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EY Seeks Clarification of Provision Under Debt-Equity Regs

JUL. 7, 2016

EY Seeks Clarification of Provision Under Debt-Equity Regs

DATED JUL. 7, 2016
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July 7, 2016

 

 

Notice of Proposed Rule Making Relating to Sec. 385

 

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

 

Internal Revenue Service

 

Room 5203

 

P.O. Box 7604

 

Ben Franklin Station, Washington, DC 20044

 

 

We are writing on behalf of a client in response to the request for comments to the proposed regulations under Section 385 ("Proposed Regulations"),1 generally which would treat certain debt instruments issued between members of an expanded group as equity under either the transaction-based rules of Prop. Treas. Reg. § 1.385-3 or the documentation-based rules of Prop. Treas. Reg. § 1.385-2. Although a number of issues exist under both of these parts of the Proposed Regulations, this letter only addresses an issue that arises under Prop. Treas. Reg. § 1.385-2 in the context of entities that do not have "legal personality" or separate legal existence under local law, but are regarded as business entities for U.S. federal income tax purposes.

Prop. Treas. Reg. § 1.385-2(b)(2)(ii) provides that written documentation must establish that the holder has the rights of a creditor, and that such rights "typically include", inter alia, the right to sue to enforce payment. Where the issuer of debt is recognized as an entity for U.S. federal income tax purposes, but not as an entity under local law, it may not be possible to sue the issuer under local law. Thus, it is arguably unclear whether this aspect of the documentation requirement of the proposed regulations could be satisfied, even if the arrangement or instrument is otherwise structured and treated as debt for U.S. federal income tax purposes.

Treas. Reg. § 301.7701-1(a)(1) provides:

 

Whether an organization is recognized as an entity separate from its owner for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.

 

Further, a joint venture or other contractual arrangement may create a separate entity for U.S. federal income tax purposes ("Contractual Entity"),2 even though the venture or arrangement does not have legal personality or is otherwise not recognized as a separate, juridical entity under local law. There are a number of examples of such vehicles and arrangements, including an English general partnership, German Stillegesellschaft (silent partnership), Dutch Commanditaire Vennootschap (CV), Japanese Tokumei Kumia (TK), and Belgian Maatscap. See also PLR 201305006 (Oct. 15, 2012) (holding, inter alia, that an agreement between two entities with respect to a branch created a separate business entity within the meaning of Treas. Reg. § 301.7701-2) and ILM 201323015 (collaboration agreement created partnership for US federal income tax purposes). Such Contractual Entities generally are classified as either partnerships or corporations for U.S. federal income tax purposes.

In a number of structures, for example, one of the owners of a Contractual Entity treated as a corporation may loan money to the Contractual Entity under an arrangement that is treated as debt for U.S. federal income tax purposes. Under local law, the owner may not possess the right to enforce payment via a specific right to sue the Contractual Entity because the Contractual Entity does not exist (or have "legal personality" or "legal capacity") for local law purposes. Prop. Treas. Reg. § 1.385-2(b)(2)(ii) arguably could be read to cause a debt instrument issued by the Contractual Entity to be treated as equity for U.S. federal income tax purposes simply because the Contractual Entity could not be sued under local law due to the absence of separate legal personality or capacity.

We request that consideration be given to revising Prop. Treas. Reg. § 1.385-2(b)(2)(ii) to clarify that the existence of creditor rights is determined by taking into account all the facts and circumstances surrounding the transaction, including (a) the right to share in the assets of the issuer in case of dissolution and which is superior to interests in the entity that are treated as equity for U.S. federal income tax purposes, or (b) if applicable under local law for the obligation, the right to sue to force payments under the obligation.

These and other solutions would be welcome to clarify that Prop. Treas. Reg. § 1.385-2(b)(2)(ii) can be satisfied by a Contractual Entity even though the Contractual Entity does not have legal personality or capacity under local law and consequently could not be sued or contract in its own name. Thus, the absence of local law existence for a Contractual Entity would not prevent it from satisfying Prop. Treas. Reg. § 1.385-2(b)(2)(ii).

 

* * * * *

 

 

If you have any questions or would like to discuss this aspect of the Proposed Regulations further, please contact Roger M. Brown (202-327-7534 or roger.brown@ey.com).

 

FOOTNOTES

 

 

1 Treatment of Certain Interests in Corporations as Stock or Indebtedness, 81 Fed. Reg. 20,912 (April 8, 2016) . Any reference to a "Section" is to a section of the Internal Revenue Code of 1986, as amended.

2 Treas. Reg. § 301.7701-1(a)(2).

 

END OF FOOTNOTES
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