Firm Targets Treatment of E&P Distributions Under Debt-Equity Regs

We are writing in response to the proposed regulations issued under section 385 of the Internal Revenue Code of 1986, as amended (the "Code"),¹ on April 4, 2016 (the "Proposed Regulations").² Other commenters have noted a wide range of concerns about various aspects of the Proposed Regulations, and we do not intend here to cover ground that has already been covered by others. We instead will focus on a somewhat less remarked-upon issue under the Proposed Regulations, namely the treatment of distributions from earnings and profits ("E&P") that have already been taxed under section 951(a) ("previously taxed income" or "PTI"). Specifically, we ask that the Treasury Department and Internal Revenue Service (together, the "Government") broaden the "Current Year E&P Exception" in Prop. Reg. § 1.385-3(c)(1) or create a separate, stand-alone exception to allow taxpayers to distribute PTI without implicating the "General Rule" of Prop. Reg. § 1.385-3(b)(2) or the "Funding Rule" of Prop. Reg. § 1.385-3(b)(3).

The Proposed Regulations attempt to rein in the scope of the Funding Rule to some extent with the Current Year E&P Exception. The Current Year E&P Exception, as described in the Preamble, is intended to provide taxpayers with flexibility to avoid the application of the Per Se Rule, thus balancing the goals of the Proposed Regulations in preventing perceived tax motivated transactions against the goal of accommodating ordinary course transactions. This is achieved by allowing a taxpayer to reduce its Prohibited Transactions by its current year earnings and profits ("E&P"), as defined in section 316(a)(2). The Current Year E&P Exception thus allows taxpayers, including controlled foreign corporations ("CFCs"), to distribute their current year E&P without implicating the Funding Rule (or the General Rule).³

PTI may qualify for the Current Year E&P Exception if it is distributed in the year in which it is derived, which often is the case. Section 959 and the regulations thereunder allow PTI to be distributed on a tax-free basis and provide detailed rules to facilitate such distributions. CFCs are thus incentivized to distribute their PTI to their U.S. shareholders as soon as it is derived, at a minimum to provide such U.S. shareholders with cash to pay their Subpart F tax liability.

In many cases, however, local or other non-U.S.-tax restrictions prevent CFCs from distributing their PTI on a current basis. Such restrictions may even force a CFC to forgo PTI distributions for a number of years, thus allowing significant prior year PTI to accumulate. In addition, by virtue of the distribution ordering rules, PTI from section 956 investments can never be distributed in the year it is derived.⁴ For these reasons, it is common for CFCs to have significant prior year PTI.

Absent an expansion of the Current Year E&P Exception or the creation of a new stand-alone exception, CFCs will be unable to distribute their prior year PTI within 36 months of an expanded group debt issuance without triggering the Funding Rule. Multinationals thus will be forced to suffer the harsh consequences of an equity recharacterization when prior year PTI is distributed from their CFCs or consider potentially inefficient alternatives, such as replacing internal financing with third party debt or causing CFCs to lend, rather than distribute, their PTI back to their U.S. shareholders.⁵

Creating impediments to the efficient distribution of PTI would serve no apparent tax policy purpose, particularly since the decision to forgo distributing PTI as it accumulates is almost never a tax motivated decision. Rather, as described above, CFCs forgo distributing their PTI for reasons wholly unrelated to U.S. tax planning. Treating distributions of prior year PTI as Prohibited Transactions simply penalizes taxpayers that through no fault of their own are precluded from distributing their PTI on a current basis.

The creation of barriers to the tax-free distribution of PTI also contravenes the fundamental structure of Subpart F. The Subpart F rules tax certain CFC earnings on a current basis at the U.S. shareholder level, treating the CFC as if it distributed the Subpart F income to its U.S. shareholders. This inclusion is an onerous result -- taxation prior to actual realization and reduction of the item to cash -- unless CFCs are able to easily and efficiently distribute such earnings to their U.S. shareholders without imposition of further tax. Detailed rules are thus provided in section 959 and elsewhere allowing PTI to be distributed to a CFC's U.S. shareholders without further tax, thus providing the U.S. shareholders with access to the cash.⁶ The PTI rules in effect enable a shareholder who has experienced a deemed-dividend-like Subpart F inclusion to actually receive a distribution without further U.S. federal income tax effect. This longstanding equating of an actual distribution with a Subpart F inclusion will no longer be the case if the Funding Rule is triggered by distributions of prior year PTI.

In order to avoid undermining the Subpart F rules, we ask that the Government broaden the Current Year E&P Exception such that it applies to prior year PTI or otherwise provide an exception for PTI distributions.⁷ Absent such an exception, at a bare minimum a transition rule should be provided that allows CFCs with PTI that accumulated prior to their tax year that includes April 4, 2016, the date on which distributions or acquisitions become Prohibited Transactions under the Proposed Regulations, to distribute such prior year PTI without implicating the Funding Rule or General Rule. Taxpayers were not given timely notice that new rules would prevent their CFCs from efficiently distributing their prior year PTI reserves, and the Proposed Regulations thus would upset longstanding expectations regarding the ability to access such PTI without adverse U.S. federal income tax consequences.

Treas. Reg. § 1.959-3(b), however, provides special rules for determining the sourcing of distributions made by CFCs that have PTI. Under these rules, PTI is classified based on the year in which it was included in the gross income of the CFC's U.S. shareholders and retains this classification when distributed to other CFCs. Thus, for example, PTI of a 3^rd-tier CFC resulting from a 2009 Subpart F income inclusion for its U.S. shareholders would be designated as 2009 PTI and would retain this classification as it is distributed to 2^nd-tier and 1^st-tier CFCs in its chain of ownership.

The yearly classification rule in Treas. Reg, § 1.959-3(b) is not intended to modify the general rules that classify income received in a year as current year E&P. The rule instead provides a mechanism for tracking when each year's PTI is distributed for purposes of determining foreign currency gain or loss and certain foreign tax credit consequences.⁸ Treas. Reg. § 1.959-3(b) thus should not impact how E&P, including PTI, is classified under Treas. Reg. § 1.385-3. This result should be clarified, however, because characterizing PTI received in the form of a distribution as prior year PTI, rather than as current year PTI, would have harsh and irrational consequences under the Per Se Rule, as illustrated by the following example.

² REG-108060-15, 81 Fed. Reg. 20912 (April 4, 2016).

³ Several commenters have recommended expanding the scope of the Current Year E&P Exception to cover certain E&P generated prior to the current year, in part due to the difficulties in determining the amount of current year E&P before the year has closed. We strongly support such an expansion, but for present purposes we direct our comments to the Current Year E&P Exception as it currently stands under the Proposed Regulations.

⁴See section 956(a) and (b)(1); section 959(f)(2).

⁵ Some taxpayers might find it inefficient to distribute PTI to the U.S. in any form. The Proposed Regulations thus may create further barriers to the reinvestment of foreign cash in the U.S. economy.

⁶See section 959 and the underlying regulations, which provide that distributions of PTI may be received tax-free by U.S. shareholders and other CFCs, and also provide ordering rules that elevate PTI over other E&P from a distribution ordering perspective and ensure that even unrelated successors of interest will be permitted to access the PTI. See e.g., section 959(a) and (b) (providing tax-free treatment for PTI distributions received by U.S. shareholders and their successors); Treas. Reg. § 1.959-3 (ordering rules). The purpose of such rules is to ensure that U.S. shareholders are always able to easily and efficiently access E&P that is previously taxed under section 951(a).

⁷ As noted above, there are compelling reasons to broaden the exception even for other E&P, but our focus here is PTI.

⁸See, e.g., section 986(c) and 960(b). Proposed regulations under section 959 would allow taxpayers to elect to treat distributions as being made from a single pool of PTI for purposes of computing foreign currency gain or loss under section 986(c) and basis adjustments under section 961. See Prop. Reg. § 1.959-3(b)(2)(ii), REG-121509-00, 71 Fed. Reg. 51155 (Aug. 29, 2006).

⁹ A similar clarification would be needed in the event that the Government decided to expand the Current Year E&P Exception to a longer period -- it would be important that Treas. Reg. § 1.959-3(b) not have the effect of pushing PTI outside whatever window is chosen for the exception.