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August 8, 2017

The past few weeks have brought a couple of significant course corrections in the field of U.S. tax law: one on the legislative front, dealing with possible tax reform, and a second, on the regulatory front, dealing with debt versus equity determinations.

Tax Reform: The BAT Strikes Out

Back in June of 2016, the House Republican Task Force on Tax Reform released its so-called Blueprint for tax reform, at the center of which was a destination-based cash flow tax (DBCFT) to replace the current federal income tax on corporations. At the heart of the DBCFT were so-called border adjustments, which would have taken the form of an exemption for export revenues and a disallowance of any deductions (or other forms of cost recovery, such as cost of goods sold or depreciation) for imported products and services. Because of the potential significance of its border adjustments, the DBCFT also became known as the “border-adjusted tax,” or “BAT.”

As much as we believed that the BAT was the product of some creative, out-of-the-box thinking on the part of the House Republicans (in particular, Speaker Paul Ryan and House Ways and Means Chairman Kevin Brady), we also registered several concerns regarding its potential infirmities, not the least of which were its violations of international trade law and the U.S. Constitution, its challenges in the areas of enforcement and compliance, and its potential harm to several adversely affected industry groups. For prior coverage of those and other problems, see Trade-Neutral Border Adjustments? “First, Assume a Ladder”, Republican Blueprint May Violate International Trade Law and the Constitution — in a Single Bound and Making the Tax Code Great Again…or Something Like That.

Finally, on July 27, Trump administration officials and top congressional lawmakers issued a joint statement announcing that the BAT would no longer be part of the negotiations on tax reform legislation. In addition to rendering a number of very interesting legal questions moot, the demise of the BAT holds some very important practical consequences for potential tax reform.

At the top of the list of affected items are the substantial tax rate cuts that had been proposed by both the Trump administration and the House Republicans. The BAT was estimated to generate in excess of a trillion dollars in revenue. That revenue would have paid for the proposed rate cuts. Without that revenue, the rate cuts cannot be nearly as large, or they cannot be permanent. For more on that, see BAT-er Up: Will Tax Reform Strike Out Without the BAT?

Another potentially affected item is immediate expensing of capital improvements, which was also broadly supported by both the Trump administration and the House Republicans. Although the joint statement did not entirely rule out immediate expensing, it did hint at a potential narrowing of that proposal. In that regard, the joint statement called for “unprecedented” expensing, but didn't make clear that expensing would be full or immediate.

Another important question mark in the ongoing tax reform process that may be affected relates to when (or even if) tax reform legislation will be passed. We went out on a limb a bit with our prediction (contrary to conventional wisdom) that tax reform legislation might occur before healthcare reform. For more on that, see Proposed Tax Reform of High-Net-Worth Individuals. But now that we’ve had a chance to witness, up close, the ability of the Republicans to band together to vote in major legislation, another possibility appears to be emerging: that the Republicans may pass tax reform legislation and healthcare reform legislation at precisely the same time (i.e., never). But at least for now, they are still pushing hard to make something happen on both fronts, with leading Republicans insisting that tax reform will happen before year-end.

Effective Date for Earnings-Stripping Documentation Requirements

On the regulatory front, you may recall that back in April 2016, the Treasury Department issued proposed regulations under code Section 385, dealing with debt versus equity determinations. Although these regulations were aimed at cracking down on perceived abuses practiced by former U.S. companies that have undergone inversions, they would have applied much more broadly to virtually any related-party debt arrangements.

Included in the proposed earnings-stripping regulations were stringent documentation requirements for related-party debt, for which the failure to comply would result in automatic reclassification as stock — a potentially disastrous tax consequence.

Under the proposed regulations, the documentation requirements would have been effective for debt instruments issued on or after the date that the regulations were issued in final form, which was expected to be sometime during the fall of 2016.

The proposed regulations were met with intense public debate and resistance (which continues today). Nonetheless, they were eventually published in the Federal Register in final and temporary form on October 21, 2016. Under the final and temporary regulations, the universe of affected intercompany borrowings was limited to borrowings by U.S. companies, and the effective date of the documentation requirements was pushed off until January 1, 2018.

On July 28, 2017, Treasury issued Notice 2017-36 announcing that the effective date for the documentation requirements is being pushed off further, until January 1, 2019. This should bring a sigh of relief to many foreign-owned groups operating in the U.S. But unless and until these regulations are withdrawn (which is a realistic possibility — for more on that see Potential Traps for Non-U.S. Based Multinationals Under the New Tainted Transaction Rules of the 385 Regulations), foreign-owned U.S. companies need to keep their eyes on this ball. Once again, failure to comply (if and when the documentation requirements take effect) could be disastrous.

For prior coverage of the earnings-stripping documentation requirements, see Final and Temporary Section 385 Regulations Are Here: Sigh of Relief for Some, Still a Burden for Others.

Alvarez & Marsal Taxand Says:

At the moment, the possibility of major tax reform legislation passing in 2017 still seems to be a realistic possibility. Without the BAT, the changes may not be quite as dramatic, or permanent, as originally proposed. But it will be important to stay tuned to the process, as the changes (if they happen) will likely have a major impact on the tax provisions and deferred tax accounts of most companies doing business in the U.S.

As for the earnings-stripping regulations, the postponement of the effective date for documentation not only buys additional time for the necessary preparations for compliance; it may also signal an increased likelihood that the earnings-stripping regulations may eventually be withdrawn in their entirety. 

Disclaimer

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.

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