Three Major Concerns of the Proposed Debt-Equity Regulation
July 29, 2016
On July 14th, the IRS held a public hearing for the debt-equity rule (section 385 of the IRS code) that the Treasury Department proposed last April. The hearing, which had as many as 16 speakers from various industries, was only a supplement to almost 30,000 comments that were submitted for this rule on the Federal Register. Presenters brought up three major concerns:
1. Broad Scope of the Regulation
The intent of the regulation is to stop interest stripping by companies that have inverted from the United States. However, some claim that the scope of the current version of the proposed rule may hit other transactions that have nothing to do with tax inversions. As a PricewaterhouseCoopers LLP representative pointed out at the hearing, “recent reports put the number of inversions over the last three decades at 67.” This is compared to the 2,243 U.S. parented multinational companies, 26,919 foreign affiliates of those U.S. companies, and 5,121 foreign-owned U.S. companies that could be impacted by this regulation.
Multiple ordinary business and financial transactions like shareholder loans or securitization transactions would be reclassified as equity, affecting a large number of corporations. After all, many companies use debt transactions among affiliates as a means of cash management or changing internal capital structure for more liquidity, not corporate tax avoidance. These transactions would often have to be taxed under the proposed rule – a concern shared by multiple speakers and commenters.
2. Timeliness of the Implementation of the Rule
As soon as the rule is finalized, the regulation would take effect in retrospect from April 4, 2016. However, companies would be given a 90-day grace period to adjust to the regulation as soon as it finalized. Multiple speakers raised a concern that this is by no means enough time – most speakers called for an effective year of 2019 – should the regulation pass.
The U.S. Chamber of Commerce reported that companies need time to not only to understand the impact of the rules, but also to implement systems to comply with these rules. Companies would potentially need to change the way they do business transactions following the execution of the regulation. A rule effective immediately would not only bring additional costs to companies, but also put certain companies in a position where they are unable to comply.
Some commenters stated that the compliance issue is a large one. PwC, in its public comment, claimed that “many, if not most, taxpayers do not have systems in place that would allow them to track the information needed to comply.” A lot of documentation requirements that the IRS would impose to determine whether a transaction is debt or equity are not even tracked by corporations. As a result, companies would need time to expand these responsibilities and start tracking transactions properly. Additionally, some of the past transactions may, in retrospect, be impossible to document properly, and, therefore, should not be subject to regulations.
3. Potential effective elimination of S Corporations
While this concern was brought up at the public hearing by only one speaker (National Association of Manufacturers), there were several comments pointing out a significant issue for S Corporations. S Corporations do not pay the corporate income tax; instead, the shareholders are taxed on the income they receive from owning stock of the S Corporation. This benefit comes with a caveat, however, as the number of shareholders of an S Corporation is limited at 100.
Quite often, according to the S Corporation Association, a shareholder owns equity of an S Corporation that is broken down into related affiliates. Even though the owner is the same for these affiliates, they are completely separate —but related – entities. These entities make extensive use of related party debt for the purposes of cash management and increase of liquidity of assets. If any of this debt is transformed into equity, these related entities would effectively be paying each other dividends and that, consequently, would qualify these related entities as owners of each other. That violates the shareholder requirement that an S Corporation has, forcing it to lose its status.
This issue has significant implications for more than 4.5 million companies in the United States, as these S Corporations would effectively become regular corporations and have a new set of taxes and regulations. According to the S Corporation Association, “re-characterization of related party indebtedness as stock would result in the loss of S corporation status in nearly all circumstances,” effectively getting rid of S Corporations altogether.