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Retailers Group Addresses Impact of Debt-Equity Regs on State Tax

JUL. 7, 2016

Retailers Group Addresses Impact of Debt-Equity Regs on State Tax

DATED JUL. 7, 2016
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July 7, 2016

 

 

The Honorable Mark J. Mazur

 

Assistant Secretary (Tax Policy)

 

Department of the Treasury

 

1500 Pennsylvania Ave., NW

 

Washington, DC 20220

 

 

The Honorable John Koskinen

 

Commissioner

 

Internal Revenue Service

 

1111 Constitution Ave., NW

 

Washington, DC 20224

 

 

Dear Dr. Mazur and Mr. Koskinen:

The following comments on the Proposed Regulations under Section 385 are submitted on behalf of the members of the National Retail Federation. NRF is the world's largest retail trade association, representing discount and department stores, home goods and specialty stores, Main Street merchants, grocers, wholesalers, chain restaurants and Internet retailers from the United States and more than 45 countries. Retail is the nation's largest private sector employer, supporting one in four U.S. jobs -- 42 million working Americans. Contributing $2.6 trillion to annual GDP, retail is a daily barometer for the nation's economy. NRF's This is Retail campaign highlights the industry's opportunities for life-long careers, how retailers strengthen communities, and the critical role that retail plays in driving innovation.

We believe the scope of transactions that will be covered by these regulations is excessively broad. It will impact the use of intercompany debt by both multinationals and domestic companies in their everyday business operations. One area of particular concern to NRF members is the unintended and severe impact the proposed regulations will likely have on state taxation, unless the scope of the regulations is narrowed so as to not apply to ordinary business transactions.

For the reasons discussed in our letter, as well the many comments submitted in response to these regulations, we believe the regulations should be withdrawn and re-proposed in a manner that is more targeted to abusive situations.

At a minimum, because this regulation has a more significant impact on business taxation than any regulation proposed in the last several decades, it is critical that taxpayers have the opportunity to once again comment, before these rules are effective, on proposed changes that are made in response to the many comments submitted on these regulations.

Once finalized, the regulations will take significant time to implement. Taxpayers will need to hire additional staff to deal with the documentation requirements, as well as develop systems to better track intercompany loans. We recommend that taxpayers be given until January 1, 2019 to implement the regulations.

Specific Concerns

 

1. Ordinary Course of Business Exemption Should be Expanded

 

Corporate treasury functions fund the cash needs of affiliated entities through a centralized team that allocates cash amongst group members. This internal cash management helps to reduce external financing costs. Common cash management practices include cash pooling and intercompany loans.

Through cash pooling, multiple affiliated entities pool their excess funds and make them available to other affiliated entities. Through this process, there may be hundreds or thousands of intercompany borrowings and repayments each day.

Alternatively, a cash-rich entity may loan funds to a nascent affiliate to fund the building of a new store,or a distribution center, or to remodel an existing store. Although these intercompany loans are generally documented, they may not meet the standards imposed by the proposed regulations, which are unduly burdensome for internal borrowing and may go beyond third party market practices.

We believe the ordinary course exception should be expanded to include all expenses incurred in a taxpayer's trade or business, including internal cash management arrangements that use cash pools to fund working capital needs of affiliated group members.

 

2. Expanded Ordinary Course of Business Exemption Should be Applicable to the Documentation Requirements

 

The expanded ordinary course of business exemption should apply for purposes of the documentation requirement. As discussed above, cash pooling can include hundreds or thousands of borrowings each day. Documentation that includes the robust credit analysis required by the proposed regulations every time an advance is made under one of these facilities is unduly burdensome for ordinary business transactions.

 

3. Current Year E&P Exception Should be Expanded to Include Accumulated E&P

 

The regulations provide an exception for distributions that do not exceed current year E&P. Retailers, like other businesses, are unable to accurately forecast E&P at year end. They do not know this amount until the tax return is filed the following year.

Rather than risk the tax penalties associated with a distribution that exceeds current year E&P, U.S.-owned retailers will conservatively under-estimate E&P and repatriate smaller dividends to the United States, choosing instead to re-invest those earnings outside the United States. Less capital repatriated for investment in the United States harms the U.S. economy. We believe a better approach would be to expand the exception to current and accumulated E&P.

In contrast to U.S.-owned multinational retailers, foreign-owned retailers tell us that with the current year E&P exception, they will try to maximize payment of dividends outside the United States up to their best estimate of current year E&P for fear of trapping cash in the United States and potentially having 6 years of interest deductions disallowed under the per se rule. If the exception were expanded to include accumulated E&P, they believe they would have more flexibility to follow a natural cycle of reinvestment in the United States, including investment in new stores or remodels, rather than feeling pressured to clear out current year E&P each year.

 

4. Per Se Funding Rule Should be Withdrawn

 

Under the per se rule, a debt instrument is irrebuttably presumed to be issued with the principal purpose of funding a prohibited transaction if it is issued within 36 months before or after such transaction. This test totally ignores the facts and circumstances of the issuance.

As a result of the per se rule, businesses will not be able to conduct normal operations because of the threat of adverse consequences. For example, a U.S. owned retailer may have a foreign financing company that loans money to foreign operating companies to build new stores or distribution facilities or to purchase inventory. Under the proposed rule, before such a foreign operating company can pay a dividend, it must either wait 36 months or repay the loan to the foreign financing company. Otherwise the loan will be recharacterized as equity. The practical consequences of this rule are that the taxpayer will either fund the new investment with more expensive third-party debt or make a determination to re-invest earnings overseas rather than pay a dividend to the U.S. parent. The regulations should not drive these types of consequences.

We believe the per se funding rule should be withdrawn.

 

5. Foreign-to-Foreign Transactions Should be Exempted from the Application of the Regulations

 

Debt instruments between a foreign issuer and a foreign lender do not raise the earnings stripping concerns that are the target of the proposed regulations. Cash management systems often involve frequent, periodic loans between foreign issuers and lenders. Requiring documentation for these loans would be unduly burdensome and would not aid Treasury in its stated goals. Any interest deductions and corresponding interest income will be reported and included as part of the foreign corporation's earnings and profits.

We recommend that foreign-to-foreign transactions be exempted from the proposed regulations.

 

6. S Corporations Should be Exempted from the Application of the Regulations

 

We are greatly concerned about the application of the proposed regulations to S corporations, as a large percentage of retailers are closely-held businesses that may utilize S corporation structures. The proposed regulations can recharacterize debt as stock, which likely would be considered a second class of stock for S corporation purposes thereby invalidating the taxpayer's S election.

For example, a family-owned retailer conducts operations through a C corporation and S corporation structure. The different entities reflect differences in the family ownership interests and perform different functions in support of each other. There are hundreds of "due-to's" and "due-from's" between the entities that are reconciled on a monthly basis. We believe it is far too burdensome to require that these transactions be subject to the cumbersome documentation requirements of the regulations. More importantly, we do not believe that there is a policy purpose for subjecting smaller, closely held businesses, such as these, to a potential foot-fault under the regulations that can result in the invalidation of their S election.

We recommend that S corporations be exempted from the application of the regulations.

 

7. Collateral Issues Raised by Potential State Application of the Regulations

 

Many retailers do not have any international operations. Yet, they are extremely concerned about the impact of the proposed regulations from a state tax perspective. Domestic companies that would qualify for the consolidated return exception of the proposed regulations are concerned that the states will not follow that exception. Most separate company reporting states and some combined reporting states do not follow the federal consolidated return regulations. So what is considered to be a consolidated group for federal tax purposes may not be considered to be a consolidated group for state tax purposes.

States are already aggressive about re-characterizing debt as equity, so taxpayers are being advised to assume that the states will apply the principles of the proposed regulations on audit, without the benefit of the consolidated return exception. This will create a huge burden for the domestic multi-state companies that are so prevalent in the retail industry. Retailers may perform daily cash sweeps and rely on journal entries to document the movement of cash between affiliates. Now they will have to adopt the burdensome documentation requirements of the proposed regulations for thousands of intercompany transactions.

The collateral concerns of the state tax application of the regulations is another important reason why the scope of the proposed regulations needs to be targeted to only abusive transactions. This concern reinforces the need for an expansion of the ordinary course exception and extension of the application of the ordinary course exception to the documentation requirements of the proposed regulations.

Conclusion

We respectfully request that the proposed Section 385 regulations be withdrawn and re-proposed in a manner more targeted to abusive situations.

Sincerely,

 

 

Rachelle Bernstein

 

Vice President, Tax Counsel

 

National Retail Federation

 

Washington, DC
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