Section 7701(l) of the Code authorizes the Treasury Department to prescribe regulations recharacterizing a multiple-party financing transaction as a transaction directly among any two or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent the avoidance of any tax imposed by the Code. Existing regulations under that provision allows the IRS to disregard the participation of one or more intermediate entities in a financing arrangement where such entities are acting as conduit entities, and to recharacterize the financing arrangement as a transaction directly between the remaining parties to the financing arrangement for purposes of imposing tax under sections 871, 881, 1441 and 1442 of the Code. The regulations are primarily concerned with taxpayers being able to take advantage of advantageous treaty and Code provisions by inserting a qualifying entity or person inbetween an ultimate provider of financing (that would not benefit under the treaty or Code for the favorable benefits) and an ultimate buyer – e.g., “back-to-back” loan arrangements.
New proposed regulations have been issued under Proposed Regulations 1.881-3 that seek to prevent taxpayers from getting around the conduit rules by using a “disregarded entity” as an intermediate entity in a financing arrangement.
The Preamble to the regulations also indicate that separate guidance may be issued in regard to the use of hybrid instruments issued by an intermediate entity that is treated as debt under the laws of the foreign jurisdiction where the intermediate entity is resident and is not treated as debt for U.S. federal tax purposes. The IRS is studying when such arrangements will qualify as conduit arrangements.
Most troubling in the Preamble is a discussion that the IRS is considering issuing rules when equity ownership interests would be recast as financing interests and thus implicate the conduit rules. From the language of the Preamble, the IRS could be limiting this recharacterization to situations in which hybrid instruments are used (as discussed in the preceding paragraph) – that would not be so bad. However, if the discussion portends broad rules that will recast equity arrangements as part of conduit financing arrangements outside of the use of hybrid instruments, this could have a very broad (and chilling effect) on various existing financing arrangements. For example, a loan by a foreign lender to a partner or shareholder of a partnership or corporation, followed by a capital contribution of such loan proceeds to the partnership or corporation, could trigger application of the conduit rules. Hopefully, the guidance, if and when issued, will focus on equity arrangements only in situations where hybrid instruments are used.