The debate over Section 385 continues.  The comment period ends today, and we sent in our comment letter along with the rest of the business community.

As we noted in our submission, the 385 regulations were advertised as a response to base erosion practices, but the rule itself is not limited to international transactions.  Nor is it limited to businesses of a certain size.  Instead, it targets the related party debt of domestic businesses of all sizes.   As our comments state:

Since their release, the broader business community has raised numerous concerns regarding scope of the Proposed Regulations, including the statutory authority under which they were drafted, the opaque process by which they were developed and released, and the additional costs and limitations they will impose on a broad range of traditional business loans and cash sharing arrangements. Described as a response to corporate inversions and base erosion practices, the proposed rule instead pulls in a broad array of businesses that have nothing to do with either. 

We share these concerns and recommend that the Proposed Regulations be withdrawn and recrafted. As currently drafted, the Proposed Regulations would apply to domestic businesses of all sizes – there simply is no de minimis threshold for the “bifurcation” rule that would allow the IRS to recraft debt as part equity.  See Treas. Reg. Section 1.385-1(d).  Without significant revision, we believe these Proposed Regulations are overly broad and will have a material and negative impact on business investment and hiring in the United States.  These negative effects are wholly unnecessary and could be avoided. 

As to our recommendations, S-Corp joined the rest of the business community in calling for Treasury to slow the process.  We also made a strong case for S corporations to be excluded from the rule.  Not only do S corporations have little opportunity to engage in the tax arbitrage practices targeted by the rule, but they also face a higher level of risk from the rule than other business forms.  As our comments note:

Unlike C corporations, the distinction between nondeductible dividends and deductible interest has virtually no significance for S corporations. Any income distributed to the shareholders of an S corporation in the form of dividends has already been taxed to them, and will not be taxed again upon distribution. Admittedly, income paid out in the form of interest will be deductible, but it will also be fully taxable to the recipient. Thus, all income in the S corporation context is taxed once, and only once, and there is no substantial tax motivation to recharacterize profits distributions (i.e., dividends) as interest in order to achieve deductibility at the corporate level. It was primarily this concern, which does not apply in the S corporation context, that gave rise to the enactment of Section 385 of the Internal Revenue Code to begin with.

And:

The importance of providing S corporations with an exception from the Proposed Regulations is compounded by the fact that S corporations are subject to the single class of stock requirement, as well as the limitations on eligible shareholders.  Internal Revenue Code Section 1361(b)(1)(B),(D). 

As a result, if S corporations were subject to the Proposed Regulations, recharacterization of related-party indebtedness as stock would result in the loss of S corporation status in nearly all circumstances. The requirement that qualified subchapter S subsidiaries be 100% owned by the S corporation parent would similarly result in “Q-Sub” disqualification in the vast majority of circumstances. Internal Revenue Code Section 1361(b)(3)(B)(i).

The loss of S corporation status, in turn, would result in costs far in excess of any recharacterization of debt into equity, including the payment of IRS and professional fees necessary to seek restoration of S corporation status, the need to change how the business is financed in order to avoid future disqualifying events, and back taxes and penalties related to the disqualification if the corporation is unable to “cure” the loss of S corporation status with IRS consent. 

So S corporations have little or no opportunity to game the system and they would be unduly harmed by the effects of the proposed rule.  If and when Treasury moves forward with this rule, S corporations should be excluded.

 

More Hill Actions on 385

A couple items of note on 385 from the Hill.  First, a group of Finance Committee Republicans, led by Senator Dean Heller (R-NV), wrote to Treasury late last week expressing their significant concerns over the rule. As the letter states:

Over the past few months, we have heard from numerous stakeholders, including small businesses, business associations, and companies with operations in our home states that would be impacted if the proposed regulations are implemented without significant alterations.  We respectfully request that, at a minimum, you substantially modify the proposed rules so that ordinary business transactions unrelated to tax avoidance are not adversely affected by the broad scope of these proposed rules. 

The letter goes on to highlight several of the authors specific concerns, including the harm the proposed rule will have on S corporations:

Below are just a few of the concerns we have repeatedly heard from stakeholders regarding these regulations.  We note this is not an exhaustive list.  In addition to the other critical issues that have been raised, we expect to see – at the very least – the following reforms should Treasury decide to finalize the proposed regulations:

  • Ensure that S corporations, a critical component of America’s small business community, do not lose their S corporation tax status by virtue of having their debt recharacterized as equity and are not penalized for their domestic-to-domestic transactions…

Next, the Joint Committee on Taxation hosted a “closed door” meeting yesterday morning for Treasury officials to brief a bipartisan group of tax writers from both the House and the Senate.  According to Politico:

Treasury officials were less than enthused – read, not at all – Wednesday when congressional tax writers suggested they should slow down their implementation of Section 385 regulations, which have become the most contentious tax issue in town. Our Katy O’Donnell reports that members of the Joint Committee on Taxation met behind closed doors with Mark Mazur, assistant secretary of the Treasury for tax policy, and Bob Stack, deputy assistant secretary for international tax affairs, for about two hours. House Ways and Means Chairman Kevin Brady said the men “seemed somewhat dismissive” of the idea of delaying the regs, which would re-classify some debt as equity in related-party financing transactions and are a key part of the Obama administration’s effort to fight inversions. Businesses are convinced the rules, as written now, will hamstring legitimate transactions. Rep. Sander Levin, the top Democrat on Ways and Means, was a little more charitable than Brady. “The administration made clear that they are going at this deliberately,” he said. “They know there are some specific concerns, and they expect to be able to address them.”

Tax Notes added this:

After a July 6 meeting with some Treasury officials to discuss controversial debt-equity proposed rules, some taxwriters remained unsatisfied that the Treasury Department will move to accommodate congressional and stakeholder concerns about section 385.

“It did not sound to me that they had a complete plan that would work,” Senate Finance Committee Chair Orrin G. Hatch, R-Utah, told reporters as he emerged from the closed-door meeting that also included Joint Committee on Taxation members and several House and Senate taxwriters and their staff.

“This is very complex, and it’s going to be very difficult for businesses,” Hatch said, adding that there is “a real chance” that the proposed rules (REG-108060-15) would push more U.S. companies to move abroad.

Asked if there were specific areas, such as the treatment of S corporations and cash pooling, that Treasury would accommodate, Hatch said, “They think they are making accommodations — to the degree that they are — but I question if they are making enough accommodations. We’ll see.”

Our own feedback also suggests the discussion went far beyond questions of timing and covered the effects of the proposed rules on cash pooling practices, the insurance and banking industries, and the cost the rule will impose on the business sector and the economy as a whole.  The particular plight of S corporations was raised by a number of members and discussed at length.

The “official” comment period for the proposed 385 rules may close today, but we expect the policy and political discussion surrounding the rule to continue in an energized fashion.  This rule is expansive and harmful, and it needs to be changed significantly if it’s going to accomplish the goals of its authors without destroying jobs and investment in the process.  That’s the message from the Hill and the business community.  Time will tell if Treasury is listening.