 4 proposal. This will cap interest deductibility at 30 percent of a group’s earnings before interest, tax, depreciation and amortization (EBITDA), subject to a de minimis threshold of £2m and a group ratio override rule for more highly indebted groups, allowing proportionate UK deductions by reference to the net interest to EBITDA ratio of the worldwide group. While a significant change to a regime that has historically been relatively generous in terms of interest deductibility, this proposal is not dissimilar (and no less generous) to similar restrictions introduced in other major European countries in recent years, and in the context of intra-group lending, may not restrict deductibility much more than existing thin capitalization rules.
In a change that comes sooner than many had expected, the government announced that it would adopt the revised OECD transfer pricing guidance set out in the BEPS Actions 8-10 report with effect from April 1, 2016. This opens up potential discrepancies in the way that the UK and US governments apply the arm’s length standard, particularly in relation to cost-sharing arrangements: US multinationals should tread carefully. As expected, the UK is also moving to align the patent box regime with the modified nexus approach propounded in BEPS Action 5, with these changes applying to new entrants to the regime on or after June 1, 2016, and to existing claimants from June 1, 2021.
A final BEPS-related measure (though not one specifically recommended by a BEPS report) is a change to the withholding tax regime on royalties. A new provision will deny treaty relief to structures put in place for the main purpose of obtaining the benefit of the relevant treaty.
The government has, however, signaled that it does not intend to make any changes to the UK’s CFC rules as a result of the BEPS Action 3 report, and presumably will resist European Commission proposals to implement common CFC rules across the European Union. It has also promised a review of the substantial shareholding exemption, which exempts most disposals by UK companies of interests in trading companies from UK tax—something that hopefully will reduce some of the uncertainties that occasionally crop up regarding its application.
On the purely domestic front, the government also announced proposals to remove many of the complex restrictions on loss carry-forwards from April 2017, and in particular to allow losses to be relieved against future profits of other group companies (currently, group relief is only available on a current year basis). This should reduce the phenomenon of “stranded” losses with no practical possibility of being used. The quid pro quo for this reform is that relief for carried forward losses will be restricted to 50 percent of taxable profits in excess of £5m.
In short, while this is a Budget with positive aspects for corporates, the benefits mainly go to smaller and domestic businesses. Many multinationals and private equity groups will need to re-evaluate longstanding financing structures, albeit the UK corporate tax environment generally remains positive.
Prescriptions of the Blue Book on the New Partnership Audit Rules
In November 2015, the Bipartisan Budget Act of 2015 (the Act) instituted a new regime for federal tax audits of entities treated as partnerships for US federal income tax purposes (the New Audit Rules) effective 2018. Our more in-depth discussion of these changes can be found here. In March 2016, the Joint Committee on Taxation released its “General Explanation of Tax Legislation Enacted in 2015” (the Blue Book), which provides some background and explanation with respect to the New Audit Rules. This article discusses certain of the highlights of the Blue Book explanation.
As brief background on the New Audit Rules for partnerships:
- They apply to taxable years beginning after 2017.
- Certain partnerships can elect out of the New Audit Rules altogether for a given taxable year (the Small Partnership Election Out), with the result that any adjustments to such a partnership’s items can be made only at the partner level.
- This election may be made only by partnerships with 100 or fewer partners, each of which is an individual, a C corporation (including a foreign entity that would be required to be treated as a C corporation if it were a domestic entity), an S corporation or an estate of a deceased partner.
- The New Audit Rules impose entity-level liability for income taxes, penalties and interest on partnerships in respect of Internal Revenue Service (IRS) audit adjustments, absent election of an alternative regime under which the tax liability is imposed at the partner level (the Push-out Election).
- Absent a Push-out Election, any tax deficiency arising from a partnership-level adjustment with respect to a partnership tax year (a reviewed year) is calculated using the maximum statutory income tax rate and is assessed against and collected from the partnership in the year that such audit or any judicial review is completed (the adjustment year), together with any related penalties and interest.
- However, if one or more partners file tax returns for the reviewed year that take the audit adjustments into account and pay the associated taxes, the imputed partnership underpayment amount is determined without regard to the portion of the adjustments so taken into account.
- If the partnership is able to demonstrate that a portion of the imputed underpayment is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity, or can demonstrate that reduced corporate, capital gain or qualified dividend rates apply, for example, procedures are to be developed to determine a more accurate imputed underpayment amount.
- The “tax matters partner” is replaced with a “partnership representative” with an expanded role.
- The partnership representative (not required to be a partner) has sole authority to act on behalf of the partnership in an audit proceeding, and can bind both the partnership and the partners by its actions in the audit.
- Partners neither have rights to participate in partnership audits or related judicial proceedings, nor standing to bring a judicial action if the partnership representative does not challenge an assessment.
- The statute of limitations for partnership adjustments will be calculated solely with reference to the date the partnership filed its return.
Highlights of the Blue Book Explanation
Under principles of statutory construction, legislative history is relevant only if the statutory language is ambiguous. If the Blue Book explanation supports other relevant pre-enactment legislative history, then a court is likely to find it persuasive; if other pre-enactment legislative history is absent, then the court may disregard the Blue Book explanation or find it persuasive only to the extent it supports its conclusion. See US v. Woods, 571 U.S. 310 (2013) discussed by us in depth here. With that by way of background, highlights of the Blue Book are as follows:
- To the surprise of many practitioners, although the Blue Book indicates that disregarded entity (DRE) partners should be “looked through” for purposes of the Small Partnership Election Out, it states this shall be as provided via regulations or other future guidance. In addition, it states such guidance should require that the DRE and its owner each be counted towards the 100 member limit.
- The Blue Book adopts a similar stance as regards trusts, including grantor trusts.
- The Blue Book implies that an upper tier partnership that is a partner in a lower tier partnership that has made a Push-out Election would not be able to make a further Push-Out Election to pass the adjustment on to its partners.
- The Blue Book explains that, upon a partnership’s payment of a partnership level tax, both the partnership and the partners would have a corresponding basis reduction. It states that any payments of contractual indemnities entered into between the partners and partnership with respect to the payment of partnership level taxes would be non-deductible.
- The Blue Book notes that, if a partnership ceases to exist before a partnership adjustment is made (including via a section 708(b)(1)(A) termination, but not a section 708(b)(1)(b) “technical termination”), the adjustment is taken into account by the former partners of the partnership. For these purposes, a partnership that has no significant income, revenue, assets or activities may be treated as ceasing to exist.
Small Partnership Election Out
The Blue Book provides that, for purposes of determining eligibility for the Small Partnership Election Out, a foreign entity partner that has elected to be treated as a corporation under the check-the-box rules under section 7701 would be considered a qualifying C corporation. It also provides that a C corporation partner that is a regulated investment company (RIC) or real estate investment trust (REIT) would not prevent the partnership from electing out.
The Blue Book states that, under regulations or other guidance, a DRE partner, such as a domestic limited liability company with only one member, although not one of the types of partners enumerated as permitted partners for the Small Partnership Election Out, may be a permitted partner for such election if owned by a permitted partner. An example is provided in which both the disregarded entity and its member are treated as partners for purposes of the 100 partner limitation. In light of the fact that the section 7701 regulations provide that DREs are to be disregarded for all federal tax purposes, it is not clear why regulatory or other guidance is required to conclude the use of a DRE is permissible or, further, why a DRE “takes up a spot” for purposes of the 100 partner rule.
The Blue Book states guidance to be issued may provide similar rules for partners that are trusts, adds that such guidance should require the partnership to disclose the identity of the trustee of the trust and each person deemed to be an owner of the trust and mandates that each such person be counted for purposes of the 100 partner limitation. The Blue Book also indicates that similar guidance may be provided for grantor trust partners, a former grantor trust that continues in existence for the two-year period following the death of the deemed owner or a trust receiving property from a decedent’s estate for a two-year period.
Lastly, the Blue Book indicates that forthcoming guidance may provide rules permitting the Small Partnership Election Out to be made by a partnership with one or more direct or indirect partners that themselves are partnerships. All direct and indirect partners of this first partnership taken together must not exceed 100 persons and must be disclosed
In determining the imputed underpayment amount of a partnership, the Blue Book states that netting of items of income, gain, loss or deduction is required to “take into account applicable limitations, restrictions and special rules under present law.” The Blue Book also provides examples of this netting in scenarios where the partnership has ordinary deductions and income, as well as capital gain and loss and tax credits.
In addition, the Blue Book provides an example of the determination of the imputed underpayment amount of the partnership where an adjustment reallocates depreciation and interest deductions from partner A to partner B. The imputed underpayment amount is calculated without decreasing the income allocable to partner B by the depreciation and interest deductions reallocated from partner A to partner B, with the result that the adjustment is an increase in income equal to the full amount of reallocated deductions, subject to tax at the highest rate of federal income tax. The example concludes by stating that “the partnership may implement procedures for modifying the imputed underpayment as so determined.”
The Blue Book also provides an example of how a partner’s distributive share of partnership items is determined when the partnership uses the procedures to modify the tax rate assumed applicable to the underpayment: where a partner’s distributive share differs among items, then the portion of the underpayment to which that partner’s lower tax rate applies is determined by the partner’s distributive share on a hypothetical liquidation of the partnership for fair market value.
Finally, the Blue Book notes that, pending the issuance of regulations or other guidance addressing the manner in which modifications to an imputed underpayment amount may be made, “it is anticipated that partnerships will furnish to the Secretary the necessary documentation, data and calculations to determine the amount of the reduction of the imputed underpayment with a reasonably high degree of accuracy.”
The Blue Book explains that upon a final court decision, dismissal of the case or settlement with respect to a notice of final partnership adjustment, a partnership will implement the Push-out Election by furnishing statements to the reviewed year partners showing each partner’s share of the adjustments as finally determined. In the absence of guidance relating to the time and manner of furnishing the partner statements relating to a Push-out Election, the statements are to be furnished to the IRS and all partners “within a reasonable period following the last day on which to make the election.” The date that the statement is so furnished is the date it is mailed for this purpose. The statement must include the name and taxpayer identification number of the recipient partner. The Blue Book indicates that the US Department of Treasury (Treasury) may also require the address of the recipient partner and the date the statement is mailed. Finally, the Blue Book notes that as part of any settlement, the Treasury might permit revocation of a previously made Push-out Election so that the partnership may pay the tax at the partnership level.
Among the more significant points enunciated by the Blue Book with respect to the Push-out Election rules is the treatment of tiered partnerships and other tiered entities. It states that, in the case of tiered partnerships, a partnership that receives a Push-out Election statement from the audited partnership is treated similarly to an individual who received such a statement. The recipient partnership, therefore, takes into account the aggregate of the adjustment amounts for its taxable year including the end of the reviewed year, plus any adjustments to tax attributes in subsequent years, and the recipient partnership pays the tax attributable to such adjustments, calculated as if it were an individual. The Blue Book explanation notes that the partners of the recipient partnership may have entered into indemnification agreements with respect to the risk of tax liability of reviewed year partners being borne economically by partners in the year the statements are furnished. It notes that, because a payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to the tax are also nondeductible. The Blue Book seems to be implying that the immediate upper tier partnership is not entitled to make a further Push-out Election.
Lastly, the Blue Book provides that a RIC or REIT partner that receives a statement from a partnership may wish to make a deficiency dividend under section 860 with respect to the reviewed year. Additional guidance is expected to be issued with respect to these partners.
Partnership Administrative Adjustment Requests
The Blue Book states that, in the case of tiered partnerships, a partnership’s partners that are themselves partnerships may choose to file an administrative adjustment request with respect to their distributive shares of an adjustment. These partners and indirect partners that are themselves partnerships “may choose to coordinate the filing of administrative adjustment requests as a group to the extent permitted by the Secretary.”
Among the other matters addressed by the Blue Book explanation is a discussion of some of the procedural aspects of the New Audit Rules, including as regards the period of limitations on assessment and the interplay of a Push-out Election with the rules for contesting a partnership adjustment. The Blue Book explanation also addresses new section 6241(4) (disallowing deductions for any payment required to be made under the New Audit Rules) and section 6241(7) (providing that if a partnership ceases to exist before a partnership adjustment is made such adjustment is taken into account by the former partners of the partnership). As to the former, the Blue Book explains that a basis adjustment (reduction) under section 705(a)(2)(B) to a partner’s basis in its partnership interest must be made to reflect the nondeductible payment by the partnership of the tax. As to the latter, the Blue Book clarifies that a technical termination of a partnership under section 708(b)(1)(B)(sale or exchange of 50 percent or more of total capital and profits of partnership) is ignored in determining whether a partnership ceases to exist while a section 708(b)(1)(A) termination (discontinuation of partnership business) is treated as a cessation of the partnership. An example of a section 708(b)(1)(A) termination is a partnership becoming a single member entity. The Blue Book states that the Treasury may, under regulations to be issued, treat a partnership that has no significant income, revenue, assets or activities at the time the partnership adjustment takes effect as having ceased to exist. This could prove significant as a mechanism for addressing liabilities under the New Audit Rules of a partnership lacking material assets—if the partnership is deemed not to exist the audit adjustment would have to be taken into account by the (former) partners.
The Blue Book explanation contains a number of prescriptions for guidance to come. As noted, some areas practitioners may have viewed as fairly non-controversial have been identified as among the topics to be addressed by regulation or other guidance. Timely issuance of that guidance should be a priority, and taxpayers and practitioners will have to be on the lookout for it.
Changes to China’s High and New Technology Enterprise (HNTE) Regime Both Sharpen its Focus and Make its Advantages More Broadly Available
by Robbie Chen, counsel, MWE China Law Offices
With the promulgation of the Corporate Income Tax (CIT) law in 2008, many preferential tax regimes (e.g. lower tax rates for foreign invested companies) were revoked. Under the CIT, the HNTE treatment, which reduces a qualified taxpayer’s applicable CIT rate from the standard 25 percent to 15 percent, is one of the few remaining tax preferences. As a result, any change to the HNTE rule attracts a great deal of attention.
On January 29, 2016, the Ministry of Science and Technology (MST), Ministry of Finance (MOF) and State Administration of Taxation (SAT) jointly released a notice revising the Administrative Measures for Recognition of HNTE (Guokefahuo  No.32) (Circular 32).
Circular 32 does not radically transform the HNTE rules (Guokefahuo  No.172) issued in 2008 (2008 Rules). Instead, it adjusts several aspects of the assessment standards to make HNTE status more attainable for small and medium sized companies while at the same time sharpening the focus of the rules in certain respects. This is consistent with the government’s efforts to transform the declining manufacturing and export-oriented economy into a technology and innovation-driven economy. Circular 32 also revised the scope of encouraged technologies for HNTE purposes, including a few state of the art technology areas such as encryption technology and cloud computing technology.
1. Assessment Criteria
Circular 32 institutes the following key changes to the assessment criteria for HNTE status:
1.1 Intellectual Property Ownership
Under the 2008 Rules, qualification for HNTE status required either (a) ownership of intellectual property rights (IPRs) in core technologies via self-development, grant, transfer, donation, or merger or acquisition in the last 3 years or (b) a global, exclusive license to use the core technologies for over 5 years.
Under Circular 32 qualification for HNTE status requires that “the company shall obtain the ownership of IPRs via its own R&D, grant or transfer, donation, and merger or acquisition, which make core technical contributions to its main products (services).” The option to acquire IPRs via license is eliminated as is any stated timeframes for acquisition or ownership of IPRs.
Circular 32 further emphasizes the correlation between IPRs and the main products (services) of an HNTE. The 2008 Rules provided that “the products (services) shall fall within the technology areas of the Catalogue of High and New Technology Areas Specifically Encouraged by the State (2008)” (the 2008 Catalogue). The 2008 Rules were more focused on whether the product (service) is included in the 2008 Catalogue, whereas Circular 32 provides that “the technology that made a core technical contribution to its main products (services) of the company shall fall within the technology areas of the Catalogue of High and New Technology Areas Specifically Encouraged by the State (2016)” (2016 Catalogue). Circular 32 and its catalogue stress the technology rather than the products (services). This change could be designed to address the situation where a company purchases IPRs unrelated to its products (services) solely for the purpose of meeting the requirement for HNTE status.
1.2 R&D Personnel
The 2008 Rules stipulated that “the number of technology personnel with a college diploma or above shall be over 30 percent of total employees, and R&D personnel shall be over 10 percent of total employees.”
Circular 32 provides that “technology personnel participating in the R&D and related technology innovation activities shall not be less than 10 percent of the total number of employees of the current year.”
Companies in labor-intensive industries should benefit from the removal of the 30 percent college degree requirement since higher education is not a prerequisite for fulfillment of much of their labor needs. Companies who acquire IPRs via contract R&D arrangements also could benefit from the lowered requirement for technology personnel.
1.3 R&D Expense Ratio
Circular 32 lowers the R&D expense ratio from 6 percent to 5 percent of the total revenue for companies with sales revenues of up to RMB 50 million in the preceding year. For companies with revenues over RMB 50 million in the preceding year, the R&D expense ratio remains unchanged at 4 percent (if annual revenue exceeds RMB 50 million but is not over RMB 200 million) or 3 percent (if annual revenue is over RMB 200 million).
The reduced threshold of the R&D expense ratio is believed to help small and medium sized enterprises achieve HNTE status.
1.4 Indicator Requirements
According to the 2008 Rules, a company shall meet the requirements in the Guidelines on the Administration of Determination of HNTE with respect to several indicators which include the organization and management of R&D activities, the ability to convert R&D results into productivity, the number of self-developed IPRs, and the growth of sales and the total assets. The 2008 Rules applied a scoring system to assess the HNTE applicant’s performance under each indicator. Out of a total score of 100, a company must achieve a score of over 70 to be qualified as an HNTE company.
Circular 32 replaces the complicated indicators with a requirement that the company “satisfy the requirement for innovation capability evaluation.” It is expected that new guidelines will be formulated to guide taxpayers through the HNTE application process. Currently, “innovative capability evaluation” is undefined.
1.5 Compliance Record
Circular 32 states that “the company shall not have any serious security or quality accidents, or incidents which seriously violate environmental laws in the preceding year before the application for HNTE status.” If an HNTE company commits such a violation after attaining HNTE status, its status will be revoked and it will be required to pay back all the taxes that it saved as a result of attaining HNTE status.
This compliance record test is new. The 2008 Rules mainly focused on requirements regarding IPRs and the company’s growth potential. The emphasis on the compliance record of an HNTE company stresses the importance of a “green” operation. HNTE status also hinges on the operation of a safe and stable company. However, it is unclear how the authorities will determine a “serious” accident or incident.
2. Application Procedure and Follow-up Supervision
Circular 32 shortens the application process for HNTE status. However, once the HNTE status is obtained, the company faces a heavier information disclosure burden than it previously had under the 2008 Rules. Moreover, the company will be continuously supervised by the authorities.
2.1 Application Procedure
The application procedure for HNTE status is as follows:
- The applicant company registers on the HNTE Company Assessment and Administrative Website (Website) and prepares and submits application documents. The required documentation includes a special audit report on R&D expenses, audited financial statements, corporate income tax returns for the last three years, and information regarding revenues derived from high-tech products (services) from the prior year.
- The HNTE Assessment Committee reviews the application documents.
- The HNTE Assessment Committee posts a public notice on the Website for ten working days for public comments.
- The HNTE Assessment Committee grants the HNTE Certificate if the committee does not receive any objections within the ten-day period.
The new application procedure adopts the old practice except that the public notice time period is reduced from 15 to 10 working days. This will surely be good news for HNTE applicants. However, Circular 32 requires applicants to provide certain documents from the last three years. This may indicate, though Circular 32 is not clear, that companies established for less than three years may not qualify for HNTE status.
2.2 Follow-up Supervision
An HNTE company will have new reporting obligations under Circular 32:
- Upload annual development forms to the Website by the end of May of each year on information regarding IPRs, technology personnel and R&D expenses and revenues for the preceding year.
- Report a change to the company name or significant changes to the company relevant to the HNTE assessment criteria within 3 months of the change.
- Report any relocation of the HNTE company. Complete relocation of a company does not affect its HNTE status. Partial relocation (e.g. relocation of a functional unit) may require re-evaluation of a company’s HNTE status.
Under Circular 32, HNTE status will be revoked and the tax authority will claw back tax benefits if the HNTE commits any of the following acts:
- Substantial fraud during the application and assessment process.
- Serious security or quality accidents, or incidents seriously violating environmental laws.
- Failure to report significant changes relating to the assessment criteria in a timely manner or to submit the annual development forms for two years.
3. New Encouraged Industry Areas
The 2016 Catalogue adds new encouraged industries to the industry catalogue that will qualify for HNTE purposes:
- Cloud computing technology
- Mobile internet
- Encryption technology
- E-commerce and modern logistics
- Inspection certification and standardized services
- Supportive technologies for cultural and creative industries
- Natural disaster monitoring
- Alert and emergency solutions
In some respects, Circular 32 loosened the assessment criteria for HNTE status. However, in other respects, the HNTE regime has been tightened. Enterprises should pay close attention to the following matters in the application for HNTE status and to assure HNTE status is maintained:
- The revision to the IPR requirements implies that the authorities will be placing more emphasis on the quality of the technology and the connection between IPRs and R&D activities, core technologies, and the main products (services). An HNTE applicant should have this in mind and demonstrate its qualifications.
- An HNTE will have to invest more effort than in the past to maintain its status. It will need to attend to keeping proper documents to demonstrate its capabilities, reporting significant changes relating to the assessment criteria and updating information on an annual basis.
- HNTE companies and prospective HNTE applicants should review their compliance record with a focus on product quality and environmental protection.