IRS Revisits Debt-Equity and Disguised Sales

Author: Keith Martin Publication | August 2017

Two US Tax regulations that affect the project finance market are in limbo.

President Trump directed the US Treasury in late April to review “all significant tax regulations” issued in 2016 and early 2017 before Trump took office and to flag any in an interim report by June that “impose an undue financial burden” on US taxpayers, “add undue complexity” to the tax laws or “exceed the statutory authority.”

The Treasury said in Notice 2017-38 in June that had it reviewed 105 regulations issued during the time period and identified eight that it said merit further review. It asked the public for suggestions for how to deal with the regulations by August 7.

The eight include two that affect project finance transactions.

One addresses when a developer forming a partnership with a money party to own a project on which the developer has been working will be treated as having made a taxable sale of the project to the partnership rather than a tax-free capital contribution. A developer is assumed to have made a “disguised sale” of the project if the developer is distributed cash by the partnership within two years after contributing the project.

This basic principle is not in limbo, but detailed rules the IRS issued for calculating the amount paid by the partnership for the project in cases where there is existing project-level debt will be revisited. This is most likely to affect tax equity partnerships formed to finance projects that are already subject to construction or term debt. (For more information, see “Tax Triggered When Partnership Formed?” in the October 2016 NewsWire.)

The other regulations put in limbo deal with affiliate or shareholder debt.

Many foreign investors investing in US projects form US holding companies to hold the investments and inject capital into the US partly as equity and partly as a shareholder loan to the US holding company. The loan allows the foreign investor to “strip” US earnings by pulling them out as interest on the shareholder loan. Earnings pulled out as interest are not taxed in the United States, since the US holding company paying the interest can deduct it. The only tax is a possible withholding tax on the interest at the US border, but many US tax treaties reduce or eliminate any such withholding taxes.

The IRS said in 2016 that it would require companies with shareholder debt to have four kinds of documents to prove the loans are really debt.  The documentation was considered burdensome. Therefore, the IRS was only requiring it where the shareholder making the loan owns the holding company at least 80% by vote or value and then only in cases where a publicly-traded company is involved somewhere in the ownership chain or else the entire chain of affiliated companies has more than $100 million in assets or revenue of more than $50 million a year in any of the three prior years.

The IRS said in early August that it will delay the need to produce such documentation until 2019. The IRS made the announcement in Notice 2017-36. The documentation will be required for shareholder debt issued after 2018.

The part of the regulations that reclassify some shareholder debt as equity have not been delayed. (For more detail, see “New US Tax Rules Could Reclassify Debt as Equity” in the April 2016 NewsWire.)

The Treasury has until September 19 to report to the White House on specific actions it will take to cancel or fix regulations it put on the list to revisit.


Contacts

Keith  Martin

Keith Martin

Washington, DC