Recharacterization rules under Code s. 385 (p.1152)
Most fundamentally, the proposed regulations would automatically treat what would otherwise be classified as a debt instrument as equity when a debt instrument is part of some distributions or related-party transactions. The proposed regulations identify: (i) debt instruments that are distributed by a corporation to a related corporate shareholder, (ii) debt instruments that are issued by corporations in exchange for affiliate stock, and (iii) debt instruments that are issued by corporations under some internal asset reorganizations, as transactions that may result in the subject debt instrument being recharacterized as equity under the general rule for U.S. income tax purposes.
Further, the proposed regulations also contain a funding rule that would treat related-party debt instruments as equity when a corporation issues a debt instrument to a related party with a principal purpose of funding a distribution or acquisition described in the above-noted general rule, which principal purpose is determined based on all the facts and circumstances. The proposed regulations also contain a general though rebuttable presumption that the principal purpose test will be satisfied when the debt instrument is issued during the period beginning 36 months before, and ending 36 months after, any distribution or acquisition is made….
Description of Luxembourg structure for financing U.S. Opco (p. 1157)
Canada forms a Luxembourg société à responsabilité limitée (SARL) to facilitate a double-dip financing into the U.S. that Canada wants to finance its U.S. subsidiary's active business. Canada borrows funds and invests in sufficient common shares of U.S. Opco to satisfy U.S. thin capitalization and earnings stripping rules. Canada invests the balance in the minimum amount of common shares of the Lux SARL to satisfy Luxembourg thin capitalization. The balance of the funds invested by Canada in the Lux SARL would be by way of share subscriptions for private equity certificates (PEC), convertible private equity certificates (CPEC), mandatorily redeemable preferred shares (MRPS), or interest-free loans… .
Luxembourg rulings for MRPS (p. 1157)
Recently, Luxembourg stopped issuing rulings on MRPS but has now started again on a limited basis. Luxembourg tax rulings were essential as the accounting and tax treatment would differ. For accounting purposes, PEC, CPEC, and MRPS may be regarded as equity, while for tax purposes with the comfort of a ruling these hybrid instruments are treated as debt. For accounting purposes, MRPS have recently been accepted as debt for accounting purposes in Luxembourg. Distributions on PEC, CPEC, and MRPS are deductible as interest in Luxembourg….
Luxembourg deduction for imputed interest/no s. 17 imputation (p. 1157)
Canada would generally treat PEC, CPEC, and MRPS as shares and the distributions as dividends. If instead interest-free loans were made by Canada to Lux SARL, Luxembourg would impute interest on the loans and allow a deduction for the imputed interest. The deductible interest on the PEC, CPEC, and MRPS, or imputed interest on the interest free loans, are intended to shelter the interest income realized in Luxembourg,…
No interest is paid for Canadian tax purposes and no income is included for the imputed interest….
Art. XI exemption on U.S. Opco interest/s. 95(2)(a)(ii) exclusion (p. 1158)
The Lux SARL would lend funds to U.S. Opco at a reasonable interest rate. Interest would be deducted in the U.S. and not be subject to U.S. withholding tax. The derivative benefit exemption from the limitation on benefits provision in the Luxembourg-U.S. treaty allows a Lux SARL to be wholly owned by a Canadian taxpayer and still benefit from the Luxembourg-U.S. treaty. Article XI of the Canada-U.S. treaty provides an exemption from withholding tax on all nonparticipating loans from related parties.
As Canada does not gain a U.S. withholding tax advantage by interposing a Luxembourg SARL, the LOB provision does not apply. Moreover, interest paid by a U.S. Opco to the Lux SARL is recharacterized for Canadian tax purposes from income from property to income from an active business….
Potential non-application of proposed Code s. 385 Regs. (p. 1158)
[T]here is a new advance of money being invested in the U.S. operations — the debt from the Luxembourg SARL to U.S. Opco arises as a consequence of a real advance of money that is sourced from an arm's-length lender bank through Canada. The debt would not appear to be issued as part of any distribution or redemption, in exchange for stock of a member of the expanded group, as part of a tax-free reorganization or a multistep transaction designed to circumvent the above noted in order to fund distributions or acquisitions. But, as noted above, the presumption underlying the funding rule would still need to be overcome as distributions or acquisitions are (or had been) made within the requisite 72-month period.
Note: the Article also discusses the potential non-application of these Regs. to other hybrid arrangements, viz., forward subscription arrangements for a USCo financing of Canco, and a tower or repo structure for the financing of U.S. Opco by Canco.
Description of financing by U.S. lender of Canadian real estate company (Canadian RealCo) through hybrid debt (pp. 1158-1159)
[I]nstead of [the U.S. taxpayer] investing in shares of the Canadian RealCo, a debt structure may be created that has the economics of a share investment. …
The U.S. taxpayer may lend funds to the Canadian RealCo at a reasonable rate of interest. The U.S. taxpayer may through another entity make a second loan that would be participating as to profits. Interest on a participation in a loan is not deductible in Canada; rather it is treated as a dividend subject to Canadian withholding tax. Because the U.S. taxpayer owns no shares, there would be no thin capitalization restrictions, no "taxable Canadian property" or section 116 clearance concerns that normally arise on a share sale, and Canadian withholding tax is limited only to the participating interest.
Buttressing U.S. equity treatment (p. 1159)
To ensure that the loans are treated as equity for U.S. tax purposes, if desired by the U.S. lender, there can be an inter-creditor agreement that the simple interest loan will never be sold without the participating loan. The loan agreement may contain negative covenants for the borrower to allow the requisite veto of business decisions in the Canadian company by the U.S. resident….Only interest payments would be made until a sale unless there was a refinancing. The intended result is for the U.S. to regard the two loans combined as equity.
Potential non-application of proposed Code s. 385 Regs. (p. 1159)
The U.S. lender may not otherwise have an equity interest in Canada RealCo, and, if it did, it may not exceed a threshold of 50 percent ownership in Canadian RealCo that would otherwise render it a related party in the first place. This fact alone could cause the transactions to fall outside the proposed regulations. However, if the ownership interest (if the investment were equity) were sufficient to cause the U.S. lender to be related to Canadian RealCo, then, like the forward share subscription financing structure, the efficiency arises as a consequence of treating what is, in form, debt as equity. In other words, if applicable, a recharacterization under the proposed regulations might actually assist in achieving the desired tax outcome.
The impact to Canada RealCo should be irrelevant because it should not be a CFC of the U.S. lender.
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