U.S. Companies Still at Risk of Debt-Equity Loan Recasts

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By Alison Bennett

Oct. 25 — U.S. multinationals aren’t home free when it comes to having loans recast as equity under final earnings-stripping rules (T.D. 9790), despite major rollbacks, practitioners said.

Even though the government listened to fiery criticism of the proposed rules (REG-108060-15) and most of the loan recast provisions now largely affect foreign multinationals, companies on this side of the ocean still need to be vigilant, they told Bloomberg BNA in a series of interviews.

“The name of the game is to make sure you fall within an exception,” David Schnabel, a tax partner with Davis Polk & Wardwell LLP, said Oct. 24. “Don’t take for granted that you don’t have a loan to a foreign corporation.”

The Oct. 13 guidance lifts much of the weight of the controversial rules proposed in April, intended to prevent multinational companies from “stripping” income out of the U.S. through loans to subsidiaries and affiliates. The April rules cast a shadow over a network of intercompany transactions all over the world, including a broad swath of those originating in the U.S.

The Treasury Department proposed “per se” and “funding” rules that taxpayers would have to meet to avoid entire loans being recharacterized—an action that would derail interest deductions and potentially impose hefty withholding taxes. The government also set out rigorous documentation rules to get taxpayers in the door so they can try to prove their instruments involve genuine debt—a requirement that also carries the threat of loan recasts if it isn’t met.

No Fundamental Changes

Practitioners said in interviews that significant easing in both areas is welcome, but the shape of these requirements remains fundamentally the same, and U.S. companies should be paying attention to both.

Scott M. Levine, a tax partner with Jones Day, said among U.S. multinationals, “I think there’s relief that the per se loan recharacterization rules don’t apply.” Further, he said Oct. 24, the exceptions make the Section 385 rules “much more manageable” for these companies.

Levine and other tax lawyers said while foreign multinationals will bear the brunt of the recharacterization rules, U.S. companies need to be watchful.

U.S. companies that lend to their controlled foreign corporations could run into problems under some circumstances, Levine said. Further, a U.S. multinational that doesn’t consolidate could be subject to the rules if it has U.S. affiliates that lend to each other, he told Bloomberg BNA.

Donald Bakke, a principal in Ernst & Young LLP’s National Tax Mergers and Acquisitions practice, also said U.S. companies have to stay on the lookout. “They need to be aware of their intercompany debt inventory and their transactional activity,” he said. “The need to monitor their distributions and acquisitions.”

Beware Exceptions

Exceptions are the key, Schnabel and others said—and they still aren’t a guarantee. For example, Schnabel said, taxpayers need to be wary of an exception for some types of cash pooling. Broadly, these are arrangements where subsidiaries lend and borrow from a central deposit of cash at a single bank.

“It’s not a general rule that cash pooling is good,” Schnabel said. “It’s kind of a living process. You need to be confident that it’s going to continue in a way that falls within the exceptions.”

Albert Liguori, managing director with Alvarez & Marsal Taxand in New York, said companies need to carefully watch what the government does with an exception for foreign debt issuers that takes a lot of weight off the shoulders of U.S. multinationals. U.S. Treasury officials have stressed in recent days that they’ll continue to work on this issue and it shouldn’t be considered a set-in-stone exception.

“It’s not as though they’ve indicated that they’re not going to write regulations,” on this issue, Liguori said in an Oct. 24 interview.

James Duncan, a partner at Cleary Gottlieb Steen & Hamilton LLP, called that reservation “another storm cloud. They reserved on a lot of other issues. We’ll have to see whether and when they take action.”

Foreign Parent Companies at Risk

Joe Calianno, partner and international technical tax practice leader at BDO USA LLP, said foreign parent companies need to monitor activities by their U.S. subsidiaries closely. If a U.S. subsidiary distributes a note to its foreign parent, that can trigger the recast rules, he said.

Additionally, a U.S. subsidiary that uses a note to acquire a related corporation from its foreign parent potentially can trigger the recast rules, he said. “When these types of transactions are undertaken, a taxpayer should evaluate all potential exceptions in the regulations that may mitigate or eliminate a potential recast,” Calianno said Oct. 25.

Duncan said for foreign multinationals, the rules will have “the intended effect of making it harder to push down debt into a U.S. company.”

Donald Bakke, a principal in Ernst & Young LLP’s National Tax Mergers and Acquisitions practice,

Nearly all the practitioners interviewed said companies need to make sure they are complying with the strict documentation requirements under the rules. Internal Revenue Service Associate Chief Counsel (Corporate) Robert H. Wellen recently called documentation a “gateway” for taxpayers to pass through in order to get to even more challenging hurdles for proving debt.

Strict Requirements

Jones Day’s Levine said these requirements are “fairly rigid” and multinationals should be focused on them.

The standard required in the Section 385 rules is much tougher than the one a court would require, he said. This is true even in cases where a “good housekeeping” exception is satisfied for foot faults, according to Levine.

He said with a preamble and rules totaling over 500 pages issued less than two weeks ago, much of the work of applying the loan recast provisions to real-life fact patterns remains ahead. That process is likely to yield some “glitches” in the rules, he said, and some “ancillary consequences” that aren’t favorable to taxpayers might emerge.

Levine said challenges to the rules are likely, and it remains to be seen “what other issues are out there that we haven’t thought about.”

To contact the reporter on this story: Alison Bennett in Washington at abennett@bna.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bna.com

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