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Cargill Inc. Presses IRS to Mitigate Debt-Equity Regs' Damage

JUL. 7, 2016

Cargill Inc. Presses IRS to Mitigate Debt-Equity Regs' Damage

DATED JUL. 7, 2016
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July 7, 2016

 

 

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

 

Room 5203

 

Internal Revenue Service

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

Re: Proposed Treasury Regulations under section 385

 

Dear Sir or Madam:

This letter responds to the request for comments on regulations under section 3851, as proposed by the Treasury Department ("Treasury") and the Internal Revenue Service (the "Service") in the Federal Register on April 8, 2016 (the "proposed regulations").2

Damage to U.S. Competitiveness Abroad

The proposed regulations are intended to reduce or eliminate inversions by U.S.-headquartered multinational enterprises ("U.S. MNEs"). Unfortunately, they not only fail to address this concern, but increase the burdens imposed by the U.S. international corporate tax system, making U.S. MNEs less competitive in the global market and more attractive inversion targets for non-U.S. competitors.

Global capital will flow through and be managed by companies with the best after-tax returns. MNEs must earn the right to keep and raise capital by the after-tax returns they generate for capital providers. Many factors make MNEs more or less competitive, but tax plays an important role. If U.S. MNEs are burdened by a tax system that imposes costs not borne by competitors of similar strength, they will lose bids to buy foreign businesses, fail to compete and raise capital for foreign organic growth and expansion, and sell foreign operations to more efficient owners to maximize shareholder returns.

By further burdening U.S. MNEs, the proposed regulations will hasten inversions, rather than discourage them. Capital providers and their MNE managers are making long-term decisions based not only upon current law, but projections of future law. Each government threat to increase the tax burdens on U.S. MNEs, and each legislative and policy proposal to increase the cost U.S. MNEs bear doing business abroad, signal to the market that the United States is not only uncompetitive, but unstable, and not a reliable host jurisdiction to MNEs that manage the world's businesses. The issuance of proposed regulations that are economically ill-conceived, deeply flawed technically, of dubious legality, retroactive in application, sweeping in scope, and hopelessly expensive to administer, with intentionally limited time for comment and a manifest intent to finalize regardless of cost, warns the world that we are unworthy stewards of their capital.

The ongoing, well-documented and inevitable demise of the U.S. as a holding company jurisdiction for non-U.S. investment will only be hastened by the proposed regulations. Even if the regulations are withdrawn, damage has been done.

Global capital will fund and flow to business investments wherever they are most efficiently located with or without U.S. MNEs. U.S. tax policy cannot alter this inevitable flow of capital, but it can stop U.S. MNE from participating. Much is at stake for our nation. The knowledge gleaned from managing business in all corners of the world provides U.S. MNEs with the business intelligence they need to compete and win. Enhanced competitiveness attracts capital. Management of that capital at U.S. headquarters creates high-paying, knowledge-based jobs. It also creates support jobs and businesses. All of which strengthen our economy and country.

Damage to U.S. Competitiveness at Home

Application of the proposed regulations to domestic U.S. entities should also be reconsidered. A country's tax code is a profit-sharing contract with global capital providers. Foreign MNEs are permitted under U.S. tax law to debt-fund their U.S. operations and reduce tax through the payment of interest. The interest deduction and right to use debt funding are as much a part of our tax code as our tax rate and are mathematically considered in cash flow modeling when deciding to make an investment.

The United States has relatively favorable thin capitalization rules. It also exempts interest expense from withholding tax without the need of a tax treaty under the portfolio interest rules. The United States seeks to negotiate zero-withholding rules in our treaties, and has benefited from the global tax exemption it has given to foreign capital providers through very large inbound foreign direct investment. Having received capital to the benefit of the U.S. economy, we now seek to change the contract by altering our interest deduction rules in a way that could not have been reasonably foreseen under U.S. tax law. The United States may enjoy a short-term benefit in tax collections, but in the long-run, the effect on capital formation and tax collections will be as detrimental as any increase in marginal tax rates.3

The United States needs tax policy that is competitive, predictable and favorable to both capital deployed in the United States and to capital deployed abroad but managed from the United States. The proposed regulations undermine these goals.

The Purpose for Debt Funded Dividends

In the preamble to the proposed regulations, Treasury questions whether issuing debt to an affiliate in connection with a dividend has meaningful non-tax significance. It does. The only reason to form a business is to earn dividends. Because money is fungible, every dividend paid by a non-liquidating business results in more debt than would be incurred in the absence of such dividend. Debt-funding a dividend is consequently not only a valid business purpose, but without it, business would have no purpose. Even when the resulting debt is held by the dividend recipient, the extraction of equity and increase in debt has important economic significance in reducing country risk, foreign exchange risk, the possible cost of contingent liabilities, the subordination of trade creditors, and in making a business more marketable to buyers.4

The Problem with Hybrids

The United States has agreed to the base erosion and profit shifting ("BEPS") principles drafted by the OECD, including the action plan to counteract the prevalence of hybrid mismatch arrangements, such as hybrid instruments. However, the proposed regulations effectively create an entire new class of hybrid instruments. For example, assume that a CFC borrows funds from its U.S. parent and the loan is recast as equity under the proposed regulations. If the U.S. lender does not pay tax on the interest income, either because interest does not accrue and could be capitalized, or because of deemed paid credits or previously taxed income, then the recast could trigger application of anti-hybrid rules in the CFC's jurisdiction. Local tax deductions would then be denied in the country of the borrower, not through tax planning deemed abusive under the BEPS guidelines, but solely through the impact of the proposed regulations, which create a hybrid instrument where none existed previously.

Given the well-documented contagion effect of recasts on inter-company loans, the leaching from the system of foreign tax credits that could result, and the unpredictable application of the rules, the proposed regulations will force U.S. MNEs to move loans to foreign affiliates offshore and increase reliance on disregarded structures under subpart F, none of which further U.S. policy goals.

Super Factor Proposal

If after consideration of the many comments Treasury receives it intends to finalize the proposed regulations, consideration should be given to including a "super factor" that would characterize an instrument as debt under section 385 if such instrument is treated as debt in the tax jurisdiction of the issuer.

Although this would not totally curb repatriation transactions Treasury views as inappropriate, Treasury has many other regulatory tools for such transactions that have been described by other commentators.

While not explicit in the regulations, it appears from subsequent comments of officials that Treasury may believe any attempt to explicitly limit application of the proposed regulations to interests in U.S. corporations would not be supportable under the statutory text of section 385 or perhaps under U.S. income tax treaties. However, the application of these rules to loans between foreign affiliates of U.S. MNEs and from U.S. MNE's to their foreign affiliates ("intercompany foreign subsidiary debt", or "ICFS debt") leads to unacceptable outcomes that have been outlined in many comment letters Treasury has received. The costs of increased compliance burdens, inadvertent and cascading debt-equity recharacterizations and decreased administrability of the rules for the Service, substantially outweigh any benefits to the United States of applying the proposed regulations to foreign affiliates of U.S. MNEs.

U.S. and non-U.S. MNEs use ICFS debt for a variety of business and non-U.S. tax reasons, including cash management, legal priority, ease of repayment (as compared with the often more involved corporate formalities and exchange control restrictions in many jurisdictions to make dividend or return of capital payments), reduction of country risks, capital control risks, and foreign currency risk, internal allocation of cost of capital, lower withholding tax rates, and locally supportable base erosion.5 Upending those purposes by applying the proposed regulations to ICFS debt does not further Treasury's efforts to mitigate the erosion of the U.S. income tax base or encourage better record keeping.

Treasury's willingness to consider a specific and appropriately drafted cash pooling exception is laudable, but a simpler exception is available that should be acceptable both to Treasury and U.S. MNEs engaged in legitimate and customary ICFS financing (including cash pooling). The regulations could be amended to include a "super factor" in favor of debt treatment under section 385 if the tax jurisdiction of the issuer treats the interest as debt for its own local income tax purposes as determined on a final local income tax return ("Issuer's Local Tax Treatment" treatment or "ILTT".

The ILTT would yield the following benefits:

 

1. ILTT is consistent with Treasury's objectives to prevent U.S. base erosion and ensure proper documentation of related party debt. Non-U.S. debts are generally subject to documentation and substance rules under local tax rules, and so there would be no need to impose separate and likely inconsistent debt documentation rules for ICFS debts.

2. ILTT would dramatically improve the ability of U.S. MNEs to ensure the form and U.S. tax characterization of their ICFS financing are consistent, and eliminate the compliance burden of having to track thousands of intercompany transactions to determine their potential impact on the U.S. tax characterization of ICFS financing.

3. ILTT would not facially distinguish between interests in U.S. corporations and non-U.S. corporations. Thus, the regulations would still be neutral and universal in application. ILTT, as applied to U.S. issuers, would incorporate all other factors deemed appropriate by Congress and Treasury (including those in the proposed regulations).

4. ILTT would be consistent with the substance of the instrument and reduce opportunities for tax arbitrage, because the U.S. treatment under ILTT would generally coincide with the local treatment.

5. ILTT would be broadly consistent with the spirit of OECD's anti-hybrid initiatives and also further international tax comity.

6. ILTT would be easier to administer than a narrower cash-pooling specific exception and would not provide opportunities for avoidance of the application of the regulations to U.S. indebtedness.

 

One potential objection that Treasury may raise to the incorporation of ILTT is that it would require Treasury and the Service to analyze and determine a taxpayer's compliance with foreign law. However, the application of foreign law is already a feature of many U.S. domestic tax and treaty provisions. In addition, the United States has committed itself to cooperate in anti-hybrid legislation under the OECD base erosion and profit shifting initiatives, which by its nature will require U.S. rules to take cognizance of foreign tax characterization. In any case, since the ILTT as proposed would be conclusively established based on the final filed local income tax return of the issuer, Treasury would not be required to separately analyze the local tax classification of the instrument.6

In summary, the ILTT super factor would be administrable and consistent with the text of Section 385(c), and would serve the various objectives of the Treasury, Service and taxpayers.

 

* * *

 

 

For the foregoing reasons, the proposed regulations should not be finalized. However, if Treasury and the Service insist on moving forward, the regulations should include the ILTT super factor to mitigate the damage done by the proposed regulations to intercompany financing structures that U.S. MNEs rely upon to manage their non-U.S. activities.

I would be pleased to discuss this proposal further and address any questions you have.

Sincerely,

 

 

Scott Naatjes

 

VP and General Tax Counsel

 

Cargill, Incorporated

 

Wayzata, MN

 

FOOTNOTES

 

 

1 Unless otherwise noted or clear from the context, all references to "section" are to sections of the Internal Revenue Code of 1986, as amended (the "Code").

2 81 Fed. Reg. 20912 (April 8, 2016)

3 Low tax rates should properly be viewed as competition between countries to attract capital, not a windfall to investors who provide it. In an efficient global market, the risk-adjusted after-tax rate of return on capital is equalized. Lower tax rates, holding all else equal, will attract capital until the return on capital diminishes and the arbitrage opportunity is neutralized. The benefit of low-tax rates on capital are consequently enjoyed primarily by the capital recipient (the country), not the capital provider. A simple example can be seen in municipal bond markets. The federal tax exemption on municipal bonds creates demand for such bonds. This demand reduces interest rates so that the after-tax, risk-adjusted returns to holders of taxable and tax exempt bonds are approximately equal. The tax exemption provides a very slight benefit to the holder (just enough to motivate them to buy the exempt bonds and incur the transaction costs and tax risks). The primary benefit accrues to the municipalities who receive cheaper financing than bond issuers whose interest payments are taxable. If the U.S. suddenly changed the rules, and made holders of tax-exempt bonds taxable, the U.S. would take away a benefit that holders never really enjoyed since their returns were lower because of it. The change in tax law should be correctly viewed as a simple breach of contract. The government first benefited from the cheap capital available to it because of the exemption, and then collected tax anyway.

4 Acquirers to not want to purchase cash or significant retained earnings because it is costly to move and administer and gives rise to future tax costs and risks.

5 Congress's recent extension of Section 954(c)(6) indicates that Treasury should not be concerned with foreign-to-foreign base erosion by U.S. MNEs per se.

6 In addition, because of the "no affirmative use" rule, the proposed regulations as written are not self-executing and in fact already require the Service to examine a purported debt instrument in great detail. So, even if the ILTT were modified to require a separate determination by the Service of the local tax classification, it would not substantially change the complexity and would be far more limited in scope that what the proposed regulations already require.

 

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