This article reviews and analyzes recent law changes and IRS guidance for federal income tax issues this past year.
This article was published in the November/December 2016 issue of Tax Executive, published by the Tax Executives Institute. It is reprinted here with permission.
Section 385 Proposed Regulations — Impact on Related-Party Financing
Section 385 has been in the Internal Revenue Code since 1969. It was enacted to provide guidance for whether to classify an interest in a corporation as debt or equity, but it requires the adoption of regulations to be effective. There have been three previous attempts at adopting regulations, none of which made it past the proposal stage. For many years, courts filled in the gap by creating multifactor tests to determine whether an instrument was classified as debt or equity. On April 4, 2016, the Internal Revenue Service and the Treasury Department issued proposed regulations under Section 385. Final and temporary regulations were issued on October 13, 2016, providing a completely new way to analyze whether an instrument is debt or equity in certain related-party transactions. The regulations apply to covered debt instruments issued on or after April 4, 2016.
Certain Transactions in Which Debt May Be Recharacterized. An instrument issued to a member of an expanded group will be treated as equity for all federal income tax purposes if it is issued by a domestic corporation (other than an S Corporation, a RIC, or a REIT) in one of the following three transactions, outside of a federal consolidated return group:
As issuance of debt for no consideration (e.g., a dividend of a note)
A note issued in exchange for stock of a member of the expanded group (e.g., a Section 304 transaction), and
A note issued in internal asset reorganization (e.g., a cash "D" reorganization).
An expanded group (EG) generally includes corporations connected through a common parent corporation by ownership of eighty percent vote or value, and it includes non-U.S. corporations and corporations that meet the ownership test through a partnership. Importantly, all corporations that are members of the same federal consolidated return group are treated as one corporation, so the reclassification rules will have no impact within a consolidated group.
The Funding Rule
If a taxpayer engages in a funding transaction that has as a principal purpose of funding one of the three transactions discussed previously, the instrument issued will be treated as stock. For example, assume that a foreign parent lends cash to a U.S. subsidiary in exchange for a note. If within thirty-six months the U.S. subsidiary makes a distribution to the foreign parent, subject to certain exceptions, the note issued in the original loan is recharacterized as equity as of the date of the dividend because it is the same result as having the U.S. subsidiary issue the note for no consideration. The funding rule applies whether the instrument is issued before or after the relevant distribution or acquisition. The per se rules do not apply to ordinary course debt instruments issued for property (i.e., purchases of inventory).
The threshold exception provides that these rules do not apply if the EG has total EG debt of $50 million or less. Additionally, the earnings and profits exception provides that the amount of any general rule or funding rule distribution or acquisition is reduced by the issuer’s post-April 4, 2016, current and accumulated earnings and profits. Lastly, final regulations include exceptions for certain cash pooling, treasury centers, and entities like insurance companies and banks that are subject to regulation of their capital.
Documentation Requirements. The regulations provide minimum documentation requirements that, if not met, set up a rebuttable presumption that an expanded group instrument (EGI) qualifies as debt. Although failure to meet the documentation requirements means an EGI is stock, satisfying those requirements is not conclusive evidence that the EGI is debt.
The documentation requirements apply to an EGI if: (1) the stock of any member of the EG is publicly traded; (2) total assets on the EG’s financial statements exceed $100 million; or (3) total revenue on the EG’s financial statements exceeds $50 million. If the documentation rules apply, an EGI must be evidenced by documentation prepared no later than the due date for the filing of the tax return for the year of issuance of the instrument that establishes: (1) a binding obligation to repay; (2) creditor’s rights; and (3) a reasonable expectation of repayment (e.g., cash flow projections, financial statements, or other relevant financial data). Notably, expectation of repayment can take into account the possibility of refinancing the obligation. While consolidated return groups are generally excused from the reclassification rules, they are not excluded from the documentation rules—they have to comply if the thresholds are met.
Bifurcation of Purported Equity Instruments. Under the proposed regulations, the IRS would have had the authority to bifurcate instruments between members of an EG or a modified EG (MEG). A MEG was defined as more expansive and generally included entities connected by ownership of fifty percent vote or value, and certain individuals. Although the government has expressed that it has the authority to bifurcate an instrument, the final regulations were reserved on the bifurcation rules. Thus there was no need for the MEG, and it was deleted.
Effective Time. For an EGI issued on or after April 4, 2016, and before the date the regulations are published in the registry, the issuer has 90 days from the date of publishing in the federal registrar to restructure the EGI. After that it would be automatically converted into equity. The documentation rules apply to EGIs issued on or after January 1, 2018.
Conclusion. The final regulations provided for a much-needed narrowing of the proposed rules, given that they only apply to recharacterized debt issued by domestic corporations, and they do not apply within a consolidated group. But, they need to be carefully considered whenever a U.S. corporation issues debt to a related person outside of the consolidated group.
Update on Section 355 Guidance
Section 355 transactions allow corporations to separate two businesses housed in one corporation without triggering corporate-level or shareholder-level income tax. This past year, there were four significant pieces of guidance regarding Section 355.
1. Proposed Regulations Amending the Device Test and New Requirements for Active Trade or Business Qualification
On July 14 the IRS issued proposed regulations on the device and the active trade or business tests under Section 355. The proposed regulations, if adopted, would formalize the IRS and Treasury views on several key requirements in Section 355 spin-offs, and provide significant formula-driven rules to evaluate whether a proposed Section 355 spin-off meets the device test and the active trade or business test. The IRS also designated as matters requiring National Office coordination the potential to apply the device test in certain instances, planned sales of stock after the transaction, and debt of the distributing corporation retired with securities of the controlled corporation.
For a transaction to be eligible for tax-free treatment under Section 355, the transaction cannot have been undertaken for the purpose of distributing corporate profits and/or assets at capital gains rates. This prohibited "device" can occur if investment and liquid assets are separated from operating business assets and then distributed to shareholders. This separation of investment-type assets can have the effect of providing a return of corporate profits that appears to be equivalent to a dividend without taxation. Although capital gains rates and dividend rates are similar under current law, the IRS believes that there remains a significant difference with respect to capital gains treatment and dividend treatment due to tax basis issues and the ability of capital gains to offset capital losses.
Focus on Nonbusiness Assets. The proposed regulations provide new rules and a minimum threshold that must be met to determine whether the active trade or business test is satisfied and include a "per se device test." This per se test has two prongs, the first being whether the "nonbusiness" assets (a newly defined term) of either the distributing or the controlled corporation constitute 66 2/3 percent of the total assets of the corporation. Cash or liquid assets can be treated as "good" business assets as long as the corporation can demonstrate that such cash and other assets are required by regulatory or other business exigencies. The second prong of the per se test is that the ratio of the nonbusiness assets to business assets of the distributing and controlled corporations, when compared with each other, falls within one of three bands of percentage comparisons. If a taxpayer meets the two-prong per se test, the distribution would be a per se device and thus would not qualify as a tax-free spin-off. If the per se test does not apply, the general device rules would continue to apply to determine if a distribution is motivated by device, and there is no comfort under these general device rules that a strong business purpose can trump all other device factors.
De Minimis Threshold for ATB. Proposed Treasury Regulations Section 1.355-9 provides rules to determine the minimum percentage (generally at least five percent) of the total assets of both the distributing and the controlled corporations that represent "five-year-active-business assets" (a newly defined term). Five-year-active-business assets are those relied upon to meet the active trade or business test demonstrating that each of the distributing and controlled corporations has had income and expenses for each of the past five years, indicating that each corporation has been an active trade or business. Certain cash and other assets qualify as five-year-active-business assets if they are used for working capital, regulatory purposes, and other business operational exigencies.
2. Carve-Back for Section 355 No-Rule Issues
In a reversal of recent trends in which the IRS has reduced the number of corporate tax issues on which it will rule, in Revenue Procedure 2016-45, the IRS stated that "significant legal issues relating to" both the device test and the business purpose requirement have been removed from the "no-rule" list of Revenue Procedure 2016-3, thus allowing taxpayers to seek rulings on legal issues arising under these aspects of a potential Section 355 transaction.
3. Restriction on REIT Spin-offs
As part of the PATH1 bill signed in December 2015, new Section 355(h) was enacted. In June 2016, the IRS and Treasury issued regulations implementing Section 355(h) with respect to the tax treatment of certain distributions that separates corporate assets into a new entity that can qualify as a REIT. It generally requires gain recognition with respect to such purported Section 355 distributions as if the assets were sold at fair market value on the date of the distribution. Certain exceptions apply if, for example, the distributing corporation is already a REIT (subject to a look-back period to ensure it is not a newly elected REIT) and the corporation seeks to distribute a controlled corporation that will also operate as a REIT after the distribution. In those cases, both the distributing and controlled corporations must retain their REIT status for at least two years.
4. Revenue Procedure 2016-40 — Safe Harbors for Acquisition of Control Prior to a 355 Distribution
The IRS has issued Revenue Procedure 2016-40, which addresses certain issues associated with a transaction that can occur prior to a Section 355 distribution that results in the distributing corporation obtaining control of the controlled corporation to satisfy the control requirements of Section 355. It provides that there are two safe harbors to evaluate whether the "control" requirement of Section 355 has been met. The first safe harbor provides a twenty-four-month rule and applies if no action is taken by the controlled corporation, its board of directors, its management, or any of the controlled corporation’s controlling shareholders that would result in an unwind of the transaction in which "control" was obtained. The second safe harbor allows for an unwind within the twenty-four months if two conditions are met. The first condition borrows definitions from Treasury Regulations Section 1.355-7 and requires that "[t]here is no agreement, understanding, arrangement, or substantial negotiations (within the meaning of § 1.355-7(h)(1)) or discussions (within the meaning of § 1.355-7(h)(6)) concerning the transaction or a similar transaction…at any time during the twenty-four-month period ending on the date of the distribution." The second condition is that no more than twenty percent of the acquiring entity or other party to the transaction involving the controlled corporation is owned by the same persons that own twenty percent or more of the controlled corporation. The IRS specifically states that if these safe harbors do not apply, no inference as to the qualification of the control requirement should be made.
Section 382 Long-Term Tax-Exempt Rates Decrease Under Final Regulations
Section 382 generally requires a corporation to limit the amount of its income in future years that can be offset by historic net operating losses (NOLs) once that corporation has undergone an "ownership change." The amount of the NOLs that can be used in each year after an ownership change is generally limited to the value of the corporation immediately before the ownership change multiplied by the "long-term tax-exempt rate." Section 382(f) defines that rate as the highest adjusted federal long-term rate for each of the preceding three months ending with the calendar month in which the ownership change occurs. The long-term tax-exempt rate is determined by multiplying the monthly applicable federal rate (AFR) and an adjustment factor. Personnel in the Department of the Treasury calculate the AFRs, which are published every month in the Internal Revenue Bulletin.
In response to comments from Notice 2013-4 and proposed regulations, Treasury Regulations Section 1.382-12 was finalized on April 25, 2016, regarding the methodology used to determine the long-term tax-exempt rate for Section 382 ownership changes.
The final regulations were effective in determining the long-term tax-exempt rate beginning August 2016 and applied in September 2016 and importantly have led to a reduced long-term tax-exempt rate. For example, the rate for September 2016 was 1.41 percent. Because the top rate is used for the current month and the previous two months for determining the long-term tax-exempt rate for ownership changes, the real impact will likely begin with ownership changes in November 2016, as the published rate in Revenue Ruling 2016-26 was 1.54 percent.
New Rules on Partnership Audits
The increasing use of partnerships (including limited liability companies taxed as partnerships) as the business entity for all types of businesses has highlighted the need for partnerships to be audited at a rate similar to corporations. One significant obstacle to this, however, is TEFRA,2 which governs the audits of most partnerships. In response to the need for a more effective way to audit partnerships, Congress passed Section 1101 of the Bipartisan Budget Act of 2015 replacing the TEFRA rules. The new law will generally take effect for tax years beginning after December 31, 2017, although taxpayers may elect for the law to be applied earlier.
Under the new law, the default rule is to make partnerships subject to federal income tax upon audit. Therefore, the new rules have the potential to dramatically change the economics of many partnerships. Although we are still awaiting regulations and other guidance on how to implement the new law, parties should begin to consider these rules when structuring investments utilizing partnerships and when transferring interests in partnerships.
The new law permits partnership-level determinations and assessments, simplifying the process of auditing partnerships. The default rule is that if, on audit, the IRS determines that the partnership underreported income to its partners, the partnership will be assessed the tax liability, including interest and penalties, and will be responsible for paying the tax, unless the partnership elects to pass the tax liability through to its partners.
Although the tax assessed to the partnership will generally be computed at the highest tax rate applicable to individuals, partnerships can demonstrate that the tax should be lower based on certain tax characteristics of its partners, such as their being tax-exempt. Also, partnerships may reduce the amount of tax due by demonstrating that partners have filed amended returns taking into account the audit adjustment. However, for most partnerships, getting all partners to file amended tax returns is unlikely to be feasible.
Partnerships with 100 or fewer partners may elect to opt out of the entity-level partnership audit, but restrictions on the types of partners such a partnership may include make it unlikely that many partnerships would qualify for the opt-out. The only permitted partners in opt-out partnerships are individuals, C corporations, S corporations, and estates of deceased partners.
The new law does not give partners any rights to participate in an audit or to be notified of the audit. Therefore, partners must negotiate any participation or notification rights in the partnership agreement. All partners are bound by a final resolution in the partnership audit, and penalties are determined at the partnership level. There are no partner-level defenses against penalties. Additionally, rather than having a "tax matters partner" as partnerships currently have under TEFRA, partnerships are required to have a "partnership representative" who need not be a partner for tax purposes. Thus, LLCs with a nonmember manager or partnerships with a noneconomic general partner can use that person as the partnership representative, which is not currently permitted.
In lieu of having the partnership pay the tax due, the partnership can also elect to issue "statements," which are essentially amended K-1s, to the partners who were partners during the audited year. If the partnership issues statements, the partners are liable for the tax, plus penalties and interest. An additional interest cost of an extra two percent is imposed on partners when the partnership uses statements to pass through the payment obligation to its partners. This election replicates the usual economics of taxation of partnerships, except that the partners bear the higher interest cost.
1 Protecting Americans Against Tax Hikes Act of 2015 (PATH Act), enacted as Division Q of the Consolidated Appropriations Act, 2016, Public Law 114-113, 129 Stat. 2422. Section 311 (a) and (b) of the PATH Act added to the Code sections 355 (h) and 856 (c) (8).
2 The Tax Equity and Fiscal Responsibility Act of 1982, commonly referred to as TEFRA, set forth in Code Sections 6221 through 6234, established unified procedures for examining partnerships.