July 21, 2017 Two regulations identified under executive order review affect exempt organizations The Treasury Department has identified in an interim report (Notice 2017-38) eight significant tax regulations that may impose an undue financial burden on taxpayers or add undue complexity to federal tax laws. Among the identified regulations most likely to affect exempt organizations are the proposed regulations under Section 103 (defining a political subdivision) and the final regulations under Section 385 (related-party corporate interests). Background Executive Order 13789, signed by President Trump on April 21, 2017, called for the Treasury Department to review all "significant tax regulations" issued on or after January 1, 2016, and to identify in an interim report those regulations that impose undue financial burden, add undue complexity or exceed statutory authority. The order further instructed the Treasury Department to submit a final report to the President by September 18, 2017, recommending "specific actions to mitigate the burden imposed by regulations identified in the interim report." Notice 2017-38 identifies certain regulations as unduly burdensome or complex and states that Treasury intends to submit a report to the President with proposed reforms "potentially ranging from streamlining problematic rule provisions to full repeal." No regulations were identified as exceeding the statutory authority of the IRS. Section 103 regulations In February 2016, the IRS released proposed regulations (REG-129067-15) that provided a new definition of a political subdivision for purposes of tax-exempt bonds. In doing so, the IRS recognized the need to clarify the definition to provide greater certainty to prospective issuers and to promote greater consistency in how the definition applies across a wide array of factual situations. Under the proposed regulations, the definition of "political subdivision" would be expanded to require that an entity operate for a governmental purpose and be governmentally controlled. The proposed regulations would continue, without substantive change, the longstanding requirement that a political subdivision be empowered to exercise at least one of the three generally recognized sovereign powers (eminent domain, police power and taxing power). A governmental purpose requires, among other things, that the purpose for which the entity was created, as set out in its enabling legislation, be a public purpose and that the entity actually serve that purpose. It also requires that the entity operate in a manner that provides a significant public benefit with no more than incidental benefit to private persons. To constitute control, a collection of rights and powers must enable its holder to direct the significant actions of the entity. The proposed regulations provide three nonexclusive benchmarks of rights or powers that constitute control: the right or power both to approve and to remove a majority of an entity's governing body; the right or power to elect a majority of the governing body of the entity in periodic elections of reasonable frequency; or the right or power to approve or direct the significant use of funds or assets of the entity in advance of that use. Aside from these three arrangements, the determination of whether a collection of rights and powers constitutes control will depend on the facts and circumstances. The proposed regulations generally require control to be vested in either a general purpose state or local governmental unit or in an electorate established under an applicable state or local law of general application. The proposed regulations would affect state and local governments that issue tax-exempt bonds and users of property financed with tax-exempt bonds. Under certain transition rules, however, the proposed definition of political subdivision would not apply for determining whether outstanding bonds are obligations of a political subdivision and would not apply to existing entities for a stated transition period. Section 385 regulations In October 2016, the IRS and Treasury released highly anticipated final regulations under Section 385 (TD 9790) on the classification of certain intercompany loans as debt or equity for federal income tax purposes. The Section 385 regulations significantly affect a wide range of ordinary course business and financing transactions for a variety of corporations, including tax-exempt organizations. Specifically, these regulations operate to expand the IRS's ability to recast related-party debt as equity. (See EY Tax Alert 2016-2036.) The regulations establish threshold documentation requirements that must be satisfied for certain related-party interests in a corporation to be treated as debt for federal tax purposes, and treats as stock certain related-party interests that otherwise would be treated as debt for federal tax purposes. Before the issuance of regulations, the characterization of related-party debt was largely covered by a complex body of case law. The regulations supplemented existing law by creating significant documentation requirements for certain taxpayers (the documentation rule) and mandating specific documentation and information to support certain related-party corporate debt instruments. The regulations also recharacterize as stock certain related-party corporate debt instruments issued after April 4, 2016 (even if the documentation rule is satisfied) if the instrument is issued in one or more of the several specified "tainted" transactions or funds a tainted transaction (collectively referred to as the re-characterization rule). For federal tax purposes, the documentation and recharacterization rules apply only to debt issued by domestic corporations to expanded group members that are not part of the same federal consolidated group. Although under final regulations, taxpayers have until the filing date of their federal tax return for the tax year that includes January 1, 2018, to complete the documentation rule for the first time. Term loans, demand loans, cash pools (including certain notional pools), trade payables and open accounts are all subject to the documentation rule creating a substantial compliance burden. Although several comments offered on the underlying proposed regulations, issued in April 2016, had specifically requested exceptions for corporations exempt from taxation under Section 501, the final regulations did not adopt the recommendation to exclude tax-exempt corporations from the scope of the rules. Implications Having met the identification mandate of Executive Order 13789, the Treasury Department now seeks comments on whether the previously described regulations should be rescinded or modified, and in the latter case, how the regulations should be modified to reduce burdens and complexity. According to Notice 2017-38, commenters on the Section 103 proposed regulations stated that the longstanding "sovereign powers" standard was settled law and had been endorsed by Congress, and additional limitations were unnecessary. Commenters also reportedly stated that the proposed regulations would disrupt the status of numerous existing entities and that it would be burdensome and costly for issuers to revise their organizational structures to meet the new requirements of the proposed regulations. Those commenting on the Section 385 final regulations "criticized the financial burdens of compliance, particularly for more ordinary course transactions" and "requested a longer delay in the effective date of the documentation rules," the notice states. Commenters also objected to "the complexity associated with tracking multiple transactions through a group of companies and the increased tax burden imposed on inbound investments." Notice 2017-38 does not make any specific regulatory changes and does not provide a specific date when any proposed changes would become effective. The most prudent course of action for an exempt organization would be to continue to apply the regulations in their present construct and to monitor guidance as it becomes available. Tax-exempt organizations should consider submitting written comments to the Treasury Department. Comments concerning existing regulations that should be modified or eliminated in order to reduce unnecessary burdens are due July 31, 2017, and comments concerning the regulations identified in Notice 2017-38 are due August 7, 2017. ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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