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Comments on proposed regulations on the allocation of interest expense under Sections 861 and 864(e): July 24, 1991.

On March 11, 1991, the Internal Revenue Service issued proposed Income Tax Regulations under sections 861 and 864(e) of the Internal Revenue Code concerning the allocation and apportionment of third-party interest expense of an affiliated group of corporations. The proposed regulations (INTL-952-86) were published in the Federal Register on March 12, 1991 (56 Fed. Reg. 10397); corrections were issued on March 22, 1991 (56 Fed. Reg. 12141); and conforming, proposed regulations were published in the April 8, 1991, issue of the Internal Revenue Bulletin (1991-14 I.R.B. 27). A public hearing on the proposed regulations was held on June 21, 1991. When final, the proposed regulations will replace existing temporary regulations promulgated under section 1.861-10T(e) of the Income Tax Regulations. (1)


Tax Executives Institute, Inc. is the principal association of corporate tax executives in North America. Our nearly 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply. Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operations of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the allocation of third party (2) interest expense of an affiliated group to interest income received from "related" controlled foreign corporations.

The "Netting Rule" Lacks

a Sound Statutory or Tax

Policy Basis

Proposed regulations to implement section 864(e) of the Internal Revenue Code of 1986 were initially published in the Federal Register on September 11, 1987. The proposed regulations were withdrawn and replaced by temporary regulations and a notice of proposed rulemaking on September 14, 1988. In certain circumstances, Temp. Reg. [Section] 1.861-10T(e) requires that third-party interest expense of an affiliated group of corporations be allocated directly to interest income received from related controlled foreign corporations (CFCs). (3) The March 1991 proposed regulations endeavor to respond to the numerous comments on Temp. Reg. [Section] 1.861-10T(e), which sets forth the roundly criticized "netting" rule.

In prior comments filed on November 9, 1987, and February 14, 1989, TEI stated its position on the netting rule: it violates the general fungibility principle adopted by Congress in enacting section 864(e). TEI reiterates its opposition in principle to any form of netting rule -- including the latest mutation. As we pointed out in our comments of February 14, 1989:

The statute and related legislative history provide absolutely no authority for the Treasury's emasculation of the fungibility principle. Indeed, the legislative history not only supports the fungibility concept, but evinces a congressional intent to encourage lending rather than equity investment in foreign subsidiaries. (Citations omitted.)

TEI continues to believe that the concept of fungibility mandated by Congress should be respected by the Treasury Department and IRS in uniform, even-handed regulations. The IRS should not invoke the fungibility concept only when it enriches the U.S. Treasury. The quotation in the preamble, which is cited as the authority for a netting rule, from the Conference Report to The Tax Reform Act of 1986, is inapposite. The quotation is excerpted from a paragraph dealing with integrated financial transactions under section 864(e)(7)(B) of the Code. (4)

Although the proposed regulations endeavor to narrow the focus of the reformulated netting rule to "tax motivated on-lending" of U.S. shareholder indebtedness, the Treasury Department and IRS still paint with too broad a brush and from too indiscriminate a palette. Legitimate, non tax-motivated financing of controlled foreign corporations is tinged with the same scarlet taint as the tax-motivated borrowing and subsequent on-lending that the proposed regulations seek to curb. (5)

The latest reincarnation of the netting rule alters the groups of taxpayers burdened by the regulations. Concededly, if there is to be a netting rule at all, some taxpayers undoubtedly will prefer the latest version, whereas other taxpayers will find the temporary regulations preferable. The threshold question, however, is whether the Treasury Department and IRS have the authority to fashion two sets of regulations with such disparate effects. Congress clearly has the power to determine which taxpayers are disadvantaged by its laws, and, indeed, to enact succeeding sets of rules that shift the burdens from one class of taxpayers to another. In the absence of a clear congressional mandate for a netting rule, however, the Treasury and the IRS should not arrogate to themselves the power to issue uneven rules. (6)

Furthermore, taxpayers have relied upon the temporary regulations for nearly three years in financing their CFCs. Capital and debt structures may have been adjusted and transactions entered into in response to and in reliance on the temporary rules. Depending upon the size and nature of a financing transaction, considerable planning, negotiation, and legal documentation were necessary to implement domestic affiliated group and CFC capital and debt structures, and those structures have both economic effect and substance. Taxpayers generally will be unable to instantaneously "unwind" decisions made during the incumbency of the temporary regulations. Consequently, transitional relief in the form of additional safe harbors may be necessary to mitigate ongoing adverse consequences from good faith reliance upon the temporary regulations. (7) In promulgating the proposed regulations, the Treasury and the IRS ignored the mandate of Congress regarding the fungibility of debt, disregarded the numerous constructive criticisms of tax practitioners, and fashioned rules that, at once, make it more difficult for U.S. corporations to compete abroad and are so complex that they make voluntary compliance with the U.S. tax laws extremely difficult, if not literally impossible. TEI believes the Treasury Department and the IRS should exorcise one of the demons of the complexity by abandoning the netting rule. (8)

Even assuming that promulgation of a netting rule is properly within the scope of the law and the Treasury Department's delegated authority, TEI recommends that the rule be rescinded as totally at odds with the principles of tax simplification and sound tax administration. Thus, the Treasury Department should pay heed to the words of Commissioner Goldberg who recently testified:

[T]he well-meaning quest for theoretical purity, coupled with an unending stream of "microamendments" of marginal importance, have spawned an unacceptable burden of complexity and uncertainty -- complexity and uncertainty that impose a staggering cost on business taxpayers, compound the federal deficit by eroding voluntary compliance, and undermine the ability of the IRS to carry out its mission. (9)

Proposed Changes to the

Netting Rule

Despite TEI's belief that a netting rule contravenes congressional intent and sound tax policy, there are a number of specific technical comments that we wish to submit to assist the IRS in clarifying the application of the rule (if the Treasury Department persists in its effort to maintain the rule) and to render the regulation less offensive and more administrable.

A. Overview

Temp. Reg. [Section] 1.861-10T(e) treats lending by a U.S. affiliated group to its related CFCs as tax-motivated if the related CFC group owes a disproportionately small amount of indebtedness to unrelated third parties. Under the temporary regulations, a related CFC group has "excess related person indebtedness" (ERPI) if the aggregate debt-to-asset ratio of all CFCs is less than 80 percent of the debt-to-asset ratio of the U.S. affiliated group. The temporary regulations prescribe complex rules for recharacterizing a CFC's ERPI until the aggregate debt-to-asset ratio is at least 80 percent of the related affiliated group. Under the rules, third-party interest expense of the U.S. group is allocated directly to the interest income received on the ERPI by the group.

The temporary regulations were criticized for not recognizing that the debt-to-asset ratios of CFCs may vary from that of the related U.S. group for legitimate, non-tax business reasons and, further, that to the extent intercompany loans are financed by the retained earnings of the U.S. group, there is no tax-motivated lending. The proposed regulations attempt to respond to these criticisms by more closely approximating the amount of tax-motivated U.S. group borrowing and on-lending to CFCs. Specifically, the proposed regulations set out a two-step process to identify the amount of tainted interest income from CFCs. The third step in the process is to allocate the third-party interest expense of the U.S. group among the various separate foreign tax credit limitation categories of section 904(d).

Step One of the proposed regulations identifies the potentially tax-motivated lending to the related CFC group and defines it as "excess related group indebtedness" (ERGI). ERGI is the amount of intercompany loans (related-group indebtedness) in the current year (which is an average of the beginning and end of the year amounts) in excess of the amount that would have been proportionate to the average allowable related-group indebtedness to CFCs during the five base period tax years. (10) The allowable related group indebtedness is equal to the product of multiplying the aggregate value of CFC assets by the foreign base period ratio (FBPR). The FBPR is the average of the base period years' ratios of related group indebtedness to CFC assets. Again, for purposes of the FBPR, the related-group loan and CFC asset amounts are averages of the beginning and end of the year amounts. Under a de minimis safe harbor rule, ERGI does not exist in a given year if the related group indebtedness for such year does not exceed (i) the prior year's allowable ERGI; (ii) 10 percent of the average aggregate value of CFC assets; or (iii) the current year's allowable related group indebtedness (RGI).

Step Two of the proposed regulations attempts to determine the amount of affiliated group borrowing used to finance tax-motivated related group indebtedness. The tainted borrowing, defined as "excess U.S. shareholder indebtedness," is the excess of the amount of the affiliated group's borrowing for the year (again, an average of beginning and end of the year amounts) over the amount that would have been proportionate (given the average current year's assets of the affiliated group) to the average of the U.S. group's debt-to-asset ratio during the base period tax years. The average of the five years of debt-to-asset ratios is referred to as the "U.S. base period ratio."

The moving average formulas used for determining the foreign and U.S. base period ratios are averages of the five-year ratios. Thus, the ratios are unaffected by the absolute amounts of assets, debt, or intercompany loans on the books of the affiliated group or the CFCs. An additional limitation prevents the year-to-year increase in the base period ratios from exceeding 10 percent.

B. Specific Comments

1. Base Period Ratios. When calculating the foreign base period ratio (FBPR) (Prop. Reg. [Section] 1.861.10(e)(2)(iv)) and the U.S. base period debt-to-asset ratio (Prop. Reg. [Section] 1.861-10(e)(3)(iv)) for the year, the relevant debt-to-asset ratio for any base period year may not exceed 110 percent of the relevant base period ratio for that base year. TEI recommends that the mechanics of this rule andits application to particular years be clarified. Read literally, the 110-percent limitation requires that each year of the base period ratio itself be tested against its base period ratio. Accordingly, the allowable related group indebtedness and the FBPR must be calculated from the first tax year that a CFC was incorporated or acquired. (11) Similarly, the U.S. debt-to-asset base period ratios must be calculated from the earliest incorporation date of any one member of the affiliated group.

The purpose of the 110-percent rule is presumably to provide "limitations. . . on the extent to which a substantial increase in a current year ratio may be reflected in the base period ratio for subsequent years." (12) TEI objects to the 110-percent limiation on base period ratios for a number of reasons.

a. Tethered Ascent/Free Fall Descent. For valid business reasons, U.S. indebtedness and lending to CFCs will fluctuate from year to year. TEI objects to a rule that limits increases in the base period ratios but does not apply correspondingly to limit decreases in the ratios. The rule retards the effect of increase in intercompany lending or U.S. incurred debt on subsequent year's allowable amounts of related group indebtedness. In contrast, decreases in intercompany lending or outstanding levels of debt in any given tax year fully and immediately limit subsequent future increases because the decrease is reflected without a limitation. In other words, taxpayers have a tether slowing the ascent of allowable intercompany loans to CFCs but free fall without a parachute to the lowest possible level when either U.S. debt levels or intercompany loans decline. Taxpayers who pay down U.S. third-party debt without reducing intercompany loans become subject to the netting rule when U.S. debt subsequently increases. The proposed regulations presume that taxpayers whose U.S. debt levels fluctuate are engaged in tax motivated on-lending to CFCs. That presumption is fallacious, however, where intercompany loans remain at a fixed level and U.S. debt increases as a result of unrelated business decisions.

b. Redundant Anti-Abuse Measure. The proposed regulations represent a classic case of "piling on." A five-year moving average ratio limitation is more than adequate as a prophylactic against ill-conceived, tax-motivated transactions. Standing alone, the five-year U.S. and foreign base period ratios substantially limit the ability of a taxpayer to manipulate the netting rule. Nevertheless, the regulations containe the redundant 110-percent limitation. TEI submits that the 110-percent limitation is an unnecessary, administratively complex, preventive measure. If the percentage limitation is retained, it should be increased to at least 125 percent. (13)

c. Base Year or Tax Year Limitation? TEI believes that application of the 110-percent limitation to each base period year for each ratio serves no valid purpose. If a secondary limitation beyond the five-year averaging rule is necessary, TEI submits that the rule should be applied to limit the allowable increase in the tax year to 110 percent of the cumulative average base period ratio rather than applying the 110-percent limitation to each base year prior to averaging. Thus, the actual data for each year would be used in calculating the base period ratios and so long as the average increase per year during the preceding five years does not exceed 10 percent, the secondary limit should not apply. This proposed refinement of the rule accommodates fluctuating levels of debt and intercompany lending. For example, a taxpayer could increase its debt or loans to CFCs by 5 percent in year one and by 15 percent in year two but the average increase would only be 10 percent.

d. Low Ratio Base Periods, Start-up Operations, or Expansion of Foreign Investment. Because the netting rule is triggered by increases in debt levels without regard to their motivation, the proposed regulations penalize taxpayers that borrow a finance start-up operations and expanded foreign investments. Moreover, the "penalty" period caused by the proposed regulations' 110-percent limitation will persist for an excessive length of time. Indeed, the length of the initial penalty period will be inversely related to the amount of the first tax year's base period ratio. As the base period ratio approaces zero, the penalty period extends infinitely. (14) The drafters of the regulation recognized this problem and crafted a rule that allows taxpayers with no CFCs at the effective date of the regulations to have as a minimum base an FBPR and U.S. debt-to-asset ratio of 0.10. That relief is far too modest. A taxpayer with a relatively low foreign base period ratio will be unable to increase its related person indebtedness without application of the rule because small absolute amounts of increases in intercompany lending will cause a substantial increase in the foreign debt-to-asset ratio. For example, a taxpayer whose loans to CFCs represent 5 percent of total CFC assets would be permitted to increase related group indebtedness by on 0.5 percent under the 110-percent rule. Similarly, a taxpayer increasing its investment in foreign operations will be handicapped vis-a-vis established businesses with existing high levels of FBPR. The hardships to taxpayers in these circumstances can be mitigated by eliminating the 110-percent limitation and adopting the additional recommendations set forth below in the discussion of safe harbor rules.

e. Summary. For the foregoing reasons, TEI recommends that the 110-percent limitation be deleted from the regulations. In the alternative, the limitation should be increased to 125 percent.

2. Safe Harbor Provisions. Under Prop. Reg. [Section] 1.861-10(e)(2)(vii), a U.S. shareholder will not have ERGI for the year if (i) the related group indebtedness does not exceed the immediately preceding year's allowable related group indebtedness; (ii) the related group debt-asset ratio for the year does not exceed its FBPR; or (iii) the related group debt-to-asset ratio does not exceed 10 percent. The safe harbors, which TEI applauds in concept, fail in practice to accommodate a number of nonabusive situations. We recommend that they be expanded.

Safe harbor rules should carve out minimum zones of acceptable activity. The 10-percent safe harbor in Prop. Reg. [Section] 1.861.10(e)(2)(vii), however, operates in a cliff-like fashion -- exceed it by as little as one dollar, and the entire amount of related person indebtedness is subject to the rigors of the two-step process of identifying tax-motivated CFC financing. TEI recommends that, at a minimum, only the incremental amounts of indebtedness in excess of the safe harbor amount should be subjected to the two-step identification process. Thus, two similarly situated taxpayers, taxpayer A with related group indebtedness of 10 percent of taxpayer B with related group indebtedness of 11 percent, should not incur disparate tax results with all of the A's RGI "safe" and all of B's RGI potentially "tax motivated." Taxpayer B's related group indebtedness in excess of the 10-percent safe harbor should be the relevant measure of "tax-motivated" indebtedness.

The proposed regulations prescribe no safe habor level of U.S. indebtedness. TEI recommends such a safe harbor be crafted. To establish a realistic level of safe harbor U.S. indebtedness, the IRS should review statistical abstracts published by corporate credit rating agencies such as Moody's or Standard & Poor's. As a starting point, TEI recommends that the IRS a de minimis rule recognizing that a certain level of third-party debt (say, 20 percent of the U.S. shareholder's assets) is reasonably necessary to operate the worldwide business of the group. The de minimis amount should be disregarded in determining the existence of "excess U.S. shareholder indebtedness." We submit that this proposal, which reflects a one-to-four debt-equity ratio, is quite conservative.

In addition, TEI recommends that the safe harbor allowing up to 10 percent of CFC assets to be financed through intercompany loans be increased to 20 percent. (15) Such a rule would give businesses the flexibility to make short- and intermediate-term financing decisions to cover fluctuating working capital requirements. Again, we believe that only incremental loans to CFCs above the de minimis safe harbor percentage should be subject to the netting rule.

Finally, if the 110-percent limitation rule is retained, TEI recommends that the proposed regulations allow taxpayers to use the greater of the safe harbor percentage noted above (20 percent of worldwide assets financed by third-party debt and 20 percent of CFC assets funded through related person indebtedness) or the taxpayer's actual (or allowable) base period data when calculating the relevant debt-to-asset ratio. As previously noted, the proposed regulations handicap taxpayers with relatively low levels of U.S. shareholder debt or low levels of related person indebtedness vis-a-vis business competitors. Taxpayers should be able to increase or decrease related group indebtedness within a minimum floor without concern for future tax implications.

3. Determination of CFC Asset Values. Prop. Reg. [Section] 1.861-10(e)(6) provides that for purposes of computing the allowable related group indebtedness in paragraph (e)(2)(iii) and related group debt-to-asset ratio of the U.S. shareholder in paragraph (e)(2)(iv), the value of assets of a related CFC are to be determined in accordance with the valuation method (tax book value or fair market value) elected for the year pursuant to Temp. Reg. [Section] 1.861-9T(g) or (h). The proposed regulations, however, make no reference to Temp. Reg. [Section] 1.861-9T(f)(3), which permits a taxpayer to apportion interest expense at the CFC level using a modified gross income method. The alternative was developed in recognition of the difficulty of valuing CFC assets.

A U.S. shareholder using the modified gross income method under Temp. Reg. [Section] 1.861-9T(f)(3) to apportion interest expense at the CFC level will not normally determine the value of its related CFC's assets under either of the indicated methods (though the basis of assets must be determined when the asset is sold or the section 1248 amount determined.) Consequently, the proposed regulations will vitiate the salutary effects of the modified gross income method by requiring taxpayers that elect that method to nevertheless value related CFC assets. TEI submits that Form 5471 provides asset and liability information that is sufficient to meet the purpose of Prop. Reg. [Section] 1.861-10(e)(f). We recommend that the IRS allow taxpayers to use this information in lieu of imposing another data collection burden. (16)

4. Definition of Indebtedness. "Indebtedness" is defined in Prop. Reg. [Section] 1.861-10(e)(8)(i) to have the same meaning that it has under section 163. The latter section, however, concerns itself with the deductibility of interest on indebtedness paid or accrued within the taxable year, and does not itself clearly define "indebtedness." (17) TEI believes that more is needed than a cross-reference to section 163 and recommends that Temp. Reg. [Section] 1.861-13T(a)(3) be used as the model for a definition of indebtedness. (18)

In addition, TEI objects to the IRS's attempt to create a method of accounting for the classification of indebtedness on the balance sheet. TEI appreciates the IRS's desire for consistent classification of assets and liabilities from year to year to avoid manipulation of the netting rule. Fiddling with the Code's accounting method rules, however, is not the proper way to act upon that desire. Accounting methods relate to the treatment of income and expenditures -- whether as capital or expense items. TEI believes that it is improper for the IRS to create a new rule requiring permission from the Commissioner whenever a change in the classification of an asset or liability is made. For example, in the normal course of debt repayment, a portion of long-term debt (payment due more than one year beyond the balance sheet date) may be reclassified annually to short-term debt. Accounting rules promulgated by the SEC and FASB require such reclassification. Would this change in classification require the approval of the Commissioner under the proposed regulations?

TEI submits that the IRS is venturing into uncharted territory when it endeavors to impose accounting method status on balance sheet classifications. If the accounting method rule is retained, IRS should consider adopting a materiality exception for the classification of liabilities as indebtedness. The materially principle of generally accepted accounting principles, which affords management reasonable latitude in the presentation of the balance sheet, provides a greater degree of flexibility than the Internal Revenue Code's "accounting method" standard. In the alternative, a safe harbor could be crafted for balance sheets presented in accordance with generally accepted accounting principles.

5. CFC Stock as Related Person Indebtedness. Under Prop. Reg. [Section] 1.861-10(e)(8)(iii), certain stock of CFCs is to be classified as related person indebtedness if such CFC claims a deduction under foreign law for distributions on such stock. A longstanding axiom of federal tax law, however -- one defended fervently by the IRS and upheld by the Supreme Court in Goodyear v. United States -- is that U.S. tax principles govern the determination of U.S. income tax liability. Prop. Reg. [Section] 1.861.10(e)(8)(iii) ignores this principle by substituting the foreign law characterization of a financial instrument in the determination of whether stock is recharacterized as an intercompany loan. If an instrument is considered equity under U.S. law, it should be treated as equity for purposes of the netting rule.

6. Substantial Distortion Resulting from Significant Acquisition. Prop. Reg. [Section] 1.861.10(e)(9)(iii)(A) states that the taxpayer must take into consideration the average values of acquired indebtedness and assets when "major acquisitions" are made near the end of the year that result in a "substantial distortion of values for the year." The rule requires taxpayers to make judgments without objective standards on key issues, and subjects these judgments to IRS review upon examination. TEI believes the regulations themselves should provide guidance on what constitutes a "major acquisition," how a "substantial distortion of values" is determined, and how the average values are to be weighted to reflect the time held by the taxpayer. Without objctive standards, application of these rules may be inconsistent and arbitrary.

To be consistent in approach, the IRS presumably intends to use a monthly average of debt-to-asset ratios for the year to avoid weighting the result by the absolute amount of assets and debt acquired. TEI recommends that, in the event of acquisitions near year end, the IRS adopt a monthly averaging convention to compute the various ratios and related group indebtedness for the year. Regardless of whether the debt-to-asset ratios are determined on a weighted or unweighted basis (i.e., whether a monthly average of debt-to-asset ratios is computed or monthly average debt and monthly average assets are used to compute a single ratio), the alternative method of calculation should be enumerated so that taxpayers have certainty of the result rather than await potentially inconsistent or arbitrary administrative action by IRS agents.

7. Acquisition Debt. Under the proposed regulations, indebtedness incurred to finance U.S. stock acquisitions will be taken into account in determining whether a tainted increase in U.S. shareholder indebtedness has occurred. If a taxpayer pays a significant premium above the historical asset tax basis for the stock of a company that becomes a member of the affiliated group, a significant hardship will occur under the proposed regulations (assuming a section 338 election is prohibitive expensive.) For purposes of the netting rule, the taxpayer should be permitted to use the basis of the shares acquired (outside basis) rather than the basis of the assets (inside basis) of an acquired company for purposes of calculating the related person indebtedness. TEI further suggests that these rules include a provision to prevent inequity when the basis in the acquired shares "disappears" as a result of a liquidation of the acquired company or a transfer of the assets within the affiliated group.

In the IRS's proposed "earnings stripping" regulations under section 163(j), an analogous problem of measuring an appropriate debt-to-asset ratio is sensibly handled: a special wasting asset is created and amortized over a 15-year period. (19) TEI suggests that a similar rule be crafted for purposes of Prop. Reg. [Section] 1.861-10(e). TEI proposes that a special tax asset be included in the U.S. asset base for purposes of measuring the debt-to-asset ratio. The basis of this special asset would be equal to the difference between the acquisition price of the shares of the subsidiary (including its liabilities) and the sum of the tax bases of the assets acquired. The special asset might be amortized over an appropriate period, perhaps as long as 40 years if the premium represents entirely goodwill.

8. Corporate Events. Prop. Reg. [Section] 1.861-10(e)(9) should be expanded to include additional examples involving corporate events such as acquisitions, dispositions, section 355 transactions, and other changes in affiliated group status. Under Prop. Reg. [Section] 1.861-10(e)(9)(iii), the various base period ratios are generally not recalculated in case of corporate events. A limited exception applies at the election of the taxpayer to treat the acquired or disposed group's assets and liabilities separately for a two-year period.

The two-year exclusion of an acquired (or disposed) group is provided apparently in recognition that debt-financed stock acquisitions are not abusive transactions and that stock acquisitions significantly alter the debt-to-asset ratio of an affiliated group. We are uncertain about the rationale for limiting the exclusion period to two years. The exclusion period for acquired or disposed groups should, perhaps, be consistent with the number of base period years selected for averaging debt-to-asset ratios.

As a further alternative to the "exclusions" method of the proposed regulations, TEI recommends that taxpayers be given an election to combine the assets and debt of acquired companies -- whether CFCs or members of the affiliated group -- and to recalculate the base period years for tax years including and subsequent to the corporate event. The base period doubt should be adjusted for the incremental debt incurred to purchase the business, and base period assets should be reduced to the extent cash or other assets of the business are used to purchase the business. Such an election, with the noted adjustments to base period data, is desirable because acquisitions can so alter the prospective course of the business that the prior base period is irrelevant.

Finally, TEI questions why the exclusion is limited to stock acquisitions. Asset acquisitions generally involve assumption of liabilities and incurring of additional debt to fund the purchase. Asset acquisitions "distort" the ratios as much as stock acquisitions. If IRS and Treasury are concerned about tracing the acquired assets and liabilities subsequent to the acquisition date, the exclusion could be limited to asset acquisitions where a separate entity is incorporated to acquire and operate the business. Or, at a minimum, IRS might require separate books and records and financial statements be maintained for the acquired business.

9. Effective Date of Regulations. Taxpayers have been waiting for final regulations under the interest expense allocation rules of section 861 and 864(e) for more than four years. The proposed regulations issued on March 11, 1991, were the subject of a public hearing on June 21, 1991, and are proposed to be effective for taxable years beginning after December 31, 1990, unless earlier application is elected by the taxpayer. More than one-half of the year in which the proposed regulations become effective has already elapsed.

Prior to March 11, 1991, taxpayers had made decisions regarding the financing of their foreign subsidiaries during 1991 based on the temporary regulations. Taxpayers that have relied upon the temporary regulations in structuring their financing in 1991 are in need of immediate guidance on how they should restructure CFC financing to avoid application of the netting rule -- particularly when related group indebtedness exceeds the proposed regulations' safe harbor amount. Taxpayers should be accorded an election to apply the temporary regulations until the first taxable year beginning after the regulations become final.

Subsequent to March 11, the existence of two sets of regulations containing very different regimes for netting of interest on intercompany loans has created considerable uncertainty in making decisions affecting the financing of CFCs. Until the regulations are final, a pall of uncertainty will impede business decisions. Taxpayers are in need of both immediate guidance and transitional rule relief. (20)

One form of transitional relief would be to grandfather existing levels of related group indebtedness at the maximum amount loaned during the period of the temporary regulations without regard for subsequent changes in U.S. shareholder indebtedness. Alternatively, taxpayers should be given the opportunity to rebut the presumption of the proposed regulations that increases in CFC loans were tax motivated if the bright-line objective tests are flunked.

Finally, our reading of the preamble leaves us puzzled whether a taxpayer electing to apply the proposed regulations retroactively to years beginning after December 31, 1987 (the effective date of the temporary regulations' version of the netting rule), must apply them to all previous years affected by the temporary regulations, some of the affected tax years, or whether a taxpayer may choose a beginning year and apply the new rule consistently to all subsequent tax years. Given the overlap between the proposed regulations and the temporary regulations, we believe taxpayers should be accorded an election to apply either regime to each affected tax year preceding the effective date of final regulations. In any event, we recommend that the final regulations clarify the years affected by retroactive application of a revised netting rule.

10. Alternative Step Two. The preamble to the proposed regulations invites comments with respect to a simpler determination of affiliated group debt allocable to related group indebtedness. (21) Under the alternative Step Two, the tax-motivated on-lending would be determined for any taxable year by multiplying the group's ERGI (the potentially tax-motivated lending) by the U.S. debt-to-asset ratio for the year. Under the alternative approach, a portion of the ERGI would be deemed financed by tax-motivated borrowing in proportion to the U.S. group's debt-to-asset ratio. The preamble suggests that this is a simpler method and is more consistent with the fungibility concept of section 864(e).

TEI acknowledges that the alternative calculation would be simpler. However, the statement that the alternative approach is "more consistent" with the fungibility concept of section 864(e)(7) leads us to renew our objection to the notion that a netting rule is in any way consistent with the statute. The calculation should be retained since it will generally reduce the amount potentially subjected to netting in a way that the alternative will not. Since the netting rule is fundamentally at odds with the statute, every means available to reduce the impact of netting should be preserved. Thus, at most, the alternative Step Two should be elective for taxpayers desiring simplicity.


Tax Executives Institute appreciates the opportunity to present its views on the proposed regulations relating to the allocation and apportionment of third-party interest expense under Prop. Reg. [Section] 1.861-10(e). If you have any questions, please call Raymond G. Rossi, chair of TEI's International Tax Committee, at (408) 765-1193, or Jeffery P. Rasmussen of the Institute's professional tax staff, at (202) 638-5601.

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [Section]". The temporary and proposed regulations which this rule will replace are referred to as the temporary regulations; specific provisions are cited as "Temp. Reg. [Section]". References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2) Strictly speaking, the proposed regulations affect interest expense on "unaffiliated indebtedness" which would include loans from CFCs or members of a controlled, but not affiliated, group of corporations.

(3) CFCs are "related" to shareholders with more than 50-percent control under section 267(b). See Temp. Reg. [Section] 1.861-10T(e)(2)(ii). Prop. Reg. [Section] 1.861-10(e)(5)(ii) continues this requirement.

(4) 1991-14 I.R.B. at 28. Ironically, five years after enactment of section 864(e)(7)(B), the IRS has still not issued regulations on the proper treatment of integrated financial transactions.

(5) Intercompany loans are used for a number of business purposes. Among the ends served by intercompany lending are (1) to limit equity investments in foreign jurisdictions with strict capital repatriation limits or cumbersome legal requirements affecting capital restructuring and to minimize foreign capital taxes on equity; (2) to leverage the incremental borrowing advantage that the U.S. parent may be able to negotiate in the U.S. debt market -- because of the parent's stronger financial rating and reputation, the large size of the U.S. debt markets, or the corporate treasurer's negotiating skill -- versus local country borrowing; (3) to minimize parent guarantees of foreigh debt; (4) to save foreign taxes where the withholding tax rate on dividend repatriation exceeds the withholding tax rate for interest payments; (5) to employ idle, excess U.S. cash for a greater overall return to U.S. shareholders of the U.S. parent; (6) to finance a subsidiary located in a country with adverse economic conditions where local debt is impossible to secure at economical interest rates; (7) to engage in sophisticated interest rate or currency arbitrage; and, (8) to engage in a form of tax rate differential arbitrage approved in the Conference Report to the Tax Reform Act of 1986 -- i.e., to lend to subsidiaries in jurisdictions with higher effective rates than the U.S. to obtain local tax deductions and achieve a lower worldwide, consolidated tax expense. In summary, intercompany lending is a legitimate tool for corporate financial management.

(6) We commend the IRS for proposing alternative base periods and allowing taxpayers to elect retroactively to apply the proposed regulations to tax years affected by the temporary regulations. Disparate taxpayer treatment, however, persists and will persist until the rule is abandoned.

(7) For example, to avoid reverse interest arbitrage arising from excess U.S. parent cash (from retained earnings) and contemporaneous CFC borrowing from third parties at interest rates in excess of the U.S. investment rate, the U.S. parent may have lent its excess U.S. case to the CFCs to reduce consolidated interest expense. The loan may have been made under the temporary regulations' safe harbor. Subsequent to the loan to the CFC (which may have been on a long-term basis with a corresponding foreign currency hedge), unanticipated business decisions one or two years later (such as a significant acquisition or a recapitalization of the business) may cause the U.S. business to become more highly leveraged. The subsequent increase in U.S. debt under the proposed regulations would be tainted excess U.S. shareholder indebtedness.

(8) To minimize the unfair effect of the proposed regulations, corporate groups may look to borrow funds in foreign jurisdictions rather than the United States. This action will be to the benefit of foreign lending institutions and the detriment of U.S. lending institutions and will concomitantly reduce the taxable interest income of such U.S. lenders. TEI questions whether the revenue gain from the netting rule will be offset by the U.S. taxes lost on interest income shifted away from taxable U.S. banks and to exempt banks located in foreign countries.

(9) Statement of the Honorable Fred T. Goldberg, Jr., Commissioner of Internal Revenue, before the House of Representatives Committee on Ways and Means, Hearings on International Competitiveness, June 20, 1991.

(10) The "base period" years for any current year generally consist of the five immediately preceding tax years, except that a t ransitional rule permits a taxpayer to elect an alternative rolling five-year base period for the first five affected tax years. If the transitional alternative base period is elected, tax years 1982 through 1986 form the base period years for the first tax year to which the proposed regulations apply. In the second affected tax year, the earliest transitional base period year (1982) is eliminated and the first tax year affected by the proposed regulations is added as a base period. The substitution of affected tax years for the initial base period years is repeated until the base period ultimately consists of the five immediately preceding tax years.

(11) Based on comments of Treasury representatives, TEI understands that the 110-percent limitation is to be applied on a prospective basis. We recommend that the Treasury clarify that the taxpayer's actual historical foreign base period and debt-to-asset data will be used without limitation in 1991. Thus, on a taxpayer's 1991 tax return the FBPR and debt-to-asset ratio will be determined by the five-year base period average -- either the immediately preceding five taxable years or the alternative base period -- based on actual historical data. The first year to which the 110-percent limitation will apply will be 1991.

Furthermore, the limitation should apply only to the extent that 1991 data are applicable in the calculation of the base-year amounts allowable for 1992. If a taxpayer elects to apply retroactively the revised netting rule, the 110-percent limitation should apply to the first taxable year that follows the original base-period years and becomes a part of the second tax year's FBPR and debt-to-asset data. Thus, 1988's FBPR and debt-to-asset ratios are not limited, but the increase in the 1988 data is limited to 110 percent of its base years' data when calculating 1989's allowable FBPR and debt-to-asset ratio.

(12) 1991-14 I.R.B. at 29.

(13) Hereinafter, references to the 110-percent limitation should be read to incorporate this proposal.

(14) There are a number of reasons a taxpayer may have a low base-period ratio -- one of which could be compliance with the temporary regulations. A complementary reason would be a preference for local country debt to minimize the balance sheet effect of translating the net, non-U.S. dollar equity in foreign subsidiaries.

(15) See Prop. Reg. [Section] 1.861-10(e)(2)(vii)(B).

(16) We note that the proposed regulations omit rules for transition of nonfunctional currency items. Adoption of TEI's proposal cures the omission.

(17) Section 163 is quite broad. For example, interest (within the meaning of section 163) could be paid on items such as trade payables and other current account intercompany items, which are not normally considered to be debt instruments. In this regard, we note that, under section 482, imputed interest income may arise on export sales from a U.S. company to its CFCs. Is this imputed interest income subject to the netting rule? If so, the question becomes how the "asset" is to be included in the U.S. company's base for testing? Of course, the asset giving rise to the imputed interest income may not be present at year-end balance sheet dates since the regulations under section 482 trigger imputation on CFC receivables outstanding for more than 120 days (or the comparable trade practice, whichever is longer.) We doubt that this is the type of "tax-motivated on-lending" that Treasury is seeking to curb. We recommend that the final regulations expressly provide an exception for section 482 imputed interest on indebtedness arising in the ordinary course of business from sales, leases, or the rendition of services between members of a group.

(18) Adoption of this proposal would, we believe, generally exclude trade payables from indebtedness. If the proposal is not adopted, the IRS should clarify whether payables are included as indebtedness.

(19) See Prop. Reg. [Section] 1.163(j)-5(e).

(20) TEI recognizes the need for time to craft workable rules and does not wich to hurry the IRS to issue poorly drafted regulations that may require still further amendment. The overlay of new proposed regulations on top of temporary regulations covering the same period (at least until superseded), however, leaves taxpayers in a quandary. Should they restructure CFC financing immediately on the presumption that final regulations will be promulgated by year end? Or should they continue to adhere to the temporary regulations which are effective until superseded? The proposed rules, if adopted as final, should not be effective for any time also covered by the existing temporary regulations, except at the election of the taxpayer. Suppose, for example, the proposed regulations are not finalized until after the end of 1991. We assume the effective date would be rolled forward, but we wonder if a taxpayer can rely upon the proposed regulations (or, indeed, the temporary regulations if the effective date is not rolled forward) in the determination of its 1991 tax liability?

(21) 1991-14 I.R.B. at 29-30.
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Title Annotation:Tax Executives Institute
Publication:Tax Executive
Date:Sep 1, 1991
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