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Proposed 385 Regulations Could Severely Impact Treasury

  • By Andrew Deichler
  • Published: 5/23/2016

The U.S. Treasury Department’s proposed regulations under Internal Revenue Code section 385, which are intended to deter corporate tax inversions, would also overturn established rules that determine whether an instrument is considered debt or equity—making life a lot more difficult for many corporate treasury and tax departments.

As explained in a letter sent to Treasury Secretary Jacob Lew by a number of advocacy groups and associations, whether an instrument is debt or equity has “significant, collateral consequences” for business operations. The advocacy groups stressed that by overturning analysis used by the courts and the Internal Revenue Service (IRS) to determine whether an instrument is debt or equity, the regulations have the potential to affect all aspects of a company’s capital structure and the funding of its ordinary operations. “These issues present a severe impediment to the use of intercompany financing for even normal operations and will significantly increase the cost of capital and limit the amount of capital available in the United States,” the advocacy groups wrote.

The letter requests that Treasury:

  • Change the effective date of the proposed debt-equity characterization rule—which currently applies to debt instruments issued on or after April 4, 2016—to instruments issued 90 days after the regulations are finalized
  • Extend the public comment period from July 7, 2016 to October 5, 2016 or later
  • Dedicate adequate time and resources to a thorough analysis of the public comments on the proposal.

The retroactive effective date is of particular concern; companies have to conduct their operations as if the proposed regulations are already in effect, even as they are still attempting to interpret them.

Impact on treasury

AFP spoke with corporate treasury and tax professionals to get their take on the proposed regulations. The overall sentiment among them is that the Treasury Department hasn’t fully thought through the ramifications that these rules would have on businesses.

In particular, the rules would affect multinational corporations with centralized treasury functions that rely on cash pooling structures. “Cash pooling, a common instrument to manage global liquidity within corporate treasury, will be affected as daily intercompany deposits and borrowings might be re-characterized as equity transactions,” said one treasurer who works for an insurance company.

An assistant treasurer for a major logistics provider stressed that he doesn’t believe that Treasury fully understands how cash pooling structures work. “I don’t think that [Treasury] has been advised properly about how money actually moves around the globe, the onshore offshore issues, and how these structures are actually part of working capital and are not tax evasion,” he said.  
Another logistics assistant treasurer agreed, adding that that Treasury is putting cash pooling structures in jeopardy, “especially given the backwards-looking potential time periods and the sense that this is in effect as of the announcement date, even if it becomes effective later.”

One assistant treasurer, who works for a major pharmaceutical company that relies on pooling structures and intercompany loans for day-to-day cash management, said that these new reporting and maintenance requirements are so onerous that they may cause his organization to reconsider all of its operations. “Obviously, that should not be the intent of the rules,” he said. “This has been poorly advised in terms of the broad nature of what’s been proposed, and we’d definitely be supportive of educating those who are writing the rules to make sure that they’re not causing undue stress on corporates.”

A corporate tax professional pointed out that the rules would also likely lead to new tax issues for companies. “If you enter into one of these transactions that they’re after—distributing a note or doing a dividend—then you could potentially turn an intercompany loan into equity,” he said. “Once you start paying out what you thought was interest as dividends, you could run into withholding tax issues and other problems.”

The pharmaceutical assistant treasurer added that intercompany loans will only move from debt to equity if a company fails the documentation test—but in that documentation test, the company would have to prove there’s an intent to repay with a specific repayment date. “There would be tests of whether payments of interest have been made, and I think a lot of us know that often, intercompany loans are rolled over,” he said. “There might be a three-month duration and then they’re automatically rolled over. And often, that’s done by book entries and we don’t actually see a flow of funds. So how would we prove to a regulator that the loan had been repaid and reissued effectively or extended?”

Craig Martin, executive director of the Corporate Treasurers Council (CTC), noted that it’s very unlikely that Treasury realized the impact that these regulations would have on global cash management when it proposed them. Therefore, it’s crucial that corporates speak up about this now. “Don’t fool yourself into thinking that they know how corporate treasury, finance and tax work,” he said. “They don’t, for the most part.”

The proposed regulations under Internal Revenue Code section 385 are the subject of a session at this week's CTC Corporate Treasurers Forum in San Francisco. Stay tuned for updates.

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