The section 385 regulations on the distinction between debt and equity are now final, and despite what tax advisers and Congress have been saying for months, the world did not come to an end. In fact, the barrage of negative comments and nasty letters from lawmakers profoundly affected Treasury, and the once-sweeping regulation package was significantly carved back. In a few years, when the U.S. tax base is even further eroded, the government will almost certainly rue this guidance as a profound missed opportunity.
Far from gloating over their success in trimming the section 385 regulations back, practitioners are still upset that the funding rule and its six-year presumption survived. Without that rule, however, there would have been little point to the package. And Treasury carved out a ton of exceptions for cash pooling, foreign loans, regulated financial entities, passthroughs, and short-term loans. Of course, it shouldn't be shocking that the tax planning community wanted more. In fact, what it wanted was the package scrapped altogether so multinationals could continue to manufacture deductions at will.
The goal of the section 385 regulations was to recast intragroup debt as equity when that debt was being used to strip earnings out of the United States. Interest stripping has been a major factor in the decline in U.S. corporate tax revenues and contributes to the impression that the U.S. corporate tax base is under siege. Companies use transactions that are not economically motivated to essentially strip income out of the United States and shift it to lower-tax jurisdictions. These transactions often take the form of loans that aren't really loans.
The original regulations were broad. Practitioners cried that many ordinary course transactions would be implicated, without really addressing whether those transactions should ever have existed to begin with. Lawmakers, primarily the GOP heads of the taxwriting committees, argued that Treasury was impinging on the prerogatives of Congress -- without acknowledging both the broad grant in section 385 and Congress's failure to address base erosion.
There were almost certainly problems with the original section 385 regulations. And taxpayers may still be successful in challenging the guidance in court despite the exceptions that Treasury granted (although a successful APA challenge would tell us little about the substantive merits of the regs). But commentators and average taxpayers should not lose focus on what the regulations were trying to stop.
Because of how U.S. tax laws are written and especially how they are administered by a pro-business Treasury Department, U.S. multinationals engage in myriad paper transactions that have little economic or business purpose. Intragroup loans are among the least necessary of these types of deals. It makes almost no sense for a government to allow multinationals to generate interest deductions at will by moving money around their component parts. This is separate company accounting at its worst.
Shortly after the regulations were released, Robert Stack, Treasury deputy assistant secretary (international tax affairs), said that multinationals do not have a God-given right to generate deductions anywhere in the world. Unfortunately, it's his agency that has long permitted companies to think they have that right. And by scaling back the scope of the section 385 regulations, Treasury missed a major opportunity to finally roll back some of the tax abuses that it has long enabled.