Related party loans are a great way to shift income and protect assets. Congress told the IRS to update its regulations to take into account credit risks of the related party. The IRS said “no”.
Shifting income to a lower tax entity is easy when using debt to transfer the income producing asset. The IRS required related party loan interest rate is below one percent regardless of the financial strength of the related party.
The flaw in the tax law is that all promissory notes have the same economic substance regardless of the credit worthiness of the borrower. The IRS requires an interest rate of about one percent on a unsecured loan to a related party. Yes.. it is a sham rate and it is required. No need to look at the credit worthiness. The IRS rules require an abusive tax sham for you to use.
The most famous case in the Rushing Trust case (on this link) where a related party installment sale note of a family trust was considered to be for adequate consideration. The trust issued the note and purchased the asset from the settlor. The trust had almost no capital. The trust was not credit worthy. Yet, the court held that section 482 (related party transactions) and section 1001 (sale of property) were satisfied.
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The Great Recession caused Congress to demand all Federal agencies to look their regulations and to correct them if they did not take into account credit worthiness under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Well, the IRS started to follow the law; and then decided to say “No” to Congress.
Below is the IRS’s announcement
Section 939A(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203 (124 Stat. 1376 (2010)), (the “Dodd-Frank Act”), requires each Federal agency to review its regulations that require the use of an assessment of credit-worthiness of a security or money market instrument, and to review any references or requirements in those regulations regarding credit ratings.
Section 939A(b) directs each agency to modify any regulation identified in the review required under section 939A(a) by removing any reference to, or requirement of reliance on, credit ratings and substituting a standard of credit-worthiness that the agency deems appropriate. Numerous provisions under the Code are affected.
These temporary regulations amend the Income Tax Regulations (26 CFR part 1) under sections 150, 171, 197, 249, 475, 860G, and 1001 of the Code. These sections were added to the Code during different years to serve different purposes. These temporary regulations also amend the Manufacturers and Retailers Excise Tax Regulations (26 CFR part 48) under section 4101 that provides registration requirements related to Federal fuel taxes.
Explanation of Provisions
These temporary regulations remove references to “credit ratings” and “credit agencies” or functionally similar terms in the existing regulations. Some changes involve simple word deletions or substitutions. Others reflect the revision of a sentence to remove the credit rating references. In some cases, multiple sentences have been modified.
Where appropriate, substitute standards of credit-worthiness replace the prior references to credit ratings, credit agencies or functionally similar terms. Language revisions serve solely to remove the references prohibited by section 939A of the Dodd-Frank Act and no additional changes are intended.
Section 1.150-1. Section 1.150-1 provides definitions for purposes of sections 103 and 141 through 150. Section 1.150-1(b) defines issuance costs to mean costs to the extent incurred in connection with, and allocable to, the issuance of an issue within the meaning of section 147(g). Section 1.150-1(b) lists as non-exclusive examples of issuance costs: underwriters’ spread; counsel fees; financial advisory fees; rating agency fees; trustee fees; paying agent fees; bond registrar, certification, and authentication fees; accounting fees; printing costs for bonds and offering documents; public approval process costs; engineering and feasibility study costs; guarantee fees, other than for qualified guarantees (as defined in § 1.148-4(f)); and similar costs.
These temporary regulations replace the § 1.150-1(b) reference to rating agency fees with “fees paid to an organization to evaluate the credit quality of the issue.” No substantive change is intended.
Section 1.171-1. The temporary regulations change credit rating in § 1.171-1(f) Example 2 (i) to credit quality. The change does not affect the analysis in the example. In addition, the temporary regulations make other nonsubstantive changes to the example (for example, the dates in the example are updated).
Section 1.197-2(b)(7). The temporary regulations remove “the existence of a favorable credit rating” from the examples of supplier-based intangibles in the third sentence of § 1.197-2(b)(7). No substantive change in the treatment of a favorable credit rating as a supplier-based intangible under section 197 is intended.
Section 1.249-1. The temporary regulations change credit rating and ratings of credit rating services in § 1.249-1(e)(2)(ii) to credit quality and widely published financial information. In the existing regulations, a change in the credit rating of an issuer or obligation is one of the facts and circumstances used to determine how much of a repurchase premium is attributable to the cost of borrowing and not to the conversion feature of a convertible bond. Credit rating services is used as a means to determine the credit rating of an issuer or obligation. None of these changes affect the substantive rules in the existing regulations.
Section 1.475(a)-4(d)(4). Example 1, Example 2, and Example 3 in § 1.475(a)-4(d)(4) are revised to remove references to credit ratings or credit rating agencies. In these three examples in the existing regulations, credit rating or specific references to certain ratings by certain credit ratings agencies (such as AA/aa or AAA/aaa) were used to set up the factual scenario that illustrates the factors that go into the determination of whether it is appropriate for a dealer to take a credit risk adjustment.
These terms were also used to describe the credit risk adjustment implicit in the yield curve used to discount the present value of the cash flows. This adjustment affects whether any additional credit risk adjustments are warranted. These examples also used credit rating agency to set up the factual scenario that a counterparty’s credit-worthiness was based upon an industry standard of a certain credit quality and illustrates the factors that go into the determination of whether it is appropriate for a dealer to take a credit risk adjustment. The changes that have been made to the language of the examples do not alter the purpose of the illustrations and present the factual issues in a more generalized way.
Section 1.860G-2. Section 1.860G-2(g)(2) defines qualified reserve fund as an amount that is reasonably required to fund expenses of the REMIC or amounts due on regular or residual interests in the event of defaults on the underlying pool of mortgages. In defining the amount reasonably required, § 1.860G-2(g)(3)(ii) refers to the amount required by a nationally recognized independent rating agency as a condition of providing the rating for the REMIC interest desired by the sponsor. Because an alternative and fully adequate standard of reference is already set forth in these regulations, these temporary regulations remove the rating agency alternative standard.
Section 1.1001-3. Section 1.1001-3 provides rules for determining whether a modification of a debt instrument results in an exchange for purposes of § 1.1001-1(a). These temporary regulations remove the terms rating andcredit rating from § 1.1001-3 and generally replace those terms with credit quality. Section 1.1001-3(d) Example 9is revised so that the event that triggers an option to increase a note’s rate of interest is a breach of certain covenants in the note, rather than a specific decline in the corporation’s credit rating.
The temporary regulations also revise § 1.1001-3(g) Example 5 so that the debt instrument described in the example allows a party to be substituted for the instrument’s original obligor on the basis of the party’s credit-worthiness, rather than the party’s credit rating. The temporary regulations also revise § 1.1001-3(g) Example 8 to explain that a bank’s letter of credit supporting a debt instrument is substituted for another bank’s letter of credit when the first bank encounters financial difficulty, thus removing references to rating agencies and either bank’s credit rating.
Section 48.4101-1(f)(4). Section 4101 requires certain persons to be registered by the IRS for purposes of several fuel tax provisions of the Code. Under § 48.4101-1, the IRS will register an applicant for registration only if, among other conditions, the applicant has adequate financial resources to pay its expected fuel tax liability. To make this determination, § 48.4101-1(f)(4)(ii)(B) instructs the IRS to look to the applicant’s financial information. These temporary regulations remove the examples of the types of documents the IRS should review and instructs the IRS to look at all information relevant to the applicant’s financial status.
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), please refer to the Special Analysis section in the preamble to the cross-referenced notice of proposed rulemaking in the Proposed Rules section in this issue of the Federal Register. Pursuant to section 7805(f) of the Code, these regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.
These regulations were drafted by personnel in the Office of Associate Chief Counsel (Financial Institutions and Products), the Office of Associate Chief Counsel (Income Tax and Accounting), the Office of the Associate Chief Counsel (International) and the Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and the Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 48
Excise taxes, Reporting and recordkeeping requirements.
Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 48 are amended as follows:
PART 1 — INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.150-1 is amended as follows:
1. Paragraph (a)(4) is added.
2. In paragraph (b), the definition of Issuance costs is revised.
The additions and revisions read as follows:
§ 1.150-1 Definitions. (a)
(4) [Reserved] For further guidance, see § 1.150-1T(a)(4).
(b) * * *
Issuance costs [Reserved]. For further guidance, see § 1.150-1T(b), Issuance costs.
* * * * *
Par. 3. Section 1.150-1T is added to read as follows:
§ 1.150-1T Definitions (temporary).
(a) through (a)(3) [Reserved]. For further guidance, see § 1.150-1(a) through
(4) Additional exception to the general applicability date. Section 1.150-1T(b), Issuance costs, applies on and after July 6, 2011.
(5) Expiration date. The applicability of § 1.150-1T(b), Issuance costs, expires on or before July 1, 2014.
(b) Bond through the definition of Governmental bond [Reserved]. For further guidance, see § 1.150-1(b) Bondthrough the definition of Governmental bond.
Issuance costs means costs to the extent incurred in connection with, and allocable to, the issuance of an issue within the meaning of section 147(g). For example, issuance costs include the following costs but only to the extent incurred in connection with, and allocable to, the borrowing: underwriters’ spread; counsel fees; financial advisory fees; fees paid to an organization to evaluate the credit quality of an issue; trustee fees; paying agent fees; bond registrar, certification, and authentication fees; accounting fees; printing costs for bonds and offering documents; public approval process costs; engineering and feasibility study costs; guarantee fees, other than for qualified guarantees (as defined in § 1.148-4(f)); and similar costs.
(c) Issue date through paragraph (e) [Reserved]. For further guidance, see § 1.150-1(b) Issue date through paragraph (e).
Par. 4. Section 1.171-1(f) Example 2 is revised to read as follows: § 1.171-1 Bond premium.
* * * * *
(f) * * *
Example 2. [Reserved]. For further guidance, see § 1.171-1T(f) Example 2.
* * * * *
Par. 5. Section 1.171-1T is added to read as follows:
§ 1.171-1T Bond premium (temporary).
(a) through (f) Example 1 [Reserved]. For further guidance, see § 1.171-1(a) through (f) Example 1.
Example 2. Convertible bond — (i) Facts. On January 1, 2012, A purchases for $1,100 B corporation’s bond maturing on January 1, 2015, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $30 on January 1 and July 1 of each year. In addition, the bond is convertible into 15 shares of B corporation stock at the option of the holder. On January 1, 2012, B corporation’s nonconvertible, publicly-traded, three-year debt of comparable credit quality trades at a price that reflects a yield of 6.75 percent, compounded semiannually.
(ii) Determination of basis. A’s basis for determining loss on the sale or exchange of the bond is $1,100. As of January 1, 2012, discounting the remaining payments on the bond at the yield at which B’s similar nonconvertible bonds trade (6.75 percent, compounded semiannually) results in a present value of $980. Thus, the value of the conversion option is $120. Under § 1.171-1(e)(1)(iii)(A), A’s basis is $980 ($1,100 – $120) for purposes of §§ 1.171-1 through 1.171-5. The sum of all amounts payable on the bond other than qualified stated interest is $1,000. Because A’s basis (as determined under § 1.171-1(e)(1)(iii)(A)) does not exceed $1,000, A does not acquire the bond at a premium.
(iii) Effective/applicability date. This Example 2 applies to bonds acquired on or after July 6, 2011.