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Reg 385 Offers Only Two Endings for Treasury: Bad or Worse

  • By Bob Stark
  • Published: 7/13/2016

While there are many regulations treasurers need to pay attention to, the Treasury Department’s proposed changes to Internal Revenue Code section 385 have the potential to significantly impact treasury departments at large. The focus of the proposed changes is generally to minimize tax inversions and the use of intercompany financing to repatriate profitability from global operations.

The issue for U.S. treasurers is that global cash pooling managed within an in-house bank, perhaps inadvertently, falls within the crosshairs of section 385. In many cases, in-house banking transactions would be reconsidered equity instead of intercompany debt/investment. This presents many complications, not the least of which are the knock-on effects of a parent company being considered to have taken an equity position in an overseas subsidiary, which in turn manages regional and local cash pools. These consequences have driven AFP to communicate its views to the IRS on behalf of its membership.

It is still possible that the proposed changes to section 385 will be modified to allow forms of in-house banking to support cash and liquidity management without reclassifying IHB transactions as equity. But if that change does not occur, there are two likely outcomes:

  1. Treasurers will collaborate with tax to reclassify relevant IHB transactions as equity and will generate the appropriate documentation to comply, including the extensive tax adjustments.
  2. Treasurers will restrict the use of in-house banking for cash and liquidity management.
Realistically, out of these two choices, treasury would move to limit the use of in-house banking as a cash management tool. However, this would have consequences for treasurers.

The driving benefit offered by in-house banking is optimized liquidity across the organization. When borrowing, the parent can fund subsidiaries more efficiently than through external financing. Without the immediacy of cash pooling from parent to sub, subsidiaries would rely upon locally arranged financing (such as a line of credit) to fund short-term funding requirements. Longer term, subsidiaries could arrange more formalized intercompany loans with defined payment and repayment schedules. But the issue remains in the short term: without in-house banking, the cost of funding increases for a subsidiary. On aggregate across the organization, this can have significant bottom line impact.

On the investing side—when subsidiaries have excess cash—an in-house bank will sweep out balances and compensate the subsidiary with a reasonable rate of interest. This interest rate may be higher than a subsidiary could receive from self-managed investments, as the cash aggregated across subsidiaries has more value to the parent than the individual entity.  

Whether the parent company funds or sweeps cash to and from subsidiary in-house bank participants, removing in-house banking as a tool for treasurers to leverage will decrease the ability to mobilize cash and deploy liquidity where it is needed most. Subsidiary borrowing will instead increase, creating unnecessary interest expenses and banking fees when excess cash exists elsewhere within the organization.

Bob Stark is vice president, Strategy for Kyriba and a speaker at the 2016 AFP Annual Conference.

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