David Forst, Jim Fuller
The Treasury and the IRS have proposed far-reaching new § 385 regulations. They were issued in the context of inversions, but their ramifications extend well beyond inversion-related earnings
Proposed Treas. Reg. § 1.385-2 sets forth important new documentation requirements. Contemporaneous documentation supporting the debt nature of a related-party instrument must be timely prepared and maintained for related-party debt to be treated as indebtedness for federal tax purposes. Without it, a taxpayer that is subject to the documentation requirements (below) cannot even argue that its debt instrument constitutes debt.
The documentation and financial analysis must support four central characteristics of indebtedness. Those characteristics are: a legally binding obligation to pay, creditor's rights to enforce the terms of the obligation, a reasonable expectation of repayment at the time the instrument is created and an ongoing debtor-creditor relationship during the life of the instrument.
The "binding obligation to repay" documentation evidence must be in the form of timely prepared written documentation executed by the parties.
The "creditor's rights to enforce terms" means that the taxpayer must establish that the creditor/holder has the legal rights to enforce the terms of the instrument. The proposed regulations provide examples of these rights, including the right to trigger a default and the right to accelerate payments. The creditor/holder must have superior rights to shareholders to share in the assets of the issuer in the event that the issuer is dissolved or liquidated.
The "reasonable expectation of repayment" means that the taxpayer must timely prepare documents evidencing a reasonable expectation that the issuer could in fact repay the amount of the purported loan. The proposed regulations provide examples of applicable documents, including cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity and other relevant financial ratios of the issuer (compared to industry averages). If a disregarded entity is the issuer and its owner has limited liability, only the assets and financial position of the disregarded entity are relevant.
The "genuine debtor-creditor relationship" requires taxpayers to prepare timely evidence of an ongoing debtor-creditor relationship. The documentation can take two forms. Issuers that complied with the terms of the instrument must include timely prepared documentation of any payments on which the taxpayer relies to establish debt treatment under general federal tax principles.
Issuers which failed to comply with the terms of the instrument, either by failing to make required payments or by otherwise suffering an event of default under the terms of the instrument, the documentation must include evidence of the holder's reasonable exercise of the diligence and judgment of a creditor.
The documentation must be prepared no later than 30 days after the date of the relevant event, which is either the date that the instrument becomes a related-party debt instrument or the date that an expanded group member becomes an issuer with respect to the instrument – generally the latter.
The proposed regulations authorise the IRS to treat an instrument issued in the form of debt between related parties (for this purpose, 50% of vote or value) as part debt and part equity, depending on the facts and taking into account general federal tax principles. For example, if the IRS's analysis supports a reasonable expectation that, as of the issuance of the instrument, only a portion of the principal amount will be repaid. The IRS determines that the instrument should be treated as debt only in part, the instrument may be treated as part debt and part equity.
Prop. Treas. Reg. §§ 1.385-3 and 1.385-4 provide rules that treat as stock certain instruments that otherwise would be treated as indebtedness for federal income tax purposes. The general rule treats an expanded group debt instrument (80% vote or value) as stock to the extent that it is issued by a corporation to a member of the corporation's expanded group (1) in a distribution; (2) an exchange for expanded group stock, other than an exempt exchange (as defined); or (3) in exchange for property in an asset reorganisation, but only to the extent that, pursuant to the plan of reorganisation, a shareholder that is a member of the issuer's expanded group immediately before the reorganisation receives the debt instrument with respect to its stock in the transferor corporation.
The term "distribution" is broadly defined as any distribution by a corporation to a member of the corporation's expanded group. Thus, a debt instrument issued in exchange for stock of the issuer of the debt instrument (that is, in a redemption) is a distribution.
The second provision, addressing debt instruments issued in exchange for expanded group stock, applies regardless of whether the expanded group stock is acquired from a shareholder of the issuer of the expanded group stock, or directly from the issuer. For purposes of this second provision, the term "exempt exchange" means an acquisition of expanded group stock in which a transferor and transferee of the stock are parties to a reorganisation that is an asset reorganisation in certain cases.
The third rule applies to asset reorganisations among corporations that are members of the same expanded group. Specifically, the third rule applies to a debt instrument issued in exchange for property but only to the extent that the shareholder that is a member of the issuer's expanded group receives the debt instrument with respect to its stock in the transferor corporation. This second step could be in the form of a distribution of the debt instrument to shareholders of the distributing corporation in a divisive asset reorganisation, or in redemption of the shareholder's stock in the transferor corporation in an acquisitive asset reorganisation. Because this rule only applies to a debt instrument that is received by a shareholder with respect to its stock in the transferor corporation, that debt instrument would, absent the application in Prop. Treas. Reg. § 1.385-3, be treated as "other property" within the meaning of § 356.
The funding rule treats as stock an expanded group debt instrument that is issued with a principal purpose of funding a transaction described in the general rule. Specifically, a principal purpose debt instrument is a debt instrument issued by a corporation (funded member) to another member of the funded member's expanded group in exchange for property with a principal purpose of funding:
1) a distribution of property by the funded member to a member of the funded member's expanded group, other than a distribution of stock pursuant to an asset reorganisation that is permitted to be received without the recognition of gain or income under § 354 or 355 or, when § 356 applies, that is not treated as "other property" or money described in § 356;
2) an acquisition of expanded group stock, other than in an exempt exchange, by the funded member from a member of the funded member's expanded group in exchange for property other than expanded group stock; or
3) the acquisition of property by the funded member in an asset reorganisation but only to the extent that, pursuant to the plan of reorganisation, a shareholder that is a member of the funded member's expanded group immediately before the reorganisation receives "other property" or money within the meaning of § 356 with respect to its stock in the transferor corporation.
The regulations are proposed to apply to any debt instrument issued on or after April 4, 2016 and to any debt instrument issued before that date but treated as issued after that date as a result of an entity classification election that is filed on or after that date. However, when provisions of the proposed regulations otherwise would treat a debt instrument as stock prior to the date of publication in the Federal Register of the Treasury Decision adopting these rules as final regulations, the debt instrument will be treated as indebtedness until the date that is 90 days after the date of publication in the Federal Register of the decision adopting the rule as final.
Guidant involves a group of US corporations that filed consolidated federal income tax returns (collectively, the "taxpayer"). During the years in issue, the taxpayer consummated transactions with its foreign affiliates including the licensing of intangibles, the purchase and sale of manufactured property, and the provision of services.
The IRS utilised § 482 to adjust the reported prices of the different transactions. The IRS asserted an adjustment to the taxpayer's income without making specific adjustments to any of the subsidiaries' separate taxable incomes. The IRS also did not make specific adjustments for each separate transaction, but rather asserted an aggregated transfer pricing adjustment.
The taxpayer filed a motion for partial summary judgment asserting that the IRS adjustments were arbitrary, capricious, and unreasonable as a matter of law since the IRS did not determine "true taxable income" of each controlled taxpayer as required under Treas. Reg. § 1.482-1(f)(iv) and did not make specific adjustments with respect to each transaction.
The court denied the taxpayer's motion stating that neither § 482 nor the regulations thereunder requires the IRS to determine the true taxable income of each separate controlled taxpayer within a consolidated group contemporaneously with the making of a § 482 adjustment. The court also held that the IRS is permitted to aggregate one or more related transactions instead of making specific adjustments with respect to each type of transaction.
While the court stated that Treas. Reg. § 1.482-1(f)(1)(iv) requires the IRS to determine both consolidated taxable income and separate taxable income when making a § 482 adjustment with respect to income reported on a consolidated return, the court held that as a matter of law the IRS can assert a § 482 adjustment before it determines the separate taxable income. The court stated that the regulation does not preclude the IRS from deferring making the separate taxable income determinations for each member until the time when such a determination is actually required.
The court stated that whether the IRS's decision to delay the separate-company taxable income computations constitutes an abuse of discretion under these circumstances is still in dispute and remains to be determined on the basis of the full record as developed at trial. Thus, the court did not conclusively hold that the IRS's § 482 adjustments were not arbitrary, capricious or unreasonable as a matter of fact. It only held that the IRS's § 482 adjustments were not arbitrary, capricious, or unreasonable as a matter of law.
The taxpayer also argued that the IRS's § 482 adjustments were arbitrary, capricious and unreasonable because the Service did not make separate adjustments for each transfer of intangible property, transfer of tangible property and provision of services. The applicable regulations in determining the arm's-length consideration aggregation is permitted if it serves as the most reliable means of determining the arm's length consideration for the transactions.
In a significant victory for the taxpayer, the Tax Court in Medtronic, Inc. v. Commissioner, T.C. Memo 2016-112, held that the IRS's transfer pricing adjustments (which amounted to almost $1.4 billion for the 2005 and 2006 tax years) were arbitrary, capricious, or unreasonable. The Tax Court's decision in Medtronic follows significant taxpayer victories in other § 482 cases, including Veritas v. Commissioner, 133 T.C. 297 (2009), nonacq., and Altera Corporation v. Commissioner, 145 T.C. 91 (2015).
The primary issue in Medtronic was whether income, related to certain inter-company licenses for intangible property required to manufacture medical devices and leads, should be reallocated under § 482 from Medtronic US to its Puerto Rican subsidiary (MPROC). Interestingly, the taxpayer and the IRS had reached an agreement on the royalty rates in a previous audit cycle, which resulted in a memorandum of understanding (MOU) between the parties regarding the royalties. However, after completing its examination of Medtronic's 2005 and 2006 returns, the IRS departed from the approach in the MOU and asserted a large royalty adjustment, which prompted Medtronic to then assert a refund based on its pre-MOU pricing.
Whereas the taxpayer in Medtronic applied the comparable uncontrolled transaction (CUT) method to determine the arm's length royalty rate on the intercompany sales, the IRS asserted that the comparable profits method (CPM) was the best method to determine the arm's-length royalty rates on intercompany sales. The IRS's position was based largely on its contention that MPROC performed only assembly of finished products, with Medtronic US performing all other economically significant functions.
The Tax Court rejected the IRS's use of the CPM method, as well as the IRS's characterisation of MPROC as providing only minimal contributions and functions. The Court stated that the commensurate-with-income standard under § 482 does not replace the arm's length standard, and that the IRS's use of CPM was therefore not required under the commensurate-with-income standard.
The Court ultimately found that the royalty rates charged for inter-company sales of devices and leads were not arm's length because certain adjustments were required to account for variations in profit potential. However, the Tax Court also appeared to criticise the IRS for adopting an 'all-or-nothing' approach by advocating a result based on the CPM using a value chain methodology, while refusing to suggest adjustments to Medtronic's CUT method for the devices and leads. Ultimately, the royalty rates determined by the Court appeared to generally fall in line with the royalty rates previously agreed to in the MOU.
Significantly, the Tax Court rejected the IRS's proposed aggregation of the transactions at issue, which would have treated MPROC as an ordinary contract manufacturer. Noting that the functions at issue in the covered transactions are able to exist independently, the Court determined that aggregation was not the most reliable means of determining arm's-length consideration for the controlled transactions.
The Tax Court also rejected the IRS's alternative argument that if a § 482 adjustment was not warranted, then Medtronic should be required to recognise a deemed royalty under § 367(d) for the transfer of intangible property by Medtronic US to MPROC. The Tax Court rejected this IRS alternative argument, stating that the IRS did not identify specific intangibles that were purportedly transferred from Medtronic US to MPROC.
Treasury and the IRS issued final regulations regarding country-by-country (CbC) reporting under BEPS Action 13. Treas. Reg. § 1.6038-4 generally incorporates the CbC report template proposed in BEPS Action 13. As such, the new reporting requirement would include reporting by a multinational group on income earned, headcount, taxes paid, and certain other economic indicators along with the location of the relevant economic activity. CbC reports would be required of U.S. parented multinational groups with $850 million or more in annual revenue.
The regulations take effect in the first tax year beginning on or after the date they were finalised. Thus, for calendar year taxpayers, they are effective beginning January 1 2017. The preamble states that the Treasury and the IRS have determined that the information required under the regulations will assist in better enforcement of the federal income tax laws by providing the IRS with greater transparency regarding operations and tax positions taken by US multinational groups. In addition to this direct benefit expected from collecting US CbC reports, pursuant to income tax conventions and other conventions and bilateral agreements relating to the exchange of tax information, a US CbC report filed with the IRS may be exchanged by the US with other tax jurisdictions in which the US multinational group operates that have agreed to provide the IRS with foreign CbC reports filed in their jurisdiction by foreign multinational corporate groups that have operations in the US.
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Alvarez & Marsal, Taxand USA offers various services, including federal, state and local tax, international tax, transfer pricing, controversy, and restructuring. Keith Kechik and Dan Rahill are managing partners of the firm's Chicago office. Rahill has more than 30 years of experience across sectors including consumer and industrial products, energy, manufacturing, retail distribution, alternative investment funds, professional services and family offices.
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Tom Driscoll is the US leader for international tax and TP. His fields of speciality are international tax and financial services taxation. Deloitte is a full-service firm and advises on all tax issues. In international tax, professionals help companies address their US outbound and inbound tax issues. With its 1,182 partners and 9,118 associates nationwide, Deloitte is one of the largest tax service firms in the US. The firm offers a number of resources such as newsletters and apps to help its clients stay on top of tax issues.
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Sharp Sorensen is a co-leader of the firm's national tax practice and is based in Chicago. He focuses on federal tax matters, representing domestic and foreign entities in various transactions such as M&A, spin-offs, securitisations and other asset-based financings, joint ventures, leveraged leasing and regulated investment companies.
Skadden, Arps, Slate, Meagher & Flom offers a variety of transactional, litigation and regulatory services to local, national and international clients. The office has been open since 1984 and offers a wide range of services to its clients. Brian Duve leads the practice and concentrates his practice on M&A, corporate finance and general corporate and securities matters.
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|Tier 1 - US: Chicago|
|Baker & McKenzie|
|Kirkland & Ellis|
|McDermott Will & Emery|
|Skadden, Arps, Slate, Meagher & Flom|
|Tier 2 - US: Chicago|
|Latham & Watkins|
|Winston & Strawn|
|Tier 3 - US: Chicago|
|Jenner & Block|
|Katten Muchin Rosenman|
|Tier 4 - US: Chicago|
|Alvarez & Marsal, Taxand USA|
|Neal, Gerber & Eisenberg|