Section 385 Proposed Regulations

Section 385 Proposed Regulations USS Where Have All the Factors Gone? Moderator Karen Gilbreath Sowell, EY, Washington, DC Panelists Jeff Maddrey, PwC, Washington, DC Peter Marrs, General Electric Company, Fairfield, CT Kevin Nichols, Senior Counsel, ITC, Department of Treasury, Washington, DC David Schnabel, Davis Polk & Wardwell LLP, New York, NY Tom West, Tax Legislative Counsel, TLC, Department of Treasury, Washington, DC Brett York, Attorney Advisor, TLC, Department of Treasury, Washington, DC ABA Tax Section Corporate Tax Committee May 7, 2016

Overview of Proposed Regulations Bifurcation Rules: Prop Reg. 1.385-1 Apply prospectively Commissioner may treat an EGI as part debt and part stock Documentation Rules: Prop. Reg. 1.385-2 Apply prospectively Extensive contemporaneous documentation required as necessary (but not sufficient) requirement for treatment of related party instruments as debt Per Se Stock Rules: Prop. Reg. 1. 385-3 and -4 Apply to related party debt issued on or after April 4 Apply to related-party debt issued: (1) In a distribution (including a straight spin-off) (2) In exchange for stock of an affiliate (3) As boot in an asset reorganization (4) by an affiliate in exchange for property, where issued with a principal purpose of funding one of the transactions described in (1) (3) (the Funding Rule ); nonrebuttable presumption of principal purpose when issued within 36 months before or after such transaction described in (1) (3) 1.385-4 contains rules for applying -3 to a consolidated group when an instrument ceases to be or becomes a consolidated group debt instrument All rules apply to foreign and domestic related parties, except members of a consolidated group are treated as a single entity. Page 2

Expanded Group / Modified Expanded Group Expanded Group ( EG ): an affiliated group as defined in Section 1504(a) with the following modifications: (i) includes foreign and tax-exempt corporations, (ii) includes corporations held directly or indirectly (through application of Section 304(c)(3)), and (iii) modifies the ownership test to 80 percent vote OR value (i.e., not vote AND value). applies generally for purposes of the Proposed Regulations the application of downward attribution under Section 318(a)(3) can result in otherwise unrelated corporations treated as members of an EG Modified Expanded Group ( MEG ): determined by substituting 50 for 80 in Section 1504(a)(2)(A) and (B); also includes 50 percent ownership of a partnership capital or profits interest, and persons who own at least 50 percent of a MEG member. applies solely for purposes of Bifurcation Rule Expanded Group Instrument ( EGI ): an instrument between EG members that is in form a debt obligation applies for purposes of Documentation Rule Broader definition of debt instrument under -3 (i.e., satisfies the requirements of -1 and -2 and that is indebtedness under general principles of federal income tax law) Page 3

The Per Se Stock Rules: Prop. Reg. 1.385-3

Overview of the Per Se Stock Rules Subject to certain limited exceptions, the Per Se Stock Rules treat related party debt as stock if it is issued in certain enumerated transactions, even though it would otherwise be characterized as debt under existing case law General Rule: Treats related party debt as stock if issued (1) in a distribution, (2) in exchange for EG stock, or (3) as boot in an asset reorganization. The Funding Rule: Mechanical rule that recharacterizes related party debt issued in the 36-month period before or after a distribution or acquisition described in the General Rule. No Affirmative Use: Taxpayers cannot affirmatively use the Per Se Stock Rules to recharacterize related party debt as stock if the principal purpose of doing so is to reduce the federal tax liability of the taxpayer or any member of its EG. Page 5

Exceptions to the Per Se Stock Rules Current E&P Exception: The aggregate amount of any distributions or acquisitions described in the General Rule and the Funding Rule is reduced by an amount equal to the member s current E&P. See Slide 8. Threshold Exception: Aggregate amount of debt held by EG members that would be treated as stock under the General Rule or the Funding Rule does not exceed $50 million. Once $50 million, all debt is recharacterized (cliff rule). No other de minimis exception for small debt issuances Additional Exceptions Applicable to the Funding Rule: Funded Acquisitions of Subsidiary Stock: A transfer of property by a funded member (transferor) to an EG member (transferee) in exchange for stock if the transferor owns >50% for 36 months after. If applicable, subsidiary is treated as a successor Ordinary Course Exception: Debt issued in the ordinary course of business or in connection with the purchase of goods or services (e.g., trade payables). Requirements of ordinary course exception result in narrow applicability Page 6

Significance of April 4th Under 1.385-3 and 1.385-4, all related party debt issued on or after April 4 th may be recharacterized when/if the regulations are final Debt issued on or after April 4 will be respected as debt until 90 days after final regulations; thereafter, it will be recharacterized as equity if the Per Se Stock Rules apply. Impact of recharacterization on characterization of original transaction? Interaction with step transaction doctrine? Planning for basic M&A transactions (e.g., sales or spins) must take into account the impact of the rules as proposed All distributions (including straight spin-offs), stock acquisitions and D reorganizations undertaken on or after April 4 th may result in the recharacterization of related party debt issued on or after April 4 th Why was it necessary to make the regulations retroactive? Page 7

Preamble: Policy Concerns Related party debt issued in the Per Se Stock Rules often lacks meaningful non-tax significance, such that respecting the [related party debt] as indebtedness for federal tax purposes produces inappropriate results. Base erosion: Inverted groups and other foreign-parented groups use these types of transactions to create interest deductions that reduce U.S. source income without investing any new capital in the U.S. operations. Avoidance of repatriation tax: U.S.-parented groups obtain distortive results by, for example, using these types of transactions to create interest deductions that reduce the earnings and profits of controlled foreign corporations (CFCs) and to facilitate the repatriation of untaxed earnings without recognizing dividend income. Page 8

Effects of Per Se Stock Rules Intended? Conversion of true debt into equity Bias in favor of external debt; increased role for third parties (e.g., banks) Uncertainty for taxpayers due to complexity Inconsistent treatment of transactions depending upon consideration and interaction with other Code sections Impacts normal business transactions (e.g., Treasury center lending) Loss of Section 902 credits Creation of hybrid instruments Creation of hook stock Potential listed transactions: Fast-pay stock and basis shifting Inability to utilize Treas. Reg. 1.1032-3 to purchase property or to compensate employees Impact on future nonrecognition transactions (e.g., Sections 351 and 355) Deconsolidation Significant and costly compliance burdens Complex due diligence Costly financial audit analysis Page 9

Similar Transactions (May Be) Characterized Differently Facts: Case 1A CFC 3 acquires CFC 2 stock for cash Case 1B CFC 3 acquires CFC 2 stock for note Case 2 CFC 3 acquires CFC 2 stock for cash; contemporaneously, CFC 3 issues note to CFC 4 Case 1 CFC 1 CFC 2 USP stock A) cash B) note CFC 3 CFC 4 Questions/Issues: Policy reasons for differential treatment of economically similar transactions? Case 2 USP Interaction with No Affirmative Use Rule (e.g., recharacterization dependent on E&P consequences associated with characterization)? Recast of the Section 304 recast CFC 1 stock cash CFC 3 What if CFC 1 loans an amount equal to the sale proceeds to CFC 3 a year prior to the acquisition? CFC 2 CFC 4 loan Page 10

Purchase of Assets vs. Stock Facts: FS sells UST DRE to USP in exchange for a USP Note. Proposed Regulations: The USP Note is not recharacterized (unless -1 or -2 applies). Questions: Why the different treatment for sales of stock and sales of assets? Recharacterization may still result where (i) USP engages in a funding transaction or (ii) the asset acquisition is principal purpose transaction does a sale of assets implicate the principal purpose test? FS UST FP UST Note USP Page 11

Current E&P Exception Facts: USS has current E&P of $50. Case 1: USS distributes $50 cash to FP and, subsequently, distributes a note worth $50 to FP. Case 2: USS Note is distributed first and cash is distributed second Proposed Regulations: Case 1: Does the Current E&P exception apply to the USS Note? Case 2: Current E&P exception applies to USS Note Questions: Partial recharacterization could result in bifurcated instrument if current E&P is less than $50 Why is accumulated E&P not considered? Treatment of PTI? If the cash in Case 1 makes the Current E&P exception unavailable to the USS Note, why? USS may not ever borrow from a related party. Interaction of uncertain interpretation with immediate effective date. CEP $50 CEP $50 Case 1 FP USS Case 2 FP USS 1) $50 distribution 2) USS Note distribution 1) USS Note distribution 2) $50 distribution Page 12

The Mechanical Funding Rule: Many Unintended(?) Consequences

Treasury Centers and Ordinary Transactions Facts: Treasury Center engages in numerous lending transactions to fund ordinary-course needs of affiliated group. CFC OpCo 1 enters into a 3-year revolving borrowing facility with Treasury Center to fund its ongoing operating needs. Within 36 months of making a cash draw under the facility, CFC Opco 1 distributes cash to CFC Holdco. USP CFC Holdco 2) Cash Distribution Proposed Regulations: Under the Funding Rule, the CFC Opco 1 Note is recharacterized as stock. Questions/Issues: Is it intended that such debt incurred to fund ordinary-course operating needs be recharacterized as equity? Uniform application to all treasury center activities? Distinguish cash pools? Consequences if note repaid before distribution? Same vs different year? Possibility of cascading recharacterization? Impact on tax treatment of hedges? Mechanical application creates substantial diligence/compliance burdens CFC OpCo 3 CFC OpCo 4 Cash Pool Draw Cash Pool Deposit Centralized Treasury Center Cash Pool Deposit 1) 3-Year Revolver Loan CFC Opco 1 CFC OpCo 2 Page 14 No Current E&P

Third Party Acquisitions: Form Matters Case 1 Case 2 UST P 2 UST FP Note P 1 Cash FP Note Cash 1 2 UST USS Cash UST USS UST stock Facts Case 1: 1) FP loans cash to USS in exchange for note 2) USS purchases UST stock for cash Facts Case 2: 1) FP purchases UST stock for cash 2) USS purchases UST stock from FP in exchange for note Questions: Are these two cases treated differently? There is new capital in both Case 1 and Case 2. Page 15

Common Transactions: Equity Compensation Facts: CFC 1 issues note to CFC3. Within 36 months after issuance, CFC1 compensates employee EE with stock of USP. USP USP Stock Result: Reg. 1.1032-3 treats this transaction as if, immediately before CFC1 disposes of the USP stock, CFC1 purchased the USP stock from USP for fair market value with cash contributed to CFC1 by USP. CFC3 Prior Note CFC1 USP Stock EE Question: Is this an acquisition of expanded group stock, other than in an exempt exchange, by the funded member from a member of the funded member s expanded group in an exchange for property other than expanded group stock under Prop. Reg. 1.385-3(b)(3)(ii)(B)? Page 16

Predecessors and Successors The Funding Rule applies to predecessors and successors of the funded member: Predecessor: (1) the distributor or transferor corporation in a Section 381(a) transaction in which the funded member is the acquiring corporation; (2) the distributing corporation in a D/355 transaction. Successor: (1) the acquiring corporation in a Section 381(a) transaction in which the funded member is the distributor or transferor corporation; (2) the controlled corporation in a D/355 transaction. It appears the Funding Rule applies regardless of when the transaction occurs that creates a predecessor/successor. Thus, the Funding Rule expands well beyond the 72-month timeframe. Page 17

Predecessors and Successors Beyond 72 months Year 1 Year 2 or Year 10 USP 2) Cash distribution USP FS3 FS1 FS2 FS3 FS1 FS2 1) Note In Year 1, FS3 loans $100 to FS1 in exchange for the FS1 Note. Later in Year 1, FS2 distributes $100 to USP. 2) Merger In Year 2, FS1 merges into FS2 in a Section 381 transaction, thereby becoming a successor to FS3. Under the Funding Rule, the FS1 Note is treated as stock because it was issued to FS3 within 36-months of the distribution by FS1 s successor, FS2. Same result if merger occurs in Year 10? Preamble: For purposes of [the Funding Rule] references to the funded member include references to any predecessor or successor of such member. Questions: Why do the predecessor/successor rules apply to recharacterize debt in Year 10? Page 18

Predecessors and Successors D/355 transactions Year 1 2 Year 10 1 USP USP External Spinco $ FD External Spinco Treasury Center FD FC FC FC Note In Year 1, FD contributes assets to newly formed FC and distributes the stock of FC to USP FC is a successor to FD Later in Year 1, USP contributes FC to newly formed External Spinco and distributes the stock of External Spinco to the shareholders of USP In Year 10, FC distributes cash to External Spinco. Later in Year 10, Treasury Center loans money to FD in exchange for a note. Under the Funding Rule, is the FD Note treated as stock because it was issued to Treasury Center within 36-months of the distribution by FD s successor, FC? Questions/Issues: Is this result intended? What policy objective is served? Creates reporting obligations between unrelated parties Page 19

Common Restructurings: Liquidations Facts: CFC3 loans money to CFC2. Later that year, CFC2 makes a checkthe-box election to be disregarded as an entity separate from CFC1. CFC1 issued debt to CFC3 the prior year. Proposed Regulations: Deemed liquidation is a distribution with respect to the CFC2 stock. Note is recharacterized as equity upon issuance. Questions/Issues: Is the deemed liquidation also an acquisition of EG stock? Can convert a tax-free liquidation into taxable was this intended? If Section 332 applies, debt of CFC1, a successor to CFC2, may be recharacterized Can t qualify as an upstream reorganization Significant diligence burdens CFC3 USP Prior Note 1) Note CFC1 CFC2 2) CTB to DRE Page 20

The Funded Member s Expanded Group Testing and Timing Facts: P1 and P2 are unrelated public companies. In Year 1, when Target is a member of the P2 expanded group, Target issues a note to Target Sub. In Year 2, P1 acquires the stock of Target in exchange for cash with Target Note still outstanding. Later in Year 2, Target makes a distribution of property to P1. 3) Distribution P1 2) Acquisition P2 Questions: At what point in time is the funded member s expanded group measured for purposes of the Funding Rule? Target Target 1) Target Note If measured at two points in time, how do you account for changes in expanded group membership? Target Sub Target Sub Page 21

Examples of Collateral Consequences of Recharacterization as Stock

Listed Transaction? Fast Pay and Basis Hopping Facts: FS1 holds a $100 note issued by FS2 (the FS2 Note ) that is treated as nonvoting stock under Prop. Reg. 1.385. FS2 repays the FS2 Note at a time when it has $150 of E&P. Results: FS2 is treated as redeeming the FS2 Note in a dividend-equivalent redemption. Questions: Is the FS2 Note fast-pay stock? Is the overall transaction a fast-pay arrangement? The basis in the FS2 Note shifts to USP s basis in its FS2 stock under Treas. Reg. 1.302-2(c), and FS2 s E&P moves to FS1? Should USP report the transaction under Notice 2001-45 and/or Treas. Reg. 1.7701(l)-3? FS1 $100 USP FS2 Note FS2 E&P = $150 Page 23

Loss of FTCs Facts Same facts as previous. FS2 has foreign tax credits of $25. Questions/Issues: Section 902 applies when shareholder owns 10% voting power What are the consequences to the foreign tax credits as a result of Section 302(d) characterization of FS2 Note repayment? Compare Rev. Ruls. 91-5 and 92-86 FS1 $100 USP FS2 Note FS2 FTC $25 Page 24

Creation of Hybrid Instruments Facts: USP makes loan to FS1 in exchange for a Note, which is recharacterized as nonvoting stock under under Prop. Reg. 1.385. Impact of Recharacterization: Note is respected as debt for foreign tax purposes, but treated as stock for US federal tax purposes. Creates hybrid instrument. Question: How does this result comport with the OECD BEPS project? 1) Note USP FS1 Page 25

Unanticipated Taxable Transactions Facts: In Year 1, FS2 issues the FS2 Note that is recharacterized as nonvoting stock under Prop. Reg. 1.385-3. In Year 2, USP contributes appreciated property to FS2. USP 2) Contribution Impact of Recharacterization: USP recognizes gain on the property. USP does not have Section 368(c) control of FS2. Note USP could not spin FS2 under Section 355. FS1 1) FS2 Note FS2 Page 26

The Bifurcation and Documentation Rules: Prop. Reg. 1.385-1 and -2

Bifurcation Rule Prop. Reg. 1.385-1(d)(1): Commissioner may treat an EGI as part debt and part stock Preamble: all-or-nothing approach is particularly problematic in cases where only slightly more support for characterization of the entire interest as indebtedness than for equity characterization Bifurcation Rule only applicable where Documentation Rules has been satisfied When will the Bifurcation Rule be applied? Convertible debt? What is the threshold for slightly more support? Is the 3:2 ratio in the preamble example informative? (Preamble example) FP USS $5M note Facts: USS issues a $5M note to FP. Commissioner determines that at time of issuance, USS can t reasonably be expected to repay more than $3M Page 28

Documentation Rules Expanded Group members must maintain contemporaneous documentation to establish: 1. Binding obligation to repay: issuer has an unconditional and legally binding obligation to pay a sum certain 2. Creditor s rights to enforce terms: holder has traditional creditor s rights to enforce obligation (e.g., ability to trigger default or acceleration, preferred right to share in assets upon issuer s dissolution before shareholders) 3. Reasonable expectation of repayment: documents necessary to establish (e.g., cash flow projections, financial statements and forecasts, appraisals, debt-to-equity ratio) 4. Ongoing arm s length creditor-debtor documentation: payments of principal or interest (or, in the event of default, a holder s reasonable exercise of diligence and judgment of a creditor) Satisfaction of these requirements is a necessary but not sufficient condition for treatment of an intercompany debt as debt for federal tax purposes. Taxpayers may not fail to comply with the Documentation Rules in order to obtain equity characterization ( no affirmative use ) Page 29

Documentation Rules Cash Pooling Facts: Pursuant to a cash pooling arrangement, CFC1, CFC2, and CFC3 transfer cash received from operations to a treasury center (TC) in exchange for an intercompany receivable at the end of every day. Documentation Rules apply to cash pooling arrangements (as well as revolvers) Is a comprehensive agreement that governs all of the operations of a cash pooling arrangement sufficient? Is the examination of standalone creditworthiness on a daily basis required to establish reasonable expectation of repayment? USP CFC 1 CFC 2 CFC 3 $ $ $ Treasury Center Page 30