Having the appropriate documentation is often the key to being entitled to certain deductions or tax credits. For those who make charitable contributions, written acknowledgement from the charity of any contribution of $250 or more is required. A copy of the check or the charge card receipt isn’t enough documentation when the contribution hits the $250 threshold.
For businesses, stringent documentation requirements for claiming a deduction for business meals and entertainment have long been in place. Certain information must be maintained regarding the individuals entertained, purposes of the meeting and when and where the meal or entertainment occurred.
For businesses that claim the research and experimentation credit, documentation is needed for the qualifying research expenditures. It is not uncommon for businesses to have binders full of the supporting documentation for the credit. Even then, the IRS may take a different view of whether an item or project qualifies for the research credit.
On April 4, a new set of documentation rules were proposed by the Treasury Department and the Internal Revenue Service. As part of a package dealing with inversions and earnings stripping, proposed regulations were issued regarding documentation for related-party debt. The proposed regulations also covered other debt and equity issues in addition to documentation and contain many changes that will also affect related-party debt situations.
The surprise to many tax professionals was that these proposed regulations were not only directed at the companies that have or were considering inversion transactions. They were actually broader in their application. If finalized in their proposed form, these regulations would apply to many related-party debt situations having nothing to do with inversions.
The proposed regulations were issued under section 385 of the Internal Revenue Code. Section 385 was originally enacted to allow for the characterization of an instrument or interest in a corporation as either stock or indebtedness for U.S. tax purposes.
The proposed regulations include a new requirement for contemporaneous documentation by taxpayers for certain related-party indebtedness in order to allow for the indebtedness to be respected as debt for U.S. tax purposes. The proposed regulations provide that, if a taxpayer does not prepare and maintain such documentation, the related-party indebtedness would be treated as stock (equity) rather than debt upon IRS examination.
The documentation requirements are broad. The requirements focus on taxpayer substantiation of four key elements of the instrument: binding obligation to repay; creditor’s rights to enforce terms; reasonable expectation of repayment; and genuine debtor-creditor relationship.
The preamble to the proposed regulations provides some examples of the types of documentation that could be used to support these four elements. The preamble and regulations state that, in the absence of this documentation, treatment as indebtedness will not be allowed.
The preamble also states satisfaction of these four factors by way of the contemporaneous documentation does not conclusively establish the instrument as indebtedness, but rather simply allows for the possibility of indebtedness treatment pending further analysis by the IRS based on the facts and circumstances under existing federal tax principles and case law.
The regulations provide a few limitations and exceptions to the applicability of the documentation requirements described above. The documentation requirements are intended to apply to taxpayers that are “highly related” (i.e., over 80 percent relatedness by ownership) and also only to certain “large taxpayer groups.”
Therefore, an instrument is not subject to the documentation requirements unless one of the following conditions is met:
- The stock of any member of the taxpayer’s group is publicly traded.
- All or any of the portion of the expanded group’s financial results are reported on financial statements with total assets exceeding $100 million.
- The expanded group’s financial results are reported on financial statements that reflect annual total revenue that exceeds $50 million.
As mentioned earlier, the new requirements don’t apply only to inversion-related companies and their transactions. They can apply to foreign to domestic, domestic to foreign, and domestic to domestic loan transactions. There are exceptions for loans between U.S. corporations that are part of a U.S. consolidated federal tax return filing.
The required documentation may need to include a detailed analysis of the creditworthiness of the borrower and its capacity to borrow and service the scheduled interest and principal payments. This generally includes the documentation a third-party lender would require. Additionally, this documentation would generally need to be in place within 30 days or the related party loan.
The penalty for not having the contemporaneous documentation completed can be onerous. If the debt instrument is recast as equity, then the interest payments will not be a deductible expense for tax purposes. In addition, the payments of any principal and interest under the terms of the instrument have the potential to be treated as dividend distributions that are subject to different income tax and withholding tax treatment than what interest payments have. Thus, the resulting U.S. tax impact can be significant.
Businesses that engage in related-party debt transactions will need to take note of these changes if the proposed regulations are finalized in their current form, and will need to evaluate what documentation is appropriate for their particular situation.
Taking from the military strategy and sports adage that “a good offense is a good defense” may be applicable here. Robust documentation may aid a taxpayer in its audit defense of any related-party debt instruments.
Bill Roth is a tax partner with the local office of accounting firm BDO USA LLP. The views expressed are the author’s and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.