The Treasury Department and the Internal Revenue Service have released final regulations on earnings stripping in an effort to reduce the tax benefits of corporate inversions.
Jacob Lew
The final regulations limit the ability of companies to lower their taxes by using transactions involving debt that do not support new investment in the U.S. The regulations require large corporations claiming interest deductions to document any loans to and from their affiliates, as businesses typically do when they borrow from unrelated lenders.
The Treasury proposed the controversial rules for Section 385 of the Tax Code in April along with temporary anti-inversion regulations (see Treasury Takes Further Action to Limit Tax Inversions). The proposals met with swift reaction, pro and con, including from Big Four accounting firms (see Big Four Protest Proposed IRS Regulations on Tax Treatment of Corporate Debt and Equity). The final regulations come after extensive public comment and engagement.
“This administration has long called for legislative action to fix our broken tax system,” Treasury Secretary Jacob J. Lew said in a statement Thursday. “In the absence of Congressional action, it is Treasury’s responsibility to use our authority to protect the tax base from continued erosion. We have taken a series of actions to make it harder for large foreign multinational companies to avoid paying U.S. taxes and reduce the incentives for U.S. companies to shift income and operations overseas. Such tax avoidance practices are wrong and should be stopped.”
He noted that throughout the rulemaking process, the Treasury sought comments and engaged with businesses, tax experts, the public and lawmakers. He insisted the Treasury carefully considered their comments and recommendations before issuing the final regulations.
“As a result of this process, the final rule effectively addresses stakeholder concerns by more narrowly focusing the regulations on aggressive tax avoidance tactics and providing certain limited exemptions,” said Lew.
One outcome of the feedback is that the final regulations exemp cash pools and short-term loans. The Treasury is providing a broad exemption for cash pools, which are basically common funding accounts for related businesses. In addition, the Treasury is also exempting loans that are short-term in both form and substance.
In addition, the Treasury is providing limited exemptions where the risk of earnings stripping is low. Therefore, transactions between foreign subsidiaries of U.S. multinational corporations and transactions between pass-through businesses are exempt from the final regulations. Financial institutions and insurance companies that are subject to regulatory oversight for their capital structure are also excluded from certain aspects of the rules.
On top of that, the Treasury has expanded the exceptions for distributions to generally include all future earnings and allowing corporations to net distributions against capital contributions. The Treasury is also including more exceptions for ordinary course transactions, such as acquisitions of stock associated with employee compensation plans.
The Treasury is also easing the documentation requirements in the final regulations. The Treasury has relaxed the intercompany loan documentation rules for U.S. borrowers. The regulations also extend the deadline by one year until Jan. 1, 2018.
“Coupled with our previous actions to address corporate inversions, these changes balance the operational needs of companies while preventing the erosion of our U.S. corporate tax base,” said Lew. “Nonetheless we cannot fully solve problems like inversions and earnings stripping through administrative action alone. The real solution is for Congress to enact comprehensive business tax reform with specific anti-inversion and earnings stripping provisions.”
Rep. Kevin Brady, R-Texas, who chairs the tax-writing House Ways and Means Committee, said the process was still too hurried for the Section 385 rules.
“American businesses and Members of Congress from both sides of the aisle have repeatedly asked the Administration to slow down and do the work necessary to ensure that final regulations under section 385 will not damage our economy and hurt American workers,” he said in a statement. “By rushing the review process—despite the extensive comments received—and finalizing these regulations so quickly, it appears that the Obama Administration has ignored the real concerns of people who will be most impacted by these far-reaching rules. I am going to carefully review these final regulations in the days ahead and hear directly from people across America about how these rules will impact our workers, our job creators, and our communities.”
Sen. Orrin Hatch, R-Utah, who chairs the Senate Finance Committee, also expressed his misgivings, saying he would have preferred for the Treasury to re-propose the regulations before moving forward.
“Since the day the regulations were first proposed, the Treasury Department has heard pointed concerns from both Republicans and Democrats, and from numerous American job creators and a wide variety of sectors across the U.S. economy that proceeding with the rules would be ill-advised and lead to unintended consequences for America’s innovators,” Hatch said in a statement. “While the final regulations will need to be scrutinized closely, it is immensely concerning that, despite stark bipartisan concern, the Obama Administration moved forward with completing rules that could jeopardize American businesses and the economy here at home. While Treasury has indicated they have attempted to address some of the major concerns such as cash pooling transactions, foreign subsidiary-to-foreign-subsidiary transactions, and Subchapter S Corporation financing, among others, the devil’s in the details. And, we’ll now have to carefully examine whether the regulations will make the policy less intrusive on some categories of legitimate business transactions.”
The final regulations drew some support from Democrats. Rep. Sander Levin, D-Mich., the ranking Democrat on the House Ways and Means Committee, praised them. “These regulations are another significant step the Administration has taken to restore fairness to the tax system and ensure multinational corporations pay their fair share of taxes,” Levin said in a statement. “For years, companies have been inverting and engaging in earnings stripping to unfairly lower their tax bills. In the absence of Republican action on tax reform, Treasury has used its Administrative authority to help bring fairness to the tax system. Today’s regulations from Treasury—which took into account extensive comments from the public and intensive meetings with Republicans and Democrats in Congress—go straight to the core of that fairness issue by strongly limiting a company’s ability to use this tax avoidance strategy, which involves disproportionately leveraging a U.S. company with debt and ‘stripping’ the U.S. tax base through deductible interest payments.”
Levin said the final regulations made “sensible changes” to the proposed regulations, so they would not unintentionally interfere with ordinary business transactions, such as transactions related to cash management and transactions where there is a low risk of earnings stripping, such as those between highly regulated companies. Democrats on the Ways and Means Committee had raised those issues in a June letter to Lew. However, Levin would still like to see Congress pass a bill he introduced in February to address the issue of earnings stripping and he blamed Republicans for blocking the legislation.
Sen. Ron Wyden, D-Ore., the ranking Democrat on the Senate Finance Committee, also praised the final Treasury regulations, but agreed with the need for Congress to act. “These final rules on Section 385 clearly reflect a lot of input and careful study, and in my view they will go a long way to protecting our corporate tax base,” Wyden said in a statement. “What this does not change is the need for tax reform. For too long Congress has sat on a broken and outdated tax system, which is why the U.S. has resorted to rule changes to respond to wave after wave of tax avoidance. The answer is for Congress to reform the tax code on a bipartisan basis.”
At least one tax expert sees both positives and negatives in the new regulations. “The rules are an improvement over those proposed but leave a number of problematic features,” said Ronald Dabrowski, a principal in the Washington National Tax practice of KPMG LLP, in a statement. “On the plus side, the documentation rule’s applicability date of 1/1/18 and the exception—for the time being at least—for foreign issuers were responsive to comments and were absolutely necessary. The carve outs for S corps, RICs, REITs, and certain regulated industries were also welcome.”
“But the rules’ general response regarding cash pooling will still be highly burdensome where they apply as will the retroactive application of the re-characterization rules,” Dabrowski added. “In addition, the focus will now shift to the states and how they will implement section 385.”