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Taxnotes® Volume 152, Number 3 July 18, 2016 C a Nlss21.Alrgt Eevd a Nlssde O Li Oyih Naypbi Oano Hr at Content

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Taxnotes® Volume 152, Number 3 July 18, 2016 C a Nlss21.Alrgt Eevd a Nlssde O Li Oyih Naypbi Oano Hr at Content taxnotes® Volume 152, Number 3 July 18, 2016 (C) Tax Analysts 2016. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Debt-Equity Controversy Echoes Entity Classification Debate By David F. Levy, Nickolas P. Gianou, and Kevin M. Jones Reprinted from Tax Notes, July 18, 2016, p. 363 SPECIAL REPORT (C) Tax Analysts 2016. All rights reserved. does not claim copyright in any public domain or third party content. tax notes™ Debt-Equity Controversy Echoes Although folks far more talented and influential than the three of us will undoubtedly write on Entity Classification Debate weighty topics such as the regulations’ validity, by David F. Levy, Nickolas P. Gianou, and their arbitrary nature, and so on, we thought it Kevin M. Jones might be interesting to explore one aspect of the proposed regulations not yet discussed: the para- llels between Treasury’s current approach on debt- equity classification and its initial approach (beginning in the 1920s) on entity classification. Although the questions may at first blush seem completely unrelated, whether a particular corpo- rate financial instrument is classified for tax pur- poses as debt or equity and whether a particular business entity is classified for tax purposes as a corporation or a passthrough are, from the perspec- David F. Levy Nickolas P. Gianou Kevin M. Jones tive of corporate tax policy, two sides of the same David F. Levy is a partner, and Nickolas P. coin. And given that Treasury’s initial pre-check- Gianou and Kevin M. Jones are tax associates, with the-box approach to entity classification proved to Skadden, Arps, Slate, Meagher & Flom LLP. be a seven-decade tax policy nightmare that in- In this report, the authors discuss Treasury’s flicted as much pain on the government as it did on issuance of proposed regulations under section 385, taxpayers, we thought it might be useful to high- arguing that there are parallels between the current light some of these parallels. approach to debt-equity and Treasury’s initial ap- That the proposed regulations will be severely proach to entity classification. criticized by the tax bar seems certain but in all The views expressed herein are not necessarily likelihood irrelevant; regardless of how persuasive those of Skadden Arps or any of its clients. those criticisms may be, Treasury unfortunately Copyright 2016 David F. Levy, appears poised to relive past mistakes. Given the Nickolas P. Gianou, and Kevin M. Jones. political climate around corporate tax issues, Trea- All rights reserved. sury would appear to have gone all-in on its new approach to debt-equity classification, and the body language exhibited by folks at Treasury and the IRS Table of Contents certainly seems to suggest that the proposed regu- lations will be finalized in something resembling The Corporate Tax and Debt-Equity ......... 363 their current form before the inauguration of our next president. The Proposed Regulations ................ 366 We harbor no illusions about this report altering We’ve Been Down This Path Before ......... 366 the government’s behavior or changing in any way Why Is This Happening Again? ............ 369 what the final regulations will say. We simply thought that before we all go down a path that our So, What Happens Next? ................. 371 profession has already beaten, it might be helpful to explore our past so that we might better understand Conclusion ........................... 374 the present and prepare for the future. If the past really is prologue, this process will not be pretty. Treasury dropped a bombshell on April 4 when it issued proposed regulations under section 385 that The Corporate Tax and Debt-Equity impose equity treatment on some debt instruments issued by a corporate borrower to a related lender.1 The proposed regulations would appear in large part to target earnings stripping by U.S. corpora- tions. ‘‘Earnings stripping’’ is a loaded term used to describe the practice in which a foreign parent 1Prop. reg. section 1.385-1 and -2; REG-108060-15. capitalizes a U.S. corporate subsidiary with debt TAX NOTES, July 18, 2016 363 For more Tax Notes content, please visit www.taxnotes.com. COMMENTARY / SPECIAL REPORT and equity and relies on interest payments on the and more of their earnings, individual shareholders debt to reduce the subsidiary’s income tax. The paid less and less annual income tax on their shares (C) Tax Analysts 2016. All rights reserved. does not claim copyright in any public domain or third party content. proposed regulations also focus on the use of inter- of the corporations’ profits. High earners were company indebtedness by U.S. multinational corpo- enjoying accessions to wealth in the form of earn- rate groups to either repatriate the earnings of ings locked inside corporate solution (which earn- foreign subsidiaries or manage parent-level recog- ings could be expected to increase the value of nition of tax attributes of those subsidiaries.2 shares held by those shareholders), while corporate The proposed regulations’ focus on these two managers were enjoying accessions to power in the issues implicates two bedrock principles of the tax form of control over larger piles of cash and larger law: the taxability of corporate earnings and the businesses.7 distinction between debt and equity. Although During the interwar period in general and dur- these principles are integrally related, the way in ing the Great Depression in particular, the govern- which they interact is not always evident. That ment became concerned about the ability of interaction becomes clear, however, if one properly individual shareholders to defer taxation on their understands the historical underpinnings of each shares of corporate earnings, and it began pushing principle. for corporations to distribute their earnings. Corpo- As we described in a recent paper,3 the corporate rate managers, however, fought hard against any tax was enacted in 1909 as an antitrust enforcement tax incentive or requirement to distribute earnings, mechanism and developed in the late 1920s and because they generally valued the ability to fund early 1930s into an anti-deferral mechanism. The business opportunities with retained earnings with- corporate tax was enacted to reduce the retained out having to go to the capital markets to validate earnings of the large industrial concerns that by the their ideas.8 late 19th century had come to dominate the U.S. These opposing positions triggered a decades- economy.4 Over the decades following 1909, indi- long legislative struggle that ended when the gov- vidual income tax rates increased much more ernment and corporate managers reached what quickly than corporate tax rates,5 and corporations could best be described as a political settlement: began to retain larger and larger portions of their The government would increase the corporate tax earnings to ensure their ability to finance their rate as a proxy for taxing shareholders on their businesses.6 These two developments resulted in a annual accessions to corporate wealth, and manag- potential tax deferral opportunity for wealthy indi- ers would keep their ability to retain earnings at the vidual shareholders: As corporations retained more corporate level (albeit on an after-tax basis).9 Thus, once the dust settled in the late 1930s, the corporate tax was, from the government’s perspec- 2See, e.g., preamble to REG-108060-15, 81 F.R. 20912, 20917 tive, a rough-justice anti-deferral regime. Under this (Apr. 8, 2016) (expressing concern over ‘‘inverted groups and regime, corporate shareholders would not pay tax other foreign-parented groups [using specific] transactions to on their shares of corporate profits until the corpo- create interest deductions that reduce U.S. source income with- ration distributed the profits to shareholders; the out investing any new capital in the U.S. operations. In addition, corporation, in turn, would pay an entity-level tax U.S.-parented groups obtain distortive results by, for example, using these types of transactions to create interest deductions every year for the privilege of retaining that year’s that reduce the earnings and profits of controlled foreign earnings. From the perspective of the corporation corporations (CFCs) and to facilitate the repatriation of untaxed and its shareholders, the corporate tax could be earnings without recognizing dividend income’’). viewed as the amount of shareholder wealth that 3David F. Levy, Nickolas P. Gianou, and Kevin M. Jones, ‘‘Modern REITs and the Corporate Tax: Thoughts on the Scope corporate managers were willing to surrender to of the Corporate Tax and Rationalizing Our System of Taxing Collective Investment Vehicles,’’ 94 Taxes 217 (Mar. 1, 2016) (hereinafter Modern REITs). 4See id. at 226-227; see generally Reuven S. Avi-Yonah, ‘‘Cor- 7See Avi-Yonah, supra note 4, at 1215-1225; and Modern porations, Society, and the State: A Defense of the Corporate REITs, supra note 3, at 224-229. In addition to laying out the Tax,’’ 90 Va. L. Rev. 1193 (2004); and Marjorie E. Kornhauser, historical case, Avi-Yonah locates a normative justification for ‘‘Corporate Regulation and the Origins of the Corporate Income the corporate tax in its facility in restraining the ability of Tax,’’ 66 Ind. L. J. 53 (1990). corporate managers to wield power using other people’s money, 5For example, in 1913 the corporate rate was 1 percent while i.e., corporate retained earnings. See generally Avi-Yonah, supra the top individual rate was 7 percent (including the individual note 4, at 1231. surtax). By 1917 the corporate rate had risen to 6 percent, but the 8See Bank, ‘‘Corporate Managers, Agency Costs, and the Rise top individual rate (including the individual surtax) had been of Double Taxation,’’ 44 Wm. & Mary L. Rev. 167, 199 (2002) raised to 67 percent to fund the war effort.
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