On December 12, the Treasury Department issued Proposed Treasury Regulations which, for the first time, appear to provide a potential window into the Internal Revenue Service’s view as to when an investment in debt potentially constitutes a trade or business for U.S. federal income tax purposes (the “Proposed Regulations”), notwithstanding that no inference is intended.
While the Proposed Regulations will, if adopted as proposed, only apply to foreign governmental taxpayers subject to Section 892 of the Internal Revenue Code (“Section 892”), private investment funds, CLOs and other market participants should pay close attention to the Proposed Regulations as they may provide useful insight into when the IRS may view credit investments as a trade or business for U.S. federal income tax purposes.
The Proposed Regulations address whether an investment in a debt instrument is treated as a “commercial activity” for purposes of Section 892. We note that the standard for an investment to be treated as a “commercial activity” is lower than the standard for being treated as engaged in a U.S. trade or business, which causes a non-U.S. person to realize income which is effectively connected with a U.S. trade or business (“ECI”). While the Proposed Regulations explicitly do not apply to determining whether a non-U.S. person earns ECI, the concepts are broadly similar in certain respects.
The Proposed Regulations provide an acquisition of debt will be treated as a “commercial activity” unless it “qualifies as investment.” Two safe harbors and a general facts and circumstances test as to whether an acquisition of debt is treated as an “investment” are provided, along with several examples that provide additional guidance. Under this framework, all debt acquisitions are commercial activities unless one of the safe harbors applies or the facts and circumstances test is satisfied.
The first safe harbor is available when bonds or other debt securities are (1) acquired in an offering registered under the Securities Act of 1933 and (2) the underwriters of the offering do not bear certain relationships with the purchaser.
The second safe harbor is available when (1) the debt is traded on an “established securities market,” (2) the acquirer does not acquire the debt from the issuer of the debt or participate in negotiation of the terms of the debt or issuance of the debt and (3) the debt is acquired from a person that is not under common management or control with the acquirer (unless such person acquired the debt as an investment). This safe harbor appears to be designed to address the widely-syndicated loan market. However, this safe harbor appears to vary substantially from current market practice in the CLO and private credit fund industry, particularly by including a requirement that the debt be traded on an “established securities market” (which includes an interdealer quotation system).
The facts and circumstances test applies to the extent that an entity’s expected return from acquiring the debt is exclusively a return on its capital rather than including a return on activities it conducts. The Proposed Regulations provide a non-exclusive list of eight factors to be considered in determining whether an investment in a debt instrument is an “investment” or a “commercial activity”:
- Whether the investor solicited prospective borrowers, or otherwise held itself out as willing to make loans or otherwise acquire debt at or in connection with its original issuance;
- Whether the investor materially participated in negotiating or structuring the terms of the debt;
- Whether the investor is entitled to compensation (other than interest) for making the loan;
- The form of the debt and the issuance process (e.g., a bank loan or a privately placed debt security);
- The percentage of the debt issuance acquired by the investor (based on an example in the regulations, one-third appears to be the relevant threshold);
- The percentage of equity in the borrower held or to be held by the investor;
- The value of equity in the borrower acquired by the investor relative to the amount of the debt acquired by the investor; and
- If debt is deemed to be acquired in a debt-for-debt exchange as a result of a significant modification, whether there was, at the time of acquisition of the original unmodified debt, a reasonable expectation, based on objective evidence, that the original unmodified debt would default.
The Proposed Regulations do not provide any guidance as to how the factors should be weighted.
The factors cited above are consistent in some respects with current market practice regarding whether a private investment fund or CLO earns ECI by investing in loans. Not surprisingly, the factors considered include whether the investor holds itself out as making loans, whether the investor negotiated the debt, whether the investor receives a fee, the percentage of the debt issuance acquired by the investor and whether the investor holds equity in the borrower.
However, some factors raise questions with respect to current market practice and, if extended beyond Section 892 to non-U.S. persons more broadly, could be problematic. For example, one of the factors is whether the investor materially participated in “negotiating or structuring the terms of the debt.” Investors in widely-syndicated debt facilities commonly comment on a proposed term sheet provided by an originator of a debt instrument; whether such involvement is problematic under the Proposed Regulations, even where the investor has no direct communication with the borrower, is unclear.
Interestingly, the Proposed Regulations also provide for the first time insight into whether debt restructurings could be treated as a loan origination. The eighth factor cited above references debt exchanges that constitute a “significant modification” under the tax rules. This strongly suggests that debt restructurings which are not a “significant modification” are not problematic, which is consistent with current market practice. In addition, the eighth factor appears to bless debt restructurings that are undertaken to avoid a default (often referred to as rescue financing). The Proposed Regulations also include two factors that look at the equity ownership of the investor in a borrower. The inclusion of these factors could suggest that rescue financing provided by investors to companies in which they hold equity would not be problematic.
Notably, two examples contained in the Proposed Regulations should give pause to investors in this space. These examples lay out a fact pattern where an investor acquires debt on the secondary market that was not in default and at a time when there were no objective indications that the borrower would default on its debt. In the examples, the borrower went into default and negotiated a modification (which was a “significant modification”) of its debt with a creditors’ committee. Interestingly, new funding does not appear to be advanced by the investor. In the first example, the investor was treated as making an investment in the restructured loan (and not being engaged in a commercial activity) in part because the investor did not participate in the creditors’ committee. In contrast, in the second example, the investor’s participation in the creditors’ committee caused its acquisition of the restructured loan to be treated as commercial activity. Under these examples, participation in a creditors’ committee would likely be viewed by the IRS as problematic in the Section 892 context. It is unclear whether this is also the IRS’s view in the ECI context.
Two other examples in the Proposed Regulations also may raise significant questions.
The first posits a situation where an investor negotiates a single loan with a borrower in a calendar year. The example concludes that this is a “commercial activity.” This example, if extended to the ECI context, would raise significant questions about the continued viability of the industry’s view that originating a small number of loans per year is not a trade or business (the “bullet” theory). It should be noted that there is a substantial amount of case law and other authority that being engaged in a U.S. trade or business for ECI purposes requires activity which is substantial, regular and continuous. Therefore, the standard for “commercial activity” is generally understood to be lower than the standard for being engaged in a U.S. trade or business.
The second addresses debt financing combined with equity financing of an 80 percent owned subsidiary. The entity was capitalized with a 1:2 debt-to-equity ratio and the investor was not treated as engaged in a commercial activity. However, a key factor cited is that the amount of debt was not significant as compared to the equity investment. Given that blocker entities are often financed with more debt than equity, this example raises questions about whether loans made to a subsidiary could constitute a trade or business.
In summary, the Proposed Regulations provide the most detailed insight into the IRS’s thinking around loan origination issues that we have seen in the past fifteen years. While the Proposed Regulations are not directly applicable to determining whether investments in loans will generate ECI, they could be a preview of a future regulatory package in this area.
Our memorandum discussing all of the proposals related to Section 892 in this regulatory package can be found here.
Seward & Kissel LLP actively monitors changes to the legislative landscape and how any changes may impact the investment management industry. For additional information on recent income tax changes, please contact a member of Seward & Kissel’s Tax Department.
