On April 4, 2016, the U.S. Treasury Department and the Internal Revenue Service released proposed regulations under Section 385 of the U.S. Internal Revenue Code.
The proposed regulations would, among other things, limit the effectiveness of a wide range of corporate tax planning ideas by characterizing certain types of related party debt as equity for U.S. federal income tax purposes.
In particular, the proposed regulations would limit the ability of a foreign holding company to make a leveraged distribution in the form of a tax-free return of capital to its U.S. parent corporation. Prior to the issuance of the regulations, the issuance of debt by a foreign holding company to its U.S. parent corporation could be made as a tax-free return of capital if:
The general impact of the proposed regulations, treating such related party debt as equity, is that future payments of principal and interest on the related party debt will be treated as taxable dividends for U.S. federal income tax purposes. The proposed regulations generally apply to related party debt instruments issued on or after April 4, 2016.
In general, the proposed regulations treat certain types of related party debt as equity for US federal income tax purposes, but only if the issue price of all of the tainted related party debt instruments exceeds a $50 million threshold in the aggregate. It should be noted that this $50 million threshold functions as a cliff. Once the $50 million threshold is reached, all of the related party debt instruments which would otherwise be treated as equity absent the $50 million threshold, will be treated as equity for U.S. federal income tax purposes.
Planning Opportunities for Mid-Size Corporations
As drafted, the proposed regulations place limitations on certain treasury management techniques used by larger corporations, but still allow smaller corporations to continue to use related party financing subject to the rules provided for under existing law.
If the $50 million threshold is not satisfied, a foreign holding company may be able to make a leveraged distribution in the form of a tax-free return of capital provided that certain requirements are satisfied. One method for making a leveraged distribution is described below.
Step 1: A foreign holding company can issue and distribute its own note payable to its U.S. parent corporation. Alternatively, a foreign holding company can borrow from a third party and distribute cash proceeds to its U.S. shareholder corporation. The distribution is commonly referred to a "leveraged distribution."
The distribution of the note (or, alternatively, the borrowed cash) should not qualify as a taxable dividend to the U.S. parent corporation to the extent that the foreign holding company does not have any current or accumulated earnings and profits for U.S. federal income tax purposes in the tax year of the distribution. Instead, the distribution can generally be treated as a tax-free return of capital to the extent that the amount of the distribution does not exceed the U.S. parent corporation’s tax basis in the stock of the foreign holding company.
Step 2: In a subsequent tax year, foreign operating subsidiaries (which are held by the foreign holding company) can distribute cash to the foreign holding company and the foreign holding company can use such cash to repay its debt owed to the U.S. parent corporation. Alternatively, the foreign holding company can repay its debt owed to the 3rd party lender.
A distribution of cash from the foreign operating subsidiaries to the foreign holding company should not be treated as taxable subpart F income (if the CFC look-though rule under Section 954(c)(6) is satisfied and remains in effect). And, the repayment of principal on the debt owed by the foreign holding company to the U.S. parent corporation is generally not a taxable event for U.S. federal income tax purposes.
While this financing technique appears to be relatively straightforward, it can be a trap for the unwary as there are a number of important things to consider.
A taxpayer will need to monitor potential changes in U.S. and foreign tax laws prior to making a leveraged distribution as tax laws are subject to change. It should also be noted that other types of repatriation planning may be more appropriate depending upon the tax profile of your company.
Information contained in this article is not intended as legal or tax advice to any person. All readers must rely on their own legal and tax advisors.