ABA Tax Section 2017 May Meeting. Tax Reform, Treaties, and Inbound Investment

ABA Tax Section 2017 May Meeting Tax Reform, Treaties, and Inbound Investment Robert Stack, Moderator Layla Asali, Miller & Chevalier Jesse Eggert, KPMG Gretchen Sierra, Deloitte

Agenda Key Features of Border Adjustment Tax (BAT) BAT Treaty Issues BAT and Anti-Hybrid Rules Tax Reform and Earnings Stripping 2

Key Features of Border Adjustment Tax Border Adjustment Tax (BAT) or Destination Based Cash Flow Tax Based on House Blueprint A Better Way, Tax imposed on a business entity s cash revenues minus cash outflows, taking into account: Export revenue is excluded from base Export revenue expected to include revenue from exports of IP, for which royalties are received from the non-us company using the IP Cost of imports are not subtracted from the tax base COGS Royalties for use by U.S. persons of foreign owned IP 3

Key Features of Border Adjustment Tax Capital expenditures are immediately expensed Interest is not deductible for non-financial companies U.S. Wages are deductible It is a territorial tax, meaning active income earned abroad by business entities is not taxed again when repatriated Subpart F retained for passive income 4

Key Features of Border Adjustment Tax Although not specifically referenced in the House Blueprint, it has been widely assumed in the U.S. tax community that the BAT would apply to U.S. purchases by U.S. consumers of goods from foreign sellers, for example, an online purchase of a consumer product from a non-us seller 5

Key Features of Border Adjustment Tax Note that immediate expensing of capital expenditures, disallowance/limitation of interest deductions, and territoriality are features that could be included in tax reform, even if the BAT approach is not adopted. That is, they are not exclusively features of a BAT. 6

BAT Treaty Issues The day after the effective date of the BAT, what treaty issues would arise? How would they be resolved in practice? 7

BAT Treaty Issues Most provisions of U.S. tax treaties apply only to so-called covered taxes But some provisions specifically the non-discrimination article apply broadly to all taxes (more on this later) Whether a tax is a covered tax or not has important consequences. For example, in order to impose a covered tax on a non-us entity conducting activities in the U.S., the non-us entity must have a permanent establishment (as defined in Article 5 of the treaty) in the U.S. Countries may have obligated themselves to give a credit for or exempt a tax that is a covered tax. 8

BAT Treaty Issues Income tax treaties typically use a combination of ways to identify a covered tax Because treaties are hard to amend and are intended to last a long time, they typically provide some flexibility in the definition. The treaty will often describe the type of tax a tax on income The treaty will often specifically list agreed covered taxes, and The treaty will often provide that it will apply to any identical or substantially similar taxes enacted after entry into force of the treaty. 9

BAT Treaty Issues Article 2 of 2016 US Model, which was not changed from the 2006 model and which is virtually identical to the OECD Model (other than the specific reference to the US federal income tax) follow this approach (emphasis added below). 1. This Convention shall apply to taxes on income imposed on behalf of a Contracting State irrespective of the manner in which they are levied. 2. There shall be regarded as taxes on income all taxes imposed on total income, or on elements of income, including taxes on gains from the alienation of property. 3. The existing taxes to which this Convention shall apply are: a) in the case of [the other Contracting State]:. b) in the case of the United States: the Federal income taxes imposed by the Internal Revenue Code (which do not include social security and unemployment taxes) and the Federal taxes imposed on the investment income of foreign private foundations. 4. This Convention also shall apply to any identical or substantially similar taxes that are imposed after the date of signature of this Convention in addition to, or in place of, the existing taxes. The competent authorities of the Contracting States shall notify each other of any significant changes that have been made in their taxation laws or other laws that relate to the application of this convention. 10

BAT Treaty Issues Technical Explanation to the 2006 U.S. Model (there is no TE for the 2016 U.S. Model yet) explains that paragraphs 1 and 2 (referring generally to income taxes) are based on the OECD model. OECD Model Commentary does not expand on these paragraphs in a way that helps define an income tax. 11

BAT Treaty Issues How about paragraph 3? Article II, Paragraph 3(b) of the 2016 U.S. model specifically states that the treaty applies to Federal income taxes imposed under the Internal Revenue Code... Does that aid the analysis of how the BAT should be treated? While the BAT would presumably be part of the Internal Revenue Code does that leave us with the problem of deciding whether it is an income tax? 12

BAT Treaty Issues Does Article 2, paragraph 4 shed any light? Recall that it provides: This Convention also shall apply to any identical or substantially similar taxes that are imposed after the date of signature of this Convention in addition to, or in place of, the existing taxes. The competent authorities of the Contracting States shall notify each other of any significant changes that have been made in their taxation laws or other laws that relate to the application of this convention. (Emphasis added) 13

BAT Treaty Issues The term income tax is not defined in the US or OECD Model Treaties Treaties contain a special rule on how to interpret undefined terms in the treaty Article 3, paragraph 2 of the 2016 US Model Tax Treaty (same as in 2006 Model and substantively same as OECD model) provides: As regards the application of this Convention at any time by a Contracting State, any term not defined herein shall, unless the context otherwise requires, or the competent authorities agree to a common meaning pursuant to the provisions of Article 25 (Mutual Agreement Procedure), have the meaning that it has at that time under the law of that Contracting State for the purposes of the taxes to which this Convention applies, any meaning under the applicable tax laws of that Contracting State prevailing over a meaning given to the term under other laws of that Contracting State. 14

BAT Treaty Issues To what extent are the criteria set forth in Treas. Reg. 1.901-2 relevant to answering the question whether the BAT is an income tax for treaty purposes? That regulation explains that Section 901 allows a credit for an income tax, and explains in part that a foreign levy is an income tax, only if the predominant character of that tax is that of an income tax in the U.S. sense. 1.901-2(a)(1)(ii). The regulations go on to explain that the predominant character of a foreign tax is that of an income tax in the U.S. sense, if the foreign tax is likely to reach net gain in the normal circumstances in which it applies. 1.901-2(a)(3)(i). 15

BAT Treaty Issues 1.901-2(b)(4)(i) further explains that a tax reaches net gain, inter alia, if the base of the tax is reduced to permit (A) [r]ecovery of the significant costs and expenses (including significant capital expenditures) attributed, under reasonable principles, to [] gross receipts. Does expensing run afoul of this rule? Denial of interest deductions? Denial of royalty deductions for importation of foreign IP? Denial of COGS treatment for imports into the US? All or some combination of the above? Are there other qualifiers in U.S. tax law, that might nonetheless render the BAT an income tax under U.S. rules? 16

BAT Treaty Issues Under what circumstances has the U.S. had to face similar issues with respect to whether a non-us tax would be treated as a covered tax and therefore creditable by the US? Does this experience teach us anything? German trade tax, or (Gewerbesteuer) Italian regional tax on productive activities 17

BAT Treaty Issues If the BAT is not a covered tax what are the consequences? The U.S. would not need to find that a foreign enterprise has a PE in the U.S. under Article 5 before imposing the BAT on B to C sales into the U.S. The other Contracting State likely can refuse to grant a credit or exemption for BAT taxes paid by their residents in the U.S. Even if the BAT is an income tax, Congress is free to override the treaty under U.S. later in time principles? What are the practical consequences or effects of a treaty override with our treaty partners? 18

BAT Treaty Issues Possible Scenario: ForCo, a company resident in a jurisdiction that has an income tax treaty with the U.S., runs on online marketplace and sells vacuum cleaners to U.S. customers from outside the U.S. The BAT applies to the sale, such that 20% is withheld from the purchase price of the vacuum cleaner (under a to-be determined mechanism) ForCo files for a refund on the basis that the BAT is a covered tax and ForCo does not have a PE in the US under Article 5 of the treaty. IRS denies the refund on the basis that the BAT is not a covered tax because it is not an income tax under the laws of the U.S. Alternatively, IRS denies the refund and takes the view that even if the BAT is an income tax, Congress, in enacting the BAT overrode Article 5, the PE Article, and Article 7, the attribution of profits article. 19

BAT Treaty Issues Note that under Article 3(2), the U.S. is the contracting state applying the treaty, and, unless the context requires otherwise, can apply U.S. law principles to determine whether the BAT is an income tax under U.S. principles. Does the context require otherwise? Are there any other practical constraints on the U.S. that might give it pause before taking the position that the BAT is not an income tax? 20

BTA Treaty Issues When the UK enacted the diverted profits tax, it took the position that that tax is not a covered tax under UK tax treaties, presumably under the theory that Article 3(2) permits it to define terms in the treaty under UK law? Analogous to the US potential position on a BAT? 21

BAT Treaty Issues Even if the BAT were not to cover inbound B to C sales, so that the PE issue does not arise, a treaty issue would arise as to whether another country would grant relief from double taxation under Article 23 of the 2016 US Model (which is substantially the same as the 2006 and OECD models). Similarly, if the BAT were to cover inbound B to C sales, but the US were to take the view that the BAT is a covered tax and that Congress intended to override PE and attribution of profits, the other jurisdiction would need to decide whether to grant relief from double taxation. The structure and logic of our treaties strongly suggests that relief would be given by other countries only for covered taxes, although the language is not always so precise. But in this context (looking at the need to grant relief) the other country (not the US) may get to decide under Article 3(2) (relating to definitions) whether the BAT is an income tax. 22

BAT Treaty Issues Consider: The OECD model requires relief whether through credit or exemption, [w]here a resident of a Contracting State derives income... which in accordance with the provisions of this Convention, may be taxed in the other contracting state.... (Emphasis added) 23

BAT Treaty Issues Note that the provision refers only to income which may be taxed in the other jurisdiction. When parties to a convention eliminate double taxation through the exemption method (exempting income that may be taxed from that contracting party s tax base), the provision does not require that actual tax be imposed or paid. Article 23A. However, under the OECD model, when parties to the convention eliminate double taxation through the credit method, the OECD model specifically refers to the need to credit an amount equal to the income tax paid in that other state Article 23B. Thus, whether the BAT would be a creditable tax falls back on whether it is an income tax 24

BAT Treaty Issues Two illustrative treaties demonstrate the application of the credit method, including in the case of the analog to a Section 902 deem paid credit: U.S. Ireland: (Emphasis added) Irish Treaty: Article 24(4): Subject to the provisions of the law of Ireland regarding the allowance as a credit against Irish tax of tax payable in a territory outside Ireland (which shall not affect the general principle hereof): a) United States tax payable under the law of the United States and in accordance with the Convention (other than payable solely by reason of citizenship), whether directly or by deduction, on profits, income or chargeable gains from sources within the United States (excluding, in the case of a dividend, tax payable in respect of the profits out of which the dividend is paid) shall be allowed as a credit against any Irish tax computed by reference to the same profits, income or chargeable gains by reference to which the United States tax is computed; and b) in the case of a dividend paid by a company which is a resident of the United States to a company which is a resident of Ireland and which controls directly or indirectly 10 percent or more of the voting power in the company paying the dividend, the credit shall take into account (in addition to any United States tax creditable under the provisions of subparagraph a) of this paragraph the United States tax payable by the company in respect of the profits out of which such dividend is paid. 25

BAT Treaty Issues U.S. Italy Treaty: (Emphasis added) If a resident of Italy derives items of income which are taxable in the United States under the Convention,.... Italy may, in determining its income taxes specified in Article 2 of this Convention, include in the basis upon which such taxes are imposed the said items of income... In such case, Italy shall deduct from the taxes so calculated, the tax on income paid to the United States.... For purposes of applying the Italian credit in relation to tax paid to the United States the taxes referred to in paragraphs 2 (a) [the Federal income taxes imposed by the Internal Revenue Code] and 3 [identical or substantially similar taxes subsequently imposed] of Article 2 (Taxes Covered) shall be considered to be income taxes. 26

BAT Tax Treaty Issues Article 25(2) of the U.S. Luxembourg treaty illustrates the exemption method. It provides in pertinent part: In Luxembourg double taxation shall be eliminated as follows: (a) where a resident of Luxembourg derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the United States, Luxembourg shall... exempt such income or capital from tax.... Does a provision such as this leave open the door to double nontaxation of income if a country wants to exempt income from its own tax base that was not in fact taxed in the other jurisdiction? (Consider U.S. exporters under a BAT). Doing so would be a way to provide a benefit to multinationals as a form of tax competition? 27

BAT Treaty Issues Non-Discrimination (Article 24 (2016 Model)) Virtually identical to OECD model. Note Paras 1 and 4 in relevant part (Emphasis added). 1. Nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith that is more burdensome than the taxation and connected requirements to which nationals of that other Contracting State in the same circumstances, in particular with respect to residence, are or may be subjected. This provision shall also apply to persons who are not residents of one or both of the Contracting States.... + + + + + 4. Except where the provisions of paragraph 1 of Article 9 (Associated Enterprises), paragraph 8 of Article 11 (Interest), or paragraph 7 of Article 12 (Royalties) apply, interest, royalties, and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned Contracting State. Similarly, any debts of an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable capital of the firstmentioned resident, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned Contracting State. 28

BAT Treaty Issues How might a BAT affect MAP? Consider the case of a U.S. corporation that exports to Italy, and claims the value of the export of $100, resulting in COGS of 100 in Italy. Italy claims that the proper transfer price for the export should have been $40 resulting in extra taxable income in Italy, but this adjustment does not affect U.S. taxable income since the income from the export is eliminated from the U.S. tax base. 29

BAT Treaty Issues Might the BAT be discriminatory? Consider: Are domestic companies that manufacture and sell in the US advantaged over non-us companies that manufacture abroad and sell into the US? Are domestic companies that acquire inputs and sell here (and therefore able to deduct COGS) advantaged over non-us companies that acquire from abroad and sell here? Is it relevant to the analysis that all U.S. companies would be precluded from deducting COGS for imports? Are domestic companies that can deduct U.S. wages, advantaged over non-us companies that pay non-us wages? Other? 30

BAT Treaty Issues Is a typical VAT discriminatory? Why not? The VAT applies equally within a market to companies that import into the market and those that operate in the domestic market It is sometimes said that a US multinational is subject to income tax in the US plus the VAT in the other jurisdiction when it exports, whereas VAT is relieved on sales into the US. The U.S. domestic seller is not charged VAT in this market so relief at border by foreign exporting countries results in the foreign seller and domestic seller being on an equal playing field here. Similarly the foreign entity that exports to the US is subject to income tax in its home jurisdiction, and if it has a PE here, is subject to income tax in the US as well, just as the U.S. seller is subject to income tax here. 31

BAT Treaty Issues Could the BAT be a special tax regime under the US model? (See 2016 U.S. model Income Tax Convention, Preamble and Articles 3(1), 28 32

BAT Treaty Issues What is likely to happen as a practical matter between the U.S. and its treaty partners? Notice, and a call to re-negotiate? Termination of treaties by other countries? Await actual cases to play out, as discussed above? 33

BAT & Inbound Supply Chain Considerations CONSIDER U.S. CENTRALIZATION OF GLOBAL IP Steps: 1. Purchase of IP: before the effective date of BAT, U.S. Group acquires IP (both U.S. and foreign rights) held by other related parties outside of the U.S. 2. License of IP: Going forward, US group licenses IP to related parties. Tax Considerations: Sale of IP generally taxable in the country of seller. Currently (before BAT), purchase of IP in a taxable transaction to give rise to a step-up amortizable over a 15 year period (subject to anti-churning rules). If purchase post-bat, then payment is nondeductible/non-amortizable. Tax Profile of the Group: Payment by foreign affiliates to the U.S. for the use of IP not taxable in the U.S. and is deductible in the jurisdiction of the payor. IP purchased by the US (pre-effective date of BAT) amortizable in the U.S. over a 15-year period. CONSIDER CONVERTING FROM U.S. TOLLING TO U.S. CONTRACT MANUFACTURING Steps: 1. Convert U.S. Toller to a Contract Manufacturer: U.S. Group converts U.S. toll manufacturer to a contract manufacturer. U.S. manufacturer rather than foreign principal acquires local supply used in manufacturing process 2. Contract Manufacturer Sells Finished Goods To Foreign Principal: U.S. contract manufacturer transfers legal title to finished goods to foreign principal. Goods to be sold in U.S market remain in the U.S. and are sold by the foreign principal to the U.S. distributor. Goods destined for export are shipped out to the U.S. Tax Considerations: Local supply (plus mark-up) is added to the sales price to the foreign principal. Presumably, this additional revenue is tax exempt in the U.S. and provides a deduction to the foreign principal. Tax Profile of the Group: U.S. toll manufacturer with local suppliers can convert export income of third party suppliers to export income of the U.S. taxpayer.

BAT and Anti-Hybrid Rules Royalty IP Sales proceeds Goods USCo UKCo USCo UKCo USCo excludes from income royalty for non-us use of IP under BAT UKCo deducts royalty payment Is this result appropriate? USCo excludes income from export sale of goods under BAT UKCo, which intends to on-sell the goods, includes amount in cost of goods sold Is this result appropriate? Does it matter that COGS is an offset to gross income, rather than a deduction? 35

BAT and Anti-Hybrid Rules OECD BEPS Action 2 made recommendations for payments under hybrid mismatch arrangements that give rise to: Deduction/No Inclusion (D/NI): payment gives rise to deduction in the payer s jurisdiction, is not included in income of the payee Double Deduction (DD): two deductions in respect of the same payment Indirect Deduction/No Inclusion: payment gives rise to deduction in the payer s jurisdiction, payee s income inclusion is offset by a deduction under a hybrid mismatch arrangement 36

BAT and Anti-Hybrid Rules Hybrid mismatch arrangements rely on a hybrid element to produce a cross-border mismatch Hybrid financial instrument Disregarded payment made by a hybrid entity Payment to a reverse hybrid entity Deductible payment made by a hybrid entity Deductible payment made by a dual resident Imported mismatch arrangement Scope limitations Control group Related parties Structured arrangements BAT is not within BEPS Action 2 definition of a hybrid mismatch arrangement Mismatch is not due to a hybrid element; both jurisdictions see the same transaction What are implications of whether the BAT is or is not an income tax? 37

Tax Reform and Earnings Stripping House GOP Blueprint Current Law Section 163(j) 2014 Camp Proposal Obama Administration Proposals Section 385 Regulations 38

Tax Reform and Earnings Stripping House GOP Blueprint Proposals would disallow deduction for business interest expense Will there be transition rules? Partial disallowance over time? Grandfather? Disallowance is based on net interest expense To the extent receivables can be held in the US, interest income would be offset by interest expense Consider whether it may still be beneficial for inbound companies to retain debt in their capital structure because in most U.S. treaties withholding tax rates for interest are lower than for dividends 39

Tax Reform and Earnings Stripping Limitation on Interest Deductibility Section 163(j) Current section 163(j) applies if Borrower has excess interest expense, and Borrower s debt-to-equity ratio exceeds 1.5 to 1 If section 163(j) applies, no deduction is allowed for disqualified interest paid by the U.S. borrower to the extent of excess interest expense. To the extent not deductible, interest expense may be carried forward to future years. Disqualified interest Interest paid or accrued to a related person if no U.S. tax imposed on interest (including by treaty) Interest paid or accrued to an unrelated person if debt is guaranteed by a related foreign person 40

Tax Reform and Earnings Stripping Limitation on Interest Deductibility Section 163(j) Excess interest expense Excess of the corporation s net interest expense over the sum of 50% of the corporation s adjusted taxable income plus any excess limitation carryforward Adjusted taxable income Taxable income computed without regard to deductions for net interest expense, NOL, and depreciation, amortization, or depletion Excess limitation carryforward Excess in any of the prior three taxable years of 50% of the adjusted taxable income of the corporation over the corporation s net interest expense 41

Tax Reform and Earnings Stripping Limitation on Interest Deductibility Section 163(j) FP Facts USCo Interest income = $130 Interest expense = $200 Adjusted taxable income = $100 Disqualified interest = $60 USCo $200 Interest Section 163(j) Limitation Net interest expense = $70 ($200-130) Excess interest expense = $20 Excess of $70 net interest expense over 50% of $100 adjusted taxable income Disallowed interest deduction = $20 (may be carried forward) 42

Tax Reform and Earnings Stripping 2014 Camp Proposal Retain but tighten section 163(j) for foreign-parented groups Reduce section 163(j) adjusted taxable income restriction from 50% to 40% Eliminate carryforward for excess section 163(j) limitation Limit deduction for interest expense for U.S.-parented groups with excess domestic indebtedness Group has excess domestic indebtedness if debt of U.S. members exceeds 110% of debt those members would hold if aggregate U.S. debt-to-equity ratio were proportionate to the ratio of debt-to-equity in worldwide group, or Net interest expense of U.S. members exceeds 40% of adjusted taxable income (as defined in section 163(j)) Considered necessary in context of move to a territorial system 43

Tax Reform and Earnings Stripping Obama Administration Excessive Interest Proposal Restrict deduction for interest expense if net interest expense of a U.S. subgroup exceeds its proportionate share of net interest expense reported on the financial reporting group s consolidated financial statements ( excess financial statement net interest expense ) Proportionate share of financial reporting group s net interest expense determined based on proportionate share of group s EBITDA U.S. subgroup treated as a single member of a financial reporting group Under safe harbor, taxpayer may elect to limit deduction for net interest expense to 10 percent of member s adjusted taxable income (as defined under section 163(j)) Disallowed interest may be carried forward indefinitely, and excess limitation may be carried forward 3 years Exception for financial service entities 44

Tax Reform and Earnings Stripping Obama Administration Minimum Tax Proposal 19% per country minimum tax on foreign earnings of U.S. corporations and their CFCs Current U.S. taxation of foreign earnings at a rate of 19% less 85% of the per-country foreign effective tax rate (residual minimum tax rate) Residual minimum tax rate is applied to minimum tax base for that country Minimum tax base reduced by an allowance for corporate equity Interest expense incurred by a U.S. corporation that is allocated and apportioned to foreign earnings on which minimum tax is paid would be deductible at the residual minimum tax rate applicable to those earnings No deduction permitted for interest expense allocated and apportioned to foreign earnings for which no U.S. income tax is paid Minimum tax proposal applies after the proposal for excessive interest, for a U.S. member of a U.S. subgroup that owns CFCs U.S. subgroup s interest expense that remains deductible after the excessive interest proposal is then subject to limitations on deductibility in the minimum tax proposal 45

Tax Reform and Earnings Stripping Section 385 Regulations Status? Executive Order 13789 (April 21, 2017) instructs the Secretary of the Treasury to immediately review all significant tax regulations issued by the Department of the Treasury on or after January 1, 2016 to determine if they impose an undue burden on United States taxpayers; add undue complexity to the Federal tax laws; or exceed the statutory authority of the Internal Revenue Service Interim report due within 60 days Final report due within 150 days with specific recommendations to mitigate burden For example, delaying or suspending effective date, modifying or rescinding regulations as appropriate and consistent with law, including, if necessary, through notice and comment rulemaking 46

Tax Reform and Earnings Stripping Section 385 Regulations Policy Issues Related parties do not have the same commercial incentives as unrelated parties to properly document their interests in one another, making it difficult to determine whether there exists an actual debtor-creditor relationship. [B]ecause debt, in contrast to equity, gives rise to deductible interest payments, there are often significant tax incentives to characterize interests in a corporation as debt, which may be far more important than the practical commercial consequences of such characterization. Distribution of a note by a corporation to its controlling shareholder and similar transactions lack meaningful non-tax significance, including because they do not finance new investment in the operations of the borrower. 47

Tax Reform and Earnings Stripping Section 385 Regulations Policy Issues FP FP $100 Note Distribution $100 Cash Distribution USCo FS $100 Loan USCo Prior Law: FP may not be subject to tax on distribution (e.g., no E&P or due to treaty benefits) USCo has deductible interest (within section 163(j) limits) No new investment in United States 48

Tax Reform and Earnings Stripping Section 385 Regulations Policy Issues Data regarding corporate inversions and earnings stripping (Preamble to 2016 Section 385 Regulations) Inverted companies increased U.S. interest deductions by $1 billion per year on average in 2002-2003 (J. Seida and W. Wempe, National Tax Journal (Dec. 2004)) Tax savings of between $2.8 billion and $5.7 billion in 2015 (Z. Mider, Bloomberg BNA Daily Tax Report (Dec. 2, 2014)) Form 1120 data (2012) shows that foreign-parented U.S. corporations have a nearly 50 percent higher ratio of net interest deductions relative to EBIT than U.S. MNCs 49

Tax Reform and Earnings Stripping Section 385 Regulations Overview General rule in 1.385-1(b) provides that whether an interest in a corporation is treated as stock or debt is determined based on common law, including the factors prescribed under such common law Documentation Rule ( 1.385-2) Contemporaneous documentation requirement for related-party debt Adjusted weighting of certain common law factors Rebuttable presumption based on compliance Implementation delayed until January 1, 2018 Recharacterization Rules (General Rule and Funding Rule) ( 1.385-3) Related-party debt is treated as equity on a per se basis when debt is issued in the context of, or within 36 months of, certain transactions: Distributions Acquisitions of affiliate stock Consideration in internal asset reorganization (e.g., Cash D reorganization) These rules elevate two common law factors (lack of new investment in the operations and the issuer, and relatedness) into determinative factors Changes from proposed regulations: Final Regulations do not apply to debt issued by foreign corporations and certain other issuers (S corporations, RICs, REITs, partnerships) Bifurcation rule dropped 50

Section 385 Recharacterization Rule Example General Rule and Funding Rule FP FP $100 Note Distribution $100 Cash Distribution US FS $100 Loan US General Rule: $100 Note recharacterized as equity Funding Rule: Loan occurs within 36 months of distribution $100 Loan recharacterized as equity (Example assumes no exceptions apply.) 51

Section 385 Recharacterization Rule Exceptions for Certain Issuers Issuer Exceptions Foreign corporations S corporations Regulated financial institutions Regulated insurance companies Non-controlled RICs and REITs EGIs issued by these issuers (other than foreign corporations) are still subject to documentation rules Members of a U.S. consolidated group are treated as one corporation for purposes of the recharacterization rules 52

Section 385 Recharacterization Rule Exceptions for Certain Instruments Qualified short-term debt instruments Short-term funding arrangement Current assets test or 270-day borrowing Ordinary course loan Issued as consideration for the acquisition of property other than money, in the ordinary course of business Reasonably expected to be repaid within 120 days Interest-free loan Deposits with a qualified cash pool header Qualified dealer debt instrument Excluded statutory or regulatory debt instrument 53

Section 385 Recharacterization Rule General Exceptions Expanded group earnings account Look-through rule for dividends from CFCs (to the extent paid from post-2015 earnings) Acquisition or formation of new expanded group parent resets expanded group earnings account Qualified contributions Allows netting of capital contributions (i.e., new investment in U.S.) and distributions Reduce distributions subject to recharacterization rule by amount of qualified contributions during prior 36-month period Threshold exception No recharacterization if aggregate adjusted issue price of covered debt instruments that would be treated as stock does not exceed $50 million No cliff effect only the amount of the covered debt instrument in excess of $50 million is treated as stock 54

Tax Reform and Earnings Stripping House GOP Blueprint Net interest expense not deductible in connection with destination-based cash flow tax Do section 385 regulations have a role to play in light of this legislative proposal? Other legislative proposals (e.g., 2014 Camp Proposal, Obama Administration Proposal, other)? 55