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April 5 — The administration's far-reaching guidance to curb corporate inversions and earnings stripping casts a broad net that could catch common planning deals not intended to avoid taxes, practitioners told Bloomberg BNA.
Unveiled April 4, the proposed and temporary rules are likely to affect ongoing transactions and could take away the benefits of some recent deals, they said. The regulations come as the U.S. has struggled to stop massive deals where U.S. multinational companies have structured their transactions around laws intended to stop them from changing their tax residence to cut or avoid U.S. taxes.
But the guidance intended to prevent U.S. companies from “stripping” income out of this country goes far beyond inversion transactions and could reach common structures where U.S. multinationals use the tax benefits of debt in their planning, practitioners said April 5.
It will change the landscape for these companies by creating broader circumstances where that debt could be converted to equity.
David Hariton, a partner with Sullivan & Cromwell LLP, said under the proposed tax code Section 385 guidance, U.S. companies could lose not only their interest deductions on debt, but also face withholding taxes on interest payments on that debt if the government changes it to equity.
“This goes well beyond inversions and could apply to all foreign corporations,” Hariton said in an April 5 interview.
Call for Legislation
At a news briefing on April 5, President Barack Obama said the rules are a critical part of the government's effort to crack down on inversions, but the Treasury Department can't stem the problem completely without help from Congress.
“When companies exploit loopholes like this, it sticks the rest of us with the tab,” Obama said. Only lawmakers, he said, can fully take away the opportunity for transactions that, though they may be “technically legal, are egregiously unfair,” he said.
Obama stressed that the U.S. has joined forces with countries around the world to prevent global tax avoidance, but said Congress still needs to act.
White House spokesman Josh Earnest said during the briefing that the Treasury guidance isn't aimed at any particular transaction, even as Pfizer Inc. and Allergan Plc work on one of the biggest inversions in U.S. history (see related story in this issue).
Republicans and Democrats on the Hill largely agreed that legislation is needed, but differed on how this should be accomplished.
With regard to the regulations, practitioners said, however, that the Section 385 rules came as a surprise. According to Treasury, the proposed earnings stripping regulations would:
• curb transactions that increase related-party debt if it doesn't finance new investment in the U.S.;
• allow the Internal Revenue Service to take action during audits to divide a debt instrument into part debt and part stock; and
• require members of large corporate groups to document their actions, including important information for analyzing how debt and equity are handled for tax purposes.
The rules specifically targeting corporate inversions were released as proposed regulations (REG-135734-15) cross-referencing final and temporary regulations (T.D. 9761). The regulations on earnings stripping were issued in proposed form (REG-108060-15).
Paul Schmidt, chair of tax at BakerHostetler LLP, called the regulations “potentially a game-changer.” He said, taken as a whole, “I do think as it relates to inversions and the benefits of inverting, this is a very comprehensive package.
As it affects debt-equity analysis out of the inversions arena, it could have a meaningful impact on fairly common planning techniques that are applied by U.S. multinationals.”
Many of those transactions employ related-party debt, Schmidt said. One type of deal, he said, involves transfers to subsidiaries around a group.
Cash Important for Debt Treatment
Schmidt said April 5 that the guidance appears to have a theme that unless actual cash was provided as part of the deal, “they don't want to give debt treatment.”
To explain how the regulations work in this area, Hariton gave two different examples. In one, he said, a U.S. corporation issues debt to its foreign parent in exchange for $1 billion. In that case, the debt would be treated as debt.
In another, the U.S. company distributes $1 billion of its debt to its foreign parent without receiving any cash. Under these circumstances, that debt would be treated as equity, he said.
The rules on distributions of debt “could significantly impact or curtail common transactions among multinational groups,” Dentons USA LLP partner John Harrington said April 5. It is “quite common” for subsidiaries to distribute, or be considered to have distributed, indebtedness or another obligation to its parent, he said.
Documentation: Tough Requirement
Both Harrington and Joe Calianno, a partner with the international technical tax practice at BDO USA LLP, said the rule requiring some companies to document why they should get debt treatment is very important.
Calianno said if companies can't provide the complicated information Treasury wants, they stand to lose that treatment. Harrington said without careful documentation—and actions consistent with debt—companies “greatly reduce the likelihood that they will prevail in a dispute with the IRS.”
Reaction to the rules on the Hill was mixed, although most lawmakers agreed legislation is needed.
Republican leaders in Congress said the new Treasury regulations would not be enough to tackle corporate inversions. Senate Finance Committee Chairman Orrin G. Hatch (R-Utah) questioned Treasury's authority to issue the rules.
“There is a real question if they have stepped outside their lane. Frankly, I think they have,’ Hatch said. “It would be better if they [Treasury] would say, we all know what we got to do is to reduce corporate tax rates down to at least 25 percent, hopefully 20 percent.”
Earnest said in the briefing with President Obama that the administration is confident it has the legal authority to issue the regulations.
Senate Majority Leader Mitch McConnell (R-Ky.) echoed Hatch's comments, saying that the new regulations underscored the need for comprehensive tax reform. The regulations underscore that the U.S. has “one of, if not the highest corporate tax rate in the world, which is an invitation to go offshore,” McConnell said at a weekly press conference for Senate leaders.
Problem Not Solved
Some lawmakers such as Senate Finance Committee member Rob Portman (R-Ohio) pointed to previous statements from Treasury Secretary Jacob J. Lew saying that actions by Congress would be the best way to tackle inversions.
“And by the way, go to Secretary Lew's previous statements about what they can do through the regulatory system as compared to law and you will see he says this will not solve the problem,” Portman said.
Portman said there will continue to be a lot of foreign companies that buy U.S. companies. “It is just not the fact that there are inversions. It's the fact that U.S. companies are not competitive,” he said.
Call for Tax Overhaul
Democrats said the regulations could be the first steps toward a broader tax overhaul. Senate Finance Committee ranking member Ron Wyden (D-Ore.) said he regarded the new regulations from the administration as constructive, and what is needed now is a long-term effort to fix the tax code. But fellow committee member Sen. Benjamin L. Cardin (D-Md.) was more circumspect.
“The challenge I have with any regulation is that tax minds will figure out ways to get around them,” he said. Congressional action would be the best solution to fix the inversions, he added.
Injury Seen to Foreign Investment
Nancy McLernon, president and chief executive officer of the Organization for International Investment, said in an April 5 interview that the rules could deeply harm investment into the U.S. “The administration has not provided a reason why they're going after all foreign companies,” she said.
Earnest said during the White House news briefing that the U.S. welcomes foreign direct investment and creates conditions that are attractive to overseas companies.
With assistance from Kaustuv Basu in Washington.
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