Observations concerning the broader institutional background to the section 385 regulations

As noted in a previous blog entry, I had planned to attend an NYC Bar Association event this Wednesday evening discussing the newly issued section 385 regulations.  It turns out now that I unfortunately won't be there.  However, since I had already prepared remarks for the session, I've decided to flesh them out slightly and post them here.

In short (or long), what I had planned to say was something like this:

I’ll address 3 topics.  The first is the use of regulations, instead of legislation, to address the second big wave of corporate inversions.

The second is the currently highly contested issue of the breadth of the Treasury’s regulatory authority generally.

And the third is the use of interest deductions to strip out US source taxable income, in relation not just to the new section 385 regulations but corporate tax reform.

1.         REGULATIONS VS. LEGISLATION

The Treasury’s recently issued section 385 regulations emerge from the 2^nd wave of corporate inversions.  Twelve years ago, the first wave of pure paper-shuffling self-inversions promptly gave rise to the enactment of section 7874.  This was not just a bipartisan process, but a Republican-led one, as George W. Bush was president and the Republicans controlled both houses of Congress.

The second wave of inversions raised harder policy issues, because it involved, not just paper-shuffling, but real business transactions, even if significantly tax-motivated.  But I think it should easily have been a bipartisan no-brainer to slow down the inversions wave, at least as a stopgap while deciding what to do about their underlying causes.

By the way, whether or not the U.S. statutory corporate tax rate is too high, that is not what second-wave inversions are about.  Instead, they’re about two main things.  The first is the gigantic buildup of foreign earnings that, as an accounting matter, have been labeled as permanently reinvested abroad.  Companies want to be able to access the funds more conveniently without taking an actual tax hit or a reported earnings hit.  The second is the aim of using interest deductions to reduce U.S. source income, which is easier for foreign corporations than U.S. corporations.

Both of these issues need to be addressed, but it’s foolish to encourage an inversion wave before we get around to dealing with them.  So it should have been uncontroversial to slow down inversions in the interim.  But because the legislative process in Washington has completely broken down, due to partisan disputes since 2009, this was not possible.

As many will recall, the Treasury initially thought that it couldn’t do anything if Congress wouldn’t act.  But then Stephen Shay and others weighed in to say that the Treasury actually does have some reg authority, so we got the first set of anti-inversion regulations, followed by the section 385 regulations that we’re discussing today.

Some people have been shocked by this, because they think it violates informal comity norms between the executive branch and Congress that have been well-accepted for many decades.  They’re right that the Treasury is indeed departing from those norms.  But guess what.  Those norms are dead, and they’re not coming back.  They were killed by the breakdown of the bipartisan tax legislative process that we used to have.  Once that happened, there was no reason to expect the Treasury, with either party in control of the executive branch, to figure that it would just defer until Congress got around to legislating.  So long as our politics is so dysfunctional, the action is inevitably not just going to disappear – it’s going to move up Pennsylvania Avenue from Capital Hill to the Treasury Building (or else the White House).

Just to put this in the context of the upcoming election, even if we assume that Clinton wins, Republicans in Congress have already announced their plan to confirm no judges, devote the next four years to investigations, and gear up for impeachment proceedings.  So I don’t think there will be a whole lot of actual legislating.

Whether all this is good or bad, taxpayers and their advisors are going to have to get used to it – and, of course, adjust their lobbying and other government outreach accordingly.  But it brings us to the second question: how broad is the Treasury’s regulatory authority, both in specific cases and in general.

2.         THE TREASURY’S REGULATORY AUTHORITY

I’m not going to address today the particulars of challenges to the Treasury’s claim of regulatory authority under section 385.  But I will say this: Congress deliberately gave the Treasury very broad discretion.  It wasn’t limited to things that Congress particularly had in mind when it enacted the grant.  And of course the Treasury hasn’t limited the new regulations to inversion transactions.  It has addressed broader issues that relate to interest deductions, via the distinction between debt and equity.  So any court challenges that are based on Treasury’s discretion under section 385 face a steep uphill climb.

One unfortunate byproduct of the breakdown of the legislative process is that, while Congress can use any tool it likes, the Treasury can only use the tools that it has.  Thus, suppose it would make more sense to disallow interest deductions than to reclassify what’s nominally debt as equity.  The Treasury may not have that choice when it’s exploring what to do.  But that doesn’t necessarily mean that it shouldn’t do anything. If the best response is unavailable, it shouldn’t be the enemy of the good.

Now, the shift in ability and willingness to act from Capital Hill to 1500 or 1600 Pennsylvania Avenue has happened at the same time as other tectonic shifts in the legal environment.  Treasury regulations are now, in the aftermath of the Mayo Foundation Supreme Court decision, fully subject to the standard administrative law regime.  This raises transition issues, given all the regs that were finalized before Mayo, and it has also required both the Treasury and the Tax Court to face a bit of a learning curve.

One recent chapter in this process was the Tax Court’s ludicrously misguided decision in the Altera case, concerning transfer pricing under the cost-sharing regs, which is currently on appeal to the 9^th Circuit.  One of the things that the Tax Court did particularly poorly in that case was look at the regulatory preamble that accompanied the regulations at issue in light of the requirement of reasoned deliberation to qualify for deference. 

While reasoned deliberation by administrative agencies is a good thing, the Tax Court’s ham-handed version of testing for it meant that the role of regulatory preambles was bound to change.  Instead of preambles’ being useful and informative documents that explain the Treasury’s reasoning and beliefs to taxpayers, as they had previously been, the Tax Court ensured that, henceforth, they will simply be litigating documents, composed with an eye to heading off future regulatory challenges.  That’s unfortunate but necessary from the Treasury’s standpoint, and we can certainly see it at work in the lamentably interminable Treasury preamble to the section 385 regulations.

Once again, the new world we live in now may be worse than the old one, but we’d better get used to it, because it’s not going away any time soon.

3.         INTEREST DEDUCTIONS AND CORPORATE TAX REFORM

Again, the section 385 regulations are not just about inversions, but more broadly about the use of debt that yields interest deductions to strip profits out of the U.S. tax base.  This reflects the fact that our current rules for addressing excess leverage are very weak, especially for non-U.S. companies that don’t need to worry about subpart F.  It also reflects how weak our earnings-stripping rules are, under section 163(j).

Our defenses against the use of interest deductions against earnings-stripping are weak in two senses: absolutely, and relatively for foreign as opposed to U.S. companies. That of course has been a key reason for the second inversions wave.  Peer countries, such as Germany and the UK, appear to have absolutely tougher rules against earnings-stripping than we do, if I’ve been accurately informed by people who know those countries’ rules better than I do, but they also don’t place the same relative weight on corporate residence as our overall regime does, given the role played by subpart F. And importantly, I gather that they look at the global debt of a worldwide affiliated group, without being confined to looking at the resident company and its foreign subsidiaries (as distinct from corporate parents and siblings).

I think that the U.S., if we are able to overcome the breakdown of our tax legislative process, needs to consider addressing earnings-stripping through rules that look at the debt of the entire multinational group, whether it is U.S.-headed or not.  And while I have been, and remain, pessimistic about the legislative prospects for corporate tax reform, there are several pieces of a package that one could imagine making sense for everyone who is rational, including the companies themselves.

While the companies are unlikely to welcome tougher rules against earnings-stripping, they could support an accompanying reduction in the corporate rate.  And while in isolation they might not like a deemed repatriation of their trapped foreign earnings, this could be at less than the full rate, and they’d benefit from loosening the use-of-funds shackles that they now face.

So there are important things that the Treasury can’t do on its own, but that Congress could do if our politics got less poisonous and dysfunctional.  That’s a lot to hope for, but we do have an election next week, so perhaps this is as good a time to be hopeful as any.