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July 15, 2016

2016-Issue 21 – Yesterday, the U.S. Treasury Department held its much-anticipated hearing on the controversial proposed earnings stripping regulations under Section 385 of the Internal Revenue Code. We attended the hearing on behalf of our clients and readers.

In spite of all the legitimate concerns expressed by the more than a dozen speakers at the hearing and in the written comments, there was no indication of any appetite at Treasury or IRS for any major changes or delays in implementation. The IRS and Treasury attendees expressed no interest in responding to comments or questions raised by the speakers. Even many speakers themselves commented as if these proposed regulations would certainly be finalized and therefore spent their allotted time suggesting modifications.

Given the volume and content of written comments received by Treasury and published prior to the hearing, the hearing itself provided no major surprises. Nonetheless, many of the statements made by speakers revealed some common themes worthy of note.

Actionable Items:
From a practical perspective, perhaps the most important observation from the hearing relates to something that was largely left unsaid by the speakers. Specifically, apart from concerns regarding the application of the documentation rules to cash pooling arrangements and trade payables entered into as part of the ordinary course of business and a desire for the documentation not to be required until the extended due date of the tax return for the year in which the instrument was entered into, none of the speakers raised serious concerns about any of the first three out of the four documentation requirements imposed by Section 1.385-2. Those first three requirements are:

(i) There must be written documentation establishing an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates;

(ii) The written documentation must establish that the holder has “creditor’s rights;” and

(iii) There must be written documentation establishing that the issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the debt agreement.

The lack of any objection to those documentation requirements might be explained by the fact that, even prior to the issuance of the proposed regulations, many (if not most) competent tax professionals advised their clients to prepare and maintain those types of documentation to minimize risk that debts might be recast under preexisting case law. But a surprising number of taxpayers have failed to implement such documentation procedures. Every indication from the hearing and previous statements by Treasury officials suggests that a failure to heed that advice in the future will no longer be a viable option.

To us, this means that taxpayers should at least be complying with these minimum requirements. For some clients, this will involve adopting new processes and procedures, including preparing financial analytics to satisfy the reasonable expectation of repayment documentation requirement.

Other Comments:
Several speakers suggested that Treasury may have exceeded its authority in creating several of the rules in the proposed regulations. Several speakers also suggested that Treasury’s aggressive timetable for finalization of the proposed regulations may render it vulnerable to challenge under the Administrative Procedure Act (the same basis on which a recent cost-sharing regulation was struck down by the Tax Court in Altera). Through their lack of response, representatives from Treasury and IRS refused to acknowledge any vulnerability to challenge on either of those bases.

At the other end of the spectrum, one speaker from academia praised the proposed regulations and expressed the view that Treasury acted well within the authority delegated to it by Code Section 385. Just two days earlier, Bernie Sanders announced similar support for Treasury and the proposed regulations.

As expected, many of the speakers described numerous and potentially severe problems that would result if the regulations were to be finalized without substantial changes, including but not limited to the following: 

  • There is a lack of clear guidance as to the application of the documentation rules to cash pooling arrangements and the inability of taxpayers to satisfy such requirements without excessive burden.
  • Several of the rules are extremely complicated and will pose a significant compliance burden for many companies, particularly with respect to documenting routine trade payables.
  • The broad application of the proposed regulations has unintended consequences impacting many taxpayers that do not engage in highly tax-motivated intercompany lending transactions.
  • The 72-month non-rebuttable presumption of tax avoidance, contained in the so-called funding rule in Section 1.385-3, would cause the regulations to apply to numerous non-abusive routine lending transactions.
  • The speed at which these rules could be implemented with little to no transition time could result in inadvertent recasts with dire consequences if there isn’t a postponement of the effective date.

Several speakers voiced concerns that it would be virtually impossible to comply with some of the rules in the proposed regulations as they apply to trade payables and cash pooling arrangements. Representatives from the financial services industry voiced concerns about the unduly harsh impact of the proposed regulations on their industry sectors (banking in particular).

Can This Train Be Stopped? 
Based on the lack of any attempt to comment or respond by the Treasury Department and IRS officials at the hearing, it seems that Treasury is not open to considering any change of course. Query whether that may indicate that a deal has already been made behind the scenes (perhaps with members of Congress or special interest groups). Or maybe the orders to proceed on course are coming from a higher authority. Other than the possibility of a behind-the-scenes deal, there appears to be nothing stopping this train. Chairman Kevin Brady of the House Ways and Means Committee has threatened to invoke the Congressional Review Act, but we wonder how likely this is in our current political environment. If the regulations are finalized, taxpayers hoping for a change might have to wait until either: (1) a subsequent administration revokes them, or (2) eventually someone challenges these regulations on constitutional grounds or via the Administrative Procedure Act.

Alvarez & Marsal Taxand Says:
For most of our clients and readers, in terms of immediate actionable reactions, it’s not what has been spoken or written in comments, but rather what was not discussed that matters most. We recommend immediate compliance with at least the first three documentation requirements.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.

Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisers in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

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