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By Robert E. Ward, Esq. Ward Chisholm, P.C. Bethesda, Maryland
The initial offering from one of the most important regulations projects of the last 35 years has the potential to significantly affect more than related-party transactions involving public companies and large privately held enterprises. The documentation requirements of Prop. Reg. §1.385-2 would apply to public companies or groups of privately owned companies with total assets exceeding $100 million or annual total revenues in excess of $50 million. The rules of Prop. Reg. §1.385-3, which would recharacterize as stock certain debt instruments issued in a distribution, in exchange for expanded group stock, or as boot in an asset reorganization, would also be subject to a threshold exception. None of the group's debt instruments would be subject to recharacterization until the “aggregate issue of all expanded group debt instruments that otherwise would be treated as stock” exceed $50 million. However, the thresholds in the -2 and -3 sections of the proposed regulations should not obscure that there are no thresholds for application of the rules set forth in Prop. Reg. §1.385-1. Further, although privately held entities that do not satisfy the thresholds set forth in Prop. Reg. §1.385-2 will not automatically be denied debt treatment for obligations that fail to satisfy the documentation and information requirements of Prop. Reg. §1.385-2(b)(2), in practice such failures will likely invite recharacterization.
For publicly held companies and privately held expanded groups subject to Prop. Reg. §1.385-2, §1.385-3, and §1.385-4, Prop. Reg. §1.385-1 will primarily be significant as a source for definitions of key terms used in those later provisions: control partnership, disregarded entity, expanded group, indirect stock ownership, modified controlled partnership, and modified expanded group. For publicly held companies and those privately held expanded groups that satisfy the thresholds of Prop. Reg. §1.385-2 and §1.385-3, Prop. Reg. §1.385-1(c) would require the holder of a debt instrument deemed to be exchanged for stock to realize an amount equal to the holder's adjusted basis in that portion of the indebtedness as of the date of the deemed exchange. The issuer would be treated as having retired that portion of the debt instrument for an amount equal to the adjusted issue price as of the date of the deemed exchange. The guidance provides that accrued but unpaid qualified stated interest on the debt instrument or any foreign exchange gain or loss with respect to the accrued but unpaid qualified stated interest would be ignored, subject to other exchange gain or loss required to be recognized by Reg. §1.988-2(b)(13) . These rules may also apply to debt instruments issued to related parties by members of privately held groups that do not meet the asset and gross revenue thresholds of Prop. Reg. §1.385-2(b)(2)(i).
The broader application of Prop. Reg. §1.385-1 is the authority granted to the Commissioner of Internal Revenue to engage in partial recharacterizations of debt as stock under Prop. Reg. §1.385-1(d). This assumption of Solomonic wisdom to divide any putative debt instrument issued by minimally related parties will be undertaken based upon analysis “of the relevant facts and circumstances…under general tax principles” as those facts and circumstances exist on the date the debt instrument is issued. The only example set forth in the proposed regulations is a debt instrument with respect to which there is a “reasonable expectation” that the entire principal amount will not be repaid.
The opportunity for partial recharacterization of debt as equity is extended only to the Commissioner. Taxpayers are bound by the issuer's initial characterization of the debt instrument. Holders are only allowed to treat a debt instrument as part debt and part stock if the issuer does the same.
As the proposed regulations are currently written, careful readers of Prop. Reg. §1.385-1 might conclude that the Commissioner's ability to recharacterize debt instruments as part debt and part stock is limited to entities satisfying the thresholds required by Prop. Reg. §1.385-2 for application of the documentation and information requirements set forth in that provision. Prop. Reg. §1.385-1(d)(1) explicitly references Prop. Reg. §1.385-2 three times. While several critical definitions of terms recurring throughout the proposed regulations are set forth in Prop. Reg. §1.385-1, two other terms are defined in Prop. Reg. §1.385-2: applicable instrument and expanded group instrument (EGI). Consequently, one might reasonably infer that the Commissioner's ability to recharacterize EGIs as part stock and part debt applies only to public companies and privately held companies that meet the asset and gross revenue thresholds of Prop. Reg. §1.385-2(a)(2)(i). Conversations with two individuals involved in the drafting of the proposed regulations have dispelled that inference. The author is advised that the ability of the Commissioner to recharacterize indebtedness as part debt and part stock is intended to apply to any indebtedness of any issuer that is a member of a modified expanded group if held by another member of the group.
While the publicly traded asset and gross revenue thresholds of Prop. Reg. §1.385-2 would not be applicable to limit the entities subject to the Commissioner's authority to engage in partial recharacterization of debt as equity, limitations nonetheless exist. Only EGIs are subject to recharacterization. An EGI is defined by the proposed regulations as a debt instrument issued and held by members of the same expanded group. An expanded group is a rather disparate assortment of §1504 affiliated group entities or chains of entities under the common control of a corporation with direct or indirect ownership of at least 80% (by vote or value). Under this broad notion of common ownership, members include U.S. and foreign corporations, tax-exempt entities, S corporations, RICs, REITs, DISCs, insurance companies, and §936 corporations. However, for purposes of entities among which debt instruments are subject to recharacterization, the holder and issuer need only be members of a modified expanded group (MEG) as that term is defined in Prop. Reg. §1.385-1(b)(5). A MEG is an expanded group defined to include a less related and much broader array of taxpayers. First, the common ownership (whether direct or indirect) is reduced from 80% to 50%. Second, entities may include partnerships if members of the MEG own directly or indirectly 50% of the capital or profits interest in the partnership. Third, MEG members are not limited to corporations and partnerships. Any person (as defined by §770(a)(1) ) who is treated by the attribution rules of §318 as owning at least 50% of the stock of a MEG member (based on the stock's value) is treated as a member of the MEG. Loans from individuals, trusts, and estates to corporations and partnerships, as well as other individuals, trusts, and estates, may be recharacterized as partially an equity interest.
The opportunity for mischief created by the assumption of administrative authority to engage in partial recharacterizations of debt as equity will, at best, create a climate of uncertainty. At worst, professional fees for taxpayers who are not publicly held or are members of expanded groups with less than $100 million in assets or $50 million in gross revenue will increase significantly because of documentation necessary to protect against the potential for partial recharacterization or respond to an actual partial recharacterization of debt as equity. Although the potential circumstances in which such havoc may be created are practically limitless, two obvious ones come to mind.
Consider a cross-border marriage: two spouses, one of whom is a U.S. citizen, the other not, both residing in a country which in a manner consistent with most of the civilized world taxes on the basis of residency (for example, Canada). Each of them owns exactly 50% of the stock of a foreign corporation. Section 958(b)(1) provides that stock owned by a nonresident alien is not attributed to a U.S. shareholder. If, in such a case, the U.S. shareholder has made a loan to the foreign corporation that is later partially recharacterized by the Commissioner as equity, the U.S. shareholder now owns more than 50% of the total value of the stock of such corporation, thereby converting the foreign corporation to a controlled foreign corporation.
Of greater concern than surprise CFC status is the consequence to shareholders of S corporations. Because the definition of a MEG includes individuals among the members of the MEG, loans made by shareholders of an S corporation to the corporation are at risk of partial recharacterization as stock. Such recharacterization will inevitably result in the automatic revocation of the corporation's S election because of the requirement that an S corporation have only one class of stock. In this regard, §1361(c)(5) provides a safe harbor for shareholder loans that satisfy the definition of “straight debt” appearing in §1361(c)(5)(B) . Most practitioners would assume that a statute will control in cases in which there is a conflict between the statute and the Treasury's regulations. However, a representative of the U.S. Department of the Treasury appearing before a panel sponsored by the S corporation subcommittee of the ABA Section of Taxation at its May 2016 meeting expressed the opinion that this might not necessarily be the case, given that the final regulations will be issued pursuant to the grant by Congress of rulemaking authority in §385(a) .
It may well be that creation of CFCs and revocation of S elections by recharacterizing a sliver of debt as stock are simply examples of unintended consequences if the proposed regulations are finalized in their current form. The far-reaching effect of the proposed regulations will inevitably create many other unintended consequences. With regard to down-market application, Treasury should consider carving out areas in which the Commissioner's authority to recharacterize even the smallest portion of indebtedness as stock will not apply. To exclude all privately held corporations from the scope of the §385 regulations as proposed would be inconsistent with the anti-inversion objectives described in the preamble to the proposed regulations and too much for practitioners to hope for. However, preventing “surprise equity” to convert foreign corporations into CFCs or loss of S corporation status would not materially impede those objectives. At the very least, confirming the straight-debt safe harbor of §1361(c)(5) is not too much to ask.
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