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Proposed Regulations under Section 385: Nightmare on Main Street and Pipe Dream for Wall Street?

This presentation discusses the proposed regulations under Section 385 and their potential impact on businesses and taxpayers. It covers topics such as the Part-Stock Rule, Documentation Rules, Per Se Stock Rules, Consolidated Groups, and more.

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Proposed Regulations under Section 385: Nightmare on Main Street and Pipe Dream for Wall Street?

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  1. Proposed Regulations under Section 385: a Nightmare on Main Street and Pipe Dream for Wall Street? TEI Program September 21, 2016, Dearborn, Michigan Presenters: Jerred G. Blanchard, Jr. Baker & McKenzie LLP 700 Louisiana, Suite 3000 Houston, Texas 77002 Office Phone: (713) 427-5019 jerred.blanchard@bakermckenzie.com Alexandra Minkovich Baker & McKenzie LLP 815 Connecticut Avenue NW Washington, D.C. 20006 Office Phone: (202) 452-7015 alexandra.minkovich@bakermckenzie.com

  2. I. Outline of Proposed Regulations – pp. 3-4 II. Part-Stock Rule – pp. 6-13 III. Documentation Rules – pp. 15-24 IV. Per Se Stock Rules – pp. 26-46 V. Consolidated Groups – pp. 48-50 VI. Interesting and Troubling Transactions – pp. 52-57 VII. Validity of Per Se Stock Rules – pp. 59-74 Section 385 Proposed RegulationsTable of Contents

  3. I. Outline of the Proposed Regulations • Prop. Reg. §1.385-1:* • Definitions and operating rules, including a part-debt/part-stock rule (the “Part-Stock Rule”). The Part-Stock Rule provides the Service with far more leeway than current law for determining whether an instrument is part stock and part debt. For example, there is no requirement that the instrument have an “equity kicker” or be convertible into, or exchangeable for, issuer stock or assets. • Prop. Reg. §1.385-2: • Documentation and information requirements necessary for certain instruments issued between related parties to be treated as debt for federal tax purposes (the “Documentation Rules”). The Documentation Rules are intended to (i) impose “discipline” on taxpayers and (ii) provide IRS auditing agents with the information needed to characterize related party instruments as debt or equity. *Unless otherwise stated, all “Section” or “§” references in this presentation are to provisions of the Internal Revenue Code of 1986, as amended (the “Code”), or to provisions of the Treasury regulations (“Reg.”) or proposed Treasury regulations (“Prop. Reg.”) issued or proposed pursuant to the Code.

  4. I. Outline of the Proposed Regulations (cont’d) • Prop. Reg. §1.385-3: • Treatment of debt instruments between related parties in connection with certain transactions as stock even though otherwise qualifying as debt (the “Per Se Stock Rules”). The Per Se Stock Rules can apply to recharacterize an instrument between related parties as stock even though the instrument qualifies as debt for federal income tax purposes under general tax principles, the Documentation Rules, and the Part-Stock Rules. The sole basis for application of the Per Se Stock Rules is the kind of transaction connected with the issuance of the instrument, whether factually connected or simply because the transaction closes within 3 years of the date on which the instrument is issued, and the relationship between issuer and holder. This rule is by far the rule most susceptible to challenge as beyond the scope of Section 385. • Prop. Reg. §1.385-4: • Special rules for applying the Per Se Stock Rules to consolidated groups. Because none of the Proposed Section 385 Regulations applies to intercompany obligations between members of the same consolidated group, the principal function of these rules is to provide guidance as to how the Per Se Stock Rules apply when a related party instrument enters a consolidated group from a related party or leaves a consolidated group to a related party. 4

  5. II. Part-Stock Rule

  6. Part-Stock Rule – Background • Current law generally treats an instrument as wholly debt or wholly equity based on a multi-factor test weighing debt and equity factors to determine which predominate. • Section 385(a), amended as part of the 1989 Omnibus Budget Act, authorizes the Service to bifurcate an instrument into separate debt and equity components. See H.R. Rep. No. 386, 101st Cong., 1st Sess. (1989). However, the legislative history also indicates that the amendment was viewed as a clarification rather than a substantive revision of existing law. See 16 Legislative History of the Omnibus Budget Act of 1989, Pub. Law No. 101-239 (1989). • While most courts applied an “all or nothing” weighing of debt factors and equity factors (see, e.g., Monon Railroad v. Commissioner, 55 T.C. 345, 356 (1970) (acq.), and Curry v. Commissioner, 43 T.C. 667, 686 (1965)), some courts did bifurcate corporate interests possessing significant equity features (see Richmond Fredericksburg & Potomac R.R. Co. v. Commissioner, 528 F.2d 917 (4th Cir. 1975), and Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2nd Cir. 1960)) (a $70,000 second mortgage loan, entitling the lender to fixed interest plus a 50% share of any future appreciation in the value of the underlying real estate, was bifurcated and treated as part debt ($70,000 plus the fixed interest) and part equity (the 50% interest); thus, no interest deduction was allowed for the $50,000 paid to lender’s estate in satisfaction of its claim with respect to the equity portion of the loan). But see alsoRev. Rul. 83-51, 1983-1 C.B. 48 (not bifurcating shared appreciation mortgage where full payment of principal and interest terminated 40% sharing in proceeds from sale of underlying real estate). • Thus, under the case law decided at the time of the 1989 Act, bifurcation was extremely rare and was limited to cases in which an instrument contained both debt and equity features, such as an “equity kicker” (as in Farley Realty Corp.).

  7. Part-Stock Rule – Prop. Reg. §1.385-1(d) • Prop. Reg. § 1.385-1(d)(1) & (2) authorize the IRS to treat certain related-party interests as part indebtedness and part stock. • The Part-Stock Rule contains few (if any) limitations on the IRS’s authority to recharacterize debt as part equity, and an example indicates the only requirement is a determination by the IRS that the issuer is reasonably expected to pay only part of the principal. • If a portion of the instrument is recharacterized as stock, it may be common or preferred stock based on the instrument’s terms. See Preamble; Prop. Reg. §1.385-3(g)(3), Ex. 8. • Absent an “equity kicker” (e.g., an unlimited participation in issuer earnings or specific assets as in Farley Realty Corp.), a right to convert the instrument into stock or exchange the instrument for issuer assets, or some other “equity-like” feature (e.g., interest that is contingent on earnings or subordination to one or more shareholders), one wonders if the Service could succeed in treating an instrument with predominant debt feartures as part stock. 7

  8. Part Stock Recast Bifurcation: Example Facts: USS borrows $5 million from its sole shareholder, FP, in exchange for a $5 million USS recourse note, none of the terms of which contains an “equity kicker” or other “equity-like” feature. The IRS determines that, at issuance, USS cannot reasonably be expected to repay more than $3 million of the principal due under the USS note. FP (Foreign) $5 million note $5 million loan USS (US) Analysis: Based solely on that determination, it appears that the IRS is authorized to treat $2 million of the $5 million note as USS stock. See Preamble, p. 33; Prop. Reg. § 1.385-1(d)(1). Under the case law, because the note’s debt features predominate, the entire $5 million note likely would be characterized as debt for tax purposes.

  9. Part-Stock Rule: Definition of MEG • Application: Applies to an “expanded group instrument” or “EGI” (defined in Prop. Reg. §1.385-2(a)(4)(i)(A) and (ii) as any interest that is “in form a debt instrument” issued between members of an expanded group), but issued between members of a Modified Expanded Group (“MEG”). See Prop. Reg. §1.385-1(d)(1). • MEG - 50% direct or indirect ownership threshold for relatedness, applying the attribution rules of Section 304(c)(3). Prop. Reg. §1.385-1(b)(5). An individual, estate, trust, or partnership can be a MEG member if such person constructively owns under Section 318 at least 50% in value of the equity of another MEG member. Id. A partnership can also be a MEG member if MEG members own, directly or under the Section 304(c)(3) attribution rules, at least 50% of the partnership’s capital or profits interest. Prop. Reg. §1.385-1(b)(4). • Note – the MEG threshold is lower than the 80% requirement for expanded groups under the Documentation Rules (-2) and Per Se Stock Rules (-3) discussed below. • Consolidation: Does not apply to intercompany obligations between members of the same consolidated group (as defined in Reg. §1.1502-1(h)), and all members of a consolidated group are treated as one corporation. Prop. Reg. §1.385-1(e). • Effective Date: Prospective - applies to in-form debt instruments between MEG members issued, or deemed issued as a result of a check-the-box election made, on or after the date the Proposed Section 385 Regulations are issued as final regulations. Prop. Reg. §1.385-1(f).

  10. Facts: LBO Fund (a partnership) owns all the stock of USP (a domestic corporation), and USP owns (directly and under the Section 304(c)(3) attribution rules) 50% in value of the stock of USS (a domestic corporation). USP lends $500 million to LBO Fund in exchange for a recourse LBO Fund note. MEG Membership: Example 1 LBO Fund • Observations: • Treating the $500 million LBO Fund note as in part a partnership interest may adversely impact the manner in which partnership items are allocated, especially the allocation of liabilities under Section 752. • Also, Section 385 does not authorize regulations addressing the characterization of interests in partnerships or individuals. $500 million loan 100% $500 million LBO Fund note USP (US) 50% USS (US) Analysis: Because USP owns 50% in value of the USS stock, USS is a member of USP’s MEG. Also, because LBO Fund constructively owns under Section 318(a)(2)(C) 50% in value of the USS stock and directly owns all the USP stock, LBO Fund is also a member USP’s MEG. Thus, the $500 million LBO Fund note may be recharacterized as part partnership interest/part partnership debt. This would not be the case if LBO Fund had owned (directly and under the Section 304(c)(3) attribution rules) only 99% in value of the USP stock because then LBO Fund would not have owned at least 50% in value of the equity of another MEG member under Section 318. Does this make any sense at all? 10

  11. MEG Membership: Example 2 Facts: Individual A owns all the stock of USP (a domestic corporation), and USP owns (directly and under the Section 304(c)(3) attribution rules) 50% in value of the stock of USS (a domestic corporation). USP lends $500 million to A in exchange for a recourse A note. *In Alterman Foods Inc. v. U.S., 505 F.2d 873 (5th Cir. 1974), advances routinely made by subsidiaries to a parent corporation, that were characterized as debt on the parent's books, were recast as dividends. However, the basis for the recast was: (i) there was no written evidence of any parent obligation, no fixed maturity date, and no accruals of interest; (ii) prior repayments were offset by additional loans; and (iii) the only source of repayment was dividends on the stock held by the parent in the lending subsidiaries. Individual A $500 million loan 100% USP (US) $500 million A note 50% USS (US) Analysis: As in Example 1, because USP owns 50% in value of the USS stock, USS is a member of USP’s MEG. Also, because Individual A constructively owns 50% in value of the USS stock and directly owns all the USP stock, A is also a member USP’s MEG. Thus, the $500 million A note may be recharacterized as part equity/part debt. Becausean individual cannot issue equity in herself, would the rule treat USP as owning an undivided interest in one or more of the individual’s assets? Perhaps part of the $500 million loan would be recast as a Section 301 distribution to A?*Does this make any sense at all? 11 11

  12. MEG Membership: Example 3 Facts: USP owns all the stock of USS, and USS owns (directly and under the Section 304(c)(3) attribution rules) 50% of the capital or profits interests in PS (a partnership). Unrelated Persons own the balance of the PS interests. USP lends $500 million to PS in exchange for a recourse PS note. $500 million PS note $500 million loan 100% USP (US) Unrelated Persons 50% 50% USS (US) PS Analysis: PS is a “modified controlled partnership” within the meaning of Prop. Reg. §1.385-1(b)(4) because one or more members of USP’s MEG (USS) own (directly and under the Section 304(c)(3) attribution rules) at least 50% of the capital or profits interests in PS. Therefore the Part-Stock Rule applies. If the $500 million PS note is recast under the rule as part equity/part debt (e.g., the IRS determines that PS can reasonably be expected to pay only $200 million of the principal of the PS note), then PS will be treated as issuing a partnership interest to USP (e.g., a $300 million “preferred” interest in the capital and profits of PS). This entity theory of partnerships could have deleterious consequences with respect to allocations of PS items (especially liabilities) among its partners. 12 12

  13. Part-Stock Rule (cont'd) • Practical Implications • Recharacterization Risks: • Recharacterization of an inbound loan as part equity could raise effectively connected income and permanent establishment risks. • Recharacterization of the debt of a corporate JV could create a CFC. • Because partnerships and disregarded entities can be issuers of applicable instruments (an entity theory), characterization of such an instrument as part debt/part stock can (i) adversely affect partnership allocations (especially under Section 752) and (ii) turn a disregarded entity into a partnership. • Key Ambiguities: • Little guidance on how an instrument will be bifurcated into stock and debt or how various common law factors will be weighed (Treasury has requested comments on this point and has received quite a few). • If an individual’s note to a member of the individual’s MEG must be treated as part equity/part debt under Prop. Reg. §1.385-1(d), what happens? • If there is a recast of an interest as part stock, how will basis, issue price, and subsequent payments with respect to the interest be allocated?

  14. III. Documentation Rules

  15. Documentation Rules – Prop. Reg.§1.385-2 • The rule establishes threshold documentation requirements that must be satisfied for certain related-party interests in a corporation to be considered indebtedness. • Purposes: • To provide the IRS with information necessary to analyze the nature of an instrument for federal tax purposes and to impose the same kind of discipline on taxpayers required by unrelated lenders. See Preamble at 16-20. • Effective date: • Prospective: applies to instruments issued, or deemed issued as a result of a check-the-box election made, on or after the date the Proposed Section 385 Regulations are issued as final regulations. Prop. Reg. §1.385-2(f).

  16. Documentation Rules (cont’d) • Required for Expanded Group Instruments (“EGIs”) (as defined in Prop. Reg. §1.385-2(a)(4)(i)(A) and (ii)) • “Expanded Group” (“EG”) is defined as a group of corporations (which can include tax-exempt corporations, insurance companies, foreign corporations, S corporations, and other corporations that are excluded from the definition of affiliated group under Section 1504(b)) in respect of which (i) a common parent owns, directly or indirectly, 80% of the stock (in vote or value) of at least one other group member, and (ii) 80% of the stock (in vote or value) of each of the other corporate members is owned directly by one or more other corporate members. Prop. Reg. §1.385-1(b)(3). • The constructive ownership rules of Section 304(c)(3) apply in determining indirect stock ownership. Id. • Documentation is a threshold requirement only. It does not limit the IRS’s ability to recharacterize an instrument as stock under general tax principles, even if the required documentation is present. • Does not apply to intercompany obligations between consolidated group members. • Like the Part-Stock Rule, the Documentation Rules contain an entity theory of partnerships. See Prop. Reg. §§1.385-1(b)(1) and 1.385-2(c)(6). 16

  17. Attenuated EG Expanded Group: Example 1 Facts: P lends $500 million to S in exchange for a recourse S note. Individuals A and B are unrelated. A owns 80% of S and 1% of partnership AB. B owns 99% of partnership AB, and AB owns all the P stock. Individual A Individual B 99% 1% 80% AB (US Partnership) S (US “S” Corporation) $500 million loan 100% P (US “C” Corporation) $500 million S note Analysis: A’s 80% interest in S is attributed to AB under Section 318(a)(3)(A) (partner-to-partnership attribution with no threshold ownership requirement), and then attributed from AB to P under Section 318(a)(3)(C) (shareholder-to-corporation attribution with 50% threshold ownership requirement). Therefore P and S constitute an EG. Thus, the S note is subject to the Part-Stock Rule, the Documentation Rules, and the Per Se Stock Rules. Does this make any sense??!! 17

  18. Expanded Group: Example 2 Multiple EGs and Single MEG Facts: Individual A owns 100% of P and 30% of T. P owns 75% of S, and Unrelated Persons own 25% of S. S owns 70% of T. A lends $20 million to P; P lends $5 million to S; T lends $10 million to S; and T lends $50 million to P. Conclusion 1: Based on the analysis below, (i) T’s $50 million loan to P is subject to the Documentation Rules and Per Se Stock Rules; (ii) T’s $10 million loan to S is also subject to the Documentation Rules and Per Se Stock Rules; but (iii) P’s $5 million loan to S is not subject to either set of these rules. Individual A $20 million loan 30% 100% P (US “C” Corporation) Unrelated Persons $50 million loan $5 million loan 25% 75% Conclusion 2: Because A and all the corporations are MEG members, all loans (including A’s $20 million loan to P) are subject to the Part-Stock Rule. S (US “C” Corporation) $10 million loan Analysis: S is not a member of P’s EG because P does not actually or constructively own at least 80% in vote or value of the S stock. However, T is a member of P’s EG because P indirectly owns 82.5% of the T stock (30% attributed from A and 52.5% [75% x 70%] from S). T is also a member of S’s EG (S directly owns 70% of the T stock and is attributed 30% of the T stock from A to P to S). None of the corporations are members of a consolidated group, and Individual A and all the corporations are members of a single MEG. 70% T (US “C” Corporation) 18

  19. Documentation Rules (cont'd) • An EGI (as defined in Prop. Reg. §1.385-2(a)(4)(i)(A) and (ii) – see p. 9) will be subject to the Documentation Rules only if at least one of the following three gateway tests is met (Prop. Reg. §1.385-2(a)(2)): • (1) Publicly traded stock test: The stock of any member of the EG is publicly traded; • (2) Asset test: All or any portion of the EG’s financial results are reported on a specified financial statement with total assets exceeding USD 100 million; or • (3) Income test: All or any portion of the EG’s financial results are reported on specified financial statements that reflect total annual revenue exceeding USD 50 million. • There is no de minimis rule. • Probably must aggregate multiple financial statements.

  20. Documentation Rules (cont'd) • If one or more gateway tests are satisfied, the required documentation must establish the following four requirements for an EGI to be considered debt: • (1) A binding obligation to repay the advanced funds on demand or on one or more dates; • (2) Creditor’s rights to enforce the terms of the debt; • (3) A reasonable expectation that the funds advanced can be repaid; and • (4) After the instrument is issued, actions evidencing an ongoing and genuine debtor-creditor relationship. • Timing requirements for the documentation – the first three requirements must be satisfied 30 days from the issuance of the EGI, and the fourth must be satisfied 120 days following any payment or default on the EGI. Prop. Reg. §1.385-2(b)(3). If an EGI is deemed reissued due to a “significant modification” within the meaning of Reg. §1.1001-3(e), the issuer must submit documentation regarding its reasonable expectation that the “new” EGI can be fully satisfied within 30 days after the deemed issuance of the “new” EGI. Prop. Reg. §1.385-2(b)(3)(i) and (ii)(B).

  21. Documentation Rules (cont'd) • Types of documentation required: • Written obligation evidencing: • Obligation to pay a sum certain on demand or at fixed time(s); • Enforceable creditor’s rights (e.g., right to trigger default/acceleration for nonpayment of interest/principal); and • Liquidation preference over shareholders. Prop. Reg. §1.385-2(b)(2). • Collateral agreements (e.g., guaranties, subordination agreement) must be documented. Id. • Documents must show an ability to pay (e.g., analysis of issuer’s debt/equity ratio, cash flow projections, financial statements, business forecasts, asset appraisals, etc.). Prop. Reg. §1.385-2(b)(2)(iii). • Must provide the documentation on request by the IRS (failure to do so permits the IRS to characterize the EGI as equity). Prop. Reg. §1.385-2(b)(1)(ii). • Must maintain the documentation until the statute of limitations expires for each year for which the treatment of the EGI is relevant. Prop. Reg. §1.385-2(b)(4).

  22. Documentation Rules (cont'd) • Cash pooling • EGI issued pursuant to cash pooling arrangement or internal banking service that involves account sweeps, revolving cash advance facilities, overdraft set-off facilities, operational facilities, or similar features must comply with the documentation requirements. Prop. Reg. §1.385-2(b)(3)(iii). • Documentation must contain the relevant legal rights and responsibilities of any members of the EG and any entities that are not members of the EG in conducting the operation of the cash pooling arrangement or internal banking service. Prop. Reg. §1.385-2(b)(3)(iii)(B). • Comments requested on whether special rules are warranted for cash pools, cash sweeps, and similar arrangements for managing cash of an expanded group. [Treasury has informally indicated that some form of relief will find its way into the final regulations, and that the only concern is that such arrangements may encompass longer term instruments. Treasury has also informally indicated that netting will be an acceptable form of payment.] • Not clear how the rules apply to notional cash pooling arrangements involving a third party financial institution.

  23. Practical Implications/Strategies • Infrastructure should be created to: • Create and implement a central location for the required loan documentation; • Track payments of principal and interest on debt instruments; • Provide notifications for missed payments, steps taken to collect, and amendments to agreements; • Provide notification when debt instruments (including those issued before or after 4/4/16) are modified; and • Provide notification if any transactions occurred or will occur that would trigger the Per Se Stock Rules.

  24. Practical Implications/Strategies (cont'd) • Draconian consequences for failure to comply even if debt clearly satisfies common law facts and circumstances test. • Groups should establish new guidelines on lending by affiliates. • Need strong coordination among Tax, Treasury and Legal. • Terms of related-party debt instruments should be carefully crafted (e.g., provide for annual interest instead of quarterly, loans perhaps should be non-amortizing, perhaps provide for covenants typically required by unrelated lenders).

  25. IV. Per Se Stock Rules

  26. Per Se Stock Rules – Prop. Reg. §1.385-3 • Prop. Reg. §1.385-3(b)(2) & (3) provide two sets of Per Se Stock Rules that would treat EG debt instruments as stock for U.S. federal tax purposes. • The General Rule. • The Funding Rule. • As noted, Prop. Reg. §1.385-1(b)(3) defines “EG” as entities connected through a chain of equity ownership (at least 80% vote or value). • Includes foreign corporations, insurance companies, RICs, REITs, S corporations, and “controlled partnerships” as defined in Prop. Reg. §1.385-1(b)(1), but subject to a partnership aggregate theory or look-thru rule in Prop. Reg. §1.385-3(d)(5). • Purpose: • To address related party transactions identified as tax motivated and with minimal non-tax significance (e.g., FP causes a US subsidiary to issue debt in order to reduce the subsidiary’s federal tax burden via interest deductions). Partially motivated to address earnings stripping.

  27. General Rule • Under Prop. Reg. §1.385-3(b)(2) (the “General Rule”), unless an exception applies, a “debt instrument”* issued by a corporation to an EG member is treated as stock for all federal income tax purposes if it is issued— • (i) as a distribution to shareholders (whether or not taxable as a dividend or a sale or exchange); • (ii) in exchange for EG stock (except for “exempt exchanges” (see the following two pages); or • (iii) in exchange for property in an asset reorganization if the instrument is received by an EG member with respect to target stock. *Prop. Reg. §1.385-3(f)(3) defines “debt instrument” as an interest that, but for the Per Se Stock Rules, would qualify as a debt instrument defined in Section 1275(a) and Reg. §1.1275-1(d). Section 1275(a)(1) provides that a “debt instrument” is “a bond, debenture, note, or certificate or other evidence of indebtedness,” and Reg. §1.1275-1(d) defines “debt instrument” as “any instrument or contractual arrangement that constitutes indebtedness under general principles of Federal income tax law.”Thus, the Per Se Stock Rules are applicable only to interests that qualify as debt under general federal tax principles, the Part-Stock Rule, and the Documentation Rules.

  28. Definition of “Exempt Exchange” • Prop. Reg. §1.385-3(f)(5) defines "exempt exchange" as an acquisition of EG stock in which both (i) the transferor and transferee of the EG stock are parties to an asset reorganization and either (a)(1) the EG stock is an asset of the transferor, (2) Section 361(a) or Section 361(b) applies to the transfer of the EG stock, and (3) the EG stock transfer is not by issuance (e.g., Rev. Rul. 78-47, 1978-1 C.B. 113, approved a“C” reorganization in which 71% of target’s historic net assets consisted of acquiring corporation voting stock that target distributed to its shareholders pursuant to the plan of reorganization), or (b) Section 1032 or Reg. §1.1032-2 applies to the transferor of the EG stock; and (ii) the EG stock is distributed by the transferee pursuant to the plan of reorganization • Question: Is there any form of reorganization other than a divisive “D” reorganization that can satisfy the second requirement (that the EG stock be distributed by the transferee pursuant to the plan of reorganization)?

  29. Example of “Exempt Exchange” Prop. Reg. §1.385-3(g)(3), Example 8: FP, a foreign corporation owning all the stock of USP2, a domestic corporation, lends $200x to USP2. Later, in an unrelated series of transactions, USP2 transfers part of its assets to another domestic corporation, DS2, in exchange for all the stock and notes of DS2, then distributes all the DS2 stock and notes to FP pursuant to a divisive Section 368(a)(1)(D) reorganization (the parties to which are DS2, the transferor of the EG stock, and USP2, the transferee of the EG stock).Because Section 1032 applies to DS2's issuance of its stock to USP2 and USP2 distributes the DS2 stock to FP pursuant to the plan of reorganization, the transaction is an "exempt exchange." FP 3 1 Distribution of DS2 stock and notes Loan of $200x to USP2 USP2 2 2 DS2 Transfer of part of USP2’s assets to DS2 Issuance of DS2 stock and notes to USP2 DS2 29

  30. Recast Section 304 Transaction Recast Note Distribution General Rule: Examples 1 and 2 Facts and Analysis:USS issues a promissory note to FP as a Section 301 distribution. The note is recast as stock under the General Rule. The note will also be “section 306 stock” under Section 306(c)(1) if (i) it is recast as nonvoting preferred stock, and (ii) USS has E&P for the year of the distribution. Facts and Analysis:CFC2 issues a promissory note to CFC1 in exchange for CFC3 stock. The note is recast as stock under the General Rule. CFC2 recognizes gain or loss under Section 1001 (but loss is deferred under Section 267(f)) because Section 351 does not apply to the exchange. Gain will constitute subpart F income under Section 954(c)(1)(B). USP (US) FP (Foreign) CFC2 Note Stock CFC1 (Seller) (Foreign) CFC2 (Acquiring) (Foreign) Distribution of USS NoteStock USS (US) CFC3 Stock CFC3 (Target) (Foreign) CFC3 (Target) (Foreign)

  31. Asset Reorganization General Rule: Example 3 Facts and Analysis:First, CFC2 issues a promissory note to CFC1 in exchange for all the CFC3 stock. Second, CFC3 makes an election to be classified as a disregarded entity for U.S. federal income tax purposes. While the General Rule recasts the CFC2 note as stock, the transaction should still qualify as an acquisitive Section 368(a)(1)(D) reorganization. However, unless the recast note constitutes “nonqualified preferred stock” within the meaning of Section 351(g)(2), CFC1 recognizes no gain or loss under Section 354(a). USP (US) CFC2 Note Stock CFC1 (Seller) (Foreign) CFC2 (Acquiring) (Foreign) 1 CFC3 Stock CFC3 (Target) (Foreign) CFC3 (Target) (Foreign) CFC3 elects to be classified as a disregarded entity 2

  32. General Rule: Example 4 Triangular “B” Reorganization Facts and Analysis:First, USS issues a promissory note to FP in exchange for FP voting common stock (an acquisition of EG stock described in Prop. Reg.§1.385-3(b)(2)(ii)). Second, USS acquires Target stock from Target’s shareholders in exchange for the FP voting common stock. Under the General Rule, because the USS note was issued in exchange for EG stock (i.e., FP’s stock), it is recast as stock, presumably nonvoting preferred stock (and possibly “nonqualified preferred stock” within the meaning of Section 351(g)) if the note does not have managerial rights or an equity feature and has a fixed maturity date with a fixed interest rate (or floating rate based on an objective index). Because Section 351 applies to the exchange, treatment of the note as nonvoting preferred stock results in its constituting “section 306 stock” under Section 306(c)(3) if USS has any amount of earnings and profits for the year of issuance. Target Shareholders FP (Foreign) 2 1 1 Target Stock FP Stock USS NoteStock USS (US) FP Stock Target 2 Target 32

  33. Funding Rule • Under the “Funding Rule,” a debt instrument is treated as stock if it is a “principal purpose debt instrument.” Prop. Reg. §1.385-3(b)(3)(i). • A “principal purpose debt instrument” (defined in Prop. Reg. §1.385-3(b)(3)(ii)) is a debt instrument issued by a corporation (the “funded member”) to an EG member in exchange for property with “a” principal purpose of funding— • (i) a distribution of property by the funded member to an EG member (other than a distribution pursuant to an asset reorganization in which the EG member receives EG stock without gain recognition under Section 354(a) or Section 355(a)(1)); • (ii) an acquisition of EG stock (other than in an “exempt exchange”) by the funded member from an EG member in exchange for property other than EG stock; or • (iii) an acquisition of property by the funded member in an asset reorganization (to the extent that a target shareholder that is an EG member receives boot with respect to its target stock that is taxable under Section 356).

  34. Funding Rule (cont’d) • Generally determinations of whether a debt instrument is a principal purpose instrument is based on the surrounding facts and circumstances. Prop. Reg. §1.385-3(b)(3)(iv)(A). • However, subject to the “ordinary course of business exception” summarized below, Prop. Reg. §1.385-3(b)(3)(iv)(B)(1) provides a non-rebuttable presumption that: • A debt instrument must be treated as issued with a principal purpose of funding a distribution or acquisition if it is issued by the funded member during a 72 month period— • beginning 36 months before the date of the proscribed transaction; and • ending 36 months after the date of the proscribed transaction. • Prop. Reg. §1.385-3(b)(3)(iv)(B)(2) excepts from the non-rebuttable presumption debt instruments that are (1) issued in the ordinary course of a trade or business of the issuer, (2) are currently deductible under Section 162 or included in the issuer’s cost of goods sold, and (3) at no time exceed the amount that would be ordinary and necessary to the conduct of the issuer’s trade or business if the issuer had been unrelated to the lender.

  35. Funded Distribution Funding Rule: Example 1 Facts and Analysis: USP is the common parent of a consolidated group that owns all the stock of two CFCs, CFC1 and CFC2. First, CFC2 loans $100x to CFC1 in exchange for a promissory note. Second, within 36 months after the loan, CFC1 distributes $100x to USP. The Funding Rule (Prop. Reg. §1.385-3(b)(3)(ii)(A)) via the non-rebuttable presumption (Prop. Reg. §1.385-3(b)(3)(iv)(B)(2)) recasts the CFC1 note as stock. USP (US) 2 Distribution of $100x CFC1 (Foreign) CFC2 (Foreign) High Basis Low Basis Loan of $100x Zero E&P High E&P 1 CFC1 Note Stock

  36. Funding Rule: Example 2 Funded Section 304 Transaction Facts and Analysis: Same facts as the preceding Example 1, except that CFC1 uses the $100x cash borrowed from CFC2 to purchase all the USS stock from USP in lieu of making a $100x distribution to USP. The Funding Rule (Prop. Reg. §1.385-3(b)(3)(ii)(B)) via the non-rebuttable presumption recasts the CFC1 note as stock. Section 304 applies to USP’s “sale” of the USS stock to CFC1 without adverse tax consequences to USP.* However, USP’s Section 956 inclusions by reason of its investment in United States property (the USS stock) are determined by reference to CFC2’s applicable earnings.** *While Section 304 applies, because Reg. §1.1502-33(e)(1) eliminates USS”s E&P immediately before it leaves the USP consolidated group and CFC1 has no E&P, USP should have no dividend under Section 304(b)(2). USP (US) Sale of USS stock for $100x 2 High Basis CFC1 (Foreign) CFC2 (Foreign) High Basis Ppurchase of USS stock for $100x Low Basis Loan of $100x USS (US) Zero E&P High E&P 1 **The anti-abuse rule of Reg. §1.956-1T(b)(4) applies to determine USP’s Section 956 inclusions by reference to the E&P of CFC2. CFC1 Note Stock USS (US) 36

  37. Failed Triangular “B” Reorganization Facts and Analysis:First, USS borrows cash from FS in exchange for a USS note. Second, USS transfers the loaned cash to FP in exchange for FP voting common stock. Third, less than 36 months after the FS loan to USS, USS acquires all the Target stock from Target’s shareholders solely in exchange for FP voting common stock in a putative triangular Section 368(a)(1)(B) reorganization. Under Prop. Reg.§1.385-3(b)(3)(ii)(B) and the non-rebuttable presumption, the USS note received by FS is treated as issued with a principal purpose of funding the FP stock acquisition. Thus, assuming no exception applies, the USS note is recast as stock (presumably nonvoting preferred stock). Adding insult to injury, it appears that the recast causes the failure of the triangular “B” reorganization.* Funding Rule: Example 3 FP (Foreign) Target Shareholders 3 FP Stock 2 2 Cash FP Stock 3 Cash Target FS (Foreign) USS (US) Target Stock 1 USS NoteStock *Notwithstanding Prop. Reg. §1.385-3(b)(3)(vi) (providing that a recast of a debt instrument as stock under the Funding Rule does not affect the transaction with respect to which it was issued), because Prop. Reg. §1.385-3(b)(1) states that the recast of a debt instrument as stock applies for all federal tax purposes, it appears that FP does not “control” USS within the meaning of Section 368(c) at the time of step 3, and, hence, step 3 does not qualify as a triangular reorganization. Is this appropriate?? What policy justifies this result?? Target

  38. Funding Rule: Ordering Rules Prop. Reg. §1.385-3(b)(3)(iv)(B)(3) and (4) provide ordering rules for instruments and transactions. The most interesting rule is the instrument ordering rule in Prop. Reg. §1.385-3(b)(3)(iv)(B)(3). That rule provides that, when two or more debt instruments may be treated as potentially funding the same acquisition or distribution, the debt instruments are tested in the temporal order in which they were issued. For example: FP (Foreign) 1 3 Loan of $200x Distribution of $200x cash 2 FS (Foreign) USS (US) Loan of $200x FP first lends $200x to FS in exchange for an FS debt instrument, after which FS lends $200x to USS in exchange for a USS debt instrument, after which USS makes a $200x distirbution to FP. Because both loans were between EG members and occurred within 36 months of USS’s distribution of $200x to FP, absent an ordering rule, the non-rebuttable presumption applies to either note to treat it as a principal purpose note that funds the $200x distribution. Under the ordering rule, apparently only one of the notes can be characterized as a principal purpose note. Thus, because the $200x loan by FP to FS is the first in time, it appears that only the note issued by FS to FP is recast as stock under the funding rule and ordering rule, meaning the note issued by USS to FS is not recharacterized as stock under the funding rule. If this is a correct interpretation of the ordering rule and the aim of the transactions is to lower USS’s tax base via interest deductions on the FS loan to USS, then a taxpayer favorable result is obtained that is likely contrary to the purposes of the Per Se Stock Rules. N.B.: The Service has indicated that foreign-to-foreign loans may be excluded from the operation of the Per Se Stock Rules when the regulations are finalized. If that is done, then the $200x loan by FP to FS will be disregarded and the $200x loan by FS to USS will be recast as USS stock. 38

  39. Exceptions to General Rule and Funding Rule • Current E&P Exception: • The aggregate amount of any proscribed transactions subject to the General Rule or Funding Rule are reduced by the issuer’s current E&P. Prop. Reg. §1.385-3(c)(1). [N.B. Treasury has informally indicated it may change the test from current E&P to another test such as operating cash flow.] • If there are multiple proscribed transactions during the year, the reduction for current E&P is applied in the temporal order in which the transactions occur. Id. • Threshold Exception: • A debt instrument will not be treated as equity under the General or Funding Rules if immediately after the instrument is issued, the aggregate adjusted issue price of all debt instruments held by all members of the EG does not exceed $50 million. Prop. Reg. §1.385-3(c)(2). • The threshold exception has a cliff effect: If EG debt instruments at any time exceed the $50 million threshold, the General Rule and Funding Rule apply to all EG debt that remain outstanding, not just the excess over $50 million. Id. • EG Stock Issuance Exception: • Neither the General Rule nor the Funding Rule applies to an acquisition of EG stock by a funded member from another member of the EG in exchange for property other than EG stock if the acquisition results from a transfer of property by the funded member (the transferor) to another EG member (the issuer) in exchange for issuer stock, provided more than 50% of the total voting power and value of the issuer's stock is held, directly or indirectly, by the transferor for the 36-month period following the stock issuance. Prop. Reg. §1.385-3(c)(3). What purpose does the 50% ownership requirement serve?

  40. Example of Failure to Meet the Current E&P Exception in Consolidation Interaction of Exception with Reg. §1.1502-33(e)(1) Facts: FP owns all the stock of USP1, the common parent of a consolidated group, and USP1 owns all the stock of each of DS1, DS2 and DS3 (all members of the USP1 consolidated group). DS3 owns all the stock of CFC. DS1 (the “funded member”) has $120x of current E&Pfor year 1, all of which tier up and are reflected in USP1's year 1 current E&P under Reg. §1.1502-33(b)(1). In year 1, the following transactions are completed: (i) DS2 lends $100x to DS1 (the “funded member”) on April 15 of year 1 in exchange for a DS1 promissory note respected as debt for federal income tax purposes; (ii) on April 16 of year 1, DS1 purchases all the CFC stock from DS3 for $100x cash (an acquisition that would be described in Prop. Reg. §1.385-3(b)(3)(ii)(B) but for the fact that the sale of the CFC stock occurs in consolidation);*and (iii) on December 30 of year 1, USP1 distributes all the DS1 stock to FP, resulting in DS1 leaving the USP1 consolidated group but remaining in the EG. Because Reg. §1.1502-33(e)(1) eliminates DS1’s current E&P immediately before it leaves the USP1 consolidated group, it appears that the exception in Prop. Reg. §1.385-3(c)(1) does not apply. Thus, under Prop Reg. §§1.385-3(b)(3)(ii)(B) and 1.385-4(b)(1)(i), DS1’s note payable to DS2 likely is treated as exchanged for DS1 stock immediately after DS1 leaves the USP1 consolidated group. FP (Foreign) 3 *Section 304 does not apply to DS1's purchase of the CFC stock from DS3 because Section 304 does not apply to intercompany transfers of controlled corporation stock. Reg. §1.1502-80(b). USP1 distributes all the DS1 stock to FP USP1 (US) $100x DS1 note payable to DS2 recast as DS1 stock immediately after step 3 DS1 (US) DS1 (US) CFC (Foreign) DS2 (US) DS3 (US) 1 $120x of current E&P DS2 lends $100x to DS1 DS3 sells all the CFC Stock to DS1 for $100x CFC (Foreign) CFC (Foreign) 2 40

  41. Departure from the EG • If a debt instrument qualifying as debt under general tax principles (and the Part-Stock Rule and Documentation Rules) but previously characterized as stock under the General Rule or Funding Rule leaves the EG (for example, the EG member holding or issuing the instrument leaves the EG or the instrument is sold to a non-member), then, immediately before the debt instrument leaves the EG, the issuer is treated as issuing a new debt instrument (respected as debt for federal tax purposes) to the holder in exchange for the old debt instrument that was characterized as stock in a transaction that is disregarded for purposes of the Per Se Stock Rules. Prop. Reg. §1.385-3(d)(2). • Prop. Reg. §1.385-1(c) generally provides that, in the case of an EG member treated as exchanging an EGI or debt instrument for stock under the Proposed Section 385 Regulations, the holder is treated as realizing an amount equal to its basis in the instrument, and the issuer is treated as realizing an amount equal to the adjusted issue price of the instrument (although foreign currency gain or loss to the holder or issuer must be recognized other than with respect to accrued and unpaid interest). It appears that this taxpayer-favorable rule does not apply to a transaction in which “new” debt is deemed issued in exchange for an “old” debt instrument characterized as EG stock. • The quid pro quofor the exchange of “old stock” for “new debt” is that "all other debt instruments of the issuer that are not currently treated as stock are re-tested to determine whether those other debt instruments are treated as funding the distribution or acquisition that previously was treated as funded by the debt instrument that ceases to be treated as stock pursuant to this paragraph (d)(2)." Prop. Treas. Reg. § 1.385-3(d)(2).

  42. Disregarded Entities and Partnerships • Disregarded Entities: • If the General Rule or the Funding Rule applies to recast debt issued by a disregarded entity owned by an EG member as stock, the owner of the disregarded entity is deemed to issue the relevant instrument and the corresponding equity interest, thereby preserving the disregarded entity's disregarded status. Prop. Reg. §1.385-3(d)(6). • Partnerships: • Similarly, EG members owning an interest in a “controlled partnership” (defined in Prop. Reg. §1.385-1(b)(1) as a partnership in which EG members own directly, or under the Section 304(c)(3) attribution rules, at least 80% of the capital or profits interests) are treated as owning their proportionate shares (determined by reference to profits percentages) of partnership assets and issuing their proportionate shares of debt instruments issued by the partnership (an aggregate theory). Thus, if a “controlled partnership” issues debt that is recharacterized as stock under the General Rule or the Funding Rule, the partners (rather the partnership) are treated as issuing the equity in proportion to their interests in the partnership’s profits, thereby avoiding the creation of a new interest and partner in the partnership. Prop. Reg. §1.385-3(d)(5). [Note: to the extent a controlled partnership issuing purported debt owed to a consolidated group member is owned (in whole or in part) by consolidated group members, the debt is disregarded for purposes of the Per Se Stock Rules due to the aggregate treatment of partnerships but regarded for purposes of the Documentation Rules and Part-Stock Rules due to their entity treatment of partnerships.] • These aggregate or look-thru theories for disregarded entities and partnerships under the Per Se Stock Rules should be compared to the entity theories of the Documentation Rules and Part-Stock Rule.See the example on the following page.

  43. Per Se Stock Rules: Partnership Example Facts: USP (the common parent of a consolidated group) owns all the stock of USS (a member of the consolidated group) and CFC (an EG member). USS owns60% of the capital and profits interests in PS (a partnership). CFC owns the balance of the PS interests. USP lends $500 million to PS in exchange for a recourse PS note. $500 million PS note $500 million loan USP (US) CFC (Foreign) 60% 40% USS (US) PS Analysis: PS is a “controlled partnership” within the meaning of Prop. Reg. §1.385-1(b)(1) because one or more members of USP’s EG (USS and CFC) own (directly and under the Section 304(c)(3) attribution rules) at least 80% of the capital or profits interests in PS. Therefore the Part-Stock Rule and Documentation Rules apply to the entire $500 million note payable by PS to USP (PS is treated as an entity). However, under Prop. Reg. §1.385-3(d)(5), the Per Se Stock Rule can apply only to 40% of the note (the percentage of PS profits owned by CFC). The remaining 60% is treated under Prop. Reg. §1.385-3(d)(5) as not outstanding because the aggregate theory treats 60% of the note as owed by USS to USP. What would be the result if all items of income and gain attributable to the note were specially allocated to USS? 43 43 43

  44. Anti-Abuse Rules • A debt instrument may be treated as stock if issued with a principal purpose of avoiding application of Prop. Reg. §1.385-3 or Prop. Reg. §1.385-4. Ditto for Section 483 contracts and non-periodic swap payments. Prop. Reg. §1.385-3(b)(4). • Examples • Debt instrument issued to, and later acquired by an EG member from, a person that is not a member of the issuer’s EG. • Debt instrument issued to a person that is not a member of the issuer’s EG, but the person later becomes a member of the EG. • Debt instrument issued to an entity that is not taxable as a corporation for U.S. tax purposes (e.g., a trust the beneficial interest in which are owned by EG members). • Allows IRS to treat instruments not denominated as debt as stock. • Also, Prop. Reg. §1.385-3(e) provides that the rules of Prop. Reg. §§1.385-3 and 1.385-4 do not apply to the extent a person enters into a proscribed transaction with a principal purpose to reduce the federal tax liability of any member of the EG. Thus, heads the IRS wins and tails the taxpayer loses.

  45. Timing Rules • An EG debt instrument subject to the General Rule, Funding Rule, or Anti-Abuse Rule is generally treated as stock upon issuance. Prop. Reg. §1.385-3(d)(1)(i). • There are exceptions (which generally treat an EG debt instrument as exchanged for stock after its issuance), including if (i) a debt instrument is considered to fund a distribution or acquisition under the 72-month non-rebuttable presumption and the debt instrument is issued in a taxable year prior to the proscribed transaction, (ii) the $50 million threshold is exceeded in a taxable year after the proscribed transaction, or (iii) the 50% ownership requirement of the EG stock issuance exception is violated prior to the expiration of the 36-month period. Prop. Reg. §1.385-3(d)(1)(ii)-(v).

  46. Effective Date • General Effective Date: • Retroactive Effective Date: Prop. Reg. §1.385-3 applies to (i) debt instruments issued on or after April 4, 2016, and (ii) debt instruments treated as issued earlier as a result of a check-the-box election that is filed on or after April 4, 2016. Prop. Reg. §1.385-3(h)(1). The retroactive effective date is one of the many troubling aspects of the Per Se Stock Rules. • Transition Rules: • When applying the Funding Rule, proscribed transactions are only taken into account if they occur on or after April 4, 2016. Prop. Reg. §1.385-3(h)(2). • Recharacterization of a debt instrument as equity can only occur 90 days after the date final regulations are issued. Prop. Reg. §1.385-3(h)(3). • Refinancing: • The effective date rules relate to the date an instrument is issued, including deemed issuances. • Thus, an instrument that undergoes a “significant modification” under Reg. §1.1001-3(e) and, hence, is deemed reissued may be subject to the Per Se Stock Rules if the deemed reissuance is on or after April 4, 2016 and the debt instrument remains outstanding more than 90 days after final regulations are issued. What happens if a taxpayer relies on a rule in the Proposed Section 385 Regulations that is changed by the final regulations to the taxpayer’s detriment?

  47. V. Consolidated Groups

  48. Consolidated Groups – Prop. Reg. §1.385-4 • Single Entity Treatment: • For purposes of the Proposed Section 385 Regulations, all members of a consolidated group are treated as a single corporation. Prop. Reg. §1.385-1(e). • Also, Prop. Reg. §1.385-2(c)(4)(i) provides that, during the time the holder and issuer of an applicable instrument are members of the same consolidated group, the instrument is "treated as not outstanding.” • Consequently, none of the provisions of the Proposed Section 385 Regulations apply to intercompany obligations between members of a consolidated group during the period they are between such members. • Moreover, because a consolidated group is treated as a single corporation, other intercompany transactions generally should be disregarded for purposes of the Proposed Section 385 Regulations, subject to Prop. Reg. §1.385-4(b)(1)(i). Seethe examples on pp. 40 and 56. • In addition, “[i]f an applicable instrument ceases to be an intercompany obligation and, as a result, becomes an EGI, the applicable instrument is treated as becoming an EGI immediately after it ceases to be an intercompany obligation.” Prop. Reg. §1.385-2(c)(4)(ii).

  49. Consolidated Groups (cont’d) • Member Leaving a Consolidated Group: • If (i) a member issuing or holding an EG debt instrument leaves a consolidated group but continues to be a member of the EG while the instrument is outstanding, and (ii) but for the treatment of the consolidated group as a single corporation the instrument would be recast as stock under the Per Se Stock Rules, then the debt instrument issued or held by the departing member is treated as exchanged for stock immediately after the member's departure. Prop. Reg. §1.385-4(b)(1)(i). Such instruments are referred to as “exempt consolidated group debt instruments.” This is a strong indication that, for example, an intercompany distribution funded by an intercompany obligation is taken into account for purposes of the Funding Rule if the lender or borrower leaves the consolidated group but remains in the EG. Seepp. 40 and 56 for examples illustrating the operation of Prop. Reg. §1.385-4(b)(1)(i). • Any other debt instrument issued or held by such a departing member (a “non-exempt consolidated group debt instrument”) is treated as stock if and when the instrument becomes a principal purpose debt instrument (recast as stock) due to a proscribed transaction occurring after the member's departure. However, the 72-month non-rebuttable presumption period begins ticking when the instrument is first issued. Prop. Reg. §1.385-4(b)(1)(ii). 49

  50. Consolidated Groups (cont’d) • Transfer of Instrument Outside the Consolidated Group: • If a member holding a consolidated group debt instrument transfers the instrument to an EG member that is not a member of the consolidated group, the instrument is treated as issued by a single corporation (that includes the transferor and issuer of the instrument) to the EG transferee member, and if the instrument is treated as stock under the Per Se Stock Rules, then it is treated as exchanged for stock immediately after the transfer. Prop. Reg. §1.385-4(b)(2). • Transfer of Instrument Treated as Stock into the Consolidated Group: • Finally, if a debt instrument treated as stock under the Per Se Stock Rules becomes a consolidated group debt instrument respected as debt for federal income tax purposes, the EG transferor is deemed to exchange the “stock” for debt immediately before the transfer in a transaction that is disregarded for purposes of Prop. Treas. Reg. §1.385-3(b) (i.e., the “ new” debt instrument received by the EG transferor is respected as debt for federal income tax purposes – see p. 55for an illustration). Prop. Reg. §1.385-4(c). • Retroactive Effective Date: the effective date is the same as the Per Se Stock Rules. See Prop. Reg. §1.385-4(e).

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