Debt-Equity Rules Still Skirt State Tax Conundrum

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By Jennifer McLoughlin

Oct. 17 — The Treasury Department’s narrowed earnings-stripping regulations may have softened the impact on taxpayers, but didn’t eliminate uncertainty regarding the state-side impact.

The final and temporary rules ( T.D. 9790) announced Oct. 13 continue to target the manipulation of related-party financings as a tool of tax avoidance. Practitioners have noted that several provisions lighten the burden on businesses, including a documentation exemption for transactions between members of a consolidated group, relaxed contemporaneous documentation requirements and extended effective date for documentation obligations.

However, it remains to be seen whether—and how—states will track the federal debt-equity regime.

“The proposed regulations created a tremendous amount of uncertainty,” Steve Wlodychak, a Washington-based principal with EY LLP’s Indirect (State and Local Tax) Practice, told Bloomberg BNA Oct. 14. “I think that these final regulations eliminated a significant amount of uncertainty. But there’s still uncertainty with respect to the state application here.”

Following Federal Rules

The threshold inquiry for many practitioners is if, and how, states will apply the federal provisions—raising questions regarding conformity with the final regulations under tax code Section 385.

“The states that have an automatic tie to federal taxable income, I think the new regulations logically become part of their law, subject to any tweaking they might need in order to tie them to any quirks in that state’s tax laws,” Bruce Ely, a partner with Bradley Arant Boult Cummings LLP, told Bloomberg BNA Oct. 14. “So I think the state departments of revenue will have to issue some, at least interpretive if not implementing, regulations quite soon.”

Jamie Yesnowitz, principal and SALT-National Tax Office leader with Grant Thornton, expects that the federal rules will prompt action among states—although they may first consider the effect of conformity on their respective revenue prior to acting.

“Either states can explicitly (or implicitly) conform to all federal recharacterizations in this area, or states can decouple and provide their own guidelines on what constitutes equity instead of debt,” Yesnowitz told Bloomberg BNA in an Oct. 14 e-mail, identifying Massachusetts as a “prominent example” of a state with extensive common law guidance on the debt-equity issue. A substantial majority of states are likely to follow the federal regime, but he noted that “state-specific tweaks” can’t be ruled out, particularly in separate reporting states—in which entities file individual income tax returns.

Contemplating Federal Carve-Out

As a general rule under the earlier regime proposed in April, and now the final regime, federal consolidated groups fall outside the regulations. With a consolidated group, the underlying policy concerns with debt-equity distortions aren’t present between affiliated members with corresponding interest deduction and interest income offsetting one another.

Criticism started to mount over a consolidated group carve-out that may not translate to states that don’t recognize consolidated returns or follow federal consolidated return rules—such as separate reporting states. Even in those states with combined reporting, the makeup of a federal consolidated group may not match the makeup of a combined return.

In the preamble, the final regulations recognized concerns over increased tax costs and compliance burdens at the state level, informed in part through comments raised by prominent state groups, including the Council On State Taxation (COST). As Wlodychak explained, one problem was that the proposed rules abandoned the consolidated group exemption for documentation requirements.

However, it isn’t clear that the issues are resolved.

“I don’t think conclusively they’ve solved the problems,” Wlodychak said. For example, the final regulations now remove transactions between consolidated group members from the definition of an “applicable interest.” Accordingly, such interests aren’t subject to the documentation rules.

“But we’re still in the same conundrum with respect to state and local,” he said, adding that it is unclear whether states will follow the federal exemptions.

Generating Guidance

Some states have already contemplated the need for guidance on how the federal rules will play out in their jurisdictions.

During the New York University Summer Institute in Taxation in July, Michael Fatale, deputy general counsel for the Massachusetts Department of Revenue, said there had been inquiries about state-specific guidance, including instruction on the rules’ application in the context of the non-income measure of the corporate excise. He anticipated that the DOR would issue guidance on that subject if the federal framework was finalized.

The scope of guidance will vary state to state. And in those states with laws that don’t correspond with the consolidated group carve-out, practitioners hope state taxing authorities will offer an explanation of their intentions.

“Some states, like Illinois for example, they’ll probably follow these, because they follow consolidated group rules, and so these exceptions should apply, unless they decide to change them,” Wlodychak said. “But a state like New Jersey or California that doesn’t necessarily follow these rules, they’re going to have to come up with some guidance to taxpayers to let them know, how are they going to apply these regulations.”

Varying State Interpretations?

Given the complexities and breadth of the originally proposed regulations, coupled with the potential flow-through to states, some have suggested that the Multistate Tax Commission weigh in.

During the MTC’s July annual meeting in Kansas City, Mo., the Uniformity Committee decided not to immediately initiate a project on the proposed rules. Wood Miller, Uniformity Committee chairman, said that as the MTC continues to consider the issue, it may determine that further action is needed.

In an Oct. 14 e-mail, MTC Counsel Helen Hecht confirmed that the Uniformity Committee hasn’t decided to take up a project at this time. However, from the Uniformity Committee’s informal discussions on the issue, varying schools of thought have surfaced over how states may apply the rules.

“Based on these informal discussions, it appears that some states believe that the regulations will apply in analogous circumstances at the state level (that is, for transactions between affiliated companies not filing as part of the same return) without the need for the state to do anything in particular to adopt those regulations,” she told Bloomberg BNA in an Oct. 14 e-mail. “Other states may feel that they need to at least provide some guidance as to the extent to which the regulations will apply or will be followed.”

Adding to States’ Arsenals

Several practitioners have characterized the debt-equity regulations as another “arrow in the states’ quiver” to capture revenue lost through offshore and onshore earnings stripping.

Particularly for those states that tie to federal taxable income as their tax base, “they probably can indeed initiate their own audits,” Ely said. “But most will need implementing regulations to do so.”

However, states may not reach for the Section 385 rules to fend off intercompany transactions that mischaracterize debt versus equity.

State mechanisms such as add-back statutes are devised to cut profit shifting—under those laws, select expenses paid to affiliates are added back to taxable income. Likewise, combined reporting regimes attempt to eliminate distortions through intercompany debt instruments by treating related corporations as one entity.

“It remains to be seen whether or not the states will exercise the authority under 385, when you think about the powerful tools that they already have,” Wlodychak said, referring to add-back laws and combined reporting.

Regardless of whether states resort to the rules, taxpayers may face more scrutiny over intercompany debt. During a Sept. 21 webinar hosted by Grant Thornton LLP, Senior Manager Caroline Balfour cautioned that the regulations will encourage more audit activity among states.

Time Needed for Clarity

Aside from the flow-through impact of debt-equity recharacterizations on states’ income tax base, Yesnowitz highlighted several other state-specific considerations flowing from the originally proposed regulations, such as potential disallowance of interest expense addbacks, adjustments to the dividends-received deduction, modification of combined unitary filing groups and apportionment issues.

With the final regulations, the wide span of possible state-specific issues doesn’t vary. Nor do the final rules change “the ability of the states to go down their own path with respect to when they think a recharacterization may be appropriate,” he said.

“Instead, the question becomes how often the recharacterization rules will come into play in states that do follow the federal regulations given the changes from the proposed to the final version,” Yesnowitz said, noting that the regulatory scope requires some time for practitioners, taxpayers and tax authorities to “achieve a sense of clarity on this issue.”

To contact the reporter on this story: Jennifer McLoughlin in Washington at jmcloughlin@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

For More Information

Text of the final rules is at http://src.bna.com/jqd.

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