FOR LIVE PROGRAM ONLY Final Section 385 Regs: Navigating State and Local Tax Impact of New Debt-to-Equity Reclassification Rules THURSDAY, JANUARY 12, 2017, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.
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Final Section 385 Regs Jan. 12, 2017 Jaye A. Calhoun, Partner Kean Miller, New Orleans jaye.calhoun@keanmiller.com Kelley C. Miller, Attorney Reed Smith, Washington, D.C. kmiller@reedsmith.com
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
What Do We Do About Intercompanies? State Treatment of Related Party Transactions
Existing State Approaches to Taxing Unitary (?) Businesses Combined reporting Transfer pricing adjustments (482-Style Provisions) Related-company addback provisions State-specific common law distinguishing debt and equity Absence of uniformity creates opportunity/issues 6 Reed Smith LLP Kean Miller LLP
Existing State Approaches Combined Reporting Mandatory in 25 states and DC 7 Reed Smith LLP Kean Miller LLP
Existing State Approaches - Combined Reporting cont d. Transactions between members of filing group generally eliminated Doesn t reach transactions with entities outside the filing group, including: o Entities not part of unitary business o Entities outside U.S. (water s edge elections) o Other entities not included in combined filings (e.g. insurance companies, financial institutions, RICs, and REITs) o Tax Haven Modifications for WE States 8 Reed Smith LLP Kean Miller LLP
Existing State Approaches - Combined Reporting cont d. Pros: States believe Combination addresses tax minimization strategies States believe separate reporting causes revenue loss Consider state studies Consider shift to passthroughs as choice of entity Principle appeals to scholars 9 Reed Smith LLP Kean Miller LLP
Existing State Approaches - Combined Reporting cont d. Cons: o May not address tax minimization strategies o Always winners/losers either way o What s wrong with tax minimization anyway if its legal o Lots of controversy regarding what unitary means and what businesses are unitary o May distort instate income (Constitutional issues) o Compliance costs o Lack of uniformity creates potential for multiple taxation of same income 10 Reed Smith LLP Kean Miller LLP
Existing State Approaches-Transfer Pricing Adjustments Unclear that all separate-filing states have authority to adjust intercompany pricing o Does adoption of federal taxable income starting point include an implied adoption of IRC 482? o Has the state enacted its own transfer-pricing adjustment statute? (e.g. MA G.L. c. 63, 39A) Most states lack transfer pricing expertise at the audit level o MTC program (State Intercompany Transactions Advisory Service SITAS) 11 Reed Smith LLP Kean Miller LLP
Existing State Approaches-Interest Addback Adopted in 9 states and the District of Columbia Additional states (including PA) have addback limited to relatedcompany interest related to intangibles 12 Reed Smith LLP Kean Miller LLP
Existing State Approaches- Interest Addback cont d. Not designed to distinguish between true debt and other intercompany arrangements o Addback exceptions only applicable after true debt determination e.g. Staples, Inc. v. Commissioner, MA ATB Docket Nos. C310640 and C310639 (2015) Typical exceptions include payments to payees subject to tax in another state/country, payees in treaty countries, payments where addback would be unreasonable, etc. o Factors demonstrating true debt (e.g. written note, arms-length interest) may contribute toward showing that addback would be unreasonable Addback (denying interest deduction) does not address whether obligation was debt or equity for non-income-based taxes or equity ownership tests (combined reporting, dividends received deductions, reorganizations, etc.) 14 Reed Smith LLP Kean Miller LLP
Existing State Approaches-State- Specific Common Law Based on federal common law Alterman Foods, Inc. v. U.S., 505 F.2d 873 (5 th Cir. 1974) Massachusetts Examples o NY Times Sales, Inc. v. Commissioner, 667 N.E.2d 3012 (Mass. App. Ct. 1996) o Overnite Transportation Co. v. Commissioner, 764 N.E. 2d (Mass. App. Ct. 2002) o National Grid Holdings, Inc. v. Commissioner, Mass. App. Ct. Docket No. 14-P-1662 (2016) May still be relevant despite enactment of combined reporting e.g. are intercompany obligations liabilities for purposes of state taxes based on net worth Common law not effected by new federal regulations 15 Reed Smith LLP Kean Miller LLP
Existing State Approaches- LA as an example 16 Reed Smith LLP Kean Miller LLP
Act 16 (HB 55) Intercompany Expense Addback Requires that certain deductible interest expenses, intangible expenses, and management fees be added-back when computing corporation income tax liability by enacting La. R.S. 47:287.82 Requires corporations to add-back otherwise deductible items, specifically: Interest expenses and costs Intangible expenses and costs Management fees Directly or indirectly paid, accrued, or incurred to or with one or more related members Unless certain safe harbors apply Effective for all tax years beginning on or after January 1, 2016 17 Reed Smith LLP Kean Miller LLP
Act 16 (HB 55) Intercompany Expense Addback Safe harbors include: Subject to Tax Exception - If the corresponding item of income was in the same taxable year either subject to a tax based on or measured by the related member's net income in Louisiana or any other state, or was subject to a tax based on or measured by the related member's net income by a foreign nation which has an enforceable income tax treaty with the United States, if the recipient was a "resident" as defined in the income tax treaty with the foreign nation; or Substantial Business Purpose Exception - the transaction giving rise to the interest expenses and costs, the intangible expenses and costs, or the management fees between the corporation and the related member did not have as a principal purpose the avoidance of any Louisiana tax. Conduit Exception - If the transaction giving rise to the interest expenses and costs, intangible expenses and costs, or the management fees has a substantial business purpose and economic substance and contains terms and conditions comparable to a similar arm's length transaction between unrelated parties, the transaction shall be presumed to not have as its principal purpose tax avoidance, subject to rebuttal by the Secretary of the Department of Revenue. 18 Reed Smith LLP Kean Miller LLP
Act 16 (HB 55) Intercompany Expense Addback LDR has issued Notice of Intent re: reg LAC 61:I.1115 Adopts very broad definitions Terms defined include: interest expenses, intangible expenses, intangible property, and management fees Requires contemporaneous documentation for the business purpose exception Provides that [m]ere statements or assertions that a transaction was intended to allow for better management or greater utilization of intangible assets, or similarly unsubstantiated claims are not sufficient to establish a principal non-tax business purpose. Imposes a debt over asset percentage test for some interest expense deductions Compares intercompany debt to asset ratio to third party debt to asset ratio Requires a written statement with the return for exceptions Hearing date was 11/30/16 19 Reed Smith LLP Kean Miller LLP
The New Federal Regulations State Conformity in General Conformity likely o States that start tax computation with federal taxable income as computed under the current Internal Revenue Code either as filed (e.g. IL) or on a separate company basis (e.g. NJ and PA) Conformity unclear o Fixed-date conformity states (e.g. AZ -1/1/2016 and VA -12/31/2015) Does fixed-date conformity matter when IRC 385 was enacted in 1969? o States that adopt specific IRC sections (e.g. CA although CA generally adopts subchapter C as of the latest conformity date 1/1/2015) o States may not necessarily follow all Treas. Regs. (e.g. CA FTB takes position that it can opt out of Treas. Regs.) 20 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Documentation Application at State Level Federal exemption for debt between members of the same consolidated group Unclear exemption has any application in states that don t conform to the federal consolidated return rules Separate analysis required for state purposes for debt covered by consolidated group exception for federal purposes States will likely limit exception to obligations between members of the same the state combined filing unit Documentation rules only applicable to expanded groups that are: o o o o Publicly traded; Have total assets in excess of $100M; or Have total revenue in excess of $50M for financial statement purposes Will states apply these limitations on a separate company basis? 22 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Documentation Implications Complying with documentation rules for state purposes will likely be a major compliance burden o Consider application to typical cash pooling / cash management practices Lack of documentation could be used to recharacterize intercompany obligations that otherwise would be treated as debt under common law Silver Lining?: Compliance with documentation requirement should help with classification under common law 23 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Recharacterization One Corporation Exception Federal exemption for debt between members of the same consolidated group won t be applicable in most states o Exemption likely limited to obligations between corporations included in the state combined filing group o Thus, exception likely will not apply to obligations between a corporation and expanded group members non-unitary corporations 80/20 companies captive insurance companies, etc. 24 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Recharacterization Other Exceptions cont d. Exception for qualified short-term debt instruments o Intended to cover typical cash management / cash pooling arrangements State rules requiring imputation of interest on intercompany debt (e.g. NJ) may throw obligations out of exception for interest-free loans Exception for obligations to extent of expanded group earnings account o Unclear how this will apply at state level where there is no expanded group concept May be limited to distributing corporation s E&P in separate filing states 25 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Recharacterization Other Exceptions cont d. Exceptions for corporations with special federal income tax treatment o S corporations Application unclear in states allowing separate state S election or opt out from federal election- e.g. NJ, NY and PA Also unclear in states that do not follow federal S treatment e.g. IL o REITs o RICs o Regulated financial companies and certain non-captive insurance companies 26 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Recharacterization State Consequences Consequences for payors o Interest (deductible) and return of principal recharacterized as dividend (nondeductible) and return of capital Consequences for payees o Interest (income) and return of principal recharacterized as dividends (offset by partial or full DRD) and return of capital and gain o Apportionment Interest (typically included in receipts factor) re-characterized as dividends (typically excluded from receipts factor) 27 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Recharacterization State Consequences cont d. Recharacterization may o change composition of state combined filing unit o create differences in state and federal stock basis o generate a deferred intercompany stock account ( DISA ) in CA or WV o impact satisfaction of ownership / control thresholds for legal entity reorganizations at state level Re-characterization may also impact computation of: o Franchise taxes based on net worth reported for federal income tax purposes (not GAAP) o Gross receipts taxes Are dividends included in gross receipts? Are dividends sourced in the same manner as interest? o NH Business Enterprise Tax based in part on dividends 28 Reed Smith LLP Kean Miller LLP
The New Federal Regulations Other Implications Interplay with state related- company interest addback provisions o Is addback superfluous with issuance of debtequity rules? o Is addback per se unreasonable if an obligation is classified as debt State-specific common law (e.g. MA) not superseded 29 Reed Smith LLP Kean Miller LLP
Questions? Jaye Calhoun Kean Miller LLP 909 Poydras Street, Suite 3600 New Orleans, Louisiana 70112 504.293.5936 (direct) 504.293.6828 (facsimile) Jaye.Calhoun@keanmiller.com Kelley C. Miller Reed Smith LLP 2500 One Liberty Place 1650 Market Street Philadelphia, PA 19103 215.851-8855 (direct) 215-851-1420 (facsimile) kmiller@reedsmith.com 30 Reed Smith LLP Kean Miller LLP