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Attorney Seeks Withdrawal of Proposed Debt-Equity Regs

JUN. 6, 2016

Attorney Seeks Withdrawal of Proposed Debt-Equity Regs

DATED JUN. 6, 2016
DOCUMENT ATTRIBUTES

 

6 June 2016

 

 

Internal Revenue Service

 

Via Federal eRulemaking Portal

 

 

Ladies and Gentlemen:

I. Introduction

I would like to submit these comments (this "Letter") on the proposed Section 385 regulations published in the Federal Register on April 8, 2106 (the "Proposed Regulations") that purport to interpret and apply Section 385 of the Internal Revenue Code of 1986, as amended (the "Code").1 As discussed more below, Proposed Regulation Section 1.385-3 (the "Proposed Earnings-Stripping Rules") exceeds the authority granted under Section 385 and reflects poorly thought-out policy choices and therefore should be withdrawn.

The comments expressed in this Letter reflect solely my own views and were not prepared on behalf of a client. This Letter does not summarize the Proposed Regulations and assumes a familiarity with their contents.

II. The Proposed Earnings-Stripping Rules

The Proposed Earnings-Stripping Rules create a new, complex, administratively crafted interest disallowance regime that applies only to certain categories of "related" investors -- e.g., investors that purport to own both stock and debt in a corporation.

Doing so is both clearly outside the scope of the authority granted to Treasury by Section 385, a fact which Treasury implicitly acknowledges, as discussed further below, and represents a poor policy choice for the following reasons:

  • First, to the extent that a bedrock principle of the corporate tax regime -- that a corporation can effectively avoid corporate tax on the competitive, time-value return that accrues from its activities by distributing that return in the form of deductible interest payments -- is to be changed, it should be done so by Congress after real and substantial debate and deliberation, not by an administrative agency, given that the Constitution explicitly assigns the ability to enact tax legislation to the legislative branch.

  • Second, it should be done honestly, openly and deliberately, not disguised in a complicated and poorly-designed regulatory regime that sets forth no reason for its rules.

  • Third and closely related, though not the focus of this Letter, the regulatory regime is needlessly complicated and makes distinctions that make little sense, have no policy support, and are unexplained.

  • Fourth, overriding U.S. obligations under tax treaties should also be done explicitly and by Congress.

  • Fifth, while Congress clearly has the power to do what the regulations purport to do administratively -- which is primarily to impose a heavier tax burden on U.S. corporations owned by non-U.S. entities -- it is not at all clear that it should do so.

 

These points are elaborated further below, following a brief discussion of the distinction the tax law has made between debt and equity in order to provide context for the comments that follow.

III. Background on The Distinction Between Debt and Equity

Despite misguided but well-meaning attempts to view the distinction as one that is "simple in concept"2 , the truth is that there is no significant conceptual, non-tax economic difference between corporate debt and equity.3 Both involve an investment in the corporation in exchange for an opportunity to make a return on that investment.4 Both are ultimately subject to the risk that the corporation won't be able to pay a positive return5, and may not be able to repay the investment at all. While they are subject to potentially differing levels of risk, and differing rights and expectations regarding the timing and amount of the payment of their potential return, these differences are relative, both compared to other stakeholders in the corporation, and compared to other investment opportunities.6 The Code, nevertheless, uses these relative differences as the basis to create very distinct tax consequences, the primary one of which is that "interest" paid on "debt" by corporations is deductible, but "dividends" paid on "stock" generally are not.7

Tax law has generally applied a formal analysis to determine in particular cases whether an instrument should be treated as debt or equity8 and has eschewed a purpose-based approach that looks to why interest is deductible but dividends are not, largely because no compelling answer to this question has been provided.9 As a result, the distinction between debt and equity serves as a means to lower the effective tax rate of corporations by financing some of their operations through debt. Put another way, the deduction for interest essentially allows some investors -- those whose instruments are called "debt" -- to invest in corporations in a manner that integrates the corporate and individual10 income tax regimes.11 Although debt can have participation and conversion features that can allow it to share in upside potential, this ability to use deductible interest to integrate the corporate income tax is largely confined to what some economists refer to as the "normal" or what Nobel laureate Myron Scholes refers to as the "competitive" return -- supra-normal returns -- those that exceed the competitive, market-based cost of capital -- accrue to "equity" holders who are subject to corporate level tax because that supra-normal return is not deductible.12 The corporate tax thus becomes, in effect, a tax on, and only on supra-normal returns.13

Suppose for example a corporation has $100 of annual "taxable" earnings before any deduction for interest. If there was no distinction between debt and equity, the corporation would be subject to tax on this $100 of income. Whether it paid any portion of this $100 out as dividends or interest would be irrelevant for tax purposes. If, for example, approximately $40 of the $100 represented a relatively predictable, less risky income stream, this $40 income stream could potentially be used to service investors who are looking for a debt-like time-value return. The corporation, or its shareholders, could then sell off this $40 annual income stream to debt investors. The corporation would then pay $40 of its annual income as interest.

The corporation, or its shareholders, would likely create debt in this manner, as opposed to selling off the income stream as equity or retaining it, only if they could invest the proceeds in a manner that they expect would have a higher yield than the $40 they need to pay on the debt. If the interest was also deductible, however, the shareholders would then also be able obtain a tax advantage by financing the corporation in part with debt. In our example, if the interest was deductible, the corporation would have only $60 of taxable income. The equity holders would be entitled only to this residual $60 of income, which would be subject to corporate income tax, while the $40 of annual income earmarked for the debt investors would not be subject to corporate tax in the hands of the paying corporation because it would be entitled to a deduction for the $40 of interest payments.

Given that to be treated as deductible "interest" for tax purposes the payment of interest and the ultimate return of principal generally needs to have priority to equity, and the amount of the interest needs to be closely tied to the then market time value of money, it is generally only the riskier, and uncapped earnings that accrue to the equity holders that are subject to the corporate income tax -- e.g., the "supra-normal" return.

This has been the result even where both returns are paid to the same investors -- e.g., where an investor is both an equity holder and a debt holder, though the cases, the Internal Revenue Service, and the Code itself have had a more difficult time determining when to draw the line in these situations.14 This is because an investor who holds both debt and equity will largely not care from an economic standpoint on which instrument it receives its return, but may be more inclined to claim that more of the return is in the form of the deductible "normal" return that constitutes "interest" in order to more fully integrate the corporate and individual tax.15 Given the lack of an inherent distinction between "debt" and "equity", when the question exists only for tax purposes, as is the case where the same investor holds both corporate debt and equity, it becomes much harder to draw a line that appears to be "objective" rather than arbitrary. As a result, the tax law has generally considered whether debt and equity is held by the same investor as a factor that warrants greater scrutiny of the other terms of the instrument.

In the case of certain investors who own both stock and equity, such as those who are not subject to tax on the interest they receive because they are either tax-exempt or are non-U.S. investors entitled to an exemption from the U.S. withholding tax that would otherwise apply under an applicable tax treaty, the Code has also resorted to limiting the interest deduction to an arbitrary level, for example by enacting Section 163(j). Although the Section 163(j) limit has some basis in "objectivity" by being loosely based on what might take place if the debt holders and equity holders were not related, it is still largely arbitrary as it is fixed in the Code and does not vary based on market norms, or facts and circumstances. In this manner, it is a similar arbitrary line as the statutory corporate income tax rates. The Code is, of necessity, filled with many such "arbitrary" lines, and it is Congress' job in enacting and updating the tax Code to determine where such lines should be drawn.

It is worth pausing for a moment to analyze who ultimately benefits from the integration provided by the fact that interest is deductible -- the debt holders or the equity holders?16 Put another way, does the fact that interest is deductible allow the equity holders to pay a lower level of tax on the residual corporate earnings not used to service the debt, or do the debt holders obtain a larger return than they otherwise would have received because of that deductibility? We will return to this question later, but for the moment, it's a fair assumption that in a well-functioning debt market, where not all borrowers are corporations that can use interest deductions to avoid the corporate level of tax, at least some of the benefit accrues to the equity holders.

Moreover, this benefit -- the ability to avoid corporate level tax by deducting interest payments -- exists independent of whether the debt and equity are held by the same investors.

This is because the existence of deductible debt allows the equity holders to invest less money in order to earn the supra-normal returns that accrue to them than they would have had to invest if the debt was not deductible. To see why this is so, suppose in our example that the corporation is worth $1,000. This could be either because the relevant investment that produces the $100 of income costs $1,000 for the corporation to undertake, or the $100 represents a stream of income that is worth $1,000 given its expected risk profile and the then current time value of money. If the debt was not deductible, or there was no debt, of that $100 of income, $65 would remain after the payment of taxes (assuming a 35% corporate tax rate), for an annual yield to equity of 6.5%.

Instead, suppose the corporation issues $600 of debt to unrelated taxpayers and earmarks $39 of income toward that debt. Suppose further either that the $600 is distributed to the equity holders or is used at inception so that the net equity investment is only $400. The debt now earns the same annual yield of 6.5% equity was earning before. However, there is still $61 of income left, which is subject to tax at a 35% rate, for a tax payment of approximately $22. $39 is thus available to be distributed to equity, for a yield of 9.75 on the $400 of invested equity capital. This increase in yield to equity is attributable entirely to the reduction in corporate tax paid as a result of the deductibility of the interest payments.

The essential point of the above example is that because of the deduction for interest, there are more earnings to distribute to both stakeholders in the corporation -- debt and equity.

Returning to our question of whether debt or equity captures the benefits of interest being deductible, we can now see that it is largely irrelevant for purposes of evaluating the Proposed Regulations. Even if the extra return in our example accrued to the debt holders, and the equity holders continued to earn only the same 6.5% annual yield, the aggregate of all stakeholders in the corporation -- debt and equity -- benefit from the interest deduction irrespective of whether the debt and equity holders are related.

Simply put, a corporation's ability to deduct interest provides a benefit to investors in that corporation. This benefit provided by the deductibility of interest exists independently of whether the debt and equity holders are related.

This is why Section 163(j) limits the deductibility of interest to related taxpayers, who are exempt from tax on that interest, but does not eliminate the deduction. The idea is not to penalize companies who issue debt to related parties relative to corporations who issue debt to third parties, but to try to achieve parity between those two situations. Section 163(j)'s relatively bright, arbitrary line is, arguably, necessary because the frictions that would exist between true unrelated parties, and would typically operate to restrict the amount of debt a corporation could issue to the amount of its expected "normal" return, are not present.17

When debt is held by unrelated taxpayers, it simply means that the equity holders have effectively monetized the normal return by selling it to unrelated debt investors. When debt is held by holders related to the equity holders it means instead that the equity holders have retained that normal return. There is no rational reason why this decision, however, whether to retain or sell the normal return, should have any effect whatsoever on whether the normal return is deductible, which is why the Code does not currently contain an outright prohibition on deducting interest paid to related parties.

While it is appropriate to treat whether taxpayers are related as a "factor" in applying the formal analysis to determine whether an instrument is debt or equity, that is only because in the related party context it can be more difficult to ensure that debt is limited to the "normal" return. Scrutinizing the related party debt more closely by emphasizing other factors and by imposing limits such as those of Section 163(j) serves to protect the implicit decision to subject only the supra-normal return to corporate income tax and prevent taxpayers from completely integrating the corporate and individual income tax regimes by calling all of their investment "debt". This same concern is present in the case of unrelated debt, but the policing of the line can be done in part by relying on the adverse interests of the debt and equity holders. If the shareholders sell off part of the supra-normal return to unrelated debt holders (in addition to the normal, competitive return), then they are giving up that return. This they may be reluctant to do, and so there may be less need to scrutinize debt sold to third parties.

It should be emphasized, however, that even when debt is sold to third parties, equity holders could still benefit by selling off even the supra-normal return if the supra-normal return thereby becomes deductible when paid to the new debt holders. As a result, even in the unrelated context, there still may be a tendency on the part of investors to characterize as many interests in the corporation as debt as possible. Although the equity holders would then no longer retain the supra-normal return they have transferred to "debt" holders, they would get the benefit of that stream of income because it would be reflected in the price paid for the debt. Moreover, that price paid would reflect the tax benefit of the return being deductible, thereby reducing the corporate income tax.18 Thus, even when debt is issued to unrelated taxpayers, there is still no assurance that only the normal return will be sold and utimately paid to debt holders. Perhaps the best that can be said is that where the investors in the debt are subject to regulatory constraints that limit the amount of risk they can take, or the supra-normal return is risky enough that debt investors might be reluctant to pay an appropriate price for it, the presence of a true third-party relationship between debt and equity holders serves as at least a limited friction to ensure that the corporate income tax continues to be imposed on the supra-normal return.

When equity holders retain the normal return by issuing debt to themselves, however, this same adverse interest is not present and so it becomes necessary to subject the terms of the debt to more scrutiny to help ensure that the corporate tax continues to be imposed on the supra-normal return.

There is no reason, however, to prohibit a corporation from deducting the normal return merely because it is paid to investors related to the equity holders. Yet this is precisely what the Proposed Earnings-Stripping Rules purport to do. Moreover, they do so without any explanation of why they do this or why they should do this.

IV. The Proposed Earnings-Stripping Rules Exceed the Scope of Authority Granted by Section 385

Section 385 authorizes Treasury to set forth factors to be used in the analysis of whether an instrument issued by a corporation is debt or equity -- e.g., whether an instrument entitles a holder to only or primarily the "normal" time value of money component of a corporation's earnings or also attempts to turn the supra-normal return that is supposed to continue to be subject to corporate level tax into deductible interest.

The Proposed Regulations, however, don't make any attempt to create factors.19

Instead, the Proposed Regulations make one factor the sine qua non and sole test of the inquiry -- whether the equity holders have sold off the normal return to unrelated investors or whether they have kept it for themselves or related investors. If they have sold it to unrelated investors, the proposed rules have absolutely no consequences for them; it they have kept it themselves, then they are subject to a complicated and bizarre regime that severely restricts their ability to deduct interest.

Rather that create factors that can be used to determine whether an instrument has the necessary formal characteristics of debt, the regulations create a series of per se rules that deny the ability to deduct interest paid to related taxpayers in all but a small handful of situations. Doing so is clearly the intended, and the only, point of the Proposed Earnings-Stripping Rules. The regulations are not issued to help with the analysis of whether an instrument is debt or equity, nor to ensure that a corporation is only able to deduct the "normal" time-value return that the Code has allowed for over a century.

Instead of setting forth factors that can be used to evaluate whether an instrument should be treated as debt or equity, these complex rules20 create a per se interest disallowance regime that treats similar and in some cases identical instruments differently depending on who issues them, who holds them, and what happens in unrelated events that happen years before and after the instrument is issued. All of these considerations are facts that may be relevant in debating, from a policy perspective, whether it is appropriate to allow an interest deduction; they have no direct relevance, and none is asserted by the Proposed Earnings-Stripping Rules, however, to the question of whether an instrument has the characteristics of debt or equity.

By creating an interest disallowance regime -- a regime governing "earnings-stripping" -- that alters a bedrock feature of the corporate income tax that has existed for over a century, rather than setting forth factors to be taken into account in evaluating an instrument, and by doing so without any explanation as to why this should be done, the Proposed Earnings-Stripping Rules exceed the authority granted under Section 385.

V. The Proposed Earnings-Stripping Rules are a Poor Policy Choice and Should be Withdrawn

Even if it could be argued that the Proposed Earnings-Stripping Rules somehow fit within the authority granted by Section 385, there are strong policy rationales that argue in favor of their being withdrawn.

The Proposed Earnings Stripping Rules reflect a frustration on the part of Treasury that the Code's existing restrictions on interest deductibility are not strong enough to prevent foreign-owned corporations from deducting interest paid to related foreign investors and, in Treasury's view, allow these investors to "inappropriately" reduce the amount of corporate earnings subject to the corporate income tax. While Treasury is allowed to disagree with the policy choices that Congress makes in enacting tax laws, its remedy is to make recommendations to Congress rather than to enact an entirely new interest disallowance regime.

As a result, Treasury should withdraw the proposed regulations under Section 385 and, if it desires, use them as the basis for a detailed recommendation to Congress as to how it could craft a new interest disallowance rule to increase the burden on non-U.S. investors who choose to invest in U.S. corporations, as well as a discussion of why this is or is not a desired policy goal.

 

A. It is Congress's Prerogative to Create Interest Disallowance Rules

 

Nowhere in Section 385 does Congress authorize Treasury to craft per se rules that serve to deny cross-border interest payments only when the recipient of the interest owns more than a specified percentage of the U.S. corporation.

Nevertheless, the Proposed Earnings-Stripping Rules purport to create an entirely new regime governing interest deductibility that obliterates decades of case law and statutory development. The careful statutory balance of cross-border interest deductibility created by Congress in provisions such as Section 163(j) and Section 267, and covered by a variety of carefully negotiated tax treaty exemptions, is jettisoned in favor of an absurdly complex, administrative regime that has no basis in any clearly expressed Congressional policy and follows no Congressional mandate.

The "principal purpose" of the proposed regulations is not to create factors to evaluate whether an instrument is debt or equity but to disallow, in certain peculiarly defined scenarios, the deductibility of interest paid to non-U.S. shareholders who wish to use that interest to lower the effective tax rate of a related U.S. corporation.

While this may or may not be a good policy choice, it is a choice that is to be made by Congress.

By seeking to unilaterally impose such a regime, Treasury is attempting to usurp the power of Congress to debate and craft tax policy through amendments to the Code. By so doing it shows a lack of commitment to the rule of law. If the Constitution itself can be disregarded through hyper-technical arguments that purport to show Treasury has authority to issue rules that are clearly outside the intended scope of Section 385, merely because Treasury thinks it's a good idea to do so, why shouldn't taxpayers feel that they can similarly use hyper-technical arguments to disregard the purpose of administrative rules that have less "authority" than the Constitution when it suits their purpose to do so? Treasury cannot expect taxpayers to have a commitment to the rule of law if they are not willing to demonstrate that same commitment.

 

B. Interest Disallowance or Interest-Stripping Rules should be Done in a Clear Manner With as Little Complexity as Possible

 

Treasury has crafted rules that result in the disparate treatment of identical instruments issued by different taxpayers as well as the disparate treatment of identical instruments issued by the same taxpayer, depending on who holds the instrument. Under the Proposed Earnings-Stripping Rules, an instrument that should be treated as debt can subsequently lose that status if it is acquired by a taxpayer that is considered "related" to the issuer or the holder of the instrument becomes related to the issuer, and can become subject to the rules depending on what happens years after the instrument is issued in completely unrelated transactions, and even when unrelated transactions prior to the issuance of the debt are subsequently recharacterized for reasons that have nothing to do with the debt issuance.

In one fell swoop, the regulations thus represent an unprecedented expansion of the step-transaction doctrine that has no basis in case law and which applies only in the narrow category of transactions covered by the rules.

Moreover, the Proposed Regulations create their new earnings-stripping regime in a manner so complicated that they can be expressed only through over a dozen examples rather than by clearly articulated, logical rules.

In fact, Treasury makes no attempt to explain or rationalize the plethora of arbitrary distinctions the rules create. If the rules are intended to implement a clear policy goal, what is that goal and why can't it be implemented in a way that is clear and that demonstrates how the rules serve that policy?

The answer is that the Proposed Earnings-Stripping Rules cannot do this because Treasury is hamstrung by the fact that it doesn't have the authority to issue earnings-stripping rules. As a result, it cannot clearly articulate a policy and explain how it is implementing that policy because to do so would require admitting that is acting outside the scope of authority granted by Section 385.

Congress, by contrast, would suffer no such constraint and, if it decided to craft new earnings-stripping rules, could do so in a manner that was clear, logically articulated, and which would allow taxpayers to understand both the rules and the intent of the rules.

Whatever the merits of the creating new earnings-stripping rules are, it is difficult to see how creating needless complexity, that taxpayers will only be able to navigate with detailed and intensive assistance from tax advisors, can possibly be considered a desirable outcome when that complexity could easily be avoided by allowing Congress to do its job.21

 

C. The Proposed Regulations Contain Needless and Unexplained Complexity and Distinctions

 

Whether debt is issued at the time an investment is made or later in time is not a factor that is relevant to the formal analysis of what characteristics the instrument poses. However, the Proposed Earnings-Stripping Rules make this seemingly inconsequential fact the principal talisman to determine whether a corporation paying interest to related debt holders can deduct that interest.

At best, this represents a peculiar policy choice because it means that corporations can shield the normal time-value return of an investment from tax only if they know what that normal return is expected to be at the inception of making that investment. If the investment grows in size or unexpectedly reaches a point at which it can produce greater normal returns, the corporation cannot refinance to move into a scenario where the future normal returns are integrated with the non-corporate tax regime. By contrast, if it sells that investment to a new investor, that new investor is free to extract the normal return without the imposition of corporate tax. It is not clear what the policy is for -- distinguishing between these situations, or for distinguishing between investments where the normal return is known and can be predicted with accuracy when the investment is made and investments that are more speculative and therefore won't support issuing debt at inception but would support issuing debt at a future point.

Exactly what is the policy of imposing harsher rules on riskier companies who take some time before they can establish a stable plateau of normal returns? And what are the policy rationales for the other intricate distinctions and traps the Proposed Earnings-Stripping Rules create?

At a minimum, the Proposed Regulations should explain why these distinctions are necessary, what they are hoping to accomplish, and then re-propose them so that taxpayers can meaningfully comment on the Proposed Earnings-Stripping Rules once they know what Treasury intends to accomplish and why Treasury believes it has the authority to create a new interest disallowance regime.

 

D. The Proposed Regulation are Inconsistent With the U.S. Tax Treaty Network

 

As a set of rules that primarily burden U.S. corporations owned by non-U.S. corporations, the Proposed Earnings-Stripping rules make it more difficult for a non-U.S. corporation to invest in the U.S.

While a U.S. corporation with a diverse set of owners is free to deduct the normal return paid in the form of interest on debt -- even if the recipients of these interest payments are not subject to U.S. tax -- a foreign corporation that invests in the U.S. through a U.S. subsidiary is not. In fact, discriminating against foreign corporations that acquire U.S. corporations is one of the principal purposes of the Proposed Earnings-Stripping Rules. In doing so, the regulations thereby raise significant questions as to the U.S.'s commitment to the non-discrimination provisions contained in the majority of the U.S. tax treaty network, even if an argument can be made that the rules don't violate the technical language in those treaties.

 

E. While Congress Has the Power to Enact Something Similar to the Proposed Regulations, it is Not Clear That it Should Do So

 

Whether Congress wants to effectively increase the tax burden of investing in the U.S. is a decision that Congress may make. In its most recent legislative changes it has not done so and, in fact, has gone in the opposite direction, for example by exempting a large class of foreign investors from the U.S. income tax on real estate gains that would otherwise apply through the enactment of the qualified foreign pension fund regime of Section 897(l).

Moreover, as a set of rules that are designed, in part, to discourage inversions, the Proposed Regulations will have little impact in that regard, and, in fact, will increase rather than decrease the benefit of using non-U.S. corporations to be the parent of an international business, so that non-U.S. subsidiaries can be subsidiaries of the foreign rather than the U.S. parent and thereby avoid the immense complications the Proposed Regulations will otherwise impose on the foreign subsidiaries and on the U.S. parent entity.22

The Proposed Earnings Stripping Rules arguably do raise an interesting question -- should the ability to integrate the corporate and individual tax regimes with respect to the normal return apply when the recipients of the normal return are themselves not subject to U.S. tax? However, this question arises regardless of whether those recipients are "related" to the corporation. Yet, the Proposed Regulations apply only to "related" taxpayers.

If the concern is that integrating the corporate and individual income tax regimes is not appropriate when no tax is imposed at the individual level, what is the policy rational for restricting interest deductions only when the debt holders are related to the equity holders?

It is also not clear what the policy would be for tying the ability of corporations to deduct the normal return to whether the recipient of that return is subject to U.S. tax. Tax-exempt and non-U.S. investors seeking a normal return have many options for obtaining that return. If a U.S. corporation is penalized for seeking investments from these investors by not being able to deduct interest paid to them, they will either seek to pay those investors less, or will have to confine themselves to taxable U.S. investors. Either course of action will shrink the available supply of capital however. And shrinking the supply of available capital will inevitably drive up the cost of that capital. Debt financing will therefore become more expensive for U.S. corporations, either by causing them to pay higher interest to taxable investors or by denying them interest deductions that would otherwise be available. Perhaps this would be a good policy choice -- though it is difficult to see why -- but it is clearly one that Congress, rather than Treasury, should make.

VI. Conclusion

For all of the above reasons, and in order to demonstrate Treasury's commitment to the sound administration of the tax system and the broader principle of the rule of law including the U.S.'s bedrock principle of the separation of legislative and executive powers, the Proposed Earnings-Stripping Rules should be withdrawn.

Respectfully yours,

 

 

Scott L. Semer, Esq.

 

TORYS, LLP

 

New York, NY

 

FOOTNOTES

 

 

1 Section references in this Letter are to the Code. This Letter does not summarize the Proposed Regulations and is not intended to be a comprehensive examination or critique and instead focuses on the narrow question of whether the Proposed Earnings-Striping Rules are within the ambit of authority granted by Section 385 and, if so, are an appropriate and beneficial exercise of that authority.

2 See Joint Committee on Taxation, Overview of the Tax Treatment of Corporate Debt and Equity (JCX-45-16), May 20, 2016 at 61 (hereinafter "Joint Committee Overview").

3 See, for example, Martin D. Ginsburg, "Comment on Distinguishing Debt From Equity in the Junk Bond Era", at 170 in Debt, Taxes & Corporate Restructuring, (John B Shovan and Joel Waldfogal, eds., Brookings Institution 1990) (hereinafter "Debt, Taxes") at 169-172 ("other than in terms of outcome, in the tax law there is not and never was 'reality' to a debt-equity distinction").

4 See, for example, David P. Hariton, Distinguishing Between Equity and Debt in the New Financial Environment, 49 Tax L. Rev. 499 (1994) ("In exchange for capital, corporations can offer investors any set of rights that can be described by words, subject to any conceivable set of qualifications, and in consideration of any conceivable set of offsetting obligations.").

5 While an investor in equity, at least in publicly-traded corporations, may more often receive this return by selling their shares to another investor, the shares have value only if their claim to the assets of the corporation has value.

6 See generally Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance (5th ed. McGraw-Hill 1996) at 376 ("Financing [a corporation] is principally a marketing problem. The company tries to split the cash flows generated by its assets into different streams that will appeal to investors with different tastes, wealth, and tax rates.").

7 See, for example, Ginsburg, supra note 4 at 170 ("There is in federal tax law an important difference between debt and equity, but it is precisely that the yield on debt is deductible and the yield on equity is not.").

8 See William T. Plumb, Jr., The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369, 408 (1971) at 409 (the question of whether an instrument is debt or equity is "at the mercy of the particular trial judges 'experience with the mainsprings of human conduct,' the acuity of his sense of smell, and the degree of his commitment to the established system of double taxation of corporate income") (citations omitted).

9 Former Secretary of the Treasury Lawrence Summers, however, has argued that the tax distinction between debt and equity, and the corresponding incentive this places on corporations not to make payments on equity so as to avoid the double taxation on dividends, serves the useful purpose of keeping money in corporate solution, where it can be invested again in useful projects instead of 'wasted' on consumption. See Jeremy I. Bulow, Lawrence H. Summers, and Victoria P. Summers, "Distinguishing Debt from Equity in the Junk Bond Era" at 161 in Debt, Taxes. This argument would support making all interest non-deductible.

10 For ease of terminology, references in this letter to the "individual" income tax regime are meant to apply to all stakeholders who are not themselves subject to the corporate income tax of Section 11, and therefore includes tax-exempt U.S. corporations and non-U.S. corporations.

11 In fact, two significant major proposals to integrate the corporate and individual income taxes recommended a regime that would extend the deductibility of interest to dividends as superior to other integration proposals. See, for example, the seminal report by the Treasury Department, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department Report to the President, November 1984; American Law Institute, Federal Income Tax Project -- Subchapter C (Supplemental Study): Reporter's Study Draft, (June 1989). The version of corporate tax integration advocated by these two studies is in fact already used with respect to real estate investment trusts, who are allowed to pay deductible dividends.

12 See Myron S. Scholes and Mark A. Wolfson, "Converting Corporations to Partnerships through Leverage" at 194 in Debt, Taxes.

13 See, for example, Laurie Simon Bagwell, "Comment on Converting Corporations to Partnership Through Leverage" at 200 in Debt, Taxes 196-200 (the corporate tax "may be inducing the implementation of lower net-present-value projects owing to the non-deductibility of excess returns"); William J. Baumol and Alan S. Blinder, Economics: Principles and Policy 635 (5th Ed. 1991) (this double taxation of supra-normal corporate profits may be unfortunate from the viewpoint of the efficiency of the economy).

14 See, for example, Plumb, supra note 9 ("it has justly been said that the courts are at liberty to arrive at opposite results on identical facts depending upon their own whims as to which factors they wish to stress, and that one can find a case which supports almost any reasonable argument") (internal quotes and citations omitted).

15 Plumb, supra note 9 at 407 (courts have been forced to attempt to analyze the instrument designated as debt or equity by the taxpayer "in terms of its economic reality [which has] unfortunately . . . generated intolerable confusion") (internal quotes and citations omitted).

16 See, for example, Edward J. McCaffery, Manager's Journal: Remove a Major Incentive to Cheat, Wall St. J., July 9, 2002, at B2 ("The question of the ultimate incidence of the corporate tax has been a holy grail for public-finance economists, who are not sure who really pays it anyway.").

17 See generally, House Report 101-386, "Limitation on deduction for certain interest paid to related persons" (PL 101-239, 12/19/89).

18 See, for example, Alan J. Auerbach, "Debt, Equity, and the Taxation of Corporate Cash Flows" at 91-126 in Debt, Taxes.

19 See Joint Committee Overview at 15 (regulations issued under Section 385 "must set forth factors") (emphasis added).

20 That Treasury doesn't believe it has authority to issue these rules is also confirmed by the complexity of the Proposed Earnings-Stripping Rules themselves. If Treasury had the authority to amend or create new earnings-stripping rules, it would not need to do so by creating a convoluted and impractical regime that takes up dozens of pages in the Federal Register.

21 No less a jurist than Learned Hand has complained about the often needless complexity of the tax system. See, for example, Learned Hand, The Spirit of Liberty: Papers and Addresses of Learned Hand 213 (Irving Dilliard ed., 2nd ed. 1953) ("In my own case the words. . . merely dance before my eyes in a meaningless procession: cross-reference to cross-reference, exception upon exception -- couched in abstract terms that offer no handle to seize hold of -- [and which] leave in my mind only a confused sense of some vitally important but successfully concealed, purport, which it is my duty to extract, but which is within my power, if at all, only after the most inordinate expenditure of time.'). See also Commissioner v. Gordon, 382 F.2d 499, 501 (2nd Cir. 1967) ("All too frequently, Commissioners and courts launch into an analysis of tax sections, subsections, paragraphs and subparagraphs which practically exhaust the alphabet and Roman and Arabic numbers. In this intellectual exercise, the taxpayer often is only an incidental (though necessary) figure.").

22 Compare McCaffery, supra note 17 ("Killing the corporate income tax would improve the efficiency and competitiveness of U.S. business; eliminate incentives to relocate overseas or to engage in mind-boggling shelter transactions; [and] cut down a major source of accountants compensation and a temptation to look the other way . . .").

 

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