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Verizon Opposes Debt-Equity Regs as Unfair, Costly, and Burdensome

JUL. 5, 2016

Verizon Opposes Debt-Equity Regs as Unfair, Costly, and Burdensome

DATED JUL. 5, 2016
DOCUMENT ATTRIBUTES

 

July 5, 2016

 

 

Internal Revenue Service

 

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

 

Room 5203

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

 

Internal Revenue Service

 

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

 

Courier's Desk

 

1111 Constitution Avenue NW

 

Washington, DC 20224

 

Re: Verizon Comments to Proposed Regulations under Section 385

 

Dear Sir or Madam:

Verizon Communications Inc. ("Verizon") appreciates the opportunity to offer its comments on the Internal Revenue Code Section 3851 regulations proposed by the Department of Treasury and the Internal Revenue Service on April 4, 2016 (the "Proposed Regulations"). We refer below to final regulations implementing the Proposed Regulations as the "Final Regulations."

Verizon is a holding company that, through its subsidiaries, is one of the world's leading providers of wireline and wireless communications services. Through various corporate subsidiaries, Verizon operates a wireline business in the Northeastern United States that provides broadband data and video services, data center and cloud services, security and managed network services, and local and long distance voice services. Through its wholly-owned Cellco partnership, and hundreds of subsidiary partnerships and corporations owned by Cellco, Verizon provides wireless voice and data services throughout the entire United States. Through various foreign subsidiaries, Verizon provides telecommunications, data center, cloud, security and managed network services to multinational enterprise and government customers in more than 80 countries worldwide. Finally, Verizon's most recent acquisition, AOL, operates a global media technology business that provides a suite of digital brands, products and services to advertisers, publishers and subscribers both inside and outside the United States.

During 2015, Verizon and its subsidiaries generated $131.6 billion of operating revenues, and incurred $17.8 billion of capital expenditures, primarily to expand and upgrade our broadband wireline and wireless networks in the United States. Verizon has been making a similar annual investment in America's communications infrastructure for the past decade. As of December 31, 2015, Verizon and its subsidiaries had a workforce of approximately 177,000 employees, with the vast majority of such workforce based in the United States.

Concerns over Proposed Regulations

Verizon is extremely concerned about the potential adverse impacts of the Proposed Regulations. This is not because Verizon engages in base erosion or distortive repatriation transactions, which it does not, nor because Verizon has inverted, which it has not. Rather, Verizon is concerned because, in the ordinary course of its business, Verizon and its subsidiaries engage each day in a significant number of routine intercompany borrowing, lending and services transactions that result in the creation of related party debt.

Because of the consolidated group exception of Prop. Reg. Section 1.385-1(e), one might expect the Proposed Regulations to have a minimal impact on Verizon and other companies that are based primarily or entirely in the United States and file a U.S. consolidated federal income tax return. This is not the case, however, for two reasons. First, as explained above, Verizon's wireless business is operated by Cellco, a wholly-owned partnership, and hundreds of subsidiary partnerships and corporations owned by Cellco. Neither Cellco nor any of its subsidiaries is a member of Verizon's U.S. consolidated group. Second, as discussed later in these comments under State Tax Impacts and Policy Considerations, states that otherwise adopt the Final Regulations may choose not to apply the consolidated return exception. Thus, in order to comply with state law requirements, Verizon and other U.S.-based companies may be forced to adhere to the Final Regulations even within a U.S. consolidated group.

Accordingly, as discussed more fully below, the Proposed Regulations in their current form would impose a substantial administrative burden and would, in certain circumstances, unfairly penalize Verizon for engaging in routine transactions necessary for the operation of its business. If the Proposed Regulations are finalized in their current form, Verizon, like many similarly situated U.S.-based companies, will face substantial increased costs and burdens (and potentially additional taxes) without having undertaken any of the misdeeds at which the Proposed Regulations are aimed. This is in part because while the Proposed Regulations are intended to address certain specific abuses, they are not appropriately targeted at abusive transactions and, as drafted, unnecessarily implicate highly routine and vitally necessary cash "pooling" and intercompany services arrangements.

For a business the size of Verizon's, it is not feasible to maintain an external bank account for each subsidiary. Instead, to facilitate efficient cash management and reduce borrowing costs, Verizon has three separate cash pooling arrangements; one that applies to its domestic wireline businesses, one that applies to its domestic wireless businesses, and one that applies to its foreign businesses. Each cash pooling arrangement functions in essentially the same way, allowing participating companies with excess cash to make that cash available to other participating companies with cash needs (such as for wage payments, payments to third parties for goods and services, and capital expenditures to repair, expand or upgrade our premier wireline, wireless and broadband networks). On a daily basis, certain companies generate excess cash from customer receipts; while other companies may have cash needs to fund their operations. Companies with excess cash deposit that cash with an internal finance company, and other companies with cash shortfalls withdraw or borrow cash from the finance company to meet their operating needs. A deposit of cash results in the creation of an intercompany debt obligation owed by the finance company to the company making the deposit (or a reduction in an obligation owed to the finance company), and a withdrawal of cash results in the creation of an intercompany debt obligation owed by the withdrawing company to the finance company (or a reduction in a deposit with the finance company). These transactions occur daily and involve dozens of participating companies. Each finance company therefore enters into dozens of related party funding transactions daily and thousands of such transactions per year.

In addition, Verizon subsidiaries regularly provide numerous services to each other, including telecommunications transport services provided by wireline companies to wireless companies, accounting, legal, human resources, marketing, procurement, and strategic planning services provided by service companies to operating companies, and telecommunications services provided by an operating company licensed in one jurisdiction to an operating company licensed in another jurisdiction. The recipient of such services is initially charged through an accounting journal entry, resulting in an intercompany debt obligation owed by the recipient of the service to the service provider. These debt obligations are periodically settled either through (i) offset against a debt obligation owed from the service provider to the service recipient (if such an obligation exists), or (ii) the borrowing by the service recipient from an internal finance company to satisfy the debt owed to the service provider (typically followed by the service provider depositing the debt proceeds with the internal finance company). Again, because numerous Verizon subsidiaries provide services to each other on a daily basis, these transactions result in the creation of hundreds of related party debt obligations each day and tens of thousands of such obligations each year.

Given the number of debt obligations between Verizon controlled entities that arise from the ordinary course transactions described above, the Proposed Regulations, in their current form, would impose an onerous and costly compliance burden on Verizon, with no corresponding benefit to the federal fisc. Our comments urge the Internal Revenue Service to reduce both that compliance burden and the complexity of the Proposed Regulations. To summarize our detailed comments below, we propose clarifications and modifications that would:

  • Establish an exception from the documentation requirements for debt arising from ordinary course transactions or, at a minimum, simplify the documentation requirements for such debt;

  • Expand the ordinary course exception to the per se re-characterization rule;

  • Clarify the application of the consolidated group exception to certain controlled partnerships;

  • Establish exceptions from both the documentation and re-characterization rules for certain debt owed by controlled foreign corporations ("CFCs") and certain debt owed to CFCs;

  • Clarify the definition of an "applicable instrument," the interest/principal payment rules, and the grandfather rule; and

  • Simplify the effects of debt being re-characterized as equity.

 

We also comment briefly on the potential state tax impacts of the Proposed Regulations and on certain other policy considerations.

Specific Comments

 

1. Establish an Exception from the Documentation Requirements for Debt Arising from Ordinary Course Transactions or, at a Minimum. Simplify the Documentation Requirements for Such Debt

 

Prop. Reg. Section 1.385-2(b)(2) establishes four threshold requirements that must be satisfied for an expanded group instrument ("EGI") to be treated as indebtedness for Federal tax purposes:

 

(1) Documentation that the issuer of the EGI has an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates;

(2) Documentation that the holder of the EGI has typical creditor's rights;

(3) Documentation supporting a reasonable expectation that the issuer of the EGI intends to and will be able to meet its payment obligations; and

(4) Documentation of subsequent actions evidencing a debtor-creditor relationship.

 

Complying with these requirements would be extremely burdensome for Verizon and other taxpayers with multiple subsidiaries that generate hundreds of related party debt obligations each day through ordinary course of business transactions. Verizon and its subsidiaries, many of which are not members of the same consolidated group, have three cash pooling arrangements that enable participating subsidiaries with excess cash to make that cash available to other participating subsidiaries with cash needs. In addition, Verizon subsidiaries provide numerous services to each other on a daily basis in order to facilitate Verizon's provision of communications services to its customers.

Cash pooling arrangements are a routine and efficient way for affiliated companies to finance their operations, and intercompany services arrangements are equally routine for large taxpayers with multiple subsidiaries (especially a taxpayer such as Verizon that needs to maintain a global network in order to provide seamless services to its multinational customers around the world).

Such arrangements are not tax-motivated, but rather are ordinary and necessary business transactions. We recommend that, to reduce the administrative burden and cost of complying with the Proposed Regulations, debt arising from ordinary course transactions (hereafter, "ordinary course debt obligations") should be excepted from the documentation requirements of Prop. Reg. Section 1.385-2(b)(2). For purposes of this exception, an ordinary course debt obligation should be defined as debt that either (i) is issued by an internal finance company to companies that make cash deposits to it pursuant to a cash pooling arrangement, or (ii) arises in the ordinary course of the issuer's trade or business in connection with the purchase, rental, license or use of property or the receipt of services, and reflects an obligation to pay or finance the payment of an amount that is (A) currently deductible by the issuer under Code Section 162, (B) currently included in the issuer's cost of goods sold or inventory, or (C) depreciable by the issuer under Code Section 167 with a class life under Code Section 168 of no more than 7 years. We are suggesting a class life of no more than 7 years because longer lived property, such as buildings, wireless spectrum and other intangible assets, is likely to be more expensive and the purchase of such property is likely to be an extraordinary transaction as opposed to a routine transaction. Also, if the issuer is a holding company, it should be treated as being in the same trades or businesses as its controlled subsidiaries. Further, if the issuer is a foreign company, the above definition should be satisfied with respect to a debt obligation incurred in connection with an amount that would be either currently deductible, currently included in cost of goods sold or inventory, or depreciable with a class life of no more than 7 years if the issuer were a U.S. issuer.

Alternatively, if a complete exception for ordinary course debt obligations is not implemented, then, at a minimum, the Final Regulations should expressly establish simplified documentation requirements for such ordinary course debt obligations. More specifically, under this alternative approach for ordinary course debt obligations, the documentation requirements of Prop. Reg. Section 1.385-2(b)(2) should, at a minimum, be clarified to specifically provide as follows:

  • The first two requirements (documentation of the issuer's payment obligations and the holder's rights as creditor) can be satisfied by a written master or "umbrella" agreement among the members of the expanded group setting forth the unconditional obligation to pay a sum certain and granting creditor's rights. In the case of cash pooling arrangements, the agreement would be among the internal finance company and the affiliated companies that enter into lending or borrowing transactions with the finance company. In the case of services or other arrangements pursuant to which ordinary course intercompany transactions are undertaken, the agreement would be among the affiliated companies participating in those arrangements.

  • The third documentation requirement (establishing the creditworthiness of the issuer) should be satisfied if the issuer has a balance sheet, prepared in accordance with GAAP or IFRS, which shows that the issuer is solvent. Alternatively, if the issuer's balance sheet does not show solvency but the issuer is, in fact, solvent because its assets have a fair market value in excess of its liabilities, the issuer could then use cash flow projections, asset appraisals, or other reasonable methods to demonstrate that it has adequate financial resources to pay its debt.

  • Prop. Reg. Section 1.385-2(b)(3)(i) generally provides that documentation must be prepared no later than 30 days after a debt issuance, but it is not clear how far in advance of a debt issuance such documentation can be prepared. We recommend, with respect to ordinary course debt obligations, that documentation supporting the issuer's creditworthiness (i.e., the balance sheet or alternative documentation referred to above) be acceptable if such documentation is prepared and in existence within three years prior to the date on which the obligation is incurred.

  • 2. Expand Ordinary Course Exception to the Per Se Rule of Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(1)

 

Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(2) provides that the "per se rule" of Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(1) "does not apply to a debt instrument that arises in the ordinary course of the issuer's trade or business in connection with the purchase of property or the receipt of services to the extent that it reflects an obligation to pay an amount that is currently deductible by the issuer under Section 162 or currently included in the issuer's costs of goods sold or inventory. . . ." For the reasons explained below, this exception should also apply to debt instruments that arise in connection with either (i) the license, rental or use of property in the ordinary course of the issuer's trade or business, (ii) the purchase of depreciable property that has a class life of no more than 7 years, or (iii) cash deposits pursuant to cash pooling arrangements.

As explained in Part VI of the Background section of the preamble to the Proposed Regulations (the "Preamble"), the re-characterization rules of Prop. Reg. Section 1.385-3(b)(2) are designed to prevent taxpayers from engaging in transactions that artificially create related party debt. According to the Preamble, these transactions -- the distribution of a debt instrument, the issuance of a debt instrument in exchange for stock of an affiliate, and certain issuances of debt instruments in connection with internal asset reorganizations -- typically lack "meaningful nontax significance, such that respecting the . . . debt instrument for federal tax purposes produces inappropriate results."

Similarly, to prevent taxpayers from achieving, through a multi-step transaction, results that could not be achieved in a one-step transaction, Prop. Reg. Section 1.385-3(b)(3) establishes a "funding rule," which treats a debt instrument as stock if it is issued with a principal purpose of funding certain distributions or acquisitions. Further, to enforce the funding rule, Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(1) establishes a non-rebuttable presumption (the "per se rule") that a debt instrument is issued with a principal purpose of funding any distribution or acquisition that occurs within 36 months before or after the date the debt instrument is issued.

As noted at the outset of this discussion, Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(2) provides an exception to the per se rule for certain debt instruments that arise in the ordinary course of the issuer's trade or business. This exception appears to be based on the recognition that, unlike debt instruments that arise in connection with the transactions described in Prop Reg. Section 1.385-3(b)(2), ordinary course debt instruments have meaningful non-tax significance and respecting such instruments does not produce inappropriate tax results. Upon issuance, ordinary course debt instruments are clearly not subject to re-characterization under Prop. Reg. Section 1.385-3(b)(2), nor should they be subject to re-characterization under the per se rule of Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(1).

As currently proposed, however, the ordinary course exception is unduly narrow in the following respects: it does not apply to debt incurred to fund the rental, license or use of property, nor does it apply to debt incurred to fund the purchase of depreciable assets used in the day-to-day conduct of the taxpayer's business (i.e., normal capital expenditures). Taxpayers commonly borrow for those purposes in the ordinary course of business, and debt incurred for such legitimate business purposes -- as opposed to debt that is artificially created through distribution of a note, a sale of related party stock, or an internal reorganization -- should not be subject to re-characterization under the per se rule. For example, Verizon regularly purchases transmission equipment, routers, fiber optic cable, and other capital assets to upgrade and maintain its wireless and wireline networks, and these purchases are commonly funded by intercompany borrowing by the purchasing company from an internal finance company. Such purchases are ordinary course transactions, notwithstanding that the purchased items must be capitalized and depreciated. Further, as currently proposed, the ordinary course exception does not cover all aspects of a cash pooling arrangement because it does not apply to debt issued by an internal finance company to companies that make cash deposits to it.

We therefore recommend that the ordinary course exception of Prop. Reg. Section 1.385-3(b)(3)(iv)(B)(2) be expanded to apply to (i) the license, rental or use of property in the ordinary course of the issuer's trade or business, (ii) the purchase of depreciable property that has a class life of no more than 7 years, and (iii) debt issued by an internal finance company to companies that make cash deposits pursuant to a cash pooling arrangement. We further recommend that holding companies be treated as being in the same trades or businesses as their subsidiaries for purposes of the ordinary course exception, and that the exception be clarified to expressly provide that debt of a foreign issuer will qualify if incurred to fund an amount that would qualify in the case of a U.S. issuer.

The failure to adopt these suggested changes would impose an extraordinary and continuous burden on the tax departments of U.S. multinationals. To cite a routine example, suppose a CFC wishes to distribute earnings to its shareholders, or a CFC wishes to purchase the stock or assets of a newly acquired affiliate in the same jurisdiction for the purpose of integrating their separate operations or obtaining foreign tax synergies (e.g., forming a fiscal unity). Under the Proposed Regulations, any intragroup transaction entered into by the CFC within three years after such distribution or purchase would have to be submitted for approval by the group's U.S. tax department before it can be implemented in order to determine whether the debt resulting from the transaction satisfies one of the existing narrow exceptions to the per se rule (and, if it does not, the transaction would be rejected). In Verizon's case, routine intragroup transactions necessary for the operation of the business occur every day, and without the visibility of (let alone the pre-approval of) the Verizon tax department. An expanded ordinary course exception, as we have suggested, would substantially reduce this burden and significantly lessen the likelihood that taxes dictate how the business operates.

 

3. Consolidated Group Exception.

 

Prop. Reg. Section 1.385-1(e) provides that all members of a consolidated group are treated as one corporation for purposes of the Proposed Regulations. As a result, indebtedness between members of a consolidated group is not subject to the bifurcation rules of Prop. Reg. Section 1.385-1, the documentation requirements of Prop. Reg. Section 1.385-2 or the re-characterization rules of Prop. Reg. Section 1.385-3. The reason for this exception, as explained in Part VI of the Background section of the Preamble, is that "the concerns addressed in the proposed regulations generally are not present when the issuer's deduction for interest expense and the holder's corresponding interest income offset on the group's consolidated federal income tax return." The same reasoning applies to indebtedness between consolidated group members and controlled partnerships in which the expanded group partners are members of the consolidated group, as well as indebtedness between such controlled partnerships. Taxpayers that have such controlled operating partnerships or whose industries require them to operate a portion of their business in partnership form should not end up with an anomalous result. The Final Regulations should clarify that the consolidated group exception applies to such partnerships by treating them as members of the consolidated group for purposes of Prop. Reg. Sections 1.385-1 and 2.

 

4. Exception for Debt between Related CFCs.

 

Part VI of the Background section of the Preamble also makes clear that the principal purpose of these regulations is to prevent the reduction or elimination of federal income tax liability through excessive related party indebtedness in both the cross border and domestic contexts. Given that purpose, there is no reason that debt between CFCs that are members of an expanded group should be subject to the Proposed Regulations as long as the debt does not provide a U.S. tax benefit to the expanded group by reducing subpart F income. For example, if interest on the debt qualifies for the look-through rule of Code Section 954(c)(6), the interest income of the payee is not treated as foreign personal holding company income under Code Section 954(c), and the interest expense of the payor does not reduce the subpart F income of either the payor or another CFC in the expanded group. Thus, there is no impact on the taxable income of the 10% U.S. Shareholders of the CFC and no potential to eliminate or reduce the federal income tax liability of such shareholders. Accordingly, debt between CFC members of an expanded group should be excepted from the documentation and re-characterization rules of the Proposed Regulations as long as (i) interest on that debt qualifies under the look-through rule of Code Section 954(c)(6), or (ii) interest on the debt results in subpart F income for the payee and a reduction in subpart F income or E&P for the payor.

 

5. Exception for Debt Owed by U.S. Shareholders to CFCs.

 

The interest income of a CFC that is subpart F income, subject to certain exemptions and limitations, is includible in the gross income of 10% U.S. Shareholders in the same manner as a deemed dividend. Accordingly, if a U.S. member of an expanded group has indebtedness to a CFC, the U.S. member's interest deduction on its U.S. tax return may be fully offset by a subpart F inclusion of the CFC's interest income. To the extent the interest deductions of a U.S. issuer are proportionally offset by subpart F inclusions or such interest deduction is disallowed under another applicable section of the Code (e.g., Code Section 267), the indebtedness does not provide a tax benefit to the U.S. issuer and should be, on a proportionate basis, excepted from the documentation and re-characterization rules of the Proposed Regulations.

 

6. Exception for Previously Taxed Earnings and Profits.

 

Prop Reg. Section 1.385-3(c)(1) provides an exception to the re-characterization rules for distributions of an amount equal to the expanded group member's current year earnings and profits ("E&P"). For group members that are CFCs, this exception should be expanded to include previously taxed E&P within the meaning of Code Section 959. Accordingly, in the case of a CFC, the exception for distributions should include both previously taxed E&P and current year E&P.

 

7. Definition of Applicable Instrument.

 

The types of obligations that are subject to Prop. Reg. Section 1.385-2 should be clarified. Prop. Reg. Section 1.385-2 applies to "applicable instruments" between expanded group members, and Prop. Reg. Section 1.385-2(a)(4)(i)(A) defines an applicable instrument as "any interest issued or deemed issued that is in form a debt instrument." Given this definition, it is not clear at what point (if any) an ordinary course debt obligation, such as a payment due for goods or services provided, would become an applicable instrument if the only documentation of the obligation is through accounting entries or an intercompany services agreement. Presumably, such obligations are intended to be considered applicable instruments even if no debt instrument is issued or deemed issued. The definition of applicable instrument should be clarified to capture such debt obligations.

 

8. Payments of Principal and Interest.

 

Prop. Reg. Section 1.385-2(b)(2)(iv)(A) arguably implies that in order for the documentation rules to be satisfied, it may be necessary for principal and interest payments to be made in cash (i.e., the rule provides that bank statements and wire transfer records are evidence of payment). Requiring the use of cash to effect such payments would be costly and inefficient for taxpayers, requiring them to maintain multiple bank accounts and incur additional transaction fees. In some instances, it might also result in cash being trapped offshore (which seems contrary to the government's desire for more cash to be brought to and reinvested in the United States). Requiring cash payments would also be contrary to the common practice of settling internal debt by offsetting payables and receivables, or through internal financing without the actual movement of cash. Assume, for example, that Company A owes Company B $100 for services provided by Company B. Company A then borrows $100 from an internal finance company ("FinCo"), uses the $100 to pay Company B, and Company B deposits the $100 with FinCo. This is all done without the actual movement of cash. At the end of these steps, Company A has paid its debt to Company B, Company A owes $100 to FinCo, and FinCo owes $100 to Company B. Settling internal debt in this manner is an expedient and common practice of corporate taxpayers, and the Proposed Regulations should not interfere with this practice.

 

9. Grandfathered Indebtedness.

 

Prop. Reg. Section 1.385-2 applies to debt instruments issued after the Final Regulations are issued, and Prop. Reg. Section 1.385-3 applies to debt instruments issued on or after April 4, 2016. It is not clear from the Proposed Regulations, but presumably interest on a grandfathered debt instrument that accrues after the grandfather date would be considered newly issued indebtedness and would therefore be subject to the documentation and re-characterization rules of the Proposed Regulations. For the sake of administrative convenience, the grandfather rule should also apply to any interest accrued on a grandfathered debt instrument. The Proposed Regulations would then become applicable to existing debt only if there is a significant modification to such debt under Code Section 1001 and the Treasury regulations thereunder.

In addition, certain debt that qualifies for the grandfather rule could be demand debt, which could be viewed as reissued each day it is outstanding and therefore lose its grandfathered status immediately after the applicable grandfather date. To make clear that demand debt qualifies for the grandfather rules for a reasonable period of time, the grandfather rules should expressly apply to demand debt for a period of up to five years after April 4, 2016, with respect to Prop. Reg. Section 1.385-3, and the date the Final Regulations are issued with respect to Prop. Reg. Section 1.385-2.

 

10. Inadvertent Deconsolidation.

 

The Proposed Regulations generally provide that any debt instrument that is recharacterized as equity will be treated as stock of the issuer of the debt instrument. Accordingly, the holder of the instrument will become a stockholder of the issuer, which could result in an inadvertent deconsolidation of a U.S. issuer if the new stockholder is a foreign member of the expanded group. Under Code Section 1504(a)(2), a U.S. corporation can be included in a consolidated group only if 80% of its stock (in terms of both vote and value) is owned by members of the consolidated group. If a U.S. corporation in a consolidated group owed a significant amount of debt to a foreign affiliate that was part of its expanded group, and such debt was recharacterized as equity pursuant to the Final Regulations, the foreign affiliate could become the owner of more than 20% of the stock of the U.S. corporation, causing inadvertent deconsolidation of such corporation (plus any consolidated group member owned by that corporation). The Final Regulations should provide that if any debt of a consolidated group member is converted to equity, such equity will be treated as Code Section 1504(a)(4) stock to avoid deconsolidation.

 

11. Partnership Impacts.

 

As described in the introduction to this letter, Verizon's Cellco partnership operates its wireless business and owns hundreds of subsidiary partnerships and corporations. The corporations owned by Cellco are not part of Verizon's consolidated tax group, so even if the consolidated group exception is clarified as we have requested in our third specific comment above, there will still be borrowing and services transactions between Cellco and its subsidiary corporations resulting in related party debt that does not qualify for the consolidated group exception. We therefore believe that certain partnership impacts of the Proposed Regulations need to be amended in order to prevent inadvertent tax consequences not just to Verizon, but to similarly situated taxpayers operating in partnership form.

More specifically, under Prop. Reg. Section 1.385-3, if debt of a partnership is re-characterized as stock of a partner, "appropriate conforming adjustments" are to be made to reflect that treatment. In Example 14, the appropriate conforming adjustments are to treat the partner as issuing stock to the lender and then acquiring equity in the partnership. Similarly, in Example 15, the appropriate conforming adjustment is to treat the partner as assuming debt from the partnership, thereby increasing the partner's equity in the partnership. When a partnership is treated as issuing equity instead of debt as a conforming adjustment, it can wreak havoc with the tax reporting for the partnership. The Proposed Regulations should permit conforming adjustments that limit the collateral consequences of debt re-characterization (e.g., rather than being treated as making an equity contribution to the partnership, the funded partner could be treated as making a back-to-back loan; however, the loan could continue to be treated as owed to the actual lender in determining the allocation of the loan for purposes of allocating partnership debt under Code Section 752 and applying the disguised sale rules of Code Section 707).

 

12. Election to Forgo Interest Deduction.

 

As described in detail above, Verizon utilizes cash pooling to facilitate routine intercompany cash management that creates hundreds of loans among affiliates. Also as described above, numerous Verizon subsidiaries provide services to each other on a daily basis, resulting in the creation of hundreds of related party debt obligations each day and tens of thousands of such obligations each year. If any of these debt obligations fail to satisfy the requirements of the Proposed Regulations, the impact of re-characterization as equity for all purposes could result in exceedingly complicated and cumbersome cross-ownership. In addition, the volume of the transactions combined with the re-testing provisions could cause that cross-ownership to be highly volatile.

To limit the collateral consequences of debt re-characterization, the government should consider permitting taxpayers to make an election to simply forgo the interest deduction under Code Section 163 with respect to a re-characterized debt instrument, but otherwise continue to treat such an instrument as debt for tax purposes. While this might not address some of the repatriation concerns identified in the Preamble to the Proposed Regulations, it would certainly address the earnings stripping concerns, which appear to be the catalyst for the Proposed Regulations.

State Tax Impacts and Policy Considerations

 

1. State Tax Impacts.

 

The consolidated group exception in Prop. Reg. Section 1.385-1(e) provides an important carve-out from the Proposed Regulations that, on the surface, appears to significantly reduce the administrative burden of these regulations. As a practical matter, however, debt between members of a federal consolidated group may still be subject to the Final Regulations depending on how the regulations are applied for state income tax purposes. More specifically, if states were to adopt the documentation and re-characterization rules as set forth in the Proposed Regulations, but not strictly apply the consolidated group exception, the resulting administrative burden on taxpayers operating in such states would be horrendous, particularly if the Proposed Regulations are not modified to except ordinary course debt obligations from the documentation requirements or at least simplify the documentation requirements for such debt. While we recognize that the Internal Revenue Service cannot dictate the states' application of the Final Regulations, we think it is appropriate for the federal government to recognize that the purported relief from administrative burden afforded by the consolidated group exception could be largely illusory from a state and local tax perspective.

 

2. Policy Considerations.

 

If a foreign subsidiary in an expanded group has been funded with loans from a U.S. parent, the U.S. parent might have to convert all or a substantial portion of that debt into stock, or otherwise recapitalize the foreign subsidiary with an additional infusion of equity, to bolster its financial position to satisfy the creditworthiness documentation requirement of Prop. Reg. Section 1.385-2(b)(2)(iii). Such a debt to equity conversion would have the effect of reducing taxable interest income in the U.S., which does not seem consistent with the "earnings stripping" concerns that in large part are said to be the motivation underlying the Proposed Regulations. Further, by causing U.S. companies to contribute additional equity to foreign subsidiaries to enhance their financial position, the Proposed Regulations would encourage the flight of capital from the U.S. Finally, the Proposed Regulations seem inconsistent with the OECD Base Erosion and Profit Shifting ("BEPS") initiative, in that the Proposed Regulations would result in the creation of "hybrid" interests that are treated as stock for U.S. tax purposes and debt for foreign tax purposes.

We appreciate your consideration of our comments. Please feel free to contact us if you have any questions or if we can provide any further assistance.

Very truly yours,

 

 

William P. Van Saders

 

Senior Vice President &

 

Deputy General Counsel --

 

Corporate Tax

 

Verizon

 

Basking Ridge, NJ

 

FOOTNOTE

 

 

1 Unless specified otherwise, all references to the "Internal Revenue Code" or the "Code" are to the United States Internal Revenue Code of 1986, as amended.

 

END OF FOOTNOTE
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