Financing Across Borders - The Impact of the Final Section 385 Regulations

Osler Hoskin & Harcourt LLP

October 25-November 2, 2016

Financing Across BordersThe impact of the Final Section 385 Regulations

2

On October 13, 2016, the U.S. Treasury released final intercompany debt regulations that were first proposed on April 4, 2016

Source: Preamble to the finalized Section 385 Regulations

When the checks and balances of the market are removed, as they are when related corporations transact, there are often few practical economic or legal forces thatconstrain the choice between employing debt or equity.

In these circumstances, the financing choice thus can be determined solely on the basis of income tax considerations, which often favor debt. The absence of market forces operating among related corporations can, in addition to influencing internal financing decisions, create incentives for corporations that do not require financing to incur debt solely for tax-related reasons.

While [tax arbitrage opportunities using intra-group debt] have been a longstanding problem, their associated economic and revenue costs appear to haveincreased in recent years.

- U.S. Treasury

3

Agenda

I. Background

II. Overview of New Rules

III. Application of New Rules to Canadian Companies

IV. Practical Takeaways

4

Background

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

5

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

6

U.S. Treasury first proposed these regulations on April 4, 2016

Imposing documentation requirements as a prerequisite for debt treatment

Treat debt issued in three “bad” transactions as per se stock (the “general rule”)

Treat debt issued with a principal purpose of funding the “bad” transactions as per se stock (the “funding rule”)

Treat debt issued within a 6-year period of (the 3 years before or after) the “bad” transactions as per se stock (the “per se funding rule”)

• Documentation Rule

• Per Se Stock Rules

• Bifurcation Rule Commissioner may treat an instrument as partly debt and partly stock under “general federal tax principles”

7

Overview of the New Rules

Source: Preamble to the finalized Section 385 Regulations

“Many of the comments expressed concern that the proposed regulations would impose compliance burdens and result in collateral consequences that were not justified by the stated policy objectives of the proposed regulations.

In response to the comments received, the final and temporary regulations substantially revise the proposed regulations to achieve a better balance between minimizing the burdens imposed on taxpayers and fulfilling the important policy objectives of the proposed regulations.” - U.S. Treasury

8

Comparison to April 4, 2016 proposed regulations

Bifurcation RuleThe bifurcation rule has been removed

Foreign IssuersDebt issued by non-U.S. issuers is generally excluded

Per Se Stock Rule Exceptions & Exclusions• New “short-term debt exception” from the funding rule• Expanded the earnings and profits exclusion• New “qualified contribution” reduction rule• Removal of the cliff effect from the $50 million exception• Added specific carve-outs for certain transactions

Exclusion for Financial InstitutionsThe per se stock rule no longer applies to certain highly regulated financial companies on the basis that these companies are already subject to regulatory scrutiny

Documentation Rule (timing)• Extended the period for “timely”

prepared documentation• Only applies to debt instruments issued

on or after 1/1/18

Per Se Stock RuleThe basic architecture of the per se stock rule (including the per se funding rule) remains intact

Documentation RuleDocumentation requirement remains a general prerequisite for debt treatment

Rules that are new or were significantly modified

Rules that were left largely unchanged

9

Foundational Concepts

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

a) Includes corporations held directly or indirectly (through application of modified Section 318(a) rules)

b) Modifies the ownership test to 80 percent vote or value (i.e., not vote and value).

Covered Member: Any member of an Expanded Group that is a domestic U.S. corporation.

Debt Instrument: Any interest that would be treated as a debt instrument under Section 1275, but for the 385 regulations.

Covered Debt Instrument: A Debt Instrument issued after April 4, 2016 that is issued by a Covered Member that is not an excepted regulated financial company or a regulated insurance company. Exclusions:

a) Qualified dealer debt instrument – A debt instrument issued to or acquired by an expanded group member that is a dealer in securities in the ordinary course of its business (and to the extent that certain other requirements are met).

b) Excluded statutory or regulatory debt instrument – Various instruments expressly treated as debt under the Code (e.g., Section 636 production payments)

10

Foundational Concepts [continued]

Excepted Regulated Financial Company: Among the 17 enumerated inclusions:• A regulated bank holding company• A national bank• An insured depository institution

Controlled Partnerships: Treated as aggregates under the final rules.

Deemed Transfer: Occurs pursuant to which an Expanded Group lender is deemed to transfer debt to the actual partner, matching income and deductions.

• A registered broker or dealer• A swap dealer• A small business investment company.

Also includes expanded group subsidiaries of such entities.

11

Foundational Concepts

Is the issuer a U.S. corporation issuing the debt instrument to an EG member?

Common Law Debt/Equity

Analysis

Documentation Rule

Common Law Debt/Equity

Analysis

Per Se Analysis

Yes

No

1 2 3

12

The “Documentation Rule” – Policy Concerns

• Timely documentation requirements are too stringent and "impossible to satisfy without an expense to taxpayers far in excess of any benefit to be achieved“

• Per se stock treatment is "too harsh"; the penalty of mandatory stock treatment "would often be substantially disproportionate to the failure to comply“

• Broader exemptions requested for debt that "lacks earnings-stripping potential"

“The lack of… guidance, combined with the sheer volume of financial records taxpayers produce in the ordinary course of business, makes it difficult to identify the documents that will ultimately be required to support such a characterization … such that forensic accounting expertise is required to isolate and evaluate relevant information. [T]he ability of the Commissioner to administer the Code efficiently with respect to related party interests is impeded.”

Proposed Preamble

Comments

Final Preamble

“The Treasury Department and the IRS have determined that the [Documentation Rules] further important tax administration purposes. Moreover, the Treasury Department and IRS have determined that the presence or absence of documentation evidencing the four indebtedness factors is more than a ministerial issue to be policed with a fine or penalty. These factors are substantive evidence of the intent to characterize [debt instrument] as indebtedness for federal tax purposes”.

13

The “Documentation Rule”

Documentation Rule: If an "expanded group instrument" (EGI) does not comply with the documentation requirements of 1.385-2 within provided time limits, then, unless an exception applies, the EGI will be treated as stock for all U.S. federal income tax purposes.

Key Scoping Concepts:1. Foreign Issuers excluded

• "EGI" is an instrument issued in the form of debt (and certain intercompany payables/receivables that are recorded as debt in intercompany accounts) that is issued by a member of the EG and held by another member of the EG or a "controlled partnership".

• An EGI is subject to the Documentation Rule only if it is issued by a "Covered Member" (i.e., a U.S. corporation).

2. Small Issuers excluded• This rule only applies to related party groups if a publicly traded company is in the group; or if any

financial statement (consolidated or standalone) within the last three years shows:• Total assets > $100m; or• Total revenue > $50m

3. Hybrid instruments reserved• i.e. instruments not issued in the form of debt, such as repos.

4. Delayed effective date• Applies to debt instruments issued (or deemed issued) on or after 1/1/2018.

14

The “Documentation Rule” – What needs to be Documented?Taxpayer must prepare and maintain documentation evidencing the following "factors":

1. An unconditional obligation to pay a sum certain• Generally satisfied with documentation of the arrangement in debt "form" payable on demand or one

or more fixed dates.• One writing may support multiple EGIs (e.g., a revolver, cash pool agreement, omnibus agreement)

subject to prescribed requirements.

2. Creditor's Rights• Typically include right to trigger an EOD, acceleration for non-payment. • Local law rights may be taken into account.

3. Reasonable expectation of ability to repay• Must establish that "issuer's financial position supported a reasonable expectation that the issuer

intended to, and would be able to, meet its obligations pursuant to the terms" of the instrument; ability to refinance now clearly taken into account.

• Taxpayer may perform an "annual credit analysis" to support multiple EGIs (subject to limitations).

4. Actions evidencing debtor-creditor relationship• Must document payments of interest and principal. • If there is any EOD on the debt, must document evidence of the holder's "reasonable exercise of the

diligence and judgment of a creditor”.• If the holder refrains from enforcing creditor rights, must produce evidence to support that decision as

being consistent with the reasonable exercise of the diligence and judgment of a creditor.

15

The “Documentation Rule” – Deadlines Relaxed

Under the proposed regulations, taxpayers were subject to very strict 30-day or 45-day deadlines for satisfying the documentation requirements.

The Final Regulations significantly ease these timing constraints.

Issuer's U.S. Federal Income Tax Return• Under the final regulations, documentation is treated as prepared on a timely basis

if it is in place no later than the time for filing the issuers tax return (including extensions) for the taxable year (that includes the "relevant date“).

• In general a "relevant date" includes the date of issuance, the date of certain deemed re-issuances, the date a debt instrument becomes an EGI subsequent to its issuance, and the date of an EOD.

16

The “Documentation Rule” – Exceptions/Relaxation

The following exceptions from Per Se treatment are available:

1. Highly Compliant Taxpayers• If an EGI issued by a covered member would otherwise be treated as stock under the Per Se rule but

the taxpayer shows that the EG is "highly compliant" with the documentation requirements, then the EGI is not automatically treated as stock – instead, the EGI is presumed, subject to rebuttal, to be stock.

• Presumption may be rebutted if taxpayer "clearly establishes that there are sufficient common law factors present to treat the EGI as indebtedness…"

• An EG is highly compliant if for a taxable year if:• The average "issue price" of all "undocumented EGIs" is less than 10% to total issue price of all

EGIS outstanding (tested quarterly); or• If no undocumented EGI has an issue price in excess of (a) $100M, the total number of

undocumented EGIs is less than 5% of the total number of all EGIS outstanding (tested quarterly), or (b) $25M, the total number of undocumented EGIS is less than10% of the total number of all EGIs outstanding.

• For purposes of these tests, only count EGIs issued by a U.S. corporation.

2. Reasonable Cause• If noncompliance is attributable to a reasonable cause, such failure will not be taken into account

under the Documentation Rule.

3. Taxpayer Discovery and Remedy of Ministerial or non-Material Failure or Error• Protection against foot faults if detected by taxpayer.

17

The “Per Se Stock Rule” – Policy Concerns

Preamble to Final Regulations (2016):

“Comments requested that proposed §1.385-3 be withdrawn or thoroughly reconsidered before being finalized…the Treasury Department and the IRS decline to adopt the alternative approaches suggested by comments and have determined that the general approach of proposed §1.385-3, including the per se funding rule, should be retained. However, based on comments received, the Treasury Department and the IRS have determined that it is appropriate to make significant modifications to the scope…”

“…the final and temporary regulations are more narrowly focused on purported debt instruments that do not finance new investment. The Treasury Department and the IRS have determined that, when this factor, along with the relatedness factor, is present, the purported debt instrument should be treated as stock without regard to whether the issuer is over leveraged…”

18

“Per Se Stock Rule”: General Rule

A covered debt instrument is treated as stock if it is issued by a U.S. corporation to a member of the U.S. 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.

Items 2 and 3 are included as “bad” transactions because the IRS and Treasury are of the view that they can operate “…as a device to convert what otherwise would be a distribution into a sale or exchange transaction without having any meaningful non-tax effects”.

In response to very strong public comment pushback on these comments, the IRS and Treasury noted that they “continue to view the transactions described in [2 and 3 above] as sufficiently economically similar to distributions such that they should be subject to the same rules….”.

19

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

A covered debt instrument is treated as stock to the extent it is issued by a U.S. corporation to a member of the U.S. 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 Canco stock

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

Public2) Canco stock for UST stock

+

_

20

“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” (Proposed Regs Preamble). More specifically, the Funding Rule treats debt as stock if it is treated as funding one of the three “bad” transactions under the “per se funding rule” or the “principal purpose rule”:

1

2

3

A distribution of cash or property on stock held by another group member (other than in an exempt distribution)

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

21

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

Public Comments related to the funding rule were highly critical. The following soundbites were taken from the Final Preamble:

“…comments recommended that the regulations adopt a tracing approach to connect a funding with a distribution or acquisition…

[m]ultiple comments suggested eliminating the per se funding rule entirely…”

Entirely Replace the Per Se Rule

“The Treasury Department and the IRS continue to be of the view that, because money is fungible, an objective rule is an appropriate way to attribute a distribution or acquisition, in whole or in part, to a funding…..[m]ore fundamentally, however, because money is fungible, a taxpayer’s particular purpose for a particular borrowing is largely meaningless.”

“In adopting a per se funding rule based on the fungibility of money, the Treasury Department and IRS recognize that all outstanding debt, regardless of how much time has transpired between the issuance and the distribution or acquisition, could be treated as funding a distribution or acquisition.”

Taxpayers’ purposes are meaningless Fungibility of money

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

The Per Se Funding Rule: An instrument issued within the 3 years before or after one of the “General Rule” transactions is treated as funding such transaction for purposes of the Funding Rule. This was originally formulated as a “non-rebuttable presumption” in the proposed regulations.

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

Date of funding transaction

-36 months

+36 months

Note: Transactions occurring prior to April 5, 2016 are not considered for the Funding Rule (so we will be working with a truncated “look-back” period until 2019).

22

The Principal Purpose Rule: An instrument issued outside the per se period is treated as a “bad transaction” if it is issued with a principal purpose of funding such transaction.

23

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

• The 72-month non-rebuttable presumption (the formulation of the per se funding rule in the proposed regulations) attracted particularly scathing reviews from public commentators.

• Despite this harsh reception, the preamble concludes that “…the Treasury Department and the IRS have determined that, because money is fungible, an objective set of rules using a fixed time period and various stacking rules is the most administrable approach to determine whether a debt instrument funded a distribution or acquisition.

• The IRS noted that, most of the comments requesting a shorter testing period were focused on compliance burdens. In response to this the IRS belies that the combined effect of:

• The additional of numerous exceptions (including an exception for short-term debt instruments”• An enhanced E&P exception• Allowing certain capital contributions to be taken into account

Will have an effect that will “substantially narrow” the scope of this rule and focus it more sharply on non-ordinary course debt instruments and extraordinary distributions and acquisitions.

• IRS and Treasury believe that the 72 month testing period “is a reasonable testing period that appropriately balances the need for an administrable rule and the fact that transactions involving indebtedness are inextricably linked due to the fungibility of money.”

24

Qualified short-term debt exception

1

2

3

Ordinary course loans

Interest-free loans

Deposits with a qualified cash pool header

4

5

270-Day Test

Specified Current Assets Test

Qualified short-term debt exception: The following debt instruments are excluded from the Funding Rule.

25


1

2

3


Interest-free loans


4

5

270-Day Test


Instruments issued as consideration for the acquisition of property other than money in the ordinary course of the issuer’s trade or business and that are reasonably expected to be repaid within 120 days of issuance.

26


1

2

3


Interest-free loans


4

5

270-Day Test


Interest-free loans that do not have OID and do not (and are not required to have) imputed interest under Sections 483, 7872 and 482.

This category is limited in application because most loans are subject to imputed interest rules.

27


1

2

3


Interest-free loans


4

5

270-Day Test


A demand deposit received by a qualified cash pool header pursuant to a cash-management arrangement.

A “qualified cash pool header” is a member of the EG (or certain others) that has as a principal purpose managing a cash management arrangement for participating EG members, and maintains deposits in excess of loans to participating EG members. Limitations apply to what the qualified cash pool header may do with any excess cash.

The “principal purpose” test may preclude entities that perform other functions

28


1

2

3


Interest-free loans


4

5

270-Day Test


Loans issued with an at-the-market or below-the-market interest rate pursuant to a revolving credit agreement (or with a term no longer than 270 days), provided that the issuer is a net borrower for no more than 270 days during the taxable year (or 270 consecutive days over consecutive tax years).

The determination of “net borrower” position excludes ordinary course and interest-free loans

Inadvertent failure to satisfy the 270-day test may be disregarded if taxpayer maintains written due diligence procedure to prevent such failures.

29


1

2

3


Interest-free loans


4

5

270-Day Test


Loans issued with an at-the-market or below-the-market interest rate, but only to the extent (together with any ordinary course, interest-free or 270-day loans) not exceeding the amount expected to be necessary to finance short-term financing needs during the course of the issuer’s normal operating cycle.

Short-term financing needs calculated by reference to the maximum “specified current assets” (assets reasonably expected to be realized in cash or sold in the ordinary course of business) amount expected to be reflected on the balance sheet during the subsequent 90-day period (or, if longer, the issuer’s normal operating cycle).

30

Exceptions to the Per Se Stock Rule

Osler, Hoskin & Harcourt LLP – New York | Taxation

Acquisitions of affiliate stock are not caught by the Per Se Stock Rule if the acquisition results from a transfer of property in exchange for stock, and 50% of the vote and value of the affiliate from whom the stock was acquired are owned by the funded party for 3 years following the issuance (or if presumption to relinquish control rebutted).

Acquisitions of expanded group stock are not caught by the Per Se Stock Rule if such stock is delivered to employees, directors, or independent contractors as consideration for services rendered to a member of the expanded group.

Distributions or acquisitions deemed to occur under transfer pricing adjustments pursuant to Section 1.482-1(g) are not caught by the Funding Rule.

1 Funded Subsidiary and Other Exclusions50% Subsidiary Stock Compensatory Stock Acquisitions Transfer Pricing Adjustments

Acquisitions of expanded group stock by a dealer in securities operating in the ordinary course of the dealer’s business of dealing in securities are not caught by the Per Se Stock Rule, if:• The dealer accounts for the stock as securities held primarily for sale to

customers in the ordinary course of business• The dealer disposes of the stock within a period of time consistent with

holding the stock for the ordinary course of business• The dealer does not sell or transfer the stock to a person in the same

expanded group, other than in a sale that in turn satisfies this “Securities Dealer” exception

Securities DealerCertain deemed acquisitions of expanded group stock that would result in a “cascading” set of recharacterizations are not caught by the Funding Rule, provided that they are not part of a plan to prevent the application of the Funding Rule.

Anti-Cascade Rules

31

Exceptions to the Per Se Stock Rule [Continued]

The amount of “bad” transactions under the Per Se Stock Rule is reduced by the earnings and profits of the covered member accumulated in taxable years ending after April 4, 2016 and certain capital contributions of property to the covered member in exchange for stock made during the applicable per se period.

Certain exceptions and limitations apply to the calculation of earnings, including in the case of a change of control of the covered member. This would require that corporations keep an “expanded group earnings account” that is separate from its normal U.S. tax E&P calculations.

Qualified contributions must have the effect of increasing the capital and aggregate fair market value of the covered member. There is an extensive list of excluded property.

The Per Se Stock Rule does not apply to the extent that the aggregate issue price of all Expanded Group debt that would be recharacterized as equity under the Per Se Stock Rule does not exceed $50 million. If the $50m threshold exceeded, only the excess would be treated as stock.

“Cliff” effect removed. This exception may help address de minimis inadvertent errors.

2 3Reductions for Expanded Group Earnings and Qualified Contributions

Threshold Exception

32

- Special documentation rules for revolvers/cash pooling

385 Summary

Section 385 Final and

Temporary Regulations

Per Se Rule

Documentation Rule

- Applies only to large issuers

- Applies to debt issued on or after Jan 1, 2018

- Rebuttable presumption for “highly compliant” taxpayers

- Applies (currently) only to non-hybrid debt

- Qualified short-term debt exception (Temp)- Subsidiary stock issuance and other exclusions- Reductions for post-April 4 earnings and profits and certain qualified contributions- $50m threshold exception for all expanded group debt- Applies to debt issued on or after April 5, 2016- Transitional relief – tainted debt is not recharacterized until 1/19/2017

33

385 in the International Context

385 and U.S. Tax Treaties• Limitation on Benefits (LOB) considerations• Article X (Dividends) considerations• Article IX (Associated Enterprises) considerations

385 and BEPS• Action Item 4 (Limiting Base Erosion Involving Interest

Deductions and other Financial Payments)• Action Item 2 (Neutralize the effects of Hybrid Mismatch

arrangements)

34

Examples

35

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 after April 4, 2016.

All entities have no earnings and profits in post-April 4, 2016 taxable years and none of the entities have issued any stock in a qualified contribution.

All notes are issued in the form of debt for US federal income tax purposes.4

There is already an outstanding intercompany debt with an issue price of $50m within the expanded group that would be re-characterized as equity under the Per Se Stock Rule but for the $50m threshold exception.

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

6 All entities have a calendar taxable year.

36

Example 1 – Luxembourg financing structure

CanCo

USCo1) USCo Note

Facts• On June 7, 2016, the USCo Note is refinanced• In 2017, USCo makes a $100 distribution to CanCo

AnalysisThe $100 distribution by USCo to Canco in 2017 is a "bad" transaction, and $100 of the USCo Note is recharacterized as equity under the per se funding rule on the date that the distribution occurs.

What if USCo makes an upstream loan in lieu of a dividend?Analysis: Assuming that the upstream loan is properly characterized as debt under the common law debt/equity analysis, the USCo Note would not be recharacterized as a result of the upstream loan.

What if USCo has $50 of E&P in 2017?Analysis: Only $50 of the USCo Note would be recharacterized.

What if USCo has an earnings deficit of $100 in 2018?Analysis: Assuming that USCo has $50 of E&P in 2017 and earnings deficit of $100 in 2018, it is currently unclear whether the earnings deficit in 2018 could cause more than $50 of the USCo Note to be recharacterized. Presumably this would not be an appropriate result.

LuxCo2) $100

2016 E&P: $02015 E&P: $300

+

_

37

Example 2 – Ordinary Rule E&P Exception

CanCo

USCo

1) $100 note distribution on June 5, 20172) $100 cash distribution October 5, 2017

2017 E&P: $100

CanCo

USCo

1) $100 cash distribution on June 5, 20172) $100 note distributionOctober 5, 2017

2017 E&P: $100

Scenario A Scenario B

AnalysisUnder the proposed regulations, it appeared that Scenario A was eligible for the current year E&P exception but Scenario B was not.

Under the final regulations, the note should be recharacterized as equity in both cases.

38

Example 3 – Group debt exceeds $50m threshold

CanCo

US Co 3US Co 1 US Co 2

$49m loan distribution

+

_

+

_

$5m SPA paid with a note

Facts• Assuming no other expanded affiliate debt (i.e., $50m threshold

intact prior to the steps below)• US Co 3 distributes a $49m note to CanCo• US Co 1 purchases all of US Co 2 stock with a $5m note

AnalysisUnder the proposed regulations, both notes would be recharacterized as equity. Under the final regulations, only $4m of the cross-border debt is recharacterized as equity.

39

Example 4 – 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

Analysis• Under the proposed regulations, the

distribution in (2) would have caused (1) to be recharacterized as equity, which would then have caused the loan from Luxco to USCo to be recharacterized as equity.

• Under the final regulations, no loan would be recharacterized here.

Public CanCo

CanCo

USCo

1) Loan

2) Distribution

+

_

LuxCo

+_

Loan to USCo

40

Example 5 – Third party acquisitions

FAIT

USCo

+

_

USCo note

UST

UST Shareholders

Cash

Fact Scenario A• FAIT advances cash to USCo in exchange for USCo note • USCo purchases UST shares for cash

FAIT

USCoUST

USCo note

+

_

UST Shareholders

Cash

Fact Scenario B• FAIT purchases UST shares for cash • FAIT transfers UST shares to USCo in exchange for USCO note (in a 304

transaction)

AnalysisThis example illustrates that the ordering of the steps matters. Economically, the two scenarios reach the same result. However, the note would not be recharacterized under Fact Scenario A but would be recharacterized under Fact Scenario B.

41

Example 6 – FIRPTA

Facts• In year 2017, FIRPTA Co 2 borrows $100m from LuxCo• In Year 2018, FIRPTA Co 2 has $400m of E&P and makes a distribution to CanCo of $475m• In Year 2019, CanCo contributes FIRPTA Co 1 to FIRPTA Co 2 in exchange for common shares of FIRPTA Co 2

AnalysisIn 2018, $75m of the FIRPTA Co 2 loan is recharacterized as equity. As a result, Luxco is deemed to own preferred non-voting equity in FIRPTA Co 2. In 2019, the contribution by Canco of FIRPTA Co 1 to FIRPTA Co 2 would not qualify as a nonrecognition transaction under Section 351 of the Code because Canco will not have the requisite Section 368(c) control over FIRPTA Co 2 (which requires that Canco own at least 80% of the total voting power of FIRPTA Co 2 and at least 80% of the value of all non-voting classes of stock of FIRPTA Co 2)

CanCo

FIRPTA Co 2 LuxCoFIRPTA Co 1

$100m loan to FIRPTA Co 2

_ +

NIB Loan

42

Example 7– Private Equity (continuing issues)

Private Equity fund

USCo 1 UKCo CanCo

Lux USCo 2U.S. Real

Estate

1. Under the finalized regulations, USCo 1, UKCo, and CanCo are not members of an expanded group (although the IRS has “reserved” on the key issue – downward attribution of ownership).

2. Although the IRS had requested comments on whether “leveraged blockers” like UsCo 1 should be caught by these rules, the final regulations declined to do so. However, the IRS is continuing to study these structures in the context of the 385 rules.

_

+

_

+

_+

43

Example 8 – Continuing Issues

1. Canadian Banks – or lenders to Canadian-based borrowers with U.S. activities – will be significant stakeholders in the 385 compliance of those borrowers

Bank _+$1B Loan

CanCo

Lux USCO+ _

$1B Intercompany Loan

$1B Capital Contribution

+

44

Other Rules

• Ordering/timing rules

• Consolidated group

• Partnerships/disregarded entities

• Successor/Predecessor

• Anti-abuse rule

• No affirmative use [reserved]

• Tax consequences of a deemed exchange

45

Practical takeaways

Osler, Hoskin & Harcourt LLP – New York | Taxation

1

2

3

Scope

Impact

Management

– The reach of these rules remains very broad, but with important exceptions

– The impact of these rules can be harsh

– These rules can, in many cases, be managed with focused coordination between tax, treasury, and other internal functions

Financing Across Borders - The Impact of the Final Section 385 Regulations

Law

Transcript of Financing Across Borders - The Impact of the Final Section 385 Regulations