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April 21 — The Treasury Department's effort to curb the manipulation of intercompany debt transactions has raised sweeping questions about the impact on states' authority to make independent debt-equity determinations.
On April 4, Treasury released proposed regulations (REG-108060-15) under tax code Section 385 to rein in earnings stripping through excessive indebtedness between related parties—both domestic and foreign (65 DTR GG-1, 4/5/16).
“If these regulations are finalized, I do believe they are going to have major state tax consequences, really because they impact so many types of Treasury functions that are common business practices,” Scott Austin, a principal with PricewaterhouseCoopers LLP' State and Local Tax Practice in Philadelphia, told Bloomberg BNA April 21. “Moving cash around the group, cash pooling, cash management, funding debt among the group.”
The rules were expected to target only cross-border debt instruments, but intercompany debt issued in wholly domestic transactions falls within the regulatory scope. However, consolidated groups fall outside the regulations for federal income tax purposes.
That has triggered speculation among practitioners whether states will be authorized or restricted to make adjustments for their tax base, particularly separate-entity taxing states.
“A complication, of course, is that in our federal system, the states are oftentimes free to interpret the rules separately,” said Steve Wlodychak, a Washington-based principal with EY LLP’s Indirect (State and Local Tax) Practice, in an April 22 e-mail. “That means these proposed debt-equity regulations may serve as an additional tool in addition to add-back statutes, for example, that the states can employ, and already are employing, to redetermine state taxable income.”
The Treasury regulations don't apply to interests between members of a federal consolidated group, given the underlying policy concerns aren't present when the “issuer's deduction for interest expense and the holder's corresponding interest income” offset one another.
Some state tax officials have indicated that the Treasury regulations may not limit adjustments at the state level. Specifically, the logic for disregarding intercompany indebtedness in federal consolidated groups may not translate to separate-entity states, which generally don't have consolidated groups at the state level.
But while state agencies and the Multistate Tax Commission continue to study the reach of the Treasury regulations, practitioners are questioning if states will—and should—abide by this federal exception for state tax purposes.
“The grant of authority by Congress in I.R.C. Section 385 to develop regulations to determine debt-equity matters is explicitly provided to the IRS and no other agency, including state taxing authorities,” Wlodychak said, observing that absent an opt-out, IRS debt-equity determinations will flow through to states using federal taxable income as a starting point.
“On the other hand, in our federal system, states are free to review tools devised not only by the IRS, but also by other states, to more properly reflect income,” he added, raising states' adoption of combined reporting, add-back legislation and decoupling from the Internal Revenue Code. “This often starts in one state and then spreads to others. Accordingly, I expect that many states will review the IRS' actions and consider whether it would be appropriate to implement their own rules.”
Richard D. Pomp, a professor at the University of Connecticut School of Law, told Bloomberg BNA April 22 that the Treasury regulations may have a more restrained impact on states. “Between the add-back states and the domestic combined reporting states, I don't know how many states are left for which this is going to be a major issue,” he said.
Combined reporting regimes generally eliminate concerns arising from intercompany transactions, and some practitioners view the consolidated group carve-out a moot point in combined reporting states. But where the makeup of a federal consolidated group doesn't match the makeup of a combined return, the Treasury regulations may have implications.
In situations where an entity falls outside the federal consolidated group but is in a combined return, which “happens all the time,” Austin observed that states may consider federal adjustments in converting debt to equity under the Treasury rules and “then follow that through on a combined return.”
Some expect far-reaching repercussions for states, particularly separate entity regimes. However, the states may not approach the issue with a collective voice.
“I think we've seen disparity among the separate entity states, in terms of how they deal with consolidated groups,” Austin said, explaining how some follow select consolidated return principles, while others don't. “So I think we're going to have a variety of reactions from states on this.”
Notwithstanding any distinction between state reporting regimes, practitioners suggest those differences aren't sufficient to justify any departure from federal authority.
“Whether a state allows or requires combined or consolidated reporting or is a separate reporting state, it should not have the ability to make separate debt-equity determinations independent of the IRS under these regulations,” Wlodychak said.
Whereas add-back statutes are intended to recuperate interest expenses, the Treasury regulations exclude certain expenses as constituting debt at the outset. Some state officials may find the rules more effective than the current add-back regimes for challenging debt.
“The more aggressive the IRS is, the better it is for the states, because they will have less of a problem of a deduction for interest to the payor and an exemption for the payee,” Pomp said, noting skepticism with add-back statutes that can interfere with legitimate transactions. “Which is what we hope to deal with an add-back statute, this sort of tax arbitrage, the mismatch.”
However, others perceive add-back statutes as “a powerful tool to combat perceived abuses” addressed under the Treasury regulations, potentially negating the need for state-specific IRC Section 385 powers.
“It seems doubtful that the proposed debt-equity regulations would cause a rollback of these state add-back statutes that already seem to be working the way the legislatures of the states intended them to,” Wlodychak said. “You have to ask yourself if you already have the state add-back statutes, why would you need these additional powers?”
Should the proposed regulations take effect, Austin anticipates a period of confusion that derives from states' add-back provisions for intercompany interest and differences in conforming to the IRC and regulations.
Wlodychak expects confusion will ripple into chaos, for both taxpayers and state taxing authorities, should states adopt different approaches to assess related-party debt instruments.
“State tax policy suggests that in the development of their income taxes, the states should strive for relative uniformity in the determination of the tax base and nothing could be more important in determining the tax base than uniformity in determining whether an instrument should be treated as debt or equity,” he said.
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