Financial Management Group Claims Debt-Equity Regs Are Overbroad

Financial Executives International ("FEI")is a leading organization and advocate for the views of corporate financial management. Its more than 10,000 members hold policy-making positions as chief financial officers, treasurers, controllers, tax executives, and other senior-level financial executives at companies from every major industry. FEI enhances member professional development through advocacy, peer networking, career-management services, conferences, research, and publications. The members of FEI's Committees on Taxation, Treasury, and Corporate Reporting submit this letter to provide comments on the Proposed Regulations. This document represents the views of the Committee on Taxation, Committee on Corporate Treasury, and Committee on Corporate Reporting, and not necessarily the views of FEI or its members individually.

The Preamble to the Proposed Regulations states that the regulations are intended to reduce the federal income tax incentives for related parties to engage in transactions that result in excessive cross-border indebtedness. The Proposed Regulations are overbroad for this purpose. The overwhelming majority of debt instruments that are at risk of recharacterization by these rules are not motivated by federal income tax incentives. And only a small percentage of debt affected by the proposals crosses the U.S. border. Finalizing the Proposed Regulations will result in significant administrative, financial, and tax costs and uncertainties for companies, even those which are in no position to strip earnings from the U.S. The consequences of recharacterizing debt to equity will increase taxpayers' burden in unpredictable ways that have nothing to do with earnings stripping and will touch all aspects of financing from trade payables to cash management to capital investments.

For these reasons, Treasury should withdraw the Proposed Regulations. If Treasury instead moves to finalization, we urge Treasury to modify the Proposed Regulations to reduce the deleterious effects on the non-tax motivated, common transactions that comprise the treasury operations necessary for any large company.

Please feel free to contact Brian Cove, Managing Director, Technical Activities at 973.765.1092 if you would like additional information on any of the issues or recommendations in this letter.

While we recommend withdrawal of the Proposed Regulations, if Treasury remains committed to finalization, the recommendations in this letter will somewhat reduce their impact on the innocuous transactions that comprise most debts of U.S. corporations.

The two main operative sections of the Proposed Regulations are § 1.385-2, which causes related-party instruments to be treated as equity if the taxpayer fails to prepare certain contemporaneous documentation, and § 1.385-3, which characterizes related-party debt instruments as equity if they are issued, or deemed to be issued, in connection with a distribution, certain purchases of affiliate stock, or certain reorganizations. Our comments focus on these sections as they create nearly all of members' critical concerns.

II. Distinguishing between cash pooling and other financing activities

In the Preamble, Treasury has expressed a particular interest in comments that will assist in writing an exclusion in the Proposed Regulations for permissible cash pooling and other short-term treasury activity. Crafting an exclusion is difficult because cash pooling and other ordinary-course treasury activities entered into for administrative convenience are complex and may vary in structure from member to member.

Cash-pooling arrangements provide many important operational benefits to multinational enterprises.

First, a multinational group can maintain a smaller aggregate cash balance when cash pooling is functioning effectively. Cash pooling is commonly used in Europe and has been widely implemented by multinationals in Europe to take advantage of efficiencies which were made possible by the advent of the euro as a common currency. For example, consider a group of 20 CFCs that collectively maintain €100 million of cash sufficient to meet overall working capital needs. One CFC with temporary excess cash can loan to another CFC with a temporary shortfall. If the risk of equity characterization due to the Proposed Regulations forces each CFC to rely solely on its own cash on deposit with third parties to meet short-term needs, then the group as a whole must keep more cash or borrow from third-party banks. If the average cash requirement per affiliate at any particular point is €5 million, but the peak cash requirement per affiliate is €7.5 million, the group must maintain €50 million of excess cash, which provides no benefits for the multinational's shareholders. This excess is not available for repatriation or for investment in worthwhile business opportunities. The multinational is disadvantaged due to its inflated balance sheet relative to other multinationals who are able to freely operate cash pooling structures.

Second, the legal entity holding the cash pool can efficiently negotiate a single external credit facility benefiting all CFCs participating in the cash pool. The facility, even if undrawn, allows European CFCs to operate effectively with a smaller working-capital cash balance because emergency funds can be accessed with little notice.

Third, pooling facilitates operations across multiple foreign currencies. Banks earn spreads on each currency-conversion transaction. A CFC that has excess euros but a shortfall in pounds sterling can borrow pounds from the pool and deposit euros, thereby minimizing counterparty exposure and avoiding the cost of exchanging currencies due to temporary cash imbalances. Additionally, a larger pool of funds allows a multinational to negotiate a lower spread because of its economy of scale. Finally, pooling foreign currencies minimizes risk in cases where the currencies involved are subject to onerous legal restrictions on exchange.

Fourth, cash pooling facilitates the quick movement of funds to meet business needs. Equity funding, returns of capital, and dividend declarations are subject to local-country legal requirements, which often cannot be completed in a short time, or can be legally so restrictive as to be impractical. Cash pooling is an important and efficient treasury tool to cover short-term, ongoing, and recurrent critical business needs (e.g., meeting payroll).

Fifth, a dedicated cash-pooling affiliate or division allows for more efficient treasury operations. Fewer people, with greater expertise, can be dedicated to managing the pool. The internal-control environment is improved. Small CFC's often lack adequate staffing to have appropriate expertise and separation of duties.

Cash pools are not the only short-term activity that the Proposed Regulations may catch. Some multinationals manage settlement of affiliate-group invoices indirectly through the use of in-house clearinghouses. For large corporate groups, maintaining separate accounts to settle on an invoice-by-invoice basis can be inefficient. As an alternative, some multinationals have a clearinghouse maintained by an affiliate or affiliates through which affiliate payables can be managed. This arrangement centralizes and reduces the number of payables and receivables between affiliates, making them easier to centrally administer and account for. Provided the affiliate balances with the clearinghouse are settled on a similar timeline as trade payables directly between two operating affiliates, the clearinghouse performs an essentially administrative, not financing, function.

Because these arrangements are established to meet business needs, and each taxpayer has different business needs and affiliate structures, it is probably not possible to draft a narrow cash-pooling definition that will provide significant relief to all taxpayers' ordinary-course cash pooling and treasury-center activities. Furthermore, because cash pooling and other treasury-center activities are so intricately linked, it is probably not possible to draw a non-arbitrary line between a permissible cash pool and revolving loan agreements. Any such line will still require significant additional compliance and monitoring resources to ensure that affiliated transactions do not cross the line and create unintended changes in affiliate ownership. Despite these limitations, FEI suggests that Treasury consider the following exclusions to reduce the impact on cash pooling and other treasury activities.

Any concerns that taxpayers could use this rule to avoid equity recharacterization for longer-term loans are misplaced. The anti-abuse rule in Proposed Regulations § 1.385-3(b)(4) allows Treasury to recharacterize a debt instrument issued with a principal purpose of avoiding recharacterization under the rules of Proposed Regulations § 1.385-3.

These are broad exceptions, but their breadth is necessitated by the importance of preserving members' cash-management systems if the Proposed Regulations become effective.

III. Comments regarding Proposed Regulations § 1.385-2 documentation requirements

To provide such an exception, a new Proposed Regulations § 1.385-2(a)(4)(i)(C) could be added to read as follows:

Therefore, the Proposed Regulations should adopt a safe-harbor exception to the documentation requirements which will provide that the documentation requirement of Proposed Regulations § 1.385-2(b)(2)(iii) will be satisfied if it is documented that the debtor satisfies certain safe-harbor financial ratios. Such ratios could include (i) a minimum debt-to-equity ratio of 1:3 or (ii) a minimum interest-coverage ratio (earnings before interest, taxes, depreciation, and amortization to total interest expense) of 3:1. A borrower that meets one of these ratios can reasonably be expected to be able to meet its obligations, and these ratios can be computed and documented without third-party assistance.

The members recognize that the Proposed Regulations require timely documentation in order to evidence the intent to create binding indebtedness and that the overarching requirement for debt categorization-a reasonable expectation of repayment-is satisfied. But the deadlines for preparing this documentation are unreasonably short in the context of a multinational enterprise with complex operations. In many multinationals, the finance and treasury functions operate separately from the tax function and fund transfers between entities that would be subject to the documentation rules may occur on routine basis without any involvement by the company's tax advisors. It would be extremely difficult for even the best-managed multinational enterprise, especially ones operating on a decentralized basis, to identify all transactions subject to the Proposed Regulations in sufficient time to prepare the prescribed documentation within 30 days.

Even if all intercompany loans were identified by the time of issuance, preparing the required documentation within the 30 day period would be difficult as a practical matter. Assuming no local regulatory or corporate-law requirements delay the process, a promissory note evidencing an unconditional promise to pay and establishing creditor's rights could conceivably be prepared and executed within 30 days. However, regulatory or local-law requirements may make it impossible to meet this deadline.

In addition, 30 days is an unreasonably short period of time for taxpayers to gather the necessary information and prepare an analysis of the issuer's ability to repay the EGI. Most tax professionals have neither the skills nor the experience required to prepare this credit analysis. Therefore, it will be necessary to rely on either outside advisors or other members of a multinational's finance staff, persons who undoubtedly have many competing demands on their time and may view assisting in the tax compliance process to be a peripheral responsibility. In many companies, engaging an outside advisor to prepare the credit analysis requires a lengthy contracting process that often cannot be completed within 30 days. If a taxpayer's general-contracting procedures are such that it cannot engage the necessary assistance to prepare the documentation in less than 30 days, it certainly cannot be expected to prepare the documentation itself within 30 days.

A more reasonable deadline to prepare the required documentation is the due date for the tax return, with extensions, as is the case with the transfer-pricing documentation required under Section 6662(e) and Treas. Reg. § 1.6662-6(d)(2)(iii). The transfer-pricing documentation requirements serve a similar purpose to the documentation required by the Proposed Regulations: to impose discipline on related-party transactions to ensure they occur on an arm's-length basis. As the Section 6662(e) regulations indicate, this objective can be met if the necessary documentation is prepared by the due date of the tax return, with extensions. In addition, such a deadline would make preparing documentation part of the annual tax-return-preparation process. This contemporaneousness would make preparation part of a work effort under which the persons responsible for a company's tax compliance gather information from throughout the company. Information regarding intercompany loans could more readily be obtained through the process. Moreover, the deadline would give taxpayers enough lead time to obtain any assistance necessary to prepare appropriate documentation. Given the harsh and irrevocable penalty imposed on missing the documentation deadlines, we believe it is appropriate for the Proposed Regulations to follow Treasury's transfer-pricing approach and use as their deadline the tax return due date, with extensions.

IV. Comments regarding Proposed Regulations § 1.385-3

Therefore, if not eliminated, Proposed Regulations § 1.385-3(b)(3)(iv)(B)(1) should be modified to state:

Furthermore, the exception should be expanded to eliminate the requirement that taxpayers trace an ordinary-course instrument to an amount deductible under Section 162 or included in cost of goods sold or inventory. It is unclear why such tracing was considered necessary, and Treasury provided no rules for tracing such funds to specific items on the return. Making qualification for the ordinary-course exception contingent on funds being traced to the treatment of an item on the U.S. tax return will effectively require taxpayers to review each trade payable with a tax professional prior to its issuance to ensure that the exception is met, which will slow ordinary business activities and negate any anticipated mitigation of the administrative burden on trade payables.

Treasury should also explicitly allow such ordinary-course payables to be managed through a third affiliate other than buyer and seller to allow for clearinghouse arrangements used by some taxpayers to manage intercompany trade payables.

Failing that, the E&P exception should at least be expanded to all accumulated E&P before the finalization of the Proposed Regulations and the greater of current-year E&P and the total E&P of the current and the preceding two years. This allows distribution of pre-finalization earnings that taxpayers were not on notice may be subject to a restriction, and better approximates ordinary-course distributions in the future from affiliates while discouraging a large accumulation of E&P.

V. Exclude potential double taxation by carving out a Section 902 exception

The Proposed Regulations will cause double taxation of the foreign income of U.S.-based multinationals, frustrating the purpose of Section 902. The holder of an instrument treated as equity by Proposed Regulations §§ 1.385-2 or -3 will rarely if ever have at least 10% direct voting interest in the borrower. Payments on such a recharacterized instrument will be treated as deemed dividend distributions, but the recipients of the distributions will not be entitled to claim Section 902 credits. Meanwhile the borrowers will have the foreign tax credits associated with the earnings deemed distributed eliminated from their tax pools. The foreign tax credits will therefore be lost, and the foreign earnings of the borrowers will thus be subject to foreign income taxes plus the full 35% U.S. income tax. Treasury should take steps to mitigate this double taxation by issuing rulings similar to the rulings which maintain credits in the similar situation of a deemed distribution under Section 304. See Revenue Rulings 91-5 and 92-86.

VI. Conclusion

The modifications to the Proposed Regulations discussed above will somewhat mitigate the impact of these regulations on companies' ordinary financial activities. However, the modifications do not solve all of the concerns we have with the Proposed Regulations. Even with these modifications, the Proposed Regulations create serious adverse tax consequences and substantial new compliance burdens for companies with U.S. tax-reporting obligations regardless of whether they are engaged in earnings-stripping activities. These burdens are far out of proportion to the harm Treasury is trying to prevent. Consequently, Treasury should withdraw the Proposed Regulations.

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