TEI comments on section 385 proposed regulations allowing IRS to recharacterize related-party debt to equity.

PositionInternal Revenue Code

On July 6,2016, TEI submitted comments to the Internal Revenue Service regarding its proposed regulations for 26 U.S.C. [section] 385, which would give the IRS broad authority to recharacterize related-party debt to equity. TEI submitted these comments pursuant to the REG-108060-15 notice of proposed rulemaking. The comments discuss the negative macroeconomic effects the proposed regulations could have, the technical tax complexities they would create for corporate taxpayers, and suggested changes Treasury and IRS should make to the proposed regulations before finalizing them.

  1. Introduction

    On April 4, 2016, the Treasury Department and IRS issued proposed regulations pursuant to [section] 385 of the Internal Revenue Code to be promulgated at [section][section] 1.385-1 through 1.385-4 of Title 26 of the Code of Federal Regulations. These proposed regulations authorize the IRS to recharacterize a taxpayer's intercompany debt as equity and require taxpayers to prepare and maintain documents and information substantiating certain intercompany debt transactions as such. Under a new "per se" rule, the proposed regulations mandate the recharacterization of debt instruments to equity if the debt is issued by a corporation to a related company (1) in a distribution, (2) in exchange for expanded group stock, (3) in exchange for property in an asset reorganization, or (4) in transactions funding these first three transactions.

    TEI acknowledges the government's base-erosion concerns surrounding use of related-party debt to achieve excessive interest deductions, particularly in the context of corporate inversions. The proposed regulations, however, are overly broad, covering routine and non-tax motivated financing transactions, and appear intended to force multinational businesses to resort to third-party lending in almost all cases. Businesses use intercompany financing for a wide variety of non-tax business purposes, including, to name a few, increasing speed and efficiency of funding activities, reducing external lending fees, improving administration, minimizing harm to company credit ratings, improving consolidated balance sheets, and increasing return on invested capital. We discuss below several adverse macroeconomic impacts of the proposed regulations. Thereafter, we examine specific technical complexities the regulations would create--complexities without clear solutions that merit a thorough vetting process before adoption of final regulations. Further, we urge Treasury and the IRS to consider the following changes to the proposed regulations:

  2. harmonize the deemed-issuer rules,

  3. establish a 25 percent safe-harbor floor below which debt will not be recharacterized to equity,

  4. exempt non-interest bearing obligations and ordinary-course loans from documentation requirements,

  5. clarify the documentation requirements,

  6. make the per se rule of Prop. Treas. Reg. [section] 1.385-3 a rebuttable presumption and shorten its 72-month time period,

  7. expand the exception for distributions to encompass all earnings and profits, current and accumulated, and also exclude distributions of previously taxed income,

  8. expand the ordinary-course exception to cover all tangible personal property used in the ordinary course of business,

  9. except employee stock compensation from the documentation and recharacterization requirements, and

  10. except cash pooling arrangements from the documentation and recharacterization requirements.

    Finally, we discuss our position that Treasury lacks the statutory authority to recharacterize certain debt instruments as equity on a per se basis.

    Tax Executives Institute

    TEI is the preeminent association of in-house tax professionals worldwide. Our approximately 7,000 members represent more than 2,800 of the leading corporations in North and South America, Europe, and Asia. TEI represents a cross-section of the business community and is dedicated to developing and effectively implementing sound tax policy, promoting the uniform and equitable enforcement of the tax laws, and reducing the cost and burden of tax administration and compliance to the benefit of taxpayers and governments alike. TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient and predictable manner.

    TEI, as a professional association of in-house tax executives, offers a unique perspective. Members of TEI manage the tax affairs of their companies and must contend daily with provisions of the tax law impacting business enterprises throughout the world, including transactions directly affected by these proposed regulations. Our members work for companies involved in a wide variety of industries, and their collective perspectives are broad-based. The diversity, background, and professional training of TEI's members place the organization in a uniquely qualified position from which to comment on these issues.

    * * *

  11. Macroeconomic Effects

    The proposed regulations create new rules in three areas. First, they authorize the IRS to recharacterize and treat a debt instrument as part debt and part equity. Second, they require documentation supporting a debt instrument for it to be treated as debt for U.S. federal income tax purposes. Third, they create a per se rule that recharacterizes and treats certain related-party debt instruments (referred to as Expanded Group Instruments or "EGIs") as stock if issued: (1) in connection with a distribution to a related shareholder, (2) in exchange for an affiliates stock, (3) in an internal asset acquisition, or (4) in exchange for property with a principal purpose of funding one of these three transactions. The per se rule carries an irrebuttable presumption of equity characterization if an instrument is issued within 36 months before or after one of these targeted transactions.

    All laws create unintended consequences, and the proposed regulations are no exception. TEI takes no position on the government's efforts to prevent inversion activity and tax-motivated earnings stripping. We believe, however, the proposed regulations could actually have a negative impact--or at least a countervailing impact eroding the objectives the government seeks to achieve--on the U.S. fisc for the simple reason they would stifle U.S. corporations from making outbound loans to their related foreign entities. If a U.S. parent seeks to fund its outbound investment with third-party lending to a foreign related company, the foreign company would likely pay a higher interest cost, reducing the U.S. parent company's taxable income as compared to making intercompany loans to international affiliates, thus reducing interest income to the parent. (1) In this circumstance, the foreign related company would likely see its foreign profits and tax burden decrease due to higher interest costs.

    Equity financing may be thought of as an alternative to third-party lending. Issuing equity, however, is generally more expensive, complex, and time-consuming than issuing debt. Thus, multinationals have historically relied on related-party debt to manage cash flows and fund routine business operations around the globe. In addition, if a U.S. parent were to fund related foreign companies with equity, the U.S. parent's taxable income would also decrease compared to funding related foreign companies with debt, because of reduced interest income to the parent. The foreign related company would likely see its foreign tax burden increase in light of reduced interest payments to the U.S. parent, rather than deductible interest payments to the U.S. parent, which in turn would increase the availability of indirect foreign tax credits to the U.S. parent. Essentially, to the extent the proposed regulations might stifle transactions resulting in outbound interest payments, otherwise reducing federal tax revenue, the regulations would also stifle loans by U.S. companies to foreign related entities, which would otherwise increase federal tax revenue.

    Similarly, the proposed regulations are likely to have a negative impact on the U.S. fisc because of their impact on foreign-owned U.S. companies. The proposed regulations would steer companies to third-party lenders or to parent-company equity financing. This would negatively affect foreign-owned U.S. subsidiaries wishing to invest in expansion facilities and large equipment purchases. Both U.S.-parented and foreign-parented companies use intercompany debt because it is more efficient than having multinational affiliates maintain independent, third-party banking relationships. Further, equity financing is usually more expensive than debt financing because most tax treaties have lower withholding rates on interest than they do on dividends. Multinational companies will inevitably take these factors into account when deciding whether to invest capital in an affiliate in the United States or in another jurisdiction. Increasing the cost of capital for U.S. investment will result in higher internal hurdle rates, i.e., required rates of return that new business investments must clear to obtain management approval. Thus, the proposed regulations risk stifling capital flowing into the United States, hindering job creation and economic growth. Put another way, less investment means less growth, and less growth means lower future wages and earnings.

    Furthermore, the proposed regulations produce unintended and inappropriate restrictions on I.R.C. [section] 304 transactions. Congress enacted I.R.C. [section] 304 in keeping with its preferred tax policy that, in the case of related-party corporate ownership, cash from the related corporations, received either as a distribution or as a related-party sale transaction, be treated first as a distribution of earnings and profits before being treated as return of capital or capital gain from the sale of stock of one corporation to a related corporation. These transactions often...

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