Attention Taxpayers: New IRS Rules May Deem Debt to Be Stock

16 May 2016 Manufacturing Industry Advisor Blog

In April, the IRS proposed rules that would treat debt between related corporations as stock for U.S. tax purposes. These rules would apply to all corporations (including regular C corporations, S corporations, foreign corporations, and exempt organizations) related through 80% stock ownership, taking into account constructive ownership rules, except that members of a U.S. consolidated group would be exempted and treated as a single corporation. For example, the rules would apply to a U.S. parent and subsidiaries if they do not file U.S. federal consolidated returns; a foreign parent and U.S. subsidiary; and brother-sister corporations owned by a private equity fund, family, or exempt organization.

What this Means for Manufacturers

Stock treatment would apply for all U.S. tax purposes, meaning there would be no interest deduction; repayment would be treated as a stock redemption, likely dividend-equivalent; and the debt would have to be taken into account as stock in determining whether any of the tax law’s many stock ownership standards are met.

The proposed rules were issued in conjunction with other measures to combat perceived erosion of the U.S. tax base through inversions and multinational groups’ leveraging their U.S. operations to strip out U.S. earnings free of U.S. tax through interest deductions. However, the proposed rules are not limited to such scenarios and would apply to a purely domestic group, and could be adopted independently of those other provisions.

The proposed rules would impose stock treatment unless extensive debt qualification documentation is maintained for all such related party debt, even ordinary course daily accruals and borrowings. This rule would apply prospectively to debt issued after the rules are finalized.

Even with such documentation, stock treatment would be imposed for debt issued in specified transactions that are have or are deemed to have the effect of displacing equity of a group member. This rule would apply even now to debt issued after April 3, 2016, although the stock treatment would not be imposed until 90 days after the rules are finalized.

Finally, another rule, applicable to 50% related parties, would give the IRS authority to bifurcate debt instruments into separate debt and stock components, such as where only a portion of a debt is sufficiently certain of repayment to qualify as debt. This rule would apply prospectively to debt issued after the rules are finalized.

The rules contain a number of exceptions and thresholds to imposition of stock treatment. Groups would have to track a host of new related party debt parameters to monitor where they stand under and comply with the rules.

What’s Next

Although just proposed, already commentators are raising many issues and problems that arise thereunder, many of which have not been fully thought through. The proposed rules must go through a comment and hearing process before being finalized. Congress could get involved as well. Taxpayers can weigh in on the debate individually or through trade associations such as the National Association of Manufacturers, and in any event should keep informed of developments and know that if finalized as proposed, the equity displacement rules are in effect now.

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