Bifurcation in Proposed Debt-Equity Regs Is Good Policy, Academic Says

I. Bifurcation Is Good Policy

Any area of law has basically three ways to remedy questionable behavior: impose a draconian penalty; impose a proportional remedy; or do nothing.¹ Current debt-equity law gives the IRS and the courts only two of the three options. Either the debt can be recharacterized as 100% equity (a draconian remedy) or the debt can be fully respected (i.e., doing nothing). The Bifurcation Rule gives the IRS the middle option of a proportional remedy, allowing a recast of the proportion of the debt not reasonably expected to be repaid.

Allowing proportional remedies is generally good policy and has been the trend across many areas of law. Consider a common tort law scenario: a factory that employs hundreds of workers makes noise that cannot be reduced and that harms homeowners who live near the factory. As absurd as it may seem today, until 1970, a court hearing a suit brought by the homeowners had only two options. First, the judge could enjoin the factory from making the noise, a draconian remedy which would shut the factory and result in layoffs.² Or, second, the judge could do nothing.³ Now, of course, tort law sensibly allows a third option: courts can allow the factory to continue but award homeowners damages proportional to the harm caused by the noise.⁴

But current debt-equity law remains stuck with the absurd choice between debt being 100% respected or 100% recharacterized. Proposed Regulation § 1.385-1(d) sensibly allows a proportional remedy, bringing debt-equity law into the modern age. This change is good policy for the following reasons.

A. Bifurcation Will Reduce Taxpayer Aggressiveness

Bifurcation will reduce aggressive use of intragroup debt. Current law's all-or-nothing approach incentivizes taxpayers to push into the gray areas of intragroup debt. Consider the conundrum facing an IRS agent who comes across a multi-million-dollar intragroup "loan" that is at the high end of what an unrelated bank might have extended to the borrowing subsidiary. Suppose that several factors weigh towards respecting this loan as debt, while several factors weigh towards recharacterizing it as equity.

In this situation, the IRS agent's current incentives clearly weigh in favor of doing nothing.⁵ The all-or-nothing stakes will cause the taxpayer to spend heavily on legal fees to fight recharacterization as equity, creating a great deal of work for the IRS agent and his or her colleagues. The ambiguity of the multifactor test means the taxpayer may well ultimately prevail, making all the effort for naught. But even success in complete recharacterization may strike the IRS agent as unpalatable as well, since it imposes a draconian increase in the taxpayer's tax burden, even though some portion of the loan may have been commercially reasonable.

The option of bifurcation will completely change IRS agents' incentives in handling aggressive intragroup loans. Bifurcation can be done proportionally to the extent that the loan is questionable, so the remedy would be entirely palatable and just. Moreover, since the stakes would not be all-or-nothing, taxpayers would fight back less aggressively, consuming fewer resources and creating less unpleasantness.

Changing IRS agents' incentives will have an immediate effect on the incentives of taxpayers, who will know that aggressive intragroup loans are much more likely to result in an increase in their tax bill on audit. Moreover, since bifurcation is a proportional remedy, taxpayers will know that the more aggressive their planning, the higher the expected increase in their tax on audit.

B. Bifurcation Will Ease Settlements

Bifurcation will make it easier for the IRS and taxpayers to settle disputes over debt-equity issues.⁶ In any area of law, if the only available outcomes are either a draconian remedy or no remedy at all, the parties face a huge bargaining range in negotiations, which are often "protracted and costly."⁷

For example, consider the tort-law scenario discussed earlier, with the homeowners suing the nearby noisy factory. If the only possible remedies are an injunction shutting down the factory or no remedy at all, then the bargaining range for a settlement will be $0 up to 100% of the profits generated by the factory. By contrast, if compensatory damages are an available remedy, then the negotiating range between the homeowners and the factory will be much narrower, specifically the range of possible compensation.

Current debt-equity law is all-or-nothing. If the IRS asserts that a purported $100m loan should be recharacterized as equity, then the bargaining range is huge, ranging from $0 being stock up to $100m being stock. But if the IRS asserts that $30m of the purported $100m loan should be recharacterized as equity, then the bargaining range will be much smaller: $30m is the top of the range. And because the IRS's assertion of $30m is not merely an opening bid but a likely final outcome if litigated, taxpayers would be wise to consider the $30m as an anchoring point for any counteroffers. In sum, giving the IRS the option of bifurcation will make it substantially easier for the IRS and taxpayers to settle debt-equity disputes.

C. Bifurcation Will Reduce Uncertainty for Taxpayers

Tax law can improve economic efficiency by minimizing uncertainty about the tax liability that will be imposed on an economically beneficial transaction.⁸ Intragroup loans can serve economically beneficial purposes, such as reducing transaction costs like bankers' fees associated with borrowing from banks. But every intragroup loan runs some risk of being recharacterized as equity,⁹ and under current all-or-nothing law, recharacterization has draconian consequences. By contrast, when bifurcation is an option, recharacterization has much lower expected consequences.

Consider again the tort-law scenario where homeowners sue over noise produced by a neighboring factory. A manufacturing company will hesitate to build a factory in a state where the only remedy available to homeowners complaining about the noise is an injunction shutting down the factory. In contrast, the availability of a proportionate damages remedy will encourage factory building. Both factories and intragroup loans can be economically beneficial. Both activities are encouraged by the use of proportional remedies in place of draconian remedies.

As discussed below, you should refine and expand the Bifurcation Rule in two ways to reduce taxpayer uncertainty. First, you should publish at least rough guidance on how the bifurcated portion will be calculated, so that taxpayers will know the approximate amount of their tax risk, provided they do not use intragroup loans aggressively. Second, you should expand the Bifurcation Rule so that minor failures of the Documentation Rules in Prop. Treas. Reg. § 1.385-2 result in only part of the debt being recast as equity, rather than 100% of the debt being recast as equity.

D. Rejecting the Calculation-Costs Argument against Bifurcation

The New York State Bar Association Tax Section, in its comments¹⁰ on the proposed § 385 regulations, makes the following argument against the Bifurcation Rule:

Precision in calculating proportional remedies is not necessary.¹² Indeed, our country's legal system allows juries of laypersons to determine damages in many areas involving complex economics, including contract disputes and patent infringement. In a Harvard Law Review article,¹³ two law-and-economics scholars demonstrate that proportional remedies are superior to all-or-nothing remedies -- even if the proportional remedies are only rough approximations -- as long as the approximations are correct on average.¹⁴ In tax law, bifurcation can be substantially better than current all-or-nothing law, even if bifurcation is done roughly.

Current debt-equity law already involves a great deal of potentially difficult computation, even though the outcome is all-or-nothing. A perfect example is the case Bauer v. Commissioner.¹⁵ This case had seemingly straightforward facts: a closely held meatpacking corporation had two shareholders, who had also "loaned" money to the corporation. The IRS argued for recharacterizing this debt as equity. One debt-equity factor is whether the corporation has "thin or adequate capitalization."¹⁶ So the Tax Court calculated the corporation's debt-to-equity ratio, which appeared to be 92-to-1.¹⁷ The Tax Court gave great weight to this factor and held for the IRS.¹⁸ But the Ninth Circuit found that the Tax Court had incorrectly calculated the debt-to-equity ratio, and lengthy recalculations using the proper approach showed the ratio was never more than 8-to-1.¹⁹ Adding insult to injury, the Ninth Circuit also found that the Tax Court had miscomputed the relative debt holdings of the two shareholders,²⁰ which is relevant to the factor about the "identity of interest between creditor and stockholder." The Ninth Circuit reversed the Tax Court and held for the taxpayer.

Current debt-equity law already requires extensive and potentially tricky computations -- all to determine whether debt is 100% recharacterized or 100% respected. Instead, it makes much more sense to use the results of these computations to determine approximately what percentage of the debt should be recast as equity.²¹

II. Provide Guidance on Calculating the Bifurcation Percentage

The IRS and Treasury should provide at least rough guidance on how the IRS will determine the percentage of a purported debt that will be recast as equity. As noted above, precision is not essential to make a proportional remedy work well -- in tax law or in any area of law.

Providing calculation guidance would further the policy goals served by the Bifurcation Rule. Recall that intragroup loans can serve valid economic purposes like minimizing bankers' fees, but that all intragroup loans are subject to some risk of being recast as equity. Calculation guidance can give taxpayers a sense of their maximum tax exposure given a chosen intragroup loan arrangement. Moreover, calculation guidance promotes horizontal equity, ensuring that taxpayers with similar intragroup loan arrangements are treated similarly. Even more importantly, calculation guidance will further ease settlements between taxpayers and the IRS, since the IRS's opening position will have legal grounding.

The final regulations need not provide calculation guidance. Rather, a Revenue Procedure might be a better vehicle. Since debt bifurcation is a novel legal concept and potentially involves huge sums of money, it may be necessary in the first few years to make numerous modifications. Revenue Procedures allow such modifications without the same administrative-law formalities as regulations. The IRS has used Revenue Procedures in analogous ways in areas such as tax-exempt bonds²² and qualified retirement plans.²³

III. Remedy Documentation Failures with Bifurcation Rather Than 100% Stock Recast

While the Bifurcation Rule at Prop. Treas. Reg. § 1.385-1(d) is a wise move toward proportional remedies, the Documentation Rules at Prop. Treas. Reg. § 1.385-2 unwisely move in the opposite direction -- towards always imposing a draconian remedy. If a taxpayer fails to meet the various documentation and retention rules, then 100% of the loan is recast as equity, which is draconian.

Imposing draconian remedies for accidental violations that cause little actual harm creates incentives for wasteful compliance expenditures. Law-and-economics scholars have mathematically demonstrated this wastefulness.²⁴ A simple example illustrates the point. Suppose that a ski-resort operator had to pay $1,000,000 in statutory damages to any neighboring landowner if one of its employees trespassed on the neighboring land, even if the trespass was accidental and resulted in no harm (such as getting lost and skiing quietly through a neighbor's forest). Quite rationally, the ski-resort operator would spend money on surveyors and real estate lawyers to ensure that it knew the exact boundaries of its land, and it would spend money to monitor its employees' whereabouts via GPS. Such expenditures are rational because the consequences of accidental trespass are so draconian. Yet such expenditures are an economic loss to society, bringing little or no benefits.

The draconian remedy currently proposed for violating the Documentation Rules at Prop. Treas. Reg. § 1.385-2 will similarly result in economic waste. Quite rationally, companies will use an expensive lawyer to draft each intracompany loan and to extensively research whether any possible legal wrinkle might make the loan not legally binding.²⁵ Companies will pay an expensive financial professional to prepare extensive documentation about the issuer's financial position.²⁶ Companies will hire staff to ensure payments on the loan are made promptly by accounting systems.²⁷ Companies will pay information-technology companies to ensure that all documents are electronically stored, backed up, maintained, and kept accessible.²⁸ These expenditures are rational because the proposed consequences of accidentally violating the Documentation Rules are so draconian. Yet these expenditures will be socially wasteful.

Comments from the business community have rightly criticized the Documentation Rules for the compliance costs that will result.²⁹

The solution is simple: recast only a portion of a loan for violation of the Documentation Rules. As noted earlier, rough proportionality suffices to make bifurcation effective. For example, if an intercompany loan has only meager documentation about the debtor's financial position,³⁰ then automatically recast x% of the debt as equity. Choose x based on the average discount that a bank would pay to buy a poorly-documented loan from the bank that originally made the loan. As another example, if a debtor misses one interest payment on an intracompany loan, without the creditor engaging in any "reasonable exercise of the diligence and judgment of a creditor,"³¹ then automatically recast y% of the debt as equity. Choose y based on the average fall in the price of corporate bonds at the time that an issuer has missed a payment, but before any of the creditors' remedies have been asserted. These are merely examples of how bifurcation might work. Such bifurcation mirrors economic reality. More importantly, bifurcation is proportional, not draconian, thus substantially reducing the amounts that companies will rationally spend to comply with the Documentation Rules.

Conclusion

The Bifurcation Rule is good policy. But you should provide at least rough guidance as to how bifurcation will be calculated in practice. Meanwhile, violations of the Documentation Rules should not result in 100% of a purported loan being recast as equity; rather, violations should result in bifurcation.

²See, e.g., Whalen v. Union Bag & Paper Co., 101 N.E. 805 (N.Y. 1913).

³See, e.g., McCann v. Chasm Power Co., 105 N.E. 416 (N.Y. 1914).

⁴See Boomer v. Atlantic Cement Co., 257 N.E.2d 870, 873 (N.Y. 1970).

⁵ For a mathematical model of the incentives facing an IRS agent, see Blair-Stanek, 99 Va. L. Rev. at 1203-09.

⁶ In law-and-economics terms, "liability rules" such as bifurcation facilitate settlements, as discussed id. at 1211-13.

⁷ Walgreen Co. v. Sara Creek Prop. Co., 966 F.2d 273, 278 (7th Cir. 1992) (Posner, J.); accord Ian Ayres & Eric Talley, Solomonic Bargaining: Dividing a Legal Entitlement to Facilitate Coasean Trade, 104 Yale L.J. 1027, 1032-33 (1995); Ian Ayres, Optional Law: The Structure of Legal Entitlements at chs. 9 & 10 (2005).

⁸ To use the law-and-economics terminology, "liability rules" such as bifurcation prevent ambiguity from discouraging economically efficient transactions. See Blair-Stanek, 99 Va. L. Rev. at 1199-1200.

⁹ For example, every intragroup loan has an identity of interest between creditors and shareholders, which is a factor weighing towards recharacterizing as equity. See, e.g., Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968) (factor (2)); Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972) (factor (9)); Bauer v. Commissioner, 748 F.2d 1365, 1368 (9th Cir. 1984) (factor (9)).

¹⁰ New York State Bar Association Tax Section, Report on Proposed Regulations under Section 385 (June 29, 2016), available at http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Report_1351.html.

¹¹Id. at 48.

¹² For a discussion of how calculation costs impact the choice between draconian remedies (i.e., "property rules") and proportional remedies (i.e., "liability rules"), see Blair-Stanek, 99 Va. L. Rev. at 1214-16.

¹³ Louis Kaplow & Steven Shavell, Property Rules Versus Liability Rules: An Economic Analysis, 109 Harv. L. Rev. 713 (1996).

¹⁴ 109 Harv. L. Rev. at 728-30.

¹⁵ 748 F.2d 1365 (9th Cir. 1984).

¹⁶ This factor is relevant in all circuits. See, e.g., Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972) (factor "(8) 'thin' or adequate capitalization"); Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968) (factor "(5) the 'thinness' of the capital structure in relation to debt").

¹⁷ Bauer, 748 F.2d at 1368.

¹⁸Id. ("In the present case, the Tax Court gave great weight to the eighth factor: whether Federal was adequately capitalized").

¹⁹Id. at 1369.

²⁰Id. at 1370.

²¹Cf. Kaplow & Shavell, 109 Harv. L. Rev. 713, 729 (noting that if remedies are all-or-nothing, then courts already estimate the considerations on each side and balance them; instead courts should just use these estimates to impose a proportional remedy).

²² Rev. Proc. 97-15 § 6.

²³ Rev. Proc. 2013-12 § 1.03 (overview), § 5.01(5) (defining "Maximum Payment Amount"), § 14.01(1)-(2) (using a multifactor test for "[d]etermination of sanction"), modifying and superseding Rev. Proc. 2008-50, modifying and superseding Rev. Proc. 2006-27.

²⁴ Stewart E. Sterk, Property Rules, Liability Rules, and Uncertainty About Property Rights, 106 Mich. L. Rev. 1285, 1304 (2008); Thomas W. Merrill, Trespass, Nuisance, and the Costs of Determining Property Rights, 14 J. Legal Stud. 13 (1985); see also Blair-Stanek, 99 Va. L. Rev. at 1195-98 (applying these scholars' insights to tax law).

²⁵See Prop. Treas. Reg. § 1.385-2(b)(2)(i)-(ii).

²⁶See Prop. Treas. Reg. § 1.385-2(b)(2)(iii).

²⁷See Prop. Treas. Reg. § 1.385-2(b)(2)(iv).

²⁸See Prop. Treas. Reg. § 1.385-2(b)(4).

²⁹See, e.g., Comment of the Business Roundtable (June 7, 2016), available at http://businessroundtable.org/resources/brt-letter-the-office-management-and-budget-debtequity-regulations.

³⁰Cf. Prop. Treas. Reg. § 1.385-2(b)(2)(iii).

³¹ Prop. Treas. Reg. § 1.385-2(b)(2)(iv)(B).