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By James J. Tobin, Esq. Ernst & Young LLP New York, New York
This commentary focuses on the extensive and very complex proposed regulations under §385 issued on April 4, 2016 (the Proposed Regulations). The Preamble alone exceeds 75 pages, more than the Proposed Regulations themselves! A lot has been written about the Proposed Regulations and, given the limited space for this commentary, I cannot do justice to a full analysis of the Proposed Regulations nor the full depth of my concerns and disapproval. So I'll just comment on a few highlights (and lowlights) that hopefully can add to the debate.
Section 385 was enacted as part of the Tax Reform Act of 1969 and authorizes the Treasury Department (Treasury) to promulgate, in part, regulations “to determine whether an interest in a corporation is to be treated for [U.S. tax purposes] as stock or indebtedness.” Further, the statute provides that such regulations “ shall set forth factors” which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists, and provides a non-exclusive list of factors that might be taken into account in making that determination.
Treasury issued proposed and final regulations under §385 in 1980 that were subsequently withdrawn, presumably after recognition of their many problems. I have a warm spot in my heart for those regulations. I was a tax manager for Arthur Young when those regulations were issued and spent many hours identifying problems with those regulations, which I'm sure helped my development as an international tax practitioner and promotion to partner. Although those regulations were ultimately withdrawn, happily my promotion to partner was not.
Treasury had hinted at possible earnings-stripping guidance under §163(j) to attack inversion transactions but ultimately selected a less focused option to take on earnings-stripping and sweep in other transactions, some would argue with the encouragement of certain interested commentators. As described below, I think they significantly overshot by using what it perceived as a more comprehensive grant of regulatory authority under §385 .
I'll focus this commentary on Prop. Reg. §1.385-2, the “threshold” documentation and information rules, and Prop. Reg. §1.385-3, the per se stock rules. Keep in mind, as I'll point out repeatedly, that the Proposed Regulations apply to all related-party debt (generally an 80% common stock ownership threshold (by vote or value)), whether issued by a U.S. corporation, a foreign corporation (whether or not a CFC), a partnership, or a disregarded entity. It seems clear that Treasury's zeal in attempting to limit base erosion by foreign-owned U.S. corporations (whether or not qualifying as expatriated entities under §7874 ) distracted them from the complexities and collateral effects of the Proposed Regulations in the broader context and from the certain consequential commercial impacts which could be expected. More below…
Prop. Reg. §1.385-2 sets forth significant documentation and information reporting requirements for debt instruments issued by a member of an expanded group to another member of the expanded group. The documentation and information reporting must establish the following in order for an instrument to potentially constitute indebtedness for U.S. tax purposes (necessary but not sufficient conditions):
These four elements constitute threshold requirements that must be satisfied within 30 days of the issuance of a related-party instrument (except for item four). Subject to a reasonable cause exception, failure to satisfy any requirement will result in the instrument being treated as stock for U.S. tax purposes. Satisfying the documentation requirements doesn't insure debt status but permits the instrument to be treated as debt if an analysis under general U.S. tax principles results in that determination. The Preamble makes the point that one of Congress's motivations in authorizing Treasury to issue regulations was “the inconsistent analysis of the relevant factors by different courts…” and thus the need for more certain standards. Instead, the Proposed Regulations merely add costs and the administrative burden of threshold documents for all intercompany debts but with no added certainty, as all of the “inconsistent” case law still would have application. Plus, the Proposed Regulations make it clear that taxpayers cannot use a lack of documentation affirmatively to assert that debt should be treated as stock if there is a principal purpose of reducing the U.S. tax liability of an expanded group member. I'll comment on the practical impact of this below.
Some reactions to the documentation and information reporting requirements:
Prop. Reg. §1.385-3 provides per se recharacterization rules that would treat as stock certain debt instruments in connection with the following proscribed transactions:
As a backstop, the Proposed Regulations include a “funding rule” which provides that any related-party debt incurred to fund any of these three types of transactions is also treated as equity. The funding rule provides an unrebuttable presumption that, where any of the three transactions above occurs within 72 months (36 months before and 36 months after) of the related-party loan, the related-party loan would be deemed connected and equity treatment would result.
These per se rules would apply to debt instruments issued on or after April 4, 2016, but any instruments issued on or after that date but before final regulations are published in the Federal Register would not be deemed stock until the 90th day after final regulations (if ever) are published.
There are tremendous complexities in these rules, particularly around how the funding rule will operate. There is also some discussion of the complexity of treating the debt as equity for all U.S. tax purposes and what the collateral effect of such treatment is. But I think the regulations and Preamble merely scratch the surface of some of these complex issues and I fear, as stated above, that the collateral effects were not sufficiently considered. Some observations:
Lots more to complain about, including the treatment of debt instruments issued by disregarded entities and partnerships, possible impact of the OECD BEPS anti-hybrid rules, the consolidated return, the Subchapter C, S corporation, and §902 impacts of being deemed to have issued non-voting, preferred stock, the predecessor and successor rules, and the impact on financial services groups. But space constraints will spare readers from rants on these topics, at least for now. I am sure others will weigh in with comments in those and other areas.
I realize I have a tendency to be a bit critical of guidance from the United States and many foreign governments. I do think it's generally justified as I feel that in the current environment there is too much focus on preventing perceived abuse and little if any concern about collateral damage to non-abusive transactions and to commercial consequences generally. But it would be a shame if my prior criticisms in any way undermined my complaints on these Proposed Regulations — maybe the boy-who-cried-wolf syndrome? Because, in my view, these Proposed Regulations really are the worst example of the one-sided approach referred to above I have seen. I consider the Proposed Regulations replete with inappropriate (and hopefully unintended) consequences, over-inclusive, and in many respects unadministrable, all in an attempt to fix perceived abuse which, if addressed at all, should more appropriately be addressed by legislation. Hopefully, these regulations will disappear more quickly than the 1980 version.
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