Proposed Debt-Equity Regs Overshoot the Mark, Firm Says

We are concerned these Proposed Regulations represent a departure from the arm's length principles for intercompany transactions that are a foundation of U.S. tax law and reflected in Section 482. In third party capital transactions, the financial instrument is negotiated and priced on the basis of its characterization as debt or equity. Whether or not another transaction preceded or followed the issuance of that instrument, the characterization of the instrument as either debt or equity does not change, excepting for convertible instruments which require the subsequent action of a party and are priced including the conversion feature. However, the Proposed Regulations at § 1.385-3 can operate to change the characterization of an instrument based upon other transactions, including issuing a debt instrument within 36 months (or more) of a distribution. Assimilating other transactions occurring within a 36 month period of the issuance of a debt instrument into the characterization of the financial instrument is not reflective of third party transactions. Therefore, this approach should not be endorsed as guidance under Section 385 since it conflicts with Section 482 and the arm's length principle. In practice, this change in principles would result in significant administrative burdens for S&P Global and challenges for our IRS CAP auditors.

Many common legal entity restructuring transactions could be affected by these Proposed Regulations, leading to confusion both internally and with tax authorities where a hybrid instrument is created by the Proposed Regulations and thereafter treated differently for U.S. and non-U.S. tax purposes. The effect of these rules is especially challenging when multiple debt instruments are issued and the subsequent holding of a financial instrument by unrelated parties requires re-testing of an instrument that was previously determined to be treated as either debt or stock. In addition, the rules are very complex and may be nearly impossible to administer, as demonstrated by Example 17. We expect that if the Proposed Regulations are finalized in the current form, S&P Global will have to hire additional tax compliance staff to help the company comply. Further, the wide-scale expansion of hybrid instruments is inconsistent with international tax policy initiatives, specifically the OECD's Project of Base Erosion and Profit Shifting ("BEPS"). The BEPS Project states that hybrid instruments "have an overall negative impact on competition, efficiency, transparency and fairness." Despite the Department's commitment to the BEPS Project, it has opted to unilaterally propose regulations that would proliferate the existence of hybrid instruments.

Another concern is the consequence of re-characterizing debt as equity with respect to foreign tax credits. Given the re-characterized equity would be treated in many cases as non-voting stock, a dividend with respect to that stock would not carry the related foreign taxes as a credit in situations where the lender did not hold a preexisting equity interest in the borrower. Certainly the drafters of Section 385 did not intend that it would act to permanently deny taxpayers the application of the foreign tax credit and thereby cause double taxation under our worldwide tax system.

These approaches would have a magnified effect with respect to ordinary business operations such as cash pooling activities performed by the Treasury function within many companies, including S&P Global. We understand that the Department intends to revise the Proposed Regulations, perhaps through expanding the Ordinary Course Exception, to preclude this application and its cascading effect, and we applaud you for that action.

We appreciate your consideration of these comments and look forward to measures that address these concerns. Please let us know if we can be of assistance as you move forward.