Chemistry Council Seeks Withdrawal of Proposed Debt-Equity Regs

The American Chemical Counsel ("ACC") is pleased to enclose comments on the recently proposed regulations under section 385. ACC represents the leading companies engaged in the business of chemistry. ACC members apply the science of chemistry to make innovative products and services. The business of chemistry is an $812 billion enterprise and a key element in the nation's economy. It is the nation's largest exporter, and the membership involves both U.S.-owned and foreign-owned chemical companies. Plentiful and affordable domestic supplies of natural gas have led to massive new investment in U.S.-based chemistry and plastics production. As of this month, 267 projects valued at $163 billion have recently been completed, or are under construction or in the planning phase. Fully 62% of this is foreign direct investment. These new factories and capacity expansions could create $105 billion in new annual Page 2 of 49 chemical industry output and 738,000 permanent new jobs throughout the U.S. economy by 2023. As a result, our members are interested in the proposed section 385 regulations and the impact that they may have on their business operations.

Our membership greatly appreciates the opportunity to comment on these proposed regulations. If you have any questions with respect to these comments or wish to discuss these further, please call me at (202) 249-6200.

• Authorize the Commissioner of the Internal Revenue Service to treat certain related party interests in a corporation as indebtedness in part and stock in part for federal income tax purposes;

• Establish requirements for the preparation and maintenance of extensive documentation as a necessary condition for certain related party debt instruments to be treated as indebtedness for federal income tax purposes; and,

• Treat as stock certain related party interests that otherwise would be treated as indebtedness for federal income tax purposes.

The regulations would impose unwarranted restrictions on the financial policies of our members and interfere with the management of the capital structure of member entities. These are not trivial matters. Moreover, the breadth of transactions and operating entities to which the proposed regulations would apply, in addition to the cascading "ownership" changes and other collateral effects that the rules could set in motion, leave open to question whether it would be possible, in practical terms, to implement the regulations. These are among the reasons that ACC respectfully requests that the Treasury/IRS withdraw the proposed regulations.

If, despite these serious concerns, the Treasury/IRS move to issue final regulations, a decision with which ACC would strongly disagree, major changes would be needed to mitigate the harmful effects and make the regulations workable for the chemical industry. At a minimum, changes would be needed to allow members to continue key internal treasury practices and other routine lending practices that are essential to the financial management of a large corporate group, to accommodate other business concerns expressed herein, and to provide a new effective date to implement the proposals as revised. If final regulations are put into effect, it is imperative that that they reflect clear policy judgments and that they be grounded in sound tax principles. The Treasury/IRS must find ways to address our policy concerns without discouraging or unnecessarily intruding on the legitimate business practices of the companies that have invested heavily in the economy of the United States.

The chemical industry has been a vital source of investment in the manufacturing sector of the United States, particularly with the growth of shale gas production and lower costs for fuel and feedstock. To date, the chemical industry has announced over 260 new projects to be constructed in the United States, amounting to $164 billion in new capital investment, more than 60 percent of which is direct foreign investment. These investments are expected to create 426,000 permanent new jobs in the chemical industry and its direct suppliers, as well as an additional 312,000 jobs in communities where workers spend their wages. By 2023, these new projects are projected to produce $301 billion in new economic output and $22 billion in new federal, state, and local tax revenues. The chemical industry is important to the United States, and the United States has become an attractive destination for new manufacturing capacity to serve the domestic market.

These new investments will all require funding. To carry out these investment projects, the member companies of ACC will need to rely on their internal treasury functions to ensure a timely, reliable, and efficient flow of funds. Especially because of our members' concerns that the proposed regulations would impede their internal treasury functions, ACC appreciates the opportunity to present its views on the proposed regulations and to provide an overview of the workings of our members' internal treasury functions and how the proposed regulations would affect them.

Our comments in this letter are divided into three parts. Part I discusses some preliminary authority issues with regard to the proposed regulations. Part II describes the financing environment for large, affiliated groups with global operations and the general impact of the proposed regulations on the internal treasury functions of an affiliated chemical group. Part III explains certain specific issues raised by the proposed regulations and offers our recommendations.

There are numerous conceptual flaws and negative implications with the proposed regulations, including:

• The Treasury/IRS do not have the necessary authority to issue the proposed regulations under section 385; section 385 does not authorize the promulgation of "per se" anti-abuse rules targeted at perceived earnings stripping among a select group of corporate taxpayers.

• The proposed regulations would unnecessarily disrupt companies' treasury functions and dividend policies by linking loans and dividend distributions and other transactions through various "per se" rules even though such transactions are not related and serve real business purposes.

• The proposed regulations would cripple the internal networks that ensure adequate funds are supplied where needed to support day-to-day, global business operations and investments in a reliable cost efficient, timely, and risk-controlled manner.

• The proposed regulations would impose an unwarranted 72 month "waiting period" for issuing debt that would prevent companies from accessing group funds when needed to meet unexpected expenses and to respond quickly to emergencies, changes in the business environment, or new opportunities.

• The proposed regulations would give rise to situations in which even one, inadvertent transaction could trigger the "per se" funding rule to set in motion a cascading series of recharacterizations of intercompany debt, which in turn would trigger a series of severe collateral tax consequences, such as taxing the repayment of principal on a loan as if it were income to the lender.

• The proposed regulations will impose unnecessary and overly burdensome documentation requirements at significant costs by including unrealistic requirements and time limits and imposing "per se" equity treatment for failure to satisfy any of these requirements.

• The proposed regulations would apply to too many inconsequential high-volume transactions to make implementation workable or to permit taxpayers to effectively control against missteps.

• The proposed regulations seek to apply U.S. tax law and standards in jurisdictions not subject to U.S. tax authority.

• The proposed regulations conflict with many U.S. treaty provisions, thereby subjecting U.S. taxpayers to double taxation.

• The proposed regulations represent a unilateral action inconsistent with the BEPS recommendations of the OECD, and will act as roadblocks for multi-national affiliated groups attempting to align their intercompany debt to comply with BEPS-oriented tax measures enacted by other OECD members.

• The proposed regulations do not correspond to their stated purposes; the use of "excessive indebtedness" to reduce U.S. tax liability is cited as the policy concern they were intended to address, but the evidence from reports by the Treasury Department have concluded that debt levels were excessive only within a limited group of taxpayers -- U.S. companies that had engaged in inversion transactions; further, despite the intent to address such excessive indebtedness and associated interest deductions, the anti-abuse measures would apply without regard to the level of indebtedness of the taxpayer and without regard to whether the debt instrument bore sufficient interest to materially affect the U.S. tax liability of the debtor; and, despite the intent to target debt that was not associated with an increase in the assets of the debtor, they would apply to many transactions that do increase the debtor's assets and to debt instruments issued for the specific purpose of financing the purchase or construction of an asset.

• Provide exceptions to address concerns raised with cash pooling;

• Provide an exemption for debt issuances that have little or no bearing on Treasury's concern that intercompany debt could be used to generate "excessive" interest deductions against U.S. taxable income (short-term debt and low-interest rate loans);

• Change the proposed regulations such that a documentation failure is not a fatal flaw;

• Provide a mechanism for companies to overcome an inadvertent documentation violation;

• Make the documentation requirements better suited to corporate practice and business needs;

• Permit acquisitions and restructuring of ownership of affiliates for business purposes;

• Protect intercompany debt issued for valid business purposes from being recast by permitting tracing principles or some other method to exempt debt that can be traced to business use of cash by the borrower;

• Provide a metric that would give greater flexibility and certainty than would be provided by the exception for distribution of current earnings and profits;

• Limit the cascading effect of the rules;

• Prevent the loss of deemed paid foreign tax credits due to payment on a debt recast as equity;

• Limit the collateral fallout from artificial ownership percentages; and,

• Provide a realistic effective date that will allow companies adequate time to prepare for and implement policy and system changes needed to comply with the regulations.

In apparent anticipation of the authority concerns that these regulations raise, the Preamble cites to the legislative history to support that the regulations need not rely on the factors listed in section 385(b). That legislative history, however, does not justify presenting no factors at all and instead using section 385 as an anti-abuse rule to address perceived tax avoidance earnings stripping transactions within a select group of taxpayers -- i.e., highly related corporate groups. The Preamble further asserts as justification for the proposals that a debt instrument issued between highly related corporations "lacks meaningful non-tax significance." Yet, as discussed below, it is precisely because of the essential role that intercompany debt plays in the financial management of a large corporate group that ACC member companies are so profoundly disturbed by these proposed rules. Further, it is well established that taxpayers -- even related taxpayers -- may choose whether to use debt or equity to finance their business, even if one reason for using debt is to obtain an interest deduction. (Cf. H.R. Rep. No. 111-443, at 296 (2010) "section 7701(o) does not apply to alter the tax treatment of "certain basic business transactions . . . merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages, including the choice between capitalizing a business enterprise with debt or equity."). Moreover, the proposed rules do not treat all related party corporate debt as equity or focus on the presence or absence of such significance as would be the case if the lack of meaningful non-tax significance were actually a factor. Instead, the proposed regulations treat only certain related party debt that is perceived as tax avoidance as "per se" equity without regard to the terms, company debt levels, or the reality of the transactions.³

In light of the authority issue that the regulations raise by using section 385 for a purpose for which it was not intended, the serious issues these proposed regulations present for normal business transactions (as discussed in more detail below), and the difficulty in revising the regulations to make them work properly for normal business transactions, ACC recommends that Treasury/IRS withdraw the proposed regulations.

If the Treasury/IRS, however, continue to pursue finalizing these proposed regulations, significant changes are needed in the substantive rules and in the effective dates to make these rules workable for the chemical industry.

The proposed regulations would directly affect these internal treasury functions. They would interfere with dividend policies, impede management of the company's capital structure, impose arbitrary documentation requirements on debt, and subject intercompany debt and payables to unacceptable uncertainties posed by their possible recharacterization as stock, resulting in inappropriate and severe collateral consequences, in addition to the loss of interest deductions. Further, the proposed regulations appear to regard debt and equity within the context of an affiliated group as indistinguishable but for their tax consequences. Distinctions between debt and equity within the affiliated group are neither arbitrary nor meaningless, and it is primarily their non-tax consequences that determine the role they play in the financing of a large corporate group.

Understanding the impact of the proposed regulations on global affiliated groups requires an understanding of how internal treasury functions ensure the funding of the group's global operations and the importance of intercompany lending in supporting business operations and investment.

External debt financing of a large corporate group is generally centralized within the parent. The parent can access more extensive credit markets, commercial paper and corporate bonds in ways unavailable to its subsidiaries, the parent can capitalize on the volume of group transactions in order to achieve economies of scale, and the parent can manage maturities of debt issuances in order to reduce risk. Further, financing at the parent level takes into account the value of the group as a whole, the entire range of group assets and the diversity of the group's mix of business activities, markets, and regional operations so that the parent is viewed as being more credit-worthy than its separate subsidiaries. For example, a parent may merit an A rating, while its individual subsidiaries might merit, on average, a B or BB rating. The difference in interest rates between those applied to a parent and those that might apply to a subsidiary obtaining its own external financing might be 475 to 500 basis points. The parent can access broader credit markets and obtain financing at far lower interest rates than would its subsidiaries pursuing external financing on their own.

Although external group financing is obtained and managed centrally, it must be disseminated among the subsidiaries where needed to maintain operations and carry out approved investments in plant, property, and development of the business. Arm's length principles dictate that affiliates bear their own costs of financing and, conversely, be compensated for use of their surplus funds by the group. An appropriate mix of debt and equity financing at the subsidiary level is considered by treasury in order to achieve financial ratios that are within financially sound, industry norms and to match cash flow at the subsidiary level with the debt that the subsidiary incurs to fund investment and operating costs. It is through intercompany debt that the funds obtained externally and associated borrowing costs are distributed where needed within the group. This function of intercompany debt has far more than insignificant non-tax benefits. It is how affiliates access funds procured by the parent from a broad range of external sources, such as commercial paper and bonds, otherwise unavailable to the subsidiary.

The chemical industry is subject to perennial business cycles. The timing of these business cycles differs by region and by product market so that subsidiaries located in different regions and with different product portfolios may provide cash surpluses during one period, but have cash deficiencies in another. Further, more mature subsidiaries operating in more stable environments tend to generate more reliable cash flow than their younger siblings operating in developing markets. Moving and redeploying cash surpluses generated by affiliates where needed in the group are critical internal treasury functions. What might otherwise be idle cash is quickly and efficiently reinvested in business operations. Intercompany debt is the vehicle by which this is accomplished. This function of intercompany debt, too, has considerable non-tax significance to the group. It is how day-to-day business operations throughout the globe are funded.

Further, dividend distributions cannot move cash quickly, making them unsuitable to meet rapidly changing business and financial conditions. The timing of dividend distributions is highly restricted in most foreign jurisdictions, many of which prohibit payment of any interim dividends (i.e., those declared outside the annual meeting). Where permitted, they are subject to further restrictions and typically would require preparation of audited interim financial statements. According to the estimates of one of our members, the additional accounting fees for each interim audit for each entity in the ownership chain, which would vary depending on the size of the entity and relative complexity of the jurisdictional restrictions, would range from $10,000 to up to $480,000 for major operational entities in restrictive localities such as Switzerland, China, Brazil, and Hong Kong.

Thus legal restrictions and transaction costs make dividend distributions ill-suited for moving surplus cash throughout the group, but dividends are primarily intended as the means to distribute earnings to shareholders. Jurisdictional restrictions placed on dividends are generally directed toward ensuring that dividends are paid from earnings, without drawing down capital or capital reserves. Dividends provide the shareholding entities a return on their investment, and, importantly, the income needed to pay dividends upstream.

The correlative of the jurisdictional limitations on payment of dividends is the virtual prohibition against recovery of capital contributions before the liquidation of the corporation. Reflecting their characterization under law, internal governance provisions of large corporate groups generally consider and treat capital contributions as permanent financial investments in a subsidiary. Capital contributions and reductions in capital are undertaken only after extensive review and with formal Board-level approval. In certain jurisdictions, a lengthy governmental approval process is required in order to increase the capital of a subsidiary. This makes capital contributions wholly unsuitable as a means for moving funds to finance operations throughout the group. Further, affiliates making their temporary cash surpluses available to the group do not intend and have no reason to permanently capitalize the affiliate who happens to need funding at the time. Affiliates lend money to the group, because like third party lenders, they expect to be repaid. Similarly, treasury centers within the group provide intercompany loans to affiliates to meet their business needs at the time -- to provide timely funding apart from and beyond the approved level of permanent capital investment; they do not provide funds intended to increase the permanent investment commitment.

The proposed regulations would subject intercompany debt to possible re-characterization as stock for tax purposes because of a failure to meet arbitrary documentation requirements that exceed requirements under current law and do not reflect the documentation and analysis typically needed for business purposes. Alternatively, intercompany debt might be treated as stock for tax purposes because a "per se" funding rule would arbitrarily link the debt to certain corporate distributions, acquisitions of affiliate stock or business reorganizations that happened to occur within 3 years before or 3 years after the debt was issued. The result would be that the debt, even though incurred for a specific, unrelated purpose, would be deemed to have been issued for the principal purpose of funding the distribution or acquisition and would thereby be recast as stock.

The problem with formulating tax rules that are not grounded in the reality of transactions, which treat transactions as if they were something else, is that collateral tax treatments will be wholly inappropriate. By disregarding the substance of the transaction, the proposed regulations undermine the integrity of the Code and all its provisions that have been purposefully fashioned to provide tax treatment appropriate to the degree of economic and legal control that one entity has -- or does not have -- over another entity.

For example, section 351 codifies a basic tenet of our tax system that permits a tax-free incorporation of a business and tax-free contributions to the capital of a corporation by its controlling shareholder. However, under the proposed regulations, intercompany debt issued by a wholly owned corporation to another member could be recast as stock, perhaps because a piece of documentation had been deemed insufficient by a tax auditor, or because of an error in calculating or estimating earnings and profits, or because an audit adjustment or the decision of competent authority resulted in a deemed distribution that exceeded current year earnings and profits. Under such circumstances, the proposed rules would create a new, artificial class of stock deemed to be held by the creditor. It would not matter that the debt was clearly debt, that the new "class of stock" did not exist, or that the creditor clearly had the rights of a creditor but no equity rights and that the sole shareholder was clearly the only shareholder. The shareholder would no longer have the requisite control under section 351 to make tax-free contributions to its wholly owned subsidiary. By recasting the debt as stock, the proposed regulations would frustrate the purpose of section 351 and many other provisions that turn on the existence of ownership in the form of stock.

Similarly, the repayment of what is legally and economically valid debt, and which would be treated as the repayment of debt under current tax law would be treated instead as a section 302(d) distribution, with the result that repayment of the debt would be taxed as dividend income to the creditor. Whether or not it would constitute sound tax policy, Congress can limit the deductibility of expenses, like interest expense, under certain conditions, or provide for a different treatment of income, like interest income, depending on the conditions under which it arises. But it is beyond the authority of the income tax law, and certainly beyond the regulatory authority of the Treasury/IRS, to tax what is not income, but a return of principal. That the tax regulations would treat valid debt as if it were stock does not change the substance of the debt. Indeed the proposed regulations make no assertion that such recharacterized debt is or would become stock, simply that it will be "treated as stock" for purposes of U.S. income tax law. It is still debt; the lender still has the rights of a creditor, not an equity holder, and the issuer still has the obligation of a debtor to repay the loan. Such a repayment of principal is not income to the creditor under tax principles or under any economic or accounting standard. If no economic income is realized from a transaction, the tax regulations cannot pretend that income was realized and tax the fictitious income so created. Tax law cannot deem income into existence.

The loss of the deductibility of the debtor's interest expense and the application of different withholding rates to the interest income of the creditor would be direct results of the recharacterization of the debt. These consequences were clearly intended and are the only ones that could have any bearing on the stated target of the proposed regulations -- the deduction of interest expense from "excess indebtedness" for purposes of reducing U.S. income tax liability. However, the re-characterization of valid debt would do more than change the tax treatment of the interest. As noted above, it would result also in the creation of artificial ownership interests that would serve to dilute the actual ownership interests. And because of the pervasiveness of Code provisions that apply different tax treatments tailored to the degree of control over an entity, the list of potential consequences from the recharacterization of a debt instrument is long. In itself, the economic cost of taxing repayment of loan proceeds under section 302(d) would be staggering. Other consequences are discussed later in this letter, but a sampling follows here: reorganizations that would be tax-free under section 368 and stock acquisitions that would fall under section 304 based on actual share ownership would become taxable exchanges; payment of interest and repayment of debt proceeds would result in the transfer of foreign taxes paid from the tax pool of the entity eligible to credit such taxes against U.S. tax to an entity that did not hold the requisite ownership interest, with the result that foreign tax credits would be lost permanently; consolidated groups could be deconsolidated; controlling shareholders might lose eligibility for the favorable Treaty rates that corresponded to their actual ownership interest; hedges could be disassociated from the hedged loan. These collateral consequences would impose steep and unwarranted tax burdens on the implicated transactions. None of these consequences would serve the stated purpose of the proposed regulations, but they all would prevent application of the particular tax treatment to the specific factual conditions and ownership relationships they were intended to address, and would misapply tax treatments intended to address conditions and ownership relationships that would be absent from the situations at hand. Accordingly, these collateral consequences are not only severe but unwarranted and wholly inappropriate to the substance of the underlying transactions and relationships; they would undermine the intended purpose of many provisions of the Code.

Second, the exceptions from the documentation rules and the funding rules are very limited. There is no exception applicable to a large corporate group for de minimis transactions or for low-or no-interest intercompany loans or payables. The "ordinary course exception," which applies to the "per se" funding rule, is limited to payables for certain expenses that would be currently deductible under section 162 or for costs currently included in the cost of goods sold or inventory. ACC companies may have thousands of intercompany transactions per year with cumulative amounts in the billions. Including in-house banking for third party payables and receivables would entail tens or hundreds of thousands of transactions per year. Because the ordinary course exception does not apply to the documentation requirements, the full volume of intercompany payables would be subject to the documentation rules. Intercompany payables for the purchase of raw materials, an inventory cost, might be excluded from the funding rule, but not payables for rents and royalties or for engineering services that would be capitalized as plant construction costs, or for research services, or for interest. Since intercompany payables are generally netted on a global basis without distinguishing the types of transaction giving rise to the payables, it would be exceedingly difficult to isolate payables that were, from those that were not, subject to the funding rule. Given the huge volume of intercompany payables, it would be virtually impossible to know if they each had satisfied the documentation requirements, and if undocumented payables implicated as funding sources for a distribution or acquisition described in § 1.385-3(b)(3) could be identified, it would be impossible to track them and the deemed ownership changes that might result from recharacterization.

Such prohibitions, if followed, might provide some protection from the recharacterization of intercompany debt and payables under the funding rule, but at what cost? These are serious restrictions that would severely impede group dividend policies and the funding of new investment projects. The payment of dividends from accumulated earnings to shareholders is a legitimate corporate activity, one in line with what is arguably the main purpose of an incorporated business -- to provide a return to shareholders on their equity investment. Simply because the dividend is paid from a subsidiary to a parent corporation does not lessen its importance. Similarly issuing debt to fund business operations, expansions, construction or purchase of new business assets or upgrading existing assets, or business acquisitions is a legitimate business activity. That the two events happen to take place within the same 6-year period does not transform these legitimate activities into tax avoidance schemes. Our members do not believe it is abusive for an entity to distribute a dividend and then, a year or two later, for the same entity to embark on building a new plant financed by intercompany debt.

The funding rules of the proposed regulations would effectively prohibit the funding of new investments within 36 months after payment of a dividend, thereby discouraging new investments in the United States for an unduly lengthy period. This prohibition would exacerbate the planning challenges already faced by the chemical industry. Planning for and constructing a new chemical plant is a major undertaking that literally takes years. Before the project can even be assessed for approval, market projections, anticipated revenues, future raw material prices and other manufacturing costs must all be forecasted over at least a 10-year period, in addition to the cost of constructing the plant. Between the time such projections are evaluated and the time that the plant and infrastructure are designed and then constructed, the safety and operational procedures developed, the technology tweaked, the production processes started up and tested, and the time that saleable product is first manufactured, the economic, financial and political environments will all have been changing, sometimes rapidly. Oil and natural gas prices may rise and fall dramatically; a regional market may be growing exponentially one year and stagnate or decline the next. Political upheaval, changing public attitudes, even the weather all require nimble responses. New investment opportunities may arise, but only for those companies that can act quickly enough. The chemical industry must manage long-term strategies and respond quickly to current, changing conditions. What all this means is that a 72 month waiting period to obtain needed funding would have a devastating effect on the ability of the chemical industry to respond to and thrive in a rapidly changing environment.

Once a single loan is treated as stock under the regulations, that loan will set off a contagious series of additional recharacterizations throughout the group. For example, if an affiliate borrows from the treasury center and the note is recast, then the treasury center will be treated as acquiring the "stock" of an affiliate, itself a targeted transaction. Accordingly, under the" per se" rule and the proposed ordering rule, the earliest deposits with or loans to the treasury center made during the previous 36 months could be deemed as having funded the "stock" acquisition, and that loan to the treasury center would in turn be recast as stock, with the result that the interest would then be treated as dividend income, and the repayment of the loans as a stock redemption taxable as a dividend. The interest payments on the first recast loan would be treated as dividend distributions on stock, and would constitute a second targeted transaction to which a debt instrument issued by the affiliate would be linked and then recast as stock.

This cascading effect makes the cash rich affiliate which lends it surplus to the treasury center thereby susceptible to having its loan recast on account of any documentation failure with respect to any of the intercompany loans emanating from the treasury center, or on account of any targeted transaction engaged in by any affiliate in the group which borrowed and will borrow funds from the treasury center during the applicable 72 month period.

These cascading effects are multiplied in the case of overnight cash pooling through the treasury center, described in the following section of this letter, in which "loans" and "deposits" are made on a daily (or nightly) basis by a network of participating affiliates. The risk of a single recast debt instrument infecting the entire pool or network of affiliates which lend money to or borrow money from the treasury center jeopardizes the entire network through which intercompany loans are made and funds flow through the group. The consequences are so harsh and would be so widespread that it is not clear whether the treasury center structure or the funding of the group through intercompany loans would be viable. Yet there are no other reasonable alternatives that would move funds through the group with the same reliability and efficiency. Our members rely on internal treasury centers to conduct their businesses and have no realistic alternatives. Clearly drastic changes would be needed in the regulations to allow our members to maintain their network of intercompany loans to fund group operations.

What is troubling about these justifications for so severely restricting the payment of dividends and the issuance of debt is first, the regulations would apply broadly to all corporate groups having a U.S. nexus, not just those that have completed an inversion. Second, that there are no exceptions from the documentation requirements or the funding or the "per se" rules for loans that do not result in "excessive indebtedness." Indeed, there is no indication of what level of indebtedness is "excessive" nor do the criteria under which the proposed rules would treat debt as stock make any reference to the level of debt or interest deductions resulting from issuance of the debt. There is no exception from the rules for no-interest loans: the recast rules would apply equally to debt issued by entities that had no other outstanding debt.

Further, there is no exception from these rules for loans that do introduce new capital into the entity issuing the debt, or for distributions that do have a substantial non-tax business purpose.⁷ That the issuance of the debt occurred within 36 months before or 36 months after the transaction would be deemed sufficient to link the debt to the funding of the transaction and consequently treat the debt as if it were stock, regardless of whether the debt funded new investment in the debtor's business. The Preamble's conclusion about the legal distinction between debt holders and stock holders within an affiliated group belies the fact that the distinctions are real and that they matter. As discussed, there is a great deal of significance to the distinction between debt and equity in the context of an affiliated group. The two are not interchangeable at will. An affiliate that permits use of its surplus funds for a certain time period through an intercompany loan fully expects that it will have the right to repayment of those funds in accordance with the terms of the debt instrument. This is a major difference from the legal right of a shareholder to distributions of earnings but not to the withdrawal of capital contributions for what may be an indefinite time period. Our members are extremely concerned that the proposed regulations dismiss the significance of these and other distinctions between intercompany debt and equity.

There are two ways of pooling cash -- physical and notional. Physical pooling involves the physical movement of cash from one account to a header or master account. All cash balances on participating bank accounts are physically transferred to the header account. This header account is usually held in the name of the group treasury or headquarters, or in the name of a separate treasury company. There are a number of different ways to operate a physical pooling structure. One way is referred to as an "automated sweep." As of a specified time towards the end of the day, balances are automatically swept from participating accounts to the header account. The size of the transferred balance can be varied. The simplest form of sweep is a zero-balancing pool. This has the effect of reducing all balances on participating bank accounts to zero (where a bank account is in deficit, the transfer takes the form of a payment from the center). A second method is referred to as "compulsory participation in an in-house bank." Requiring group entities to participate in an in-house bank creates a de facto physical cash pool. Cash is concentrated at the in-house bank as group entities are required to hold bank accounts with the in-house bank, rather than with external banks. A third method is referred to as "discretionary participation on periodic basis." Balances are pooled when cash surpluses reach a certain level, or on a weekly, monthly or quarterly basis, at the discretion of an authorized individual. Unlike a physical cash pool, a notional cash pool does not involve any physical movement of cash balances. Instead, a bank notionally aggregates balances participating in the pool, and allocates debits or credits interest to each participating bank account as appropriate. Unlike a physical cash pool, all participating entities must hold bank accounts with the same bank. A notional cash pool means that participating entities retain control of their bank accounts.

ACC members use cash pooling primarily to accommodate the working capital needs of the group. When used in this way, deficit cash positions of members would generally be maintained only for short time, typically no longer than 12 months. Deficit balances that remain outstanding for more than 12 months would prompt an assessment of the reasons behind the cash shortages and of the continued viability of the subsidiary. If it were determined that intercompany debt is still appropriate, the procedure followed by some members would be to remove the balance from the pool (at least notionally, even if the debt remains in the cash sweep mechanism), transferring it to a short- or medium-term intercompany loan, while other members might leave the balance in the cash pool treating it as a revolving loan. However, some ACC members permit the pool to be used not only for short-term working capital needs but also to fund construction or other capital projects. Moreover, there is variation among ACC members in how cash pools are organized. Some ACC members, particularly U.S.-owned chemical companies, use regional treasury centers to avoid section 956 issues and thus apply cash pooling strictly on a regional basis. Other members, particularly foreign-owned chemical companies, may apply cash pooling on a global basis. Pools may also be organized by region and by currency, but then integrated globally.

As discussed in the previous section of this letter, cash pooling is but one example of intercompany funding structured through the use of treasury centers. When the funding rule in the proposed regulations is applied to debt structured through a treasury center, the debt is particularly vulnerable to being recast on account of unrelated transactions, even if carried out by entities under different ownership chains and which have few if any common business dealings. Further the treasury center framework, whether used in cash pooling or other intercompany debt, is conducive to the cascading of collateral consequences of a debt recharacterization throughout all entities participating in the network of intercompany loans.⁸

Cash pooling multiplies these adverse effects through the volume, magnitude and frequency of transactions taking place within the cash pool. As an example of this volume, one ACC member provided data showing that within its cash pooling structure, more than 270 group companies hold more than 350 automatic and 100 manual cash pool accounts in more than 35 countries, resulting in approximately 35,000 transactions per year. The average value of transactions is over $310 million per day. If a single transaction resulted in the recast of a transaction in the pool thereby setting in motion the inevitable cascading of collateral ownership changes, it would be virtually impossible to track the resulting daily fluctuations in ownership, deemed dividends, deemed redemptions, and deemed acquisitions of affiliate stock, or to identify which entities would be deemed to have funded the proscribed distributions and acquisitions that would continue to cascade through the group. Clearly the proposed rules could not be administered without broad exemptions for the vast majority, if not all, of the transactions occurring within the pool.

As demonstrated from the above explanation, it is of critical importance to ACC members that normal treasury cash management functions, including cash pooling, be allowed to continue without being subject to recharacterization as equity with all the collateral consequences that follow. Cash pooling is necessary to ensure the liquidity of the group -- to ensure that each participating member can meet its payroll on time, regardless of when customers pay their invoices. Cash pooling substantially reduces the cost of financing. An unrelated party assessment of a cash pooling network for one member estimated associated savings of nearly $4 million per year. These are vital functions that are business motivated and are essential to ACC member companies.

The myriad ways in which members manage cash pooling makes it difficult to provide a single solution that would address the concerns of all members. Further, since other types of intercompany debt are structured through treasury centers in essentially the same general lending network used for overnight cash pooling, the problems raised by applying the proposed regulations to cash pooling apply also to other forms of intercompany debt. Accordingly, ACC does not recommend that specific changes to the regulations be applied solely to cash pooling, but believes that a number of changes to the regulations would be needed in order to address concerns affecting cash pooling and other forms of intercompany debt.

The situation is also troublesome because the tests may not be as mechanical as they might first appear. It is not clear what standard an individual IRS agent would apply on audit to judge whether the documentation provided would be acceptable, especially with respect to the analysis of the ability of the debtor to repay, or documentation of enforcement of the terms of the loan. If documentation is maintained and presented to an IRS auditor, but the auditor does not think the projections were sufficiently rigorous, or thinks that the enforcement actions were too lax, the proposed regulations would give the auditor the latitude to dismiss the validity of a loan solely because in the agent's subjective judgment, the documentation insufficiently addressed an element of the documentation requirements. In other words, even though the taxpayer thought it fulfilled the documentation steps, the auditor could deem one portion of the documentation to be inadequate and solely on that basis recast the loan without regard to facts and circumstances that support the substance of the debt. This increases the uncertainty regarding whether the debt will be respected.

Further, ACC believes that applying U.S. tax standards to the expanded affiliated group's foreign debt could be problematical, as documentation will generally focus on what is important under local law and to the local tax authorities. Thus, the focus of documentation of loans issued outside the U.S. may be almost entirely on demonstrating that the interest rate is at arm's length, with little regard to U.S. tax standards. Imposing U.S. tax standards that go beyond normal commercial standards and local law standards shows the overreach of the proposed regulations from an administrative standpoint. From an administrative standpoint, implementation of these standards outside the United States will be difficult for taxpayers to implement and for the IRS to audit.

Although the regulations provide a "reasonable cause" exception that would incorporate the "principles of § 301.6724-1," this standard imposes a high bar for obtaining relief, which in the experience of ACC members is exceedingly difficult to meet. ACC members have little confidence that such a standard would provide much relief from this harsh treatment.

ACC has asked members to estimate the potential costs associated with complying with the proposed documentation rules. Estimates per company have ranged up to 20 additional full-time equivalent staff and several millions of dollars in additional automation.

ACC believes that there is also a significant authority issue as to whether the Treasury/IRS can require an instrument that is otherwise debt to be classified as stock merely because the taxpayer failed to satisfy one of the documentation requirements, or failed to timely satisfy a documentation requirement, particularly given the severe impacts of equity classification. The only specific grant of authority is in section 385(c)(3), which provides as follows: "The Secretary of the Treasury is authorized to require such information as is deemed necessary to implement this subsection." The subsection in question is section 385(c), so that the authority granted is limited to that needed with respect to information related to whether the issuer and the holder have treated the instrument consistently, not more broadly. Even this grant of authority does not authorize automatic "deemed" equity treatment.

ACC believes there is no tax policy reason for imposing such a severe penalty for failing to properly document what is in substance debt, and that the proper treatment would be to simply treat a failure as one factor in the facts and circumstances analysis provided under the case law of whether the instrument should be classified as debt or stock. Treating the failure to document as simply another factor to be considered in the analysis would be consistent with the section 385 statutory grant of authority.

If the Treasury/IRS are unwilling to adopt this proposal, then, at most, the failure to document should create a rebuttable presumption that the instrument should be treated as equity. Taxpayers would at least then be allowed to demonstrate on a facts and circumstances basis that the instrument should still be classified as debt.

In addition to an exception for ordinary course business transactions, other exceptions to the § 1.385-3 rules that are proposed below (e.g., for short-term debt, low- or no-interest debt, and foreign-to-foreign transactions) should also apply for § 1.385-2 purposes. Given that these transactions do not raise significant policy concerns and the time and effort that it would require to document each and every one of these transactions in accordance with the regulation to avoid the harsh treatment that failing to comply entails, ACC believes that these proposed exceptions, as discussed in more detail below, are important to apply for § 1.385- 2 purposes also.

The Preamble includes one example in which a related party issues a $5 million loan but can repay only $3 million. The Preamble says that in that situation the debt would be bifurcated into $2 million of equity and $3 million of debt. Not much guidance can be derived from this example which is more of a restatement of the rule. Expectation of repayment seems to be the decisive factor but more guidance is required with respect to how to establish this "reasonable expectation of repayment," and further, more guidance is needed on the import of this factor since, as the Courts have acknowledged, third party commercial lenders may make their credit decisions based on the expected ability of the borrower to obtain refinancing, and not necessarily on its ability to repay the full principal. The only facts and circumstances identified is the Preamble example where the agent concludes that there was a "reasonable expectation" as of the date of issuance of the instrument that only a portion of the principal amount would be repaid.

This type of broad rule with unlimited discretion granted to tax authorities has been criticized by the U.S. Treasury in the context of the BEPS project. A more targeted approach, including additional guidance as to the type of instruments that can be bifurcated, using objective standards (e.g., thin capitalization) or providing safe harbors as to elements that support debt characterization, would provide taxpayers with a better ability to predict potential consequences of the transactions.

Additionally, more guidance is required on the consequences of the application of the bifurcation. What can a taxpayer do to unwind the portion treated as equity, such as contributing that portion to the company in exchange for stock? What is the appropriate treatment of the cash payments made through the life of the instrument? ACC believes that a taxpayer should be allowed to designate its transactions -- i.e., have the equity portion contributed back to capital such that the only cash payments made are with respect to the debt piece and thus no portion is made with respect to the equity unless paid out under the normal terms of the equity. This would allow the taxpayer to avoid the section 302(d) treatment that would otherwise occur on repayment of the "deemed" equity piece. For example, in Example 17, absent further guidance, instead of originally issuing a single note for $19 million, the taxpayer would need to issue, say, 19 separate notes for $1 million over 19 different days in order to tranche the debt to make sure the amount of any single mixed debt/equity instrument was minimized if a subsequent recast occurs, as the taxpayer then could affirmatively capitalize the loans that were treated as "deemed" equity before repayment, so that no repayments were made on that portion that would trigger section 302(d) dividend treatment.

Further, the use of a special relatedness standard, the modified expanded group, for purposes of applying the bifurcation provision instead of the related-party threshold used throughout the rest of the proposed regulations adds additional complication to an already dense, difficult set of rules. ACC suggests in order to simplify the proposed regulations a consistent relatedness test, the expanded group, should be used and the modified expanded group concept should be eliminated.

For example, when an ACC member acquires a target from a third party seller or shareholders, a common reason for making the acquisition is that the business of the target complements the acquirer's existing business. The savings and additional revenues expected to arise from business synergies obtained from the acquisition would have been included in the valuation of the acquisition. The business may seek to unite the target's technical and research staff with its own in order to fill gaps in its knowledge base or simply to combine research efforts. It may wish to supplement its product lines with those of the target in order to offer a full palette of products to customers. After the acquisition, the acquirer will wish to combine sales, marketing, manufacturing, and supply chain processes within the member's existing legal entity structure in order to realize the anticipated value of the acquisition. Nearly always, only one member of the acquirer's affiliated group will be a party to the acquisition, but the target will have business assets and/or separate business entities in a number of jurisdictions. Accordingly, a member often follows a third party acquisition with a series of asset or share transfers between the target's legal structure and the member's legal structure, frequently to combine same-country distribution, manufacturing or other business operations. Outside of acquisitions, businesses often seek to consolidate legal entities in order to streamline processes and minimize costly administrative duplication. Entity restructures are also completed in order to facilitate more efficient cash deployment and minimize currency risk.

In a section 304 transaction, aligning legal ownership of same country affiliates can be the desired business integration end state, in order to isolate legal liability, retain certain incentives, or secure consolidated reporting, while at the same time capturing synergies created through common ownership. Integration through section 304 or section 368(a)(1)(D) transactions offers the tax efficient means to accomplish the business integration goal. Yet, the Preamble asserts, without providing any support, that in a D reorganization the non-tax consequences are "typically insignificant relative to the federal tax benefits obtained through the introduction of a related party debt instrument." This is dismissive of a D reorganization's very real business purpose.

A section 332 liquidation is also frequently used to accomplish legal entity reduction objectives. If the liquidating entity issued a debt instrument to a related party within the prior 36 months, as discussed below, the proposed 385 regulations would recast the debt as equity. This split ownership may well result in all or a part of the liquidation no longer meeting the 80 percent ownership requirement to qualify for a section 332 liquidation. As a result, all or a part of the liquidation would instead be treated as a taxable section 331 liquidation.

These business driven integration transactions, however, would nonetheless fall into the category of suspect transactions identified in both the general and the funding rules of §§ 1.385-3(b)(2) and (3). Regardless of whether the acquisitions were funded by intercompany notes, by third party commercial financing, or, in unusual circumstances, without the need for additional debt, these normal business transactions would taint any outstanding intercompany debt that had been issued by the acquirer within the previous 36 months or that might be issued within the next 36 months. The tainted debt would be treated as if it were stock for tax purposes, with all the odious collateral consequences.

The proposed regulations would create an untenable situation in which the only way a business could achieve the necessary level of integration to combine businesses after an acquisition or to streamline the group's legal entity structure would result in the recharacterization of valid intercompany debt as stock. The Preamble to the proposed regulations acknowledges that "the change in direct ownership of the affiliate's stock may have a non-tax significance...such as harmonization of a group's corporate structure following an acquisition" but the proposed regulations do not carve out an exception for situations in which there is a non-tax reason for the sale of affiliate stock or assets.

With respect to debt-financed asset acquisitions, the Preamble fails to even acknowledge the business purpose of placing new assets in the entity in which the business will be integrated and managed. The Preamble notes that such transactions do not increase the assets of the group or change the "ultimate" ownership of the assets. This misses the point. It is not the group that is issuing the debt, it is the entity to which the business assets are being transferred. Ownership of the asset may remain within the group, but that does not mean that the ownership of the assets has not changed. It matters which entity within the group holds the legal ownership rights, and that entity has changed. Indeed, aligning ownership within the appropriate entity may been the purpose of the reorganization. Consistent with the Preamble's policy concern that an increase in an entity's debt should be accompanied by an increase in its assets, the transaction introduced new investments and assets into the entity issuing the debt. Consistent with the arm's length principle, the entity using the assets and benefitting from their use must bear their cost, including the financing cost of acquiring the assets.

The proposed section 385 regulations would block business driven, post-acquisition integration and entity structure optimization that are not tax motivated. In current form, the proposed section 385 regulations would prevent members from efficiently achieving business objectives related to acquisition integration and legal entity consolidation.

As noted below, the funding rule will implicate many unrelated transactions which clearly should not be impacted by the proposed regulations. The funding rule is the source of many problems and ACC believes significant changes are needed to narrow its scope.

These rules would have a chilling effect on the funding of the chemical industry. As explained earlier in this letter, debt is a necessary component of the capital structure of a company. Corporations must use debt in order to achieve an optimal cost of capital and to provide attractive returns to investors. Further, the funding of operations of a large affiliate group requires the use of intercompany debt. The funding and "per se" rules make any intercompany loan incurred for any business reason vulnerable to being labelled as the funding instrument for an unrelated acquisition or distribution, regardless of whether the transaction was within the control of the issuer of the debt, and regardless of whether the transaction served legitimate business purposes.

Although similar "per se" rules have been included to address inversions under the section 367 and 7874 regulations,¹¹ ACC believes that the approach is not appropriate here. Unlike in the inversion context, the proposed rules would disrupt many non-tax motivated commercial activities and would have significant, unwarranted federal income tax implications, including non-deductible interest, imposition of U.S. withholding taxes, treating principal repayment as a section 302(d) dividend or denying foreign tax credits as discussed in more detail below.

ACC recommends that the regulations be amended to follow the approach taken in the conduit rules under Treas. Reg. §§ 1.881-3 and Temp. Treas. Reg. § 1.956-1T(b)(4). Namely, the final regulations should treat the funding rule as an anti-abuse rule that serves to backstop the rules in § 1.385-3(b)(2). Thus, the funding rule should apply only in cases where a taxpayer makes a loan as part of a plan or arrangement that includes a distribution or acquisition described in § 1.385-3(b)(2) by the funded member which has a principal purpose of achieving substantially the same economic effect as the applicable distributions and acquisitions in § 1.385-3(b)(2). Accordingly, taxpayers should be permitted to prove that the funds were used for capital investment, when the borrowed funds can be shown to have been invested in working capital or other business investments, and permitted to show tracing for back-to-back borrowing, for example, if foreign parent borrows and relends to its U.S. subsidiary within reasonable parameters.

If the Treasury/IRS insist upon retaining some deemed period, then ACC recommends that the rule be limited to fundings that occur 12 months before and after the relevant distribution or acquisition, and that the rule be made a rebuttable presumption, so that the taxpayer can rebut on a facts and circumstances basis.

• Capital Expenditures. The exception should cover debt instruments arising in connection with the construction or purchase of property that reflect a current obligation to pay an amount that will be capitalized, and then depreciated or amortized under section 167 or section 197. Like section 162 expenses, the expense incurred in these transactions will be deductible, and in many cases the depreciation or amortization of the cost will be included in the cost of inventory. But, as currently proposed, the exception would not be available until the costs are deducted or included in inventory costs, which would occur over the period of time prescribed for depreciation and amortization, not when the associated debt instrument arises. The exemption for the payable is not available at the time the payable is incurred and due. Debt instruments that arise in connection with the construction, purchase or process of property that reflect a current obligation to pay an amount will be capitalized, and then depreciated or amortized under section 167 or section 197. Like section 162 expenses, the expense incurred in these transactions will be deductible, and in many cases the depreciation or amortization of the cost will be included in the cost of inventory. But these costs that will be deducted or included in inventory costs occur over the periods of time prescribed for depreciation and amortization, not when the associated debt instrument arises. The exemption for the payable is not available at the time the payable is incurred and due.

• For example, say that a chemical company constructing a plant incurs an intercompany payable for engineering services in Year 1. That payable would constitute a debt instrument that arises in the ordinary course of business, but the services being purchased would not be deductible under section 162; they would be capitalized as part of the basis of the chemical plant. In Year 3, construction has been completed, the plant is placed in service and is producing inventory. In Year 3, a portion of the capitalized construction costs, say 20 percent, will be included as depreciation in the cost of the inventory produced in Year 3. Had the payable for the engineering services arisen in Year 3, 20 percent of the payable would have been excluded under the ordinary course business exception. However, the payable arose and payment was due in Year 1, and in Year 1, the payable would not have been excluded under the current ordinary course exception in the proposed regulations. Likewise, the company providing the engineering services was doing so in its ordinary course of business and reflecting the revenue in its current income.

• Section 174 deductions. Debt instruments that arise in connection with the purchase or property or the receipt of services that would give rise to a section 174 deduction, regardless of whether the taxpayer elects to currently deduct or amortize the deduction, or regardless of whether some portion of the amount qualifies for a credit under section 41.

• Rent and royalties. The proposed rule is unclear as to how it would apply to debt instruments that give rise to payment of amounts that constitute rents or royalties. For example, it appears that such amounts would qualify as a debt instrument that arises in connection with the acquisition of property, but would only be covered if the amounts are not currently deductible under section 162. The final regulations should make clear that debt instruments that give rise to payment of rents or royalties are covered regardless of whether the payments are currently deductible under section 162 or must be capitalized and deducted over a longer period of time.

• Captive insurance or reinsurance. Normally payments for captive insurance or reinsurance are deductible under section 162. However, it is unclear whether the intercompany payable that arises for such payments would be considered a debt arising in connection with the payment for services. The final regulations should make clear that these transactions are covered.

• Trade or Business. A clarification should be provided that it is the expanded group's trade or business that is considered, not only the issuer's trade or business. Members are concerned that trade or business is an ambiguous standard that could be interpreted to exclude some types of entities despite those entities incurring innocuous trade payables. For example, an expanded group member functioning as partner in an operating partnership could be viewed as not having a trade or business and therefore be ineligible for the proposed regulations' ordinary course exception. A subsidiary that is in a start-up situation also may not be considered engaged in a trade or business when the debt obligation arises. The final regulations should also treat a start-up business as engaged in a trade or business for this purpose if the activities that it is engaged in will be treated as constituting a trade or business in the future.

• Netting and similar arrangements. Finally, the exception should apply to netting arrangements, internal clearing houses, and reimbursements related to amounts described in the ordinary course business exception.

As the amount of current year E&P cannot be calculated until after the close of the tax year, it would be necessary to set the amount of the distribution based on an estimate of what the current year E&P will be. Even after the close of the year, it might not be possible to determine the amount with any certainty. This makes current year E&P an unsuitable metric for determining the "safe" amount that may be distributed or used in an acquisition without triggering the recharacterization of debt under the funding rule. Estimation error and subsequent adjustment are certain to occur, with serious consequences.

Additionally, many foreign countries do not allow a company to distribute current year earnings. As discussed earlier, legal restrictions on distributions are strictly enforced and vary by jurisdiction. In general, however, they do not reference current year E&P. Instead, they permit earnings to be distributed only after they have been reflected on the audited statutory accounts for the preceding year. Further E&P is not the earnings metric used. Typically, earnings would be measured in accord with the statutory accounting and in some cases, in accord with specific accounting standards mandated by the jurisdiction.

Greater flexibility is needed to allow normal dividend distributions to be made without fear of a potential recast. ACC members need certainty that their companies can make dividend distributions that comply with jurisdictional restrictions when they are needed for business purposes, such as to fund stock buy backs and pay dividends to external shareholders or to provide cash for strategic projects of the parent.

Accordingly, ACC recommends that the current year E&P exception be dropped and replaced with a modified, expanded exception that would encompass accumulated E&P, starting from the first year before the final regulations are effective. Thus, if the final regulations were made effective on January 1, 2019, accumulated E&P for this purpose would include accumulated E&P for the taxable year beginning on January 1, 2018 for a calendar year taxpayer and all additional accumulated E&P for years thereafter. If the Treasury/IRS are unwilling to allow accumulated E&P to be taken into account on a going forward basis, then the E&P exception should at least be expanded to include accumulated E&P in the three years prior to the relevant year at issue. Additionally, to address concerns that arise with computing E&P under U.S. tax principles for every member of the expanded affiliated group that might be relevant, ACC recommends that taxpayers be allowed to elect to use either U.S. tax E&P, U.S. GAAP, IFRS, or local statutory books and records to compute accumulated E&P. The election would be binding on members of the expanded affiliated group that filed a consolidated return in the United States, but otherwise allowed on a country-by-country basis provided that the taxpayer applied the election consistently to entities located in each such country. Interest, tax, depreciation, depletion, and amortization should be added back in making the annual computations of accumulated E&P pool to better reflect cash flow available for distributions or acquisitions subject to the rules. To address concerns where a business may generate losses that eliminate positive E&P amounts, an E&P deficit attributable to a year included in the pool should be excluded from the pool computation. A special rule for previously taxed income should also be considered. Subpart F inclusions under section 951 create previously taxed income ("PTI"). Although previously taxed, these earnings are part of the earnings and profits of the controlled foreign corporation, the rules provided by Congress in section 959 clearly intend that taxpayers should be allowed to distribute or otherwise make investments of PTI in the United States without triggering further U.S. tax consequences. Indeed, the ordering rules under section 959(c) provide that previously taxed earnings are treated as distributed first. Consideration should therefore be given to including in accumulated E&P pool E&P attributable to PTI that relates to subpart F inclusions from the E&P of a year not included in the pool.

Finally, ACC notes that as a result of going to a pooling concept, the available pool would need to be reduced by the amounts that previously were excluded from § 1.385-3 as a result of the E&P exception. Rules will also be needed to account for distributions not subject to the exclusion, and certain other ordering rules may be necessary.

Example. Assume that ACC's proposal to permit distributions from E&P accumulated since the first year prior to the effective date of final regulations, as well as the other recommendations regarding the election to use alternative income measures and the various adjustments to E&P are adopted, and that the regulations are finalized on January 1, 2019. Foreign parent owns 100 percent of the stock of a U.S. subsidiary that distributes a note in 2021 for $100 to its foreign parent. U.S. subsidiary elects to use E&P as calculated under U.S. tax principles to compute its accumulated E&P beginning in 2018. U.S. subsidiary's current E&P in each year as adjusted by adding back interest, tax, depreciation, depletion and amortization for 2018 was ($30), for 2019 was $70, for 2020 was $40, and for 2021 is $50. U.S. subsidiary has made no distributions prior to 2021 that would impact E&P, or distributions or acquisitions that otherwise would result in an exclusion as a result of accumulated E&P exception under § 1.385-3.

Because the ($30) deficit in 2018 is excluded from the pool, accumulated E&P pool equals $110. Thus, the entire amount of the note distribution in 2021 of $100 is excluded. At the end of 2021, the accumulated E&P pool is $60 ($110 pool at the end of 2020 minus $100 § 1.385-3 E&P exclusion plus 2021 current E&P of $50).

The two policy concerns that are identified for outbound transactions between CFCs in the Preamble do not appear to justify the problems that the rules would create for such transactions. The first example provided by the Preamble is where interest deductions are used to reduce the earnings and profits of a CFC. Loans between related CFCs, however, are not intended to have any immediate U.S. tax consequences. Section 954(c)(6) was enacted specifically to allow U.S. shareholders to reinvest or deploy active foreign earnings of one CFC in a related CFC without current taxation. Thus it seems questionable from a policy standpoint to enact a rule by regulation that would deny a deduction on such loans.

The second example involves the use of intercompany debt to "facilitate the repatriation of untaxed earnings without recognizing dividend income." For example, as the Preamble notes, a first-tier CFC with no earnings and profits could distribute a note to its U.S. shareholder that is repaid in subsequent years with the proceeds of distributions from the earnings and profits of a lower-tier CFC, or could borrow from a related CFC and distribute cash. Or a first-tier CFC with a relatively high ratio of foreign taxes to earnings and profits could distribute cash to its U.S. shareholder that is funded by the proceeds of a loan from a CFC with a relatively low ratio of foreign taxes to earnings and profits so as to allow the repatriation of income that is shielded by foreign tax credits. But except for the note distribution from the CFC to the U.S., which would still be covered, the application of the regulations would not eliminate the tax benefits from the transactions proposed to be excluded. Taxpayers could achieve the same results through capital contribution in exchange for a separate class of voting stock. One CFC could contribute cash to another CFC that would then distribute the cash to the United States. Because the contribution could be structured as a separate class of stock with voting rights, the various collateral consequences, discussed below, of a deemed recast of debt to stock could be avoided.

Furthermore, ACC believes that foreign to foreign transactions between non-CFCs should be excluded from the application of the proposed regulations, as there is no relevance to the U.S. fisc. Foreign affiliates of inbound companies having no U.S. connection whatsoever should not be subjected to these U.S. tax rules, e.g., documentation requirements, "per se" rules, looking to foreign distributions or acquisitions, etc. Holding these foreign affiliates to standards and restrictions imposed under U.S. tax law would not only be questionable tax policy, but would impose serious questions regarding the administration of the rules. How would a U.S. subsidiary impose the rules on its foreign affiliates? Who in the foreign affiliate would understand the rules and be able to implement them? How could entities outside the jurisdiction of the United States be audited by U.S. tax authorities?

ACC believes that foreign-to-foreign transactions do not raise the same sorts of tax policy concerns as transactions involving a U.S. party and that the Treasury/IRS should except these transactions given the significant business concerns that applying these rules in the foreign context would raise. The potential damage that applying these rules creates to the general corporate and international tax rules in the outbound context outweighs any positive policy objectives that might be achieved. With regard to the issue of whether applying the rules only to transactions that are between related parties with a different tax status would violate the non-discrimination rules under tax treaties, it seems that such an approach would be similar to that taken in Section 163(j), which restricts the deductibility of interest only on loans between related parties with a different tax status, where, as a result of that tax status, the interest income is subject to a reduced rate of U.S. tax. For example, section 163(j) does not apply to interest paid by a foreign corporation to another foreign corporation where neither is subject to U.S. tax even if both are CFCs, nor does it apply to interest paid between two U.S. C corporations. It only applies to debt between a related U.S. corporation and a foreign corporation where there is a reduced rate of tax imposed on the interest paid to the foreign corporation, or between a related U.S. corporation and a U.S. tax exempt entity. If the Treasury/IRS do not believe that section 163(j) violates the non-discrimination rules under our tax treaties, they should not be concerned that non-discrimination rules preclude their providing a similar approach here. Moreover, the proposed regulations already exclude transactions between consolidated return members and between individuals, on the basis that they do not raise the same sorts of earnings stripping concerns. Therefore providing an exception for transactions between corporations that do not have a different tax status for similar reasons should not raise an additional authority issue under section 385.

Even if no tracing is provided, the retroactive effect of these proposed regulations is irresponsible. No notice has been given by the Treasury to taxpayers of this far reaching consequence for taxpayers in order to change their ordinary course use of parent stock by subsidiaries. Accordingly, transactions otherwise governed by Treas. Reg. § 1.1032-3 should not become subject to the funding rule until at least six months after the proposed regulations become final to the extent the stock has not been provided to a member of the expanded group.

In addition, similar tracing exceptions should apply for deemed payables that arise as a result of section 482 adjustments pursuant to Rev. Proc. 99-32, or section 367(d) or other similar provisions.

Elimination of foreign tax credits. Foreign tax credits can be lost because the lender does not meet the stock ownership tests needed to claim credits under section 902, which requires a corporation to own 10 percent of the voting stock of a foreign corporation in order to claim indirect credits. Normally a debt instrument would not provide for voting rights. And typically the newly converted equity would not own 10 percent of the stock. Another lesser, but still important, consideration, is that the holder might not satisfy the minimum holding period test under section 901(k) because of the commercial rights it has as a creditor. See Rev. Rul. 94-28, 1994-1 C.B. 86.

Withholding tax consequences. U.S. treaties generally have a different withholding tax rate for interest than dividends. Thus, a payment of interest that would have had a zero U.S. withholding tax rate would now be subject to potentially 15 percent U.S. withholding tax. This would be in addition to the non-deductibility of interest expense, which would create multiple levels of taxation for inbound taxpayers. This will obviously impact foreign direct investment into the United States.

Basis shifts within the group. If a debt instrument that is recast as stock is repaid, then to the extent the repayment is treated as a dividend, the lender will have unrecovered basis in the loan. Under Treas. Reg. § 1.302-2(c), if the lender is not otherwise a direct shareholder of the borrower, the basis will migrate to a related direct shareholder. With the potential for multiple recasts, basis may shift back and forth among members, even during the same year.

Uncertainties in location of E&P. If debt is recast as stock, payments are treated as dividends that move earnings and profits, not just equal to the interest paid but also for payments of principal, as noted above. In the international context, knowing the amount of E&P of various subsidiaries is of critical importance.

Ownership shifts, with uncertain consequences. If recast as stock, the lender now is treated as an owner of potentially a separate preferred class of stock. This may prevent transfers to the borrower from benefitting from section 351 or other provisions where control is defined by reference to test in section 368(c), such as section 355. Control under section 368(c) means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. Additionally, if the loan to a U.S. company that was part of a consolidated group was large enough, it could cause the U.S. company to become deconsolidated.

Mismatches in the timing and character of income. For example, if the lender hedges the loan and had integrated the loan and swap under Treas. Reg. § 1.1275-6 or § 1.988-5, that integration no longer is allowed because the integration rules do not apply to stock. Or the special foreign exchange rules in section 988 (and the related rules netting foreign exchange gains and losses in computing subpart F income under section 954(c)(1)(D)) would no longer apply because issuing stock is not a section 988 transaction. There are many other examples because under many provisions in the tax law debt and stock are treated differently in computing timing and character.

Cascading effects. The treatment of one loan as stock under the proposed regulations could have a cascading effect. The recast of debt as stock can result in other debt instruments being recast as stock. For example, the recast as stock under the proposed regulations constitutes a purchase of member stock, and the repayment of the loan would be a distribution by a member to another on stock, which will trigger the funding rule as applied to other debt instruments. There could be no end to these results, particularly if modifications are not made to address cash pooling. We would also note that these cascading effects could also happen with respect to long term lending which is typically not covered under cash pooling.

Creation of hybrid instruments, with uncertain foreign law and BEPS implications and potentially triggering section 909. Given that the proposed regulations recharacterize as equity what is otherwise a debt instrument, this will give rise to an increase in the proliferation of hybrid instruments. Thus the hybrid instruments would be subject to the recommendations in BEPS Action 2 that are likely to be adopted by foreign countries and could have negative ramifications under foreign law. Section 909 could also apply. Under those rules, a foreign tax credit splitting event occurs if a taxpayer receives income under an instrument that is equity for U.S. purposes and debt for foreign law purposes, if the income and deductions for foreign law purposes do not match the income inclusion on the equity for U.S. tax purposes.¹³

To satisfy the documentation thresholds of § 1.385-2, an expanded group instrument must, in addition to other items, be supported by a reasonable expectation of the borrowing entity to repay the debt. To this end, § 1.385-2(b)(2)(iii) states that if a DRE is the issuer of a debt instrument, and the DRE's owner has limited liability under Treas. Reg. § 301.7701-3(b)(2)(ii) (meaning that the DRE's owner has "no personal liability for the debt of or claims against the entity by reason of being a member" under local law), then "only the assets and financial position of the [DRE] are relevant for purposes" of testing the ability to repay the debt. If the DRE's owner does not have limited liability, then all the assets and financial position of both the DRE and the DRE's owner are relevant for testing purposes. To this end, if the expanded group instrument issued by a DRE were to fail the documentation requirements, § 1.385-2(c)(5) recasts that debt as stock of the DRE and thus potentially causes a partnership to spring to life. While it was clearly the intention of the Treasury/IRS to require an analysis of the DRE's ability to repay debt for documentation purposes, it's not evident how this is supposed to coordinate with § 1.385-3(d)(6)'s rule (discussed above) that treats a DRE as a branch of its regarded owner (as is the prevailing case throughout most of the Internal Revenue code and Regulations).

To eliminate this mismatch, the Treasury should modify § 1.385-2(c)(5) to track the manner in which DREs are treated in the § 1.385-3 rules under § 1.385-3(d)(6) and make a potential recast of debt as equity in such circumstances as discussed above as stock in the DRE's owner rather than that of the DRE. This would still require an analysis of the DRE's ability to repay, of which the Treasury is clearly concerned, without prejudicing the entity classification election process and remaining consistent with a DRE's treatment as a branch of its owner, which is respected throughout the rest of the Internal Revenue Code and regulations.

This approach is novel. It has never before been presented to the public as part of any prior proposal regarding debt or the deductibility of interest expense, either from the administration or from Congress, or from the OECD. The 90 days that have been allotted for the public to analyze the proposed rules, understand how they might affect business practice, and what changes might make them workable has been too short a period for ACC members to feel confident that we have identified all problem areas or that the suggestions presented here would adequately address them. The inadequacy of time provided for public comment is why ACC joined with 22 trade groups and organizations on May 12, 2016, to write Treasury Secretary Lew to request an extension of the comment period; a request also made by the American Institute of Certified Public Accountants, the U.S. Chamber of Commerce, and the Michigan Chamber of Commerce.

We reiterate that the proposed regulations will profoundly impact the ordinary, day-to-day intercompany finance transactions essential to enabling the chemical industry to function. We trust that the Treasury/IRS will carefully consider the concerns presented here as well as those submitted by others within the business community. Further, we ask that the Treasury/IRS actively engage in dialogue with the business community as they consider how to change the proposed rules with an eye, not only to policy concerns, but also to the impact of the rules on legitimate business practice, and the practical challenges of implementing them across global organizations.

Complying with the proposed rules will require extensive changes to the internal policies and procedures developed by our members to supply funds as needed throughout their global operations and maintain sufficient oversight over their use. Because these regulations hit at the heart of their financial operations, great care will be needed to ensure that changes made to comply with the regulations will not impede the reliability of cash flows, or weaken controls against misappropriation of funds or money laundering.

The degree of changes needed will depend largely on the modifications made to the proposed rules, particularly whether sufficient exemptions are added to exclude a large volume of ordinary business transactions that would have little, if any, relevance to the purported purpose of the rules. This will be of the utmost importance to implementation efforts and costs. Intercompany payable transactions, cash pooling transactions and other daily intercompany transactions can amount to hundreds of thousands of transactions per year for a multi-national group.

However the proposed regulations are modified, it will take our members time to analyze rules in final form, survey their global finance operations to identify specific impacts, develop and assess possible responses, and implement necessary changes in global policies, procedures and internal controls. Dividend payments, acquisitions, and intercompany loans of affiliates in dozens of jurisdictions would need to be tracked for one or two hundred subsidiaries for some of our member companies, while larger groups may need to track transactions of over 600 subsidiaries. Documentation of hundreds of actual intercompany loans will need to be produced, reviewed, and monitored by a taxpayer. Much of the staff who design and implement the global intercompany financial systems of our members work outside the United States. The treasury functions of our members, not their tax functions, make and carry out company finance policies, so the staff involved will not have tax backgrounds and little understanding of U.S. tax rules. Training and hiring of staff will be considerable. Typically, commercial financial institutions are involved in the administration of internal cash networks so that changes in internal systems will need to be coordinated with third parties and applicable contracts renegotiated. Considerable cost and effort would be needed to implement the new processes and new IT systems, and to undergo extensive legal and tax reviews with respect not only to U.S. law, but the laws of the many jurisdictions in which our members do business. Changes to financial policy of this magnitude will require extensive internal review and board level approvals.

It remains to be seen whether systems can be designed to sufficiently monitor and control the timing of dividend distributions and coordinate these against the timing of debt issuance of all affiliates throughout the global organization for the purpose of avoiding recharacterization of debt under the funding and "per se" rules. Further, it is not clear whether it would be possible to comply with the restrictions under the "per se" rules while still maintaining intercompany cash flows; ensuring payment of dividends, compliant with all local regulations, and sufficient to support dividends to external shareholders; and, ensuring that loans can be made to affiliates when needed. Accordingly, we have recommend that the "per se" rule be withdrawn and that the funding rule be withdrawn or, if retained, modified considerably.

Should these portions of the rules not be withdrawn and other portions not sufficiently modified, it is not clear that intercompany financing will remain viable. It may be necessary for our members to incur the greater costs and risks associated with arranging commercial loans to subsidiaries. Especially for subsidiaries which are not fully established or which are located in regions or business units experiencing the inevitable downward portions of the chemical industry business cycles, substituting commercial loans for intercompany debt will be costly and difficult. It will take time to adequately vet commercial suppliers and to negotiate terms for affiliates, which have relied on the efficiencies and cost-effectiveness of intercompany financing based on the parent's well-developed relationships within the credit markets. Corporate leaders will need to make business decisions in light of these additional risks. Assessing such a situation from a business perspective will also take time.

The effective dates proposed with these rules do not provide a realistic timetable for businesses to make these decisions and the extensive changes needed for implementation. Other regulatory projects in recent history with significant implementation requirements have provided considerably more time for public discussion and extensive dialog between business, tax professionals and the administration before final rules were issued, and then permitted longer periods for implementation after regulations were finalized. For example, after enactment of section 409A, preliminary guidance, issuance of proposed rules and dialog with businesses extended for roughly 2 1/2 years before final regulations were issued, after which employers were given 20 1/2 months to modify compensation arrangements, to amend or redraft plan documents, and to modify administrative procedures, all changes which, while considerable, were far more limited than those proposed here. It was 7 years after enactment of withholding requirements under section 871(m) that the regulations were effective, during which time 3 sets of regulatory guidance were issued reflecting considerable dialogue between the administration and affected businesses. The regulations regarding capitalization of tangible property were not made effective until nearly 10 years after the Treasury/IRS first requested public comment on the issues, during which time considerable dialog with taxpayers was reflected in issuance of proposed regulations, their withdrawal, followed by issuance first of re-proposed regulations and then, of temporary regulations, before the regulations were made final.

In line with these prior regulatory projects, ACC proposes that should the regulations be finalized, with the "per se" rule withdrawn, that their effective date be no less than 24 months after final rules are issued, but in any event, not before January 1, 2019. Should the "per se" rule not be withdrawn, it is difficult to estimate the time that would be needed.

² As explained by the Supreme Court in Chevron U.S.A. Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837, 844 (1984), even a legislative regulation must be a reasonable means of achieving the objectives committed to the agency's care by the statute.

³ In the recent case of Altera Corp. v. Commissioner, 145 T.C. No. 3, at 23 (2015), (quoting Motor Vehicle Mfrs. Ass'n of United States, Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)), the Tax Court invalidated a Treasury regulation on the basis that "(1) by failing to engage in any fact finding, Treasury failed to 'examine the relevant data,' and (2) Treasury failed to support its belief that unrelated parties would" transact in the manner prescribed by the regulations. The Treasury/IRS have cited no evidence or empirical study that large corporate taxpayers as a whole have created intercompany indebtedness as a means of generating "excessive indebtedness" in the United States, which the Preamble states as a justification for these regulations. Indeed, the last Treasury study conducted in 2007, based on 2004 data, did not find evidence that foreign controlled domestic companies were reducing U.S. taxable income with interest disproportionately to U.S. owned domestic companies, although it did recognize evidence of this in the specific case of inverted corporations. See "Report to the Congress on Earnings Stripping, Transfer Pricing and U.S." November 2007 at www.treasury.gov/resource-center/tax-policy/Documents/Report-Earnings-Stripping-Transfer-Pricing-2007. An analysis of more recent data does not indicate any change. See, e.g., Scott Hodges's analysis at www.taxfoundation.org/blog/irs-data-contradicts-kleinbard-s-warnings-earnings-stripping-inversions. Accordingly, the proposed regulations may be susceptible to challenge under this line of authority as well.

⁴ Only bona fide debt instruments would be recast as stock under the proposed regulations. Under the framework of the proposed regulations, any purported debt instrument which was not debt in substance would be characterized as equity under current common law and principles developed under case law, without application of the proposed rules. Bona fide debt instruments that were not supported by required documentation or issued in a distribution would be recharacterized under the proposed rules. Other bona fide debt instruments might be treated as such when issued, but could be recast later on the occurrence of an unrelated distribution or acquisition within the 36 months after debt issuance, even though the terms of the debt and the relationship of the parties had remained unchanged, and even though the purpose for which the debt was issued and for which its proceeds were used had remained unchanged. For example, an intercompany debt may be treated under the proposed rules as a valid debt when issued and up until a time, within the following 36 months, that a distribution or acquisition described in § 1.385-3(b)(3) occurred. At that time, the debt would be recast as stock despite its characteristics remaining unchanged. See Example 6. Similarly, an intercompany debt that is valid debt would be treated as such as long as the $50 million threshold described in § 1.385-3(c)(2) had not been met, but would be treated as stock beginning on the date that the threshold had been exceeded. See Example 17.

⁵ Intercompany debt that was issued and held by members of a U.S. consolidated return group, however, are excepted from the scope of the rules and thus would not be impacted if dividends were paid.

⁶See, supra, note 3.

⁷ The distribution of a note may be warranted for non-tax business reasons in instances in which it is necessary for the parent to receive additional dividend income from its subsidiaries in order to support payment of a dividend to external shareholders at a time when the subsidiary has sufficient earnings to support the distribution but insufficient liquidity to distribute cash. Further, as different jurisdictions enact limitations on the deduction of interest in line with the BEPS recommendations, complying with such limitations may require groups to redistribute debt within the group.

⁸See the attached article by PwC entitled, "Section 385 proposed regulations would vitiate internal cashmanagement operations," for a detailed discussion of the cascading and other significant problems that the proposed regulations would create for cash pooling and other intercompany funding arrangements.

⁹See, e.g., C. M. Gooch Lumber Sales Co. V. Comm'r, 49 T.C. 649 (1968) ('[t]he absence of a written debtinstrument, security, or provision for payment of interest is not controlling; formal evidences of indebtedness are at best clues to proof of the ultimate fact."

¹⁰ As discuss later in the text, ACC believes that the ordinary course of business exception in § 1.385-3 should be expanded to include other ordinary course transactions and that such expanded exception should also apply for § 1.385-2 purposes.

¹¹See Treas. Reg. §§ 1.367(a)-3T(c)(3)(iii)(C), 1.7874-10T.

¹²See Treas. Reg. §§ 1.956-2(b)(1)(v), -2T(d)(2)(i)(B).

¹³ Treas. Reg. § 1.909-2(b)(3).