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Tax Insights, April 13, 2016
Tracking Tax News You Need to Know

April 13, 2016
Publications

IRS Publishes Proposed Earnings Stripping Regulations
The IRS issued proposed regulations (REG-108060-15; 81 F.R. 20912-20943) under Section 385 (section references are to the Internal Revenue Code of 1986, as amended (the Code)) that would authorize the IRS to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes and establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. The proposed regulations also would treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes. The proposed regulations generally affect corporations that issue purported indebtedness to related corporations or partnerships. Treasury intends that the proposed regulations will address earnings stripping by “[t]argeting transactions that generate large interest deductions by simply increasing related-party debt without financing new investment in the United States; [a]llowing the IRS on audit to divide debt instruments into part debt and part equity, rather than the current system that generally treats them as wholly one or the other; [and f]acilitating improved due diligence and compliance by requiring certain large corporations to do up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt. If these requirements are not met, instruments will be treated as equity for tax purposes.”

Section 385(a) authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is treated as stock or indebtedness for purposes of the Code. Section 385(b) provides that the regulations prescribed under Section 385 will set forth factors that are to be taken into account in determining in a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. Under Section 385(b), those factors may include, among other factors, (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest; (2) whether there is subordination to or preference over any indebtedness of the corporation; (3) the ratio of debt to equity of the corporation; (4) whether there is convertibility into the stock of the corporation; and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question.

The proposed regulations exercise the authority granted by Section 385(a) to permit the IRS to treat a purported debt instrument issued between related parties as in part indebtedness and in part stock for federal tax purposes, because the Treasury Department and the IRS have determined that the interests of tax administration would best be served if the IRS were able to depart from the all-or-nothing approach where appropriate to ensure that the provisions of the Code are applied in a manner that clearly reflects the income of related taxpayers. Additionally, the Treasury Department and the IRS have determined that timely preparation of documentation and financial analysis evidencing four essential characteristics of indebtedness (described in the next sentence) are necessary factors in the characterization of a covered interest as indebtedness for federal tax purposes. Accordingly, the proposed regulations require (1) a legally binding obligation to pay, (2) creditors’ rights to enforce the obligation, (3) a reasonable expectation of repayment at the time the interest is created and (4) an ongoing relationship during the life of the interest consistent with arm’s-length relationships between unrelated debtors and creditors.

The Treasury Department and the IRS have identified transactions between affiliates that raise significant policy concerns. The proposed regulations treat as stock, subject to certain exceptions, related-party debt instruments issued in any of the following transactions: (1) distributions of debt instruments by corporations to their related corporate shareholders; (2) issuances of debt instruments by corporations in exchange for stock of an affiliate (including “hook stock” issued by their related corporate shareholders); (3) certain issuances of debt instruments as consideration in an exchange pursuant to an internal asset reorganization; and (4) a related-party debt instrument issued in a separate transaction to fund (a) a distribution of cash or other property to a related corporate shareholder, (b) an acquisition of affiliate stock from an affiliate or (c) certain acquisitions of property from an affiliate pursuant to an internal asset reorganization.

Regulations Address Post-Inversion Tax Avoidance Transactions
The Treasury Department has released temporary regulations (TD 9761) in order to limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. Treasury expects that the regulations “will prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition.” The regulations affect certain domestic corporations and domestic partnerships whose assets are directly or indirectly acquired by a foreign corporation and certain persons related to such domestic corporations and domestic partnerships. The text of the temporary regulations also serves as the text of the proposed regulations.

An inversion is generally a transaction that results in a domestic parent corporation of a multinational group being replaced with a foreign parent corporation. On Sept. 22, 2014, the Treasury Department and the IRS issued Notice 2014-52, 2014-42 I.R.B. 712, which announced the intention to issue regulations described therein to address certain transactions structured to avoid the purposes of Section 7874 and Treasury Regulations Section 1.367(a)-3(c) and certain post-inversion tax avoidance transactions. On Nov. 19, 2015, the Treasury Department and the IRS issued Notice 2015-79, 2015-49 I.R.B. 775, which announced the intention to issue regulations described therein to address certain additional transactions structured to avoid the purposes of Section 7874 and § 1.367(a)-3(c) and certain additional post-inversion tax avoidance transactions (see our prior coverage here).

The temporary regulations include the rules described in the two notices. In addition, the temporary regulations set forth the following new rules that address issues that were not discussed in either notice: (i) rules for identifying a foreign acquiring corporation when a domestic entity acquisition involves multiple steps; (ii) rules that disregard stock of the foreign acquiring corporation that is attributable to certain prior domestic entity acquisitions; (iii) rules that require a controlled foreign corporation (CFC) to recognize all realized gain upon certain transfers of assets described in Section 351 that shift the ownership of those assets to a related foreign person that is not a CFC; and (iv) rules clarifying the definition of group income for purposes of the substantial business activities test. The temporary regulations also contain the rules described in Notice 88-108, 1988-2 C.B. 445; Notice 2008-91, 2008-43 I.R.B. 1001; Notice 2009-10, 2009-5 I.R.B. 419; and Notice 2010-12, 2010-4 I.R.B. 326 concerning the short-term obligation exception from United States property for purposes of Section 956.

SIFMA Comments on Rules for Reporting Complex Debt and Dividend Equivalent Regulations
The Securities Industry and Financial Markets Association (SIFMA) submitted comments to the IRS regarding the reporting requirements for complex debt, expressing concern that the calculation of basis for complex debt instruments will be inconsistent, difficult or even impossible based on the information to which broker-dealers have access. SIFMA requested that the IRS consider providing exemptions from broker reporting obligations, safe harbors to facilitate compliance and a reasonable delay in the effective date for reporting on certain complex debt instruments until more detailed regulations can be promulgated. SIFMA also commented on final, temporary and proposed dividend equivalent regulations; addressed the implementation of the regulations; and requested that the IRS consider certain changes given the regulations’ novel and complex withholding regime and the impact that the regulations will have on the equity derivatives markets.

CRS Summarizes Financial Instruments Tax Proposals
The Congressional Research Service released a report that provides background on various high-frequency trading (HFT) strategies and some associated policy issues; recent regulatory developments and selected enforcement actions by the SEC and CFTC on HFT; and congressional action such as proposed legislation and hearings related to HFT. The report was issued in response to numerous bills that have been introduced in the 114th Congress that would tax financial instrument transactions; however, it is not certain whether the proposals would affect high-frequency trading involving the issuing and canceling of high numbers of bid orders.

IRS Rules on REIT Transactions for Like-Kind Exchange Purposes
In Private Letter Ruling 201614009, the IRS ruled that the receipt of boot in a like-kind exchange by a REIT does not convert the exchange to a sale for purposes of the prohibited transaction rules under Section 857(b)(6). However, to the extent that gain is recognized by a REIT on boot received as part of a like-kind exchange transaction, that portion of the transaction may be treated as a sale for purposes of Section 857(b)(6). Accordingly, to the extent that the taxpayer, a REIT, receives boot in the proposed transaction, only the same proportion of the adjusted basis of the relinquished property the boot bears to the total consideration received will be counted for purposes of determining whether the taxpayer exceeds the 10 percent rule in Section 857(b)(6)(C)(iii)(II). Further, to the extent that the taxpayer receives boot in the proposed transaction, only the same proportion of fair market value of the relinquished property the boot bears to total consideration received will be counted for purposes of the 10 percent rule in Section 857(b)(6)(C)(iii)(III).

Income From Oil and Gas Activities Is Qualifying Income
In Private Letter Ruling 201614004, the IRS ruled that income derived, directly or indirectly, by a publicly traded partnership from transportation of oil and gas, natural gas parking, and delivery and transportation of water will constitute qualifying income under Section 7704(d)(1)(E). Additionally, income from certain hedging activities will constitute qualifying income within the meaning of Section 704(d)(1) and Treasury Regulations Section 1.7704-3(a)(1).

Interests Will Be Considered Obligations in Registered Form
In Private Letter Ruling 201614026, the IRS ruled that the interests in a partnership are similar evidence of interest in a similar pooled fund within the meaning of Section 1.163-5T(d)(1) and that if the requirements of Section 5f.103-1(c)(1) are satisfied, the interests in the partnership will be considered obligations in registered form.

ICI Submits Letter to Treasury Regarding EU Reclaims
The Investment Company Institute submitted a letter to Treasury and the IRS requesting modifications to Notice 2016-10 (see our prior coverage here). The ICI requested, in part, that RICs be permitted to carry forward the amount of any refunded taxes that cannot be offset in the year refunded, that netting be permitted for RICs that are held predominantly by insurance companies and that guidance be issued to standardize the terms of any required closing agreements.

U.S. FATCA IGA Competent Authority Arrangements Available
The following competent authorities have signed arrangements to implement FATCA:

IRS Releases Practice Unit on Transfer Pricing Adjustments
The IRS made available its international practice unit on the three requirements that must be met under Section 482 before the IRS may make allocations to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the evasion of taxes.

Senate Panel Releases Report on Various Tax Treaty Protocols
The Senate Foreign Relations Committee has released several reports regarding the following:

  • The proposed protocols to the U.S. income tax treaties with Switzerland, Spain, Japan and Luxembourg.
  • The proposed U.S. income tax treaties with Poland, Chile and Hungary.
  • The proposed protocol to the Convention on Mutual Administrative Assistance in Tax Matters.

New York City Releases Memorandum for Corporations and Banks on New Business Corporation Tax
The New York City Department of Finance released a Finance Memorandum related to the new corporate tax that applies to corporations and banks, other than federal S corporations, that do business, employ capital, own or lease property, or maintain an office in New York City. The new tax is set forth in Subchapter 3-A of Chapter 6 of Title 11 of the Administrative Code of the City of New York and the Department of Finance. The Finance Memorandum provides background on the new forms that will be used, explains penalty relief for underpayments of estimated tax installments due for the 2015 tax year and provides general information about the reasonable cause exception to other penalties that may be incurred in the 2015 tax year.

Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

Copyright © 2016 Stradley Ronon Stevens & Young, LLP. All rights reserved.

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