Withdraw or Narrowly Tailor Debt-Equity Regs, MasterCard Says

MasterCard Incorporated and subsidiaries is a U.S. headquartered company that operates what we believe is the world's fastest payment processing network, connecting consumers, financial institutions, merchants, governments and businesses in more than 210 countries and territories. We have significant operations in the U.S. and our ability to compete as a U.S. multinational group operating in a competitive global business environment is essential to our continued success.

Following the coordinated release of the guidance in Notice 2014-52 and Notice 2015-79, as well as public statements made by the U.S. Department of the Treasury ("Treasury") prior to the issuance of the proposed regulations under Internal Revenue Code section 385 (the "proposed 385 regulations" or "proposed regulations") on April 4, 2016, we believed the intent of Treasury was to limit corporate inversions and prevent multinationals from implementing earnings stripping strategies. The sweeping changes contained within the proposed regulations, however, go far beyond these objectives, contradicting long-standing tax principles founded on well-established case law and create unintended collateral consequences. The proposed 385 regulations, if finalized as currently drafted, will have a significant and negative impact on U.S. companies that are neither considering an inversion nor stripping the U.S. tax base.

The U.S. has one of the highest corporate income tax rates in the world, which, without the restrictions imposed by the proposed regulations, already places U.S. multinationals at a competitive disadvantage. As discussed below, the proposed regulations negatively and disproportionately impact MasterCard, as well as other U.S. multinationals. Thus, we recommend that the proposed regulations be withdrawn.

If the proposed regulations are not withdrawn, we recommend the following changes which would narrow their application, mitigate harm to U.S. multinationals not engaged in abusive or tax-motivated transactions, and reduce the required changes to day-to-day operations:

• Exclude from the regulations instruments solely between non-U.S. entities ("foreign to foreign");

• Increase the earnings and profits ("E&P") exception to include current and accumulated E&P;

• Correlate the threshold exception to the size of the expanded group;

• Significantly reduce the window under the per se rules and remove the non-rebuttable presumption;

• Modify the documentation period and requirements; and

• Extend the effective date of the regulations.

1. Decreases Earnings Per Share due to Third Party Debt Bias

The proposed regulations do not apply to third party debt. This exclusion creates a preference for U.S. multinationals to use external sources of financing to gain certainty in the characterization of the transaction, even when free cash flow is available. Third party debt directly impacts earnings per share and, ultimately, market value. Intercompany debt, however, does not have a similar and negative impact on earnings and market value since intercompany debt and intercompany interest expense are eliminated in consolidated financial statements prepared under U.S. Generally Accepted Accounting Principles. Similarly, this bias for third party debt could also negatively impact the credit ratings of U.S. multinationals.

The bias toward third party debt is particularly harmful in connection with acquisitions, as the proposed regulations would discourage U.S. multinationals from using free cash flow to finance potential acquisitions. This increased cost of capital is particularly detrimental in the context of post-acquisition integration, restructuring, and reorganization, as these items are typically a significant component when analyzing any potential acquisition. It is quite common, for example, in the case of a large foreign acquisition to restructure post acquisition in order to align newly acquired entities with existing entities by country, so that all entities within a single country exist within the same ownership chain. This additional cost of capital will clearly impact the business case for a potential acquisition and will very likely result in U.S. multinationals losing acquisitions to foreign competitors. This result could harm a large number of major U.S. multinationals that rely on acquisitions as a core part of their growth strategy.

2. Increases Foreign Tax Expense

The proposed regulations also create a bias for U.S. multinationals to fund foreign operations with equity. The use of equity will preclude foreign subsidiaries of U.S. multinationals from taking interest deductions that would otherwise be permitted in the respective foreign jurisdictions, resulting in an overall increase in foreign tax expense that U.S. multinationals will incur. To the extent U.S. multinationals ultimately repatriate some portion of these foreign earnings, the proposed regulations will increase the costs for the Treasury since, under current U.S. tax law, a larger deemed paid foreign tax credit would be granted.

3. Increases Instances of "Trapped Cash"

Another troubling aspect of the bias under the proposed regulations to fund foreign operations with equity as opposed to intercompany debt is the ultimate ability to repatriate the invested cash at some point in the future. In many foreign jurisdictions, it is significantly easier to repay debt than to extract cash via an equity transaction such as a distribution of earnings or a capital reduction.

There are certain foreign jurisdictions which require local subsidiaries to set aside a fixed portion of retained earnings that cannot be distributed through dividends. Further, in some jurisdictions, local law requires a lengthy and often costly approval process for dividends, capital contributions, and capital reductions. Similarly, certain jurisdictions restrict distributions, or limit distributions to positive retained earnings or "distributable reserves." These limitations typically do not apply to interest and principal payments on debt. The collective impact of these types of limitations will lead to increased instances of trapped cash for many U.S. multinationals, making it difficult and costly to use their free cash flow to meet the needs and strategic imperatives of their global businesses.

4. Limits Options to Fund Foreign Operations and Results in Competitive Disadvantages

Foreign multinationals that are not subject to U.S. tax will have greater flexibility to efficiently fund their operations or acquisitions relative to U.S. competitors. U.S. multinationals will have fewer options to fund their global businesses without increased tax risks and uncertainties, and will face significant competitive disadvantages.

5. Burdens Ordinary Course Transactions

The uncertainty associated with the per se rules¹ of how a purported debt instrument will be treated under the proposed regulations, as well as the burdensome documentation requirements² creates a bias for funding foreign operations with equity rather than intercompany debt in many ordinary course, non-abusive circumstances. To the extent U.S. companies choose to use intercompany debt, the documentation rules will result in significantly greater costs. The documentation required under the proposed regulations is far more burdensome in many cases than the documentation required for a third party loan. For example, there may be less documentation required if the principal amount is relatively small or the borrower is clearly qualified and not viewed as risky. Foreign companies not subject to U.S. tax will not be impacted by the proposed regulations and will not incur these costs, giving them a further competitive advantage.

6. Creates Hybrid Instruments

It is unclear how a debt instrument that has been re-characterized as equity in whole or in part will be treated for foreign law purposes if the local statutes include anti-hybrid legislation. The recasting of debt as equity for U.S. tax purposes will create a hybrid loan where the instrument is respected as debt for local tax purposes. This may cause the debt to fall within the anti-hybrid legislation of the relevant jurisdiction and lead to very unfavorable results, despite the fact that there is nothing abusive about the debt and the taxpayer did not intend to issue a hybrid instrument. The recast is independent of the facts or the intent of the taxpayer. In many instances, this will lead to an increase in local tax expense, which may ultimately be borne by the Treasury to the extent such increased taxes become creditable.

7. Negates the Benefits of Cash Pooling

The proposed 385 regulations also have negative implications for the corporate treasury operations of U.S. multinationals. Companies typically use cash pooling arrangements, managed by their treasury departments, to efficiently manage cash and optimize returns, and not for tax avoidance purposes. In many cases, U.S. multinationals have automatic daily mechanisms in place to sweep cash into the cash pool, whether physical or notional. Cash pooling benefits the day-to-day operations of companies that are members of the pool by providing efficient accessibility to cash to fund ordinary operations. For example, there are a number of jurisdictions within Europe where, due to the current interest rate environment, invested cash is yielding negative returns. The ability to pool cash and make a single, larger investment will typically provide a better yield.

If the proposed regulations apply to standard cash pooling arrangements, it will become exceedingly burdensome and costly for U.S. multinationals to comply with the documentation requirements and the 72-month tracking required by the per se rules. The proposed regulations are unclear as to whether each drawdown from the pool will be required to comply with the documentation requirements, which would require many U.S. companies to implement costly new systems and processes to track, price, and document every single transaction into and out of the pool.

8. Impedes the Ability of U.S. Multinationals to Acquire Foreign Targets

In the context of acquisitions, the documentation requirements pose additional challenges. For U.S. multinationals, acquisitions will trigger a need to ensure the documentation requirements are met within 30 days of the acquisition date for all intercompany debt of the acquired group. Even with substantial pre-acquisition due diligence, it is very unlikely that a validation and remediation process could be completed within this time. This would be a material impediment to acquisitions of wholly non-U.S. targets since such targets would not have been previously subject to these documentation requirements.

9. Triggers Detrimental Collateral Consequences

The proposed regulations will have unintended consequences on the operation of other taxpayer-favorable provisions such as the ability to do internal tax-free reorganizations under section 368 and the ability to treat stock acquisitions as asset acquisitions under section 338(g). The ability and desire of companies to reorganize in response to business needs, commercial strategies, or, as mentioned above, post-acquisition integrations, will be significantly restricted because what could have been previously accomplished in a tax-free manner will now give rise to a taxable transaction if debt is recast as some form of non-qualified equity, resulting in an unacceptable level of uncertainty. In addition, given the current year E&P exception in the proposed regulations,³ U.S. multinationals will be deterred from making section 338(g) elections so as not to reduce current year E&P through amortization deductions.

The proposed regulations will also lead to duplicative reporting and compliance obligations, which will burden a company's tax function. For example, section 6662(e) already covers some of the same (or similar) documentation requirements contained in the proposed regulations.

10. Increases Uncertainty in the Context of International Tax Treaties

Determining the correct application of the proposed regulations in the context of U.S. income tax treaties (e.g., the interplay of debt/equity recasts and limitation on benefits provisions) will lead to an increase in cross-border controversies and mutual agreement proceedings, which are expensive and time consuming for U.S. multinationals and burden the resources of the IRS.

11. Exceeds Authority Granted under Section 385(b)

The proposed regulations are not consistent with section 385(b) which requires Treasury and the IRS to set forth factors to determine whether an instrument is debt or equity. We believe the proposed regulations do not provide the guidance that Congress intended for Treasury and the IRS to provide to taxpayers. This inconsistency with the plain language of section 385(b) may very well render the proposed regulations invalid.

Recommendations

Based on the discussion above, MasterCard respectfully recommends the following:

1. Withdraw the Proposed Regulations

We recommend a complete withdrawal of the proposed regulations. When Congress granted Treasury and the IRS the regulatory authority to issue regulations in this area, the economy was far less global than it is today. The proposed 385 regulations, as drafted, will have an extremely negative effect on how U.S. multinationals conduct ordinary business transactions and put them at a further disadvantage vis-à-vis their foreign competitors. The proposed regulations will disrupt business and lead to unexpected, non-intuitive, and costly results for mere foot faults or for reasons unrelated to abusive transactions.

More importantly, the proposed regulations ignore the need for U.S. multinationals to finance their operations as they deem most appropriate to remain competitive. U.S. multinationals need the ability to use internal sources of funding in the most economical manner, taking into account many factors, including the tax implications of financing.

If the proposed 385 regulations are withdrawn, we anticipate that Treasury and the IRS would issue new proposed regulations under section 385 that set forth factors that will help companies determine the fundamental character of instruments as debt or equity. We believe that the dramatic changes in the characterization of debt and equity that would be imposed by the proposed 385 regulations, if deemed necessary, should only be undertaken in the context of overall tax reform.

2. Narrow the Application of the Proposed Regulations

In the absence of a complete withdrawal, the following details our recommendations concerning how the proposed regulations could be narrowed to reduce the negative impact on ordinary business transactions and still prevent the abuses with which Treasury and the IRS are concerned.

²Prop. Reg. 1.385-2.

³Prop. Reg. 1.385-3(c)(1).

⁴Prop. Reg. 1.385-3(c)(2).

⁵Prop. Reg. 1.385-2(b)(3).