Tax Analysts Blog

Treasury Flubs Golden Opportunity With Debt-Equity Regs

Posted on Oct 19, 2016

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.  

Read Comments (2)

Mike55Oct 19, 2016

While I agree with your larger perspective (i.e., interest expense driven base erosion is a problem that must be addressed), I nevertheless believe the proposed 385 regs. were abhorrent. The reason for this seeming contradiction is that I think the "means" matter, not just the intended "ends."

Even supporters freely admitted the proposed 385 regs. were a blunt, flawed, haphazard instrument for tackling interest expense driven base erosion, so there's no need for me to belabor that point. The standard defense was to point out that Treasury can only use the tools available to it, and inexcusable Congressional inaction resulted in a toolkit containing nothing but a sledge-hammer with a cracked handle. This much is quite true. But the problem with this line of thinking is that it's ultimately hollow: there's no amount of blame laying ("the Republicans made us do it!"), excuses ("we were just trying to save the tax base!"), or brilliant mental gymnastics (see e.g., any Stephen Shay article on 385) that can turn bad tax policy into good tax policy. As a result what this article is really saying is that Treasury missed a "Golden Opportunity" to enact bad tax policy.

Some might counter that even really bad tax policy is better than nothing at all. I disagree. There's a benefit to having well established, predictable laws that those impacted understand and can efficiently comply with. This is why, as a general rule, we endeavor to only pass new tax laws that represent a meaningful improvement over what existed before: the law must be at least good enough to overcome the benefits of predictability and clarity. No matter how well intentioned (and I agree that the 385 regs. were well intentioned; had the text accomplished what the preamble claimed, all would be well), bad tax policy cannot satisfy that threshold.

*My personal favorite is one of the more extreme solutions: significantly curtail ALL interest deductions -- even those paid to unrelated parties -- then use the proceeds to further accelerate cost recovery. Keep it revenue neutral on a static basis (presumably acceptable to Republicans when one tax benefit is being traded for another tax benefit). Opportunities for meaningless rhetoric would be available on both sides of the aisle, hopefully placating the countless legislators who only care about their next election (Democrats can say they "went after the Big Banks and Wall Street investment funds" while Republicans can say they "slashed taxes for U.S. manufacturers"). This would also be an incremental step towards fundamental corporate tax reform (since an interest expense deduction scale back and full expensing are likely to be key features of almost any rational plan). Some core Republicans would of course complain about the lack of any statutory rate relief, but too bad, compromise is never perfect.

Mike55Oct 20, 2016

I deleted the reference to the "*" accidently: the intended point was that there are several good, bipartisan options for eliminating interest driven base erosion. I'd do so by ending the disparity between debt and equity capitalization generally, thereby curing the disease rather than attacking one of its symptoms.

There are numerous less extreme options available as well.

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