Attorney Seeks to Narrow Proposed Debt-Equity Regs

I. Introduction

This letter comments on certain aspects of the proposed section 385 regulations.¹ The letter assumes familiarity with the proposed regulations and does not summarize them. The comments are not intended to be comprehensive. These comments reflect my views and were not prepared on behalf of a client.

I believe that the proposed regulations in their present form are too broad, in terms of both the transactions they cover and their effect. Adoption of the rules would have significant, immediate, and seriously adverse effects on conventional intercompany loans of cash. Specifically, they would in many cases severely disrupt routine group treasury functions. They also would prevent a corporate group from changing how subsidiaries are owned within the group, even where changes are needed to address regulatory or other non-tax objectives.

I am writing to suggest ways in which the proposed regulations can be better tailored to the fact patterns that are their apparent targets. The hope is to reduce the costs and burdens the proposed regulations otherwise would impose without undermining their purpose. My recommendations are summarized in Part II, below, and then discussed in more detail in Part III.

The debt instruments that are most prominently in the cross-hairs include those that (1) are issued by a domestic corporation and are held by a foreign corporation or vice versa, and (2) are issued to the holder (x) as a dividend (or otherwise in a corporate distribution) or (y) in exchange for stock of another expanded group ("EG") member.² The government's goal for such debt is to eliminate interest deductions and to convert principal payments to income (dividends) to the extent of issuer earnings. The objective is met by converting such debt to stock. My comments are not directed at arrangements of this type.

The over-breadth of the proposed regulations stems mostly from the fact that they apply not just in the context of cross-border distributions of notes or purchases of stock with debt, but also (1) to loans between domestic corporations or between foreign corporations (with an exception for loans within a domestic consolidated group) and (2) under a "funding rule" to debt that is not distributed by a corporation or used to buy EG member stock but that evidences a conventional intercompany loan made for cash, if the borrower (referred to as the "funded member") makes a distribution or purchases EG member stock (including from the issuer) within three years before or after the date of the loan. Thus, if P owns two foreign subsidiaries S1 and S2, S2 borrows from an unrelated party and on-lends the funds to S1, and within three years before or after the loan is made, S1 makes a distribution to P at least equal to the borrowed amount, the intercompany loan is converted in its entirety to stock.

The funding rule is described in the first instance as a principal purpose test that is applied based on all facts and circumstances. However, through operation of a per se rule, it applies without regard to the facts and circumstance to treat a loan as stock even though the loan has no factual connection to the distribution or EG member stock acquisition, through either the borrower or the lender. Thus, it does not matter in the example above that S2 derived the borrowed funds from a third party rather than obtaining them directly or indirectly from P (the party receiving the distribution). It also does not matter whether S1 funded the distribution with the borrowing. Indeed, a taxpayer cannot show any facts and circumstances to prevent the conversion of debt to stock under the funding rule.

By way of further illustration, it does not matter in applying the funding rule to an intercompany loan whether (x) the taxpayer group derives any tax advantage from deducting interest payments or from the distribution that triggers the funding rule (it could be fully taxable), (y) the loan is short term (or even overnight) or long term, or (z) the loan is subordinated or 100% secured by U.S. Treasuries.³

It also does not matter whether there are net distributions during a period that need to be funded with debt -- a gross distribution by the funded member will trigger the rule even if it has been repaid or is matched with a capital contribution to the funded member from shareholders. The financial condition of the borrower is irrelevant. The rules can even apply where a loan is repaid before the distribution or stock purchase it purportedly funds is made.⁴Nothing matters except for the existence of an intercompany loan and a distribution or EG member stock purchase by the borrower over a six year period.

The proposed regulations are based on the exercise of general authority under section 385, which does one thing. It determines if an instrument is debt or equity (or part debt and part equity). Once a loan is classified as stock under the proposed regulations, the loan carries all of the baggage associated with equity status under the Code.⁵

The most obvious results of stock classification are the ones mentioned above, which are denying interest deductions and treating payments of interest and principal as a dividend to the extent of earnings under section 302(d). Other consequences that have come up in conversations with clients about the proposed regulations include the following:

• Eliminating foreign tax credits. Loan payments that become dividends paid by a foreign corporation would carry with them related foreign taxes whether or not those taxes can be credited by the lender. Credits may be lost because the lender does not meet the stock ownership tests needed to claim credits under section 902.⁶

• Creating uncertainty in calculating earnings and profits ("e&p") and in locating e&p within a group. Knowing those amounts is important.

• Shifting basis between debt instruments and within a group.⁷

• Causing mismatches in the timing and character of income as between borrowings from third parties and intercompany loans that are now stock.⁸

• Changing tax ownership of the borrower, with an array of potentially serious consequences (such as preventing transfers to the borrower from benefitting from section 351 because of a failure of the control test in section 368(c)).

• Potentially creating listed transaction issues under the fast-pay stock rules.

• The status of a debt instrument will no longer depend on its legal terms and the financial condition of the borrower. Instead, a complex list of factors will need to be considered, including the history of distributions or acquisitions of stock and the timing and amount of other loans. This will pose a significant challenge in determining the status of instruments by a taxpayer and in the context of acquisitions and investments.

• The status of an instrument can change after issuance. For example, a loan may become allocated to a distribution after the loan is made. Under current law, the testing of debt status is usually done only at issuance. Further, the status of a loan can change because of a failure to document the exercise of creditor rights or because of loan modifications. Loan modifications can occur because of relatively modest changes in loan terms. Those changes did not matter much in the past but will matter a great deal going forward.

• In a departure from current law, a given instrument could be partly debt and partly equity (not just under the rule in -1(d) doing that explicitly but under the funding rule) and, under the regulations, the mix can change over time (for example as different instruments are reallocated to distributions or stock acquisitions). It is not clear how payments are to be allocated among the identical components of a debt instrument that are debt and equity.

• The treatment of one loan as stock under the proposed regulations could have a cascading effect, resulting in other debt instruments being recast as stock. Specifically, the making of a loan that is recast as equity under the proposed regulations would seem to be a purchase of EG stock, and the repayment of the loan would be a distribution by an EG member to another on stock, which can trigger the funding rule as applied to other debt instruments.⁹ The results could extend over decades.¹⁰ It is not clear if this result was intended.

II. Summary of Recommendations

My recommendations are discussed in Part III, below, which is divided into ten sections, discussing various aspects of the proposed regulations. The recommendations are summarized here.

Part III.A recommends that the proposed regulations (-2 and -3) generally be limited to debt instruments with an issuer and holder that have a different tax status. The section suggests reliance on section 351(g)(4) relating to nonqualified preferred stock ("NQPS") as a possible source of additional authority to achieve this result.

Part III.B has a number of recommendations for applying the funding rule (in -3(b)(3)):

• The funding rule should not be considered a separate rule but only an anti-abuse measure that backstops the general rule in -3(b)(2) (which applies to debt issued in a distribution or in consideration for EG member stock).

• Accordingly, the funding rule should apply only in cases where a taxpayer makes a loan as part of a plan or arrangement that includes a distribution or EG stock acquisition by the funded member and has a principal purpose of achieving substantially the same economic effect as a distribution of a debt instrument or use of a debt instrument to buy EG stock.

• The per se rule should be changed to a presumption modeled after the disguised sale rule in the section 707 regulations that can be rebutted with clear evidence. Following the section 707 model, the time period for the presumption should be shrunk from six years to four (two years forward and two back).

• There should be separate exceptions from the funding rule for debt refinancings (including debt modifications) and debt that is repaid before a distribution or stock acquisition occurs.

• The exception for distributions not exceeding current year e&p should be expanded. Taxpayers often do not know the amount of e&p for a year until after the year has ended, and so the current rule means that the effect of a distribution may not be known when it is made. At a minimum, the exception should allow distribution of the earnings for a year in the following year when accounts are available. Another option might be an exception for "ordinary course" distributions, based on the dividend history of the issuer in question, or a rule allowing distributions of earnings accumulated over a longer period.

• The types of distributions that invoke the funding rule should exclude complete liquidations.

• The EG stock purchases that trigger the funding rule (and also the general rule in -3(b)(1)) should be limited to those covered by section 304 and to purchases of hook stock.

• The making and repayment of loans that are converted to stock under the proposed regulations should not be treated as EG member stock purchases and distributions in applying the funding rule to other loans.

Part III.D suggests limiting the consequences to taxpayers of the conversion of stock back to debt when it leaves an EG (there is already a rule limiting consequences when debt becomes stock).

Part III.E recommends that the scope of the anti-abuse rule in -3(b)(4) be narrowed and that it never be applied to third-party loans.

Part III.F proposes an ordinary course of business exception for banks and securities dealers.

Part III.G suggests that section 351(g)(4) be used to treat debt that is treated as NQPS under the section 385 regulations as debt (or "not stock") for purposes of the control test in section 368(c) and other tax ownership tests.

Part III.H asks for clarification that the documentation requirements are not intended to change the treatment of nonrecourse or limited recourse debt.

Part III.I ask for clarification that taxpayers may treat a debt instrument as stock if it is so treated under the documentation rules.

Finally, Part III.J comments on the treatment of disregarded entities.

III. Recommendations

The most obvious case of a difference in tax status would be where one party is a taxable domestic C corporation and the other is a foreign C corporation not acting through a U.S. branch. Two domestic C corporations would be considered to have the same tax status. A domestic corporation that is tax-exempt would have a different tax status from a taxable domestic C corporation.¹¹

Adopting different rules based on a difference in tax status should not violate nondiscrimination rules under tax treaties. The suggested approach is modeled after section 163(j), which applies to interest paid to a related person if no tax is imposed on the interest income regardless of why the income is tax exempt.

My suggestion is consistent with the framework of the proposed regulations because you have already tied the tax status of an instrument directly to the tax consequences of that status by preventing taxpayers from using the rules in -2 and -3 to convert debt to equity where equity treatment produces a better tax result.¹² Thus, if a corporation distributes a note to its parent as a dividend, the note is recast as equity under -3(b)(2) unless the tax consequences of equity treatment favor the taxpayer. The instrument's treatment depends directly on the tax consequences for the parties.

Additional regulatory authority for this approach exists under section 351(g)(4), which grants the government broad authority to determine the tax treatment of NQPS under all sections of the Code.¹³ That authority should include treating NQPS as if it were debt in specified circumstances. Almost all conventional intercompany debt that would be converted to stock under the proposed regulations would become NQPS. Relying on the authority granted under section 351(g)(4), there could be an exception to the rules in -2 and -3 that applies to any instrument if (1) the issuer and holder have the same tax status and (2) the instrument otherwise would be treated as NQPS. In short, if regulations authorized only under section 385 otherwise would require that more instruments be treated as stock than is desirable from a policy or administrative perspective, the authority in section 351(g)(4) should be used to trim the overgrowth.

The funding rule applies to treat a debt instrument as stock if it is a "principal purpose instrument", i.e., it is issued by a corporation (funded member) to a member of the funded member's EG in exchange for property with a principal purpose of funding any of (1) a distribution to another EG member, (2) an acquisition of EG stock from another EG member (with a limited exception), or (3) certain acquisitions of property from another EG member in asset reorganizations. Thus, the list of triggering events is similar to the one in -3(b)(2).

The per se rule in -3(b)(3)(iv)(B) then turns the principal purpose test into a rigid mechanical rule by deeming the test to be met with respect to any debt instrument if one of the three triggering events (distribution, stock acquisition or asset acquisition in a reorganization) occurs during the six years beginning three years prior to the date of the debt issuance. There is an exception in -3(c)(1) for distributions or acquisitions by the funded member made during a taxable year to the extent they do not exceed the e&p of the member for the current year.

The next four sections comment on the funding rule as it relates to distributions and to acquisitions of stock, the cascading effect of the funding rule, and the per se rule. The fifth following section has recommendations.

The preamble then explains that the funding rule is needed to prevent taxpayers from using multiple-step transactions to avoid the general rule while achieving economically similar results:

That would indeed be a classic circular transaction, and on the right facts would be a good candidate to be treated the same as a distribution of a note.

The preamble then goes on to justify the application of the funding rule to transactions that are not circular:

To help make this point a little more concrete, suppose P has two direct subsidiaries S1 and S2.¹⁴ S1 has excess capital and P needs cash. S1 could make a distribution to P but does not have liquid funds. S2 has surplus funds and makes a loan to S1 to fund a distribution by S1 to P. Something real has happened because cash has moved through the loan to S1 and then from S1 to P. P has cash it did not have before.

An even more stark case would be if S2, the funding vehicle, were owned by S1 rather than being a sister company. If S1 made a distribution to P using funds borrowed by S1 from its own subsidiary S2, then the loan would be caught by the funding rule even though the distributed funds are coming from cash owned at all times indirectly by S1.

Even accepting that money is fungible, that principle should not lead to disregarding separate legal and tax entities. In the example above, P, S1 and S2 are treated effectively by the proposed regulations as one entity within which all money is fungible, even though they are not in fact one entity and are not treated as one for tax purposes generally. The funding rule applies to S2's loan to S1 to pay P without any requirement that S2's funds be traced back to P. It would not matter under the proposed regulations if the taxpayer could show that S2 derived its funds not from P but from retained profits or by borrowing from an external creditor.

The government could argue that even though entities within an EG are separate, tracing funds among entities is just too complicated. However, complicated is not impossible and some administrative costs should be bearable if the alternative is severely disrupting non-tax motivated commercial activity. If the funding rule does not ever allow taxpayers to show that no funds came directly or indirectly from P, even where that showing could be made, then the rule needs to be justified on its own merits beyond concerns about circular flows of funds. It is not in fact a "principal purpose" test based on facts and circumstances and cannot be evaluated or defended as such. The excerpt from the preamble quoted above suggests the funding rule is indeed intended to be justified on the independent ground that nothing significant happens when money travels from S2 to P. That justification is weak.

The preamble does assert that there is factual support for the broader principle that intercompany loans are never real. It states: "Subsidiaries often do not have significant amounts of debt financing from unrelated lenders (other than trade payables) and, to the extent they do, they may minimize any potential impact of related-party debt on unrelated creditors, for example, by subordinating the related-party debt instrument."

But this generalization would not support a rule that applies to all affiliate loans made to a funded member that makes distributions. Subsidiaries often do have significant amounts of external debt financing.¹⁵ What about them? The funding rule is not limited to cases in which the borrower has no external creditors or those where intercompany loans are subordinated to external creditors. Furthermore, the argument proves too much. If intercompany loans to a subsidiary are fatally artificial because subsidiaries do not have external creditors, how does that justify the funding rule? It would seem to lead to the conclusion that loans to subsidiaries should always be treated as stock.

I have two other comments on the funding rule as it applies to distributions. First, the term "distribution" is defined in -3(f)(4) as any distribution made by a corporation with respect to its stock. It should be clarified that the term does not include distributions made in complete liquidations. A distribution by a corporation of its own note to its shareholders in a complete liquidation would not make sense as the corporation ceases to exist.

If a corporation makes distributions and also receives new contributions of equity from shareholders, the two are not netted under the proposed regulations. They should be. Otherwise, a taxpayer would be better off under the proposed regulations making a loan to a corporation rather than a capital contribution, because only the loan would effectively be netted against the distribution.¹⁶

The general rule and funding rule include not only acquisitions of stock of one EG member from another EG member, but also purchases of stock from its issuer.¹⁸ Absent this rule, purchases by a subsidiary of newly issued parent stock from the parent (the most classic hook stock) would not be caught.

There is an exception to the funding rule in -3(c)(3) for acquisitions from the issuer of subsidiary stock ("subsidiary exception"). Specifically, the funding rule does not apply to an acquisition of stock that results from transfers of property to an EG issuer in exchange for stock of the issuer, provided that for the 36-month period following the transfer, the transferor holds, directly or indirectly, more than 50% of the voting power of all classes of stock of the issuer entitled to vote and more than 50% of the total value of the stock of the issuer. Apart from the subsidiary exception, the general rule and subsidiary rule apply to all purchases of EG stock from EG members.

I recommend that you limit the stock acquisition rule to two cases, (1) where section 304 would apply (determined before applying -3 to convert debt to stock), and (2) purchases of hook stock, which is to say stock of a corporation that owns a direct or indirect controlling interest in the purchaser.¹⁹ Section 304 transactions are already treated as distributions, so they should be caught by the distribution rule anyway. The rationale for hook stock purchases is that they have a higher risk of artificiality because a subsidiary is transferring property to its parent by purchasing parent stock rather than through a distribution.

One type of stock purchase that would be removed from the scope of the rules under the recommended change would be sales of stock up a chain. Suppose P owns S1, which owns S2. A sale by S1 of the S2 stock to P for a note of P is not within section 304, because the seller (S1) does not control the buyer (P). See Rev. Rul. 74-605. Also, of course, the S2 stock is not hook stock in the hands of P (the holder P is not controlled by the issuer S2). Accordingly, the sale would not be caught by a rule that applies to section 304 transactions or purchases of hook stock. By contrast, this transaction does fall within -3 as currently written. Why? It is hard to view the transfer of P's note to a subsidiary of P as a corporate distribution. Viewed separately from the transfer of S2 stock to P, the issuance of the P note to S1 would be if anything a contribution.

Stock in EG member subsidiaries may also be acquired through a complete liquidation. Suppose again that P owns S1, which owns S2. S1 has outstanding debt. If P checked the box on S1 so that its assets (including stock of S2) are deemed acquired by P, then it would seem that the funding rule could potentially apply to P. To the extent P acquires S1 assets by assuming S1 debt, P would acquire the S2 stock for property. But this transaction also does not resemble a distribution.

The subsidiary exception is helpful but does not cover many cases involving corporate joint investments. For example:

• P owns three direct subsidiaries, S1, S2 and S3. These three subsidiaries undertake a capital intensive project through a newly formed corporation S4, which is 1/3 owned by each of S1, S2 and S3. The subsidiary exception would not apply, so that cash purchases of stock of S4 by S1, S2 and S3 would trigger the funding rule.

• P owns S1. S1 establishes a wholly owned S2 to engage in a new business. It is alternatively wildly successful or a flop and S1 sells S2 to an unrelated buyer within 3 years. Any contributions by S1 to the capital of S2 within three years of the sale date would fall outside of the subsidiary exception.

• P owns S1 and S2. S2 establishes a subsidiary S3 to engage in a new business and owns all of S3's capital stock. S3 needs new capital, and so S1 buys nonvoting preferred stock of S3. The subsidiary exception does not apply to S1's purchase of preferred stock because the stock is nonvoting. For any period in which the preferred stock represents at least half of the value of the stock of S3, S2 also would fail to qualify for the subsidiary exemption because it would not own more than 50% of the value of the stock of S3.²⁰

If the rules were narrowed to cover only section 304 redemptions and purchases of stock of a corporation that directly or indirectly controls the stock issuer, then none of the stock purchases in the examples would be caught. Section 304 does not apply to purchases of stock from the issuer and the stock issuer does not control the buyer.

Suppose P owns directly S1, S2 and S3. S2 makes a loan to S1. S1 buys newly issued stock of S3 representing a small portion of its equity. The stock purchase would be treated as an EG stock acquisition for purposes of applying the funding rule under the proposed regulations to S2's loan since the subsidiary exception would not apply (S3 is not a subsidiary of S1). The purchase would not, however, be caught under the rule I propose because S3 does not control S1.

If the reason for the investment is to fund a new capital project undertaken by S3, it is difficult to see why this example is different from the ones given above. It is not artificial and does not resemble a distribution. At the least, the fact that S3 is not a subsidiary of S1 is not a sufficient reason to conclude that S1's stock investment is artificial.

Consider the following fact patterns in which a lender would run afoul of the per se rule because of a distribution by the funded member even though it could show clearly that the loan was not used to fund the distribution. Assume in the examples a corporate group headed by P that includes among others direct subsidiaries S1, S2 and S3. S2 makes or will make a loan to S1 (or a partnership that includes S1) and S1 makes a distribution to P.

• S2 has outstanding a ten year loan to S1. In year 4 of the loan, S1 makes a distribution and in year 6, S1 and S2 modify how interest is computed on the loan causing a significant modification and a deemed reissuance of the debt. The modification raises no new funds within the six years surrounding the distribution.

• S2's loan to S1 was made in the same year as the distribution but is made to refinance external debt. A wire transfer of the loan principal amount was made by S2 to the prior lender to pay off S1's prior debt.

• PRS is a partnership between S1 and S3. S2 makes a loan to PRS and PRS does not make any cash distributions to S1 (PRS is in an expansion mode). Even if PRS is treated as an aggregate for some tax purposes, it is still a separate legal entity with its own accounts, and it can be shown easily that money did not leak out of PRS to S1.

• S2 makes a loan to S1 that is repaid before S1 makes its distribution to P. The loan is made in the same year as the distribution. It is impossible for the loan to fund the distribution because it no longer exists when the distribution is made.²²

• S1 makes a distribution out of available cash. Two years later, S1 has a need for funds (to be paid to third parties) based on a discrete event and meets the need by borrowing from S2.

• In year 1, S1 borrows 100 from S2. In year 2, S1 issues 100 of preferred stock to P which S1 redeems (by exercising an option) in year 3. It does not matter that the net distribution is zero.

The funding rule should be an anti-abuse rule that serves as a backstop to -3(b)(2). Specifically, a loan between EG members should be recast as stock as a result of a distribution or EG stock acquisition by the funded member only if a taxpayer makes the loan to the funded member as part of a plan or arrangement that includes a distribution or EG stock acquisition by the funded member with a principal purpose of achieving substantially the same economic effect as a distribution of a debt instrument or use of a debt instrument to buy EG stock.

The per se rule should be changed to a presumption, which could be similar to section 1.707-3(c). Thus, if an intercompany loan is made within two years on either side of a distribution or stock acquisition by the funded member, then the funding rule would apply unless the facts and circumstances clearly establish that the substantially the same economic effect test described above is not met. A taxpayer could make the required showing by establishing that either (1) the loan proceeds were not used by the funded member to make the distribution or acquisition but for a different purpose, or (2) the funds that were loaned were not derived by the lender directly or indirectly from the EG member receiving the distribution or selling the EG stock.

There should be a number of narrower rules that a taxpayer could rely on to show no connection between a loan and a distribution or acquisition, including the following:

• A loan that is repaid prior to a distribution or acquisition would not be considered to fund the distribution or acquisition.

• A loan made to refinance another borrowing would be considered used for the same purpose as the refinanced borrowing. Accordingly, the refinancing would be subject to the funding rule in the same way as the refinanced debt. The refinancing rule would apply to debt modifications.

The definition of distribution should exclude a complete liquidation.²³

The distributions by the funded company over any period that trigger the funding rule should be netted against contributions made to the equity of the funded company by its shareholders over the same period.²⁴

EG stock acquisitions that trigger conversions to debt under -3(b) (either the general rule or the funding rule) should be limited to two cases: (1) where section 304 would apply (determined before applying -3 to convert debt to stock), and (2) purchases of hook stock, which is to say stock of a corporation that owns a direct or indirect controlling interest in the purchaser.

A distribution or stock acquisition that arises only because an instrument is converted into stock under the proposed regulations should be disregarded in applying the funding rule to other debt.

The funding rule applies where a loan is made to a member of the lender's EG, provided within the six year period, the funding member makes distributions to an EG member (or buys EG stock from an EG member). The regulations do not explicitly require that the same EG be involved in both transactions. They should be revised to impose the requirement that the lender and distributee/stock seller be part of the same EG (subject to the general anti-abuse rules). A loan to fund a distribution cannot possibly be equivalent to a distribution of a note if the lender is unrelated to the distributee. Also, following an acquisition of a EG member from its seller parent by a new parent, the acquiring group very likely will not allow the seller to control distributions within the acquiring group and may not be willing to share information.

Two small drafting points. In -1(b)(3)(i)(B), the reference to section 1504(a)(1)(B)(i) should be expanded to also include (ii). In -1(b)(3)(ii), I suggest you say that indirect stock ownership is determined "applying the constructive ownership rules of section 304(c)(3)" to make it clear that is what you have in mind. The reference is confusing because section 304(c)(3) does not refer to indirect ownership.

Suppose that P would, absent the section 385 regulations, borrow directly from a bank and on-lend borrowed amounts to its subsidiaries. P is aware of the regulations and to avoid them, has its subsidiaries borrow directly from the third parties with a P guarantee. Read literally, the anti-avoidance rule in -3(b)(4) could apply. The result, however, would be to treat the bank loan as stock, which would be absurd. A guaranteed loan from a third party is unquestionably a real transaction and not a disguised way of distributing a note to P.

I suggest that you consider narrowing the scope of the anti-abuse rule. It should never apply to loans that are in form and substance between unrelated parties. I suggest adding an example showing that guaranteed loans are not subject to the anti-abuse rule.

There should also be ordinary course of business exceptions for banks and securities dealers. They are different from other types of businesses in ways that affect how the proposed regulations will practically apply to them. Developing these proposals is beyond the scope of this letter, and you will presumably receive comprehensive proposals from or on behalf of the affected taxpayers. However, at the least, ordinary course exceptions should cover lending transactions of the type that would be excluded from being investments in U.S. property if entered into between a CFC and its United States shareholder under section 956(c)(2), (I), (J) and (K). Also, purchases of instruments treated as stock that are required to meet regulatory capital requirements should not trigger the funding rule. Otherwise, there would be significant tax barriers to meeting minimum capital requirements.

These ancillary consequences raise serious substantive and administrative issues for taxpayers without advancing the policy of the proposed regulations. I suggest that the government use its authority under section 351(g)(4) to treat any instrument that is treated as stock under the section 385 regulations as not stock for purposes of the control test in section 368(c) and other tax law tests that are based on the ownership of stock.

If you do not make that change, then you should clarify that the exception for loans within a consolidated group extends to loans made by one consolidated group member to a disregarded entity owned by another member. That is unclear under -2(c)(4), which creates an exception for intercompany obligations as defined in section 1.1502-13(g)(2)(ii). A loan to a disregarded entity would not be considered an intercompany obligation if the disregarded entity (which is not a group member) were viewed as the issuer, which is what -2 calls for.

I hope these comments will be helpful to you. Please feel free to contact me if you would like to discuss them.

² There are also rules for asset reorganizations which are not addressed in this letter.

³ There is an exception based on the amount of debt (a $50 million floor that disappears if it is exceeded) and an exception for distributions of current year earnings. However, based on discussions to date with clients, these exceptions are not likely to significantly mitigate the effect of the rules on large corporate groups.

⁴ The rule in -3(d)(1)(ii) that defers the conversion of debt to stock until the date of the distribution or stock acquisition does not apply where the distribution or acquisition occurs in the year in which the loan is made. In that case, the loan is treated as stock even though it is repaid prior to the distribution or stock acquisition and thus cannot possibly be the source of funds for the transaction.

⁵ As indicated below, it may be possible to cut back on the consequences of having stock by looking outside of section 385 to the rules for nonqualified preferred stock in section 351(g).

⁶ Section 902 requires a corporation to own 10% of the voting stock of a foreign corporation in order to claim indirect credits. If a loan made by one sister company to another is recast as stock, the lender would not own any voting stock in the borrower and thus would fail the 10% voting test. Also, if a debt instrument is treated as equity, the holder may not be considered to meet the minimum holding period test to qualify for credits under section 901(k) because of the commercial rights it has as a creditor. See Rev. Rul. 94-28.

⁷ If a loan that is recast as stock is repaid, then to the extent the repayment is treated as a dividend, the lender will have unrecovered basis in the loan. Under section 1.302-2(c), if the lender is not otherwise a direct shareholder of the borrower, the extra basis will migrate to a related direct shareholder. If a lender has multiple loans that are converted to stock, basis could bounce around, as some loans are repaid, over to whatever loan remains and then when all debt is repaid would be shifted to another group member. Treasury groups are not set up to monitor these kinds of basis shifts among thousands of loans.

⁸ For example, if the lender hedges the loan with a swap and thought it had integrated the loan and swap under section 1.1275-6 or 1.988-5, it would discover that integration no longer is allowed because the integration rules do not apply to stock. The special foreign exchange rules in section 988 (and the related rules netting foreign exchange gains and losses in computing subpart F income under section 954(c)(1)(D)) would no longer apply because stock is not a section 988 transaction. The character matching rules for hedging transactions in section 1221(a)(7) and related regulations would no longer be available because while loans made in a loan origination business are ordinary assets under section 1221(a)(4), stock is not. If the lender were a securities dealer under section 475, stock in a related party could not be marked to market under section 1.475(b)-1(b)(1) (automatically treats stock in related persons as held for investment) even though related party debt can be marked to market.

⁹ To illustrate, P has subsidiaries S1, S2 and S3. S2 makes a loan of 100 to S1, which makes a distribution of 100 to P. That causes the S2-S1 loan to become stock, so that S2 is now considered to have purchased 100 of EG member stock. That in turn can affect loans made within three years from S3 to S2. When the S2-S1 loan is repaid, S1 will be deemed to make a distribution of 100 to S2 (in addition to the distribution of 100 to P), which can cause other intercompany debt of S1 to be recast as equity.

¹⁰ S1 makes a distribution in 2017 that causes a 10 year loan made to S1 in 2020 to be treated as stock. When that loan is repaid in 2030, debt issued by S1 three years later in 2033 could then become stock, all because of the one distribution in 2017.

¹¹ A corporation that is exempt from taxation under section 501 can be an EG member because the definition in -1(b)(3) is based on the affiliated group definition but without the carve out for tax-exempt corporations in section 1504(b)(1).

¹² See -2(d) and -3(e).

¹³ Section 351(g)(4) reads as follows: "The Secretary may prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection and sections 354(a)(2)(C), 355(a)(3)(D), and 356(e). The Secretary may also prescribe regulations, consistent with the treatment under this subsection and such sections, for the treatment of nonqualified preferred stock under other provisions of this title."

¹⁴ In all of the examples in this letter, P, S1, S2, S3 and S4 are corporations that are not consolidated.

¹⁵ Most banks and securities dealers are subsidiaries (e.g., Citibank N.A. is a subsidiary of Citigroup Inc.). Many corporate groups have operating divisions organized as separate corporations with their own external funding. Funding companies that issue debt externally are often subsidiaries. Based on my experience, it would seem that the Treasury and IRS are on shaky grounds developing tax rules on the assumption that subsidiaries do not have external debt.

¹⁶ To illustrate, P owns S1 and S2. S2 makes two loans of 100 to S1, loan A (which comes first) and loan B. S1 makes a distribution of 100 to P. Under the funding rule, loan A is converted to stock, and loan B remains as debt. Effectively, loan A is matched against the distribution of 100 (under the FIFO ordering rule in -3(b)(3)(iv)(B)(3)). As a result of such pairing, loan B is not recast as equity. By contrast, if S2 had purchased 100 of preferred stock of S1 rather than making loan A, then the capital infusion would not be netted against the 100 distribution. Instead, loan B would be considered to fund the distribution and it would be converted to stock. Accordingly, taxpayers would be better off making loans than equity contributions, which is an odd result.

¹⁷ The preamble states the following: "While the change in the direct ownership of the affiliate's stock may have some non-tax significance in certain circumstances, such as the harmonization of a group's corporate structure following an acquisition, other purchases of affiliate stock including purchases of 'hook stock' from a parent in exchange for a debt instrument typically possess almost no non-tax significance." Note that the general rule and funding rule relating to stock purchases apply without regard to whether an acquisition of stock is only or mostly tax motivated. Thus, the operative rule is not tied to the facts given in support of it.

¹⁸ Apparently, there is also a view that a redemption of EG member stock is a purchase of stock by the issuer, although that view does not much matter because a redemption would be a distribution anyway.

¹⁹ The test I have in mind would look through intermediaries but not otherwise apply constructive ownership rules. Technically, it could be described as applying section 958(a) without regard to whether entities are foreign or domestic. (Cf. the penultimate sentence of -3(c)(3) applying a similar rule.) Accordingly, if P owns S1 and S2, S1 would not be considered to own S2 by reason of P's ownership of S2. Control could be defined as owning a majority of the stock, directly or indirectly, by vote and value.

²⁰ For a subsidiary with different classes of stock owned in different proportions, the subsidiary exception seems to require ongoing testing of the value of the different classes. Note that application of the subsidiary exception could be affected by loans made to a subsidiary by other EG members (not the direct shareholders) that are recast as stock under the proposed regulations.

²¹ For an illustration, see footnote 9, above.

²² The funding rule itself does not condition the conversion to stock on a loan being outstanding when a distribution is made. -3(d)(1)(ii) states that debt is converted to stock only at the time of a distribution, but this rule does not apply if the distribution is effected in the same year as the loan.

²³ If the liquidation is a complete liquidation under section 332, then the shareholder would be a successor to the liquidating corporation. While it can be argued that a distribution from a predecessor to a successor cannot have been intended to be a "distribution" on the ground that a distribution by a corporation to itself should not count, there is a special rule in -3(f)(11)(ii) stating that a distribution from a successor to a predecessor is not taken into account in applying the funding rule to the predecessor. Thus, at least in one setting, some clarification of the treatment of payments between a successor and predecessor was thought to be necessary.

²⁴ Some Treasury officials have indicated that there is no netting because distributions and contributions are not generally netted under subchapter C. The issue, however, is not the tax treatment of the distribution but whether it is appropriate factually to deem the distribution as being funded by a loan. If the funded member borrows 100, receives 100 from a shareholder and distributes 100 to a shareholder, the two equity transactions together do not factually create a cash need that should be allocated to the borrowing. Also, as indicated in footnote 16, above, the lack of netting creates a strange incentive to put money into subsidiaries through loans rather than equity contributions.

²⁵ The rule does not neutralize the cascading effect, discussed above, and does not prevent the recognition of certain currency gain or loss.