The IRS has issued much-anticipated final regulations intended to keep multinational companies from moving their profits offshore to avoid paying U.S. income taxes. The regulations are part of a larger campaign against corporate inversions, whereby a U.S. company merges with a foreign firm and then changes its tax address (i.e., domicile) to the foreign country. In particular, the rules address earnings stripping, a practice commonly used to minimize taxes after an inversion.
A “High Tide” for New Earnings Stripping Regulations
Since 2014, the Treasury Department has taken several steps to limit the recent wave of corporate inversions. For example, earlier this year, the IRS issued temporary regulations to prevent “serial” inversions. These mandates disregard foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. Specifically, the rules – which have yet to be finalized but remain in effect – prevent a foreign company that acquires multiple U.S. companies in stock-based transactions within a three-year period from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition. Their release in April led almost immediately to the collapse of a pending $160 billion merger between U.S.-based Pfizer and the much smaller Ireland-based company Allergan.
At the same time it released the temporary directives, the IRS issued proposed regulations to tackle so-called “earnings stripping” by tightening the tax rules that distinguish between debt and equity. According to the IRS, multinational corporations often use earnings stripping after a corporate inversion to minimize their U.S. taxes by paying deductible interest to the new foreign parent or one of its foreign affiliates in a low-tax country, such as Ireland. The technique can generate significant interest deductions without any corresponding new investment in the United States.
The finalized regulations contain numerous changes that expand and modify the proposed rules, and many of these changes address the extensive feedback on the temporary regulations. The IRS asserts that the final rules will apply to only 6,300 companies. Those companies, the agency says, make up 0.1% of U.S. corporations but report more than half of corporate net income and almost two-thirds of corporate interest deductions.
The Stern Restrictions and Requirements
The final mandates limit the ability of corporations to pursue earnings stripping by allowing the IRS to treat certain debt transactions among related parties (for example, a parent company and an affiliate) as equity transactions. In other words, the IRS can now convert deductible interest payments into taxable dividends for certain transactions.
The final rules also require corporations claiming interest deductions on related-party loans to provide documentation for the loans – just as businesses usually do for loans from unrelated parties. Generally, corporations will need to provide documentation of:
- an unconditional and binding obligation to make interest and principal payments on certain fixed dates,
- the debt holder’s rights as a creditor (including superior rights to shareholders in the case of dissolution),
- a reasonable expectation of the borrower’s ability to repay the loan, and
- conduct consistent with a debtor-creditor relationship.
Because the ability to minimize income taxes through the issuance of related-party financial instruments is not limited to the related companies in different countries, the documentation rules also apply to related U.S. affiliates of a corporate group. This stipulation is a point of contention for many U.S. businesses that engage in related-party transactions.
On a more taxpayer-friendly note, the final regulations somewhat relax the intercompany loan documentation rules. If an expanded group is otherwise generally compliant with the documentation requirements but does not comply for a certain purported debt instrument, then a rebuttable presumption (rather than an automatic recharacterization of the instrument as stock) will apply. The rules also move the deadline for submitting the required documentation from within 30 days of the loan to the date on which the lender’s federal income tax return is due (the tax return due date takes extensions into account). They also extend the effective date of the documentation rules by one year to January 1, 2018.
In addition, the standards eliminate the bifurcation rule that was included in the proposed regulations. That rule would have allowed the IRS to treat certain debt instruments as part debt and part equity. The IRS has stated, however, that it will continue to study the need for such a rule.
A Boatload of Exceptions
Even though the release of the new rules has led to criticism from certain business groups, the Treasury has received praise from some quarters for including several limited exceptions. The exceptions reflect comments the Treasury received on the proposed regulations from businesses, tax specialists, the public, and legislators.
For example, the mandates include a broad exemption for cash pools and other loans that are short-term in both form and substance. Many companies use such tools to manage cash among their affiliates on a day-to-day basis, sweeping their daily excess cash into a single account. Companies will be allowed to continue to treat short-term instruments issued among related entities as debt in the ordinary course of a group’s business.
Given that the risk of earnings stripping is low for such arrangements, the rules include exemptions for transactions between:
- foreign subsidiaries of U.S. multinational corporations,
- regulated financial companies,
- regulated insurance companies, and
- mutual funds that are regulated investment companies and real estate investment trusts (other than those owned by affiliated groups of companies).
The final regulations expand the exceptions for ordinary business or course transactions. The exceptions for distributions (i.e., payments made to affiliates) now generally include future earnings and allow corporations to net their distributions against capital contributions. The exceptions for ordinary course transactions have been expanded to include acquisitions of stock associated with employee compensation plans, among others.
Preparing Now for the Earnings Stripping Rules Does Not Mean Going Overboard
The proposed standards indicated that the regulations (other than the documentation requirements) would generally be effective when made final. However, the final regulations provide a 90-day delay, making the rules that will recharacterize debt as equity effective on or after January 19, 2017. Moreover, the documentation rules do not go into effect until January 1, 2018. For more information on how the new guidance applies to your business and its related-party debt transactions, please contact CRI. We are ready to support (or “shore up”) your organization and help you prepare for the changes that the new regulations may bring.