Menu
Tax Notes logo

KPMG LLP Lays Into IRS on Proposed Debt-Equity Regs

JUL. 7, 2016

KPMG LLP Lays Into IRS on Proposed Debt-Equity Regs

DATED JUL. 7, 2016
DOCUMENT ATTRIBUTES
[Editor's Note: Full text, including attachment .]

 

July 7, 2016

 

 

CC:PA:LPD:PR

 

(REG-108060-15)

 

Internal Revenue Service Room 5302

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

Re: Proposed Regulations under Section 385

 

Ladies and Gentlemen:

KPMG LLP appreciates the opportunity to comment on the proposed regulations under section 3851 that were released on April 4, 2016, and published in the Federal Register on April 8, 2016 (the proposed regulations).2

KPMG LLP, the audit, tax and advisory firm, is the U.S. member firm of KPMG International Cooperative. KPMG is a global network of professional firms providing Audit, Tax and Advisory services. We operate in 155 countries and have more than 174,000 people working in member firms around the world. On a daily basis, KPMG LLP assists numerous clients by providing financial accounting audit and attestation services, business advisory services, general U.S. federal, state, local and international tax advice, and transactional planning.

Please note that while we anticipate the proposed regulations would materially affect many of our clients, our comments in this letter reflect the concerns of our organization, and the concerns of many of the tax professionals who practice within our organization (more than 25 of whom were contributors to this comment letter); we have not been engaged by a client to make these comments, nor do we write on behalf of any particular client.

I. Introduction

We believe that the proposed regulations are extraordinary and unprecedented in scope and potential effect. The proposed regulations, if adopted in their current form, would have a virtually immediate and material impact on our clients that are subject to U.S. federal income tax laws, in ways that would have little relation to the proposed regulations' stated purpose. The impacts of the proposed regulations could extend well beyond the tax worlds, and result in adverse financial statement and credit rating impacts.

The proposed regulations potentially represent the single most consequential change in the laws of corporate taxation in a generation, rivaled only perhaps by the so-called "check the box" regulations under section 7701. The proposed regulations have been framed as comprising part of an effort to attack so-called inversion transactions,3 and were released simultaneously with a series of guidance under section 7874 (the anti-inversion statute). We appreciate the significant policy concerns raised by inversion transactions. However, the proposed regulations are in no way limited in their application to inverted entities, and they would most heavily burden entities that have not inverted, do not intend to invert, and do not have the characteristics of an entity that is likely to invert.

We believe the proposed regulations are inconsistent with Congress' delegation of regulation-writing authority under section 385(a). Moreover, they raise numerous and important substantive issues, would impose an inappropriately large compliance burden on routine corporate transactions, and would cause far-reaching collateral consequences, many of which appear to have been unintended by the drafters, and some of which we no doubt remain unaware. In short, the proposed regulations are grossly overbroad, and would impose unnecessary collateral damage.

Finally, we seriously question whether the objectives that the Treasury Department intends to achieve through the proposed regulations are worth the costs they would impose on the Service itself in its role as a tax administrator, on taxpayers that seek in good faith to comply with our nation's tax laws, and on the integrity of the tax system itself through a new set of complex rules that potentially would result in numerous unadministrable situations.

II. Validity of the Recast Rules

 

1. Discussion

 

We believe the general, funding, and per se rules in Prop. Treas. Reg. § 1.385-3 exceed Treasury's regulatory authority under section 385.4 Although section 385(a) grants Treasury authority to prescribe regulations to determine whether an interest in a corporation is to be treated as stock or debt (in whole or in part), section 385(b) explicitly states that such regulations "shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists."

Moreover, the legislative history makes clear that, in enacting section 385, Congress contemplated that any Treasury regulations issued under that section would set forth factors that are indicative of debtor-creditor or corporation-shareholder relationships in an attempt to resolve the ambiguities and uncertainties reflected in the abundance of case law regarding whether corporate arrangements in substance constitute debt or equity. In other words, the statute and the legislative history contemplate regulations that would improve upon the case authorities, drive more uniformity, and provide a series of generally applicable rules to distinguish indebtedness from equity.

More specifically, section 385 originated in the Senate Finance version of the Tax Reform Act of 1969. The Senate Finance Committee's report states:

 

In view of the uncertainties and difficulties which the distinction between debt and equity has produced in numerous situations other than those involving corporate acquisitions, the committee further believes that it would be desirable to provide rules for distinguishing debt from equity in the variety of contexts in which this problem can arise. The differing circumstances which characterize these situations, however, would make it difficult for the committee to provide comprehensive and specific statutory rules of universal and equal applicability. In view of this, the committee believes it is appropriate to specifically authorize the Secretary of the Treasury to prescribe the appropriate rules for distinguishing debt from equity in these different situations.5

 

The Conference Committee accepted the Senate proposal, and section 385 was enacted into law.6

We believe the proposed regulations exceed the regulatory authority granted by section 385 and go beyond Congressional intent. They do not seek to delineate a general debt-equity distinction or to clarify or rationalize debt-equity analysis. Instead, the proposed regulations would simply treat certain arrangements as equity in order to ensure that interest expense deductions are not available in the case of certain transactions. We believe that legislation would need to be enacted to allow Treasury to provide such treatment by regulation.

In addition, there is nothing in section 385 or its legislative history that suggests that Congress authorized regulations to determine the status of an interest in a non-corporate entity; rather, the legislative history suggests section 385(a) was intended to be limited to corporate issuers. The statutory provision is in subchapter C of Chapter 1 of the Code, the portion of the Code addressing corporate distributions and adjustments. Yet, the proposed regulations would recharacterize certain debt instruments issued by a partnership, either as equity in the partnership or as equity in the partner(s) of the partnership.

In the legislative history underlying the enactment of section 385, the Senate Finance Committee report states: "[a]lthough the problem of distinguishing debt from equity is a long-standing one in the tax laws, it has become even more significant in recent years because of the increased level of corporate merger activities and the increasing use of debt for corporate acquisition purposes."7 As indicated in the passage cited above, the Senate Finance Committee report goes on to state:

 

In view of the increasing use of debt for corporate acquisition purposes and the fact that the substitution of debt for equity is most easily accomplished in this situation, the committee also agrees with the House that it is appropriate to take action in this bill to provide rules for resolving, in a limited context, the ambiguities and uncertainties which have long existed in our tax law in distinguishing between a debt interest and an equity interest in a corporation . . .

In view of the uncertainties and difficulties which the distinction between debt and equity has produced in numerous situations other than those involving corporate acquisitions, the committee further believes that it would be desirable to provide rules for distinguishing debt from equity in the variety of contexts in which this problem can arise. The differing circumstances which characterize these situations, however, would make it difficult for the committee to provide comprehensive and specific statutory rules of universal and equal applicability. In view of this, the committee believes it is appropriate to specifically authorize the Secretary of the Treasury to prescribe the appropriate rules for distinguishing debt from equity in these different situations. . . .

For the above reasons, the committee has added a provision to the House bill which gives the Secretary of the Treasury or his delegate specific statutory authority to promulgate regulatory guidelines, to the extent necessary or appropriate, for determining whether a corporate obligation constitutes stock or indebtedness. The provision specifies that these guidelines are to set forth factors to be taken into account in determining, with respect to a particular factual situation, whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists.8

 

The above legislative history makes clear that the focus of Congress in enacting section 385 was the characterization of corporate debt, and thus the statute makes no reference to whether an interest in a partnership is to be treated as stock or indebtedness.

Similarly, the proposed regulations would recharacterize debt instruments issued by a disregarded entity either as equity in the issuing entity (which could result in the entity being treated as a partnership) or as equity in the owner of the entity (even though the debt instrument is not an interest in the owner). These proposed rules cannot be squared with the grant of regulatory authority regarding the debt-equity status of an interest in a corporation.

 

2. Recommendation

 

Therefore, we respectfully make the following recommendations:
  • We urge the Treasury Department and the Internal Revenue Service to withdraw the proposed regulations, in their entirety.

  • If the Treasury Department and Service do not withdraw the proposed regulations in their entirety, we recommend that they withdraw Prop. Treas. Reg. § 1.385-3.

  • If the proposed regulations are not withdrawn, we recommend that the regulations, if and when finalized, should only apply to debt issued by corporations.

 

A more detailed discussion of the lack of statutory authority for the proposed regulations is set forth in a subsequent portion of this letter. We address the remainder of our comments to particular aspects of the proposed regulations.

III. The Expedited Timeframe for Finalizing the Proposed Regulations Raises Significant Tax Policy Concerns Given the Potential Collateral Consequences

 

1. Discussion

 

The effective dates of the proposed regulations and the expedited effort to finalize them, taken together or separately, raise significant tax policy concerns given the numerous uncertainties and collateral consequences that would result. We appreciate that there may be political considerations that are being brought to bear on the issue of inversions. Nonetheless, we believe the primary effect of the proposed regulations would be felt by business enterprises that have not inverted, and have no intention of inverting. In addition, we appreciate that the Treasury Department and this Administration have advanced legislative proposals to alter the applicable, substantive tax laws in relation to "leveraged distributions," "boot D reorganizations," section 304 transactions, and "earnings stripping." We believe that any "solution" in respect of these issues should be pursued exclusively in the legislative arena or through the renegotiation of income tax treaties.

As noted throughout our comments, the proposed regulations would have an extraordinary reach. The effect of recharacterizing debt instruments as equity -- especially under the inadministrable funding and per se rules -- will place significant additional pressure on many historic fault lines in corporate tax law and create new discontinuities. The Treasury Department has previously indicated significant concerns regarding the shifting of earnings and profits, the shifting of stock basis, and the issuance of upstream equity ownership ("hook equity"). We expect the proposed regulations would directly and substantially increase the occurrence of these issues, resulting in additional taxpayer disputes and considerable additional complexity. We expect the proposed regulations would lead to new uncertainties in determining control for purposes of the incorporation, reorganization, and liquidation provisions. In the context of troubled companies, we anticipate that there would be a number of inadvertent deconsolidations and other unexpected and unintended results, and the potential to substantially increase the use of "Granite Trust"9 techniques, even without taxpayers intending to do so. Similarly, the unexpected and perhaps retroactive creation of non-voting equity by means of a debt's recharacterization could create taxable transactions (such as in a transfer of appreciated property to an otherwise controlled subsidiary). These would have the effect of upsetting Congress' tax policy choices underlying the non-recognition provisions as well as taxpayers' reasonable expectations about having an ability to predict their tax liabilities. Perhaps these would give taxpayers the opportunity retrospectively to claim an increase in the basis of transferred assets and the stock of the transferee corporation.

We are deeply concerned that extending the proposed regulations to cash pool and treasury center arrangements and the no affirmative use rules are invitations to sheer incoherence. The funding and per se rules are also particularly troubling, in that taxpayers do not have systems in place today to capture and track the information necessary for compliance. The Service cannot be in a much better position in terms of its ability to audit taxpayers' compliance with any of these rules, or to determine the consequences of noncompliance.

As a financial audit firm that is asked to certify the financial statements of large corporate enterprises and to attest to management's assessment of the company's internal controls over financial reporting, we are deeply troubled by these rules. How long will it take taxpayers to establish and implement systems to capture and track the information necessary properly to apply the unprecedented standards in the proposed rules? How difficult will it be to determine that management has adequately assessed the accuracy of its financial accounting for income taxes?

We understand that the Treasury Department and Service intend to finalize the proposed regulations quickly. This, notwithstanding that the regulations would be effective with respect to certain debt instruments issued on or after April 4, 2016, the date the proposed regulations were publicly released, and generally with respect to debt instruments issued the day the regulations are published as final.10 The unprecedented breadth and scope of the proposed regulations and the many, many serious issues that they raise strongly counsel against hasty finalization. We believe that good tax policy demands that the process of finalizing this guidance deliberately take the time necessary to minimize the widespread, difficult, serious, collateral damage that the proposed regulations will engender if they were to be issued as final in their current form. A rush to meet an arbitrary deadline that might be construed as expedited for political considerations would represent a poor policy choice.11

A further consideration counsels for providing taxpayers with the time necessary to absorb and understand the rules in the proposed regulations -- as they may be amended by final regulations -- and to create and implement systems to properly comply with them. For obvious efficiency reasons that have nothing to do with tax planning, few large corporate groups currently employ systems that would satisfy the elaborate documentation and financial due diligence requirements demanded by the proposed regulations. Large corporate groups often use intercompany debt in lieu of bank debt in large part due to the significant non-tax cost savings and non-tax financial management benefits. Common practices among many large corporate groups may be found wanting in one or more respects under the proposal -- after all, why would such taxpayers undertake the elaborate, expensive documentation often utilized in bank borrowings when such documentation has neither been required nor serves any useful function in the related-party context? Thus, large corporate groups will be required to design and implement changes to their current practices to support debt characterization under the proposed regulations. They reasonably can be expected to encounter numerous practical difficulties and questions as they design and effectuate their new systems.

We note that the effective dates for the Chapter 4 "FATCA" withholding tax regime and for withholding under section 871(m) have been repeatedly extended in acknowledgement of very similar concerns. Those experiences highlight the need for a more measured approach in this context.

Some changes are obvious and can be implemented in due course, such as new internal policies requiring generally that attorneys (either in-house counsel or outside counsel), paralegals or other professionals in a particular jurisdiction be consulted to prepare or review the necessary operative legal documentation. Some policies might take longer, such as those surrounding financial due diligence (which in many cases will be standardized across a large corporate group) and those involving third-party relationships (such as cash pooling operations that involve a bank). Other changes are more intractable, such as the need immediately to begin tracking all intercompany lending, as well as all actual and deemed inter-corporate distributions, acquisitions of expanded group (EG) member stock (including dividend equivalent "redemptions" of recharacterized debt instruments) and intercompany asset reorganizations by a borrowing entity -- as well as these types of transactions that are engaged in by a borrowing entity's predecessors and successors -- and systems to integrate the intercompany lending information with this other information. These requirements are particularly worrisome in the context of cash pooling and treasury center functions. Treasury Department and Service attorneys have made comments in panel discussions (and that were reported in the tax press) indicating that substantial changes will be considered with respect to these arrangements. However, taxpayers do not know what those changes will be, what effect they might have, or what they will need to do to comply with whatever the modified new requirements might be. We are particularly dismayed at the prospect that taxpayers might be expected to immediately comply with whatever rules are included in final regulations (in part based on transactions that have occurred after April 3, 2016), and without being given any time to design and implement new systems to comply with the regulations. To be sure, taxpayers are on notice now that new rules are coming and on the general direction that the new rules will take. Taxpayers are not, however, on notice as to the specifics of the final rules -- especially as they relate to cash pooling and treasury functions -- and they cannot reasonably be expected to create and implement expensive and disruptive new systems before knowing the details of what the final rules will require. We note that in other areas where compliance is reasonably expected to require extensive systems changes, the Treasury Department and Service have consistently crafted applicability dates to allow time for taxpayers to comply.12 The proposed regulations create similar burdens but do not provide for necessary implementation time.

A further, practical point. Large domestic corporate taxpayers are subject to the laws of the states in which they operate. Many of the states have income tax rules that have significant features in common with the U.S. federal income tax rules, and there is considerable uncertainty as to the state tax effects of the proposed regulations.13 In order to avoid the cost and other burdens of duplicative systems, taxpayers will want to design and implement systems that would facilitate both U.S. federal and state tax compliance. However, basic questions remain, and they remain for most large domestic corporate groups. While a consolidated group of corporations would be partially exempted from the ambit of the proposed regulations with respect to intercompany obligations due to the treatment of consolidated corporations as a single corporation (Prop. Treas. Reg. §§ 1.385-1(e), -2(c)(4)(i), -4(a)), some group members might file separate returns in one or more states, and the group might file unitary returns in one or more states. Some states which might otherwise adopt the rules of the proposed regulations need not adopt the single entity treatment principle, or apply it in the same manner. This presents the possibility that an intragroup debt instrument could be respected as indebtedness for U.S. federal income tax purposes under this single entity principle, yet at the same time the very same debt instrument could be treated as stock for State A and/or State B tax purposes. We recognize that state tax considerations are not typically given much attention by the Treasury Department when writing regulations. However, large domestic corporate groups cannot ignore these important considerations, which they must take into account in designing and implementing information collection and compliance systems. The Treasury Department should not be under the false impression that the single entity principle means that purely domestic consolidated groups are free to disregard how the rules could apply to intragroup debt instruments.14

The proposed regulations have been designated a "significant regulatory action" under section 3(f) of Executive Order 12866, and have been designated as "economically significant." The official Regulatory Impact Analysis filed with the proposed regulations at the regulations.gov website estimates the paperwork costs of compliance to be $13 million on an annualized basis (which we believe to be grossly understated), and estimates that the proposed regulations would impose an annual $843 million tax increase (on a discounted basis). These official designations and estimates acknowledge that the proposed regulations comprise important new rules, and will impose significant costs; there is also the implicit acknowledgement that many taxpayers will be required to adapt their policies and procedures and substantially adjust their behaviors in order to comply.15 Notwithstanding, the Treasury Department and Service chose not to issue an advanced notice of proposed rulemaking, even though an ANPRM would appear to have been contemplated in section 2(c) of Executive Order 13563 issued by President Obama.16

Taxpayers who in good faith seek to comply with our nation's tax laws should be given a reasonable amount of time to establish operational information tracking and compliance systems. With all due respect, the debt-equity distinction has been around since the infancy of our income tax laws; it has been almost 50 years since Congress authorized regulations under section 385, and more than 30 years since the Treasury Department withdrew its prior effort at drafting regulations. The transactions targeted by the general, funding and per se rules were already tried and true (and approved of or accepted by trial and appellate courts) when section 385 was enacted in 1969. Those transactions rely on Code provisions and general tax principles that were black-letter law at that time, and that remain in the law notwithstanding repeated efforts to have Congress change the law. There is no reasonable tax policy argument for an accelerated due date for the proposed regulations, except -- to take the Treasury Department at its word -- in the context of anti-inversion efforts. And in that context, we do not believe there is a credible argument that justifies overturning decades of stable tax law in an effort to impose the rules in the proposed regulations on an accelerated basis to U.S. corporate groups that have not inverted, do not intend to invert, and are not candidates for an inversion.17

There is a further concern with the accelerated due dates. Many large corporate taxpayers that would be subject to these rules are required to file audited financial statements with the U.S. Securities and Exchange Commission, and to assess the effectiveness of their internal controls over financial reporting, in accordance with the standards established by the Public Company Accounting Oversight Board. An accelerated timeline for finalization of the proposed regulations could result in insufficient time to consider the numerous, substantive comments that the Treasury Department and Service have received and will receive, and insufficient time for companies to adapt to final regulations. In particular, we are concerned that if final regulations are issued on an accelerated schedule this fall with the currently proposed effective dates, the effect of the numerous uncertainties in the regulations and the relative lack of time for taxpayers to adapt to the final regulations could be reflected in companies' financial statements and could in certain circumstances needlessly complicate the ability to attest to companies' internal controls over their financial reporting, for purposes of the annual reports filed by companies with their Forms 10-K for years ending on Dec. 31, 2016.

We recommend that taxpayers be given no less than one year after finalization to comply with whatever new documentation requirements are imposed by final regulations. If the Treasury Department and Service are concerned that taxpayers might choose to "game the system" by rushing to issue poorly documented related-party debt instruments in the interim, a rule could be written to require reasonable documentation, including objective, contemporaneous evidence of an intent to create a debtor-creditor relationship (including appropriate journal entries) for the interim transition period.

  •  

    2. Recommendation

  • Extend the time for comments for 90 additional days, through October 5, 2016, to allow other interested parties the time necessary to identify additional significant issues and submit comments.

  • Given the significant changes that should be made to the proposed regulations and the potential scope of the changes, re-propose the regulations with necessary changes, to allow for additional comments and assessment of the potential for additional collateral damage.

  • Revise the effective date provisions, so that the regulations would apply with respect to debt instruments issued on or after the day that is one year after temporary of final regulations are published in the Federal Register, and provide grandfather rule relief with respect to currently outstanding obligations.

 

IV. The Proposed Recast Regime Would Create Incentives Leading to Unintended Economic Results

 

1. Discussion

 

The proposed regulations are extraordinarily sweeping in their potential scope, and will have an inevitable and unfortunate effect on routine corporate transactions, thus providing a distortive difference in costs and uncertainties between U.S. corporations that would be subject to the rules and business entities that would not.

 

a. The proposed regulations favor ownership of U.S. corporations by individuals or entities not organized as corporations, which creates noneconomic incentives, because such non-corporate entities generally will not be a member of an expanded group. For example, consider a partnership formed by unrelated individual and corporate partners, none of which owns 80 percent or more of the partnership. U.S. corporations can issue debt to such non-expanded group persons, and deduct the interest on such obligations.18

b. The dual consolidated loss regime in section 1503(d) was motivated by a concern that foreign taxpayers' use of dually incorporated entities, which permitted the double use of interest deductions, provided an undue tax advantage to foreign acquirers that engaged in leveraged buyouts of U.S. companies.19 The proposed regulations will likely have the perverse and opposite effect of encouraging leveraged buyouts of U.S. companies. This is because the proposed regulations would not apply to a "formation-based" injection of leverage into a U.S. holding company or acquisition company, yet would apply to later recapitalizations of existing businesses.

 

Example. USP, a U.S. parent corporation, has a 3:1 external debt-equity ratio, which is standard in its industry. USP transfers $100 of assets to a newly organized, non-consolidated subsidiary in exchange for $75 of debt and $25 of equity. Two years later, the subsidiary has prospered and is worth $500, but has a sub-optimal debt-equity ratio.20

 

The proposed general rule would preclude the subsidiary from issuing and distributing a note to the parent, or from undergoing a recapitalization. However, the U.S. parent could sell the subsidiary to an unrelated foreign buyer, which could insert $375 of leverage into the subsidiary and thus re-establish the original debt-equity ratio without triggering the general rule.21 In addition, the foreign buyer would be free to utilize an intercompany borrowing from a related foreign finance company to finance the purchase, without losing an interest deduction on that debt.22 To be sure, the new leverage might be subject to recharacterization under the funding and per se rules if the purchased entity itself were to make a distribution, purchase related-party stock, or acquire assets in a related-party reorganization with boot within 36-months, but if the foreign acquirer is willing to wait for more than 36 months, the new acquisition-based leverage would not be recharacterized under the rules.23

c. By the same token, the proposed regulations would create incentives for U.S. corporations to sell their subsidiaries to foreign purchasers (and for foreign corporations to sell their U.S. businesses to other foreign buyers). In addition, when it comes to acquisitions of corporate business enterprises with no prior U.S. tax relevance, the complexity and likely effect of the proposed regulations combined with the failure to exclude such previously U.S-tax-irrelevant corporate business enterprises from their scope would impose on potential U.S. purchasers significant costs and uncertainties that rival foreign purchasers would not face.

d. While the proposed rules were said to be issued in connection with a desire to prevent departures from the U.S. tax system through inversions, the increased cost to comply with the rules in the proposed regulations and to manage the extraordinary complexities that will result from the general and funding rules (particularly in light of the per se rule) will have the perverse effect of further encouraging corporations to expatriate. In addition, the denial of interest deductions for inbound investment could simply disincentivize conducting operations in the United States, thereby adversely impacting the economy. We recognize that "earnings stripping" is not intended as a tax subsidy for foreign purchasers; however, a foreign corporation that seeks to use an optimal level of debt (perhaps mirroring the foreign acquirer's debt-equity ratio) will surely consider the additional U.S. income tax burden in losing an interest deduction and the cost of additional bank borrowings when determining whether to make additional investments in its existing U.S. entities. We expect this to be particularly acute in the financial sector.24

e. A number of the transactions targeted by the proposed regulations (such as so-called earnings stripping and leveraged distributions) will continue to work for taxpayers who employ borrowings from unrelated lenders. For obvious reasons, the proposed regulations do not target indebtedness held by unrelated lenders,25 such as the bank borrowing employed in the very transaction at issue in Falkoff.26 The proposed regulations would create an incentive for transactions to be undertaken in a manner that involves external rather than internal borrowing, thus creating unnecessary additional borrowing by large corporate groups, together with the attendant increased transaction costs, fees, and market risk. This would also be the case for routine intercompany borrowings that are effected for nontax reasons (such as reducing interest rates and transactions costs) by large corporate groups that channel their external borrowing through a central finance subsidiary or a corporate parent. Those corporate groups would be incentivized to restructure much of their routine intercompany debt as external borrowing, thereby incurring higher borrowing costs and other inefficiencies, and including increasing their external debt ratios (thus increasing risk in the U.S. corporate sector).

f. The proposed regulations would affect the amount of leverage reported on the financial statements of U.S. corporations subject to its regime. As discussed above, the substantiation and documentation requirements together with the general rule and funding rule will incentivize large corporate groups to substitute external borrowing from third-party lenders that are not members of the borrower's expanded group for internal financing. Under generally accepted accounting principles, internal borrowing often is eliminated on a corporation's consolidated financial statements. Conversely, generally accepted accounting principles do not allow external debt to be eliminated. If finalized, the proposed regulations would lead to an increase in the aggregate external debt-load on financial statements. This, in turn, would have an adverse impact on corporate debt-to-equity ratios and other financial indicators27 that will negatively impact the credit ratings for U.S.-based corporations fully in the crosshairs of the proposed regulations. Foreign competitors will not suffer an equivalent burden.

g. The issuance of intercompany indebtedness is not subject to the general rule of Prop. Treas. Reg. § 1.385-3(b)(2) if incurred in the initial capital structure of a subsidiary corporation, but can be vulnerable to recharacterization if the subsidiary corporation issues an instrument with the identical terms thereafter in a recapitalization or distribution. This can be expected to lead to a greater amount of intercompany debt being issued upon corporate formations, including in the debt-pushdown context.

h. Certain tax rules operate on a counter-cyclical basis. For example, taxpayers undergoing financial stress often will pay less tax, and those that generate losses can carry the losses back to flusher taxable years. The current Administration and Congress have recognized this phenomenon in proposing and enacting a lengthened net operating loss carryback period during the so-called Great Recession.28 In contrast the proposed regulations would operate on a pro-cyclical basis and punish corporations that are undergoing financial stress, by reducing access to internal borrowing, disallowing interest deductions for such borrowing, and increasing the likelihood of debt-to-equity conversions when debt is restructured.

 

The potential incentives that would be created if the proposed regulations were finalized in their current form can be expected to have macroeconomic effects and, as discussed below, would impose material costs, both monetary and nonmonetary, in terms of compliance, complexity, and uncertainty. Economic neutrality has long been a positive goal in terms of tax policy, yet the proposed regulations would seem to violate this goal.

The Treasury Department concedes that the proposed regulations constitute a "significant regulatory action" as that term is used in Executive Order 12866, and the Regulatory Impact Analysis acknowledges that the proposed regulations would result in approximately $1.0 billion in additional U.S. federal income taxes each year. However, the Treasury Department and Service did not issue an advanced notice of proposed rulemaking, as is contemplated in section 2(c) of Executive Order 13563, and have instead provided a comment period that seems rather truncated given the potential effect of the proposed changes. Nor, so far as we are aware, has there been any significant consideration given as to the most cost-effective manner of achieving the regulatory objectives or whether the regulatory objectives could be satisfied with rules that would impose a lesser burden, at least apart from adding in a few exceptions designed to exclude taxpayers with relatively modest assets or revenues.

  •  

    2. Recommendations

  • Carefully consider the potential non-tax effects of the proposed regulations, and scale back the scope of the proposed rules to limit these effects.

  • Refocus the proposed regulations on the characteristics of debt instruments and the key factors underlying debt-equity considerations, with the actual or deemed use of the proceeds no longer serving as a thinly-veiled surrogate to address perceived abuses that are unrelated to section 385.

  • Consider alternative approaches (including renewed efforts to seek legislative changes on the underlying issues) that would not impose the severity of collateral effects that would result from the proposed regulations.

 

V. Collateral Damage under the Recast Rule, and Other Issues

The proposed regulations are unprecedented in their scope, and would effect the most significant change in corporate tax practice in a generation. While the proposed regulations may have been framed29 as part of an effort to combat inversion transactions, their primary effect would be imposed upon entities that have neither inverted nor are candidates for an inversion. Treasury Department officials have acknowledged that the proposed regulations are intended to be "disruptive" and not "easy to sidestep."30 One of our concerns is that the proposed regulations will cause an inappropriately large amount of collateral damage.

We realize that new rules inevitably create some degree of uncertainty; indeed, prior efforts to issue regulations under section 385 inspired Dean Manning to pick up his author's pen and coin the phrase "hyperlexis."31 However, we believe that the proposed regulations would create uncertainty of a higher order of magnitude, due to the extraordinary breadth of the proposed rules, the fundamental nature of the debt-equity distinction, the range of issues that would be affected by the debt-equity classification, the potential tax costs and complexities inherent in a misclassification, the potential for duplicative, evergreen, and cascading (or "viral") consequences following an equity recharacterization of a debt instrument, and the complex "equity" ownership structures (and tangled legal entity organizational charts) that would result from debt recharacterizations.

We believe the proposed regulations to be ultra vires and inadvisable. However, recognizing that the Treasury Department and Service appear insistent on finalizing the proposed regulations notwithstanding these issues, we offer comments on certain ways in which the regulations could be made moderately less intrusive, burdensome and arbitrary. There are too many issues to discuss in detail. Some key points, below, warrant additional discussion. We attach an Appendix to our comments to illustrate a number of additional questions that the proposed regulations raise.

Please note that for purposes of the examples set forth below and in the Appendix, we use typical naming conventions; in addition, we assume that unless otherwise stated no exceptions apply, the relevant entities do not file consolidated returns, and the relevant foreign entities neither engage in a U.S. trade or business nor have a permanent establishment in the United States.32

 

A. Cash Pooling Arrangements and Treasury Center Functions33

 

1. Discussion
Perhaps the most significant negative impact would be caused by the failure of the proposed regulations to include administrable rules that reflect corporate business practices involving liquidity management functions. As business has become more globalized, the need to fund, manage cash, and hedge risk on a global scale has increased. Companies take different approaches to managing these global needs, but there has been a near-universal trend away from decentralized operations that serve only a single business line or geography, toward consolidated operations that need to function seamlessly on a regional or global basis. This trend has not been driven by tax considerations.

Treasury centralization is a product of increasing demands on treasury functions to reduce operating costs, strengthen governance, and position the organization for growth. Nuances in modern treasury structures are driven by its intended scope -- from simple on-lending to fully integrated in-house banking, cash pooling, payment netting, etc. -- and considering factors such as the locations of key business operations, banking relationships, and treasury talent, and limitations such as time zones and the ability to invest in new technology. The lack of any correlation between the complexity of a company's treasury operations and any intent to engage in a disfavored transaction is ignored under the proposed regulations, imposing an inordinate amount of the compliance burden and potential for unintended consequences on growth-motivated business transformation that is not justified in any way by an increase in actual abuse.

The Treasury Department and Service recently faced a similar realization through the comment process with respect to the regulations issued under section 1471, ultimately concluding that a treasury center managing a group's working capital, such as by pooling the cash balances of affiliates (including both positive and deficit cash balances), or by investing or trading in financial assets, or acting as a financing vehicle for the group should receive a specific exception to onerous compliance burdens as it did not pose a significant risk of tax abuse.34

Cash pooling is a feature of most modern centralized treasury operations. Pooling structures take various forms, but generally involve working with a banking partner to facilitate a variant of either physical (zero-balance) or notional pooling. Both structures allow for the automatic transfer of cash between affiliates' local operating accounts and accounts centralized at a branch of the pooling bank. In a physical pooling, the pooling accounts are owned by a single entity (often a treasury center) and those balances are then converted to a single currency and combined into a single account. With notional pooling, separate pooling accounts may be owned by a single or each respective affiliate and are not combined, but balances are treated as if they had been for interest calculation purposes.35

Cash pooling programs provide many important operational benefits, including that they:

  • increase visibility into local entities' cash positions (and reduce the effort required to gain an overall understanding of the corporate group's cash position), often reducing overall minimum cash requirements and facilitating additional business growth;

  • facilitate the optimal allocation of internal liquid funds, optimize cash flow management, coordinate varying cash flow cycles among local entities, and simplify liquidity management at the local entity level;

  • reduce the corporate group's external borrowing and overdrafts, thus reducing the overall cost of funds and the corporate group's external debt-to-equity ratio;

  • create economies of scale and bargaining power that can reduce the cost of external borrowing; and

  • create economies of scale -- and a platform to integrate with central payment and risk management functions -- that facilitate improved investment returns, and better and more efficient overall management of interest rate, currency, and other financial risks.

 

In short, the treasury function's goal with cash pooling is to ensure that the business operations have access to funds at the right time, in the proper location, and in the appropriate currency, while (a) minimizing its cost of funds, including with respect to interest and foreign currency exchange, and (b) maximizing the return on short-term surplus funds.

Pursuant to a cash pooling program, participating EG members might be considered for U.S. tax purposes to have borrowed from affiliates (that is, the "deposits" by positive balance members funding the "negative" balance members). In many cases, sweeps between local and pooling accounts occur on a daily basis. The high frequency of deposits and withdrawals, and lack of clear guidance generally, collides violently with the proposed regulations, such as the funding rules in Prop. Treas. Reg. § 1.385-3(b)(3) and the documentation rules of Prop. Treas. Reg. § 1.385-2. In particular, the proposed regulations do not contain any "short term" or "de minimis" loan exceptions to either the -2 or -3 regimes. The absence of these common-sense short term and de minimis materiality exceptions is all the more remarkable (if not inexplicable) given that the U.S. international tax system contains numerous examples of them in other regulations implementing "anti-abuse" rules.36

Centralized corporate cash management systems do not pose an inherent danger to the public fisc, nor are they inevitably a tax planning mechanism. We understand that the Treasury Department is concerned that the use of corporate cash management programs presents the potential for an "end-run" around the proposed regulations, to the extent they could be employed to effect long-term borrowings. Thus, while the Treasury Department and Service representatives have, to their credit, made public statements regarding a willingness to consider modifications to the proposed regulations to take cash pooling nuances into account -- statements that we appreciate -- the representatives have also made it clear that the proposed regulations, if and when finalized, will not exempt pooling transactions.

Taxpayers could adapt to the rules in the proposed regulations simply by discontinuing all of their present cash pooling arrangements. The trade off, however, is that the efficiency, cost, and management considerations discussed above would be forfeited. We would not expect most large corporate business groups to accept that trade-off and abandon a core component of their cash management systems due to the non-tax benefits the systems deliver; rather, we would expect these taxpayers would try to find ways to manage the tax consequences.37

We believe that it would be extremely imprudent to finalize the proposed regulations in their current form without seriously and comprehensively modifying the rules to accommodate cash management programs commonly used by large corporate groups today. The consequences of equity recharacterization of a cash pool balance would be extraordinary and draconian:

  • Imagine a multinational cash pool for which the government asserts that a local overdraft should be treated as an exempt group instrument (EGI) and recharacterized as equity, but there was no one, clear counterparty to the balance. Would it then treat all cash pool participants with positive balances as holding some portion of the debt? The proposed regulations are silent as to methodologies. Would those "holder corporations" be treated as having acquired stock in an EG member? If so, then would those "holder corporations" be at risk of having some of their unrelated borrowings be recharacterized under the per se rule, either at the time of the cash pool reclassification or within three years thereafter? And if a "holder corporation" reduces its positive balance in the cash pool, would it be treated as selling EG member stock (i.e., the recharacterized debt) to other cash pool members?

  • Would the accrual of interest on every negative balance result in a deemed distribution of "stock" that would implicate the section 305(c) rules?38 Whether on accrual or payment, would the interest be subject to recharacterization as a dividend distribution under section 301(c)(1) (or as a return of basis under section 301(c)(2)), or would it qualify as a tax-free stock distribution under section 305(a)? If the latter and if the balance is treated as preferred stock, will it be section 306 stock (implicating those consequences)? We would expect that in most situations, any underlying "equity" resulting from a cash pool balance would be nonvoting, thus causing significant impediments to foreign tax credit utilization.39

  • Further complexities would be driven by the funding and per se rules, under which it is surprisingly irrelevant if a particular debt had been issued and repaid in the same year but prior to a disfavored distribution or acquisition and is no longer outstanding at the time of such other transaction. If a cash pooling arrangement utilizes daily sweeps and balances are recharacterized as stock, what would be the effect if a participant "goes negative" one day a month due to, say, payroll, with the negative balance restored in the following days from its business receipts?40 A cash pool balance that went negative in January and was returned to positive in February and stayed positive throughout the remainder of the taxable year could be linked with a distribution in November, and retrospectively recharacterized as stock (absent a modification to the general timing rule of Prop. Treas. Reg. § 1.385-3(d)(1)(i) or exceptions for short-term and ordinary course transactions).

  • Additional complexities could result when a balance is reduced or paid down, which we assume is intended by the Treasury Department to be treated as a section 302(d) "dividend-equivalent" redemption.41 Such a deemed redemption, we would note, not only could shift earnings and profits amongst various related corporate entities, but it would also result in a very large number of basis shifts -- a scenario the Treasury Department and Service targeted in a 2009 basis proposal42 and tried to eliminate in a 2002 basis proposal.43

  • Finally, we anticipate that there would be a significant "cascading" or "viral" effect to the cash pool; as soon as one participant generates a balance that would be recharacterized as equity under the proposed regulations, the "holder" of such "stock" -- however that might be determined -- would be treated as having purchased EG member stock, with its "stock purchase" becoming vulnerable to linkage with its other borrowings under the funding and per se rules.

 

The complexities inherent in the issues discussed above are staggering. An extension of the general, funding and per se rules in the proposed regulations to the high-frequency intercompany borrowings arising from cash pooling and treasury center operations -- operations that are overwhelmingly driven by non-tax business factors and through which the lifeblood of business flows -- is an invitation to incoherence. A corporate taxpayer would want to accurately report its interest income and expense and its dividend income (and dividends received deduction, if applicable). In addition, going forward, a taxpayer will need to calculate earnings and profits, stock basis in other EG members (including any basis that might have been augmented through a basis shift), foreign taxes, and the like. At the same time, the Service with its increasingly limited resources must audit these issues and efficiently examine taxpayers. From our perspective, the proposed regulations would significantly complicate a large corporate group's financial accounting for income taxes determinations of its deferred tax assets and liabilities as of a particular date, and the income tax expense for a given period, for purposes of reporting such items on its financial statements.
2. Recommendations
Given that the cash management systems are not -- and should not -- be viewed as inherently suspect from a tax policy perspective, given their importance in managing business operations, and given the extraordinary consequences the proposed regulations would have, the Treasury Department and Service should make every effort to ensure that the rules in the proposed regulations do not hamstring corporate groups that seek to efficiently manage their treasury operations. Thus, the Treasury Department and Service should either (i) wholly exempt cash management systems from the ambit of the regulations until such time as the rules can accommodate such systems without imposing undue damage or (ii) substantially modify the rules in the proposed regulations to limit unnecessary collateral damage.

There is no principled tax policy reason to subject routine, short-term deposits and withdrawals to the complexities associated with the funding and per se rules of Prop. Treas. Reg. § 1.385-3(b)(3). We therefore recommend limiting the rules' application to situations involving long-term negative balances that do not originate in the ordinary course of the borrower's business operations. In addition, the Treasury Department and Service should consider the effect the rules would have on taxpayers undergoing financial stress; a further proposal is added to prevent financially troubled entities from being penalized under the regulations.

  • Wholly exempt cash pooling programs from the scope of the rules unless and until a workable set of rules can be drafted, commented upon, and amended as necessary. One possible way to accomplish this would be to leverage the definition of treasury center in the regulations under section 1471.

  • Absent a complete exemption, at the very least provide that the per se rule of Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B) does not apply to cash pooling arrangements. To the extent the cash pool balances lead to one group member being a long-term borrower from another for U.S. tax purposes generally, the general principal purpose rule in Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(A) could still apply. Thus, the proposed regulations would still have a mechanism that could address any particular negative cash pool balance that was created with a principal purpose contrary to whatever the final regulations deem problematic.

  • If neither of the two foregoing recommendations are adopted, then the next best alternative would appear to be to add an ordinary course exception that would exclude cash pool balances that are incurred in the ordinary course of the taxpayer's financial and business operations. As a further example, an exemption could also be added for all balances that are outstanding for less than 365 days -- a tenor common for revolvers used for routine liquidity management.

  • If qualified short-term borrowings aren't entirely exempt, a separate excepted borrowing amount should be established based on a liquidity measure instead of an overall debt ratio; for example, a measure of average unrestricted current assets, relative to average current liabilities, as recorded on an entity's financial statements (including pro forma financial statements). Special rules should be provided for finance companies that are not required under applicable financial accounting standards to present classified balance sheets, and the excepted amount should be reset no more frequently than annually, absent an indication of abuse.

  • Allow a borrower to net its positions on a monthly basis (or longer) in applying the above rules to avoid unnecessary burdens on routine fluctuations. In addition, determine a corporation's borrowing from a cash pool for a particular day (where relevant) with reference to the balance at the close of the day.44

  • Explicitly provide that a taxpayer should net across all of its accounts in a cash pool to determine its net position, including for example, where multiple accounts are maintained in different currencies, or where there are multiple branches, each with a separate account. Further, allow all members of a single consolidated group (and all of their controlled partnerships and disregarded entities) to net their balances inter se, to determine the relevant cash pool position.45

  • Absent a complete exemption, and short of withdrawal of the proposed regulations, the Treasury Department and Service should consider limiting the scope of the proposed regulations to only cross-border situations in which U.S. tax concerns are most pronounced. One way of achieving that limitation would be to treat all EG members that are controlled foreign corporations and all EG members that are foreign corporations but are not controlled foreign corporations as each one person for purposes of the proposed regulations. This treatment mirrors that afforded to U.S. consolidated groups and would better focus the rules on situations in which the U.S. tax policy concerns appear to be most prevalent.

  • Include a rule similar to Treas. Reg. § 1.1001-3(f)(7)(ii)(A) that would, for purposes of the substantiation rules in Prop. Treas. Reg. § 1.385-2, disregard a deterioration in the financial condition of a cash pool participant with a negative cash balance, when the deterioration arises subsequent to the time the participant joins the pooling arrangement and the balances are otherwise still exempted from the funding rule under an applicable exception.

  • Provide specific guidance as to the application of authorities such as Rev. Rul. 76-19246 to various notional pooling arrangements to clarify when the government will take the position that such arrangements create EGIs. Specifically, address which, if any, security provisions provided to the bank by pooling participants -- pledges of deposits, cross-guarantees, overall guarantees, rights of offset, etc. -- will cause a notional pooling program to be treated as subject to the final regulations under section 385.

  • Explicitly provide rules that allow the application of the cash pooling exceptions to similar short-term lending arrangements that are operated with or without a third-party bank or in-house bank, and regardless of whether cash movements are executed automatically or manually.

  • Absent a complete exemption, and in the case that our recommendations with respect to the effective dates are not adopted, allow a period of no less than one year from the finalization of the proposed regulations for companies to coordinate on a global basis and negotiate with third-party banks to restructure any balances in existing cash pooling arrangements that would not meet the requirements of the limited cash pooling exemptions, without treating any resulting changes in the cash pool or corresponding extensions of other forms of debt as new issuances subject to the final regulations under section 385.

  • B. Acquisitions of Non-U.S.-Tax Relevant Groups

     

    1. Discussion
The proposed regulations make no distinction as to their application on a territorial basis. Based on comments that have been made on various panels, the Treasury Department intends the proposed regulations to apply in the domestic-to-domestic and foreign-to-foreign contexts, in addition to the cross-border context. We also note that the proposed regulations could also apply to a foreign corporate group that has no connection whatsoever with the United States, and informal discussions with attorneys with the Treasury Department and Service confirm this.

First, as a matter of policy, the rules in the proposed regulations simply should not apply to a corporate group with no nexus to the U.S. federal income tax. The Treasury Department and Service acknowledge in the preamble to the proposed rules that they seek to "impose discipline" on taxpayers with the documentation and substantial requirements of Prop. Treas. Reg. § 1.385-2, and the requirements do have some relevance to certain aspects of a traditional debt-equity analysis. The general and funding rules in Prop. Treas. Reg. § 1.385-3 are clearly focused on the use of related-party debt instruments in distributions, section 304 transactions, and intercompany reorganizations. Without regard to the merits of the rules, there is no rational tax policy support to extend the proposed regulations to entities that entirely lack a nexus to the U.S. tax base. The debt-equity characterization of a debt instrument between such entities will have no bearing on any interest income, interest deduction, dividend income, or dividends received deduction reported on a U.S. federal income tax return. In short, there is no legitimate purpose to be served in extending the rules of the proposed regulations to corporate groups that completely lack a U.S. federal income tax connection. The Treasury Department and Service have previously recognized that rules of general applicability should be limited to entities that have relevance for U.S. federal income tax purposes (such as in the entity classification regulations47), and for similar reasons a special rule should be added to the proposed regulations.

Second, as a practical matter, extending the rules of the proposed regulations to corporate groups that completely lack a U.S.-tax connection would create a significant degree of uncertainty when the group is acquired by a U.S.-tax-relevant group.

 

Example. USP, a U.S.-headquartered multinational corporate parent, acquires FP, a foreign corporation that owns multiple subsidiaries. At the time of the acquisition, neither FP nor any of its subsidiaries has or ever had a trade or business or a permanent establishment in the United States. At the time of its acquisition, FP and its subsidiaries have multiple related-party loans outstanding, participate in a common physical cash pooling arrangement, and had issued and repaid numerous related-party loans in the three years prior to the acquisition (we expect these assumptions would be true with respect to nearly all large foreign business enterprises).

 

FP would have had no reason to comply with any documentation requirements imposed under the tax regulations issued by the Treasury Department and Service, nor any reason to put in place bookkeeping systems or protocols to identify, track and potentially link related-party debt issuances or negative cash balances with distributions, related-party stock sales, and internal asset reorganizations. It is unlikely that any intercompany balances at or below the parent level would be "cleaned up" immediately prior to the acquisition. This raises a number of questions:
  • How might USP go about determining whether a particular debt instrument issued by a member of the FP group and that is outstanding at the time of the acquisition should have been treated as stock upon its issuance or subsequent to its issuance under any of the rules in the proposed regulations? What about debt instruments issued in the past that are no longer outstanding? The FP group might not have generated or retained sufficient information upon which determinations under the documentation, general, funding, or per se rules could be made (even without taking into account the evergreen and cascading effects of the proposed regulations).

  • If a debt instrument issued by a member of the FP group would have been characterized as stock under the proposed regulations prior to the acquisition, how can USP "clean-up" the debt instrument without causing unanticipated or unwarranted consequences? We observe that a competing foreign acquirer would not face similar uncertainties or costs.

  • If USP wants to make a deemed asset sale election under section 338(g) with respect to FP and to "push down" the election to the FP subsidiaries, and if the proposed regulations would have recharacterized a significant amount of intercompany debt as hook equity, there might be some question as to whether the elections might be available at the lower tiers. For example, if FP owned F1, F1 owned F2, and F1 had issued a debt instrument to F2 that represented more than 20 percent of F1's value and that was subject to a "stock" recharacterization under the proposed regulations, would there be a qualified stock purchase of F1 or F2? If it were FP instead of F1 that had issued the debt instrument, would USP have effected a qualified stock purchase of FP?48 Assuming a deemed asset sale election is effected under section 338(g), how might the aggregate deemed purchase price calculations be affected by the recharacterization of a debt instrument as stock?49

  • If no section 338(g) elections are to be made, how might USP go about determining the earnings and profits and stock bases in FP and its subsidiaries, if the information necessary to determine how the proposed regulations might have applied to the FP group does not exist or was not maintained?

 

Similar complexities would arise with respect to the acquisition if FP had some U.S. subsidiaries, but had multiple foreign EG members either "above" the U.S. subsidiaries or in separate corporate chains in the organizational chart. How likely is it that FP and its foreign subsidiaries would have been in compliance with U.S. Treasury regulations with respect to its non-U.S. businesses and entities? Why would we expect the FP group to alter its foreign intercompany lending or cash pooling practices to mitigate the effect of the proposed regulations, or to create and employ the tracking systems necessary to generate the information that would allow the funding and per se rules to be administered with respect to non-U.S. entities?

We recognize that a previously U.S.-tax irrelevant entity can become U.S.-relevant upon an acquisition. In this situation, due to the entity's lack of historic nexus to the U.S. tax base and absence of U.S. tax-planning activities, it would be appropriate to allow the entity some period of time to "clean up" the intercompany debt structure it has in place at the time of the acquisition and allow the acquiring group to transition the target to compliance with the rules through grandfather rules and transition relief.

We note that the Treasury Department years ago considered a very similar issue of "relevance" in the entity classification (or "check-the-box") regulations in Treas. Reg. § 301.7701-2 and -3. Under those rules, an entity's classification is not relevant -- with the effect that it is effectively not considered a pre-existing entity -- until its classification is relevant to the U.S. taxpayer's tax liability or information reporting obligations. Events that establish relevance include if the foreign entity receives a U.S.-source payment subject to U.S. withholding or the entity is owned in a sufficiently large amount by U.S. persons to trigger reporting under sections 6038, 6038A, etc.50 The administrative and fairness considerations that led the Treasury Department to issue the relevance "exception" in the entity classification area apply with equal force to the proposed regulations.

We also note that similar issues can arise when a large corporate group acquires a smaller group that had not previously been subject to the rules in the proposed regulations, or when two smaller groups merge and as a result would become too large to qualify for the exclusions in the proposed regulations. Appropriate transition relief and grandfather rules should be provided in these circumstances as well.

  • 2. Recommendations
  • Exempt U.S.-tax irrelevant entities from the ambit of both the documentation requirements of Treas. Reg. § 1.385-2, as well as from the general, funding and per se rules of Treas. Reg. § 1.385-3. This would be a relatively simple matter to draft with respect to a foreign group that has no members with any trade or business or permanent establishment in the United States. Possibilities might be to exclude wholly irrelevant foreign entities from an expanded group, or exclude their debt instruments from the applicable instrument and debt instrument definitions. Drafting a rule with respect to foreign groups that have some U.S. subsidiary entities would be a more complex undertaking. For example, one of the "legs" of a "funding transaction" might have U.S. relevance while at the same time multiple other transactions within the foreign target group might not. The existing definition of relevance in Treas. Reg. § 301.7701-3(d)(1)(i) appears a useful analogy, as the debt instruments of a foreign entity would not be considered relevant (and thus would not be taken into account) unless held by a U.S. taxpayer or if the entity was owned by U.S. taxpayers in a sufficiently large amount for the instrument's characterization to implicate their information reporting and substantive tax obligations.

  • Address how a previously U.S.-tax-irrelevant entity or debt instrument, and U.S. taxpayers that have historically been exempted from the section 385 rules due to their relatively small size, can transition into the section 385 rules. We would recommend that all debt instruments issued by a these entities be fully grandfathered from the rules in the proposed regulations, because it is unlikely that the debt instrument had been issued with a purpose to avoid U.S. federal income tax or to avoid the section 385 regulations. The grandfather rule should be written in a manner that allows such a debt instrument to be extended and repaid without affecting its characterization, and without triggering a deemed redemption.

  • If the Treasury Department and Service are concerned about the possibility that an aggressive U.S.-tax-irrelevant target might seek to abuse the grandfather rule by issuing debt instruments on the cusp of an acquisition and did not want to solely rely on the no-affirmative use rule, the Treasury Department and Service could specifically provide a description of such a case as a context in which the anti-avoidance rule of Prop. Treas. Reg. § 1.385-3(b)(4) might apply.

  • C. Over-Expansive Definition of an EG -- Attribution Rules

     

    1. Discussion
One key term in the proposed regulations is expanded group (EG).51 The EG definition was written with reference to the rules of section 1504(a), though without the exclusions of section 1504(b), and with regard to the expansive constructive stock ownership rules of section 31852 (as modified by section 304(c)(3)). The proposed regulations would include the quirks of the underlying attribution rules, but would imbue them with far greater significance. For purposes of this comment, we assume that Prop. Treas. Reg. § 1.385-1(b)(3)(i)(B) would be expanded to substitute "directly or indirectly" in lieu of "directly" in section 1504(a)(1)(B)(ii) (the proposed regulations currently refer solely to section 1504(a)(1)(B)(i)).53

A few examples of how far these rules could extend:

  • U.S. corporation X and foreign corporation Y, each a publicly traded corporation with multiple subsidiaries, engage in a joint venture through a 50-50 ownership of the stock in Z, a corporation. Under section 318(a)(2)(C), each of X and Y would be treated as owning 50 percent of Z and its subsidiaries. At the same time, under section 318(a)(3)(C), Z and its subsidiaries would be treated as owning 100 percent of the stock of all of the X subsidiaries and 100 percent of the stock of all of the Y subsidiaries.54 The result -- the X and Y subsidiaries would be part of an expanded group with Z as the parent corporation, and a debt instrument issued by an X subsidiary to a subsidiary of Y could be subject to recharacterization under the funding rule.55 In addition, Z and its subsidiaries would be included in two "modified expanded groups," one with X as the parent corporation and the other with Y as the parent corporation.56

  • X and Y from the prior example each own, say, a one percent interest in partnership PRS, with the other 98 percent of the interests held by unrelated persons. PRS directly owns the stock of corporation Z, and Z conducts substantial business operations directly and through multiple subsidiary corporations. Under section 318(a)(2)(A), X and Y are each treated as owning its proportionate share of the stock of Z corporation and its subsidiaries, an intuitive result that presents no unusual issues. However, under section 318(a)(3)(A) (which lacks a proportionality rule and a de minimis threshold), PRS is treated as owning 100 percent of the stock owned by each of X and Y, and Z is treated as owning 100 percent of this stock under section 318(a)(3)(C) (with reattribution under section 318(a)(5)(A)). While section 318(a)(5)(C) can preclude partner-to-partner reattribution of stock through a partnership, the provision does not apply to preclude reattribution to Z in this example. If X happened to be a financial institution, and Y happened to be a conglomerate that was a customer of X's, debt between X's subsidiaries and Y's subsidiaries would be subject to the funding and per se rules, because they all would be a part of the Z expanded group, even though to any impartial observer the X and Y subsidiaries would be in an arm's length relationship. This, solely because X and Y happened to hold relatively modest, non-controlling interests in the same partnership -- interests to which the relevant loan officers and in-house treasury/finance personnel might give little weight, even if they were somehow to know about it.57

 

The fact patterns outlined above might seem absurd. However, dozens of U.S. and foreign multinational corporate groups have formed significant joint venture businesses with corporate and partnership formats. Some of these could be quite large, such as those in the energy industry (including co-ownership of oil and gas properties treated as partnerships for tax purposes). And some of them involve financial institutions, where the likelihood that a customary banking relationship could be picked up in the rules seems not at all remote. In addition, the expansive definition of a corporation for purposes of the EG definition potentially could include certain sovereign wealth funds (potentially, a foreign per se corporation under section 892(a)(3)), pension funds, exempt organizations, and numerous private equity investors. Many of these joint ventures will have some related-party debt in their structure. Also, in many of these ventures, either there will be co-venturers with potentially conflicting interests as to ownership (e.g., a 50-50 corporate joint venture ownership arrangement), or the attributive link will run through a minority partnership interest that imparts no realistic possibility of controlling the joint venture's structure or financing. And in either of these contexts, there is no reasonable tax policy to be served by extending the reach of the proposed regulations, especially in light of the costs and complexities.

Moreover, in numerous circumstances, the proposed regulations could create "hook equity," which could in many fact patterns implicate latent ambiguities in the constructive ownership rules

 

Example. USP owns 100 shares in CFC1 worth $100, and CFC1 owns 100 shares in CFC2 worth$80, and CFC2 owns a debt instrument issued by CFC1 that is worth $150 and that has been recharacterized as stock in CFC1.

 

USP's actual stock ownership in CFC1 would represent less than 50 percent of the value of the CFC1 "stock" when taking the CFC1 recharacterized debt instrument into account. It is not immediately apparent whether or to what extent USP would be treated as constructively owning the reclassified "stock" in CFC1 that CFC2 owns, or any of the actual stock in CFC2 that CFC1 owns.58 Because of the "vote or value" rule in Prop. Treas. Reg. § 1.385-1(b)(3)(i)(C), we would expect that USP and CFC1 would be part of an EG59 and that CFC1 and CFC2 would be part of an EG, but are not sure whether USP and CFC2 would be part of the same EG. These and similar attribution through hook equity issues are alluded to in the tax literature,60 but currently do not arise often in practice. We would expect the proposed regulations to increase the frequency with which these issues occur, with their attendant complexity.
  • 2. Recommendations
  • Consider defining an expanded group through the prism of the section 1563(a) controlled group rules rather than the section 1504(a) affiliated group rules, in order to avoid back attribution and some of the other issues.

  • In applying the proposed regulations, consider eliminating back attribution, perhaps through a rule similar to that in Temp. Treas. Reg. § 1.337(d)-3T(c)(2)(i). Alternatively, modify the back attribution rule of section 318(a)(3)(C) (the rule that treats a corporation as owning 100 percent of the stock owned by its shareholder, if the shareholder owns 50 percent or more of the stock in the corporation) to provide that the corporation owns a proportionate amount of the stock owned by the shareholder. This is similar to the rule in section 304(c)(3)(B) with respect to shareholders who own between 5 percent and 50 percent of the corporation's stock.

  • Similarly, in applying the proposed regulations, modify the back attribution rule of section 318(a)(3)(A) (the rule that treats a partnership as owning 100 percent of the stock owned by a partner) to provide that the partnership is to be treated as owning a proportionate amount of the stock owned by its partner.

  • Alternatively, add an override rule that that would provide that notwithstanding the general constructive ownership rules, two entities will not be in the same expanded group unless one of the entities has a direct or indirect ownership of 80 percent or more in the other, applying proportionality principles.

  • Provide guidance regarding the application of the rules of section 318 in the context of hook equity.

  • D. Over-Expansive Definition of EG -- S Corporations and Other Entities

     

    1. Discussion
The proposed regulations define an EG to include S corporations.61 In our experience, S corporations can include large corporate enterprises, which is reflected in government statistics.62 Also, in our experience, a number of large S corporations own stock in C corporations. The various dollar thresholds in the proposed regulations cannot be counted on to screen out all S corporations from the rules.

We are concerned that applying the rules in the proposed regulations could present an existential threat to the S corporation status of a large S corporation and could cause other collateral consequences. We cannot imagine that Congress intended such results in enacting section 385.

  • Assume individual A owns stock in corporations X and P.63 X is an S corporation, and P is a C corporation and the parent of an affiliated group of corporations. P (or one of its subsidiaries) loans funds to X in exchange for an exempt group instrument (EGI). If the EGI is recharacterized as stock (either under the documentation and substantiation rules or the general and funding rules), X's status as an S corporation will terminate. This is because P is not an eligible shareholder, thus violating section 1361(b)(1)(B). It may also be the case that the EGI would be treated as a second class of stock, thus violating section 1361(b)(1)(D) and potentially not qualifying for the "straight debt" safe harbor of section 1361(c)(5).

  • Assume X, an S corporation, owns all of the stock of a P, a C corporation, and P is the parent of an affiliated group of corporations. P (or one of its subsidiaries) loans funds to X in exchange for an EGI. If the EGI is recharacterized as stock, X's status as an S corporation will terminate (as noted in the example above). In addition, X would no longer be described in section 1504(b)(8), with the result that the P consolidated group would terminate (due to its acquisition by another C corporation, i.e., X).

 

In the latter example, it is ironic that if X were to elect to file consolidated returns, the EGI that triggered the consequences would become a "disregarded" consolidated group debt instrument under Prop. Treas. Reg. § 1.385-4(c) and thus would no longer be treated as stock of X. As a result, X would no longer have an ineligible shareholder (or potentially a second class of stock). X could become eligible to make a new S corporation election, but if it did so the EGI would revert to stock status, and if so the cycle noted above would repeat.

In either situation, the effect would be to terminate the S corporation election for X. In the absence of a specific Congressional directive, we do not believe that the Treasury Department or Service intend to use, or that it is proper to use, "anti-inversion" regulations as a tool to attack the S corporation status of a large corporate enterprise. In addition, if the Treasury Department and Service believe that there is some abuse with debt instruments issued by S corporations, they should evaluate, make appropriate evidence-based findings, and articulate the findings and squarely address the rationale in the preamble. Similarly, we do not believe that tax-exempt corporations,64 RICs, REITs, or other entities referenced in section 1504(b) should be included in the ambit of the rules. If the Treasury Department and Service disagree and decide to include these entities within the scope of the proposed regulations, then it is incumbent upon them to articulate the issue and articulate evidence-based findings in the preamble justifying the unusual application.65 We recognize that, at the conceptual level, there might be some opportunity for base erosion with respect to some of these entities, and that for completeness such entities should be included in rules of general application. Nonetheless, the Treasury Department and Service should not lose sight of the practical; a conceptual purity must be weighed against the strong and longstanding tax policies inherent in the special, Congressionally-provided tax status of these entities. We do not believe that these entities should be at risk of losing their Congressionally-authorized tax status simply because of a debt instrument issued to a related-party, in the absence of compelling justifications. The debt-equity conundrum of section 385 does not present such a justification. Moreover, the Treasury Department and Service should consider a broader range of policy issues in determining whether the proposed regulations should apply to corporations that are instrumentalities of the government of a state or U.S. possession (and political subdivisions of such governments) the income of which is exempt under section 115, or to sovereign wealth funds.

  • 2. Recommendations
  • Exclude S corporations, as well as certain other entities, from the ambit of the proposed regulations (i.e., revise Prop. Treas. Reg. § 1.385-1(b)(3)(i)(A) so that it only "turns off" paragraph (3) of section 1504(b)).

  • Alternatively, issue regulations under section 1361(c)(5)(C) to provide that a debt instrument issued by an S corporation can qualify for the "straight debt safe harbor" of section 1361(c)(5), and if it so qualifies it will not be treated as stock for purposes of subchapter S, regardless of whether the debt instrument may have been recharacterized as stock under the general, funding, or per se rules of Prop. Treas. Reg. § 1.385-3(b).

  • Undertake fact findings to determine whether there is an abuse potential that justifies subjecting tax-exempt and pass-through corporate entities to the burden of complying with the Prop. Treas. Reg. § 1.385-3 rules, and in particular with needing to closely guard against a potential loss of their special tax status, simply because the entity issues a debt instrument to a related-party and, within the 72-month window of the per se rule, acquires EG member stock.

  • E. Effect on Deemed Paid Foreign Tax Credits under Section 902

     

    1. Discussion
Foreign tax credits have been allowed for almost 100 years, to reduce double taxation of income.66 Under section 902(a), a domestic corporate taxpayer which owns 10 percent or more of the voting stock in a foreign corporation from which it receives dividends in a taxable year is deemed to have paid a proportion of the foreign corporation's foreign taxes. A problem arises under the proposed regulations if a debt instrument with traditional terms is recast as stock, when the holder does not otherwise own 10 percent of more of the voting stock of the issuer.

 

Example. USP owns USS1 and CFC1 (as brother-sister corporations). CFC1 is an operating company that has significant earnings and profits and some amount of associated foreign taxes. CFC1 borrows funds from USS1 in an amount in excess of 10 percent of the equity value of CFC1 in exchange for a debt instrument with straightforward terms (and no voting rights), and in a later year the CFC1 debt instrument is reclassified as stock under the funding rule.

 

USS1 owns no stock in CFC1 apart from the CFC1 reclassified debt instrument, which confers no voting rights. When CFC1 pays interest on the debt instrument, it would be treated as making a dividend payment to USS1. When CFC1 retires the debt instrument, it would be treated as redeeming its stock in a dividend-equivalent redemption under section 302(d). However, USS1 did not and does not own 10 percent or more of the voting stock in CFC1, and USS1 is not allowed to aggregate its "stock" ownership with that of USP.67 Thus, USS1 cannot qualify for a deemed paid credit under section 902.68 Further, it seems clear that the foreign tax credits associated with the distribution disappear for U.S. tax purposes.69

Congress did not envision that regulations would be written under section 385 to preclude a taxpayer's ability to claim foreign tax credits that otherwise would have been available, simply because a foreign subsidiary had issued a straightforward debt instrument to a related-party. Similarly, there is no indication that Congress envisioned, when it enacted section 909, that regulations would be written under section 385 to create foreign tax credit splitting events.

There seem to be two obvious ways to mitigate the issue. First, treat the holder of the recharacterized debt instrument as a shareholder that is entitled to deemed paid credits, either through a stock aggregation rule (such as Treas. Reg. § 1.1502-34 or by means of the attribution allowed for foreign tax credit purposes in section 304 transactions70) that would apply for purposes of section 902 or through a rule that would treat a recharacterized debt instrument as voting stock for section 902 purposes. This result is not ideal, however, because it would have the effect of sprinkling foreign taxes across a range of related parties, substantially complicating foreign tax credit calculations (which are far from simple to begin with). In addition, treating a recharacterized debt instrument as voting stock (without providing the attribution allowed for foreign tax credit purposes in section 304 transactions) would not mitigate the issue if the value of the recharacterized debt instrument was less than ten percent stock ownership in the issuer.

We note there is administrative precedent for adopting an approach similar to this first alternative. In Rev. Rul. 91-571 and Rev. Rul. 92-86,72 the Treasury Department and Service addressed whether section 902 credits should be available for deemed dividends arising from dividend equivalent section 304 stock sales, when selling shareholder of the issuing corporation did not directly own any stock in the acquiring foreign corporation. The rulings cite to legislative history of the 1984 amendments to section 30473 to support the result that the selling shareholder is entitled to a section 902 credit to the same extent. Unlike the cases in those rulings, there is no oddity regarding that the dividend is considered to come directly from the redeeming affiliate. Thus, the policy consideration that motivated the issuance of those rulings -- viz., that the "relatedness" that caused dividend treatment despite the lack of actual stock ownership ought to in fairness be imputed for purposes of section 902 -- is even stronger in this case.

A second way to address the issue that is also not ideal but better than a loss of credits would be to disregard the recharacterized debt instrument for purposes of section 902. This would retain the foreign taxes at the issuer level for use by its actual stockholders, though it would at best have the effect of potentially accelerating U.S. income taxation and deferring the use of foreign taxes.

In this latter regard, we note that the preamble to the proposed regulations specifically requests comments on the treatment of recharacterized debt as "U.S. equity hybrid instrument" splitter arrangements under Treas. Reg. § 1.909-2(b)(3)(ii).74 The tone of the request suggests that the Treasury Department and Service fully expect that such instruments will be subject to the section 909 rules, despite acknowledging the potential "proliferation" of such creatures. We do not believe that instruments recharacterized under section 385 are the types of events or transactions that section 909 was intended to address (i.e., those that were intentionally structured to "separate away" the underlying income and earnings and profits from the associated foreign tax credits). Subjecting recharacterized debt instruments to the section 909 regime would be unduly burdensome for taxpayers to comply with, even more difficult for the Service to monitor and audit, and would further no principled tax policy objective. We therefore recommend that the Treasury Department instead use its authority under section 909(e) to exempt from section 909 splitter status all hybrid instruments arising from the government's own recharacterization mechanism in the proposed regulations.

  • 2. Recommendation
  • Revise the proposed regulations to ensure that foreign tax credits that would have been available but for the application of the proposed regulations will continue to be available, without accelerating U.S. income taxes or causing double taxation of foreign source income. The revisions also should address foreign tax pool dilution issues.

  • F. Effect of Recharacterized Debt Instruments on Various Control Requirements

     

    1. Discussion
Numerous provisions of the Internal Revenue Code are premised upon a transferor or an issuer owning stock that possesses a certain quantum of voting rights and value in a corporation, or upon an acquirer acquiring such a quantum of stock. For example, a person who transfers appreciated property to a corporation in exchange for stock in the corporation can qualify for non-recognition treatment under section 351 if the transferor is in control of the transferee corporation. For this purpose, control is defined in section 368(c) as ownership of stock that possesses at least 80 percent of the total combined voting power of all classes of voting stock and the ownership of at least 80 percent of the total number of shares of each class of outstanding non-voting stock.75 Similarly, a corporation can acquire the stock or property of an unrelated corporation in a tax-free reorganization under section 368(a)(1) using stock of its parent corporation, provided the parent corporation is in control of the acquiring corporation.76 For this purpose, the same section 368(c) control definition applies. In addition, to acquire the stock of a target corporation in a tax-free reorganization, the acquiring corporation must either acquire control of the target corporation77 or acquire an amount of stock in the target corporation that constitutes control in exchange for parent voting stock.78 The section 368(c) control definition is also relevant for purposes of a tax-free spin-off, split-off, and split-up under section 355.79 Under any of these provisions, the presence of a single recharacterized debt instrument that does not confer voting rights can defeat "control," and thus can result in a taxable transaction. To be clear, the control requirement applies to reorganizations involving previously unrelated target corporations as well as transactions amongst commonly controlled entities. It is difficult to imagine what rational tax policy could, on balance, mandate a taxable transaction result in the face of the Congressional purposes underlying the incorporation and reorganization provisions.80 Ironic, perhaps, that while the proposed regulations would treat debt as stock, the current Administration is asking Congress to repeal rules that treat stock as debt, due to a concern that taxpayers can structure into taxable transactions.81

Similar concerns occur with respect to provisions that contemplate ownership of stock that satisfies the requirements of section 1504(a)(2). For example, a tax-free subsidiary liquidation requires the parent corporation to directly own such stock in a liquidating subsidiary,82 a section 336(e) qualified stock disposition and a section 338 qualified stock purchase trigger off the section 1504(a)(2) standard, and of course the standard is key to determining the composition of an affiliated (and thus a consolidated) group.83 In cases of "straight debt" debt instruments that bear adequate stated interest and have no voting rights, an equity recharacterization might not present an issue in the section 1504 context because the "plain vanilla stock" rules in section 1504(a)(4) could exclude such debt from the section 1504(a)(2) test. However, in certain circumstances, the exclusion would not be available.

 

Example. Foreign parent corporation FP owns USP, a domestic corporation. USP owns S1, and S1 borrows funds from USP in exchange for a debt instrument. If USP distributed the S1 debt instrument to FP and if it were to be recharacterized as "stock" under the documentation and substantiation rules, it might qualify as "plain vanilla preferred" equity and the USP-S1 consolidated group would not terminate.

 

However, if S1 was in some financial distress, the S1 debt instrument might be worth less than its face amount, creating is a risk that the recharacterized debt instrument84 would be viewed as having a redemption or liquidation right that exceeded a reasonable premium, and thus would not qualify for the "plain vanilla preferred" exclusion. The result might very well be to terminate the USP-S1 consolidated group, and to prevent S1 from being able to liquidate tax-free into USP.

We are deeply troubled that taxpayers that are planning a transaction might not be able to accurately determine section 368(c) control at the time of the transaction if the relevant entity has issued a related-party debt instrument, because the debt instrument could be recharacterized as equity with retroactive effect.85 For example, if FP owned all of the stock of FS1 and US1, US1 had issued a debt instrument to FS1 in January, and the entities were calendar-year taxpayers, the US1 debt instrument could be recharacterized as stock at the time of its issuance under the funding rule if the disfavored transaction that triggered the funding rule occurred in the same year (even if not until December).86 As should be evident by now, the potential for retroactive adverse tax results under this provision is a recurring source of uncertainty and a matter that urgently requires correction, if the proposed regulations are to be finalized.

 

Example. FP owns all of the stock of FS1 and US1. US1 is a holding company that is the parent corporation of a consolidated group, and it owns all of the stock of US2, a subsidiary member of its group. US2 owns multiple lower-tier consolidated subsidiaries. On January 1 of Year 2, US2 issues a $100 debt instrument to FS1. The debt instrument is properly documented, and confers no voting rights. On December 31 of Year 2, when US1 estimates that it will have $30 in current year earnings and profits, US1 distributes $25 to FP as a dividend in reliance on the current year earnings and profits exception in Prop. Treas. Reg. § 1.385-1(c)(1). In September of Year 2, US1 transfers a group of appreciated and loss properties to US2, in an exchange it believes will qualify for nonrecognition treatment under section 351. In Year 4, after an IRS audit, a $40 deduction claimed for Year 1 by a lower-tier subsidiary below US2 is disallowed for that year, and instead is allowed for Year 2. The earnings and profits adjustment tiers up through US2 to US1, and as a result, US1's Year 2 earnings and profits are retrospectively eliminated under Treas. Reg. § 1.1502-33.

 

In the example, neither US1 nor US2 would have had any current year earnings and profits after the audit adjustment; thus $25 of the US2 debt instrument would be recharacterized as stock (presumably, as stock in US2) under the funding rule, effective as of the time of its issuance on January 1 of Year 2. Prop. Treas. Reg. § 1.385-3(d)(1)(i). After the issuance of the US2 "non-voting stock," US1 would not possess section 368(c) control of US2, and its transfer of properties to US2 in September of Year 2 would not qualify for non-recognition treatment.

Alternatively, if two years after the issuance of a debt instrument the Service were to determine that the documentation requirements had not been fully satisfied, perhaps due to a failure to undertake and memorialize a sufficiently robust financial due diligence (or perhaps through the type of inadvertent error that would normally justify section 9100 relief but that could not qualify under the narrowly drafted reasonable cause exception of Prop. Treas. Reg. § 1.385-2), the debt instrument could be recharacterized as stock upon its issuance.87

 

Example. T, a domestic target corporation, owns CFC. T also has 100 shares of stock outstanding,all owned by individual A. In Year 1, T issued a debt instrument to CFC. It is unclear whether the T debt instrument, which does not provide for voting rights, could be treated as stock under the documentation requirements of Prop. Treas. Reg. § 1.385-2. USP, which is not related to T or A, seeks to acquire T in a tax-free reorganization. To effect the acquisition, USP forms a merger corporation, which merges into T in Year 3. As a result of the merger, A receives solely shares of USP voting stock, and USP owns all 100 shares of T stock.

 

On its face, the transaction appears to qualify as a parenthetical or triangular section 368(a)(1)(B) reorganization, and as a reverse subsidiary merger qualifying for tax-free reorganization treatment under section 368(a)(1)(A) by reason of section 368(a)(2)(E). Each of these provisions, however, requires USP to acquire an amount of stock in T that satisfies the control definition in section 368(c), meaning stock possessing 80 percent or more of the vote and 80 percent or more of each class of nonvoting stock. If, upon audit, the T-CFC debt instrument is recharacterized as stock under the documentation rule, the recharacterization would be effective as of the Year 1 date of issuance. The result is to call into question whether in Year 3 USP acquired control of T -- even though USP acquired all 100 shares of T's outstanding stock, and indirectly acquired ownership of the T-CFC debt instrument.88

The proposed regulations are likely to upset the reasonable expectations of corporate groups planning certain transactions -- including transactions with unrelated parties -- all due to the potential for a retroactive recharacterization of a debt instrument.89 This result is certainly not compelled by the policies underlying the proposed regulations, and it cannot be squared with the longstanding policies underlying subchapter C's non-recognition provisions.90

  • 2. Recommendations
  • Provide that for purposes of the various control requirements, debt instruments recharacterized as stock under the proposed regulations would not be treated as stock and would be respected as debt, provided the debt instruments would qualify as indebtedness under general debt-equity principles.91

  • Alternatively, provide that a debt instrument will not be retroactively recharacterized as stock, for purposes of making a control determination.

  • G. Intercompany Payables or Distributions Arising Due to Tax Adjustments

     

    1. Discussion
Large multinational corporate groups routinely face transfer pricing and audit adjustments, some favorable, some unfavorable. Often, transfer pricing adjustments are made, which give rise to correlative adjustments. The proposed regulations should contain special rules to address how these correlative adjustments relate to the funding rule.

 

Example. USP owns USS, which owns CFC1, CFC2, and CFC3. In Year 1, CFC1 transfers $100 to USS in exchange for goods, services, or the use of intangible property. In Year 3, CFC1 issues a $250 debt instrument to CFC2 in exchange for $250 in local currency, and USS issues a $75 debt instrument to CFC3. In Year 4, the taxpayer and the Service agree (or it is determined in IRS Appeals or in litigation) that the proper transfer price was $90. As a correlative adjustment, the parties might agree that CFC1 made a $10 distribution to USS, or that USS has a $10 payable to CFC1.92

 

Would CFC1's $10 deemed distribution cause $10 of its Year 3 debt instrument to be recharacterized as stock under the funding and per se rules? If so, would this be effective as of the issuance of the Year 3 debt instrument, or at the time of the audit adjustment in Year 4? If the account payable route were chosen, could it be recharacterized as hook equity under the funding and per se rules? Would it be treated as arising in Year 1 when the underpayment was made, or in Year 4 at the time of the audit adjustment?93 Would it be treated as stock under the documentation rules of Prop. Treas. Reg. § 1.385-2, due to the failure timely and properly to document the overpayment as a loan (or, more absurdly, for failure to conduct a financial due diligence, ab initio)?

 

Example. The facts are the same as in the previous example, except that the proper transfer price was $110. The parties agree that as a correlative adjustment, USS made a contribution of $10 to CFC1, or CFC1 has a $10 payable to USS.

 

If CFC1 had paid too little for the goods, services or use of intangibles, might there be some deemed contribution of property from USS to CFC1? If so, is USS treated as having made a funded acquisition of $10 of CFC1 stock within the meaning of Prop. Treas. Reg. § 1.385-3(c)(3), with CFC1 as the successor to USP for purposes of the funding rule (and if so, when)?94

Similar issues can arise outside of the transfer pricing area. For example, if on audit it is determined that there has been a constructive distribution or contribution, might these constructive transactions implicate the funding, per se, and successor rules? For example, if in the example above, CFC1 had transferred some of its property directly to CFC2 without payment, CFC1 might be viewed under general tax principles as having made a constructive distribution to USS, which then made a constructive contribution to CFC2, equal to the value of the use of the property.

  • 2. Recommendations
  • Exempt any deemed contribution or distribution arising as a correlative adjustment from the ambit of the funding rule. This could be achieved through a specific exception to the definition of "debt instrument" in Prop. Treas. Reg. § 1.385-3(f) or, more broadly, through a global short-term (e.g., 90 day) indebtedness exception, which taxpayers using Rev. Proc. 99-32 could avail themselves of if they repay the accounts within 90 days of the closing agreement,95 as is required by the Revenue Procedure and on the basis that the indebtedness does not exist, if at all, until the closing agreement takes effect.

  • Provide similar rules with respect to other retroactive adjustments that could have the effect of triggering the application of the rules, such as an audit adjustment that finds a constructive contribution or distribution to have occurred.

  • H. Repayment of Intercompany Balances -- Determination of Dividend Equivalency

     

    1. Discussion
The complexity of the proposed regulations is on display when one considers the many potential consequences of the repayment of a reclassified debt instrument. Some of this is discussed above in connection with cash pooling and treasury center arrangements, and below in connection with the duplication, cascading and evergreen effects. We make the following, additional observations.
  • Due to the broad constructive ownership rules that apply for purposes of testing under section 302, it is anticipated that in most circumstances, the repayment of a debt instrument that has been recharacterized as stock would be treated as a dividend-equivalent redemption by reason of section 302(d) or section 306(a)(2). We understand this to be consistent with the Treasury Department's intent. In this context, the holder's "stock basis" in the recharacterized debt instrument should not disappear,96 but rather should in effect be transferred to and included in an actual shareholder's stock basis in the issuer, pursuant to Treas. Reg. § 1.302-2(c).97 This would result in the very basis shift that the Treasury Department and Service targeted in the 2009 "big basis" proposed regulations package,98 and tried to eliminate in the 2002 stock basis proposals,99 yet stock basis shifts would occur with much greater frequency as a direct result of the proposed regulations.

  • Some redemptions might not be dividend equivalent, however, because of a limited rule that precludes a corporation from being treated as owning its own stock. For example, assume USP owns CFC1, CFC1 owns CFC2, and a debt instrument issued by CFC1 to CFC2 is recharacterized as stock in CFC1 under the funding rule. When CFC1 repays its recharacterized debt instrument, it is redeeming hook equity owned by its shareholder CFC2. CFC2 does not actually own any stock in CFC1, nor does it constructively own any of the stock in CFC1 that is actually owned by USP;100 thus, because CFC2 would be treated as having all of its stock in CFC1 redeemed, the redemption would be treated as a sale or exchange from the perspective of CFC2 by reason of section 302(a), and no dividend consequences would result.

  • Some redemptions might be effected through an offset of reciprocal positions.101

  • Example. USP owns CFC1 and CFC2, CFC2 owns CFC3. CFC1 had issued a debt instrument to CFC2 that had been recharacterized as stock in CFC1, and CFC3 had issued a debt instrument to CFC1 that had been recharacterized as stock in CFC3. To "clean up" the intercompany debts, CFC2 contributes the recharacterized CFC1 debt instrument to CFC3. Thereafter, the two debt instruments are offset under local law.102

 

The tax characterization of the offset transaction is not free from doubt. In the example above, each corporate entity involved in the offset would be simultaneously acting both in its capacity as a corporation redeeming its stock held by a shareholder, and in its capacity as a shareholder having the stock it owns redeemed by the issuing corporation. The Service has not issued any guidance on concurrent section 302(d) redemptions in 35 years, and the limited pre-General Utilities repeal guidance was obsoleted more than a decade ago.103 In this fact pattern, would any gain or loss be recognized by a redeeming corporation under section 311? What would happen to the "stock" basis each entity had in the "stock" of the other? What would happen to the earnings and profits of each entity, as well as foreign taxes associated with those earnings and profits? If the two debt instruments each had a value of $100, CFC1 had $5 of earnings and profits, and CFC2 had no earnings and profits, would the transaction result in an iterative earnings and profits calculation, such that both CFC1 and CFC2 would each have $100 in current earnings and profits at the end of the taxable year?104
  • 2. Recommendations
  • Add rules that would provide guidance relating to the movement and location of earnings and profits (and associated foreign taxes) in situations when reciprocal recharacterized debt instruments are redeemed in the same taxable year or are offset.

  • Provide an example to confirm a holder's basis in a recharacterized debt instrument that is redeemed in a dividend-equivalent redemption under section 302(d) or section 306(a)(2) will augment basis of actual stock (and recharacterized debt instruments) in the issuer. The proposed regulations should also provide a methodology to address the situation when the issuer has multiple EG-member shareholders, and perhaps also cover the situation when there are multiple classes of stock (including one or more recharacterized debt instruments).

  • I. Repayment of Intercompany Balances -- Duplication, Cascading and Evergreen Issues

     

    1. Discussion
We would expect the repayment of a recharacterized debt instrument, in most circumstances, to be treated as a section 302(d) redemption or a section 306(a)(2) redemption, and thus as a section 301 distribution. There is nothing in the per se rule, however, that would exclude or "turn off" the original transaction that caused the recharacterization of the debt instrument from continuing to cause mischief, presenting the potential for duplication.105 In addition, the recharacterization of a debt instrument as stock is viewed as though the lender had acquired stock in the EG member that issued the debt, creating risk for the lender's own debt instruments to be recharacterized as stock under a cascading application of the funding and per se rules. Finally, payments of interest and principal on a recharacterized debt instrument themselves are characterized as distributions, each of which is vulnerable to being linked with another debt instrument under the per se rule, creating an evergreen effect.

 

Example. Assume FP owns FS1 and FS2, FS1 owns US1, and FS2 owns US2. In Year 1, US1 borrows $100 from FS1 and issues a debt instrument to FS1. In Year 2, US1 pays an $80 dividend to FS1 out of its accumulated earnings and profits. In Year 3, US1 transfers $100 to FS1 in satisfaction of the Year 1 debt instrument. In Year 4, US1 borrows $175 from US2 and issues a debt instrument to US2. All of the loans are properly documented, and no exceptions from the proposed regulations apply.

 

In Year 2, when the $80 dividend distribution is made, the distribution is linked to the $100 Year 1 debt instrument under the per se rule in Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(1). The result is that (i) $80 of the $100 Year 1 debt instrument would become treated as stock under the funding rule in Prop. Treas. Reg. § 1.385-3(b)(3)(i), and (ii) for purposes of the per se and funding rules, FS1 has now acquired EG member stock. This latter result could have a cascading effect given the extraordinary reach of the funding and per se rules, and could cause debt instruments issued by FS1 to be subject to recharacterization under the funding and per se rules.

In Year 3, when the Year 1 debt instrument is repaid, $80 of the repayment would be treated as a redemption of the "stock" portion and $20 as satisfaction of the "debt" portion. The $80 redemption would be treated as a dividend equivalent redemption under section 302(d) or section 306(a)(2), and thus as a distribution for purposes of section 301 and the proposed regulations. This creates an evergreen effect, as each payment of interest and principal effectively triggers a new 72-month, per se rule period. In the example, the $80 "redemption" would cause a portion of the Year 4 debt instrument to be recharacterized as equity. If that was a 10-year debt instrument, its repayment in Year 14 would be a further distribution, placing US1 debt instruments issued in Years 11-17 at risk of stock recharacterization. In this manner, a single $80 distribution in Year 2 could cause successive US1 debt instruments to face recharacterization in years to come.

When US1 issues a new $175 debt instrument in Year 4, the per se and funding rules would apply to recharacterize it as stock in whole or in part. It is unclear whether a recharacterization would be triggered by reason of the Year 2 dividend distribution, or by reason of the Year 3 dividend-equivalent redemption that occurred when the Year 1 debt instrument was repaid, or by both. Both distributions are within the 36 months preceding the issuance of the Year 4 debt instrument, and there is nothing in the per se rule or any other rule that tells us to disregard either the Year 2 distribution or the Year 3 dividend-equivalent redemption for this purpose.

In particular, we note that the entire Year 2 distribution of $80 was already fully "linked" to the Year 1 loan of $100 and this linkage served as the basis for recharacterizing $80 of the Year 1 debt instrument. The premise for this result is that under the per se rule, $80 of the Year 1 loan was issued with a principal purpose of funding the Year 2 distribution. Having reached this conclusion, how can any of the Year 4 debt also be considered to have been issued with a principal purpose of funding the same Year 2 distribution, when all $80 of the Year 2 distribution was already considered to have been funded by the Year 1 debt. Read literally, however, there is no "coordination" rule that prevents the Year 2 distribution from serving "double duty" of multiple linkages under the per se rule and funding rules in this context.106 The result is particularly arbitrary because if the Year 1 loan had not been repaid at the time of the Year 4 borrowing, such that there was not a new deemed distribution in Year 3, Prop. Treas. Reg. § 1.385-3(b)(iv)(B)(3) would provide that the Year 2 distribution was linked only to the Year 1 loan and was not "free" to also be linked at the same time to the Year 4 loan. Although a post-Year 4 repayment of the Year 1 loan would create a new distribution at that time that could be linked to the Year 4 loan, no rule authorizes (or precludes) a "re-testing" of the Year 4 loan vis-à-vis the Year 2 distribution upon the repayment of the previously linked principal purpose debt instrument from Year 1.107

Perhaps more than any other aspect of the proposed regulations, the foregoing results would represent an egregious overstepping of the government's discretion and authority in interpreting and issuing guidance under section 385. Even if one concedes (which we do not) that it is valid for debt to be characterized as equity under the funding rule, the idea that multiple debt instruments could each be recharacterized on the premise of having had a principal purpose of (fully) funding the same funding rule transaction prima facie defies logic, to say nothing of any principled tax policy objective. Moreover, FS1 would have $160 in dividend income, even though the "substance" involves a single $80 distribution. This is because the $80 Year 2 distribution would retain its character as a dividend, as provided in Prop. Treas. Reg. § 1.385-3(b)(3)(vi) (providing that the acquisition or distribution treated as funded with a debt instrument under the funding rule is itself not recharacterized as a result of the treatment of the debt instrument as stock).

Returning to the example, the ordering rule in Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(4) specifically provides that if a debt instrument can be treated as funding two or more distributions, it is treated as funding distributions and acquisitions based on the order in which they occurred; however, because the issue price of the Year 4 debt instrument exceeds both the amount of the Year 2 distribution and the Year 3 dividend-equivalent redemption, it would not preclude a duplication. If both distributions, notwithstanding the forgoing, are to be taken into account (given that both occurred within the 36 months preceding the issuance of the Year 4 debt instrument), then $80 of the $175 Year 4 debt instrument would be recharacterized as stock by reason of the Year 2 distribution, and an additional $80 of the $175 Year 4 debt instrument would be recharacterized as stock by reason of the $80 Year 3 dividend-equivalent redemption. The result is that a single $80 distribution (or equity reduction) has now tainted $160 of the Year 4 related-party debt -- a duplication effect. And this after the Year 2 distribution already recharacterized $80 of the Year 1 debt, such that the single $80 Year 2 distribution ultimately resulted in $240 of recast debt! While we would argue for an interpretation of the rules that does not permit arbitrary and unprincipled duplication results of this type, duplication is improper and it would be far preferable for the final rules to explicitly confirm this result.

An additional duplication issue is discussed in the Appendix.

  • 2. Recommendations
  • Provide an anti-duplication rule. It might be possible to accomplish this by clarifying that the multiple interests rule in Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(3) that associates a distribution with respect to the first available debt instrument continues to apply even after the first instrument is retired, such that it does not thereafter also taint another debt instrument. Moreover, consider the cascading and evergreen issues, and whether a rule or a mechanism could be devised to minimize disruptions these issues could cause.

  • J. Repayment of Intercompany Balances -- Other Issues

     

    1. Discussion
The proposed rules facilitate the sideways movement of earnings and profits (including when favorable to taxpayers) by mechanically requiring the movement of such earnings and profits upon repayment of most recharacterized debt instruments. This could have results similar to those intended to be prevented by the fast pay regulations.108 While the fast-pay regulations do not apply when the arrangement was not structured with the objective of moving earnings and profits through repayments of debt,109 the ubiquity of such cross-chain equity instruments would automatically maximize the movement of such earnings and profits, regardless of intent.

The no affirmative use rules create unmanageable uncertainty. As one of many possible examples:

 

Example. USP owns USS1 and CFC1, and USS1 owns CFC2. During Year 1, CFC1 issues a $150 debt instrument to CFC2 that is recharacterized as stock in CFC1. Assume that at the time CFC1 issued its debt instrument to CFC2, USP and CFC1 employees were aware that the CFC1 debt instrument could be recharacterized as stock, and that USP would subsequently seek one or more distributions from CFC1 and/or CFC2 (the latter, via USS1). In Year 5, when CFC1 has $100 of earnings and profits and CFC2 has no earnings and profits, CFC1 transfers $150 to CFC2 to repay its debt instrument.

 

It is unclear whether either CFC can make a distribution of its own cash without triggering a dividend. If the USP corporate group tax department was aware of the possibility that the CFC1 debt instrument could be recharacterized as stock under the proposed regulations, and if there might be some attendant tax savings (such as a return-of-capital distribution from one of the CFCs vs. a dividend distribution from the other CFC), can the tax department have confidence that the proposed regulations would apply? For purposes of the no affirmative use rule, how are the tax benefit to be measured? The no affirmative use rule in Prop. Treas. Reg. § 1.385-2(d) looks to the federal tax liability of any EG member or members (or that of "any other person relying on the characterization of an EGI as indebtedness for federal tax purposes"), but what if the aggregate U.S. federal income tax liabilities of the EG as a whole in each taxable increases as a result? Or if there is a decrease in Year 1, but an equal or a larger increase in Year 2, such that there is no net reduction or even a net increase? The no affirmative use rule in Prop. Treas. Reg. § 1.385-3(e) looks to the federal tax liability of any EG member, again without any reference to the aggregate tax liability of the EG in any particular table year or the net tax liability for the EG over a term of years.

If the proposed regulations were to apply in the example above, the mechanical rules would treat CFC1's retirement of its debt instrument as a $100 dividend distribution to CFC2 under sections 302(d) and 301(c)(1) (and as a $50 return-of-capital distribution under section 301(c)(2)), with the result that CFC2 would have the $100 of earnings and profits formerly held by CFC1. However, under the affirmative use rule, CFC1 might have retained its earnings and profits notwithstanding the dividend-equivalent "redemption" of its debt instrument. Should USP create a series of tax projections for all of the EG members, including the potential for the application of the PTI rules, section 1248 and section 964(e), the ability to use foreign tax credits, etc.? Or is it enough that the movement of earnings and profits from CFC1 to CFC2 would create the opportunity for a return-of-capital distribution from CFC1 to USP (without considering whether that should be offset by any increase in USS1's tax liability with respect to any distribution from CFC2)? Taxpayers would be hard pressed to gauge their tax position.

  •  

    2. Recommendations

  • Eliminate the no affirmative use rules.

  • Provide rules that clarify the application of the earnings and profits rules. Given the significant complexities of the proposed regulations, it is difficult to make recommendations that could address all of the potential fact patterns. However, at a minimum, it should be made clear that the aggregate amount of earnings and profits within an EG should not be increased as a result of cross-redemptions.

  • In addition, a rule should be provided that taxpayers who make good faith estimates as to the location of earnings and profits will not be penalized if their estimates turn out to be incorrect.

  • Clarify that the fast-pay rules would not apply to a debt instrument that is recharacterized as stock under the proposed regulations.

  • K. Current Year Earnings and Profits Exception110

     

    1. Discussion
We commend the Treasury Department and Service for including a few exceptions partially to ameliorate the general, funding and per se rules, such as the current year earnings and profits (CYEP) exception in Prop. Treas. Reg. § 1.385-3(c)(1). We recommend a few modifications to the CYEP rule to allow it to serve a more useful function.

The principal difficulty with the rule is that the amount of a corporation's earnings and profits for a particular year might not be determinable with any degree of certainty for some period of time after the close of the taxable year. For example, a calendar-year corporation that seeks to make a distribution in, say, March of a year cannot know for sure what its business results (let alone its net income) will be for the year. Given the effect of the ordering rule in the second sentence of Prop. Treas. Reg. § 1.385-3(c)(1), a corporation might choose to defer making distributions until the end of the taxable year, to avoid limiting its ability to use the CYEP exception. (Additionally, the corporation will remain vulnerable to adjustments that occur after the close of the year, such as adjustments that arise due to an audit adjustment.) Moreover, as discussed elsewhere in our comments, a corporation might have issued and repaid a debt instrument in a particular year, only to have the note retroactively recharacterized later in the same year as stock (due to a subsequent distribution, acquisition of EG member stock, or other transaction), with the result that repayment of the debt instrument is retroactively characterized as a distribution (thus absorbing earnings and profits for purposes of the CYEP exception).

In other contexts, Congress has enacted rules that contemplate that certain entities will distribute most or all of their current earnings and profits. Examples include the REIT and RIC regimes. In addition, Congress has enacted certain penalty rules when a corporation that accumulates too much earning and profits will face a penalty tax unless it makes a distribution. In these situations, Congress has enacted rules to provide a grace period, allowing the affected entities the opportunity to make their distributions within, say, 75 days after the close of the taxable year. Such a rule enhances administrability and certainty. If the CYEP exception is not expanded in accord with our recommendation below, we would recommend a similar 75-day grace period be added to the rules to make the CYEP exception more "workable" for taxpayers. However, we recognize that coordinating rules might need to be added with respect to a distribution made during the period.

 

Example. CFC1 has earnings and profits of $100 in each of Years 1 and 2. CFC1 makes $75 of distributions during Year 1, and $120 of distributions during Year 2, of which $30 occurs in January of Year 2.

 

Overall, the $195 of distributions in Years 1 and 2 are less than the $200 of earnings and profits generated in those years. The $75 in Year 1 distributions should qualify for the CYEP exception in Prop. Treas. Reg. § 1.385-3(c)(1). The $120 in Year 2 distributions exceed the Year 2 earnings and profits. A rule could be written to allow the first $25 of the $30 distribution in January of Year 2 to qualify for the CYEP exception for Year 1. Coordination rules would then be advisable to address distributions made during the early part of a table year, so that it is clear to which year or years the distributions relate.

As a more limited and less preferable alternative, it would be simpler to provide corporations an election to use CYEP or prior year earnings and profits, to exempt distributions made in a year to the extent of CYEP or the current year's earnings and profits for the immediately preceding year. This would not require any special coordination rules to address the potential for a particular distribution to be matched to earnings and profits of more than one year.

  •  

    2. Recommendations

  • Modify the CYEP exception to allow taxpayers to elect to use CYEP or an entity's earnings and profits of the immediately preceding year. We note that since April 4, some taxpayers may have relied on the proposed regulations to determine the consequences of applying the -3 recharacterization rules. Such taxpayers should be allowed to rely on the proposed regulations' description of the CYEP exception. Accordingly, the Treasury Department and Service should expressly allow taxpayers to apply the proposed regulations' rules for taxable years beginning before the finalization of the -3 rules.

  • L. Dividends Received Deduction

     

    1. Discussion
A payment of interest on a debt instrument that has been recharacterized as stock under the proposed regulations would be treated as a dividend, to the extent the issuer has current or accumulated earnings and profits. Similarly, most redemptions of a recharacterized debt instrument are expected qualify as a dividend-equivalent redemption under section 302(d) or section 306(a)(2).

In general, a corporation that receives a dividend and that is otherwise subject to tax on its receipt of the dividend is entitled to claim a dividends received deduction under section 243. The U.S. generally employs a classical double taxation system with respect to corporate profits, when corporate income is taxed to the corporation when earned,111 and is subject to a second tax when distributed to a shareholder.112 Intercorporate holdings present the possibility that income might be subject to three or more levels of tax; to mitigate, section 243 provides a dividends received deduction.113 The dividends received deduction is subject to certain minimum holding period requirements and, in measuring this requirements, periods for which the shareholder has a "diminished risk of loss" with respect to the stock are not taken into account.114 By cross-reference, the holding period rules and restriction for periods of diminished risk of loss also apply in section 901(k) vis-à-vis claiming a foreign tax credit for foreign withholding taxes paid on dividends.

In 1994, the Service issued Rev. Rul. 94-28,115 which would appear to deny taxpayers a dividends received deduction with respect to dividends received on mandatorily redeemable stock when the holder has the rights of a creditor and the instrument is not stock for corporate law purposes but is stock for U.S. federal income tax purposes apparently on the theory that such investment carried a "diminished risk of loss." The ruling appears to have been issued with respect to certain types of transactions; the ruling should not be viewed as establishing a general rule nor should it be extended to debt instruments that are recharacterized as stock under the proposed regulations. Whatever tax policy the proposed regulations are intended to achieve would not be furthered by subjecting income earned by an expanded group member to triple taxation, or by denying a foreign tax credit with respect to foreign taxes associated with dividends; similarly, whatever tax policy Rev. Rul. 94-28 was intended to achieve would not be furthered by creating triple taxation or denying foreign tax credits due to a debt instrument's recharacterization as stock.

  •  

    2. Recommendations

  • Expressly provide that ownership of a recharacterized debt instrument is deemed to satisfy section 246(c), such that payment of a dividend can qualify for a dividends received deduction and for foreign tax credits, notwithstanding Rev. Rul. 94-28, and include an example that illustrates this point.

  • M. Consolidated Groups -- Subgrouping Rules

     

    1. Discussion
The proposed regulations that address the interactions with consolidated groups do not contain any subgrouping rules. For example, assume the parent of one consolidated group acquires all of the stock of the parent of another consolidated group, and the target group had multiple intercompany obligations that were disregarded by reason of the consolidated group rules in the proposed regulations. As a result of the acquisition, the target group would terminate, and the intercompany obligations amongst the target group's members would no longer be debt instruments between members of "the" target group, as that term is used in Prop. Treas. Reg. § 1.385-4(b)(1). However, the target group's intercompany obligations would continue to be intercompany obligations, and should continue to be exempted from the proposed regulations. Similar issues could arise when two or more corporations from one group join an acquiring group. The consolidated return regulations that apply to intercompany obligations contain subgrouping rules;116 the section 385 rules should have similar rules, for similar reasons.
  • 2. Recommendations
  • Provide subgroup rules similar to those contained in Treas. Reg. § 1.1502-13(g) that would apply when an issuer and a holder that are part of a consolidated group leave "the" consolidated group and join a different consolidated group, provided the two entities remain in a consolidated group relationship with each other.

  • N. Documentation, Substantiation, Diligence, and Behavioral Requirements

     

    1. Discussion
We have observed a number of issues with respect to the documentation and related requirements, and include additional comments in the Appendix. Overall, we believe that these requirements are overbroad, and would serve little purpose other than to significantly increase costs and legal fees, and encourage external borrowing (which itself would drive up costs and increase economic risks). These requirements illustrate the aphorism that the perfect should not be the enemy of the good.

The appropriate objective seemingly to be achieved by these requirements -- clear identification of certain items as indebtedness or as objectively identifying when a debtor-creditor relationship exists as to a particular flow of funds -- is largely satisfied today by contemporaneous journal entries. Large corporate taxpayers might not employ perfect documentation, but in almost all cases their actual documentation is practical and sufficient. The reported cases litigated in recent years that involve large corporate enterprises do not involve a complete lack of documentation.117 Rather, a lack of documentation and other informal conduct inconsistent with debtor-creditor status is largely seen as the hallmark of small taxpayers in the closely held corporation setting,118 the very ones excused from the scope of the documentation, substantiation, financial diligence, maintenance and behavioral requirements.

The proposed regulations leave the unmistakable impression that certain transactions and related-party debt are simply disfavored. The Treasury Department and Service seemingly are not responding to genuine problems in the documentation and substantiation area with large taxpayers, but rather are seeking to take advantage of an opportunity to discourage certain transactions by imposing as many obstacles and costs as can be justified by any means. In this regard, we note that there is little discussion in the preamble that validates the Treasury Department's and the Service's professed desire to "impose discipline" on taxpayers. There are no evidence-based discussions or findings that justify the imposition of these requirements on large corporate taxpayers, let alone that would tend to establish that the anticipated costs of compliance (and costs of the attendant taxpayer disputes) are justified by the desired tax policy or administrative benefits. We would also note that we expect the costs of compliance to far exceed the estimate published in the Regulatory Impact Analysis.119

In the related-party context, there is little need to undertake all of the documentary formalities that accompany a bank borrowing, often because the very nature of the related-party relationship provides the creditor with safeguards and remedies that are not available in the unrelated-party context. For example, a bank cannot force its borrowers to undertake certain actions absent contractual requirements or economic compulsion. In the related-party context, a creditor can seek recourse to management to force actions by the debtor. Additionally, in the unrelated borrowing context, long, detailed, and complex documentation often is put in place to cover a wide swath of potential yet quite remote contingencies, to ensure that no possible course of action or occurrence is left unaddressed by contractual provisions. The calculus is quite different in the related-party context. For obvious reasons, related-party lending transactions are not often accompanied with long-form documentation addressing all known contingencies. Such documentation would serve little if any purpose other than to drive up internal costs and complexities without any corresponding benefit, and cost savings is one of the key drivers for routine internal borrowing within a large corporate group.

The requirement to document financial metrics and capacity to pay every time there are drawdowns of facilities and incurrences of indebtedness pursuant to pooling and treasury functions is administratively excessive, and should be changed. This is not done in the context of bank borrowing facilities, nor in the context of letters of credit with unrelated lenders. This is also not done each time the holder of a credit card incurs a charge. In those contexts, the financial diligence is performed up front. Why is this heightened requirement suddenly reasonable or appropriate in the related-party context?

The requirement to document action in the capacity of a creditor in the event of default goes beyond documentation and creates significant substantive problems. While it is true that qualification as intercompany debt requires the intent to create a bona fide creditor relationship, it is also obvious that intercompany creditors will take broader interests into account in deciding whether and how to pursue creditor remedies in the event of default, given their overlapping equity interests. In addition, the requirement to act with the same judgment that an unrelated creditor would have could cause intercompany creditors to exercise remedies that could trigger cross-defaults with respect to outside lending, and drive corporations into bankruptcy.

As the U.S. Court of Appeals for the Second Circuit has stated:

 

[I]t is one thing to say that transactions between affiliates should be carefully scrutinized and sham transactions disregarded, and quite a different thing to say that a genuine transaction affecting legal relations should be disregarded for tax purposes merely because it is a transaction between affiliated corporations. We think that to strike down a genuine transaction because of the parent-subsidiary relation would violate the scheme of the statute and depart from the rules of law heretofore governing intercompany transactions.120

 

What the court said 60 years ago is equally perspicuous and proper today. When the parties have a genuine intent to enter into a debtor-creditor arrangement, memorialize the arrangement with reasonable and objective manner, and engage in conduct that is reasonable under the particular circumstances, the debt characterization of the underlying instrument should not be upset. The standard in the proposed regulations as to the parties' conduct should be articulated with reference to what is reasonable under the circumstances. Stated differently, the documentation standard should not be to emulate the behavior of an unrelated creditor, but rather to act with the diligence and judgment of a creditor in similar circumstances.
  • 2. Recommendations
  • Eliminate the requirement to document actions taken as a creditor in the event of a default attributable to financial distress. As noted above, given related-party status, such an expectation is not realistic and any documentation is likely to be inadequate or mendacious.

  • We have made a number of additional recommendations in the Appendix.

  • O. Controlled Partnerships and the Aggregate Rule

     

    1. Discussion
Prop. Treas. Reg. § 1.385-3(d)(5) provides that a controlled partnership within the meaning of Prop. Treas. Reg. § 1.385-1(b)(1) is treated as an aggregate of its partners for purposes of Prop. Treas. Reg. § 1.385-3. Further, each EG partner within the meaning of Prop. Treas. Reg. § 1.385-3(f)(7) of a controlled partnership is treated as holding its "proportionate share" of the controlled partnership's assets and issuing its "proportionate share" of any debt instrument issued by the controlled partnership. The proposed regulations would determine an EG partner's proportionate share for these purposes "in accordance with [the EG partner's] share of partnership profits."121

The proposed regulations do not define "partnership profits" or provide any guidance on how to determine an EG partner's share of partnership profits. A partner's share of partnership profits is a vague measurement standard with no single answer, except perhaps in a "straight up" partnership where all items of income, gain, loss and deduction are allocated strictly in accordance with capital percentages. Without additional guidance, any deviation from the simplest partnership sharing arrangement would cause uncertainty in the application of the proposed regulations. For example, if a partnership agreement contains special allocations of particular items or a preferred return, there would be multiple potential computations of a partner's share of the partnership's overall profits.122

We also note that the proposed regulations do not provide guidance with respect to when a partner's "proportionate share" is to be determined. A partner's share of partnership profits or capital can vary dramatically over the life of a partnership and raises another significant area of uncertainty with regard to the application of these rules to an EG.

As noted previously in this comment letter, because the application of the proposed regulations to an EG would cause significant and far reaching adverse tax consequences and financial reporting concerns, it is imperative that the triggers for application of these rules be absolutely clear.

We also recommend that the final regulations clarify the extent of the application of the funding rule under Prop. Treas. Reg. § 1.385-3(b)(3) when an EG partner issues an applicable instrument to a controlled partnership or holds an applicable instrument issued by a controlled partnership that may be subject to recharacterization under Prop. Treas. Reg. § 1.385-3. To the extent the aggregate treatment of controlled partnerships results in a partner that is both the deemed lender and issuer of an applicable instrument, we believe the applicable instrument should not be subject to the proposed regulations.

 

Example. X and Y are corporations that are members of an EG and each owns a 50 percent interest in PRS, a partnership for U.S. tax purposes. Assume that X's and Y's proportionate share of the PRS is 50 percent for purposes of Prop. Treas. Reg. § 1.385-3. X issues an applicable instrument to PRS, and X makes a distribution to its corporate parent within 36 months of issuing the applicable instrument.

 

Under the aggregate rule of the proposed regulations, each of X and Y are treated as holding 50% of the applicable instrument issued by X. Accordingly, with respect to 50% of the applicable instrument, X is both the issuer and the holder. Under these facts, 50% of the applicable instrument should be disregarded as a single person cannot be the holder and issuer of the same debt instrument; at the very least, 50% of the applicable instrument should not be subject to recast as equity under Prop. Treas. Reg. § 1.385-3. Similarly, if PRS issues an applicable instrument to X, to the extent the aggregate treatment of PRS results in X being both the holder and issuer of 50 percent of the applicable instrument, the proposed regulations should not apply to recast that portion of the applicable instrument.

One further observation. At the "35,000 foot level," the aggregate rule would overlay one counter-factual abstraction on top of a second counter-factual abstraction -- the partnership is a legal entity that is engaged in particular transactions (which would be attributed to the partners in some manner), and a debt instrument that is recharacterized under the general or funding rules will be a debt instrument that satisfies the documentation rules, and thus has terms typical of debt instruments (rather than equity-like terms). We explore some additional issues regarding the aggregate rule in the attached Appendix.

  • 2. Recommendation
  • As noted above, we recommend that the regulations, if and when finalized, apply solely to debt instruments issued by corporations, and that debt instruments issued by partnerships be wholly exempt.

  • The final regulations should provide a specific method for determining a partner's share of partnership profits for purposes of Prop. Treas. Reg. § 1.385-3; or allow taxpayers to apply an alternative measurement (such as a partner's "proportionate share" in the partnership's capital).

  • For purposes of Prop. Treas. Reg. § 1.385-3, a partner's "proportionate share" should be determined at the time a controlled partnership issues an applicable instrument to an EG member or an EG member issues an applicable instrument to a controlled partnership. If the Treasury Department and Service are concerned that partnership interests might be changed shortly before or after a debt instrument is issued (i.e., within one year) with a principal purpose to manipulate the section 385 rules, an anti-abuse rule could be written. Such a rule should allow taxpayers to establish, where warranted under the facts, that change was not motivated with such a principal purpose.

  • The final regulations should clarify that, to the extent the aggregate treatment of a partnership results in a partner being deemed to be both the issuer and holder of an applicable instrument, the applicable instrument should not be subject to recharacterization as equity.

  • P. The Bifurcation Rule

     

    1. Discussion
The intended scope of the bifurcation rule is unclear. The only example in the proposal is one in which there is an expectation that 60 percent of a debt can be repaid, and that the other 40 percent won't be repaid. In such a case, existing authorities would entirely deny treatment as debt. The proposed rule seemingly allows the government to treat the instrument as debt in part, but because the rule can only be asserted by the government, it is difficult to conceive of when such favorable treatment would occur.

Apart from the circumstance where it is expected that only a portion of the debt can be repaid, it is questionable that the rule would ever be relevant, unless the government proposes to alter the longstanding treatment of instruments like convertible debt. If such alteration is desired, the rule should be narrowly tailored to such instruments. Finalization of the current proposal would simply create irreducible, inherent uncertainty as to the characterization of financial instruments other than straight nonconvertible debt.

The ongoing treatment of instruments bifurcated by either the bifurcation rule or the recast rule would be unmanageable. Either, it would be unclear whether repayments are treated as payments on the debt or equity components, or an ordering rule would create the need for extensive additional rules to prevent circumvention of the ordering rule. These issues are discussed in the Appendix.

Because an individual can be a member of a modified expanded group, the rules could in theory require treatment of debt as equity in individuals -- clearly an absurd result. Moreover, the result of treating natural persons as modified expanded group members combined with the invocation of the section 318 constructive ownership rules could result in applying the bifurcation rule to a debt instrument issued by one natural person and held by a related natural person. All that would be required is that one person be treated as a member of a modified expanded group, after which all natural persons related to the first person under section 318 themselves could become members of the modified expanded group.123

In addition, there are certain statutory rules -- like section 636(a) -- that require instruments to be treated as debt. The bifurcation rule, as well as other rules in the package, would create reams of similarly unanswerable collateral questions and distortions, hardly a proper policy to implant into a rule that might potentially apply to a large number of taxpayers. 124

  • 2. Recommendation
  • Withdraw the bifurcation rule. Alternatively, the rule should be modified consistent with our comments in the Appendix.

  • Q. Bilateral Tax Treaties

     

    1. Discussion
The proposed regulations would cause collateral effects with respect to international agreements memorialized in bilateral tax treaties. Some of these issues are the subject of the comments of a recent Treasury Department official.125

First, we observe that the statutory language of section 385(a) provides for the treatment of an instrument as stock or debt for purposes of the Code ("this title," i.e., Title 26 of the United States Code). The language does not expressly authorize or contemplate regulations that could affect the treatment of a debt instrument for purposes of bilateral tax treaties between the U.S. and certain of our trading partners. Second, we observe that the term "stock" generally is left undefined in U.S. tax treaties, and the U.S. tax characterization of a debt instrument as stock generally can determine the application of treaties to income from U.S. sources.

We would expect the proposed regulations to result in collateral consequences in the treaty area in two ways -- qualification for treaty benefits (i.e., does an entity qualify for a benefit under the treaty), and which treaty benefits are implicated (i.e., the applicable withholding rate).

A recharacterized debt instrument could affect whether a treaty resident meets an ownership requirement under an applicable limitation on benefits ("LOB") provision, particularly under future treaties that follow the recently proposed U.S. model treaty (the "Proposed Model Treaty"). Most current U.S. income tax treaties contain LOB articles with provisions requiring various levels of stock ownership to be satisfied with respect to corporate residents. Broadly, the "publicly traded subsidiary" tests generally require that qualifying ownership exist at each intermediate owner level but "derivative benefits" and "ownership/base erosion" tests generally do not.126 The tests that look at "qualified" intermediate ownership are more likely to be affected by the proposed regulations. The Proposed Model Treaty would require intermediate owners to be "qualifying intermediate owners" for purposes of the subsidiary of a publicly traded test, the ownership/base erosion test, and the derivative benefits test.

 

Example. UKCo, a publicly traded UK corporation, owns all of the stock of UKSub1 and FSub, aCayman corporation; UKSub has for more than 12 months owned all of the stock of USP, a domestic corporation. In Year 4, UKSub1 issues a debt instrument to FSub, and uses the borrowed funds for corporate purposes (perhaps to fund growth organically or through acquisitions). The UKSub debt instrument is a meticulously documented, 10-year instrument with customary debt provisions, and its value exceeds the value of UKSub1's actual stock. During Years 1 and 2, however, UKSub had made distributions to UKCo (or had purchased stock of UKCo subsidiaries), and as a result the funding rule would operate to recharacterize the UKSub debt instrument as stock upon its issuance. In Year 10, while the UKSub-FSub debt instrument remains outstanding, USP distributes money to UKSub as a dividend distribution. Assume that USP has not issued any related-party debt instruments.

 

The USP dividend distribution does not implicate any of the concerns underlying the proposed regulations -- it is a straightforward, un-"funded" distribution of money -- and the proposed regulations would have no direct application to the distribution. The UKSub debt instrument does not implicate any of the concerns underlying the proposed regulations, because it is a wholly-intra-UK transaction that has no direct U.S. tax effects. However, the proposed regulations would have a collateral effect on the distribution; the funding rule would recharacterize the UKSub debt instrument, with the result that UKSub would be treated as majority-owned by FSub -- not UKCo. The consequence of this is that the USP dividend would be subject to the 30% statutory rate under section 881(a), because UKSub might not be treated as a qualified UK resident and might be ineligible for a treaty benefit.127

The proposed regulations also would potentially affect the treaty rate applicable to a payment of interest on a recharacterized debt instrument.

 

Example. UKCo, a publicly traded UK corporation, owns UKSub and USP. In Year 1, USP issues adebt instrument to UKSub in exchange for funds used by USP for corporate purposes (perhaps to expand USP's business organically or through the acquisition of a U.S. target corporation). The USP debt instrument has customary debt terms, confers no voting rights, and satisfies the relevant documentation requirements. USP business prospers and UKCo requires money for its business operations, and UKCo causes USP to make a dividend distribution to it in Year 3 in an amount in excess of USP's current year earnings and profits. As a result, the USP debt instrument issued to UKSub is recharacterized as stock under the funding rule. USP timely pays all interest and principal due on the recharacterized debt instrument, which is retired in Year 6.

 

UKCo should be entitled to claim a zero treaty rate benefit for the Year 3 dividend distribution, because it owns all of the USP stock that has been issued (including 100% of the voting power), and it has owned the stock for more than 12 months at the time of the Year 3 USP distribution.128 But what rate would apply when USP transfers money to UKSub to pay interest129 and principal on the recharacterized debt instrument, which the proposed regulations would treat as dividends (including as a dividend equivalent redemption)? The 15% treaty rate would appear applicable, because UKSub does not own any voting stock in USP (a prerequisite for the 5% rate).

The foregoing discussion has focused on the treatment of payments of interest on debt instruments, where the debt instruments have been recharacterized as equity. Next, consider that the repayment of the principal on a recharacterized debt instrument, perhaps in most cases, would be treated as a dividend-equivalent redemption, even where the debt instrument is in form a straightforward promissory note with no equity-like terms or features. This invokes the prospect of imposing a withholding tax on a remittance of principal amounts, surely not what our trading partners might have contemplated when negotiating a treaty with our nation's negotiators.

We do not believe that the results in these examples are appropriate, or are even necessary to achieve the policies underlying the proposed regulations. However, we recognize that there are competing considerations, which upon further reflection illustrate the lack of wisdom underlying the proposed regulations. If the Treasury Department and Service revise the proposed regulations so that the debt instruments in the examples above retain their debt characterization for treaty purposes, the result would be to exacerbate the favoritism that the rules in the proposed regulations show toward inbound investment (over domestic investors). These issues demand greater consideration, and the Treasury Department should ensure that its policy decisions are well articulated in the preamble so that taxpayers can understand the decisions that are being made, and why the Treasury Department believes those decisions are appropriate.

  • 2. Recommendations
  • We recommend that the proposed regulations not apply to recharacterize the debt status of any debt instrument, unless and until the Treasury Department and Service thoroughly study the issue and come to some informed determination as to the wisdom of such an approach (and the implications for our treaty network). If the Treasury Department and Service intend to override the tax treaties and to have debt instruments be recharacterized as stock for treaty purposes (and not only for purposes of the Code), the preamble should clarify the intent, should articulate what tax policy choices mandate such a result, and should discuss why it is appropriate for the proposed regulations to override the policies underlying tax treaties. If the Treasury Department and Service intend to exempt inbound debt instruments, the preamble should similarly clarify the intent, articulate what tax policy choices mandate such a result, and discuss why it is appropriate to exempt debt instruments issued in the inbound investment context but not extend a similar exemption for domestic investors.

  • R. Validity of the Recast Rules

     

    1. Discussion
In our view, the proposed regulations exceed the boundaries of the Congressional grant of regulatory authority in section 385. The proposed regulations do not seek to delineate a general debt-equity distinction or to clarify or rationalize debt-equity analysis; rather, the proposed regulations were issued with the specific intent to alter current substantive law and to deter certain specific transactions that are otherwise clearly permitted under current law and that have been approved by courts.

Congress, in articulating the grant of regulatory authority in section 385, specifically referred to "factors" to be "taken into account"; not "conditions" that are "determinative." However, the approach taken in the proposed regulations would legislate a series of ipso facto rules to disallow debt characterization to a related-party debt instrument.

Section 385 originated in the Senate Finance Committee's version of the Tax Reform Act of 1969. The Senate Finance Committee's report states:

 

In view of the uncertainties and difficulties which the distinction between debt and equity has produced in numerous situations other than those involving corporate acquisitions, the committee further believes that it would be desirable to provide rules for distinguishing debt from equity in the variety of contexts in which this problem can arise. The differing circumstances which characterize these situations, however, would make it difficult for the committee to provide comprehensive and specific statutory rules of universal and equal applicability. In view of this, the committee believes it is appropriate to specifically authorize the Secretary of the Treasury to prescribe the appropriate rules for distinguishing debt from equity in these different situations.130

 

The Senate Finance Committee thus included a provision to grant specific statutory authority to promulgate regulatory guidelines for determining whether a corporate obligation constitutes stock or indebtedness. The Senate Finance Committee report explained:

 

The provision specifies that these guidelines are to set forth factors to be taken into account in determining, with respect to a particular factual situation, whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists.131

 

The Conference Committee accepted the Senate proposal, and section 385 was enacted into law.132

The text of section 385(a) authorizes Treasury Department to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as indebtedness or equity. Section 385(b), enacted at the same time as section 385(a), provides:

 

The regulations prescribed under this section shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists.

 

Not surprisingly, this statutory language closely mirrors the Senate Finance Committee's instructions in its report. Similarly, the Joint Committee on Taxation's "Bluebook" explanation of the provision also mirrors this factor-centric approach, stating that the provision provides Treasury Department:

 

. . . with specific statutory authority to promulgate regulatory guidelines, to the extent necessary or appropriate, for determining whether a corporate obligation constitutes stock or indebtedness for all purposes of the Internal Revenue Code. These guidelines are to set forth factors to be taken into account in determining in a particular factual situation whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists.133

 

The Section 385 regulatory grant of authority refers to "regulations [that] shall set forth factors to be taken into account" (emphasis added). The statutory language, Senate Finance Committee report, and Joint Committee on Taxation Explanation are quite consistent. Collectively, they contemplate regulations that would improve upon the case authorities, drive more uniformity, and provide a series of generally applicable rules to distinguish indebtedness from equity.

This language does not grant the Treasury Department the ability to combat perceived tax abuse that might involve a debt instrument or related-party indebtedness. Nor does it allow Treasury to legislate a series of per se rules with respect to certain underlying transactions. Likewise, it does not authorize Treasury to "equitize" what is, in substance, a debt instrument simply because the instrument was issued to a related-party and that related-party happened to have implemented a disfavored transaction within a six-year period surrounding the issuance of the debt instrument (or because a taxpayer happened to distribute a debt instrument rather than -- as in the Falkoff case -borrow funds from a bank and distribute those funds).134 The Treasury Department's decision that a related-party debt instrument is equity raises even more concerns in that (i) it completely disregards whether the debt instrument would unambiguously qualify as indebtedness under historic and current law, (ii) a debt instrument issued to an unrelated-party on the same day with identical terms could be respected as debt, and (iii) the rules do not even consider whether the instrument has a factual nexus with the disfavored transaction.

Once an issuer would have satisfied the documentation and substantiation requirements of Prop. Treas. Reg. § 1.385-2, the general and funding rules of Prop. Treas. Reg. § 1.385-3 would come into play, including the per se rule's "irrebuttable presumption." These rules do not list factors, nor articulate how various factors are to weighted, analyzed, or ultimately balanced. These rules do not purport to distinguish indebtedness from equity based on any intent to repay, any ability to repay, or any other characteristic that historically has been relevant in the debt-equity case law (apart from being issued in a related-party context). In fact, in the related-party context only the proposed regulations ignore the factors typically relevant to a good-faith debt-equity determination. Rather, two points would control -- is the debt instrument held by a related-party, and has there been some disfavored transaction at some point during a 72-month period (a distribution, a related-party reorganization or related-party stock sale, etc.), regardless of any factual or other connection between the debt issuance and the disfavored transaction. Under these rules, the credit quality of a debt instrument or its issuer is simply not relevant, nor is the intent or conduct of any of the parties. The proposed regulations could, in the related-party context, for example, disregard one hundred pages of documentation and a perfected purchase-money security interest that over-collateralizes a debt. The proposed regulations ignore the connection, or lack thereof, between the debt and the disfavored transaction and prohibit any attempt to trace the debt proceeds to a specific use.135 The Congress that enacted section 385 in 1969 intended to provide a broad grant of regulatory authority to address the debt-equity conundrum. However, it did not contemplate regulations that would disregard the debt-equity conundrum in its entirety and instead be used as a tool to attack particular transactions -- many of which were already "old hat" at that time.136

In fact, the legislative history underlying the 2010 codification of the economic substance doctrine shows Congressional awareness with customary debt-equity tax planning. The Joint Committee on Taxation, in explaining the provision that was enacted as section 7701(o), stated:

 

The provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. Among these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; (2) a person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm's length standard of section 482 and other applicable concepts are satisfied.137

 

This -- in the very context of codification of the economic substance doctrine -- is further evidence that Congress has been well aware of -- and has been comfortable with -- taxpayers capitalizing subsidiaries with a mix of debt and equity, and using related-party indebtedness.

The proposed regulations do not attempt generally to distinguish debt from equity based on any characterization other than the relationship of the borrowing and lender. Rather, the proposed regulations address transactions that do not raise issues with respect to whether arrangements in substance are debt or equity, which is the focus of section 385. It is clear that the Treasury Department has concerns with taxpayers' efforts to rely upon the statutorily prescribed rules in section 356(a)(2), or in section 304(a)(1), depending on which provision might yield better results. Thus, the Treasury Department has repeatedly proposed legislative changes that seek to harmonize the two sets of rules.138 Similarly, the Treasury Department has concerns with taxpayers' use of the bedrock annual accounting period of U.S. federal income tax law139 to time distributions so as to qualify for return-of-basis treatment (i.e., so-called Falkoff140 planning),141 or "earnings-stripping" (or "debt-pushdown") transactions by foreign-parented U.S. corporations. Thus, the Treasury Department has proposed legislative changes addressing these kinds of transactions.142 In this same vein, Congress repeatedly has been urged to "tighten" the earnings stripping rules of section 163(j),143 to repeal the "boot within gain" limitation of section 356(a)(2), and to remove selling corporations from the ambit of section 304.144 These proposals have been made by Republican and Democratic Administrations alike. Yet, multiple Congresses -- Democratic, Republican, and split -- have chosen not to enact such legislation. Similarly, it is clear that the Treasury Department has concerns with inversions (and has issued multiple rounds of guidance designed to discourage these transactions and implement the rules of section 7874 and other provisions145), yet Congress has chosen not to act in the manner the Treasury Department has recommended. Substantive rules like those at issue here fall within the purview of Congress, which is the proper forum for promulgation of rules like those included in the proposed regulations. This is particularly so in light of their scope, the underlying legislative provisions and their histories, and the importance of the tax policies involved.

The Treasury Department's concerns with certain transactions do not justify or sanction the results-oriented approach employed by, or the extraordinary scope of, the proposed regulations. Congress, in delegating regulation-writing authority to the Treasury Department to provide for factors, clearly intended a factor-based approach which would have built upon and hopefully improved the long-standing problem in the tax law of drawing an appropriate distinction between debt and equity.

The debt-equity distinction is a fundamental one that predates our Nation's modern income tax law.146 For many years, taxpayers have carefully structured their arrangements in ways to qualify as indebtedness,147 and the courts have often -- though not always -- upheld the taxpayers' characterizations.148 The courts have also recognized that corporations that engage in business activity have a tax identity separate from their shareholders.149 Congress too recognizes this principle, which is bedrock upon which the direct taxation of corporate income rests.150 As the Second Circuit Court of Appeals has stated:

 

[I]t is one thing to say that transactions between affiliates should be carefully scrutinized and sham transactions disregarded, and quite a different thing to say that a genuine transaction affecting legal relations should be disregarded for tax purposes merely because it is a transaction between affiliated corporations. We think that to strike down a genuine transaction because of the parent-subsidiary relation would violate the scheme of the statute and depart from the rules of law heretofore governing intercompany transactions.151

 

In looking over almost one hundred years of case law in the debt-equity arena, what is remarkably consistent is that taxpayers that seek to issue debt in lieu of equity -- whether with tax or non-tax motivations -- that are financially able to support a debt characterization, that unambiguously document and substantiate the debtor-creditor relationship, and that act consistently with the documentation, will have their debt characterization sustained by the courts, regardless of their tax motivations in selecting debt in lieu of equity and related-party debt in lieu of bank borrowings. The ability to create a valid debtor-creditor relationship between shareholder and corporation had become black letter law long before the time Congress enacted section 385(a) in the Tax Reform Act 1969, and was the black letter law context in which section 385 was written.152 To be sure, taxpayers lost cases when their substantiation and conduct were ambiguous or the terms of the debt departed from the norm, but as a general tax principle, financially sound taxpayers were free to choose to issue either debt or equity, and debt characterization was accepted provided the parties intended to create a debtor-creditor relationship and they acted in a manner that generally was consistently with that relationship. Had Congress intended to provide the Treasury Department with authority to negate years of well-settled general tax principles or overturn black-letter law, it would have expressed its intent in unmistakable terms. However, Congress did not do this -- rather, it gave the Treasury Department a more limited mandate as described above in respect of identifying factors.

Moreover, it is clear that Congress is aware that corporations can be indebted to their shareholders, and can even distribute debt instruments to their shareholders,153 and that Congress has consented to this situation, because Congress has enacted Code provisions that explicitly address this situation.154 In 1984, Congress enacted sections 312(a)(2) and 1275(a)(4), which explicitly deal with a corporation's section 301 distribution of a debt instrument to its shareholder, to address the situation where the debt instrument is a discount obligation (i.e., bears original issue discount).155 In their description of the present law context in which these provisions were enacted, the Congressional tax-writing committees wrote that "a corporation can distribute as a dividend its own debt obligations," a phrase that appears in the reports of the House Ways and Means Committee, the Senate Finance Committee, and the conference committee.156 Can the general rule of the proposed regulations apply to treat a debt instrument as stock, when the debt instrument is a discount obligation and is "four-square" within these statutory provisions? These statutory provisions were enacted after section 385; perhaps they should be read to have implicitly restricted the grant of regulatory authority.157

Additionally, even if the Treasury Department possessed the authority the proposed regulations imply, using it as it has here create bizarre results, which Congress cannot reasonably have intended to permit. Under the proposed regulations, identical debt instruments issued under identical financial circumstances and documented with the same legal formalities could be subject to disparate characterization based solely on whether the holder is a related corporation, and whether the issuer happened to have engaged in some other potentially unrelated transaction at some point within a 72-month period surrounding the issuance. If a financially successful corporation were to distribute a dividend in the form of notes to its shareholders, the notes' debt-equity characterization could differ under the proposed regulations based solely on whether the shareholder-recipient was a controlling corporation or an individual.158 Alternatively, the characterization of a debt instrument could differ depending upon whether a note was part of an original capital structure, or if it was issued in a recapitalization undertaken to modify the capital structure or in a distribution intended to modify the corporation's capital structure and leverage ratio.159 What tax policy consideration relative to the debt-equity distinction is implicated by the issuance of a note in a recapitalization or distribution, as opposed to a corporate formation? 160 Similarly, if a corporation chooses to borrow funds from a commonly controlled corporation to finance, say, a business expansion, and within the six-year period surrounding the borrowing also happens to have engaged in an otherwise separate reorganization with a related-party (or had distributed accumulated earnings and profits), the corporation's borrowing would be treated differently than if it had waited to engage in the reorganization or earnings and profits distribution for 37 months (or had waited to borrow for that period of time). The proposed regulations do not require any factual connection between the borrowing and the intercompany reorganization or distribution, and in fact actual proof that no linkage is present is expressly made irrelevant.161 These proposed rules are not justified. The claim that such a rule is made necessary due to the fungible nature of cash has little to do with the debt-equity considerations central to section 385(a), and cannot mask the fundamentally arbitrary nature of the way these rules would operate. There is no clear tax policy underpinning for the distinctions the proposed regulations would make that relates to the concerns that motivated Congress to enact section 385.

Would the Treasury Department contend that section 385 gives it the authority to deny interest deductions to (or impose dividend treatment on) taxpayers who engage in other transactions it might disfavor at some future date? What if a taxpayer borrowed funds and issued a debt instrument to a related-party, and within some "irrebuttable presumption" period of time the taxpayer also engaged in an otherwise unrelated listed transaction, or reported a lower effective tax rate, or contested an IRS transfer pricing determination? Why is it permissible to use section 385(a) to attack taxpayers who effect a repatriation (including one that would, in the absence of the proposed regulations, be respected as a dividend and upon which a U.S. federal income tax would be paid or that represents previously taxed income), a "debt-pushdown" to "earnings strip," a return-of-capital distribution to manage the timing of the recognition of earnings and profits, or some other transaction, when the taxpayers employ general and longstanding tax principles to do so, and the transaction is consistent with the longstanding terms of the Internal Revenue Code and generally applicable judicial doctrines? The Treasury Department should be wary of creating the precedent of writing regulations untethered from the policy that motivated Congress to enact the underlying law.

The Treasury Department's real concern appears to have nothing to do with the historic debt-equity conundrum. The Treasury Department's concern appears to be with taxpayers' use of other, long-standing, general tax principles to achieve results with which it has concerns and on which Congress has not acted. Congress is the proper governmental instrumentality to act to combat these perceived tax abuses. The Treasury Department has proposed legislative changes, and the solution to these perceived problems is, in short, legislation if Congress decides to act. Bypassing Congress and using a grant of regulatory authority issued to provide debt-equity guidance for an unrelated purpose exceeds the Treasury Department's authority under section 385.

Finally, as discussed in the text of our comments, section 385(a) provides, "[t]he Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness)" (emphasis added). There is nothing in section 385 or its legislative history that suggests that Congress authorized regulations to determine the status of an interest in a non-corporate entity; rather, the legislative history suggests section 385(a) was intended to be limited to corporate issuers. The statutory provision is in subchapter C of Chapter 1 of the Code, the portion of the Code addressing corporate distributions and adjustments. Yet, the proposed regulations would recharacterize certain debt instruments issued by a partnership, either as equity in the partnership or as equity in the partner(s) of the partnership.

In the legislative history underlying the enactment of section 385, the Senate Finance Committee report states, "[a]lthough the problem of distinguishing debt from equity is a long-standing one in the tax laws, it has become even more significant in recent years because of the increased level of corporate merger activities and the increasing use of debt for corporate acquisition purposes."162 The Senate Finance Committee report goes on to state:

 

In view of the increasing use of debt for corporate acquisition purposes and the fact that the substitution of debt for equity is most easily accomplished in this situation, the committee also agrees with the House that it is appropriate to take action in this bill to provide rules for resolving, in a limited context, the ambiguities and uncertainties which have long existed in our tax law in distinguishing between a debt interest and an equity interest in a corporation. . .

In view of the uncertainties and difficulties which the distinction between debt and equity has produced in numerous situations other than those involving corporate acquisitions, the committee further believes that it would be desirable to provide rules for distinguishing debt from equity in the variety of contexts in which this problem can arise. The differing circumstances which characterize these situations, however, would make it difficult for the committee to provide comprehensive and specific statutory rules of universal and equal applicability. . . .

In view of this, the committee believes it is appropriate to specifically authorize the Secretary of the Treasury to prescribe the appropriate rules for distinguishing debt from equity in these different situations. . . . For the above reasons, the committee has added a provision to the House bill which gives the Secretary of the Treasury or his delegate specific statutory authority to promulgate regulatory guidelines, to the extent necessary or appropriate, for determining whether a corporate obligation constitutes stock or indebtedness. The provision specifies that these guidelines are to set forth factors to be taken into account in determining, with respect to a particular factual situation, whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists.163

 

The above legislative history makes clear that the focus of Congress in enacting section 385 was the characterization of corporate debt and thus the statute makes no reference to whether an interest in a partnership is to be treated as stock or indebtedness.

Similarly, the proposed regulations would recharacterize debt instruments issued by a disregarded entity either as equity in the issuing entity (which could result in the entity being treated as a partnership) or as equity in the owner of the entity (even though the debt instrument is not an interest in the owner). These proposed rules cannot be squared with the grant of regulatory authority regarding the debt-equity status of an interest in a corporation.

2. Recommendations
As noted at the beginning of this letter, we make the following recommendations:
  • We urge the Treasury Department and the Internal Revenue Service to withdraw the proposed regulations, in their entirety.

  • If the Treasury Department and Service do not withdraw the proposed regulations in their entirety, we recommend that they withdraw Prop. Treas. Reg. § 1.385-3.

  • If the proposed regulations are not withdrawn, we recommend that the regulations, if and when finalized, should only apply to debt issued by corporations.

 

VI. Additional Complexities and Taxpayer Disputes

 

1. Discussion

 

The rules in the proposed regulations can be expected to spawn multiple new taxpayer disputes. As discussed throughout our comments, we expect there will be significant complexities and opportunities for disputes in determining how to apply these rules, particularly in light of the reach of the per se rule and the potential for cascading effects. Additionally, the proposed regulations will result in new and significant (and unfortunate) uncertainties in the calculation of a corporation's earnings and profits, and in the basis in a corporation's stock (including the basis in debt instruments recharacterized as stock). New opportunities for taxpayer disputes will arise in the context of merger and acquisition activities, when an acquiring corporation will be required to try to determine a target group's potential exposures under these new rules, to "clean up" the target's intercompany debt structure, and to integrate the target's treasury function into its own. None of these issues are so much as referenced in the preamble, nor do we have any sense that they factored into the Treasury Department's and Service's regulatory decision-making or costs and benefits determinations.
  •  

    2. Recommendations

  • Eliminate the funding and per se rules.

  • Expand the reasonable cause exception in Treas. Reg. § 1.385-2(c)(1), and allow for "section 9100"-type relief.

 

VII. Additional Tax Planning Opportunities

 

1. Discussion

 

The extraordinary breadth and reach of the proposed regulations, and the numerous changes and collateral consequences that they would impose, will inevitably open up significant new planning opportunities. Our comments in prior sections of this letter have focused on a number of complexities that could create problems for taxpayers. However, it has been our experience that in many situations, creating a non-economic, counter-factual situation leads to interesting discontinuities, thus creating opportunities for subsequent mischief.164 To coin a phrase, discontinuities fertilize the soil from which future tax avoidance can sprout.

For example, the proposed regulations will result in numerous "issuances" of hook equity. Up to this point it has been our experience that the Treasury Department and Service have looked askance on the use of hook equity.165 If the proposed regulations are finalized in their current form, the result would be hook stock in many foreseeable situations, and likely in many unforeseen situations where the complexities of the per se rule become apparent only with hindsight. Similarly, the proposed regulations would create numerous instances of hybrid instruments that are "straight debt" under a traditional debt-equity analysis, but that would be recharacterized as equity under the general, funding, or per se rules.

We find it unfortunate that the proposed regulations are written as a "one way street" to recharacterize debt instruments as stock, notwithstanding that the Service repeatedly has sought the opposite -- to treat equity interests as indebtedness -- in a variety of contexts. For example, in a number of structured finance cases, the Service sought to establish that a financial institution was a secured lender rather than an equity holder in a partnership,166 or that an equity interest was in substance indebtedness that could not support a foreign tax credit.167 As a thought experiment, what might have happened in those cases if the proposed regulations were final, and if those taxpayers had structured the deal in a manner that brought the issuer and holder into the same EG by invoking the option or partnership attribution rules? Would the government have been willing to argue in court that the equity-in-form interests at issue in those cases should be treated as indebtedness? How would the government respond when it is pointed out that those very same interests -- if they had been labelled as debt -- would have been vulnerable to equity recharacterization under the rules of the proposed regulations? (Literally, the no affirmative use and anti-avoidance rules would not apply to an instrument that is in form an equity interest.)

As discussed above, the repayment of a debt instrument that is recharacterized as stock is likely to be treated as a section 302(d) or section 306(a)(2) dividend-equivalent redemption. Again, this is likely the intended result of the proposed regulations, but it will substantially increase opportunities for taxpayers -- inadvertently or otherwise -- to shift stock basis and earnings and profits amongst commonly controlled corporate entities. To be sure, there would be new anti-avoidance and no affirmative use rules, but those rules can have only limited application when the direct, inevitable, and intended consequences of repaying a recharacterized debt instrument lead to movements in stock basis and earnings and profits. In addition, those rules might be heeded by well-advised, risk-adverse taxpayers, but cannot be expected to halt aggressive taxpayers who stretch certain rules to their fullest to gain every conceivable tax advantage. This is a further caution, because the rules would incentivize and reward aggressive taxpayers who play a tax lottery while punishing compliant taxpayers.

We surely cannot predict all of the ways in which the rules in the proposed regulations could be used to create tax planning opportunities, at the time of the issuance of a debt instrument. However, we are confident that the discontinuities that the proposed regulations would create will lead to new tax planning opportunities, some of which will become apparent only after a debt instrument has been issued and recharacterized (the no affirmative use and anti-avoidance rules cannot police post-issuance planning when awareness of a tax benefit was not present at the time of a debt instrument's issuance). We are in some ways reminded of the experience with nonqualified preferred stock, which was enacted in 1997 as an anti-avoidance revenue raising measure and is currently proposed to be repealed for the very same reason.

  • 2. Recommendation
  • The proposed regulations should be withdrawn. Alternatively, if the proposed regulations are not withdrawn, the Service's current no-rule policy for "the treatment or effects of hook equity" in section 4.02(11) of Rev. Proc. 2016-3 should be repealed.

 

VIII. Opportunity Costs

The Service has been operating under severe and perhaps historic budgetary constraints. It has had to curtail much-desirable activities and programs, and has been unable to timely complete many of the items that have appeared on recent Priority Guidance Plans. The Treasury Department and Service might have productively devoted resources to finalizing regulations under section 163(j) that had been proposed in 1991, or to finalizing the earnings and profits rules in Prop. Treas. Reg. § 1.367(b)-8, that had been proposed in 2000, or to finalizing basis regulations that were initially proposed in 2002 and were re-proposed in 2009 (which, in part, also would update the section 304 regulations to reflect statutory changes to section 304 made in 1982 and in subsequent years). Each of those projects could have had an impact on the type of tax planning targeted in the proposed regulations, and would also have provided much needed guidance to a large group of taxpayers. The Treasury Department and Service could have deployed executive and staff hours to other guidance projects that might not affect inverted companies, but that nonetheless are important projects that would affect a large number of taxpayers, such as updating regulations under section 351(e) to reflect statutory changes made in 1997, or finalizing the "no net value" regulations that were proposed in 2005, or finalizing the proposed regulations issued in 2006 that would update the historic section 959 and 961 regulations to reflect statutory changes made in years subsequent to 1983, or finalizing the regulations that were proposed in 2007 to update the section 355 active trade or business regulations and reflect statutory changes made in 2005. All of the projects referred to above have appeared on the Priority Guidance Plan.

In producing the proposed regulations, the Treasury Department and Service have clearly expended significant executive and staff hours, enough to reflect a conscious management and policy decision to forego work on other projects. If the Treasury Department and Service intend to finalize the proposed regulations, it is essential that they devote significant additional resources to consider the numerous technical and other changes to the proposed regulations that have been suggested by us and by other commenters -- it would be unwise to do otherwise.

As a final point, we also note that debt instruments recharacterized under the proposed regulations may be considered hybrid instruments for cross-border tax purposes, and the issuer's local-country expense disallowed if that country has adopted rules similar to those recommended in the OECD BEPS Project's Action 2 Hybrid Mismatch report. The Treasury Department was an active participant in the BEPS process and spent significant resources in doing so. It is strange and seemingly counter-productive for the Treasury Department, having worked to curtail cross-border hybrid instruments presumably out of concern regarding their vitality as a matter of sound tax policy, to now unilaterally take actions that, in its own words, may cause a "proliferation" of hybrid instruments.168 A readily foreseeable effect is that when the earnings of affected issuers are eventually subject to U.S. tax, the U.S. fisc will earn less revenue because the U.S. owner will be entitled to greater foreign tax credits. More broadly, this only further underscores our concerns about the Treasury Department's and the Service's decision to commit the resources they have to the proposed regulations.

IX. Conclusion

In addition to being in large part invalid, the proposed regulations would create large-scale noneconomic incentives that would dis-incentivize investment in the United States and distort investment and ownership decisions when investment is made. The proposed regulations would give rise to far-reaching collateral consequences ranging from the disappearance of tax attributes such as foreign tax credits, the routine shifting of earnings and profits and stock basis in potentially distortive directions, the inability to comply with and understand the tax consequences of routine transactions given the dichotomy between the mechanical rules and the "affirmative use" turn-offs (as well as the potential "de-controlling" effect of the retroactive recharacterization of a debt instrument), and the unparalleled documentation and compliance burdens, all of which will lead to further taxpayer disputes. Additionally, we anticipate that the proposed regulations would provide additional tax tools, and create new planning opportunities, while imposing huge costs in terms of tax administration and taxpayer compliance, casting further doubt on the underlying wisdom of the approach and scope of the proposed regulations. The proposed regulations should be withdrawn in their entirety.

We welcome the opportunity to discuss our comments further with any interested personnel at the Treasury Department and the Internal Revenue Service. Please feel free to contact Joe Pari at 202-533-4444, Steven Lainoff at 202-533-3158, Ron Dabrowski at 202-533-4274, Seth Green at 202-533-3022, Mark Hoffenberg at 202-533-4058, or Maury Passman at 202-533-3775.

Very truly yours,

 

 

KPMG LLP

 

Washington, DC

 

cc:

 

The Honorable Mark J. Mazur

 

Assistant Secretary (Tax Policy)

 

Department of the Treasury

 

 

The Honorable John Koskinen

 

Commissioner

 

Internal Revenue Service

 

 

The Honorable William J. Wilkins

 

Chief Counsel

 

Internal Revenue Service

 

 

Emily S. McMahon

 

Deputy Assistant Secretary (Tax Policy)

 

Department of the Treasury

 

 

Robert Stack

 

Deputy Assistant Secretary (International Tax Affairs)

 

Department of the Treasury

 

 

Danielle Rolfes

 

International Tax Counsel

 

Department of the Treasury

 

 

Thomas C. West

 

Tax Legislative Counsel

 

Department of the Treasury

 

 

Krishna Vallabhaneni

 

Deputy Tax Legislative Counsel

 

Department of the Treasury

 

 

William M. Paul

 

Deputy Chief Counsel (Technical)

 

Internal Revenue Service

 

 

Robert H. Wellen

 

Associate Chief Counsel (Corporate)

 

Internal Revenue Service

 

 

Marjorie A. Rollinson

 

Associate Chief Counsel (International)

 

Internal Revenue Service

 

 

Devon Bodoh

 

KPMG LLP

 

Principal, Washington National Tax -- International M&A

 

 

Michael Cornett

 

KPMG LLP

 

Principal, Washington National Tax -- International Taxation

 

 

Kevin Cunningham

 

KPMG LLP

 

Managing Director, Washington National Tax -- International Taxation

 

 

Ronald Dabrowski

 

KPMG LLP

 

Principal, Washington National Tax -- Federal Taxation

 

 

Jon Finklestein

 

KPMG LLP

 

Principal, Washington National Tax -- Passthroughs

 

 

Kevin Glenn

 

KPMG LLP

 

Partner, Washington National Tax -- International Taxation

 

 

Seth Green

 

KPMG LLP

 

Principal, Washington National Tax -- International Taxation

 

 

Mark Hoffenberg

 

KPMG LLP

 

Principal, Washington National Tax -- Corporate

 

 

Doug Holland

 

KPMG LLP

 

Managing Director, Washington National Tax -- International Taxation

 

 

Charles Kaufman

 

KPMG LLP

 

Senior Manager, Washington National Tax -- Passthroughs

 

 

Stephen Marencik

 

KPMG LLP

 

Manager, Washington National Tax -- Corporate

 

 

Steven Lainoff

 

KPMG LLP

 

Principal, Washington National Tax -- Federal Taxation

 

 

Joseph Pari

 

KPMG LLP

 

Principal, Washington National Tax -- Corporate

 

 

Maury Passman

 

KPMG LLP

 

Managing Director, Washington National Tax -- Corporate

 

 

Justin Weiss

 

KPMG LLP

 

Partner, Washington National Tax -- Financial Products

 

 

David Wheat

 

KPMG LLP

 

Principal, Washington National Tax -- Corporate

 

[ Editor's Note: Appendix omitted. To view the Appendix,

 

See , p. 75.]

 

 

FOOTNOTES

 

 

1 Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (the "Code"), or the applicable regulations promulgated pursuant to the Code (the "regulations") as of the date of this comment letter.

2 Notice of Proposed Rulemaking, Treatment of Certain Interests in Corporations as Stock or Indebtedness, REG-108060-15, 81 Fed. Reg. 20912 (Apr. 8, 2016) (publishing Prop. Treas. Reg. §§ 1.385-1 through -4).

3See Press Release, The White House, Remarks of President on the Economy (Apr. 5, 2016, 12:15PM), https://www.whitehouse.gov/the-press-office/2016/04/05/remarks-president-economy-0; and Press Release,The White House, Press Briefing by Press Secretary Josh Earnest (Apr. 5, 2016, 12:30 PM) https://www.whitehouse.gov/the-press-office/2016/04/05/press-briefing-press-secretary-josh-earnest-452016.

4 The documentation and substantiation rules of Prop. Treas. Reg. § 1.385-2, regardless of their propriety or advisability, generally appear consistent with a broad view of the regulatory authority in section 385(a). The proposed regulations avowedly seek to "discipline" taxpayers, a punitive motivation inconsistent with Congressional purpose underlying section 385, which is to provide criteria by which to classify an instrument as debt or equity in a corporation. Nonetheless, documentation and substantiation historically have been viewed as important factors in a debt-equity analysis. While we have significant reservations regarding the propriety and the drafting of the documentation and substantiation rules as proposed (and question the ability to write the rule as a per se rule that would ipso facto "equitize" debt instruments that fail to meet the requirements, without consideration of other factors), we acknowledge that the substance of these requirements could be articulated in a fashion that more closely aligns with the grant of regulatory authority. Thus, we view the documentation and substantiation rules (to the extent they relate to instruments issued by a corporation) as arguably thematically consistent with the broad regulatory grant in section 385(a), albeit significantly overbroad. Our comments regarding the invalidity of the proposed regulations are focused on the general, funding, and per se rules in Prop. Treas. Reg. § 1.385-3.

5 S. Rep. No. 91-552, at 138 (1969). The House bill had included a more limited provision addressing certain corporate acquisition indebtedness, which was enacted as part of the bill and is now codified in section 279.

6 The Conference Report simply noted that the conference substitute followed the Senate amendment. H.R. Conf. Rep. 91-782, at 308-309 (1969). Tax Reform Act of 1969, Pub. L. No. 91-172, § 415(a), 83 Stat. 487, 613-614. Section 385 has been amended three times. See Tax Reform Act of 1976, Pub. L. No. 94-455, § 1906(b)(13)(A), 90 Stat 1719, 1834 (a clerical amendment replacing "Secretary or his delegate" with "Secretary"); Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, § 7208, 103 Stat. 2106, 2337 (inserting parenthetical language in section 385(a) to authorize prospective regulations to treat certain corporate interests as in part stock and in part indebtedness); and Energy Policy Act of 1992, Pub. L. No. 102-486, § 1936(a), 106 Stat. 2776, 3032 (adding section 385(c)).

7 S. Rep. No. 91-552, at 137 (1969) (emphasis added).

8Id. at 138 (emphasis added).

9Granite Trust Co. v. United States, 238 F.2d 670 (1st Cir. 1956).

10 The effective dates in the proposed regulations are inconsistent with the requirement in section 553(d) of the Administrative Procedure Act (5 U.S.C. § 553(d)) that the required publication of a substantive rule be made not less than 30 days before its effective date. Certainly, there is no discussion in the preamble regarding any finding of good cause for an accelerated effective date, nor does good cause for an accelerated date exist because many of the transactions impacted by the rules have been well-known for decades. The current version of section 7805(b) does not authorize an earlier effective date with respect to regulations under section 385 because section 385 predates the effective date of section 7805(b). Taxpayer Bill of Rights 2, Pub. L. No. 104-168, § 1001(b), 110 Stat. 1452, 1468-1469 (1996).

11 For comparison, the General Utilities doctrine was not repealed in a day, nor were comments limited to a 90-day period. Repeal had been debated as part of a political process, with an "unusually voluminous" literature, for years. Boris Bittker & James Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 8.20[3], n.288 7th ed. 2015). Professor Yin stated that the repeal process gained "important momentum" in 1982 -- four years before full repeal -- with the American Law Institute's publication of proposals to revise subchapter C, George K.Yin, Taxing Corporate Liquidations (and Related Matters) After the Tax Reform Act of 1986, 42 Tax L. Rev. 573, 579-580 (1987), and parts of the General Utilities doctrine were eliminated in the years preceding complete repeal. The absence of any comparable lead time is evidenced by the many issues and widespread collateral damage that the proposed regulations would create.

Also, for comparison, the original section 385 regulations were proposed to be effective more than nine months after the publication of the proposed regulations. Prop. Treas. Reg. § 1.385-1(a) (1980), 45 Fed. Reg. 18957, 18963 (Mar. 24, 1980) (proposing rules to be effective for instruments issued after December 31, 1980). The final regulations would have given an additional four-month grace period. Treas. Reg. § 1.385-1(a)(1) (1980); T.D. 7747, 45 Fed. Reg. 86438, 86445 (Dec. 31, 1980) (effective for instruments and loans issued after April 30, 1981). Ultimately, the effective dates were postponed and the regulations were withdrawn. See Joint Comm. on Tax'n, Report to the House Committee on Ways and Means on Present Law and Suggestions for Reform Submitted to the Tax Reform Working Groups, JCS-3-13, at 72-73 (May 6, 2013).

12See Treas. Reg. §§ 1.1474-1(d)(4)(iii)(C) and 1.1474-1(i) (applicability dates regarding the implementation of FATCA); T.D. 9734, 80 Fed. Reg. 56866, 56878 (Sept. 18, 2015) ("The final and temporary regulations [regarding the implementation of section 871(m)] are generally effective on September 18, 2015. To ensure that brokers have adequate time to develop the systems needed to implement the regulations, however, the final and temporary regulations generally apply to transactions issued on or after January 1, 2017.").

13See Peter L. Faber, SALT Implications of Proposed Section 385 Debt-Equity Regulations, 80 State Tax Notes 931(June 20, 2016); Amy Hamilton, Roundup of State Commentary on Proposed IRS Debt-Equity Regs, 2016 State Tax Today 117-1 (June 17, 2016).

14 In addition, large domestic corporate groups may have occasion to determine whether an intercompany obligation is an exempt consolidated group debt instrument or a non-exempt consolidated group debt instrument for purposes of Prop. Treas. Reg. § 1.385-4(b)(1). Such a determination will require access to information regarding the issuance of debt instruments, as well as all distributions, EG-member stock acquisitions and intercompany asset reorganizations during the relevant 72-month periods, including those that take place wholly within a consolidated group. The point is that every large corporate group -- even those ostensibly covered by the "treat-all-members-of-a-consolidated-group-as-one-corporation" rule -- will have to implement entirely new systems to enable them to comply with the proposed regulations.

15 The Supreme Court recently stated that "[o]ne of the basic procedural requirements of administrative rulemaking is that an agency must give adequate reasons for its decisions. The agency must examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made." Encino Motorcars, LLC v. Navarro, No. 15-415, slip. op. at 9 (decided June 20, 2016) (quotation marks and citations omitted). We observe that the preamble to the proposed regulations contains little in the way of data or fact findings, and no real discussion relating to (or an acknowledgement of) the direct consequences of the proposed regulations.

16 Section 2(c) of Executive Order 13563 states: "Before issuing a notice of proposed rulemaking, each agency, where feasible and appropriate, shall seek the views of those who are likely to be affected, including those who are likely to benefit from and those who are potentially subject to such rulemaking." The proposed regulations would have an extraordinary effect and would overturn decades of well-settled law, and are clearly intended to affect all large corporate groups regardless of their inversion status. Moreover, the bifurcation rule in Prop. Treas. Reg. § 1.385-1(d) could apply to numerous closely held corporations. Amy S. Elliott, Debt-Equity Regs Could Apply to Millions of Closely Held Corps, 2016 Tax Notes Today 113-2 (June 13, 2016) (reporting on the discussion of a panel that included a Treasury Department official, a senior attorney with the Service, and the former IRS Associate Chief Counsel (Corporate)). When would it ever be "feasible and appropriate" for tax regulations to adhere to this requirement, if these proposed regulations are excused?

17 Throughout the history of our nation's income tax laws, the Service had respected intercompany debt, and it issued elaborate rules addressing various aspects of intercompany debt. This is evidenced in regulations and proposed regulations that apply to indebtedness amongst related parties, such as regulations under Treas. Reg. § 1.1502-13(g), proposed regulations under section 163(j), and the section 301 regulations discussed in a later part of this letter; this is also consistent with the statutory provisions and legislative history discussed above. In our experience, the Service's enforcement policy has been to evaluate related-party debt under general tax principles, and taxpayers have relied on this policy for many decades. There is no discussion in the preamble why this policy must be so abruptly altered.

18 The Service has seen an "explosive growth" in partnership business structures, as noted in Michael J. Bologna, IRS Attorney Forsees Continued Growth in Partnerships, 81 BNA Daily Tax Rep. G-2, (Apr. 27, 2016). This is consistent with the data presented in Joint Committee on Taxation, Background on Business Tax Reform, JCX-35-16 (Apr. 22, 2016). See also, Ron DeCarlo & Nina Shumofsky, Partnership Returns, 2012, IRS Statistics of Income Bulletin (Winter 2015) (Table 1 reflects that Year 2013 partnership returns reflected $5.4 trillion in total income, $768 billion in total net income, and $24.1 trillion in total assets).

19See Joint Comm. on Tax'n, General Explanation of the Tax Reform Act of 1986, JCS-10-87, at 1063-1067 (1987)(explaining that the dual consolidated loss rules were intended to eliminate an undue tax advantage that favored certain foreign investors over U.S. investors in purchasing U.S. businesses).

20See Jasper L. Cummings, Jr., Can Treasury Bully Corporations into Shaping up their Debt?, 151 Tax Notes 1647,1649 (June 20, 2016 ) ("Evidently, Treasury has never talked to the CFOs who choose to impose fiscal discipline on profitable subsidiaries by making them carry the same debt load their competitors do."). We remind the Treasury Department and Service that Congress has recognized that taxpayers are free to choose to capitalize entities with a mix of stock and debt, even when the choice has tax considerations. Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as Amended, in Combination with the "Patient Protection and Affordable Care Act," JCX-18-10, at 152-153 (2010).

21 $375 of debt could be inserted into a newly-formed U.S. holding corporation formed to effect the acquisition, or into the target company through a cash merger of a transitory domestic merger corporation into the target company. While that debt could be subject to the funding rule of Prop. Treas. Reg. § 1.385-3(b)(3), a patient foreign taxpayer could wait for 37 months before allowing (or causing) the funded member to engage in a transaction that might otherwise have triggered equity-recharacterization under the funding rule.

22 The foreign acquiring corporation and the related foreign finance entity would not be subject to the U.S. income tax, and thus might not care whether the proposed regulations might restrict the interest deduction on the foreign-to-foreign intercompany borrowing. At the same time, the foreign acquiring corporation is likely to be able to deduct the interest on the intercompany borrowing under the rules applicable in its jurisdiction -- an advantage the proposed regulations would deny to a U.S. acquiring corporation.

23 While as a theoretical matter, the new leverage would be subject to equity recharacterization outside the 36-month post-acquisition period if the debt had been incurred with a principal purpose of funding a distribution, the principal purpose test cannot reasonably be interpreted to automatically turn all acquisition debt in leveraged buyouts into principal purpose debt.

24 This issue could be particularly troublesome with respect to foreign-owned financial institutions when, for regulatory reasons, additional reserves and capital infusions might be advisable, or when liquidity could be affected. See Federal Reserve System, Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations, 79 Fed. Reg. 17240 (Mar. 27, 2014).

25 We note that the anti-avoidance rule in Prop. Treas. Reg. § 1.385-3(b)(4) applies to debt instruments issued with a principal purpose of avoiding the application of the proposed regulations. Under a literal reading, this rule could apply to a debt instrument issued to an unrelated bank in lieu of an intercompany borrowing, a result that is absurd on its face.

26Falkoff v. Commissioner, T.C. Memo. 1977-93, rev'd, 604 F.2d 1045 (7th Cir. 1979) (i.e., the loan from the First National Bank of Chicago to Henry Crown and Company).

27See Standard & Poor's Ratings Criteria, including its Definitions and Glossary of Common Business and Financial Terms, https://www.standardandpoors.com/en_US/web/guest/ratings/ratings-criteria/-/articles/criteria/corporates/filter/fundamentals (last visited June 23, 2016) (identifying the financial indicators used to analyze the risks and volatility associated with incremental leverage; ratios and indicators that would be affected by the proposed regulations include a corporation's debt leverage and financial leverage ratios).

28See Dep't of the Treasury,General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals, at 16 (2009); Worker, Homeownership, and Business Assistance Act of 2009, Pub. L. No. 111-92, § 13(a), 123 Stat. 2984, 2992-2994 (2009) (enacting the five-year NOL carryback rules of section 56(d)(1)(A)(ii) and former section 172(b)(1)(H)).

29See Press Release, The White House, Remarks by the President on the Economy (Apr. 5, 2016, 12:15 PM), https://www.whitehouse.gov/the-press-office/2016/04/05/remarks-president-economy-0 ("[T]hese new actions by the Treasury Department build on steps that we've already taken to make the system fairer. But I want to be clear: While the Treasury Department actions will make it more difficult and less lucrative for companies to exploit this particular corporate inversions loophole, only Congress can close it for good, and only Congress can make sure that all the other loopholes that are being taken advantage of are closed."); Press Release, The White House, Press Briefing by Press Secretary Josh Earnest (Apr. 5, 2016, 12:30 PM), https://www.whitehouse.gov/the-press-office/2016/04/05/press-briefing-press-secretary-josh-earnest-452016 ("And we have seen previous steps by the Treasury Department because the President has said Congress needs to act to close these loopholes and to definitively prevent these kinds of transactions. But short of that, the President vowed to use all of the executive authority that's vested in the executive branch to take a look at this. That authority is vested in the Treasury Department. And it's the Secretary of the Treasury, Jack Lew, who has been at the forefront of putting in place regulations that could limit the ability of large corporations to benefit from these unfair tax practices. And there have been a series of announcements over the last couple of years from the Treasury Department. This is just the latest one.").

30See Amy S. Elliott & Lee A. Sheppard, Expanded Group Definition in Debt/Equity Regs May be Narrowed, 2016Tax Notes Today 90-1 (May 10, 2016) (citing remarks made at a bar panel discussion).

31 Bayless Manning, Hyperlexis and the Law of the Conservation of Ambiguity: Thoughts on Section 385, 36 Tax Law. 9 (1982).

32 In other words, FP and FSub are foreign corporations, USP and S1 are domestic corporations, P is a parent corporation and S is a subsidiary corporation, and a CFC is a controlled foreign corporation within the meaning of section 957(a). Also, we assume that all debt instruments are properly characterized as debt under general tax principles and comply with all relevant requirements in Prop. Treas. Reg. § 1.385-2, and are issued by entities that exceed the applicable size limitations in Prop. Treas. Reg. § 1.385-2(a)(2)(i); further, we assume that the current year earnings and profits, threshold, and funded acquisitions of subsidiary stock by issuance exceptions in Prop. Treas. Reg. § 1.385-3(c) do not apply.

33 It has been said that taxes are the lifeblood of government, their prompt and certain availability an imperious need, without which they perish. Bull v. United States, 295 U.S. 247, 259 (1935); Eddy's Steam Bakery v. Rasmusson, 47 F.2d 247, 248 (D. Mont. 1931), rev'd, 57 F.2d 27 (9th Cir. 1932). It is no less true that money and credit are the lifeblood of business, ultimately the lifeblood of jobs. See Herbert Hoover, Address at Des Moines, Iowa (Oct. 4, 1932) (from The Public Papers of the Presidents of the United States: Herbert Hoover, 1932-1933, at 467).

34See Treas. Reg. § 1.1471-5T(e)(5)(i)(D)(1)(iv)-(v).

35 As balances are not combined across pooling accounts, a combination of cross-guarantees, cross-pledges, and similar contractual terms are provided to protect the bank from exposure to gross overdrafts.

36See Treas. Reg. § 1.482-2(a)(1)(iii)(B)-(E) (exceptions for which interest is not required to be charged on intercompany borrowings that arise in the ordinary course and are of short duration); Treas. Reg. § 1.956-2(b)(1)(v) (exception to U.S. property for debt arising from sales or processing of property which the obligations are ordinary and necessary); Temp. Treas. Reg. § 1.956-2T(d)(2)(ii)-(v) (similar treatment for payables debt arising from the provision of services, and also excluding entirely short-term loans that are outstanding for only a certain period and not more than a total number of days during the year). See also section 871(g)(1)(B) (exempting from withholding tax short-term obligations -- any obligation payable 183 days or less from the date of original issue).

37 We note that the proposed regulations would hobble U.S. taxpayers in their efforts to manage their cash pooling programs; foreign competitors would face no comparable restrictions.

38 In most situations, a negative cash pool balance would automatically accrue an interest obligation under the relevant legal documentation. Compare stock, where dividends typically are not payable until such time as they are declared through board action.

39 For example, as discussed below, payments on or repayment of a debt instrument that is recharacterized as nonvoting stock could be treated as dividend payments that do not bring (and in fact eliminate) foreign taxes, for failure to satisfy the voting stock requirement of section 902(a), and that fail to qualify for a reduced treaty rate for the same reason. Surely, the Treasury Department did not intend this result.

40 As discussed in the Appendix, a borrowing that occurs on a day in January of Year 1 and that is repaid the following day can nonetheless result in the retroactive recharacterization of the borrowing under the funding rule based on a transaction that might occur any time during that taxable year, even after the borrowing has long since been repaid. Prop. Treas. Reg. § 1.385-3(d)(1)(i) (the general timing rule, which would cause a borrowing to be recharacterized as stock ab initio when the disfavored distribution or acquisition occurs in the same taxable year as the borrowing). The Prop. Treas. Reg. § 1.385-3(d)(1)(ii) exception to the general timing rule would only apply when the disfavored distribution or acquisition occurs in a taxable year subsequent to the borrowing.

41 Alternatively, if the negative cash pool balance recharacterized as equity is held by a subsidiary of the "issuer," the deemed redemption could qualify for sale or exchange treatment under section 302(a). See Rev. Rul. 74-605, 1974-2 C.B. 97; Treas. Reg. § 1.318-1(b)(1).

42 Notice of Proposed Rulemaking, The Allocation of Consideration and Allocation and Recovery of Basis in Transactions Involving Corporate Stock or Securities, REG-143686-07, 74 Fed. Reg. 3509 (Jan. 21, 2009) (publishing Prop. Treas. Reg. § 1.302-5).

43 Notice of Proposed Rulemaking, Redemptions Taxable as Dividends, REG-150313-01, 67 Fed. Reg. 64331 (Oct. 18, 2002) (publishing Prop. Treas. Reg. § 1.302-5) (subsequently withdrawn in Announcement 2006-30, 2006-1 C.B. 879, 71 Fed. Reg. 20044 (Apr. 19, 2006)).

44 For example, assume a corporation commences a day with a positive balance of $100, during the day deposits $350 and withdraws $180, and ends with a positive balance of $270. If all of the draws occur prior to any of the deposits, the corporation could have a negative balance of $80 during a portion of the day, if the pool has intra-day sweeps. The ostensible tax policies underlying the proposed regulations would not be served by seizing on an intra-day negative balance to link it to some other transaction. For obvious practical concerns, a close-of-the-day approach would be preferable.

45 To illustrate, assume a foreign parent corporation owns US1 and US2, each a domestic corporation and a parent of its own consolidated group with numerous lower-tier subsidiaries. If both the US1 group and the US2 group join in a common domestic cash concentration pool and each group maintains a net positive balance overall, but one subsidiary of one group (say, US1 group) has a negative balance, would the US1 subsidiary be considered to be a borrower from each member of the US1 and US2 groups that has a positive balance? Presumably, any borrowing apportioned to other US1 group members would be disregarded under the single corporation rule of Prop. Treas. Reg. § 1.385-1(e), but how should the remaining "borrowing" be apportioned? Would the apportionment change every time the positive or negative balance of any pool member changes? How could the Service administer this rule? Is there any benefit in attempting to do so?

46 Rev. Rul. 76-192, 1976-1 C.B. 205.

47See Treas. Reg. § 301.7701-3(d).

48 A "qualified stock purchase" is defined in section 338(d)(3). Note that this issue is implicated when a debt instrument is reclassified as stock other than section 1504(a)(4) stock, and thus is not expected to apply in all circumstances.

49 An election under sections 336(e), 338(g) or 338(h)(10) and the deemed transactions that would arise as a result of such an election would not cause intercompany debt (including recharacterized debt) amongst a target company and its subsidiary entities to disappear. Thus, these elections would not serve as a mechanism to simplify the target group's historic intercompany debt structure or otherwise moot section 385 considerations. Rather, additional questions would be raised, as noted in the Appendix.

50See Treas. Reg. § 301.7701-3(d)(1)(i).

51See Prop. Treas. Reg. § 1.385-1(b)(3).

52See Rickey v. United States, 592 F.2d 1251, 1255 (5th Cir. 1979) (referring to the attribution rules in sections 318(a)(1), (a)(2), (a)(3) and (a)(4) as "four horror stories for taxpayers").

53 We note that the Treasury Department and Service are on notice of this issue. See Amy S. Elliott, Practitioners Question Application of Related-Party Debt Rules, 2016 Tax Notes Today 76-2 (Apr. 20, 2016).

54 The constructive ownership by an entity of stock actually owned by the entity's shareholders or partners is also referred to as "back attribution." Fred Ringel, Stanley Surrey & William Warren, Attribution of Stock Ownership in the Internal Revenue Code, 72 Harv. L. Rev. 209, 218 (1958); William Goldstein, Attribution rules: undue multiplicity, complexity can create liabilities, 15 Proc. Ann. Tul. Tax. Inst. 384, 389 (1965).

55 This example exists in practice -- a number of large publicly traded corporate enterprises, both domestic and foreign, have entered into 50-50 corporate joint venture arrangements. Note that if X had funded Z in part with debt capital, and if Z were itself a foreign entity, the reclassification of some of the Z-to-X debt could cause Z to become a controlled foreign corporation (CFC) within the meaning of section 957(a), even when there was no U.S. tax motivation to the debt capitalization, and even if in substance Z remained 50 percent foreign-owned and foreign-controlled. If thereafter Y were to fund Z with debt capital, the recharacterization of the Z-to-Y debt instrument could have the effect of "de-CFC'ing" Z, surely not what the Treasury Department or Service might have intended the proposed regulations to accomplish.

56 In other contexts, "tie-breaker" rules are provided to prevent the complexities and absurdities that can occur when a corporation is part of two groups at the same time. See section 1563(b)(4); Treas. Reg. § 1.1563-1(c)(1); Prop. Treas. Reg. § 1.163(j)-5(a)(4). We recommend that a tie-breaker rule be added to the proposed regulations, for reasons similar to those underlying the other tie-breaker rules.

57 Recently, the "May Co." regulations were retroactively corrected (the official terminology) to eliminate some problems that arise due to the extraordinary reach of the section 318 attribution rules in the partnership context. See Correcting Amendments to T.D. 9722, 80 Fed. Reg. 38940 (July 8, 2015) (correcting Temp. Treas. Reg. §§ 1.337(d)-3T(c)(2)(i) and - 3T(f)(2)(ii) by providing that control is to be determined with reference to section 304(c), "except that section 318(a)(1) and (3) shall not apply"); Deanna Walton Harris, Long Awaited Section 337(d) Regulations Leave Some Questions Unanswered, 42 J. Corp. Tax'n., 37, 41 (Sept./Oct. 2015).

58 The constructive ownership rules that apply with respect to stock owned by or for a corporation -- sections 318(a)(2)(C) and 318(a)(3)(C) -- are based on a shareholder owning 50 percent or more in value of the stock of a corporation. In the example, at first impression, USP would directly own less than 50 percent of the value of the stock in CFC1 ($100/$250).

59 If the CFC1 debt instrument in nonvoting, USP would directly own stock representing 100 percent of the CFC1 voting power.

60See Stephen B. Land, Strange Loops and Tangled Hierarchies, 49 Tax L. Rev. 53 (1993); David F. Shores, Section 304 and the Limits of Statutory Law, 16 Va. Tax Rev. 455 (1997).

61See Prop. Treas. Reg. § 1.385-1(b)(3)(i)(A), which references the definition of section 1504(a) without regard to S corporation exclusion in section 1504(b)(8).

62 From tax returns filed for in 2012, more than 3,700 S corporations reported assets in excess of $100 million, and more than 15,000 reported revenues in excess of $50 million. Joint Comm. on Tax'n, Background on Business Tax Reform, JCX-35-16, at 24 tbl.4 (Apr. 22, 2016).

63 We understand that the Treasury Department and Service intend to expand Prop. Treas. Reg. § 1.385-1(b)(3)(i)(B) so that it would substitute "directly or indirectly" in lieu of "directly" in section 1504(a)(1)(B)(ii).

64 We would note the potential, perhaps unlikely, that if a tax-exempt section 501(c)(3) organization were to issue a debt instrument to a related or subsidiary C corporation and the debt instrument were to be recharacterized as "stock" in the tax-exempt, there might be unfortunate complications under various rules, perhaps including the no-private-inurement rule. See John Woodhull & Erica Reiderbach, Taxable Subsidiaries of Tax-Exempt Organizations, 25 Tax'n Exempts 19 (Jan./Feb. 2014) ("Tax-exempt organizations have been creating taxable subsidiaries for as long as most practitioners can remember.").

65 For example, the Treasury Department exempted S Corporations, RICS, and REITs from the dual consolidated loss rules when the section 1503(d) regulations were revised in the 2005-2007 timeframe. See Treas. Reg. § 1.1503(d)-1(b)(1). The reason for this exemption was that the entities were not generally subject to corporate level U.S. federal income tax. See Dual Consolidated Loss Regulations, T.D. 9315, 72 Fed. Reg. 12902, 12902-12903 (Mar. 19, 2007) (discussing RICs and REITs); Dual Consolidated Loss Regulations, REG-102144-04, 70 Fed. Reg. 29868, 29870 (May 24, 2005) (discussing S Corporations). The actual or effective pass-through nature of these entities similarly militates against subjecting such entities to rules whose ostensible purpose is to combat erosion of the corporate income tax base through "earnings stripping."

66 The foreign tax credit originated in sections 222(a) (as to individuals), 238(a) (as to domestic corporations), and 240(c) (the deemed paid credit) of the Revenue Act of 1918, ch. 18, 40 Stat. 1057, 1073, 1080, 1082 (1919). Its purpose has been described as "to mitigate the evil of double taxation" and facilitate the foreign enterprises of domestic corporations (Burnet v. Chicago Portrait Co., 285 U.S. 1, 7-8 (1932)) and "to obviate double taxation" (American Chicle Co. v. United States, 316 U.S. 450, 451 (1942)).

67 For purposes of the section 902 deemed paid credit, USS1 would not be treated as owning the stock in CFC1 that is owned by USP, regardless of whether USP and USS1 consolidate. See Rev. Rul. 85-3, 1985-1 C.B. 222; First Chicago Corp. v. Commissioner, 96 T.C. 421 (1991), aff'd, 135 F.3d 457 (7th Cir. 1998). Moreover, the all-members-of-a-consolidated-group-as-one-corporation rule in Prop. Treas. Reg. § 1.385-1(e) would apply for purposes of the section 385 regulations, not for purposes of the deemed paid credit under section 902.

68 Similarly, a deemed paid foreign tax credit might not be available to a CFC in an alternative fact pattern where debt between two CFCs is recharacterized as non-voting equity. Rev. Rul. 74-459, 1974-2 C.B. 207. Nevertheless, the CFC making distributions on a recharacterized debt instrument would continue to be required to reduce its foreign tax credit pool by the amount of taxes attributable to the dividend thereby preserving its effective tax rate. Treas. Reg. § 1.902-1(a)(8). See Kevin M. Cunningham, The New Section 385 Proposed Regulations: No More Alice in Wonderland, 43 J. Corp. Tax'n 4 (July/Aug. 2016).

69See Treas. Reg. § 1.902-1(a)(8).

70 See Rev. Rul. 91-5, 1991-1 C.B. 114; Rev. Rul. 92-86, 1992-2 C.B. 199.

71 Rev. Rul. 91-5, 1991-1 C.B. 111.

72 Rev. Rul. 92-86, 1992-2 C.B. 149.

73 The legislative history indicates that Congress intended foreign tax credits to be available "to the same extent as if the distribution had been made directly by the corporation that is treated as having made the distribution [under section 304(a)]." H.R. Conf. Rep. No. 98-861, at 1223 (1984).

74 81 Fed. Reg. 20912, 20929-20930 (Apr. 8, 2016).

75 Rev. Rul. 59-259, 1959-2 C.B. 115.

76 This can apply in the context of a forward triangular merger under section 368(a)(1)(A) by reason of section 368(a)(2)(D), a reverse subsidiary merger under section 368(a)(1)(A) by reason of section 368(a)(2)(E), a triangular stock acquisition under section 368(a)(1)(B), and a triangular asset acquisition under section 368(a)(1)(C).

77 Section 368(a)(1)(B).

78 Section 368(a)(2)(E)(ii).

79 Section 368(c) is also referred to in sections 108(e)(7)(C), 367(a)(5), 1202(h)(4)(D), and 1361(f)(2)(B).

80See Hempt Bros., Inc. v. Commissioner, 490 F.2d 1172, 1177 (3d. Cir. 1974) ("Section 351 has been described as a deliberate attempt by Congress to facilitate the incorporation of ongoing businesses and to eliminate any technical constructions which are economically unsound."). See also Rev. Rul. 2003-51, 2003-1 C.B. 938, Rev. Rul. 2015-9, 2015-21 I.R.B. 972 and Rev. Rul. 2015-10, 2015-21 I.R.B. 973, in which the Service seems to have taken pains to ensure that certain transactions could qualify for section 351 treatment notwithstanding the step-transaction doctrine. In addition, the non-recognition provisions, in many instances, serve an anti-avoidance function as well, as is evidenced by the numerous liquidation-reincorporation cases decided in the context of the tax-free reorganization definition of section 368(a)(1)(D) (where the Service argued there had been a reorganization -- in the face of taxpayer arguments that the transactions involved taxable corporate liquidations). This latter point is also evidenced by the history of the Revenue Act of 1934, when a Congressional subcommittee proposed repealing the tax-free reorganizations, only to have the provisions retained at the behest of the Treasury Department. See Statement of the Acting Secretary of the Treasury Regarding the Preliminary Report of a Subcommittee of the Committee on Ways and Means, 9-10 (1933); H.R. Rep. No. 704, 73d Cong., 2d Sess., at 12-13 (1934); S. Rep. No. 558, 73d Cong., 2d Sess., at 16-17 (1934). The point is that there are significant and multifaceted tax policy rationales underlying the non-recognition provisions in subchapter C, which will be upset in many situations if the proposed regulations were to be finalized in their current form.

81See Dep't of the Treasury, General Explanations of the Administration's Fiscal Year 2017 Revenue Proposals, at 239 (2016) (proposal to repeal the nonqualified preferred stock provisions).

82 Section 332(b)(1).

83 Numerous provisions of the Code refer to section 1504(a), including in sections that apply to inversions (sections 4985(e)(4) and 7874(c)(1)).

84 This accrues because the recharacterized debt instrument would have gone through the deemed satisfaction and reissuance rules of Treas. Reg. § 1.1502-13(g), and would have been treated as having been reissued at its fair market value, reflecting a discount to the debt instrument's stated redemption price at maturity.

85 We believe that "control" will be inappropriately affected in many situations when sophisticated taxpayers would be cognizant and able to accurately evaluate the current status of a recharacterized debt instrument. However, we understand that the Treasury Department and Service are unsympathetic to this issue, and believe that a debt instrument that is recharacterized under the rules should be treated as stock for all purposes. Thus, this comment is focused on the fundamental unfairness of a retroactive recharacterization of a debt instrument.

86 Prop. Treas. Reg. § 1.385-3(d)(1)(i).

87 Prop. Treas. Reg. § 1.385-2(c)(3)(i).

88 Under Prop. Treas. Reg. § 1.385-2(a)(3), once T characterizes the debt instrument as indebtedness, T, CFC, and "any other person relying on the characterization of [the T-CFC debt instrument] as indebtedness for federal tax purposes" must treat the T-CFC debt instrument as debt. This appears to bind USP, even if it has some doubt as to whether the debt instrument, for example, had been supported by a sufficiently robust financial due diligence.

89 In certain limited circumstances, a tax-free transaction that no longer qualified as such due to a retroactive recharacterization of a debt instrument under the documentation rule, might have been consummated in a taxable year closed to assessment under the statute of limitations. The Treasury Department and Service have previously encountered this phenomena. See Karen C. Burke, The Story of Hendler: From Pyrrhic Victory to Modern Section 357, in Business Tax Stories (Steven A. Bank and Kirk J. Stark, eds. 2005) (Foundation Press).

90 A number of tax rules outside of the subchapter C/consolidated returns context hinge on membership in the same affiliated group or that otherwise are based on section 1504(a) control, and these rules could be affected by stock recharacterizations of debt instruments under the proposed regulations. As one perhaps obscure example, section 6715A imposes a penalty for the tampering with a mechanical dye injection system used to indelibly dye fuels for purposes of the section 4802 exemption from the excises on diesel fuels and kerosene. We understand that there has been an historic concern with respect to the evasion of diesel fuels taxes by various individuals and organized crime elements, and that the diesel dyeing system is an important component of law enforcement efforts. Section 6715A(c)(2) imposes joint and several liability on the parent corporation of an affiliated group, if a member of the group is liable for a monetary penalty for tampering. See Joint Comm. on Tax'n, General Explanation of Tax Legislation Enacted in the 108th Congress, JCS-5-05, at 436-439 (2005). Section 1504(a) is also referred to in other provisions outside of subchapter C, such as the corporate equity reduction transactions rules (section 172(g)(3)(E)(i)), the LIFO inventory rules (section 472(g)(2)(A)), the worldwide interest apportionment election in section 864 sourcing rules (section 864(f)(1)(C)), the rules addressing sales of stock to an employee stock ownership plan or cooperative (section 1042(b)(2)(A)), the section 1092 straddle rules (section 1092(d)(3)(B)), and special rules relating to the definition of price for purposes of the manufacturers tax (section 4216(b)(3)(A) and (b)(4)(A)).

91Cf. Treas. Reg. § 1.1361-5(b)(1) ("For purposes of determining the application of section 351 with respect to this transaction, instruments, obligations, or other arrangements that are not treated as stock of the QSub under § 1.1361-2(b) are disregarded in determining control for purposes of section 368(c) even if they are equity under general principles of tax law.").

92 Treas. Reg. § 1.482-2(g)(3)(i); Rev. Proc. 99-32, 1999-2 C.B. 296.

93 We note that the Fifth Circuit Court of Appeals in BMC Software, Inc. v. Commissioner, 780 F.3d 669 (5th Cir. 2015), squarely rejected the government's contentions that account payables arising under Rev. Proc. 99-32 could be considered to be in existence retroactively for purposes of section 965 vis-à-vis the years implicated by the adjustment. The Court's reasoning would apply with equal force to provide in this hypothetical that the account payable should not be treated as in existence until Year 4, to the extent it is even treated as "indebtedness" at all for federal tax purposes.

94 We observe that while the proposed regulations assume that a capital contribution should be treated the same as an actual issuance of stock (Prop. Treas. Reg. § 1.385-3(g)(3), Example 11(i)), the proposed regulations contain no operative rule that would provide for this result. Cf. section 367(c)(2) (creating a deemed issuance of stock in certain capital contributions made to a foreign corporation); Treas. Reg. § 1.368-2(l)(2)(i) (deeming a nominal share of stock to have been issued in the context of a stockless reorganization under section 368(a)(1)(D)).

95See Rev. Proc. 99-32, § 5.01(4)(e).

96 The premise underlying dividend-equivalent redemptions is that the cancellation of some number of shares does not fundamentally alter the redeemed shareholder's economic investment in the distributing/redeeming corporation. Thus, the shareholder's basis in the distributing/redeeming corporation, which measures the shareholder's investment, should be preserved.

97 The "all boot D" basis regulations specifically instruct the shareholder to designate the particular share to which unrecovered basis attaches. Treas. Reg. § 1.358-2(a)(2)(iii)(B). A similar rule here could provide some clarity, especially when the redeeming corporation might have issued multiple debt instruments to disparate EG members that are potentially subject to recharacterization as stock. Alternatively, a rule could provide that when the holder of the recharacterized debt instrument does not actually own stock in the issuer, the holder's "stock basis" attaches to the particular actual shareholder that furnished the requisite attributive link implicating section 302(d). See Rev. Rul. 71-563, 1971-2 C.B 175 (generally providing this result in the context of a section 304 sale of less than100% of the Issuing corporation stock, where the selling shareholder did not actually own any stock of the constructively related acquiring corporation).

98 Notice of Proposed Rulemaking, The Allocation of Consideration and Allocation and Recovery of Basis in Transactions Involving Corporate Stock or Securities, REG-143686-07, 74 Fed. Reg. 3509 (Jan. 21, 2009) (publishing Prop. Treas. Reg. § 1.302-5).

99 Notice of Proposed Rulemaking, Redemptions Taxable as Dividends, REG-150313-01, 67 Fed. Reg. 64331 (Oct. 18, 2002) (publishing Prop. Treas. Reg. § 1.302-5) (subsequently withdrawn in Announcement 2006-30, 2006-1 C.B. 879, 71 Fed. Reg. 20044 (Apr. 19, 2006)).

100See Rev. Rul. 74-605, 1974-2 C.B. 97; Treas. Reg. § 1.318-1(b)(1).

101 Similar issues might arise where two entities repay borrowed funds from each other at various points during the same taxable year. For example, assume on Jan. 15 of Year 2, CFC1 repaid a recharacterized debt instrument it had issued to CFC2 in Year 1, on June 1 of Year 2 CFC2 issued a new debt instrument to CFC1 in a general rule transaction, and on Nov. 30 of Year 2 CFC2 repaid its debt instrument. During the Year 2, CFC1 and CFC2 would each have redeemed a recharacterized debt instrument from the other. The issue might arise more frequently where multiple entities participate in a common cash pool or treasury center arrangement, or when a U.S. acquirer purchases a foreign corporate group and seeks to "clean up" the foreign target's intercompany debts.

102 The offset could also arise in other ways, such as if CFC3 were to liquidate into CFC2.

103 The Service addressed a reciprocal redemption fact pattern prior to General Utilities repeal in Rev. Rul. 79-314, 1979-2 C.B. 132 (nonliquidating distributions in a section 302(a) cross-redemption context), and in Rev. Rul. 80-181, 1980-1 C.B. 70 (liquidating distributions). These rulings were obsoleted in Rev. Rul. 2003-99, 2003-2 C.B. 388. Perhaps the Service has considered variations of this issue when issuing regulations in the May Company context. See T.D. 9722, 80 Fed. Reg. 33402 (June 12, 2015) (adding Treas. Reg. § 1.337(d)-3T) (where a partner is acting in its partner capacity as receiving a distribution from a partnership, and it its capacity as a corporation that is transferring a partnership interest to its shareholder to redeem its stock). Note that if one corporation were to transfer a recharacterized debt instrument issued to it by an EG member to retire a recharacterized debt instrument it had previously issued to a different EG member, the retirement itself could be viewed as a section 304(a)(1) transaction leading to a simultaneous, cross-section 304(d) redemption fact pattern (and itself potentially setting up further complexities under the per se rule).

104 Earnings and profits for a taxable year are computed at the close of the year, without diminution by reason of distributions made during the year. Section 316(a)(2). In the example, CFC1's $5 of earnings and profit would be treated as having been distributed to CFC2, thus creating $5 in earnings and profits for CFC2 for the year, which could then be treated as having been received by CFC1 in the CFC2-to-CFC1 distribution, which would give CFC1 $10 ($5 plus $5) in current earnings and profits, and so on. Clearly this type of duplication is absurd, yet it appears mandated by a literal application of the mechanical rules in section 316.

105 The rule in Prop. Treas. Reg. § 1.385-3(b)(3)(iii) appears to be focused on a situation where a specific distribution or acquisition is picked up in more than one of the triggers of Prop. Treas. Reg. § 1.385-3(b)(3)(ii) (i.e., overlap situations), and not on the situation where a particular distribution or acquisition could serially taint successive debt instruments.

106 The multiple interests rule in Prop. Treas. Reg. § 1.385-3(d)(3)(iv)(B)(3) does not appear to apply, because in Year 4, the Year 1 debt instrument has been retired and is no longer treated as having funded the Year 2 distribution.

107Cf. Prop. Treas. Reg. § 1.385-3(d)(2) (expressly authorizing re-testing when a recharacterized debt instrument leaves the EG).

108 Treas. Reg. § 1.7701(l)-3.

109 Treas. Reg. § 1.7701(l)-3(b)(2)(ii) (providing that "stock is not fast-pay stock solely because a redemption is treated as a dividend as a result of section 302(d) unless there is a principal purpose of achieving the same economic and tax effect as a fast-pay arrangement."). Our recommendation addressing the interaction of the proposed regulations and the fast-pay stock rules is contained in the Appendix.

110 We have added to the Appendix additional comments and recommendations regarding the current year earnings and profits exception, to address the exception's application in the context of consolidated groups.

111 Section 11(a).

112 Section 61(a)(7).

113 Corporations generally have been permitted to deduct dividends received from other corporations beginning with the enactment of a dividends received deduction. Payne-Aldrich Tariff Act of 1909, ch. 6, § 38, 36 Stat. 11, 112 (1909). See Daniel C. Schaffer, The Income Tax on Intercorporate Dividends, 30 Tax Law. 161, 163 (1979); Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders, ¶ 5.05 (7th ed. 2000 & Supp. 2015-03).

114 Section 246(c).

115 Rev. Rul. 94-28, 1994-1 C.B. 86. See Jasper L. Cummings, Jr., Dividends and Sales of Privately Held Stock - Avoiding the Limitations of Section 246(c), 108 J. Tax'n 156 (2008).

116 Treas. Reg. § 1.1502-13(g)(3)(i)(B)(8) (outbound subgroup exception); Treas. Reg. § 1.1502-13(g)(5)(i)(b)(2) (inbound subgroup exception).

117See Schering Plough v. United States, 651 F.Supp.2d 219 (D. N.J. 2009), aff'd sub nom. Merck & Co. Inc. v. United States, 542 F.3d 475 (3d. Cir. 2011); Hewlett-Packard Co. v. Commissioner, T.C. Memo. 2012-135; NA General Partnership v. Commissioner (Scottish Power), T.C. Memo. 2012-172; PepsiCo Puerto Rico, Inc. v. Commissioner, T.C. Memo. 2012-269.

118See DF Systems, Inc. v. Commissioner, 548 Fed. Appx. 247 (5th Cir. 2013) (unpublished); Ramig v. Commissioner,T.C. Memo. 2011-147, aff'd, 496 Fed. Appx. 756 (9th Cir. 2012) (unpublished); Hubert Enterprises, Inc. v. Commissioner, 125 T.C. 72 (2007), aff'd in part, vacated in part, 230 Fed. Appx. 526 (6th Cir. 2007) (unpublished).

119 We note that other commenters have written that the estimate of the compliance costs woefully understates the actual costs that the documentation and substantiation requirements of the proposed regulations would impose. See the comment letters from the Business Roundtable (June 7, 2016) and the United States Council for International Business (June 7, 2016).

120Kraft Foods Co. v. Commissioner, 232 F.2d 118, 124 (2d. Cir. 1956).

121 Prop. Treas. Reg. § 1.385-3(d)(5)(i).

122 A well-known article on this topic concludes that there are up to 25 different ways to calculate a partner's share of profits. See Sheldon I. Banoff, Identifying Partners' Interests in Profits and Capital: Uncertainties, Opportunities and Traps, 85 Taxes 197, 209 (2007).

123 If individual A directly or indirectly owns 50 percent or more of the stock in two or more corporations, A is a member of the modified expanded group that includes both corporations, as is A's spouse, children, grandchildren, and parents (each of whom would be treated as owning the stock owned by A, by reason of section 318(a)(1)(A)). We observe that section 318(a)(5)(B) provides a limited exception to the section 318(a)(5)(A) reattribution rule, so that stock constructively owned by a member of A's family under would not be further reattributed to other members of A's family; thus, a spouse of one of A's children would not be included in the modified expanded group.

124 Amy S. Elliott, Debt-Equity Regs Could Apply to Millions of Closely Held Corps, 2016 Tax Notes Today 113-2 (June 13, 2016).

125 Robert H. Dilworth, U.K. Treaty Conflict: Unintended (?) Consequences of the U.S. Debt-Equity Regulations, 82 Tax Notes Int'l 975 (June 6, 2016).

126Compare, e.g., U.S.-U.K. Income Tax Treaty, art. 23(2)(c)(ii) (requiring that at least 50 percent of the aggregate vote and value of the shares in the company be owned directly or indirectly by five or fewer companies that are qualified residents because they are publicly traded and, in the case of indirect ownership, requiring each intermediary company to be a resident of either the U.S. or the U.K.), with U.S.-U.K. Income Tax Treaty, art. 23(2)(f)(ownership/base erosion test). Examples of other U.S. treaties that require intermediate owners to be "qualified" under the publicly traded test: Australia, Canada, France, Germany, and the Netherlands.

127 Generally, treaties would allow a subsidiary such as UKSub to be a qualified resident if a recharacterized debt instrument does not represent 50% or more of the subsidiary's value. However, a class of stock owned by a non-qualifying intermediate owner (such as FSub) appears to disqualify UKSub from qualifying as a subsidiary of a publicly traded corporation even if the recharacterized debt instrument represents less than 50% of UKSub's value. See Dep't of the Treasury, Technical Explanation of the U.S.-U.K. Income Tax Treaty, art. 23 (Mar. 5, 2003) (the subsidiary of a publicly traded entity test requires that 50% of each class of stock be owned by qualifying owners).

128 U.S.-U.K. Income Tax Treaty, art. 10(1).

129 The treaty defines "interest" as "income from debt-claims of every kind. . . ." U.S.-U.K. Income Tax Treaty, art. 11(2). The proposed regulations would appear to effectively override this definition.

130 S. Rep. No. 91-552, at 138 (1969). The House bill had included a more limited provision addressing certain corporate acquisition indebtedness, which was enacted as part of the bill and is now codified in section 279.

131Id. The Conference Report simply noted that the conference substitute followed the Senate amendment. H.R. Conf. Rep. 91-782, at 308-309 (1969).

132 Tax Reform Act of 1969, Pub. L. No. 91-172, § 415(a), 83 Stat. 487, 613-614. Section 385 has been amended three times. See Tax Reform Act of 1976, Pub. L. No. 94-455, § 1906(b)(13)(A), 90 Stat 1719, 1834 (a clerical amendment replacing "Secretary or his delegate" with "Secretary"); Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, § 7208, 103 Stat. 2106, 2337 (inserting parenthetical language in section 385(a) to authorize prospective regulations to treat certain corporate interests as in part stock and in part indebtedness); and Energy Policy Act of 1992, Pub. L. No. 102-486, § 1936(a), 106 Stat. 2776, 3032 (adding section 385(c)).

133 Joint Comm. on Internal Revenue Tax'n, General Explanation of the Tax Reform Act of 1969, JCS-16-70, at 123 (1970).

134Falkoff v. Commissioner, 604 F.2d 1045 (7th Cir. 1979).

135 As to the latter point, we note that similar "no-tracing" methodologies are used in narrow contexts, for compelling reasons, and only when the no-tracing rules would have a quite limited effect. For example, a no-tracing rule is used in the corporate equity reduction transaction (or CERT) context. However, that rule was adopted per Congress' specific direction that in computing a corporate equity reduction interest loss, a strict avoided cost methodology would apply. Section 172(g)(2)(B). In addition, the CERT rules have a narrow application, only serving to preclude taxpayers from carrying back certain interest-deduction-fueled net operating losses to prior taxable years (taxpayers remain able to use those deductions currently and to carry over interest deduction-fueled losses to offset income in future taxable years). Similarly, an approach that rejects tracing was promulgated as part of the current Unified Loss Rule (ULR), Treas. Reg. § 1.1502-36. However, the ULR regime is a rule with limited application, in that it applies on a loss limitation model, and only seeks to (i) disallow losses that result from noneconomic basis adjustments otherwise enabled by the consolidated return regulations, and (ii) prevent the duplication or multiplication of a single economic loss. Neither the CERT rule nor the ULR rule has the potential to apply to nearly as many taxpayers or as many transactions as would the proposed regulations.

136 For example, in the "leveraged distribution" context, the corporation in John Kelley Co. v. Commissioner, 326 U.S. 521 (1946) issued and distributed its debt instruments in 1937, the corporation in Bazley v. Commissioner, 331 U.S. 737 (1947) issued and distributed its debt instruments in 1939, and the taxpayer in Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d. Cir. 1956) issued and distributed its debt instruments beginning in 1934. Note or"open account" distributions were at issue in the income and excess profits cases of Logan-Gregg Hardware Co. v. Heiner, 26 F.2d 131 (W.D. Pa. 1928) (note distributions made in 1918) and Weed & Bro. v. United States, 38 F.2d 935 (Ct. Cl. 1930) (distributions were credited in 1919 to the accounts of shareholders, who were free to draw upon at accounts at any time). In each of these cases, the underlying debt instruments (or journal entries) were issued -- and the cases were decided -- years before the 1969 enactment of section 385. As for tax planning around the timing of a distribution and the particular pool of earnings and profits from which a distribution is made, multiple statutory amendments and Supreme Court cases from the 1910s and 1920s evidence that Congress was exquisitely aware of the issue during the infancy of the income tax laws, as can be seen from the discussion in Edwards v. Douglas, 269 U.S. 204 (1925). For example, the combined income, surtax and excess profits tax rates applicable to dividends ranged from 0% (for distributions of pre-1913 earnings and profits) to 67% (for distributions of earnings and profits generated in 1917).

Congress was aware that taxpayers might seek to time corporate distributions to take advantage of a temporary absence of earnings and profits, when it enacted section 312(i) in response to the decision in Commissioner v. Gross, 236 F.2d 612 (2d. Cir. 1956). At the time Congress codified the General Utilities doctrine in 1954, it was well-understood that a corporation with no earnings and profits could distribute appreciated assets without recognizing gain, without generating earnings and profits, and without having the shareholder receiving the distribution be liable for a dividend tax. Randolph E. Paul, Ascertainment of 'Earnings or Profits' for the Purpose of Determining Taxability of Corporate Distributions, 51 Harv. L. Rev. 40, 51-61 (1937); Leonard Raum, Dividends in Kind: Their Tax Aspects, 63 Harv. L. Rev. 593 (1950); Commissioner v. Timkin, 141 F.2d 625, 630 (6th Cir. 1944); Gross, 236 F.2d at616 (describing the issue as "familiar"). Nothing in the legislative history suggests Congress had these issues in mind when it enacted section 385. To the contrary, it is fair to infer that Congress knows precisely how to amend substantive tax law (which it did in enacting section 312(i)) when it does not like the substantive results from tax planning, and the fact that Congress has not done so -- especially given the Treasury Department's energetic insistence in multiple proposals -- is not some implicit authorization for the Treasury Department to bypass Congressional inaction. In this regard, we observe that as discussed elsewhere in our comments, Congress specifically amended the Code to address the effect of a corporation's distribution of its own discounted debt instruments. See sections 312(a)(2) and 1275(a)(4). Congress is aware that corporations can distribute their debt instruments, and it has never decided to outlaw this practice. The Treasury Department cannot credibly claim that its proscribing note distributions in the proposed regulations would faithfully further the purposes of the Congress that enacted section 385.

137 Joint Comm. on Tax'n, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as Amended, in Combination with the "Patient Protection and Affordable Care Act," JCX-18-10, at 152-153 (Mar. 21, 2010) (citations omitted) (emphasis added).

138See Dep't of the Treasury,General Explanations of the Administration's Fiscal Year 2017 Revenue Proposals,114-116 (2016). The section 356(a)(2) issue is well known, and has even given rise to an exhaustive treatment in the tax literature. See Michael L. Schler, Rebooting Section 356: Part 1 - The Statute, 128 Tax Notes 285 (July 19, 2010). This hardly is some new-found awareness -- the House of Representatives proposed repealing it in 1954, and it was repeatedly the subject of proposals to Congress including proposals by the Staff of the Senate Finance Committee and the Joint Committee on Taxation. Id. at 289; Jasper L. Cummings, Jr., Form vs. Substance in the Treatment of Taxable Corporate Distributions, 85 Taxes 119, 155 n.123 (2007). See also Walter J. Blum, The Earning and Profits Limitation on Dividend Income: A Reappraisal, 53 Taxes 68, 80 n.17 (1975).

139Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931).

140Falkoff v. Commissioner, 604 F.2d 1045 (7th Cir. 1979). See also Kraft Foods Co. v. Commissioner, 232 F.2d 118(2nd Cir. 1956).

141 As early as 1956, Professor Andrews concluded that "[t]he requirement that a distribution, to be taxed as ordinary income, must be out of earnings and profits has outlived its usefulness" William D. Andrews, "Out of its Earnings and Profits": Some Reflections on the Taxation of Dividends, 69 Harv. L. Rev. 1403, 1438 (1956). Professor Andrews was neither the first nor the last person to call for repealing the earnings and profits limitation on dividends; however, the limitation endures, notwithstanding multiple suggestions that Congress repeal it. As noted by the Seventh Circuit in Falkoff, 604 F.2d at 1051-1052:

 

The Commissioner, of course, has argued that to reverse the Tax Court's judgment would permit taxpayers to determine for themselves the time and manner of taxation, in frustration of Congressional directive and with prejudice to the federal fisc. We think our decision here will have no such dire consequence. Congress in enacting the revenue code adopted the annual accounting concept and permitted the wholly-owned corporation to be treated as an entity separate from the shareholder. We believe the taxpayers here did no more than use these characteristics of the tax system to their best advantage. The situation here is an unusual one a corporation without accrued or current earnings and profits but with substantial assets against which it can borrow to make a cash distribution to its shareholders. Yet, even here the effect is only to delay, not escape, taxation. A distribution reduces a shareholder's basis in his shares and thereby increases taxable gain upon disposition of the stock. The Corporation's future earnings and profits will be taxed as dividends when distributed.

 

142See Dep't of the Treasury,General Explanations of the Administration's Fiscal Year 2017 Revenue Proposals, 2-4, 114-116 (2016); Dep't of the Treasury, Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties (Nov. 2007).

143See Department of the Treasury,General Explanations of the Administration's Fiscal Year 2004 Revenue Proposals, 104-106 (2003). Similar proposals have been included in a number of subsequent budget proposals under Presidents Bush and Obama.

144See David H. Brockway, Section 304 is Very Strange, Tax Forum No. 517, reprinted in 76 Tax Notes 189 (July 14,1997). See also Boris Bittker & James Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 9.09[1] (7th ed. 2015) ("[S]ection 304 itself rests on a fiction and in turn employs other fictions and minutiae. . ., a fantasia surprising even for the fiction-happy tax law. Like other dividend-versus-sale rules, it has generally been used by corporations to obtain dividend treatment and avoided by individuals seeking capital gains. What started out as a modest anti-dividend avoidance rule has grown into a considerable monster."); Tax Section, N.Y. State Bar Ass'n, Report No. 716, Report on Section 304(b)(4), at 3 (1992) ("Viewed with the modern eye, the concerns that section 304 addresses seem to some degree exaggerated, and the statute itself a kind of antique musketry, as likely to backfire on the fisc as to hit any intended taxpayer target."); id. at 5 ("If the anti-bailout policies of section 304 have elements of anachronism as applied to individual shareholders, the statute's application to a selling corporate shareholder has been a puzzle since its enactment. . . . For corporate shareholders, section 304 has thus commonly served not as a sanction but as a planning tool, throwing the taxpayer into a briar patch of dividend treatment.").

145 While we have reservations concerning the Treasury Department's guidance under sections 367 and 7874 that were targeted at inversions, our comments in this letter are not intended to address the Treasury Department's authority to issue regulations that are in fact focused on inversion transactions.

146 By 1946, the Supreme Court noted that the terms "interest" and "dividends" were "well understood words as used in the tax statutes." John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946). The debt-equity distinction in the income tax existed as early as the Wilson-Gorman Tariff Act, ch. 349, § 32, 28 Stat. 509, 556 (1894) (the income tax bill invalidated by Pollock v. Farmers' Loan & Trust Co., 158 U.S. 601 (1895)), and it was continued in the Tariff Act of 1909, ch. 6, § 38(3), 36 Stat. 11, 114 (1909) even though there was no U.S. federal individual income tax in effect in 1909 (the 1909 act was upheld in Flint v. Stone Tracy Co., 220 U.S. 107 (1911)), with the result that individual bondholders were not subject to a federal income tax on their receipt of interest issued by corporations even though corporations could deduct interest payments. See Steven A. Bank, Historical Perspective on the Corporate Interest Deduction, 18 Chapman L. Rev. 29 (2014). See also Jonathan Talisman, Do No Harm: Keep Corporate Interest Fully Deductible, 141 Tax Notes 211 (Oct. 14, 2013).

147 For example, the subject instruments in Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2nd Cir. 1956) had been issued in 1934.

148 For example, the Supreme Court upheld the John Kelley Co.'s interest deductions on notes issued in 1937 and distributed to its shareholder, while simultaneously disallowing the Talbot Mills corporation's interest deductions in a companion case on debt which had quite different terms. John Kelley, 326 U.S. 521.

149Moline Properties v. Commissioner, 319 U.S. 436 (1943).

150See section 11(a).

151Kraft Foods, 232 F.2d at 124.

152 The proposed regulations state the premise that there is little or no non-tax relevance to the debt-versus-equity classification of a corporate instrument held by a shareholder. In fact, debt or equity characterization of an instrument has material non-tax relevance in determining the adequacy of equity capitalization of corporate entities under state and non-U.S. corporate, commercial, bankruptcy, and regulatory laws, which relevance pre-dates the income tax relevance of the debt-versus-equity classification of an instrument held by a shareholder.

153 The Treasury Department and Service also have long recognized that corporation can distribute its own debt instrument to its shareholders. For example, current regulations contain provisions expressly addressing a corporation's distribution of its own debt instrument to its shareholder. Treas. Reg. § 1.301-1(d)(1)(ii). The substance of the relevant language in this regulation is not new -- it was present in the version published in 1955 T.D. 6152, 20 Fed. Reg. 8875, 8877 (Dec. 3, 1955), 1955-2 C.B. 61 (". . . If the property distributed consists of the obligations of the distributing corporation, or stock of the distributing corporation treated as property under section 305(b), or rights to acquire such stock treated as property under section 305(b), the amount of such distribution shall be an amount equal to the fair market value of such obligations, stock, or rights. . . .")) and in the version published in 1960 (T.D. 6500, 25 Fed. Reg. 11402, 11607 (Nov. 26, 1960) (the relevant language was identical to that in T.D. 6152)). This language was expressly preserved and restated in the 1964 changes to the regulations (T.D. 6752, 29 Fed. Reg. 12701 (Sept. 9, 1964); 1964-2 C.B. 84), the 1971 changes to the regulations (T.D. 7084, 36 Fed. Reg. 266 (Jan. 8, 1971), 1971-1 C.B. 230); and the 1972 changes to the regulations (T.D. 7209, 37 Fed. Reg. 20800 (Oct. 4, 1972), 1972-2 C.B. 204). Subsequently, the particular provision was reorganized, and the provision continued without substantive change. T.D. 7587, 44 Fed. Reg. 1376 (Jan. 5, 1979), 1979-1 C.B. 126. Treas. Reg. § 1.301-1(d)(1) was amended again in 1995, albeit in a non-substantive manner. T.D. 8586, 60 Fed. Reg. 2497, 2500 (Jan. 10, 1995), 1995-1 C.B. 147. With this history, it is hard to conceive that the Treasury Department or the Service were unaware that corporations could -- as a matter of black-letter law -- distribute debt instruments to their shareholders.

154 There is a long history of note dividends to which Congress is surely aware. See Jos. Schlitz Brewing Co. v. Commissioner, 134 F.2d 165(7th Cir. 1943) (involving the distribution of notes in 1937 for which a "dividend paidcredit" was claimed); Logan-Gregg Hardware Co. v. Heiner, 26 F.2d 131 (W.D. Pa. 1928) (involving the distribution of notes in 1918).

155 Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 61(c), 98 Stat. 494, 581-582 (1984).

156 H.R. Rep. No. 98-432, at 1203 (1984); S. Prt. No. 98-169, at 188 (1984); H.R. Conf. Rep. No. 98-861, at 843 (1984). The sentence also appears in the Joint Committee Bluebook, though the word "can" (which signifies ability) was replaced with the word "may" (which signifies permissiveness and electivity). Joint Comm. on Tax'n, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), at p. 185 (1984).

157 In 1989, Congress enacted the earnings stripping rules of section 163(j) to limit the deductibility of interest paid on certain related-party debt, another implicit recognition that one corporation could be indebted to a related corporation. Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, § 7210, 103 Stat. 2106, 2339-2342 (1989). That very bill also amended section 385(a) to add the parenthetical part-debt, part-stock language. The portion of the relevant House committee report that addresses section 163(j) explicitly acknowledges that a corporation may deduct interest paid to related persons, and notes that section 385(a) authorizes regulations to set forth various factors. H.R. Rep. No. 101-247, at 1240 (1989). Congress likely would have said something in the legislative history, or written different rules in section 163(j) or section 385(a), had it believed or intended the Treasury Department and Service to possess the authority to issue regulations to outlaw a large swath of related-party debt solely based on transactions the borrower might have undertaken three years before or after a borrowing. Similarly, the Congressional acknowledgement in the section 7701(o) legislative history that a shareholder is free to select between debt and equity capitalization of a subsidiary based on tax considerations can be read as an implicit limitation of the scope of section 385(a).

158 For example, assume individual A owns all of the stock of corporation P, P owns 80 percent of corporation S, and A owns the remaining 20 percent of S. If S were to declare a dividend distribution to its shareholders and payable in the form of debt instruments, the debt instruments issued to P would be subject to recharacterization as stock under the general rule, and the debt instruments issued to A would not, even if the debt instruments were identical in all respects save for the name of the payee.

159 For example, assume corporation P forms corporation S1, and transfers $100 to S1 in exchange for $25 of S1 stock and $75 of S1 debt. Assume further that P had formed corporation S2, and transferred $100 to S2 in exchange for $100 of S2 stock, and subsequently either recapitalized S2 (exchanging $100 of S2's original stock for $25 of new S2 stock and $75 of S2 debt) or caused S2 to distribute a $75 debt instrument. The S1 debt would retain its debt characterization (assuming no recharacterization under the funding and per se rules), whereas the S2 debt would be recharacterized as stock upon its issuance under the general rule, even though the economics and the issuer's ability to repay are identical.

160 The Supreme Court, in Bazley v. Commissioner, 331 U.S. 737 (1947), and John Kelley Co. v. Commissioner, 326 U.S. 521 (1946), dealt with debentures that had been issued in tax-motivated recapitalizations, and respected the debt characterization of the debentures. The key focus in Bazley was whether the taxpayer received the debt instrument as a taxable dividend distribution, and in John Kelley was whether the corporation could deduct the interest payments on the distributed debentures. In neither case did the transaction in which the debts were issued seem to matter at all to the debt-equity characterization. The John Kelley court upheld interest deductions as to the John Kelley Co.'s debentures, and denied deductions in the Talbot Mills companion case expressly based upon the terms of the Talbot Mills debentures (the "characteristics of the obligations") rather than the relationship of the parties. John Kelley, 326 U.S. at 526.

161 The Treasury Department may provide an irrebuttable presumption that a debt instrument is a principal purpose debt instrument, implicitly issued with some evil motive, but such a presumption cannot establish the fact of that motive -- the presumption merely means that the particular rule applies categorically, regardless of actual motivations, and notwithstanding the complete absence of any direct factual linkage between the borrowing and some other use of money or property.

As discussed elsewhere in our comments, a debt instrument could be retroactively characterized as stock under the per se rule after it had been issued and repaid, based on an unrelated distribution or acquisition that occurs later in the same taxable year, due to the manner in which the timing rule would operate. Such a debt instrument cannot possibly have funded a distribution or acquisition that occurs after it had been repaid. The per se rule is based on the concept that money is fungible, but money is not that fungible.

162 S. Rep. No. 91-552, at 137 (1969) (emphasis added).

163Id. at 138 (emphasis added).

164 Martin D. Ginsburg, The National Office Mission, 27 Tax Notes 99, 100 (Apr. 1, 1985) ("When you grab a technical nicety and sharpen it to spear a legitimate transaction, and no impelling tax policy or unavoidable statutory mandate requires that result, you court disaster. You have assumed the risk of Moses -- nee Aaron's -- Rod, the Murphy's Law of the tax field. As I never tire of repeating, it reminds us that every stick crafted to beat on the head of a taxpayer will, sooner or later, metamorphose into a large green snake and bite the Commissioner on the hind part. Nothing, you see, works one way in the tax field. Those folk out there are exceedingly ingenious. If, in aid of particular mayhem, you espouse an interpretation too narrow or too broad or just plain skewed, before you can turn around the tax bar will do you in.").

165See Notice 89-37, 1989-1 C.B. 679 (the "May Company" notice); Notice of Proposed Rulemaking, Partnership Transactions Involving Equity Interests of a Partner, 57 Fed. Reg. 59324 (Dec. 15, 1992) (Prop. Treas. Reg. § 1.337(d)-3); T.D. 9722, 80 Fed. Reg. 33402 (June 12, 2015) (publishing Temp. Treas. Reg. §§ 1.337(d)-3T and 1.732-1T); Notice 94-93, 1994-2 C.B. 563 (addressing the effect of an inversion on certain General Utilities gain); S Rev. Proc. 2016-3, Section 4.02(11), 2016-1 I.R.B. 126, 138 (the hook equity "no-rule" policy).

166 For example, the Castle Harbor cases -- TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94 (D. Conn. 2004), rev'd, 459 F.3d 220 (2d. Cir. 2006), remanded to, 660 F. Supp. 2d 367 (D. Conn. 2009), rev'd, 666 F.3d 836 (2d. Cir. 2012), remanded to, 8 F. Supp. 3d 142 (D. Conn. 2014), rev'd, 604 Fed. Appx. 69 (2d. Cir. 2015), cert. denied, 136 S. Ct. 796(2016). See also ASA Investerings Partnership v. Commissioner, T.C. Memo. 1998-305, aff'd, 201 F.3d 505 (D.C. Cir. 2000); Saba Partnership v. Commissioner, T.C. Memo. 1999-359, vacated and remanded, 273 F.3d 1135 (D.C. Cir. 2001); Boca Investerings Partnership v. United States, 167 F. Supp. 2d 298 (D.D.C. 2001), rev'd, 314 F.3d 625 (D.C. Cir. 2003). See also Chemtech Royalty Assocs., L.P. v. United States, 2013-1 U.S.T.C. (CCH) ¶ 50,204; 111 A.F.T.R.2d (RIA) 953 (M.D. La. 2013), aff'd, 766 F.3d 453 (5th Cir. 2014).

167See Hewlett-Packard Co. v. Commissioner, T.C. Memo. 2012-135.

168See 81 Fed. Reg. 20912, 20930 (Apr. 8, 2016)("Given that these section 385 regulations may give rise to a proliferation of U.S. hybrid equity splitter arrangements. . .").

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
Copy RID