Treasury Keeps Costly Debt-Equity Tax Regs

U.S. Treasury Secretary Steven Mnuchin Visits ″Lou Dobbs Tonight″
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Treasury’s play is clearly designed to hedge against the potential failure of the Tax Cuts and Jobs Act's tax cuts to protect the U.S. tax base. If Treasury believes the tax cuts will be ineffective in completely curbing base erosion, the new guidance works as an ideal fail-safe while checking off the tax deregulatory effort box.

While Treasury appears to have removed the debt-equity documentation rules in final regulations (T.D. 9880) — after two long years of consideration — because they were unduly burdensome and thus inconsistent with executive orders, it went on to warn taxpayers that it's continuing to consider the issues that led to the rules and that it may propose streamlined regulations in the future. While taxpayers will have to wait while Treasury continues its lengthy study of the need for the documentation regulations, the good news is that Treasury stated in the preamble to the final regulations that any future documentation regulations would have a prospective effective date. But that statement is also necessary in order for Treasury to say that the removal reduced regulatory burdens because the rules were “rendered obsolete” by the tax cuts and that this is a win for its deregulatory policies.

Similarly, an advance notice of proposed rulemaking (REG-123112-19), also issued October 31, stated that the government plans to retain but streamline the distribution regulations for reclassifying some related-party debt as stock for federal income tax purposes. This suggests that Treasury isn't strictly adhering to executive orders meant to reduce regulatory burdens and that taxpayers can count on only temporary relief from the costs of complying with the documentation and distribution regulations while they are being considered and streamlined.

If the TCJA doesn't fully address base erosion concerns, something Treasury is clearly worried about based on its long and ongoing consideration of the documentation and distribution regulations, Treasury can simply point to its continued consideration of regulations that it just said violate the executive order in order to issue even more burdensome rules. 

The debt-equity regulations establishing minimal documentation requirements and the distribution regulations were identified by the executive branch in an October 2, 2017, report as imposing an undue financial burden on U.S. taxpayers. The final regulations removing the documentation requirements said that burden exceeded the benefits of the regulations. However, the distribution regulations present many of the same financial burdens on taxpayers. They are expensive; result in uncertainties; and increase taxes, administrative costs, and regulatory costs.

Regarding removing the section 385 distribution regulations, the October 2, 2017, report explained that “Treasury has consistently affirmed that legislative changes can most effectively address the distortions and base erosion caused by excessive earnings stripping.” So Treasury is streamlining the section 385 regulations to protect the tax base even though it said the TCJA would accomplish that. And if it issued tax regulations to prevent the base erosion it said was successfully addressed, it would likely argue that retroactive regulations were necessary to protect against “abuse” targeted by the TCJA tax cuts. So an exception for retroactive regulations based on abuse may eliminate the good news mentioned above about future regulations being prospective.

The uncertainty about future streamlined documentation and distribution regulations can be expected to hurt American businesses and families and their investments and retirement accounts. It seems like Treasury could have concretely determined the need for regulations by now since the issue has been under consideration for two years. It’s easy to see why many would view this as a temporary measure to support a deregulatory win. After all, the same final regulations that removed the documentation regulations requested “comments regarding approaches” that would balance taxpayer burdens while “ensuring the collection of sufficient documentation and other information necessary for tax administration purposes” (emphasis added).

Treasury expects that the modified distribution regulations will include a rule that will apply to debt “only if its issuance has a sufficient factual connection to a distribution to a member of the taxpayer’s expanded group or an economically similar transaction” (emphasis added). This fact-based rule on what is connected to a distribution would be more uncertain than the six-year rule, and it would allow for more planning opportunities. Regulations requiring a sufficient factual connection are vulnerable to manipulation. Yet the massive body of law on debt-equity provides more than enough guidance to make the appropriate debt-equity determination, including case law on deemed distributions resulting from debt. 

Taxpayers must now wait for the updated distribution regulations and an ultimate determination on the documentation regulations under consideration. One can only guess how the markets will react to the forthcoming regulatory costs that contradict Mnuchin's statements.

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Treasury Secretary Steven Mnuchin said in an October 31 release: “Because tax cuts made our business environment more competitive, we are now able to remove regulatory burdens that have been rendered obsolete, further reduce costs for job creators and hardworking Americans, and protect the U.S. tax base.” However, the guidance Treasury issued that day indicates that it's continuing to work on streamlined versions of the debt-equity documentation and distribution regulations that may impose more costs in violation of Executive Order 13789, which is meant to reduce tax regulatory burdens.

Treasury’s play is clearly designed to hedge against the potential failure of the Tax Cuts and Jobs Act's tax cuts to protect the U.S. tax base. If Treasury believes the tax cuts will be ineffective in completely curbing base erosion, the new guidance works as an ideal fail-safe while checking off the tax deregulatory effort box.

While Treasury appears to have removed the debt-equity documentation rules in final regulations (T.D. 9880) — after two long years of consideration — because they were unduly burdensome and thus inconsistent with executive orders, it went on to warn taxpayers that it's continuing to consider the issues that led to the rules and that it may propose streamlined regulations in the future. While taxpayers will have to wait while Treasury continues its lengthy study of the need for the documentation regulations, the good news is that Treasury stated in the preamble to the final regulations that any future documentation regulations would have a prospective effective date. But that statement is also necessary in order for Treasury to say that the removal reduced regulatory burdens because the rules were “rendered obsolete” by the tax cuts and that this is a win for its deregulatory policies.

Similarly, an advance notice of proposed rulemaking (REG-123112-19), also issued October 31, stated that the government plans to retain but streamline the distribution regulations for reclassifying some related-party debt as stock for federal income tax purposes. This suggests that Treasury isn't strictly adhering to executive orders meant to reduce regulatory burdens and that taxpayers can count on only temporary relief from the costs of complying with the documentation and distribution regulations while they are being considered and streamlined.

If the TCJA doesn't fully address base erosion concerns, something Treasury is clearly worried about based on its long and ongoing consideration of the documentation and distribution regulations, Treasury can simply point to its continued consideration of regulations that it just said violate the executive order in order to issue even more burdensome rules. 

The debt-equity regulations establishing minimal documentation requirements and the distribution regulations were identified by the executive branch in an October 2, 2017, report as imposing an undue financial burden on U.S. taxpayers. The final regulations removing the documentation requirements said that burden exceeded the benefits of the regulations. However, the distribution regulations present many of the same financial burdens on taxpayers. They are expensive; result in uncertainties; and increase taxes, administrative costs, and regulatory costs.

Regarding removing the section 385 distribution regulations, the October 2, 2017, report explained that “Treasury has consistently affirmed that legislative changes can most effectively address the distortions and base erosion caused by excessive earnings stripping.” So Treasury is streamlining the section 385 regulations to protect the tax base even though it said the TCJA would accomplish that. And if it issued tax regulations to prevent the base erosion it said was successfully addressed, it would likely argue that retroactive regulations were necessary to protect against “abuse” targeted by the TCJA tax cuts. So an exception for retroactive regulations based on abuse may eliminate the good news mentioned above about future regulations being prospective.

The uncertainty about future streamlined documentation and distribution regulations can be expected to hurt American businesses and families and their investments and retirement accounts. It seems like Treasury could have concretely determined the need for regulations by now since the issue has been under consideration for two years. It’s easy to see why many would view this as a temporary measure to support a deregulatory win. After all, the same final regulations that removed the documentation regulations requested “comments regarding approaches” that would balance taxpayer burdens while “ensuring the collection of sufficient documentation and other information necessary for tax administration purposes” (emphasis added).

Treasury expects that the modified distribution regulations will include a rule that will apply to debt “only if its issuance has a sufficient factual connection to a distribution to a member of the taxpayer’s expanded group or an economically similar transaction” (emphasis added). This fact-based rule on what is connected to a distribution would be more uncertain than the six-year rule, and it would allow for more planning opportunities. Regulations requiring a sufficient factual connection are vulnerable to manipulation. Yet the massive body of law on debt-equity provides more than enough guidance to make the appropriate debt-equity determination, including case law on deemed distributions resulting from debt. 

Taxpayers must now wait for the updated distribution regulations and an ultimate determination on the documentation regulations under consideration. One can only guess how the markets will react to the forthcoming regulatory costs that contradict Mnuchin's statements.

I am a contributing editor for Tax Notes and write the column Willis Weighs In covering controversial cross-border corporate tax issues. I worked in PwC’s national merg

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