Treasury Missed Some Regs Suitable for Burden Reduction, PwC Says

August 7, 2017

CC:PA:LPD:PR (Notice 2017-38)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: Notice 2017-38, Implementation of Executive Order 13789 (Identifying and Reducing Tax Regulatory Burdens)

Dear Sir/Madam:

PricewaterhouseCoopers LLP ("PwC") respectfully submits this letter in response to Notice 2017-38, "Implementation of Executive Order 13789 (Identifying and Reducing Tax Regulatory Burdens)," published by the Department of the Treasury ("Treasury") and the Internal Revenue Service (the "IRS" or the "Service") in the Internal Revenue Bulletin on July 24, 2017 (the "Notice").¹

In the Notice, Treasury identifies eight tax regulations it proposes to be modified or rescinded to implement Executive Order 13789 ("EO 13789").² EO 13789 is a directive, signed by the President on April 21, 2017, designed to reduce tax regulatory burden.³ EO 13789 directs Treasury to undertake immediately a review of "all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016," and instructs Treasury to identify all significant "regulations that: (i) impose an undue financial burden on United States taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the Internal Revenue Service."⁴ In addition, EO 13789 sets forth the President's policy objectives, which include that the "Federal tax system should be simple, fair, efficient, and pro-growth" and "[t]he purposes of tax regulations should be to bring clarity to the already complex Internal Revenue Code . . . and to provide useful guidance to taxpayers."⁵

The Notice summarizes Treasury's review of all significant regulations issued by Treasury and the IRS between January 1, 2016, and April 21, 2017,⁶ as instructed by EO 13789. The Notice indicates that Treasury determined that 52 regulations were "potentially significant" and subject to review for purposes of the EO 13789.⁷ Treasury identified eight regulations that "impose an undue financial burden on U.S. taxpayers" and/or "add undue complexity to the Federal tax laws", with respect to which Treasury intends to propose reforms ranging from streamlining problematic provisions to fully repealing the regulations in order to mitigate the burdens of such regulations.⁸ The regulations identified include:

The Notice requests comments on "whether the regulations described in this notice should be rescinded or modified, and in the latter case, how the regulations should be modified in order to reduce burdens and complexity."⁹

PwC recognizes the difficulty involved in determining how best to mitigate the burdens imposed by the regulations identified in the Notice, and we appreciate Treasury's consideration of these issues.

Nevertheless, PwC believes the Notice overlooked certain regulations that meet the criteria described in EO 13789, including temporary and proposed regulations under section 901(m)¹⁰ and proposed regulations under section 305(c).¹¹ Furthermore, many pre-2016 regulations are overly complex and burdensome and should be simplified. Therefore, we encourage Treasury and the IRS to continue their efforts promoting reduced regulatory burdens and simplification; much work remains in that regard.

As discussed herein, PwC has focused on three of the regulations identified by the Notice that significantly and detrimentally burden U.S. taxpayers and add undue complexity to an already exceedingly complex set of tax laws. We have focused on these three regulations given their significance and the limited time for comments provided by the Notice. By not addressing the remaining five regulations identified in the Notice, we do not mean to imply that we disagree with the assessment that such regulations are overly burdensome and complex. Specifically, this letter addresses:

• Final Regulations under Section 367;¹²

• Final and Temporary Regulations under Section 385;¹³ and

• Final and Temporary Regulations under Section 987.¹⁴

I. Final Section 367 Regulations: Final Regulations under Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations (T.D. 9803; 81 F.R. 91012)

A. Background — Final Section 367 Regulations

The Final Section 367 Regulations, which were issued on December 15, 2016, address the treatment of outbound transfers of certain property.¹⁵ Among other things, the Final Section 367 Regulations deny the tax-free treatment of outbound transfers of foreign goodwill and going concern value that had existed under prior law for over 30 years.¹⁶

The Final Section 367 Regulations largely finalize proposed regulations issued on September 14, 2015¹⁷ without fundamental change, despite numerous comments recommending modifications and questioning Treasury's authority to issue the regulations.¹⁸ In addition, the Final Section 367 Regulations finalize, amend, or remove certain temporary regulations issued on May 16, 1986,¹⁹ and generally apply retroactively to transfers occurring on or after September 14, 2015, the date the proposed regulations were issued.²⁰

Specifically, the Final Section 367 Regulations modify prior law under which an outbound transfer of foreign goodwill or going concern value was eligible for tax-free treatment under section 367 pursuant to either the active trade or business exception under section 367(a)(3) or former Temp. Reg. § 1.367(d)-1T(b), which excepted the outbound transfer of foreign goodwill and going concern value from the application of section 367(d).²¹ In this regard, the Final Section 367 Regulations limit the scope of property that is eligible for the active trade or business exception to "eligible property"²² and eliminate former Temp. Reg. § 1.367(d)-1T(b).²³ With respect to property other than eligible property (e.g., goodwill and going concern value), the Final Section 367 Regulations permit taxpayers to apply section 367(d) to an outbound transfer of such property that may otherwise be subject to upfront gain recognition under section 367(a)(1).²⁴ As a result, an outbound transfer of foreign goodwill or going concern value is ineligible for tax-free treatment under the Final Section 367 Regulations and, instead, would be subject to either current gain recognition under the general rule of section 367(a)(1) or, alternatively, periodic income inclusion under section 367(d).

B. Comments

We applaud Treasury for identifying the Final Section 367 Regulations as significant in view of the Presidential priorities for tax regulation outlined in EO 13789 and as imposing an undue financial burden on U.S. taxpayers and/or adding undue complexity to Federal tax laws.²⁵ In addition, we recognize the significant complexity involved in interpreting and applying the rules under section 367 with respect to outbound transfers and in defining and valuing nebulous concepts such as goodwill and going concern value, and we appreciate Treasury's and the IRS's consideration of these issues. We also recognize, however, that the tax-free treatment of outbound transfers of foreign goodwill and going concern value had long been part of the Federal tax law and that the Final Section 367 Regulations' denial of such treatment significantly changes the application of the law to the detriment of taxpayers. Because goodwill and going concern value are an integral part of virtually every actively conducted business, such a change in effect imposes a punitive exit tax on the transfer of any operating business to a foreign corporation without any support in the statute or legislative history for such a position. First and foremost, we believe a change to the treatment of outbound transfers of foreign goodwill and going concern value in a way that alters the statutory structure should only be effectuated through legislation. To the extent Treasury seeks to exercise its regulatory authority to address taxpayer abuses, we urge it to adopt a more measured approach that is properly tailored to abusive scenarios. For these and other reasons discussed below, we respectfully, but strongly, recommend that Treasury, in its final report to the President, propose to rescind the Final Section 367 Regulations.

PwC believes that the Final Section 367 Regulations' deviation from the statutory structure of section 367 represents a usurpation of Congressional authority. The architecture of section 367 is one under which all property used in an active trade or business is permitted to be transferred outbound tax-free unless explicitly carved out.²⁶ The Final Section 367 Regulations, however, in effect, invert the statutory structure by subjecting all outbound transfers of property to taxation unless explicitly permitted under a narrow definition of "eligible property,"²⁷ which does not include foreign goodwill or going concern value. Changes in this nature should only be effectuated through a statutory amendment.

As discussed in our prior comments submitted to Treasury and the IRS as well as highlighted in our oral testimony presented at the hearing on the 2015 proposed regulations, the rules as adopted under the Final Section 367 Regulations exceed Treasury's statutory grant of authority²⁸ by disregarding clear Congressional intent that outbound transfers of foreign goodwill and going concern value ordinarily will be tax-free and by altering the statutory structure.²⁹ This calls the validity of the regulations into question. As a result, there is significant uncertainty with respect to the treatment of outbound transfers of foreign goodwill and going concern value under the Federal tax law as to the appropriate rules to follow as well as with respect to the tax cost of undertaking transactions. The tax imposed by the Final Regulations create undue financial burdens on U.S. taxpayers that wish or are required to undertake transactions that implicate section 367 but are not susceptible to improper valuation of intangibles or otherwise motivated by tax avoidance.

The undue financial burden imposed on taxpayers by the Final Section 367 Regulations, individually and cumulatively, can be profound, as every incorporation of a foreign branch — a routine event for sole proprietors, multinational enterprises, and many other businesses — would be subject to an exit tax. In many industries, such as financial services, telecommunications, and utilities, the choice to incorporate or operate in branch form may not be a choice for the taxpayer, but instead may be mandated by local and/or industry regulations. In all these cases, 35 percent of the unrealized present value of what often is the business's most valuable asset — much of which likely does not readily generate cash but instead is tied to prospective earnings — becomes an immediate cash expenditure. Suddenly, an enterprise could have to liquidate or mortgage its assets just to pay the U.S. federal government's toll for operating a business in different form.

The undue financial burdens and added complexity to the Federal tax laws imposed by the Final Section 367 Regulations are further exacerbated by the changing landscape of international tax laws, as foreign jurisdictions consider enacting laws such as the anti-hybrid rules based on recommendations from the OECD pursuant to its Base Erosion and Profit Shifting ("BEPS") initiative. For example, if a foreign jurisdiction enacts BEPS anti-hybrid legislation,³⁰ a U.S. multinational enterprise that operates in that jurisdiction through branches or entities treated as partnerships for U.S. federal tax purposes may be placed in the dilemma of deciding whether it is feasible to incorporate the foreign operations to mitigate the impact of the anti-hybrid legislation if, in doing so, it would voluntarily subject the incorporation to taxation under section 367 despite a lack of tax avoidance motive.³¹ The Administration's continued focus on comprehensive tax reform legislation further complicates this situation, considering that previous proposals suggest a deemed controlled foreign corporation ("CFC") approach with respect to the treatment of foreign branches, which, absent special rules providing exceptions, would result in the deemed incorporation of a foreign branch to be subject to section 367.³² In each of these cases, the taxpayer would be required to monetize business asset value in order to pay the income tax, which is in direct conflict with the concerns raised by Congress in the legislative history relating to section 367.³³

Admittedly, the financial burdens imposed on U.S. taxpayers by the Final Section 367 Regulations are more severe for some than others, as the seemingly arbitrary application of the regulations effects similarly situated taxpayers unequally. The Final Section 367 Regulations impose substantial financial burdens on taxpayers with insignificant tangible assets but significant residual business value (e.g., many service providers) while providing more favorable treatment to those taxpayers that derive greater value from tangible assets (e.g., manufacturers, transportation businesses, leasing business, etc.). This is the case despite the fact that both conduct active trades and businesses and despite Congress drawing no such distinction in the statutory language or legislative history of section 367.

The disparate treatment and undue financial burden imposed on U.S. taxpayers by the Final Section 367 Regulations is quite apparent when viewed in the context of real-life business situations as illustrated above. We do not believe that these frustrations and the onerous exit tax that stem from the Final Section 367 Regulations are either appropriate or in furtherance of the President's policy objectives described in EO 13789, which include that "[t]he Federal tax system should be simple, fair, efficient, and pro-growth." Furthermore, as previously mentioned, the Final Section 367 Regulations run contrary to the other policy objectives described in EO 13789, namely that "[t]he purposes of tax regulations should be to bring clarity to the already complex Internal Revenue Code." The Final Section 367 Regulations do anything but bring clarity to the Federal tax laws; rather, these regulations add further complexity to the Federal tax laws due to the significant uncertainty as to the validity of the regulations.

PwC believes that the Final Section 367 Regulations exceed Treasury's authority to issue regulation under section 367(a) and section 367(d).³⁴ Therefore, while not expressly stated in the Notice, PwC believes that these regulations also satisfy the third criteria set forth in EO 13789 (i.e., that the Final Section 367 Regulations "exceed the statutory authority of the Internal Revenue Service"). In this regard, as discussed below, the Final Section 367 Regulations contradict and disregard clear legislative intent manifested in the statutory structure of section 367 and as expressed in abundant legislative history with respect to the tax-free treatment of outbound transfers of foreign goodwill and going concern value.

The active trade or business exception set forth in section 367(a)(3)(A) contains the general rule that a transfer of any property used in the conduct of an active trade or business outside of the United States will be excepted from the application of section 367(a)(1). Section 367(a)(3)(B) carves out from this general rule a narrow list of enumerated items (so-called "tainted assets"), which include intangible property as defined in section 936(h)(3)(B). In section 367(a)(3)(B)(iv), Congress created an exception to section 367(a)(3) that was perfectly coterminous with section 367(d). Intangible property as defined in section 936(h)(3)(B) was not eligible for the active trade or business exception,³⁵ but was subject to the rules of section 367(d).³⁶ Congress further carved out from the active trade or business exception the transfers of foreign branches with previously deducted losses in section 367(a)(3)(C). Except as provided in regulations, all other property is eligible for the active trade or business exception.³⁷ This is as precise as Congress can be in delineating the boundary between subsections of the Code. Congress affirmatively chose to enact a statute under which certain intangible property is not defined in section 936(h)(3)(B) (e.g., goodwill and going concern value) and, therefore, eligible for the active trade or business exception.³⁸

The Final Section 367 Regulations turns the statutory structure of section 367 on its head, changing the rule from one in which every asset used in an active trade or business outside of the United States qualifies for the active trade or business exception unless expressly carved out to a rule in which every asset that is used in an active trade or business outside of the United States may not qualify for the exception unless it is one of the "eligible" items of property enumerated in the regulations. In essence, the Final Section 367 Regulations change the active trade or business exception from an exception for active trade or business assets to an exception for non-passive tangible assets. Congress authorized Treasury to promulgate regulations to address circumstances of potential tax avoidance,³⁹ but we do not believe Congress authorized Treasury to rewrite the rules Congress enacted or otherwise reverse the decision Congress made to allow assets such as foreign goodwill and going concern value to be eligible for the active trade or business exception.

Not only do the Final Section 367 Regulations disregard the statutory framework of section 367, they also disregard the legislative history of section 367. In this regard, the legislative history of section 367(a)(3) is replete with indications that foreign goodwill and going concern value were intended to qualify for the active trade or business exception. Indeed, the House, Senate, and JCT reports mention the anticipated tax-free treatment of outbound transfers of these assets no fewer than seven times.⁴⁰ The consistent statements set forth in the legislative history make clear that Congress carefully contemplated the outbound transfer of foreign goodwill and going concern value and intended to provide a general rule that such transfers would not be taxed.⁴¹ Any regulations under section 367 that fail to provide this treatment fail to carry out the unambiguous legislative intent behind the active trade or business exception. Notwithstanding the foregoing, the Final Section 367 Regulations tax all transfers of foreign goodwill and going concern value. Therefore, the Final Section 367 Regulations fail to give effect to the unambiguously expressed intent of Congress as manifested in abundant legislative history. Furthermore, Congress's authorization for Treasury to prescribe rules to address potential tax avoidance⁴² was not a delegation for Treasury to categorically deny the tax-free treatment with respect to outbound transfers of foreign goodwill and going concern value in common ordinary business transactions. Treasury failed to exercise its regulatory power to prescribe exceptions and specific rules appropriately tailored to abusive scenarios.

The preamble to the Final Section 367 Regulations claims that legal and factual developments since Congress amended section 367 in 1984 have increased the relevance of section 367(d) and taxpayers' incentive to maximize value attributable to goodwill and going concern value, thus justifying re-evaluating the premise of the original congressional intent.⁴³ For example, the preamble asserts that the enactment of section 197 in 1993 providing for the amortization of acquired goodwill over 15 years eliminated taxpayers' prior incentive to minimize the value of goodwill in order to maximize the value of amortizable intangibles; that the promulgation of the "check-the-box" regulations under Treas. Reg. § 301.7701-3 in 1996 reduced obstacles to transferring high-value intangibles offshore; and that the growth in the share of business values attributable to intangible assets increased taxpayers' incentive to transfer valuable intangibles to related offshore affiliates.⁴⁴

We do not believe that these subsequent developments undermine the premise of the original legislative intent. Nowhere in the legislative history does Congress premise its intent for outbound transfers of foreign goodwill and going concern value on the appeal of section 367(d), taxpayers' incentive to transfer intangible assets offshore, or taxpayer practices with respect to the allocation of business values to or among intangibles. Moreover, none of the legal changes are relevant to the outbound transfers of intangibles; to the extent these changes concern U.S. taxpayers using intangible property in foreign subsidiaries without incurring current U.S. federal income tax pursuant to anti-deferral regimes such as subpart F, Congress has implicitly endorsed deferred U.S. taxation of profits attributable to property used in an active trade or business outside of the United States. Lastly, the frequency and magnitude of outbound transfers of foreign goodwill and going concern value do not implicate the general policy underlying section 367 that active business assets, including goodwill and going concern value, should be permitted to be transferred offshore tax-free while passive, liquid intangibles should not. Even if Congress did not anticipate in 1984 the legal and factual changes noted in the preamble, or even if subsequent development of practical experience merited revisiting existing rules, it is up to Congress to take appropriate actions.⁴⁵ By denying the favorable treatment of outbound transfers of foreign goodwill and going concern value under long-standing law based on reasons that do not bear on the legislative policy underlying such treatment, Treasury and the IRS have exceeded the permissible scope of its administrative power.

Moreover, we recognize that some taxpayers take the position that goodwill and going concern value are property covered by section 367(d) rather than section 367(a), which is based on a reading of the 1986 temporary regulations and other administrative guidance put forth by Treasury and the IRS in 1986.⁴⁶ The legislative history arguably is consistent with this interpretation.⁴⁷ The Final Section 367 Regulations fail to provide clarity with respect to the applicable framework for the treatment of outbound transfers of foreign goodwill and going concern value, as Treasury and the IRS declined to resolve the issue.⁴⁸ Instead, the Final Section 367 Regulations subject the outbound transfers of foreign goodwill and going concern value to taxation under either section 367(a) or section 367(d), based on a taxpayer's position as to the applicable provision for foreign goodwill and going concern value and an election mechanism.⁴⁹ This approach is arbitrary, adds to the uncertainty with respect to the treatment of goodwill and going concern value under the Federal tax law, and is inconsistent with general legislative intent that outbound transfers of foreign goodwill and going concern value ordinarily will be tax-free.⁵⁰

The Final Section 367 Regulations also fail to address Treasury's stated concern relating to the valuation of goodwill and going concern value. In the preamble to the Final Section 367 Regulations, Treasury and the IRS express that significant policy concerns are raised by taxpayers using valuation methods that are inconsistent with section 482 and taking an expansive interpretation of the scope of the foreign goodwill exception.⁵¹ Treasury and the IRS go on to explain that, based on the IRS's experience in administering section 367(d), valuation has led to taxpayer abuse and administrative difficulties due to "the uncertainty inherent in distinguishing between value attributable to goodwill and going concern value and value attributable to other intangible property."⁵² Thus, the tax avoidance the Final Section 367 Regulations purport to address relates to valuations, not the transfers to which Treasury's regulatory authority is expressly related. Indeed, drafters of the Final Section 367 Regulations have publicly confirmed that they were not concerned with the outbound transfers of foreign goodwill and going concern value when promulgating the regulations, but rather with the under-allocation of value to identifiable section 367(d) intangible property that may be transferred at the same time.⁵³ Therefore, the policy underlying the tax-free treatment of outbound transfers of foreign goodwill and going concern value used in an active business remains valid, with only the valuation of these assets at issue. While we recognize the complexity involved in defining and valuing nebulous concepts such as goodwill and going concern value, we do not believe that section 367 should be used to achieve an end result Treasury and the IRS have found difficult to achieve through other means.⁵⁴ We believe Treasury and the IRS's stated concerns should be more appropriately addressed under transfer pricing rules tailored to the valuation of intangible property. In this respect, we note that courts have invalidated regulations that do not address the proper policy concerns even under a broader grant of regulatory authority than that provided under section 367.⁵⁵

C. Recommendations

For the foregoing reasons, PwC believes that the Final Section 367 Regulations' change to the section 367 statutory structure represents a usurpation of Congressional authority to alter a statutory regime under which all property is permitted to be transferred outbound tax-free unless explicitly carved out. PwC further believes that Treasury has exceeded the permissible scope of its administrative power in the case of the Final Section 367 Regulations by denying the favorable treatment of outbound transfers of foreign goodwill and going concern value under long-standing law based on reasons that do not bear on the legislative policy underlying such treatment. In addition, we believe that the Final Section 367 Regulations import uncertainty into the application of Federal tax law with respect to the treatment of goodwill and going concern value while at the same time imposing undue financial burden on U.S. taxpayers that may be required to undertake transactions involving the transfer of such items that are not motivated by avoiding U.S. federal income tax. Therefore, we strongly recommends that Treasury, in its final report to the President, propose to rescind the Final Section 367 Regulations.

II. Final and Temporary Section 385 Regulations: The Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness (T.D. 9790; 81 Fed. Reg. 72858)

A. Background — Final and Temporary Section 385 Regulations

During 2016, the IRS and Treasury proposed and finalized regulations under section 385 addressing the characterization of certain related-party financial arrangements. The proposed regulations, issued on April 4,⁵⁶ were extremely controversial. The proposed regulations would have recharacterized debt between affiliated group members in the event the arrangement either failed to satisfy detailed documentation requirements or ran afoul of one of the broad categories of proscribed transactions set forth in the proposed regulations. If finalized as proposed, the regulations would have harmed both U.S. businesses competing in a global marketplace and foreign investment in the United States far in excess of any conceivable policy benefits. Businesses, professional services firms, industry associations, and other interested parties submitted detailed comments in response to the notice of proposed rulemaking and many urged the Treasury to withdraw and/or at least substantially modify the regulations to limit the impact of the rules and the associated complexity and burden.⁵⁷

In response to these comments, the Final and Temporary Section 385 Regulations were considerably narrowed to better focus on related-party financings that have the potential to erode the U.S. tax base. The Final and Temporary Section 385 Regulations also incorporate many of the suggestions made throughout the comment process, including, among other things, the removal of the bifurcation rule; generally limiting the application of the rules to debt issued by U.S. corporations, and providing general exclusions for S corporations and non-controlled REITs and RICs; modifications to the documentation rules under Treas. Reg. § 1.385-2 intended to alleviate the administrative burdens and the consequences of non-compliance;⁵⁸ exceptions to the transaction rules under Treas. Reg. § 1.385-3 and Temp. Reg. § 1.385-3T relating to specific types of issuers (e.g., certain regulated financial institutions and insurance companies), instruments (e.g., certain debt instruments issued as part of defined cash pooling and related arrangements), and transactions (e.g., certain acquisitions of subsidiary stock, specific types of tax-free reorganizations and similar transactions); and an extended transition period. Recently, on July 27, 2017, Treasury and the IRS issued Notice 2017-36, announcing the intent to amend the documentation provisions to apply only to interests issued or deemed issued on or after January 1, 2019.⁵⁹

B. Comments

PwC acknowledges and appreciates the IRS and Treasury's efforts to reduce the collateral impact and administrative burdens relating to the regulations. We also appreciate the IRS and Treasury's recent announcement of their intent to delay the effective date of the documentation rules to interests issued or deemed issued on or after January 1, 2019.⁶⁰ As indicated in Notice 2017-36, the delay in the application of the documentation rules is in response to concerns raised by taxpayers and in light of further actions concerning the review of the Final and Temporary Section 385 Regulations.

We applaud the IRS and Treasury for reviewing the comments submitted and for making a conscious effort to incorporate the recommendations into the Final and Temporary Section 385 Regulations and to delay the effective date of the documentation requirements; their actions in these instances demonstrate that the notice and comment period is constructive, not fruitless. For these same reasons, however, we believe it is necessary to explain that despite the substantial modifications made to the proposed regulations and the delayed effective date of the documentation requirements, the Final and Temporary Section 385 Regulations remain highly complex, financially and administratively burdensome, and susceptible to producing collateral consequences out of proportion to the stated goals. PwC believes that Treasury and the IRS instead should target perceived abuses with careful precision. Due, however, to the deep economic significance of the Final and Temporary Section 385 Regulations, we believe the appropriate course of action is for Treasury and the IRS to rescind the regulations and leave this for the legislative process. Therefore, as discussed in more detail below, we respectfully, but strongly, recommend that Treasury, in its final report to the President, propose to rescind in full the Final and Temporary Section 385 Regulations.

The Final and Temporary Section 385 Regulations were issued more than eight months ago and taxpayers, practitioners, and other interested parties continue to struggle with how to account for and comply with the rules. After thorough reflection, we strongly believe that the Final and Temporary Section 385 Regulations impose substantial financial and administrative burdens on U.S. companies disproportionate to the policy concerns the regulations are intended to address. We also strongly believe that the regulations are significant in view of the Presidential priorities for tax regulation outlined in EO 13789 and support Treasury's conclusion set forth in Notice 2017-38 that the Final and Temporary Section 385 Regulations impose an undue financial burden on U.S. taxpayers and/or add undue complexity to Federal tax laws.⁶¹

Despite the fact that the scope of the Final and Temporary Section 385 Regulations was significantly narrowed, the regulations still impose undue financial burdens on U.S. taxpayers, add undue complexity to the Federal tax laws, and create regulatory uncertainty by overturning decades of case law and settled expectations.⁶² The undue financial burden imposed by the Final and Temporary Section 385 Regulations is due in part to the complicated web of unnecessarily convoluted requirements, exceptions, and limitations set forth therein, which once mastered must be carefully managed and monitored in order to avoid triggering the recharacterization of related-party debt instruments.

Consider, for example, the compliance burdens imposed on taxpayers with respect to the Treas. Reg. § 1.385-2 documentation requirements. At a high-level, the documentation provisions set forth in Treas. Reg. § 1.385-2 require documentation to be prepared and maintained with respect to expanded group debt, specifying the nature of the documentation needed to substantiate debt treatment and requiring contemporaneous documentation and maintenance of such information evidencing indebtedness (i.e., "evidencing the indebtedness factors set forth in [Treas. Reg. § 1.385-2](c)").⁶³ In general, the issuer must prepare⁶⁴ and maintain documentation⁶⁵ and information that evidence: (i) an unconditional obligation to pay a sum certain, (ii) creditor's rights, (iii) a reasonable expectation of repayment, and (iv) actions evidencing a debtor-creditor relationship.⁶⁶ Additional documentation and information may also be required to supplement these enumerated items.⁶⁷ The Final Regulations also contain special documentation rules relating to certain types of reoccurring transactions (e.g., revolving credit facilities, umbrella agreements for trade payables, cash pools, etc.).⁶⁸ The required documentation must be maintained for all taxable years that each relevant debt instrument is outstanding and until the period of limitations expires for any federal tax return with respect to which the treatment of that instrument is relevant for U.S. federal tax purposes.⁶⁹

For taxpayers with only a handful of intercompany financing arrangements, the documentation requirements are manageable. But the reality is that for most multinational taxpayers, compliance with the documentation requirements will be a significant undertaking and, in many cases, will require groups to revise their legal agreements and put in place more robust systems to monitor the creditworthiness of obligors and to track and document timely payment. In the context of cash pooling and similar arrangements, this will be a tremendous financial and operational burden, given that there is no general exception from the documentation requirements provided for cash pools and similar arrangements.

Indeed, as Treasury and the IRS recently acknowledged in Notice 2017-36, the implementation of the Final and Temporary Section 385 Regulations will force U.S. companies to alter their business practices and incur significant costs to design, develop, and implement the systems, processes, and internal controls necessary to comply with the regulations. These administrative costs compound when considered in combination with the anticipated administrative costs of complying with and monitoring the impact of the Final and Temporary Section 385 Regulations. It is difficult to see how the financial, administrative, and compliance burdens imposed by the Final and Temporary Section 385 Regulations are appropriate for the purported objectives the documentation requirements are intended to achieve.

As explained in the preamble to the Final and Temporary Section 385 Regulations, one of the stated rationales for the documentation rules is that the IRS is at an informational disadvantage with respect to taxpayers in debt-equity disputes: "The Treasury Department and the IRS have determined that the documentation rules of proposed § 1.385-2 further important tax administration purposes."⁷⁰ In our view, the documentation rules impose significant administrative burdens on taxpayers while yielding minimal benefits to the government in terms of additional revenue or litigation support. It is well settled that the taxpayer, not the IRS, has the burden of proof to demonstrate entitlement to a deduction, including an interest deduction.⁷¹ Therefore, in any debt-equity dispute, the IRS can simply demand that the taxpayer substantiate (or prove) that an instrument is appropriately characterized as debt. Having that information prepared on a rolling basis with respect to nearly all intercompany loans, which for purposes of the Final and Temporary Section 385 Regulations includes everything from trade payables to long-term debt, is a waste of time and resources. Rather, the IRS should target loans that present a risk of earnings stripping and request documentation supporting the associated interest deductions under its preexisting summons powers. Nearly all well advised taxpayers will comply with the documentation rules with respect to meaningful loans. As such, the documentation requirements set forth in the Final and Temporary Section 385 Regulations will disproportionately catch inadvertent foot faults by poorly advised taxpayers.

The documentation requirements are not the only aspect of the Final and Temporary Section 385 Regulations that require taxpayers to incur significant costs relating to the development of systems, processes, and internal controls to ensure compliance with the regulations. Taxpayers will need sophisticated systems for continuously monitoring an array of attributes relating to issuers of debt instruments and the relevant debt instruments of those issuers in order to utilize many of the exceptions to the transactions rules set forth in Treas. Reg. § 1.385-3 and Temp. Reg. § 1.385-3T (e.g., the expanded group earnings exception, the qualified short-term debt exception). Without these systems, at least one of the qualified short-term debt instrument exceptions surely will be crucial for many multinational enterprises: the exception for short-term funding arrangements.⁷² This exception applies to debt instruments of an issuer satisfying one of two tests during a taxable year.

The first test is the specified current asset test, which allows a U.S. issuer to be funded continuously from foreign affiliates (e.g., a foreign cash pool) in an amount up to a reasonable estimate of the noncash current assets reflected on the borrower's balance sheet over its next operating cycle.⁷³ Complying with this exception will require continuously monitoring outstanding balances and forecasting expected future current asset balances.

The second test is the 270-day test, which allows a U.S. issuer to borrow an unlimited amount for a maturity of less than 270 days. This exception does not permit continuous funding, however, because it is conditioned on the borrower not having any short-term debt outstanding to any affiliate, other than ordinary course trade payables and interest free borrowings, for more than 270 days during the tax year.⁷⁴ The 270-day test cannot be utilized by a borrower in the same tax year as the specified current asset test. Like the specified current asset test, the 270-day test will require taxpayers to monitor the debt maturities and clean up periods and would involve a considerable potential for error.

The detailed explanation in the preamble relating to the exception for short-term funding arrangements, as well as the other qualified short-term debt instrument exceptions, indicates that Treasury and the IRS spent significant time and effort developing these exceptions and believed that these exceptions would "further reduce compliance costs" and "substantially reduce[ ] the compliance burden of applying the per se funding rule during the 36-month testing periods."⁷⁵ We too believed similar exceptions would alleviate the compliance burdens, but as we and many companies have discovered, we were wrong. Given the complexity of these exceptions and the systems necessary to ensure compliance, it remains to be seen how multinationals will realistically rely on these short-term funding exceptions or instead arrange to fund the working capital needs of U.S. affiliates externally.⁷⁶

The aforementioned examples are intended to illustrate the undue financial, administrative, and compliance burdens imposed by the Final and Temporary Section 385 Regulations, but these examples also illustrate the added undue complexity that the regulations import to the Federal tax laws. And the added complexity is not negligible when taken in the entirety. The additional complexity and challenges associated with the Final and Temporary Section 385 Regulations is a product of the extensive harm that would have been imposed by the proposed regulations. In an effort to limit the scope of the regulations, the IRS and Treasury were forced to import a myriad of intricate issuer, instrument, and transaction exceptions into the Final and Temporary Section 385 Regulations, many of which are impractical in real-life business situations. For example, in order to determine whether an instrument satisfies the exception for short-term funding arrangements, which the IRS and Treasury believed would "substantially reduce[ ] the compliance burden of applying the per se funding rule during the 36-month testing periods",⁷⁷ it is necessary to separately record and monitor on an ongoing basis (i) all loans that are more than 270 days; (ii) all ordinary course and interest-free loans; (iii) all demand deposits received by a qualified cash pool header; (iv) the entirety of a covered member's borrowing and lending transactions (both in the aggregate with members of the issuer's expanded group, and with respect to particular lenders); and (v) whether the covered member or any member of the expanded group is in a borrowing position for more than 270 days (both total days during a taxable year and consecutive days). And this is just one of the qualified short-term debt exceptions. When considered in combination with the other instrument exceptions, the expanded group earnings exception, the nuanced issuer exceptions, and the peculiar results that can arise in a variety of other contexts (e.g., the partnership context), it quickly becomes apparent that the Final and Temporary Section 385 Regulations run contrary to the President's policy objectives described in EO 13789, which include that the "Federal tax system should be simple, fair, efficient, and pro-growth" and "[t]he purposes of tax regulations should be to bring clarity to the already complex Internal Revenue Code . . . and to provide useful guidance to taxpayers."⁷⁸

Following the release of the proposed regulations, a senior Treasury Department official compared the complexity of the regulations to the recently enacted Foreign Account Tax Compliance Act ("FATCA") regulations. At that time, we found the comparison to the FATCA regulations, which themselves have created a significant burden on taxpayers, inapt. But after Treasury and the IRS subsequently incorporated into the Final and Temporary Section 385 Regulations a barrage of intricate exceptions relating to certain types of issuers, instruments, and transactions that only added further complexity to the rules, the comparison to the FATCA regulations is clearly misplaced — the complexity, costs, and administrative burdens imposed by the Final and Temporary Section 385 Regulations far exceed those associated with FATCA. The analogy to FATCA is instructive, however, when considering the implementation of those regulations. Acknowledging the complexity and systems implementation requirements associated with FATCA, the government deferred the implementation dates for the FATCA rules multiple times to grant taxpayers time to comply. We believe a similar approach may be warranted in the case of the Final and Temporary Section 385 Regulations (if the regulations are not rescinded in full), beyond the most recent delayed effective date of the documentation regulations announced in Notice 2017-36, and for all aspects of the regulations, not just the documentation provisions. Even if the effective date of the Final and Temporary Section 385 Regulations were to be further delayed (e.g., to January 1, 2021), the undue financial burdens on U.S. taxpayers and the added undue complexity to the Federal tax laws imposed by the regulations would remain.

The administrative costs of complying with and tracking the impact of the Final and Temporary Section 385 Regulations are daunting. The practical effect of these rules is that many U.S.-based multinationals now find it difficult to efficiently deploy their financial resources, thereby making it more difficult for U.S. businesses to compete in the global marketplace. The regulations also discourage foreign investment in the United States by restricting foreign investors' ability efficiently to recover returns on and of their investments and by significantly increasing the cost of doing business in the United States.⁷⁹ Congress recognizes the importance of foreign investment and the repatriation of U.S. dollars, as it has crafted a legislative balance between encouraging foreign investment⁸⁰ and eroding the U.S. tax base.⁸¹ Yet the Final and Temporary Section 385 Regulations completely undo this balance.

The Final and Temporary Section 385 Regulations tamper with the definition of debt in an effort to prevent earnings stripping and to "further limit the benefits of post-inversion tax avoidance transactions." Rather than adopting a focused and targeted approach to address earnings stripping, Treasury instead used a blunt instrument — its authority under section 385 to characterize an instrument as equity for all purposes of the Code — and adopted an expansive and complex set of rules that impose substantial burdens on U.S. taxpayers yet are only moderately effective at achieving the primary goal and are fairly arbitrary in their application to similarly situated taxpayers. Because they rely upon a general grant of definitional authority to overrule long-standing legal principles in the absence of a political consensus for change, the Final and Temporary Section 385 Regulations have drawn hostile scrutiny from Congress. Given that the Administration continues to focus on comprehensive tax reform legislation that will address, in relevant part, the structural issues encouraging inversions and earnings stripping planning, it would appear that the Final and Temporary Section 385 Regulations may become irrelevant after tax reform. PwC supports legislative efforts to address these issues by statute and believes specific targeted legislation would be a more effective way to combat the structural issues giving rise to inversions and earnings stripping by inverted companies. We believe the appropriate course of action is for Treasury and the IRS to step back and leave this for the legislative process.

C. Recommendations

1. Primary Recommendation: Rescind the Final and Temporary Section 385 Regulations.

In light of impending comprehensive tax reform and the undue financial burdens and added undue complexity to the Federal tax laws imposed by the Final and Temporary Section 385 Regulations, PwC respectfully recommends that Treasury rescind in full the Final and Temporary Section 385 Regulations.

2. Alternative Recommendations:

a. Delay effective date of the Final and Temporary Section 385 Regulations

The Administration's focus on historic comprehensive tax reform may render the Final and Temporary Section 385 Regulations obsolete. Therefore, while we strongly urge that the Final and Temporary Section 385 Regulations be rescinded in full, we recommend that the Treasury, at a minimum, delay the recast of debt into equity under the Final and Temporary Section 385 Regulations to a date at which time we can confidently say will follow the enactment of comprehensive tax reform (e.g., January 1, 2021). A delayed effective date of the regulations would provide the Administration and Congress time (and perhaps an incentive) to adopt and implement comprehensive tax reform and would prevent U.S. businesses from unnecessarily expending significant time, capital, and resources to design and implement the systems and internal controls necessary to comply with these highly complex and burdensome regulations, which may be rendered obsolete post-tax reform. Furthermore, by solely delaying the "recast" imposed under those rules, the Final and Temporary Section 385 Regulations would still play a role in deterring transactions motivated by interest deductions. In other words, taxpayers could not rely upon tax benefits associated with long-term earnings stripping, provided that either the section 385 or comprehensive tax reform may limit those tax benefits in the future.

The documentation rules should be completely removed, however, for the reasons stated above. Delaying their effective date does not address the root issue that the regulations impose inordinate burdens and complexity without a corresponding revenue or policy benefit.

b. Remove "Per Se" Aspect of the Funding Rule

The presumption of the Funding rule should be switched. In other words, there should be no per se period whatsoever under the funding rule, and the government should have the burden of proving that a taxpayer undertook a series of steps with the principal purpose of avoiding the General Rule. This reversal would allow taxpayers to continue operating their businesses without the fear of an inadvertent foot fault and the associated need to track a host of tax attributes. It would also preserve the government's ability to effectively combat earnings stripping in a targeted manner.

c. Additional Exceptions

In the short time that taxpayers have dealt with the Final and Temporary Section 385 Regulations, they have discovered many ambiguities and glitches. In order to address these issues, we believe that additional exceptions should be included in the Final and Temporary Section 385 Regulations. For example, an exception should be provided where taxpayers can show that a loan did not facilitate base erosion, which would be the case with many — if not most — U.S.-to-U.S. loans that cannot avail of the consolidated return exceptions.⁸² In addition, given the many glitches taxpayers have discovered in the rules, the government should provide a ruling procedure whereby taxpayers can receive a ruling that a technical violation of the rules should be excepted based on the outcome not offending the policies of the Final and Temporary Section 385 Regulations.⁸³

III. Final Section 987 Regulations: Final Regulations under Section 987 on Income and Currency Gain or Loss With Respect to a Section 987 Qualified Business Unit (T.D. 9794; 81 F.R. 88806)

A. Background

Section 987 was enacted in the Tax Reform Act of 1986⁸⁴ as part of a comprehensive consideration of the tax rules regarding foreign currency transactions and translation. Proposed section 987 regulations were first issued on September 25, 1991 (the "1991 Proposed Regulations").⁸⁵ These regulations adopted an "equity pool" paradigm under which currency gain or loss was imputed to all equity on a section 987 QBU's balance sheet in a manner similar to (although not identical with) the financial accounting rules⁸⁶ but with a "remittance" timing convention as required by the section 987 statute.⁸⁷ On September 7, 2006, the Treasury Department issued a new set of proposed section 987 regulations⁸⁸ (referred to as the "2006 Proposed Regulations") and withdrew the 1991 Proposed Regulations.⁸⁹ As explained in the preamble, the 2006 Proposed Regulations adopted a different paradigm (referred to as the "foreign exchange exposure pool" method or "FEEP" method) in response to perceived abuses attributable to the 1991 Proposed Regulations.⁹⁰

The rationale of the government in rejecting the equity pool method of the 1991 Proposed Regulations was that the imputation of section 987 gain or loss to non-financial assets (such as land, buildings, inventory, other tangible property and stock) combined with a remittance based timing convention allowed taxpayers to trigger section 987 losses that were not economically realized or were realized inappropriately.⁹¹ Because the 1991 Proposed Regulations were similar to the financial accounting rules in many material respects, the adoption of the FEEP method in the 2006 Proposed Regulations represented a deviation from those rules and a compliance challenge for taxpayers.

The final section 987 regulations that were issued on December 7, 2016 (the "Final Regulations") are largely based on the paradigm set forth in the 2006 Proposed Regulations.⁹² Accompanying the final regulations was a set of temporary⁹³ and proposed regulations⁹⁴ (collectively referred to as the "Temporary Regulations"). The Temporary Regulations set forth anti-abuse rules applicable to certain section 987 QBU terminations, an alternative "hybrid method" to the FEEP method set forth in the Final Regulations and other special rules.

1. Summary of 1991 Proposed Regulations

The 1991 Proposed Regulations adopt an "equity pool" paradigm under which currency gain or loss is imputed to all assets on a QBU's balance sheet, similar to the rules under FAS 52/ASC 830, with a "remittance" timing convention as required by the section 987 statute. The 1991 Proposed Regulations were written prior to the publication of the "check-the-box" regulations⁹⁵ and thus do not take the effects of those regulations into account. The regulations are divided into three sections: the first addresses the computation of a QBU branch's taxable income; the second addresses the computation of section 987 gain or loss of a QBU branch; and the third addresses terminations of a QBU branch. For purposes of the 1991 Proposed Regulations, the term "QBU branch" means a qualified business unit of the taxpayer having a functional currency different from that of a taxpayer and that does not use the dollar approximate separate transaction method of accounting as defined in Treas. Reg. § 1.985-3.⁹⁶

a. Determination of a QBU branch's income

The 1991 Proposed Regulations require the use of what it terms a "profit and loss method of accounting." Under this method of accounting a QBU branch's taxable income or loss is generally computed by:

b. Determining the section 987 gain or loss attributable to a remittance

In addition to determining branch income as described in paragraph (a) above, under section 987(3) a QBU branch must determine foreign currency gain or loss when there is a net transfer of property from the QBU branch to the taxpayer (referred to as a "remittance" in section 987(3)(A)) or the QBU branch terminates. The section 987 statute does not define the term "remittance" but 1991 Prop. Reg. § 1.987-2(b)(4) provides that "remittance" means the amount of any "transfer" from a QBU branch to the extent the aggregate amount of such transfers during the taxable year does not exceed the positive year-end balance of the equity pool.⁹⁸ The term "transfer" generally means the net amount of the basis of property that, on any day,⁹⁹ is contributed to the QBU branch or distributed by the QBU branch to the taxpayer.

The general structure of the equity pool paradigm mandates the creation of two pools — the equity pool and the basis pool. The equity pool is maintained in the functional currency of the section 987 QBU (assume €) and the basis pool in the functional currency of the owner of the QBU (assume USD). The equity pool balance is the sum of the adjusted basis of the QBU branch's assets less liabilities adjusted upward for income of the QBU and contributions to the QBU and adjusted downward for QBU branch losses and distributions from the QBU.¹⁰⁰ We have assumed that the functional currency of the QBU is the euro and therefore these calculations are in euro. The basis pool is essentially the taxpayer's functional currency basis in the euro equity of the QBU branch.¹⁰¹ Thus, the opening balance of the basis pool equals the QBU branch's opening balance of the equity pool translated into dollars (under our owner functional currency assumption) at the spot rate on the date the QBU branch begins to use the equity pool method. This basis pool is increased by the dollar amount of branch income (translated at the average rate for each year) and by the cash and basis of property transferred to the branch (translated into dollars at the spot rate on the day of transfer, if necessary). The basis pool is decreased by the dollar amount of branch losses and the portion of the basis pool attributable to any remittance made during the year.

Basis is assigned to a remittance under the following formula:

Once dollar basis is attributed to the functional currency cash or property remitted, section 987 gain or loss is determined by translating the euro amount of the remittance at the spot rate on the day remitted and subtracting from such amount, the portion of the dollar basis pool attributable to the remittance.¹⁰²

c. Source and character of section 987 gain or loss

Under the 1991 Proposed Regulations, section 987 gain or loss is ordinary gain or loss.¹⁰³ It is sourced and characterized using the same method the taxpayer uses to allocate and apportion its interest expense with certain modifications.¹⁰⁴

2. Summary of the 2006 Proposed Regulations

a. Reasons for change

As set forth in the preamble to the 2006 Proposed Regulations, Treasury and the IRS believed the 1991 Proposed Regulations imputed section 987 gains and losses that were not economically exposed to currency movements and allowed the cherry-picking of section 987 losses. Thus, the preamble provides:

As indicated above, the equity pool paradigm in the 1991 Proposed Regulations imputes currency gain or loss to all equity of a QBU whether or not the assets of the QBU are economically exposed to changes in the value of the functional currency of the QBU. The IRS has faced many cases in which taxpayers have claimed substantial non-economic exchange losses largely on the basis of the 1991 Proposed Regulations. An example may be instructive. Assume that a domestic corporation (US Corp) with the dollar as its functional currency forms a foreign corporation in Country X and then elects under the check the box regulations to treat that corporation as a DE. The DE conducts mineral extraction and owns all the necessary equipment. The equipment owned by the DE was contributed by US Corp. The DE has no employees and contracts with a subsidiary of US Corp for the employees needed in the business of extraction. US Corp, as the entity's sole owner, claims that the DE is a QBU for purposes of section 987. The DE has minimal financial assets and conducts no activities other than mineral extraction. US Corp claims that the DE's functional currency is Country X currency. A decline in the value of Country X currency relative to the dollar does not produce any economic loss for US Corp because the assets of the DE are not financial assets subject to currency fluctuation. Nevertheless, US Corp claims under the 1991 Proposed Regulations that the equity of the DE, which consists almost exclusively of equipment, gives rise to a substantial non-economic exchange loss and that terminating the DE (for example, by another check the box election) triggers recognition of such loss. Taxpayers have claimed similar results under other fact patterns. The IRS and Treasury have serious concerns about these types of transactions.

b. Scope

The 2006 Proposed Regulations apply to a "section 987 QBU."¹⁰⁵ A section 987 QBU is an "eligible QBU" that has a functional currency different from that of its owner. Generally, an eligible QBU means the activities of an individual, corporation, partnership or disregarded entity if (i) the activities constitute a trade or business under Treas. Reg. § 1.989(a)-1(c), (ii) separate books and records are maintained for the QBU, and (iii) the activities are not conducted in a hyperinflationary currency.¹⁰⁶ Partnerships, other than those subject to a 5 percent de minimis test, are treated as an aggregate and are subject to the 2006 Proposed Regulations. An owner may elect to group all section 987 QBUs owned directly that have the same functional currency and treat such QBUs as a single QBU.¹⁰⁷ The effect of this election is to simplify the calculation of section 987 gain or loss by allowing an owner to disregard transactions between such QBUs which might otherwise be treated as distributions and contributions to the QBUs. This election is also available to section 987 QBUs owned indirectly through a single section 987 partnership.¹⁰⁸

The 2006 Proposed Regulations adopt a "flat" approach to tiered section 987 QBUs.¹⁰⁹ For example, if a U.S. corporation owns "section 987 QBU-1" which owns "section 987 QBU-2" which, in turn, owns "section 987 QBU-3," the ownership structure is reconfigured for purposes of section 987. That is, the U.S. corporation is considered as directly owning section 987 QBU-1, -2, and -3 and no QBU is considered as owning another QBU under these facts.¹¹⁰

The 2006 Proposed Regulations do not apply to banks, insurance companies and similar financial entities including leasing companies, finance coordination centers, regulated investment companies, and real estate investment trusts.¹¹¹ In addition, the regulations do not apply to trusts, estates, and S corporations.¹¹² The preamble to the regulations suggests that excluded entities must comply with the section 987 statute by using a reasonable method consistently applied.

c. Differences between a "marked item" and "historic item"

A "marked item" is a monetary asset or liability that is properly reflected on the books and records of a section 987 QBU; would be a section 988 transaction if entered into by the owner of the QBU; and is not a section 988 transaction to the QBU.¹¹³ A "historic item" is any item that is properly reflected on the books of a section 987 QBU which is not a marked item.¹¹⁴ Generally, section 988 transactions entered into by a section 987 QBU (for example, pound denominated cash, or a yen debt receivable, of the euro QBU) are also historic items.¹¹⁵

As discussed below, it is only marked items that generate section 987 gain or loss under the 2006 Proposed Regulations. This principle is the cornerstone of the FEEP method adopted by the 2006 Proposed Regulations.¹¹⁶

d. Determination of the net income of a section 987 QBU

Generally, each item of income, gain, deduction or loss is determined in the functional currency of the section 987 QBU and translated into the functional currency of the owner at exchange rates set forth in 2006 Prop. Reg. § 1.987-3(b). Net income (or loss) of the section 987 QBU is taken into account by the owner under generally applicable timing rules of the Internal Revenue Code.

The default translation rate for an item of income, gain, deduction or loss is the average rate for the year or, if the owner elects, the spot rate for each day an item is properly taken into account for tax purposes under the owner's method of tax accounting.¹¹⁷ An important exception to the general translation rule is that depreciation and basis recovery through a sale, exchange or otherwise with respect to a historic asset is translated at the historic exchange rate (generally, the spot rate for the day the property was acquired by the QBU).¹¹⁸ This principle represents a policy decision by Treasury and the IRS to align sections 987 and 988 as closely as possible.

e. Determination of section 987 gain or loss

Section 987 gain or loss is determined under the FEEP method, which is a balance sheet approach. Under the FEEP method, the owner of the section 987 QBU, first determines the net value of the QBU in the functional currency of the owner by translating marked items on the QBU's tax balance sheet at the year-end exchange rate and historic items at the historic exchange rate.¹¹⁹ The owner then subtracts from this amount, the "net value" of the QBU at the end of the prior year giving rise to an amount which reflects the change in net value from the prior year.¹²⁰

The change in net value in a taxable year is generally composed of three classes of items: (1) a change in net value due to a change in exchange rates with respect to the marked items for the year; (2) a change in net value due to contributions and distributions of assets and regarded liabilities to the QBU during the year; and (3) a change in net value due to profit or loss for the year. The seven step process described in 2006 Prop. Reg. § 1.987-4(d) essentially determines the section 987 gain or loss on the marked items for a taxable year by backing out from the total change in net value, the change in net value due to (2) and (3) above.¹²¹ The amount so determined for a taxable year is added to the FEEP pool of unrecognized section 987 gain or loss and becomes a component of the "net unrecognized section 987 gain or loss."¹²² Net unrecognized section 987 gain or loss is taken into the income of the QBU's owner below.

Section 987 gain or loss is taken into account by the owner of a section 987 QBU when the QBU makes a remittance of cash or property¹²³ to the owner.¹²⁴ A remittance is determined in the functional currency of the owner on the last day of the taxable year with reference to the basis of property remitted, and is the excess of distributions from the QBU to the owner for the taxable year over the contributions from the owner to the QBU for the taxable year.¹²⁵ If marked items are distributed from the QBU, such items are translated into the functional currency of the owner at the spot rate on the day distributed.¹²⁶ If historic items are distributed from the QBU, the amount of the remittance is calculated by translating the local currency basis amount into the functional currency of the owner at the historic exchange rate.¹²⁷

The amount of section 987 gain or loss residing in the FEEP pool of net unrecognized section 987 gain or loss taken into account for a taxable year is determined under the following formula:¹²⁸

Section 987 gain or loss is also taken into account if a QBU terminates.¹²⁹ In the case of a QBU termination, the remittance fraction set forth above is deemed to be 1/1 and accordingly, the entire amount of net unrecognized section 987 gain or loss is taken into account.¹³⁰

f. Transition rules

The 2006 Proposed Regulations allow taxpayers to choose between two methods to transition to the regulations provided that the taxpayer's prior section 987 method was reasonable. The two methods were the deferral method and the fresh start method.

Under the deferral method, all section 987 QBUs were deemed to terminate (solely for purposes of section 987) on the day prior to the transition date and reform on the transition date. On the deemed termination, section 987 gain or loss was computed under the taxpayer's prior method. The amount of the section 987 gain or loss so computed was deferred and treated as "net unrecognized section 987 gain or loss" in the taxable year following the deemed termination. In computing the exchange rates used in determining the amount of assets and liabilities deemed transferred to the new section 987 QBU, any deferred gain or loss was an adjustment to the historic exchange rates. The effect of this rule was to carry forward into the FEEP method, section 987 gain or loss determined under the taxpayer's prior method.

Under the fresh start method, all QBUs subject to section 987 were also deemed to terminate (solely for purposes of section 987) on the day prior to the transition date and reform on the transition date. Section 987 gain or loss determined under the taxpayer's prior method was not taken into account. Rather, the historic exchange rates were used in determining the amount of assets and liabilities deemed transferred to the new section 987 QBU.

The effect of this rule was threefold. First, currency gain or loss that would have been generated under the 1991 Proposed Regulations is never recognized. Thus, section 987 gain or loss that was imputed to the QBU's historic assets (e.g., plant, equipment and inventory) under its prior method disappeared. Second, at the end of the first year to which the FEEP method applies, the marked items, having a historic basis, will generate section 987 gain or loss for the period between the time the asset was acquired by the QBU to the last day of the first year. Note this amount is not recognized unless there is a remittance. Third, currency gain or loss that was determined for book purposes with respect to assets that were no longer on the QBU's balance sheet on the transition date was permanently lost.

3. Summary of the Final Regulations

The Final Regulations adopt the approach and material rules of the 2006 Proposed Regulations. Because these rules have been summarized in the preceding section, we focus on the relevant changes made in the 2006 Proposed Regulations by the Final Regulations. Changes made in the Temporary Regulations are described in a different section of this letter.

Relevant changes made in the Final Regulations include:

4. Summary of relevant provisions in the Temporary Regulations

Several material changes were made to the section 987 regulations in the Temporary Regulations. The most material were the rules set forth in Temp. Reg. § 1.987-12T.

a. Temp. Reg. § 1.987-12T

Temp. Reg. § 1.987-12T provides a sophisticated and complex regime designed to prevent the use of certain technical terminations referred to as "deferral events" and "outbound loss events" to immediately recognize section 987 losses (and gains in some cases) both before and after the Final Regulations are effective. It is important to note that Temp. Reg. § 1.987-12T generally applies to section 987 QBUs that are subject to the Final Regulations as well as to those that are not.¹³⁹

Temp. Reg. § 1.987-12T is generally effective with respect to any deferral or outbound loss event (explained below) that occurs after January 6, 2017.¹⁴⁰ However, if such an event is undertaken with a principal purpose of recognizing section 987 loss, then the effective date is a deferral or outbound loss event that occurs on or after December 7, 2016.¹⁴¹ There are two overarching exceptions to the application of the rules in Temp. Reg. § 1.987-12T. First, Temp. Reg. § 1.987-12T does not apply to a section 987 QBU for which a deemed termination election described in Temp. Reg. § 1.987-8T(d) is in effect.¹⁴² Second, Temp. Reg. § 1.987-12T does not apply to a section 987 QBU in a taxable year where its net unrecognized section gain or loss is $5 million or less.¹⁴³

As indicated previously, there are two "events" targeted by Temp. Reg. § 1.987-12T: (1) a deferral event, and (2) an outbound loss event.¹⁴⁴ A deferral event refers to a termination of a section 987 QBU¹⁴⁵ if immediately after the transaction or series of transactions, assets of the section 987 QBU are reflected on the books of a "successor QBU."¹⁴⁶ A successor QBU is a section 987 QBU that immediately after the termination transaction: (1) reflects assets on its books and records that were previously reflected on the books of the terminated QBU ("prior QBU"),¹⁴⁷ (2) the owners of the prior QBU and successor QBU are members of the same controlled group¹⁴⁸ (i.e., persons with a relationship to each other described in section 267(b) or 707(b)),¹⁴⁹ and (3) in the case where the owner of the prior section 987 QBU was a U.S. person, the potential successor QBU is owned by a U.S. person.¹⁵⁰

Generally, an outbound loss event is a termination of a section 987 QBU in connection with a transfer by a U.S. person of the assets of a section 987 QBU to a foreign person that is a member of the same controlled group immediately before the transaction that would result in the recognition of section 987 loss but for the outbound loss event rules.¹⁵¹ An outbound loss event also includes a transfer where the transferee did not exist immediately before the transaction but does exist immediately after the transaction such as when a section 987 QBU is checked closed to become a CFC, assuming the other criteria are met (a section 987 loss would result from the transaction). It is important to note that while the deferral event rules apply to section 987 gains and losses, the outbound loss event rules apply only to section 987 losses.¹⁵²

The technical details regarding the effect of entering into a deferral event or outbound loss event are beyond the scope of this comment. Suffice it to say that with respect to a deferral event, section 987 gain or loss is generally attributed to the transferor and deferred.¹⁵³ In the context of an outbound loss event, section 987 loss either adjusts the basis of stock received or, in certain cases, is deferred until the owner leaves the controlled group.¹⁵⁴

b. The hybrid method

In an effort reduce the complexity of the FEEP method, Treasury has provided on an elective basis for a "hybrid method" alternative to the FEEP method. The "hybrid method" is derived from two elections — an annual deemed termination election under Temp. Reg. § 1.987-8T(d) and an election under Temp. Reg. § 1.987-3T(d) to translate all items of income and expense at the yearly average exchange rate.

Key features of this hybrid method are that: (1) depreciation is determined differently for P&L (translated at a current exchange rate in determining net income or loss) and balance sheet purposes (translated historically in determining section 987 gain or loss); (2) the basis of assets and the amount of liabilities are also determined differently for P&L (basis is determined at a current exchange rate) and balance sheet purposes (basis is determined at a historic exchange rate); and (3) a taxpayer elects to deem all section 987 QBUs of which it is an owner to terminate on the last day of each taxable year.

It is important to note several features of this election. First, the election generally applies not only to section 987 QBUs of the taxpayer but to all section 987 QBUs owned by any person related to the taxpayer under sections 267(b) or 707(b).¹⁵⁵ Second, there is an important exception to this general rule. A taxpayer may make a separate election for a section 987 QBU owned by the taxpayer if the year in which the election is made there would be a section 987 gain recognized on the deemed termination or a loss of $1 million or less.¹⁵⁶ Third, an annual deemed termination election cannot be revoked.¹⁵⁷ Finally, it should be noted that the annual deemed termination election is independent of the hybrid method election under Temp. Reg. § 1.987-3T(d) even though it is a condition precedent for making the hybrid method election.¹⁵⁸

c. Allocation of assets and liabilities of a section 987 aggregate partnership to its partners

As mentioned above, the Final Regulations do not apply to partnerships other than section 987 aggregate partnerships. With respect to section 987 aggregate partnerships, the Final Regulations generally apply an aggregate approach for section 987 purposes that effectively disregards the partnership as a separate entity. Each partner of a section 987 aggregate partnership is attributed its share of the assets and liabilities recorded on the books and records of the section 987 aggregate partnership's eligible QBU.¹⁵⁹ Those assets and liabilities become a section 987 QBU of such partner (and not of the section 987 aggregate partnership) if the QBU has a functional currency different from that of the partner in the section 987 aggregate partnership.¹⁶⁰

The 2006 Proposed Regulations generally introduced an aggregate approach (for all partnerships) and provided that a partner's share of assets and liabilities reflected on the books and records of an eligible QBU held indirectly through the partnership must be determined in a manner consistent with how the partners have agreed to share the economic benefits and burdens corresponding to those partnership assets and liabilities, taking into account the rules and principles of subchapter K.¹⁶¹ The Temporary Regulations provide more specific rules through the introduction of a "liquidation value percentage" methodology for determining a partner's share of the assets and liabilities reflected on the books and records of an eligible QBU owned indirectly through a section 987 aggregate partnership.¹⁶²

Under the liquidation value percentage methodology, in any taxable year, a partner's share of each asset, including its basis in each asset, and the amount of each liability reflected on the books of an eligible QBU held indirectly through a section 987 aggregate partnership is proportional to the partner's liquidation value percentage with respect to the section 987 aggregate partnership for that taxable year.¹⁶³ A partner's liquidation value percentage is the relative liquidation value of the partner's interest in the section 987 aggregate partnership on the applicable determination date (i.e., generally the most recent optional section 704(b) revaluation event, whether or not the partnership in fact revalued section 704(b) capital accounts).¹⁶⁴ A partner's liquidation value percentage is determined based on the amount of cash the partner would receive with respect to the interest if, immediately following the applicable determination date, the partnership sold all of its assets for cash equal to the fair market value of such assets (taking section 7701(g) into account), satisfied all of its liabilities (other than those described in Reg. § 1.752-7), paid an unrelated third party to assume all of its contingent liabilities (within the meaning of Reg. § 1.752-7) in a taxable transaction, and then liquidated.¹⁶⁵

Although this liquidation value percentage methodology clarifies the manner for determining a partner's share of the assets and liabilities reflected on the books and records of an eligible QBU owned indirectly through a section 987 aggregate partnership, it ignores the application of section 704(c), the allocation of liabilities for section 752 purposes, and other subchapter K concepts.

B. Recommendations

1. The Final and Temporary Regulations should be withdrawn

We believe several aspects of the Final and Temporary Regulations are inordinately burdensome for taxpayers. The regulations would require taxpayers to maintain yet another separate set of books and records solely for section 987 purposes in order to track historical basis and historical deductions (e.g., depreciation and amortization expense). Taxpayers already maintain separate books and records for U.S. GAAP and U.S. tax purposes. In most cases, the historical data necessary to comply with the regulations is not readily maintained by taxpayers. As a result, given the complexity and administrative burden of the Final Regulations and Temporary Regulations, we recommend full repeal of the Final Regulations and Temporary Regulations to relieve taxpayers of the onerous compliance burden imposed on them by such regulations.

2. If the Final and Temporary Regulations are not withdrawn, we suggest the following modifications

a. Allow taxpayers to elect to use the methodology set forth in the 1991 Proposed Regulations (with modifications) but either (a) defer section 987 gains and losses until the property of the QBU is sold outside of the controlled group as defined in Temp. Reg. § 1.987-12T(f)(1), or (b) defer section 987 losses to the extent they exceed previously recognized section 987 gains of a QBU.

We are cognizant of the concerns that motivated Treasury to withdraw the 1991 Proposed Regulations in favor of the FEEP approach contained in the 2006 Proposed and Final Regulations. In summary, these concerns were the over-imputation of section 987 translations gains and losses and the ability to selectively trigger section 987 losses through strategic remittances or technical terminations of a QBU. However, as we pointed out above, the FEEP approach creates administrative burdens that we believe can be ameliorated by providing elections¹⁶⁶ described below.

i. Election to defer section 987 gains and losses until the property of the QBU is sold outside of the controlled group as defined in Temp. Reg. § 1.987-12T(f)(1).

We recommend an election that would allow taxpayers, including excluded entities, to follow the 1991 Proposed Regulations in determining a QBU's net income and section 987 gain or loss (with modifications described below). As a condition of making this election, the taxpayer would have to agree to a timing convention for the recognition of section 987 gains and losses that would be roughly analogous to book timing conventions for releasing deferred translation gain or loss from the cumulative translation account. That is, section 987 gain or loss would be triggered for tax purposes when the assets of a section 987 QBU (whether or not still held in QBU solution) were sold outside the controlled group as defined in Temp. Reg. § 1.987-12T(f)(1).

Under this suggested approach, a section 987 QBU would determine its income and section 987 gain or loss under the method described in the 1991 Proposed Regulations annually and report such amounts to the IRS on a dedicated section 987 form (so that the IRS would have a vehicle for tracking section 987 gain or loss over long periods). That is, the QBU would determine its net income in its functional currency and translate the bottom line number into the functional currency of the owner at the average rate for the year. Thus, the need for historic basis data would be removed from the calculation of income. To address concerns regarding the over-imputation of section 987 gains and losses, we suggest modifying the calculation of section 987 gain or loss under the 1991 Proposed Regulations by maintaining the rule in Reg. § 1.987-2(b)(2) which excludes stock and partnership interests from the balance sheet of a section 987 QBU. We further suggest that any tangible property that is not expected to be on the books and records of a section 987 QBU for substantially its entire useful life also be removed from the books and records of the section 987 QBU. In addition, we suggest modifying the 1991 Proposed Regulations to incorporate several features of the 2006 Proposed Regulations such as the grouping election, annual netting convention, and adopting a "flat" approach for tiered section 987 QBUs. While such calculations would not be identical to book calculations, they would be reasonably close in most cases and data from the taxpayer's books could be used to make the calculations.

This elective approach would ameliorate the major concerns of taxpayers by providing much greater book/tax conformity in the required calculations while at the same time addressing concerns of the Treasury Department by preventing the cherry-picking of inflated section 987 losses.

ii. Election to defer section 987 losses to the extent they exceed previously recognized section 987 gains of a QBU.

Like the election above, this election would combine the administrative ease of applying the 1991 Proposed Regulations (with the modifications described above to the section 987 calculation) but with a different timing convention than a remittance based convention. Under this election, the taxpayer, including excluded entities, would compute the income and section 987 gain or loss of a QBU under the principles of the 1991 Proposed Regulations but any section 987 loss arising from a remittance in excess of previously recognized section 987 gain would be deferred until the deferred loss is offset by an amount of section 987 gain recognized with respect to that QBU. A taxpayer would need to maintain a deferral account for each of its section 987 QBUs or combined section 987 QBUs (if the taxpayer elected to group its section 987 QBUs). For example, assume in Year 1 a taxpayer realizes section 987 loss of $100,000 with respect to QBU1 under the principles of the 1991 Proposed Regulations (as modified). Such loss would be deferred because the taxpayer has yet to realize any section 987 gain with respect to QBU1. If in Year 8, the taxpayer realizes section 987 gain of $80,000 with respect to QBU1, the taxpayer would be allowed to recognize $80,000 of its deferred $100,000 section 987 loss in Year 8 and net such loss with its section 987 gain of $80,000. We would recommend that this election apply to all of a taxpayer's section 987 QBUs.

iii. We believe that the election set forth in (i) above would be preferable given the symmetry in the way section 987 gains and losses are treated.

The election described in (ii) above systematically disadvantages taxpayers to the extent taxpayers make remittances from section 987 QBUs that generate section 987 gains and others that generate section 987 losses. Under this election, such taxpayers would be required to recognize the section 987 gains but would be required to defer section 987 losses. The election described in (iii) above does not produce this harsh result but rather provides for timing symmetry among all section 987 QBUs of a taxpayer. That said, either election would simplify the section 987 calculations and provide greater book/tax conformity.¹⁶⁷

b. Restore the deferral transition rule for any taxpayer that makes an election described above.

We suggest that a taxpayer that makes an election that is based on the 1991 Proposed Regulations (including an "earnings only" method) be allowed to transition to the Final Regulations using the deferral transition rule or the fresh start transition rule. This essentially would allow taxpayers to choose continuity between its old and new methods.

We note that the more balanced approach of the transition rules in the 2006 Proposed Regulations was replaced with a largely anti-taxpayer regime that required taxpayers to assess the financial accounting effect of the Final Regulations for the financial statement period that included the date the Final Regulations were issued (i.e., December 7, 2016). This effect was reported in continuing operations and negatively affected many taxpayers. We believe this was inappropriate.

c. Make reasonable changes to some of the rules regarding partnerships.

There are a number of changes warranted in the way the Final Regulations address partnerships. First, we believe the de minimis rule set forth in 2006 Prop. Reg. § 1.987-1 (b)(i)(ii) should be restored and raised to 10 percent. This would keep the vast majority of investment partnerships characterized by small partnership interests from having to address the complexity of section 987. The absence of such a rule creates serious administrative burdens on investment partnerships. Second, we believe the liquidation value percentage method for allocating assets on a partnerships balance sheet to the partners is too rigid and ignores the application of section 704(c), the allocation of liabilities for section 752 purposes, and other subchapter K concepts. Accordingly, we believe it should be withdrawn and the more flexible rule of the 2006 Proposed Regulations be restored. Finally, it would be helpful if Treasury made it clear that use of an entity approach with respect to excluded partnerships was acceptable.

* * * * *

If you have any questions, please do not hesitate to contact Tim Anson at (202) 414-1664, Michael DiFronzo at (202) 312-7613, Marty Collins at (202) 414-1571, or Wade Sutton at (202) 346-5188.¹⁶⁸

Respectfully submitted,

PricewaterhouseCoopers LLP