Proposed debt-equity regulations—unintended state tax headache
In this edition of Inside Deloitte, the authors discuss several state tax issues raised by the proposed US Treasury regulations under Internal Revenue Code (IRC) section 385, including state conformity, the potential state tax issues that may arise for states with filing groups that differ from the federal affiliated group, and the potential issues for documentation of intercompany debt transactions for state tax purposes.
On April 8, 2016 the Internal Revenue Service (IRS) issued proposed Treasury regulations under Internal Revenue Code section 3851 that, if adopted in their current form,2 would have a wide-ranging impact on treasury operations, intercompany debt, federal income tax recharacterization of some debt as equity,3 and that would establish minimum documentation requirements that must be satisfied for intercompany debt instruments to be respected. For federal income tax purposes, the proposed regulations do not apply to debt between members of a group filing a consolidated federal return; however, the potential effect of the proposed regulations at the state income tax level is less clear. As this article shows, there may be potential unintended state tax impacts associated with domestic debt that exists between affiliates relative to some states’ partial conformity to the taxable income starting point, and a lack of conformity to the federal consolidated return rules (CRRs) and other state requirements to determine federal taxable income as if a separate return has been filed.
1 Prop. reg. section 1.385-1, et seq., 81 Fed. Reg. 20911 (Apr. 8, 2016).
2 References to the proposed regulations, as the context dictates (for example, to the date of conformity), are to the proposed regulations once adopted or published in final form.
3 The proposed regulations generally refer to the stock of a corporation and the equity of other entities such as partnerships. Notwithstanding the subtle differences that may exist between the terms, for this article we generally use the term ‘‘equity.’’
State Tax Issues in a Nutshell
As a general rule, the state tax effects resulting from new federal income tax legislation or IRS promulgations are not given significant consideration by Treasury. Accordingly, significant analysis is necessary to adequately gauge the scope of a state’s conformity to federal income tax law and the associated interpretations of those issues by a state revenue agency. The proposed regulations contain many provisions that could give rise to a wide-ranging application at the state level. This article considers several of the more significant potential implications.
The proposed regulations address whether a given debt instrument between related parties will be treated as debt, equity, or part-debt, part-equity.4 Debt issued in some transactions between related parties would be automatically recharacterized as equity, and intercompany debt instruments would generally be subject to strict documentation requirements that, if not satisfied, would also lead to automatic recharacterization as equity. The proposed regulations contain several exceptions, including but not limited to an exception for all debt instruments issued between members of an affiliated group of corporations filing a federal consolidated return. Even with those exceptions, the universe of affected debt instruments is expected to be vast.
4 The article does not attempt to address or concede the validity of the proposed regulations, if adopted.
If you have questions regarding this edition of Inside Deloitte, please contact:
Valerie Dickerson, partner, Deloitte Tax LLP
Scott Schiefelbein, senior manager, Deloitte Tax LLP
Alexis Morrison-Howe, senior manager, Deloitte Tax LLP
The authors thank Mike Porter, Dave Vistica, Mike Bryan, Michael Blinder, Tom Cornett, Christian Miller, Snowden Rives, Jeremy Sharp, and Doug Sweeney for their contributions to and review of this article.