Regulations May Change for Taxpayers with Global Operations
Author: Justin Stenberg
Calling for a fair, simple, efficient and pro-growth federal tax system, President Donald Trump issued Executive Order (EO) 13789 on April 21, 2017. This EO directed Secretary of the Treasury Steven Mnuchin to identify tax regulations that impose an undue financial burden on taxpayers, add excessive complexity to federal tax laws or exceed the statutory authority of the IRS. In connection with the EO, Mnuchin was directed to recommend actions to mitigate the burden imposed by these regulations and formulate a plan to either delay or suspend these regulations and modify where appropriate. Accordingly, on October 2, 2017, Mnuchin issued his second report to the president in which he identified eight regulations that may be withdrawn entirely, partially revoked or substantially modified. Of these eight regulations, two are of particular interest to taxpayers operating globally.
Final & Temporary Regulations Under Section 385
Proposed regulations under Internal Revenue Code Section 385 were issued on April 4, 2016, addressing whether a taxpayer’s direct or indirect interest in a related corporation is treated as stock, debt or a combination of both. The highly controversial proposed regulations target taxpayers attempting to use debt instruments as a method to shift earnings through interest deductions into low-tax jurisdictions outside the United States. In response to criticisms, final and temporary regulations were issued on October 13, 2016, to help minimize complexity, reduce administrative hardships and limit the scope of the proposed regulations. The final and temporary regulations establish minimum documentation requirements that must be met for related-party debt to be respected as debt for tax purposes. Further, safeguards were put in place to limit inversions and foreign takeovers of U.S. taxpayers to hinder earnings-stripping from the United States.
The final and temporary regulations have been highly criticized due to their administrative burden; in response, the IRS issued Notice 2017-36, which delayed adopting the minimum documentation requirements. Pursuant to the Treasury report in response to the EO, the documentation requirements in their current form may be revoked in favor of substantially simplified and more taxpayer-friendly requirements. However, the report states unless substantive tax reform occurs, the portions of the regulations dealing with corporate inversions and foreign takeovers will be retained, and as of today their implementation won’t be delayed. Nevertheless, taxpayers are wise to carefully consider the intent of §385 when engaging in related-party transactions, keeping in mind the IRS rolled out a related-party transaction audit campaign on January 31, 2017.
Final Regulations Under §987
Final and temporary regulations were issued December 7, 2016, addressing the taxation of foreign currency translation gains and losses related to a qualified business unit (QBU). A QBU generally is a foreign branch or other foreign pass-through entity. These regulations’ principal features deal with translating branch income or loss into the branch owner’s functional currency, determining currency gains and losses with respect to a branch’s financial assets and liabilities and the means by which a taxpayer recognizes a currency gain or loss when a branch transfers cash or property to its owner. A major component of the regulations is a mandatory “fresh start” transition method. Under this method, only the assets and liabilities on the balance sheet of a QBU as of the transition date and their corresponding unrealized built-in currency gains and losses are carried forward as determined under the new regulations. Moreover, unrecognized currency gains or losses determined under the 1991 or 2006 §987 regulations are permanently eliminated.
Many taxpayers and other commentators fiercely criticized the new §987 regulations, particularly the “fresh start” transition method, because prior period currency losses are completely disregarded. In addition, the IRS received many comments stating the regulations are financially burdensome and overtly complex. As a result, the IRS expects to issue guidance that may allow taxpayers to elect to defer implementation of the regulations until at least 2019. Furthermore, the IRS is considering a variety of potential modifications to the regulations to help simplify currency gain and loss computations and ease the burden of transition. Regardless, affected taxpayers must continue applying their prior §987 method until such time as these new regulations, in some form, are enforced.
Financial Reporting Considerations
While the implementation date of the aforementioned regulations either has or will be deferred by the IRS, taxpayers issuing financial statements in accordance with generally accepted accounting principles (GAAP) in the U.S, must consider the effect of these regulations in their financial statements. Under GAAP, the effect of a change in tax law is recognized in an entity’s financial statements in the financial reporting period that includes the date a new law is enacted.
Contact Justin or your trusted BKD advisor for more information and stay tuned for possible additional changes as a result of potential tax reform.