Determining the difference between debt and equity is a problem that has bedeviled taxpayers and tax administrators for decades. Taxpayers, recognizing that there are tax advantages to financing a corporation with debt (e.g., the deductibility of interest, the tax-free repayment of principal) have favored using debt as a form of capital. The Internal Revenue Service (IRS) and, increasingly, state revenue departments have often challenged what purported to be debt, asserting that it was actually equity and that the tax advantages of debt should be disallowed. The federal cases addressing the issue and listing a variety of factors that should be taken into account in determining whether purported debt is really debt are legion. State and local tax (SALT) practitioners have generally looked to the federal case law in addressing these issues.
In an effort to bring order out of the chaos, Congress, in the Tax Reform Act of 1969, enacted section 385 of the Internal Revenue Code (IRC). In effect, it passed the buck to the US Treasury Department. Section 385(a) provides that the Treasury is “authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or in part stock and part indebtedness).”
The Treasury’s mandate appeared to have been limited to designating factors that should be taken into account. Section 385(b) provided that the regulations “shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists.” The provision went on to indicate some factors that might (but that did not have to) be considered in making this determination, including whether there was a written unconditional promise to pay, whether the debt was subordinated to other debt, the debt-equity ratio, whether the debt was convertible into the corporation’s stock, and the relationship between holdings of stock in the corporation and holdings of the debt instrument. Thus, the Treasury’s mandate in subsection (b) seems to have been merely to identify the factors that should be taken into account in determining whether debt should be treated as debt for tax purposes. The quoted language did not give the Treasury the right to prescribe absolute rules. Still, the language in subsection (a), that indicated that the regulations were designed “to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness,” could be read to imply a broader mandate.
The Treasury did not act for some time, but it eventually proposed regulations under section 385 in the early 1980s. They were long and complicated and practitioners (including this one) spent many hours attempting to master their intricacies. They were controversial and the Treasury eventually gave up and withdrew them. If the Treasury was thinking about reviving the project, it kept it a secret, and most practitioners assumed that the project was dead.
The 2016 Regulations
On April 4, 2016, without warning, the Treasury proposed a new set of comprehensive regulations under section 385. There had been no advance indication that regulations were even under consideration, and the tax bar and the taxpayer community in general were taken by surprise. Although the Treasury indicated that the proposed regulations were issued in the context of addressing corporate inversions, their application went well beyond the inversion space and they apply to inter-corporate debt regardless of whether it occurs in an international context. The following is a brief discussion of the proposed regulations.
Generally, they apply only to debt issued by a corporation to a related party (typically a shareholder). In general, they provide that inter-corporate debt must be treated as equity under certain circumstances. In other words, they establish fixed rules for determining whether the status of debt will be respected for tax purposes—they do not merely list factors that will be taken into account in making such a determination.
The proposed regulations are designed to apply only to large corporations. A debt instrument will not be treated as stock under the regulations if, at the time it is issued, the aggregate issue price of all such debt instruments that would otherwise be treated as stock under the regulations does not exceed $50 million.
Among the most controversial provisions of the proposed regulations are the documentation requirements. In the past, documentation supporting the existence of a debtor-creditor relationship was helpful to taxpayers in defending the status of debt, but it was not required. Under the proposed regulations, what was once a suggestion is now a command. If the documentation requirements are not met, purported debt will be treated as equity even if it meets the requirements for debt under the case law and under the other provisions of the regulations. This will disrupt many established procedures for handling inter-company debt, which has often been structured and administered informally. It is clear, for example, that open account debt will not qualify.
The documentation must evidence a written binding obligation to repay the debt and creditor rights to enforce the debt’s terms (including the rights to trigger a default and accelerate payments). The documents must establish a reasonable expectation of repayment based on financial analyses such as cash flow projections, financial statements, financial forecasts, debt-to-equity ratios, and other relevant financial ratios. The documentation must be contemporaneous.
It can be expected that IRS auditors will not only look for the existence of such documentation but will also, on occasion, challenge whether the documentation supports the treatment of the instrument as debt. One can imagine situations in which the IRS will hire economists to analyze the documentation to determine whether it supports an ability of the debtor to repay the debt in accordance with its terms. The documentation requirement would apply only to debt instruments issued or deemed to be issued on or after the date on which the regulations are finalized.
The documentation rules apply only to large corporations. They apply only if the group of related corporations includes at least one publicly held company, total group assets exceed $100 million or annual total group revenues exceed $50 million.
The “General Rule” and the “Funding Rule”
Under the so-called general rule, debt instruments issued by a corporation to a related shareholder as a distribution will be treated as stock, as will debt issued in exchange for stock of an affiliate or debt issued as part of an internal asset reorganization (e.g., a transfer of assets in exchange for a note that is distributed to a parent company in a reorganization under IRC section 368(a)(1)(D)). This provision of the proposed regulations is intended to reverse the result of Kraft Foods v. Commissioner, in which the court held that debentures issued by a wholly owned subsidiary to its sole corporate shareholder as a dividend would be respected as debt for federal income tax purposes (232 F. 2d 118(2d Cir. 1956)). The court in that case explained that a corporation was free to capitalize a subsidiary with both debt and stock and that the effective conversion of some stock to debt through the distribution of a note as a dividend was perfectly acceptable.
It is known that the Treasury was unhappy with the result in Kraft and, if this provision remains in the regulations, it will have expressed that displeasure in a definitive form. In my view, the Kraft case was correctly decided and the Treasury’s attempt to reverse it by regulation is misguided. It is clear at the outset that a corporation can capitalize a subsidiary using a mixture of stock and debt. The fact that the decision to use debt may be tax-motivated is irrelevant if the debt is true debt. MBA students learn this in the first week. That being the case, if a corporation decides to convert part of its equity in a subsidiary into debt at a later date and the amount and terms of the debt are such that it would have been respected as debt if it had been issued when the subsidiary was formed, it should be respected as debt later. The fact that the parent does not contribute new capital to the subsidiary or that the conversion was tax-motivated should be irrelevant. Put another way, if a corporation, in capitalizing a subsidiary, uses more equity than sound tax planning would dictate, it should be allowed to reverse course. It should not be condemned to live with its mistake forever.
In the so-called funding rule, debt that is issued to an affiliate in exchange for property with a principal purpose of funding certain types of distributions or acquisitions will be treated as equity (Prop. Reg. Section 1.385-3(b)(3)). Under a non-rebuttable rule, a debt instrument will be treated as issued with the principal purpose of funding a proscribed distribution or acquisition if it is issued during the 72 months beginning 36 months before the date of the distribution or acquisition and ending 36 months after that day.
The regulations provide an exception to the general and funding rules if the aggregate amount of distributions or acquisitions in question does not exceed the corporation’s current-year earnings and profits. The exception does not apply to distributions from earnings and profits accumulated in prior years.
Sweeping, Draconian Regulations (with some Limitations and Exceptions)
The proposed regulations do not purport to establish a comprehensive set of rules governing all debt-equity determinations. They set forth certain circumstances under which debt must be treated as equity. If a given debt instrument is not treated as equity under the proposed regulations, it must still be tested under the multi-factor standards laid down by the courts.
The proposed regulations are sweeping and arguably draconian. They are aimed at recharacterizing instruments as equity to accomplish other objectives having nothing to do with whether the instruments in fact represent equity. The proposed regulations could result in reclassifying purported debt as equity even when it is obviously debt under any customary analysis.
For example, short-term debt issued to a clearly solvent subsidiary where the subsidiary’s debt-to-equity ratio was 1:10 could be reclassified as stock if the documentation requirements were not met. One can imagine extreme circumstances such as these, in which a court might declare the regulations invalid as applied to a particular taxpayer because they far exceeded the mandate that was given to the Treasury by Congress.
In an important exception, the proposed regulations do not apply to debt issued between members of a federal consolidated return group. The Treasury’s thinking is that the elimination rules of the consolidated return regulations will prevent abuses in these situations. While the consolidated return exception may limit the principal federal tax effect of the regulations to international cross-border debt, it would be a mistake to assume that they would not apply in domestic contexts. They would apply, for example, to debt with another consolidated return group or with an ineligible corporation.
Internal Revenue Code 385(a) specifically authorizes the Treasury to adopt regulations that treat an instrument as part debt and part stock. The proposed regulations accept this invitation and so provide. The Treasury explanation indicates that, for example, if an analysis of a $5 million debt instrument showed that the issuer cannot reasonably be expected to repay more than $3 million, the IRS could treat $3 million of the instrument as being debt and $2 million as being stock. It is unclear how the payments of interest would be ordered.
The proposed section 385 regulations may have implications for state and local taxation. Affected companies and their advisors should begin planning for their possible adoption. I understand that the Treasury hopes to have them become final by Labor Day of 2016, so time will be of the essence.
A basic question is the extent to which state departments of revenue will adopt the literal language or principles of the proposed regulations. State statutes typically base state taxable income on federal taxable income, with changes to reflect differences between federal and state tax policies. If a state’s statute so provides, will the 385 regulations automatically become part of the state’s tax law? The answer in most cases will be “no.” Although the regulations would be adopted pursuant to a statutory mandate, they would not be part of the Internal Revenue Code and state revenue departments have generally not felt that they were bound by Internal Revenue Service determinations or interpretations of other IRC provisions. Even where Congress has delegated authority to the Treasury to make the law in a particular area, as with respect to the treatment of inter-company transactions when companies file consolidated income tax returns, the states have not regarded themselves as being bound by Treasury regulations implementing that mandate.
Even if state revenue departments do not consider themselves to be bound by the terms of finally adopted section 385 regulations, they may look to them for guidance and it can be expected that they will be a factor in state and local tax audits. I 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 making their own detailed examination of the many factors that the courts have taken into account in reaching debt-equity determinations. One can anticipate disputes with state auditors as to whether meeting the documentation requirement of the federal regulations would be necessary to have debt respected for state tax purposes. I am advising clients that it would be prudent to meet those standards where possible, even with respect to debt that is not subject to the federal regulations (e.g., because the companies are too small or because they are filing consolidated federal income tax returns).
In other words, it is possible that state revenue departments will apply the principles of the 385 regulations in making debt-equity determinations, even if they do not adopt similar or substantially similar regulations.
If states do adopt comparable regulations, it is possible that the state regulations will conform to the basic principles of the federal regulations with respect to documentation and function but not with respect to the size of the corporations affected. For example, comparable state regulations may have lower thresholds for the size of affected corporations and/or debt or have no thresholds at all. A state revenue department might decide to apply the regulations without regard to the $50 million threshold, thus applying them to small corporations as well as to large ones. A department could also retain the threshold concept but reduce it so as to bring more corporations into the net.
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 that also file separate state returns. This is, of course, a common situation; many corporations that file consolidated federal returns are not engaged in a common unitary business and, hence, file separate state returns in one or more states. It is certainly 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. This position could be taken either in state regulations or by auditors without the benefit of regulations.
Conversely, some corporations file state combined returns even though they file separate federal returns. For example, in New York state, 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 such situations, could taxpayers argue that, even though the federal regulations literally apply and require certain debt 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 eliminations in inter-company transactions under the Treasury consolidated return regulations (U.S. Treas. Regs. Section 1.1502-13).
As indicated above, the proposed regulations contain an exception to the general and funding rules for distributions out of current-year 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? Obviously, earnings and profits for state purposes can differ from federal earnings and profits because of differences in calculating state and federal taxable income.
The treatment of a purported debt instrument as being part stock and part debt could have state tax consequences. Many states tax interest income received by a corporation differently from dividend income. Some states exempt from tax gain on the sale of a subsidiary’s stock but not gain on the sale of debt from a subsidiary. If a bifurcated debt instrument is sold, how would the gain be allocated?
A further state tax consequence can result with respect to corporations that are paying franchise taxes based on the amount of their capital and not on the amount of their net income. If inter-corporate debt is not treated as capital for this purpose, a required conversion of debt to equity can increase franchise tax liabilities.
Under the recently enacted corporate tax reform legislation in New York state, related corporations that are not engaged in a unitary business can elect to file combined returns. The election is irrevocable for seven years. If the New York State Department of Taxation and Finance adopts the principles of the 385 regulations, presumably the regulations will not apply to an electing group. This could be a factor that weighs in favor of making the election.
The Treasury’s proposed regulations under section 385 are controversial and more and more issues are emerging as time passes. It is by no means certain that the regulations will be finalized or, if they are, that they will be finalized in their current form. Nevertheless, it is important that affected corporations plan for their possible implementation and that this planning be done with their state and local tax advisors as well as with their federal tax advisors.