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American Express Seeks Changes to Proposed Debt-Equity Regs

JUL. 7, 2016

American Express Seeks Changes to Proposed Debt-Equity Regs

DATED JUL. 7, 2016
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July 7, 2016

 

 

Commissioner of Internal Revenue

 

Attention: CC:PA:LPD:PR (REG-108060-15)

 

Internal Revenue Service

 

1111 Constitution Avenue, N.W.

 

Washington, DC 20224

 

RE: REG-108060-15-Proposed Regulations on Treatment of Certain Interests in Corporations as Stock or Indebtedness ("Proposed Regulations")

 

American Express Company, on behalf of itself and its affiliates, ("American Express" or the "Company") appreciates the opportunity to provide comments to the Treasury Department and the Internal Revenue Service on the Proposed Regulations which would be adopted under section 385 of the Internal Revenue Code.1 The Proposed Regulations would treat certain debt interests in corporations as equity.

The Company supports the Treasury Department and Internal Revenue Service's policy objective to stem erosion of the U.S. tax base. We respectfully note, however, that the Proposed Regulations, if finalized in their current form, would run counter to business models such as ours that have been built on longstanding inter-affiliate funding arrangements. Those funding arrangements are essential to a global lending and payments business such as ours and differ when compared with traditional global banking organizations. We therefore request that the Treasury Department make several important changes to the Proposed Regulations to ensure that they ultimately are more narrowly and appropriately targeted. As described in greater detail in Section V of this letter, the Company proposes exceptions to the funding rule in § 1.385-3(b)(3) (the "Funding Rule") for debt used to finance ordinary course of business activities of a "banking, insurance, financing, or similar business" as defined in section 904; for loans between foreign subsidiaries; and for all dividends paid by a foreign subsidiary. We also respectfully request clarifications to the "in part indebtedness and in part stock" rule of § 1.385-1(d) of the Proposed Regulations as provided further below.

I. Background

American Express is a global financial services company. Our general-purpose card network, card issuing, and merchant acquiring and processing businesses are global in scope. These businesses exhibit both large cash outflows and large cash inflows that are driven to a very large degree by the spending and repayment patterns of our Card Members. For a sense of scale, in 2015, more than $1 trillion of spending occurred on our network. These transactions represent spending on over 100 million cards-in-force at merchant locations in more than 140 markets. To manage that volume, our business requires a financing model with high capacity, flexibility, and sustainability across a wide range of business and market environments. As described in greater detail below, American Express's global financing model relies heavily on a central source of funding, largely from the U.S. capital markets, which is then deployed through a series of intercompany financing arrangements to meet the funding needs of American Express's businesses, subsidiaries, and markets. Interest expense in our business is a routine operating expense, like the cost of goods sold for merchants.

The operation and structure of our business reflects, in part, our heritage as a 160-year old travel company. The travel company existed before we entered financial services nearly a century ago. It also predated American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. ("TRS"), becoming bank holding companies under the Bank Holding Company Act of 1956, as amended,2 and becoming subject to supervision, regulation, and examination by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). Our financing model is based on valid business reasons and must satisfy regulatory expectations for bank holding companies, including those related to safe and sound liquidity risk management.

II. Our Business Model

American Express operates our payment products business in what is commonly referred to as a "closed loop" network. This means we not only issue charge, credit, pre-paid, and gift cards to consumers, small businesses, and corporations; we also manage a global network, connecting buyers and sellers and "clearing" millions of payments every day. We also acquire merchants who agree to accept American Express cards as a form of payment. Our global network first began to develop more than 100 years ago with the invention of the Traveler's Cheque. Americans traveling abroad had a need for a payment tool that could be utilized in countries around the globe, without regard to local currency. In order to provide such a payment tool, American Express had to convince hotels, restaurants, and merchants around the globe to accept the Traveler's Cheque. The key to that acceptance was a guarantee that they would be paid in reasonable time and in their local currency. As a result, American Express established operations through local subsidiaries and branches in many countries outside the United States. Today, what was once a payments business built around the Traveler's Cheque is now a global business that issues payment products (credit, charge, pre-paid, and gift cards), manages a general-purpose card network, acquires merchants to accept the payment products, and facilitates corporate payments and foreign exchange.

Largely because we began a century ago in the Traveler's Cheque business as opposed to traditional banking, our operating subsidiaries and branches outside of North America that conduct American Express's card issuing and network services that require funding are not, for the most part, banks. Unlike a traditional global banking operation, our global funding model is not structured to accept deposits and does not rely on developing a deposit base in multiple countries to fund our business.

III. How American Express Funds Its Business

As referenced earlier, our network is managing more than $1 trillion in transactions per year. In a typical transaction, the merchant is paid by American Express within 1-3 days. The Card Member, in turn, will not pay us for 30-45 days or, with our revolving credit card products, a potentially longer period of time. It is the time lag between paying the merchants and receiving payments from our Card Members that generates the financing requirements within the Company's subsidiaries, affiliates, and branches. Our operations outside of North America generally do not have the banking licenses, management, staff or processes and capabilities that would allow them to meet their funding needs in the local markets. Instead, the financing of their assets is raised from the capital markets largely by American Express Credit Corporation ("Credco"), a domestic SEC registrant that is licensed, staffed, and managed to be a central source of funding for assets originated by certain other American Express affiliates throughout the American Express group of companies globally. Credco is wholly owned by TRS and both are members of the American Express Company and Subsidiaries U.S. tax consolidated group.

Credco has a long history and high visibility in the capital markets and maintains financial characteristics that rating agencies and fixed income investors seek in providing investment grade financing to American Express. Credco is a highly efficient and cost-effective source of debt financing. It has the issuing capacity to meet expected and unexpected funding requirements.

Funds raised at Credco are pooled and deployed through a series of intercompany financing arrangements to meet the funding needs of American Express's businesses, subsidiaries, and markets. Funds originally used for one purpose may be redeployed to meet changing needs. For example, seasonal or cyclical increases in funding needs in one market or currency can be confidently satisfied at times through seasonal or cyclical decreases in funding needs in other markets or currencies. Examples of seasonal or cyclical events include the annual U.S. Holiday Season and the 2016 Olympics in Brazil. The American Express Treasury group devotes the greater proportion of its resources to ensuring that daily intercompany funding needs can be, and are, satisfied in full -- and with the highest confidence -- at each subsidiary and branch.

The card-issuing affiliates of American Express often finance their operations through internal sources by selling or factoring their charge and credit card receivables. Typically, one affiliate, such as Credco, will borrow the funds needed to purchase the factored receivables. Sales of receivables increase liquidity for the seller. Another common financing arrangement involves transferring receivables to allow them to be pledged to secure borrowings. All this is done in the ordinary course of business to provide financing when and where it is needed.

As foreign American Express affiliates generate profits, they may ultimately distribute those profits to the United States. Depending on, among other things, the current and anticipated needs of the businesses, the distributions may not be on an annual basis and, therefore, may be out of accumulated as well as current earnings and profits. In some cases, distributions may also be made from capital (as measured for U.S. tax purposes). Profits distributed from foreign affiliates to the United States can be used to meet ordinary course business needs.3

IV. Impact of the Proposed Regulations

American Express believes that the most practical, cost-effective, and financially prudent way to fund its global businesses is through centralized third-party funding and intercompany financing. The Funding Rule as applied to our current businesses would convert intercompany loans to stock where the borrower makes a distribution exceeding current year earnings or acquires stock of an American Express affiliate within the six year period beginning three years before the distribution or purchase.

One significant consequence of this proposal would be to deny a deduction in the borrowing subsidiary for interest expense. Interest for a financial company like American Express is comparable to the cost of goods sold for a merchant or manufacturer and should be deductible. There would be other adverse tax consequences of stock treatment. For instance, the repayment of principal on intercompany loans would be taxed as dividends to the extent of the issuer's earnings and profits resulting in taxation of funds that are not economic income. In addition, the Proposed Regulations would result in the permanent loss of indirect credits for foreign taxes under section 902 where the holder of a loan treated as stock owns less than 10% of the voting power of the issuer. The Proposed Regulations would also raise issues under rules governing hybrid instruments and foreign tax credit splitter arrangements.

These consequences could lead American Express to consider modifying or replacing its centralized financing structure with a more decentralized, local market, third-party financing structure. A decentralized structure would inevitably be less cost-effective and flexible. Our branches and subsidiaries outside the United States are not licensed, operated, or managed as third-party financing entities, and raising financing in all the markets in which we operate would simply not be feasible or advisable. As described earlier, our subsidiaries are typically not banks and, therefore, are not able to rely on deposits as a source of funding. In the absence of viable intercompany sources of funding, our subsidiaries would need to consider local credit markets. These potential local credit markets would generally lack the depth and liquidity of the U.S. credit markets accessed by Credco which would likely lead to increased cost and/or reduced funding capacity. The added cost would reduce our competitiveness. The reduced flexibility would make it more difficult for us to respond to changing business needs and different macroeconomic and market environments.

V. American Express's Suggested Modifications to the Proposed Regulations

 

A. Expansion of the Ordinary Course Exception

 

Section 1.385-3(b)(3)(iv)(B)(2) of the Proposed Regulations provides an exception for debt issued in the "ordinary course" of the issuer's trade or business in connection with the purchase of property or the receipt of services. For American Express and other financial services companies, borrowing money to fund charge card, credit card, and other customer receivables is an ordinary course business activity analogous to the sale of goods or provision of services.

We respectfully request that this exception be extended to apply to debt issued to finance assets that are acquired or created by a member of the expanded group that is a financial services entity in the ordinary course of a banking, insurance, financing, or similar business. A financial services entity could be defined by reference to section 904(d)(2)(C). That definition generally requires that an entity or group be predominantly engaged in the active conduct of a banking, insurance, financing, or similar business. We believe it is appropriate to treat each member of a group as a financial services entity if the group as a whole qualifies as a financial services group under section 904(d)(2)(C)(ii) and Treas. Reg. § 1.904-4(e)(3)(ii).

The current ordinary course exception is an exception only to the per se rule of § 1.385-3(b)(3)(iv)(B)(1), and not to the Funding Rule of § 1.385-3(b)(3) generally. We respectfully request that the exception apply to the Funding Rule of § 1.385-3(b)(3) generally.

The revised ordinary course exception should apply not just to trade receivables but to loans used to finance credit and charge card receivables and other assets acquired or created in the course of a financial business. This is captured by referring to debt issued "to finance" such assets.

In such an instance, the ordinary course exception should apply to a loan used to finance purchases of customer receivables from another expanded group member, provided the receivables were acquired or created in the ordinary course of business by a member of the expanded group that is a financial services entity. This clarification would be needed by American Express to cover internal factoring arrangements.

The ordinary course exception should also apply to series of loans that are ultimately used within a group to finance activities of a financial business, even if one or more of the borrowers in the chain is not itself an operating entity. This could be accomplished by treating a debt instrument that qualifies for the ordinary course exception as property arising in the ordinary course of a banking, insurance, financing, or similar business of the holder of the debt instrument for purposes of applying the exception to debt which is in turn issued by that holder.

The proposed financial services entity definition is a tax law definition that looks to the nature of the business being conducted and not to whether or how an entity is regulated. Although the American Express group of companies includes domestic banks and a limited number of foreign banks, most of our operating subsidiaries outside of North America are not banks or otherwise regulated as financial institutions, yet are routinely funded with intercompany debt. Thus, an exception limited only to debt issued by regulated entities is too narrow to accommodate the legitimate financial services functions that we fund through related party debt. However, if the proposed financial services entity exception were determined to be too broad, the exception could be limited to financial services entities and financial services groups that, for instance, were part of a group that included a bank holding company under the Bank Holding Company Act of 1956, as amended.4

In addition, American Express does on occasion acquire businesses from unrelated parties. Debt used to fund such an acquisition would not easily fit within an ordinary course of business exception. Consideration also should be given to having an exception for debt used for transactions that are not distributions or internal stock acquisitions.

 

B. Exception for Foreign to Foreign Loans Not Connected with a U.S. Trade or Business

 

We respectfully request that the final regulations include an exception from the Funding Rule of § 1.385-3(b)(3) for debt issued by a foreign corporation to another foreign corporation where the debt is not considered a U.S. liability (a liability of a U.S. trade or business) under section 884. Such an exception is appropriate and consistent with the underlying policy objectives of the Proposed Regulations because these types of loans would not generate interest deductions in the United States and should not raise concerns about earnings stripping.

 

C. Expanded Exception for Certain Dividends

 

Section 1.385-3(c)(1) of the Proposed Regulations includes an exception from the general rule of § 1.385-3(b)(2) and the Funding Rule for distributions during a year that do not exceed current year earnings and profits. We respectfully request that the rule be changed to allow some time after the end of a year to determine earnings and profits for the prior year as it is very difficult to determine the current year's earnings and profits during that year.

In addition, we recommend that the exception be expanded to include any distribution from a foreign corporation that is treated as a dividend under sections 301 and 316 (including a distribution of previously taxed income under section 959). Debt-funded distributions from a foreign corporation should not raise earnings stripping concerns (assuming the foreign corporation does not derive a significant portion of its income from a U.S. trade or business), and a distribution from a foreign corporation that is a dividend (or that has already been taxed in the case of a distribution of previously taxed income) should not raise concerns about taxpayers engaging in repatriation planning strategies that are inconsistent with U.S. tax policy.

 

D. Clarification of § 1.385-1(d) of the Proposed Regulations

 

Section 1.385-1(d) of the Proposed Regulations permits the Commissioner to treat an expanded group instrument ("EGI"):

 

as in part indebtedness and in part stock to the extent that an analysis, as of the issuance of the EGI, of the relevant facts and circumstances concerning the EGI (taking into account any application of § 1.385-2) under general federal tax principles results in a determination that the EGI is properly treated for federal tax purposes as indebtedness in part and stock in part. For example, if the Commissioner's analysis supports a reasonable expectation that, as of the issuance of the EGI, only a portion of the principal amount of an EGI will be repaid and the Commissioner determines that the EGI should be treated as indebtedness in part and stock in part, the EGI may be treated as indebtedness in part and stock in part in accordance with such determination, provided the requirements of § 1.385-2, if applicable, are otherwise satisfied and the application of federal tax principles supports this treatment. (Emphasis added)

 

Although not entirely clear, § 1.385-1(d) suggests that the Commissioner will be permitted to recharacterize an EGI as in part indebtedness and in part stock if the Commissioner has a "reasonable expectation" that only a portion of the principal amount of an EGI will be repaid and the application of federal tax principles supports this treatment, provided the requirements of § 1.385-2 are otherwise satisfied. This "reasonable expectation" standard may be interpreted as a relatively low standard (e.g., akin to a reasonable basis standard) for allowing the Commissioner to recharacterize a portion of indebtedness as stock. In addition, as the preamble to the Proposed Regulations recognizes '"there has been a tendency by the courts to characterize an instrument entirely as debt or entirely as equity.' H.R. Rep. No. 101-386, at 562 (1989) (Conf. Rep.)."5 Consequently, it is difficult to see how the application of federal tax principles would support the treatment of an instrument as in part indebtedness and in part stock.

In light of (1) the adverse consequences of recharacterizing an instrument as stock (even in part); (2) the apparently low bar set by the § 1.385-1(d) rule; and (3) the vagueness of the standards it uses to recharacterize debt, if § 1.385-1(d) is not withdrawn, we request that the rule be changed so that the Commissioner's exercise of its authority to recharacterize debt as in part stock be subject, at a minimum, to a more stringent standard that is explained in detailed guidance.

VI. Conclusion

For the reasons discussed above, we respectfully request that the final regulations include the exceptions and clarifications discussed in this letter.

We look forward to continuing to work with the Internal Revenue Service and the Treasury Department on these important issues. If you have any questions or comments regarding the content of this letter, please contact me directly.

Respectfully,

 

 

Joe Gagliano

 

Senior Vice President -- Global Tax

 

(212) 640-2740

 

Joe.Gagliano@aexp.com

 

American Express Company

 

New York, NY

 

FOOTNOTES

 

 

1 Unless otherwise noted, all "section" references are to the Internal Revenue Code of 1986, as amended, and all references to "§ 1.385-" are to the Proposed Regulations in their current form.

2 12 U.S.C. § 1841 et seq.

3 As a simplified example, Credco may provide financing indirectly through one or more foreign subsidiaries to a foreign affiliate ("FA") that issues charge cards. The financing received by FA may be secured by the charge card receivables generated by FA's ongoing business activities. FA will use the proceeds from the financing in the course of its business to provide credit (i.e., financing) to its Card Members as they use their charge cards. FA will have continual, fluctuating financing needs which will depend upon the use of its charge cards by its Card Members. In this simplified example, the spread between the amount FA makes from providing financing to its Card Members and the amount FA pays for its funding is generally its profit for a particular year. If, in the subsequent tax year, FA makes a distribution of the profits which is in excess of its then current earnings and profits during that subsequent tax year, the ongoing funding of FA's charge card business during the prior or following 36 months could result in all or a portion of that funding being recharacterized as equity for tax purposes under the Funding Rule. As a result, FA may choose to not make a distribution of its profits or to make a smaller distribution, thus potentially denying FA's ultimate domestic parent, a bank holding company, access to that liquidity.

4 12 U.S.C. § 1841 et seq.

5 Preamble to proposed regulations (REG-108060-15), Fed. Reg. Vol. 81, No. 68 (April 8, 2016).

 

END OF FOOTNOTES
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