Disguised sales and earnings stripping

Author: Keith Martin Publication | October 2017

The US Treasury moved closer in early October to withdrawing two sets of tax regulations the IRS issued in 2016 that would affect the project finance market.

One deals with “disguised sales” of assets by partners to partnerships.

A developer forming a partnership with an investor to own a project on which the developer has been working is sometimes 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 dispute, but the Treasury said it is considering withdrawing detailed rules the IRS issued for calculating the amount paid by the partnership for the project. The withdrawal is most likely to affect tax equity partnerships formed to finance projects in cases where the projects were already subject to construction or term debt. (For more information, see “Tax Triggered When Partnership Formed?” in the October 2016 NewsWire.)

The other regulations in play 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 proposed requiring it only where the shareholder making the loan owns the holding company at least 80 percent 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.

In early August, the IRS said in Notice 2017-36 that it will delay the need to produce such documentation until 2019.

In early October, the Treasury said that it now plans to withdraw the documentation requirements entirely and come up with new rules that will be “substantially streamlined and simplified.”

The part of the regulations that reclassify some shareholder debt as equity will remain place for the time being to see what Congress does in a tax reform bill later this year. (For more detail on when shareholder loans may be reclassified as equity, see “New US Tax Rules Could Reclassify Debt as Equity” in the April 2016 NewsWire.)

This part of the regulations was part of a package of steps the Obama Treasury took to try to stop corporate inversions where US corporations move their headquarters to lower-taxed countries. The Treasury said while it expects Congress to address inversions as part of any tax reform bill, revoking the regulations before the tax reforms are enacted “could make existing problems worse.”

The Treasury made the announcements in a report to the president on October 2. The report responds to a Trump directive in Executive Order 13789 to examine all regulations issued by the Obama administration during the last 13 months before Trump took office. (For earlier coverage, see “Recent IRS Regulations in Limbo” in the June 2017 NewsWire and “IRS Revisits Debt-Equity and Disguised Sales” in the August 2017 NewsWire.)


Contacts

Keith  Martin

Keith Martin

Washington, DC