Significant legislative developments this year include proposed regulations and notices issued by the U.S. Internal Revenue Service (IRS) and Department of Treasury significantly affecting U.S. companies doing business globally. Notably, the debt-equity regulations under section 385 may have an impact on all businesses with intercompany debt instruments. In addition, the Organisation for Economic Co-operation and Development (OECD) remains active with its base erosion and profit shifting (BEPS) project in an effort by OECD countries to counteract aggressive international tax strategies and transfer pricing. As a result of the OECD action plan, the IRS released final regulations that require annual country-by-country (CbC) reporting by any U.S. business considered the ultimate parent entity of a multinational enterprise (MNE) group.
Debt-equity regulations released with broad carveouts
On Oct. 13, 2016, Treasury released final and temporary debt-equity regulations. The regulations allow the IRS to recharacterize certain related-party debt instruments as equity if the debt is issued in specified transactions or if documentation requirements are not met. These regulations retain significant portions of the proposed regulations that were released on April 4, 2016, but provide revisions that will eliminate the applicability of the rules to many corporations.
The debt-equity regulations are intended to restrict the ability of certain corporations to engage in “earnings stripping” by allowing the IRS to recharacterize debt as equity in certain instances. In a typical example of earnings stripping, a foreign parent loads a U.S. subsidiary with significant debt payable to the foreign parent. The U.S. subsidiary would be allowed interest deductions for U.S. purposes at high tax rates while the foreign parent pays little or no income tax on the interest income in the foreign jurisdiction. While the thrust of the regulations appears to limit earnings stripping, the regulations deal with many other types of transactions and can affect corporations that are based solely in the U.S.
The regulations apply to corporations that are members of an expanded group. An expanded group is generally defined as a group of corporations directly or indirectly related using a threshold test of ownership of at least 80 percent of the vote or value of stock. Debt between members of a group that files a consolidated federal income tax return is excluded. Changes from the proposed regulations provide exclusions for foreign issuers, S corporations and noncontrolled regulated investment companies and real estate investment trusts.
The regulations also impose documentation requirements on debt issued to expanded group members. The documentation requirements address whether there is a binding obligation to repay the debt, the creditor’s rights to enforce the debt, a reasonable expectation that the debt can be repaid and evidence of a genuine debtor-creditor relationship. The documentation requirements apply if any member of the group has (a) stock that is publicly traded, (b) total assets on the financial statements exceed $100 million or (c) the group’s financial statements reflect annual revenue exceeding $50 million. Failure to maintain the documentation requirements may result in the debt being recharacterized as equity. The documentation requirements apply to loans issued on or after Jan. 1, 2018.
Possibly the most controversial provision in the regulations are the rules that automatically recharacterize intragroup debt (covered debt) as equity in specified transactions that do not finance new investment. Subject to a variety of exceptions, these rules apply to covered debt distributed by an issuer to another group member, covered debt issued in exchange for another member’s stock or covered debt exchanged for property in internal asset reorganizations. The rules also create a presumption that treats debt as equity if, within 36 months before or after covered debt is issued by a group member, the borrowing member uses the funds to engage in any of the specified transactions listed above. A welcome provision added to the final regulations allows taxpayers to exclude the first $50 million of debt that would otherwise be recharacterized under these rules. These rules are effective for covered debt issued on or after April 4, 2016; however, the general effective date is 90 days after the regulations are published as final, giving taxpayers three months to clean up their intragroup debt.
Now that the federal regulations were released, it remains to be seen how the states will react to the rules. Some states are not bound by federal regulations which are essentially interpretations of the code. Another issue may be the general exclusion for debt between members that file a consolidated federal return. States may decide not to allow this exclusion if the members file separately in their state.
The package of final and temporary regulations is 518 pages long. This article contains only a brief summary of the rules. Based on comments received by Treasury, the final and temporary regulations contain substantial revisions from the proposed regulations. Most notably, more taxpayers are exempt from the rules. For those subject to the rules, now is the time to examine your intragroup debt and determine whether it complies with the regulations. In addition, for those subject to the documentation requirements, procedures will need to be put in place to ensure you can meet the requirements. The consequence of having debt recharacterized as equity can have a substantial impact on both your tax liability and the integrity of your financial statements.
Strengthening the reach of the section 909 foreign tax credit splitter regulations
The Treasury Department and IRS issued Notice 2016-52 in September, announcing that additional regulations will be forthcoming under section 909. Generally, the section 909 rules, commonly referred to as the “foreign tax credit splitter rules” or “anti-splitter rules,” address certain arrangements whereby a U.S. corporate taxpayer attempts to recognize foreign tax credits without repatriating the associated income. This attempt to “split” the foreign taxes from the associated income is nullified by the rules and regulations under section 909. Section 909 achieves this by identifying certain transactions, restructurings or instruments and requires a U.S. taxpayer may not recognize a foreign tax credit before the year in which the related income is recognized for U.S. federal tax purposes.
Notice 2016-52 identifies two new types of arrangements that will be added to the section 909 regulations. First, instances in which a foreign-initiated adjustment to which section 905(c) applies will be considered a splitter arrangement under section 909. Section 905(c) authorizes the IRS to revise a taxpayer’s U.S. federal income tax liability where there has been a modification to the taxpayer’s foreign tax liability for a prior year. In addition, section 905(c) provides for a prospective adjustment to the foreign corporation’s post-1986 foreign earnings and profits (E&P) and tax pools for deemed foreign taxes. As a result, both the IRS and taxpayers avoid recalculating the U.S. taxpayer’s federal income tax liability for that prior year.
Second, instances in which a foreign corporation pays a distribution in advance of a foreign-initiated tax adjustment will be considered a splitter arrangement under section 909. Specifically, section 909 will prevent tax strategies that shift post-1986 E&P between section 902 corporations using distributions timed to occur exactly before a section 902 corporation is required to make a payment related to a foreign-initiated adjustment. Under both instances, the U.S. owner of the foreign corporation will be required to match the foreign taxes paid with its related income for foreign tax credit purposes. In conclusion, taxpayers should closely consider the impact Notice 2016-52 may have on global restructurings or distributions, which may have been implemented or will be implemented on or after Sept. 15, 2016.
Apple ordered to pay Ireland 13 billion euros in back taxes
The European Commission (EC) is requiring Apple to pay 13 billion euros, plus compound interest, in back taxes as part of a State aid investigation. The EC concluded Ireland provided unlawful State assistance to Apple in the form of tax rulings granted in 1991 and 2007. The tax rulings provided by Ireland to Apple pertain to the allocation of profits between two Irish subsidiaries of Apple. Due to the tax residency of these Irish subsidiaries and the agreed-upon allocation of profits among them, the EC considered Apple’s arrangement an “artificial allocation of profits.” The EC also noted Apple paid substantially less tax than other companies.
The EC ordered Ireland to recover the back taxes from Apple. Apple publicly stated it will be exploring all avenues to appeal the EC’s decision and noted it expects to win on appeal. Since the announcement was made in late August, the Irish government has been vocal about contesting the EC decision. Furthermore, the U.S. Department of Treasury and IRS publicly expressed concerns regarding the EC’s decision to assess such a retroactive recovery on a U.S. multinational such as Apple. Moreover, Brian Jenn, an attorney-advisor with the U.S. Department of Treasury Office of International Tax Counsel, voiced concern on the validity of bilateral tax treaties should the EC continue its current strategy of attacking previously granted state tax rulings. This represented a rare instance where the IRS advocated for the taxpayer. However, it is important to note that within 16 days of the EC’s ruling in the Apple case, the Treasury Department and IRS adapted to shifting tax winds blowing across the Atlantic and issued Notice 2016-52 (as noted in the previous section ). Furthermore, the Treasury Department specifically stated in the preamble of the Notice that the section 909 splitter rules may be triggered by retroactive tax payments mandated by European Union State aid rulings.
Subsequent sale of assets of foreign subsidiary do not trigger GRA
In Private Letter Ruling (PLR) 201639014, the IRS ruled that the subsequent sale of a foreign subsidiary’s assets to an unrelated party did not trigger gain recognition under an existent gain recognition agreement (GRA). As outlined in the PLR, the U.S. taxpayer entered into the following transactions prior to the final sale of the foreign subsidiary’s assets:
- U.S. taxpayer (Parent) transferred the stock of one foreign subsidiary (Sub1) to another foreign subsidiary (Sub2). The exchange qualified as a section 351 exchange and the Parent entered into a GRA (GRA1) for that transfer.
- In the following tax year, Sub1 converted into a foreign limited liability company. This change in classification resulted in Sub1 being treated as a disregarded entity for U.S. federal tax purposes. Furthermore, the change in Sub1’s classification was treated as a tax-free liquidation of Sub1 into Sub2 under section 332. This was a triggering event of the GRA1, but did not amount to a gain recognition event under Treas. Reg. 1.367(a)-8(k)(8) since the Parent entered into a new GRA (GRA2) with respect to the initial transfer.
- In the third tax year, Sub2 elected to be treated as a disregarded entity for U.S. federal tax purposes. As a result, the Parent was deemed to acquire all of the assets of Sub2, which included the assets of Sub1, in an inbound reorganization. Under section 362(a), the Parent obtained a carryover basis in the assets of Sub 2 and Sub1.
- Immediately following its most recent transaction (detailed in No. 3), the Parent contributed the assets of Sub1 to a U.S. partnership under section 721. The Parent entered into an amended GRA (GRA3) and the GRA2 terminated without further effect.
- Finally, the Parent sold the Sub1 assets to an unrelated party in a transaction that would require the Parent to recognize gain under GRA3.
The U.S. taxpayer sought a private letter ruling to determine whether the inbound reorganization outlined in third bullet above terminated the GRA2 or if this transaction was a triggering event that required the recognition of gain.
The IRS found that the inbound reorganization did not trigger a gain recognition under the GRA2 due to the exceptions provided under Treas. Reg. 1.367(a)-8(k)(14) which stated that (1) the disposition of Sub2 stock and Sub1 assets qualified as a nonrecognition transaction, (2) the Parent retained a direct interest in Sub1 assets, and (3) GRA3 met the requirements under Treas. Reg. 1.367(a)-8(k)(14)(iii).
Accordingly, the IRS viewed Sub1’s assets, in the hands of the U.S. taxpayer, as a proxy for the stock of the foreign subsidiary. Therefore, any subsequent gain resulting from the sale of the foreign subsidiary’s assets would subject the U.S. taxpayer to U.S. federal income tax. Although not binding, PLR 201639014 should be viewed as a taxpayer-friendly ruling since the current section 367 regulations only provide for the termination of a GRA upon the inbound transfer of the foreign subsidiary’s stock. The regulations are silent with regard to the inbound transfer of a foreign subsidiary’s assets.
Transfer pricing: Final regulations for country-by-country reporting
In June, the IRS released the final Treasury regulations (TD 9773) that require annual CbC reporting by any U.S. business considered the ultimate parent entity of a MNE group, if annual groupwide revenue meets or exceeds U.S. $850 million in the prior reporting period. These regulations are effective for tax years beginning on or after July 1, 2016 (generally effective for 2017 calendar-year taxpayers). Form 8975, Country-by Country Report, was designated for this purpose and will be finalized in the near future for issuance and release. The filing deadline for the new form will be the taxpayer’s tax return deadline (including extensions). Notably, voluntary filing for years beginning before June 30 will be allowed (to enable compliance with CbC reporting requirements already implemented in other countries) under a procedure to be released separately. U.S. businesses that meet the above threshold and are required to meet local country reporting requirements for 2016 should consider voluntary filing.
This new U.S. tax compliance requirement is a supplement to existing transfer pricing documentation requirements. According to IRS, the new regulations “will help the IRS perform high-level transfer pricing risk identification and assessment.” Particularly, the IRS may share CbC reports with any foreign tax jurisdiction with which it has a Tax Information Exchange Agreement (TIEA) and the new reporting requirements may assist foreign tax authorities with transfer pricing reviews of U.S.-based MNEs. However, the information provided in CbC reports will be treated as tax information subject to the confidentiality protections of section 6103, i.e., not made available to the public.
In addition to the U.S. requirements, U.S. businesses operating globally may also be subject to other foreign transfer pricing compliance requirements under local CbC rules. These rules may be in effect earlier than the effective date of the U.S. regulations. Any reader of a properly completed CbC report can easily identify where an MNE earns income and incurs expenses, as the CbC report also facilitates the identification of intercompany transactions. That said, MNEs should expect the CbC report will be subject to scrutiny outside the U.S. Accordingly, transparency provided by CbC reports will provide foreign taxing jurisdictions with the information needed to initiate additional tax audits.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.