International Tax Alert – October 2017

Department of the Treasury Releases Report Recommending Changes to Eight Tax Regulations

Summary

On October 2, 2017, the Secretary of the Department of Treasury (“Treasury”) issued a second report to President Trump on identifying and reducing tax regulatory burdens as directed by President Trump’s Executive Order 13789, a directive that instructed the Secretary of Treasury, to review “all significant regulations” issued on or after January 1, 2016, that (i) impose an undue financial burden on U.S. taxpayers, (ii) add undue complexity to Federal tax laws, or (iii) exceed the statutory authority of the Internal Revenue Service (“IRS”). Notice 2017-38 was published in July 2017 identifying eight regulations for review in response to Executive Order 13789. The Report states that Treasury continues to analyze all recently issued significant regulations and is considering possible reforms of several recent regulations not identified in Notice 2017-38 including regulations under Section 871(m), relating to payments treated as U.S. source dividends, and the Foreign Account Tax Compliance Act.
 
In addition, the Report states that Treasury and the IRS have initiated a comprehensive review, coordinated by the Treasury Regulatory Reform Task Force, of all tax regulations, regardless of when they were issued. This review will identify tax regulations that are unnecessary, create undue complexity, impose excessive burdens, or fail to provide clarity and useful guidance, and Treasury and the IRS will pursue reform or revocation of those regulations. As part of the process coordinated by the Treasury Regulatory Reform Task Force, the IRS Office of Chief Counsel has already identified over 200 regulations for potential revocation, most of which have been outstanding for many years. The Report states that Treasury and the IRS expect to begin the rulemaking process for revoking these regulations in the fourth quarter of 2017 and also seek to streamline rules where possible. Later reports and guidance will provide details on the regulations identified for possible action, the reasons that they may be revoked, and the manner in which revocation would occur.
 
Most importantly, the Report sets forth the Treasury Secretary’s recommendations on the eight regulations identified in Notice 2017-38. Treasury expects to issue additional reports on reducing tax regulatory burdens, including, as directed in the executive order, the status of Treasury’s actions recommended in the Report. An overview of the Report’s recommendations on three regulations that particularly impact international tax and cross border transactions are discussed below.
 

Details

1. Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness^[1]

These final and temporary regulations address the classification of related-party debt as debt or equity for U.S. Federal income tax purposes. The regulations are primarily comprised of (i) rules establishing minimum documentation requirements that ordinarily must be satisfied for purported debt obligations among related parties to be treated as debt for Federal tax purposes (the “Documentation Regulations”); and (ii) rules that treat as stock certain 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 (the “Distribution Regulations”).^[2] For a discussion of the final and temporary regulations under Section 385 see our October 2016 Tax Alert.
 
The Report states that Treasury and the IRS are considering a proposal to revoke the Documentation Regulations as issued and are actively considering the development of revised documentation rules that would be substantially simplified and streamlined in a manner that will lessen their burden on U.S. corporations, while requiring sufficient legal documentation and other information for tax administration purposes. In place of any revoked regulations, the Report states that Treasury and the IRS would develop and propose streamlined documentation rules, with a prospective effective date that would allow time for comments and compliance. Consideration is being given, in particular, to modifying significantly the requirement, contained in the Documentation Regulations, of a reasonable expectation of ability to pay indebtedness. The treatment of ordinary trade payables under the documentation regulations is also being reexamined. It is also expected that any proposed streamlined documentation rules would include certain technical, conforming changes to the definitional provisions of the Section 385 regulations.
 
The Distribution Regulations address inversions and takeovers of U.S. corporations by limiting the ability of corporations to generate additional interest deductions without new investment in the United States. Regarding the Distribution Regulations, the Report states that Treasury has consistently affirmed that legislative changes can most effectively address the distortions and base erosion caused by excessive earnings stripping, as well as the general tax incentives for U.S. companies to engage in inversions. In the view of Treasury, tax reform is expected to obviate the need for the Distribution Regulations and make it possible for these regulations to be revoked. Treasury believes that proposing to revoke the existing Distribution Regulations before the enactment of fundamental tax reform, could make existing problems worse. If legislation does not entirely eliminate the need for the Distribution Regulations, Treasury will reassess the Distribution Regulations and Treasury and the IRS may then propose more streamlined and targeted regulations.
 

2. Final Regulations under Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations^[3]

Section 367 of the Internal Revenue Code generally imposes immediate or future U.S. tax on transfers of property (tangible and intangible) to foreign corporations, subject to certain exceptions, including an exception for certain property transferred for use in the active conduct of a trade or business outside of the United States.  Final regulations under Section 367 eliminate the ability of taxpayers to transfer foreign goodwill and going concern value to a foreign corporation without immediate or future U.S. income tax. For a discussion of the final regulations under Section 367, see our December 2016 Tax Alert. 
 
The Report states that Treasury and the IRS have concluded that an exception to the current regulations may be justified by both the structure of the statute and its legislative history. Thus, to address taxpayers’ concerns about the breadth of the regulations, the Office of Tax Policy and IRS are actively working to develop a proposal that would expand the scope of the active trade or business exception described above 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 administrative difficulties, including those involving valuation. The Report further states that Treasury and the IRS currently expect to propose regulations providing such an exception in the near term.
 

3. Final Regulations under Section 987 on Income and Currency Gain or Loss with Respect to a Section 987 Qualified Business Unit^[4]

These final regulations provide rules for: (i) translating income from branch operations conducted in a currency different from the branch owner’s functional currency into the owner’s functional currency; (ii) calculating foreign currency gain or loss with respect to the branch’s financial assets and liabilities; and (iii) recognizing such foreign currency gain or loss when the branch makes certain transfers of any property to its owner. Commenters argued that the transition rule in the final regulations imposes an undue financial burden because it disregards losses calculated for years prior to the transition but not previously recognized. Many taxpayers have also commented that the method prescribed by the final regulations for calculating foreign currency gain or loss is unduly complex and financially burdensome to apply, particularly where the final regulations differ from financial accounting rules. For a discussion of the final and temporary regulations under Section 987, see our December 2016 Tax Alert.
 
To address these difficulties, Treasury and the IRS published Notice 2017-57 that announced the intention to amend the regulations under Section 987 to defer the applicability date of the final regulations under Section 987, as well as certain provisions of the temporary regulations under Section 987 to taxable years beginning on or after two years after the first date of the first taxable year following December 7, 2016 (i.e., 2019 for calendar year taxpayers).
 
The Report states that Treasury and the IRS also intend to propose modifications to the final regulations to permit taxpayers to elect to adopt a simplified method of calculating Section 987 gain and loss and translating Section 987 income and loss, subject to certain limitations on the timing of recognition of Section 987 loss. Under one variation of a simplified methodology currently being considered, taxpayers 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. This methodology generally would result in determinations of amounts of Section 987 gain or loss that are consistent with amounts of translation gain or loss that would be determined under applicable financial accounting rules, as well as under the 1991 proposed Section 987 regulations.
 
The Report also provides that the IRS and the Office of Tax Policy are considering alternative loss recognition timing limitations that would apply to electing taxpayers. Under the base limitation under consideration, the electing taxpayer would be permitted to recognize net Section 987 losses only to the extent of net Section 987 gains recognized in prior or subsequent years. As a possible additional approach to limiting losses, the IRS and the Office of Tax Policy are also considering the administrability of a limitation under which the electing taxpayer would defer recognition of all Section 987 losses and gains until the earlier of (i) the year that the trade or business conducted by the Section 987 QBU ceases to be performed by any member of its controlled group or (ii) the year substantially all of the assets and activities of the QBU are transferred outside of the controlled group.
 
Finally, the Report states that the IRS and the Office of Tax Policy are considering alternatives to the transition rules in the final regulations. One alternative would be to allow taxpayers that elect to apply the loss limitations applicable to the simplified methodology discussed above to carry forward unrealized Section 987 gains and losses, measured as of the transition date with appropriate adjustments, and subject to such loss limitations. A second alternative under consideration would be to allow taxpayers adopting the final regulations to elect to translate all items on the QBU’s opening balance sheet on the transition date at the spot exchange rate, but not carry forward any unrealized Section 987 gains or losses.
 

BDO Insights

The Report’s recommendations on the three sets of regulations discussed above when effectuated should provide relief for taxpayers and alleviate certain compliance burdens that would otherwise apply. In particular, the Report’s recommendation on the Section 987 regulations could reduce complexity and simplify how the Section 987 regulations are applied. BDO can assist in reviewing how the Report’s recommendations can impact our clients.
 

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