PwC Suggests Eliminating Distribution Rules from Future Debt-Equity Regs

February 3, 2020

CC:PA:LPD:PR (REG-123112-19)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments Regarding Future Proposed Regulations under Section 385 (NPRM REG-123112-19)

Dear Sir or Madam:

PricewaterhouseCoopers LLP (“PwC”) respectfully submits this letter on behalf of a client (such client, “we”) in response to the Advance Notice of Proposed Rulemaking (“ANPR”) published by the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “IRS” or “Service”) in the Federal Register on November 4, 2019, which announced Treasury and the Service's intent to issue proposed regulations modifying certain rules under Treas. Reg. § 1.385-3 (the “Distribution Regulations”).¹

We commend the Treasury and IRS's initiatives to reduce compliance burdens and simplify existing administrative guidance, including the withdrawal of unduly burdensome documentation regulations under section 385.² We appreciate the opportunity to provide, and your consideration of, these comments.

I. Summary of Recommendations

We respectfully submit the following recommendations:

II. Summary of the Distribution Regulations

The Distribution Regulations were promulgated in 2016 under section 385 to address debt instruments that do not finance any new investment of the borrower or have any significant non-tax purpose, and thus have the potential to create certain tax benefits such as interest deductions deemed to erode the U.S. tax base.³ Although not limited to U.S. companies that had redomiciled to a non-U.S. jurisdiction (a kind of transaction sometimes referred to as an inversion), the Distribution Regulations were issued in part in an effort to address inversions.⁴

Under the Distribution Regulations' general rule, the issuance of a debt instrument by a member of an expanded group to another member of the same expanded group in a distribution (or an economically similar transaction) may result in the treatment of the debt instrument as stock.⁵

The Distribution Regulations include a funding rule that treats as stock a debt instrument that is issued as part of a series of transactions that achieves a result similar to a distribution of a debt instrument.⁶ The Distribution Regulations also include a per-se rule, which treats a debt instrument as funding a distribution to an expanded group member (or other transaction with a similar economic effect) if it was issued in exchange for property during the period beginning 36 months before and ending 36 months after the issuer of the debt instrument made the distribution (or undertook a transaction with a similar economic effect).⁷ If a debt instrument is not issued within this per-se period, then the funding rule will apply only to the extent the debt instrument is issued with a principal purpose of funding a similar transaction, based on all the facts and circumstances.⁸

III. Overview of REITs

In general, a real estate investment trust (“REIT”) for U.S. federal income tax purposes is an entity that satisfies certain tests related to the entity's income, assets, distributions, and organization. A REIT is taxed as a regular corporation with certain adjustments including a deduction for dividends paid. As a result, if a REIT distributes 100 percent of its income, the REIT generally would not have a U.S. federal income tax liability.

As discussed in greater detail below, a REIT is allowed a deduction for earnings distributed on a current basis. Thus, income that is currently distributed to the shareholders is not taxed at the REIT level, but any income that is not currently distributed to the shareholders is taxed at the REIT level, as in the case of other corporations.

As noted above, in order to qualify for the aforementioned tax treatment, a REIT must satisfy a number of requirements. A REIT is a corporation, trust, or association that meets each of the following requirements:

A. Income tests

There are two REIT income tests that an entity must satisfy to qualify as a REIT, each of which is tested on an annual basis. First, to ensure that a REIT derives substantially all of its income from real estate-related sources, a REIT must derive at least 75 percent of its gross income each year from specified items that generally include real estate-related income such as rents from real property, interest on obligations secured by mortgages or real property, and gain from the sale or other disposition of real property (the“75% Income Test”).¹⁰ In addition to satisfying the 75% Income Test, a REIT must derive at least 95 percent of its gross income each year from certain specified sources that include income that qualifies for the 75% Income Test, dividends, interest, and gains from the sale or other disposition of stock or securities (the “ 95% Income Test” and, collectively with the 75% Income Test, the “Income Tests”).¹¹

B. Asset tests

To qualify as a REIT, the REIT must principally invest in real estate assets and have a sufficient percentage of qualified assets. At the close of each quarter of REIT's taxable year, at least 75 percent of the value of the REIT's total assets must be real estate assets, cash and cash items (including receivables), and government securities (the “75% Asset Test”).¹² In addition, except with respect to securities issued by a taxable REIT subsidiary, not more than 5 percent of the value of the REIT's total assets may be represented by securities of any one issuer, and a REIT may not hold more than 10 percent of the total vote or value of the outstanding securities of any single issuer.¹³

C. Distribution requirement

Each taxable year, a REIT must distribute at least 90 percent of its taxable income, excluding any net capital gain (the “REIT Distribution Requirement”).¹⁴ A REIT must make such distributions in the taxable year to which they relate, or in the following taxable year if either (i) the REIT declared the distribution before it timely filed its U.S. federal income tax return for the year and paid the distribution on or before the first regular dividend payment date after such declaration or (ii) the REIT declared the distribution in October, November, or December of the taxable year, payable to stockholders of record on a specified day in any such month, and it actually made the distribution before the end of January of the following year.¹⁵

A REIT is allowed a dividends-paid deduction in computing its taxable income (the “REIT DPD”).¹⁶ Therefore, if a REIT distributes 100 percent of its taxable income, it generally will not be subject to U.S. federal income tax.

Although the REIT Distribution Requirement permits a REIT to retain all of its long-term capital gains and up to 10 percent of its other REIT taxable income, a REIT must pay regular corporate-level taxes on any amounts that it does not distribute.¹⁷ Additionally, a REIT is subject to a 4 percent nondeductible excise tax on any amount by which distributions paid in any calendar year are less than the sum of 85 percent of the REIT's ordinary income, 95 percent of the REIT's capital gain net income, and 100 percent of the REIT's undistributed income from previous years.¹⁸

D. Taxable REIT subsidiaries

As discussed above, a REIT generally cannot own more than 10 percent of the vote or value of a single issuer. An exception applies for ownership of a taxable REIT subsidiary (“TRS”) that is taxed as a corporation, provided that securities of such TRS do not represent more than 20 percent of the total value of REIT assets.¹⁹ Additionally, the rules impose a 100 percent excise tax on redetermined rents, redetermined deductions, and excess interest, which are generally defined as the transactions between a TRS and its parent REIT or the REIT's tenants that are not conducted on an arm's-length basis.²⁰

E. Failure to qualify as a REIT

A REIT must stay compliant at all times with the qualification requirements described above to maintain its status. In limited circumstances, a REIT may be able to cure a failure to meet the qualification requirements.²¹ If no relief provision applies, a REIT loses its status and becomes subject to federal income tax and any applicable alternative minimum tax on its taxable income at regular corporate rates.²² In addition, subject to certain exceptions, if a REIT loses its status for any tax year (the “termination year”), the former REIT is ineligible to reelect to be treated as a REIT for the four tax years following the termination year.²³

IV. Comments

A. The Distribution Regulations should be withdrawn

The Distribution Regulations were issued in response to certain post-inversion earnings-stripping transactions purportedly engaged in for the purpose of eroding the U.S. tax base through interest deductions on related-party loans. The preamble to the final and temporary section 385 regulations²⁴ indicates that the ability of related parties to create intercompany debt generates undesirable tax incentives in certain circumstances. In particular, the preamble lists foreign controlled domestic corporations as having a significant advantage when equity is mischaracterized as debt, which practice Treasury and the IRS asserted was supported by the increasing amount of corporate inversions taking place prior to the issuance of the Distribution Regulations. However, as the preamble states, at the time the regulations were finalized the only two potential limitations on earnings stripping through related-party interest that were applicable to foreign-controlled domestic corporations were former section 163(j) and a general limit based on debt/equity case law.²⁵

In 2017, Congress enacted the Tax Cuts and Jobs Act (“TCJA”),²⁶ which reformed the U.S. federal income tax system and introduced the most significant changes to the U.S. international tax rules in over fifty years. As discussed below, the TCJA and subsequent regulations have specifically addressed earnings-stripping concerns and significantly reduced the U.S. tax benefits resulting from related-party interest deductions in a number of ways.

First, the TCJA reduced the maximum U.S. federal income tax rate on corporations from 35 percent to 21 percent, thus reducing the potential tax savings from a related-party interest deduction. The new corporate tax rate is the second lowest of all leading economies in the G7 (above the United Kingdom) and is below the average rate of the member countries of the Organisation for Economic Co-operation and Development (“OECD”).²⁷

The TCJA also amended section 163(j) by further limiting a taxpayer's ability to deduct interest. Former section 163(j) generally limited interest deductions in excess of 50 percent of adjusted taxable income for certain related-party debt (and certain guaranteed third-party debt); applicable to corporations with a debt-to-equity ratio greater than 1.5 to 1 as of the close of such corporation's taxable year.²⁸ The new section 163(j) is broader in scope and applies to debt instruments between all taxpayers, regardless of their debt-to-equity ratio or their relatedness to the creditor. In addition, the general rule of section 163(j)(1) limits a taxpayer's ability to deduct its net business interest expense to 30 percent of its adjusted taxable income.²⁹ Removal of the related-taxpayer and the debt-to-equity ratio requirements, together with the reduction of the adjusted taxable income threshold, greatly expanded the scope and impact of this limitation on interest deductions.³⁰

To address the concern that taxpayers could attempt to use hybrid arrangements to strip income out of the United States, Congress enacted section 267A, which disallows interest (as well as royalty) deductions for certain types of hybrid arrangements with related parties. Section 267A and the proposed regulations predominantly apply to foreign-headquartered companies that otherwise may employ hybrid arrangements to strip income from the U.S. tax base.³¹

The TCJA also created a new minimum tax under section 59A that may apply with respect to related-party interest. The new base erosion and anti-abuse tax or “BEAT” targets certain base erosion tax benefits (including interest deductions) or similar tax benefits attributable to certain base erosion payments made to foreign related parties by certain applicable taxpayers.³²

Moreover, Treasury and the IRS specifically addressed perceived tax-motivated incentives to invert in final inversion regulations promulgated in 2018.³³ These regulations go far beyond limiting deductions for related-party interest expense.

Finally, U.S. companies with significant foreign subsidiaries now are subject to the global intangible low-taxed income or “GILTI” rules.³⁴ These rules subject most earnings of a U.S. company's foreign subsidiaries to an immediate, reduced rate of U.S. tax against which a foreign tax credit is allowed. These foreign tax credits are limited based on the U.S. company's domestic expenses allocable to foreign-source income, including related-party interest expense.

Moreover, ongoing developments in international tax policy continue to reduce the incentive to engage in earnings stripping transactions. For example, in recent years the OECD has continued to address base erosion and profit shifting (“BEPS”), the European Union has issued an anti-tax avoidance directive (“ATAD”) to be implemented by member states, and a number of other countries have initiated their own tax reform legislation. Most recently, the OECD released a public consultation document on a Global Anti-Base Erosion (GloBE) Proposal — Pillar Two (the “Pillar Two”),³⁵ the main focus of which is addressing the ongoing risks from structures that allow multinational companies to shift profits into no or low tax jurisdictions.³⁶

In light of these developments, there exists significantly less incentive to engage in earnings — stripping transactions than at the time the Distribution Regulations were promulgated.

Nevertheless, in some cases, the Distribution Regulations continue to create disproportionate, inappropriate results. For example, a REIT can lose its status as such by reason of failing an asset restriction (e.g., owning more than 10 percent of the value of a single issuer). As another example, a debt instrument issued between two related domestic corporations could be subject to the Distribution Regulations, even though the instrument must be issued on arm's-length terms and there is little potential for earnings stripping.³⁷ In addition, the Distribution Rules continue to create significant complexity and compliance burdens. For instance, when considering making a distribution the issuer must forecast its anticipated earnings and profits for that year in order to ensure eligibility for the expanded group earnings exception.

Consequently, the present-day policy merits of the Distribution Regulations are greatly outweighed by the inappropriate results, complexity, and compliance burdens the Distribution Regulations create. Therefore, we recommend the Distribution Regulations be withdrawn.

B. The Distribution Regulations should not apply to REITs

If Treasury and the IRS conclude that the Distribution Regulations should be retained, then the future proposed regulations should be more narrowly tailored to their stated purpose. As previously mentioned, the Distribution Regulations were issued to address erosion of the U.S. tax base through related-party interest deductions. In the case of a REIT, however, interest deductions do not significantly erode the U.S. tax base because the REIT DPD generally prevents a REIT from being subject to U.S. federal income tax.

The REIT DPD creates the effect of a REIT and its owners being taxed similar to a pass-through entity and its owners, such as in the case of an S corporation. Much as S corporations are not subject to the Distribution Regulations (because S corporations are explicitly excepted from being members of an expanded group), so too REITs should not be subject to the Distribution Regulations.

Moreover, although a reclassification from debt to equity affects all taxpayers subject to the Distribution Regulations, the effect of a reclassification on REITs can be more profound, because, as discussed above, REITs are subject to numerous qualification tests that a REIT could fail to satisfy if a debt instrument is recharacterized as equity. For example, a loan secured by a mortgage on real property is considered to be a qualified asset for purposes of the 75% Asset Test and generally generates income that qualifies for purposes of the Income Tests. However, if a REIT makes a mortgage loan to a TRS (taxable REIT subsidiary) that is recharacterized as equity, then the income from the mortgage loan would no longer qualify for purposes of the 75% Income Test. Moreover, equity in a TRS is not listed as a qualifying asset under section 856(c)(4)(A) for purposes of the 75% Asset Test. Thus, a reclassification of a mortgage loan as equity creates a situation in which REIT qualification could be jeopardized in multiple ways.

Congress also recognized the unique nature how the real estate industry operates when amending section 163(j) in 2017. Specifically, high leverage is common in the real estate industry and is not motivated by a desire to erode the U.S. tax base or benefit inappropriately from U.S. interest expense deductions. Accordingly, Congress allowed real estate businesses to elect out of section 163(j).³⁸ Treasury and the IRS have gone further, expressly providing in proposed regulations that REITs may qualify for this election.³⁹

We acknowledge that, to the extent Treasury and the IRS believe the Distribution Regulations still are warranted, a blanket carve-out for REITs might incentivize some taxpayers to insert REITs into their structures to avoid the purpose of the Distribution Regulations. However, we believe such a concern is largely mitigated by the onerous requirements (including ongoing monitoring and compliance) to qualify as a REIT and the existence of an anti-abuse rule within the Distribution Regulations. Any remaining concern can be addressed through a narrowly tailored exception, such as excluding REITs from the definition of a “covered member” or excluding debt instruments issued by REITs from the definition of a “covered debt instrument” (as is the case for certain financial instruments and insurance companies).⁴⁰

While we acknowledge that Treasury and the IRS may have base erosion concerns in this regard, we believe that such concerns should not overshadow Congress's expressed purpose of providing REITs certain tax benefits, particularly in light of the significantly reduced role of the Distribution Regulations after enactment of the TCJA and ongoing international tax developments.⁴¹ The purpose of enacting the REIT legislation was to attract additional capital to the real estate markets and provide more investors the opportunity to invest in diversified real estate portfolio. REITs contributed the equivalent of an estimated 2.3 million full-time jobs to the economy in 2017, generating $140.4 billion of labor income, and provided investment opportunities through retirement plans to approximately 87 million Americans.⁴²

In order to strike a balance between, on the one hand, preserving the economic benefits and Congressional objectives of REITs, and, on the other hand, continuing to pursue the policy objective of the Distribution Regulations, Treasury and the IRS could provide a narrow exception for REITs. Specifically, under this approach, a REIT could be excluded from the definition of “covered member” (i.e., the class of corporations to which the Distribution Regulations apply) or debt instruments issued by a REIT could be excluded from the definition of “covered debt instrument” (as is the case for certain financial institutions and insurance companies), in lieu of providing a broader REIT exception from being a member of an expanded group such (as that afforded to S corporations). This recommendation is narrowly tailored to prevent an overbroad application of the Distribution Regulations to REITs for which the Regulations' policy objective is not relevant without creating incremental opportunities to avoid application of the regulations.

C. The Distribution Regulations should contain a safe harbor for REIT distributions

If the Distribution Regulations are not withdrawn and continue to apply to REITs, then the unique nature of the REIT distribution requirements should be taken into account. A REIT's decision to make a required annual distribution does not evince an intent to erode the U.S. tax base through related-party interest deductions or to distribute related-party debt. Rather, it is a statutory requirement that must be satisfied for a REIT to maintain its classification.

Applying the Distribution Regulations to the REIT Distribution Requirement does not further the policy objective of the Distribution Regulations. Instead, it penalizes REITs for complying with requirements set forth in the Code. In other similar circumstances, the Distribution Regulations currently provide exceptions for distributions required under U.S. federal tax law, such as those resulting from employee stock awards or transfer pricing adjustments. A REIT's required annual distributions should be afforded the same exception.

In practice, REITs frequently rely on the expanded group earnings exception under Treas. Reg. § 1.385-3(c)(3)(i) to ensure required annual distributions do not violate the funding rule. However, this exception may not always be available given the transactions undertaken by REITs and potential mismatches between taxable income and expanded group earnings. Eliminating the per-se rule would provide welcome relief with respect to required annual distributions, but it would not eliminate the possibility of funding rule violations triggered by distributions mandated by the Code.

Therefore, in addition to retaining the expanded group earnings and other exceptions in the Distribution Regulations, we recommend treating a REIT's annual distributions as exempt distributions for purposes of the Distribution Regulations or otherwise providing a safe harbor from the funding rule for distributions made to satisfy the REIT Distribution Requirement.

D. The facts-and-circumstances test should be clarified

In addition, if the Distribution Regulations are not withdrawn, future proposed regulations should provide additional clarity to alleviate uncertainty and compliance burdens created by the Distribution Regulations. The ANPR announces that future proposed regulations will apply the funding rule to a debt instrument only if its issuance bears a sufficient factual connection to a distribution to a member of the taxpayer's expanded group or an economically similar transaction. It is unclear what constitutes a “sufficient factual connection.”

As mentioned previously, REITs must distribute substantially all (specifically, 90 percent) of their taxable income on an annual basis in order to satisfy the REIT Distribution Requirement. Thus, as a practical matter, the REIT Distribution Requirement naturally limits a REIT's ability to reinvest its earnings and therefore makes a REIT dependent on raising new capital, in part through debt offerings, to sustain and expand its investments. In many cases, a REIT may borrow this additional capital from a related party to facilitate quicker access to the capital or to maintain a desired capitalization structure vis-à-vis outside investors, which is common in the typically highly leveraged real estate industry. In these cases, the related-party borrowing would not appear to bear a sufficient factual connection to the REIT's required annual distribution.

Without more clarity, however, the facts-and-circumstances test would create significant uncertainty for taxpayers, including REITs in the situation described in the preceding paragraph. This uncertainty would inhibit taxpayers from engaging in otherwise sound business transactions and ultimately create unnecessary costs that do not serve the policy objective of the Distribution Regulations.

Therefore, we recommend that future proposed regulations provide additional clarity with respect to the facts-and-circumstances test under the Distribution Regulations. Specifically, the regulations should provide a list of factors to consider in determining whether the issuance of a debt instrument bears a sufficient factual connection to a distribution or an economically similar transaction, including, but not limited to:

We also recommend that the proposed regulations provide examples illustrating when these factors rise to the level of demonstrating that the issuance of a debt instrument bears a sufficient factual connection to a distribution or other transaction so as to warrant a recharacterization under the Distribution Regulations. For example, a REIT borrowing to finance a new real estate investment should not be penalized for borrowing from a related party where it can demonstrate that it otherwise could have borrowed from a third-party lender (e.g., a bank) on similar terms.

E. Existing exceptions in the Distribution Regulations should be retained

As part of the intended revisions of the funding rule, the ANPR announces Treasury and the IRS's intent to make substantial revisions to, and potentially remove, certain existing exceptions in the Distribution Regulations.⁴³ In the event the Distribution Regulations are not withdrawn, we recommend that the existing exceptions be retained, including in particular the exceptions for expanded group earnings accounts, qualified contributions, and short-term debt instruments.

These exceptions to the Distribution Regulations are founded on the principle that the Distribution Regulations should not apply in certain circumstances. If Treasury and the IRS believe, as we do, that the Distribution Regulations should at least be narrowed if not completely eliminated, then the scope of the Distribution Regulations should not be broadened through the elimination of exceptions. These exceptions may create complexity, but they also create certainty, which militates the economic and administrative burdens created by the Distribution Regulations.

The existing exceptions in the Distribution Regulations generally comport with a narrower, facts- and-circumstances approach to the funding rule. For example, distributions made from expanded group earnings, or distributions not in excess of qualified contributions, do not implicate the policy concern of the Distribution Regulations because there has been a net increase in the borrower's gross assets, demonstrating the related-party loan was issued to fund the borrower with new assets and not to strip the U.S. tax base through related-party interest deductions. Similarly, short-term debt instruments are unlikely to implicate the policy concerns targeted by the Distribution Regulations because those instruments bear low rates of interest, are outstanding for short periods of time, and are closely related to the ongoing business operations of the borrower.

Absent clear, explicit exceptions for these circumstances, however, taxpayers would need to demonstrate on a facts-and-circumstances basis that the future proposed regulations do not apply and would be left with the uncertainty as to whether that position could be subject to challenge. The Distribution Regulations appropriately eliminate this uncertainty by including exceptions to narrow the scope of the regulations, and the future proposed regulations should do the same.

F. Future regulations should permit early reliance and provide for retroactive relief

The significant complexity of the final and temporary regulations under section 385 has created substantial uncertainty for taxpayers as to whether a related-party debt instrument may have inadvertently run afoul of the regulations. These traps for the unwary are particularly concerning for taxpayers such as REITs, where a recharacterization could create collateral consequences beyond merely the loss of interest deductions, potentially causing a REIT to lose its status.

Where there was no principal purpose to obtain a U.S. tax deduction or avoid the purpose of the regulations, these collateral consequences inappropriately and disproportionately would punish taxpayers for inadvertent errors. This is particularly inappropriate where the foot fault would not be problematic in the future, and thus its mere timing penalizes the taxpayer.

Nevertheless, the ANPR indicates that the future proposed regulations would only apply for tax years beginning on or after the date the future proposed regulations are finalized. This means that taxpayers will continue to be subject to the burdensome Distribution Regulations for the foreseeable future.

In order to reduce administrative burdens on the IRS and taxpayers, and in order to avoid inappropriate results under the Distribution Regulations, taxpayers should be permitted to rely on the future proposed regulations prior to finalization. In addition, any relief provided under future proposed regulations should be available for taxpayers retroactively with respect to open tax years, provided the relevant instrument issued in a prior year was not issued with a principal purpose to obtain a U.S. federal income tax deduction or to avoid the purpose of the regulations under section 385.

We greatly appreciate the opportunity to provide these comments and your attention to them. Should you have any questions, please do not hesitate to contact Oren Penn at (202) 413-4459 or Aaron Junge at (202) 739-1053.

Very truly yours,

PricewaterhouseCoopers, LLP

cc:
L.G. “Chip” Harter, Deputy Assistant Secretary (International Tax Affairs), U.S. Treasury Department
Kevin Nichols, Deputy International Tax Counsel, Office of the International Tax Counsel, U.S. Treasury Department
Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service Raymond J. Stahl, Special Counsel, Office of Associate Chief Counsel (International), Internal Revenue Service
Azeka J. Abramoff, Staff Attorney, Office of Associate Chief Counsel (International), Internal Revenue Service