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Debt-Equity Regs: Withdraw, Modify, or Leave to Legislation?

POSTED ON Sep. 12, 2017

Corporate advocates have urged Treasury to withdraw, substantially modify, or suspend its debt-equity regulations until after Congress passes tax reform legislation, citing undue burdens, complexities that make the rules unadministrable, and taxpayers’ need for certainty.

Several accounting firms and professional associations responded in August to the IRS’s request (Notice 2017-38, 2017-30 IRB 147) for recommendations on how to alleviate the burdens associated with the eight significant Obama-era regulations that Treasury identified in response to Executive Order 13789. That order directed Treasury to review its recent tax regulations. For the final and temporary section 385 regulations (T.D. 9790) included in the list, Treasury acknowledged criticisms concerning the financial burdens of the documentation rules — particularly the more ordinary course transactions — and the complexity and increased tax burden associated with the transaction rules.

Several commentators called for Treasury to withdraw the regulations, but some also suggested changes that could alleviate the burdens and complexities if Treasury modifies the rules instead. Practitioners commended Treasury and the IRS for their July announcement (Notice 2017-36, 2017-33 IRB 208) that delayed the documentation rules under reg. section 1.385-2 by one year — effective only for applicable instruments issued after 2018. However, they still contended that Treasury's action failed to address the possible collateral consequences of the regs.

The section 385 debt-equity regulations target incentives for shifting income offshore via corporate inversions and discourage interest-stripping tactics. An inverted company can avoid taxes on some of its U.S. earnings by claiming excessive deductions for interest paid on purported debt to its new foreign parent. The regulations establish minimum documentation requirements for some related-party interests in a corporation to be treated as debt and to reclassify some related-party debt as equity for federal tax purposes.

In its letter to Treasury, PwC recommended rescinding the section 385 regulations and having the legislative process take care of the structural issues that encourage inversions and earnings stripping by inverted companies, noting that the tax reform efforts of Congress and the White House could render the section 385 rules obsolete.

Adam Looney of the Urban-Brookings Tax Policy Center agreed that “a more thorough legislative solution would be ideal to address interest stripping,” but suggested that some of the section 385 documentation rules might still need to be retained. To the extent some disparity might remain post-tax-reform in the treatment between debt and equity, “there’s always going to be some incentive to play fast and loose with the definitions . . . so you’re going to need some rules to clarify” those terms, he told Tax Analysts.

Critics of the Trump administration’s decision to revisit and delay components of the section 385 regulations contend that the rules remain necessary to limit incentives for corporate inversions and interest stripping. In August a group of 12 senators urged Treasury to reject calls to eliminate those regs, and to instead strengthen the anti-inversion rules and work with Congress “to curb these abusive tax avoidance schemes for good.”

Stakeholders could learn the fate of the regulations, or at least see an interim decision on them, when Treasury publishes its recommendations in the Federal Register by September 18 in accordance with the executive order.

Tax Reform Alignment

Tax reform proposals that limit the deductibility of interest expenses and those that impose strict earnings stripping limits negate the need for the section 385 rules, Wade Sutton of PwC told Tax Analysts. “In fact, repealing the section 385 regulations creates additional revenue-scoring headroom for a future tax reform bill,” he said.

It’s hard to believe tax reform will not solve the post-inversion interest-stripping issue, Looney said, adding that any meaningful corporate tax reform proposal recently contemplated has addressed it. The matter was discussed in former House Ways and Means Committee Chair Dave Camp’s 2014 tax reform plan, Present Obama’s 2016 business tax reform framework, and the House Republicans’ 2016 “A Better Way” tax reform blueprint.

Camp’s provision to limit earnings stripping would have reduced the allowable interest deductions to foreign related parties by lowering the excess interest expense threshold from 50 percent of adjustable taxable income to 40 percent for taxpayers with a debt-to-equity ratio in excess of 1.5 to 1, while also limiting carryforwards. Another Camp provision to modify section 163 would have denied an interest expense deduction for U.S. shareholders that are members of worldwide affiliated groups with excess domestic indebtedness (defined as the lesser of 100 percent of the worldwide group or net interest expense in excess of 40 percent adjusted taxable income).

Some observers have argued that neither the current interest deduction limits under the code nor Camp’s proposed revisions would adequately limit earnings stripping.

The Obama-era plan would have also limited interest deductions for U.S. operations so that corporations couldn’t load up their U.S. subsidiaries with interest and strip income out, Looney said. The House Republicans’ original cash flow tax proposal would solve the interest-stripping problem entirely by eliminating deductibility of net interest expense, he said.

Corporate integration proposals, on the other hand, tackle the problem by allowing corporations to deduct dividends paid. In July several former Treasury officials said they favored that approach over limiting interest deductibility to address lawmakers’ concerns about the disparate tax treatment of debt and equity financing.

The fundamental principle of a corporate integration solution is to tax corporate income once, and only once, and to eliminate or reduce the biases in corporate decision-making with the classical two-level tax system. Eliminating one level of tax effectively reduces the corporate tax and the preference for debt over equity financing, which could lessen the incentives for inversions and earnings-stripping planning.

Senate Finance Committee Chair Orrin G. Hatch, R-Utah, has been critical of the section 385 rules as a means to eradicate inversions and earnings stripping. “If we want to prevent future inversions, we should spend less time tinkering around the regulatory edges and engaging in partisan rhetoric and more time trying to find common ground to actually fix our tax code,” he said in an April 2016 floor statement. Hatch said his corporate integration proposal would “relieve a great deal of the inversion pressure on American companies and, at the very least, significantly alter the economic calculation for inversion transactions. Best of all, it would do so without punishing companies or imposing burdensome mandates.”

According to some observers, Hatch’s proposal could make its way to the detailed tax reform blueprint if lawmakers aspire to pass comprehensive tax reform. The proposal is anticipated to be a 40 percent dividends paid deduction without withholding, compared with an earlier approach to offer a full dividends paid deduction with withholding on both dividends and interest at a nonpreferential 35 percent rate.

But absent a tax regime that denies corporate interest expense deductions or one that allows companies to deduct their dividend payments, the government’s interest in differentiating debt from equity would remain strong, Looney said. The IRS has identified abusive transactions in which, for example, corporations create “purported debt instruments solely for the purpose of generating interest for a high rate taxpayer,” or create hybrid securities in which one party treats the transaction as interest paid and the other treats it as dividends received, he said. “Having some more formal documentation of what’s going on in circumstances like that is . . . a necessary part of enforcing our rules,” Looney said.

In the Interim

While the right solution for some of the debt-equity rules would be to reform the tax code, the section 385 regulations provide a stopgap in the meantime that allows lawmakers to develop a legislative solution while still inhibiting inversions, Looney said. Although Treasury could defer a decision on the regulations until there’s a statutory solution, the government may not need to do much, given the recent delay until 2019 for the documentation rules, which are the most onerous ones, he said. 

But PwC argued that if Treasury doesn’t rescind the final and temporary section 385 regulations, then at a minimum it should delay the recast of debt into equity under reg. section 1.385-3 until after comprehensive tax reform — possibly to January 1, 2021. According to PwC, even with a delay in the recast provision the regulations “would still play a role in deterring transactions motivated by interest deductions [because] . . . 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 benefits in the future.” PwC contends, however, that “the documentation rules should be completely removed [because] . . . 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.”

Benefits and Burdens

Some commentators said the significant burdens and costs of complying with the regulations outweigh the expected benefits. In the preamble to the final regulations, Treasury states that the revenue effect for the section 385 rules is $7.4 billion over 10 years, with a compliance cost increase of $56 million per year and initial start-up costs and infrastructure investment in the first few years of $224 million.

“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,” PwC said.

The documentation rules require taxpayers to provide evidence of an unconditional and binding obligation to make interest and principal payments on specific fixed dates; evidence that the holder of the loan has the rights of a creditor, including superior rights to shareholders for dissolution; a reasonable expectation of the borrower’s ability to repay the loan; and evidence of conduct consistent with a debtor-creditor relationship.

The Tax Executives Institute argued that Treasury’s compliance cost estimates “appear grossly understated.” Based on its members’ experience, TEI said total start-up costs to comply with the reg. section 1.385-2 documentation requirements would exceed $1 million for an affected multinational corporation, compared with the IRS’s estimate of $35,600 per organization, which assumes the rules would apply to 6,300 C corporations.

Looney, formerly the Treasury deputy assistant secretary for tax analysis, whose office was responsible for the section 385 regulatory impact assessment, acknowledged that the original estimates for taxpayers’ cost to comply with the April 2016 proposed regulations (REG‐108060‐15) were understated. But Treasury revamped its estimates for the October 2016 final regulations using a “formal model” for determining compliance costs and revising advisers’ hourly rates in response to comments received on the earlier estimates, he said.                                                 

According to Looney, many companies said they document intercompany debt “as if taking a loan from a bank or lending to a third party,” and therefore their costs would be minimal to comply with the rules. For companies without those practices in place, however, the costs could be more substantial. Thus, start-up and ongoing incremental compliance costs will vary across companies, and the computed average reflects that many corporations appear to already document their activities, he said.

In its letter to Treasury, TEI pointed out that the government’s compliance cost estimates appear to disregard the additional financial burden of complying with the transaction rules under reg. sections 1.385-3 and -3T. “Multinational enterprises are particularly hard‐hit by these rules . . .  [as] those companies will be required to develop complex administrative processes and computer systems to track all of their intercompany debt,” the letter continued. “Complying with the per se funding rule will be particularly costly, as it arguably is the most burdensome, complex, and disruptive to companies’ cash‐management practices.”

PwC agreed that “taxpayers will need sophisticated systems for continuously monitoring an array of attributes” of debt issuers and their relevant debt instruments to be eligible for many of the exceptions to the transactions rules.

Provide Certainty, Apply Prospectively

Deloitte Tax LLP recommended the regulations be withdrawn not only “to avert the burdens and costs imposed by the regulations, [but] . . . to avoid uncertainty as their interim application, while Treasury considers its options, including its options to narrow the regulations.”

Deloitte emphasized that any future regulations should be effective prospectively, and at that time allow taxpayers to implement necessary systems and procedures. In the interim — before Treasury and the IRS issue binding guidance — taxpayers should be allowed “to use any reasonable method to interpret the Code provisions under which those regulations were promulgated,” the firm said in its letter to Treasury.

KPMG LLP urged Treasury to either repeal or indefinitely suspend section 385 regulations and called for “legal certainty” in the regulatory review process. During this transition period, while Treasury is reviewing and reconsidering those regulations, the taxpayer community is uncertain about how to respond to the rules, KPMG said in its letter. In some cases the retroactive effective dates, such as April 4, 2016, for the section 385 regulations, have affected “U.S. and non-U.S. companies’ investment decisions and business planning by making it difficult or even impossible for companies to reliably estimate the future tax costs associated with a given course of action,” the firm added. If the regulations are indefinitely suspended, KPMG agreed that Treasury should only apply rules prospectively after vetting any proposed amendments through an appropriate notice-and-comment process.

Remove Per Se Rule

Practitioners reiterated their concerns about the 72-month per se rule in the August letters to Treasury. Under the regulations, if debt was issued for a principal purpose of funding any per se rule distribution, it would be converted to equity. A principal purpose would be irrebuttably presumed if debt was issued within three years on either side of the per se distribution. Treasury officials have defended the rule, saying that it’s necessary to prevent taxpayers from doing in two steps what they could have done in one.

The American Institute of CPAs said the 72-month period, which is irrebuttable and provides no exceptions, “could capture transactions that at the time of the transaction were not abusive, but are now arbitrarily recast as abusive years later.”

The regulations represent a “complicated web of unnecessarily convoluted requirements, exceptions, and limitations . . . which once mastered must be carefully managed and monitored in order to avoid triggering the recharacterization of related-party debt instruments,” PwC said.

If Treasury modifies the regulations, PwC suggested in its letter that the funding rule’s 72-month per se period be removed, and that the government should bear the burden of “proving that a taxpayer undertook a series of steps with the principal purpose of avoiding the General Rule.” That change would eliminate taxpayers’ “fear of an inadvertent foot fault” and the need to track various tax attributes, along with preserving “the government’s ability to effectively combat earnings stripping in a targeted manner,” the firm said.

While acknowledging that section 385 can be a powerful tool to combat earnings stripping achieved through excessive related-party debt, the American Bar Association Tax Section urged Treasury to shift from a per se rule based on the context in which the debt was created to “an approach based on the reasons why related-party debt might not normatively qualify as debt.”

Exclude Ordinary Course Transactions

According to the AICPA, the regulations “impose significant documentation and analysis requirements on U.S. corporations for routine and ordinary intercompany transactions, including in cases where these transactions have no tax avoidance impact or motive.” The ABA agreed that the rules failed to provide adequate relief for ordinary course transactions and noted that the transactional documentation would likely be the responsibility of foreign subsidiaries, which “may make it difficult to achieve the level of high compliance necessary for relief from automatic recharacterization.”

The documentation rules under section 385 apply when a covered member in an expanded group issues, or is deemed to have issued, an interest in the form of a debt instrument and has an intercompany payable and receivable documented as debt in an accounting system, open account intercompany debt ledger, trade payable, journal entry, or similar arrangement.

The Securities Industry and Financial Markets Association said its members — large global financial institutions — are affected more severely than other industries in part because they “can engage in thousands of intercompany funding transactions as frequently as daily in amounts in the billions of dollars among hundreds of affiliates in the ordinary course of business.” The documentation rules require enormous efforts “to develop and then maintain additional systems, processes, and procedures necessary to effectively administer, manage and control the high volume of intercompany funding that occurs.”

TEI said Treasury “should incorporate appropriate and administrable scope limitations that except, for example, intercompany debt arising in ordinary‐course business transactions, such as non‐interest-bearing trade payables and receivables.” Treasury provided an exception for qualified short-term debt instruments under the transaction rules, but didn’t provide anything similar under the documentation rules, TEI noted.