July 7, 2016

Mr. Jacob Lew

Secretary of the Treasury

U. S. Department of the Treasury

1500 Pennsylvania Avenue, N.W.

Washington, D.C. 20220

Mr. Mark J. Mazur

Assistant Secretary for Tax Policy

Department of the Treasury

1500 Pennsylvania Avenue, NW

Washington, DC 20220

Mr. Robert Stack

Deputy Assistant Secretary

International Tax Affairs

Department of the Treasury

1500 Pennsylvania Avenue, NW

Washington, DC 20220

The Honorable John Koskinen

Commissioner

Internal Revenue Service

1100 Constitution Avenue, NW

Washington, DC 20224

Mr. William Wilkins

Chief Counsel

Internal Revenue Service

1111 Constitution Avenue, NW

Washington, DC 20224

and submitted electronically with the Federal eRulemaking Portal at:

www.regulations.gov (IRS REG-108060-15)

Re: REG-108060-15 Proposed Section 385 Regulations

Dear Sir:

The Organization for International Investment ("OFII") is a not-for-profit U.S. business association that

represents the U.S. subsidiaries of global companies headquartered outside the United States. On behalf of

its member companies, OFII promotes policies that enable global companies to establish U.S. business

operations. We advocate for fair, non-discriminatory treatment of businesses engaged in inbound U.S.

investment and support economic policies that facilitate cross-border trade and investment.

As of December 2014, there was almost $3 trillion of cumulative foreign direct investment in the United

States. This investment supports more than 24 million workers in the United States, including 6.1 million

2

American workers directly employed by U.S. subsidiaries of foreign-based companies.1 Importantly,

compensation for employees of U.S. subsidiaries of foreign based companies is 33 percent higher than the

private sector average. Over the course of more than two (2) decades of promoting inbound investment in

the United States, OFII has always supported transparency, compliance with U.S. laws, and a level playing

field for U.S. inbound investment.

On April 4, 2016, the United States Treasury ("Treasury") and the Internal Revenue Service ("Service")

proposed regulations (hereinafter, "Proposed Regulations") under section 385 of the Code.2 The Proposed

Regulations contain three (3) distinct sets of rules. None of the rules apply to loans between members of a

U.S. consolidated group so long as the loan remains between members of a consolidated group.3

The first rule is the "Part-Stock Rule" which permits the Service to recast a single advance as equity "in

part".4 The Proposed Regulations apply to instruments where the issuer and the holder are members of the

same modified expanded group ("MEG").5

The second rule is the "Documentation Rule", which requires the taxpayer to create and maintain

documentation associated with certain instruments upon issuance and over the life of the instrument.6

Failure to comply with the Documentation Rule results in automatic recharacterization of the instrument as

equity. The Documentation Rule applies to debt issued in the form of a loan where the issuer and holder

are part of the same affiliated group of corporations ("Expanded Group").7 The Proposed Regulations refer

to these instruments as expanded group instruments or "EGIs".8

We refer to the third rule as the "Per Se Stock Rule", which, under certain circumstances, causes an

instrument that would otherwise be considered "debt" under the common law to be considered "equity".9

The Per Se Stock Rule applies to instruments that are considered debt under general tax principles where

the issuer and holder are part of the same Expanded Group.10 We sometimes refer to these instruments as

expanded group debt instruments or "EGDIs". At a high level, the Per Se Stock Rule applies if an EGDI

arises pursuant to a "tainted" transaction11 (the "General Rule"),12 arises 36 months before or after (the "72-

1 Report, Organization for International Investment, Jobs We Need. Washington, DC: Organization for International Investment,

available at https://ofii.uberflip.com/i/692268-global-investment-provides-the-jobs-we-need. (June 20, 2016).

2 Unless otherwise noted, all Code, section and Treas. Reg. § references are to the United States Internal Revenue Code of 1986,

as amended, and regulations issued pursuant thereto.

3 Prop. Reg. §1.385-1(e).

4 Prop. Reg. §1.385-1(d).

5 Prop. Reg. §1.385-1(d)(2).

6 Prop. Reg. §1.385-2.

7 Prop. Reg. §1.358-2 and Prop. Reg. §1.358-1(b)(3) (defining Expanded Group) and Prop. Reg. §1.385-2(a)(4)(ii) (defining

expanded group instrument).

8 Prop. Reg. §1.385-2(a)(4)(ii).

9 Prop. Reg. §§1.385-3 and 4.

10 Prop. Reg. §1.358-3(b) and (f)(3).

11 The regulation identifies a tainted transaction as a distribution by a corporation of its own note to its shareholders, the issuance

of a note for stock of another Expanded Group member or the issuance of a note in certain tax-free asset reorganizations. See Prop.

Reg. §1.385-3(b)(2)(i)-(iii).

12 Prop. Reg. §1.358-3(b)(2).

3

month window period") the occurrence of a "tainted" transaction (the "Funding Rule"),13 or is issued with

a principal purpose of avoiding the General Rule or Funding Rule (the "Anti-Abuse Rule").14 In brief,

tainted transactions involve the borrower making a distribution, 15 acquiring stock of an Expanded Group

member from another member,16 or issuing a note or property other than stock in an asset reorganization to

an Expanded Group member.17

Summary of Concerns and Recommendations

Our membership is profoundly concerned about the impact these regulations will have on their ongoing

operations in the United States. Specifically, if finalized in their current form, the Proposed Regulations

will incentivize our membership to reduce existing investment in the United States and curtail future

investment in the United States.

This is because the Proposed Regulations are not targeted to the specific behaviors the Administration

purportedly desires to address. Instead, they would broadly disrupt normal, routine, daily business activities,

creating unintended consequences and real economic harm. The Proposed Regulations are a significant

departure from common law regarding the classification of debt and equity. Under these Proposed

Regulations, classic debt issued at arm’s length and respected under existing U.S. tax principles can be

reclassified as equity, effectively eliminating U.S. adherence to the international arm’s length standard,

creating double taxation, and adding significant uncertainty for taxpayers looking to invest and grow their

operations in the United States.

In summary, our membership believes that the Per Se Stock Rule is invalid both substantively and

procedurally. The Per Se Stock Rule will also be subject to challenge under applicable tax treaties, which

will increasingly contain mandatory arbitration provisions.18 The Proposed Regulations are overly broad,

imposing documentation requirements and possibly recasting transactions that cannot possibly have a tax-

avoidance purpose. Other aspects of the Proposed Regulations are simply unworkable as illustrated most

clearly with respect to cash pooling, a common and legitimate business practice that will be effectively

eliminated by the Funding Rule.

To address these concerns, OFII makes the following recommendations:

1. The Per Se Stock Rule is invalid and should be withdrawn.

2. In all events, the scope of both the Per Se Stock Rule and Documentation Rule should be

dramatically narrowed.

a. The Documentation Rule and Per Se Stock Rule should not apply to instruments that bear

little or no interest. The Documentation Rule and Per Se Stock Rule should not apply to

short term instruments.

13 Prop. Reg. §1.358-3(b)(3).

14 Prop. Reg. §1.358-3(b)(4).

15 Prop. Reg. §1.385-2(b)(2)(i) (General Rule) and Prop. Reg. §1.385-2(b)(3)(ii)(A) (Funding Rule).

16 Prop. Reg. §1.385-3(b)(2)(ii) (General Rule) and §1.385-3(b)(3)(ii)(B) (Funding Rule).

17 Prop. Reg. §1.385-3(b)(2)(iii) (General Rule) and §1.385-3(b)(3)(ii)(C) (Funding Rule).

18 See e.g., Article 25, paragraph 7 of the United States Model Income Tax Convention (2016).

4

b. The Documentation Rule and Per Se Stock Rule should not apply to instruments issued by

persons who are not subject to U.S. taxation.

c. The Documentation Rule and Per Se Stock Rule should not apply to instruments issued

between two U.S. corporations or a U.S. branch and a U.S. corporation that are part of the

same Expanded Group but do not join in filing a consolidated tax return.

3. The operation of the Per Se Stock Rule, if retained despite our objections, should be modified as

follows:

a. The presumption contained in the Funding Rule should be rebuttable.

b. The 72-month window period should be dramatically shortened.

c. Deposits by Expanded Group members in a treasury center should be exempt from the Per

Se Stock Rule.

d. Deemed acquisitions of Expanded Group member stock should not be considered a

"tainted" transaction triggering application of the Per Se Stock Rule.

e. The $50 million threshold exception should be modified to more accurately reflect

Treasury's stated objective of combatting earnings stripping.

f. The current year earnings and profits ("E&P") exception should be expanded to include

all E&P accumulated during the Expanded Group's holding period for the distributing

entity.

g. The funded acquisition of subsidiary stock rule should be expanded to apply whenever a

funded member contributes assets to an affiliate regardless of whether the funded member

owns sufficient stock directly or indirectly.

h. The composition of the Expanded Group at the time of the loan should be clarified so the

rules do not apply to situations that cannot possibly result in abuse.

i. The Per Se Stock Rule should not apply to trigger de-consolidation of U.S. consolidated

group members.

4. The operation of the Documentation Rule should be modified as follows:

a. The Documentation Rule should be used to provide guidance to the Field on substantive

issues and not exalt form over substance.

i. The regulations should better clarify what types of documentation will satisfy the

Documentation Rule's requirement that Creditor's Rights be documented.

ii. The Documentation Rule should clarify that a borrower may demonstrate a

reasonable expectation to repay even if the borrower plans to refinance old debt

with newly issued debt at maturity.

iii. The Documentation Rule should clarify that offsetting journal entries or

adjustments to a cash pool balance represent "payment" during the life of the loan.

b. The Documentation Rule should provide more realistic time frames within which

borrowers may assemble the necessary documentation.

5

c. The Documentation Rule should simply be considered part of the documentation taxpayers

are required to assemble under section 6662. Failure to comply with the Documentation

Rule should not trigger a recast of debt into equity.

d. The exemption for smaller companies should be clarified.

5. The Operation of the Part-Stock Rule should be clarified to:

a. explain when the rule should apply;

b. explain the mechanics of repayment of interest and principal when it does apply; and

c. place internal procedural limitations on field agents to ensure that the rule is only invoked

when it is appropriate to do so.

In support of our request, this letter proceeds in six (6) parts. First, we explain the negative impact these

regulations will have on foreign direct investment ("FDI") and legitimate business operations in the United

States. Second, we explain why the Per Se Stock Rule is substantively and procedurally invalid and will

conflict with existing U.S. tax treaties. Third, we recommend the scope of the Per Se Stock Rule and

Documentation Rule be dramatically narrowed so they only address the transactions Treasury and the

Service actually care about. Fourth, we outline modifications that could be made to the operation of the

Per Se Stock Rules to make them more administrable. Fifth, we outline modifications that could be made

to the operation of the Documentation Rules to make them more administrable. Lastly, we request Treasury

provide guidance as to when the Service's agents should apply the Part-Stock Rule so that it is not abused.

I. THE PROPOSED REGULATIONS WILL HAVE A PROFOUNDLY NEGATIVE IMPACT ON

INVESTMENT IN THE UNITED STATES AND HINDER LEGITIMATE BUSINESS ACTIVITY.

We are concerned that the Proposed Regulations directly undercut the Administration’s efforts to encourage

foreign companies to invest in the United States. President Obama has consistently prioritized a variety of

initiatives to ensure the United States is open to foreign direct investment. Most notably, the President

created the office of SelectUSA within the Department of Commerce for the sole purpose of attracting and

retaining foreign direct investment.19 In 2011, President Obama issued an open investment statement, in

part affirming:

My Administration is committed to ensuring that the United States continues to be the most

attractive place for businesses to locate, invest, grow, and create jobs…In a global economy,

the United States faces increasing competition for the jobs and industries of the future.

Taking steps to ensure that we remain the destination of choice for investors around the

world will help us win that competition and bring prosperity to our people.20

Since that time, the Administration has worked to improve the U.S. investment climate and send a clear

message to companies that America is the best destination for their investments. The Council of Economic

Advisers issued a report in 2011 highlighting the benefits of foreign-based companies investing in the

19 Press Release, White House, Executive Order #13577—SelectUSA Initiative (June 15, 2011), available at

https://www.whitehouse.gov/the-press-office/2011/06/15/executive-order-13577-selectusa-initiative (”There is established the

SelectUSA Initiative, a Government wide initiative to attract and retain investment in the American economy. The Initiative is

to be housed in the Department of Commerce. The mission of this Initiative shall be to facilitate business investment in the

United States in order to create jobs, spur economic growth, and promote American competitiveness.”)

20 Press Release, White House, Statement by the President on United States Commitment to Open Investment Policy (June 20,

2011), available at https://www.whitehouse.gov/the-press-office/2011/06/20/statement-president-united-states-commitment-

open-investment-policy

6

United States and underscoring the need to maintain an open investment climate.21 In 2012, the State

Department hosted their first ever Global Business Summit, where Secretary Clinton identified increasing

inward investment as one of her three top policy priorities under her “economic statecraft” plan.22

The United States has hosted three SelectUSA Investment Summits, gathering existing foreign investors

and potential new investors to share the benefits of investing in the United States. 23 This year, the United

States was the official partner of Hannover Messe, the world’s largest trade fair, where the President

encouraged businesses to locate in the United States.24 In addition, the Department of Commerce recently

established an Investment Advisory Council to “provide advice and strategies to attract foreign direct

investment” to the United States.25

The Proposed Regulations, particularly the Per Se Stock Rule, if finalized in their current form, will reduce

foreign direct investment in the United States contrary to the efforts of the Administration.26 Specifically,

the rules will: (i) increase the cost of financing U.S. operations; (ii) incentivize foreign multinationals to

cause their U.S. subsidiaries to annually distribute their U.S. E&P instead of reinvesting in the U.S.; and

(iii) hinder or eliminate many legitimate non-tax-motivated business transactions.

A. The Per Se Stock Rule will Increase the Cost of Financing U.S. Operations.

For foreign-based multinationals, the foreign parent company represents the most efficient entity in the

organization to borrow money. It owns all of the assets of the group (both U.S. and non-U.S.), will typically

have an established credit rating, will have a balance sheet lenders are familiar with, and can borrow in a

variety of currencies. Much intercompany lending from foreign based multinationals to their U.S.

subsidiaries merely represents on-lending of amounts that the foreign parent has borrowed from third parties

in various currencies. This has a number of advantages. First, it allows the multinational group to borrow

using the entity that can borrow most inexpensively. Second, it allows foreign multinationals to reduce

their exposure to foreign currencies while creating a natural currency hedge:

21 Blog Post, White House, Promoting and Open Investment Policy to Create Jobs and Grow the Economy (June 20, 2011),

available at https://www.whitehouse.gov/blog/2011/06/20/promoting-open-investment-policy-create-jobs-and-grow-economy

(“Our report highlights how the Administration’s open investment policy allows foreign-based companies to grow and expand their

businesses across the country. These companies are building new facilities, investing in research and development, and growing

warehouses, sales offices and service centers—creating millions of high-quality, well-paying jobs for American workers.”

22 Fact Sheet, U.S. Department of State, Economic Statecraft: U.S. Foreign Policy in an Age of Economic Power (February 16,

2012), available at http://www.state.gov/r/pa/pl/2012/184182.htm (“Our Missions work with a broad range of local partners across

the globe to help attract investment to the United States.”

23 Press Release, White House, Remarks by the President at the 2016 SelectUSA Investment Summit (June 20, 2016), available at

https://www.whitehouse.gov/the-press-office/2016/06/20/remarks-president-2016-selectusa-investment-summit (“In today’s

world, where business doesn’t stop at borders, and when trade is how we shape economic change to our advantage, when the

term “global economy” is redundant because of global supply chains being tied into every element and every aspect of our lives,

these partnerships are the keys to success for all of us no matter where we live, no matter if you’re a small startup or a ma jor

multinational. As the local economic development experts here all know, communities that open their doors to foreign

investment create more jobs and economic activity than those that don’t.”)

24 Speech, White House, President Obama Speaks at the Hannover Messe Trade Fair (April 24, 2016), available at

https://www.whitehouse.gov/photos-and-video/video/2016/04/24/president-obama-speaks-hannover-messe-trade-fair (“As you

look around the globe and try to decide where to invest, where to set up shop, I urge you to select the United States of America,

select USA…In the United States, you’ll have access to one of the world’s largest markets — more than 320 million people.”)

25 Department of Commerce, International Trade Administration, Notice, “Notice of Establishment of The United States Investment

Advisory Council,” Federal Register 81, no. 53 (March 18, 2016): 14835, https://www.gpo.gov/fdsys/pkg/FR-2016-03-

18/pdf/2016-06231.pdf.

26 See enclosure.

7

EXAMPLE 1: FP, a foreign publicly traded corporation, owns all of the stock of USCO,

a U.S. subsidiary, and JCO, a Japanese subsidiary. FP has the Euro as its functional

currency. The balance sheet FP prepares and shows to the public is denominated in Euro.

USCO and JCO use the U.S. dollar and Japanese Yen, respectively, as their currency.

FP could borrow money at the FP level in Euros and equity fund USCO and JCO. This

would increase FP's balance sheet exposure to the U.S. dollar and Japanese yen, however.

Rather than borrowing in Euros and equity funding its subsidiaries, FP can borrow in

U.S. dollars and Japanese Yen and then on-loan those funds to USCO and JCO in U.S.

Dollars and Japanese Yen. By borrowing in the desired currency and on-loaning in that

same currency, FP avoids increasing its exposure to the U.S. dollar and Japanese Yen

while creating a natural hedge of its currency exposure on the loans.

The Proposed Regulations will not cause FP to borrow abroad and equity fund USCO, which is the behavior

Treasury apparently wants to encourage. At a minimum, this would create undesirable currency exposure

for FP's group. Instead, the Proposed Regulations will incentivize USCO to borrow directly from third

parties with or without an FP guarantee. The interest paid to the third party bank (coupled with a guarantee

fee for any applicable parent guarantee)27 may in many cases exceed the arm's length deduction that USCO

would have claimed on an intercompany loan payable to FP. Thus, the Proposed Regulations will actually

have the perverse effect of increasing deductions claimed in the United States, while at the same time

increasing the third party cost of financing U.S. operations. Hence, the Proposed Regulations will have the

unintended impact of decreasing future foreign direct investment and potentially lowering U.S. tax

revenues at the same time.

B. The Per Se Stock Rule will Incentivize Foreign-Based Multinationals to Extract their

Earnings Every Year Rather than Reinvest Them in the United States.

The Per Se Stock Rule allows a corporation to reduce the amount of a "tainted" transaction by the

corporation's E&P accrued during the year in which the tainted transaction occurs. If a U.S. subsidiary of

a foreign-based multinational fails to distribute its earnings for the year, those earnings are effectively

"trapped". This is because any distribution of those earnings in a later year cannot qualify for the current

year E&P exception28 and could trigger a recast of any related party loan arising three years prior or three

years hence. Although the group would presumably know about prior loans, it cannot possibly predict

whether any loans would be granted in the following three year period.

The Per Se Stock Rule (as currently drafted) presents foreign-based multinationals with two alternatives.

They either refrain from extending any loans to their U.S. group or they treat the earnings of their

subsidiaries as trapped capital. This "use it or lose it" feature of the current year E&P exception incentivizes

foreign-based multinationals to ensure that their U.S. subsidiaries distribute all of their current year earnings

every year, rather than re-invest them in the United States. Given that reinvested earnings accounted for

88 percent of foreign direct investment in the United States in 2014 (most recent data available), this will

have a dramatic and negative impact on future foreign direct investment.29

C. The Proposed Regulations will Interfere with Many Routine and Legitimate Business

Transactions, thereby Reducing the Incentive to Invest in the United States.

The Proposed Regulations will hinder or eliminate many legitimate business transactions.

27 Importantly, if a guarantee is in place, FP's jurisdiction will require a guarantee fee be paid.

28 Prop. Reg. §1.385-3(c)(1).

29 Bureau of Economic Analysis, Survey of Current Business, Activities of U.S. Affiliates of Foreign Multinational Enterprises in

2014.

8

1. The Funding Rule will Eliminate Cash Pooling as a Cash Management Tool.

The Proposed Regulations refer to "cash pooling"30 but the regulations are incredibly vague as to how they

will apply to different types of cash pooling structures. In fact, government officials have acknowledged

that there is no comprehensive definition and guidance regarding cash pooling.31 That is presumably why

the drafters explicitly asked for comments about how the rules should apply to cash pooling. 32 The

following discussion attempts to highlight some of the salient issues that are presented by cash pooling and

why the existing regulations will eliminate cash pooling as a business practice outside of the U.S.

consolidated group.

a. Multinationals Do NOT Establish a Cash Pool for Tax Reasons.

Multinational groups do not set up cash pooling operations for tax reasons. Cash pooling creates

complexities from a tax perspective that have to be navigated such as withholding tax issues, currency

exchange issues, etc…. If anything, tax planning would often be easier if each entity held its cash in its

own decentralized account.

Multinationals engage in cash pooling because it allows them to minimize borrowing costs. Instead of

having one subsidiary borrow cash at a 2% rate while another subsidiary is depositing cash at a .1% rate,

the cash rich subsidiary's excess cash can be deposited in the pool and drawn down by the cash poor

subsidiary. Cash pooling also allows multinationals to aggregate their excess cash and invest larger

amounts in one currency (typically USD or Euro) rather than smaller amounts in a range of currencies (i.e.,

GBP, Zloty, Kroner etc…). By aggregating cash and investing in a single liquid currency, the treasury

function can maximize its return on cash that is not deployed in the business at that moment in time. In

addition, treasury centers allow all of the currency risk to be centralized in a single entity that can hedge

the net exposure33 with various counterparties that have analyzed the treasury center and have applicable

agreements in place with the treasury center.

Another advantage of having a single treasury center for some companies is that there is one entity that can

issue commercial paper and access the commercial paper markets. That entity can then lend that cash to

whomever needs it. The use of a cash pool can also be coupled with a centralization of treasury functions

that allows for economies of scale and greater visibility into how the multinational is using its cash.

b. Physical Pooling vs. Notional Pooling.

The Code does not make distinctions between different types of cash pooling scenarios. Nevertheless a

practice has developed that distinguishes between "physical" pooling and "notional" pooling.

At a very high level, in a "physical" cash pooling scenario, various members of an affiliated group have

accounts with a single bank. One participating member of the affiliated group acts as the "treasury center"

30 Prop. Reg. §1.385-2(b)(3)(iii)(B).

31 Amy S. Elliott & Lee A. Sheppard, Expanded Group Definition in U.S. Debt-Equity Regulations May be Narrowed, 2016 WTD

90-3 (quoting an Attorney Advisor to Treasury's Office of Tax Legislative Counsel, as saying that "cash pooling can just be a label,

and I think we're going to need help drawing lines here based on the substance of these intercompany loan arrangements,"); Alison

Bennett, Controversy Ahead: Treasury Rules Threaten Cash Pooling, BNA DAILY TAX REPORT (Apr. 26 2016) (quoting senior

counsel in Treasury's Office of International Tax Counsel, as saying “We would like to understand what people mean when they

say ‘cash pooling.’ I view that term as a label. We need to understand what's behind it.”).

32 81 F.R. 20911, 20915, 20929 (Apr. 4, 2016).

33 For example, a Dutch sales subsidiary may deposit €1,000,000 with the treasury center while a French subsidiary may withdraw

€700,000 from the treasury center. If the treasury center has the U.S. dollar as its functional currency for accounting purposes, it

will only have to hedge the net €300,000 exposure.

9

which has its own account with a bank. The various members of the group who participate in the pool,

transfer cash from their individual accounts to an account owned by the treasury center which then records

liabilities payable on its books to those depositing members. Importantly, these deposits are typically made

in the depositor's functional currency. It is not uncommon, for example, in a European physical cash

pooling scenario to have a UK affiliate deposit in GBP, a Swedish affiliate deposit in Kroner and other

Eurozone affiliates deposit in Euro.

At any time, a participating member may withdraw cash from the treasury center. It is common for the

withdrawing member to withdraw monies in its own functional currency. Thus, a Swedish affiliate would

typically borrow in Kroner. Similarly, a U.S. affiliate would borrow in U.S. dollars. This would be true

even if the treasury center was incorporated in The Netherlands and used the Euro as its functional currency.

In that case, the treasury center's bank account is reduced, and the withdrawing member's bank account is

increased. The withdrawing member records a liability on its books and the treasury center records a

receivable on its books. Normally, the system is set up such that withdrawals cannot exceed deposits. If

withdrawals are allowed to exceed deposits, the treasury center would have a liability owing to the third-

party bank and the withdrawing affiliate member would have the payable to the treasury center.

Importantly, for both commercial and tax purposes, the intercompany loans are between the affiliates and

the treasury center.34 This has a number of corollary effects. If withholding taxes apply to the interest

received, the treasury center bears those taxes.35 The currency gains or losses that arise when deposits are

made in one currency and withdrawn in a different currency are recognized by (and may be hedged by) the

treasury center. If the loans in a non-functional currency are not offset by borrowings in that currency, the

treasury center may enter into a hedge with a bank, which would typically take the form of rolling forward

contracts. It is helpful to have all of the currency risk centralized, because the treasury center will already

have contractual arrangements in place with the counterparty on the hedge to facilitate entering into a

derivative.36

In contrast, in a “notional” pooling scenario, a third party bank acts as the treasury center. Participating

members deposit with the bank. They typically deposit in their own functional currency. Withdrawing

members withdraw from the bank, typically in their own functional currency. The "loans" and "receivables"

are between members and the bank. Any foreign currency gain or loss is recognized (and may be hedged)

by the bank, not a participating affiliate. In fact, one of the big advantages of using notional pooling is that

it allows the participating members to aggregate their cash without having to address the currency issues

associated with having deposits and withdrawals in multiple currencies. One participating member will

typically act as a "pool leader" vis-à-vis the bank, but this is a fundamentally different role from that of a

"treasury center". The cash pool leader would typically be responsible for paying the fee to the bank,

covering for any defaults of withdrawing members, and would receive the net interest payment for positive

cash balances in the pool (if any).37

34 Depending on the status of the borrower and treasury center, the Code's look-through rules, such as those found in section 904(d),

954(c)(6) and 1297(b)(2)(C), could apply to the interest payments.

35 If the treasury center happens to be a CFC, the treasury center would add those taxes to its foreign tax credit pool.

36 If the treasury center is a CFC, the treasury center may take the position that it is a dealer under section 475 of the Code due to

its activities, benefit from mark-to-market treatment, and thereby more easily match its foreign currency gains and losses and avoid

whipsaw treatment that can easily arise under subpart F of the Code.

37 In the event that there are positive amounts paid to the cash pool leader, the leader would typically be responsible to pay out

appropriate amounts to the depositors or lenders to reflect an increase in the amount they earned or reduce the amount they paid.

10

c. Difficulties with Finding the "Funded Member" and Measuring the

Funding.

Given that the Proposed Regulations fail to distinguish between Physical Pooling and Notional Pooling,

they also fail to explain how the taxpayer is supposed to identify the "Funded Member" under the Funding

Rule when cash pooling is used.

i. Does the Funding Rule Apply to Notional Pooling?

A threshold question is whether notional pooling arrangements are, in fact, subject to the Funding Rule.

EXAMPLE 2: FP is a publicly traded corporation that owns all of the outstanding shares

of F1, F2, and F3 all of which are foreign corporations. F1 and F2 have the Euro as their

functional currency. F3 has the GBP as its functional currency. FP also owns all of the

outstanding shares of USCO, a U.S. corporation. FP uses a notional pooling arrangement

with a bank, BANK XYZ, pursuant to which each of USCO, F1, F2, and F3 can deposit

monies with BANK XYZ or withdraw monies from BANK XYZ. No participating

member is entitled to withdraw more than the positive cash pool balance. F1 serves as

the cash pool leader. On June 1, 2017, USCO makes a deposit with BANK XYZ of $100

million.

Will the Service respect Bank XYZ as a third party and conclude that the Funding Rule does not apply? Or

will the Service apply the Anti-Abuse Rule to "look through" Bank XYZ? It is unclear under the Proposed

Regulations. Yet, this is an issue the final regulations will have to address.

We believe that if the Proposed Regulations are clarified to indicate that BANK XYZ should be respected

as a third party bank such that there is no funding of an Expanded Group member, then every multinational

group subject to the Proposed Regulations will seek to replace their physical pooling structures with

notional pooling structures. This will prove very difficult for smaller businesses, however.38 Smaller

businesses may not have the scale of financing activities that make notional pooling practical. As such,

they will be at a competitive disadvantage.

If the final regulations provide that the Funding Rule does apply to notional pooling structures, then it

means that the regulations will "look through" the treasury center / third party bank. This then leads to

further questions as noted below.

ii. If the Funding Rules do Apply then do Look-Through Concepts

Apply to Physical Pooling as well?

If the Proposed Regulations indicate that BANK XYZ in Example 2 should be "looked through" for section

385 purposes, then the next question is whether the treasury center in a Physical Pooling scenario will be

similarly looked through. Stated differently, if BANK XYZ is replaced by F1, a member of the Expanded

Group, will the Proposed Regulations stop at F1 and consider F1 the "funded member"? Or will the

Proposed Regulations "look through" F1 and treat the various affiliates who withdraw from F1 as the

"funded members"?

38 The Third Basel Accord (a.k.a. Basel III) introduced the Liquidity Coverage Ratio (or "LCR") which may require BANK XYZ

in the example to hold additional capital despite the fact that the deposits should always equal the withdrawals. In practice, banks

have already proven reluctant to provide notional pooling services for new, smaller clients until the uncertainty about the LCR is

resolved.

11

iii. Who is the Funded Member and what is the Amount of the Funding?

If the Proposed Regulations do "look through" to the withdrawing affiliates, the next question will be how

precisely the regulations will look through the treasury center?

EXAMPLE 3: The facts are the same as in Example 2. F3 withdraws the GBP equivalent

of USD $100 Million on the morning of June 2, 2017, which is GBP 67 million. On the

afternoon of June 2, 2017, F3 repays GBP 40 million of its withdrawal, and F2 withdraws

the Euro equivalent of GBP 40 million, or €90 million.

In the foregoing example, which entity is the "funded member"? Is it F3 or F2? What is the "currency" of

the loan that will potentially be converted to equity? Is it U.S. dollars, GBP or Euro?

These are all questions Treasury will have to address if it proceeds to finalize the Funding Rule.39

d. The Funding Rule will Eliminate Cash Pooling, a Legitimate Cash

Management Tool.

The Funding Rule, as currently drafted, will eliminate cash pooling, a legitimate management tool, for any

entities outside of the U.S. consolidated group. In Examples 2 and 3, if USCO's deposit is recast as an

equity interest in F1, F2 or F3, that entity, which is not currently subject to U.S. tax, could become a CFC

(if the recast equity represents more than 50% of the issuer's value) or possibly a PFIC.40 Even if the issuer

is not considered a CFC or a PFIC, the repayment of the recast equity will be considered a section 302(d)

redemption, not a tax-free return of principal, causing USCO to recognize up to $100 million of income41

with no associated foreign tax credits.42

The repayment of that recast EGDI can then beget another recast, thereby triggering a cascading series of

recasts. Specifically, once an EGDI is recast as equity, its repayment will likely be considered a redemption

governed by section 302(d) of the Code. The borrower's redemption distribution, in turn, represents a

"tainted transaction" which can then cause other related party loans to that borrower entity to be recast.43

Given the grave consequences of recast, it is highly unlikely that a corporate treasurer is going to run the

risk that his/her department can monitor and prevent a treasury center, or an affiliate who withdraws cash

from a treasury center, from engaging in a tainted transaction 3 years prior or 3 years subsequent to the loan.

Instead, what he or she will do is tell management that cash of U.S. consolidated group members cannot be

pooled with any other affiliates. Moreover, CFC affiliates cannot effectively pool their cash with one

39 See also, L.G. "Chip" Harter, et. al., Section 385 Proposed Regulations Would Vitiate Internal Cash Management Operations,

available at www.pwc.com.

40 There is a "look through" rule in section 1297(b)(2)(C) that treats interest and royalties received from related parties as "active"

income in certain cases, but even that look through rule does not apply to "gains". The ease with which companies can inadvertently

become PFICs is one of the main reasons Congress eliminated the CFC-PFIC overlap in 1997. See Pub. L. 105-34, 111 Stat. 788

§ 1121; H.R. REP. NO. 105-148, 105th Cong., 1st Sess., ay 533.

41 This assumes the borrower has sufficient earnings and profits under sections 312 and 301(c)(1).

42 Section 902(b) imposes a 10 percent voting threshold and the recast equity would not presumably have any voting rights

associated with it.

43 For treasury centers that are also CFCs, the recast loans can also wreak havoc with the group's attempt to manage currency

exposure. As noted above, if a physical pooling arrangement is used, the group seeks to ensure that receivables and payables in

non-functional currencies are either matched or hedged with a third party. If some loans are recast, and others remain, there will

be net currency exposure. This will then lead to a whipsaw effect. This is because a U.S. shareholder of the treasury center is

taxed under subpart F on currency gains, with no offsetting benefit for a subsequent loss in a later year.

12

another or with non-CFCs. This will increase the cost of doing business in the United States44 and only

further the incentive to distribute current year earnings each year from the U.S. rather than reinvesting them.

Statements by treasury officials suggest that they are attempting to somehow distinguish "good" cash

pooling from "bad" cash pooling. We are concerned that Treasury and the Service are under the impression

that "legitimate" cash pooling somehow must only involve short-term transfers of cash.45 This is not at all

accurate. Although treasury centers make many cash transfers every day, it is also the case in most groups

that certain companies are consistent net cash generators. The net cash generators tend to always be making

deposits in the treasury center. Thus, they have a perpetual "loan" to the treasury center, as their deposits

tend to grow over time. Thus, limiting "cash pooling" to "short term" deposits effectively nullifies cash

pooling.

We respectfully suggest that the goal should not be to distinguish between "good" cash pooling and "bad"

cash pooling. Instead, the sheer breadth of the Funding Rule should be significantly reduced to focus solely

on those transactions that truly present a possibility for abuse. In the event Treasury chooses to retain the

Per Se Stock Rule while (as we suspect) taxpayers challenge its validity, we provide some recommendations

below for how its scope could be reduced in ways that facilitate cash pooling.

2. The Funding Rule will Inhibit the Use of Equity-Based Compensation.

Many of our members use equity of the foreign parent to compensate employees of their U.S. subsidiaries

and CFCs owned by those U.S. subsidiaries. Under applicable U.S. treasury regulations, 46 the U.S.

subsidiary (or CFC) is deemed to acquire shares of the foreign parent, albeit only for an instant, before the

shares are transferred to the employee. This incredibly routine non-tax motivated acquisition of foreign

parent stock represents a "tainted" transaction under the Per Se Stock Rule and can cause loans to the U.S.

subsidiary or CFC to be recast as equity.

The Proposed Regulations do provide a current year E&P exception to the application of the Per Se Stock

Rule.47 Under this exception, a borrower member may engage in tainted transactions up to the amount of

its current year E&P without triggering a recast. Yet, as noted above, the current year E&P exception is

44 Inability to pool excess U.S.-generated cash increases the cost of investing in the United States. This is because the excess U.S.-

generated cash cannot be redeployed and invested to earn the highest return possible. Instead, it remains ring-fenced in the U.S.

earning whatever return the U.S. group can get for its idle cash.

45 Alison Bennett, Controversy Ahead: Treasury Rules Threaten Cash Pooling, BNA DAILY TAX REPORT (Apr. 26, 2016) (quoting

Brenda Zent, a special adviser in the Treasury Department's Office of International Tax Counsel as saying that “the government is

looking at whether cash-pooling arrangements are designed for short-term liquidity, versus arrangements that look more like longer-

term loans.”); Alison Bennett, Treasury Opens to Cash-Pooling in Earnings Stripping, BNA DAILY TAX REPORT (May 9, 2016)

(reporting on statements made by Danielle Rolfes, Treasury’s International Tax Counsel, explaining that Rolfes had said that “the

Treasury Department wants to write an exception in final earnings-stripping regulations for cash-pooling arrangements that involve

routine, daily ‘sweeps’ of cash, while cracking down on long-term financing arrangements that look like problematic loans,”

reporting further that Rolfes “asked for help from the tax community in writing the exception in a way that would protect

arrangements in which cash pools—central bank structures maintained by multinationals to provide cash to their subsidiaries—are

used to 'sweep’ up cash for use in daily business operations” adding that Rolfes said that Treasury is more worried about “long-

term financing arrangements through a treasury financing center involving significant sums,” adding further that Rolfes had stated

that “a line should be drawn between those and arrangements where subsidiaries borrow substantial amounts of money through a

treasury center on a long-term basis . . . . there are taxpayers who call both types of arrangements cash-pooling and she thinks they

are two different scenarios.”); Alison Bennett, Pain of Earnings-Stripping Rules Might Ease: Treasury, BNA DAILY TAX REPORT

(May 10, 2016) (quoting Kevin Nichols, senior counsel in Treasury's Office of International Tax Counsel, as saying in response to

questions about automated cash movement in a cash pooling system “There could be complexities that go beyond automation.

We're looking at substance. If an entity is making long-term loans and also doing borrowing that could be problematic.”).

46 Treas. Reg. §1.1032-3.

47 Prop. Reg. §1.385-3(c)(1).

13

only available if the borrower has E&P in the year that the tainted transaction occurs. Moreover, it is not

practical for multinationals to establish an equity-based compensation system that only grants stock in years

when there is sufficient E&P.

If this is not fixed, then U.S. employees of foreign based multinationals may have to be excluded from

stock-based compensation plans. This will only make it harder for foreign based multinationals to recruit

talented employees in the United States.

3. The Per Se Stock Rule will Hinder Pre-Closing and Post-Closing Integration

Transactions.

It is exceedingly common for multinationals to cause one member of the Expanded Group to sell stock of

another member within the group prior to a sale or joint venture with a third party as part of an attempt to

pre-package operations before they are sold or contributed.

EXAMPLE 4: FP, a foreign publicly traded corporation, owns USS1, a domestic

corporation. USS1 owns all of the stock of CFC1. CFC1 also owns all of the stock of

CFC3. CFC1 and CFC3 are controlled foreign corporations. FP owns FC2, a foreign

corporation. The FP group wants to engage in a 50/50 joint venture with an unrelated

foreign counterparty named FT. From FP's perspective, only FC2 and CFC3 will be part

of the joint venture, however. Moreover, the parties agree that FC2 will serve as the joint

venture entity. From FT's perspective, FT will contribute certain assets and cash. FT

needs to contribute cash to ensure that it receives a 50% ownership interest in FC2. Were

it not for the Proposed Regulations, USS1 could simply have CFC1 sell the shares of

CFC3 to FC2 for a note.48 FT would contribute its assets and cash to FC2. FC2 would

use the cash to repay the note owing to CFC1.

Even though FC2 and CFC3 leave the USS1 Expanded Group pursuant to the same overall plan in which

the note was created, the Per Se Stock Rule applies to recast the note as equity. As such, the repayment of

the note is treated as a section 302(d) redemption potentially fully taxable to CFC1.49 CFC1 will forfeit its

tax basis in the note,50 along with any credits removed in connection with the redemption.51 To avoid these

results, USS1 is forced to take what would otherwise be a fairly straightforward plan and seek to structure

the transaction as a taxable sale of CFC3's assets52 to FC2 in order to avoid the scope of the rules. The same

issues arise in post-closing scenarios, where the acquiring corporation simply wants to position Expanded

Group members organized in the same jurisdiction under one another or in a brother-sister relationship to

facilitate mergers and entity reduction. Importantly, this pre-positioning is often done to reduce the non-

U.S. tax consequences of the combination.

There is simply no abuse in these fact patterns. In the case of pre-closing transactions leading up to a sale

or a joint venture, the issuer of the debt, or the Expanded Group member whose shares or assets are

48 USS1 could determine, based on the stock basis, value and earnings and tax pools of CFC3 whether it is better to elect to treat

CFC3 as disregarded and report the transaction as a section 368(a)(1)(D) reorganization or, instead, report the transaction as a

section 304 transaction.

49 If the note is repaid immediately after CFC2 ceases to be in a section 954(d)(3) relationship with CFC1, the look through rules

in section 954(c)(6) will not apply.

50 The basis would presumably attach to the basis that FP has in its FC2 shares but FP cannot use tax basis that only exists for U.S.

purposes.

51 Treas. Reg. §1.902-1(a)(8).

52 The sale would have to avoid characterization as a section 368(a)(1)(D) or else the Per Se Stock Rule would still apply.

14

transferred, leaves the group as part of the same overall transaction. Hence, it is difficult to understand why

the government feels the need to include these transactions within the ambit of the rule.

4. The Proposed Regulations will Inhibit Acquisitions of Other Companies by the

U.S. Group.

The Proposed Regulations will inhibit acquisitions of other companies by U.S. companies or foreign

subsidiaries of those companies. This is because there is simply no realistic prospect that foreign target

corporations will comply with the Documentation Rule or the Per Se Stock Rule.

EXAMPLE 5: FP, a foreign publicly traded company, owns USS1, a domestic

corporation that, in turn, owns many foreign subsidiaries, the holding company for which

is CFC1. CFC1 has excess cash and would like to acquire a foreign corporation ("FT"),

a foreign, publicly traded corporation in 2018. FT owns a number of foreign subsidiaries.

FP hires a firm to perform due diligence and learns, not surprisingly, that FT has not

complied with (or even knows about) the Prop. Reg. §1.385-2 Documentation Rules or

the -3 Funding Rule. As such, if CFC1 acquires FT, it is confronted with the reality of

having to deal with potentially thousands of "micro-equities" the redemption of which

will have profoundly negative effects on USS1's effective tax rate. Thus, FP acquires FT

directly, rather than have CFC1 acquire FT.

Of course, U.S.-based multinationals will not have the same structuring options that FP does in the

foregoing example. A U.S.-based multinational may be forced to simply forego acquiring FT altogether

due to the tax exposure it may otherwise be stepping into.

II. THE PER SE STOCK RULE IS INVALID, VIOLATES EXISTING TREATIES, AND SHOULD BE

WITHDRAWN.

The Per Se Stock Rule is substantively and procedurally invalid, violates existing treaties and should be

withdrawn. The discussion below relays the pertinent history leading to the enactment of the Proposed

Regulations, explains why the Per Se Stock Rule is substantively and procedurally invalid, and highlights

how the rule violates existing treaties.

A. The Law Prior to 1969.

As long as the United States has had an income tax, there has been a distinction between debt and equity.53

In the early years of the corporate income tax, Congress made attempts to place limits on the amount of

debt a corporation could incur.54 Yet, Congress did not define what the term "debt" meant. In the absence

of a statutory definition, the distinction between debt and equity was decided by the courts. Seemingly

inconsistent results in the appellate courts ultimately led, in 1946, to the Supreme Court addressing the issue

53 Congress enacted an income tax in the Act of Aug. 5, 1861. Act of Aug. 5, 1861, ch. 45, §§49-51 12 Stat. 309. Despite being

enacted, Secretary of the Treasury, Salmon B. Chase, made no effort to actually collect the tax. EDWIN R. A. SELIGMAN, THE

INCOME TAX: A STUDY OF THE HISTORY, THEORY AND PRACTICE OF INCOME TAXATION AT HOME AND ABROAD 435-36 (1911). There

was, at the time, a debate over whether the tax should be imposed on “net” income, which implied that various deductions could

be claimed, or whether the word “income” was sufficiently clear to allow for deductions from gross receipts. Cong. Globe, 37th

Cong., 1st Sess. 315 (1861). As one author has noted, this distinction was the precursor of the U.S.'s current debt-equity distinction

because interest on “debt” was deductible in computing “net” income whereas dividends paid on equity were not. See Camden

Hutchinson, The Historical Origins of the Debt-Equity Distinction, 18 FL. TAX REV. 95, 102–103 (2015).

54 Mortimer Caplin, The Caloric Count of a Thin Incorporation, 43 MARQUETTE L. REV. 31, 62-63 (1959) (noting how Congress

enacted legislation in 1909, 1913, 1916 and 1919 impacting the amount of debt that could be incurred).

15

in John Kelley Co. v. Commissioner.55 In Kelley, the Court reviewed an appeal of two different cases,

Kelley and Talbot Mills, where the Tax Court was required to conclude that an instrument was either debt

or equity. The Supreme Court decision was not very illuminating and so litigation continued.

Over the years, different appellate courts developed different tests to try and distinguish debt from equity.

Although the factors used by the courts overlap, there were (and continue to be) several significant

differences among the circuits. 56

B. Congress Enacts Section 385 in 1969.

In 1954, in response to a plethora of litigation surrounding debt v. equity issues, Congress sought to provide

guidance. The original House version of the Internal Revenue Code of 1954 sought to define the terms

"securities", "participating stock" and "non-participating stock".57 Interest would only have been deductible

with respect to "securities."58 The House's approach was rejected in the Senate, however.59

The House of Representatives tried to provide guidance again in 1959.60 This time, the House took a

different approach and tried to create a safe harbor. If instruments contained certain key provisions they

would, in all events, be considered "debt". However, the bill was not enacted. 61

It was not until 1969 that Congress was able to pass a bill that provided guidance on the debt-equity

distinction. The original House version of the Tax Reform Act of 1969 only addressed debt issued in the

context of acquisitions in a provision that subsequently became section 279 of the Code.62 Section 279

55 326 U.S. 521 (1946).

56 See Mortimer Caplin, The Caloric Count of a Thin Incorporation, 43 MARQUETTE L. REV. 31 (1959) (discussing case law

developments before and after the Supreme Court's John Kelley decision). For example, the Third, Fifth, and Ninth circuits all

consider whether or not the obligor could obtain debt from a third party as a factor to determine whether a shareholder loan should

be considered debt. The Third Circuit, however, applies this test by asking whether or not a third party would lend to the obligor

on the same terms that were used in the borrowing at issue. See Scriptomatic, Inc. v. Comm’r, 555 F.2d 364 (3rd Cir. 1977)

(phrasing the test as “whether the transaction would have taken the same form had it been between the corporation and an outside

lender . . ..”); Segel v. Comm’r, 89 T.C. 816, 827 (1987) (also applied the test strictly because the case could be appealed to the

Third Circuit). The Fifth Circuit phrases the test quite differently, suggesting that the independent creditor factor will be satisfied

if the borrower can demonstrate that it could borrow the same amount pursuant to any terms. See Montclair v. Comm’r, 318 F.2d

38, 40 (5th Cir. 1963); Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967). The Ninth Circuit is less clear, but appears to side

with the Fifth Circuit. Hardman v. United States, 827 F.2d 1409 (9th Cir.. 1987 (“If a corporation is able to borrow funds from

outside sources, the transaction has the appearance of a bona fide indebtedness . . . .”); Bauer v. Comm’r, 748 F.2d 1365 (9th Cir.

1984) (“Federal's financial structure and these other factors indicate that Federal could readily have obtained a loan from a bank or

other financial institution for the purpose for which the stockholders' loans were made . . . .”). The Eleventh Circuit also appears

to side with the Fifth Circuit. See Stinnett’s Pontiac Services, Inc. v. Comm’r, 730 F.2d 634 (11th Cir. 1984). But see Brazoria

County Stewart Food Markets, Inc. v. Comm’r, 48 Fed. Appx. 917 (5th Cir. 2002) (“But the real purpose of this factor is to

determine ‘whether the shareholder contributor acted in the same manner toward their corporation as ordinary reasonable creditors

would have acted’ . . . . Although UPE may have been able to obtain one or two loans from outside sources, Brazoria has not shown

that it has dealt with UPE on the same terms as outside ‘ordinary reasonable creditors.’”). The Fifth Circuit also provides a three

part test for determining the persuasive value of thin capitalization under the debt-to-equity ratio factor that other Circuit Courts of

Appeal do not use. See Pepsico Puerto Rico, Inc. v. Comm’r, T.C. Memo 2012-269 (describing the circuit split on this issue).

57 Leon Gabinet, The Interest Deduction: Several New Installments in a Continuing Saga, 21 CASE WESTERN RESERVE L. REV. 501,

502 (1970).

58 H.R. 8300, 83rd Cong. 2d Sess. §§275 and 312 (1954).

59 S. REP. NO. 1622, 83rd Cong., 2d Sess. 42 (1954).

60 H.R. 4459, 86th Cong., 1st Sess. (1959).

61 See Warren, Jr., Alvin C., The Corporate Interest Deduction: A Policy Evaluation, 83 YALE L. J. 1585, 1606 n. 103 (1974).

62 H.R. 13270, 91st Cong., 1st Sess. §411 (1969).

16

seeks to deny interest expense with respect to "corporate acquisition indebtedness" which generally

constitutes debt containing equity-like features that is issued in connection with an acquisition of stock or

assets of another company. When the bill reached the Senate, however, the Senate decided that additional

guidance was required outside of the acquisition context. The legislative history provides:

In view of the uncertainties and difficulties which the distinction between debt and equity

has produced in numerous situations other than those involving corporation acquisitions,

the committee further believes that it would be desirable to provide rules for distinguishing

debt from equity in the variety of contexts in which this problem can arise.63

Thus, Congress enacted sections 279 and 385 of the Code at the same time. Congress made it clear that

even if an instrument withstood scrutiny under section 279, it would not automatically be considered debt

for other purposes of the Code, such as section 385.64

Importantly, Congress believed that the use of debt in the acquisition of stock and assets was to be addressed

under section 279. The purpose of section 385 was to provide more general guidance outside of the

acquisition context on the difference between debt and equity. There is no indication that Congress believed

that debt incurred to acquire stock of a related or unrelated company to which section 279 did not apply

should somehow be suspect under section 385.

C. Section 385(b) Directs Treasury to Develop a Multi-Factor Analysis that Rationalizes

Existing Case Law.

In 1989 Congress amended section 385(a) to authorize Treasury to issue regulations that treated an interest

in a corporation as stock "in part."65 In passing the amendment, Congress stated that, "it is important that

the Treasury Department provide guidance to taxpayers in an expeditious manner."66 Congress even stated

that "the Treasury Department is directed to increase the issuance of IRS published rulings on debt-equity

issues."67

In 1992, Congress added section 385(c), which imposes a consistency requirement on the issuer and holder

of an instrument. Specifically, if the issuer characterizes the instrument as debt then that classification is

binding on the holder unless the holder notifies the issuer of the inconsistent treatment. Importantly, the

consistency requirement only applies to the U.S. tax treatment. There is no prohibition on treating an

instrument as equity for U.S. purposes and debt for another country's purposes (or vice-versa).68

63 S. REP. NO. 91-552, pt. 2, at 138 (1969).

64 Section 279(i). This concept is also reflected in the regulations in Treas. Reg. §1.279-1(a).

65 Pub. L. No. 101-239, 103 Stat. 2106. There was also a technical change in 1976. Pub. L. No. 94-455, 90 Stat. 1520.

66 H.R. REP. NO. 101-247, 101st Cong., 1st Sess., at 1235 (1989).

67 Id. at 1236.

68 H.R. REP. NO. 716, 102d Cong., 2d Sess. at 3 (“It has come to the attention of the committee that certain issuers and holders may

be taking inconsistent positions with respect to the characterization of a corporate instrument as debt or equity. For example, a

corporate issuer may designate an instrument as debt and deduct as interest the amounts paid on the instrument, while a corporate

holder may treat the instrument as equity and claim a dividends received deduction with respect to the amounts paid on the

instruments. The committee believes that the fisc should be protected from this whipsaw potential of inconsistent debt-equity

classifications.”); 138 Cong. Rec. H7165-66 (daily ed. August 3, 1992) (statement of Rep. McGrath) (“[Section 385(c)] will help

prevent an illegal tax avoidance scheme known among practitioners as the debt-equity whipsaw. Issuers of stocks or bonds and

the holders of those interest classify their interests differently to maximize tax advantages.”) See also, Philip R. West, Foreign

Law in U.S. International Taxation: The Search for Standards, reprinted in 96 TAX NOTES INTERNATIONAL 161-13 at fn. 119 (Aug.

16, 1996) (“In the domestic context, inconsistent treatment of hybrid instruments is severely limited by section 385(c), enacted in

17

Yet, the core provision, section 385(b), has remained unchanged since 1969.69 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 an 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. 70

Although the Code provides Treasury with discretion as to what factors it develops, the Congressional

mandate has always been clear. Treasury was to develop multiple (i.e., more than one) factors that

taxpayers and courts could "take into account" in determining whether an instrument was debt or equity.

Importantly, there is absolutely no indication that Congress was concerned about debt issued to pay

dividends or acquire affiliated companies outside of the fact patterns addressed by section 279. Instead,

every indication is that Congress wanted Treasury to look at the common law and attempt to rationalize the

myriad multi-factor tests that had hitherto been employed by the courts.71

1992 (Pub. L. No. 102-486, section 1936(a), 106 Stat. 2776, 3032), which provides that the issuer’s characterization, at the time of

issuance, of an instrument as stock or debt is binding on the issuer and on all holders except holders who disclose on their tax

returns that they are treating the instrument in a manner inconsistent with the issuer's characterization. Although section 385(c)

generally mandates consistent treatment for U.S. income tax purposes, it has no effect on the treatment of an instrument under

foreign law. Consequently, it does not limit the inconsistent treatment of a hybrid instrument under the laws of the United States

and a foreign jurisdiction.”)

69 Compare § 385(b) with Pub. L. 91-172, 83 Stat. 487 § 415.

70 I.R.C. § 385 (1970) (emphasis added).

71 S. REP. NO. 91-552, 91st Cong., 2d Sess., at 138 (“It is a difficult task to draw an appropriate distinction between dividends and

interest, or equity and debt. Even though a corporate obligation is labeled debt, it may be treated for tax purposes as equity, the

payments on which are non-deductible dividends, if, in fact, the obligation represents an equity interest in the corporation . . . . For

the above reasons, the committee has added a provision to the House bill which 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 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.”); Joint Committee on Internal Revenue Taxation, General Explanation of

the Tax Reform Act of 1969, H.R. 13270, 91st Cong. Pub. L. 91-172 (December 3, 1970) (“The first of these provides the Secretary

of the Treasury or his delegate with specific statutory authority to promulgate regulatory guidelines, to the extent necessary or

appropriate, for determining whether a corporate obligation constitutes stock or indebtedness for all purposes of the Internal

Revenue Code. These guidelines are to set forth factors to be taken into account in determining in a particular factual situation

whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists.”); Tax Reform Proposal

Contained in the Message from the President of April 21, 1969 of the Treasury Department to the Committee on Ways and Means

at Public Hearings on the Subject of Tax Reform on Tuesday, April 22, 1969, 91st Cong., 1st Sess. (1969) (statement of the

18

The Service's own statements confirm that its Congressional mandate was to develop a multi-factor test to

rationalize the case law. Specifically, proposed regulations under Section 385(a) were issued on March 24,

1980.72 Final regulations were issued in December 1980 (with a delayed effective date).73 The final

regulations were withdrawn in 1983.74 Since 1983, there have been no regulations implementing section

385.75 Instead, the Service has issued guidance in the form of notices and revenue rulings.76

The preambles to these regulations indicate the Service clearly understood that the Congressional mandate

was to develop factors in an attempt to rationalize the case law. The preamble to the March 24, 1980,

regulations stated:

The question of whether an interest in a corporation is stock or indebtedness has created

considerable difficulties and led to much litigation. A large body of case law has failed

to produce any fully satisfactory method for resolving the problem.77

By the Service's own admission, the "problem" to be solved was that there was significant litigation

surrounding the debt and equity classification. In addressing this problem, the Service understood that

Congress wanted the Service to set forth factors to be considered in the analysis:

Specifically, the legislation requires the Secretary to set forth factors in the regulations

which are to be taken into account in determining whether a particular interest is stock or

indebtedness.78

The Service similarly understood the Congressional mandate when it issued Notice 94-47,79 listing eight

factors that "may be considered" in distinguishing between debt and equity.

The Per Se Stock Rule does not rationalize the common law. The Per Se Stock Rule does not set forth

factors that may be "taken into account". Instead, by its terms, the rule only applies to instruments that the

taxpayer (and a reviewing court) have already determined to be "debt" without regard to the Per Se Stock

Honorable Edwin S. Cohen, Assistant Secretary of the Treasury for Tax Policy, before Committee on Ways and Means, April 22,

1969) (“In our tax structure, an interest deduction is properly disallowed only if the underlying obligation constitutes equity rather

than debt . . . . The Treasury is presently seeking to develop rules or a regulation that will aid in distinguishing debt from equity

and disallow the interest deduction where the interest payments represent in substance a return on equity. These rules would apply

whether the instrument comes into existence in an acquisition, in a recapitalization, or in any other manner, and whether the

company is closely held or publicly held.”); H.R. Rep. No. 101-247, 101st Cong., 1st Sess., at 1235 (“In 1969, Congress granted

the Secretary of the Treasury the authority to prescribe such regulations as may be necessary or appropriate to determine whether

an interest in a corporation is to be treated as stock or as indebtedness for Federal income tax purposes (sec. 385). The regulations

were to prescribe factors to be taken into account in determining, with respect to particular factual situations, whether a debtor-

creditor relationship or a corporation-shareholder relationship existed.”).

72 45 Fed. Reg. 18,957 (Mar. 24, 1980).

73 45 Fed. Reg. 86,438 (Dec. 30, 1980).

74 T.D. 7920, 1983-2 C.B. 69.

75 81 Fed. Reg. 20,911, 20913 (Apr. 8, 2016).

76 Notice 94-47, 1994-1 C.B. 357. See also, Rev. Rul. 83-98, 1983-2 C.B. 40; and Rev. Rul. 85-119, 1985-2 C.B. 60.

77 45 Fed. Reg. 18,958 (Mar. 24, 1980).

78 Id.

79 1994-1 C.B. 357.

19

Rule.80 Thus, taxpayers and reviewing courts are still required to wade through (sometimes conflicting)

case law in different circuits to ascertain whether a given instrument is debt or equity, just like they did

before the Proposed Regulations were issued.

Instead, the Proposed Regulations seek to effect (through the Per Se Stock Rule) various policy changes

that the Administration has been unable to make through legislative action. This is the precise abuse that

at least one commentator warned Congress of soon after section 385 was enacted.81 It is also why, not

surprisingly, members of Congress have indicated that they are concerned about Treasury's issuance of the

Proposed Regulations.82 Thus, a reviewing court will likely conclude that the Per Se Stock Rule is invalid

as it is not rationally related to the Code provision it is purporting to interpret.

D. The Per Se Stock Rule does not Interpret Section 385, but Instead Seeks to Achieve

Policy Results that the Administration has been Unable to Achieve Through

Modification of Other Code Provisions.

The Administration has repeatedly sought legislative changes that would: (i) further restrict the ability of

U.S. subsidiaries to claim deductions for interest paid to their foreign parents; (ii) limit the ability of foreign-

based multinationals to integrate their U.S. subsidiaries without incurring U.S. withholding tax; and (iii)

prevent taxpayers from utilizing offsetting corporate property distributions with tax basis as Congress

intended in section 301(c)(2).

These may all be legitimate goals for the Administration to pursue, but they do require the Administration

to work through Congress and the U.S.'s treaty partners to change Code or treaty provisions. Instead, the

Administration has decided to achieve similar policy goals through regulation.

This is not mere speculation on our part. As we explain below, the Administration's objectives were set

forth quite clearly in the plain language of the Preamble.

The problem, from a validity standpoint, is that the issue Treasury is seeking to address in each case is not

rationally related to section 385, the Code provision Treasury relies on for its authority to issue the Per Se

Stock Rule.

80 81 Fed. Reg. 20911, 20922 (Apr. 8, 2016) ("Proposed §1.385-3 applies to debt instruments that are within the meaning of section

1275(a) and §1.1275-1(d), as determined without regard to the application of proposed §1.385-3. Section 1275(a) and §1.1275-

1(d) generally define a debt instrument as any instrument or contractual arrangement that constitutes indebtedness under general

principles of federal income tax law. Thus, the term debt instrument for purposes of proposed §§1.385-3 and 1.385-4 means an

instrument that satisfies the requirements of proposed §§1.385-1 and 1.385-2 and that is indebtedness under general principles of

federal income tax law.").

81 Note, Toward New Modes of Tax Decisionmaking - The Debt-Equity Imbroglio and Dislocations in Tax Lawmaking

Responsibility, 83 HARV. L. REV. 1695, 1720 (1970) (noting that there has been a tendency by the Treasury to use its regulatory

authority to achieve what it could not otherwise achieve from Congress, citing an earlier commentator’s assertion that there had

“been a tendency on the part of the Treasury, when it did not get what it wanted from Congress, to try to reach its goal through an

ambitious regulation,” and countering that such “overreaching is precisely what judicial review would guard against in the optimal

tax institutional structure” along with the “procedural safeguards” of the Administrative Procedures Act).

82 See Letter from U.S. House of Representatives Committee on Ways and Means to The Honorable Jacob Lew, United States

Treasury Secretary (Jun. 28, 2016) (“To be clear, Congress did not intend section 385 to serve the purpose for which it is presently

being used in policing inversion or earnings stripping activities, and we respectfully remind the Treasury that they have co-opted

section 385 for purposes other than what Congress intended.”)

20

1. The Per Se Stock Rule Seeks to Limit Related Party Borrowing in Ways that Do

Not Appear in Section 163(j).

This Administration has repeatedly proposed to reduce the section 163(j) deduction limitation for interest

paid to related foreign persons by “expatriated entities,” as defined in Section 7874(a)(2). 83 The

Administration has not been successful modifying section 163(j) thus far, however.

In an influential article Mr. Secretary, Take the Tax Juice Out of Corporate Expatriations, a former

Treasury official, introduced the strategy to use section 385 to circumvent Congress and accomplish the

Obama Administration’s tax policy objectives stating:

Cross-border, related-party debt equity issues need to be addressed in tax reform and,

indeed, have been targeted by Camp's tax reform plan and an administration budget

proposal. There is clear regulatory authority, however, to address excessive related-party

debt under current law.84

Treasury has indicated that the aforementioned articles influenced its approach to the Proposed

Regulations.85 Furthermore, in the days leading up to the announcement of the Proposed Regulations,

numerous letters to Treasury from several House and Senate Democrats identified these articles and

implored Treasury to execute on the strategy contained therein to accomplish through regulations what

Congress had refused to legislate.86

This desire to alter the results permitted under existing statutes through regulation is further evidenced by

the preamble to the Proposed Regulations, which states:

In many contexts, a distribution of a debt instrument . . . lacks meaningful non-tax

significance . . . . For example, inverted groups and other foreign-parented groups use

83 Department of the Treasury, General Explanation of the Administration’s Fiscal Year 2014 Revenue Proposals, p. 53 (April

2013) (proposal to eliminate the 1.5:1 debt-to-equity ratio safe harbor and to reduce the 50 percent of adjusted taxable income

threshold from 50 to 25 percent); Department of the Treasury, General Explanation of the Administration’s Fiscal Year 2013

Revenue Proposals, p. 92 (February 2012) (same); Department of the Treasury, General Explanation of the Administration’s Fiscal

Year 2012 Revenue Proposals, p. 47 (February 2011) (same); Department of the Treasury, General Explanation of the

Administration’s Fiscal Year 2011 Revenue Proposals, p. 46 (February 2010) (same); Department of the Treasury, General

Explanation of the Administration’s Fiscal Year 2010 Revenue Proposals, p. 33 (May 2009) (same).

84 Stephen E. Shay, Mr. Secretary, Take the Tax Juice Out of Corporate Expatriations, 144 TAX NOTES 473 (July 28, 2014), at 398

(“This article demonstrates that it is not necessary for Treasury to wait for Congress to act on corporate expatriations”); More

recently, the same author reaffirmed his advocacy for this strategy in another article. Stephen E. Shay, et al., Treasury's Unfinished

Work on Corporate Expatriations, 150 TAX NOTES 933 (Feb. 22, 2016).

85 Andrew Velarde, U.S. Moves on Earnings Stripping, 82 TAX NOTES INTERNATIONAL 130 (Apr. 11, 2016) (quoting Jacob Lew,

the Secretary of the Treasury, as saying “We look at all the work that is being done in the academic community, others in the tax

policy community. It does help inform our judgments there . . . . Frankly, I think the work that Steve Shay and others have done

has been incredibly helpful in identifying the issue and bringing to attention some things that need to be addressed.”)

86 See Bernard Sanders, Letter 3, BNA DAILY TAX REPORT (March 23, 2016); Richard J. Durbin, et al., Letter From Seven Senate

Democrats to Treasury Secretary Lew on Expanded Regulations on Corporate Inversions, BNA DAILY TAX REPORT (February 26,

2016); Lloyd Doggett, et. al., Letter From Nine House Democrats to Treasury Secretary Lew on Expanded Regulations on

Corporate Inversions, BNA DAILY TAX REPORT (February 26, 2016); Press Release, Office of Congressman Lloyd Doggett, House

Democrats Urge Administration to Take Immediate Action to Stop Corporate Inversions following Report on Extent of Pfizer Tax

Dodging and Price Gouging (Feb. 25 2016).

21

these types of transactions to create interest deductions that reduce U.S. source income

without investing any new capital in the U.S. operations.87

The problem is that it has been clear since the Second Circuit's decision in Kraft Foods Co. v. Commissioner

in 1956, that the mere fact that a corporation distributed its note to its shareholder does not automatically

cause the instrument to be considered equity.88 Moreover, the Code and regulations implicitly acknowledge

that corporations can in fact issue valid debt to their shareholders without having received any property in

exchange.89 Thus, for over half a century it has been clear that the mere fact that a corporation distributes

a debt instrument to its shareholder is not, by itself, a reason to treat the debt instrument as equity.

Treasury's citations to cases in the preamble such as Talbot Mills v. Commissioner,90 and Sayles Finishing

Plants, Inc. v. United States,91 as support for its position that the regulations are consistent with existing

law is disingenuous. Those cases looked at the issuance of debt in an equity-for-debt swap as "a" factor to

be considered in a multi-factor analysis for distinguishing debt from equity. As noted above, however, the

Per Se Stock Rule does not create factors. It does not seek to rationalize the existing case law. Instead, in

a dramatic departure from existing law, the Per Se Stock Rule simply deems debt to be equity if it is not

issued in exchange for new property.92

The fact is that Congress has already established an upper limit on the amount of interest that a U.S.

corporation may deduct on related party debt under section 163(j). There is no requirement in section 163(j)

that a U.S. corporate subsidiary invest borrowed proceeds in the United States in order to claim an interest

deduction under U.S. law. Nor is there anything in section 163(j) that prohibits a company from deducting

interest on a note that it created via a distribution to its shareholder. These are policy decisions that

Congress has made. Treasury cannot engraft onto section 163 a new requirement that debt is only valid

when issued in exchange for new property (other than stock of an affiliate). We respectfully suggest that a

reviewing court, when confronted with this issue, will conclude that Treasury's stated rationale for the Per

Se Stock Rule is not rationally related to the problem Congress directed Treasury to resolve when it enacted

section 385 in 1969.

2. Treasury is Seeking to Use the Per Se Stock Rule to Prevent Foreign Multinationals

from Availing Themselves of the Boot-within-Gain Limitation.

The Administration has also repeatedly attempted to repeal the "boot-within-gain" limitation in section 356

which can apply to allow a foreign shareholder to receive cash or a note in an asset reorganization of a U.S.

target corporation without recognizing dividend income that may otherwise be subject to U.S. income or

withholding tax.93 The theory behind the proposed change is that an exchanging shareholder in a section

87 81 Fed. Reg. 20,911, 20917 (Apr. 8, 2016) (emphasis added).

88 232 F.2d 118 (2d Cir. 1956).

89 For example, section 311(b)(1)(A) refers to a corporation distributing its own obligation to its shareholders. Treas. Reg. §§1.301-

1(d)(1)(ii) and (h)(2)(i) also refer to a corporation issuing its own note to its shareholders.

90 146 F.2d 809 (1st Cir. 1944), aff'd sub nom, John Kelley Co. v. Commissioner, 326 U.S. 521 (1946).

91 399 F.2d 214 (Ct. Cl. 1968).

92 Prop. Reg. §1.385-3(b)(2)(i).

93 DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2017 REVENUE PROPOSALS,

FEBRUARY 2017, at 116 (proposal to eliminate the boot-within-gain limitation for reorganizations, to the extent receipt of boot

would be treated as receipt of a dividend under Code Section 356(a)(2) and taking into account all of the corporation’s E&P (not

just the shareholder’s ratable share) to determine the extent of the dividend); DEPARTMENT OF THE TREASURY, GENERAL

EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2016 REVENUE PROPOSALS, FEBRUARY 2015, at 121 (same); DEPARTMENT

22

368(a)(1)(D) reorganization should not be treated significantly different from an exchanging shareholder

in a related party stock sale subject to section 304. In the government's view, both exchanging shareholders

should be considered to receive dividend income equal to the cash, note or other property received, and

potentially be subject to withholding tax.

Yet, the Administration has not managed to persuade Congress to agree to revise the Code. Instead, by

Treasury's own admission, it is promulgating the Per Se Stock Rules to right this perceived wrong:

The proposed regulations also address certain debt instruments issued by an acquiring

corporation as consideration in an exchange pursuant to an internal asset reorganization.

Internal asset reorganizations can operate in a similar manner to section 304

transactions . . . . Congress noted this similarity in 1984 when it harmonized the control

requirement for section 368(a)(1)(D) reorganizations with the control requirement in

section 304 . . .. Consider the following example: A foreign parent corporation (Parent)

owns all of the stock of two U.S. subsidiaries, S1 and S2. In a transaction qualifying as

a reorganization described in section 368(a)(1)(D), Parent transfers its stock in S1 to S2

in exchange for a note issued by S2, and S1 converts to a limited liability company. For

federal tax purposes, S1 is treated as selling all of its assets to S2 in exchange for a debt

instrument and, under section 356, Parent is treated as receiving the S2 debt instrument

from S1 in a liquidating distribution with respect to Parent's S1 stock. This transaction

has similar effect (and tax treatment) as a section 304 transaction . . . . 94

Again, the Administration is free to propose legislative changes to the Code to better confirm the results

under section 304 and section 368(a)(1)(D) reorganizations. As noted above, they have repeatedly done

so.

But the economic equivalence of section 304 and 368(a)(1)(D) has nothing whatsoever to do with the debt

vs. equity distinction. What the Administration cannot do, and a reviewing court will not let it do, is to use

section 385 to prevent a taxpayer from availing itself of a provision that the Administration has been seeking

(but failing) to change through Congress. Stated differently, a reviewing court will likely conclude that

Treasury's stated rationale for the Per Se Stock Rule is not rationally related to the problem Congress asked

Treasury to solve when it enacted section 385 in 1969.

3. Treasury Issued the Per Se Stock Rule to Give Effect to its Anti-Repatriation

Proposal.

Finally, the administration has repeatedly sought legislation that would prevent taxpayers from receiving

cash or property through a tax-free return of basis transaction. This can occur when a low-tax foreign

subsidiary with significant cash reserves loans that money to a subsidiary without significant earnings. The

borrower then distributes the cash to the shareholder. The shareholder reports the cash received as a return

OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2015 REVENUE PROPOSALS, MARCH 2014, at

96 (same); DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2014 REVENUE

PROPOSALS, APRIL 2013, at 91 (same, except without the provision taking into account all of the corporation’s E&P); DEPARTMENT

OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2013 REVENUE PROPOSALS, FEBRUARY 2012,

at 133 (same); DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2012 REVENUE

PROPOSALS, FEBRUARY 2011, at 60 (same); DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S

FISCAL YEAR 2011 REVENUE PROPOSALS, FEBRUARY 2010, at 38 (same); DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION

OF THE ADMINISTRATION’S FISCAL YEAR 2010 REVENUE PROPOSALS, MAY 2009, at 35 (same).

94 81 Fed. Reg. 20,911, 20918 (Apr. 8, 2016).

23

of capital the shareholder previously invested in the borrower as Congress permits under section 301(c)(2).95

The Administration has been unsuccessful in revising the operation of section 301(c)(2) through Congress,

however. So, once again, Treasury has announced that it will use the Per Se Stock Rule to accomplish what

it was unable to achieve through legislation:

In addition, 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. An example of the latter type of

transaction could involve the distribution of a note from a first-tier CFC to its United

Shares shareholder in a taxable year when the distributing CFC has no earnings and

profits (although lower tier CFCs may) and the United States shareholder has basis in the

CFC stock. In a later taxable year, when the distributing CFC had untaxed earnings and

profits (such as by reason of intervening distributions from lower-tier CFCs), the CFC

could use cash attributable to the earnings and profits to repay the note owed to its United

States shareholder.96

Under the Per Se Stock Rule, the Service will simply "deem" the loan to be equity and thereby deny the

first-tier CFC a way to repatriate funds to the U.S. tax-free.

Again, we understand that the Administration may not like the taxpayer's motivation for creating the related

party debt in the foregoing example. Yet, the taxpayer's motivation for creating the debt in this case has

nothing to do with whether the instrument in question should be viewed as debt or equity under the Code.

A reviewing court will likely conclude that the Per Se Stock Rule is simply not rationally related to the

problem Congress directed Treasury to resolve when it enacted section 385 in 1969.

E. If Finalized in its Current Form, A Reviewing Court will Find the Per Se Stock Rule

Substantively and Procedurally Invalid.

We would respectfully point out to Treasury and the Service that if it is finalized in its current form, a

reviewing court will find the Per Se Stock Rule substantively and procedurally invalid.

95 DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2017 REVENUE PROPOSALS,

FEBRUARY 2017, at 115–116 (proposal to treat a corporation’s leveraged distribution otherwise treated as a return of capital that

was funded by a related corporation as a dividend from the related corporation, when a principal purpose of the funding was to

avoid making a dividend distribution from the funding corporation); DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF

THE ADMINISTRATION’S FISCAL YEAR 2016 REVENUE PROPOSALS, FEBRUARY 2015, at 120–121 (same); DEPARTMENT OF THE

TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2015 REVENUE PROPOSALS, MARCH 2014, at 55

(proposal to disregard the basis of a distributing corporation in determining the tax treatment of the distribution, when the

distribution is funded by a related corporation with a principal purpose of avoiding dividend treatment on a distribution to a U.S.

shareholder); DEPARTMENT OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2014 REVENUE

PROPOSALS, APRIL 2013, at 59 (same, except without the provision taking into account all of the corporation’s E&P); DEPARTMENT

OF THE TREASURY, GENERAL EXPLANATION OF THE ADMINISTRATION’S FISCAL YEAR 2013 REVENUE PROPOSALS, FEBRUARY 2012,

at 98 (same).

96 81 Fed. Reg. 20,911, 20917 (Apr. 8, 2016).

24

1. The Per Se Stock Rule is Substantively Invalid as it Does not Comply with the

Congressional Mandate.

Tax regulations are subject to the Administrative Procedure Act ("APA") (5 U.S.C. §§551-559, 701-706).97

Section 706(2)(C) of the APA provides that a reviewing court shall hold unlawful and set aside any agency

action found to be, “in excess of statutory jurisdiction, authority, or limitations, or short of statutory right.”

When confronted with a validity challenge to a regulation that has the force and effect of law, courts apply

the two-step analysis set forth by the Supreme Court in Chevron USA Inc. v. Natural Resources Defense

Counsel Inc.98

In the first step, a court asks “whether Congress has directly spoken to the precise question at issue. If the

intent of Congress is clear, that is the end of the matter.”99 In ascertaining Congressional intent, the court

may look to other statutory provisions and also legislative history as one of the traditional tools of statutory

construction during the step one analysis.100 The time between statutory enactment and the issuance of the

regulation is also considered. As the Supreme Court has recently noted, "When an agency claims to

discover in a long-extant statute an unheralded power to regulate . . . we typically greet its announcement

with a measure of skepticism."101 Moreover, the Supreme Court has noted in U.S. v. Home Concrete &

Supply, LLC, et. al., if a court has already interpreted the plain language of the statute as having a given

unambiguous meaning, then an administrative agency cannot issue a subsequent regulation altering that

meaning.102

If a court determines that the statute is silent or ambiguous on the relevant issue, the court proceeds to

Chevron step two and asks, “whether the agency’s answer is based on a permissible construction of the

statute.”103 As the Supreme Court noted in Chevron:

97 Mayo Foundation for Education and Research v. United States, 131 S. Ct. 704 (2011); and Altera Corp. & Subs. v. Comm'r, 145

T.C. No. 3 (2015).

98 467 U.S. 837 (1984). United States v. Mead Corp., 533 U.S. 218, 226-27 (2001) ("We hold that administrative implementation

of a particular statutory provision qualifies for Chevron deference when it appears that Congress delegated authority to the agency

generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the

exercise of that authority. Delegation of such authority may be shown in a variety of ways, as by an agency's power to engage in

adjudication or notice-and-comment rulemaking, or by some other indication of a comparable congressional intent."); and Kristin

E. Hickman, Unpacking the Force of Law, 66 VAND. L. REV. 465 (2013) ("Some agency rules are obviously both legislative and

reviewable under Chevron; other agency rules are clearly neither. But a small subset of agency rules falls somewhere in the middle:

possibly but not obviously legislative, and potentially but not clearly within Chevron's scope. Over the years, the courts have

employed various standards for designating the rules within that subset as either legislative or not, and Chevron eligible or not. To

date, however, applying those standards has not resulted in a consensus view of the property characterization of temporary Treasury

Regulations and IRB guidance documents.")

99 Chevron, 437 U.S. at 842-43.

100 FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 132-33 (2000), superseded by statute 21 U.S.C. § 387 as recognized

by Bullitt Fiscal Court v. Bullitt County Bd. of Health, 434 S.W.3d 29 (Ky. 2014) ("In determining whether Congress has

specifically addressed the question at issue, a reviewing court should not confine itself to examining a particular statutory provision

in isolation. The meaning -- or ambiguity -- of certain words or phrases may only become evident when placed in context.")

101 Utility Air Regulatory Group v. EPA, et. al., 134 S. Ct. 2427, 2444 (2014).

102 132 S. Ct. 1836, 1841 (2012) ("In our view, Colony determines the outcome in this case. The provision before us is a 1954

reenactment of the 1939 provision that Colony interpreted. The operative language is identical. It would be difficult, perhaps

impossible, to give the same language here a different interpretation without effectively overruling Colony, a course of action that

basic principles of stare decisis wisely counsel us not to take.")

103 Chevron, 437 U.S. at 842-43.

25

If Congress has explicitly left a gap for the agency to fill, there is an express delegation

of authority to the agency to elucidate a specific provision of the statute by regulation.

Such legislative regulations are given controlling weight unless they are arbitrary,

capricious, or manifestly contrary to the statute.104

This language is consistent with section 706(2)(A) of the APA which provides that agency action will be

invalid if found to be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with

law.”105

In making a determination as to whether a regulation is arbitrary or capricious, the agency at issue must

provide a cogent explanation as to how the rule was rationally related to the problem the agency sought to

solve. As the Supreme Court noted in Motor Vehicle Manufacturers Association of the United States, Inc.

et. al. v. State Farm Mutual Automobile Insurance Co. et. al., an agency rule is arbitrary and capricious if

“the agency has relied on factors which Congress has not intended it to consider . . . ."106

In all events, in determining whether to give effect to a regulation, statutory “[p]urpose is paramount.”107

“[R]egulations are not to be construed to stultify that purpose.”108 Thus, agencies are “‘bound, not only by

the ultimate purposes Congress has selected, but by the means it has deemed appropriate, and prescribed,

for the pursuit of those purposes.’”109

Importantly, even regulations issued pursuant to a broad grant of authority cannot overrule other Code

provisions absent a directive from Congress. For example, in Rite-Aid Corporation v. United States,110 the

Federal Circuit addressed the validity of Treasury Regulation section 1.1502-20, which sought to prevent

taxpayers from using consolidated groups to duplicate losses. The Federal Circuit held that the regulation

was invalid “because the regulation is not within the authority delegated by Congress under Internal

Revenue Code (I.R.C.) section 1502.”111

In 1984, Rite Aid acquired eighty percent of Penn Encore (Encore), a small discount bookstore chain,

through a $3 million asset purchase. Rite Aid later purchased all remaining Encore stock in 1988 for $1.5

million. Rite Aid included Encore in its affiliated group of corporations and filed consolidated income tax

returns under section 1501. In 1994, Rite Aid sold Encore to an unrelated company, CMI Holding Corp.

(“CMI”). CMI refused to make a section 338(h)(10) election to treat the transaction as a sale of assets for

tax purposes.112

104 Chevron, 467 U.S. at 843-44.

105 (emphasis added).

106 463 U.S. 29, 43 (1983).

107 Xilinx, Inc. v. Commissioner, 598 F.3d 1191, 1196 (9th Cir. 2010).

108 Id.

109 Chamber of Commerce v. NLRB, No. 12-1757, slip op. at 25 (4th Cir. June 14, 2013) (quoting Colo. River Indian Tribes v.

Nat’l Indian Gaming Comm’n, 466 F.3d 134, 139 (D.C. Cir. 2006) (quoting MCI Telecomms. Corp. v. AT&T, 512 U.S. 218, 231

n.4 (1994))).

110 255 F.3d 1357 (Fed. Cir. 2001).

111 Id.

112 Id.

26

Rite Aid claimed a section 165 loss with respect to the sale of Encore stock. However, Treasury Regulation

section 1.1502-20 operated to disallow a shareholder’s investment loss to the extent of the subsidiary’s

“duplicated loss factor.” The duplicated loss factor was calculated as the excess of the subsidiary’s adjusted

basis in its assets over the value of its assets immediately after the sale. Encore’s duplicated loss factor was

$28,535,858. Because this loss exceeded Rite Aid’s investment loss of $22,136,739, Treasury Regulation

section 1.1502-20 applied to prohibit Rite Aid’s otherwise valid loss deduction.113

The Court was presented with the sole question of whether Treasury Regulation section 1.1502-20 was a

proper exercise of Treasury and the Service’s regulatory authority. The Federal Circuit analyzed the

statutory text, history, and purpose to determine the scope of the authority granted to the Secretary of the

Treasury under section 1502:

Section 1502 grants the Secretary “the power to conform the applicable income tax law

of the Code to the special, myriad problems resulting from the filing of consolidated

income tax returns.” Am. Standard, 602 F.2d at 261. There may be several reasonable

methods to correct problems created from the filing of consolidated returns, and the

Secretary’s authority in choosing among them is absolute. See id. The purpose of section

1502 is to give the Secretary authority to identify and correct instances of tax avoidance

created by the filing of consolidated returns. But section 1502 “does not authorize the

Secretary to choose a method that imposes a tax on income that would not otherwise be

taxed.” Id. “Income tax liability is not imposed by the Secretary’s regulations, but by

the Internal Revenue Code.” Id. Therefore, in the absence of a problem created from

the filing of consolidated returns, the Secretary is without authority to change the

application of other tax code provisions to a group of affiliated corporations filing a

consolidated return.114

The Court of Appeals for the Federal Circuit invalidated regulations under Section 1502, finding that the

regulations were manifestly contrary to the statute because the regulations at issue “contravene[d] Congress'

otherwise uniform treatment of limiting deductions for the subsidiary's losses” under other Code provisions

like section 165 of the Code and “does not reflect the tax liability of the consolidated group.”115

For the reasons we discuss below, the Per Se Stock Rule is invalid under Chevron Step One and Chevron

Step Two. A court will also likely conclude it was procedurally defective due to its retroactive application.

a. The Per Se Stock Rule is Invalid Under Chevron Step One.

The Per Se Stock Rule is invalid under Chevron step one because section 385(b) provides that “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.”116 Section 385(b)(1)-(5) then lists five factors which may be

included in the regulations.

The legislative history only supports this reading of the statute. The Joint Committee explained that the

Secretary was granted regulatory authority “to set forth factors to be taken into account in determining”

113 Id.

114 Id. at 1359.

115 Id. at 1360.

116 (emphasis added).

27

whether an instrument was debt or equity.117 The JCT discussion notes that the statute identified factors

which may be taken into account, but pointed out that “it is not intended that only these factors be included

in the guidelines or that, in a 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.”118 Every reviewing court that has issued an opinion on this issue since the

enactment of section 385 in 1969 has weighed a multitude of factors in reaching its decision.119 As noted

above, both Treasury and the Service understood (prior to April 4, 2016) that their job has been to develop

one or more tests taxpayers and courts could use to weigh multiple factors against one another in

determining the difference between debt and equity.

The Per Se Stock Rule does not set forth factors (plural). Instead, the regulations set forth a single factor -

i.e., did the borrower engage in a tainted transaction or not? The answer is either "yes" or "no". If the

borrower did engage in a tainted transaction, that fact is not "taken into account" in determining whether

the advance is debt or equity. The regulations simply cause the advance to be deemed to be equity, no

further questions asked.

Thus, the regulations violate the plain language of the statute in three ways. First, the regulations fail to set

forth multiple factors. Second, the regulations do not direct that the factors be "taken into account". Instead,

they deem debt to be equity if one factor is present - i.e., the existence of a tainted transaction. Third, the

Proposed Regulations do not look to the characteristic of the instrument itself. It looks solely at the "use"

of the borrowed money. Restricting interest deductions on debt used for a specific purpose must be done

by legislation, and not by Treasury decision. If “use of proceeds” is now the sole determining factor that

distinguishes debt from equity, then section 385 can be used to deny interest deductions for any purpose

Treasury decides. This is clearly not what was intended by the congressional mandate given to Treasury

under section 385 and far exceeds Treasury’s authority.

The Proposed Regulations also contradict every debt vs. equity case issued after the enactment of section

385 in violation of the Supreme Court's decision in Home Concrete. Once a court (or, in this case, courts)

117 General Explanation of the Tax Reform Act of 1969, Joint Committee on Taxation, p. 123, December 3, 1970.

118 Id at 123-24.

119 See, e.g., In re: Uneco, Inc., 532 F.2d 1204 (8th Cir. 1976) (reversing the district court for failing to undertake a multi-factor

analysis in determining that an interest was debt, noting that “Section 385 of the Internal Revenue Code, 26 U.S.C. §385, supports

our conclusion that objective factors should be given consideration in the decision on this issue . . . . The importance of this section

is not so much that it identifies relevant factors but that it indicates a congressional desire to have the debt-equity issue resolved by

examination of objective criteria.”); Casco BK. & Tr. Co. v. United States, 544 F.2d 528 (1st Cir. 1976) (stating that the debt vs.

equity determination is a question of fact not law, stating “Congress itself has acknowledged the general factual approach to debt-

equity problems,” citing section 385); Slappey Drive Industrial Park v. United States, 561 F.2d 572 (1977) (explaining that the

debt vs. equity determination is made using a multi-factor test and stating, “Congress has recently authorized the Secretary to

promulgate regulations setting forth appropriate factors. See I.R.C. §385. For the time being, however, we must rely on our own

pronouncements.”); Bauer v. Commissioner, T.C. Memo 1983-120, rev’d on other grounds, 748 F.2d 1365 (9th Cir. 1984) (stating

that “[d]etermination of whether a shareholder's interest constitutes debt or equity depends on particular facts and circumstances”

and supporting with a citation stating “Sec. 385(a), Internal Revenue Code of 1954, as amended, authorizes the promulgation of

regulations for determining whether an interest in a corporation is stock or indebtedness, and sec. 385(b), I.R.C. of 1954, as amended,

suggests factors which, among others, may be included in said regulations.”); Bauer v. Commissioner, 748 F.2d 1365 (9th Cir.

1984) (stating “In 1969, Congress authorized the Secretary of the Treasury to prescribe regulations setting forth the factors to be

considered in determining whether an advance is debt or equity. 26 U.S.C. §385. The Secretary did not issue such regulations until

1982, and those regulations apply only to obligations issued in 1983 or later. See 26 C.F.R. §1.385-1-10. Here we must still be

guided by the case law and by the five factors that Congress suggested, as part of the 1969 statute, might be included in the

regulations.”)

28

have interpreted section 385 as requiring a multi-factor analysis, Treasury cannot issue a regulation

specifying a one-factor rule that deems debt to be equity.

Treasury's attempt to legitimize its actions are unconvincing. Specifically, the preamble to the Proposed

Regulations mischaracterizes the Congressional mandate when it states that “section 385(b) provides the

Secretary with discretion to establish specific rules for determining whether an interest is treated as stock

or indebtedness for federal tax purposes in a particular factual situation.”120 This statement is inaccurate

because any rules must set forth factors, as the statute and the legislative history both clearly state. In fact,

the Per Se Stock Rule is perhaps the quintessential example of an "unheralded power to regulate" of a "long

extant statute" that the Supreme Court has suggested deserves significant scrutiny.121

Previous regulations issued by Treasury and the Service under section 385, and subsequently withdrawn

(the 1980 Proposed Regulations), demonstrate that Treasury understood that section 385(b) required it to

set forth factors. In describing section 385, the Preamble to the 1980 Proposed Regulations states that “the

legislation requires the Secretary to set forth factors in the regulations which are to be taken into account in

determining whether a particular interest is stock or indebtedness.”122

The preamble to the Proposed Regulations makes no effort to hide Treasury and the Service's lack of

compliance with section 385(b)’s requirement to set forth factors. In the “Purpose of the Proposed

Regulations” section, the Preamble states that:

Treasury . . . and the IRS have identified three types of transactions . . . that should be

addressed under the Secretary’s authority to prescribe rules for particular factual

situations: (1) distributions of debt instrument by corporations to their related corporate

shareholders; (2) issuances of debt instruments by corporations in exchange for stock of

an affiliate (including “hook stock” issued by their related corporate shareholders); and

(3) certain issuances of debt instruments as consideration in an exchange pursuant to an

internal asset reorganization. Similar policy concerns arise when a related-party debt

instrument is issued in a separate transaction to fund (1) a distribution of cash or other

property to a related corporate shareholder; (2) an acquisition of affiliate stock from an

affiliate; or (3) certain acquisitions of property from an affiliate pursuant to an internal

asset reorganization. Accordingly, the proposed regulations treat related-party debt

instruments issued in any of the foregoing transactions as stock, subject to certain

exceptions.123

In order to comply with the requirement that Congress established in section 385(b) for Treasury to set forth

factors in regulations, the emphasized language would need to be struck and replaced with a list of factors

to be applied in the factual situations identified in the regulations. Because Treasury and the Service failed

to do so and, instead, completely read the words “set forth factors” and "taken into account" out of section

385(b), the Per Se Stock Rule will be held invalid at Chevron step one.

b. The Proposed Regulations are Invalid Under Chevron Step Two as they

are Arbitrary, Capricious, and Seek to Advance the Government's Policies

Under Other Code Provisions.

120 81 Fed. Reg. 20913 (Apr. 8, 2016).

121 Utility Air, 134 S. Ct. at 2444.

122 45 Fed. Reg. 18958 (Mar. 24, 1980).

123 81 Fed. Reg. 20916 (Apr. 8, 2016) (emphasis added).

29

Even if the Proposed Regulations withstand a challenge under Chevron step one, a reviewing court will

conclude that they are invalid under Chevron step two. The fact that the Proposed Regulations are arbitrary

and capricious is easily illustrated using an example:

EXAMPLE 6: FP is a publicly traded foreign corporation that owns all of the stock of

USS1. UST is an unrelated corporation that owns all of the stock of a foreign subsidiary,

FT. FT makes a dividend distribution to UST in 2017 of $100. FT had no current year

earnings and profits in 2017. USS1 then acquires UST in 2018. FP makes a loan to FT

in 2019. Under the Funding Rule, the loan by FP to FT is recast as equity because FT

engaged in a tainted transaction within 36 months of the loan being advanced by FP to

FT.

There is clearly no abuse in this fact pattern. Yet, the Funding Rule, with its sweeping breadth, captures

this advance and recasts it as equity. There is simply no rational relationship between the breadth of the

rules and the problem that Treasury was purportedly attempting to solve, as required by the Supreme Court

in State Farm.

Moreover, there is absolutely no indication that Congress ever considered acquisitions of related party or

unrelated party stock to be relevant under section 385. In fact, the legislative history proves the opposite.

Section 279 was designed to address leveraged acquisitions. Section 385 was enacted at the same time to

authorize Treasury to rationalize the common law regarding debt and equity. In this case, Treasury is

relying on "factors which Congress has not intended it to consider" just like in State Farm. Thus, the

regulations will not withstand the reasoned decision-making standard.

In fact, by Treasury's own admission, the Per Se Stock Rule allows the administration to achieve various

policy goals it could not achieve by modifying other Code provisions. The boot-within-gain limitation rule

is a case in point. Instead of seeking a legislative change to section 356, Treasury, by its own admission,

is seeking to prevent taxpayers from using debt to take advantage of the boot within gain rule by using its

regulatory authority under section 385. This is not a permissible action for the executive branch of

government to take.

As the court noted in Rite-Aid, Treasury cannot draft a regulation under section 1502's consolidated return

provisions to deny a taxpayer a loss the taxpayer was clearly permitted to take under section 165, without

demonstrating the rational connection between the regulation and an abuse targeted by the consolidated

return regulations.

Similarly, Treasury cannot draft regulations under section 385 to achieve a series of policy goals it has

under section 356 and other Code provisions without explaining how the problem at hand is rationally

related to section 385. In this case, there can be no rational connection. After all, nothing prevents a

multinational group from borrowing money from a third party, using the cash proceeds to purchase an

affiliate, and availing itself of the boot-within-gain limitation in section 356. There is no indication that

using related party debt is somehow more abusive just because it is issued in the context of a reorganization.

Either way, an interest deduction is obtained and the target corporation shareholder avoids income

recognition.

If Treasury wants to issue a regulation pursuant to its authority under section 385, the regulation has to be

rationally related to a policy concern under section 385. Section 385 cannot be used as a back-door to

prevent taxpayers from availing themselves of the boot-within-gain limitation of section 356 or any other

Code provision.

30

Perhaps anticipating such a challenge, Treasury argues that the sweeping breadth of its rules, which is

magnified by the existence of an irrebuttable presumption and a 72-month window period, is justified

stating:

The Treasury Department and the IRS have determined that this nonrebuttable

presumption is appropriate because money is fungible and because it is difficult for the

IRS to establish the principal purposes of internal transactions.124

Yet, the fact that a rule is difficult to draft and audit does not give Treasury the right to draft an overly broad

rule that recasts EGDIs that could not have been created with an intent to fund a "tainted" transaction (as

illustrated by Example 6). The fact that Treasury had a difficult time drafting a more targeted loss-

disallowance rule was not persuasive in Rite-Aid,125 and it will not be persuasive here.

In summary, the Funding Rule does not satisfy the reasoned decision-making standard in Chevron Step

Two. Any attempt by the Service to excuse its failure to draft a more targeted rule due to ease of

administration and the fact that money is fungible will be rejected by a court.

2. The Per Se Stock Rule is Procedurally Invalid.

Treasury regulations are subject to the APA's procedural requirements.126 They are invalid to the extent

they fail to comply with those procedural requirements. The importance of complying with the APA and

allowing for meaningful notice and comment before changing a longstanding rule was highlighted by the

Supreme Court very recently in its 6-2 decision in Encino Motorcars, LLC v. Navarro, et. al.127

The Encino decision involved a case where "service advisors" who worked at automobile dealerships

asserted they were entitled to overtime pay under the Fair Labor Standards Act ("FLSA"). A number of

courts had decided that service advisors were exempt from the overtime requirements under an FLSA

exception for "salesmen, partsman or mechanic". The Department of Labor itself treated service advisors

as exempt from the overtime rules since 1987.128 Yet, in 2011, without any prior notice, the Administration

issued a final rule interpreting the "salesman" exception narrowly such that "service advisors" would be

subject to the FLSA's overtime rules.129

The Court noted that, "One of the basic procedural requirements of administrative rulemaking is that an

agency must give adequate reasons for its decisions."130 The Court acknowledged that administrative

agencies were free to change positions, but that, "In explaining its changed position, an agency must also

be cognizant that longstanding policies may have 'engendered serious reliance interests that must be taken

into account.'"131 The Court concluded that the Administration's 2011 rule was arbitrary and capricious

stating that, "The retail automobile and truck dealership industry had relied since 1978 on the Department's

124 81 Fed. Reg. 20,923 (Apr. 8, 2016).

125 T.D. 8660 (Mar. 13, 1996) (explaining why Treasury did not limit the loss-disallowance rule to more targeted situations and

why it rejected a tracing approach).

126 Mayo, 131 S. Ct. 704 (2011).

127 No. 15-415, 2016 U.S. S. Ct. LEXIS 3924, at *1 (S. Ct. June 20, 2016).

128 Id. at *11.

129 Id. at *11-12.

130 Id. at *15.

131 Id. at *16 (quoting FCC v. Fox Television Stations, Inc., 556 U.S. 502, 515 (2009)).

31

position that service advisors are exempt from the FLSA's overtime pay requirements."132 As such, "In

light of this background, the Department needed a more reasoned explanation for its decision to depart from

its existing enforcement policy."133

Importantly, the Court did not invalidate the Administration's rule because it directly contradicted the plain

language of the FLSA. Instead, the Court invalidated the Administration's rule because it substantially

changed a long-standing rule without adequately explaining why it needed to change its position.

The long-standing rule at issue in Encino dated from 1978. In contrast, the common law of debt and equity

date spans almost a century. As noted above, the Per Se Stock Rule represents a profound departure from

common law principles that Treasury and the Service have applied for decades.134 Treasury did not explain

its significant change in position or why it abandoned the multi-factor test in favor of the Per Se Stock Rule.

It also did not explain "how" section 385 provides the authority to promulgate a per se rule.135

Treasury will likely argue that (unlike the Department of Labor in Encino) it did provide significant reasons

for issuing the Per Se Stock Rule. Yet, as noted above, the problems Treasury says that it is trying to solve

do not have anything to do with section 385. They have everything to do with other problems the

government believes it needs to solve under other Code provisions like section 163(j) or 301(c)(2) or 356.

Even if there was some rational connection between the problems highlighted in the preamble and section

385, a reviewing court will conclude the Per Se Stock Rule was issued without appropriate notice and

comment. Specifically, the Per Se Stock Rule applies to loans issued on or after April 4, 2016. The Per Se

Stock Rule is therefore procedurally invalid because the effective date violates the APA's requirement that

final regulations be published 30 days before their effective date, subject to certain exceptions.136 None of

those exceptions are pertinent here.

The only potential exception that would permit an immediate or retroactive effective date is the “good cause”

exception in 5 U.S.C. §553, although Treasury is likely foreclosed from claiming this exception because it

failed to include a statement with the Proposed Regulations explaining why Treasury had good cause for a

retroactive effective date. Even if Treasury had included a “good cause statement” in the Proposed

Regulations, it is unlikely that such statement would have been sufficient because there is no public interest

requiring the agency to act immediately. Section 385 was enacted in 1969, and there are no circumstances

here—nearly half a century after the statute was enacted—that would justify departing from the APA’s

general rule that final rules must be published 30 days before they are to become effective.

Treasury may argue that section 7805(b) permits an earlier effective date for regulations without regard to

the APA's good cause requirement. Yet, section 7805(b) must be read in conjunction with the APA. This

is because a subsequent statute (such as section 7805(b)) cannot modify or supersede the APA, “except to

the extent that it does so expressly.”137

132 Id. at *17-18.

133 Id. at *18-19.

134 See, e.g., Notice 94-47, 1994-1 C.B. 357 (listing eight factors and noting that the distinction between debt and equity depends

on all of the facts and circumstances); see also Notice 2003-79, 2003-2 C.B. 1206 (“The characterization of an instrument for U.S.

federal income tax purposes depends on the terms of the instrument and all surrounding facts and circumstances.”).

135 See Encino, No. 15-415, 2016 U.S. S. Ct. LEXIS 3924 at *11 (criticizing the agency for failing to “analyze or explain why the

statute should be interpreted to except dealership employees who sell vehicles but not dealership employees who sell services”).

136 5 U.S.C. § 553(d).

137 5 U.S.C. § 559.

32

Section 7805(b) does not expressly modify or supersede the APA. Because there is no exception for a

delayed effective date under the APA, section 7805(b) cannot permit a retroactive date that the APA

prohibits. Hence, Prop. Reg. §1.385-3 is invalid under the APA.

In addition, Treasury and the Service failed to satisfy other applicable administrative law requirements,

which calls the validity of the Proposed Regulations into question. For example, the requirements of

Executive Order 12866, as modified by Executive Order 13563, were not satisfied.

Although Treasury designated the Proposed Regulations as a “significant regulatory action” under section

3(f) of Executive Order 12866, the Regulatory Impact Analysis published with the Proposed Regulations

does not satisfy the requirements of section 6(a)(3)(B) and (C) of Executive Order 12866. Notably, the

Regulatory Impact Analysis fails to provide:

“[A]n explanation of the manner in which the regulatory action is consistent with a

statutory mandate and, to the extent permitted by law, promotes the President’s

priorities;”138

“An assessment, including the underlying analysis, of benefits anticipated from the

regulatory action . . . together with, to the extent feasible, a quantification of those

benefits;”139 and

“An assessment, including the underlying analysis, of costs and benefits of potentially

effective and reasonably feasible alternatives to the planned regulation, identified by the

agencies or the public (including improving the current regulation and reasonably viable

nonregulatory actions), and an explanation why the planned regulatory action is

preferable to the identified potential alternatives.”140

Although Treasury did not identify any reasonably feasible alternatives to the Proposed Regulations in its

Regulatory Impact Analysis, one such reasonably feasible alternative would be for the Service to engage in

more effective case selection of debt/equity cases on audit and to require taxpayers to satisfy their existing

burden of proof to demonstrate that an instrument that is treated as debt should, in fact, be treated as debt.

These reasonably feasible alternatives would not require the issuance of regulations at all. Another

reasonably feasible alternative to the Per Se Stock Rule would be to promulgate regulations providing a list

of factors to be taken into account in determining whether an instrument is debt or equity, as Congress

instructed Treasury to do in section 385(b).

Even the requirements that the Regulatory Impact Analysis purports to satisfy - like estimating costs - are

inadequately and incompletely addressed. As other groups have noted in their letters to OMB,141 the

Regulatory Impact Analysis significantly underestimates the direct costs of complying with the Proposed

Regulations, excludes the start-up costs of complying with the Proposed Regulations, and fails to estimate

138 E.O. 12866, section 6(a)(3)(B)(ii).

139 E.O. 12866, section 6(a)(3)(C)(i).

140 E.O. 12866, section 6(a)(3)(C)(iii).

141 See, e.g., Letter from the Business Roundtable to the Office on Management and Budget, June 7, 2016, and Letter from the

United States Council for International Business to the Office on Management and Budget, June 7, 2016.

33

indirect costs resulting from the Proposed Regulations, including the effects of an increased cost for

taxpayers subject to the Proposed Regulations.142

Finally, executive agencies are required to provide interested parties an opportunity to comment on any

factual findings that the agency relied on in drafting proposed rules.143 The preamble to the Proposed

Regulations is filled with conclusory statements, the factual basis for which is unclear. If Treasury and the

Service are relying on specific factual findings or empirical evidence to support their conclusions, that

evidence should be made available for public review and comment.

For the foregoing reasons, a reviewing court may conclude the Per Se Stock Rule is invalid to the extent

applied to instruments issued before adequate notice and comment due to its failure to comply with the

APA's procedures.

F. If Finalized in its Current Form, The Service's Application of the Per Se Stock Rule

will Violate Treaties, Some of which have Mandatory Arbitration Clauses.

The Proposed Regulations are not consistent with existing U.S. treaty obligations.144 If the Proposed

Regulations are applied to a fact pattern where a treaty also applies, the U.S. competent authority will likely

be overwhelmed with competent authority proceedings as a result of the inconsistent positions on

debt/equity issues that will arise between the United States and its treaty partners. In at least some cases,

the issue could be referred to mandatory arbitration by an impartial arbitration panel.

Before addressing the technical conflict between the Proposed Regulations and applicable tax treaties, it is

important to point out that the Administration, in promulgating these rules, is engaging in the same behavior

that it has criticized other countries for. Specifically, when other countries like the UK, with its Diverted

Profits Tax ("DPT"), or Australia, with its Multinational Anti-Avoidance Law ("MAAL"), have proceeded

to enact rules that go beyond the international consensus represented by the OECD's Base Erosion and

Profit Shifting ("BEPS") action items, this Administration has, correctly, been highly critical of those

actions. 145 Yet, the Proposed Regulations, although purportedly addressing base erosion, bear no

discernible relationship to the BEPS recommendations for Action Item 4 - the action item that was supposed

to represent a multilateral approach to addressing interest deductibility. The fact that the Proposed

142 E.O. 12866, section 6(a)(3)(C)(ii) requires agencies to assess the “costs anticipated from the regulatory action (such as, but not

limited to, the direct cost both to the government in administering the regulation and to businesses and others in complying with

the regulation, and any adverse effects on the efficient functioning of the economy, private markets (including productivity,

employment, and competitiveness), health, safety, and the natural environment), together with, to the extent feasible, a

quantification of those costs.”

143 E.O. 13563, section 2(b) requires agencies to provide "an opportunity for public comment on all pertinent parts of the rulemaking

docket, including relevant scientific and technical findings."

144 Others have made the same point. See e.g., Robert H. Dilworth, U.K. Treaty Conflict: Unintended (?) Consequences of the U.S.

Debt-Equity Regulations, 2016 WTD 108-17 (Jun. 6, 2016).

145 See Robert B. Stack, U.S. Treasury Deputy Assistant Secretary for International Tax Affairs, Address at the OECD/U.S. Council

for International Business Tax (June 10, 2015) in 147 TAX NOTES 1593 (June 29, 2015) (criticizing the U.K.’s DPT and Australia’s

MAAL); Kevin A. Bell, U.S. and U.K. OECD Delegates Differ on Their Evaluation of the BEPS Project, BNA TRANSFER PRICING

REPORT (June 11, 2015) (discussing Mr. Stack’s disapproval of the DPT and MAAL); Lee A. Sheppard & Stephanie Soong Johnston,

U.S. 'Extremely Disappointed' in DPT and BEPS Output, Stack Says, 2015 W.T.D. 112-2 (2015) (same); Ajay Gupta, News Analysis:

The U.S. and BEPS -- Return of the Big Bad Bully, 79 Tax Notes Int'l 563 (Aug. 17, 2015) (same); see also Kevin A. Bell, U.S.

Official: Unilateral Measures Violate Spirit of BEPS, BNA DAILY TAX REPORT (May 16, 2016) (citing Mr. Stack’s more recent

comments of a similar nature).

34

Regulations are not consistent with the OECD's BEPS proposals146 means that the United States’ treaty

partners will actively oppose them.147

The conflict between the Proposed Regulations and existing treaty obligations can be most easily shown

through a simple example:

EXAMPLE 7: FP, a foreign publicly traded corporation located in Country X, owns all

of the stock of USS1, a U.S. corporate subsidiary and calendar year taxpayer. The United

States has entered into an income tax treaty with Country X similar to the 2006 U.S.

Model Treaty. FP loans USS1 $100,000,000 in 2017. USS1 is profoundly over-

capitalized and the loan complies with all requirements that have been applied by the

courts and the Service to distinguish debt from equity. USS1 acquires the stock of an

expanded group member on January 1, 2018. Under the Proposed Regulations, the loan

from FP to USS1 is recast as equity in 2018. USS1 pays $3,000,000 of "interest" on the

loan to FP during 2018. The applicable U.S. income tax treaty with Country X (the

"U.S.-X Treaty") prohibits the United States from imposing U.S. withholding tax on

"interest" but allows for imposition of U.S. withholding tax of 5% on "dividends" paid

to FP.148 However, had USS1 used the funds to acquire the stock of an unrelated entity,

the Proposed Regulations would not have recast the loan from FP to USS1 as equity.

Hence, no U.S. withholding tax would have been imposed on the "interest" paid by USS1

to FP.

In the example, USS1 should not have to withhold on "interest" payments. Yet, the Service will assert that

withholding is due because of the Per Se Stock Rule. At the same time, FP has to recognize the interest

income and pay tax in its home country, thus suffering double taxation. Assume that the treaty provides

that "interest" is defined as "income on debt claims of any kind",149 but that the tax treaty does not define

146 See OECD (2015), Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2015 Final

Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris (“Action 4”). Action 4 focuses on rules to

prevent base erosion through the use of interest expense deductions. The Action would require countries to implement a rule that

limits an entity’s net interest deductions to a fixed percentage of the entity’s earnings before interest, taxes, depreciation and

amortization ("EBITDA") (each country would have its own ratio between 10% and 30% ) (the “Fixed Ratio Rule”). Countries

may make an exception to the Fixed Ratio Rule, allowing an entity to take interest deductions when a relevant benchmark (such as

ratio of net interest expense to EBITDA, or its net equity) indicates that the entity’s proportion of debt financing is consistent with

the proportion of debt financing of the entity’s world-wide group (the “Group Ratio Rule” and together with the Fixed Ratio Rule,

the “General Interest Limitation Rules”). Countries also may make certain general exceptions to the General Interest Limitations

Rules, specifically they may make a de minimis exception, an exclusion for interest expenses incurred to fund certain public benefits

projects, and an allowance for the carry forward of disallowed interest expenses. The Action also includes “targeted rules” that

apply to specific transactions and arrangements, focusing on transactions or arrangements designed to circumvent the General

Interest Limitations Rules. There are, a group of targeted rules that do not relate to circumvention of the General Interest

Limitations Rules. However, none of those targeted rules apply based on a manner in which the cash proceeds of a debt are spent

(unlike the Funding Rule). More importantly, the Action 4 rules would deny the interest deduction and not recast the debt as equity.

Therefore, the Per Se Stock Rules contradict Action 4 in both method and result.

147 Page 82 of the Final Report for Action 4 does allude to "other" rules that a country may employ in conjunction with the "best

practice approach" suggested by Action 4. Nevertheless, we believe that when U.S. treaty partners realize that the consequence of

recasting debt as equity in inbound loan situations results in U.S. withholding tax, not just interest deductibility, they will quickly

and strenuously argue that the U.S. is acting outside of the consensus reached in Action 4.

148 This amount will often be increased to 15% if the lender happens to be an affiliate that does not own any other stock in the

borrower.

149 See Article 11(4) of the United States Model Income Tax Convention (2016).

35

the term "debt". As noted below, USS1 will be able to pursue its rights under the applicable treaty in both

the U.S. courts and in competent authority proceedings.

1. Treaties are Contracts between Sovereign States.

The United States considers an income tax treaty to represent a contract between the two participating

countries (each a "Contracting State").150 What this means is that any changes made to how a treaty is

interpreted should generally be consistent with the shared intentions of the Contracting States at the time

the treaty was negotiated. This concept has been adopted by U.S. courts and has been approved by the U.S.

Supreme Court.151 Article 31(1) of the Vienna Convention on the Law of Treaties provides that "[a] treaty

shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the

treaty in their context and in the light of its object and purpose."152 Although, as discussed below, there is

a mechanism for revising the meaning of undefined terms in a treaty after a treaty is negotiated, it is clear

that this mechanism was not intended to permit one Contracting State to subsequently re-write previously

agreed-upon fundamental rules without limitation.

2. How Terms like "Interest" and "Dividends" are Defined under the Treaty.

Article 11(4) of the 2016 U.S. Model Treaty provides that the term "interest" is defined to mean:

income from debt-claims of every kind, whether or not secured by mortgage, and whether

or not carrying a right to participate in the debtor's profits, and in particular, income from

government securities and income from bonds or debentures, . . . and all other income that

is subjected to the same taxation treatment as income from money lent by the taxation

law of the Contracting State in which the income arises. Income dealt with in Article 10

(Dividends) . . . shall not be regarded as interest for the purposes of this Convention.153

Article 10(7) provides that the term "dividends" means, "income from shares or other rights, not being debt-

claims, participating in profits, as well as income that is subjected to the same taxation treatment as

income from shares under the laws of the State of which the payer is a resident."154

In both cases, these definitions provide that the definition of "interest" and the definition of "dividends" can

be affected by the taxation law of the Contracting State in which the income arises. Effectively, these

150 Tax Treaties: Hearing Before the S. Comm. on Foreign Relations, 108th Cong. 11 (2003) (statement of Barbara Angus,

International Tax Counsel, Department of the Treasury); S. REP. NO. 103-19, at 19 (1993); Tax Treaties: Hearings Before the S.

Comm. on Foreign Relations, 97th Cong. 9 (1981) (statement of John Chapoton, Deputy Assistant Secretary, Tax Policy,

Department of Treasury).

151 Maximov v. U.S., 299 F.2d 565, 568 (2d Cir. 1963) ("In deciding whether a given taxpayer in a specific instance is protected by

the terms of a treaty, we must 'give the specific words of a treaty a meaning consistent with the genuine shared expectations of the

contracting parties.'"), aff'd, 373 U.S. 49 (1963); see also United States v. Stuart, 489 U.S. 353 (1989) (the literal terms of a

convention must be interpreted consistently with the expectations and intentions of the United States in entering into the income

tax convention).

152 Although the United States has not ratified the Vienna Convention, it has persuasive authority. See Letter from Roberts B.

Owen, Legal Advisor of the Dep't of State, to Senator Adlai E. Stevenson (Sept. 12, 1980), quoted in 75 AM. J. INT'L L. 142, 147

(1981) ("While the United States has not yet ratified the Vienna Convention on the Law of Treaties, we consistently apply those of

its terms which constitute a codification of customary international law. Most provisions of the Vienna Convention, including

Articles 31 and 32 on matters of treaty interpretation, are declaratory of customary international law.") (emphasis added).

153 (emphasis added).

154 (emphases added). Prior U.S. Model Treaties contained similar definitions.

36

definitions constitute specific cases of the general rule contained in Article 3(2) of the 2016 U.S. Model

Treaty which provides rules governing the tax treatment of undefined terms. The question is whether a

Contracting State has (or should exercise) the unilateral ability to fundamentally revise ex post facto the

meaning of an undefined treaty term (such as "debt-claim" or "income from shares") to provide for

fundamentally different tax treatment than that originally contemplated by the Contracting States at the time

the treaty was negotiated and entered into.155 This issue is discussed in greater detail below.

In the example given above, if the loan from FP to USS1 were used by USS1 to purchase an unrelated target

corporation there would be no question that the "interest" subsequently paid by USS1 to FP would be treated

as bona fide interest, exempt from U.S. withholding tax pursuant to Article 11(1) of the U.S.-X Treaty.156

USS1 and FP intended the funds to be a "loan," the arrangement was structured as a loan, USS1 is not thinly

capitalized, and the parties have acted in a manner that is consistent with the form of the transaction.

However, by virtue of the fact that USS1 acquires the stock of an Expanded Group member, the Per Se

Stock Rule would treat the payments by USS1 to FP as a "dividend" despite the fact that all other indicia

of debt are present. The use of the funds has nothing to do with the character of FP's funding of USS1.157

That is, nothing suggests that the mere use of funds should, by itself, turn a "debt-claim" into an item of

income from shares (i.e., a dividend).

3. Historical Consideration of Treatment of Debt/Equity Issues in the Legislative

History to U.S. Treaties.

The legislative history to U.S. income tax treaties between 1980 and 1983 (i.e., the period during which the

initial section 385 regulations were being developed and considered), indicates that the definitions of

“dividends” and “interest” were intended to take account of section 385 (and the initial section 385

regulations).

For example, the Senate Foreign Relations Committee Report for the 1982 US-New Zealand Treaty

provided:

The proposed treaty does not define interest. Therefore, the proposed treaty's general rule

for undefined terms applies: unless there is mutual agreement between the competent

authorities, each country may apply its rules for determining when a payment by a resident

company is on a debt obligation or an equity interest thus, the United States could apply

its section 385 rules for determining whether an interest is debt or equity.158

155 Although a significant number of U.S. income tax treaties contain a definition of "interest" similar to that contained in the 2016

U.S. Model Treaty, a number of U.S. income tax treaties do not contain a definition that considers source country law for purposes

of determining whether the payment should be treated as "interest". These include existing U.S. income tax treaties with Austria,

Barbados, The People's Republic of China, Hungary, India, Jamaica, Sweden, Switzerland, and Tunisia. In these cases, any

argument that the Proposed Regulations should override the treaty's own definition of "interest" is even less supportable than it is

in the case of other U.S. income tax treaties.

156 We assume that §§163(e)(5), (j), (l) and 279 would not prevent the interest from being deducted or viewed as "interest" under

domestic law.

157 The leading article on debt-equity considerations, William T. Plumb, Jr., The Federal Income Tax Significance of Corporate

Debt: A Critical Analysis and a Proposal, 26 TAX LAW REVIEW 369, 520 (1971), makes clear that under historical U.S. tax rules,

the use of the funds by the borrower is only one factor to be taken into consideration in determining whether an amount should be

treated as debt or equity. Moreover, when it has been considered, it has been in the context of how the use of funds impacts the

borrower's ability to repay.

158 (emphasis added). S. EXEC. REPT. NO. 98-15, 98th Cong., 1st Sess. 20 (1983). Similar language was included in the legislative

history to U.S. income tax treaties with a number of other countries.

37

This does not mean that the U.S. has the unfettered right to define "debt" when the issuer is a U.S.

corporation. It certainly does not mean that the Service can unilaterally change the characterization of an

instrument years after it has been issued, because a subsequent “tainted” transaction has occurred. Rather,

other authorities make clear that any conflicts that result from section 385 will need to be addressed through

the competent authority mechanism. For example, the Senate Foreign Relations Committee Report to the

1980 US-Egypt Treaty provided:

It is understood that this provision permits the United States to apply its rules for

distinguishing between debt and equity (section 385) with the competent authorities

settling disputes if conflicts between United States and Egyptian rules cause double

taxation.159

Finally, outside the specific context of section 385, treaty legislative history has made clear that these

definitions are broad enough to address thin capitalization situations.160

Although the foregoing suggests Congress believed that guidance under section 385 would inform how the

U.S. interpreted the term "debt" in its treaties, nothing contained in the initial section 385 regulations would

have resulted in the disparity of treatment shown in the example set out above. Rather, those initial section

385 regulations attempted to rationalize the existing case law for purposes of distinguishing debt from

equity ab initio.161 For the reasons discussed in prior sections of this letter, we believe the Per Se Stock

Rule is in not rationally related to the Congressional mandate given to Treasury in 1969.

For the following reasons, the Per Se Stock Rule should not be applied in a treaty context. If it is so applied,

it is highly likely that recast instruments will eventually become the subject of contentious competent

authority proceedings (since in most cases, the treaty partner will reach a result that is inconsistent with the

result arising under the Proposed Regulations) or, in some cases, will result in treaty partners adopting self-

help remedies in response to the Proposed Regulations.

4. Absent a Congressional Directive to the Contrary, Treaties will Overrule the

Proposed Regulations.

Example 7 highlights a conflict between the Per Se Stock Rule and U.S. tax treaties. There is no indication

that Congress intended to override existing treaties when it enacted section 385 in 1969. The enactment of

section 385 occurred long before certain changes were made to section 7852 of the Code, and so the

Proposed Regulations can only override existing treaties to the extent Congress mandated a treaty override.

Given that there is no indication in Congress' adoption of section 385 that Congress intended the Treasury

to override inconsistent treaties, the Proposed Regulations cannot override existing treaties on their own

basis. That is, while Congress can, when it wishes to, override existing treaties, nothing arrogates to the

159 (emphasis added). Similar language was included in the legislative history to U.S. income tax treaties with a number of other

countries.

160 Technical Explanation to the 2003 U.S.-Sri Lanka Protocol at 33 ("Finally, a payment denominated as interest that is made by

a thinly capitalized corporation may be treated as a dividend to the extent that the debt is recharacterized as equity under the laws

of the source State."). Out of an excess of caution, the legislative history sometimes indicates that section 163(j) is covered, although

section 163(j) does not actually recharacterize debt as equity; it may simply defer the current deductibility of interest payments.

161 For example, in determining whether a "straight" debt instrument would be treated as "debt" or "equity" the initial section 385

regulations focused on: (i) the terminology used, (ii) the debt-to-equity ratio of the borrower, and (iii) whether the parties treated

the instrument in accordance with its form (e.g., timely payment of interest). See Prop. Reg. § 1.385-2 (1980). These were all

factors taken into account under the historical case law. See, e.g., Roth Steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir.

1986); Estate of Mixon, Jr. v. United States, 464 F.2d 394 (5th Cir. 1972); Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d

Cir. 1968).

38

Treasury and the Service the right to override existing treaties in the absence of an explicit indication by

Congress that an override was clearly intended.

The relationship of treaties and Congressional legislation is governed by the Supremacy Clause of the U.S.

Constitution. Article VI, section 2 of the Constitution states: "This Constitution, and the Laws of the United

States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the

authority of the United States, shall be the supreme Law of the Land".

The U.S. Supreme Court has interpreted this statement to mean that treaties do not enjoy a status superior

to acts of Congress:

so far as a treaty made by the United States with any foreign nation can become the subject

of judicial cognizance in the courts of this country, it is subject to such acts as Congress

may pass for its enforcement, modification, or repeal.162

The principle has long been established that when a treaty and an act of Congress conflict "the last

expression of the sovereign will must control".163 This rule has been colloquially referred to as the "later

in time" rule. However, the Supreme Court has stated that "[a] treaty will not be deemed to have been

abrogated or modified by a later statute unless such purpose on the part of Congress has been clearly

expressed."164 In Cook v. United States, subsequent inconsistent legislation was held not to supersede an

earlier treaty provision because neither the committee reports nor the debates on the subsequent legislation

mentioned the earlier treaty.165

Thus, as the Service summarized in Rev. Rul. 80-223,166 when an act of Congress and a treaty relate to the

same subject, the courts will endeavor to construe them so as to give effect to both, if this can be done

without violating the language of either. If they cannot be reconciled, the courts do not favor repudiation

of an earlier treaty by implication. Instead, the courts require clear indications that Congress, in enacting

subsequent inconsistent legislation, meant to supersede the earlier treaty. The ruling gave as an example of

such a clear indication the presence of subsequent inconsistent legislation together with a committee report

indicating that Congress intended such legislation to supersede the earlier treaty.

At the time Section 385 was adopted in 1969, the only standard in the Code implementing the later in time

rule was contained in Section 7852. At that time, section 7852(d) provided:

No provision of this title shall apply in any case where its application would be contrary to

any treaty obligation of the United States in effect on the date of enactment of this title.

During the period from 1954 (when Section 7852 was added to the Code) through the mid to late 1970s, it

is clear that Congress was extremely careful to ensure that any treaty overrides were absolutely intentional

and documented.167 For example, in adopting Section 31 of the Revenue Act of 1962, the House of

162 Edye v. Robertson, 112 U.S. 580, 599 (1884).

163 Chae Chan Ping v. United States (Chinese Exclusion Case), 130 U.S. 581, 600 (1889); Whitney v. Robertson, 124 U.S. 190,

194 (1888); United States v. Felter, 546 F. Supp. 1002 (D. Utah 1982), affd., 752 F.2d 1505 (10th Cir. 1985).

164 Cook v. United States, 288 U.S. 102, 120 (1933) (emphasis added).

165 Id.

166 1980-2 C.B. 217.

167 See generally, Irwin Halpern, United States Treaty Obligations, Revenue Laws, and New Section 7852(d) of the Internal Revenue

Code, 5 FL. INT. L. J. 1 (1989).

39

Representatives stated: "if any provision of this bill should contravene any existing treaty, the new statutory

law is intended to have precedence over the prior treaty obligation."168 Similarly, section 110 of the Foreign

Investors Tax Act of 1966 stated, "No amendment made by this title shall apply in any case where its

application would be contrary to any treaty obligation of the United States. For purposes of the preceding

sentence, the extension of a benefit provided by any amendment made by this title shall not be deemed to

be contrary to a treaty obligation of the United States."169 Accordingly, at the time of the Tax Reform Act

of 1969, Congress had a record of clearly stating when it intended to override existing treaties. Nothing

contained in the Tax Reform Act of 1969 suggests that Congress intended to override existing treaties by

adopting Section 385.

In 1988, during its consideration of the Technical and Miscellaneous Revenue Act of 1988 ("TAMRA"),170

Congress amended section 7852(d) to provide that neither a provision of a treaty nor a law of the United

States affecting revenue would have preferential status by reason of its being a treaty or a law.171 Congress

intended this change to ensure that treaties and revenue statutes would be placed on the same footing, so

that conflicts in their provisions would be resolved under the rule that the provision adopted later-in-time

controls.172 Congress also intended this change to codify the approach of the courts under which the same

canons of construction applied to the interaction of two statutes enacted at different times would be applied

to the interaction of revenue statutes and treaties enacted and entered into at different times.173

Even with this change, the U.S. Treasury has strongly argued against treaty overrides. For example, in

1990, Kenneth Gideon, the then Assistant Secretary of the Treasury for Tax Policy, stated to the Senate

Foreign Relations Committee:

Our treaty partners have voiced strong objections to treaty overrides in both bilateral and

multilateral forums. Several major U.S. treaty partners have recently suggested in the

course of treaty discussions that they may insist on reserving in a new treaty the right to

retaliate automatically against U.S. overrides. It is also becoming increasingly difficult to

negotiate reciprocal concessions when the foreign government fears that the United States

may unilaterally reverse the bargain by legislative action. For these reasons, the

administration has consistently objected to treaty overrides.174

In Example 7, it would not be possible to reconcile the terms of the treaty with the application of the Per

Se Stock Rule. Specifically, under the Vienna Convention, the term "debt claim" should have its ordinary

meaning. It should not be dependent on whether the borrowed proceeds were used to acquire a stock of a

related party vs. an unrelated party within an arbitrary 72-month period.

The Service's challenge in arguing that the results under the Per Se Stock Rule are consistent with the plain

meaning of the words "debt claim" will be compounded for any instrument that is not recast ab initio.

Specifically, it will be difficult (if not impossible) for the Service to convince a reviewing court that a loan

168 H.R. REP. NO. 1447, 87th Cong., 2d Sess. at 96.

169 Pub. L. 89-809, 80 Stat. 1593 § 110.

170 Pub. L. 100-647, 102 Stat. 3342.

171 TAMRA, Pub. L. 100-647§ 1012(aa)(1), 102 Stat. 3342, 3531.

172 S. REP. NO. 100-445, 100th Cong. 2d Sess., at 321-322

173 Id. at 321.

174 Statement of Kenneth W. Gideon, Assistant Secretary (Tax Policy), U.S. Department of the Treasury, before the Senate Foreign

Relations Committee during the hearing on the approval of the treaty; Senate Hearing 101-1062 (June 14, 1990), Pending Bilateral

Tax Treaties and OECD Convention, at 5.

40

advanced in 2017 and which bore interest in 2017 that was exempt from withholding tax during 2017,

should not be considered "debt" in 2018 just because the borrower happened to engage in a tainted

transaction in that year. We believe it will be exceedingly difficult for the Service to explain to a court how

a valid debt claim, the payments on which were not subject to withholding in 2017, all of a sudden became

"equity" in 2018 due to a tainted transaction that may bear no factual relationship to the loan whatsoever.

For the foregoing reasons, a reviewing court will very likely apply the later in time rule. If the later in time

rule were to apply, the treaty will, in almost all cases, be later in time. Specifically, when a regulation and

a treaty conflict, the regulation is dated by reference to the date of the authorizing statute.175 Thus, absent

a treaty pre-dating 1969, the treaty provision will be "later in time" and should control.

5. Courts May Apply the Treaty Over Proposed 385 Regulations.

In the absence of an explicit Congressional treaty override, case law makes clear that U.S. courts will uphold

a treaty over an inconsistent administrative interpretation. In Rev. Rul. 79-152,176 the Service asserted that

a former U.S. citizen who expatriated to a country with which the United States had entered into an income

tax treaty would be subject to U.S. tax on gain from the disposition of a capital asset pursuant to section

877 of the Code irrespective of the terms of the applicable treaty. The ruling asserted that the former U.S.

citizen was not entitled to treaty benefits because he was subject to the "saving clause" contained in the

applicable treaty. The saving clause provided that each country, notwithstanding any other provision of the

treaty, could, in determining the taxes of its citizens or residents, include in the basis upon which such taxes

were imposed all items of income taxable under its revenue laws as though the treaty had not come into

effect. Thus, the Service's argument was that the term "citizens" (as used in a treaty saving clause) included

not only U.S. citizens themselves but former citizens covered by section 877 who had expatriated to avoid

tax.177

The issue was litigated in Crow v. Commissioner.178 In Crow, a U.S. citizen and resident gave up his U.S.

citizenship and moved to Canada. Shortly after expatriating, Crow sold all the stock of a U.S. corporation

he owned. Crow asserted the gain was exempt from U.S. tax pursuant to Article VIII of the U.S.-Canada

Treaty (as then in effect) since he was a resident of Canada at the time of the sale. In contrast, the Service

argued, consistent with its position in Rev. Rul. 79-152, that Crow was not entitled to benefits under the

U.S.-Canada Treaty because the word "citizens" used in the saving clause contained in Article XVII of the

U.S.-Canada Treaty should be interpreted in accordance with the definition of the term "citizens" contained

in the Code. Under section 877, as then in effect, the term "citizen" included not only current "citizens" but

also former citizens who expatriated to avoid tax.

The Tax Court held for Crow. First, the Tax Court found nothing in the legislative history to the U.S.-

Canada Treaty that suggested the Contracting States had intended to give the word "citizens" a broader

175 Under the Supremacy Clause, a treaty override resulting from regulations must be pursuant to a "Law of the United States". As

Professor Richard Doernberg has pointed out, a regulation only has authority as law insofar as it is authorized by statute. Doernberg

notes quite correctly that there is no independent authority for a regulation to override a treaty provision. See Richard L. Doernberg,

Treaty Override by Administrative Regulation: The Multiparty Financing Regulations, 2 FL. TAX REV. 521, 532 (1995). Thus, in

the absence of any indication that Congress intended section 385 to override inconsistent treaties, the Proposed Regulations will

not be applied by reviewing courts to the extent they create a result inconsistent with U.S. treaty obligations ratified after 1969.

176 1979-1 C.B. 237.

177 See Sidney Roberts, Is Revenue Ruling 79-152, Which Taxes an Expatriate's Gain, Consistent with the Code? 51 J. TAX. 204

(1979).

178 85 T.C. 376 (1985)

41

meaning than its literal meaning. Nothing in the legislative history suggested that the parties intended, or

even contemplated, the application of Article XVII to nonresident aliens of the United States.

The Tax Court also focused on the Service's argument that Canada would have no reason to object to its

interpretation of the saving clause. The Tax Court did not find this argument compelling. First, Canada had

agreed to provide a credit for taxes paid to the United States. Thus, if the U.S. was permitted to impose its

tax on Crow, Canada would likely be obliged to provide a credit offsetting its own tax. Further:

even if Canada has no interest in encouraging expatriation from the United States, Canada

could reasonably object to the scope of section 877, which would deny treaty benefits for

10 years to expatriate Americans who acquired Canadian citizenship and residency. Finally,

under respondent's interpretation of the term "citizens," the United States could, without

violating the Canadian treaty, enact legislation significantly more burdensome to Canadian

interests than is section 877.179

All the Tax Court's arguments against application of an extended definition of "citizens" are equally

applicable to the Proposed Regulations. U.S. treaty partners will have strong objections to the Proposed

Regulations. Their residents will be subject to clear cases of double taxation. Moreover, to the extent the

Contracting State provides a foreign tax credit, its revenues will suffer for any U.S. dividend withholding

tax imposed.

It is the case that definitions of "debt-claim" or "income from shares" as used in Articles 10 and 11 of the

2016 U.S. Model Treaty (and in other U.S. treaties) do contemplate the relevance of domestic law

definitions. Yet it is also fair to say that the U.S.'s treaty partners never contemplated subsequent rules such

as the Per Se Stock Rule or its impact on the dividend and interest articles. Thus, the Service should expect

that taxpayers will assert their rights in court to avoid the results of the Per Se Stock Rule.

6. Consideration of Proposed Regulations Under the Article 3(2) Undefined Term

Rule.

It is the case that Article 3(2) grants each Contracting State the right to interpret undefined terms in a treaty

in accordance with its internal law on an ambulatory basis.180 Nevertheless, there are clearly limits to this

ability to revise definitions under domestic law. These limits can be seen in cases like Crow v.

Commissioner. Such a conclusion is particularly clear in a case where Congress has not explicitly indicated

(or even implied) that a treaty override was intended. To take a simple example, the term "permanent

establishment" is a defined term in most U.S. income tax treaties. However, if a Contracting State wished

to do so, it could define for purposes of its internal law an undefined treaty term used in the permanent

establishment article (like "fixed place of business") to include any type of activity carried on in the source

country directly by the taxpayer or by any agent acting on behalf of the taxpayer, thus effectively overruling

all the other provisions of the permanent establishment definition. Such a profound revision to an existing

179 85 T.C at 383.

180 See Rev. Rul. 80-243, 1980-2 C.B. 413 and Pr. Ltr. Rul. 1978-44-008 (July 26, 1978). The purpose of the ambulatory approach

to interpretation of undefined term was, in the Service's view, to give treaties "breathing room." Pr. Ltr. Rul. 1978-44-008 (July 26,

1978). The U.S. view that Article 3(2) should be interpreted in an ambulatory manner has not been adopted by other countries. For

example, the Canadian Supreme Court in The Queen v. Melford Developments, Inc., 1982 D.T.C. 6281, gave this provision a static

interpretation.

42

treaty through a change in the definition of an undefined term would universally be seen as inappropriate

and inconsistent with the intentions of the parties when they negotiated the treaty.181

Treaty legislative history also reflects an understanding that there are very real limits to the ambulatory

approach of interpreting undefined terms. The Technical Explanation of the 1997 U.S.-Ireland Treaty ended

its discussion of the ambulatory nature of Article 3(2) with the following statement:

The use of an ambulatory definition, however, may lead to results that are at variance

with the intentions of the negotiators and of the Contracting States when the treaty was

negotiated and ratified. The reference in both paragraphs 1 and 2 to the "context otherwise

requiring" a definition different from the treaty definition, in paragraph 1, or from the

internal law definition of the Contracting State whose tax is being imposed, under

paragraph 2, refers to a circumstance where the result intended by the negotiators or by the

Contracting States is different from the result that would obtain under either the paragraph

1 definition or the statutory definition. Thus, flexibility in defining terms is necessary and

permitted.182

Thus, the Treasury, like the Tax Court in Crow v. Commissioner (discussed above), is also on record

indicating that some source country changes to its internal law should not affect existing treaties where to

do so would be fundamentally at variance with the intentions of the negotiators.

In fact, the United States has itself protested and sought relief when other Contracting States have made

changes to their internal law that has adversely affected the tax position of U.S. taxpayers under an existing

treaty. For example, Rev. Rul. 69-326,183 referenced a competent authority agreement entered into between

the United States and Belgium. As a result of certain changes to Belgian law, Belgium became entitled to

impose tax on U.S. permanent establishments of U.S. corporations at a rate significantly in excess of the

rate previously imposed on such permanent establishments. By virtue of the mutual agreement, Belgium

agreed to impose tax on such permanent establishments at a significantly lower rate than provided by its

domestic legislation. Although this decision was predicated on application of the non-discrimination

provision in the relevant treaty,184 the ruling still stands for the proposition that a Contracting State that

upsets existing tax rules should be willing to address the concern of the affected treaty partner.

In this case, the Per Se Stock Rule represents a fundamental revision to a century of common law

differentiating debt from equity. The Per Se Stock Rule, if implemented as drafted, would result in

significant incidences of taxation not in accordance with applicable income tax treaties and certainly not in

accordance with the intentions of the Contracting States.

181 In this context, it is worth noting that the Treasury has added a new article (Article 28) to the 2016 U.S. Model Treaty that is

described by the Treasury in the Preamble to the Model Treaty as obligating the treaty partners to consult with a view to amending

the treaty as necessary when changes in the domestic law of a treaty partner draw into question the treaty’s original balance of

negotiated benefits and the need for the treaty to reduce double taxation. The impact of the Proposed Regulations on U.S. treaties

would certainly seem the type of change for which a provision like Article 28 was intended to apply.

182 (emphasis added).

183 1969-1 C.B. 365.

184 The changes made by the Proposed Regulations are drafted to apply equally to U.S. lenders and foreign lenders. Nevertheless,

it is obvious that they will predominantly have an impact on foreign lenders. Formalistic compliance with non-discrimination

should not be used to avoid U.S. treaty obligations.

43

7. Double Taxation, Competent Authority and Mandatory Arbitration.

The application of the Per Se Stock Rule in situations like Example 7 will result in double taxation. If the

United States treats what is intended to be an interest payment as a dividend, this will have significant tax

consequences both in the United States and in the Contracting State of the lender. In the United States, the

"interest" will not be deductible and will likely result in imposition of a U.S. withholding tax on the

"dividend" paid to the lender. The country of residence will almost certainly not treat the payment as a

dividend. This will have the following consequences. First, the dividend exemption rules common in many

jurisdictions will not apply. Second, it is likely that in the lender's home jurisdiction, the other Contracting

State will treat the amounts paid by the borrower and received by the lender as "interest" which will be

subject to full residence country taxation. Third, the borrower will not receive a deduction in the United

States for the amounts paid by the borrower to the lender while the lender will pay residence country tax at

the full statutory rate. This is classic double taxation which the U.S. tax treaties seek to address through

competent authority.

Article 25 of the 2016 U.S. Model Treaty specifically lists inconsistent characterizations of income as an

issue that an adversely affected taxpayer can address to one or the other of the competent authorities.185

There are at least 34 existing U.S. income tax treaties that specifically provide a similar rule.186 Other

treaties without this specific language provide that taxpayers can request competent authority assistance so

that the parties give the same meaning to any term used in the treaty.187 Almost certainly, if the Proposed

Regulations are treated as applicable to existing U.S. income tax treaties, the United States will swiftly face

scores of competent authority proceedings seeking double taxation relief. If the United States is unwilling

to compromise on an issue where the other Contracting State can reasonably claim that this result was never

intended when the treaty was negotiated, it is likely that U.S. corporations will face retaliatory actions taken

by other Contracting States. These actions could involve other countries imposing similar rules on U.S.

companies or by such Contracting States being unwilling to settle other competent authority issues with the

U.S. competent authority.

In addition, the Treasury should bear in mind that the 2016 U.S. Model Treaty now provides for mandatory

arbitration (as do a number of existing income tax treaties with some of the United States' most significant

trading partners).188 The arbitration methodology is so-called "baseball arbitration",189 and so an arbitration

185 Article 25(3) provides:

"The competent authorities of the Contracting States shall endeavor to resolve by mutual agreement any difficulties or doubts

arising as to the interpretation or application of this Convention. They also may consult together for the elimination of double

taxation in cases not provided for in this Convention. In particular the competent authorities of the Contracting States may agree:

. . .

c) to the settlement of conflicting applications of this Convention, including conflicts regarding:

i) the characterization of particular items of income . . ."

Similar rules are contained in prior U.S. Model Treaties.

186 cite. Even absent a specific reference to conflicts in characterization, the terms of the mutual agreement article are likely broad

enough to cover any issue that results in double taxation or in taxation not in accordance with the treaty.

. . .

187 See e.g., 1982 U.S.-Australia Treaty, art. 24(2)(d).

188 2016 U.S. Model Treaty, Art. 25(6). Compulsory arbitration rules are currently included in the 2006 U.S.-Belgium Treaty, art.

24(7); 1980 U.S.-Canada Treaty, as amended, art. XXVI(6); 1994 U.S.-France Treaty, as amended, art. 26(5); and 1989 U.S.-

Germany Treaty, as amended, art. 25(5).

189 2016 U.S. Model Treaty, art. 25(9)(j).

44

panel will presumably have only two options. First, the panel can accept the result created by the Proposed

Regulations even though it may create a characterization (equity) that is inconsistent with the plain meaning

of "debt" and the historical intentions of the Contracting States. Second, and alternatively, the panel can

conclude that the recast is simply incompatible with the agreement reached between the Contracting States

in the plain language of the applicable treaty. It is very likely that an arbitration panel will take the latter

approach.

8. Finalization of the Per Se Stock Rule will Lead to Possible Retaliation by the U.S.'s

Treaty Partners.

Finally, certain U.S. income tax treaties already contain provisions that permit one Contracting State to

react to a treaty override by its treaty partner. For example, Protocol paragraph 20 of the U.S.-Mexico

income tax treaty provides that:

When the competent authority of one of the Contracting States considers that the law of

the other Contracting State is or may be applied in a manner that eliminates or significantly

limits a benefit provided by the Convention, that State shall inform the other Contracting

State in a timely manner and may request consultations with a view to restoring the balance

of benefits of the Convention. If so requested, the other State shall begin such consultations

within three months of the date of such request.

If the Contracting States are unable to agree on the way in which the Convention should

be modified to restore the balance of benefits, the affected State may terminate the

Convention in accordance with the procedures of paragraph 1, notwithstanding the five

year period referred to in that paragraph, or take such other action regarding this

Convention as may be permitted under the general principles of international law.190

Other U.S. income tax treaties with provisions similar to that included in the U.S.-Mexico Treaty include

U.S. treaties with Canada (Article XXIX(7)), Israel (Article 6(8)), Italy (Protocol paragraph 7(1)), Japan

(Article 29), Kazakhstan (Protocol paragraph 9), Spain (Protocol paragraph 20), Switzerland (Article 28(5)),

and Venezuela (Article 30(2)). In addition, the United States and the Netherlands adopted a similar principle

pursuant to an exchange of letters dated December 18, 1992.

Thus, it is likely that these countries will seek redress from the impact of the Proposed Regulations and, in

the absence of such redress, will have the right to terminate the treaty or, more likely, take some other steps

to redress the balance of benefits adversely affected by the Proposed Regulations.

III. IN ALL EVENTS, THE SCOPE OF THE DOCUMENTATION AND PER SE STOCK RULES SHOULD BE

SUBSTANTIALLY NARROWED.

The sheer scope of the Proposed Regulations makes them exceedingly problematic. We respectfully request

the scope of the Documentation Rule be narrowed. In addition, if Treasury decides to finalize the Per Se

Stock Rule, despite the validity issues, it too should be narrowed. Some of our suggested scope limitations

apply to both the Documentation Rule and the Per Se Stock Rule. Others relate solely to the Per Se Stock

Rule.

190 (emphasis added)

45

A. The Documentation Rule and Per Se Stock Rule Should Apply to Fewer Instruments.

The purported rationale for the Proposed Regulations was to combat "earnings stripping".191 If that is the

case, then the scope of the Documentation Rules and Per Se Stock Rules should be limited to those

instruments that pose a significant risk that a U.S. company will incur significant and sustained interest

deductions over time that are disproportionate to its business activities.

As noted above, the Documentation Rule applies to EGIs. The Per Se Stock Rule applies to EGDIs. Either

way, the Proposed Regulations capture a significant number of instruments that present little or no

possibility of "earnings stripping". Specifically, we recommend the instruments to which the

Documentation and Per Se Stock Rules apply be limited by type and term.

1. The Documentation and Per Se Stock Rules Should Only Apply to Instruments

that will Likely Bear Significant Amounts of Interest.

Our membership is particularly concerned about the application of the Documentation and Per Se Stock

Rules to payables that arise every day amongst Expanded Group members. The Documentation Rules

appear to apply to any trade payable arising between Expanded Group members without exception. The

Per Se Stock Rule would exempt limited types of trade payables (i.e., those incurred for property or services

that generate a deduction under section 162 or a cost of goods sold deduction) from the ambit of the Funding

Rule but continues to apply to other non-interest bearing payables (i.e., payables for capital equipment,

leases, licenses etc…).

Taxpayers frequently transfer property and services via "intercompany accounts" that they maintain in their

accounting systems. Quite often, these intercompany accounts do not bear interest and are not separately

documented via a "loan" agreement. A taxpayer's determination to charge interest is either correct or it

isn't. We respectfully suggest that the propriety of not charging interest on a given payable is already

governed by the common law debt-equity analysis and section 482. Section 482, for example, does not

even require that interest be charged on significant amounts of intercompany "trade payables" for up to

ninety (90) or one-hundred and twenty (120) days, depending on whether the debtor is located inside or

outside of the United States.192 Even then, the interest charge on these short-term payables is not typically

significant due to the nature of the transactions involved. Moreover, the "term" is short, as the payables are

intended to be repaid in short-order. Thus, even if these trade payables do bear interest after 90 or 120 days,

they will not bear interest for significant periods of time. There is very little risk that taxpayers would be

earnings stripping by way of trade payables. The potential for abuse with trade payables is far outweighed

by the burden imposed on taxpayers to prepare, and the Service to review, the information required by the

rules.

In all events, however, we respectfully request that any payable that does not properly bear interest, or is

described in section Treas. Reg. §1.482-2(a)(iii)(B) (which means it may conceivably bear interest if left

outstanding long enough), should be exempt from the Documentation Rule and the Per Se Stock Rule. If

a payable does not bear interest or only bears interest after a safe-harbor period, then it clearly was not

issued with an intent to engage in earnings stripping. Hence, there is no need for the Documentation and

Per Se Stock Rule to apply.

191 81 Fed. Reg. 20,914 (Apr. 8, 2016) ("Notice 2014-52 and Notice 2015-79 also provided that the Treasury Department and the

IRS expect to issue additional; guidance to further limit the benefits of post-inversion tax avoidance transactions. The notices

stated, in particular, that the Treasury Department and the IRS are considering guidance to address strategies that avoid U.S. tax on

U.S. operations by shifting or "stripping" U.S.-source earnings to lower-tax jurisdictions, including through intercompany debt.")

192 See Treas. Reg. §1.482-2(a)(iii)(B).

46

2. The Documentation and Per Se Stock Rules Should not Apply to Instruments that

have a Short Term.

If a loan is put in place to accomplish earnings stripping, we would expect it to bear interest for a significant

period of time. A short-term loan at an arm's length interest rate is not likely to present a significant risk of

earnings stripping. A short-term loan exception would not appear to present an opportunity for abuse. It

would also ease the burden on those companies that have seasonal operations that require periodic increases

in borrowing levels. We would thus recommend that only loans with a term exceeding 12 months be subject

to the Documentation and Per Se Stock Rules.

B. The Documentation and Per Se Stock Rules Should not Apply to Issuers Who are Not

Subject to U.S. Taxation.

The other way to narrow the scope of the regulations is to focus on those issuers within the Expanded Group

that the government most cares about. The Documentation and Per Se Stock Rule, as currently drafted,

apply to foreign corporations that are not CFCs and do not have a trade or business in the United States.

As noted above, subjecting these entities to the Documentation Rule imposes significant costs to our

membership without enhancing the Service's ability to audit transactions that are actually relevant to the

U.S. tax system.

In fact, we would argue that applying the Documentation Rule to these entities is harmful to the Service's

audit efforts in that field agents will simply be buried with useless pieces of paper that document loans

having no possible bearing on U.S. tax liability. The Service has been down this road before in the context

of section 6011 reportable transaction rules, where Treasury initially required reporting for every

transaction having a significant "book-tax" difference. Once the Service actually received voluminous

Forms 8886, it realized its agents were consuming a significant amount of valuable audit time reviewing

information that did not lead to adjustments. Thus, the book-tax difference trigger was eventually

removed.193 We respectfully suggest that Treasury and the Service are, again, creating a documentation

rule that will simply consume audit resources with no discernible purpose.

For this reason, we recommend that all foreign corporate debt issuers that are not CFCs be removed from

the scope of the Documentation and Per Se Stock Rules.194 The only exception would be for non-CFCs

that have actual tax liability under section 882 of the Code and interest expense allocable against their U.S.

effectively connected income. In this regard, we note that many foreign companies file "protective" Forms

1120-F with zeroes on them to ensure that if they are found to have a U.S. taxable presence they can claim

deductions from their gross income rather than be assessed on a gross basis.195 Thus, the mere filing of a

Form 1120-F should not be sufficient to sweep a foreign corporation into the rules. Instead, only those

foreign corporations having an actual U.S. tax liability that has been reduced by allocable interest expense

should be subject to the rules.

C. The Documentation Rule and Per Se Stock Rule Should not Apply to EGIs or EGDIs

Between U.S. Corporations.

Some of our members own two or more U.S. consolidated groups. A loan from one member of the first

consolidated group to a member of the second consolidated group would be considered an EGI or EGDI

due to the fact that both groups are ultimately owned by the same common foreign parent. The fact that

193 Notice 2006-6, 2006-1 C.B. 385.

194 This should be the case even if the lender is a U.S. company. Stated differently all loans to a non-CFC, regardless of the lender's

status, would be exempt from the rule.

195 Treas. Reg. § 1.882-4(a)(3)(i); see also Swallows Holding, Ltd. v. Commissioner, 515 F.3d 162 (3d Cir. 2008) (vacating the Tax

Court’s judgment that the regulation was invalid).

47

the Proposed Regulations treat all members of a single consolidated group as one entity does not alleviate

the situation because the lender and borrower are not members of the same consolidated group. Thus, these

loans can be subject to the Proposed Regulations.

We respectfully suggest that there cannot be any abuse in this situation. Any deduction incurred would be

offset by a corresponding taxable income inclusion. Thus, these loans do not merit the same sort of scrutiny

that motivated Treasury to issue the Documentation Rules. Similarly, there is no earnings stripping concern

that motivated Treasury to issue the Per Se Stock Rule. Hence, we recommend that EGIs and EGDIs

between two U.S. companies be exempt from both the Documentation Rule and the Per Se Stock Rule so

long as the loan remains between two U.S. corporations.

We recommend this same exception apply if the lending entity happens to be a U.S. branch of a foreign

corporation (rather than a U.S. corporation) and the interest income is reflected on the applicable Form

1120-F for the branch. It is not uncommon for a foreign bank or financial institution to operate in branch

form in the U.S. So long as the interest income is reported on a Form 1120-F, it is difficult to see how the

loan could result in an abuse.

IV. IF THE PER SE STOCK RULE IS FINALIZED PENDING A COURT CHALLENGE CONCERNING

THEIR VALIDITY, THE OPERATION OF THE PER SE STOCK RULE SHOULD BE MODIFIED.

The Per Se Stock Rule is a composite of three (3) distinct sub-rules: (i) the General Rule; (ii) the Funding

Rule; and (iii) the Anti-Abuse Rule. Our recommendations below relate to all three rules, but our

membership is particularly concerned about the Funding Rule. It is our membership's opinion that the

Funding Rule is impossible to comply with as currently drafted. There is simply no way for multinationals

to comply with this rule. Even if Expanded Group members ceased advancing cash in exchange for loan

instruments with each other, and the only EGIs that existed between Expanded Group members were non-

interest bearing payables, the Funding Rule (as drafted) could still apply. As noted above, the exception

for ordinary course trade payables arising in connection with the acquisition of property or services in

amounts that can be deducted under section 162 as ordinary business expenses or added to cost of goods

sold or inventory is not broad enough to cover many routine payables.196 The Funding Rule still applies to

payables for rents, royalties or capital equipment, even if they are not interest-bearing and present no

possible avenue for earnings stripping.

If Treasury proceeds, despite our concerns, to finalize the Per Se Stock Rule, we respectfully recommend

the following adjustments be made.

A. The Presumption for Transactions Occurring within a 72-Month Window Period

Should be Rebuttable.

The Funding Rule provides that an EGDI will automatically be treated as issued with a principal purpose

of engaging in a tainted transaction (i.e., a property distribution, an acquisition of Expanded Group member

stock, or certain tax-free asset reorganizations) if the debt is issued within the 72 month period beginning

36 months before and ending 36 months after the tainted transaction (the "72-month window period").197

As such, it will automatically be recast as equity. As we noted above in Example 6, this automatic recast

can occur even when it can be demonstrated that the EGDI could not have been used to fund the tainted

transaction.

196 Prop. Reg. §1.385-3(b)(3)(iv)(B)(2).

197 Prop. Reg. §1.385-3(b)(3)(iv)(B)(1).

48

As a policy matter, this rule is out of step with statutory presumptions like sections 707 (partnership

disguised sales) and 355(e) (governing acquisitions occurring before or after a spin-off) and numerous other

presumptions in the Code.198 In all of these provisions, Congress allowed taxpayers a right to rebut the

presumption that the taxpayer had a bad intention.199 There is no sound policy reason why the Proposed

Regulations should take a different approach.

In fact, if Treasury retains the Funding Rule as is, with a factual presumption regarding a taxpayer's intent

that cannot be rebutted, taxpayers may argue that it is unconstitutional.200 Specifically, the Supreme Court

held in Heiner v. Donnan that when a statute (or regulation) "deems" a fact (i.e., the taxpayer's intent) to

exist without giving the taxpayer any chance to prove that the fact is not true, it can violate the taxpayer's

due process rights (the so-called "irrebuttable presumption doctrine"). It is the case that more recent

Supreme Court decisions have limited the application of the irrebuttable presumption doctrine, especially

in cases involving tax and economic issues.201 Nevertheless, it remains the case that even economic

regulations have to have a "rational relationship" between the presumption and a legitimate Congressional

purpose.202 Assuming, for the sake of argument, that a court upholds the validity of the Per Se Stock Rule,

a taxpayer could still easily argue that the sheer length of the 72-month window period makes it irrational.

After all, in Heiner v. Donnan, the Court concluded that an irrebuttable presumption involving a transfer 2-

years prior to death was unconstitutional. The Per Se Stock Rule involves a period that is three times as

long as the one at issue in Heiner.

198 See also § 183(d) (establishing rebuttable presumption that an activity resulting in net income in 3 out of 5 consecutive years is

an activity engaged in for profit); § 672(c) (establishing rebuttable presumption that a “subordinate party” is subservient to a trust’s

grantor in respect of the exercise or nonexercise of the trust powers conferred on such party); § 999(e) (establishing rebuttable

presumption that both a corporation and a person in control of the corporation participate in a boycott if either the person or the

corporation participates in the boycott); § 1092(c)(3) (establishing rebuttable presumption that two or more financial positions are

“offsetting” and subject to the straddle rules if any of a list of factual circumstances apply to the positions); § 5121(c)(4)

(establishing rebuttable presumption that a seller of 20 wine gallons or more of distilled spirits, wines, or beer to the same person

is a wholesale dealer of such product); § 6867(a) (establishing a rebuttable presumption, for purposes of the jeopardy assessment

procedures under section 6861 and the termination assessment procedures under section 6851, that the collection of income tax is

jeopardized by delay if an individual, who has physical possession of more than $10,000 in cash denies ownership of the cash and

doesn't claim that it belongs to another identifiable person who acknowledges that he owns the cash, causing the entire amount of

the cash is presumed to represent gross income of a single individual for the year); § 7430 (establishing rebuttable presumption that

a position taken by the United States is not substantially justified when the Service does not follow its applicable published guidance

in the administrative proceeding”); § 382(l)(1)(B) (capital contributions made within 2-years prior to ownership changes deemed

to be part of a plan to increase loss carryforward limitation, with exceptions (rebuttals) to be provided by regulations).

199 The Code does contain some provisions that could be considered irrebuttable presumptions as well. See Treas. Reg. §1.382-

8(b)(2) (deeming certain built-in losses to relate to a period before a particular year). See also, §7874(c)(3) (deeming a foreign

corporation's acquisition of substantially all of the properties of a domestic corporation within a 4 year period beginning 2 years

before the ownership requirements in section 7874(a)(2)(B)(ii) are satisfied)). See also, §436 (2016) (Certain defined, single-

employer benefit plans may be considered to be underfunded after the 10th month of the plan year. If there is no certification by

the plan provider of the adjusted funding target attainment percentage before the first day of the 10th month of the plan year then

it is conclusively presumed that the adjusted funding target attainment percentage is less than 60 percent for the plan year in

question.).

200 Heiner v. Donnan, 285 U.S. 312 (1932) (holding that irrefutable presumption that gifts made within 2 years of death were made

in contemplation of death and so included in the decedent's estate for Federal estate tax purposes violated Fifth Amendment due

process protections); Schlesinger v. Wisconsin, 270 U. S. 230 (1926) (concluding that State's irrefutable presumption violated

Fourteenth Amendment due process protections).

201 The more recent Supreme Court cases applying the “irrebuttable presumption” doctrine appear to have limited the Court’s

holding in Donnan and in Schlesinger, at least in non-tax cases. See Michael H. v. Gerald D., 491 U.S. 110, 112 (1989); Usery v.

Turner Elkhorn Mining Co., 428 U.S. 1 (1976); Weinberger v. Salfi, 422 U.S. 749 (1975).

202 Sakol v. Commissioner, 574 F.2d 694 (2nd Cir. 1978).

49

In all events, we would point out that by making the presumption irrebuttable, Treasury is effectively

vitiating those portions of the regulations that prohibit the taxpayer from affirmatively relying on the

regulations. Specifically, Prop. Reg. §1.385-3(e) provides that the Per Se Stock Rules do not apply if a

person enters into a transaction with "a" principal purpose of reducing the federal tax liability of any

member of the Expanded Group that includes the issuer and the holder.

Thus, if an Expanded Group member loans $100 to another Expanded Group member and the borrower

distributes cash of $100 in excess of its current year earnings and profits, the members must treat the loan

as equity under the Proposed Regulations. There is no ability to rebut the notion that the $100 loan funded

the $100 distribution. Yet, the Service has the opportunity to claim that the filing position was wrong by

arguing that the taxpayer wanted to treat the transaction as equity.

It is exceedingly unlikely that a reviewing court would conclude that a taxpayer's compliance with an

irrebuttable presumption should be set aside due to a subsequent determination by the Service that the

treatment of the loan as equity lead to a favorable outcome for the taxpayer. Specifically, a court could

simply hold in favor of the taxpayer citing the taxpayer's lack of any meaningful choice as to how to file its

original return.203 Alternatively, a court could conclude that the irrebuttable presumption coupled with Prop.

Reg. §1.385-3(e) makes the Funding Rule unconstitutionally void for vagueness.204 Courts could also hold

that the irrebuttable presumption is as binding on the Service as it is on the taxpayer, and so refuse to set

aside a recast the regulations clearly provided for.205 Courts could refuse to set aside the recast simply to

203 In Patchen v. Commissioner, regulations at issue required taxpayers to obtain the Commissioner's consent prior to changing

their method of accounting. 258 F.2d 544 (5th Cir. 1958). At the same time, the Code requires taxpayers to use the same method

of accounting for book and tax purposes. The taxpayer in Patchen, was a partnership using the cash method of accounting for tax

and book purposes. It changed its method of accounting to an accrual basis for book purposes. The taxpayer continued using the

cash basis method for tax purposes, however. After all, it could not change its accounting method without the Commissioner's

consent and no consent had been given. On audit, the Service asserted that the taxpayer had to change to the accrual method. The

Tax Court agreed with the Service, but the Fifth Circuit reversed stating that this, ". . . would leave the taxpayer in the weird

predicament of having the Commissioner determine that his tax was deficient because it ought to have been reported on a different

basis even though, under the Regulations, the taxpayer had no legal right to prepare and file his return on the basis which would

have avoided such liability." Id. at 548-49.

204 The void for vagueness doctrine applies to U.S. federal regulations. See, e.g., FCC v. Fox TV Stations, Inc., 132 S. Ct. 2307

(2012) (analysis of FCC regulation); Rath Packing Co. v. Becker, 530 F.2d 1295 (9th Cir. 1975) (analysis of federal regulations

under the Wholesome Meat Act); United States v. Pitt-Des Moines, Inc., 168 F.3d 976 (7th Cir. 1999) (analysis of OSHA

regulations). The doctrine has been applied to Treasury regulations. Big Mama Rag, Inc. v. United States, 631 F.2d 1030 (D.C.

Circuit 1980) (Treasury regulations were impermissibly vague for failing to articulate a standard for what it means to be an

“advocacy” group and for requiring that an advocacy group present “a sufficiently full and fair exposition of the pertinent facts as

to permit an individual or the public to form an independent opinion or conclusion” for the advocacy group to be an educational

organization for tax-exemption purposes. Facts and opinions were too indistinguishable for an ambiguous standard like “full and

fair” to connect the two.).

205 In Pacific National Bank v. Commissioner, Treasury regulations provided that if a regulated financial institution was required

by a relevant regulatory authority to charge off debts as worthless, they were presumed to be worthless for tax purposes to the

extent written off. The taxpayer was instructed to write off certain debts and so claimed a deduction for worthlessness. The Service

contended that the presumption should only bind the taxpayer, not the Service. The court disagreed stating, “The suggestion that

Treasury Regulations having the force and effect of law are binding on taxpayers, but not on the Commissioner or on the Board of

Tax Appeals, cannot be entertained. Tax officials and taxpayers alike are under the law, not above it.” 91 F.2d 103, 105 (1937)

50

provide a level of certainty.206 Finally, courts could simply conclude that they will not save the Service

from a mess of its own making.207

A rebuttable presumption would be more consistent with the policy objective, consistent with other similar

fact-based timing presumptions, and less subject to challenge by taxpayers. For the foregoing reasons, we

strongly recommend the presumption be made rebuttable.

206 In Buffalo Bills, Inc. v. United States, the issue was whether compensation paid to football players 15 days after the end of the

year they performed their services could be considered deferred compensation within the meaning of section 3121(v)(2) of the

Code. 31 Fed. Cl. 794 (1994). The Service argued that such a short deferral period was "absurd" and should be set aside. The

court rejected the Service's position stating, "The taxpayer and the IRS both expect and are entitled to receive a reasonable degree

of certainty in their tax planning. The ad hoc factual analysis urged by defendant in determining under section 3121(v)(2) when a

given deferral period is appropriate and when it is not, introduces an unacceptable level of administrative and judicial confusion

into the tax process. Such a scenario could not have been intended by Congress and is not required by the plain meaning of section

3121(v)(2)." See also, Coggin Automotive Corp. v. Commissioner, 292 F.3d 1326, 1333 (11th Cir. 2002) ("It is worrisome to think

that a taxpayer may not know in advance whether this would be the day that the fictional aggregate theory or the fictional entity

theory of partnerships will be applied on an ad hoc basis. Relying upon the plain meaning of the statute, in a legitimate business

transaction, a taxpayer deserves the right to be able to predict in advance what the tax consequences of such transaction will be

with reasonable certainty.") Raymond Concrete Pile Company, BTA Memo 1940-558 (Regulation provided that if services were

rendered at a stipulated price, in the absence of evidence to the contrary, such price will be presumed to be the fair value of the

compensation received. The taxpayer “followed the Regulations to the letter,” reporting preferred stock received as compensation

in its returns and paying taxes thereon. The court held that the Service could not subsequently argue that the prices should have

been different and deny the taxpayer a worthless stock deduction).

207 Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985) (Allowing the taxpayer to enjoy what the Service characterized as

a double deduction based on an interplay between section 312(k) explaining, "Based upon the foregoing, we conclude that petitioner

reached the result mandated by respondent’s consolidated return regulations and section 312(k) in computing its basis in the

subsidiaries’ stock. We believe that judicial interference sought by respondent is not warranted to alter this result. This Court will

apply these regulations and the statute as written. If we were to make a judicial exception with respect to the adjustment for

depreciation, we would be opening our doors for respondent every time he was dissatisfied with a certain earnings and profits

adjustment. If respondent believes that his regulations and section 312(k) together cause petitioner to receive a “double deduction,”

then respondent should use his broad power to amend his regulations."); Corn Belt Hatcheries of Arkansas, Inc. v. Commissioner,

52 T.C. 636 (1969) (refusing to adopt Service's post-hoc interpretation of an ambiguous administrative ruling and instead siding

with taxpayer stating, "We consider this [taxpayer's] interpretation a plausible one and we are not disposed to reject it by importing

into the ruling the subsidiary qualification asserted by respondent. Taxpayers are already burdened with an incredibly long and

complicated tax law. We see no reason to add to this burden by requiring them anticipatorily to interpret ambiguities in respondent’s

rulings to conform to his subsequent clarifications, particularly in an area, such as consolidated returns, where Congress has placed

such reliance on respondent’s expertise."); and Gottesman & Co. v. Commissioner, 77 T.C. 1149 (1981) (“We cannot fault petitioner

for not knowing what the law was in this area when the Commissioner, charged by Congress to announce the law (sec. 1502), never

decided what it was himself. Petitioner had no reason to assume that the definition provided in the old regulations applied under

the new regulations. In fact, for reasons already stated, petitioner had every reason to assume the opposite. Thus, we find that the

Commissioner’s regulations regarding the manner in which the accumulated earnings tax was to be imposed on corporations making

consolidated returns were ambiguous during the years at issue. This ambiguity was of the Commissioner’s making, and, as such,

must be held against him. (citation omitted). Petitioner’s interpretation of these regulations was reasonable under the circumstances.

We think that under these circumstances the failure of petitioner to comply with respondent’s post hoc view of the regulations is

an insufficient ground on which to impose the accumulated earnings tax, and we hold for petitioner on the issues herein presented.”)

51

B. The 72-Month Window Period Should be Shortened.

The 72-month window period is unreasonably long. Other Code and regulatory provisions employ, at most,

a two year window.208 We would remind Treasury of its experience with section 355(e) regulations,209 the

dual consolidated loss regulations,210 and the gain recognition agreement regulations.211 In each case,

Treasury started with a very broad and lengthy testing period that subsequently proved unwieldy and had

to be carved back.

The only constant in today's economy is change. A lot can happen to a multinational enterprise in 72-

months. New businesses can be acquired; significant portions of the business can be sold. A whole new

business can be created. The parent company of the Expanded Group can change ownership. All of this

can happen in 72-months.

We recommend a 12-month window period beginning 6 months before the tainted transaction and ending

6 months after the tainted transaction. We recognize this is much shorter than what the Proposed

Regulations provide, but there is a rational basis for our proposal.

Specifically, the primary alternative to using an EGDI is to obtain third party debt. An obvious impediment

to using third party debt is that it bears interest that is paid to a third-party, not another member of the

208 Typically, rules that presume transactions to be part of the same plan use, at most, a 2-year window. See e.g., §355(e)(2)(B)

(acquisition of stock representing a 50-percent or greater interest in a distributing corporation or controlled corporation in a section

355 distribution with 2-year before or after the section 355 distribution presumed to be part of a plan); § 269(b)(1) (tax benefits of

liquidation of target within 2-years after a qualified stock purchase denied if principal purposes was avoidance of US federal income

tax); § 1031(e)(2) (taxable disposition by a related party within 2-years after a taxpayer’s tax-free like-kind exchange treated as a

disposition by the taxpayer); § 382(c)(1) (new loss corporation is not treated as continuing its business if business is ceased within

2-years after ownership change); § 382(l)(1)(B) (capital contributions made within 2-years prior to ownership changes deemed to

be part of a plan to increase loss carryforward limitation); Treas. Reg. § 1.707-3(c) (contribution and distribution within a 2-year

period generally deemed to constitute a sale to a partnership); Treas. Reg. § 1.381(c)(22)-1(b)(13)(iii) (acquiring corporation’s

transfer of an insurance or annuity contract it received in the liquidation or reorganization to another person within two-years

deemed to be pursuant to a plan in existence at the time of the liquidation or reorganization).

209 In the first draft of proposed regulations under section 355(e), released in 1999, Treasury proposed to require that a taxpayer

rebut the presumption with clear and convincing evidence, providing an exclusive list of rebuttals the taxpayer could use. The

proposed regulations also did not provide any safe harbors for transactions that were at a low risk of being a part of a plan, even if

they were executed within the two year presumption period. 64 Fed. Reg. 46155, 46157 (Aug. 24, 1999); 66 Fed. Reg. 67, 67 (Jan.

2, 2001). Commentators pointed out that Congress never indicated that such a high evidentiary standard as clear and convincing

evidence was required to rebut the 2 year presumption. 66 Fed. Reg. at 67. They also pointed out the unreasonableness of an

exclusive list of rebuttals, noting that any evidence rebutting the existence of a plan should be taken into account. Id. Finally,

Commentators urged that Treasury provide safe harbors so that normal business transactions would not be inhibited just because

they fall within a presumption period. Id. The comments were accepted by Treasury and, in 2001, the proposed regulations were

amended accordingly. For example, under the 1999 proposed regulations an acquisition more than 2-years after a distribution was

presumed to be part of a plan if, with respect to the acquisition, there was an agreement, understanding, or arrangement within 2-

years of the distribution. 64 Fed. Reg. at 46162. The 2001 proposed regulations reduced the 2-year period for agreements,

understandings, or arrangements down to 6 months. 66 Fed. Reg. at 69. Still, the list of factors tending to show a plan contained

terms that were overbroad and the safe harbors were also too few and too narrow in scope. See T.D. 8988 (Apr. 23, 2002). These

omissions lead to an amendment of the proposed regulations in 2002. Id. The regulations were finalized in 2005. T.D. 9198 (Apr.

19, 2005) The driving theme of the modifications to the regulations was the concern that a 2 year presumption period should not

become a pervasive and burdensome problem and pitfall for taxpayers’ normal business transactions.

210 The 1992 version of the dual-consolidated loss rules required taxpayers to certify the loss for 15 years. See Treas. Reg. §1.1503-

2(g)(2)(vi) (1992). This was subsequently reduced to 5 years in 2007. See Treas. Reg. §1.1503(d)-6(g).

211 Historically, taxpayers had to certify gain recognition agreements for 10 years. See Notice 87-85, 1987-2 C.B. 395. This was

subsequently reduced to 5 years. T.D. 8770, 1998-2 C.B. 3.

52

Expanded Group. Taxpayers may be willing to incur that cost, however, if it is for a relatively short period

of time.

The question is what constitutes a sufficiently long period to ensure that taxpayers are unlikely to use third

party debt to provide bridge financing between an EGDI and a tainted transaction that, absent the Proposed

Regulations, would simply occur proximate to one another.

We would suggest that the period beginning six months before and ending six months after the tainted

transaction is a useful benchmark. This is because a more significant (and somewhat intangible) cost than

interest is incurred by a multinational if the debt is reflected on the taxpayer's financial statements across

multiple quarter ends. Stated differently, a multinational is far less likely to incur debt solely to bridge the

time period between a tainted transaction and a loan if the consequence is that the debt has to be reflected

on its balance sheet for two quarters.

By establishing a 6-month window period before and after the tainted transaction, the Proposed Regulations

would ensure that taxpayers could not borrow money from a third party within a financial quarter, engage

in the tainted transaction, and then repay the debt without reflecting the third-party liability on their financial

statements. Instead, the multinational would have to show the third party debt on its balance sheet for at

least two quarters, which is much less likely to occur solely to gain a tax advantage.

We understand that the Per Se Stock Rule (unlike the Documentation Rule) may apply regardless of whether

the Expanded Group members have public financial statements. Nevertheless, by Treasury's own admission,

the $50 million threshold was intended to exclude smaller corporations from the application of the Per Se

Stock Rule.212 Thus, the vast majority of corporations that will be subject to these regulations will be those

that prepare audited financial statements that are submitted either to shareholders or creditors or both.

Incurring third party debt that is reflected on the balance sheet has various negative second and third order

effects for these corporations that will act as a significant deterrent from simply borrowing money from a

third party to effect a tax-motivated transaction.

C. Deposits by an Expanded Group Member in a Physical or Notional Cash Pool Should

not be Considered EGDIs.

Most Expanded Groups have at least one or more members who are consistent net cash generators. These

entities typically have increasing deposit balances with an affiliated treasury center (in the case of physical

pooling) or a bank (in the case of notional pooling). A rule that excepts "short term" loans to an affiliate

will not allow these net cash generating entities to deposit their cash with the cash pool.

The deposits made to a physical or notional cash pool do not present an earnings stripping concern. This

is because the treasury center (in the case of physical pooling) or bank (in the case of notional pooling) will

always seek to earn a higher rate of return on the deposited cash than what it pays out as interest on the

deposits. The higher return can be earned by loaning monies to other affiliates or investing in the capital

markets to achieve the highest possible rate of return given the amounts on hand and the term over which

the cash can be invested.

For the foregoing reasons we respectfully request that Treasury simply exempt deposits to a physical or

notional cash pool from the application of the Per Se Stock Rule. At a minimum, this will allow the

212 81 Fed. Reg. 20,919 (Apr. 8, 2016) ("Other rules, discussed in Section III.A (limiting the application of proposed §1.385-2 to

large taxpayers) and Section IV.C ($50 million threshold exception for proposed §1.385-3) of this Explanation of Provisions limit

the application of the proposed regulations to large taxpayers.")

53

Expanded Group to aggregate the cash generated by its cash-rich affiliates in one currency and invest it.

This will accomplish one of the goals of cash pooling, without any risk of an earnings stripping abuse.

Exempting deposits will assist Treasury and the Service as well. Exempting deposits helps the Treasury

because (as noted in Part I) it will be very difficult, if not impossible, for Treasury to write a rule that

properly identifies the Funded Member and the amount of the funding. Exempting deposits helps the

Service because it allows the Service to focus its audits of the Per Se Stock Rule on Expanded Group

members which borrow from the pool, where the existence of a net interest deduction is more likely.

For this purpose, a "treasury center" could be defined as, "an Expanded Group member or a bank which

routinely: (i) accepts cash deposits from other Expanded Group members; (ii) makes loans to other

Expanded Group members; and (iii) invests any excess deposited cash as directed by the Expanded Group

when not loaned to other Expanded Group members." The term "deposit" or "deposits" could be defined

to mean, "an asset reflected on the balance sheet of an Expanded Group member resulting from the

member's transfer of cash to a person and the member's legal right to receive back cash on demand from

that same person."

D. Deemed Acquisitions of Expanded Group Member Stock Under Treas. Reg. §1.1032-

3 Should Not be Considered Tainted Transactions.

As we note above, the Proposed Regulations, as currently drafted, can apply when one Expanded Group

member is "deemed" to acquire stock of another Expanded Group in a typical stock-based compensation

situation. This could discourage some of our members from granting stock-based compensation to U.S.

employees which, in turn, makes it harder for them to hire talented people in the United States.

We believe the foregoing result is unintended. Hence, we respectfully request that any deemed acquisition

of stock under Treas. Reg. §1.1032-3 be exempted from the list of tainted transactions under the Per Se

Stock Rule.

E. The Threshold Exception Should be Revised to Reflect Treasury's Objective of

Combating Earnings Stripping.

The Per Se Stock Rule does not apply if the aggregate adjusted issue price of all debt instruments held by

members of the Expanded Group that would otherwise be recast as equity under the General Rule, Funding

Rule or Anti-Abuse Rule does not exceed $50 million at the time the debt in question was issued.213 If the

$50 million threshold is exceeded at any time, however, then debt that was previously exempted but remains

outstanding can be subject to recast.214 The formulation of this threshold does not appear to have any

relationship to earnings stripping, however. As a practical matter, earnings stripping is accomplished by

country. The Expanded Group will include companies formed in multiple countries. Thus, an Expanded

Group operating in 50 different countries would only need to have $1 million of loans outstanding per

country before the group could become subject to the Per Se Stock Rule.

Instead, we recommend a different de minimis threshold that excludes transactions the government will not

want to review and address in any event. OFII understands the concerns the government would have about

creating a de minimis threshold that could be easily abused. Any threshold that references the amount of

213 Prop. Reg. §1.385-3(c)(2). If the debt is denominated in a non-U.S. dollar currency, it must be translated at the spot rate on the

date the instrument is issued.

214 Prop. Reg. §1.385-3(d)(iii).

54

principal for an individual instrument could be easily skirted by simply using multiple instruments with

smaller principal amounts.

We would thus recommend a de minimis threshold designed by reference to the practice that ostensibly

motivated the issuance of the Proposed Regulations - i.e., earnings stripping. If earnings stripping really is

the rationale for the regulations, then the government should only want to review documentation involving

debt that bears interest that is high relative to the tax base in question.

Thus, we would suggest that each member of an Expanded Group be considered part of a sub-group for

purposes of crafting a de minimis rule. A U.S. consolidated group would be one taxpayer, as the regulations

currently provide. In addition, all members of the Expanded Group that are tax-resident in the same country

would similarly be viewed as one sub-group for this purpose. EGDIs issued by one member of the sub-

group to another member of the same sub-group would be ignored. Only EGDIs issued by a sub-group

member to someone who does not belong to that sub-group would be counted towards the de minimis

exception. The de minimis rule would then apply by sub-group, instead of the Expanded Group as a whole.

F. The Current Year E&P Exception Should be Expanded to include all E&P

Accumulated During the Expanded Group's Holding Period for the Distributing

Entity.

The Per Se Stock Rule reduces the amount of a tainted transaction by the borrower-member's current year

E&P.215 Yet, this produces a "use it or lose it" mentality for our membership. If they do not automatically

cause their U.S. subsidiaries to distribute their earnings every year, as they are earned, they are confronted

with two unenviable options: (i) cease all intercompany lending to the U.S. group; or (ii) treat the earnings

as effectively "trapped". As noted above, this creates a significant disincentive for foreign-based

multinationals to reinvest earnings in the United States.

We recommend that Treasury consider the practical limitations of a current year E&P exception. As

Treasury and the Service already know, U.S. subsidiaries of foreign groups do not typically compute E&P

every year. Any E&P figure that is computed would, by necessity, merely be a forecast. Requiring them

to do so to take advantage of this exception would represent a significant additional cost of doing business

in the United States.

Moreover, we would ask that Treasury consider the fact that it is simply not possible in some jurisdictions,

particularly in continental Europe, to distribute current year earnings in the year those earnings accrue. In

countries such as Germany and Switzerland, for example, the earnings generated in 2017 have to be

reflected on a 2017 balance sheet that has undergone a statutory audit. That only occurs in 2018. It is thus

only in 2018 that the earnings can be distributed.216 It is absolutely the case that U.S. earnings and profits,

and local law statutory earnings are distinct concepts. It is possible that a company can distribute its U.S.

E&P in 2017 if it has accumulated earnings reflected on its statutory accounts in 2017. However, in the

case of a growing company without accumulated earnings from prior years, it will simply not be possible

to distribute current year earnings every year.

For these reasons, we urge Treasury to expand the exception to include all E&P (whether current or

accumulated) accrued while any member of the Expanded Group held the stock of the relevant Expanded

Group member. This would remove the disincentive created by the Proposed Regulations to distribute

215 Prop. Reg. §1.385-3(c)(1).

216 See e.g., Article 798 of the Swiss Law on Obligations. Interim dividends, such as quarterly dividends, are not permitted. An

exception to this rule applies, if an interim balance sheet was prepared, which shows a profit, and in addition, the written audit

report confirms the lawfulness of the interim dividend.

55

earnings every year. Yet, it would also address Treasury's concern about inverted companies or foreign

companies that acquire U.S. companies and inject significant amounts of leverage.

Thus, for example, if a foreign parent corporation forms a U.S. subsidiary and holds the stock of the

subsidiary during its entire life, then all of the U.S. subsidiary's E&P would be considered in applying the

E&P exception. Similarly, if the foreign parent corporation forms the U.S. subsidiary, but transfers the

stock of the U.S. subsidiary at some point to another Expanded Group member ("New Shareholder"), all of

the U.S. subsidiary's earnings would be considered in applying the E&P exception. It ought not matter

whether the New Shareholder's holding period includes the foreign parent's holding period under U.S. tax

principles,217 because the U.S. subsidiary has been held by "a" member of the Expanded Group since

inception.

In contrast, if the shareholders of a U.S. publicly traded corporation that was formed in 1980 exchange the

shares of that U.S. corporation for shares of a foreign parent corporation in 2017, then shares of the U.S.

publicly traded corporation will only have been held by an Expanded Group member from 2017. Thus,

only earnings generated from that point forward would count towards the exception. Similarly, if that U.S.

company (which is now a subsidiary of the foreign parent) acquires stock of another U.S. company on

January 1, 2019, the only earnings of that newly acquired subsidiary that would be considered in the E&P

exception would be those accruing on or after January 1, 2019.

We believe that this approach would also be more in line with Congress's intent that the regulations provide

factors that have traditionally been used to distinguish between debt and equity. After all, if a corporation

lacks any earnings and profits, or has not earned money during the shareholder's holding period, it is at

least possible that it will be less likely to be able to repay debt incurred via shareholder distribution (which

does not add assets to the issuer's balance sheet) or a related party stock acquisition (which does add an

asset to the issuer's balance sheet but may not be a liquid asset). In contrast, the "current year" E&P

limitation included in the Proposed Regulations, bears no rational relationship to the Congressional mandate.

It is thus more susceptible to an invalidity challenge.

We would also ask that if a corporation has current year E&P, but an accumulated deficit, that they be

entitled to rely on the current year E&P for purposes of claiming the exception. This is consistent with the

application of the nimble-dividend rule in section 316(a)(1).

Lastly, we would also ask that the regulation be clarified to confirm that all E&P of all U.S. consolidated

group members is aggregated for purposes of applying the exception. This appears to be the case given

that Prop. Reg. §1.385-1(e) treats all members of the same consolidated group as one company.

Nevertheless, it would be helpful if the regulations clarified that point.

G. The Funded Acquisition of Subsidiary Stock Rule Exception Should be Expanded.

A third exception is limited to the Funding Rule.218 The exception applies when the Funded Member

transfers cash or other property to another member of the Expanded Group in exchange for newly issued

stock of that member, provided that, for the following 36 months, the Funded Member owns, directly or

indirectly, more than 50 percent of the total voting power and value of the member's stock. This exception

is severely limited by the fact that the shareholder must own the stock of the subsidiary directly or indirectly,

and not constructively. In measuring the 50 percent ownership threshold, the drafters used the direct or

217 §1223.

218 Prop. Reg. §1.385-3(c)(3).

56

indirect ownership rules in section 958(a) without any reference to constructive ownership rules.219 If the

ownership requirement is satisfied for the entire 36 months, the debt issued by the Funded Member is

forever exempted. If the ownership requirement ceases to be satisfied during the 36 month period, then the

debt issued by the Funded Member is recast at that time, not the date the debt was originally issued.220

We recommend this exception be broadened such that a borrowing member will be considered to satisfy

the rule so long as the contribution of cash or property to the affiliate subsidiary is arm's length. It is not

clear to us why Treasury believed that a contribution of property to another Expanded Group member in

exchange for less than 50 percent of that member is somehow more abusive than an acquisition of more

than 50 percent of the voting power and value of the same subsidiary. In our view, the relevant inquiry is

simply whether property is going downstream in exchange for stock of equivalent value. If it is, and the

transferor retains ownership of the transferee, then the transferor's ownership percentage in the transferee

would appear to be immaterial.

H. The Composition of the Expanded Group Should be Clarified So the Rules do not

Apply to Situations that Cannot Result in Abuse.

As we outlined in Example 6, the Funding Rule can apply even when the loan is made by a corporation that

was not a member of the Expanded Group when the "tainted" transaction occurred. We find it very difficult

to understand what the abuse could be in this situation. Thus, we recommend that an exception be provided

for an EGDI extended by a corporation that was not a member of the Expanded Group at the time the tainted

transaction occurs.

I. The Per Se Stock Rule Should not Apply to Trigger De-Consolidation of U.S.

Consolidated Group Members.

A number of our members loan money to specific U.S. subsidiaries within their U.S. consolidated group.

They do this to match funding with specific projects, or to align financing costs with the revenues they

generate for managerial or accounting purposes. There is no U.S. tax advantage to this practice, given that

all members of the U.S. consolidated group file a single federal tax return.

As currently drafted, the Proposed Regulations could incentivize our members to make all of their loans to

the parent of the U.S. consolidated group, which is contrary to their business objectives. This is because

the Per Se Stock Rule could conceivably apply to cause loans from a foreign parent to any subsidiary of the

U.S. consolidated group parent to be recast as equity and thereby de-consolidate the U.S. subsidiary for

U.S. tax purposes. It is the case that loans which are recast as equity may qualify as "plain vanilla preferred

stock" within the meaning of section 1504(a)(4) such that a recast would not necessarily cause the U.S.

subsidiary to be de-consolidated. Nevertheless, something as simple as a limited participation right or

"break fee" that is considered to represent an unreasonable redemption premium could cause the loan to be

considered "stock" within the meaning of section 1504(a) and thereby bust consolidation.

We understand that this result may not have been intended by Treasury. To rectify this situation, we would

ask that the Per Se Stock Rule be modified to provide that if an EGDI is issued by a consolidated group

member that is not the parent of the U.S. consolidated group, and the EGDI is recast as equity, it should be

recast as equity issued by the parent of the consolidated group rather than the issuer of the EGDI. Or,

219 For this purpose, "indirect" ownership is determined using the rules in section 958(a) without regard to whether the intervening

corporations are domestic or foreign. Prop. Reg. §1.385-3(c)(3).

220 Prop. Reg. §1.385-3(g)(3) Example 12.

57

alternatively, that the recast equity simply not be considered for applying the section 1504 ownership

requirements.

V. THE OPERATION OF THE DOCUMENTATION RULES SHOULD BE TAILORED TO BETTER

REFLECT TREASURY AND THE SERVICE'S CONCERNS AND REDUCE THE COMPLIANCE

BURDEN FOR TAXPAYERS.

OFII understands that Treasury and the Service have legitimate concerns about the manner in which many

related party loans are documented. We respectfully suggest, however, that the Documentation Rule exalts

form over substance without providing any helpful guidance to field agents about how to interpret existing

case law. For that reason, we recommend Treasury revise the Documentation Rule to provide substantive

guidance on the documentation it is requesting, in addition to narrowing the scope of the rules as noted

above.

A. The Documentation Rule Should be Used to Provide Guidance to the Field on

Substantive Issues, and not Exalt Form Over Substance.

As a preliminary matter, the Documentation Rule (as currently formulated) will not enhance the Service's

ability to audit tax-motivated earnings stripping transactions. Taxpayers who are intending to create large

debt instruments bearing significant amounts of interest over extended periods of time will ensure that they

expend the effort required to comply with the rules. The taxpayers who will be caught by the

Documentation Rules will be those who simply cannot maintain the voluminous amount of information

required for every EGI created within their group.

We respectfully suggest that the stated rationale for the Documentation Rule is unclear and Treasury's own

statements are somewhat contradictory. Treasury stated in the preamble to the Proposed Regulations that:

The absence of reasonable diligence by related-party lenders can have the effect of limiting

the factual record that is available for additional scrutiny and thorough examination.

Nonetheless, courts do not always require related parties to engage in reasonable

financial analysis and legal documentation similar to that which business exigencies

would incent third-parties in connection with lending to unrelated borrowers. . . .

The lack of such guidance, combined with the sheer volume of financial records taxpayers

produce in the ordinary course of business, makes it difficult to identify the documents that

will ultimately be required to support such a characterization, particularly with respect to

whether a reasonable expectation of repayment is present at the time an interest is issued.221

Yet, Treasury also states in the preamble that the Documentation Rule is derived directly from common

law:

The core of proposed §1.385-2 is the guidance regarding the nature of the documentation

and information that must be prepared and maintained to support the characterization of

an EGI as indebtedness for federal tax purposes. The regulations organize the

requirement into four categories, each reflecting an essential characteristic of

indebtedness for federal tax purposes: a binding obligation to repay the funds advanced,

creditor's rights to enforce the terms of the EGI, a reasonable expectation that the

advanced funds can be repaid, and actions evidencing a genuine debtor-creditor

relationship. Together these categories represent a distillation of case law principles

221 81 Fed. Reg. 20911, 20915 (Apr. 8, 2016) (emphasis added).

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established for determining that an instrument is genuine indebtedness for federal tax

purposes.222

So, according to Treasury, the Documentation Rule is needed to fill a gap created by the common law, but

yet the Documentation Rule is a distillation of common law. Both of these statements cannot be true.

The fact is that the Documentation Rule represents a departure from common law. The reason courts do

not typically require the same exchange of financial analysis and negotiation that would arise between

unrelated parties is because related parties already have the information a lender would typically require

from a third party. Moreover, reviewing courts know that taxpayers have the burden of proof in a tax

dispute, not the Service.223 So if the taxpayer cannot prove that, at the time a debt was created, the borrower

had the ability to repay the advance, then the Service should be able to prevail in court. There is no tax

policy reason to require a lender and borrower to engage in a hypothetical loan negotiation or "diligence".

The fact is that a borrower either has the financial wherewithal to repay the debt or it does not. That is

why the common law has focused on the substantive reality of the borrower and whether the borrower could

in fact repay the obligation.224

As currently drafted, Prop. Reg. §1.358-2 has the effect of exalting form over substance, which is the

antithesis of the common law. In the event of a late interest or principal payment or other event of default,

the regulations require written documentation, "evidencing the holder's reasonable exercise of the diligence

and judgment of a creditor."225 The Proposed Regulations suggest the borrower meet its burden by

documenting, "evidence of the holder's efforts to assert its rights under the terms of the EGI . . .."226 Simply

put, related parties do not sue one another. Issuing a regulation that requires related parties to have a mock

negotiation as if they are not related is not a helpful addition to the law and merely exalts form over

substance.

We make certain pointed recommendations below to try and ensure the Documentation Rules provide more

substantive guidance.

1. The Requirement in Prop. Reg. §1.358-2(b)(2)(ii) that Creditors Rights be

Documented Should be Clarified.

The Proposed Regulations require that the holder's "rights of a creditor" be documented. 227 Yet, the

regulations do not specify what precisely the Service will be expecting to see. For example, the regulations

222 81 Fed. Reg. 20911, 20921 (Apr. 8, 2016).

223 See Rule 142(a) of the Tax Court Rules of Practice and Procedure. See e.g., Indmar Products Co., Inc. v. Commissioner, 44

F.3d 771 (6th Cir. 2006); Bauer v. Commissioner, 748 F.2d 1365 (9th Cir. 1984); Gooding Amusement Co. v Commissioner, 236

F.2d 159 (6th Cir. 1956); Adams v. Commissioner, 58 T.C. 41 (1972); Mennuto v. Commissioner, 56 T.C. 910 (1971).

224 Scriptomatic, Inc. v. United States, 555 F.2d 364 (3d Cir. 1977) (“If . . . an outsider would have advanced funds on terms similar

to those agreed to by the shareholder . . . the obligation is debt—despite the fact that the negotiations leading to its issuance were

not at arm's length. As is apparent, if there is proof or agreement that an outsider would have purchased an instrument on the terms

available to a shareholder, the question as to whether the form of the obligation resulted from arm's- length negotiation is irrelevant

to resolution of the debt-equity issue. The crucial issue is the economic reality of the marketplace: what the market would accept

as debt is debt”); R.M. Edwards v. Commissioner, 50 T.C. 220 (1968) rev’d in favor of taxpayer by 415 F.2d 578 (10th Cir. 1969)

(rejecting the Service's assertion that notes were not debt because holders did not negotiate for them); cf. Electronic Modules Corp.

v. United States, 48 AFTR 2d 81-5691 (Ct. Cl. 1981), aff’d, 695 F.2d 1367 (Fed. Cir. 1982) (“this absence of formality is not

determinative, particularly in relations between a parent and a wholly-owned subsidiary”); Westin v. Commissioner, T.C. Memo

1987-238 (“In cases where the parties are related, such as petitioner and Constructors, certain formalities usually respected in arm's-

length transactions are sometimes ignored”).

225 Prop. Reg. §1.385-2(b)(2)(iv)(B).

226 Id.

227 Prop. Reg. §1.385-2(b)(2)(ii).

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state that, "The rights of a creditor must include a superior right to shareholders to share in the assets of the

issuer in case of dissolution."228 Yet, the superiority of debt over equity is not typically set forth in the four

corners of the debt instrument. Instead, the superiority is established by applicable commercial law which

is either the applicable state corporate law, or the Uniform Commercial Code or mortgage law in the case

of secured financing. Thus, the regulations are imposing a requirement that does not align with the loan

agreements companies have with third party lenders.

Our membership is concerned that agents in the field will be expecting to see loan agreements that precisely

mirror third party loan agreements, even in those circuits where the courts have not imposed that standard.

These loan agreements can easily run hundreds of pages and contain significant amounts of verbiage that

are not required or useful between related parties. Examples would include dispute resolution procedures,

international arbitration clauses, extensive notice provisions, etc. Moreover, there is a lot of variation

between different types of loans. The creditor rights one would typically see in a bond differ from those in

a negotiable promissory note or a revolving credit facility. Extensive corporate law training would be

required to educate agents in the field regarding the specific terms to expect in different types of loans. As

it seems unlikely that all agents would receive such training, we would expect a higher volume of cases

going to Appeals to resolve adjustments proposed as a result of the Documentation Rule.

It would be helpful if the regulations were revised to simply require that the holder must have the right to

accelerate payment upon default, and not leave the impression that additional features are required. If the

Service is expecting additional features, then it should specify what those features are by referencing actual

third party transaction types (i.e., public bonds, negotiable notes, syndicated loan facilities, revolving credit

facilities etc…). Given the range of different instruments and terms that exist in the marketplace, we think

that it will be difficult for Treasury to come up with a definitive list, which is why we suggest a minimalist

approach.

2. The Reasonable Expectation of Ability to Repay Requirement Should be Clarified.

The Proposed Regulations require the taxpayer demonstrate that there is a reasonable expectation that the

issuer can repay the amount loaned. This is a perfectly reasonable ask, in theory. Nevertheless, our

membership is concerned as to how agents in the field will interpret this requirement.

Specifically, our membership is concerned that if an EGI has $1 billion of principal and a five year term,

agents in the field will ask to see financial statements projecting $1 billion of free cash flow that can be

used to repay the entire loan. Failing that, the agent will assert the Documentation Rule is not satisfied.

This is unrealistic and not in accord with arm's length dealings.

It is the case that corporations routinely pay off third party debt at maturity. Yet, it is not typical for

corporations to pay down all of their third party borrowings such that they have no liabilities after the

repayment. Instead, they refinance and borrow new monies on new terms to pay off existing debt. We

address this point in more detail below with respect to our comments on the Part-Stock Rule.

It is important that the regulations reflect (through examples or otherwise) the fact that refinancing is a

common business practice and does not evidence a lack of ability to repay. We further recommend that if

the borrower can demonstrate that it reasonably projected sufficient cash flow before considering capital

expenditures and dividends/redemptions to repay the principal during the term of the debt, that it will be

deemed to satisfy its documentation requirement. The point is that, if needed, a corporation can delay

dividends/redemptions and capital expenditures in order to accumulate cash and pay down debt.

228 Prop. Reg. §1.385-2(b)(2)(ii).

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3. The Proof of Ongoing Debtor-Creditor Relationship Requirement Should be

Clarified.

The Proposed Regulations state that the taxpayer must prepare documentation evidencing a debtor-creditor

relationship during the life of the instrument.229 The regulations indicate that this documentation should, at

a minimum, include documents evidencing payment of interest or principal that support the taxpayer's

treatment. This evidence could include wire transfers or bank statements.230

The regulations do not specify what happens when the "payment" is effected via offsetting journal entries.

For example, it is not uncommon for affiliates to have offsetting payables and receivables against one

another for products or services provided. These are often netted in the ordinary course. The regulations

should confirm that the journal entries will be sufficient evidence of payment under the Documentation

Rules. This would include, for example, entries that reflect changes in cash pool balances.231

B. The Time Frames for Compliance Should be Extended.

As noted above, it is not at all clear why the Proposed Regulations contain 30 day and 120 day timeframes

within which to assemble the paperwork necessary to comply with the Documentation Rule. The short time

frames increase the cost of complying with the rules without enhancing the Service's ability to audit

taxpayers. The Service will never see those documents until the audit begins.

With one exception, we recommend that the Documentation Rule be satisfied if the relevant documentation

is assembled by the time the taxpayer files its tax return for the year in which the event occurred that

necessitated the documentation. This is consistent with the taxpayer's obligations under section 6662 of the

Code and most other countries' transfer pricing rules. Given that transfer pricing documentation is often

required for the interest rate on material loans anyway, aligning these requirements makes sense.

The exception is for the requirement that evidence of payment be assembled within 120 days of payment.

We suggest that this requirement should be satisfied if the taxpayer can provide that evidence within 60

days of request by the Service on audit. Assembling this information in advance of a Service request is

costly and burdensome for the taxpayer and does not advance the Service's ability to audit the transaction.

C. The Consequence of Failure to Comply with the Documentation Rule Should be a

Potential Penalty and not an Equity Recast.

We recommend that the consequence of failing to comply with the Proposed Regulations should be a

potential penalty under section 6662 and not a recast of the EGI of the debt to equity. We further

recommend that the standard for penalizing the borrower be a "willful" standard.

1. The Consequence of Failing to Comply with the Documentation Rule Should be a

Potential Penalty, not a Recast.

The consequence of failing to comply with the Documentation Rule under the Proposed Regulations is that

the EGI is recast as equity from inception or in a subsequent year. This can have truly draconian

consequences that are disproportionate to any tax advantage that can be achieved using an interest

deduction.232 Thus, we believe that recast is not an appropriate remedy.

229 Prop. Reg. §1.385-3(b)(2)(iv).

230 Prop. Reg. §1.385-3(b)(2)(iv)(A).

231 Specifically, it should be sufficient for a borrowing affiliate to evidence repayment to a lending affiliate by entries which reflect

the fact that the borrowing affiliate's cash pool deposit was reduced and that the lending affiliate's cash pool balance was increased.

232 Examples abound. It is possible that inbound loans that are recast could, upon repayment, attract significant dividend

withholding tax. Recast debt could cause a consolidated group member to cease to be a consolidated group member, thereby

61

Moreover, by making the penalty so draconian, Treasury is making it less likely a reviewing court will hold

taxpayers to the letter of the Documentation Requirements. Generally, a taxpayer may be excused for

failing to strictly to comply with regulations that are “procedural” in nature when: (1) the taxpayer has a

good reason for failing to literally comply and (2) the procedural regulation either: (i) has ambiguous terms

or (ii) is not essential to the tax collection scheme in question.233 Most courts have agreed that a regulation

cannot override the doctrine of substantial compliance by expressly mandating a that literal compliance is

required.234

The Documentation Rule is procedural as the statute does not refer to it and its stated purpose is “to enable

an analysis to be made whether an EGI is appropriately treated as stock or indebtedness.”235 Moreover, the

Documentation Rule does not go to the essence of whether an instrument is debt or equity. This is because

compliance with the rule “does not establish that an interest is indebtedness” and failure to abide by the rule

does not establish that an instrument is not indebtedness.236 Instead, case law remains the substantive law

governing the debt or equity status of an instrument.

Thus, it is unlikely that a reviewing court will recast an advance as equity just because the lender failed to

engage in a mock negotiation with the borrower or the group failed to collect all evidence of repayment

within 120 days of each payment date and place it in a special file.

Moreover, as noted above, the burden of proof is on the taxpayer. If the taxpayer cannot demonstrate that

the borrower repaid the indebtedness, then the taxpayer will lose its case. Thus, if the failure is truly

substantive, then nothing prevents the Service from asserting a recast based on common law.

For the foregoing reasons, we recommend that the consequence of failing to comply with the

Documentation Rule should not be an irrevocable recast of the EGI into equity. Instead, we recommend

that the documentation requirements be considered part of the section 6662 documentation that is required

for transfer pricing purposes. The documentation requested under Prop. Reg. §1.358-2 can be helpful in

auditing the correct interest rate on the loan under section 482. Thus, there is a logical connection between

the -2 rules and the section 6662 rules. If a taxpayer fails to assemble the documentation, and if the Service

triggering deferred intercompany gains and excess loss accounts. Recast debt could cause disregarded entities to spring into

existence, thereby triggering gains related to transactions that were previously disregarded. In sum, the punishment is out of all

proportion to the perceived infraction.

233 The doctrine of substantial compliance is an equitable doctrine designed to avoid hardship in cases where a party has done all

that can be reasonably expected. Baccei v. United States, 632 F.3d 1140 (9th Cir. 2011); Estate of Chamberlain v. Commissioner,

9 Fed. Appx. 713 (9th Cir. 2001); Rogue Truck Body, LLC v. United States, 114 AFTR 2d 2014-6492 (D. Oregon 2014). Under

the doctrine, a taxpayer is relieved from the consequence of failing to comply with regulations that are merely procedural when the

taxpayer complies with the “essence” of the Code section in question. Rigas v. United States, 486 Fed. Appx. 491 (5th Cir. 2012);

Young v. Commissioner, 783 F.2d 1201 (5th Cir. 1986); Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir.

1984); American Air Filter Co. v. Commissioner, 81 T.C. 709, 719-20 (1983). A procedural requirement is “unimportant” when it

is “not essential to the tax collection scheme.” Volvo Trucks of N. Am., Inc. v. United States, 367 F.3d 204, 210 (4th Cir. 2004);

Rogue Truck Body, LLC v. United States, 114 AFTR 2d 2014-6492 (D. Oregon 2014).

234 See Woodbury v. Commissioner, 900 F.2d 1457 (“Petitioners have no support for their implicit contention that the 'must' and

'shall' language necessitates literal compliance with the requirements for an election. It is well established that in determining

whether an election has properly been made absent adherence to literal requirements, a court should assess whether the taxpayer

has substantially complied with the requirements, notwithstanding the 'shall' and 'must' language); Rigas v. United States, 107

AFTR 2d 2011-2046 (S.D. Texas 2011), aff’d, 486 Fed. Appx. 491(5th Cir. 2012). But see Rothstein v. United States, 81 AFTR 2d

98-2132 (Ct. Cl. 1998) (rejecting this principal).

235 Prop. Reg. § 1.385-2(a).

236 Prop. Reg. § 1.385-2(a); see also Prop. Reg. § 1.385-2(d).

62

makes a successful adjustment either by recasting the loan under the common law or by reducing the interest

expense under section 482, then the Service could assert a section 6662 penalty.

There are a number of advantages to this approach. First, it reduces the likelihood that debt issued by

disregarded entities and partnerships will be recast due to failures to comply with Prop. Reg. §1.358-2.

Second, a penalty only applies if there is an actual "harm" which is established via the Service's successful

recast or transfer pricing adjustment. Hence, the punishment is in proportion to the violation. Lastly, this

approach would be much less controversial with treaty partners than a permanent recast of debt to equity

(and consequent imposition of withholding tax on repayment) for mere failure to assemble documentation.

2. The Standard for Application of the Penalty Should be a Willful Standard.

If the taxpayer fails to comply with the Documentation Rule, the taxpayer may be able to claim a reasonable

cause defense.237 The regulations specifically point to the standard established in Treas. Reg. §301.6724-

1. The Preamble does not explain its reason for cross-referencing the reasonable cause standard established

in Treas. Reg. §301.6724-1.238 Other regulatory “reasonable cause” provisions do not make this cross-

reference 239 and Treas. Reg. §301.6724-1 itself limits its own application to a narrow set of

circumstances.240

The reasonable cause provisions of Treas. Reg. §301.6724-1 are more stringent than those that appear

elsewhere. Specifically, the §301.6724-1 standard requires the failure to comply be due to factors that are

outside of the taxpayer's control241 or the result of significant mitigating factors.242

This approach appears contrary to the Service's approach in other areas. For example, the Service has

moved from requiring 9100 relief requests for late §338 elections and entity classification forms to simply

requiring a reasonable cause statement with the relevant forms.243 The Service also moved from requiring

9100 relief requests for domestic use agreements to simply requiring a reasonable cause filing.244 More

recently, the Service has moved to a lower "not willful" standard for failure to file gain recognition

237 Prop. Reg. §1.385-2(c)(1).

238 81 Fed. Reg. 20911, 20921–20922 (Apr. 8, 2016).

239 See, e.g., Treas. Reg. § 1.6038-2(k)(3) (relating to failure to file Form 5471 for a controlled foreign corporations); Treas. Reg.

§ 1.6038-3(k)(4) (relating to failure to file Form 8865 for a controlled foreign partnership); Treas. Reg. § 1.6664-4 (relating to relief

from accuracy related penalties); Treas. Reg. § 1.1503(d)-1(c)(2) (relating to certain filings and elections with respect to dual-

consolidated losses); Treas. Reg. § 1.367(a)-8(p) (relating to failure to file a gain recognition agreement).

240 See Treas. Reg. §301.6724-1(j).

241 Treas. Reg. §301.6724-1(c).

242 Treas. Reg. §301.6724-1(b).

243 Rev. Proc. 2002-15, 2002-1 C.B. 490 (establishing automatic 9100 relief for late entity classification elections filed within 6

months and 75 days after the entity’s formation, available by attaching a reasonable cause statement to Form 8832); Rev. Proc.

2009-41, 2009-39 I.R.B. 439 (extending automatic 9100 relief for late entity classification elections filed within 3-years and 75

days of the requested effective date of the election by attaching a reasonable cause statement to Form 8832); Rev. Proc. 2003-33,

2003-1 C.B. 803 (establishing automatic 9100 relief for late section 338 elections filed within 12 months from the date of discovery

of the failure to file a timely election).

244 T.D. 9315 (March 19, 2007) (finalizing regulations establishing this change); 70 Fed. Reg. 29867 (May 24, 2005) (proposing

the new standard, explaining “The IRS and Treasury believe that requiring taxpayers to request relief for an extension of time to

file under §301.9100-3 results in an unnecessary administrative burden on both taxpayers and the Commissioner. The IRS and

Treasury believe that a reasonable cause standard, similar to that used in other international provisions of the Code (such as

sections 367(a) and 6038B), is a more appropriate and less burdensome means for taxpayers to cure compliance defects under

section 1503 (d).”).

63

agreements. 245 In each case, the Service recognized that companies make mistakes in their filings,

especially when those filings are frequent.

The compliance required under the Documentation Rule dwarfs the compliance required under the

foregoing rules in both frequency of application and degree of effort. Expanded Groups have thousands of

EGIs. We have suggested that the scope of the rule be dramatically reduced. Whether Treasury agrees or

disagrees, however, it behooves Treasury to embrace a more forgiving relief standard with respect to

innocent failures to comply, which we anticipate will be numerous. We therefor recommend the standard

for application of punishment for failure to comply be a "willful" standard. Stated differently, the penalty

should only apply if the taxpayer willfully failed to comply with the rules.

D. The Exemption for Smaller Companies Should be Clarified.

The regulations exempt certain smaller companies from the application of the Documentation Rules.

Specifically, documentation will only be required if one of three (3) tests is satisfied:

(i) the stock of any member of the Expanded Group is traded on (or subject to the rules

of) an established financial market within the meaning of Treas. Reg. §1.1092(d)-1(b);

(ii) on the date the purported debt instrument first becomes an EGI, total assets reflected

on a financial statement ("Applicable Financial Statement") exceed $100 million; or

(iii) on the date the purported debt instrument first becomes an EGI, total revenue on any

Applicable Financial Statement exceeds $50 million.246

For this purpose, the term Applicable Financial Statement includes: (i) a financial statement filed with the

Securities and Exchange Commission; (ii) an audited financial statement; or (iii) a financial statement (other

than a tax return) required to be provided to a federal, state, or foreign government, if it shows any assets

or revenue of any member of the Expanded Group and is filed within three (3) years prior to the Applicable

Instrument first becoming an EGI.247

It is unclear from the regulation whether the Service can "add" up the separate statutory financial statements

filed with respect to each subsidiary or, instead, whether the rule requires that "a" single Applicable

Financial Statement reflect $100 million of assets or $50 million of revenue. If the former interpretation

prevails, then many private companies will be subject to this rule, because most countries outside of the

United States impose a statutory accounting requirement. It is easy to imagine a German private company

owning subsidiaries in the U.S. and nine other jurisdictions, each with $5 million of revenue. If separate

unconsolidated balance sheets are to be aggregated in arriving at the asset or revenue thresholds, then the

Documentation Rule will be significantly broader than some taxpayers are thinking it will be. We would

respectfully request the Service clarify this issue.

245 T.D. 9704 (Nov. 18, 2014) (finalizing regulations establishing this change); 78 Fed. Reg. 6772 (Jan. 1, 2013) ("The existing

reasonable cause standard, given its interpretation under the case law, may not be satisfied by U.S. transferors in many common

situations even though the failure was not intentional and not due to willful neglect. Based on the current operation of the section

367(a) GRA regulations, the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury Department) believe

that full gain recognition under section 367(a)(1) should apply only if a failure to timely file an initial GRA or a failure to comply

with the section 367(a) GRA regulations with respect to an existing GRA is willful. The IRS and the Treasury Department believe

that the penalty imposed by section 6038B generally should be sufficient to encourage proper reporting and compliance.”).

246 Prop. Reg. §1.385-2(a)(2)(i)(A)-(C). In the event the Applicable Financial Statement is denominated in a non-U.S. dollar

currency, the statement has to be translated into U.S. dollars at the spot exchange rate on the date of the Applicable Financial

Statement. Prop. Reg. §1.385-2(a)(2)(ii).

247 Prop. Reg. §1.385-2(a)(4)(iv)(A)-(C).

64

VI. THE OPERATION OF THE PART-STOCK RULE SHOULD BE CLARIFIED.

Congress clearly intended that the Service should have the ability to recast only part of a single advance as

equity. The concern that our membership has centers around "when" the Part-Stock Rule will apply and

"how" it will apply, neither of which is explained in the Proposed Regulations or the preamble.

Specifically, much of our membership is under constant audit by the Service. Inbound loans from their

foreign parent entities are under review each year. One frequent area of inquiry and misunderstanding by

the Service's agents relates to the role that "refinancing" plays in a debt-equity analysis. This issue can be

most easily illustrated using an example.

EXAMPLE 8: FP, a foreign publicly traded corporation, owns all of the stock of USS1,

a domestic corporation. FP equity funds USS1 with $500 million. FP also makes a loan

to USS1 on January 1, 2017, for $1 billion. The loan bears an arm's length rate of interest,

is denominated in U.S. dollars and is repayable in 5 years. USS1 is a calendar year

taxpayer. USS1 uses the equity and the loan to build a plant and invest in research and

development in the United States. USS1 also establishes a line of credit with a third

party to fund working capital needs. USS1's strategic plan and cash flow projections

illustrate, as of January 1, 2017, that USS1 will be able to make all interest payments

every year through January 1, 2022, but that USS1 will only generate the following cash

flows (in millions):

2017

Projected

2018

Projected

2019

Projected

2020

Projected

2021

Projected

Cash Flow from Operations ($150) ($100) $100 $200 $300

Capital Expenditures ($1,000) $0 $0 $0 $0

Free Cash Flow ($1150) ($100) $100 $200 $300

Assume USS1's 2017 year gets audited in 2019.

It is not uncommon, in this fact pattern, for a field agent to argue that since USS1's strategic plan does not

reflect $1 billion of free cash flow being generated from 2017 through 2021 that USS1's borrowing is, in

fact, equity. After all, the company's own strategic plan does not reflect sufficient "free" cash flow (i.e.,

cash flow from operations minus amounts reinvested in capital expenditures) plus cash on hand to pay off

the entire borrowing within five years. Thus, it is clear in 2017 that USS1 will have to refinance a sizable

portion of the intercompany borrowing at maturity from FP or from other sources.

EXAMPLE 9: Assume the same facts as in the previous example except that USS1's

2017 year does not get audited until 2021. At that time, the cash flows for 2017-2020

are known and the 2021 results are revised based on better information as follows:

2017

Actual

2018

Actual

2019

Actual

2020

Actual

2021

Projected

Cash Flow from Operations ($200) ($80) $250 $300 $600

Capital Expenditures ($1,000) $0 ($100) ($200) ($300)

Free Cash Flow ($1200) ($80) $150 $100 $300

Management decided to make the additional capital expenditures because it realized that

it had underestimated the demand for its product in the U.S. market and decided to

expand its production and distribution capacity. On January 1 2022, while the audit is

ongoing, FP loans USS1 $1.2 billion, which USS1 uses to repay its existing loan payable

to FP plus fund an additional expansion in the United States.

65

In the foregoing example, cash flow from operations in 2019, 2020 and 2021 is actually sufficient to repay

the entire intercompany borrowing, but the success of the business causes management to choose to reinvest

the cash flow in the business rather than pay down its intercompany loan. We refer to this alternative

scenario as the "increasing balance sheet scenario", because it is not at all uncommon for a growing business

to constantly increase its debt levels as its balance sheet increases, using new borrowings to refinance older

borrowings as they come due.248 Yet, our members have repeatedly encountered agents who apply a non-

market based standard to their U.S. subsidiaries, often expecting the U.S. subsidiary to prove that it will

have sufficient free cash flow to pay off the intercompany obligations entirely, even though that is not what

growing (or even mature) companies do.

Our membership is very concerned that field agents will be emboldened to take the position that the

taxpayer's anticipated (or actual) refinancing of intercompany loans will result in an automatic assertion

that the Part-Stock Rule applies to the extent the debt at issue will be (or has been) refinanced. To address

these concerns, we offer some recommendations below regarding when and how the Part Stock Rule should

apply.

1. The Part-Stock Rule Should not Apply when the Taxpayer Can Demonstrate at

Issuance that the Loan can be Repaid or Refinanced at Maturity.

We recommend that Treasury clarify that the Part-Stock Rule not be invoked simply because the borrower

anticipates that it will be refinancing the loan in question. A number of cases over the years have suggested

that refinancing is an equity factor.249 Yet, these cases often involved situations where no third party would

have provided the refinancing, and so prove the maxim that bad facts make for bad law. It is simply not

the case that companies, even mature companies with significant free cash flow, pay off all of their term

debt at maturity without refinancing. Those cases that have actually considered situations where a viable

company refinances its debt have concluded that refinancing is a perfectly acceptable practice and

consistent with debt treatment if there is a reasonable expectation that the refinanced debt is arm's length

and will be paid in full or can be refinanced again in the future under similar circumstances.250

248 Qiping Xu, Kicking Maturity Down the Road: Early Refinancing and Maturity Management in the Corporate Bond Market at

10 (June 9, 2015) (finding that growth firms tend to use refinancing in order to extend the maturity of borrowings, reporting that

“[s]peculative-grade firms extend maturity from 3.91 years to 8.79 years. Investment-grade firms’ maturity moves from 11.5 years

to about 12.5 years, which is statistically indistinguishable.”); Peter R. W. Demerjian, et al., Financial Ratios and Credit Risk: The

Selection of Financial Ratio Covenants in Debt Contracts at 23 (Jan. 11, 2007) (concluding that “[b]orrowers with positive earnings,

high profitability, and low volatility earnings [generally, mature companies] tend to have coverage and debt to cash flow covenants

in their debt contracts [e.g., covenants that require debt service obligations to be under a fraction of EBITDA], while borrowers

with negative earnings, low profitability, and high volatility earnings [generally, growth companies] have net worth covenants [e.g.,

covenants guarantee a certain ratio of debt to equity],” implying that lenders do not look to growth companies’ EBITDA for debt

service); Hyman P. Minsky, The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard”

Theory, 16 NEBRASKA J. ECON. & BUS. 5, 13 (Winter, 1977) (discussing the concept of speculative financing, which takes place

when cash flows from operations are not expected to be large enough to meet payment commitments and repayment is planned

from the outset to come from refinancing and confirming that certain economic actors, such as banks, will always engage in this

form of financing).

249 McSorely’s Inc. v. United States, 11 AFTR 2d 810 (D. Colo. 1962) (deciding to treat notes held by controlling shareholders as

equity, with numerous factors supporting that conclusion including the fact that no payments were made on the notes at maturity

and, instead, the notes were refinanced by the issuance of new notes and it was unclear whether the corporation would ever have

the capacity to pay the new notes); Laidlaw Transportation, Inc. v. Commissioner, T.C. Memo 1998-232 (indicating that members

of a U.S. consolidated group of companies never intended to repay their related party advances when the aggregate amount of

advances to those entities increased during the years at issue and subsequent years).

250 See Green Bay Structural Steel, Inc. v. Commissioner, 53 T.C. 451 (1969) (rejecting the Service’s position that the refinancing

of shareholders’ subordinated notes was a factor weighing against treatment of the notes as debt, when an acquisition corporation

was formed to acquire the assets of a bankrupt partnership and was financed with a third-party debt, proceeds of the shareholder

notes and shareholder equity, and holding “we do not think the Commissioner is empowered to determine or rework the financial

structure of a corporation which is valid at its inception as we conclude petitioner's was. We conclude that petitioner's choice of

66

We recommend that the Treasury clarify that the fact the borrower anticipates or has already refinanced all

or a portion of the debt at issue is not a reason to apply the Part Stock Rule. Instead, the refinancing should

only be indicative that the Part-Stock Rule is appropriate when the borrower cannot prove that it could

borrow similar amounts from a third party at the time that the refinancing occurs.

In the case where the refinancing is anticipated, and has not yet occurred, the relevant cash flow and

financial projections should be those in existence at the time the loan was first advanced. In cases where

the refinancing has already occurred, the relevant cash flow and financial projections should be those that

exist at the time the refinancing actually occurred.

2. The Proposed Regulations Should Flesh Out How they Apply to the Recast Portion

of the Loans.

The Proposed Regulations do not articulate "how" a single advance will be recast as equity "in part". Stated

differently, the regulations do not indicate whether a pro rata portion of the outstanding principal and

interest will be recast as equity or whether the Service will recast only principal and ignore accrued but

unpaid interest. The latter approach is suggested by the deemed exchange mechanics in Prop. Reg. §1.385-

1(c), but those rules do not apply, by their terms, to the Part Stock Rule. Thus, we request the Service

provide guidance on this issue.

The Proposed Regulations also do not explain what happens on a go-forward basis, after the recast occurs.

Specifically, the regulations do not specify how payments on the instrument should be applied. Presumably,

in the absence of contrary guidance, payments will be applied on a pro rata basis to the debt and equity

portion of the related party loan. This will likely cause many borrowers to retroactively be subject to

withholding tax liabilities they were not anticipating.

EXAMPLE 10: FP, a foreign publicly traded corporation, owns all of the outstanding

shares of USS1, a domestic corporation. FP makes a loan of $100 million to USS1 on

January 1, 2017, with a 10 year term. In each of 2017 and 2018, USS1 makes a $5

million "interest" payment on the loan. USS1 does not withhold any portion of the

payments due to the application of an applicable treaty. In 2019, the Service asserts that

40% of the loan should have been equity from January 1, 2017. As such, $2 million of

financing arrangements under the circumstances of its emerging from bankruptcy was reasonable. Given this finding, we do not

see how refinancing the notes with similar instruments changes the bona fides. Refinancing to the best of our knowledge is an

accepted business practice and we see nothing wrong with it if reasonable in the context of the particular facts and we find such

practice reasonable here.”); Universal Tractor Equipment Corp. v. United States, 19 AFTR 2d 1337 (E.D. VA 1967) (upholding

debt treatment of “Old Notes” that were refinanced with “New Notes,” when debtor corporation had made substantial payments on

the Old Notes, but was not in a cash position to make full payment on the notes at maturity). See Curry v. Commissioner, 43 T.C.

667 (1965), nonacq. by Commissioner, 1968-2 C.B. 3 (holding that noteholders acted as creditors when they agreed to postpone

the maturity dates of notes, where corporation was not in a cash position to repay the notes at maturity, but there had been

meaningful payment of principal and projected earnings would enable the corporation to repay the notes in full). Indmar Products

Co., Inc. v. Commissioner, 444 F.3d 771 (6th Cir. 2006) (counting as a debt factor the fact that debtor borrowed additional funds

from a third-party lender to repay shareholder advances); Campbell v. Carter Foundation Production Co., 322 F.2d 827, 832 (5th

Cir. 1963) (counting as debt factor the fact that “[t]he notes could have been paid on their original maturity date by ‘outside’

financing which would have been commercially attractive.”); Nestle Holdings, Inc. v. Commissioner, T.C. Memo 1995-441 vacated

& remanded on other issues by 152 F.3d 83 (2d Cir. 1998) (“[the IRS] also contends that, even when [debtor corporation] made

repayments to [shareholder/creditor], it did not reduce its overall debt because such repayments were merely a result of refinancing

petitioner's debt by the issuance of Eurobonds in 1987 and 1988. The ability of [debtor corporation] to issue debt to unrelated

parties during this period, however, indicates that petitioner was not overcapitalized and that [shareholder/creditor] expected

repayment pursuant to the terms of the confirmation letters.”); Jaeger Auto Finance Co. v. Nelson, 191 F. Supp. 693 (E.D. Wisc.

1961) (treating advances as debt when “[debtor corporation] always had sufficient funds on hand to immediately satisfy a demand

for [partial] repayment of the [shareholder/creditor] advances. . . . A demand [for full payment] could have been met by

refinancing . . . .”).

67

each of the "interest" payments made in 2017 and 2018 should have been dividends and

subject to a 5% withholding tax. Moreover, absent an amendment of the loan in 2019, a

portion of future interest and principal payments on the advance will attract withholding

tax.

We recommend that the Proposed Regulations permit taxpayers to draft self-help language in their related

party loans specifying that, in the event of a Part Stock Recast, the borrower can designate whether

payments are to be allocated to the equity or debt portion of the advance from the date of the recast. If our

recommendation is adopted, and the taxpayer in the example incorporated this language into their note, the

excess of amounts paid over the interest on the portion of the loan respected as such would be treated as

principal repayments. In the event the payments amortize all of the interest and principal due on the loan,

any excess would then be treated as payments of accrued but unpaid yield on the "equity" and finally treated

as a redemption of the remaining recast equity.

3. In All Events we Recommend the Service Implement Internal Procedures to

Ensure the Part-Stock Rule is Only Invoked when Appropriate.

Unless guidance is provided to field agents on when and how the Part-Stock Rule should be applied, there

is a significant risk that field agents will apply the rule in inappropriate cases. This will, in turn, lead to

inconsistent treatment of similarly situated taxpayers. This potential for inconsistency also increases the

uncertainty for taxpayers, which does not further Congress’s intent that the regulations promulgated by

Treasury should provide more certainty for taxpayers, not less.

In addition to clarifying the Part-Stock Rule in the final regulations as described above, OFII recommends

that the Service issue a directive or similar instructions to its field agents (1) describing the standards that

field agents should use in determining when to apply the Part-Stock Rule and (2) establishing a review

process at an appropriate level of management to ensure that the Part-Stock Rule is being applied in

appropriate circumstances and on a consistent basis.

We recommend that the Service refer to the July 15, 2011 LB&I Directive 251 providing guidance to

examiners and managers on the codified economic substance doctrine as a model in developing instructions

to field agents on the application of the Part-Stock Rule. Similar to the current state of the law regarding

debt-equity analysis, when the economic substance doctrine was codified in section 7701(o), taxpayers and

the government looked to overlapping, but not entirely consistent, case law in applying the law to a specific

set of facts. The LB&I Directive helpfully provided field agents with factors to consider in deciding

whether to apply the economic substance doctrine, inquiries to be answered before seeking approval to

apply the doctrine, and a process for approval that includes the participation of the Office of Chief Counsel.

It is OFII’s understanding that the LB&I Directive was intended to, and has, helped to restrain field agents

from asserting the economic substance doctrine when it is not appropriate to do so. It has also helped to

achieve consistent treatment of similarly situated taxpayers. OFII believes that a similar directive on the

application of the Part-Stock Rule would further Treasury’s goals, encourage consistent treatment of

taxpayers, and provide taxpayers with greater certainty.

* * *

In addition to our concerns about the substance of the Proposed Regulations and their impact on investment

and economic growth in the United States, we have significant concerns with the process and trajectory by

which this regulatory action has unfolded.

251 Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties, July 15, 2011,

LB&I-4-0711-15.

68

We are particularly concerned that government personnel have indicated that they plan to finalize these

regulations swiftly, before the end of the year, which may not allow the government sufficient time to

adequately process and address the multitude of comments that it is receiving from businesses impacted by

the rules and from treaty partners. This concern was only highlighted by the Service's recent announcement

that it would schedule the hearing on the regulations seven (7) days after the comment period ends,

notwithstanding the expectation that there will be a substantial number of comments submitted by many

stakeholders.

Although we understand the timing constraints on this Administration, the fact remains that the Proposed

Regulations are a significant departure from established law with very real and harmful consequences for

legitimate business operations and investments in the United States. Thus, we respectfully request that the

Administration take the time to address the unintended consequences of the regulations, narrow their scope,

and withdraw those portions that are invalid.

Finally, we request that given the substantive issues that need to be addressed, the government reissue the

regulations in proposed form to allow for additional review and comment by taxpayers before they are

issued in final form. Our membership remains open and willing to continue our dialogue with the

Administration as work is done to finalize the rules. We appreciate the opportunity to comment.

Nancy McLernon

President & CEO

Organization for International Investment

CC:

The Honorable Penny Pritzker, Secretary of Commerce

Jeffrey Zients, Director, National Economic Council and Assistant to the President for Economic Policy

Enclosure

www.pwc.com

Potential Impacts of Proposed Section 385 Regulations: Inbound and Outbound Examples Prepared for

Business Roundtable

and

Organization for International Investment

Potential Impacts of Proposed Section 385 Regulations July 7, 2016

Potential Impacts of Proposed Section 385 Regulations

Contents Executive Summary 1

II. Overview of Proposed Section 385 Regulations 2

III. Inbound Examples 4

A. Expansion of Domestic Manufacturing Operations 4

B. Loss of Treaty Benefits Due to Foreign-to-Foreign Loan 6

IV. Outbound Examples 8

A. Cash Pooling 8

B. Hedging 13

V. Compliance Costs 15

A. Description of Documentation Requirements of Proposed Regulations 15

B. Aggregate Scope of Impact of Documentation Requirements 15

C. Cost Estimate of Documentation and Compliance Requirements 16

VI. Investment Impacts 19

A. Methodology 19

B. Results 19

Appendix. Example Details 21

Potential Impacts of Proposed Section 385 Regulations

E-1

Executive Summary On April 4, 2016, the Department of the Treasury and the Internal Revenue Service (“IRS”) issued a Notice of Proposed Rulemaking under Internal Revenue Code section 385. The Proposed Regulations contain three sets of rules: (1) they authorize the IRS to treat certain related-party debt arrangements as part stock and part debt; (2) they establish a contemporaneous documentation requirement that must be satisfied for certain related-party debt to be respected as debt; and (3) they treat certain categories of related-party debt as equity, including a rule treating debt issued within a 72-month time frame of certain distributions or acquisitions as stock for all purposes of the Code (“Per Se Recharacterization Rules”). This report provides four illustrative examples of the potential impact of the Per Se Recharacterization Rules on investment by US-based companies abroad and foreign-based companies in the United States. In addition, the report provides information obtained from a large US company on the hours of resources it estimates it would require to comply with the Proposed Regulations. These four examples, all involving internal financing with economic substance, business purpose, arm’s length terms, and appropriate documentation, illustrate that the Per Se Recharacterization Rules have the potential to cause a large reduction in (1) the amount of US investment by foreign-based multinational companies, and (2) the ability of US-based multinationals to compete for investment opportunities abroad.

For each of the four examples, the impact of the Proposed Regulations is quantified first under a base case in which the taxpayer retains its present law tax structure and then under one or more alternative scenarios in which the taxpayer restructures to mitigate the impact of the Per Se Recharacterization Rule. The four examples are summarized below:

1. Expansion of US manufacturing operations by foreign-headquartered company. A US subsidiary of a German automobile manufacturer finances a $300 million expansion of its US sport utility vehicle plant using $100 million of retained earnings and $200 million of loans from its German parent.

Increase in cost of capital: 0.23 to 1.04 percentage points Equivalent increase in corporate tax rate: 7 to 30 percentage points Reduction in investment: 16 to 72 percent.

2. Loss of US treaty benefits by a foreign-headquartered company due to a foreign-to-foreign

loan. A Japanese manufacturing company has two lines of business, one of which it is consolidating under a subsidiary in Japan and the other under a subsidiary in Hong Kong. To better align its global operations, the Japanese subsidiary, which owns the company’s US operations, buys an operating company from the Hong Kong subsidiary in exchange for a $100 million note.

Increase in cost of capital: 0.26 to 3.0 percentage points Equivalent increase in corporate tax rate: 8 to 87 percentage points Reduction in investment: 18 to 100 percent.

3. Foreign cash pooling arrangement by a US-based multinational company. A US multinational

company uses a foreign finance company to redeploy cash generated by its UK and German subsidiaries to its French subsidiary, which needs additional cash to support its operations.

Increase in cost of capital: 2.4 to 20.8 percentage points

4. Foreign currency hedging transaction by a US-based multinational company. The French subsidiary of a US multinational company borrows €100 million from an affiliated foreign finance company to finance an expansion in France. The finance company swaps the Euro-denominated loan for a $115 million US dollar-denominated loan with an unrelated counterparty.

Increase in cost of capital: 0.31 to 3.19 percentage points Equivalent increase in corporate tax rate: 6 to 9 percentage points Reduction in investment: 13 to 22 percent.

Potential Impacts of Proposed Section 385 Regulations

E-2

For the two inbound examples (examples 1 and 2), the Per Se Recharacterization Rule increases the cost of finance between 0.23 to 3.0 percentage points with a potential reduction in the affected inbound US investment of between 16 and 100 percent. This increased cost is equivalent to, at a minimum, a 7 percentage point increase in the US statutory tax rate or, at most, an 87 percentage point increase (i.e., increasing the 35-percent federal rate to a range from 42 percent to over 100 percent).

For the outbound example involving foreign cash pooling (example 3), the Per Se Recharacterization Rule potentially increases the cost of debt finance by 2.4 to 20.8 percentage points.

For the outbound example involving foreign currency hedging (example 4), the potential impact of the Per Se Recharacterization Rule on the cost of finance ranges from 0.31 to 3.19 percentage points, with a potential reduction in the affected outbound investment of as much as 22 percent. This is equivalent to an increase in the US corporate statutory tax rate of as much as 9 percentage points.

Moreover, even in situations where the Per Se Recharacterization Rules result in no reclassification of internal financings, the documentation requirements in the Proposed Regulations will impose substantial compliance costs on both US- and foreign-based taxpayers.

Both foreign-based companies with US operations and US-based companies with foreign operations will need to comply with the documentation requirements in the Proposed Regulations or risk the possibility of recharacterization of related-party debt as equity. These documentation requirements apply to ordinary course of business trade receivables, potentially affecting millions of transactions per year for each affected company. Using information obtained from a Fortune 100 company on the hours of resources it will require to comply, we estimate that the company’s one-time compliance system set up costs would be $2.75 million, and that recurring annual compliance costs in the first year and thereafter would be $1.25 million. The annual ongoing compliance costs for this one company are 10 percent of the government’s estimate of the total documentation and reporting costs for all taxpayers.

While compliance and documentation costs will vary by company, this example illustrates that total economy-wide compliance costs will be substantially greater than the documentation and reporting costs estimated by the IRS.

This report was prepared by PricewaterhouseCoopers LLP on behalf of the Organization for International Investment and the Business Roundtable.

Potential Impacts of Proposed Section 385 Regulations

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I. Introduction

On April 4, 2016, the Department of the Treasury and the Internal Revenue Service (“IRS”) issued a Notice of Proposed Rulemaking under Code section 385. The Proposed Regulations contain three sets of rules: (1) they authorize the IRS to treat certain related-party debt arrangements as part stock and part debt; (2) they establish a contemporaneous documentation requirement that must be satisfied for certain related-party debt to be respected as debt; and (3) they treat certain categories of related-party debt as equity, including a rule treating debt issued within a 72-month time frame of certain distributions or acquisitions as stock for all purposes of the Code (“Per Se Recharacterization Rules”). This report provides illustrative examples of the potential impact of the Per Se Recharacterization Rules on investment by US-based companies abroad and foreign-based companies in the United States. In addition, the report provides information on the estimated cost a multinational company would incur to comply with the documentation requirements in the Proposed Regulations. The related-party loans in each of the examples are made at arm’s length, i.e., on the same terms as would be available from an unrelated lender, and meet the documentation requirements in the Proposed Regulations. The loans all have economic substance and have non-tax business motivations, e.g., to finance new investment, hedge currency exposure, or to consolidate ownership of subsidiaries within a single line of business through an internal reorganization. Notwithstanding the economic substance, business purpose, and arm’s length terms of the loans in these examples, the Per Se Recharacterization Rules would cause one or more related-party loans to be treated as equity for all purposes of US tax law. The economic cost and potential investment impact of the Proposed Regulations is quantified under a base case in which the taxpayer retains its present law tax structure and then under one or more scenarios in which the taxpayer restructures to mitigate the impacts of the Per Se Recharacterization Rule. This report was prepared by PricewaterhouseCoopers LLP on behalf of the Organization for International Investment and the Business Roundtable.

Potential Impacts of Proposed Section 385 Regulations

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II. Overview of Proposed Section 385 Regulations Section 385 of the Internal Revenue Code provides Treasury with authority to prescribe regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for US federal tax purposes as stock or indebtedness, in whole or in part.1 It is clear from the statutory language that Congress intended for any regulations so prescribed to set forth factors to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor or corporation-shareholder relationship exists.2 On April 4, 2016, the Department of the Treasury and the Internal Revenue Service issued a Notice of Proposed Rulemaking under Code section 385. At a high level, the Proposed Regulations contain three sets of rules: (1) they authorize the IRS to treat certain related-party debt arrangements as part stock and part debt;3 (2) they establish a contemporaneous documentation requirement that must be satisfied for certain related-party debt to be respected as debt;4 and (3) they treat certain categories of related-party debt as stock, including a rule treating debt issued within a 72-month time frame of certain distributions or acquisitions as stock for all purposes of the Code.5 The Per Se Recharacterization Rules contain both a “General Rule” and a “Funding Rule.” The General Rule would recharacterize related-party debt instruments6 as stock if the instrument is issued in one of three situations: (1) in a distribution,7 (2) to acquire related-party stock,8 or (3) as consideration in an asset reorganization.9 The Funding Rule would recharacterize as equity a loan made with “a principal purpose” of funding an affiliate’s entering into one of the three transactions described in the General Rule.10 For example, a loan made between affiliates with a principal purpose of funding a cash dividend by the funded affiliate may be recharacterized as equity under the Funding Rule. Significantly, although the Funding Rule’s use of the term “principal purpose” implies a subjective, intent-based standard, for many situations the rule is quite mechanical and not dependent on intent. Under the “Per Se” prong of this rule, a related-party debt instrument would be conclusively treated as issued with a principal purpose of funding a distribution or acquisition if the instrument is issued within three years either before or 1 Section 385(a). 2 Section 385(b) (“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.”). 3 Prop. Reg. sec. 1.385-1(d)(1). 4 Prop. Reg. sec. 1.385-2. 5 Prop. Reg. secs. 1.385-3, 1.385-4. 6 The terms “related-party debt instrument” and “related party” are used as a shorthand. The Per Se Recharacterization Rules generally apply to debt instruments issued by a member of an expanded group and held by another member of an expanded group. See Prop. Reg. secs. 1.385-3(b)(2), (3). An expanded group is generally defined as an affiliated group under section 1504(a) but: (1) without regard to the exceptions under section 1504(b)(1)-(8) (relating to foreign corporations and certain other corporations), (2) by changing the requisite ownership threshold to 80 percent of vote or value (rather than vote and value), and (3) by extending the group to corporations indirectly held by other members, applying the constructive ownership rules under section 318 as modified by section 304(c)(3). See Prop. Reg. sec. 1.385-1(b)(3). For this purpose, a debt instrument means an interest that would, but for the application of Prop. Reg. sec. 1.385-3, be treated as a debt instrument as defined in section 1275(a) and Treas. Reg. sec. 1.1275-1(d). See Prop. Reg. sec. 1.385-3(f)(3). The Proposed Regulations do not apply to indebtedness between members of a consolidated group and instead treat a consolidated group as a single taxpayer (i.e., one corporation). Prop. Reg. sec. 1.385-1(e). However, certain debt instruments may become subject to the Proposed Regulations if and when the instrument or a party to the instrument ceases to be within the consolidated group. In this regard, various transition rules generally provide that if an instrument or corporation enters or exits the consolidated group, then such instrument, or any instruments issued or held by such corporation, will be treated as repaid on the date of entry or issued on the date of exit, as appropriate. 7 Prop. Reg. sec. 1.385-3(b)(2)(i). 8 Prop. Reg. sec. 1.385-3(b)(2)(ii). 9 Prop. Reg. sec. 1.385-3(b)(2)(iii). Prop. Reg. sec. 1.385-3(b)(2)(i)-(iii) sets forth the three broad categories of proscribed transactions that will be recharacterized as stock under the General Rule. 10 Prop. Reg. sec. 1.385-3(b)(3)(ii).

Potential Impacts of Proposed Section 385 Regulations

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after a distribution or acquisition (i.e., within a 72-month period centered on the date of the distribution or acquisition).11 Thus, if one affiliate (i.e., the funded member) borrows from another affiliate and if, within three years of the date of the borrowing, the funded member makes a distribution or acquisition, the debt is deemed to be a “principal purpose” debt instrument and is therefore recharacterized as equity. An exception to the Per Se Rule (but not the documentation rule) is provided for instruments that arise from a sale of inventory or the performance of services (other than treasury services)12 in the ordinary course of the issuer’s business.13 There are a few limited exceptions under the Per Se Recharacterization Rules,14 but there are no exceptions for cash pools, short-term obligations, working capital loans, purchase property indebtedness, or de minimis transactions. When a debt instrument is recharacterized under the Proposed Regulations as equity, whether pursuant to the Commissioner’s discretion, due to a documentation failure, or as a result of the Per Se Recharacterization Rules, it is so characterized for all purposes of the Code. The type of stock it becomes is determined based on the terms of the instrument.15 Consequently, recharacterized debt frequently will be treated as nonvoting preferred stock with a fixed redemption date.16

11 Prop. Reg. sec. 1.385-3(b)(3)(iv)(B). 12 See 81 Fed. Reg. 20912, 20924 (Apr. 8, 2016) (“This exception … is not intended to apply to intercompany financing or treasury center activities ...”). 13 Prop. Reg. sec. 1.385-3(b)(3)(iv)(C). 14 There are three notable exceptions: First, the aggregate amount of distributions and acquisitions taken into account with respect to any given taxable year is reduced by the issuer’s current-year earnings and profits. Prop. Reg. sec. 1.385-3(c)(1). Second, a funded stock acquisition will not result in the recharacterization of the funding debt instrument if the stock is acquired in exchange for property contributed to the issuer of the stock and the transferor owns at least 50 percent of the voting power and value of the issuer of the stock for at least three years thereafter. Prop. Reg. sec. 1.385-3(c)(3). Finally, the Per Se Recharacterization Rules do not apply at all if the aggregate amount of debt that would otherwise be recharacterized under the Per Se Rules is less than $50 million. Prop. Reg. sec. 1.385-3(c)(2). Aside from these three exceptions and the ordinary course exception described above, no other exceptions apply. 15 See 81 Fed. Reg. 20912, 20922 (Apr. 8, 2016). 16 It therefore frequently would be nonqualified preferred stock for purposes of section 351(g)(2). Depending on the circumstances, it also could be section 306 stock, section 1504(a)(4) preferred stock, or fast pay preferred stock.

Potential Impacts of Proposed Section 385 Regulations

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III. Inbound Examples

A. Expansion of Domestic Manufacturing Operations

The first inbound example illustrates the impact of the Proposed Regulations on a factory expansion in the United States by a US subsidiary that is financed by a loan from a foreign parent company.

GCAR is a publicly traded automobile manufacturer headquartered in Germany with a US plant that manufactures SUVs primarily for the US market (see Figure III.A). The US subsidiary (“GCAR-US”) earns $100 million in 2016, 2017, 2018, and 2019 and at the end of 2019 distributes a dividend of $300 million to GCAR. In 2020, GCAR-US builds another production facility in the United States to meet growing demand for SUVs in the US and foreign markets.

GCAR-US finances the $300 million expansion using $100 million of retained earnings and a $200 million loan from GCAR. GCAR borrows the $200 million that it lends to its US subsidiary from a German bank. GCAR’s collateral includes its worldwide assets while GCAR-US’s collateral is limited to its own assets; consequently, GCAR is able to borrow on better terms than GCAR-US.

In this example, it is assumed that GCAR can borrow $200 million with a 20-year term at a 3.0 percent interest rate, or $6 million per annum. GCAR then loans the funds to GCAR-US for 20 years at an interest rate of 4.0 percent per annum, which is comparable to the rate a commercial bank would charge GCAR-US. Overall, the debt-to-equity ratio of GCAR-US does not exceed 1.5 to 1.

Figure III-A

GCAR

GCAR-US

Third Party Lender

US Business Expansion by US Subsidiary Financed by Foreign Parent Loan: Present Law Structure

$200M loan

$8M interest$300M div idend

($100M current E&P)

$300M US business

expansion

$200M loan

$6M interest

Potential Impacts of Proposed Section 385 Regulations

5

Present Law

Under present law, GCAR-US may deduct the $8 million per year of interest expense on the $200 million debt incurred to expand its US production facilities. Under the US-German treaty, no withholding tax would be imposed on the interest payment.

Proposed Regulations: Scenario 1.--Retain present law structure

By contrast, under the Proposed Regulations, the $200 million loan from GCAR would be recharacterized as equity because within a 36-month period prior to the loan, GCAR-US made a distribution to GCAR that was $200 million in excess of current earnings and profits (“E&P”). As a result, the $8 million of annual interest payments would be recharacterized under the Proposed Regulations as dividends to the extent of GCAR’s current and accumulated earnings and profits, which are not deductible for US tax purposes.

Under the Proposed Regulations (and assuming US states also follow the Proposed Regulations), at a combined federal and state income tax rate of 38.9 percent17, the after-tax cost of the $8 million in interest expense would increase from $4.9 million (61.1% of $8 million) to $8 million. Relative to the $300 million investment in the US factory, this is a 104 basis point increase in the cost of finance ($8 million minus $4.9 million as a percent of $300 million).

To avoid the adverse tax consequences of loan recharacterization, GCAR-US would have to avoid paying dividends in excess of earnings and profits within the period beginning 36 months before and ending 36 months after receiving the $200 million loan from GCAR, in effect “trapping” earnings in the United States.

Proposed Regulations: Scenario 2.--Borrow from unrelated party

To mitigate the adverse impacts of the Proposed Regulations, GCAR-US could borrow from a bank rather than use parent debt. As GCAR would not be financing the expansion, it would be able to reduce its borrowing by $200 million. Under this scenario, as a result of using an unrelated lender, GCAR’s net income would be reduced by $2 million (the $8 million of interest received and the $6 million of interest paid under present law). After German federal and state income taxes, which currently average 30.2 percent18, the after-tax cost of using a third-party lender is $1.4 million ($2 million times 69.8%). Relative to the $300 million investment in the US factory, this is a 47 basis points increase in the cost of finance ($1.4 million as a percent of $300 million).

Proposed Regulations: Scenario 3.--Retain US earnings

Had GCAR anticipated the need to expand its US manufacturing operations in 2020, it could have mitigated the impacts of the Proposed Regulations by reducing the $300 million dividend in 2019 to $100 million and using GCAR-US’s retained earnings to fund the expansion. In this case, the $8 million interest payment from GCAR-US to GCAR is eliminated, with a corresponding increase in US tax and decrease in German tax. The net increase in tax is $0.699 million per year (38.9% less 30.2% times $8 million) or 23 basis points increase in the cost of finance ($0.699 million as a percent of $300 million). GCAR is assumed to continue to borrow $200 million to replace the $200 million dividend from GCAR-US.

17 The OECD Tax Database estimates that the average combined top federal and state corporate income tax rate in the United States is 38.9 percent. See, http://stats.oecd.org//Index.aspx?QueryId=58204 (accessed June 29, 2016). 18 See OECD Tax Database.

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B. Loss of Treaty Benefits Due to Foreign-to-Foreign Loan

The second inbound example illustrates how a US subsidiary can lose US tax treaty benefits under the Proposed Regulations as a result of a loan between two related foreign entities.

JCO is a diversified publicly traded Japanese manufacturing company. It has two wholly owned subsidiaries: JCO-J incorporated in Japan and JCO-HK incorporated in Hong Kong. JCO’s basis in JCO-J is $90 million. JCO’s US distribution, marketing, and customer support is conducted through JCO-US, a wholly owned subsidiary of JCO-J. JCO-J’s basis in JCO-US is $100 million. JCO-US pays a $10 million dividend annually to JCO-J. JCO’s country Z distribution, marketing, and customer support is conducted through JCO-Z, a wholly owned subsidiary of JCO-HK (see Figure III.B).

JCO wishes to reorganize its country Z operations underneath JCO-J to improve operational efficiency. To accomplish this restructuring, JCO-HK sells JCO-Z to JCO-J in exchange for a $100 million note.

Present Law

Under present law, JCO-US qualifies for the benefits of the US tax treaty because JCO-J (a wholly owned Japanese subsidiary of a publicly traded Japanese parent) owns 100 percent of JCO-US. Consequently, JCO-US does not withhold on the $10 million of dividends paid to JCO-J. Japan’s top corporate tax rate is 29.97 percent19 and Japan exempts 95 percent of dividends received from foreign subsidiaries. Consequently, $0.15 million of Japanese tax is owed on the $10 million dividend. JCO-J’s acquisition of JCO-Z from JCO-HK would have no US tax consequences under present law.

Proposed Regulations: Scenario 1.--Retain present structure

19 See OECD Tax Database.

JCO-USJCO-Z

Figure III-B. -- Foreign-to-Foreign Loan: Present Law Structure

JCO-Z

JCO

JCO-HKJCO-J

($0 current E&P)$100M note

$90M basis

Potential Impacts of Proposed Section 385 Regulations

7

Under the Proposed Regulations, JCO-J’s loan from JCO-HK would be recharacterized as a $100 million equity investment by JCO-HK in JCO-J. As a result, JCO’s ownership percentage of JCO-J would fall from 100% to 47% ($90 million/$190 million) and JCO-US would no longer qualify for the benefits of the US-Japan treaty.20 As a result, distributions from JCO-US to JCO-J would be subject to withholding at a 30 percent rate instead of the zero percent treaty rate. Consequently, total taxes paid on JCO-US’s $10 million annual dividend to JCO-J would increase by $3 million (30% withholding rate on $10 million dividend) to $3.15 million. This is equivalent to a 300 basis point reduction in the annual return on JCO-J’s investment in JCO-US (see details in the Appendix).

Proposed Regulations: Scenario 2.--Borrow from a related party

To avoid the loss of treaty benefits, JCO-J could finance the acquisition of JCO-Z by borrowing $100 million from JCO. Assuming JCO charges JCO-J the same interest as JCO-J would have paid on the note under present law and that JCO-HK distributes the full proceeds from the sale of JCO-Z to JCO, there will be a one-time increase in total taxes paid of $6.5 million (from $0.15 million to $6.65 million). The increase in tax is attributable to the 5 percent Hong Kong withholding tax on the $100 million distribution plus the $1.5 million Japanese tax on this dividend. Assuming a 4 percent discount rate (the assumed interest rate on the loan) the one-time increase is equivalent to an annual increase in taxes of $0.26 million or 26 basis points relative to JCO-J’s investment in JCO-US (see details in appendix).

20 JCO-J could previously have qualified for benefits as a subsidiary of a publicly traded company. However, JCO-J would lose the ability to qualify under this test once it has a non-US, non-Japanese intermediate owner.

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IV. Outbound Examples

A. Cash Pooling

The first outbound example illustrates the impact of the Proposed Regulations on cash pooling arrangements. Although this example is presented in the context of a US multinational, similar impacts also arise for foreign-based multinationals with US operations.

A principal treasury function in the day-to-day operations of a multinational enterprise is to redeploy cash generated by one member of the affiliated group to fund operations of other group members. Such cash deployment can take place both within a single country and across the globe. Internal cash management allows multinational enterprises, whether based in the United States or abroad, to reduce their external financing expense and maximize their returns on equity.

Multinational enterprises efficiently redeploy cash through a variety of internal cash management techniques, including cash pools and intercompany loans. Cash pools act as internal banks within a multinational group, taking deposits, or borrowing, from dozens or hundreds of affiliates and lending the proceeds to dozens or hundreds of affiliates. The balances often roll and fluctuate on a daily basis, resulting in hundreds or thousands of related-party borrowings and repayments per day passing through the corporation acting as the cash pool (i.e., the “cash pool leader” or “cash pool head”).

Effective internal cash management requires the ability to mobilize and redeploy cash quickly. Theoretically, an enterprise’s available funds could be redeployed through distributions and capital contributions, but practically it is difficult to do so. Declaring and paying distributions takes time; many jurisdictions restrict entities from declaring distributions in excess of distributable reserves; cross-border distributions frequently are subject to withholding taxes and explicit capital controls may limit distributions. These concerns multiply as funds travel through each level of a sprawling corporate structure. Consequently, a more efficient manner of mobilizing and deploying cash is through direct intercompany loans. Frequently, these loans can be issued and repaid in less time, with less cost, and subject to fewer restrictions than distributions and capital contributions.

Two common practices for internal cash management are long-term intercompany financing and short-term cash pooling. The scale and complexity of a large multinational group’s cash management practices result in some debt instruments falling along a spectrum between long-term intercompany financing and short-term cash pooling.

Long-term intercompany financing typically involves term loans or revolving credit facilities pursuant to which a cash-surplus affiliate makes available to a cash-deficit affiliate significant funds for capital expenditures and related investments. These loans are similar to bank loans, with the benefit that the interest income that would have been earned by the bank instead is kept within the enterprise to further promote growth and investment.

Short-term cash pooling typically involves multiple affiliates pooling excess funds and making those funds available to other affiliates with cash shortfalls.21 This pooling typically is accomplished by having each affiliate maintain a separate bank account within which it deposits its cash or from which it can overdraw on a daily basis to meet its operating needs. Under a standing set of transfer instructions, all positive cash balances in affiliates’ accounts are swept at the end each day into the bank account of the entity serving as the cash pool leader, and all overdrafts in accounts of affiliates are covered by automatic transfers from the cash pool leader’s

21 Treasury regulations with respect to the Foreign Account Tax Compliance Act (“FATCA”) provide a definition of treasury center activities not dissimilar from this common understanding of short-term cash pooling:

Managing the working capital of the expanded affiliated group (or any member thereof) such as by pooling the cash balances of affiliates (including both positive and deficit cash balances) or by investing or trading in financial assets solely for the account and risk of such entity or any members of its expanded affiliated group.

Treas. Reg. § 1.1471-5T(e)(5)(i)(D)(1)(iv). This definition does not, however, include the related and equally important function of long-term intercompany financing.

Potential Impacts of Proposed Section 385 Regulations

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account. Such arrangements often are referred to as daily zero-balance cash pooling because the closing daily balance in the account of each affiliate other than the cash pool leader is zero.

When positive cash amounts are transferred from an affiliate’s account to the cash pool leader account, that transfer generally is recorded pursuant to standard facility documentation as a loan to, or deposit with, the entity that owns the cash pool leader account. If, however, the affiliate currently is in a net borrowing position with the cash pool, the cash transfer is recorded as a repayment against that borrowing. When cash is transferred automatically from the cash pool leader account to cover an overdraft in an affiliate’s account, that cash transfer is recorded as a loan to that affiliate. Because these sweeps can occur on a daily basis among dozens or hundreds of affiliates, the corporation serving as the cash pool leader can be entering into dozens or hundreds of related-party funding transactions a day, and hundreds or thousands of related-party funding transactions per year.

These cash pooling arrangements allow a multinational enterprise to deploy liquidity across its various operating subsidiaries, while minimizing both the aggregate cash balances needed and external funding costs. Cash pools also allow an enterprise to aggregate cash surpluses and shortfalls within currency environments and thus minimize the enterprise’s net foreign currency exposure that must be hedged.22 In larger multinational enterprises, these cash pools often are tiered, sometimes with affiliates directly participating in a local country cash pool, which participates in a regional cash pool, which in turn participates in a global cash pool.

Example

For the sake of simplicity, we focus on an unrealistically simple hypothetical fact pattern relating to cash pooling. USP, a US parent of a multinational group, owns all the outstanding stock of four foreign subsidiaries: FSUB (French), GSUB (German), UKSUB (UK), and FINCO (UK). FSUB, GSUB, and UKSUB, are operating companies, and FINCO serves as the foreign group’s treasury center and cash pool leader (see Figure IV.A). To the extent the foreign operating entities have excess cash, they deposit that cash with FINCO in the cash pool. If one of the foreign operating entities needs funds (e.g., to service monthly payroll expenses), the entity borrows from FINCO rather than obtaining financing through the use of a third-party lender.

In this example, GSUB and UKSUB each deposit excess cash of $100 million with FINCO and FSUB borrows $200 million from FINCO for one year to cover its cash shortfall. FINCO charges 4% on loans and pays 1% on deposits and, over the course of a year, earns a net margin of 3% on the $200 million of aggregate deposits, or $6 million.

22 Because an enterprise’s affiliates typically maintain their accounts in their own functional currencies, the debts arising between the affiliates and the cash pool typically are denominated in the functional currencies of the affiliates, and the foreign currency risk is centralized in the entity serving as the cash pool leader, where it can be managed through hedging. Interest generally accrues on affiliates’ borrowings from the cash pool at a rate higher than the rate of interest that accrues on their deposits with the cash pool, with the result that the cash pool leader earns a spread on its activities.

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Present Law

Under present law, the $6 million in net earnings of FINCO is subject to UK tax at a rate of 20%, resulting in $4.8 million of after-tax income (80% of $6 million).

We further assume in this example that to resolve a transfer pricing examination issue, FSUB’s income is subject to a retroactive reduction resulting in a deemed dividend to USP of $300 million, which is $200 million in excess of FSUB’s current E&P of $100 million. This adjustment occurs within 36 months after FSUB borrows from FINCO. Under present law, this deemed dividend has no effect on FSUB’s loan. After the transfer pricing adjustment, FSUB has accumulated E&P of $1 billion on which it has paid $200 million of French tax.

Proposed Regulations: Scenario 1.--Retain present law structure

Under the Proposed Regulations, the consequence of the deemed dividend is that FSUB’s borrowing from FINCO is recharacterized as stock for all purposes of the Code. The type of stock it becomes is based on the terms of the instrument, which in many cases will be nonvoting preferred stock with a fixed redemption date.

As a result of the recharacterization, the $8 million of interest payments on FSUB’s borrowing will be treated as distributions with respect to the deemed stock now treated as held by FINCO.23 Furthermore, the $200 million principal payment on the borrowing will be characterized as redemptions of the stock and treated as distributions under section 302(d). This deemed dividend then will result in FSUB’s next draw from the cash pool being recharacterized as equity, and so on ad infinitum. These distributions will result in $208 million of dividends to FINCO.24

The dividends will reduce the foreign taxes in FSUB’s foreign tax pool by $41.6 million ($200 million tax pool times the ratio of $208 million of dividends to $1 billion of accumulated E&P),25 but will not move the foreign taxes to FINCO’s foreign tax pool because FINCO does not own at least a 10-percent voting interest in FSUB.26

23 See 81 Fed. Reg. 20912, 20922, 20925 (Apr. 8, 2016). 24 See section 301(c). 25 Sections 301(c)(1), 316(a). Presumably these dividends would not result in subpart F income due to the related-party look-through exception. See section 954(c)(6); see also Notice 2007-9, 2007-1 C.B. 401. 26 See Treas. Reg. § 1.902-1(a)(1)-(4), (8)(i), and (11).

United States USP

Figure IV-A. -- US Multinational Company Foreign Cash Pooling Arrangement: Present Law Structure

United Kingdom FINCO

Germany GSUB

United Kingdom UKSUB

$200M loan $100M deposit $100M deposit

France FSUB

Accum. E&P = $1,000M Tax Pool = $200M

Potential Impacts of Proposed Section 385 Regulations

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Consequently, the USP Group will permanently lose the $41.6 million of foreign tax credits associated with the E&P paid from FSUB to FINCO.

Further, because FSUB’s borrowing is recharacterized as a nonvoting equity interest held by FINCO, USP no longer controls FSUB within the meaning of section 368(c) while the borrowing is outstanding.27 Therefore, any contributions of assets by USP to FSUB would become a taxable exchange rather than a tax-free contribution,28 and any intended reorganizations with FSUB likely will fail because USP no longer controls FSUB.29

In addition, because FINCO is viewed as making an equity investment in FSUB, the deposits it holds from GSUB and UKSUB also will be recharacterized as equity investments. This cascading effect may cause a reduction in FINCO’s UK tax pool when GSUB and UKSUB withdraw their deposits, eliminating the possibility to credit these taxes.

At a minimum, in this example, the cash pooling arrangement causes USP to permanently lose the ability to credit $41.6 million of French tax, or 20.8 percentage points ($41.6 million/$200 million) on $200 million of loans from the cash pool. In addition, USP likely will lose the ability to credit UK tax due to the cascading impact of FSUB’s debt recharacterization.

The cumulative effect on a cash pool’s ability to engage in intercompany lending only worsens as the enterprise grows in size. The simple example described above consists of a single cash pool with only three participants. Many multinational enterprises, however, maintain a separate cash pool for each country in which they have multiple subsidiaries to minimize local tax issues such as withholding taxes. These local country cash pools then may participate in a currency-specific cash pool to minimize the impact of currency risks. Finally, the currency-specific cash pools may feed into a multi-currency global cash pool which centralizes both cash and currency risk.

In a common structure like this, if a cash pool participant engages in a proscribed transaction and thereby taints the local country cash pool head, this has the potential to successively infect the currency-specific cash pool (i.e., if the local country cash pool head borrows from the currency-specific cash pool during the 72-month period) and the global cash pool (i.e., if the currency-specific cash pool head borrows from the global cash pool during the 72-month period). As discussed above, these effects accumulate as balances fluctuate, eventually magnifying a small “foot fault” by one participant into a systemic problem that recharacterizes funding transactions across the global cash management system.

The consequences of the potential systemic recharacterization described above are severe. With extensive cross-chain equity interests being issued and repaid on a daily basis, a multinational enterprise’s global operations could experience (i) widespread loss of foreign tax credits; (ii) inability to effectuate tax-free capitalizations, reorganizations, and liquidations; (iii) non-economic subpart F income from mismatched foreign currency exposures; (iv) concerns of fast-pay stock and listed transactions; and (v) unmanageable complexity and uncertainty associated with a structure for US tax purposes that is completely disconnected from the enterprise’s structure for commercial, financial accounting, and foreign tax purposes.30

27 In particular, section 368(c) defines control as direct ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of other classes of stock. In the example described above, after the FSUB borrowing is recharacterized, USP would continue to own 100 percent of the total combined voting power of FSUB, but it would own zero percent of FSUB’s nonvoting stock (i.e., the deemed stock). 28 See section 351(a) (requiring the transferor(s) control the transferee within the meaning of section 368(c)). 29 See sections 355(a)(1)(A) (requiring a distribution of section 368(c) control) and 368(a)(1) (describing transactions that qualify as reorganizations, often by reference to control under section 368(c)). 30 The above discussion has focused on physical cash pooling and intercompany financing. Some companies use notional cash pooling to manage cash deployment and foreign currency exposures. Instead of actual cash transfers between participants and a pool head, a third-party bank notionally nets participants’ accounts to determine the aggregate interest to pay or charge based on the group’s net cash position. As a result, cash-poor affiliates can borrow from the bank based on the strength of other affiliates’ deposits at a reduced financing cost. Because each participant deposits or borrows in its functional currency, this system also effectively manages the foreign currency exposures that an internal cash pool head would otherwise need to manage.

Although notional cash pooling is conducted entirely through interactions with a third-party bank and generally does not include related-party transactions, consideration should be given to whether the bank could be treated as a

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Proposed Regulations: Scenario 2.--Use a commercial bank for cash pooling

Given the high tax and compliance costs of accidentally triggering recharacterization, US multinationals may seek to protect themselves by using third-party banks to manage their foreign subsidiary cash. In this case, assuming that FSUB can obtain bank credit at 4% and GSUB and UKSUB earn 1% on their bank deposits, net interest income of $6 million ($8 million paid by FSUB and $2 million earned by GSUB and UKSUB) will be paid to third-parties and UK tax of $1.2 million would be eliminated. Thus, the net cost of external cash pooling would be $4.8 million ($6 million of net interest payments less $1.2 million of tax savings). If commercial bank terms are less advantageous, the cost to the USP group will be more than $4.8 million, or 240 basis points on $200 million of loans from the cash pool.

conduit, resulting in the participants being treated as directly loaning to one another. For example, Rev. Rul. 87-89, 1987-2 C.B. 195 (obsoleted in part by Rev. Rul. 95-56), Rev. Rul. 76-192, 1976-1 C.B. 205, and Treas. Reg. § 1.881-3(c) address circumstances where, for purposes of sections 956 and 881, borrowings from a bank are treated as borrowings from a related party if the bank would not have made the loan on the same terms but for the related party’s deposit with the bank. The Proposed Regulations provide no guidance with respect to notional cash pooling, but these (and other) conduit authorities arguably might support treating notional cash pool deposits and borrowings as deemed related-party debt instruments that are subject to potential recharacterization.

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B. Hedging

The second outbound example illustrates how the Proposed Regulations can adversely affect a US multinational company that hedges its foreign currency exposure. Similar situations may also arise for inbound companies.

Frequently, a US multinational’s operating companies will borrow from a related finance subsidiary in a currency other than the currency used by the finance subsidiary for tax and financial reporting purposes (i.e., the “functional” currency). To hedge against a decline in value in the currency in which the loan is denominated, the finance subsidiary may enter into a currency swap contract that effectively locks in the exchange rates for future non-functional currency denominated interest and principal payments. The net effect is the same as if the finance subsidiary had made a loan to the operating company in the finance subsidiary’s functional currency, i.e., a synthetic functional currency loan.

Example

In 2017, a French subsidiary (FCO) pays a €200 million dividend to its US parent (USP) in a year when it has €100 million of earnings and profits (see Figure IV.B). In 2018, FCO wishes to undertake a €100 million expansion of its French operations. Consequently, FCO borrows €100 million, repayable in five years, with an interest rate of 4 percent, from its related UK finance subsidiary (FINCO). FINCO uses the US dollar as its functional currency and is subject to 20-percent income tax under UK law. The current exchange rate is $1.15 per Euro.

To hedge currency exposure, FINCO swaps the Euro-denominated loan into a $115 million (US dollar) loan with an interest rate of 4 percent under the tax rules for integrated hedges. In 2023, the exchange rate for the Euro decreases to $1.10, and FINCO receives repayment of the €100 million loan, and then pays €100 million and receives $115 million under the swap agreement. Under present law, no gain or loss is recognized on the loan repayment or the swap because the loan and swap are integrated for tax purposes.

Figure IV-B. -- US Multinational Company Hedging Transaction: Present Law Structure[Recharacterization and Subpart F Income]

United States USP

France FCO

United Kingdom FINCO

Partner€ 100M loan Swap

€ 100M investment in France

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Present Law

Under present law, where a finance subsidiary swaps a non-functional currency loan for a functional currency loan, the combination of the loan and the swap can be treated for tax purposes as if the finance subsidiary had borrowed in its functional currency, with the result that no gain or loss will be recognized due to currency fluctuations. As a result, in this example no gain or loss is recognized on the loan repayment because the loan and swap are integrated for US tax purposes.

Proposed Regulation: Scenario 1.--Retain present law structure

Under the Proposed Regulations, the loan from FINCO to FCO will be recharacterized as equity because FCO paid a dividend within the 36-month period prior to receiving the €100 million loan from FINCO. As a result, integrated tax treatment would not be available. USP will recognize gain of $5 million of subpart F income in 2023 (the excess of €100 million received translated at $1.15 over the $110 million amount paid on the swap). No currency gain or loss would be accounted for on the repayment of the borrowing, because the repayment would be recharacterized as redemption of shares.

At a 38.9-percent combined federal and state corporate income tax rate, this increases USP’s tax by $1.94 million in 2023. Annuitizing at a 4-percent rate over the five-year period of the hedge, the annual increase in tax burden is $0.359 million, or 31 basis points on a $115 million investment in France.

Proposed Regulations: Scenario 2.--Third-party loan

To avoid the risk of taxation on non-economic gains (i.e., gains that are offset by equal losses), USP may prefer that FCO borrow from an unrelated party rather than FINCO. In this case FCO borrows €100 million from a bank at 4 percent while FINCO has $115 million of excess cash that it deposits in a bank account that pays 1 percent interest. While FINCO could dividend this excess cash to USP, this would trigger $44.28 million (38.9 percent of $115 million) of US tax liability; consequently, unless USP never expects to need cash for future foreign investments, it will be better to retain the cash offshore. In this case, FINCO’s annual net income is reduced from €4 million (4 percent of €100 million) to $1.15 million (1 percent of $115 million). When the exchange rate for the Euro is $1.15, this amounts to a loss of $3.45 million of interest income. As the interest income received on FINCO’s deposit is subject to US tax under subpart F (because the CFC look through rules do not apply), the US parent would owe $0.45 million of US tax (38.9 percent of $1.15 million) before credit for UK tax of $0.23 million (20 percent of $1.15 million), and $0.22 million of US tax after foreign tax credit. Thus, the annual change in after-tax cash flow is the sum of the lost interest income and the additional US subpart F tax liability ($3.67 million), which is equivalent to an increase in the cost of the $115 million expansion of 319 basis points ($3.67 million/$115 million).

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V. Compliance Costs

A. Description of Documentation Requirements of Proposed Regulations The Proposed Regulations impose significant new contemporaneous documentation requirements that must be satisfied as a precondition for related-party indebtedness to be treated as such.31 If the documentation requirements are satisfied, the intended indebtedness is analyzed as debt or stock (in whole or in part) under general federal income tax principles and the other requirements set forth in the Proposed Regulations. Failure to satisfy the documentation requirements results in the intended indebtedness being treated as stock unless the taxpayer can establish that its failure to satisfy the documentation requirements is due to reasonable cause. Given the severe penalty for insufficient documentation, it is expected that taxpayers will need to implement significant new systems and controls to satisfy the documentation requirements. In addition, such systems may be necessary to monitor compliance with other aspects of the Proposed Regulations in an effort to avoid inadvertently triggering recharacterization of the debt instruments as stock. While the Proposed Regulations provide an exception to the “Per Se” rule for ordinary course of business trade receivables, no similar exception is provided to the documentation requirements. The Proposed Regulations establish four categories of documentation requirements:

1. Evidence of an unconditional and legally binding obligation to pay a sum certain on demand at one or more fixed dates.

2. Evidence that indicates the holder has rights of a creditor, including a superior right to shareholders in the case of dissolution.

3. Evidence of a reasonable expectation of the issuer’s ability to repay the debt, such as cash flow projections, financial statements, business forecasts, asset appraisals, relevant financial ratios, or information on sources of funds.

4. Evidence of timely interest and principal payments (e.g., wire transfers or bank statements) or, in the case of either a failure to make required payments or an event of default, the holder’s reasonable exercise of the diligence and judgment of a creditor.

Of the four categories of documentation, the first three must generally be completed within 30 days of the instrument being issued. In addition, documentation of a reasonable expectation of the issuer’s ability to repay the debt must also occur no later than 30 days after each significant modification of the original instrument. Documentation of timely interest and principal payments must be prepared no later than 120 days after the due date of each required payment and the date of each default or acceleration event. Documentation must be maintained for all years that the debt is outstanding and until the period of limitations expires for any tax return with respect to which treatment of the instrument is relevant. The effective date of the documentation requirements is generally for instruments issued or deemed issued on or after the date the Proposed Regulations are finalized. As a result, systems necessary for preparing and maintaining the required documentation would need to be in place at the time the Proposed Regulations are finalized.

B. Aggregate Scope of Impact of Documentation Requirements Multinational corporations typically have significant interactions between the parent company and their foreign subsidiaries, as well as transactions between their foreign subsidiaries not directly involving the parent corporation. These interactions may take the form of financing arrangements, trade, service guarantees, and employee compensation, pension and stock option arrangements. Department of Commerce data provide insight into the aggregate volume of just some of these transactions. For example, sales by US foreign

31 Prop. Reg. Sec. 1.385-2.

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subsidiaries to their US parent or to related foreign subsidiaries were $1.7 trillion in 2013 – or an average of $4.7 billion every day of the year – of which over 70 percent were sales between related foreign subsidiaries.32 For US subsidiaries of foreign multinational corporations, their imports and exports to their foreign parent and affiliated foreign subsidiaries totaled $770 billion in 2013.33 The Department of Commerce does not keep statistics on the trade among foreign multinational companies and their non-US foreign subsidiaries, but it is likely their non-US related-party trade constitutes an even larger percentage than the over 70 percent statistic for US multinational corporations cited above. These trade statistics are useful in gaining an understanding of the scope of the documentation requirements of the Proposed Regulations, as each of the trade receivables resulting from these related-party sales potentially constitutes an instrument to which the contemporaneous documentation requirements apply. It also is suggestive of the disproportionate burden placed on companies to document instruments between foreign subsidiaries (or between a foreign parent and its non-US foreign subsidiaries) for which the risk to the US tax base is remote.

C. Cost Estimate of Documentation and Compliance Requirements The Proposed Regulations will impose substantial start-up costs to develop the systems to provide contemporaneous monitoring and documentation of all interests treated as expanded group instruments. While the documentation requirements strictly apply only to instruments issued in the form of debt, systems will also need to track distributions among the parent and its subsidiaries in order to ensure that these distributions do not result in debt instruments being recharacterized as equity under the Proposed Regulations. The documentation and monitoring required under such systems will far exceed any established processes of US companies. For example, for US financial statement purposes, reporting is generally necessary for corporations on a consolidated basis each quarter of the fiscal year. In contrast, the Proposed Regulations will effectively require real time reporting of instruments for each subsidiary on its related-party debt, including trade payables and trade receivables. In addition, the design of the systems needed to document and monitor transactions cuts across all organizational lines of a company, including treasury, legal, accounting, financial planning and forecasting, tax, and even human resources. Example. The following example represents an estimate of the federal income tax compliance burden imposed by the Proposed Regulations through information obtained from one large US multinational corporation that has undertaken an assessment of the hours of resources it anticipates it will require to comply. Documentation and compliance costs will vary by company, with some companies facing higher costs and others – particularly smaller companies without international operations – facing lower costs. Costs, however, are not all proportional to the asset size of a company, as some costs will have elements of fixed costs and other costs are more directly related to the volume of transactions rather than their dollar amount. The company on which this estimate is based is a Fortune 100 company with significant operations in the United States and over a dozen foreign countries. The estimates exclude additional material compliance costs that could arise at the state level where states adopt the principles of the Proposed Regulations but require separate company reporting. These states might require that transactions within the consolidated group be monitored and documented for state income tax purposes even though such documentation would not be necessary for federal income tax purposes. Based on recent year activity, the Fortune 100 company estimates that more than 10 million intercompany transactions would be subject to the documentation requirements in a given year. The system necessary to document these transactions would require substantial engagement of its internal treasury, legal, accounting, financial planning and forecasting, tax, and information technology departments as well as external consultants providing these services. 32 Department of Commerce, Bureau of Economic Analysis, US MNE Activities: Preliminary 2013 Statistics, Majority-Owned Foreign Affiliates, Table II.E.1. 33 Department of Commerce, Bureau of Economic Analysis, US Affiliate Activities: Preliminary 2013 Statistics, Majority-Owned Affiliates, Table II.H.1.

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The company has estimated that the design of this system, including consulting with legal, tax, and accounting professionals to ensure appropriate capabilities, would require approximately 21,600 hours. The average blended hourly cost of internal personnel and outside consultants, including wages, benefits, and overhead costs, is conservatively estimated to average approximately $127 per hour based on Department of Labor data.34 As a result, the start-up cost to implement this system would be approximately $2.75 million. These start-up costs are detailed by function in Table V-1.

Table V-1.—Estimated Documentation and Compliance Costs for a Fortune 100 Company

It is further estimated that annual operational and system maintenance activities would require 9,660 hours annually, or approximately 4.8 full-time equivalent employees.35 Estimated annual operational costs are therefore approximately $1.25 million. As a result, total first year implementation and operational costs are just under $4 million. After the first year, annual operational and maintenance costs are estimated at approximately $1.25 million (in 2016 dollars).

34 The Department of Labor’s Office of Policy and Research provides estimates of wage rates, benefits, and overhead costs (such as office space) by occupation. See “Labor Cost Inputs Used in the Employee Benefits Security Administration, Office of Policy and Research’s Regulatory Impact Analyses and Paperwork Reduction Act Burden Calculations,” March 2016, available at https://www.dol.gov/ebsa/pdf/labor-cost-inputs-used-in-ebsa-opr-ria-and-pra-burden-calculations-march-2016.pdf. Estimated hourly wages for 2016 from this source range from approximately $37 for accountants to approximately $67 for lawyers. Benefits to workers increase compensation costs by about 45 to 50 percent. Total compensation used in these estimates for 2016 ranges from a low of $53 per hour for accountants to about $97 per hour for both lawyers and financial managers. Overhead costs range from about 38 percent of compensation for lawyers to 84 percent of compensation for accountants. This results in fully loaded costs per worker in 2016 ranging from $98.25 per hour for accountants to $167.32 per hour for financial managers. These estimates are conservative in that the specialized personnel necessary for compliance with the Proposed Regulations will typically be more experienced and have higher compensation costs. 35 These operational costs are estimated at 50 percent of all first-year expenses other than technology implementation costs; system maintenance costs are estimated at 35 percent of first-year technology implementation costs.

Function

Estimated Cost by 

Function (rounded to 

nearest thousand) Hours

Assumed 

Cost Per 

Hour

Start‐up estimated costs by function

Tax legal counsel consulting $145,000 1,087              $133.61

Tax accounting consulting $841,000 6,293              $133.61

Transfer pricing consulting $145,000 1,087              $133.61

Internal corporate tax $200,000 1,500              $133.61

Tax technology & implementation $370,000 3,261              $113.43

Internal corporate treasury $125,000 750                 $167.32

Internal corporate legal $100,000 750                 $133.61

Internal corporate accounting $74,000 750                 $98.25

Accounting technology & implementation $493,000 4,348              $113.43

Internal corporate financial planning and forecasting $125,000 750                 $167.32

Miscellaneous $131,000 1,029              $127.33

Esimated start‐up cost $2,749,000 21,605           $127.24

Ongoing operations:  Annual estimated operating cost $1,245,000 9,660             $128.88

Total year 1 estimated cost (start‐up and operations) $3,994,000 31,265           $127.75

Total annual estimated cost after year 1 (operations only) $1,245,000 9,660             $128.88

Source: Company estimates for hours by function; Department of Labor estimates for labor cost estimation, including wages,benefits, and overhead by occupation.

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As a point of comparison, IRS estimates the Proposed Regulation’s documentation requirements as imposing a burden of only 35 hours of time for the average respondent. The IRS estimates that 21,000 taxpayers would be required to complete this documentation, resulting in a total of 735,000 hours of documentation burden.36 The IRS estimates a total annual cost of documentation of $13 million per year,37 which would imply an average cost of labor of $18 per hour in the IRS estimates. It appears that the IRS estimates exclude start-up costs and may be limited to certain low-level reporting and documentation functions, excluding the costs of compliance to prevent related-party debt from being reclassified as equity under the Proposed Regulations. As shown in Table V-1, even excluding start-up costs, the annual compliance burden estimated by the Fortune 100 company in this example requires 9,660 hours of labor for purposes of documentation and compliance. At an average cost of labor of approximately $129 per hour, including benefits and overhead costs, this one company’s ongoing compliance costs (excluding start-up costs) of $1.245 million is equal to approximately 10 percent of the total paperwork burden estimated by IRS. Including start-up costs, the first-year documentation and compliance costs of this company (nearly $4 million) is equal to approximately 30 percent of the total paperwork burden estimated by IRS. While costs will vary by company, the estimates in Table V-1 suggest that the IRS has grossly understated the economy-wide documentation and compliance burdens of the Proposed Regulations.

36 IRS, Notice of proposed rulemaking, April 4, 2016. 37 Office of Management and Budget, Regulatory Impact Analysis, available at https://www.regulations.gov/document?D=IRS-2016-0014-0001.

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VI. Investment Impacts The examples in Sections III and IV illustrate the potential impact of the Per Se Recharacterization Rules on the after-tax cash flows of foreign-based companies in the United States and US-based companies abroad. Changes in after-tax cash flow may affect a company’s investment decisions. This section estimates the potential investment impact of the Per Se Recharacterization Rules for three of the four examples discussed above.

A. Methodology The response of foreign direct investment (“FDI”) to a change in statutory income tax rates frequently is measured as a semi-elasticity, i.e., the percentage change in investment in response to a one percentage point increase in the statutory income tax rate. There are a large number of empirical studies that attempt to estimate the responsiveness of investment and international capital flows to changes in taxes. This literature uses a number of different measures of investment and taxes and a variety of econometric techniques. To synthesize the results of this literature, de Mooij and Ederveen (2008) conducted a meta-analysis of these studies.38 A meta-analysis is a statistical method used to summarize the results of various studies. The semi-elasticity of FDI with respect to the statutory tax rate is -2.4 in the de Mooij-Ederveen meta-analysis.39 This implies that a one percentage point increase in the statutory tax rate in a country will reduce inbound FDI by 2.4 percent. We utilize this semi-elasticity to estimate the investment impacts of the Proposed Regulations by converting the change in annual after-tax cash flows in the preceding examples into equivalent income tax rate changes. According to US tax returns for US manufacturing subsidiaries with 50 percent or more foreign ownership, the average return on assets (defined as taxable income divided by total assets) was 3.5 percent over the 2004-2013 period.40 Consequently, taxable income generated on investments by US manufacturing subsidiaries is estimated to be 3.5 percent multiplied by the amount of the initial investment. Similarly, the taxable income generated by foreign subsidiaries of US companies was estimated using tax return data for US controlled foreign corporations.41 For foreign subsidiaries in France, earnings and profits averaged 5.0 percent of assets. The equivalent income tax rate change corresponding to the change in after-tax cash flows in the preceding examples is equal to the change in after-tax cash flow divided into the taxable income generated by the corresponding investment. We calculate the equivalent tax rate change using estimated taxable income, based on the IRS statistics described above. The equivalent tax rate change for the preceding examples is used to estimate investment impacts based on the de Mooij-Ederveen semi-elasticity.

B. Results Table VI-1 below summarizes the potential investment impacts of the Proposed Regulations for three of the examples discussed in this report. The estimated reduction in investment is large, ranging from 13.1 to 32.3 percent under the best case scenarios, which assume taxpayers restructure to mitigate the adverse impacts of the Proposed Regulations. These investment impacts are based on the facts and circumstances of the examples, and larger or smaller impacts could result under different fact patterns.

38 de Mooij,Ruud A. and Sjef Ederveen, “Corporate Tax Elasticities: A Reader’s Guide to Empirical Findings,” Oxford Review of Economic Policy, Vol. 24, No. 4, 2008, pp.680–697. 39 See Table 3 in de Mooij,and Ederveen (2008). 40 Data tabulated by the Internal Revenue Service’s Statistics of Income Division and is available online at (https://www.irs.gov/uac/soi-tax-stats-foreign-controlled-domestic-corporations). The calculations above represent a weighted average of the return on assets for foreign-controlled domestic corporations over the most recent ten-year period for which data were available (2004-2013). 41 Data tabulated by the Internal Revenue Service’s Statistics of Income Division and is available online at (https://www.irs.gov/uac/soi-tax-stats-controlled-foreign-corporations). The calculations above represent a weighted average of the return on assets for foreign-controlled domestic corporations for the five most recent years for which data were available (2004, 2006, 2008, 2010, and 2012).

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Table VI-1. Estimated Investment Impact of Proposed Regulations for Specific Examples

Example/Scenario

Equivalent Change in 

Statutory Tax Rate    

(Percentage Point)

Percentage 

Change in 

Investment

Example III‐A:  Expansion of Domestic Manufacturing Operations

Base Case (no mitigation) 30.0 ‐72.0%

Alternative Scenario #1 ‐ Borrow from unrelated party 13.5 ‐32.3%

Alternative Scenario #2 ‐ Use retained US earnings 6.7 ‐16.2%

Example III‐B:  Loss of Treaty Benefits

Base Case (no mitigation) 86.7 ‐208.1%

Alternative Scenario #1 ‐ Borrow from related party 7.5 ‐18.0%

Example IV‐B:  Hedging

Base Case (no mitigation) 9.3 ‐22.4%

Alternative Scenario #1 ‐ Borrow from unrelated party 5.5 ‐13.1%

Note: An investment response greater than 100 percent implies the investment would not be undertaken.

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Appendix. Example Details

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Example III.A ‐‐ Expansion of Domestic Manufacturing Operations

Additional 

Parameters

Present 

Law

Scenario   

1

Scenario   

2

Scenario   

3

Sources and Uses of Cash

GCAR‐US

2019 income 100 100 100 100

Loan from GCAR 200 200 0 0

Third party debt 0 0 200 0

Dividend paid to GCAR ‐300 ‐300 ‐300 ‐100

Investment ‐300 ‐300 ‐300 ‐300

Change in net cash position ‐300 ‐300 ‐300 ‐300

GCAR

Dividend received from GCAR‐US 300 300 300 100

Third party debt 200 200 0 200

Loan to GCAR‐US ‐200 ‐200 0 0

Change in net cash position 300 300 300 300

Annual Interest Income (+) and Expense (‐)

GCAR‐US

Loan from GCAR 4% ‐8 ‐8 0 0

Third party debt 4% 0 0 ‐8 0

GCAR

Loan to GCAR 4% 8 8 0 0

Third party debt 3% ‐6 ‐6 0 ‐6

Tax Increase (+) or Decrease (‐)

GCAR‐US

Interest deduction 38.9% ‐3.1 0.0 ‐3.1 0.0

GCAR

Interest income 30.2% 2.4 2.4 0.0 0.0

Interest deduction 30.2% ‐1.8 ‐1.8 0.0 ‐1.8

Income tax on dividend received 1.5% 4.5 4.5 4.5 1.5

Change in Total Worldwide Taxes

Net interest income/expense ‐6.0 ‐6.0 ‐8.0 ‐6.0

Net tax on investment ‐2.5 0.6 ‐3.1 ‐1.8

After tax interest income/expense ‐3.5 ‐6.6 ‐4.9 ‐4.2

Change from present law ‐3.1 ‐1.4 ‐0.7

As a % of the investment ‐1.04% ‐0.47% ‐0.23%

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Example III.B ‐‐ Loss of Treaty Benefits

Additional 

Parameters

Present 

Law

Scenario   

1

Scenario   

2

Sources and Uses of Cash

JCO‐US

2019 income 100 100 100

Dividend paid to JCO‐J ‐100 ‐100 ‐100

Change in net cash position 0 0 0

JCO‐J

Dividend received from JCO‐US 100 100 100

Loan from JCO 0 0 100

Cash payment to JCO‐HK 0 0 ‐100

Note to JCO‐HK ‐100 ‐100 0

Change in net cash position 0 0 100

JCO‐HK

Cash payment from JCO‐J 0 0 100

Note from JCO‐J 100 100 0

Dividend to JCO 0 0 ‐100

Change in net cash position 100 100 0

JCO

Dividend received from JCO‐HK 0 0 100

Loan to JCO‐J 0 0 ‐100

Change in net cash position 0 0 0

Annual Interest Income (+) and Expense (‐)

JCO‐J

Loan from JCO 4% 0 0 ‐4

Note to JCO‐HK 4% ‐4 ‐4 0

JCO‐HK

Note from JCO‐J 4% 4 4 0

JCO

Loan to JCO‐J 4% 0 0 4

Taxes on Distribution by JCO‐US

Gross dividend distributed 10 10 10

Withholding tax on dividend 0%/30% 0 3 0

Net dividend received by JCO‐J 10 7 10

Japanese tax on dividend received 1.5% 0.15 0.15 0.15

After‐tax dividend income 9.9 6.9 9.9

Taxes Paid on Interest Income/Deductions

Interest deductions for JCO‐J 30% ‐1.2 ‐1.2 ‐1.2

Interest income of JCO‐HK 0% 0 0 0

Tax on subpart F income 30% 1.2 1.2 0

Interest income of JCO 30% 0 0 1.2

Net taxes on interest income 0 0 0

Taxes on Distribution by JCO‐HK

Gross dividend distributed 0 0 100

Withholding tax on dividend 5% 0 0 5

Net dividend received by JCO 0 0 95

Japanese tax on net dividend received 1.5% 0.0 0.0 1.5

After‐tax dividend income 0.0 0.0 93.5

Other Taxes

Income tax paid by JCO‐HK on cash received 0% 0 0 0

Total Taxes 0.15 3.15 6.65

Annualized taxes 0.15 3.15 0.41

Change in annualized taxes 3.00 0.26

As a percent of investment in JCO‐US 3.00% 0.26%

Potential Impacts of Proposed Section 385 Regulations

24

Example IV.A ‐‐ Cash Pooling

Additional 

Parameters

Present 

Law

Scenario   

1

Scenario   

2

FSUB

Loan from FINCO 200 200

Foreign Tax Pool 200 200 200

Deemed dividends

Recharactarized interest payment 8

Repayment of loan to FINCO 200

Total deemed dividends 0 208 0

Accumulated E&P 1,000 1,000 1,000

Percentage reduction in foreign tax pool 0.0% 20.8% 0.0%

Lost foreign tax credits 0 41.6 0

FINCO

Income from loan to FSUB (net interest income) 3% 6 6 0

Taxes on net interest income (net of FTC) 20.0% 1.2 1.2 0.0

After‐tax net interest income 4.8 4.8 0.0

Change from present law 0.0 ‐4.8

Tax Cost ‐41.6 ‐4.8

As a percent of original loan ‐20.80% ‐2.40%

Potential Impacts of Proposed Section 385 Regulations

25

Item 2018 2019 2020 2021 2022 2023 Close out

EXCHANGE RATE

Dollars per Euro 1.15 1.15 1.15 1.15 1.15 1.15 1.1

PRESENT LAW

Notional swap amount $115

Swap interest received $4.60 $4.60 $4.60 $4.60 $4.60

Swap interest paid € 4 € 4 € 4 € 4 € 4

Net interest income on swap $0.00 $0.00 $0.00 $0.00 $0.00

Swap principal received $115

Swap principal paid € 100

Subpart F income $0 $0 $0 $0 $0 $0

Tax on Subpart F income $0 $0 $0 $0 $0 $0

After-tax cash flow $0.00 $0.00 $0.00 $0.00 $0.00 $5.00

Tax as a percent of investment 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

PROPOSED REGULATIONS

Scenario 1

Notional swap amount $115

Swap interest received $4.60 $4.60 $4.60 $4.60 $4.60

Swap interest paid € 4 € 4 € 4 € 4 € 4

Net interest income on swap $0.00 $0.00 $0.00 $0.00 $0.00

Swap principal received $115

Swap principal paid € 100

Subpart F income $0 $0 $0 $0 $0 $5.00

Tax on Subpart F income $0 $0 $0 $0 $0 $1.94

After-tax cash flow $0.00 $0.00 $0.00 $0.00 $0.00 $3.05

Annualized tax on subpart F 0.36$ 0.36$ 0.36$ 0.36$ 0.36$ 0.36$

Tax as a percent of investment 0.31% 0.31% 0.31% 0.31% 0.31% 0.31%

Scenario 2

Deposit $115

Deposit interest income $1.15 $1.15 $1.15 $1.15 $1.15

Bank loan

Bank borrowing € 100

Interest paid on bank debt € 4.00 € 4.00 € 4.00 € 4.00 € 4.00

Interest paid in US dollars $4.60 $4.60 $4.60 $4.60 $4.60

Repayment of bank debt $115

Subpart F income (deposit interest) $1.15 $1.15 $1.15 $1.15 $1.15 $0.00

Tax on Subpart F income after FTC $0.22 $0.22 $0.22 $0.22 $0.22 $0.00

After-tax cash flow ($3.67) ($3.67) ($3.67) ($3.67) ($3.67) $0.00

After-tax cash flow as a percent of investment -3.19% -3.19% -3.19% -3.19% -3.19% 0.00%

Example IV.B Hedging[Monetary amounts in millions]