Comments on proposed regulations issued under Section 385 of the Internal Revenue Code of 1986, as Amended

Transcription

1 Comments on proposed regulations issued under Section 385 of the Internal Revenue Code of 1986, as Amended Copyright 2016 Deloitte Development LLC. All rights reserved. 1

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3 Proposed Regulations are effective generally for interests issued after the Proposed Regulations are published in final form (the Final Regulations ) although, as discussed herein, can cause interests issued or deemed issued after April 4, 2016 to be recharacterized as equity if Final Regulations are published. The comments set forth in this letter (the Comment Letter ) are organized into four sections. Part I summarizes our primary recommendations. Part II describes the legislative, administrative, and precedential background related to the characterization of related-party interests as equity. Part III summarizes the Proposed Regulations and recommends significant revisions to address numerous technical issues if Treasury and the IRS decide to issue Final Regulations in substantially the same form as the Proposed Regulations. Part IV respectfully submits, on the basis of several policy concerns, that the Proposed Regulations should be withdrawn and that Treasury and the IRS should reissue a revised set of proposed regulations with a prospective effective date that addresses the issues raised in the comments that Treasury and the IRS receive in response to the Proposed Regulations. I. Primary Recommendations The Proposed Regulations should be withdrawn in order that Treasury and the IRS can devote sufficient time and resources to evaluate both the technical issues resulting from the Proposed Regulations and the operational impact of the proposals on taxpayers. Given the scope of the issues arising from the Proposed Regulations which we address in this Comment letter, any future rules should be drafted in a more targeted manner and applied prospectively with an effective date that allows taxpayers sufficient time to implement the rules. In general, and as described in greater detail in this Comment Letter, these primary recommendations are based on the following considerations: The Proposed Regulations, as currently drafted, require significant revisions to address the technical issues described in the Comment Letter and, if finalized incorporating substantial modifications, would not have the benefit of development through a public comment process; The Proposed Regulations raise serious practical concerns with respect to the ability of taxpayers to timely design, test, and implement new, crossfunctional systems and procedures necessary to comply with the rules; The Debt Recast Rules (as defined below) are inconsistent with the operation of section 163(j) and the statutory rules pertaining to foreign personal holding company income ( FPHCI ) under subpart F of the Code (i.e., sections ), which together address the policy concerns underlying the Proposed Regulations; The Debt Recast Rules would significantly change the U.S. federal income tax consequences of a broad range of routine business transactions, in some instances with pervasive and adverse collateral effects; and 2

4 Although Treasury regulations are accorded deference in appropriate situations, we believe that the Debt Recast Rules are inconsistent with section 385(b) and raise a significant question regarding the validity of the Debt Recast Rules in any final regulations. II. Background: Section 385 and the Proposed Regulations A. Section 385: Statutory Language and Legislative History Section 385(a) authorizes Treasury to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness). Section 385(b) provides: (b) Factors. The regulations prescribed under this section 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. The factors so set forth in the regulations may include among other factors: (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, and to pay a fixed rate of interest, (2) whether there is subordination to or preference over any indebtedness of the corporation, (3) the ratio of debt to equity of the corporation, (4) whether there is convertibility into the stock of the corporation, and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question. Congress enacted section 385 as part of the Tax Reform Act of In describing the Congressional grant of authority set forth in section 385, the Senate Finance Committee explained, in part, that: [Section 385] gives the Secretary of the Treasury or his delegate specific statutory authority to promulgate regulatory guidelines, to the extent necessary or appropriate, for determining whether a corporate 4 Tax Reform Act of 1969, Pub. L. No , 411(a) (amended 1989 and 1992). 3

5 obligation constitutes stock or indebtedness. The provision specifies that these guidelines are to set forth factors to be taken into account in determining, with respect to a particular factual situation, whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists. The provision also specifies certain factors which may be taken into account in these guidelines. It is not intended that only these factors be included in the guidelines or that, with respect to any particular situation, any of these factors must be included in the guidelines, or that any of the factors which are included by statute must necessarily be given any more weight than other factors added by regulations.... [T]he Secretary of the Treasury is not to be bound or limited by the specific rules [under section 279] which the committee amendments and the House bill provide for distinguishing debt from equity in the corporate acquisition context. Thus, an obligation the interest on which is disallowed under [section 279] nevertheless might be found to constitute equity (and hence the interest disallowed) under the general debt-equity regulatory guidelines. 5 Since enactment, Congress amended section 385 on two later occasions. Congress amended section 385 in 1989 to add the parenthetical (or as in part stock and in part indebtedness) to section 385(a). 6 In addition, Congress added subsection (c), which generally provides that the holders of an interest in a corporation must follow the issuer s treatment of the interest as stock or debt, unless the holder discloses its inconsistent treatment in a federal tax return. 7 B. Prior Treasury Regulations under Section 385 There are no Treasury regulations currently in force under section 385. On March 24, 1980, Treasury published proposed regulations under section 385, which were subsequently revised, finalized, and withdrawn prior to becoming effective (the 1980 Final Regulations ). 8 Treasury subsequently published new proposed regulations on 5 S. Rep. No , at (1969). 6 Omnibus Budget Reconciliation Act of 1989, Pub. L. No , 7208(a)(1) (2). 7 Energy Policy Act of 1992, Pub. L. No , 1936(a). 8 Prior Prop. Treas. Reg to -12, 45 Fed. Reg (Mar. 24, 1980); T.D (Dec. 29, 1980), C.B. 141, as modified by T.D (Apr. 29, 1981), C.B. 4

6 January 5, 1982, which were withdrawn on July 6, 1983 (the 1982 Proposed Regulations ). 9 In general, the 1980 Final Regulations and 1982 Proposed Regulations set forth factors to be taken into account in determining whether an interest in a corporation should be treated as debt or equity. C. Case Law and Administrative Guidance on Characterizing Related-Party Debt In the absence of statutory and regulatory guidance, courts have considered a variety of factors in characterizing an interest as debt or equity. 10 In general, courts apply a facts and circumstances test to distinguish debt from equity, and most courts have indicated that no one factor is controlling in this analysis. 11 Certain factors may be weighted more heavily, however, depending on the particular set of circumstances. 12 The IRS has also published guidance listing several non-exclusive 168, T.D (Dec. 30, 1981), C.B. 60, and T.D (June 29, 1982), C.B. 84, and withdrawn by T.D (Nov. 2, 1983), C.B Prior Prop. Treas. Regs to -10, 47 Fed. Reg. 163, 164 (Jan. 5, 1982); 48 Fed. Reg (July 6, 1983). 10 See, e.g., John Kelley Co. v. Comm r, 326 U.S. 521, 526 (1946) (holding that certain indicia of debt including (i) sales of debentures; (ii) exchanges of preferred stock for debentures; (iii) a promise to pay a certain annual amount, if earned; (iv) a priority for the debentures over common stock; (v) that the debentures were assignable without regard to any transfer of stock; and (vi) a definite maturity date in the reasonable future supported debt treatment); Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972) (considering the following factors: (i) the names given to the certificates evidencing the debt; (ii) the presence or absence of a fixed maturity date; (iii) the source of payments; (iv) the right to enforce payment of principal and interest; (v) participation in management; (vi) the status of the contribution in relation to regular corporate creditors; (vii) the intent of the parties; (viii) thin or adequate capitalization; (ix) identity of interest between creditor and stockholder; (x) source of interest payments; (xi) the ability of the corporation to obtain loans from outside lending institutions; (xii) the extent to which the advance was used to acquire capital assets; and (xiii) the failure of the debtor to repay on the due date or to seek a postponement); Fin Hay Realty Co. v. Comm r, 398 F.2d 694, 695 (3d Cir. 1968) (identifying the following factors: (i) the intent of the parties; (ii) the identity between creditors and shareholders; (iii) the extent of participation in management by the holder of the instrument; (iv) the ability of the corporation to obtain funds from outside sources; (v) the thinness of the capital structure in relation to debt; (vi) the risk involved; (vii) the formal indicia of the arrangement; (viii) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (ix) the voting power of the holder of the instrument; (x) the provision of a fixed rate of interest; (xi) a contingency on the obligation to repay; (xii) the source of the interest payments; (xiii) the presence or absence of a fixed maturity date; (xiv) a provision for redemption by the corporation; (xv) a provision for redemption at the option of the holder; and (xvi) the timing of the advance with reference to the organization of the corporation). 11 See, e.g., John Kelly Co., 326 U.S. at 530; Fin Hay Realty Co., 398 F.2d at See, e.g., Slappey Drive Indus. Park v. United States, 561 F.2d 572, 581 (5th Cir. 1977) ( Each case turns on its own facts; differing circumstances may bring different factors to the 5

7 factors consistent with the judicial formulation of the debt-equity standard. 13 In setting forth factors, case law and administrative guidance generally focus on (i) the terms of the interest and the legal rights and obligations of the parties; (ii) the capacity of the borrower to meet its payment obligations under the interest; and (iii) the parties intent and actions related to maintaining a debtor-creditor relationship. 14 These general considerations and the associated factors do not include the specific transaction in which the interest is issued or the transactional history of the issuer in relation to the interest. As described in greater detail in Part IV, the Proposed Regulations treatment of an interest as equity solely on the basis of such transactional identity or history represents a stark departure from existing precedent. D. The Proposed Regulations: The Bifurcation Rule, the Documentation Rules, and the Debt Recast Rules On April 4, 2016, Treasury issued the Proposed Regulations which generally and as described in greater detail below: (i) implement the grant of authority under section 385(a) to treat certain related-party interests as in part stock and in part debt (the Bifurcation Rule ); 15 (ii) impose strict contemporaneous documentation requirements on certain related-party interests as a prerequisite to debt treatment (the Documentation Rules ); 16 and (iii) treat as stock certain related-party interests issued as part of, or in connection with, certain distribution and acquisition transactions (the Debt Recast Rules ). 17 The Bifurcation Rule, the Documentation Rules, and the Debt Recast Rules are referred to herein as the Operative Rules. In addition to the Operative Rules, the Proposed Regulations contain definitional rules as well as rules of general application. fore. ); Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969) ( The object of the inquiry is not to count factors, but to evaluate them. ). 13 Notice 94-47, C.B. 357 (analyzing (i) whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future; (ii) whether holders of the instruments possess the right to enforce the payment of principal and interest; (iii) whether the rights of the holders of the instruments are subordinate to the rights of general creditors; (iv) whether the instruments give the holders the right to participate in the management of the issuer; (v) whether the issuer is thinly capitalized; (vi) whether there is identity between the holders of the instruments and stockholders of the issuer; (vii) the label placed on the instruments by the parties; and (viii) whether the instruments are intended to be treated as debt or equity for non-tax purposes). 14 See, e.g., Mixon; Fin Hay Realty; Notice 94-47, C.B Prop. Treas. Reg (d). 16 Prop. Treas. Reg Prop. Treas. Reg The term Debt Recast Rules includes the rules set forth in Prop. Treas. Reg and also Prop. Treas. Reg , as appropriate. 6

8 III. The Proposed Regulations: Summary and Recommendations The following discussion summarizes the Proposed Regulations and recommends significant revisions to address numerous technical issues raised by the Proposed Regulations. Our recommendations concerning the technical aspects of the various sections of the Proposed Regulations are provided in an effort to provide detailed comments and are not intended to be inconsistent with our broader concerns with the Proposed Regulations, which are described in Part IV. Specifically, we believe that significant issues exist related to the authority of Treasury and the IRS to prescribe the Proposed Regulations under section 385(a), the coordination of the Proposed Regulations with certain Code provisions, and the implementation burden and collateral consequences that would result if the Proposed Regulations were finalized. A. Definitions and Generally Applicable Rules 1. Relatedness and the Expanded Group The Proposed Regulations generally apply to debt instruments issued between related parties. Although these rules generally treat members of an expanded group (or EG ) as related parties, each of the Operative Rules modifies the scope of an EG in different ways, such that the separate rules each use a different concept of a related party. The term expanded group is defined by reference to an affiliated group as described in section 1504(a), modified in the following manner: To include any corporation excluded under sections 1504(b)(1) to (8); 18 To permit ownership by the common parent (but not, explicitly, by any other member of the expanded group) to include stock held indirectly for purposes of the stock ownership requirements in section 1504(a)(1); 19 and To include a corporation in the EG under the stock ownership requirements by reference to 80 percent of the vote or 80 percent of the value of that corporation s stock Prop. Treas. Reg (b)(3)(i)(A). Members of an EG would therefore include, e.g., foreign corporations and corporations described in section 1361(a) (individually, an S Corporation ). 19 Prop. Treas. Reg (b)(3)(i)(B). 20 Prop. Treas. Reg (b)(3)(i)(C). 7

9 In testing indirect ownership, stock is treated as owned indirectly if it is owned through application of the attribution rules under section 318, as modified by section 304(c)(3). 21 Under the Documentation Rules, a related party includes any member of the issuer s EG as well as any controlled partnership. 22 A controlled partnership is any partnership with respect to which at least 80 percent of the profits or capital interest is owned directly or indirectly by EG members. 23 Indirect ownership of a partnership interest is determined by applying the principles of section 304(c)(3). 24 Under the Debt Recast Rules, a related party includes any member of the issuer s EG, with a controlled partnership treated as an aggregate of its partners. 25 Solely for purposes of the Bifurcation Rule, a related party generally includes any member of the issuer s modified expanded group (or MEG ). The MEG concept is based on the EG definition but lowers the stock ownership threshold to 50 percent from 80 percent. 26 The MEG also includes any modified controlled partnership, which is any partnership with respect to which at least 50 percent of the profits or capital interest is owned directly or indirectly by MEG members. 27 Finally, the MEG also includes any person that owns, under the rules of section 318, at least 50 percent of the value of the stock of a MEG member. 28 Comments and Recommendations: Recommendation 1: The Final Regulations should clarify the extent to which indirect ownership applies for purposes of an EG satisfying the stock ownership requirement in section 1504(a)(1)(B)(ii). 21 Prop. Treas. Reg (b)(3)(ii). The principal modifications to section 318 made by section 304(c)(3) include: (i) attributing stock to or from a corporation if a shareholder owns at least 5 percent of the corporation (rather than 50 percent), but (ii) in attributing stock from a shareholder to a corporation, only a proportionate amount of stock ownership is attributed to the corporation if the shareholder owns 5 percent or more but less than 50 percent of the corporation. See section 304(c)(3)(B). If the shareholder owns 50 percent or more, all of its stock ownership is attributed to the corporation. See section 318(a)(3)(C). 22 Prop. Treas. Reg (a)(4)(ii), (c)(6). 23 Prop. Treas. Reg (b)(1). 24 Prop. Treas. Reg (b)(1) (cross-referencing the principles of Prop. Treas. Reg (b)(3)(ii)). 25 Prop. Treas. Reg (b)(2) and (d)(5)(i). 26 Prop. Treas. Reg (b)(5) and (d)(2). 27 Prop. Treas. Reg (b)(4)-(5). For this purpose, indirect ownership of a partnership interest is determined by applying the principles of section 304(c)(3) (cross-referencing the principles of Prop. Treas. Reg (b)(3)(ii)). See Prop. Treas. Reg (b)(4). 28 Prop. Treas. Reg (b)(5). 8

10 In general, there are two conditions to membership in an affiliated group: (i) ownership of at least one corporation by the common parent (section 1504(a)(1)(B)(i)), and (ii) ownership of each corporation (other than the common parent) by one or more members of the affiliated group (section 1504(a)(1)(B)(ii)). Based on the literal language of the Proposed Regulations, indirect ownership is permitted only for (i), above, and not (ii). It is unclear if direct ownership under (ii) is intended to impose a limitation on EG membership if the common parent would, by itself, indirectly own sufficient stock for membership to otherwise be met. 29 Recommendation 2: The Final Regulations should clarify whether a debt instrument between an individual and a standalone corporation or a partnership and a standalone corporation is subject to the Operative Rules. 30 Under the Proposed Regulations, it appears that an EG or MEG requires at least two corporate members such that, e.g., an individual is not a member of a MEG with its wholly owned corporation, or, a partnership that has a standalone corporation as a partner is not a controlled partnership or modified controlled partnership for purposes of an EG or MEG, respectively. Recommendation 3: The Final Regulations should confirm that debt instruments issued between related individuals are not subject to the Bifurcation Rule. In a case where an individual owns a corporation which in turn wholly owns a subsidiary, the corporations form both an EG and a MEG. The individual owner is described as a member of the MEG, as would be related individuals treated as owning at least 50 percent of the stock of any MEG member under the attribution rules of section 318. Recommendation 4: The Final Regulations should limit attribution from partners to partnerships as described in section 318(a)(3)(A) so that it applies only if there is a significant interest held by the partner in the partnership. In determining an EG or MEG, the Proposed Regulations treat a partnership as holding stock held by a partner regardless of the partner s interest in the partnership. 29 For example, in a case where a person (whether a partnership, other entity, or individual) wholly owns two corporations, if one of those corporations is treated as the common parent, it would indirectly own all of the stock of the other corporation under the attribution rules (i.e., under section 318, as modified by section 304(c)(3)). However, no corporation arguably would directly own such stock if clause (ii) imposes a separate limitation for EG membership. The preamble to the Proposed Regulations (the Preamble ) and the examples in the Proposed Regulations intend that a corporation wholly owned by another corporation indirectly through a partnership be included in the same expanded group as the corporate partner. See Preamble at 20,912 ( Unlike an affiliated group, an expanded group includes foreign and taxexempt corporations, as well as corporations held indirectly, for example, through partnerships. ); Prop. Treas. Reg (g)(3), Ex A standalone corporation refers to a corporation where no other corporation is included as a member of the EG or MEG with the wholly-owned corporation. 9

11 Unlimited attribution from a partner to a partnership could result in an EG or MEG including entities that have little, if any, relationship with each other, and interests between such entities should be outside the purview of the Operative Rules. Partnerto-partnership attribution should be limited to situations where there is a significant interest held by the partner. 31 Recommendation 5: The Final Regulations should confirm that determining the status of a partnership as a controlled partnership or modified controlled partnership is a separate and independent inquiry from determining the status of a corporation as an EG member. In determining status as a controlled partnership or a modified controlled partnership, it appears that partnership interests should be attributed to and from entities under section 318(a) (as modified by section 304(c)) as if they were stock. For example, if a person owns all of the stock of a corporation, which in turn owns a partnership interest, that person is similarly treated as owning that partnership interest. 32 It is unclear, however, whether in applying the section 318(a) attribution rules to determine partnership interest ownership, such partnership interests are then treated as actually owned for the purpose of then applying the section 318(a) attribution rules to determine stock ownership. Recommendation 6: The Final Regulations should clarify that section 304(c)(3)(B) should apply to modify the ownership requirements in sections 318(a)(2)(C) and 318(a)(3)(C), but should not be extended to other sections of 318(a), e.g., section 318(a)(2)(A). As currently drafted, indirect ownership of a partnership interest is determined by applying the principles of section 304(c)(3), which could implicate the minimum ownership percentages in section 304(c)(3)(B). Recommendation 7: The Final Regulations should provide guidance on how proportionately should be determined for purposes of sections 318(a)(2)(A) and (3)(A). In general, attribution under section 318 is based on the value of stock owned. In a partnership context, the determination of value of a partner s interest may prove difficult. We believe that the Final Regulations should provide a safe harbor for purposes of determining proportionately. We believe that an appropriate safe harbor for value for these purposes is the liquidation value of a partner s interest. Recommendation 8: The Final Regulations should clarify whether preferred stock described in section 1504(a)(4) should be treated as stock (i) for purposes of the stock ownership thresholds when identifying a member of the EG or MEG and (ii) for 31 A threshold for significant may be defined as at least 50 percent by reference to capital or profits in the partnership for purposes of determining a MEG. 32 Prop. Treas. Reg (b)(1) and (4). 10

12 purposes of the attribution rules under section 318 (as modified by section 304(c)(3), where appropriate) to attribute stock to the shareholder of the preferred shares in determining a member of the EG or MEG. Recommendation 9: The Final Regulations should clarify the extent to which option attribution under section 318(a)(4) applies for purposes of identifying EG or MEG members. Clarification is necessary because Treas. Reg more specifically governs the treatment of options to acquire stock of a corporation when determining the ownership of stock in that corporation for purposes of the affiliation tests in section 1504(a)(2), and there appear to be competing sets of rules that could apply Debt Instruments within the Scope of the Proposed Regulations The Bifurcation Rule and Documentation Rules apply to an expanded group instrument (or EGI ). 34 The term EGI is generally defined to mean an applicable instrument where the issuer is a member of the EG or MEG, as appropriate, and the holder is another member of that group. 35 The term applicable instrument means any interest issued or deemed issued that is in form a debt instrument. 36 The Preamble explains that the Bifurcation Rule and Documentation Rules are tailored to arrangements that in form are traditional debt instruments and do not address other arrangements that may be treated as indebtedness under general federal tax principles. 37 Thus, an applicable instrument must constitute debt under general federal income tax principles and must be in the form of a debt instrument. The Debt Recast Rules apply to debt instruments where the issuer is one member of an EG and the holder is another member of that same group. 38 For this purpose, the term debt instrument means an interest that would, but for the application of 33 Treas. Reg is substantially narrower in scope (i.e., options generally are not treated as exercised) than the option attribution rule under section 318(a)(4) (i.e., options generally are treated as exercised). However, it is broader in scope in certain respects including the types of instruments that are potentially treated as options for purposes of Treas. Reg (e.g., stock appreciation rights) that may not be treated as options under section 318(a)(4). 34 Prop. Treas. Reg (d)(1) and -2(a)(1). 35 Prop. Treas. Reg (d)(2) and -2(a)(4)(ii). 36 Prop. Treas. Reg (a)(4)(i)(A). The rules regarding an interest that is not in form a debt instrument have been reserved in the Proposed Regulations. See Prop. Treas. Reg (a)(4)(i)(B). 37 Preamble at 20, Prop. Treas. Reg (a). 11

13 the Debt Recast Rules, be treated as a debt instrument as defined in section 1275(a) and Treas. Reg (d). 39 Each of the Operative Rules, if applied, would treat the interest as equity for federal tax purposes without any general limitation. Comments and Recommendations: Recommendation 10: The Final Regulations should exclude short-term, non-interest bearing payables from the definitions of an applicable instrument (i.e., for purposes of the Bifurcation Rule and Documentation Rules) and a debt instrument (i.e., for purposes of Debt Recast Rules). There would be no interest required to be accrued on such debt under section 482 or under the original issue discount provisions of the Code. As such, there is no possibility of earnings-stripping and the Final Regulations should properly exclude such interests. In addition, short-term debt instruments have limited potential for repatriating untaxed earnings. 40 If this recommendation is not adopted, the Final Regulations should adopt Recommendation 11. Recommendation 11: The Final Regulations should exclude non-interest bearing payables evidenced in any form, including but not limited to ledger or journal entries or by internal balance sheets, from the definition of an in form debt instrument. The Preamble states that the Documentation Rules are tailored to arrangements that in form are traditional debt instruments suggesting that an interest would constitute in form a debt instrument only if its characteristics are susceptible to being documented in accordance with the four requirements under the Documentation Rules. A non-interest bearing intercompany payable or receivable generally may not bear such characteristics. For example, this type of trade payable or receivable does not have stated interest, may not have a stated term, and may not have articulated creditor rights, each of which are elements of a traditional debt instrument. In this regard, and in certain contexts, U.S. federal income tax law distinguishes between a debt instrument and a payable Prop. Treas. Reg (f)(3). 40 See, e.g., Notice , C.B For example, section 988 distinguishes between (i) a debt instrument and (ii) trade payable or receivable (i.e., the accrual of an item of expense or gross income or receipts which is to be paid or received after the date on which so accrued or taken into account ). See section 988(c)(1)(B). For this purpose, the term debt instrument means a bond, debenture, note, or certificate or other evidence of debt. See section 988(c)(4). Under Treasury regulations issued under section 988, a payable relating to cost of goods sold, or a payable or receivable relating to a capital expenditure or receipt clearly does not fall within 12

14 Recommendation 12: The Final Regulations should clarify whether certain arrangements or instruments treated as debt instruments as a result of the application of Code provisions, Treasury regulations, or administrative guidance should be subject to the Operative Rules, including: (i) a real estate mortgage investment conduit regular interest (as defined in section 860B(a)), (ii) safe harbor debt of an S Corporation (as defined in section 1361(c)(5)), (iii) certain non-periodic payments made with respect to notional principal contracts (as defined under Treas. Reg T(g)(4)); and (iv) intercompany payables created by operation of Rev. Proc Recommendation 13: The Final Regulations should clarify the extent to which an interest treated, in whole or in part, as equity should be treated as such for all U.S. federal income tax purposes. In general, it may be questioned whether equity treatment is warranted beyond the U.S. federal income tax effects related to payments made on the interest, particularly where the interest otherwise would not be treated as equity under general tax principles. The Operative Rules do not limit the collateral effects of characterizing an interest as equity, however, and significant and often unanticipated consequences will extend far beyond, e.g., the denial of an interest deduction. 43 We do not believe that providing for equity treatment for all purposes will be appropriate in all situations since (i) numerous Code provisions and administrative authorities involve a determination of ownership of or control over an entity; (ii) each such provision or authority would be motivated by policies unrelated to those concerns underlying the Proposed Regulations; and (iii) the Proposed Regulations may treat interests as equity that bear no traditional hallmarks of equity and that have no bearing on ownership or control over an entity under any reasonable interpretation. 44 Recommendation 14: As a specific recommendation related to Recommendation 13, the Final Regulations should provide that an interest treated, in whole or in part, as equity under an Operative Rule is not treated as stock for purposes of the control requirement set forth in section 368(c) ( section 368(c) control ). 45 the definition of a debt instrument for purposes of section 988. See Treas. Reg (a)(2)(ii). 42 See sections 860B(a) and 1361(c)(5); Treas. Reg T(g)(4); and Rev. Proc , C.B See Part IV.C for a more detailed discussion of the effects of treatment of an interest as equity. 44 This concern is particularly acute when debt is treated, in whole or in part, as stock under the Debt Recast Rules. 45 The Final Regulations should also provide that an interest treated, in whole or in part, as equity under an Operative Rule is not treated as stock for purposes of determining whether there is a qualified stock purchase for purposes of section 338. See also note 47, supra. 13

15 Routine transactions that require satisfaction of a section 368(c) control requirement include exchanges under section 351 ( section 351 exchanges ), certain reorganizations described in section 368(a), and stock distributions described in section 355. Section 368(c) requires that a shareholder hold 80 percent of the voting power of all classes of voting stock in a corporation and 80 percent of each nonvoting class of stock. Because an interest recharacterized as equity may be a separate class of non-voting stock, a transaction otherwise qualifying as tax-free may become taxable solely because of the Proposed Regulations. More specifically, the Final Regulations should provide rules preventing the collateral effects of recast debt on section 368(c) control. We recommend that, for the reasons stated above, the Final Regulations consider the same limitation for the ownership and control requirements relevant to other Code provisions. 46 Recommendation 15: As a specific recommendation related to Recommendation 13, the Final Regulations should provide that an interest treated, in whole or in part, as equity is not fast pay stock described in Treas. Reg (l)-3 (the Fast Pay Regulations ). 47 Both the Proposed Regulations and the Fast Pay Regulations recast transactions. It is unclear why application of one recast rule the application of which results in intended tax consequences should trigger application of a second recast rule which would then result in different tax consequences. For example, if a recharacterized debt instrument or EGI is treated as fast pay stock, the deemed transactions at Treas. Reg (l)-3(c)(2) could cause iterative application of the Debt Recast Rules and Fast Pay Regulations. We believe that this treatment is inappropriate. Recommendation 16: As a specific recommendation related to Recommendation 13, the Final Regulations should clarify how the assumption of an interest treated, in whole or in part, as equity is treated for U.S. federal income tax purposes. There is a well-defined set of rules that account for the assumption of a liability. 48 There are no such comparable rules when a liability that is treated as equity is 46 The same argument for section 368(c) control can be made for ownership thresholds and control requirements for purposes of other Code provisions, e.g., section 1504(a)(2); section 267; section 1563, etc. In each such case, an interest otherwise treated as debt but for the Proposed Regulations would not be a type contemplated by Congress in codifying ownership thresholds and control requirements throughout the Code and should not be a type of equity interest relevant to the determination of stock ownership or control. 47 Similarly, the Final Regulations should clarify whether recasting an interest as equity and its subsequent repayment could result in the listed transaction described generally in Notice , C.B See, e.g., section 357(c), section 304(b)(3)(B), Treas. Reg (g). 14

16 assumed. Given the scope of the Proposed Regulations, we recommend that the Final Regulations address this technical question. Recommendation 17: As a specific recommendation related to Recommendation 13, the Final Regulations should provide that an interest treated, in whole or in part, as equity that is classified as preferred stock does not cause section 305(c) to apply to the extent of any discount resulting from the fact that an interest was issued with a stated interest rate equal to or in excess of the applicable federal rate (and, thus, in compliance with section 482) but less than a market rate for dividends on preferred stock. As a more general comment, the Final Regulations should clarify that the fair market value of any recharacterized instrument will not be adjusted on the basis of a below-market yield provided the yield would otherwise comply with section 482 if the interest were treated as debt. Recommendation 18: As a specific recommendation related to Recommendation 13, the Final Regulations should clarify that Rev. Rul does not toll the holding period of instruments treated as stock. Under Rev. Rul , a taxpayer s holding period of an instrument is tolled during the period in which the instrument affords the holder the rights of a creditor, provided that such instrument is not treated as stock for corporate law purposes but is so treated for federal income tax purposes. As a result of tolling, the holder may not qualify for tax benefits that require a specified holding period including a dividend received deduction and foreign tax credits. 50 We believe that this is an unintended consequence of the Proposed Regulations and the Final Regulations should clarify that this tolling does not apply. 3. Deemed Exchanges of Debt-for-Stock If a debt instrument or an EGI is deemed to be exchanged, in whole or in part, for stock under the Proposed Regulations, the holder is treated as having realized an amount equal to the holder s adjusted basis in that portion of the debt or EGI, and the issuer is treated as having retired that portion of the debt instrument or EGI for an amount equal to the instrument s adjusted issue price. 51 These mechanics have the general effect of preventing items of realized gain, loss, income, or deduction from being recognized in the deemed exchange. In addition, neither party accounts for any accrued but unpaid qualified stated interest on the debt instrument or EGI or any foreign exchange gain or loss with respect to that accrued but unpaid qualified C.B See sections 246(c), 901(k)-(l). 51 Prop. Treas. Reg (c). 15

17 stated interest. 52 However, the holder and issuer must recognize any other foreign exchange gain or loss under section Comments and Recommendations: Recommendation 19: The Final Regulations should clarify the extent to which accrued and unpaid original issue discount may not be deductible under section 163(l) upon the deemed receipt of stock in satisfaction of such accrued amounts in the deemed exchange. Recommendation 20: The Final Regulations should clarify whether the exchange gain on a deemed exchange is limited to total gain or loss realized on the transaction. Prop. Treas. Reg (c) states that the holder and issuer are required to recognize exchange gain or loss under Treas. Reg (b)(13) where the debt is deemed exchanged for stock of the obligor. In general, under Treas. Reg (b)(13), the issuer s and holder s exchange gain or loss is recognized only to the extent of the total gain or loss realized on the transaction. But for such a limitation, the exchange gain or loss, determined pursuant to Treas. Reg (b)(5) and (6), would be equal to the principal amount multiplied by the difference between the exchange rate at the time of issuance and the exchange rate at the time of the deemed exchange. The total gain or loss on the transaction would normally be the difference between the amount realized and the adjusted basis (which would include exchange gain or loss). Prop. Treas. Reg (c) first states that the holder is deemed to realize an amount equal to the holder s adjusted basis (i.e., there is no total gain or loss at all), but then states that the exchange gain or loss is treated as total gain or loss. These two statements appear inconsistent. If the Proposed Regulations assume that there is no total gain or loss on the transaction, it seems odd to then provide that exchange gain or loss is to be recognized. It appears that Treasury and the IRS intend to require the holder and the issuer to recognize only exchange gain or loss. Assuming that is the case, the government should modify this provision to make it clearer Treatment of Consolidated Groups: In General Under Prop. Treas. Reg (e), all members of an affiliated group filing a consolidated U.S. federal income tax return (a consolidated group ) are treated as one corporation for purposes of the Proposed Regulations (the One Corporation Rule ). 55 More specific rules in Prop. Treas. Reg implement the One 52 Id. 53 Id. 54 See generally Prillaman, Mou and Yuldasheva, Treasury Centers Presumed Guilty Under Proposed Debt-Equity Regs, Vol. 151 No. 11 Tax Notes 1537 (June 13, 2016). 55 Prop. Treas. Reg (e). 16

18 Corporation Rule when debt instruments are transferred into and out of a consolidated group. 56 Comments and Recommendations: Recommendation 21: The Final Regulations should expand the One Corporation Rule to treat all domestic corporations under common control as one corporation, regardless of whether such corporations elect to file a consolidated return, for purpose of applying the Debt Recast Rules. The One Corporation Rule of the Proposed Regulations is unnecessarily limited and fails to acknowledge that debt issued between two domestic corporations does not raise the concerns that led to the promulgation of the Proposed Regulations because income arising from debt issued by one domestic corporation to another domestic corporation will be fully subject to US taxation. In addition, a rule expanding the One Corporation Rule, as suggested above, would appropriately allow an affiliated group (without regard to section 1504(b)(2)) that includes one or more domestic insurance companies taxed under section 801, which the common parent has elected under section 1504(c)(2) too treat as includible corporations for purposes of applying section 1504(a), to be treated as One Corporation Rule. Finally, such an expanded exception would limit the issues arising for state tax purposes because many states do not apply consolidated return principles. B. The Bifurcation Rule: Prop. Treas. Reg (d) Under the Bifurcation Rule, the IRS may treat an EGI between members of a MEG as in part debt and in part equity to the extent that an analysis, as of the issuance of the EGI, of the relevant facts and circumstances concerning the EGI under general federal tax principles results in a determination that the EGI is properly treated as debt in part and stock in part. 57 As an example, the Proposed Regulations provide that an EGI may be subject to the Bifurcation Rule if (i) the analysis of the IRS supports a reasonable expectation that, upon issuance, only a portion of the EGI s principal amount will be repaid; (ii) the IRS determines that the EGI should be treated as debt in part and stock in part; and provided that (iii) the Documentation Requirements are satisfied, as applicable, and federal tax principles support the bifurcated treatment. 58 The issuer of an EGI, the holder, and any other person relying on the characterization of the EGI as debt are required to treat the EGI consistent with the issuer s initial characterization. These parties cannot disclose contrary treatment on a tax return (as currently available under section 385(c)(2)). 56 See Part III.D.9 for discussion of Prop. Treas. Reg Prop. Treas. Reg (d)(1) (2). 58 Id. 17

19 Effective Date The Bifurcation Rule generally applies to any applicable instrument issued or deemed issued on or after the date the Proposed Regulations are issued as final regulations. 59 Comments and Recommendations: Recommendation 22: The Final Regulations should confirm that the analysis supporting treatment of the EGI as debt in part and stock in part does not need to be prepared contemporaneously with the issuance of the instrument but may be prepared in accordance with normal examination procedures. 60 Recommendation 23: The Final Regulations should confirm that the determination of the IRS and/or the analysis of the IRS with respect to an EGI and its treatment as debt in part and stock in part is not afforded presumptive treatment. In a judicial proceeding, a court should weigh the persuasiveness of the analysis of the taxpayer and the IRS, and reach a conclusion without a presumption in favor of one analysis or the other. This is consistent with the Bifurcation Rule s function as implementing the regulatory grant of authority under section 385(a) to bifurcate a debt instrument, and having general tax principles govern the ultimate characterization of an interest. Recommendation 24: The Final Regulations should clarify which factors and/or principles are relevant to the determination of whether an EGI is treated as debt in part and equity in part. More specifically, we recommend that the Bifurcation Rule apply on the basis of a debtor s ability to satisfy its obligations under the EGI. The Bifurcation Rule s application turns on general tax principles which are not defined under existing law. We believe that applying the Bifurcation Rule on the basis of the debtor s ability to repay would be consistent with general tax principles and would provide a meaningful and administrable standard. Further, the Bifurcation Rule should only be applied if there was a bona fide expectation not to repay a portion of the EGI at the time of issuance. Recommendation 25: The Final Regulations should limit the application of the Bifurcation Rule to balance its expansive reach and uncertainty in application, and should consider: 59 Prop. Treas. Reg (f). The Bifurcation Rule also applies to any applicable instrument treated as debt issued or deemed issued before the date the Proposed Regulations are issued as final regulations if and to the extent it was deemed issued as a result of an entity classification election (Form 8832) that is filed on or after the date on which the Proposed Regulations are issued as final regulations. Id. 60 Any information and documentation otherwise required under the Documentation Rules would have to be provided by the time specified in those rules. See discussion in Part III.C. 18

20 An exception for an EGI with a principal amount that is de minimis in relation to the issuer s ability to repay the instrument; and An exception where there is not a meaningful portion of the EGI that would be treated as stock. 61 Recommendation 26: The Final Regulations should clarify the operation of the Bifurcation Rule with respect to an applicable instrument issued by a partnership or an entity not separate from its sole regarded owner for U.S. federal income tax purposes under Treas. Reg (a disregarded entity ). The Bifurcation Rule provides, in part, that the IRS may treat an applicable instrument as part debt and part stock. Accordingly, if a partnership or disregarded entity issues an applicable instrument and the IRS subsequently determines the instrument is properly classified as part equity, it is unclear whether Treasury and the IRS intended to apply the Bifurcation Rule to treat such portion as stock in the corporate owner (if any) of the partnership or disregarded entity, or as equity in the partnership or disregarded entity. Given that the rules under Prop. Treas. Reg are intended to facilitate treatment of applicable instruments consistent with general federal tax principles, we recommend that the Final Regulations clarify that the Commissioner may treat an applicable instrument issued by a partnership or a disregarded entity as in part debt and in part equity in the issuing entity to the extent that such applicable instrument should be properly treated as in part debt and in part equity under general federal tax principles. Recommendation 27: The Final Regulations should provide guidance on how payments made with respect to the EGI are allocated between the portion that is debt and the portion that is equity Without a clearly applicable standard and limits on application, the Bifurcation Rule, e.g., may slow the resolution of audits of taxpayers. For additional recommendations to limit the scope of the Bifurcation Rule, see also Recommendation 36, regarding coordination and application of the Small Taxpayer Exception (as defined below), Threshold Exception (as defined below), and Ordinary Course Exception (as defined below) for purposes of the Operative Rules. 62 As drafted, it is not clear whether (i) a payment can be allocated to a portion of the interest treated as debt or equity; (ii) the payment should first be allocated to the portion treated as debt (so as to reflect a priority return on the portion of the interest treated as debt); (iii) a pro rata approach should be applied; or (iv) some other approach is warranted. This comment has more general application if a debt instrument is recharacterized, in part, under other Operative Rules. 19