Comments on proposed regulations on the allocation of interest expense under Sections 861 and 864(e): July 24, 1991.

• Position: Tax Executives Institute

On March 11, 1991, the Internal Revenue Service issued proposed Income Tax Regulations under sections 861 and 864(e) of the Internal Revenue Code concerning the allocation and apportionment of third-party interest expense of an affiliated group of corporations. The proposed regulations (INTL-952-86) were published in the Federal Register on March 12, 1991 (56 Fed. Reg. 10397); corrections were issued on March 22, 1991 (56 Fed. Reg. 12141); and conforming, proposed regulations were published in the April 8, 1991, issue of the Internal Revenue Bulletin (1991-14 I.R.B. 27). A public hearing on the proposed regulations was held on June 21, 1991. When final, the proposed regulations will replace existing temporary regulations promulgated under section 1.861-10T(e) of the Income Tax Regulations. (1)

Background

Tax Executives Institute, Inc. is the principal association of corporate tax executives in North America. Our nearly 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply. Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operations of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the allocation of third party (2) interest expense of an affiliated group to interest income received from "related" controlled foreign corporations.

The "Netting Rule" Lacks

a Sound Statutory or Tax

Policy Basis

Proposed regulations to implement section 864(e) of the Internal Revenue Code of 1986 were initially published in the Federal Register on September 11, 1987. The proposed regulations were withdrawn and replaced by temporary regulations and a notice of proposed rulemaking on September 14, 1988. In certain circumstances, Temp. Reg. [Section] 1.861-10T(e) requires that third-party interest expense of an affiliated group of corporations be allocated directly to interest income received from related controlled foreign corporations (CFCs). (3) The March 1991 proposed regulations endeavor to respond to the numerous comments on Temp. Reg. [Section] 1.861-10T(e), which sets forth the roundly criticized "netting" rule.

In prior comments filed on November 9, 1987, and February 14, 1989, TEI stated its position on the netting rule: it violates the general fungibility principle adopted by Congress in enacting section 864(e). TEI reiterates its opposition in principle to any form of netting rule -- including the latest mutation. As we pointed out in our comments of February 14, 1989:

The statute and related legislative history provide absolutely no authority for the Treasury's emasculation of the fungibility principle. Indeed, the legislative history not only supports the fungibility concept, but evinces a congressional intent to encourage lending rather than equity investment in foreign subsidiaries. (Citations omitted.)

TEI continues to believe that the concept of fungibility mandated by Congress should be respected by the Treasury Department and IRS in uniform, even-handed regulations. The IRS should not invoke the fungibility concept only when it enriches the U.S. Treasury. The quotation in the preamble, which is cited as the authority for a netting rule, from the Conference Report to The Tax Reform Act of 1986, is inapposite. The quotation is excerpted from a paragraph dealing with integrated financial transactions under section 864(e)(7)(B) of the Code. (4)

Although the proposed regulations endeavor to narrow the focus of the reformulated netting rule to "tax motivated on-lending" of U.S. shareholder indebtedness, the Treasury Department and IRS still paint with too broad a brush and from too indiscriminate a palette. Legitimate, non tax-motivated financing of controlled foreign corporations is tinged with the same scarlet taint as the tax-motivated borrowing and subsequent on-lending that the proposed regulations seek to curb. (5)

The latest reincarnation of the netting rule alters the groups of taxpayers burdened by the regulations. Concededly, if there is to be a netting rule at all, some taxpayers undoubtedly will prefer the latest version, whereas other taxpayers will find the temporary regulations preferable. The threshold question, however, is whether the Treasury Department and IRS have the authority to fashion two sets of regulations with such disparate effects. Congress clearly has the power to determine which taxpayers are disadvantaged by its laws, and, indeed, to enact succeeding sets of rules that shift the burdens from one class of taxpayers to another. In the absence of a clear congressional mandate for a netting rule, however, the Treasury and the IRS should not arrogate to themselves the power to issue uneven rules. (6)

Furthermore, taxpayers have relied upon the temporary regulations for nearly three years in financing their CFCs. Capital and debt structures may have been adjusted and transactions entered into in response to and in reliance on the temporary rules. Depending upon the size and nature of a financing transaction, considerable planning, negotiation, and legal documentation were necessary to implement domestic affiliated group and CFC capital and debt structures, and those structures have both economic effect and substance. Taxpayers generally will be unable to instantaneously "unwind" decisions made during the incumbency of the temporary regulations. Consequently, transitional relief in the form of additional safe harbors may be necessary to mitigate ongoing adverse consequences from good faith reliance upon the temporary regulations. (7) In promulgating the proposed regulations, the Treasury and the IRS ignored the mandate of Congress regarding the fungibility of debt, disregarded the numerous constructive criticisms of tax practitioners, and fashioned rules that, at once, make it more difficult for U.S. corporations to compete abroad and are so complex that they make voluntary compliance with the U.S. tax laws extremely difficult, if not literally impossible. TEI believes the Treasury Department and the IRS should exorcise one of the demons of the complexity by abandoning the netting rule. (8)

Even assuming that promulgation of a netting rule is properly within the scope of the law and the Treasury Department's delegated authority, TEI recommends that the rule be rescinded as totally at odds with the principles of tax simplification and sound tax administration. Thus, the Treasury Department should pay heed to the words of Commissioner Goldberg who recently testified:

[T]he well-meaning quest for theoretical purity, coupled with an unending stream of "microamendments" of marginal importance, have spawned an unacceptable burden of complexity and uncertainty -- complexity and uncertainty that impose a staggering cost on business taxpayers, compound the federal deficit by eroding voluntary compliance, and undermine the ability of the IRS to carry out its mission. (9)

Proposed Changes to the

Netting Rule

Despite TEI's belief that a netting rule contravenes congressional intent and sound tax policy, there are a number of specific technical comments that we wish to submit to assist the IRS in clarifying the application of the rule (if the Treasury Department persists in its effort to maintain the rule) and to render the regulation less offensive and more administrable.

1. Overview

   Temp. Reg. [Section] 1.861-10T(e) treats lending by a U.S. affiliated group to its related CFCs as tax-motivated if the related CFC group owes a disproportionately small amount of indebtedness to unrelated third parties. Under the temporary regulations, a related CFC group has "excess related person indebtedness" (ERPI) if the aggregate debt-to-asset ratio of all CFCs is less than 80 percent of the debt-to-asset ratio of the U.S. affiliated group. The temporary regulations prescribe complex rules for recharacterizing a CFC's ERPI until the aggregate debt-to-asset ratio is at least 80 percent of the related affiliated group. Under the rules, third-party interest expense of the U.S. group is allocated directly to the interest income received on the ERPI by the group.

   The temporary regulations were criticized for not recognizing that the debt-to-asset ratios of CFCs may vary from that of the related U.S. group for legitimate, non-tax business reasons and, further, that to the extent intercompany loans are financed by the retained earnings of the U.S. group, there is no tax-motivated lending. The proposed regulations attempt to respond to these criticisms by more closely approximating the amount of tax-motivated U.S. group borrowing and on-lending to CFCs. Specifically, the proposed regulations set out a two-step process to identify the amount of tainted interest income from CFCs. The third step in the process is to allocate the third-party interest expense of the U.S. group among the various separate foreign tax credit limitation categories of section 904(d).

   Step One of the proposed regulations identifies the potentially tax-motivated lending to the related CFC group and defines it as...