Potential State Tax Consequences of the Final and Temporary IRC Section 385 Regulations
On October 13, 2016, the United States Department of Treasury and Internal Revenue Service issued final and temporary regulations under Internal Revenue Code (“IRC”) Section 385 (the “Section 385 regulations”). The Section 385 regulations narrow the proposed regulations that were issued on April 4, 2016, yet retain the targeted transactions and funding rule, extend the period of time to comply with the regulations’ documentation and financial analysis requirements, exclude certain short-term cash pooling arrangements, and make other changes to the proposed regulations. For a discussion of the potential state tax consequences of the proposed regulations issued in April, see the BDO SALT Alert
. Based on the various ways in which states conform to the IRC and Treasury Regulations for purposes of state income tax, including the federal consolidated return regulations, the Section 385 regulations could have material consequences for state corporate income tax (and possibly other state and local tax) purposes.
The Section 385 regulations are effective October 21, 2016, the publication date, and apply to taxable years ending on or after the date that is 90 days after the publication date or January 19, 2017. However, the documentation requirements of the Section 385 regulations (see below) do not apply to debt instruments issued (or deemed issued) prior to January 1, 2018. Nonetheless, a number of transition rules could result in earlier application for some taxpayers.
The Recast Rules in Treas. Reg. §§ 1.385-3 and 1.385-3T (see, “Targeted Transactions and Funding Rule,” below) grandfather debt instruments issued before April 5, 2016 (rather than before April 4, 2016, as was provided in the proposed regulations.) In addition, Treas. Reg. § 1.385-3(b)(3))(viii) also grandfathers distributions and acquisitions occurring before April 5, 2016, for purposes of applying the Funding Rule (see below).
Debt instruments that are issued between April 5, 2016, and 90 days after the publication date (January 19, 2017) that would be re-characterized as stock under the Recast Rules are deemed to be exchanged for stock immediately after the date that is 90 days after the publication date (January 19, 2017).
Overview of Section 385 Regulations
What follows addresses a few of the notable features of the Section 385 regulations that could have state corporate income tax consequences. It is important to understand that the following only highlights certain features of the Section 385 regulations and does not address all of the myriad complex provisions, ordering rules, transition rules, and operating rules of these regulations.
- “Covered Member” and “Expanded Group”
In general, the Section 385 regulations will, in certain situations, reclassify intercompany financing arrangements as stock, not debt, and thereby re-characterize any corresponding interest payments as non-deductible distributions for federal income tax purposes. The regulations will apply to debt instruments issued by a “covered member” (defined to include only a domestic U.S. corporation) to another member of the covered member’s “expanded group.” An expanded group generally means a group of related U.S. and non-U.S. corporations that satisfy an 80 percent vote or value test, as long as the common parent is not a S corporation, real estate investment trust (“REIT”), or regulated investment company (“RIC”). Unlike the earlier proposed regulations, the Section 385 regulations currently do not apply to foreign (non-U.S.) issuers of intercompany debt instruments, including controlled foreign corporations (“CFC”). S corporations and non-controlled RICs and REITs are also excluded from being a member of an expanded group.
- Documentation Requirements
Under Treas. Reg. § 1.385-2, a debt instrument issued by a covered member to another member of the expanded group will have to satisfy contemporaneous documentation requirements for the debt to be treated as such and not as stock. However, these requirements only apply if (1) the stock of at least one member of the expanded group is traded on an established financial market, as defined in Treas. Reg. § 1.1092(d)-1(b); (2) the expanded group has total assets in separate or consolidated financial statements that exceeds $100 million; or (3) the expanded group has annual total revenue in separate or consolidated financial statements that exceeds $50 million. Further, at least for federal tax purposes, the documentation requirements do not apply to an “intercompany obligation,” as defined in Treas. Reg. § 1.1502-13(g)(2)(ii), or to intercompany debt issued by one member of a federal consolidated group to another member, but only for the period during which both parties are members of the same consolidated group.
If applicable, the written documentation must demonstrate that (a) the covered member issuer has an unconditional obligation to repay a sum certain, (b) the holder of the debt instrument has the rights of a creditor that are not subordinated to rights of shareholders (e.g., ability to enforce payment, ability to trigger an event of default or acceleration of payment, etc.), (c) there must be a reasonable expectation of repayment as of the date of issuance based on the issuer’s financial position, and (d) there are actions evidencing a debtor-creditor relationship (e.g., actual payments of principal and interest evidenced by wire transfer records, bank statements, as well as journal entries in a centralized cash management system or accounting system of the expanded group). There are a number of special documentation rules applicable to revolvers, master and cash pooling arrangements, and other certain types of intercompany financing arrangements. In addition, with respect to exercising its rights as a creditor, if principal or interest is not paid when due, there must be written documentation that the related party holder reasonably exercised the diligence and judgment of a creditor and, if rights to enforce payment were not exercised, there must be written documentation that supports the holder’s actions to not enforce payment that are consistent with the reasonable exercise of the diligence and judgment of a creditor. If all documentation requirements are satisfied, and the covered member’s debt instrument issued to another member of the expanded group satisfies the federal common law requirements to be treated as debt for federal tax purposes, then the debt instrument will be respected as debt, and not stock, for federal income tax purposes.
The Section 385 regulations relax the timely preparation requirement of the required documentation. Under the proposed regulations, the documentation of the (1) issuer’s unconditional obligation to repay a sum certain, (2) creditor’s rights, and (3) reasonable expectation of repayment had to be prepared within 30 days of the relevant date (e.g., the issuance of the intercompany debt instrument) and the documentation of the actions evidencing a debtor-creditor relationship had to be prepared within 120 days after the relevant date to which the action relates (e.g., the date of payment of interest, the date of default, etc.). The Section 385 regulations require that documentation be prepared by the date the covered member issuer’s federal income tax return (including extensions) is filed for the tax year of the relevant date.
- Targeted Transactions and Funding Rule
Like the proposed regulations, Treas. Reg. §§ 1.385-3 and 1.385-3T set forth the Recast Rules aimed at three types of targeted intercompany financing arrangements that will be treated as stock, and not debt, regardless of satisfying the documentation requirements and the federal debt or equity case law: (1) debt instrument issued by a distribution from the covered member to another member of the expanded group; (2) debt instrument issued by a covered member to another member of the expanded group to acquire another expanded group member’s stock; and (3) debt instrument issued by a covered member to another member of the expanded group to acquire another expanded group member’s assets. Certain exceptions may apply.
Further, under the “funding rule,” a debt instrument that is not a qualified short-term debt instrument (as defined in Treas. Reg. § 1.385-3(b)(3)(vii)) is treated as stock if it is issued by a covered member to another member of the expanded group in exchange for property, and it is used to fund certain distributions or acquisitions of stock or assets. A “per se funding rule” applies if the issuance of the debt instrument occurs 36 months before or 36 months after the distribution or acquisition. As with the targeted transactions, certain exceptions may apply.
There is also an anti-abuse rule aimed at transactions with a “principal purpose of avoiding the purposes of” Treas. Reg. §§ 1.385-3 or 1.385-3T. The addition of a co-obligor on an intercompany debt instrument may come within the anti-abuse rule.
Although the Section 385 regulations generally do not apply the targeted transactions rules and the anti-abuse rule to debt instruments issued in a taxable year ending before January 19, 2017, certain transition rules could apply these rules to that prior taxable year. Likewise, although the funding rules generally do not apply to a debt instrument issued prior to April 5, 2016, certain transition rules need to be taken into account.
Among other exceptions and special rules, the Section 385 regulations have three notable exceptions that could present questions for state corporate income tax purposes:
The Potential State Tax Consequences
- “[S]olely for purposes of applying §§ 1.385-3 and 1.385-3T,” members of a federal consolidated group, as defined in Treas. Reg. § 1.1502-1(h), are treated as one corporation and the rules discussed above related to the three targeted intercompany financing arrangements and funding rule do not apply under this “one corporation” exception.
- Certain “qualified short-term debt instruments” issued as part of cash pooling and similar arrangements and that satisfy a number of specific requirements are also excluded from the target intercompany financing transactions, although the documentation requirements may still apply.
- The Section 385 regulations also apply an “expanded group earnings account” exception or reduction. That is, the aggregate amount of debt instruments issued by a covered member that are treated as stock under any of the three targeted transactions or the “funding rule” are reduced (i.e., at least a portion of the debt instrument is treated as debt) to the extent of the “expanded group earnings” of the covered member. While this exception was contained in the proposed regulations, only the current earnings of the covered member counted. With the Section 385 regulations, accumulated earnings of the covered member are included, but only those earnings accumulated by the covered member in a taxable year ending after April 4, 2016, for the period during which the covered member is a member of the expanded group with the same expanded group parent.
Almost every state having a corporate income tax begins the calculation of state taxable income with federal taxable income, either before or after federal net operating losses and special deductions. The state will then apply various addition and subtraction modifications to such federal taxable income related to various items of federal income, gain, loss, and deductions. The state will also conform to the Internal Revenue Code as of a specific date (“as in effect”), on a moving date basis (“as amended”), or will only conform to specifically adopted Internal Revenue Code sections. A state may also include Treasury Regulations as part of its conformity with the IRC, may conform to Treasury Regulations as long as they are consistent with other provisions of state tax law, or may be silent with respect to conformity to Treasury Regulations. The manner of a state’s conformity to the Internal Revenue Code will be an important consideration as a threshold matter when determining whether and how a state conforms to the Section 385 regulations.
More importantly, and especially for separate return states (but also for some unitary combined reporting and nexus consolidated return states), whether a state conforms to the federal consolidated return rules will be critical. For example, a number of separate return states specifically provide that an affiliate of a federal consolidated group filing a separate state return must determine its federal taxable income starting point “as if” the affiliate had filed a separate federal return. As discussed above, the “one corporation” exception is inapplicable if a federal consolidated return is not filed or if a covered member is not an affiliated member of a federal consolidated return group. As a result, if a state adopts or conforms to the Section 385 regulations, but is an “as if” state, the “one corporation” exception is applicable for federal tax purposes, but may not be for state corporate income tax purposes.
Likewise, the documentation requirements of the Section 385 regulations do not apply to an “intercompany obligation,” as defined in Treas. Reg. § 1.1502-13(g)(2)(ii) (or, based on the “one corporation” exception, intercompany debt issued by one member of the federal consolidated return group to another member). As a result, if a state does conform to the Section 385 regulations, but not the federal consolidated return regulations, taxpayers may be in a situation where the documentation requirements need not be followed for federal tax purposes, but they will apply for state tax purposes.
Moreover, the “expanded group earnings account” exception or reduction in the amount of a covered member’s intercompany debt that is re-cast as stock may be limited in application in these separate return and other states. For instance, the Section 385 regulations indicate that a federal consolidated group has one expanded group earnings account and that it is the current and accumulated (in a taxable year ending after April 4, 2016) earnings and profits of the common parent corporation. For a separate return state (and certain unitary combined reporting states, such as California), the current and accumulated earnings may have to be calculated on a separate entity basis.
The exclusion of S corporations from the Section 385 regulations may not apply at the state level. For example, a state such as Tennessee does not conform to the federal income tax treatment of S corporations (including qualified subchapter S subsidiaries) as pass-through entities (or disregarded entities) and treats them similar to federal C corporations for franchise and excise (income) tax purposes. It is unclear whether Tennessee or a similar state, if it conforms to the Section 385 regulations, would exclude an S corporation from its application of the regulations. Other states, such as New Jersey and New York, require a separate S election be made for state tax purposes. In the event such separate election is not made, the federal S corporation is treated as a C corporation for state tax purposes. Neither New Jersey nor New York conform to the federal consolidated return regulations, but if they do conform to the Section 385 regulations, the failure to make the separate state S election could have additional state tax consequences. Similarly, states such as Georgia that require nonresident shareholders to consent to state tax jurisdiction for the entity to be treated as an S corporation, could compound failures to file consents to jurisdiction if they conform to the Section 385 regulations.
If a state recasts intercompany debt as stock by conforming to the Section 385 regulations, the recast could also have net worth franchise tax implications. See, e.g., National Grid Holdings, Inc. v. Comm’r of Revenue,
No. 14-P-1662 (Mass. Ct. App., June 8, 2016) (effect of recast of intercompany debt under federal and state common law on the non-income measure of the Massachusetts excise tax). See the BDO SALT Alert
. Lastly, the recast of the payment of principal and interest as dividends could have consequences for both the payor and recipient of the recast dividend, including for the sales factor of a state’s apportionment formula.
- The Section 385 regulations are exceedingly complex and a determination of their applicability and effect for state corporate income tax purposes should proceed in conjunction with consultation with appropriate federal income tax advisors.
- Even if the Section 385 regulations do not have federal income tax consequences, they may independently have state income tax consequences both from a documentation and intercompany debt recast standpoint depending on how a state conforms to the Internal Revenue Code and Treasury Regulations, including the federal consolidated return regulations.
- There are a number of intercompany financing arrangements employed for state tax purposes that could be affected by the Section 385 regulations, including those specifically in response to state related party interest expense “addback” statutes, depending on a state’s conformity to the IRC and Treasury Regulations.
- Taxpayers affected by state income tax consequences of the Section 385 regulations should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures.
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