Additional Section 892 proposed regulations to provide transitional relief

Treasury and the IRS this week issued additional proposed regulations under section 892 (Additional Proposed Regulations). Responding to public comments, these regulations would replace the Prior Proposed Regulations’ applicability date (generally, publication as final) with two transition periods—one for debt acquisitions and one for determining effective control. The Additional Proposed Regulations otherwise leave the Prior Proposed Regulations unchanged.

1. Debt Transition Period 

Under the proposed debt transition period, the Prior Proposed Regulations would apply only to acquisitions of debt on or after the later of (i) the first day of the acquiror’s first taxable year beginning on or after the regulations are published as final, or (ii) 90 days after the regulations are published as final (the “Applicability Date”). Any debt acquired prior to the Applicability Date would be subject to the regulations in effect before finalization of the Prior Proposed Regulations, and any debt acquired after the Applicability Date would be subject to the provisions of the Prior Proposed Regulations. A special rule provides that debt acquired after the Applicability Date, but as part of a binding commitment entered into before the Applicability Date, would be subject to the regulations in effect before finalization of the Prior Proposed Regulations. 

 
2. Effective Control Transition Period 

Under the second transition period, the effective control provisions of the Prior Proposed Regulations would not apply to a foreign government’s existing interests in an entity, unless the foreign government acquired, after the Applicability Date, new interests that constituted effective control of the entity, not taking into account any interests acquired prior to the Applicability Date. Any interest in an entity acquired prior to the Applicability Date would be subject to the regulations in effect before finalization of the Prior Proposed Regulations. Similar to the debt transition period described above, a special rule provides that new interests in an entity acquired after Applicability Date, but as part of a binding commitment entered into before the Applicability Date, would be subject to the regulations in effect before finalization of the Prior Proposed Regulations.

Aside from this transitional relief, Treasury and the IRS are still considering substantive updates to the Prior Proposed Regulations in response to public comments received. Based on a review of these public comments, the substantive items most likely to be addressed in future guidance include:

• Debt Acquisition Presumption: Under the Prior Proposed Regulations, generally acquisitions of debt are presumed to be commercial activity unless the acquisition qualifies as an investment under one of two safe harbors or under a facts-and-circumstances test. Many commenters recommended that this presumption should be reversed, arguing that an investment in debt is inherently no more commercial than an investment in equity and that the presumption should be restored to its longstanding form of treating debt as non-commercial activity unless specific criteria are met. In addition, commenters requested that the safe harbors be expanded to include private placements (such as Rule 144A offerings), offerings registered under foreign securities laws, and secondary market acquisitions of debt not traded on an established securities market.
• Definition of “Effective Control”: The Prior Proposed Regulations expanded the definition of effective control to include ownership and other factors of control, such as veto rights, blocking rights, consent rights over major decisions, and certain creditor protections. Multiple commenters stated that negative investment protection rights, such as the right to veto or block major decisions, are investor protection rights designed to monitor and protect an investment, and should be distinguished from day-to-day operational controls that implicate effective control under section 892. Commenters recommended that the concept of effective control should be limited to rights that convey actual control over the management and operations of a business, such as the ability to initiate or direct actions, and should not include customary minority investor protections.
• Creditor Committee Participation and Debt Workouts: The Prior Proposed Regulations include examples distinguishing between a foreign government that unilaterally negotiates modifications to distressed debt (treated as investment activity) and a foreign government that participates on a creditors’ committee in a workout to negotiate identical modifications (treated as commercial activity). Multiple commenters criticized this distinction, arguing that participation on a creditors’ committee is often a defensive necessity to preserve the value of an existing investment, particularly where minority creditors face materially worse outcomes if they remain outside a committee. Commenters recommended that participation on a creditors’ committee to protect the value of an existing debt investment should not, by itself, give rise to commercial activity, provided that the foreign government did not acquire the debt with the expectation of modifying it and does not use the restructuring process to originate new debt or earn separate service-type fees.

__________

If you have any questions about this Legal Briefing, please feel free to contact any of the attorneys listed or the Eversheds Sutherland attorney with whom you regularly work.