U.S. Inbound Investors: Beware of Harsh Debt Equity Rules
Proposed regulations issued by the IRS could have a detrimental impact on planned US inbound investments, converting funding planned as debt into equity. Something as simple as not properly documenting the funding as debt could result in its automatic classification as equity when the regulations are finalized. Once finalized, the rules could also convert debt to equity on certain transactions for related party debt issues after April 4, 2016. The IRS stated these proposed rules are on a fast track to being finalized, with a target date before the end of the year.
These regulations were issued mainly to target what the IRS considers to be abusive transactions and do not provide a great deal of guidance regarding the definition of debt versus equity. In fact, other than regulations that were withdrawn in 1980, these would be the first regulations covering Sec. 385 since the statute was enacted in 1969.
The Focus of the Proposed Regulations
There are three areas of focus being addressed by the proposed regulations:
- Ability for the IRS to bifurcate funding into debt and equity parts. In the past it was an all or nothing position. Often, taxpayers were able to sustain that at least part of the funding was debt, thus resulting in the entire amount being considered debt.
- Increased documentation required to support the debt characterization of funding. Analysis must be contemporaneous; failure to properly report can result in the entire amount being considered equity.
- Treating certain related party leveraging transactions as equity, especially when in connection with a distribution or acquisition transaction.
New Documentation Requirements
The documentation requirements may be the most problematic for inbound investors, especially those who are not used to dealing with IRS requirements on reporting and documentation. Prop. Reg. Sec. 1.385-2 includes documentation, timing and maintenance requirements related to the issuance of a debt instrument. Effectively, debt (referred to as an “expanded group instrument” (EGI)) will have to be evidenced by a more formal document than has normally been the case with related party debt. The requirements include:
- A written document prepared within 30 days of issuance.
- Establishment of holder’s rights to enforce obligation as a creditor.
- An analysis of ability to repay the debt under the terms of the agreement.
- Action evidencing debtor-creditor relationship that is documented within 120 days of an event.
These are the minimum requirements and satisfying them does not guarantee the instrument being classified as debt. However, failure to meet the requirements guarantees the instrument will be treated as stock.
It is not uncommon for a new US investor running a start-up operation in the US to be focused on transferring funds quickly to the US bank account to pay expenses and run the business. Only later on does the investor focus on the documentation that might be required under these proposed regulations.
Small Group Exception
There is a small group exemption from the documentation requirements related to groups where total assets do not exceed $100 million or revenues do not exceed $50 million. However, this is a test performed on an “Expanded Group” basis, so even though the US investment may be small, compliance would still be required if the group exceeds these thresholds. Also, only the documentation requirement might be avoided, not the other harsh impact of the regulations.
Having debt reclassified as equity has other impacts on a US taxpayer’s situation. The loss of an expense deduction will increase taxable income, requiring the payment of additional income tax. This will also result in possible differences in the amount of withholding tax on any interest payments that may have been made as they would now be classified as dividends, thereby potentially requiring amendments to the Form 1042 reporting. There is also the requirement to have the proper Form W-8BEN-E (or other W-8 series) on file and completed for the type of payments being made.
Careful planning, analysis and documentation will be required for US inbound investors in funding their US operations. For a checklist to help you meet the new documentation requirements click the button below.
James J. Miesowicz, CPA
Jim Miesowicz has significant experience in helping foreign-owned U.S. entities with a variety of inbound international issues and working with foreign nationals. He offers assistance with structuring international business operations and investments. Jim provides guidance with international inbound and outbound transactions, as well as assisting U.S. companies with establishing operations outside the U.S. Contact Jim at firstname.lastname@example.org or 248.244.3115.