Source: https://www.kflaw.com/are_you_anxiously_waiting_for_the_new_set_of_final_section_385_regulations
Timestamp: 2019-03-21 12:16:16
Document Index: 24815916

Matched Legal Cases: ['§7491', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1']

Are You Anxiously Waiting for the New Set of Final Section 385 Regulations? Well, Not Senate Finance Committee Chair Hatch and House Ways and Means Chair Brady - Kostelanetz & Fink, LLP
Are You Anxiously Waiting for the New Set of Final Section 385 Regulations? Well, Not Senate Finance Committee Chair Hatch and House Ways and Means Chair Brady
On April 4, 2016, the Treasury and the Internal Revenue Service issued proposed regulations on the treatment of certain interests in corporations as stock or indebtedness, or as partly stock and debt. REG-108060-15.[1] One of the stated purposes of the proposed regulations was to follow through on the anti-earnings stripping guidance that was issued by the Service in Notice 2014-62, 2014-42 IRB 712 (10/14/2014) and Notice 2015-79, 2015-49 IRB 775 (12/7/2015) to guard against post-inversion earnings stripping tax avoidance strategies. See also Section 7701(l)(conduit financing rules).
The proposed regulations provide guidance regarding substantiation of the treatment of certain interests issued between related parties as indebtedness for federal tax purposes, the treatment of certain interests in a corporation as in part indebtedness and part stock, and the need to recharacterize debt as stock in situations where there is no new capital provided to the lender and the transaction is substantially motivated by tax savings.
Wide-sweeping in their application, the proposed regulations to Section 385 are considered by some to be the most significant income tax regulations “ever”. The scope of the proposed regulations fundamentally redefine whether an intercompany instrument will constitute debt for federal income tax purposes regardless of whether the debt is linked or otherwise part of an inversion transaction or end run of Section 956.
Proposed Regulations to Section 385 Have Had Mixed Reviews And Have Been Criticized By Business and Members of Congress
The proposed regulations are long, complex and controversial and private industry, the banking sector and various professional groups have taken a few “shots” at the provisions such as “don’t issue them in their present form”. Indeed, sharp criticism on the proposed regulations has been voiced by members of the Congressional tax-writing Committees.
Recently, the “word” on the street appeared to be that the Treasury would be issuing the regulations in final form shortly, perhaps as early as right after Labor Day. Well, that’s about what the Obama Administration would want us to believe. But out of the sky comes Senator Orrin G. Hatch (R-Utah), who is Senate Finance Committee Chair who issued a letter last week asking the Treasury to re-propose the Section 385 regulations claiming that the Treasury Department is “moving at an unprecedented pace” and “attempting to regulate a very complex area on a very short timeline”. The only way to move forward in a prudent fashion Hatch asserts is for the Treasury to re-issue the regulations in proposed form and obtain more comments. House Ways & Means Committee Chair Kevin Brady (R-Texas), along with the Republicans on the Committee, again went on the record opposing the regulations contending that if promulgated they would block the ability of businesses to operate effectively and grow and hire new workers. The August 22 House letters cite the Congressional Review Act (CRA), which requires any federal agency that issues a major regulation to provide members with a copy and cost-benefit analysis of the rule before it is enacted. Brady had previously said he would explore all options to stop the Section 385 regulations, including using the CRA.
This post will provide background information behind the enactment and purpose of Section 385 and then proceed to provide a general description of the objectives of the Treasury and IRS in issuing the proposed regulations and the general areas of coverage. Specific parts of the proposed regulations will not be critiqued. Additional comments will be made as the regulations are issued in final form and to address specific parts of the final regulations instead of giving them a full panoramic view. This posting follows in format the explanation and preamble to the controversial proposed regulations.
Section 385: Tax Reform Act of 1969
Section 385(a) was enacted into law as part of the Tax Reform Act of 1969. P.L. No. 91-172. The general rule authorizes the Secretary to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is treated as stock or indebtedness for purposes of the Code. Section 385(b) states that certain factors are to be taken into account in issuing regulations on distinguishing debt versus equity for federal income tax purposes. Such factors include: (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth; (2) the presence of a stated fixed rate of interest; (3) whether the purported “debt” is subordinated to or given preference over any other debt of the corporation; (4) the debt to equity ratio of the debtor corporation; (4) whether the debt is convertible into stock; and (6) the relationship between holdings of stock in the corporation and holdings of the interest in question.
The need for regulations in this area was based on Congress’ view, adopted many years ago when Section 385 was enacted into law, that the Treasury should issue regulations to provide greater clarity and predictability of outcome to resolving a debt versus equity issue. The judicial approach of applying a multi-factor test based on all facts and circumstances was inefficient and did not foster policy goals of sound tax administration. Indeed, it was also well recognized by tax practitioners and academicians that the case law was often confusing and contradictory and produced inconsistent results. Congress had already delegated the Treasury to issue legislative type regulations to set forth appropriate rules for distinguishing debt from equity. A Senate Report further added that the list of factors set forth in Section 385(b) was not intended to be exclusive set of factors to consider. S. Rep. No. 91-552, at 138 (1969). [2]
Section 385 Amendments
Section 385 was amended in 1989 and 1992 to authorize the Secretary to bifurcate treatment of an instrument issued by a corporation as being part stock and part debt. P.L. No. 101-239 (1989). The legislative history to the 1989 amendment notes that, while “[t]he characterization of an investment in a corporation as debt or equity for Federal income tax purposes generally is determined by reference to numerous factors, . . . there has been a tendency by the courts to characterize an instrument entirely as debt or entirely as equity.” H.R. Rep. No. 101–386, at 3165–66 (1989) (Conf. Rep.).
Three years later, in 1992, Congress added Section 385(c). P.L. No. 102-486(1991). It was enacted for the purpose for requiring parties to a debt instrument to report the payments of interest and principal consistently for federal income tax purposes. Section 385(c)(1) provides that the issuer’s characterization (as of the time of issuance) as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary) (italics for emphasis added). Section 385(c)(2) provides that, except as provided in regulations, Section 385(c)(1) shall not apply to any holder of an interest if such holder on his return discloses that he is treating such interest in a manner inconsistent with the initial characterization of the issuer. Section 385(c)(3) allows for regulations to require taxpayers provide such information as the Secretary determines to be necessary to carry out the provisions of Section 385(c).
Prior Efforts to Promulgate Section 385 Regulations
Regulations projects under Section 385 were undertaken in 1980 and led to final regulations published in the same year. T.D. 7747. There were further revisions in subsequent years. However the final regulations were withdrawn in November, 1983. TD 7920. No regulations have been written with respect to the statutory amendments to Section 385(a) for part debt/part stock or for consistent treatment under Section 385(c).
The Role of the Courts in Debt Versus Equity Decisions
There are a vast number of reported decisions on the proper characterization of an interest as debt or equity. Some courts have emphasized certain factors over others. It has been a case-by-case approach. Therefore, what has evolved from the numerous court decisions is the application of the facts to a multi-factor test in determining whether the taxpayer advancing the instrument as debt for federal income tax purposes has met its burden of proof.
In the much-cited decision in Fin Hay Realty Co. v. United States, 398 F.2d 694 (3rd Cir. 1968), 16 factors were identified to determine whether an issuance was debt or equity. The factors were: (1) the intent of the parties whether the funds advanced was a loan versus an investment in stock; (2) the treatment of the advances on the books of the issuer and whether there was consistency in establishing creditor versus shareholder relationships; (3) whether the holder of the instrument participated in management; (4) the ability of the corporation to obtain funds from unrelated sources; (5) the debt to equity ratio; (6) risk of non-payment; (7) formal indicia of the instruments; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) whether the debt set forth fixed rate of interest; (11) a contingency on the borrower’s obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation.
The courts have not applied the same factors consistently or have given the same amount of weight to the factors in reaching a conclusion in a particular case. See, e.g., J.S. Biritz Construction Co. v. Commissioner, 387 F.2d 451 (8th Cir. 1967); John Kelly v. Commissioner, 326 U.S. 521, 530 (1946).
As mentioned, the purpose of the proposed regulations under Section 385 is to provide a set of specific rules and requirements in determining whether a debt instrument issued by a corporation is to be treated as stock or debt or as in part stock and in part indebtedness. Loading up debt and interest rates are generally tax favorable since the interest payments are deductible (unless required to be capitalized) by the obligor and includible in the creditor’s gross income , subject to treaty rate reduction based on the holder’s country of residence. Debt treatment is also favored by lenders since repayments of principal are generally non-taxable. The proposed rules apply to purported indebtedness issued to certain related parties, without regard to whether the parties are domestic or foreign. Debts between members of a U.S. consolidated group of corporations are not within the scope of the regulations as the same concerns of base erosion, clear reflection of income, etc., are generally absent in the consolidated return context whereby the income and related expense are to be matched and offset.
Debt Which is Bifurcated Into Part Debt, Part Equity
As previously noted, Congress amended section 385(a) in 1989 to authorize the Treasury to issue regulations permitting an interest in a corporation to be treated as in part indebtedness and in part stock. The legislative history to the 1989 amendment explained that “there has been a tendency by the courts to characterize an instrument entirely as debt or entirely as equity.” H.R. Rep. No. 101–386, at 562 (1989) (Conf. Rep.). No regulations have been promulgated under the amendment, however, and this tendency by the courts has continued to the present day. Consequently, the Commissioner generally is required to treat an interest in a corporation as either wholly indebtedness or wholly equity.
It is not apparent that an “all or nothing” outcome accurately reflects the equities of the case taken from the vantage point of the taxpayer and the IRS. To have, for example, a debt instrument that is 55% as a matter of the taxpayer’s meeting its burden of proof (and persuasion) result in a 100% characterization in favor of the taxpayer seems unfair. Perhaps one would contend that the taxpayer and the government could have settled at a more equitable dollar amount so that the “winner take all” approach to litigation is a “fair gamble”. Conversely, a taxpayer who has not met its burden of proof but is perhaps 40% persuasive, may, under the proposed regulations, avoid the adverse100% as stock outcome and thereby receive partial relief.
Suppose the government, under the bifurcated debt (final) regulation, sets up a deficiency based on the treatment of $100X in debt as $50X of debt and $50X as stock and therefore wants to disallow interested deductions on $50X of recharacterized debt. Should the taxpayer resist and fight? Well, what is the burden of proof going to be? Presumably based on the preponderance of the evidence. But how does judicial deference to the regulation factor in? This should increase the taxpayer’s burden of proof to “clear and convincing evidence” in order to prevail if not “arbitrary and capricious”. This would be a steep, uphill climb for the taxpayer one steep hill not worth taking. From this perspective, one would tend to take the 50% approach or offer that the government put on the table. It can easily be seen, therefore, that the issuance of a bifurcation regulation armed with Chevron deference would have a chilling effect in issuing debt instruments that run even a small chance of being challenged, at least in part. Taxpayers had much better odds it seems when the case was an “all or nothing” proposition.
Related-Party Indebtedness In General
Related-party indebtedness may be respected as debt where the evidence proves that there is the intent to create a true debtor-creditor relationship. But is that enough to win a debt (over equity) case? No, not by a long-shot. While still subject to the same multifactor analysis used for characterizing interests issued between third parties, “courts have consistently recognized that transactional forms between related parties are susceptible of manipulation and, accordingly, warrant a more thorough and discerning examination for tax characterization purposes.” PepsiCo Puerto Rico, Inc. v. Commissioner, T.C. Memo 2012–269, at 51, citing United States v. Uneco, Inc., 532 F.2d 1204, 1207 (8th Cir. 1976); Cuyuna Realty Co. v. United States, 382 F.2d 298, 301 (Ct. Cl. 1967) (stating that an advance between a parent corporation and a subsidiary or other affiliate under common control must be subject to particular scrutiny “because the control element suggests the opportunity to contrive a fictional debt, an opportunity less present in an arms-length transaction between strangers.”).
Special scrutiny is warranted in the eyes of the Treasury and IRS in transactions involving related parties because there is typically less economic incentive for a related-party lender to impose discipline on the legal documentation and economic analysis supporting the characterization of an interest as debt for federal income tax purposes. While a unrelated lender in general has the leverage to impose much of the terms and conditions to the loan arrangement, a related-party lender, especially one that directly or indirectly controls the borrower, may require only simple (or even no) legal documentation and may forgo any economic analysis that would inform the lender of the amount that the borrower could reasonably be expected to repay.
The absence of reasonable diligence exercised by related-party lenders can limit the factual record that is available for IRS examination and subsequent judicial review. Even so, the Preamble to the proposed regulations notes that courts do not always require related parties to engage in reasonable financial analysis and legal documentation similar to unrelated parties to prove up the debt is “real”. See, e.g., C.M. Gooch Lumber Sales Co. v. Commissioner, 49 T.C. 649 (1968) at 656 (noting that in the case of related-party debt, “the absence of a written debt instrument, security, or provision for the payment of interest is not controlling; formal evidences of indebtedness are at best clues to proof of the ultimate fact”); see also Byerlite Corp. v. Williams, 286 F.2d 285, 290–91 (6th Cir. 1960), citing Ewing v. Commissioner, 5 T.C. Memo 908 (1946) (“The fact that advancements to a corporation are made without requiring any evidence of indebtedness . . . was not a controlling consideration . . .”).
The proposed regulations set forth documentation requirements. Treasury and the Service contend that the lack of straight forward guidance in this area, combined with the sheer volume of financial records taxpayers produce in the ordinary course of business, makes it difficult to identify the documents that will ultimately be required to support the characterization of an instrument as debt and provide further proof that there was a reasonable expectation of repayment present at the time the interest was issued. The problem with related corporations, for example, doing business in multiple jurisdictions, as well as the detail in which the business records are kept and maintained, makes it very difficult to efficiently address and properly resolve the debt versus equity issues. Now, there is much more involved with analyzing intragroup transactions in determining the proper separation of the line between debt from equity (or whether there is bifurcated debt).
In addition to the lack of detailed recordkeeping, the Treasury and IRS also recognize that the dollar amounts at stake have become increasingly substantial. Therefore, it is critically import to prescribe rules which identify the types of documentation and information required to support the characterization of a related-party debt for federal tax purposes.
Proposed Regulations Announce Documentation Requirements
The proposed regulations will require timely documentation and financial analysis that is similar to the documentation and analysis created when indebtedness is issued to third parties. The documentation requirement directly goes to whether there was intent to create a true debtor-creditor relationship and also will make audit and review easier. This approach is consistent with the long-standing view held by courts that the taxpayer has the burden of substantiating its treatment of an arrangement as indebtedness for federal tax purposes. Hollenbeck v. Commissioner, 422 F.2d 2, 4 (9th Cir. 1970). Cf. §7491.
The proposed regulations identify essential characteristics of indebtedness for federal tax purposes. Such characteristics are: (i) a legally binding obligation to pay, creditors’ rights to enforce the obligation; (ii) a reasonable expectation of repayment at the time the interest is created; (iii) and an ongoing relationship during the life of the interest consistent with arms-length relationships between unrelated debtors and creditors. These characteristics are drawn from the case law and are consistent with the text of Section 385(b)(1) and (5). While the proposed regulations do not intend to alter the general case law view of the importance of these essential characteristics of indebtedness, the proposed regulations do require a degree of discipline in the creation of necessary documentation, and in the conduct of reasonable financial diligence indicative of a true debtor-creditor relationship, that exceeds what is required under current law. See, e.g., C.M. Gooch Lumber Sales Co., 49 T.C. 649; Byerlite Corp., 286 F.2d 285.
The proposed regulations acknowledge, however, that the preparation and maintenance of documentation and information are not dispositive in establishing that a purported debt instrument is debt for federal tax purposes. Rather, these requirements are necessary to the taxpayer’s being able to prove up, or alternatively the government to reject, the issuance of debt that will be determined using the multi-factor approach under case law. The final regulations should soften the timing requirements for the documentation rule and further acknowledge that the failure to meet the documentation rules does not, per se, result in stock treatment.
Certain Distributions of Debt Instruments and Similar Transactions
The Treasury Department and the IRS have identified three types of transactions between affiliates involving debt that, in their view, raise significant policy concerns and required attention in the proposed regulations, including: (i) distributions of debt instruments by corporations to related corporate shareholders; (ii) issuance of debt instruments by corporations in exchange for stock of an affiliate (including “hook stock” issued by related corporate shareholders); and (iii) issuance of debt instruments in an exchange pursuant to an internal asset reorganization. Similar policy concerns arise when a related-party debt instrument is issued in a separate transaction to fund: (i) a distribution of cash or other property to a related corporate shareholder; (ii) the acquisition of affiliate stock from an affiliate; or (iii) certain acquisitions of property from an affiliate pursuant to an internal asset reorganization. These types of problem areas are addressed in detail in the proposed regulations.
Debt Instrument Issued As a Distribution In General
In Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956), the Second Circuit addressed a situation in which a domestic corporate subsidiary issued debentures to its parent corporation in payment of a dividend. The parent and subsidiary were required to file separate returns under the Code in effect during the years at issue, and, before taking into account the interest income and deductions on the distributed indebtedness, the parent corporation had losses and the subsidiary was profitable. The government disallowed the petitioner a deduction for income and excess profits taxes for 1934-1938 on 6% debentures for $30M. The Tax Court ruled in favor of the government. 21 T.C. 513.
The court considered arguments by the government that the parent-subsidiary relationship warranted additional scrutiny in determining whether a debtor-creditor relationship was established. In these types of situations where there is an atmosphere of “self-dealing”, the characterizations appearing on the books of the related parties should not be “blandly accepted”. In particular, the Commissioner argued in Kraft, supra, that, because the issuer subsidiary was wholly-owned, “the sole stockholder [could] deal as it please[d] with the corporate entity it control[led]” and, as a result, the transaction should be treated as a sham. The Commissioner also argued that the debentures should be treated as stock because no new capital was introduced into the subsidiary in connection with the issuance of the debentures and because the taxpayer conceded that the issuance of the debentures in payment of the dividend lacked a business purpose other than tax minimization.
In reversing the Tax Court and now holding for the taxpayer, the Second Circuit determined that the debentures should be treated as debt since the debentures were unambiguously denominated as debt, were issued by and to real taxable entities, and created real legal rights and duties between the parties.
The Preamble to the proposed regulations re-announces the Treasury’s and Service’s concern with self-dealing aspects of intercompany debt and cites, in further support, other court decisions that shared the same concern. For example, some courts have closely scrutinized situations in which indebtedness is owed in proportion to stock ownership to determine whether a debtor-creditor relationship exists in substance. See, e.g., Uneco, Inc. v. United States, 532 F.2d 1204, 1207 (8th Cir. 1976) (“Advances between a parent corporation and a subsidiary or other affiliate are subject to particular scrutiny . . . .”); Arlington Park Jockey Club, Inc. v. Sauber, 262 F.2d 902, 906 (7th Cir. 1959) (“It has been held that [a cash advance made in proportion to stock ownership] gives rise to a strong inference that the advances represent additional capital investment and not loans.” (citing Schnitzer v. Commissioner, 13 T.C. 43, aff’d 183 F.2d 70 (9th Cir. 1950))). Consistent with those decisions, section 385(b)(5) specifically authorizes the Secretary, in issuing regulations distinguishing between stock and indebtedness, to take into account “the relationship between holdings of stock in the corporation and holdings of the interest in question.”
Another concern with the facts in Kraft Foods Co., supra, was the lack of new capital investment with respect to the $30M in debentures issued by the subsidiary. See e.g., Talbot Mills v. Commissioner, 146 F.2d 809 (1st Cir. 1944); John Kelley Co. v. Commissioner, 326 U.S. 521 (1946); Sayles Finishing Plants, Inc. v. United States, 399 F.2d 214 (Ct. Cl. 1968) (noting that a “lack of new money can be a significant factor in holding a purported indebtedness to be a capital transaction, particularly when the facts otherwise show that the purported indebtedness was merely a continuation of the stock interests allegedly converted”). Where no new funds are involved, the Service has frequently taken the position that the debt is generated essentially for tax purposes as there is no meaningful non-tax significance.
An example of where related party debt can be tax-motivated is where a group of corporations has gone through an inversion. Debt instruments can generate interest deductions, for example, to reduce U.S. source income of the U.S. operations without any new capital being invested in the U.S. Another illustration is the issuance of debt by a CFC to a non-CFC affiliate in order to reduce the CFC’s taxable income through the payment of interest. The reduction in the CFC’s earnings and profits thereby permit the repatriation of untaxed earnings without recognizing dividend income by the U.S. parent corporation.
The Preamble’s example of a strategy of this type is worth noting. It involves the distribution of a note from a first-tier CFC to its U.S. shareholder in a taxable year when the distributing CFC has no earnings and profits (although lower-tier CFCs may) and the U.S. shareholder has basis in the CFC stock. In a later taxable year, when the distributing CFC had untaxed earnings and profits (such as by receipt of subsequent distributions from lower-tier CFCs), the CFC could use cash attributable to the earnings and profits to repay the note owed to its U.S. shareholder. If the note is respected as debt, the repayment of the note does not result in a dividend to the U.S. shareholder to the extent of accumulated earnings and profits.
In light of these policy concerns, the proposed regulations treat a debt instrument issued in fact patterns similar to that present in the Kraft case as stock. The factors discussed in Kraft and Talbot Mills, including the parent-subsidiary relationship, the fact that no new capital is introduced in connection with a distribution of debentures, and the typical lack of a substantial non-tax business purpose, support the conclusion that the issuance of a debt instrument in a distribution is a transaction that frequently has minimal or nonexistent non-tax effects. Therefore, in fact patterns similar to that present in the Kraft case, the regulations will treat the debt instrument as stock. It should be recognized that under current case law the fact that debt is issued where is no advance of funds or property does not cause the debt, per se, to be treated as stock.
Debt Instrument Issued in Exchange for Affiliate Stock Generally to be Treated as Stock
The government also is of the view that the issuance of debt to acquire affiliate stock, as with the issuance of debt as a dividend a la Kraft, supra, frequently has limited non-tax significance in relation with the significant federal tax benefits generated in the transaction. Such transactions do not change the ultimate ownership of the affiliate, and do not inject any new operating capital to either affiliate. While the change in direct ownership of an affiliate’s stock may have some non-tax significance, that is frequently with respect to, for example, purchases of “hook stock” from a parent in exchange for debt. Accordingly, the proposed regulations generally treat a debt instrument issued in exchange for affiliate stock as stock.
Debt Instrument Issued Pursuant to an Internal Asset Reorganization
The proposed regulations also address certain debt instruments issued by an acquiring corporation as part of an internal asset reorganization. Internal asset reorganizations can use debt in an effort to end-run dividend treatment. See, e.g., Section 304 and Section 368(a)(1)(D). The proposed regulations treat a debt instrument issued by an acquiring corporation as consideration in an exchange pursuant to an internal asset reorganization as stock, consistent with the treatment of a debt instrument issued in a distribution or in exchange for affiliate stock.
Debt Instrument Issued with a Principal Purpose of Funding Certain Distributions and Acquisitions
The use of intercompany debt in a Kraft context also raises the same policy concerns to the Treasury and the IRS when a corporation issues a debt instrument with a principal purpose of funding certain related-party transactions. Specifically, the proposed regulations treat a debt instrument issued for property, including cash, as stock when the debt instrument is issued to an affiliate with a principal purpose of funding: (i) a distribution of cash or other property to a related corporate shareholder; (ii) an acquisition of affiliate stock from an affiliate; or (iii) certain acquisitions of property from an affiliate pursuant to an internal asset reorganization.
The Treasury and the Service is further concerned that any set of new restrictions on debt from being treated as debt could be “gamed” so to speak by the use of multiple parties and using different funding sources. As an illustration, a corporation could borrow funds from a sister corporation and immediately distribute those funds to the common parent corporation. Issuances of debt instruments to an affiliate in order to fund a distribution of property, an acquisition of affiliate stock, or an acquisition of an affiliate’s assets in a reorganization often would confer significant federal tax benefits without having a significant non-tax impact, regardless of whether the lender is also a party to the funded transaction. The proposed regulations treat as stock a debt instrument issued to an affiliate to fund one of the specified transactions regardless of whether the lender is a party to the funded transaction. A rule of this type can give the Service, entitled to judicial deference for its regulations as long as they are “reasonable” or “not arbitrary or capricious”, etc., broad powers to recharacterize debt as stock whenever it can find a significant tax purpose somewhere with the “infield” of the various corporate affiliates involved.
This posting did not cover all subjects covered by the proposed regulations, including the controversial if not draconian cash pooling arrangements provisions which will have a great impact on multinational groups which will be “forced” to treat cash pools as “equity”.
The debt versus equity subject involves an almost unlimited set of factual as well as statutory contexts in the Code. An attempt to staple down a set of complex rule-based provisions to address this fundamental principle for federal income taxation is most ambitious. But is it correct? Undoubtedly Congress has long authorized the issuance of regulations in this area but did it want the Service and Treasury to come up with the present set of rules of far-sweeping impacts which cross-over into other parts of the Code? Members of this Congress have said “no”. Indeed there are also supporting statements from many commentators, business organizations and professional groups that these rules are too “adventurous” and “far-sweeping” and need far more thought and re-consideration before being issued in final form.
But there are other comments to the contrary. Yes, some have applauded the new proposed regulations as fair overall and perhaps only in need of some tweaking.
From this individual’s perspective, it would be wise for the Treasury and the Service to take a “step back”, perhaps a big one, and take additional time to examine and reflect on what the final rules could be pared down to look like without sacrificing important tax policy objectives. Additional notice and comment period(s) should be issued. Treasury and the Service should further give a substantial amount of thought and consideration to the comments already submitted by the ABA Tax Section and the AICPA and others, including a group of large banks, for the need for a more balanced and simple set of regulations.
While the Treasury and the Service are legitimately concerned with base erosion and repatriation of earnings schemes, as well as setting out additional disincentives for U.S. parent corporations to invert, this set of regulations suffers greatly from overbreadth, a substantial degree of unfairness and interjects as solutions certain “make-believe” rules and protocols. The compliance costs are formidable.
It is unquestionable that the Treasury and the Service made a substantial and good-faith effort to set forth a set of workable rules to address identified problem areas. But the atmosphere is already charged with “inversion madness” and “base erosion” strategies that perhaps could be more appropriately addressed elsewhere in the Code and regulations but not directly and substantially through the debt versus equity regulations.
Perhaps the inability of Congress to engage in a bipartisan effort to enhance our non-competitive corporate tax system by substantially reducing the overall corporate income tax rate and provide some form of dividend rate relief on repatriation of foreign accumulated earnings, which has resulted in many U.S. companies moving tax residence, capital and labor overseas, invites and perhaps to some tax administrators in Washington, requires that the Treasury and Service issue a muscular set of regulations at this time. Presumably the present Administration in Washington agrees and wants these regulations to go “final” before the election. Well, they have issued a set of proposed regulations that at times may seem to blur the line between legislation and agency rule-making.
At the very least, the Treasury should push back the effective date of the regulations to instruments issued for taxable years beginning after 2017. Such delay would allow for a new Congress and a new administration to work through a list of important corporate tax areas in need of reform which reforms would include the issuance of a more tailored set of regulations under Section 385.
The foregoing post is intended for informational purposes only and may not be relied upon by any reader or other person as legal advice.
[1] The proposed regulations would apply with limited exceptions to debt instruments issued on or after April 4, 2016. The intercompany debt instruments subject to re-characterization would continue to be treated as debt for 90 days after the issuance of final regulations and would thereafter by viewed as exchanged for equity.
[2] More specifically, the proposed regulations are set forth in four sections. First, proposed Treas. Reg. § 1.385–1 prescribes definitions and operating rules applicable to the regulations under section 385 generally, including a rule treating members of a consolidated group, as defined in Treas. Reg. § 1.1502–1(h), as one corporation. Proposed Treas. Reg. § 1.385–1(d) also provides that the Commissioner has the discretion to treat certain interests in a corporation for federal tax purposes as indebtedness in part and stock in part. Second, proposed Treas. Reg. § 1.385–2 addresses the documentation and information that taxpayers must prepare and maintain within required timeframes to substantiate the treatment of an interest issued between related parties as indebtedness for federal tax purposes. Such substantiation is necessary, but not sufficient, for a purported debt interest that is within the scope of these rules to be characterized as indebtedness; general federal income tax principles also apply in making such a determination. Third, if the application of proposed Treas. Reg. § 1.385–2 and general federal income tax principles otherwise would result in treating an interest issued to a related party as debt for federal tax purposes, proposed Treas. Reg. § 1.385–3 provides additional rules that may treat the interest, in whole or in part, as stock for federal tax purposes if it is issued in a distribution or other transaction that is identified as frequently having only limited non-tax effect, or is issued to fund such a transaction. Finally, proposed Treas. Reg. § 1.385–4 provides operating rules for applying proposed Treas. Reg. § 1.385–3 to interests that cease to be between members of the same consolidated group or interests that become interests between members of the same consolidated group.