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Debt-Equity Regs Should Better Target Transactions, Firm Says

JUL. 7, 2016

Debt-Equity Regs Should Better Target Transactions, Firm Says

DATED JUL. 7, 2016
DOCUMENT ATTRIBUTES

 

July 7, 2016

 

 

CC:PA:LPD:PR (REG-108060-15)

 

Room 5203

 

Internal Revenue Service

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

Re: Proposed Section 385 Regulations (REG-108060-15)

 

We are writing on behalf of our client, a financial institution, to comment on the proposed regulations under section 385 released by the Department of Treasury ("Treasury") and the Internal Revenue Service ("IRS") on April 4, 2016.1 Our client is concerned by the breadth of the proposed regulations, which would have far-reaching and wide-ranging consequences for routine business transactions that are not driven by U.S. tax considerations. At the same time, our client understands that the Administration is committed to finalizing the regulations. To be constructive in that process, our client is suggesting changes to the regulations that would serve Treasury and the IRS's stated policy goals while promoting administrability and minimizing compliance burdens, uncertainty, and unduly harsh results.

Before turning to our specific comments, we note that debt plays a special role in the business of financial institutions. Financial institutions essentially buy money from and sell money to their customers; as a result, interest expense of a financial institution is the equivalent of the costs of goods sold of a manufacturer. To meet customer demand, financial institutions regularly engage in intra-group lending transactions through debt in form as well as transactions, such as sale and repurchase transactions ("repos"), characterized as debt for U.S. tax purposes. In addition, financial institutions are subject to a myriad of regulatory rules, including rules that limit leverage. These special circumstances have led Congress, Treasury, and the IRS to draft various special rules taking into account the special circumstances of financial institutions, including with respect to debt.2 Similar special rules are warranted in the case of the section 385 regulations. This letter mentions several areas in which such rules are warranted, and our client joins requests from other financial institutions and trade organizations for other financial institution-specific rules.

This letter reflects certain key issues that have been identified by our client to date. As discussed in the first section of the letter, which addresses several issues regarding the process for finalizing the regulations, additional time is needed to analyze the full impact of the proposed regulations. The second section of this letter proposes revisions to the documentation requirements. The third section addresses the automatic recharacterization rules and suggests how the rules could be better tailored to target transactions that raise the policy concerns identified while minimizing undue impacts on routine intercompany business transactions. The fourth section addresses certain effective date issue, while the fifth section suggests how the IRS can effectively and efficiently administer final regulations.

Our client's key suggested comments with respect to the proposed regulations are as follows:

  • Treasury and the IRS should continue to solicit and consider taxpayer feedback, even after the 90-day comment period concludes.

  • The documentation requirements should be amended to provide (a) that failure to produce contemporaneous documentation is a relevant factor in determining whether an instrument should be treated as debt or equity or (b) a rebuttable presumption that an instrument is not debt where the documentation requirements are not satisfied.

  • The documentation requirements should, as proposed, apply only to debt in form.

  • Additional guidance should be provided with respect to the documentation required to be kept with respect to revolving credit agreements and cash pooling arrangements.

  • The reasonable cause exception to the documentation requirement should be clarified.

  • The funding rule should include an exemption for regulated financial services groups. The funding rule should also be amended to require a factual connection between a covered distribution or acquisition by (a) removing the "per se" rule and replacing the "principal purpose" standard with a "but for" standard or (b) removing the "per se" rule and relying on a general "principal purpose" standard.

  • The automatic recharacterization rules, like the Prop. Treas. Reg. § 1.385-2 documentation rules, should apply only to debt in form.

  • The "ordinary course" exception should be expanded to apply to the funding rule generally. In addition, the ordinary course exception should include short-term loans, such as loans with a term of one year or less. A short-term exception could be coupled with an anti-abuse rule to target arrangements that are in fact regularly rolled over or renewed with a principal purpose of avoiding the application of the funding rules. In addition, an exception for cash pooling is needed to avoid disrupting routine treasury operations.

  • With respect to financial institutions, exceptions from the funding rule for debt that is "ordinary course" are also warranted, such as exceptions for bank deposits and ordinary course transactions of the type currently excepted from the application of section 956.

  • The current earnings and profits exception should be expanded to include accumulated earnings and profits. If Treasury and the IRS are concerned about the scope of an accumulated earnings and profits exception, the exception should, at a minimum, consider current and the prior two years' earnings and profits.

  • The effective date of the documentation rules should be extended to six months after the finalization of the regulations, while any retroactive aspect of Prop. Treas. Reg. § 1.385-3 should be limited to specific types of transactions.

  • The IRS should issue guidance to examiners on how the final rules should be interpreted and applied in practice.

 

I. Process for Finalizing Regulations

The proposed regulations would fundamentally change the law governing debt and equity, materially departing from well-established tax principles and significantly expanding the IRS's ability to reclassify instruments as equity based on newly articulated legal principles not contemplated under existing common law. Despite being described by Treasury as intended "to further reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping,"3 the proposed regulations go well beyond inversion transactions to target ordinary course intercompany transactions that are not motivated by tax. In fact, as discussed below, the regulations go well beyond perceived abusive or avoidance transactions.

Given the impact of the regulations, Treasury and the IRS should continue to solicit and consider feedback on the regulations after the 90-day comment deadline. Although Treasury and the IRS stated that they were "considering guidance to address strategies that avoid U.S. tax on U.S. operations by shifting or 'stripping' U.S.-source earnings to lower-tax jurisdictions, including through intercompany debt" in the 2014 and 2015 inversion notices (Notice 2014-52 and 2015-79), this description did not indicate that Treasury and the IRS were fundamentally re-thinking the rules governing debt and equity. Indeed, the regulations were not included on Treasury and the IRS's recent Priority Guidance Plan, which lists projects "that are priorities for allocation of the resources of [Treasury and IRS's] offices" during the year.4 The 90-day comment period does not provide taxpayers with enough time to determine the potential ramifications of the proposed regulations on their business, including identifying potential unintended consequences. Providing taxpayers with additional time to review the proposed regulations, analyze the regulations' impact, and provide input will assist the government in finalizing rules that are administrable, fair, and do not create undue compliance burdens or unintended consequences.

Numerous taxpayers and trade organizations are commenting on the regulations, pointing out ambiguities, technical issues, and unintended consequences as well as addressing issues on which the government has specifically requested comments. Given the expected volume of comments and the numerous policy and technical issues raised by the proposed rules, statements indicating that Treasury and the IRS intend to move "swiftly" to finalize the proposed regulations,5 perhaps even by Labor Day, are concerning.6 The proposed regulations can be improved through a dialogue between the government and taxpayers in which taxpayers express their views, propose solutions, and hear feedback from the government on whether proposed solutions will or will not adequately address the government's concerns. Such a dialogue would also help Treasury and the IRS understand the potential impact of the proposed rules on different industries and determine whether special rules are needed to address industry-specific business and economic ramifications.

We trust that Treasury and the IRS will take a deliberative approach in finalizing the regulations. To the extent the government makes significant changes or additions to the rules, the regulations should be re-proposed to provide taxpayers with additional opportunity to comment.7

II. Documentation Rules

 

A. Overview

 

Prop. Treas. Reg. § 1.385-2 would impose new documentation requirements that must be satisfied in order for a related-party instrument to be treated as debt. Our client understands Treasury and the IRS's desire, as stated in the preamble to the proposed regulations, to promote "the ability of the Commissioner to administer the Code efficiently with respect to related party interest."8 New documentation requirements may indeed be helpful to serving that goal. However, our client is concerned that the proposed rules are overbroad, will create uncertainty for taxpayers, and may be administered inconsistently by examiners. For these reasons, the proposed rules as drafted may in fact run counter to the government's tax administration goals, as unclear rules are likely to lead to additional disputes that will require additional IRS resources to resolve. Our client recommends several changes to the regulations that should promote more efficient IRS administration with respect to related-party debt, while minimizing compliance burdens and unduly harsh results.

The proposed documentation requirements are a blunt instrument -- if the documentation preparation and maintenance requirements of Prop. Treas. Reg. § 1.385-2 are not satisfied with respect to an instrument, the IRS will treat the instrument as stock for all federal tax purposes. This automatic recharacterization approach overrides decades of case law, which balances relevant factors in determining the classification of an instrument. The recharacterization of an instrument as stock may also have significant follow-on consequences, such as the imposition of withholding tax on payments that are recharacterized as dividends (which are generally subject to higher withholding tax rates than interest under U.S. tax treaties), loss of "control" necessary to effect tax-free transactions, and deconsolidation of subsidiaries. Such important consequences should not turn on potential "foot faults." In addition, combined with the funding rule of Prop. Treas. Reg. § 1.385-3 (discussed below), the documentation rules could have a cascading effect. For example, if an instrument is recharacterized as equity under the documentation rule, payments of interest and principal would be recharacterized as distributions. Such an occurrence could trigger the funding rule, resulting in other related-party debt being recharacterized as equity, which could, in turn, itself have cascading effects.

As drafted, the proposed rules exceed what is necessary to carry out Treasury and the IRS's stated intention to promote the efficient administration of the tax law. The regulations appear to allow the IRS to recharacterize an instrument not only because the taxpayer fails to produce documentation supporting the treatment of an instrument as debt, but also because the documentation fails to establish certain specified factors (e.g., an unconditional obligation to pay a sum certain, creditor's rights, reasonable expectation of ability to repay, and the holder's reasonable exercise of the diligence and judgment of a creditor). The regulations thus create dispositive substantive factors that must be proven through documentation in order for an instrument to be treated as debt. This result is inconsistent with Treasury and the IRS's statement in the preamble that "the proposed regulations do not intend to alter the general case law view of the importance of these essential characteristics of indebtedness." 9 If Treasury and the IRS intend to overrule case law and establish dispositive substantive factors, they should propose rules containing overt dispositive factors, explain their rationale, and provide taxpayers with the opportunity to comment. If this is not Treasury and the IRS's intent, they should amend the regulations.10

 

B. Alternative Approaches

 

Several alternative approaches would serve Treasury and the IRS's goals while promoting administrability and limiting unintended results for taxpayers. First, Treasury and the IRS could provide that failure to produce contemporaneous documentation is a relevant factor in determining whether an instrument should be treated as debt or equity. Second, Treasury and the IRS could create a rebuttable presumption that an instrument is not debt if the documentation requirements are not satisfied.
1. Failure to Produce Documentation as Relevant Factor
Treasury and the IRS could issue regulations providing that a taxpayer's failure to produce contemporaneous documentation is a relevant, but not dispositive, factor in determining whether an instrument should be treated as debt. Because taxpayers would seek to avoid the application of this factor by producing documentation, this alternative would still have the effect of "impos[ing] discipline on related parties by requiring timely documentation and financial analysis that is similar to the documentation and analysis created when indebtedness is issued to third parties."11 This alternative would also provide the IRS with greater documentation and information to assist in debt/equity determinations. At the same time, this alternative would limit the unduly harsh results that would occur when debt instruments are recharacterized as equity solely for failure to satisfy the documentation requirements.
2. Rebuttable Presumption
Alternatively, failure to satisfy a documentation requirement could establish a rebuttable presumption that an instrument should be recharacterized as equity. Like the suggestion above, this approach would have the effect of encouraging parties to (a) reflect carefully on the nature of their debt instruments and (b) prepare supporting documentation to assist the government in debt/equity examinations, while limiting unduly harsh results.

There are numerous examples of regulatory presumptions in favor of the IRS that may be rebutted by the taxpayer.12 The section 385 regulations could contain a rebuttable presumption modeled on the disguised sale rules of Treas. Reg. § 1.707-3. Treas. Reg. § 1.385-2(a)(1) could be amended to state:

 

(a) General -- (1) Scope. This section prescribes requirements regarding the preparation and maintenance of documentation and information with respect to an expanded group instrument (an EGI, as defined in paragraph (a)(4)(ii) of this section). The purpose of preparing and maintaining the documentation and information required by this section is to enable an analysis to be made whether an EGI is appropriately treated as stock or indebtedness for federal tax purposes. If a taxpayer fails to satisfy the requirements of this section, the EGI is presumed to be treated as stock for federal tax purposes unless the facts and circumstances clearly establish that the EGI should be treated as indebtedness under general federal tax principles. The rules of this section must be interpreted and applied in a manner that is consistent with and reasonably carries out the purposes of this section. Moreover, nothing in this section prevents the Commissioner from asserting that the substance of a transaction involving an EGI (or the EGI itself) is different from the form of the transaction (or the EGI) or disregarding the transaction (or the EGI) or treating the transaction (or the EGI) in accordance with its substance for federal tax purposes. Such an assertion may be made based on the documentation or information received pursuant to a request under this section or a request for information under section 7602. This section does not otherwise affect the authority of the Commissioner under section 7602 to request and obtain documentation and information regarding transactions and instruments that purport to create an interest in a corporation. If the requirements of this section are satisfied or otherwise do not apply, see §§ 1.385-3 and 1.385-4 for additional rules for determining whether and the extent to which an interest otherwise treated as indebtedness under general federal tax principles is recharacterized as stock for federal tax purposes.

C. Other Recommendations

 

1. Apply Documentation Requirements to Debt in Form Only
The documentation requirements of the proposed regulations apply to "applicable instruments," meaning "any interest issued or deemed issued that is in form a debt instrument."13 The regulations reserve on requirements for interests that are not debt instruments in form, and the preamble requests comments on whether documentation requirements should apply to instruments that are not debt in form.

The documentation requirements should apply only to debt in form. As Treasury and the IRS state in the preamble, the proposed documentation requirements are tailored to arrangements that are traditional debt arrangements. As a result, certain of the requirements in the proposed regulations (such as creditor's rights and actions evidencing a debtor-creditor relationship) would not be appropriate for the various types of instruments that are not debt in form, such as repos and swaps with upfront payments, but are treated as debt for U.S. tax purposes. New rules would need to be tailored for the many types of instruments that may be treated as debt in substance. Further, it would be extremely difficult for taxpayers, especially financial institutions, to document the significant number of transactions that can create debt in substance. In addition, such arrangements do not implicate the policy concerns behind the documentation requirements -- such arrangements are treated as debt under longstanding tax principals and do not require an additional "factual record . . . for additional scrutiny and thorough examination."14

2. Clarify Requirements for Revolving Credit Agreements and Cash Pooling
We request that Treasury and the IRS provide additional guidance with respect to the documentation requirements that must be kept with respect to revolving credit agreements and cash pooling arrangements. Although Prop. Treas. Reg. § 1.385-2(b)(3)(iii)(A) and (B) address such arrangements, they contain only general statements about "material documentation" being prepared, maintained, and provided in accordance with the requirements of Prop. Treas. Reg. § 1.385-2. The regulations provide little guidance on what constitutes "material documentation."

The regulations should make clear that separate documentation is not needed in each draw under a cash pooling arrangement. Cash pooling is used to provide short-term liquidity by pooling and lending excess funds of multiple affiliates. In a typical arrangement, one affiliate is designated as a cash pool leader. On a regular (often daily) basis, excess cash in the accounts of affiliates will be swept into the account of the cash pool leader, while affiliates in need of cash will draw upon the pooled cash held by the cash pool leader. Applying the documentation rules to individual draws would be incredibly burdensome for taxpayers. Taxpayers could be required to maintain the legal documents governing the cash pooling and any amendments to such documents. Documentation with respect to reasonable expectation of repayment could be required when the cash pooling arrangement is put in place and on some periodic basis, such as on an annual basis or when the terms of the arrangement are materially modified.

3. Clarify Reasonable Cause Exception
The proposed regulations provide that, "[i]f the person characterizing an EGI as indebtedness for federal tax purposes establishes that a failure to satisfy the requirements of this section is due to reasonable cause, appropriate modifications may be made to the requirements of this section in determining whether the requirements of this section have been satisfied. The principles of § 301.6724-1 of this chapter apply in interpreting whether reasonable cause exists in any particular case."15 We appreciate Treasury and the IRS's recognition that some reasonable cause exception is needed to prevent draconian results from inadvertent "foot faults." However, the exception as drafted is ambiguous and likely to result in inconsistent application by examiners.

The regulations also refer to the "principles" of Treas. Reg. § 301.6724-1. That provision is focused on failures to file timely correct information returns, correct payee statements, and certain other specified information. As a result, the requirements are tailored to those situations and focus on factors, such as "undue economic hardship," "certain actions of the Internal Revenue Service," and unavailability of business records caused by "supervening events." Given that several of these factors are not relevant to debt/equity documentation, reference to the specific requirements of Treas. Reg. § 301.6724-1 is not apt. Further, the proposed regulations reference the "principles" of Treas. Reg. § 301.6724-1, and it is unclear what principles should be gleaned from the specific requirements.

Treasury and the IRS should write a specific reasonable cause rule applicable to the documentation requirements. Treasury and the IRS could look to the section 6112 regulations as one example of a tailored reasonable cause rule. The section 6112 regulations excuse the section 6708 penalty for failure to make lists of advisees with respect to reportable transactions available to the IRS where the failure was due to reasonable case. The determination of whether a person had reasonable cause is made on a case-by-case basis, taking into account the relevant facts and circumstances. The regulations provide a non-exclusive list of factors establishing reasonable cause, including the extent of the person's good-faith efforts to comply, exercise of ordinary business care, the existence of supervening events, and reliance on opinion or advice.

III. Automatic Recharacterization Rules

 

A. Overview

 

Prop. Treas. Reg. § 1.385-3 would treat as equity certain related-party interests that otherwise would be treated as debt under long-standing tax principles. Specifically, the rules would generally recharacterize as equity a debt instrument issued by a corporation to a member of the corporation's expanded group (1) in a distribution, (2) in exchange for expanded group stock (other than in an "exempt exchange"), and (3) in exchange for property in certain asset reorganizations. Under a "funding rule," the proposed regulations would also generally recharacterize as equity expanded group debt instruments issued with a principal purpose of funding (1) a distribution of property by the funded member to a member of the funded member's expanded group, (2) an acquisition of expanded group stock by the funded member from a member of the funded member's expanded group in exchange for property other than expanded group stock, or (3) an acquisition of property by the funded member in an asset reorganization where money or other property within the meaning of section 356 (i.e., "boot") is received. A principal purpose is deemed to exist if the expanded group debt instrument is issued by the funded member during the period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution or acquisition.

The automatic recharacterization rules would reverse long-standing case law by focusing not on the nature and terms of an instrument itself but rather on the relationship between the holder and the issuer (e.g., whether they are related) and whether certain transactions are undertaken by the holder, regardless of whether those transactions are in fact undertaken in connection with the issuance of an instrument. Further, the recharacterization rules would have far-ranging impacts, applying to routine business transactions that are not motivated by tax. In fact, the regulations are likely to drive tax-motivated behavior -- companies may avoid or delay transactions, such as distributions, or seek out alternatives that achieve similar economic results but that do not trigger the rules (such as borrowing from a third party) to avoid the severe consequences of the recharacterization rules.

 

B. Recommended Changes to Funding Rule

 

The funding rule is of particular concern, specifically the "per se" rule of Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(1), which provides a non-rebuttable presumption that a debt instrument issued 36 months before or after a covered distribution or acquisition is treated as having a principal purpose of funding that covered distribution or acquisition. The breadth of the rule is likely to implicate a variety of routine, non-tax driven business transactions. For example, because the proposed regulations treat a consolidated group as one corporation,16 a funding of one group member followed by a distribution by the group parent several years later could trigger the rule, even where the two transactions are independent, the money from the initial funding has been used in the first group member's business, and the distribution by the second member is funded with profits from the second group member's business.

The rules are also a trap for the unwary because they look to whether there has been a distribution for any purposes of the tax law. As a result, in the example described above, the funding rule could be triggered by a deemed distribution, such as a deemed distribution from a transfer pricing adjustment that was not foreseen by the taxpayer because the taxpayer in good faith believed that its pricing was consistent with the arm's-length standard.

The preamble to the regulations states that the funding rule is needed to prevent taxpayers from using "multi-step transactions to avoid the application of these proposed regulations while achieving economically similar outcomes."17 The preamble later states that the non-rebuttable presumption is appropriate because "money is fungible and because it is difficult for the IRS to establish the principal purposes of internal transactions. In the absence of a per se rule, taxpayers could assert that free cash flow generated from operations funded any distributions and acquisitions, while any debt instrument was incurred to finance the capital needs of those operations."18 Although these concerns are understandable, the rules should not be weighed so heavily toward administrative convenience for the reasons described below.

As currently drafted, the non-rebuttable presumption will result in the recharacterization of debt instruments that, as a factual matter, were not made in connection with a covered distribution or acquisition. Where the purpose of the rule is to prevent taxpayers from intentionally structuring transactions to avoid the application of the general rule, it is appropriate for the law to consider the taxpayer's motive. There are numerous anti-avoidance rules in the tax law that look to the taxpayer's purpose in carrying out a transaction, including, as discussed below, rules involving funded distributions. There is no evidence that similar rules would not be effective in addressing the government's concerns (and in fact the proposed rules contain a general anti-abuse rule in Prop. Treas. Reg. § 1.385-3(b)(4)). In addition to the potentially extreme consequences of recharacterization of debt as equity, the presumption will also increase compliance burdens for taxpayers, who will need to set up new compliance processes to track covered funding transactions, distributions, and acquisitions in order to determine whether the funding rule may have been triggered. For these reasons, administrative convenience does not justify establishing a new substantive rule that reclassifies debt as equity contrary to decades of common law.

The application of the funding rule could be better tailored to target transactions that raise the policy concerns identified. As discussed below, an exemption from the funding rule is appropriate for regulated financial services groups. In any event, the funding rule should be modified to require a factual connection between the covered distribution or acquisition and the relevant funding. Treasury and the IRS could amend the funding rule by (a) removing the "per se" rule and replacing the "principal purpose" standard with a "but for" standard or (b) removing the "per se" rule and relying on a general "principal purpose" standard. Further, the ordinary course exception of Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(2) should be expanded.

1. Financial Services Exception
For the reasons mentioned at the beginning of this letter and covered in greater detail in other submissions from the financial industry, an exception from the funding rule for financial services groups is appropriate. The sheer volume of intercompany debt transactions between financial services entities would regularly implicate the funding rule as drafted, impairing the ability of financial institutions to engage in certain transactions, including distributions in excess of current earnings and profits. Our client endorses the proposal by the Securities Industry and Financial Market Association ("SIFMA") to exempt from the funding rule any debt instrument issued to or by any member of a "regulated financial group" (as defined in the SIFMA letter). If Treasury and the IRS decline to provide a general exception from the funding rule for the financial services industry, other rules that are tailored to the financial services industry would be appropriate, as described below.
2. "But for" Test
Regardless of whether Treasury and the IRS provide an exception from the funding rule for regulated financial services groups, the non-rebuttable presumption in the funding rule should be eliminated for the reasons described above. Consistent with the recent proposed and temporary section 956 regulations, the funding rule could look to whether a covered distribution or acquisition would not have been made "but for" a funding. This standard would appropriately target abusive transactions while avoiding undue administrative burdens and controversies.

The recently proposed and current temporary section 956 regulations look to whether a distribution by a foreign partnership to a related U.S. partner is connected to a funding of that partnership by a related controlled foreign corporation.19 Specifically, the proposed regulations contain a special rule for determining a partner's share of a foreign partnership's obligation that is treated as United States property when the foreign partnership distributes the proceeds of an obligation to a related partner and the partnership would not have made the distribution "but for" a funding of the partnership through an obligation held or treated as held by a CFC. The temporary regulations issued on the same day as the proposed regulations similarly contain a "but for" rule that applies where a partnership funding precedes a partnership distribution.20 Neither the preamble to the proposed regulations nor the preamble to the temporary regulations voice any concern about whether the "but for" test is inadministrable or insufficient to prevent abuse.

3. General "Principal Purpose" Standard
Alternatively, the funding rule could maintain the current "principal purpose" standard, which looks to all facts and circumstances to determine whether a debt instrument is issued with a principal purpose of funding a covered distribution or acquisition, but remove the per se rule. This alternative would provide the IRS with the ability to target abusive situations, but may create more uncertainty for taxpayers than the "but for" alternative described above.

 

C. Other Recommendations

 

In addition to the alternative approaches described above, several other changes would enhance the administrability of Prop. Treas. Reg. § 1.385-3 while minimizing unduly harsh results and compliance burdens and carrying out Treasury and the IRS's policy goals. In particular, our client suggests several amendments to the Prop. Treas. Reg. § 1.385-3(c) exceptions from the general rule and the funding rule.
1. Application Only to Debt in Form
The Prop. Treas. Reg. § 1.385-3 recharacterization rules would apply to "an interest that would, but for the application of this section, be treated as a debt instrument as defined in section 1275(a) and § 1.1275-1(d)." Thus, the rules apply not only to debt in form, but also, in general, any instrument or contractual arrangement that constitutes indebtedness under general principles of federal income tax law.21 It would be extremely difficult for corporations, especially financial institutions, to take into account all potential related-party arrangements that might constitute indebtedness under federal tax law when analyzing whether the recharacterization rule, especially the funding rule, applies. For example, repos, interest rate swaps with upfront payments, and principal protected notes, which are regularly entered into by financial institutions for non-tax business reasons, could all be characterized as debt in substance and could therefore be subject to the rules.

The preamble to the proposed regulations does not indicate that taxpayers use instruments or arrangements treated as debt in substance in connection with the transactions targeted by the general rule of Prop. Treas. Reg. § 1.385-3. The preamble also does not suggest that Treasury and the IRS in fact have evidence or experience that indicates that limiting the application of the funding rule to debt in form, coupled with an anti-abuse rule for instruments or arrangements that constitute debt for tax purposes and are issued with a principal purpose of avoiding the rules, would be insufficient to target the transactions of concern. It is unwarranted to subject taxpayers to the significant compliance burden of tracking all instruments that could be treated as debt in substance -- and potentially the harsh consequences of the automatic recharacterization rules -- in the absence of such evidence.

To avoid subjecting taxpayers to unwarranted compliance burdens, the funding rule, like the Prop. Treas. Reg. § 1.385-2 documentation rules, should apply only to debt in form. Treasury and the IRS could draft an anti-abuse rule to apply the funding rules to debt instruments as defined in section 1275(a) and Treas. Reg. § 1.1275-1(d) that are issued with a principal purpose of avoiding Treas. Reg. § 1.385-3.

2. "Ordinary Course" Exception
The per se rule in the proposed regulations contains an exception for debt instruments that arise in connection with the purchase of property or the receipt of services between members of the same expanded group in the ordinary course of the purchaser's or recipient's trade or business. According to the preamble, "[t]his exception is intended to apply to debt instruments that arise in connection with the purchase of property or the receipt of services between members of the same expanded group in the ordinary course of the purchaser's or recipient's trade or business, and is not intended to apply to intercompany financing or treasury center activities or to capital expenditures."22 If any form of the per se rule is maintained, the exception to the per se rule for ordinary course debt instruments should be expanded to apply for purposes of the entire funding rule and to apply to a broader range of instruments.

It would be appropriate to expand this "ordinary course" exception to short-term loans, such as loans with a term of one year or less. Short-term debt priced at arm's length does not implicate Treasury and the IRS's earnings stripping concerns. An exception for short-term loans could be coupled with an anti-abuse rule to target arrangements that are short-term loans in form but are in fact regularly rolled over or renewed with a principal purpose of avoiding the application of the funding rules. In addition, although Treasury and the IRS state in the preamble to the proposed regulations that the ordinary course exception is "not intended to apply to intercompany financing or treasury center activities," an exception for cash pooling is needed to avoid disrupting routine treasury operations. Our client joins with other taxpayers and trade organizations in requesting a cash pooling exception.

Exceptions from the funding rule for debt that is "ordinary course" for financial institutions are also warranted. Such routine, business-motivated transactions do not implicate the policy concerns behind the funding rule. For example, and discussed in greater detail in other submissions from the financial industry, exceptions are appropriate for bank deposits, as well as the ordinary course transactions excepted from the application of section 956.23

3. Expansion of Current Earnings and Profits Exception
Prop. Treas. Reg. § 1.385-3(c)(1) provides that, for purposes of applying the general and funding rules, the aggregate amount of any covered distributions or acquisitions is reduced by an amount equal to the member's current year earnings and profits described in section 316(a)(2). The preamble to the regulations states that this exception "would accommodate many ordinary course distributions and acquisitions, providing significant flexibility to avoid the application of [the per se rule]."

Applying the rule only to current earnings and profits will not carry out Treasury and the IRS's goal of accommodating "ordinary course distributions and acquisitions." Because current earnings and profits cannot be determined until the year is closed, taxpayers in many cases will be unable to determine, or at least will be uncertain about how to determine, whether a distribution or acquisition would result in a recharacterization under the regulations.

Further, limiting the exception to current earnings and profits would make it difficult for taxpayers to anticipate in advance the tax consequences of routine business transactions, such as distributions. Such uncertainty could cause taxpayers to avoid transactions that would otherwise be undertaken for non-tax business reasons.

The exception should be expanded to include accumulated earnings and profits. If Treasury and the IRS are concerned about the scope of an accumulated earnings and profits exception, the exception should, at a minimum, consider current and the prior two years' earnings and profits (which would generally correspond to the Officer of the Comptroller of the Currency 12 U.S.C. § 60 dividend limit of net retained income of the year to date, plus the retained net income of the preceding two years).

IV. Effective Date

The regulations propose to apply the Prop. Treas. Reg. § 1.385-2 documentation requirements to expanded group instruments issued on or after the date the regulations are published in final form. As currently drafted, the deadline for preparing several aspects of the required documentation is 30 days after a testing date, which includes when an expanded group instrument is issued. As a result, it would be difficult for taxpayers to prepare timely documentation for instruments issued close to the date the final regulations are issued. The effective date of the documentation rules should be extended to at least six months after the finalization of the regulations.

Prop. Treas. Reg. § 1.385-3 is proposed to be effective for debt issued on or after April 4, 2016 (that remains outstanding 90 days after final regulations are issued), and for distributions or acquisitions occurring on or after April 4, 2016. The retroactive aspect of these rules is unwarranted on a general basis. The retroactive aspect of the rules also causes significant uncertainty for taxpayers engaging in business planning that has nothing to do with tax avoidance -- businesses must consider potential impact as if the regulations are finalized as proposed as well as impact if the regulations are finalized with revisions that are currently unknowable. Government officials have expressed a concern that, without a retroactive aspect, taxpayers would engage in the types of abusive transactions being targeted prior to the finalization of the regulations. This concern can be addressed by limiting any retroactive aspect to specific types of transactions.

V. Administration of Regulations

Finally, we address how the IRS can effectively and efficiently administer final regulations. The regulations are a fundamental change from existing law. As currently drafted, application of the regulations, particularly Prop. Treas. Reg. § 1.385-3, is complex (as demonstrated by the 19 examples provided in the Prop. Treas. Reg. § 1.385-3 regulations alone). In addition, several aspects of the proposed regulations, particularly the bifurcation rule and the documentation rules, may be interpreted differently by different examiners. For these reasons, we suggest that the IRS issue guidance to examiners on how the final rules should be interpreted and applied in practice. Such guidance might include directives or training materials such as the International Practice Units.24 Although the final regulations should narrow certain aspects of the proposed regulations (such as the funding rule) and clarify ambiguities (such as when the bifurcation rule might apply and when a failure to maintain proper documentation is due to reasonable cause), additional guidance would in any event provide important clarification to examiners (and taxpayers) in applying the rules.

 

* * *

 

 

Our client appreciates the opportunity to provide comments and hopes that you will consider them favorably. Please feel free to contact me if you have any questions.
Sincerely,

 

 

Philip R. West

 

Steptoe & Johnson LLP

 

Washington, DC

 

FOOTNOTES

 

 

1 The regulations were published in the Federal Register on April 8, 2016. 81 Fed. Reg. 20911 (Apr. 8, 2016).

2See, e.g., section 163(j) (applies only to net interest expense); section 954(h) and (i) (subpart F active financing and active insurance exceptions); section 956(c)(2)(A), (I), (J), (K) (exceptions from the term "United States property" for certain obligations issued by financial institutions); Temp. Treas. Reg. 1.956-2T(b)(1)(xi) (exception from the term "United States property" for certain obligations arising with respect to notional principal contracts involving financial institutions); section 1297(b)(2)(A) and (B) (characterizing income derived in the active conduct of banking and insurance businesses as nonpassive); Prop. Treas. Reg. 1.1296-4 and -6 (characterizing certain banking and securities income as nonpassive). Treasury's most recent Greenbook proposal to "restrict deductions for excess interest of members of financial reporting groups" would not apply to financial service entities. Department of Treasury, General Explanations of the Administration's Fiscal Year 2017 Revenue Proposals (Feb. 2016), p. 2.

3 Press Release, Treasury Announces Additional Action to Curb Inversions, Address Earnings Stripping (Apr. 4, 2016).

4 Department of the Treasury, 2015-2016 Priority Guidance Plan (July 31, 2015).

5 Press Release, supra note 3.

6 Alison Bennett and Laura Davison, "Inversion Rules May Be Done by Labor Day, Koskinen Says," Daily Tax Report (Apr. 13, 2016).

7 There are several recent precedents for this approach. One example is the section 871(m) regulations, which, like the proposed section 385 regulations, implemented a new and complex regime. Treasury and the IRS issued an initial set of proposed regulations (T.D. 9572, 77 Fed. Reg. 3202) in 2012. Following a significant dialogue between the government and interested parties, those regulations were withdrawn in 2013 and replaced with re-proposed regulations (78 Fed. Reg. 73128). After an additional period of comment and dialogue, final, temporary, and proposed regulations were issued in 2015. T.D. 9734, 80 Fed. Reg. 56865. A similar approach was recently taken with respect to proposed regulations governing the issue price definition for tax-exempt bonds. Treasury and the IRS issued proposed regulations in 2013 (78 Fed. Reg. 56842; REG-148659-07) that based the determination of issue price on actual sales prices instead of reasonably expected sales at initial public offering prices. After receiving comments expressing significant concerns with the approach of the proposed regulations, Treasury and the IRS re-proposed an amended definition and provided taxpayers the opportunity to comment. 80 Fed. Reg. 36301, REG-138526-14.

8 81 Fed. Reg. 20911, 20916.

9 81 Fed. Reg. 20911, 20916. Further, the preamble to the proposed regulations justifies the documentation requirement as helpful to assist the IRS in making debt/equity determinations, not as a vehicle for establishing dispositive debt/equity factors. See, e.g., id. ("This requirement also serves to help demonstrate whether there was an intent to create a true debtor-creditor relationship that results in bona fide indebtedness and also to help ensure that the documentation necessary to perform an analysis of a purported debt instrument is prepared and maintained") (emphasis added).

10 The regulations also use certain terms inconsistently, and it is unclear whether a difference in meaning is intended. Documentation must "establish" an unconditional obligation to pay a sum certain, creditor's rights, and reasonable expectation of ability to repay but must "evidence . . . the holder's reasonable exercise of the diligence and judgment of a creditor." In addition, the preamble at times uses terminology different than the text of the regulations with respect to the same factor. Compare Prop. Treas. Reg. § 1.385-2(b)(2)(i) (requiring the taxpayer to have "written documentation. . . establishing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates") (emphasis added) with 81 Fed. Reg. 20911, 20916 ("The proposed regulations require evidence of [a binding legal obligation to repay] in the form of timely prepared written documentation executed by the parties") (emphasis added).

11 81 Fed. Reg. 20911, 20915.

12See, e.g., Treas. Reg. § 1.367(e)-1(d) (permitting a distributing corporation to rebut a presumption that distributions are to non-qualified U.S. persons by meeting certain requirements, which can include identifying qualified U.S. person distributees); Treas. Reg. § 1.482-7(c)(2)(ii) (permitting controlled participants to rebut a presumption that a platform contribution is exclusive); Treas. Reg. § 1.707-3(c) (presuming that a transfer of property to a partnership within two years of the partnership transferring money or other consideration to the partner is a sale unless the facts and circumstances clearly establish that the transfers do not constitute a sale); Treas. Reg. § 1.871-15(n)(4) (containing presumptions applying to long parties, including a presumption that transactions entered into less than two business days apart and reflected on the same trading book are entered into in connection with each other; such presumption can be rebutted by the long party "with facts and circumstances showing that the transactions were not entered into in connection with each other"); Treas. Reg. § 1.881-3(c)(2)(i) (permitting director of field operations to presume that an intermediate entity would not have participated in a funding arrangement on substantially the same terms if there is a guarantee of the financed entity's liability to the intermediate entity; taxpayer may rebut the presumption by producing clear and convincing evidence that the intermediate entity would have participated in the financing transaction with the financed entity on substantially the same terms even if the financing entity had not entered into a financing transaction with the intermediate entity). The regulations also contain numerous presumptions, not cited here, that are in favor of the taxpayer and that may be rebutted by the IRS.

13 Prop. Treas. Reg. § 1.385-2(a)(4)(i).

14 81 Fed. Reg. 20911, 20915.

15 81 Fed. Reg. 20911, 20934.

16 Prop. Treas. Reg. § 1.385-1(e).

17 81 Fed. Reg. 20911, 20918.

18Id. at 20923.

19 Prop. Treas. Reg. § 1.956-4(c)(3), REG-155164-09 (Oct. 13, 2015).

20 Temp. Treas. Reg. § 1.956-1T(b)(5), T.D. 9733 (Oct. 13, 2015).

21 Treas. Reg. § 1.1275-1(d).

22 81 Fed. Reg. 20911, 20924.

23See section 956(c)(2)(I), (J), (K), (J).

24See, e.g., IRS, International Practice Units, available at https://www.irs.gov/businesses/corporations/international-practice-units; IRS, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties (July 15, 2011).

 

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