by Amy S. Elliott -- amy.elliott@taxanalysts.org
While taxpayers who pressed for a more favorable earnings and profits exception in the final section 385 debt-equity regs (T.D. 9790
) got what they asked for -- a move away from the original exception being limited to current E&P -- the new exception means that taxpayers will have to create a whole new account to track, which like E&P studies in general could be costly. The expanded E&P exception in the regs, which creates a new E&P account referred to as the expanded group earnings account (EGEA), reduces the likelihood that a taxpayer's distributions or acquisitions will be caught up by the funding rule in reg. section 1.385-3. Under new stacking rules, distributions and acquisitions will be treated as funded first from E&P accumulated during a corporation's membership in an expanded group, taking into account reductions for E&P accumulated in tax years ending after April 4, 2016, and a resetting to zero when there is a change in control of the issuer in some cases.
"There's now a whole new [modified E&P] account that taxpayers who are so unfortunate to be within these regulations are going to have to maintain" if they want to use the EGEA exception, explained Karen Gilbreath Sowell of EY. Speaking November 3 in Chicago at a Practising Law Institute conference on corporate tax strategies, Sowell said the many special rules are required because the EGEA is limited to the post-April 4 E&P accumulated while part of the same expanded group create "a lot of complexity" and reach some inexplicable results.
Kevin M. Jacobs, branch 4 senior technician reviewer, IRS Office of Associate Chief Counsel (Corporate), said the government changed the current E&P exception from the proposed regs (REG-108060-15 ) in response to "great outcry" from taxpayers that it was too narrow. He said the EGEA is not E&P but is based on the concepts of E&P.
Jacobs explained that Treasury and the IRS decided not to adopt an approach that would allow taxpayers to take into account pre-April 4 E&P because the regulations do not apply to transactions pre-April 4, and "E&P studies are not easy." He added that such an approach would have required "everyone to redo E&P-type studies, applying this new methodology to the dawn of time," a daunting task that would benefit only taxpayers with the resources to pay for the studies. He pointed out that it also would make the rules less administrable for the IRS.
Jacobs reminded the audience that the EGEA resets to zero when there is a change of the expanded group parent, a provision Treasury and the IRS added to address their policy concern -- as described in the preamble -- to "avoid creating incentives for companies (including inverted companies) to acquire or undertake transactions with companies rich in accumulated earnings to circumvent the regulations by relying on previously accumulated E&P."
Brian Reed of EY indicated the reset-to-zero rule will have the intended effect. He added that he doubted companies would have otherwise actively sought acquisitions based on a target's EGEA because, with all of the other complexities involved in calculating the EGEA, "this is not an attribute that people would trade in, because [not many people will] know what their EGEA is, in all likelihood."
Responding to a slide showing a "horizontal double dummy" transaction, in which the EGEA of both target companies is reset to zero, Marc Countryman of EY observed that it would be more consistent with the affiliation model of the regulations to have adopted an approach that the EGEA would not be reset to zero if the expanded group would be treated as continuing under affiliation principles.
Basis-Shifting Tax Shelter
Gordon Warnke of Linklaters cautioned that the new debt-equity rules might cause taxpayers to inadvertently run afoul of Notice 2001-45, 2001-2 C.B. 129
, on loans made by foreign subsidiaries to U.S. subsidiaries. Notice 2001-45 identifies as a listed transaction a type of tax shelter that enables a taxpayer to use the section 318 attribution rules and reg. section 1.302-2(c) to treat a redemption as a dividend, shifting basis to the taxpayer before it sells the stock at a loss. (Prior analysis: Tax Notes, Aug. 13, 2001, p. 870 .) Warnke pointed out that the government has said all along that if the debt-equity rules result in a recast to equity, spurring a repayment that causes unfortunate collateral consequences for the taxpayer, that's a function of its general position that section 385 addresses debt-equity for all purposes of the code. "I think it would be useful for the government to rethink whether it could provide some guidance," he said, adding, "It's a heck of a lot more likely" that an issue involving Notice 2001-45 or other recharacterized debt will result than would have been the case under common law.
Jacobs downplayed the impact, noting that the government received relatively few comments on the issue. "Notice 2001-45 is just pointing to the fact that adjustments are not proper in all cases," he said, acknowledging that the section 385 regs could cause a taxpayer to end up in a situation that falls within the notice. He stated that having a basis hop may not be enough. In the notice, the taxpayer used the basis hop for the purpose of creating a loss. "We know it when we see it. . . . If it falls within the notice, it falls within the notice," he said.
Jacobs said, "We made conscious decisions when we drafted the 385 package, one of which was there is this open right-sized basis package that sets out to address some of the issues as far as what happens to basis as well as what happens in the E&P realm." He added, "We're cognizant of those issues [which include fast-pay stock, Notice 2000-15, 2000-1 C.B. 826 ]. They're not unique." (For the regs that led to the right-sized basis project, see REG-143686-07 .)
'You've Given Us Enough Exceptions'
At a later session, conference attendees got to witness a rare practitioner compliment of the new rules.
"There shouldn't be [serious] complaints [from inbound taxpayers] with the fact that there are pretty harsh penalties if you fall within [the funding rules], because you've given us enough exceptions that we can stay out of them," said Paul W. Oosterhuis of Skadden, Arps, Slate, Meagher & Flom LLP.
Attendees were shown a flowchart that presented a series of questions to help them determine whether the new debt-equity rules would apply to their circumstances, given the myriad new exceptions. A similar summary chart by PwC exemplifies what many are focused on, which is to steer clear of possible funding rule violations at all costs.
Oosterhuis said practitioners must know when their clients have a funding rule problem that forces them to understand the detailed provisions. He said his advice is not to bother learning a lot about the rules -- other than the rules for calculating the EGEA -- independent of having a problem, because they are necessarily very intricate rules. He added that there is no reason why practitioners need to understand the rules in detail if their clients follow their advice and avoid triggering the funding rules in the first place.
Oosterhuis said taxpayers should make sure they don't do anything that triggers the funding rule, "because the consequences can be harsh. Indeed I would argue the consequences exceed the crime that you've committed." But to avoid the funding rule, he recommended not that U.S. companies stop taking on loads of debt, but that expanded groups stop making possible triggering distributions.
The irony of his advice -- given that the rules are designed in part to discourage overleveraging -- wasn't lost on Marjorie Rollinson, IRS associate chief counsel (international). "I thought [you] were going to say don't overleverage the U.S., but no, [you said] don't make distributions," she said to Oosterhuis. "Fair enough. They're obviously well advised."
Reasonable Expectation of Repayment
The documentation requirements in reg. section 1.385-2 provide that debt instruments must show that the parties have a reasonable expectation of the ability to repay the obligation. The regs provide that ability to repay can be satisfied by an annual credit analysis.
The regs further state that "if there is a material event affecting the solvency or business of the issuer, an updated analysis of the reasonable expectation of repayment may be appropriate." But the definition of material event includes when an entity "materially changes its line of business."
Oosterhuis said the material event standard "is different than what you might have otherwise done, because normally in credit agreements, if you replace one business with another business within a certain period of time, it doesn't trigger any kind of need to refresh the credit arrangement."
Kevin Nichols, senior counsel in the Treasury Office of International Tax Counsel, said that "while banks may be willing to enter into a longer-term facility for a revolver, for example, often that's done with more strict underwriting and in particular with more strict negative covenants. Maybe they're on change of business, but also maybe they're on deterioration of the business or other financial covenants that the bank can use to police its obligation."
Nichols said the one-year credit analysis refresh requirement "is effectively a substitute for those kinds of more strict negative covenants that you may see."
Reserved Subjects
While Treasury and the IRS reserved on the bifurcation rules at new reg. section 1.385-1(e) and continue to study whether they will write rules under section 385(a) to divide a purported debt instrument into part debt and part stock, Nichols pointed out that an instrument can still be bifurcated under the general and funding rules of reg. section 1.385-3.
Treasury and the IRS also continue to study extending the rules to apply to purported debt issued by foreign issuers. Nichols acknowledged that the foreign issuer carveout currently means that U.S. branches of foreign issuers aren't subject to the rules, and he said the government is considering the stakes a carveout would have for the United States.