Group Says Proposed Debt-Equity Regs Have Disruptive Effect

January 31, 2020

The Honorable Steven Mnuchin
Secretary of the Treasury
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

The Honorable David Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 2022

Mr. L.G. "Chip" Harter
Deputy Assistant Secretary
International Tax Affairs
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

Mr. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224

Mr. Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224

Re: Comments on I.R.C. Section 385 Advance Notice of Proposed Rulemaking (REG-123112-19).

Dear Sirs:

The Organization for International Investment ("OFII") exclusively represents the U.S. operations of many of the world's leading international companies. These international companies are part of a sector that employs 7.4 million U.S. workers in jobs that pay an average of 26 percent higher compensation than the economy-wide average.

Along with creating millions of high-paying U.S. jobs, these international companies operating in the United States produce over a quarter of U.S. goods exports, sending American-made goods to customers around the world. In short, international companies help broaden America's economy and open new markets.

OFII's mission is to ensure that policymakers at the federal, state and local level understand the critical role that foreign direct investment (“FDI”) plays in America's economy. OFII advocates for fair, non-discriminatory treatment of foreign-based companies and promotes policies that will encourage them to establish U.S. operations, which in turn increases American employment and U.S. economic growth. Over the course of three decades of promoting FDI in the United States, OFII has always supported transparency, compliance with U.S. laws, and a level playing field for international companies operating in the United States.

Since the current regulations under section 385 of the Code¹ (the “2016 Regulations”)² were first proposed, OFII has submitted several comment letters on this matter (including most recently commenting on possible transition rules), testified at the regulatory hearing held by Treasury and the Internal Revenue Service (the “IRS” or “Service”), and met with U.S. Department of the Treasury (“Treasury”) and the Service on multiple occasions.

On November 4, 2019, Treasury and the Service published in the Federal Register an Advanced Notice of Proposed Rulemaking (the “ANPRM”)³ under section 385. The ANPRM generally indicates that Treasury and IRS intend to revise and streamline the 2016 Regulations. Treasury and Service requested comments “on all aspects of the rules” described in the ANPRM.⁴ OFII respectfully submits this letter in response to the request for comments.

Current Section 385 Guidance Significantly Impacts OFII Member Companies

OFII would like to take this opportunity to thank Treasury and the Service for withdrawing a portion of the 2016 Regulations, specifically Treas. Reg. sec. 1.385-2 (the “Documentation Requirements”) which were overly burdensome. OFII understands that new requirements may eventually need to be re-proposed and we look forward to the opportunity to provide Treasury and the IRS with comments to help prepare simplified and streamlined documentation requirements in the future.

While some burdens were mitigated with the withdrawal of the Documentation Requirements, the remaining current rules still broadly disrupt normal, routine business activities, increase cost of borrowing and create real economic harm. Specifically, Treas. Reg. sec. 1.385-3 (the “Distribution Regulations”) and Treas. Reg. sec. 1.385-4T (the “Consolidated Return Regulations”) represent a significant departure from common law regarding the classification of debt and equity and create substantial financial burden and undue complexity.

The current Distribution Regulations include a general rule (the “General Rule”)⁵ that applies if a domestic corporation distributes or issues a covered debt instrument (“CDI”) to an expanded group member in one of the following types of “tainted” transactions:

• in a distribution to another member of the expanded group,

• in exchange for stock in a member of the expanded group, other than an “exempt exchange,” or

• in exchange for property in an asset reorganization, but only to the extent that a shareholder of the target that is a member of the issuer's expanded group before the reorganization receives the CDI in exchange for its target stock as part of the reorganization.

The Distribution Regulations also include a funding rule that treats a CDI as stock if it is issued as part of a series of transactions that achieves a result similar to a tainted transaction (the “Funding Rule”).⁶ The types of tainted transactions that trigger the Funding Rule are similar, but not identical, to the types of tainted transactions that trigger the General Rule. As the preamble to the 2016 Regulations states, “the funding rule is designed to stop taxpayers from achieving in multiple steps what the general rule prohibits from being accomplished in one step.”⁷ Within the Funding Rule there is also a per se rule, which treats a debt instrument as stock if it was issued in exchange for property during the period beginning 36 months before and ending 36 months after one of the three types of tainted transactions (the "Per Se Rule” or “72 Month Rule”).⁸

Under these regulations debt can be reclassified as equity even if it has been issued at arm's length and is otherwise respected under U.S. tax principles. As previously identified to Treasury in OFIIʼs earlier comment letters, OFII member companies can report that the 2016 Regulations have hindered many legitimate non-tax-motivated business transactions and increased the cost of financing U.S. operations.

As an example, some of our member companies have two (or more) U.S. consolidated groups. There is no provision in the 2016 Regulations permitting relief for payments between consolidated groups, so if a company wishes to issue a loan from one consolidated group to another consolidated group to finance day-to-day business operations that transaction could be subject to section 385, even though there is no potential for earnings stripping.

Additionally, global companies often have in-house short-term cash pooling arrangements amongst their affiliates for cash management purposes. The cash pool header is the internal bank and often will deposit excess cash over the group's normal operating needs with an affiliate that serves as the external facing entity to deposit, invest or borrow from unrelated 3^rd party financial institutions. The external facing affiliate will often hold 3^rd party investments and/or debts of long, mid and short term in duration, which would disqualify it as a qualified cash pool header and resulting in the entire cash pool arrangement to be subject to section 385, even though this is a very common commercial practice solely for the purposes of efficient cash management.

The 2016 Regulations also restrict international companies' ability to return earnings to non-U.S. shareholder(s) via a distribution. To continue paying dividends to their parents, some international companies no longer borrow from their foreign parent but instead borrow from external sources in the U.S. This change in business practices — solely to allow U.S. entities to continue paying dividends to their parent without triggering the 72 Month Rule — imposes significant costs on international companies and chills investment in the U.S.

Further, under the remaining regulations affected taxpayers will still need to maintain and continually update earnings and profits calculations. Every time there is new intercompany debt, capital contributions or distributions, a new calculation is needed. These calculations must follow the complex and detailed ordering rules in the regulations. Should there be a “tainted transaction”, then a separate tax stock ownership will need to be tracked and followed and adjusted for all capital contributions, distributions, and “tainted” interest payments. Over time this could lead to differences in ownership and funds flow for many different companies. The difference between tax and legal ownership will complicate many transactions that occur in the normal course of business.

Treasury recognized these concerns even upon issuing the 2016 Regulations and conceded that “[t]he regulations do to some extent make the U.S. a less attractive location for foreign investment.”⁹

Congress also recognized the potential harm to come from the 2016 Regulations. In June and August of 2016, House Ways and Means Committee Chairman Kevin Brady sent two letters to then-Secretary Lew listing multiple concerns about the Section 385 Regulations, which had the signature of every majority member from the committee of jurisdiction on tax policy. Of note in their second letter to then-Secretary Lew, the twenty-four members summarized their concerns by stating:

“In closing, we reiterate that the proposed regulations as crafted would interfere inappropriately with businesses; investment and financing decisions. The proposal would have the effect of blocking the ability of businesses to operate effectively and efficiently and to grow and hire new workers. Ultimately, if the proposed regulations are not completely overhauled, they would damage our economy, increase the barriers to investment for American businesses and innovators, and interfere with the growth of the good-paying jobs American workers need and deserve. We cannot allow this to happen.”

Unfortunately, the previous Administration enacted only minor changes to the eventual rules and these concerns have become reality.

The 2016 Regulations Should be Fully Repealed, Not Rewritten

The stated intention of the 2016 Regulations was to address the use of related party debt for the perceived purpose of inappropriately using “excess” interest deductions for earnings stripping. Although the 2016 Regulations maintained that the perceived abuse was not limited to inverted companies, the use of interest stripping to reduce U.S. tax liabilities after an inversion was identified as a major concern. Then Secretary of the Treasury Jack Lew characterized the regulations as “. . . additional actions to further rein in inversions and reduce the ability of companies to avoid taxes through earnings stripping.”¹⁰

However, Treasury has not cited any empirical evidence that the regulations effectively stopped corporate inversions or that base erosion was previously occurring from non-inverted internationally headquartered companies, and OFII is not aware of any such empirical evidence. In fact, IRS data at the time demonstrated that historic foreign-headquartered companies were not overly-leveraged; their debt levels remained largely flat and their interest expense declined while their investments into America's economy grew.¹¹ Despite this, the 2016 Regulations took an overbroad approach that affects all taxpayers including historic foreign headquartered companies that are not over leveraged.

Instead of targeting bad actors the 2016 Regulations effectively discriminate against all inbound investment in the United States. Because the 2016 Regulations only apply to U.S. issued debt, and also do not apply to controlled foreign corporations (“CFCs”), the risk of a per se recast of a note from debt to equity falls on the inbound financing of foreign-parented multinational group's domestic subsidiaries, but there is limited application to otherwise similarly situated U.S.-parented multinational groups. While the ANPRM contemplates significant changes to the Distribution Regulations there is no indication that a new rule would not be similarly discriminatory. Only a full repeal of the 2016 Regulations would end this disparate impact.

The ANPRM states that “The Treasury Department and the IRS are cognizant that a complete withdrawal of the Distribution Regulations could restore incentives for multinational corporations to generate additional interest deductions without new investment.” OFII respectfully disagrees with this determination and avers that Congress fully addressed intraparty debt financing when it passed the tax reform legislation commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”).¹² If Congress agreed with Treasury's apparent belief that interest deductions are appropriate only when the debt at issue funds new investment, it could have incorporated such a rule when it amended section 163(j). Not only did Congress not incorporate such a rule, Congress did not even consider such a rule during the legislative process for the TCJA. As a result of the actions taken by Congress to impose limits on interest deductibility, Treasury should now remove the burdensome regulations as they represent barriers to increased investment in the United States.

Treasury has previously acknowledged that tax reform like the TCJA would likely make these regulations obsolete. On April 21, 2017 President Trump issued Executive Order 13789 which directed Treasury to "review significant tax regulations issued in 2016” to see if they “impose an undue financial burden on United States taxpayers, add undue complexity . . ., or exceed statutory authority.”¹³ Subsequently in October of 2017, Treasury issued its “Second Report to the President on Identifying and Reducing Tax Regulatory Burdens” in response to the executive order. In discussing the Distribution Regulations that report stated:

“Treasury has consistently affirmed that legislative changes can most effectively address the distortions and base erosion caused by excessive earnings stripping, as well as the general tax incentives for U.S. companies to engage in inversions. Treasury is actively working with Congress on fundamental tax reform that should prevent base erosion and fix the structural deficiencies in the current U.S. tax system. Tax reform is expected to obviate the need for the distribution regulations and make it possible for these regulations to be revoked.”¹⁴

Tax reform subsequently became law when Congress passed the TCJA in December of 2017. In the TCJA Congress enacted a variety of policy solutions to make the different elements motivating inversions and earnings stripping less attractive. For instance:

• Reducing the federal corporate income tax rate from 35% to 21% makes the United States a much more competitive jurisdiction, reversing the prior incentive to avoid U.S. taxing jurisdiction through inversions. Moreover, the general structure of the Act is intended to incentivize investment in the U.S., particularly in manufacturing.

• Limiting interest deductions in line with the OECD BEPS recommendations and strengthening them with new anti-hybrid rules severely constricts the ability of all companies, inverted or not, to use interest deductions to strip earnings out of the United States.

• Transitioning to a territorial system with a transition tax on prior earnings and an exemption for future CFC dividends eliminates the “lock-out” effect on accumulated foreign earnings that drove many inversions.

• The TCJA's provision on downward attribution, along with existing anti-conduit regulations, make de-controlling transactions ineffective, further limiting the ability to invert.

• The Base Erosion and Anti-Abuse Tax (“BEAT”) targets cross border payments made to related parties for interest, royalties, and services, constraining the ability to use cross-border intercompany payments for earnings stripping.

Enacting competitive rates and a reformed international tax system has eliminated the primary driver of earnings stripping and inversions. The TCJA has given the U.S. tax authorities multiple new and more robust tools to more directly address base erosion and inversion transactions. The anti-hybrid rules and the BEAT are targeted to address related party debt, and revised section 163(j) limits all interest expense deductions. In short, the question of how to properly address abuses in related party debt financing was carefully considered by Congress and the result of that debate can be found in the TCJA.

Treasury appropriately recognized several of the changes identified above as supporting the removal of the Documentation Requirements in the preamble removing those requirements. However, these changes also provide support for fully withdrawing the 2016 Regulations.

Upon issuing the ANPRM Secretary Mnuchin stated that “Because tax cuts made our business environment more competitive, we are now able to remove regulatory burdens that have been rendered obsolete, further reduce costs for job creators and hardworking Americans, and protect the U.S. tax base.”¹⁵ OFII agrees with this sentiment, but notes that tax cuts did not render the Documentation Requirements any more obsolete than the rest of the 2016 Regulations. The Distribution Regulations are obsolete as well.

Retaining even narrowed Distribution Regulations is inconsistent with Treasury statements and Administration policy as evidenced by executive order. Treasury and IRS should fully repeal, and not simply narrow, the remaining regulations in order to fully comply with EO 13789 and the legislative intent of tax reform.

Full Repeal of the 2016 Regulations Would Be Consistent With Changing International Tax Law.

American tax policy does not exist in a vacuum and beyond the TCJA major outside changes have occurred within the international tax system since the 2016 Regulations were finalized. The world continues to move in a direction that makes section 385 regulations unnecessary.

For example, BEPS Action 13 on country-by-country reporting has largely been implemented across taxing jurisdictions. This change makes it much less attractive to invert a company. Large multinationals are now required to report aggregate data on the global allocation of income, profit, taxes paid and economic activity among tax jurisdictions in which they operate. Companies cannot simply move their headquarters on paper; people and functions must move as well.

Likewise, the Organisation for Economic Cooperation and Development (“OECD”) continues to move forward on its global anti-base erosion proposal (“Pillar II”) as part of its work to address the tax challenges of digitalization of the economy. As outlined in the most recent consultation document Pillar II will likely consist of four rules:

• An income inclusion rule that would tax the income of a foreign branch or CFC if that income was subject to tax at an effective rate that is below a minimum rate;

• An undertaxed payment rule that would deny a deduction or impose source-based taxation (including withholding tax) for a payment to a related party if that payment was not subject to tax at or above a minimum rate;

• A switch-over rule to be introduced into tax treaties that would permit a residence jurisdiction to switch from an exemption to a credit method where the profits attributable to a permanent establishment or derived from immovable property (which is not part of a PE) are subject to an effective rate below the minimum rate; and

• A subject to tax rule that would complement the undertaxed payment rule by subjecting a payment to withholding or other taxes at source and adjusting eligibility for treaty benefits on certain items of income where the payment is not subject to tax at a minimum rate.

The practical effect of these rules would be the creation of a global minimum tax on every country's CFCs that will be backed up by a new global form of the BEAT. While TCJA removed any incentive to base erode the U.S. these rules will effectively make base erosion or earnings stripping impossible worldwide.

It is worth noting that the European Union (“E.U.”) recently adopted and implemented standards that are tougher than some of the OECD's recommendations in BEPS. The EU's Anti-Tax Avoidance Directive (“ATAD”) adopts the interest limitations and anti-hybrid rules. It also limits the use of tax treaties by adding a general anti-avoidance rule and a principal purpose test. These rules reduce or eliminate treaty benefits for interest expenses. Combined with the US rules, ATAD makes it very difficult to erode the U.S. base through related party debt.¹⁶

Alternatively, New Distribution Rules Should Only Apply if the Principal Purpose of a Covered Debt Instrument is to Fund a Tainted Transaction.

As an alternative to fully repealing the 2016 Regulations, the ANPRM indicates that Treasury and the IRS intend to streamline the Distribution Regulations, including by re-writing the Funding Rule to apply only if a CDI's issuance “has a sufficient factual connection” to a tainted transaction. OFII respectfully submits that if Treasury chooses to pursue this approach the appropriate standard for determining the existence of a connection between a debt instrument and a tainted transaction should be if the principal purpose of the CDI is to fund a tainted transaction.

Under OFIIʼs proposed test the new funding rule would only apply when taking into account all relevant facts and circumstances, funding a tainted transaction was the sole principal purpose of a debt issuance. This standard is based on existing standards elsewhere in the tax law that have the benefit of being interpreted in IRS guidance and court decisions, thereby providing certainty for both taxpayers and the government.¹⁷ Increased certainty provides taxpayer comfort and greater confidence in making investment decisions.

A lesser standard, such as one based on if funding a tainted transaction was just a principal purpose of a CDI would necessarily be more subjective and create more disputes upon audit. The ANPRMʼs reference to a ‟sufficient factual connection” is an entirely new and undefined standard that has no meaning in the tax law. As such, imposing such a standard practically guarantees exacerbating the number of future disputes and the risk that the standard will be applied inconsistently among otherwise similarly situated taxpayers.

Factors to consider when undertaking such a review should include whether the CDI directly funds a tainted transaction, if the CDI was issued as part of an overall plan to fund a transaction, and whether the CDI has an economically substantive purpose outside of the transaction. OFII is prepared to provide suggested regulatory language to implement the principal purpose test and its related factors if Treasury and the Service believe that would be helpful.

A Fact-Based Funding Rule Should Not Include a Per Se Rule.

The ANPRM also indicates that if the Funding Rule is re-written, Treasury and IRS propose to withdraw the 72 Month Rule. OFII fully supports the withdrawal of the 72 Month Rule and recommends this change be part of any new proposal.

The 72 Month Rule can cause the per se recast of a CDI from debt to equity even when that CDI has no connection to a tainted transaction. This creates uncertainty because while companies are aware of loans in the three years preceding a distribution, it is impossible for a business to predict whether loans might be needed or extended in the three years following a distribution. This uncertainty creates an administrative burden when facilitating intercompany loans – even those used to directly facilitate business and commercial investments such as third-party acquisition or U.S. expansion. While withdrawing the Documentation Requirements helps ease this burden it does not fully address it.

Any new section 385 regulations should focus on the actual connection between debt instruments and tainted transactions. The current 72 Month Rule does not consider those connections and instead focuses on temporal proximity; as such it is unsuited for a fact-based analysis and should be withdrawn entirely.

A New Funding Rule Should Preserve and Strengthen Necessary Exceptions

Treasury and IRS indicate that any revision of the Funding Rule would include a re-examination of existing exceptions to ensure they remain consistent with the revised standard. OFII submits that the earnings and profits exception (the “E&P Exception”) in particular should be strengthened.

The E&P Exception reduces the amount of a tainted transaction by the borrowing entities' post-April 4, 2016 undistributed E&P.¹⁸ OFII believes that it would be consistent with Treasury's goals and sound tax policy for this exception to include a safe harbor for distributions made at a time the issuer had reason to believe they would fall within the E&P Exception. When making a distribution the issuer must forecast their expected E&P figure for that year. These forecasts cannot be made to complete accuracy due to possible future events out of the control of the issuer. This situation gives rise to a danger of “falling out of the exception” whereby a distribution is made based on such a forecast of E&P that later proves inaccurate. We submit that any CDI using this safe harbor could utilize the issuer's annualized income to document the projected E&P at the time of the distribution.

Second, the E&P Exception only allows U.S. subsidiaries to utilize earnings accumulated in tax years ending after the initial effective date of the 2016 Regulations, April 4, 2016. This date is arbitrary and ignores the variance in business cycles across industries. We submit that this temporal restriction unfairly traps earnings in the U.S. for companies that have invested, profited and paid taxes in the U.S.

Treasury should likewise retain other exceptions, including the exception that debt issued up to $50 million is not recharacterized to equity.

Relief From the 2016 Regulations Should Be Made Retroactively

As detailed above, Treasury and IRS statements have indicated that there is an understanding that the 2016 Regulations as currently promulgated are excessive and burdensome. The issuance of the ANPRM itself is an indication that the government recognizes the inherent harm of the 2016 Regulations. Minimizing that harm should therefore be a goal of the transition to a new rule.

OFII therefore submits that taxpayers should be allowed to elect to apply any forthcoming new rule retroactively, regardless of whether it entails full repeal of the remaining 2016 Regulations or updated Distribution Regulations. A retroactive application of new rules may be necessary to avoid penalties for “foot faults” upon audit whereby unwary taxpayers may have unintentionally run afoul of the 2016 Regulations that will now be outdated. Treasury clearly has authority to provide such an election under section 7805(b)(7).

As an alternative, if Treasury chooses not to allow retroactive application of any new rule we believe that Treasury should consider relaxed enforcement and administration of the 2016 Regulations for the covered period (namely, April 8, 2016 to the date of withdrawal or issuance of new final Distribution Regulations). Enforcement should be relaxed so long as a taxpayer made a good faith effort to comply with the 2016 Regulations during the covered period. As such, this approach would be similar to enforcement policy put in place for Section 871(m) and the Foreign Account Tax Compliance Act.

Taxpayers Should Be Able to Rely on Any New Proposed Rule Prior to Finalization

The ANPRM indicates that relief from the 2016 Regulations may not be forthcoming until new rules can be finalized. This means that the business community is still operating under an obsolete, harmful regulatory regime and may be forced to do so while the new regulatory process plays out, which can take another year or more. Uncertainty of this nature cannot be condoned and undermines the efficiency of capital markets.

OFII therefore suggests that companies should be allowed to elect to rely on any proposed withdrawal of the 2016 Regulations or new proposed regulations prior to final regulations being published in the Federal Register. We believe permitting taxpayers to rely on any proposed rule issued pursuant to the APRM would appropriately reduce the compliance burden imposed on taxpayers and the administrative burden on the IRS.

Conclusion

We commend Treasury and the IRS for their efforts to address numerous issues relating to section 385, including by withdrawing the Documentation Requirements. In OFII's view, sound tax policy requires the full repeal of remaining regulations under section 385 and we hope that the above comments will be taken into account in the event new proposed regulations are drafted. We would welcome the opportunity to meet with you to discuss our comments.

Sincerely,

Nancy McLernon
President and CEO
Organization for International Investment

Cc:
Jeffrey Van Hove, Senior Advisor, Regulatory Affairs, Department of the Treasury
Doug Poms, International Tax Counsel, Department of the Treasury
Krishna Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
Brett York, Associate International Tax Counsel, Department of the Treasury
Colin Campbell, Attorney Advisor, Department of the Treasury
Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service
Daniel McCall, Deputy Associate Chief Counsel (International), Internal Revenue Service
Raymond Stahl, Special Counsel to the Deputy Associate Chief Counsel (International)
John Merrick, Special Counsel to the Associate Chief Counsel (International)