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Apparel Company Outlines Negative Effects of Debt-Equity Regs


Apparel Company Outlines Negative Effects of Debt-Equity Regs

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Re: Proposed Regulations under Section 385:

Dear Sir or Madam:

This letter is in response to a request for comments made by the United States Department of Treasury ("Treasury") and the Internal Revenue Service ("IRS") regarding the proposed regulations issued on April 4, 2016 (REG 108-060-15) under section 385 of the Internal Revenue Code (the "Proposed Regulations"). VF Corporation ("VF") appreciates the opportunity to offer its comments on the Proposed Regulations.

VF is a global leader in branded lifestyle, apparel and footwear and accessories, with more than 30 brands, 64,000 associates and $12.4 billion in revenue. The Company was founded in 1899 and is headquartered in Greensboro, North Carolina. VF's stock is publicly traded on the NYSE. VF and its wholly owned U.S. and non-U.S. subsidiaries design, manufacture, market, and distribute branded lifestyle apparel, footwear, backpacks, handbags, luggage, and related accessories. The Company's diversified brand portfolio spans geographies, product categories, consumer demographics, and sales channels. VF's brand portfolio includes The North Face®, Timberland®, Vans®, Lee®, Wrangler®, Riders by Lee®, Rock & Republic®, Nautica®, Eastpak®, JanSport®, Kipling®, Lucy®, Napapijri®, Smartwool® and many others.1

General Concerns

VF understands Treasury's view on certain expatriation transactions (commonly referred to as "inversions") and is not surprised that additional regulatory guidance was introduced to reduce the U.S. federal tax benefits of those transactions (e.g., to curb earnings stripping).2 While VF is not interested in expressing a view on inversions themselves, we are very concerned that proposed regulatory guidance and actions that were introduced primarily as an effort to curb inversions will have material adverse implications to U.S. multinationals that have not inverted nor have any plan of doing so.

VF is also concerned that the scope and impact of the Proposed Regulations must be viewed within the overall global tax environment and the numerous other challenges and burdens being imposed on U.S. multinationals, such as the OECD's Base Erosion and Profit Shifting ("BEPS") project,3 the European Commission's state-aid investigations4 and general uncertainty fostered by these and the myriad of local country tax initiatives.5

VF has significant concerns about the potential negative impact of the Proposed Regulations on U.S. multinationals, which are already at a significant competitive disadvantage relative to their non-U.S. competitors in the global marketplace. It is unclear from the preamble to the Proposed Regulations whether these consequences are intended, which would be unfortunate, or unintended, which would provide Treasury and IRS an opportunity to revisit the relevant aspects of the Proposed Regulations.

In general, the Proposed Regulations would overturn long-standing tax principles and well-established case law and regulations, and will significantly increase the cost of doing business in the United States and could also increase the cost of doing business outside the United States. In fact, the Proposed Regulations, when coupled with the global tax developments just noted, could actually result in U.S. multinationals paying more in foreign taxes and possibly less U.S. federal tax. This letter focuses specifically on the potential negative economic impact, administrative burden and uncertainty to U.S. multinationals of the Proposed Regulations.

Negative Economic Impacts to U.S. Multinationals

If finalized in their current form, the Proposed Regulations would have a number of highly negative economic consequences for U.S. multinationals, including:

  • Increase to U.S. multinationals' cost of capital, due to larger amounts of more expensive external debt being incurred to fund acquisitions, and limit flexibility for post-acquisition integration transactions (the most common of which constitute proscribed transactions for purposes of the general rule and funding rule);

  • The incentive for additional third party debt will also apply at the level of a U.S. group's CFCs to avoid the treatment as stock of related party debt instruments. Although the treatment of any instruments issued by a CFC as stock (and the resulting denial of interest expense deductions) will have less immediate U.S. federal tax consequences, the collateral consequences of such treatment could be equally or more impactful than treating as stock a debt instrument of a U.S. issuer. For example, treating a debt instrument issued by a CFC as stock would create a new class of what would likely be non-voting shares and depending on the identity of the holder could create many negative consequences including:

    • Distort the CFC's earnings and profits (E&P) since interest expense would have been deducted for local tax purposes (this could also create a splitting event as described in section 909);

    • Move E&P and foreign taxes within a CFC group upon the repayment of a debt instrument treated as stock; and

    • Create a hybrid instrument, which, depending on how the final hybrid mismatch recommendations of OECD's BEPS Action 2 are implemented locally, could result in a disallowance of interest expense locally even though all other local law limitations on interest base erosion might be satisfied;

  • Change the dividend paying practice of U.S. multinational groups, or otherwise force such groups to incur incremental (and more expensive) external debt to avoid, especially, the funding rule. Stated differently, Prop. Reg. § 1.385-3 will worsen the "lock-out effect" on the earnings of foreign subsidiaries of a U.S. multinational group;

  • Increase risk to asset security by driving company treasury departments to fund through equity rather than related party debt. In many jurisdictions, it is difficult (or in certain cases only possible) to extract cash through a return of equity. In addition, local law generally provides a preference on liquidation and other events to debt holders over equity holders. As a result, it is preferred to fund subsidiaries in these jurisdictions with a combination of equity and debt to maximize the local law flexibility and protections available to creditors;

  • Result in double taxation on earnings of foreign subsidiaries of a U.S. multinational group to the extent that dividends (in form interest) paid on a debt instrument treated as stock are not eligible for "deemed paid credits" under section 902. Because any such deemed stock will in all likelihood be non-voting, unless the holder also owns actual stock of the issuer meeting the requirements of section 902, dividends paid on the deemed stock will not be eligible for a deemed paid credit. In addition, any foreign taxes that would have otherwise been deemed paid by the recipient if the requirements of section 902 had been satisfied must nonetheless be removed (permanently) from the payor's foreign tax pool; and

  • By splitting ownership of a subsidiary because of a debt holder being treated as owning equity, render taxable many exchanges that would otherwise be eligible for tax-free treatment under the subchapter C provisions of the Code, as many of those provisions require a threshold stock ownership requirement to be met (by vote and/or value).

 

Administrative Burden to U.S. Multinationals

If finalized in their current form, the Proposed Regulations would impose an enormous administrative burden on U.S. multinationals, without a commensurate benefit to the U.S. fisc:

  • Additional compliance burden through additional head count or through the outsourcing to a service provider to comply with the Proposed Regulations. The Proposed Regulations understate substantially this compliance burden for a U.S. multinational with significant offshore presence (e.g., U.S. multinational with 100+ foreign corporations);

  • Financial statement audit costs and associated time to manage this area of the financial statement audit will increase due to the complexity of the rules and the negative consequences of related party debt being recast as equity;

  • Increase of costs relating to due diligence when acquiring a U.S. or non-U.S. target. This additional increase of costs will be necessary to even attempt to understand the target's U.S. tax profile, in light of the Proposed Regulations, and how that profile would or could affect the post-acquisition U.S. multinational group on a go-forward basis; and

  • Increase in U.S. multinationals' treasury administration costs for managing the group's offshore cash and other business transactions. Where the U.S. multinational would have used a bank-offered offshore cash pooling arrangement to manage its cash, or a bank-offered "pay on behalf of" system to manage efficiently settlement activities, the U.S. multinational likely will have to pursue other less efficient manual processes, resulting in increased costs.

 

Uncertainty to U.S. Multinationals

Regulatory uncertainty, including tax uncertainty, makes it difficult for businesses to plan for the future and leads to decreased investment. The Proposed Regulations create enormous uncertainty for U.S. multinationals:

  • The rules of the Proposed Regulations are a "one-way street" for the IRS. In other words, the IRS may recast a related party debt instrument as equity for a myriad of reasons, but taxpayers may not even try to provide themselves with tax certainty. Add to this the incredible breadth and complexity of many of the rules (e.g., the funding rule) and the fact that the IRS will have the benefit of hindsight in deciding whether or not to apply the rules. As a result, U.S. multinationals simply will not know for many years (often well after the fact) whether related party interests are debt or equity.

  • The "no affirmative use" rule seems to create the most uncertainty, and to be particularly unworkable, in the CFC context. As discussed above, the consequences of a debt instrument treated as stock in a CFC will most often be with respect to the movement of E&P and potential movement or disallowance of foreign taxes. The U.S. tax impact will in turn depend on a wide variety of interrelated factors (e.g., the identity and ownership of the impacted CFCs, the U.S. shareholder(s), the timing of distributions or deemed distributions, and the foreign tax credit limitation position of those U.S. shareholders). Thus it seems that a U.S. multinational will often be unable to discern the tax treatment of a debt instrument until and unless the IRS, with benefit of hindsight, chooses whether to apply (or not) the proposed rules to treat the debt instrument as stock, potentially based on which treatment produces the highest U.S. federal tax liability.

 

Conclusion

The Proposed Regulations (in addition to all of the other current burdens U.S. multinationals already are facing as mentioned above) would have profound negative economic effects and other negative business effects on cross-border activities of U.S. multinationals. Treasury and IRS should not finalize the Proposed Regulations unless and until it considers and addresses these effects. Otherwise, U.S. multinationals will continue to be disadvantaged against their non-U.S. competitors in the global marketplace.

We stand ready to provide additional comments and insights en route to overcoming the deep concerns we and others have about the Proposed Regulations.

Very Truly Yours,

 

 

Ryan K. Smith

 

Vice President-Global Taxes

 

VF Corporation

 

Greensboro, NC

 

FOOTNOTES

 

 

1 See http://www.vfc.com/ for additional information on the Company.

2 The Proposed Regulations were issued simultaneously with final and temporary regulations (TD 9761) under Section 7874 of the Internal Revenue Code, which apply to certain expatriation transactions or inversions. Further the Treasury "Fact Sheet" describes the Proposed Regulations as addressing the "issue of earnings stripping" that arises in the case of foreign-parented multinational groups. However, the Proposed Regulations apply to all multinational groups, whether foreign or domestic parented and whether or not the group includes an inverted U.S. company. Further, although they do not apply to instruments issued and held by members of the same consolidated group, the Proposed Regulations apply to instruments issued between affiliated controlled foreign corporations ("CFCs") of a U.S. multinational group even though there is no possibility of earnings stripping between CFCs, at least not for U.S. federal tax purposes, and in fact that type of leverage planning most often is designed to reduce the group's foreign tax liability.

3 The OECD's BEPS recommendations have been issued over the last couple of years with the last of the recommendations issued in October of 2015. It is clear that the BEPS recommendations have had (and will have) a material impact on many U.S. multinationals as different jurisdictions have and will continue to enact relevant legislation. A major component of the BEPS initiative is aimed at ensuring multinational companies pay their "fair share" of taxes, and, it seems, that U.S. multinationals are impacted as much, if not more, than other multinationals.

4 Another recent development in the global tax environment is the European Commission's state-aid investigations which is an attempt by the European Union ("EU") Commission to assess taxes up to ten years retroactively for those companies that were granted "illegal state aid". Similar to the OECD BEPS initiative, and clearly understood it seems by both major political parties in the U.S., it appears that the state-aid investigations are disproportionately targeting U.S. multinationals. The costs incurred and the resources employed in order to build one's case, draft one's objection, and engage legal support is significant; this burden is in addition to the potential financial implications associated with an adverse result.

5 In addition, U.S. multinationals have to deal with "tax uncertainty" especially given the above mentioned changes that are happening within the global tax environment. However, it seems that on a global basis, the OECD and the more developed taxing bodies are starting to shift toward pursuing a culture of greater "tax certainty". The objective of this shift is to facilitate, not impede, global commerce for multinationals through clear and consistent laws and regulations governing cross-border transactions. Regulatory guidance issued by Treasury that promotes any degree of "tax uncertainty" in relation to cross-border transactions entered into by a U.S. multinational only makes it more difficult for a U.S. multinational to compete in the global marketplace.

 

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