When the U.S. Treasury Department issued proposed debt/equity regulations on April 4, 2016 (the Proposed 385 Regulations), the impact of these rules sent shockwaves through the U.S. tax community. As taxpayers began to appreciate the invasive reach and disruptive effects of these proposals, the calls for major changes to (and even for withdrawal of) the regulatory package from taxpayers became more piercing. While virtually no subgroup of taxpayers is immune to the effects of these new rules, Canadian corporations, with their deeply-intertwined economic, operational and legal ties to the U.S. economy, are particularly vulnerable. When the proposed regulations were released, the Treasury set a July 7 deadline for public comments and held a public hearing in Washington on July 14 to discuss the new rules. Now that a massive body of taxpayer comments are in, it is appropriate to take stock of how the large body of taxpayer comments may affect the future direction of this proposal.
We anticipate that a final regulatory package will be released by the end of fall. While we expect the final rules will contain many of the principal elements of the proposal, we do anticipate meaningful modifications, as discussed below. In advance of this, we believe that Canadian companies with cross-border activities should not necessarily freeze cross-border financings (or refinancings) but should take measured action now to design controls that will coordinate tax and treasury functions and thereby help prevent costly problems under these regulations.
Although, announced as part of the Obama administration’s crackdown on U.S. corporate inversions, the U.S. Treasury’s proposed related-party debt rules could apply in circumstances that have nothing to do with U.S. corporate inversions or expatriation. The proposed regulations apply to related-party debt regardless of whether the parties are domestic or foreign, but generally do not apply to transactions among members of a U.S. consolidated group. These regulations authorize the IRS to treat certain related-party debt instruments as part-debt and part-equity for U.S. federal tax purposes (the Bifurcation Rule). The proposed regulations also establish documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for U.S. federal tax purposes (the Documentation Rule). Finally, the proposed Treasury regulations treat related-party debt as equity for all federal income tax purposes if the debt is (i) issued in a distribution on stock held by a related corporate shareholder, (ii) issued in exchange for stock of an affiliated group member, or (iii) issued in an asset reorganization between members of the same affiliated group (the General Rule). More broadly, the Treasury’s new rules irrebuttably presume that related-party debt instruments are equity per se if a corporation engages in one of the three transactions described in the preceding sentence during the six-year period beginning three years before and ending three years after the debt instrument is issued, or is deemed to be issued (the Funding Rule together with the General Rule, constitutes the Per Se Stock Rules). As currently proposed, the Per Se Stock Rules would apply to debt issued or reissued on or after April 4, 2016, while the Bifurcation and Documentation Rules would apply prospectively after final regulations are promulgated.
The recharacterization of debt as equity pursuant to these regulations can have a devastating effect on cross-border tax planning. For a description of these rules and their possible effects, see our U.S. Tax Update, dated April 6.
The Public Comments
The public comments and submissions related to the Proposed 385 Regulations were remarkably diverse in their perspective and tone. The comments ranged from unabashed calls for the full withdrawal of the proposed package to full-throated endorsement of the virtues of the proposals. In between, there were gradations of thoughtful and insightful comments about how the proposals could be made more workable, more targeted and ultimately more effective at combatting the core concern: earnings stripping. While no clear consensus or unifying principle can be extracted from these comments, certain broad themes are beginning to emerge, which, together, may provide insight on where this all is heading.
The Treasury Department Speaks
At the recent NYSBA Tax Section Summer meeting in New Paltz, N.Y., Robert Stack, Treasury Deputy Assistant Secretary, International Tax Affairs, had the opportunity to address some of these emerging themes. At the outset, Mr. Stack recognized that section 385 (and, by extension, the regulations issued under section 385) represents a blunt instrument for addressing concerns about the earnings stripping that is eroding the U.S. tax base. Rather than a surgical scalpel that can excise a taxpayer’s excessive interest deductions but leave the rest of that taxpayer’s planning intact, Treasury views section 385 as a binary tool that allows the IRS to recharacterize a debt instrument, in whole or in part, as equity—with all the collateral effects and repercussions that flow from such a recharacterization. So, given the inability of the U.S. Congress to act and the escalating pressure to address base erosion, Mr. Stack observed that Treasury had to operate with the tools it had (section 385), no matter their imperfections.
Reflecting on the nearly two-foot high pile of written comments submitted by taxpayers regarding the Proposed 385 Regulations, Mr. Stack observed that the comments generally fall into four different “buckets:”
- Cash pooling and short-term loans: The first bucket of comments relates to cash-pooling and short-term debt instruments between members of multinational groups. These comments focused on the perceived imbalance between the limited potential earnings-stripping mischief these arrangements create and the harsh, cascading impact these rules can have in this space. There appears to be sympathy among Treasury and IRS officials regarding the pernicious effects that these rules can have and recognition that some form of remedial action is merited. Accordingly, we anticipate that Treasury will include a meaningful relaxation of the 385 regulations in this area, although the mechanical parameters of this relaxation (for example, where to draw the line between short-term and longer-term loans) will be difficult to implement.
- Banks and regulated industries: A second bucket of comments attacked the implicit premise of much of the section 385 regulations that multinational groups have unconstrained tax-planning latitude to engineer intercompany debt levels to optimize U.S. earnings-stripping results. Whatever the merits of this premise in other industries, banks and other financial institutions are forcefully arguing that this is not representative of the environment in which they operate. They note that the highly-regulated nature of their industry, with rigorous capital maintenance requirements imposed by multiple jurisdictions, dramatically constrains their ability to freely create intercompany debt relationships for tax-planning purposes. Quite the contrary, their ability to comply with capital requirements frequently requires them to engage in a high volume of short-term capital allocations among legal entities in cash movements that typically would be treated as debt for U.S. tax purposes. If all these intercompany debt relationships were subjected to the full rigor of the Proposed 385 Regulations, these submissions assert, it would wreak havoc on their industry. These arguments are compelling and we anticipate that Treasury will be under significant pressure to create a robust exception in the final 385 regulations to accommodate the banking and financial industry. There are several alternative suggestions about how this exception might be implemented but, so far at least, no simple, straightforward solution that is likely to be acceptable to both Treasury and the industry.
- Foreign-to-foreign scenarios. As currently drafted, the Proposed 385 Regulations have no geographical limitation to their scope. In other words, the U.S. tax recharacterization of debt into equity that is affected by these rules may be visited upon intercompany debt transactions among entirely foreign entities, with no discernable U.S. tax impact flowing from that recharacterization. A third bucket of comments addressed the excessively broad impact this scope may have, highlighting that such a broad scope will create undue compliance costs and burdens, create traps for the unwary, and produce unintended results, all for no clear policy purpose. The Treasury Department appears to recognize that the extraterritorial effect of these rules may be deleterious and has indicated that it will consider these scenarios. It’s not clear what limits, if any, may be imposed to restrain the geographic scope of these rules, but due to the variety of factors that must be balanced, we do not anticipate significant alterations in this area if the regulations are finalized.
- Flow-throughs. A fourth bucket of comments addressed the potential interplay between the Proposed 385 Regulations and pass-through entities, such as partnerships, LLCs, and S-corporations. As currently drafted, the debt/equity regulations are primarily focused on inter-corporate debt. Many of these comments focus on the risk of unintended consequences and unnecessary damage in contexts where there is little risk of erosion to the U.S. tax base.
While Mr. Stack cautioned that his remarks should not be too finely parsed and did not “predict an outcome,” they did shed light on the thinking that’s driving Treasury’s response to the public comments. In particular, we feel that the following observations are particularly noteworthy:
- Timetable for finalization unclear: Although there were early indications that Treasury intended to finalize the Proposed 385 Regulations by the end of summer, the torrent of incisive comments appears to have slowed the process down somewhat. Mr. Stack emphasized that “we are not wedded to a particular timeline. And we won’t produce a product until we’re satisfied that it’s a quality product that has taken into account the various comments that we’ve gotten.” While this careful, deliberative approach is admirable, it also seems clear that the political calendar will impose its own pressures, with enactment more difficult after the U.S. presidential election on November 8.
- Irrebuttable presumptions here to stay? Statements made by the IRS and Treasury Department officials suggest that resource constraints at the IRS are affecting the way regulations are drafted. In particular, policymakers are opting for administratively efficient bright-line presumptions rather than more subjective principal purpose tests, which demand greater human resources to enforce. Mr. Stack noted that, “as a policymaker, I personally have come down on black and white, mechanical rules because we really don’t have the people to sit in front of your companies and do the job we need to do to talk through things like ‘what was the principal purpose’…” Given this background, we do not expect Treasury to jettison the irrebuttable presumption design feature for the Funding Rule (probably the most polarizing feature of the Proposed 385 Regulations) in favour of a more flexible principal purpose test. At best, we believe that Treasury may reduce the 72-month presumption period to something closer to 48 months.
- A new superfactor? One way of thinking about how the Proposed 385 Regulations work is to regard them as creating debt-equity “superfactors,” which, if present, mandatorily result in a debt instrument being recharacterized as equity. More particularly, the superfactor triggers contained in the Per Se Stock Rules are (1) a high degree of “relatedness” between the debtor and creditor, and (2) no new capital investment in the purported debtor. One of the chief complaints of the Proposed 385 Regulations is that their sprawling scope may frequently result in these rules inflicting tax damage that is disproportionate and more excessive than needed to address the underlying earnings stripping concern. An emerging alternative for more closely tethering the Proposed 385 Regulations to their earnings-stripping purpose is to introduce a new superfactor which would activate a mandatory presumption that debt is to be treated as equity only in cases where a given financial ratio is exceeded. For example, there is some support for the view that the irrebuttable presumption in the Funding Rule should apply only where the purported debt instrument would cause the U.S. borrower’s debt-to-equity ratio to exceed the overall debt-to-equity ratio of the affiliated group of which the U.S. borrower is a member. Such a development would adopt some of the basic anti-earnings stripping mechanisms that have been introduced as part of the OECD BEPS project, Action Item 4. To date, there has been reluctance by policymakers to introduce a debt-to-equity ratio as an explicit 385 factor because doing so would cause the Proposed 385 Regulations to closely resemble a current budgetary proposal put forward by the Obama administration to amend section 163(j) of the Code. This gives rise to a concern that Treasury could be viewed as enacting, by executive action, rules that are potentially regarded as more properly within the purview of Congress. Despite these concerns, there appears to be renewed interest in pursuing a debt-to-equity ratio superfactor in the Proposed 385 Regulation as a means of more accurately scoping these rules. We believe adopting such a factor would be very helpful in sharpening the focus of the rules and reducing their potential for unwarranted collateral damage and, accordingly, hope that Treasury will take steps to implement this.
Putting it all together and looking forward
While it is impossible to predict what the final section 385 regulations will look like based on the public comments and the reaction of government officials to those remarks, we do believe that the trajectory of these rules are changing. Based on the observations summarized above, we believe it is reasonable to anticipate some or all of the following:
- Final section 385 regulations won’t be released until the fall
- Final regulations will contain relaxation for (i) cash pooling and short-term loans and (ii) banks and other heavily-regulated institutions
- Final section 385 regulations will continue to include a Funding Rule that features an irrebuttable presumption mechanism, although the period of mandatory presumption may be reduced from 72 months to something closer to 48 months.
- Introduction of a new super-factor which would require recharacterization only in cases where a purported debt instrument would cause a prescribed debt-equity (or similar financial) ratio to be exceeded.
In light of the uncertainty, many Canadian companies with significant U.S. operations are wondering how, if at all, Proposed 385 Regulations could affect their cross-border financing and refinancing activity today. While every case is different, we do not believe the 385 proposals are sufficiently developed to affirmatively impact a decision to engage in most cross-border financings or the manner in which those financings are implemented. It seems clear, however, that Treasury will make a good faith effort to implement a 385 regulatory package that contains many of the main elements of the proposed regulations by the end of the year. In light of this, we believe it is important for Canadian multinationals to focus on designing internal systems or firewalls that will work to prevent their organization from inadvertently engaging in the types of transactions that could cause the Funding Rule to come cascading down on them. In particular, these internal systems should focus on linking and coordinating decision making between the tax and treasury functions of the company. The precise design and effectiveness of these internal controls will be different for each company and depend on each organization’s internal dynamics and operational demands for cross-border capital flows. In any case, the point is that we believe Canadian multinationals should be taking reasonable, proactive steps now, rather than doing so only after the pressure of final regulations is being felt.