On October 4, the Treasury released its Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (the Report), which contains recommended actions on eight tax regulation packages identified earlier in the year. This Tax Alert reviews the Report's recommendations for the regulations that are most relevant to alternative asset management funds, such as debt funds, hedge funds and private equity funds, and their portfolio companies.

Background on regulatory review

Since taking office, the Trump Administration has taken a number of steps to mitigate the impact of certain regulation packages issued in the final year of the Obama Administration and also to lessen the burden imposed by tax regulations more generally.

On January 20, 2017 (President Trump's Inauguration Day), the Trump Administration issued an executive memorandum freezing regulations that were issued in the final days of the Obama Administration but not yet published in the Federal Register (e.g., the BBA partnership audit rules, which were pulled and reintroduced in June — see Tax Alerts 2017-168 and 2017-1002).

On January 30, President Trump issued Executive Order 13771, which requires new federal regulations to be accompanied by the repeal of two existing regulations. On February 24, President Trump issued Executive Order 13777, which requires federal agency task forces to be established for reducing regulatory burdens.

On April 21, President Trump issued Executive Order 13789, a directive requiring review of significant Obama Administration Treasury regulations issued after January 1, 2016, with the objectives of: (1) identifying those that were deemed burdensome and (2) recommending actions to mitigate the burden. See Tax Alert 2017-671.

On July 7, Treasury released Notice 2017-38, which identified eight regulations as imposing an undue financial burden on US taxpayers or adding complexity to federal tax laws. The Section 385 regulations (discussed later) were identified as one of eight significant Treasury regulations requiring additional review, as well as regulations under Sections 752, 987 and 367 (among others). See Tax Alert 2017-1086. Treasury held open a public comment period for Notice 2017-38 until August 7, and announced its intent to submit a report to the President by September 18, 2017, with its conclusions on the regulatory review, along with proposed reforms "potentially ranging from streamlining problematic rule provisions to full repeal."

Reviewed regulations relevant to private equity funds and alternative asset managers

Four of the Obama-era regulation packages issued in 2016 that were identified for review by the Trump Administration are particularly relevant to alternative asset management funds, such as debt funds, hedge funds and private equity funds, and their portfolio companies, especially those with multinational operations and cross-border transactions.

In addition to these four regulation packages (discussed next), the Report notes that Treasury continues to analyze all recently issued significant regulations, and is considering possible reforms to other regulations, including those under Section 871(m) and FATCA. Treasury also expects to issue additional reports on reducing tax regulatory burdens, including the status of Treasury's actions recommended in the Report.

Final and temporary regulations under Section 385 on treatment of certain interests in corporations as stock or debt (TD 9790)

In October 2016, the Treasury and IRS released final and temporary regulations under Section 385 (TD 9790). Among other changes, these regulations established extensive documentation requirements that must be satisfied for a debt instrument to constitute indebtedness for US federal tax purposes (the documentation regulations). They also recharacterize a debt instrument issued after April 4, 2016, as stock if the instrument: (1) is issued in one of a number of specified transactions (tainted transactions), or (2) funds a tainted transaction. See Tax Alert 2016-1776.

On July 28, 2017, the IRS issued Notice 2017-36, which delays the application of the Treas. Reg. Section 1.385-2 documentation rules by one year, until January 1, 2019. See Tax Alert 2017-1283.

The Report states that Treasury and IRS plan to revoke the Section 385 documentation regulations and develop "substantially simplified and streamlined" documentation rules. These documentation regulations are relevant to fund blockers and domestic and foreign portfolio companies, and a pared-back version of the rules is likely to survive. The Report suggests the new streamlined documentation rules could have an effective date later than January 1, 2019 (e.g., January 1, 2020), to allow time for comments and compliance. The Report also notes that particular consideration is being given to diluting or eliminating the requirement of a reasonable expectation of ability to repay indebtedness.

The distribution rules (i.e., tainted transaction rules) are focused on multinational corporate groups with a foreign parent and US subsidiaries. Treasury believes that US tax reform legislation will address base erosion and earnings stripping and should obviate the need for those regulations, which would permit them to be revoked. In the meantime, they remain effective.

Temporary regulations under Section 752 on recourse partnership liabilities and disguised sale rules (TD 9788)

In October 2016, the IRS issued final (TD 9787), final and temporary (TD 9788), and proposed (REG-122855-15) regulations on disguised sales of property to or by a partnership under Section 707 and on the treatment of partnership liabilities under Section 752. Among other topics, the regulations address the allocation of liabilities assumed by (or taken subject to) a partnership under the disguised sale rules, the relevance of "bottom-dollar" guarantees for allocating partnership liabilities, and the situations in which payment obligations with respect to partnership liabilities may be disregarded for purposes of allocating partnership liabilities. See Tax Alert 2016-1715.

Treasury and IRS are considering whether the temporary regulations related to the allocation of partnership liabilities for disguised sale purposes should be revoked and the prior regulations reinstated. In contrast, they believe the set of regulations related to "bottom-dollar" guarantees should be retained. In addition, Treasury and IRS are considering ways to lessen the burden of partnership tax regulations governing liabilities and allocations more generally.

Final regulations under Section 987 on timing, amount, character and source of Section 987 gain or loss (TD 9794)

In December 2016, the IRS released final (TD 9794), temporary (TD 9795) and proposed regulations (REG-128276-12) under Section 987. The final regulations address how certain branch operations (known as qualified business units (QBUs)) that use a functional currency different than that of their owner (Section 987 QBUs) compute taxable income or loss (or earnings and profits, as applicable). The final regulations also provide rules for determining the timing, amount, character and source of any Section 987 gain or loss arising from a QBU. See Tax Alert 2016-2117.

On October 2, 2017, the IRS announced (Notice 2017-57) that it intends to amend the final regulations under Section 987, as well as certain related provisions of the temporary regulations under that section, to delay the applicability date of those regulations by one year. See Tax Alert 2017-1621.

The Report states that Treasury and the IRS intend to propose modifications to the final regulations, in addition to permitting taxpayers to defer the application of Reg. Sections 1.987-1 through 1.987-10 by one year. These modifications would permit taxpayers to elect to adopt a simplified methodology of calculating Section 987 gain and loss and translating Section 987 income and loss, subject to certain limitations on the timing of Section 987 loss recognition. This methodology generally would result in amounts of Section 987 gain or loss that are consistent with amounts determined under the financial accounting rules and the 1991 proposed Section 987 regulations. Also being considered are additional transition rules, including one that would allow taxpayers that elect to apply the loss limitations applicable to the simplified methodology discussed earlier to carry forward unrealized Section 987 gains and losses (measured as of the transition date with appropriate adjustments, and subject to such loss limitations). One loss recognition timing limitation under consideration would permit electing taxpayers to recognize Section 987 losses only to the extent of net Section 987 gains recognized in prior or subsequent years. A possible additional approach under consideration would defer recognition of all Section 987 losses and gains until the operations of the Section 987 QBU cease or substantially all of the assets of the QBU are transferred outside of the controlled group.

Final regulations under Section 367 on eliminating the foreign goodwill exception (TD 9803)

In December 2016, the IRS issued final regulations (TD 9803) eliminating the exception under Reg. Section 1.367(d)-1T(b) for outbound transfers of foreign goodwill and going concern value (FGGCV) and limiting application of the active foreign trade or business exception under Section 367(a)(3) to certain specified property (not including FGGCV). See Tax Alert 2016-2193.

The Report states that the Treasury and IRS have concluded that an exception to the current regulations may be justified. They are working to develop a proposal that would expand the scope of the active trade or business exception to include relief for outbound transfers of foreign goodwill in circumstances "with limited potential for abuse and administrative difficulties, including those involving valuation."

Implications

The Report recommends revoking or substantially revising four regulation packages that could affect the tax efficiency and the manner in which alternative asset management funds and their portfolio companies (e.g., private equity-backed companies) effectuate international and partnership transactions. Some of the proposed changes also dovetail with on-going proposals in the context of tax reform. Although these revisions and the broader tax reform proposal may create uncertainty, investment professionals would be prudent to monitor and assess the potential cash tax, structuring and valuation impact on current portfolio companies and prospective investments. We will continue to monitor development affecting the regulatory revision process.

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