As tax observers speculate that the IRS and Treasury could issue earnings stripping guidance related to inversions under section 385 or section 163(j), practitioners told Tax Analysts that the more broadly written section 385 may offer the government more freedom when drafting guidance and that targeted guidance under that section might be the path of least resistance.
"No path forward is without its issues, but the easiest path forward may be for Treasury and the IRS to create a tailored section 385 rule focused specifically on inverted companies and just live with the scrutiny . . . and somehow try and justify to a court the validity of such a rule if they were ever called upon to do so," Andrew M. Eisenberg of Jones Day said.
Jason S. Bazar of Mayer Brown said that given the Obama administration's limited options for addressing earnings stripping, Treasury arguably "has more room to wiggle in" regs under section 385 when compared with section 163(j).
In Notice 2014-52, 2014-42 IRB 712, Treasury said that it was considering guidance to address strategies that avoid U.S. tax on U.S. operations by stripping U.S. earnings to lower-tax jurisdictions, including through intercompany debt. Treasury also has hinted that potential earnings stripping rules could come in the form of an interest deduction limitation under section 163(j) or through a reclassification of deductible debt to nondeductible equity under the authority of section 385.
Section 385 allows for the prescription of regs that may be necessary to determine whether an interest in a corporation is to be treated as stock or debt and provides a non-exhaustive list of factors that could be used in making such a determination. Those factors include whether there is a written unconditional promise to pay on demand or on a specified date a specific sum of money in return for an adequate consideration and to pay a fixed rate of interest, whether there is subordination to or preference over any indebtedness, the ratio of debt to equity, whether there is convertibility into the stock, and the relationship between holdings of stock and holdings of the interest in question.
Although section 385 came into being in 1969, there are currently no regulations accompanying the statute. It took more than a decade after enactment for the release of related proposed regs, which set forth factors to be considered in determining whether an instrument was stock or debt. Final regs followed in December 1980, with a delayed effective date that was extended several times. However, the final regs were withdrawn in 1983.
Section 385 guidance would not be without controversy. Eisenberg acknowledged that while such guidance might accomplish the government's goal of limiting inversion benefits, a debt reclassification to prevent interest deductions on outbound interest payments would be a "pretty fundamental change" in the tax world, especially if it were targeted only at inverted companies.
"I don't recall that ever having been done with respect to a taxpayer-specific instrument," Eisenberg said. "Picking out a particular taxpayer in a particular situation and saying that their debt instrument, and just their debt instrument, would be treated as equity, that's a pretty fundamental [change], and why a lot of people believe that they don't have the authority, or if they do have the authority, they should not go that route."
Changing debt into equity, as presumably would be done with guidance issued under section 385, would not only eliminate the interest deduction, but it may result in an earnings and profits dividend payment.
"That results in withholding tax issues that may not be applicable when these U.S. companies are paying interest. Many of those cross-border withholding rates involving interest and dividend payments are the same, but not always," Eisenberg said. He added that if Treasury and the IRS were to use section 385 to treat expatriated U.S. company debt payable to its foreign parent as expatriated U.S. company equity, then repayments of principal on that debt would be recharacterized as redemption distributions treated as dividend payments, some of which would be subject to low treaty rates and some of which would not.
Advantages Not Limited to Inverters
Eisenberg also noted that there are many other non-inverting taxpayers that benefit from reducing their corporate taxable income through the use of interest paid to shareholders who are also creditors.
"A U.S. individual who has her own company may want to own a debt instrument in that company so the taxable income of that company is reduced. The company has an interest deduction as a result of that note being outstanding," Eisenberg said. He admitted that the comparison with an inverted company was not entirely congruent given that the interest income would not escape U.S. tax altogether, but that in both situations, the corporate tax base is similarly reduced.
Still, Eisenberg thinks targeted section 385 guidance limited to inverters presents the only feasible action. If Treasury and the IRS were to try and write a debt reclassification rule applicable to every note issued by a U.S. person when the note holder doesn't pay U.S. taxes on the full amount of the interest income, it would completely change the way U.S. businesses borrow funds. He cited multinational companies that borrow from lenders that don't pay U.S. tax on their interest income, including tax-exempt funds and foreign lenders.
"The field is so huge . . . it would be quite a challenge for Treasury and the IRS to figure out all the different taxpayers and situations they would touch with a general, rather than a tailored, rule," Eisenberg said. "To issue a general section 385 rule, the government would have to say if a debt instrument is issued where the issuer deducts the interest in the U.S. and the recipient doesn't pay full income tax on the interest income, then that instrument will now be treated as equity." That type of rule also would likely result in section 163(j) being written out of the law, he added.
But Stephen E. Shay of Harvard Law School, speaking at an International Tax Institute event in New York in November, said that limiting section 385 guidance to inverted companies didn't make sense from a policy standpoint. He argued that section 385 guidance could apply to instruments held, or guaranteed, by a related person with payments that would be deductible by a corporation and not subject to tax to the related person.
"The question is, in what circumstances would you want to recast a related-party debt instrument as equity. Our tradition coming out of 163(j) . . . is to look for indicia of excessive debt," Shay said. He said that the traditional approach would be to examine levels of debt compared with equity, but that a determination could also be made based on when interest expense exceeds some percentage of adjusted taxable income.
Results Under Section 163(j) Regs More Unpredictable
Section 163(j) denies U.S. tax deductions for interest paid by a corporation to a related party when the corporation's debt-equity ratio exceeds 1.5 and net interest expense exceeds 50 percent of the corporation's adjusted taxable income.
Like section 385, guidance on section 163(j) has a checkered history. The section was enacted in 1989, and proposed regs (INTL-0870-89) were issued in 1991. However, final regs never came. The New York State Bar Association for several years has called for the finalization or reproposal of the regs as part of the IRS's guidance priority list. The most recent NYSBA recommendation was in April. Despite the NYSBA effort, any regs related to section 163(j) remained off the IRS and Treasury's radar when they drafted the most recent priority guidance plan.
In its 2007 report to Congress on earnings stripping, Treasury noted that the efficacy of the current rules of section 163(j) regarding corporate inversion transactions had been questioned and that there was strong evidence that the section was ineffective at preventing inverted corporations from stripping out income.
Given that section 163(j) is more formulaic, there is less room to maneuver any earnings stripping guidance under its authority, Bazar said. He added that antiabuse provisions under the section could provide some flexibility for administrative action. Section 163(j)(9) allows for regs to prevent the avoidance of the purpose of the subsection. Still, on its face, section 385 presented broader authority and was more open to regulatory guidance, Bazar said.
Eisenberg also said that the IRS and Treasury would have a difficult time drafting regs under section 163(j), given the more specific language contained in the statutory provisions of that rule. He said that if regs were issued reducing the amount of interest a U.S. company could deduct on an outbound note, options are limited in terms of what can be changed. Section 163(j) gives Treasury the authority to write regs making adjustments to the definitional terms, including "adjustable taxable income" and "net interest expense."
If Treasury were to redefine the term "adjustable taxable income," for example, in an attempt to reduce the allowable interest deduction, it would affect only the percentage of interest deduction allowed, rather than the entirety of the deduction, as would occur in guidance under the authority of section 385, Eisenberg said. He added that the makeup of any particular taxpayer's adjusted taxable income could differ greatly compared with others', making the effectiveness of those regs unpredictable.
Immediate Challenges Unlikely
Eisenberg said that despite concerns that will likely cause Treasury to "do some deep thinking" when drafting any earnings stripping rules, he thinks that many judges will find a way to hold that the regs are valid. He argued that standards of review set by courts in these types of cases are not always objective.
"A lot of times, a judge will look at the context under which the Treasury and the IRS issued a particular regulation and see if they are overstepping their bounds in that context," Eisenberg said. "Many judges will try and find a way to get the IRS and Treasury what they want in the right situation."
The number of companies that would have standing to challenge any targeted regs would likely be limited, especially if Treasury were to release earnings stripping guidance on an expedited basis, Eisenberg said. Given that any guidance would likely be retroactive to inversions occurring after September 22, there will probably be few companies that have inverted in that narrow time frame and that have issued debt that would be recharacterized as equity under that guidance, he said.
"If the IRS and Treasury can come out with those rules before the inversions actually take place, then those taxpayers are less likely to plan themselves into a fight with the IRS," Eisenberg said.
Other practitioners have previously argued that challenges to Treasury's earlier effort to limit inversions through Notice 2014-52, on both facial and administrative grounds, may come sooner rather than later. (Prior analysis.)
Bazar was skeptical of any legal challenge in the near term to either the anti-inversion guidance under the notice or potential guidance related to earnings stripping. "People spent a lot of time arguing over the authority for a lot of things that were out there. Never say never, but challenging regulatory authority takes a lot of time, and you usually don't want to plan into a transaction on the basis that [the IRS] didn't have the authority to issue a regulation," he said.
Bazar added that while taxpayers and practitioners would no doubt submit comments to Treasury regarding any proposed guidance, they rarely assert that the government lacks the authority to issue regs altogether.
"Authority challenges end up being in the courts, and it takes years. It's not like we're going to see a notice and we're going to see litigation on this that is resolved in six months," Bazar said. "I don't think we'll see immediate challenges. However, I think we'll see a lot of criticism."
Fallout From Future Guidance
At the November International Tax Institute event, Shay said that one consequence of a reclassification of debt as equity under section 385 would be that the reclassification would be for all purposes of the tax code, which was a distinguishing factor from section 163(j). He also said that self-help would be available to taxpayers under section 385.
"Let's say you're limited and your adjusted taxable income grows in subsequent years as it typically does in normal cycles, then you could reissue debt and test it at that point," Shay said.
Any potential limitations on companies' ability to take interest deductions may adversely affect foreign investment in the high-tax U.S., Bazar said.
"I certainly see it in my practice. I see non-U.S. companies exploring how they can efficiently capitalize their operations. Among those factors is managing their leverage and deductibility of interest," Bazar said. "And we see that a lot, in terms of scrutiny the IRS has been putting on debt-equity issues as well," he added, citing NA General Partnership v. Commissioner, T.C. Memo. 2012-172 (2012). In that case, the Tax Court held that an advance made by a Scottish utility business to its U.S. subsidiary in connection with the acquisition of a U.S. utility company was properly characterized as a loan instead of a capital contribution and that the interest paid on the loan was deductible by the subsidiary.
The 2007 Treasury study found that the effect that opportunities for income shifting had on investment was ambiguous. While lowering effective tax rates in high-tax jurisdictions through income shifting may support investment in those jurisdictions, the capacity to shift income may lead corporations to invest in low-tax jurisdictions to allocate taxable income to those jurisdictions, the study found.
"Existing empirical work does not address the question of whether income shifting raises or lowers the level of investment in high-tax countries," the study said.
Citing the Treasury study, a later Joint Committee on Taxation report on cross-border income concluded: "The best way to encourage increased investment in the United States (by foreign or domestic investors) is to increase the after-tax return to investment, and that outcome is more efficiently achieved by, for example, lowering the U.S. corporate income tax rate than by narrower policies such as the facilitation of earnings stripping."
Bazar said that lowering the corporate rates would present a much more equitable way to encourage investment among both U.S. and non-U.S. businesses, whereas earnings stripping rules focus only on non-U.S. parented businesses.
Regardless of its effect on investment, earnings stripping guidance is not likely to quash all the tax benefits enjoyed by inverters.
"The immediate potential benefit from a tax perspective was the potential access to deferred earnings. . . . The medium-term benefit is the ability to reduce your tax base through leverage, earnings stripping. And the long-term benefit is that non-U.S. earnings just aren't subject to tax," Bazar said. "The notice can shut down the short-term benefit, and they can issue more guidance that would arguably eliminate or mitigate the medium-term benefits, but none of this guidance addresses . . . the [long-term] benefit."
Bazar added, "The only way that is addressed is through tax reform."