PwC Lambasts 'Most Momentous' Proposed Debt-Equity Regs

PricewaterhouseCoopers LLP ("PwC") respectfully submits this letter in response to the Notice of Proposed Rulemaking under section 385 published by the Department of the Treasury ("Treasury") and the Internal Revenue Service (the "IRS" or "Service") in the Federal Register on April 8, 2016 (the "Proposed Regulations").¹ The comments contained in this letter reflect the review and analysis of a study group of 23 clients.² Their expertise and experience have greatly informed the contents of this letter, which reflects the diverse range of real-world practices that will be adversely impacted by the Proposed Regulations.

The Proposed Regulations address whether certain financial arrangements should be characterized as debt or equity under section 385.³ They are the most momentous tax regulations proposed in many years and would overturn decades of case law and settled expectations. Their reach and impact would be tremendous, and if finalized in their current form, they would have adverse consequences for U.S. businesses competing in a global marketplace and for foreign investment in the United States. We, therefore, recommend that the Proposed Regulations be withdrawn and replaced with a narrowly tailored set of rules that address the government's concerns using the tools that Congress specifically granted to Treasury and the IRS for this purpose.

The Proposed Regulations were issued under the authority of section 385, which instructs the Secretary of the Treasury to set forth factors to be taken into consideration when distinguishing between debt and equity in particular factual circumstances. However, the Proposed Regulations do not define "debt" or set forth any factors to consider in determining whether an instrument is debt or equity. Rather, the Proposed Regulations would effectively limit the tax benefits of intercompany debt by recharacterizing a debt instrument as equity in circumstances that Treasury and the IRS perceive as abusive. Specifically, debt would be recharacterized if it is issued in certain proscribed transactions, the proceeds are used (or deemed used) in certain proscribed ways, or certain documentation requirements are not satisfied.

The Proposed Regulations incorporate none of the traditional factors used by the courts in distinguishing debt from equity: they do not look to the terms of an instrument; they do not look to the strength of an issuer's cash flows or balance sheet; and they do not take into account the intent of the debtor and creditor in making an advance. This is not what section 385 provides nor what Congress intended in enacting section 385.

The Proposed Regulations were issued in response to the recent wave of so-called "inversion" transactions, in which a U.S. multinational combines with a foreign multinational and, in the process, becomes domiciled in a foreign country. But the Proposed Regulations would have a far broader impact than merely hindering inversion transactions -- they would burden ordinary economic activity wholly unrelated to Treasury's concerns. The Proposed Regulations would affect nearly every large business in America in a number of costly and unanticipated ways, the specifics of which are detailed herein. The impact of these punitive rules would be less investment, fewer jobs, and a smaller U.S. corporate tax base.

For example, U.S.-based multinationals frequently redeploy foreign earnings through intercompany loans and other modern cash management techniques. The Proposed Regulations may treat these loans as equity in unexpected and unpredictable ways. This could result in pervasive double taxation through the loss of foreign tax credits, phantom income as a result of deemed dividends from debt repayment, the inability to engage in any internal reorganizations on a tax-free basis, inadministrable rules, and inordinate complexity. U.S.-based multinationals may be forced to rely on third-party financing even when they have adequate internal liquidity, thus increasing financing costs and external credit exposures and straining the global banking system to accommodate the sudden injection of deposits. Foreign competitors would be less burdened by these new costs and, thus, would hold additional competitive advantages over their U.S. counterparts.

The Proposed Regulations also would inhibit foreign investment in the United States, restricting foreign investors' ability to receive returns on and of their investments in the United States and increasing the cost of doing business in this country. The Proposed Regulations could produce double taxation in contravention of existing U.S. treaty obligations and international norms of cross-border taxation recently endorsed by Treasury. Consider a foreign company's debt investment in a U.S. subsidiary. If that debt is recharacterized as equity, the issuer would forego a 35% federal interest deduction, may be subject to an additional U.S. withholding tax of up to 30% on interest payments that are now characterized as dividends and additional local tax in the foreign parent company's jurisdiction, which continues to treat the income as interest (e.g., a 30% tax in Germany). Given the potential for such high combined rates of tax, foreign investors may be dissuaded from investing in the United States.

The administrative costs of complying with and tracking the impact of the Proposed Regulations are daunting. Many, if not most, taxpayers do not have systems in place that would allow them to track the information needed to comply. We anticipate that the audit costs associated with these regulations would be significant. Furthermore, taxpayers may have substantial, additional state tax compliance burdens as a result of these rules, even for wholly-domestic businesses. Some taxpayers' compliance costs have already reached millions of dollars, and many U.S.-based multinationals estimate similar non-tax compliance costs on an annual basis. Moreover, several taxpayers have expressed concerns over potential adverse impacts to their financial statements and credit ratings as a result of the Proposed Regulations.

A senior Treasury Department official recently compared the complexity of these rules to the recently enacted Foreign Account Tax Compliance Act ("FATCA"). Although those regulations have created a significant burden on taxpayers, we believe the comparison is inapt. The costs and administrative burdens imposed by the Proposed Regulations would far exceed those associated with FATCA.

The analogy to FATCA is instructive, however, when considering the Administration's approach to implementing those regulations. Acknowledging the complexity and systems implementation requirements associated with FATCA, the government deferred the implementation dates for the FATCA rules multiple times to grant taxpayers time to comply. We believe a similar approach would be warranted in the case of the Proposed Regulations. Delayed finalization would serve another purpose: we believe the rules need to be amended substantially in several areas, and we question whether this can be accomplished with an ambitious finalization schedule.

The collateral damage threatened by these regulations is out of proportion to achieving the government's intended goals. Treasury and the IRS instead should target perceived abuses with careful precision.

Congress has given Treasury specific tools to address inversion transactions: section 163(j) (which Congress enacted to combat "earnings stripping") and section 7874 (which defines inversions and limits the tax benefits thereof). Section 385 was enacted in 1969 for an entirely different reason, but it is being used by the Proposed Regulations to address several of the Administration's legislative proposals that Congress has declined to adopt. We question whether Treasury and the IRS have authority to promulgate the Proposed Regulations as drafted.

As part of the Organisation for Economic Co-operation and Development's Base Erosion and Profit Shifting ("OECD BEPS") project, the United States has agreed to a set of international norms governing interest deductibility. The U.S. government has criticized other nations, such as Australia and the United Kingdom, for taking unilateral actions that are out of step with this framework. The Proposed Regulations would significantly exceed the interest deductibility limits agreed to as part of the BEPS process.⁴ Thus, the United States would be doing the very thing for which it has criticized other nations.

Finally, we observe that the rules would create adverse consequences in numerous unanticipated areas, including the potential for pervasive double taxation and phantom income. Of importance, they would potentially impact provisions in the Internal Revenue Code, regulations, and treaties that are dependent on equity ownership percentages. They purport to give undefined and seemingly unlimited discretion to the IRS to recharacterize debt instruments. Moreover, the Proposed Regulations are vague in many respects, raise significant uncertainties, would be difficult to administer, and need many technical amendments. If Treasury and the IRS intend to finalize the Proposed Regulations as soon as possible (as has been their public position), we hope that our suggestions will be taken into account. We urge that, before final or temporary rules are issued, the regulations be reproposed to allow taxpayers to provide input on revisions made to the initial Proposed Regulations in response to comments.

For the reasons discussed herein, we believe that Treasury and the IRS should withdraw the Proposed Regulations.

² The study group comprises companies from a broad range of industries and markets, including banking, oil and gas, servers, networking, software, transportation, consumer and enterprise hardware, infrastructure investment, healthcare, construction, mobile telephony, insurance, mutual funds, food and beverages, household consumer products, automotive, steel, engineering, electronics, and private equity. These companies include both U.S.- and foreign-parented multinationals that operate throughout the world and have a combined market capitalization of nearly $2 trillion.

³ Unless otherwise indicated, all "section" references are to the Internal Revenue Code of 1986, as amended (the "Code"), and all "Treas. Reg. §" references are to the regulations proposed or promulgated thereunder.

⁴ We recognize that BEPS Action Plan 4 states that in addition to the recommended interest limitation rules, countries may introduce targeted rules where necessary to address specific base erosion and profit shifting risks. See OECD (2015), Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4: 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, at Para. 169 & 173. However, as further discussed in various sections of this letter, we believe that the Proposed Regulations are not "targeted" to combat specific abusive practices.