by Sam Olchyk and Arthur Norman, Venable LLP, Washington
About 15 business representatives lined up to speak at an IRS hearing held July 14 on controversial section 385 proposed regulations dealing with earnings stripping. While the speakers advanced a number of compelling arguments in favor of modifying the tax regulations, IRS and Treasury officials remained mostly silent, not revealing their plans regarding the regulations.
Released on April 8, the proposed regulations would allow the IRS to reclassify certain intercompany debt transactions as equity for tax purposes. The regulations respond to the recent spate of so-called “inversions” that utilize international transfers of debt between parent entities and foreign subsidiaries for tax purposes.
Nearly all of the speakers called for the repeal of reg. section 1.385-2, which provides that intercompany loans that are not correctly documented within 30 days of their issuance will be reclassified as equity.
Many speakers noted the draconian nature of the policy and offered alternative options for undocumented or poorly documented loans.
The following is a summary of positions advanced by selected witnesses:
Lou Greenwald, National Foreign Trade Council:
Greenwald called the 30-day requirement, “unworkable.” Instead, he proposed the implementation of a once-a-year requirement coinciding with each company’s tax yearly filing.
The once-a-year filing is intended to help ensure the comprehensive coverage of all intercompany loans and to decrease the risk that a company may have inadvertently excluded a certain loan in its disclosures. This proposed change was almost unanimously supported by the speakers at the hearing. Alternatively, Greenwald suggested that the automatic re-characterization rule be replaced with a monetary fine for companies that fail to document their loans within the defined window.
Greenwald pointed out that the proposed regulations place no burden of proof on the IRS in order for them to bifurcate intercompany loans. He proposed that the Commissioner should have to prove the taxpayer knew that it could not repay the debt in full and completed the intercompany loan for tax purposes.
In addition, he called for an exception for foreign-to-foreign subsidiary transfers that do not impute earnings stripping, and exceptions for equity-based compensation, hedging, and US subsidiary loans to foreign affiliates. These exceptions were also called for by almost every other speaker.
With regards to the 72-month “funding rule,” which would classify as equity any intercompany loan if the debtor engages in any acquisitions or dividend distributions within 72 months of the issuance of the loan, he noted that the “costs cannot be overstated” as companies engage in hundreds if not thousands of intercompany loans over at 72-month period.
He called for the 72-month period to be shortened to 24 months (12 months before and after the issuance of the debt). This proposed change also was supported by nearly every speaker.
Greenwald also called for an exception for acquisitions, arguing that it is highly unlikely that acquired foreign companies will have complied with the sec. 385 regulations, creating significant barriers for growth.
Finally, he argued that the current earnings and profits exemption should be lengthened. Greenwald called for a 4-year rolling average for the earnings and profits exemption because of the common mismatch between business cycles and dividend payment capabilities among MNEs.
Caroline Harris, Chamber of Commerce:
Harris pointed out that the proposed regulations far overreach the original intention of combating inversions and earnings stripping activities — noting that the regulations would affect global cash management strategies, repatriation efforts, non-double taxation, and legal entity restructuring among other ordinary business practices.
She called for the withdrawal of the regulations and, in the absence of a withdrawal, greater targeting of true earnings stripping activities and a delay of implementation of the rules until 2019.
Harris called for the consideration of a short-term safe harbor for ordinary business transactions that would take into account all internal treasury functions and business rationale considerations.
Like Greenwald and other speakers, she also called for a foreign-to-foreign company exemption, the elimination of the 30-day documentation requirement in favor of an annual requirement, and an equity compensation exception. In addition, Harris called for expanded earnings and profit exception period of 3 years at a minimum.
Joseph Judkins, Baker McKenzie:
Judkins argued that section 385 does not give the IRS the authority to automatically reclassify debt as equity. He argued that the retroactive effect of the regulations is contrary to the Administrative Procedures Act, and that section 385(b) limits the authority of the Administration because it must set forth specific analytical factors in determining whether to classify a transaction as debt or equity. As a result, reg. section 1.385-2 does not conform to section 385(b).
He pointed to previous legislation where Congress specified when to classify debt as equity or specified the circumstances under which debt could be classified as equity as evidence that section 385 does not give the IRS the power to make such distinctions.
In addition, he noted that Treasury has previously asked Congress for statutory authority to take the position they are currently taking, showing that it is essentially shifting its position irrespective of whether or not they believe they have the authority to do so.
Joshua Odintz, Baker McKenzie:
Odintz echoed the sentiments of the other speakers in calling for the reductions of the 72-month period to 24 months and the elimination of the 30-day documentation requirements.
With regards to the documentation requirements, he noted that “the penalty should not substantially outweigh the crime,” indicating that the punishments for failing to meet the requirements of the 30-day documentation standard are far too great.
In addition, he highlighted that the proposed regulations would raise numerous treaty issues as a result of the way that different countries characterize withholding taxes vs. debt. Furthermore, he noted that under OECD guidance, transactions are to be characterized under a multi-factor analysis. Currently, the proposed regulations do not follow such guidance.
Rocco Femia, United States Council for International Business (USCIB) & Miller Chevalier:
Femia argued that section 385 does not grant the IRS authority to undertake the proposed regulations and expressed his support for the delay of the implementation date until 2019. He pointed out that, under the current earnings and profit exception in the proposed regulations, related businesses that engage in the same economic activity may end up being treated differently.
Femia called the current proposed regulation’s current earnings and profit exception “arbitrary” and “distortive,” noting that it would only encourage more tax-based activities as opposed to business-based activities.
David Koenig, Retail Industry Leaders Association (RILA):
Koenig expressed concerns about the effective date of the final regulations and argued that the sec. 1.385-2 documentation requirements would be “challenging, if not impossible,” to implement. He requested that the requirements be prospective only and applicable only to debt issued after the release of the final regulations.
Like other speakers, he called for a de minimis exception, an ordinary course of business exception, the elimination of the 30-day requirement in favor of a once-a-year filing coinciding with the yearly tax filing, and the shortening of 72-month funding rule period to a 24-month period.
Pam Olson, PricewaterhouseCoopers, LLP:
Olson highlighted the economic toll that the proposed regulations would impose on businesses. She noted that the actual reach of the proposed regulations goes far beyond the original stated purpose, imposing collateral consequences that will have a “disproportionate impact” on companies.
As an example of the proposed regulation’s overreach, she noted that there were only 57 inverted companies that would be subject to the rules, while thousands of domestic companies and foreign affiliates who do not engage in earnings stripping would fall under the purview of the regulations. Furthermore, she argued that the proposed regulations do not actually limit interest deductions, only the use of debt.
As a result, ordinary business transactions that are utilized for non-tax reasons will be drawn into the regulatory regime and will affect businesses’ ability to utilize internal liquidity. In addition, Olson argued the administrative costs imposed on businesses will far exceed the estimated costs stating that the total dollar amount is a “staggering figure” when extrapolated to the thousands of companies that will be subject to the new requirements under the proposed regulations.
Like other speakers, Olson called for broad exceptions for ordinary business transactions, noting that the narrower the exception, the more detrimental to productive business practices. She also backed an exemption for foreign-to-foreign transactions, changing the effective date to 2019, and making the rules purely prospective.
Rachel Alexander, Organization for International Investment (OFII):
Alexander focused on the economic impact that the regulations would have on foreign direct investment in the United States. She stressed the need for the Treasury and IRS to undertake a more thorough evaluation of the consequences of the regulations and questioned whether they consulted with the Department of Commerce before writing the proposed regulations as they may not work alongside the initiatives the Department of Commerce is pursuing.
Alexander argued that the regulations will increase the cost of financing, create a disincentive for US companies to reinvest domestically, and will hinder non-tax related transactions. Alexander highlighted some of the analysis that OFII conducted with the Business Roundtable on the economic impact that the proposed regulations would have.
The analysis found that the proposed regulations would create an increase in capital costs, resulting in a reduction in foreign direct investment. Furthermore, she pointed out that the proposed regulations would likely lead to the loss of certain treaty benefits that will further increase financing costs.
Richard Coffman, Institute of International Bankers (IIB):
Coffman noted that foreign banking organizations (FBOs) are different from other taxpayers as a key function of banks and securities firms is to act as financial intermediaries. For FBOs, the most stable and low-cost funding source is the home-country parent organization. Furthermore, the ability to deploy excess liquidity is highly important for FBOs so that they can meet the needs of clients and customers.
Coffman said FBOs are subject to intensive regulatory rules that require them to hold certain amounts of debt and capital. They are subject to these requirements on a home-country basis and a host country basis. In the United States, FBOs are required to establish an intermediate holding company (IHC) in order to hold their US branch operations. Under the Fed’s recently proposed regulations implementing the “total loss absorbing capacity” requirements, the IHCs of global systemically important banks are required to issue long-term debt to the foreign parent institution. This debt is required to have a mandatory bail-in feature. Because there is no assurance that banks are allowed to issue dividends on an annual basis and the strict regulatory environment under which banks function, the IHCs are more likely to have to engage in “earnings stuffing” as opposed to earnings stripping, he said.
Coffman noted that if an IHC makes a distribution in excess of its current year’s earnings and profits, the excess distribution would be characterized as equity. The resulting intergroup repos and borrowings in the amount of the excess distribution would result in any repayment of the debt being characterized as a dividend and, in certain instances, subject to withholding.
In addition, the interest expense on the re-characterized debt would be disallowed, possibly rendering the transaction unprofitable on an after-tax basis. Furthermore, he argued that various intercompany borrowings would have to be traced in chronological order, given the hundreds and possibly thousands of transactions, this could end up being an impossibly complex task.
Finally, he noted that the principal and interest on the re-characterized debt would be treated as a distribution, resulting in other inter-group loans made to a US member of the group within the 72-month period also being re-characterized, creating a cascading effect.
In addition, Coffman pointed out that certain debt required to be retained by the Fed may be re-characterized as equity under the proposed regulations. Coffman called for exceptions for specific categories of loans and entities; ordinary course of business transactions that do not carry earnings stripping concerns; ordinary business loans involving securities, derivatives, and commodities; a safe harbor for transactions required by financial regulators; and clarification that the section 385 regulations will have no impact on the interest allocation rules or tax treaties.
Michael Lucki, Association of General Contractors:
Lucki voiced the same concerns raised by the other speakers. He called for the shortening of the funding rule period from 72 months to 24 months and advocated for a $50 million threshold exemption for loans.
Furthermore he called for an exemption for solely domestic corporations and S-corporations, noting that if intercompany debt issued by an S-corporation is reclassified as equity, then it may create a whole new securities class that may force the S-corporation to lose its status.
Samuel Thompson, Penn State Law School:
Professor Thompson was the only speaker that advocated for the regulations — and he pushed Treasury and IRS to make the regulations even stricter. He argued that there is clear authority for the Treasury and IRS to promulgate the regulations under section 385 and advocated for the elimination of the current earnings and profits exception.
He stated that he does “not understand rationale for the current E&P exception. While the exception may not be significant in any one year, the cumulative effect of taking advantage of the exception could be significant.”
Additionally, he argued that the documentation requirements were not overly burdensome, but are “simply insisting on good corporate practice.” He also called for the documentation requirements to extend to all corporations (public or private) with over $100 million in revenues.
He did, however, agree that exceptions should be made for certain cash pooling arrangements and the ordinary business operations of certain financial institutions. Professor Thompson also argued that many of the commentators are vastly overestimating the administrative burden that the proposed regulations would impose.
Dorothy Coleman, National Association of Manufacturers (NAM):
Coleman noted that 2/3 of the businesses polled in NAM would have their ordinary functions altered as a result of the regulations, while 60% would have to rely on 3rd party debt issuances.
As a result, financing costs would increase for these businesses especially because global manufacturers often rely on cash pooling or internal loans to fund investment. She called for an exemption for intercompany short-term loans and call pooling loans used to finance operating costs.
She noted that the current proposed regulations classify as equity the amount of debt issued in excess of current earnings and profits when it is deemed that debt is issued to fund an acquisition or distribution.
She argued that, “since there is little conceptual difference between current and accumulated E&P, not permitting the distribution of accumulated earnings is an unwarranted burden on business motivated decisions, including mitigating currency risk, managing cash needs and projections, minimizing risk factors, and managing leverage.” She asked that Treasury include accumulated E&P to determine exempt distributions.
Coleman also reiterated that S-corps are especially in danger under the current regulations as the characterization of debt into equity may create a new class of stock that could force companies to lose their S-corporation status.
In addition, Coleman advocated for the replacement of the 30-day documentation requirement with a once-a-year requirement and noted that the regulations have already had an adverse impact on the economy as 80% of businesses in NAM have had to put investments or repatriations on hold because of the uncertainty that proposed regulations create.
– Sam Olchyk is a partner with Venable LLP, Washington, where he focuses on tax and retirement policy and tax controversy matters. Before joining Venable, he served as a tax counsel with the Senate Finance Committee, and later as a legislation counsel with the Joint Committee on Taxation. He can be reached at [email protected].
– Arthur Norman, a Legislative Policy Analyst at Venable LLP, Washington, focuses on tax and financial services policy. He can be reached at [email protected].
Be the first to comment