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s part of the Obama administration’s announcement of a crackdown on inversions the U.S. Treasury issued final & temporary proposed regulations that would dramatically change the taxation of corporate debt issued to related corporations having nothing to do with inversions or foreign acquisitions. In a 518-page Treasury Decision, IRS has issued final and temporary regs under Code Sec. 385. Under these regulations, debt issued by a corporation is treated as equity for all U.S. federal tax purposes if the debt is not issued for cash or property, but is instead
- (i) issued in a distribution to a related corporate shareholder,
- (ii) issued in exchange for stock of a member of the same affiliated group or
- (iii) issued in an asset reorganization between members of the same affiliated group.
The new regulations restrict the ability of corporations to engage in earnings stripping by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances. They also require that corporations claiming interest deductions on related-party loans provide documentation for the loans, similar to the common practice for third-party loans. The ability to minimize income tax liabilities through the issuance of related-party financial instruments is not, however, limited to the cross-border context, so these rules also apply to related U.S. affiliates of a corporate group.
In a statement released by the Treasury Department the U.S. Department of Treasury and the Internal Revenue Service (IRS) issued final regulations to address earnings stripping which will further reduce the benefits of corporate tax inversions, level the playing field between U.S. and non-U.S. businesses, and limit the ability of companies to lower their tax bills through transactions involving debt that do not support new investment in the United States. These regulations also require large corporations claiming interest deductions to document loans to and from their affiliates, just as businesses of all sizes do when they borrow from unrelated lenders. The rules were proposed in April along with temporary anti-inversion regulations. The final rules announced today are the product of extensive public comment and engagement.
Coupled with Treasury’s previous actions to address corporate inversions, these final regulations balance the operational needs of companies while preventing the erosion of our U.S. corporate tax base. Specifically, today’s final regulations narrowly target problematic earnings stripping transactions, transactions that generate deductions for interest payments on related-party debt that does not finance new investment in the United States, while minimizing unintended consequences for regular business activities.
- Exempting cash pools and short-term loans: Treasury requested comments in the proposed regulations on whether special rules are warranted for cash pools, cash sweeps, and similar arrangements. In response to thoughtful feedback, Treasury is providing a broad exemption for cash pools, which are essentially common funding accounts for related businesses. Treasury is also providing an exemption for loans that are short-term in both form and substance.
- Providing limited exemptions for certain entities where the risk of earnings stripping is low: Transactions between foreign subsidiaries of U.S. multinational corporations and transactions between pass-through businesses are exempt from the final regulations. Financial institutions and insurance companies that are subject to regulatory oversight regarding their capital structure are also excluded from certain aspects of the rules.
- Expanding exceptions for ordinary business transactions: Treasury has significantly expanded the exceptions for distributions to generally include all future earnings and allowing corporations to net distributions against capital contributions. Treasury is also including additional exceptions for ordinary course transactions, such as acquisitions of stock associated with employee compensation plans.
- Easing documentation requirements: Treasury has relaxed the intercompany loan documentation rules for U.S. borrowers. The regulations also extend the deadline by one year until January 1, 2018.
However, these recently finalized regulations that characterize debt as equity for tax purposes could potentially be revoked under President-elect Donald Trump’s administration and a Republican-controlled Congress, according to House Ways and Means Committee Chairman Kevin Brady, R-Texas.
Even though the IRS ultimately scaled back the scope of the proposed rules, Brady said at a conference hosted by Bloomberg BNA and KPMG LLP on Tuesday that the rules still harm the economy from a “pro-growth” perspective by discouraging investments in the U.S.
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