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New Section 385 Rules Could Inject More Dysfunction into a Broken Tax System

Today, ITI submitted comments to the IRS on the most significant change in tax policy proposed in decades. The rules in question relate to how our member companies track and classify inter-party loans and stand to fundamentally alter investment decisions moving forward. As the Treasury Department and the IRS move ahead with their rulemaking (undoubtedly with thousands of pages of comments in hand), it is important to clarify a few misconceptions.

These rules in question are not just about inversions. The Treasury Department has long discussed its desire to crack down on so-called inversion transactions where a U.S. company merges with a foreign company to change its home base for tax purposes. Delivering on this promise, the proposed rules make a number of mergers much less desirable from a tax perspective.

That, however, is merely a small slice of the changes proposed. In addition to new rules changing the incentives for such mergers, the proposal includes broad and sweeping rules under an obscure area of the code, section 385. Specifically, section 385 provides the IRS with discretion to issue regulations determining factors to be used in classifying debt versus equity. Passed into law in 1969, regulations have never been promulgated under section 385. Instead, tax practitioners have relied on long-established case law for navigating debt/equity treatment.

The proposed rules call for a complete departure from established practice. And they don’t just impact ‘inverters.’ They impact companies of all sizes, both global and domestic.

The impacts are wide-ranging. First, they stand to increase costs and complexity for firms. Instead of fostering growth, they will make it even harder to efficiently redeploy foreign earnings and compete globally. The proposed rules also operate at odds with the Treasury Department’s recent work through the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) project, which was intended to limit unilateral action by countries and curtail the use of complex, hybrid tax arrangements by the business community. In proposing such rules, Treasury has acted alone and driven companies to confront additional hurdles in the international context. Beyond BEPS, ITI members have also raised questions about how these proposed rules could effect terms agreed upon through our tax treaties.

The rules aren’t even about earnings stripping. For those who follow tax policy, the practice of ‘earnings stripping’ is a topic of frequent conversation often tied to discussions about inversions. For those who don’t follow such conversations, ‘earnings stripping’ is when a company puts a large amount of debt into a subsidiary which reduces overall tax liability.

According to the Treasury Department, the proposed regulations are meant to crack down on this type of behavior. They do a lot more. Feeling that they lacked authority to narrowly combat such arrangements, the Treasury Department looked to section 385 as a way forward. In pursuing this approach, they pulled in all inter-party debt, including millions of ordinary course business transactions. As a result, the IRS has potentially changed the economics of many basic treasury functions for ITI members and the broader American business community.

The rules add complexity and make tax reform even harder. Some see these rules as a necessary tool to protect the tax base from future tax-motivated mergers and other bad behavior. Further, some think that this action will make tax reform more likely.

I think there’s a better way to achieve these goals. As explained above, the proposed rules go much further than preventing inversions and combating abusive debt transactions. They require companies to track millions of transactions, most of them clearly non-abusive, and apply complex new criteria to evaluate whether they should be classified as debt or equity. And the stakes are high. If one of our member companies fails to meet the new requirements, they are punished without the ability to appeal.

In terms of tax reform, many assert that these rules are so sweeping that they are in effect tax reform via regulation. To this point, comments submitted by tax experts including large accounting firms and the New York and District of Columbia Bar Associations, assert that the proposed regulations are the most sweeping changes in decades. Changes this sweeping have simply added another layer of complexity to the code and made reform more difficult in a key way. The Treasury Department has changed the economics of tax reform by making huge changes to the math that stand to make any effort at reform more difficult to achieve.

There is a better way forward. The decisions made by governments about how to treat technology companies have a significant impact on economic growth and job creation. The proposed regulations stand to have a large impact across the tech sector. In trying to capture perceived abusive uses of debt instruments, and limit the tax benefits derived by these arrangements, the proposed regulations dramatically alter the use of interparty debt and disrupt the basic treasury functions of ITI members. This unexpected departure from the long-established rules governing debt and equity characterization will impact investment decisions and provide competitors with another advantage in an already difficult environment.

ITI believes the Treasury Department and the IRS can make targeted changes to address issues with the regulations. In our comments, we ask the Treasury Department to focus the rules on problematic behavior and provide clear relief for ordinary business dealings. Further, we hope the Obama administration recognizes the scope of these changes in practice and provides our members with workable timelines to be in compliance with the new regime.

Public Policy Tags: Tax Policy