Companies based entirely in the U.S.—including insurance companies and partnerships—could feel the bite of new IRS rules largely intended to prevent multinationals from shifting income out of the country.
The guidance, intended to discourage companies from moving income out of the U.S. through tax-favored loans from foreign companies to U.S. subsidiaries, has drawn fire from many who say it could clamp down on routine crossborder intercompany loans.
It also could hurt some companies that only operate domestically, and taxpayers are closely scrutinizing its possible impact, tax attorneys told Bloomberg BNA.
“The problem is there is not a special statute that says you can pick a harsher rule for inversions,” said Steven Schneider, a partner at Baker & McKenzie LLP. “Clearly, they're targeting toward inversions and some of the foreign tax planning that's being done, but I'm not sure that they can say, ‘hey, we're going to have different rules for this deal.'”
“U.S. companies are quickly focusing on this now,” Brian Kittle, a partner at Mayer Brown LLP, said. “They're taking a very serious look at it very quickly.”
The proposed rules (REG-108060-15) under tax code Section 385 allow the Internal Revenue Service to take away deductions on interest payments for those loans, as well as to impose withholding taxes on those payments, by determining the deals involve equity instead of tax-deductible debt. Its broad reach goes beyond inverted companies.
Paul Schmidt, chair of tax at BakerHostetler LLP, said the rules “are wildly impactful on domestic companies,” and clients started calling him right away.
The IRS can recast some debt transactions entirely as stock, and it also can “bifurcate” debt instruments as part debt and part stock. Some companies will face complex and burdensome documentation requirements to prove to the IRS that their transactions involve genuine debt—features sharply criticized by many.
The guidance is generally focused on lending and borrowing between related members of a group. Mark Silverman, a partner with Steptoe & Johnson LLP, said a lot of people didn't initially think the rules would have a big impact on domestic-only companies because they carve out consolidated groups—structures common in the U.S.
But that just isn't the case for deals in the U.S. that take place outside of consolidation, Silverman said. “This is going to be a real burden on a lot of people, and there are a fair number of situations where the regulations do apply,” he said.
The government officials writing the rules try “to make the rules as universal as possible and walk this fine line, but in doing that they can't think through every possible situation in which this would apply,” Schneider said.
Both insurance and real estate transactions could be caught up in the rules, as well as structures involving partnerships, Silverman said. The guidance applies to companies that can't consolidate.
One example, Silverman said, deals with big insurance companies that own, within their structures, both life and nonlife companies. Existing tax rules say those two types of companies can't consolidate for several years, and the new earnings-stripping guidance means they could be caught in “a trap,” he said.
When an existing life/nonlife group acquires a domestic life insurance company from an unrelated party, the newly acquired corporation may be allowed to join the consolidated group after five years, said William Pauls, a partner at Sutherland Asbill & Brennan LLP. During that waiting period, if the newly acquired company were to distribute debt instrument to its new parent company, that transaction would be subject to the general rule under Proposed Treasury Regulations Section 1.385-3(b)(2).
“This happens on a not infrequent basis,” Pauls said. “It doesn't even have to be an acquisition by a holding company. It could be by a member and it would still need to wait five years to join the group.”
Another problem could arise when a newly acquired life insurer offers a product, such as a variable annuity contract, that offers the same insurance-dedicated mutual funds as investment options as a variable product offered by an affiliate in the acquiring consolidated group. In this case, the insurance-dedicated mutual funds could be members of an expanded group.
If that happens, “an acquisition of shares of such funds by the separate accounts of the newly acquired life insurance company could trigger the application of the funding rule on account of those acquisitions being treated as acquisitions of expanded group stock,” Pauls said.
Other transactions where the rules might apply would involve corporations and:
- tax-exempt entities;
- real estate investment companies and real estate investment trusts, which own companies that own or finance income-producing real estate; or
- Subchapter S corporations, which aren't required to pay corporate income tax on their profits and pass those profits to their shareholders.
Other structures could involve deals that take place between chains of corporations that are members of a controlled group, with those chains having a common individual or partnership owner. The proposed guidance could also impact corporations owned by a consolidated group through a partnership.
“It's absolutely crazy,” Silverman said.
Real Estate Impact
The rules could also pull in REITs that commonly use taxable REIT subsidiaries to offer certain services in the property that aren't allowed under the provisions of the code governing the entities. Thomas Humphreys, a partner with Morrison & Foerster LLP, said these structures could be hurt if the rules were to be made final in their current form.
By law, REITs can't have more than 25 percent of their stock in that subsidiary—an amount that is going to change to 20 percent in 2017 under the Protecting Americans From Tax Hikes (PATH) Act.
If the IRS changes some or all of the debt involved in this type of REIT structure to stock, taxpayers could end up with amounts of stock that violate the law, Humphreys said.
“People are going to want to be careful,” Humphreys said. “That could be a real headache.”
Investment Companies Affected
A blocker, such as a taxable REIT subsidiary, is a common entity used to separate unrelated business income tax that simplifies return filing for the entity at the top of the structure. These entities usually are funded by a mixture of debt and equity, which could cause them to be caught up in the proposed rules.
A fund or a tax-exempt entity uses a “blocker entity to minimize against unrelated business taxable income. It occurs in funds all the time and it is for perfectly legitimate business reasons,” Schneider said. “It simplifies it for the entity up top because they don't want the filing complications from unrelated business income tax. They create a blocker entity because it pays the taxes and files the returns.”
Another type of U.S. corporation that could be affected is a business development company, according to David Roby, a partner with Sutherland.
This is a special type of investment company created to expand the pool of capital to invest in private securities, Roby said. They can elect to be treated as real estate investment companies, which can't be part of a consolidated group.
Roby said these companies frequently have blockers to separate “bad” income that wouldn't qualify for tax-favored regulated investment company (RIC) treatment. The main investment company usually uses debt to fund the blockers, and if that debt is changed to stock, interest deductions would disappear.
Carol Tello, a Sutherland partner who shared the interview with Roby, said despite the exception for consolidated groups, the situation for many companies is “more complicated than meets the eye.”
Tello and others said taxpayers are worried and watching the process carefully as the Treasury Department and the IRS work on finalizing the rules.
“There's a lot of concern that the rules are just too broad and pick up too much,” said Jason Bazar, a partner at Mayer Brown. “The rules aren't limited in any way to cross-border transactions.”
Reproduced with permission from Daily Tax Report, 85 DTR G-2 (May 3, 2016). Copyright 2016 by The Bureau of National Affairs, Inc. (800-372-1033) <http://www.bna.com>