Financing Across Borders - Osler, Hoskin & Harcourt · Effectivefordebt issuedonorafterApril4,2016 (or before that date via post-April 4, 2016 check-the box elections) Transactions

Financing Across Borders The Disruptive Impact of Section 385 Proposed

Regulations

1

June 7, 2016

The U.S. Treasury released new proposed intercompany debt

regulations on April 4, 2016 as part of an anti-inversion package

June 2016 2

Source: U.S. Treasury Press Release, 4/4/16

Osler, Hoskin & Harcourt LLP – New York Taxation

“We are taking action to curb the use of earnings-stripping

by focusing on transactions that generate large interest

deductions by simply transferring debt between

subsidiaries without financing new investment in the

United States.”- Jacob Lew, U.S. Treasury Secretary

Agenda

3June 2016Osler, Hoskin & Harcourt LLP – New York Taxation

I. Background

II. Overview of New Rules

III. Application of New Rules to Canadian Companies

IV.Other Disruptive Effects

V. Practical Takeaways

Background

June 2016 4Osler, Hoskin & Harcourt LLP – New York Taxation

Debt Equity• Interest deductions

• No U.S. withholding tax on interest paid to Canada (Treaty)

• Repayment of principal generally not subject to U.S. tax (for both borrower and lender)

• No deduction for dividends

• Dividends subject to 5% to 15% U.S. withholding tax to Canada (Treaty)

• Repayment of debt recharacterized as equity is frequently treated as a dividend in the related party context

Why the difference between debt and equity matters

Background


1. Intent of the parties2. Identity between creditors and shareholders3. Extent of participation in management by the holder of the instrument4. Ability of the corporation to obtain funds from outside sources5. The “thinness” of the capital structure in relation to debt6. The risk involved7. Formal indicia of the arrangement8. Relative position of the debtholder as to other creditors regarding the payment

of interest and principal9. Voting power of the holder of the instrument10. The provision of a fixed interest rate11. A contingency on the obligation to repay12. The source of the interest payments13. The presence or absence of a fixed maturity date14. A provision for redemption by the corporation15. A provision for redemption at the option of the holder16. The timing of the advance with reference to the organization of the corporation

Historical 16-factor test for distinguishing debt from equity

Overview of proposed rules

May 2016 6Osler, Hoskin & Harcourt LLP – New York Taxation

Expanded Group: An affiliated group as defined in Section 1504(a) with thefollowing modifications:

a) Includes foreign and tax-exempt corporationsb) Includes corporations held directly or indirectly (through application

of Section 304(c)(3))c) Modifies the ownership test to 80 percent vote or value (i.e., not vote

and value).

Downward attribution under Section 318(a)(3) can have unexpected results

Modified Expanded Group: determined in the same fashion as the Expanded Group, but with a 50% ownership threshold. Also includes 50% ownership of a partnership capital or profits interest and individuals with a 50% ownership in a MEG member.

Only applies for the purposes of the Bifurcation Rule

Expanded Group Instrument: An instrument between Expanded Groupmembers that is in the form of a debt obligation.

Applies for the Documentation and Bifurcation Rules



CanCo

US Co

Brazil Co

3rd Party Co

Japan JV Co

Sweden Co

49%

3rd Party Co

51%



Effective for debt issued after the regulations are finalized

Effective for debt issued on or after April 4, 2016 (or before that date via post-April 4, 2016 check-the box elections)

Transactions occurring prior to April 4, 2016 are not considered for the Funding Rule

Debt issued between April 4, 2016 and finalization will not be deemed equity until 90 days after the regulations are finalized.

• Documentation Rule

• Per Se Stock Rules

• Bifurcation RuleEffective for debt issued after the regulations are finalized

The “Bifurcation Rule” – Policy Concerns


Section 385 – Legislative History (1989):

“…there has been a tendency by the courts tocharacterize an instrument entirely as debt or entirely asequity.”

Preamble to Proposed Regulations (2016):

“No regulations have been promulgated under the [1989amendment], however, and this tendency by courts hascontinued to the present day … [t]his all-or-nothingapproach is particularly problematic in cases where thefacts and circumstances surrounding a purported debtinstrument provide only slightly more support forcharacterization, a situation that is increasingly commonin the related-party context”

The “Bifurcation Rule”


Bifurcation Rule: If, on the issue date, an instrument is properly treated as partly debt and partly stock, then it may be so treated by the Commissioner.

• Applies to instruments between Modified Expanded Group members (≥50% ownership)• This determination is made under “general federal tax principles”• Historically, an instrument has been characterized as entirely debt or entirely equity.

CanCo

USS

$100 Note Facts• USS is hopelessly in debt• On Jan 1, CanCo lends $100 to USS in exchange for a Note• On Jan 1, USS can only reasonably be expected to repay $60

+

_

The “Documentation Rule” – Policy Concerns



“Historically, the absence of clear guidance regarding thedocumentation and information necessary to support debtcharacterization in the related party context did not pose asignificant obstacle, because the transactions presented by [earlydebt-equity cases]…were not factually complex”.

“Increasingly, this is no longer the case. Over time, the TreasuryDepartment and IRS have observed that business practices,structures, and activities between related parties have changedconsiderably.”

“The lack of such guidance, combined with the sheer volume offinancial records taxpayers produce in the ordinary course ofbusiness, makes it difficult to identify the documents that willultimately be required to support such a characterization … suchthat forensic accounting expertise is required to isolate andevaluate relevant information. [T]he ability of the Commissionerto administer the Code efficiently with respect to related partyinterests is impeded.”

Past

Present

Future

The “Documentation Rule”


Small issuers excluded. This rule only applies to related party groups if:• Publicly traded company in the group; or• Any financial statement (consolidated or standalone) within the last three years shows:

• Total assets > $100m; or • Total revenue > $50m

Note: Reasonable cause exception

Documentation Rule: As a prerequisite to debt treatment, information documenting the following elements of debt must be kept on file and issued to the IRS on request:

Within 30 days of issuance Within 120 days of payments or a relevant event

• A legally binding obligation to pay a sum certain

• Typical creditor’s rights• The issuer’s ability to pay (financial

forecasts, cash flow projections)• Does the ability to refinance count?

• Debtor-creditor relationship• Evidence of interest & principal payments• Evidence of actions taken to enforce

creditor’s rights

The “Per Se Stock Rule” – Policy Concerns



“The Treasury Department and the IRS have identified three typesof transactions between affiliates that raise significant policyconcerns…”

Treasury and IRS appear to be concerned when related party debt is issued in transactions that exhibit the following 3 core characteristics:

1. No new operating capital is introduced to the “borrower”.2. The transaction is with a highly-affiliated entity and lacks meaningful non-tax

significance, particularly in relation to the significant federal tax benefits that are generated in the transaction.

3. The transaction does not change the ultimate ownership of the parties/assets involved

“Per Se Stock Rule”: General Rule


A debt instrument is treated as stock if it is issued by a corporation to a member of the corporation’s expanded group in the following “bad” transactions:

1

2

3

In a distribution;

In exchange for stock of a member of the same expanded group; or

In exchange for property in an asset reorganization.

“Per Se Stock Rule”: General Rule [Continued]


A debt instrument is treated as stock to the extent it is issued by a corporation to a member of the corporation’s expanded group in the following “bad” transactions:

2 In exchange for stock of a member of the same expanded group:

Public Canco

USS

1) USS Note for Cancostock

Facts• Public Canco wants to acquire UST as a sub in its

United States group in exchange for Canco shares• USS issues the USS Note to Public Canco in exchange

for Canco stock• USS immediately transfers the Canco stock to UST’s

shareholders in exchange for all of the UST stock.

Note: “Killer B” rules do not apply here.UST

Public

2) Cancostock for UST stock

+

_

“Per Se Stock Rule”: Funding Rule


The Funding Rule: The Funding Rule “addresses transactions that, when viewed together, present similar policy concerns as the transactions that are subject to the general rule” (Preamble). More specifically, the Funding Rule treats debt as stock if it has a principal purpose of funding one of the three “bad” transactions:

1

2

3

A distribution of cash or property on stock held by another group member

An acquisition of stock of a group member (other than an acquisition in an exempt exchange)

An acquisition of property from a group member in an asset reorganization

“Per Se Stock Rule”: Funding Rule [Continued]


The Per Se Funding Rule: There is a per se non-rebuttable presumption that an instrument is issued with a principal purpose of funding one of the “General Rule” transactions if it is issued within the 3 years before or after such a transaction.

Ordinary Course Exception: Instruments that arise in the ordinary course ofthe issuer’s trade or business in connection with the purchase of property orthe receipt of services are generally exempt from “per se” rule unless issuedwith an avoidance purpose. But note that preamble clarifies: “Thisexception…is not intended to apply to intercompany financing or treasurycenter activities or to capital expenditures”.

Note: Transactions occurring prior to April 4, 2016 are not considered for theFunding Rule (so we will be working with a truncated “look-back” perioduntil 2019).

EGIs issued during this time are caught by the per se rule

Date of funding transaction

-36 months

+36 months

Limited exceptions


Neither the General Rule northe Funding Rule apply withrespect to aggregatedistributions and acquisitionsthat do not exceed currentyear E&P of the issuercorporation.

Limited to current year E&P –does not take into account accumulated E&P

Neither the General Rule northe Funding Rule apply unlessthe aggregate issue price of allExpanded Group debt thatwould be recharacterized asequity under the Per Se StockRule exceeds $50 million.

This creates an avalanche of converted debt once the total amount reaches $50 million.

Acquisitions of affiliate stock arenot caught by the Funding Rule ifthe acquisition results from atransfer of property in exchangefor stock, and 50% of the voteand value of the affiliate areowned by the funded party for 3years following the issuance.

However, the 3-year limitationcan curtail the usefulness of thisexception.

1 2 3

Current year Earnings & Profits

Threshold ExceptionFunded subsidiary stock

issuance exception

The “Funding Rule” [Continued]


Consider a company with a large factory that creates widgets. The parent CanCo pays regular $100 dividends to shareholders, and the subsidiary US Co owns the factory assets. US Co has no current year E&P in any year.

In Year 3, the factory is destroyed and US Co needs a large $800 infusion of cash to rebuild.

EGIs issued during this time are caught by the per se rule

Year 3Funding

transaction

-36 months

+36 monthsCanCo

US Co

Year 3: $800 US Co Note for cash

Year 1-6: $100 cash distributions

Year 1-6: $100 dividends to SHs

$100 distribution

$100 distribution

$100 distribution

$100 distribution

$100 distribution

$800 note

Analysis• $600 of the USCo Note is treated as stock under the Per Se

Rule under the first prong of the Funding Rule. • $200 of the USCo Note is treated as debt, subject to any

further characterization under the Funding Rule in relation to dividends paid outside of the 72-month Per Se window.

+

_

$100 distribution

- Special documentation rules for revolvers/cash pooling

- Applies (currently) only to non-hybrid debt

385 Summary

May 2016 20Osler, Hoskin & Harcourt LLP – New York Taxation

Section 385 Proposed

Regulations

Per Se Rule

Documentation Rule

Bifurcation Rule

- Applies prospectively after 385 regs are finalized

- Lower threshold of relatedness (50%)

- Applies only to large issuers

- Applies prospectively after 385 regs are finalized

- Reasonable cause exception

- Applies to debt issued on or after April 4, 2016 (with transitional relief)

- Subsidiary stock issuance exception- $50m aggregate threshold- Current year E&P exception

- Ordinary Course Exception – ordinary course debt excepted from 72 month irrebutable presumption

- Applies (currently) only to non-hybrid debt


Examples

Application of new rules to Canadian companies


Ground Rules: Unless otherwise indicated, the following assumptions apply to the examples below:

1

2

3

All notes are financed or refinanced on or after April 4, 2016.

All entities have no current year earnings and profits.

All notes are issued in the form of debt for US federal income tax purposes.

4 The aggregate issue price of all intercompany debt that would be recharacterized as equity under the Per Se Stock Rule exceeds $50 million.

5 The transactions are not part of a plan and would not be stepped together under the Step Transaction Doctrine.

Example 1 – Luxembourg financing structure


CanCo

USCo

1) USCoNote

Facts• On June 7, 2016, the USCo Note is refinanced• In 2018, when USCo has no current E&P, it makes a

$100 distribution to CanCo

• What if USCo makes an upstream loan in lieu of a dividend?

• What if USCo has $50 of current E&P in 2018

LuxCo2) $100

Current Year E&P: $0Accumulated E&P: $100

+

_

Example 2 – Ordinary Rule Current E&P Exception


CanCo

USCo

1) $100 note distribution2) $100 cash distribution

Current Year E&P: $100

CanCo

USCo

1) $100 cash distribution2) $100 note distribution


Scenario A Scenario B

AnalysisUnder the Proposed Regulations, it appears that Scenario A is eligible for the current year E&P exception but Scenario B is not.

Example 3 – Multinational debt exceeds $50m threshold


CanCo

US CoUK Co 1 UK Co 2

$49m loan distribution

+

_

+

_

$5m SPA paid with a note

Facts• US Co distributes a $49m note to CanCo• UK Co 1 purchases all of UK Co 2 stock with a $5m note

Example 4 –Timing Rule


Facts• USCo borrows cash from LuxCo on June 1, Year 1• USCo repays that loan on June 7, Year 1• USCo spins out B sub to CanCo Dec 31, Year 1

• What if USCo spins out B sub on Jan 1 of Year 2?

CanCo

USCo

LuxCo

Loan to USCo

+

_

A Sub B Sub

Example 5 – Upstream loan


Facts• Public CanCo pays annual distributions to

shareholders• USCo has excess cash, so it loans cash to

CanCo• CanCo in turn makes a return of capital

distribution to Public Canco to fund this year’s distribution

Consequences: CanCo note is recharacterized as CanCo equity

• Repayment of CanCo Note at maturity is likely treated as a dividend to the extent of current and accumulated E&P of CanCo.

• Cascading issues

• What if USCo is financed via a repo instead of a LuxCo loan?

Public CanCo

CanCo

USCo

1) Loan

2) Distribution


+

_

LuxCo

+_

Loan to USCo

Example 6 – Employee compensation


Facts• Employees of USCo receive CanCo restricted

shares as part of their equity incentive plan• Under U.S. tax law, USCo is treated as if it

purchases CanCo shares with cash contributed to it by Canco (See Treas. Reg. 1.1032-3(b))

• What if USCo reimburses CanCo for the shares (e.g., via a recharge agreement)?

• What if USCo pays for CanCo shares with a note? Which debt of USCo would be recharacaterizedunder Section 385?

CanCo

USCo

LuxCo

Employees

1) CanCostock

2) CanCostock

+

_Loan to USCo

Example 7 – Third party acquisitions


FAIT

USCo

+

_

USCo note

UST

UST Shareholders

Cash

Facts• FAIT advances cash to USCo in exchange for

USCo note • USCo purchases UST shares for cash

FAIT

USCoUST

USCo note

+

_

UST Shareholders

Cash

Facts• FAIT purchases UST shares for cash • FAIT transfers UST shares to USCo in exchange

for USCO note (in a 304 transaction)

Example 8 – Prior distributions by acquired target


Facts• In year 1, while UKCo still owns Can T, Can T

pays a $100 distribution to UKCo• In year 2, USCo lends bridge acquisition

financing to Can AcquisitionCo• Can AcquisitionCo uses these funds to

purchase Can T• In Year 3, Can AcquisitionCo and Can T

amalgamate to form Amalco

• Does it matter whether the bridge acquisition financing is refinanced with 3rd party financing in Year 2 or Year 3?

USCo

Can Acquisition

Co

Can T

UKCoSeller

OpCo

Cash

Shares

+

_

Note

Example 9 – Cash pooling


Facts• CanCo uses Lux Finance Co as a treasury center heading a cash pooling arrangement for the group• In year 1, USCo borrows $100 from Lux Finance Co • In year 1, Sweden Co distributes $100 to CanCo• In year 3, USCo lends $75 to Lux Finance Co pursuant to a short term cash pooling arrangement• In year 3, Lux Finance Co lends $150 to Sweden Co pursuant to a short term cash pooling

arrangement• Assume that Lux Finance Co is a PFIC for U.S. tax purposes

CanCo

USCoLux

Finance CoSweden Co

$100 distribution

$75 loan

$150 loan

+

_+

_$100 loan

_+

Example 10 – Securitization


Facts

• Bank forms Securitization Vehicle which issues

investment grade notes to the public in a securitization transaction

• Bank acquires and holds some of Securitization

Vehicle’s notes because initially there is some difficulty in placing all the notes

• Securitization Vehicle makes a distribution to Bank

pursuant to the waterfall in the note indenture• Bank sells the notes to a third party investor

• What if one of the underwriters is related to the Bank?

Bank

Securitization

Vehicle

1) Notes

2) Distribution

3) Notes Public Noteholders+

+

_

Example 11 – FIRPTA


Facts• In year 1, FIRPTA Co 2 borrows $100 from LuxCo• In Year 2, FIRPTA Co 2 has $20 of current year E&P but makes a distribution to CanCo of $25• In Year 3, CanCo contributes FIRPTA Co 1 to FIRPTA Co 2 in exchange for common shares of FIRPTA

Co 2

CanCo

FIRPTA Co 2 LuxCoFIRPTA Co 1

$100 loan to FIRPTA Co 2

_ +

NIB Loan

Other Rules


• Consolidated group

• Partnerships

• Successor/Predecessor

• Anti-abuse rule

• No affirmative use

• Tax consequences of a deemed exchange

Other disruptive effects


• Creates preference for external debt

• LOB disqualification

• E&P relocation and basis tracing

• Uncertainty for taxpayers due to complexity

• Impacts normal business transactions (e.g., treasury center lending)

• Proliferation of hybrid instruments

• Deconsolidation?

• Increased compliance burdens (the preamble estimates an average annual

compliance burden per taxpayer of 35 hours!)

• Due diligence complications

• Complex tax reserve analysis

• And more…

Practical takeaways


1

2

3

Scope

Impact

Management

– The reach of these rules is extraordinarily long

– You should step back and assess the (obvious and not-so-obvious) ways in which these rules may apply to your organization

– The impact of these rules can be harsh

– You should assess the potential effects of these rules in your case and determine whether action is necessary

– These rules can, in many cases, be managed with focused coordinationbetween tax, treasury, and other internal functions. In more complexcases, more robust exceptions are required.

Documents

Financing Across Borders - Osler, Hoskin & Harcourt · Effectivefordebt issuedonorafterApril4,2016 (or before that date via post-April 4, 2016 check-the box elections) Transactions