Debt-Equity Breakup Rule ‘Sweeps in the World'

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April 28 — Treasury Department officials know that a rule that could split up related-party financing instruments into equity and debt portions is all-encompassing,and are willing to be convinced it should be narrowed.

The rule is “written as a ‘could sweep in the world' scenario,” said Karl Walli, Treasury senior counsel (Financial Products). “If people want to make comments to us that say, ‘these seem to be the kind of instruments and situations that would most lend themselves to a bifurcation and maybe the others should not,' we will listen to those suggestions.”

But they want to know fast. The rules will become final “swiftly,” Brett York, an attorney-adviser in Treasury's international tax counsel office, said at an April 28 District of Columbia Bar event.

Treasury released proposed regulations (REG-108060-15) under tax code Section 385 earlier this month, exerting authority over related-party debt after concerns that some groups were treating instruments with equity-like characteristics as debt to take the interest deduction.

The rules allow Internal Revenue Service agents to bifurcate some instruments to treat them partially as debt and partially as equity. The rules also require companies to thoroughly document transactions involving debt (65 DTR GG-1, 4/5/16).

‘Odd Situation.'

The rules are substance-driven, York said. If an interest has the sufficient equity qualities, the government can choose to turn on the bifurcation rule.

“Why we have a bifurcation rule is to deal with that odd situation where you have, say 49 percent equity, and it is treated as debt, and 51 percent equity is treated as all equity,” York said. “That we think is an uneconomic result and that's what we're trying to avoid with these rules.”

Craig Gibian, a principal at Deloitte LLP, asked if these rules were needed to give the courts authority to bifurcate if the IRS were to attack a related party debt-equity situation in litigation.

“That's certainly my reading of it and that's anecdotally what I've been told how it's played out,” Walli said.

Debt Deliberations

Richard Larkins, a partners with EY LLP, asked why the rules just didn't use a Section 1275 and general tax principle definition of debt.

“We weren't smart enough to think about all the other things that were not debt in form but were debt,” Walli said, adding that the government plans to add a more robust definition in the future. “Frankly, it didn't seem critical to the message we were trying to send.”

Gibian said he views these rules as being about debt—in substance or form—that lead to an interest deduction. So, for example, a prepaid forward contract—where the government has acknowledged there is a time-value component and that it isn't debt in form or substance—shouldn't be at risk for bifurcation.

“My view is that these rules aren't touching those,” Gibian said.

Walli's response? “Interesting theory.”

To contact the reporter on this story: Laura Davison in Washington at ldavison@bna.com
To contact the editor responsible for this story: Brett Ferguson at bferguson@bna.com