Pursuant to Executive Order 13789, IRS and Treasury have been reviewing tax regulations issued since January 1, 2016 with an eye toward regulations that:
- Impose an undue financial burden on US taxpayers
- Add undue complexity to the US tax laws; or
- Exceed the statutory authority of the IRS
In a Notice released July 7, 2017, Treasury issued its first conclusions identifying eight regulations that they felt met the announced criteria. Now, in a second report, this one dated October 2, 2017, Treasury has announced its recommended actions on those regulations.
This note offers a brief roadmap of the October 2 report.
Of the 105 temporary, proposed, and final regulations issued between January 1, 2016 and April 21, 2017, Treasury identified eight which they believe meet at least one of the first two criteria of the Executive Order. Treasury also notes in its October report that they are also considering unstated reforms to regulations under Section 871(m) (related to payments treated as U.S. Source dividends) and under the Foreign Account Tax Compliance Act.
Treasury has identified two proposed regulations to be withdrawn, three temporary or final regulations to be revoked in substantial part, and three regulations to be substantially revised. I will summarize these proposed changes in order.
I. There are two proposed regulations proposed to be withdrawn entirely. These include:
1. Proposed Regulations under Section 2704 concerning restrictions on liquidation of an interest for Estate, Gift, and Generation-Skipping Transfer Taxes. Section 2704 addresses the valuation of interests in family controlled entities, for purposes of wealth transfer tax. In some cases, Section 2704 treats lapses of voting or liquidations rights as if they were transfers for gift and estate tax purposes.
The goal of the proposed regulations was to respond to developments in state statutes and case law which had reduced the applicability of Section 2704 and enabled certain family entities to generate artificially high valuation discounts for such characteristics as lack of control and marketability. By depressing the values of assets this way, taxpayers can depress the value of property for gift and estate tax purposes. Some comments on the regulations indicated that it is not practicable to value an interest in a closely held entity as if there were no restrictions on withdrawal or liquidation in the organization’s governing documents or state law simply because such a hypothetic environment does not exist.
Treasury now concludes that the approach of the proposed regulations to the issue of artificial valuation discounts is “unworkable” and plans to publish a withdrawal of the associated regulations in their entirety.
2. Prosed Regulations under Section 103 concerning the definition of a Political Subdivision. Section 103 of the Code excludes from a taxpayer’s gross income the interest on state or local bonds, including obligations of political subdivisions. The proposed regulations called for such a political subdivision, for this purpose, to possess not only sovereign power, but also to meet certain tests to demonstrate a governmental purpose and governmental control.
While Treasury continues to express the belief that some enhanced standards for qualifying as a governmental entity are needed to suit the purposes of Code Section 103, it expresses the conclusion that, in the context of the extensive impact on existing legal structures of Section 103, the proposed regulations are not justified.
II. Regulations Treasury may consider revoking in part. These include the following three final, proposed, and temporary regulations:
1. Final Regulations under Section 7602 on the Participation of a Person Described in Section 6103(n) in a Summons Interview. The final regulations allow the IRS to use private contractors to assist the IRS in auditing taxpayers. This participation includes the authority of the Service to allow the private contractor to “participate fully” in IRS interviews of taxpayers and other witnesses, including witnesses under oath. The regulation also allows private contractors to review records received in response to a summons. These regulation were first promulgated as temporary regulation in 2014, then finalized in 2016.
Only two comments were received on these regulations. However, the regulations were not well-received by the public. One federal court observed that such a practice “may lead to further scrutiny by Congress” (U.S. v. Microsoft Corp. 154 F. Supp. 3d 1134, 1143 (W.D. Washington 2015). Thereafter, the Senate Finance Committee approved legislation that would prohibit IRS from using private contractors in a summons proceeding for any purpose.
Treasury now takes the position that it may consider amending these regulations with only prospective effect. Such an amendment would serve to prohibit the IRS from using outside legal counsel in an examination or a summons interview. Outside attorneys would not be permitted question witnesses or be involved in a back office capacity such as reviewing summoned records or consulting on IRS legal strategy. IRS will continue to use outside subject matter experts such as economists, engineers, and authorities on foreign legal matters.
2. Regulations under Sections 707 and 752 on Treatment of Partnership Liabilities. These regulations include:
- Proposed and Temporary Regulations addressing allocation of liabilities for purposes of the disguised sale rules; and
- Proposed and Temporary Regulations treating so-called “bottom dollar” guarantees and generally disallowing such guarantees for purposes of calculating a partner’s liability in the context of liability allocation
The first set of rules, dealing with liability allocation in evaluating a disguised sale, effectively renders all liabilities for these purposes as nonrecourse liabilities. Treasury acknowledges that this characterization technique is “novel” and allows that it is “considering whether the proposed and temporary regulations relating to disguised sales should be revoked and the prior regulations reinstated.”
The prior, proposed regulations were largely a codification of the IRS arguments in Canal Corporation v. Comm’r, 135 T.C. 199 (2010) where the Tax Court held that a partner’s guarantee in the context of a so-called “leveraged partnership” transaction should not be respected where the partner-guarantor was undercapitalized vis-a-vis the liability and had no contractual requirement to maintain a minimum net worth. The 2014 regulations had their own cumbersome qualities, many of which were intended to be resolved by the 2016 regulations.
Treasury indicates even less willingness to change the proposed and temporary bottom dollar regulations. After an extended recitation of the perceived problems arising from non-commercial guarantees, Treasury concludes that “the temporary regulations are needed to prevent abuses and do not meaningfully increase regulatory burdens of the taxpayers affected.” Accordingly, Treasury does not plan to review the bottom dollar guarantee regulations.
3. Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness.
These regulations generally include two categories of rules:
- Rules establishing minimum documentation requirements that must usually be satisfied before claimed debt obligations between related parties can be treated as debt for federal tax purposes (known as the “Documentation Regulations”); and
- Rules that treat as stock debt that is issued by a corporation to a controlling shareholder in a distribution or in another related party transaction that achieves an economically similar result (known as the “Distribution Regulations”).
The Documentation Regulations apply principally to domestic issuers and establish minimum characteristics of a transaction whereby its tax posture can be evaluated.
The Distribution Regulations generally affect interests issued to related parties who are non-U.S. holders and serve to limit earnings-stripping, whether by way of inversions or foreign takeovers.
Treasury now proposes to:
- Revoke the Documentation Regulations in their entirety, followed by introduction of new regulations at a later date; and
- Retain the Distribution Regulations in anticipation of reforms to the Internal Revenue Code.
III. Regulations Treasury May Consider Substantially Revising
Treasury has identified two Final Regulations and a Temporary Regulation for consideration for revision:
1. Final Regulations under Code Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations.
Section 367 of the Code imposes a tax on transfers of property to foreign corporations, subject to certain exceptions, including an exception for property transferred for use in the active conduct of a trade or business outside of the United States.
These regulations eliminate the ability of taxpayers to transfer foreign goodwill and going concern value to a foreign corporation without incurring tax. The rules provide no exception for an active trade or business.
Treasury now argues that “an exception to the current regulations may be justified by both the structure of the statute and its legislative history.” Treasury, through the Office of Tax Policy, is proposing to expand the active trade or business exception to include relief for outbound transfers of foreign goodwill and going concern value attributable to a foreign branch under circumstances with limited potential for abuse and, curiously, administrative difficulties. The notion that making regulations controlling outbound transfers of foreign goodwill which simultaneously maximize simplicity and minimize risk of abuse, while noble in the articulation, has historically proven more aspirational than practical.
2. Temporary Regulations under Section 337(d) on Certain Transfers of Property to Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs)
The Temporary Regulations amend existing rules on transfers of property by C corporations to RICs and REITs. The regulations also govern application of the PATH Act to spinoff transactions involving disqualification of nonrecognition treatment for C corporation property transferred to REITs. Treasury now believes that the REIT spinoff rules could result in over-inclusion of gain in some circumstances. This might be particularly problematic, Treasury says, when a large corporation acquires a small corporation that had engaged in a Section 355 spin-off and the large corporation then makes a REIT election.
Treasury now concludes that the temporary regulations may produce too much taxable gain in some cases. Hence, Treasury is considering proposing caps in situations where, because of the predecessor and successor rule in Reg. Section 1.337(d)-7T(f)(2), gain recognition is required in excess of the amount that would have been recognized if a party to a spin off had directly transferred assets to a REIT.
3. Final Regulations under Section 987 on Income and Currency Gain or Loss with Respect to a Section 987 Qualified Business Unit
These final regulations govern:
- Translation protocols forincome from branch operations conducted in a currency that differs from the owner’s functional currency;
- Calculating foreign currency gain or loss with respect to the branch’s financial assets and liabilities; and
- Recognizing foreign currency gain or loss when the branch makes certain transfers of property to its owner
The Treasury report states that these regulations “have proved difficult to apply for many taxpayers.” While this explanation meets none of the criteria advanced by the Executive Order, Treasury proposes as a solution to “defer application of Regulations Sections 1.987-1 through 1.987-10 until at least 2019.” It is unclear how delay of application of the regulations will respond either to the problem identified by Treasury or to the Executive Order.
Treasury takes its response to the subject regulations a couple of steps further. Treasury declares its intent to propose modifications to the final regulations to adopt a simplified method of translating and calculating Section 987 gains and losses, subject to unspecified timing limitations. By way of example, the Report suggests rules that would treat all assets and liabilities of a Section 987 qualified business unit (QBU) as marked items and translate all items of income and expense at the average exchange rate for the year. Section 989 of the Code defines a QBU as “any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records.” The goal identified for this change is rendering Section 987 gain and loss consistent with currency translation gain and loss under applicable financial accounting rules and well as under the proposed Section 987 regulations proposed in 1991.
Treasury further proposes to limit a taxpayer’s Section 987 losses to the extent of its net Section 987 gains recognized in prior or subsequent years. The Report makes no reference to any proposed time limitation for this carryback and carryforward device.
The October 2, 2017 Treasury Report further identifying the regulations whore removal or revision answer Executive Order 13789 appears to apply uneven and incomplete standards for those choices, and promulgate a strategy for revision and removal that may not yield, in the final analysis, a reduction in the number or complexity of the tax regulations.
Counsel should, in any event, be aware of the changes proposed in the Report to appropriately anticipate the substantial revision in the legal landscape proposed by Treasury.