4
Changing IRS Controversy Landscape Impact on taxpayers
► IRS Budget Challenges ► LB&I Reorganization ► Change in LB&I’s Examination Approach ► Updated LB&I Examination Process
5
IRS Budget Challenges
In FY 2010, the IRS’s budget was $12.1 billion. Its budget for FY 2015 is $10.9 billion, a reduction of approximately 9.9% or around 17% adjusted for inflation.
$0$2$4$6$8
$10$12$14
FY2010
FY2011
FY2012
FY2013
FY2014
FY2015
IRS funding 2010-2015
Actual dollars(billions)Inflation adjusteddollars (billions)
“This is the lowest level of funding since 2008, and the
lowest since 1998 when inflation is considered.”
IRS Commissioner John A. Koskinen
6
Number of employees down
94,346
91,380
89,551
83,613
78,121
76,540
0 20,000 40,000 60,000 80,000 100,000
Number of full-time equivalents (FTEs) at fiscal year-end
2015
2014
2013
2012
2011
2010
Source; IRS Data Book(s) 2010 -2015, Table 30.
7
LB&I Organization effective 7 February 2016
LB&I is now organized into nine practice areas: five subject-matter based and four geographically based.
Geographic practice areas ► Northeast (New York), ► East (Downers Grove, Illinois), ► Central (Houston) ► West (Oakland, California).
Subject-matter practice areas ► Pass-through entities ► Enterprise Activities
► Includes financial products and institutions, corporate issues and credits, and penalties
► Treaty and transfer pricing, ► Withholding and international individual
compliance ► Includes FATCA
► Cross-border activities ► International activities other than those
falling under the transfer pricing and withholding areas
8
LB&I Organization Chart
Director of Field Operations
Foreign Payments Practice
Johanna McGeady-Muirphy
LB&I Commissioner
Douglas O’Donnell
Deputy Commissioner Rosemary Sereti
Assistant Deputy Commissioner International
Theodore Setzer
Director Program and Business
Solutions Susan Latham
Director Technology and
Program Solutions Kathryn Greene (A)
Director Resource Solutions
Keith Walker
Assistant Deputy Commissioner Compliance
Integration David Horton
Director Data Mgt.
William Holmes
Director Compliance Planning
and Analytics Christopher Larsen
Director Western Compliance
PA Kimberly Edwards
Director Pass Through Entities
PA Cheryl Claybough
Director Enterprise Activities
PA Kathy Robbins
Director Central Compliance
PA Tina Meaux
Director Cross Border Activities
PA John Hinding
Director Eastern Compliance
PA Lavena Williams
Director Withholding and Int’l Individual Compliance PA
Pamela Drenthe
Director Treaty and Transfer
Pricing Operations PA Sharon Porter
Director Northeastern Compliance
PA Barbara Harris
Director of Field Operations West Don Sniezek (A)
Deputy Director Pass Through
Entities Cliff Scherwinski
Director Financial Institutions and
Products Gloria Sullivan
Director of field Operations North
Central Katheryn Houston
Director of Field Operations East
Orrin Byrd
Director of Field Operations Great Lakes
Steve Whiteaker
Director of Field Operations
Transfer Pricing Practice
Cheryl Teifer
Director of Field Operations
North Atlantic Catherine Jones
Director of Field Operations Southwest Paul Curtis
Promoter Program Financial Products
Director of Field Operations West Jolanta Sander
Director of Field Operations
International Individual
Compliance Elise Gardner
Economists
Director of Field Operations Mid-Atlantic Dennis Figg
Computer Audit Specialists
Global High Wealth
Banks/Insurance/ RICs-REITs-
REMICs
Affordable Care Act
Director Corporate/Credit Holly Paz
Corporate Issues and Credits
Penalties
Engineers
Director of Field Operations
South Central Margie Maxwell (A)
Tax Computation Specialists
Director of Field Operations Southeast
John Hinman (A)
Director Advance Pricing and Mutual
Agreement Hareesh Dhawale
Director Treaty Administration
Deborah Palacheck
Treaty Assistance and Interpretation Team
Exchange of Information
Joint International Tax Shelter
Information Center
Senior Advisor Elizabeth Wagner
9
LB&I Shift in Examination Focus
► LB&I is moving to a centralized issue selection and return selection approach over the next few years. ► LB&I seeking to create a more flexible and knowledgeable
workforce, using data analytics to better identify areas of noncompliance, and creating tailored treatments to respond to issues.
► A shift to a centralized issue development process or “campaign” that focuses on how to identify and address compliance risks. ► Campaign-related actions would include development of training
materials, technical positions, and audit aids, among other tools. ► LB&I will generally be moving away from the Coordinated Industry
Case (CIC) approach ► Any potentials changes to the compliance assurance process (CAP)
have yet to be determined
10
Scan Universe of External and Internal Inputs Analyze
Risk
Develop Issues
Build Campaigns
Execute Work
Select Work
FOCUS
PLAN
EXECUTE ADAPT
Strategically identify and prioritize areas of compliance risk to more effectively address taxpayer compliance.
Decide what work is performed, who performs it, and what support is needed, based on areas of compliance risk.
Execute work with dynamic tools, enhanced training, a robust support infrastructure, and timely feedback mechanisms.
Continually gather, assess, and incorporate feedback to enhance operations and improve taxpayer compliance.
IRS Issue Examination Approach
11
New LB&I Examination Process Publication 5125 (February 2016)
► Replaces current “Quality Exam Process” incorporating ► Information Document Request Directive ► Appeals Judicial Approach and Culture
► Updates to IRM 4.46 sections 1-6 issued March 2016. ► Effective for examinations starting as of 1 May 2016. ► For cases in process as of May 1st, transition to the new
process by adopting changes in the Execution and Resolution phases.
https://www.irs.gov/Businesses/Corporations/Large-Business- and-International-Examination-Process
12
LB&I Examination Process
► Expectations for LB&I Examiners ► Expectations for Taxpayers and Representatives ► Informal Claims for Refund ► Issue Driven Examination Process ► Issue Development Model
► Fact Development/Acknowledgement
13
LB&I Examination Process – Resolution
► Issue Resolution Tools ► Consistently encourages available issue resolution tools ► Requires consideration of Fast Track Settlement with Appeals
► Exit Strategy ► Discussions must include efforts to resolve tax controversy for
certainty ► Joint critique of the exam process to recommend improvements ► Address future tax treatment of issues to eliminate
carryover/recurring issues
15
Legislation enacted in 2015 (1) proved that big things can get done in Congress and (2) took pressure off of action necessary in 2016
What did not get done in 2015: Trans-Pacific Partnership trade agreement, customs reauthorization conference report, permanent ITFA, tax reform, including international reform
2015 review: deadline-driven legislating
Spending legislation for FY 2016, delay of
some ACA taxes
Significant tax extenders package with 22 permanent
provisions
5-year highway bill, reauthorization of
Export-Import Bank
Consolidated Appropriations Act, 2016 FAST Act
Fast-track consideration of
trade pacts; trade package
$80 billion increase in
spending caps over 2 years, suspension of
debt limit
Permanent update of system for payments to
Medicare providers
TPA Bipartisan Budget Act Medicare Access and CHIP Reauthorization Act
16
Congressional timeline for 2016-2017
Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar
September 30 Government funding expires
July 15 FAA authorization, funding expires
December 31 39 tax provisions expire
March 15, 2017 Federal debt limit reinstated
July 18-21 Republican National Convention November 8
Election Day
July 18-September 6 Congress: summer recess
July 25-28 Democratic National Convention
17
Outlook for 2016: different agendas in House and Senate
House: Develop ideas Republicans can run on in elections ► Speaker Ryan: “For me, 2016 is about going on offense on
ideas…This means putting together a bold, pro-growth agenda.” ► Six committee-led task forces to develop agenda:
Senate: Appropriations a focus, but rest of agenda limited ► Senator McConnell:
► “What we take up in the Senate will be different, with a special eye toward our incumbents.”
► “The House is just better suited to be kind of an idea factory and to pursue things that the Speaker hopes will be picked up by the presidential nominee.”
Tax Reform National Security Health Care
Reform Poverty &
Opportunity Constitutional
Authority Reducing
Regulatory Burdens
18
Miscellaneous 2016 tax policy agenda items
► ID theft/taxpayer protection ► FAA reauthorization ► Puerto Rico relief measure (non-tax and possibly tax) ► 2016 expiring tax provisions ► Technical corrections package ► Tax Treaties (7 plus multilateral convention) ► BEPS/country-by-country reporting regulations/EU public
disclosure ► EU State aid/section 891 ► Panama papers ► Regulatory activity (section 385/anti-inversion items, section
367, etc.)
19
Tax reform
Scope of reform – comprehensive, business-only, international-only?
Will business tax reform benefit pass-through entities? If so, how?
Are individuals convinced of the need/benefit of tax reform? Should there be a specific revenue target for reform?
1 2 3 4 5
General tax reform questions still to be answered:
Before late 2014 ► Republicans insist on
comprehensive tax reform – business, individual and international
Early 2015 ► Republicans focus on
business tax reform as President Obama opposes individual rate cuts
Since May 2015 ► Republicans pivot to
international-only reform due to opposition from pass-through businesses to corporate-only rate cut
Over what period should revenue be measured? What baseline and methodology?
20
Tax reform: latest developments
► Elections and partisan differences make tax reform impossible in 2016
► Speaker Ryan/Chairman Brady will issue “tax reform blueprint” as part of pro-growth agenda, but it is not likely to get a House vote ► Released prior to Republican convention ► Blueprint is more detailed than an outline and less detailed than a bill ► Chairman Brady wants to “leap-frog” on rates, reduce corporate rate to 20% or
less ► Continued interest in international tax reform
► Updated Ways and Means international tax proposal not likely until September or later
► Numerous unresolved technical details including specific anti-base erosion measures and specifics of dividend exemption, innovation box, mandatory tax on foreign earnings, etc.
► Finance Chairman Hatch working on corporate integration proposal
21
Possible elements of international reform legislation
International tax reform has been under discussion by bipartisan members of both the House and Senate. The likely elements include:
Move to a dividend exemption (territorial) system 100% or something less?
Mandatory “deemed” repatriation transition tax on accumulated foreign earnings rate structure? how will revenue be used?
Patent or “innovation” box discounted rate on certain income tied to IP
Minimum tax/anti-base erosion measures for future foreign earnings of multinationals
Some form of interest expense limitation across-the-board or limited to foreign-based companies?
22
Corporate integration
► Finance Chairman Hatch crafting corporate integration bill ► Attempt to reduce or eliminate double taxation through establishment
of a corporate dividends-paid deduction (DPD) without statutory reduction in corporate rate ► International tax regime likely unchanged
► Corporation would withhold tax on gross amount of dividend paid to ALL shareholders ► Withheld amount would be a “nonrefundable credit” for the shareholder
► The 20% preferential rate for qualified dividends would be repealed ► Corporation would be required to withhold tax, at same rate, on the
gross amount of interest paid to creditors ► Policy rationale
► Address debt/equity imbalance ► Unlock “trapped” offshore earnings ► Attack earnings stripping ► Close gap with pass-throughs
24
2016 U.S. elections overview
Currently 54 Republicans, 46 Democratic votes (includes 2 independents) 24 Republican, 10 Democratic seats up for re-election
Presidential Election Day: 8 November 2016
House ► At 246 seats, largest Republican
majority in House since 1930 ► All 435 seats up for re-election ► Likely to stay under Republican
control
Senate ► 54 Republicans, 46 Democrats
(includes 2 independents) ► 24 Republican, 10 Democratic seats
up for re-election ► Control up for grabs
25
2016 presidential election
Democratic ► Hillary Clinton, former First Lady,
senator (NY), Secretary of State ► Bernie Sanders, senator (I-VT)
Republican ► Ted Cruz, senator (TX) ► John Kasich, governor (OH) ► Donald Trump, real estate mogul
Dates ► 38 States completed primary/caucus
voting as of May 2nd ► Republican National Convention:
18-21 July 2016, in Cleveland ► Democratic National Convention:
25–28 July 2016, in Philadelphia ► Election Day: 8 Nov. 2016
26
0
200
400
600
800
1000
1200
Trump Cruz Rubio Kasich
148 171
Prospects for a contested Republican convention
1237 Delegates needed to
earn nomination
# D
eleg
ates
allo
cate
d
845 559
Note: Delegate total is as of 22 April 2016
27
Remaining Republican state primary and caucus elections
Date State Delegates Allocation
May 3 Indiana 57 Winner take all statewide and in each congressional district
May 10 Nebraska 36 Winner take all statewide
West Virginia 34 Direct election
May 17 Oregon 28 Proportional
May 24 Washington 44 Proportional
June 7
California 172 Winner take all statewide and in each congressional district
Montana 27 Winner take all statewide
New Jersey 51 Winner take all statewide
New Mexico 24 Proportional allocation by statewide vote (15% threshold)
S. Dakota 29 Winner take all statewide
28
Congressional profile, 114th congress
Senate, 114th congress House, 114th congress
54 / 46*
* Includes 2 independents
246* / 188
*1 vacancy: Boehner (R-OH), election June 7
24 Republican, 10 Democratic seats up for re-election in 2016
► Majority Leader: Mitch McConnell (R-KY) ► Majority Whip: John Cornyn (R-TX) ► Republican Conference Chair: John Thune
(R-SD) ► Democratic leader: Harry Reid (D-NV) ► Democratic Whip: Dick Durbin (D-IL) ► Democratic Conference Vice Chair: Chuck
Schumer (D-NY) ► Strategic policy adviser to the DPCC:
Elizabeth Warren (D-MA)
At 246 seats, currently largest Republican majority in House since 1930
► Speaker Paul Ryan (R-WI) ► Majority Leader: Kevin McCarthy (R-CA) ► Majority Whip: Steve Scalise (R-LA) ► Democratic leader: Nancy Pelosi (D-CA) ► Democratic Whip: Steny Hoyer (D-MD) ► Asst. Democratic Leader: James Clyburn
(D-SC)
Republicans Democrats Republicans Democrats
29
2016 Senate elections
Seats up for re-election: 24 Republican, 10 Democratic Democrats Republicans ► Michael Bennet (D-CO) ► R. Blumenthal (D-CT) ► Barbara Boxer (D-CA)
retiring ► Pat Leahy (D-VT) ► Barbara Mikulski (D-MD)
retiring ► Patty Murray (D-WA) ► Harry Reid (D-NV) retiring ► Brian Schatz (D-HI) ► Chuck Schumer (D-NY) ► Ron Wyden (D-OR)
► Kelly Ayotte (R-NH) ► Roy Blunt (R-MO) ► John Boozman (R-AR) ► Richard Burr (R-NC) ► Daniel Coats (R-IN) retiring ► Mike Crapo (R-ID) ► Chuck Grassley (R-IA) ► John Hoeven (R-ND) ► Johnny Isakson (R-GA) ► Ron Johnson (R-WI) ► Mark Kirk (R-IL) ► James Lankford (R-OK) ► Mike Lee (R-UT)
► John McCain (R-AZ) ► Jerry Moran (R-KS) ► Lisa Murkowski (R-AK) ► Rand Paul (R-KY) ► Rob Portman (R-OH) ► Marco Rubio (R-FL) retiring
due to presidential run ► Tim Scott (R-SC) ► Richard Shelby (R-AL) ► John Thune (R-SD) ► Pat Toomey (R-PA) ► David Vitter (R-LA)
= state won by President Obama in 2012 presidential election
30
First major piece of legislation recent presidents enacted after taking office
Barack Obama Took office January 20, 2009
American Recovery and Reinvestment Act of 2009 Enacted February 17, 2009 - Stimulus legislation, included bonus depreciation
George W. Bush Took office January 20, 2001
Economic Growth and Tax Relief Reconciliation Act of 2001 Enacted June 7, 2001 - The “Bush tax cuts” reduced individual rates, estate tax
Bill Clinton Took office January 20, 1993
Omnibus Budget Reconciliation Act of 1993 Enacted August 10,1993 - Increased individual, corporate taxes
George H. W. Bush Took office January 20, 1989
Omnibus Budget Reconciliation Act of 1990 Enacted November 5,1990 - Increased individual taxes despite ‘no new tax’ pledge
Ronald Reagan Took office January 20, 1981
Economic Recovery Tax Act of 1981 Enacted August 13, 1981 - Sharply reduced individual, corporate taxes
32
Comparison of Republican tax plans
Trump Cruz Kasich Top corporate tax rate 15% 16% Business Flat tax 25% Taxation of future foreign earnings (now worldwide)
Immediate worldwide taxation, repeal of deferral
Territorial, no residual tax on US active foreign earnings
Territorial, no residual tax on US active foreign earnings
Mandatory tax, untaxed accumulated foreign earnings
10% 10% Unspecified “low rate”
Capital cost recovery (now MACRS)
-- Full expensing for business equipment
Full expensing for new investments
Individual tax rates 10%, 20%, 25% No taxes on first $36,000 of income, 10% flat tax on all individual income above that from wages and investment
Three rates: top no higher than 28%, two other rates unspecified
Top capital gains and dividends rate
15% in 20% bracket; 20% for in 25% bracket; 3.8% tax repealed
10% 15%
Carried interest (now capital gains)
Ordinary income Ordinary income --
Estate tax Repealed Repealed Repealed
Charitable contributions (now capped at 50% of AGI)
No change No change No change
Mortgage interest (now itemized deduction on first $1 million of debt)
No change Deduction limited to interest on first $500,000 in principal
No change
Other itemized deductions Available deductions pared back as tax rate increases
--
Unspecified effort to simplify deductions
33
Clinton vs. Sanders: two approaches to increasing taxes on individuals
Clinton
► Buffett Rule = minimum 30% effective tax rate for millionaires
► 4% Fair Share Surcharge on annual income over $5 million
► Increase capital gains rates: ► Assets held less than 2 years taxed as
ordinary income ► 23.8% capital gains rate on assets held 6
or more years
► Carried interest = ordinary income Tax on high-frequency trading
► Limit the tax value of specified deductions and exclusions to 28%
► Return to 2009 estate tax regime
Sanders ► Surtaxes above current 28% bracket
► 9%-24%, so top rate = 52%
► New 2.2% surtax on taxable income ► Lift payroll tax cap and increase payroll
tax by 0.2% ► Tax capital gains as ordinary income for
those above current 28% bracket ► Carried interest = ordinary income ► Financial Transaction Tax on each
security trade ► Limit tax value of deductions, exclusions
to 30.2% ► Repeal PEP and Pease ► Reduce estate tax exemption threshold
and increase rates
34
Comparison of candidates’ tax plan estimates
-$15
-$12
-$9
-$6
-$3
$0
$3
$6
$9
$12
$15
Sources: Citizens for Tax Justice (CTJ), Tax Policy Center (TPC), and Tax Foundation (TF) estimates. The three organizations estimate slightly different policies, so are not strictly comparable.
Trillions of dollars, 10-year
Rev
enue
gai
n or
loss
Tax Foundation (Static)
Tax Foundation (Dynamic)
Tax Policy Center
Citizens for Tax Justice
Cruz Trump
Clinton Sanders
-$10.1
-$12
-$9.5
-$12
-$0.8
-$3.6
-$8.6
-$13.9
$0.5 $1.1
$0.5 $0.2
$9.8
$13.6
$15.3
$13
36
Section 385 and its History
► Section 385(a) authorizes the Secretary to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is treated as stock or indebtedness (in whole or in part) for purposes of the Code.
► Section 385(b) provides that the regulations prescribed under section 385 shall set forth factors to be taken into account in determining whether an interest in a corporation is stock or indebtedness. Section 385(b) identifies certain factors that may be taken into account for this purpose, which generally track the case law.
► Section 385 was amended in 1989 and 1992.
► Section 385(a) was amended in 1989 to expressly authorize the Secretary to issue regulations to treat an interest in a corporation as part stock and part indebtedness.
► Section 385(c) was added in 1992 to provide that the issuer’s characterization (as of the time of issuance) of an interest in a corporation as stock or indebtedness is binding on the issuer and on all holders of the interest (but not on the Secretary).
37
Purpose of Proposed Regulations
► The proposed section 385 regulations address whether an interest in a related corporation is treated as stock or indebtedness, or as in part stock or in part indebtedness, for all purposes of the Code.
► Although the proposed regulations were partially motivated by the enhanced incentives for related parties to create “excessive” indebtedness in the cross-border context, the proposed regulations go far beyond earnings stripping and apply to a wide range of common internal transactions.
► The proposed regulations do not apply to issuances of interests and related transactions among members of a consolidated group.
38
High-level Summary
► §1.385-1: General definitions; IRS has ability to split an instrument into part-debt and part-equity
► §1.385-2: Documentation requirements
► §1.385-3: Debt issued in, or to fund, the following transactions:
Distributions Certain acquisitions of “EG” stock Boot in a reorg
► §1.385-4: Consolidated group issues ► Members of a consolidated group generally treated as one corporation ► Prop. Reg. §1.385-4 provides rules addressing when an interest
• Ceases to be a consolidated group debt instrument; or • Becomes a consolidated group debt instrument
39
Prop. Reg. §1.385-2(b): Documentation and Information Requirements
► Subject to certain exceptions, an expanded group instrument (“EGI”) is treated as stock if certain threshold documentation and information is not prepared and/or maintained. ► Exceptions apply to an expanded group with assets and revenues below certain
thresholds or with no members with stock traded on an established market. ► An EGI is a debt instrument issued by a member of an expanded group that is held
by another member of that expanded group. ► What is considered a “debt instrument”?
► The term “expanded group” means an affiliated group as defined in section 1504(a), but with the following modifications: ► includes foreign and tax-exempt corporations ► includes corporations held directly OR indirectly (through application of section
304(c)(3)) ► modifies the ownership test to 80 percent of the vote OR value (instead of 80
percent of vote AND value).
► Documentation rules effective when regulations are finalized
40
Prop. Reg. §1.385-2(b): Documentation and Information Requirements (cont’d)
► The documentation and information must satisfy the following four requirements: 1. Binding obligation to repay funds advanced under Prop. Reg. §1.385-
2(b)(2)(i): ► Written documentation which establishes that the issuer has entered into an
unconditional and legally binding obligation to pay a sum certain on demand at one or more fixed dates.
2. Creditor’s rights to enforce terms of the debt under Prop. Reg. §1.385-2(b)(2)(ii): ► The written documentation must establish that the holder has the rights of a
creditor to enforce the obligation.
► These creditor’s rights typically include the right to trigger default or acceleration of the instrument for non-payment of interest or principal, and these rights must include a superior right to shareholders to share in the assets of the issuer in case of dissolution
41
Prop. Reg. §1.385-2(b): Documentation and Information Requirements (cont’d)
3. Reasonable expectation that funds can be repaid under Prop. Reg. §1.385-2(b)(2)(iii); and ► Written documentation that establishes the issuer’s financial position supported a
reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the terms of the applicable instrument.
► E.g., cash flow projections, financial statements, business forecasts, determinations of debt-to-equity and other relevant financial ratios of the issuer in relation to industry averages, and other information regarding the sources of funds enabling the issuer to meet its obligations pursuant to the terms of the applicable instrument.
4. Actions evidencing a genuine creditor-debtor relationship under Prop. Reg. §1.385-2(b)(2)(iv). ► Evidence of payments of principal and interest which could include a wire transfer or bank
statement proving payment;
► In the event of a default or similar type event, written documentation evidencing the holder’s reasonable exercise of the diligence and judgment of a creditor; e.g., evidence of the holder’s efforts to assert its rights, the parties’ efforts to renegotiate the debt, mitigate the breach, or change any material terms, and any documentation detailing the holder’s decision to refrain from pursuing any actions to enforce payment.
42
Prop. Reg. §1.385-2(b): Documentation and Information Requirements (cont’d)
► Observations and considerations regarding documentation requirements ► The 4 documentation requirements must also be met for “revolving credit
agreements” and “cash pooling arrangements” ► The documentation requirements must be met at the time the “facility” is first
established (i.e., the relevant date) ► The documentation related to the first 3 requirements must be prepared no later than 30
days after the relevant date ► The documentation related to the 4th requirement must be prepared no later than 120 days
after the relevant date ► Appears that the “facility” must have a maximum “draw down” amount or each
“draw down” will be treated as a separate loan subject to separate documentation requirements
► How will taxpayers meet the 4 requirements for routine cash pooling arrangements? – e.g,. What processes need to be in place to satisfy requirement #3 for every draw down? ► Material documentation governing ongoing operations of cash pooling arrangements must
be maintained for EGI’s issued pursuant to the arrangement ► What are we advising clients to do now?
43
Prop. Reg. §1.385-2(b): Documentation and Information Requirements (cont’d)
► Even once the 4 documentation requirements are satisfied, general tax principles will apply to determine whether, and to what extent, an interest is debt
► The documentation and information on prior slides must be maintained for all taxable years that the expanded group instrument is outstanding, and until the period of limitations expires for any return with respect to which the treatment of the instrument is relevant.
► Debt instruments that are re-characterized as equity under §1.385 will be characterized based on the terms of the instrument.
► What are the effects of the re-characterization?
44
Prop. Reg. §1.385-3(b)(2): General Rule
► Assuming a debt instrument is not already recharacterized pursuant to the documentation requirement under §1.385-2 or based on a determination under general tax principles pursuant to §1.385-1(d) or §1.385-2(a)(1), then, subject to certain exceptions, it is treated as stock for all federal tax purposes to the extent it is issued by a corporation to a member of its expanded group, ► In a distribution with respect to its stock; ► In exchange for stock of a member of the same expanded group (“expanded group
stock”) (including “hook stock” issued by a related corporate shareholder), other than in an exempt exchange; or
► In exchange for property in an asset reorganization to the extent that, pursuant to the plan of reorganization, the debt instrument is received as “boot” by a corporation that is a shareholder of the target corporation and a member of the issuer’s expanded group immediately before the reorganization.
► An exempt exchange means an acquisition of expanded group stock in which the transferor and transferee of the stock are parties to an asset reorganization, and either ► Section 361(a) or (b) applies to the transferor of the expanded group stock and the
stock is not transferred by issuance; or ► Section 1032 or §1.1032-2 applies to the transferor of the expanded group stock
and the stock is distributed by the transferee pursuant to the plan of reorganization.
45
Leveraged Distribution (Falkoff Planning) under the General Rule
USP
CFC Holdco
CFC Opco
Basis – $100+
Note
E&P - $0
E&P - $100
$100
$100
Year 1 Year 2
► Transaction: ► Step 1: In Year 1, CFC Holdco distributes a $100 note to USP.
► Step 2: In Year 2, CFC Opco distributes $100 in cash to CFC Holdco
► Step 3: CFC Holdco repays its note to USP
► Current Law: ► The distribution of the note in Year 1 effects a recovery of basis in
the stock of CFC Holdco under Section 301(c)(2).
► The distribution of cash to USP is simply a repayment of the note.
► Proposed Regs: ► Under Reg. §1.385-3(b)(2), the note is treated as stock of CFC
Holdco. Section 305 applies to the distribution in Year 1.
► In Year 2, CFC Holdco has $100 of E&P as a result of the distribution of cash from CFC Opco.
► The payment of the note in Year 2 is treated as a redemption of the deemed stock of CFC Holdco and treated a Section 301(c)(1) dividend via Section 302(d).
Year 2
1
2
3
46
CFC CFC
Section 304 Transactions under the General Rule
USP
CFC Holdco FS
CFC Subs
CFC Target
CFC Target stock
Note
E&P – $100
Basis – $150
FMV – $100
► Transaction: ► CFC Holdco acquires the stock of CFC Target in exchange for a
note in the amount of $100.
► Current Law:
► §304(a)(1) applies to the sale of the stock of CFC Target, and §302(b) is not satisfied (i.e., dividend equivalent redemption).
► FS is deemed to contribute the stock of CFC Target to CFC Holdco in exchange for hypothetical shares of CFC Holdco stock in a transaction to which §351(a) applies. CFC Holdco is then deemed to redeem the hypothetical shares in a dividend equivalent redemption to which §301 applies.
► Proposed Regs:
► Under Reg. §1.385-3(b)(2), the note is treated as stock of CFC Holdco.
► §304 does not apply to the sale of CFC Target for CFC Holdco stock because the deemed CFC Holdco stock is not property.
► Query what the treatment would be?
47
Third party acquisition using parent stock Ex. 2 of 1.385-3(g)(3)
► Facts. On Date A of Year 1, USS1 issues USS1 Note to FP in exchange for FP stock. On Date B of Year 1, USS1 transfers the FP stock to UST’s shareholders, which are not members of the FP expanded group, in exchange for all the UST stock.
► Analysis. Because USS1 and FP are members of the same expanded group, USS1 Note is treated as stock when issued under Prop. Reg. §1.385-3(b)(2)(ii) and -3(d)(1)(i). This result applies even though, pursuant to the same plan, USS1 transfers the FP stock to persons that are not members of the FP expanded group.
The exchange of USS1 Note for FP stock is not an exempt exchange. Because the USS1 Note is treated as stock for federal tax purposes Treas. Reg. §1.367(b)-10(a) cannot apply.
Because the General Rule treats the USS1 Note as stock, the USS1 Note is not debt for purpose of the Funding Rule.
FP
USS1 UST
USS1 Note
FP stock
UST SH/s
A
B
UST
48
Prop. Reg. §1.385-3(b)(3): Funding Rule
► Subject to certain exceptions, a debt instrument is treated as stock to the extent it is issued by a corporation (funded member) to a member of its expanded group in exchange for property with a principal purpose of funding (a “principal purpose debt instrument”),
► A distribution of property by the funded member to a member of its expanded group, other than a distribution of stock pursuant to an asset reorganization that is permitted to be received without the recognition of gain or income under section 354(a)(1) or 355(a)(1), or that is not treated as “boot” under section 356;
► An acquisition of expanded group stock, other than in an exempt exchange, by the funded member from a member of its expanded group in exchange for property other than expanded group stock; or
► An acquisition of property by the funded member in an asset reorganization to the extent that, pursuant to the plan of reorganization, a corporation that is a shareholder of the target corporation and a member of the funded member’s expanded group immediately before the reorganization receives “boot” with respect to its stock in the target in the reorganization.
49
Prop. Reg. §1.385-3(b)(3): Funding Rule
► Whether a debt instrument is a principal purpose debt instrument is determined based on all facts and circumstances, whether the instrument is issued prior to or after a distribution or acquisition.
► Per se treatment: Subject to an “ordinary course exception,” a debt instrument is treated as a principal debt instrument if it is issued during the period beginning 36 months before the date of a relevant distribution or acquisition, and ending 36 months after the date of the relevant distribution or acquisition (72-month period).
► Ordinary Course Exception: The “Per-Se Treatment” does not apply to a debt instrument that arises in the ordinary course of the issuer’s trade or business in connection with the purchase of property or the receipt of services to the extent that it reflects an obligation to pay an amount that is currently deductible by the issuer under section 162 or currently included in the issuer’s cost of goods sold or inventory, provided that the amount of the obligation outstanding at no time exceeds the amount that would be ordinary and necessary to carry on the trade or business of the issuer if it was unrelated to the lender.
► Rules are provided to coordinate the application of the Funding Rule when multiple debt instruments may be treated as principal purpose debt instruments, or when a debt instrument may be treated as funding more than one distribution or acquisition.
50
Leveraged Distribution under the Funding Rule
USP
CFC Holdco
CFC Opco
Basis – $150
E&P - $0
E&P - $100
$100
$100
Year 1
Year 2
► Transaction: ► Step 1: In Year 1, CFC Holdco borrows $100 from CFC
Finco in exchange for a note. ► Step 2: In Year 1, CFC Holdco distributes the proceeds to
USP. ► Step 3: In Year 2, CFC Opco distributes $100 in cash to
CFC Holdco. ► Step 4: CFC Holdco uses the cash to repay the note to
CFC Finco.
► Current Law: ► The distribution in Year 1 effects a recovery of basis in the
stock of CFC Holdco under Section 301(c)(2).
► Proposed Regs: ► Under Reg. §1.385-3(b)(3), the note is treated as stock
of CFC Holdco. ► The distribution of the loan proceeds in Year 1 effects
a recovery of basis in the stock of CFC Holdco under Section 301(c)(2).
► Consider the consequences to CFC Finco on repayment of the note – e.g., Section 302 redemption? FTC consequences? E&P consequences?
CFC Finco
Note Year 1
Year 2
$100
$100
2 1
4 4
51
§1.385-3(g)(3), Example 1 Distribution of a debt instrument
► Facts. On Date A in Year 1, FS lends $100x to USS1 in exchange for USS1 Note A. On Date B in Year 2, USS1 issues USS1 Note B, which has a value of $100x, to FP in a distribution.
► Analysis. Because USS1 Note B is issued by USS1 to FP, a member of USS1’s expanded group, in a distribution, USS1 Note B is treated as stock when issued under Prop. Reg. §1.385-3(b)(2)(i) and -3(d)(1)(i). Accordingly, USS1 is treated as distributing USS1 stock to FP in a distribution that is subject to §305.
Because USS1 Note B is treated as stock for federal tax purposes when it is issued by USS1, USS1 Note B is not treated as property for purposes of the Funding Rule of Prop. Reg. §1.385-3(b)(ii)(A) because it is not property within the meaning specified in §317(a). Accordingly, USS1 Note A is not treated as funding the distribution of USS1 Note B.
FP
USS1 FS $100x
USS1 Note B
B
A
USS1 Note A
52
Prop. Reg. §1.385-3: Exceptions to the General Rule and the Funding Rule
► Current E&P Reduction: For purposes of applying the General Rule and the Funding Rule with respect to a taxable year to a member of an expanded group, the aggregate amount of any distributions or acquisitions described in the General Rule and the Funding Rule are reduced by an amount equal to the member’s current E&P. Multiple distributions or acquisitions are reduced based on the order in which they occur.
► Threshold Exception: A debt instrument is not treated as stock if, immediately after the debt instrument is issued, the aggregate adjusted issue price of debt instruments held by members of the expanded group that would otherwise be treated as stock does not exceed $50 million. If this limitation is exceeded, the limitation will not apply to any additional debt instruments issued by the expanded group so long as any debt instrument that is treated as debt by reason of this exception remains outstanding.
► Funded Acquisitions of Subsidiary Stock by Issuance: An acquisition of expanded group stock will not be taken into account for purposes of the Funding Rule if the acquisition results from a transfer of property by a funded member (the transferor) to an expanded group member (the issuer) in exchange for stock of the issuer, provided that, for the 36-month period immediately following the issuance, the transferor holds, directly or indirectly, more than 50 percent of the total combined voting power of all classes of stock of the issuer entitled to vote and more than 50 percent of the total value of the stock of the issuer.
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Prop. Reg. §1.385-3(b)(4): Anti-Abuse Rule
► A debt instrument is treated as stock if it is issued with a principal purpose of avoiding the application of Prop. Reg. §1.385-3 or -4.
► In addition, an interest that is not a debt instrument for purposes of Prop. Reg. §1.385-3 and -4 (e.g., a contract to which section 483 applies) is treated as stock if it is issued with a principal purpose of avoiding the application of Prop. Reg §1.385-3 and -4.
► Examples of when the anti-abuse rule may apply include,
► If a debt instrument is issued to, and later acquired from, a person that is not a member of the issuer’s expanded group with a principal purpose of avoiding the application of this section;
► If a debt instrument is issued to a person that is not a member of the issuer’s expanded group, and such person later becomes a member of the issuer’s expanded group;
► A debt instrument is issued to an entity that is not taxable as a corporation for federal tax purposes; or
► A member of the issuer’s expanded group is substituted as a new obligor or added as a co-obligor on an existing debt instrument.
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Springing “receivables”
USP ► Transaction:
► Step 1: DRE checks-the-box to be treated as a corporation (Sub) ► At the time of the CTB election, DRE has a $100
loan owing from CFC
► Proposed Regs: ► CFC treated as issuing a $100 loan to Sub in exchange
for Sub stock ► Is this an acquisition of EG stock? ► If so, CFC loan becomes equity in CFC held by Sub ► What is Sub’s basis in CFC stock
► Compare to result if CFC contributed loan receivable under current law (see, e.g, RR 68-629, Perachi, Lessinger)
► Consequences when CFC “repays” loan? ► Consequences if USP later contributes property to CFC?
CFC
DRE Receivable
Payable
$100 1
USP
CFC
Sub
55
Inbound Acquisition Structuring Issues
FP
FS USP
UST
$30 of FP stock
► Transaction: ► Step 1: USP borrows $70 from FS in
exchange for a note. ► Step 2: FP contributes $30 of FP stock to
USP. ► Step 3: USP acquires UST in exchange for
$70 of cash and $30 of FP stock.
► Proposed Regs:
► Reg. §1.1032-3 treats this transaction as if, immediately before USP disposes of the FP stock, USP purchased the FP stock from FP for fair market value with cash contributed to USP by FP.
► Is this an “acquisition of expanded group stock, other than in an exempt exchange, by the funded member from a member of the funded member’s expanded group in an exchange for property other than expanded group stock” under Reg. §1.385-3(b)(3)(ii)(B)?
$70
Note
2
3 1
UST SHs
UST
$70 cash + $30 of FP stock
UST stock
56
Outbound Acquisition Structuring Issues
USP
US1 CFC
FT
$30 of USP stock
► Transaction: ► Step 1: CFC borrows $70 from US1 in
exchange for a note. ► Step 2: USP contributes $30 of USP stock to
CFC. ► Step 3: CFC acquires FT in exchange for $70
of cash and $30 of USP stock.
► Proposed Regs:
► Reg. §1.1032-3 treats this transaction as if, immediately before CFC disposes of the USP stock, CFC purchased the USP stock from USP for fair market value with cash contributed to CFC by USP.
► Is this an “acquisition of expanded group stock, other than in an exempt exchange, by the funded member from a member of the funded member’s expanded group in an exchange for property other than expanded group stock” under Reg. §1.385-3(b)(3)(ii)(B)?
$70
Note
2
3 1
FT SHs
FT
$70 cash + $30 of USP stock
FT stock
57
Effective Dates / Transition Rules
► §1.385-1: IRS has ability to split an instrument as part debt and part equity
► §1.385-2: Documentation requirements
► §1.385-3: Re-characterization of debt issued in, or to fund,
Distributions
Acquisitions of EG stock
Boot in a reorg
► Effective when regulations finalized
► Effective when regulations finalized
► Effective for debt instruments issued on or after April 4th, 2016
► 90 day transition rule