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Cleary Gottlieb Client Seeks Exclusion From Debt-Equity Regs

JUL. 7, 2016

Cleary Gottlieb Client Seeks Exclusion From Debt-Equity Regs

DATED JUL. 7, 2016
DOCUMENT ATTRIBUTES

 

July 7, 2016

 

 

Internal Revenue Service

 

Re: IRS REG-108060-15 (Section 385 Proposed Regulations)

 

Ladies and Gentlemen:

We are pleased to submit on behalf of a client (referred to as "RFG") the attached comments on the proposed section 385 regulations ("Proposed Regulations"). This cover letter summarizes the comments.

RFG is a U.S. headquartered, multinational regulated financial group. RFG includes domestic and foreign banks, domestic and foreign securities, derivatives and commodities broker-dealers, asset managers, and other subsidiaries, including intermediate holding companies, and service and investment companies.

The parent of the group is a bank holding company. Accordingly, the parent and other members of the group are regulated by the Federal Reserve Board. Such regulation is extensive and relates to capital, liquidity and resolution. Banks, broker-dealers, asset managers, and other members of RFG are separately regulated by banking or securities regulators in the United States and other countries.

RFG qualifies as a financial services group within the meaning of section 904(d)(2)(C) ("Financial Services Group").1

RFG is highly leveraged in line with others in the financial industry. Entities that are part of RFG raise funds externally and make them available to subsidiaries through intercompany debt. The debt may take the form of loans or transactions treated as debt (such as repos or the posting of collateral). Also, internally generated surplus funds in one RFG member are routinely loaned to other members that have a need for funds. Transactions involving intercompany debt are frequent and large in volume, and provide funding in all directions (domestic to foreign and vice versa, domestic to domestic, and foreign to foreign). The intercompany debt is needed to meet significant commercial needs and to meet the requirements of regulators, rating agencies and other stakeholders. The conversion of such debt to stock for federal income tax purposes would have significant adverse consequences for RFG.

The current funding rule in section 1.385-3(b)(3) ("Funding Rule") would result in the conversion of material amounts of RFG intercompany debt to stock. RFG believes that it would be costly and impractical to attempt to avoid or significantly mitigate these results by restricting RFG members from making distributions to, or acquiring affiliate stock from, other RFG members that would trigger the Funding Rule. It would be even more costly to move to a funding model in which each subsidiary in need of funds borrows directly from unrelated lenders.

RFG would support the withdrawal of the Funding Rule or other measures that would significantly limit its reach.

If the Funding Rule is not withdrawn, RFG recommends an exception to the Funding Rule for all debt between members of a group like RFG that is subject to regulation at the group level ("Regulated Group Exception"). Such an exception would be comprehensive and easy to administer. If the Regulated Group Exception were granted, then the other recommendations set forth below relating to the Funding Rule would not be needed by RFG.

If there is not a Regulated Group Exception (or if it is adopted with material conditions or limitations), then RFG recommends all of the following changes to the Funding Rule:

  • An exception for debt used to finance ordinary course of business activities of a Financial Services Group

  • An exception for debt used to fund entities that are separately regulated as banks, broker-dealers, or asset managers

  • An exception for dividends (including distributions of previously taxed income) paid by a foreign corporation

  • An exception for foreign to foreign debt

  • An exception for acquisitions of stock involving only foreign expanded group members

  • Elimination of the "cascading" effects of stock characterization

  • Changes removing technical obstacles to the allowance of credits for foreign taxes allocated to debt that is recharacterized as stock, and

  • An exception for intercompany debt that is linked to external debt.

 

RFG also supports changes in the effective dates of any final regulations to limit their retroactive effect, changes to the documentation rules in section 1.385-2 of the Proposed Regulations that would replace the cliff effect with a rebuttable presumption and otherwise make the rules more administrable, and clarification that regulatory-required instruments do not fail to be treated as debt because of bail-in or other terms required by regulatory requirements.

If you would like to discuss the recommendations, please feel free to contact me.

Very truly yours,

 

 

James M. Peaslee

 

Cleary, Gottlieb, Steen & Hamilton,

 

LLP

 

Washington, DC

 

FOOTNOTE

 

 

1 Unless otherwise noted, all section references herein are to the Internal Revenue Code of 1986 or the Proposed Regulations.

 

END OF FOOTNOTE

 

 

Attachment

 

* * * * *

 

 

July 7, 2016

 

 

Recommended Changes to IRS REG-108060-15

 

(Proposed Regulations Under Section 385)

 

 

I. Introduction
  • The Proposed Regulations ("Proposed Regulations") were issued by the Treasury and IRS to curb earnings stripping and repatriation planning by converting certain intercompany loans to equity.1

  • This memorandum recommends changes to the Proposed Regulations that are intended to reduce their adverse effects on a taxpayer ("RFG"), which is a U.S. headquartered, multinational, regulated financial group.

  • RFG is engaged in a global financial business. For valid commercial or regulatory reasons, the business makes extensive use of intercompany debt. That debt is not the target of the Proposed Regulations but would nonetheless be affected by them in ways that would seriously interfere with RFG's ordinary course business operations.

  • Part II of the memorandum will describe additional facts relating to RFG. Part III provides overall comments on the Proposed Regulations. Part IV proposes an exception for all debt between members of a regulated group.

  • If that exception is not adopted, then Parts V, VI and VII recommend other changes to mitigate the effect of the Proposed Regulations. Part V propose an exception for debt used to finance ordinary course activities of a financial services group, as defined in section 904(d)(2)(C) ("Financial Services Group").2 Part VI proposes an exception for debt used to finance operations of regulated entities within RFG. Part VII proposes six other changes. They relate to (1) dividends paid by a foreign corporation, (2) foreign to foreign debt, (3) stock sales involving only foreign parties, (4) the "cascading" effect of stock characterization, (5) foreign tax credits, and (6) intercompany debt that is linked to external debt.

 

II. Facts
  • The parent of RFG ("Parent") is a domestic public company. Parent files a federal income tax consolidated return with its domestic subsidiaries that are members with Parent of an affiliated group under section 1504.

  • RFG includes domestic and foreign banks, domestic and foreign securities, derivatives and commodities broker-dealers, asset managers, and other subsidiaries, including intermediate holding companies, and service and investment companies.

  • RFG operates in many countries throughout the world, through several distinct corporate ownership chains.

  • Parent is both a bank holding company and a financial holding company within the meaning of section 956(c)(2)(A)(ii). Thus Parent, and through it RFG, is regulated by the Federal Reserve Board. Banks, broker-dealers and asset managers, and certain of their affiliates within RFG are also separately regulated by bank or securities regulatory bodies.

  • RFG is a Financial Services Group because it is predominantly engaged in the active conduct of a banking, financing, or similar business within the meaning of section 904(d)(2)(C), determined by applying the 80 percent gross income test in section 1.904-4(e). The main operating subsidiaries are also individually financial services entities under this test.

  • RFG makes extensive use of intercompany debt and the volume of intercompany lending transactions is very high.

  • RFG raises unsecured external funding primarily by issuing debt through one funding corporation, which makes the borrowed amounts available to domestic and foreign subsidiaries through intercompany loans. The subsidiaries in turn may on-lend the funds to other subsidiaries.

  • Broker-dealers within RFG also raise significant funds in the ordinary course of business, for example through repos, generally using securities as collateral. These transactions occur in large volumes and in all directions (domestic to foreign and vice versa, domestic to domestic, and foreign to foreign).

  • Intercompany loans are also used to make surplus funds in one subsidiary available to another subsidiary that needs money.

  • Unsecured intercompany loans that would be affected by the Proposed Regulations are made primarily from domestic members of RFG to foreign subsidiaries and between foreign subsidiaries.

  • There are significant legal, regulatory and rating agency reasons why RFG must generally provide funds to subsidiaries that do not represent permanent equity capital in the form of debt. Debt allows funds to be returned to the source without the substantial limitations imposed on payments on equity. Debt also gives RFG claims against the borrower that are superior to equity in the event of an insolvency of the borrower.

  • RFG also has a substantial volume of securities transactions between subsidiaries, including transactions treated for tax purposes as loans of money (such as repos, and securities loans or other transactions with cash collateral). Those transactions include a high volume of transactions, in both directions, between a domestic bank and broker-dealer, and foreign banks and broker-dealers.

  • As is typical of financial businesses, RFG is highly leveraged. Borrowing at the right time, place and cost, and the proper deployment of borrowed funds, are critical to RFG's business.

  • RFG has been, and almost certainly will be in the future, required to transfer the ownership of subsidiaries among RFG companies in response to regulatory requirements or changing commercial needs.

 

III. Overall Comments
  • To conduct its business, RFG must have the flexibility to transfer funds among RFG companies using intercompany debt. Although RFG raises significant external financing, the RFG companies that have the best access to funding are often different from the companies that need that funding. Further, the mix of companies with a demand and supply of funds changes frequently.

  • The conversion of intercompany debt to equity under the funding rule in the Proposed Regulations ("Funding Rule")3 would result in distortions to income and other costly and inappropriate tax results. RFG does not believe that it can in a cost-efficient and practical manner and over an extended period prevent the conversion of intercompany debt to stock under the current Funding Rule by limiting distributions or stock acquisitions or moving to a funding model in which each subsidiary in need of funds borrows externally.

  • The cases where the Proposed Regulations would apply most significantly to convert RFG intercompany debt to equity do not involve earnings stripping or repatriation planning of the kind targeted by the Proposed Regulations.

  • A number of commentators have recommended that the Funding Rule be withdrawn or limited significantly. Changes of this type would be helpful. They are not, however, the focus of this memorandum.

  • Rather, this memorandum first recommends changes to the Funding Rule to take account of the particular circumstances of a financial business. Specifically, it recommends in Part IV adoption of an exception for all debt between members of a group that is subject to regulation at the group level ("Regulated Group Exception"). Such an exception would be comprehensive and easy to administer. If the Regulated Group Exception were granted, then the other recommendations set forth below would not be needed.

  • If there is not a Regulated Group Exception (or if it is adopted with material conditions or limitations), then there should be an exception, described in Part V, for debt used to finance ordinary course activities of a Financial Services Group. This exception ("Financial Services Group Exception") would differ from the Regulated Group Exception by requiring that the activities being financed arise in the ordinary course of a banking, insurance, financing, or similar business.

  • A Financial Services Group Exception would be useful but somewhat difficult to administer, particular for businesses that mix activities within a single legal entity. Part VI recommends that the Financial Services Group Exception be accompanied by an exception for debt used to fund the operations of entities within a corporate group that are separately regulated as banks, broker-dealers, or asset managers.

  • Part VII recommends six other changes that would limit the adverse effects of the Funding Rule without undermining its purpose.

  • If the Funding Rule is not withdrawn, the final version should not apply to financial services businesses unless and until rules taking account of their special circumstances have been proposed and then adopted after comments have been received.4 Also, final rules should apply only to instruments issued, and to distributions or stock acquisitions made, after the date of issuance of final regulations. To the extent the regulations are retroactive at all (including as to dates of distributions, stock acquisitions or debt issuances), the retroactive rules should be narrow and aimed only at abuse cases.

  • Although not the focus of this memorandum, RFG supports recommendations made by the Securities Industry and Financial Markets Association ("SIFMA") and others to change the documentation rules in the Proposed Regulations ("Documentation Rules")5 in a number of ways, including by making the rules more administrable for taxpayers with large volumes of potentially affected transactions, having a failure to meet documentation requirements create only a rebuttable presumption of stock treatment, and providing a long transition period after regulations are issued in final form before the Documentation Rules become effective.

  • RFG supports proposals to clarify that regulatory-required instruments (such as TLAC instruments) do not fail to be treated as debt under the Documentation Rules or general tax law principles because of bail-in or other terms mandated by regulatory requirements.

 

IV. Regulated Group Exception
  • Parent is a bank holding company. The simplest and most comprehensive approach to granting appropriate relief from the Funding Rule would be to have a Regulatory Group Exception covering all debt between members of a group consisting of a bank holding company and its subsidiaries. Such a group is regulated by the Federal Reserve.

  • Federal Reserve regulation includes extensive rules relating to capital, liquidity and resolution. Such regulation limits the flexibility of a bank holding company group to make intercompany loans on terms that call into question their status as debt, or that would strip out equity capital from subsidiaries for tax reasons.

  • A bank holding company group exception would cover the categories of intercompany debt and transactions described in Part II above and would be easier to administer than the alternatives discussed below.

 

V. Ordinary Course Exception for Financial Services Groups
  • There should be an ordinary course of business exception from the Funding Rule that is modeled after the exception in section 1.385-3(b)(3)(iv)(B)(2) but is tailored to the financing needs of an active, customer based financial business. The test could rely on the longstanding tax law definition of a Financial Services Group.

  • Section 1.385-3(b)(3)(iv)(B)(2) applies to debt that meets three tests: (1) the debt arises in the ordinary course of business in connection with the purchase of property or services, (2) the debt reflects an obligation to pay for an amount that is a section 162 expense or is included in the issuer's cost of goods sold or inventory, and (3) the amount of debt outstanding at no time exceeds the amount that would be ordinary and necessary to carry on the trade or business of the issuer if it was unrelated to the lender.

  • This rule may be limited (as regards purchases of property) to a trade receivable delivered to a vendor in exchange for property, as distinguished from debt issued in exchange for money that is used to buy property (the "in connection with" language is unclear). If it does extend to debt incurred to fund purchases of inventory, then it would already apply to loans of money used to finance inventory positions of securities dealers.

  • The proposed rule for a Financial Services Group would apply to:

  •  

    "a debt instrument that arises in connection with the acquisition or financing of property, or other transaction (including a transaction requiring collateral or margin), where the property is acquired, held, or disposed of, or the transaction is entered into, by a financial services entity in the ordinary course of a banking, insurance, financing, or similar business, provided the amount of debt outstanding at no time exceeds the amount that would be ordinary or necessary to carry on the trade or business of the entity if it was unrelated to the other party to the debt instrument. Without limitation, an amount of debt will be considered not to exceed the amount that would be ordinary or necessary to carry on the trade or business of a financial services entity if it was unrelated to the other party to the debt instrument if the debt is created to reasonably meet capital requirements imposed by a regulatory body. A debt instrument held by an entity that qualifies under this paragraph is considered property held by a financial services entity in the ordinary course of a banking, insurance, financing, or similar business for purposes of applying this paragraph to a debt instrument issued by that entity."
  • A financial services entity would be defined by reference to section 904(d)(2)(C). That definition generally requires that an entity (or 80 percent connected group) be predominantly engaged in the active conduct of a banking, insurance, financing, or similar business. If the group meets the test (and is thus a Financial Services Group), then every member qualifies. Predominantly engaged is defined in section 1.904-4(e)(3) to require that 80 percent of gross income be derived from the active conduct of a financial business.

    • The proposed revised section 385 ordinary course test should follow the approach taken in section 904 in treating all members of a Financial Services Group as financial services entities. The exception proposed above would apply only to debt used to finance property or transactions held or entered into by a financial services entity that are acquired, held, or disposed of, or entered into, in the ordinary course of a banking, insurance, financing, or similar business. Thus, the financed activity must itself arise in the ordinary course of an active financial business, which should be enough to show a connection to such a business.

  • The current ordinary course rule is only an exception to the per se rule and not to the Funding Rule generally (so an exception to section 1.385-3(b)(3)(iv)(B)(1) and not to - 3(b)(3) generally). To be useful, the exception should apply to both rules.

  • The proposed test is intended to apply not just to a debt obligation given to a vendor of property (a trade receivable) but also to a loan of money that is used to finance activities of a financial services entity (essentially, a type of working capital loan for such an entity). Thus, for example, it would cover a loan of money used to finance dealer inventory or postings of collateral. This point is clarified in the proposed rule by saying that a debt instrument can arise in connection with the "financing" of property or transactions.

    • There is precedent for treating loans of money to financial businesses as ordinary course transactions. The conduit regulations under section 1.881-3, which address related party loans, generally apply to loans made with a tax avoidance purpose. Under section 1.881-3(b)(2)(iv), the fact that a loan between related parties occurs in the ordinary course of the active conduct of complementary or integrated trades or businesses of the parties is evidence of the lack of a tax avoidance plan. The regulation states: "A loan will not be considered to occur in the ordinary course of the active conduct of complementary or integrated trades or businesses unless the loan is a trade receivable or the parties to the transaction are actively engaged in a banking, insurance, financing or similar trade or business and such business consists predominantly of transactions with customers who are not related persons." Thus, the regulation treats loans of money like trade receivables for parties that are predominantly engaged in a financial business.

  • The proposed exception is intended to cover not only debt instruments that are obligations of a financial services entity but also those it holds, as long as the debt instrument arises in the ordinary course of its business. An example would be "cash collateral" posted by a dealer in a securities borrowing or derivative transaction, or the loan of cash made in a repo in which the dealer is the purchaser of securities and has an obligation to resell. The securities borrowing, derivative or repo would be a transaction entered into by a financial services entity in the ordinary course of a banking, insurance, financing, or similar business.

  • The last sentence of the proposed exception confirms that the exception applies to lending arrangements through intermediaries. Thus, if Parent makes a loan to a holding company that owns a broker-dealer and the holding company on-lends the borrowed funds to the broker-dealer in a transaction that would qualify for the exception, the loan to the holding company also should qualify. The same principle would apply to loans through multiple intermediaries.

  • The next to last sentence of the proposed exception clarifies that debt will not be considered excessive in amount if it is created to reasonably meet capital requirements imposed by a regulatory body. The clarification is needed because a regulator may require more capital than a taxpayer or other observers think is really needed. Also, the fact that a regulator imposes the requirements is a strong indicator that the debt exists for non-tax reasons. The "created to reasonably meet" language is intended to allow some flexibility in setting debt levels to meet capital requirements. For example, it is prudent and reasonable to set capital levels with a margin for error and taking account of reasonably anticipated changes in levels of activity or financial results.

  • There should be a separate exception (not covered by the proposed Financial Services Group Exception) for acquisitions of debt or stock of expanded group members made by a dealer in the ordinary course of business modeled after section 1.108-2(e)(2). This will allow a RFG broker-dealer to underwrite and make a market in Parent debt or stock.

 

VI. Exception for Regulated Entities
  • If a Regulatory Group Exception is not adopted, then a narrower exception would be appropriate for transactions entered into with the banks, regulated broker-dealers and regulated asset-managers that are part of RFG. Such an exception would be in addition to the Financial Services Group Exception.

  • Such an exception should cover (1) transactions in securities that are considered for tax purposes to involve loans by or to the regulated entity, (2) loans (including deposits), which typically are unsecured, made to a regulated entity that are needed to fund its overall operations, and (3) loans used indirectly to fund the regulated entity, even if the direct borrower is not itself a bank or broker-dealer (for example, is a holding company).

  • Loans to regulated entities described in (2) are necessarily limited because a regulated entity must maintain a level of equity capital that is considered appropriate for its business.

  • Because regulated entities are often funded using loans made through unregulated intermediaries, the exception should cover loans made to a regulated entity through one or more intermediaries.

  • For a financial services company like RFG that conducts much of its business through broker-dealers that are not banks, it is critically important that any exception for regulated entities cover regulated broker-dealers as well as banks.

 

VII. Other Changes
  •  

    A. Exception for dividends paid by a foreign corporation

  • Section 1.385-3(c)(1) has an exception from the general rule in section 1.385-3(b)(2) ("General Rule") and the Funding Rule for distributions that do not exceed current year earnings and profits. At the least, the exception should be changed to permit distributions of earnings for a year to be made some time after the end of the year.

  • In addition, the exception should be expanded to cover all dividends paid by a foreign corporation, whether the payee be a domestic or foreign shareholder.

    • Distributions by a foreign corporation that is not a U.S. taxpayer should not raise earnings stripping concerns. (The rule could be limited to a foreign corporation that does not derive more than 25% of its gross income from a trade or business within the United States to ensure that a borrower would not derive a material U.S. interest deduction if it incurred additional debt.)

    • Dividends paid by a foreign corporation should not allow repatriation planning (specifically, making a return of capital distribution in a year without earnings and profits to be followed by principal payments in later years when there are earnings).

    • The exception should cover dividends that are treated as distributions of previously taxed income ("PTI") under section 959. Those distributions represent the payment of income amounts that have previously been taxed to a United States shareholder. Also, under section 959(c), a distribution of PTI always comes before other earnings, so a dividend is always tax free to the extent of PTI, even if the CFC has other non-taxed earnings at the time of the distribution.

     

    B. Foreign to foreign debt exception

  • There should be an exception to the Funding Rule for a debt instrument to the extent both the issuer and the holder are foreign corporations and the debt is not a U.S. liability under section 884 (connected with the issuer's U.S. trade or business). Foreign to foreign loans do not present abuse opportunities -- there can be no earnings stripping because the borrower is not taxable, and recasting debt between foreign corporations as stock would not restrict repatriation planning (and indeed might facilitate it).

    • One beneficial effect of the rule would be to explicitly carve out foreign transactions having no effect on the United States. There could of course be no repatriation planning unless the foreign corporations were owned by a domestic parent.

    • The proposed rule would also apply where the foreign corporations are CFCs with a domestic parent. In that case, applying the Proposed Regulations to convert debt to equity would reallocate earnings and profits among CFCs, but with no reason to think that produces a better result for the government than debt treatment. CFC to CFC loans are very common for commercial reasons, and treating those loans as stock would produce essentially random tax results that would be highly disruptive (see the example below). Accordingly, in weighing the disruptive effects of converting debt to stock against the benefits to the government, the balance strongly supports having the exception and leaving the debt alone.

    • To illustrate, suppose that USP owns directly all of the stock of two foreign subsidiaries, CFC1 and CFC2. In year 1, CFC1 has no current earnings and profits but expects to having earnings in year 2 that are not subpart F income (if they were subpart F income, then they would be taxed to USP even if not distributed).

    • CFC1 distributes a note to USP in year 1 that would be treated as a nontaxable return of capital if the note were respected as debt. If the note were recognized to be debt, principal payments in year 2 would be treated as a return of capital. Section 1.385-3(b)(2) would convert the note to stock of CFC1 so that all future payment would be taxable dividends to USP to the extent of earnings.

    • Suppose instead that CFC2 makes a loan to CFC1, which distributes the borrowed funds to USP. If the Funding Rule applied to these facts to treat the loan as stock, the conversion to stock would have quite a different effect than in the original example. When payments are made in year 2 on the loan, CFC2 would receive a dividend to the extent of the earnings of CFC1, but that dividend would not be taxable under current law to USP. If CFC1 did not have subpart F income, then under section 954(c)(6), the dividend would not be subpart F income to CFC 2.6 It could also be tax free under the same country exception in section 954(c)(3). If CFC1 did have subpart F income, then the dividend paid to CFC2 would be previously taxed income that is not subpart F income to CFC2 for that reason.

    • It is true that treating the loan as stock would mean that payments on the loan in year 2 would shift earnings and profits from CFC1 to CFC2. Thus, if CFC2 made distributions in year 2 to USP and CFC1 did not, then the shift would result in more dividend income to USP than if the loan were recognized to be debt. But there is nothing in this fact pattern indicating that a distribution from CFC2 is more likely than a distribution from CFC1, or that CFC2 would not have had earnings to support a dividend absent the allocation of earnings from CFC1. It could be the opposite. Stripping year 2 earnings out of CFC1 might allow it to make return of capital distributions in future years. There is no clear benefit to the government of stock treatment and therefore no reason to depart from current law, particularly given the high costs.

    • The government would not be subject to a nondiscrimination claim if it treated foreign to foreign loans better than loans involving a domestic taxpayer. Nondiscrimination concerns arise when foreign taxpayers are treated less well than domestic ones.

     

    C. Stock acquisition involving only foreign parties

  • Parent operates outside of the United States through several distinct chains of corporations. For regulatory or commercial reasons, it has been at times in the past, and likely will be again in the future, important to be able to move a foreign subsidiary from one foreign owner to another, generally across chains.

  • RFG recommends that an acquisition of expanded group member stock not be a triggering event for the General Rule or the Funding Rule if the issuer, the transferor and the acquirer are foreign corporations. A partnership would be treated as an aggregate of its partners in applying the rule. The rule could be limited to foreign corporations that, in the case of the seller and buyer of stock, do not have significant income (say more than 25% of gross income) that is effectively connected with a U.S. trade or business.

    • To facilitate a discussion of the proposal, suppose that USP owns CFC1 and CFC2. Neither CFC1 nor CFC2 has significant income from a U.S. business. CFC2 owns all of the stock of CFC3. CFC2 sells the CFC3 stock to CFC1 for a note of CFC1 or for cash.

    • Take first the sale of CFC3 stock for a note. The preamble to the Proposed Regulations justifies the rule treating the purchase of affiliate stock with debt the same as a distribution on the ground that the acquisition of affiliate stock may not be significant, leaving behind only the transfer of the debt. In fact the sale of CFC3 stock would not reduce the net worth of either CFC1 or CFC2 (it would be an exchange of equivalent values). But even if the sale were viewed, according to the section 304 construct, as two separate steps consisting of (1) a contribution of the CFC3 stock to CFC1 in exchange for CFC1 stock and (2) a distribution by CFC1 in the form of a redemption of the CFC1 stock with the note, in the all foreign party setting, there would be no evident reason why converting the note to stock would produce a better result for the government.

    • If the note were not converted to stock (current law), section 304 would treat the sale of the CFC3 stock as a deemed dividend paid by CFC1 or CFC3 to CFC2 equal to the earnings and profits of first CFC1 and then CFC3.7

    • If instead the Proposed Regulations applied to convert the note to stock, there would no longer be a transfer of "property" by CFC1 to CFC2, so section 304 would not apply. Accordingly, the CFC3 earnings would effectively be shifted over to the CFC1 chain (as they would remain in CFC3), and the earnings and profits of CFC2 at the time of the sale would remain in CFC2. Congress has in recent years reviewed the operation of section 304 in the international area (most recently in 2010), and spelled out in section 304(b)(5) the circumstances in which earnings and profits of an acquiring corporation (CFC1 on our facts) should be taken into account under section 304. The rules specifically address the case in which earnings and profits would be received by a CFC.8 The changes did not affect when the earnings of the foreign issuing corporation (CFC3) are taken into account. The Proposed Regulations by converting the note to stock would effectively turn off section 304 as applied to the stock sale, so that the sale of stock for a note would leave earnings and profits where they are (with the CFC3 earnings shifting over to the CFC1 chain). Instead, in future years as payments are made on the note, the payments would be treated as distributions by CFC1 on its stock. To the extent of the earnings and profits of CFC1 allocable to those distributions (there could also be distributions made on other stock), the note payments would shift earnings and profits from CFC1 to CFC2. There is no particular reason to think this would produce a better result for the government than applying section 304. Given that Congress took a close look recently at how section 304 applies to foreign corporations and to CFCs, its views as to the proper treatment of stock sales should not be set aside lightly.

    • It would also not make sense to convert the note to stock in order for the ongoing interest payments to be converted to stock distributions, for the reasons given above in proposing a foreign to foreign loan exception.

    • In short, it does not seem appropriate to overturn the scheme Congress devised in section 304 and recently reaffirmed, and the traditional treatment of debt, by converting the CFC1 note issued in exchange for CFC3 stock.

    • If the sale of CFC3 stock were made to CFC1 for cash, and CFC1 had within the preceding three years received a loan in an equal or greater amount from USP, then absent an exception, that loan would be converted to stock under the Funding Rule. But again, it is difficult to see why that result is justified. The sale of CFC3 stock rearranges the holdings of cash and CFC3 stock, and earnings and profits, as between CFC1 and CFC2. The loan and sale do not result in earnings stripping (indeed the loan brings interest income to USP which may become PTI or dividends with credits). There is no apparent reason why the allocation of earnings and cash with the sale would be better or worse in terms of future repatriation opportunities than if it had not occurred.

    • Note that the parties could potentially avoid the Funding Rule if it otherwise applied by converting CFC3 to a disregarded entity and selling its assets to CFC1.9 The liquidation would not be currently taxable to CFC2 or USP. The sale of assets would not produce subpart F income so long as they are active business assets. Whether such a sale is feasible is likely to depend on factors unrelated to the policies underlying section 385, such as whether CFC3 is a per se corporation (and required to be such by regulatory or corporate law rules). Thus, if there is not an exception for all foreign stock sales, the result will be uneven treatment of taxpayers depending on somewhat random factors.

     

    D. Limit cascading effects

  • One of the biggest practical concerns in applying the Funding Rule is the prospect that the recharacterization of one loan as stock will cause other debt to be recharacterized as stock because (1) the making of the recharacterized loan is a purchase of expanded group member stock by the lender, and (2) a repayment of the recharacterized loan is a distribution by the borrower. Thus, other loans to both the original borrower and lender could be recharacterized. The tainting of a second or third loan could then taint other loans, with largely uncontrollable, unpredictable and random effects within a group.

    • For the reasons given below, these secondary effects should be turned off with respect to debt instruments that are recharacterized as stock under the Funding Rule. This can clearly be done. The regulations already provide that the distribution that otherwise would arise when stock is converted into debt upon a transfer out of an expanded group is ignored for purposes of the General and Funding Rule. See section 1.385-3(d)(2) (exchange of debt for stock is "disregarded for purposes of paragraphs (b)(2) and (b)(3) of this section"). The conversion of a debt instrument to stock under paragraph (b)(3) also should be disregarded in again applying paragraph (b)(2) or (b)(3).

    • It is not clear that the cascading effects described above were intended, or if so, what their purpose was. Although cascading would potentially extend the reach of the Funding Rule by orders of magnitude, there is no mention of it in the Proposed Regulations or preamble.

    • The first cascading effect described above applies to the lender. If a loan to an expanded group member is recast as stock, and the borrower is not a more than 50% owned subsidiary of the lender (which would often be true in intercompany lending arrangements), then under the Funding Rule, the loan would be treated as a purchase of stock of an expanded group member from another expanded group member. As a result, a corresponding amount of lender debt would be converted to stock. According to the preamble to the Proposed Regulations, the rationale for treating a purchase of expanded group member stock as an event that triggers the Funding Rule is that it resembles a distribution by the stock purchaser. That is simply not an accurate description of the transaction where the "distribution" is commercially a loan of money. The lender has a legal right to get back money it has advanced. It bought the cash it receives. Also, even if the repayment right were ignored, a payment of cash to a corporation in exchange for its stock is a contribution to the issuer, not a distribution.

    • The second cascading effect applies to the borrower. The repayment of any debt that is recast as stock represents a distribution that causes other debt of the borrower to be converted to stock under the Funding Rule. A distribution on such converted debt should not invoke the Funding Rule for two reasons. First, the distribution would be matched against a contribution (viewing the debt as stock) in the form of the cash paid in buying the debt. Thus, there would be no net reduction in the net worth of the issuer. Indeed, the contribution would come first, so if anything, the transaction temporarily boosts the issuer's net worth.

    • A second reason for not treating a repayment of converted debt as a distribution in applying the Funding Rule is that it appears to result in one actual distribution causing debt to be recharacterized as stock in amounts that are multiples of the amount of the distribution. This cannot be the right result.

    • To explain the point, start with a simple example in which a subsidiary S1 distributes a note of 100 to its parent P. Under the General Rule, the note is recast as stock. Thus, the distribution of the note is a nontaxable stock dividend (basically a tax nothing). When the note is repaid, a distribution of 100 from S1 to P occurs. There is then only one distribution, which arises when the note (treated as stock) is repaid and disappears.

    • By contrast, the Funding Rule applies when there is a loan to a borrower and the borrower separately makes a distribution. The Proposed Regulations state explicitly (in section 1.385-3(b)(3)(vi)) that the tax treatment of the distribution is not affected by the Funding Rule.

    • Thus, if P owns S1 and S2, S1 makes a distribution of cash of 100 to P, and S2 makes a loan of 100 to S1 (call it loan 1), the distribution of 100 is recognized to be a distribution of 100. The fact that loan 1 is recast as equity does not change the treatment of the distribution.

    • Now suppose that S2 makes a second loan of 200 to S1 shortly after the first (loan 2). When loan 1 is repaid (and thus no longer exists), under one reading of the Proposed Regulations, loan 2 would be retested to see if it is linked to the actual distribution of 100 (which is not affected by the recharacterization or repayment of loan 1). If there is retesting, then 100 of loan 2 would replace loan 1 as the debt instrument that is treated as stock because of the actual distribution of 100.10 But if the repayment of loan 1 is also treated as a distribution of 100 by S1, then the full 200 of loan 2 would be recast as stock, not just 100. That makes no sense because in fact S1 has made an actual distribution shrinking its net worth of only 100.

    • Even if the Funding Rule were clarified to state that only one debt instrument may be allocated to a distribution (even if that debt has been retired), treating a repayment of loan 1 as a distribution would still produce unwarranted results. The practical effect of such treatment for S1 (assuming it regularly borrows) would be that 100 of its debt would permanently be recast as stock, even if the affected debt is issued decades after the distribution of 100 and has no possible factual connection to it. To illustrate, suppose loan 1 has a term of 15 years, and is repaid at maturity. Some other debt of S1 incurred within three years prior to the repayment date would then be recast as stock. When that debt is repaid, some other debt would be treated as debt, and so on ad infinitum. There also could be a doubling up of stock amounts in the year of repayment of converted debt.11

    • The comment here concerning the cascading rule assumes that the Funding Rule will remain in the final regulations. Other commentators have recommended cutting back or eliminating the Funding Rule and the per se rule. Although the arguments are not reviewed here, they have substantial merit.

     

    E. Remove barriers to use of foreign tax credits

  • In a case where debt of a foreign corporation that is directly or indirectly owned by a domestic parent is recast as stock, dividends paid on the stock would be allocated earnings and foreign taxes under section 902. However, the lender may not meet certain technical requirements of section 902 (or section 901(k)) to enable it to use, or make available to its direct or indirect owners, indirect credits for those taxes. If so, the credits would simply disappear.

  • The policy underlying the section 385 regulations has nothing to do with eliminating foreign tax credits, and to the extent the regulations convert debt into stock, they should be accompanied by rules that preserve credits for taxes allocated to such stock.

  • Regarding section 902, final regulations should provide that in determining if the holder of a debt instrument that is treated as stock under the section 385 regulations is considered to own 10% of the voting stock of the issuer or is a member of a qualified group for purposes of section 902, the holder should be considered to own stock of the issuer attributed to it in applying the control test under section 304(c). A similar approach has been applied to dividends that are deemed paid in cross-chain sales under section 304. See Revenue Rulings 92-86 and 91-5.

  • Turning to section 901(k), that rule provides that a holder of stock in a foreign corporation may claim credits under section 902 or 960 in respect of the stock only if the holder has owned the stock for a minimum of 16 days, excluding days on which the holding period of stock would be tolled in applying the dividends received deduction under section 246(c). The section 385 regulations could create problems in meeting this test.

    • First, the regulations could recharacterize short term debt that is repaid within 16 days as stock, even though the debt is held over its entire term by a lender and clearly would be debt under general tax principles. It is inappropriate to say that a holding period test is not met just because the term of debt is less than 16 days. Revenue Procedure 2004-68, in applying a 46 day minimum holding period test for foreign tax credits that was part of the definition of reportable transaction, created through administrative action an express exception for debt held over its entire term.

    • Second, Revenue Ruling 94-28 indicates that the holding period for an instrument that is treated as stock but is in the form of debt may be tolled because the right to principal is considered an option or contract to sell. The holding of the ruling could apply to legal form debt that is treated as stock under the section 385 regulations. That result would be inappropriate. The policy behind section 901(k) is to prevent a taxpayer from entering into "dividend capture" transactions, in which the taxpayer buys stock in anticipation of receiving a dividend that is subject to a withholding tax and then almost immediately sells. That policy is not implicated where intercompany debt is converted into stock. All of the risks of the stock are held by the same economic interests and treatment as stock is involuntary.

    • Third, it is common for holders of debt to enter into interest rate or currency hedges. For high quality debt, such hedges could eliminate much of the risk of holding the debt and toll the holding period under the section 246 tests. When the holding period requirement of section 901(k) was extended to debt instrument through the enactment of section 901(l), the legislative history made it clear that adjustments would be needed, including ignoring interest rate and currency hedges.12 In addition, there should be an exception for guarantees. Revenue Procedure 2004-68 also had an exception for interest rate and currency hedges of debt instruments and guarantees.

    • To address these points, final section 385 regulations should include a rule stating that the holding period test of section 901(k) is considered to be met with respect to any debt instrument for periods in which it is treated as stock under the regulations.

    • Alternatively (and at the risk of making the rule much more complex), the regulations could provide that the holding period of a debt instrument in applying section 901(k) (1) will be considered to be at least 16 days if the holding period is the lesser of 16 days or the entire term of the debt instrument, (2) will not be reduced on account of currency or interest rate hedges or guarantees, and (3) will not be reduced on account of creditor rights in the instrument.

     

    F. Linkage to external debt

  • Parent and other subsidiaries of RFG borrow money externally and on-lend the funds to other group members. The Proposed Regulations do not apply to external borrowings, and external borrowings followed by intercompany loans are similar. Given the similarity of direct and indirect external funding, the section 385 regulations should not apply to intergroup loans that are linked through identification to external debt. The amount identified at any time would be limited to the external borrowings of the lender. The rule should apply successively to loans made through holding companies or other intermediaries to an end-user of funds.

FOOTNOTES

 

 

1 The memorandum assumes familiarity with the Proposed Regulations and does not provide a description.

2 Unless otherwise noted, all section references herein are to the Internal Revenue Code of 1986 or Treasury regulations thereunder (including proposed regulations).

3 Section 1.385-3(b)(3).

4 Financial businesses raise special issues, particularly as regards funding, and there are other cases in which regulations have been proposed or adopted with reservations for later action with respect to financial groups. See, for example, section 1.861-9T(6)(v), and section 1.987-1(b)(1)(iii). The OECD recently issued a final report regarding BEPS Action 4: Interest Deductions and Other Financial Payments. The report proposed that implementing rules for financial groups be tailored to the circumstances of such groups and be delayed to allow time for further consideration. OECD, BEPS Action 4 at Paragraphs 188 - 190 (October 2015) (noting that "countries may consider excluding entities in groups operating in [banking and insurance] sectors from the scope of these rules").

5 Section 1.385-2.

6 Section 954(c)(6) currently exists through 2020, but it has been repeatedly extended so as to become practically a permanent feature of the tax landscape.

7 Assuming the parties were affiliated when the CFC1 earnings were earned, the limitation on using foreign acquiring corporation earnings in section 304(b)(5) would not apply. If the limitation did apply, the argument would not materially change.

8 See section 304(b)(5)(B)(ii).

9 Such a transaction was approved in Dover Corporation and Subsidiaries v. Comm'r, 122 T.C. 324 (2004).

10 This assumes that once debt that has been converted to stock under the Funding Rule is retired, it is disregarded in determining if other debt of the issuer is treated as stock under the per se rule (and so other debt is retested). There is an explicit retesting rule that applies to an expanded group instrument that is treated as stock and then ceases to be stock when it is sold outside of the group. See section 1.385-3(d)(2). It may be that the explicit retesting rule was thought to be needed because the converted stock remains legally outstanding. The point is not clear under the Proposed Regulations.

11 If the S1 debt that is recast as stock is issued within the same year as the repayment of loan 1, then the new S1 debt would be treated as stock from its issue date, even though loan 1 remains outstanding.

12 See H.R. Conf. Rep. No. 108-755 at 621 ("It is anticipated that such regulations [under section 901(l)] will provide that credits are not disallowed merely because a taxpayer eliminates its risk of loss from interest rate or currency fluctuations.").

 

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