The final rule under Section 385 approved Oct. 14 -- much sooner than most anticipated -- provides exceptions for many of corporates’ intercompany lending transactions that the proposed rule appeared likely to reclassify as equity. Nevertheless, companies are by no means off the hook, especially financially troubled ones.
Intercompany financing can take many forms, but Reg 385’s impact was especially relevant to corporate treasuries’ cash pooling structures, which traditionally are used to manage short-term cash. That meant every entity borrowing from the pool, in the process putting itself in a negative position, might trigger a requirement that corporate treasury and tax departments must provide documentation demonstrating it met specified conditions to avoid the reclassification of its negative pool balances as equity. The final rule makes a similar presumption but eases the process by allowing companies to consolidate the transactions under an overarching master agreement. Due diligence must then be performed annually to ensure the potential borrowers, pool members, are creditworthy.
“You want to capture the information and to have the right kind of policies and procedures in effect so that all the requirements are met, and you have a comfort level that they will be met,” said Maury Passman, managing director in KPMG’s Washington national tax practice. “It’s doable, not rocket science, but it takes time and effort and you must implement the systems and make sure they’re followed.”
Michael Botek, CTP, senior product manager at Citigroup, said that corporates will likely still have to clarify how the nearly 500 pages of rules will impact them, but in general the final rules should provide them with confidence in pooling structures.
“On the pooling front, a lot of our clients sitting on the sidelines will start to come back,” Botek said. “They’re going to be thinking about how they can implement and expand their structures.”
The documentation requirements are one of two major prongs of requirements. Compliance with the documentation rules was extended in the final rule to Jan. 1, 2018.
Corporate debt addressed
Another major concern stemming from the proposal was that the 385 rules would apply to debt issued by companies incorporated in other countries. Treasury removed that concern by applying the rules only to debt issued by domestic companies.
A non-U.S. company acquiring a company in the U.S. in a non-inversion setting can lend to the U.S. subsidiary, although the U.S. subsidiary’s debt to its foreign parent will be at risk of being reclassified as equity. However, Passman said, the U.S. subsidiary can provide significant amounts of related party debt at the time of its leveraged acquisition, or slowly over time to the extent allowed under various exceptions in the newly finalized regulations.
“If a company realizes it wants to structure more debt into the U.S. subsidiary, it’s doable at the initial acquisition but not so easy when the ownership relationship has been established,” Passman said.
He noted that as a result companies may perform inbound acquisition planning with as much related-party debt as they can justify. They can then refrain from distributing any profits during the 36 months following the acquisition to avoid triggering an equity re-characterization of the related-party acquisition debt under the final regulations.
Transactions using bank debt are not impacted by the 385 rule.
Recast rules recast
The second prong of rules in the 385 regulation to come under scrutiny are referred to as the recast, or funding, rules. These rules allow a company to reclassify intercompany debt as equity if the company pursues certain types of transactions, such as distributing its own debt as a dividend, purchasing stock of a related company with its own debt, or pursuing the reorganization of company assets and using an intercompany debt instrument. In addition, if a company pursues one of those transactions and a related-party debt instrument is issued three years either before or after, even if not when the transaction was initiated, then that debt is at risk of being reclassified as equity.
“I believe Treasury is trying to dissuade a company that might pursue an inversion from immediately inserting a lot of related-party debt in the structure, where the U.S. company is the debtor and the foreign related party is the putative creditor, by subjecting it to these rules,” Passman said.
In fact, Treasury appears to have tailored what was a broad proposal that could have severely hindered companies’ intercompany funding strategies into a more finely tuned final rule that eliminates or reduces the ability to achieve benefits from inversions quickly.
“Treasury has limited the financial incentives to engage in one of these transactions,” Passman said, adding that the recast rules are effective for transactions completed after April 4, 2016, when the proposal was issued.
The recast rules, or funding rules, provide four exemption categories for transactions to avoid be reclassified as equity.
For example, one category requires ensuring the related-party loan is short-term funding, and one stipulation is that corporate subsidiaries must not be net intercompany borrowers for more than 270 days in a year or more than 270 consecutive days over a two-year period. Inadvertent deviations from the 270-day period can be excused if the company demonstrates that its failure to comply was reasonable in light of the facts, if the failure is promptly cured, and if the company has the right kinds of written policies and procedures in place. Passman noted that compliance will require developing new policies and procedures or adjusting existing ones, including the ability to rate the creditworthiness of corporate entities.
“A company has to have managerial-level involvement in these policies and procedures; the regulations set forth an extraordinary degree of articulation,” Passman said. “Companies will have to put in place the right procedures to make sure they’re following all these rules and fitting within the exceptions, and they can prove it. They’re also likely going to have to show their financial auditors that they have the right kind of control policies in effect.”
Passman noted the 385 rules’ bias toward pushing relate party debt instruments into stock status may be particularly problematic for financially troubled companies. In the event of a likely default, bank creditors may refuse to lend new money but they typically will work out a solution with the company and other lenders to salvage as much value as possible. However, if a corporate entity is about to default on a related-party loan, the 385 rules don’t have that sensitivity. If the related party debt is modified in an internal workout, the debt could be deemed newly reissued, triggering the documentation rule’s requirements that the intercompany creditor reevaluate the borrowing entity. And if it doesn’t have a reasonable ability to repay the loan at that point, the rule calls for the loan to be reclassified as equity, potentially worsening the company’s situation.
“There are a lot of ways throughout the regulations where financially troubled companies will have risk of the intercompany debt turned into stock,” Passman said. “There’s something of that already under longstanding debt/equity principles, but these new rules make it even more onerous.”