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Corporates Assess Reg 385’s Impact as Deadline Approaches

  • By John Hintze
  • Published: 7/6/2016
The July 7 comment deadline for the Treasury Department’s proposed revision of Internal Revenue Code section 385 is quickly approaching, and all signs point to the requirements receiving regulatory approval by the fall. And yet few companies are taking actual steps to prepare for what will likely result in the biggest change to how multinational companies fund themselves in decades.
    
“We haven’t seen a tremendous number of companies actually doing anything other than gathering information,” said Peter Frank, a principal at PwC.
    
According to Jiro Okochi, CEO of treasury and risk management software vendor Reval, companies have yet to get to that point. “Right now, companies are at the stage where they are assessing their existing cash pooling and intercompany loan structures, so when the final rules come down, they will have some understanding of what they need to change,” he said.

Uncertainty around intercompany loans
    
Some market participants hope that at least the rule’s effective date will be delayed, since under the current proposal, the rules will affect any transactions originated since April 4, when the proposal was issued. So far, however, regulators have given little indication that they may change course, leaving corporates with a lot of work to complete by summer-end.

The proposal has several components, but the one raising the biggest ruckus is a change to section 385 that would treat intercompany loans as equity under three circumstances: When a subsidiary distributes a note to a parent; acquires the stock of another corporate group member or parent for a note; or in a reorganization acquires the assets of another company in the group for a note.

This could affect a wide variety of other intercompany transactions that have been standard practice for decades. In fact, not only would intercompany loans originated since early April and meeting one of the three circumstances described in the proposal have to be treated as equity, but any transaction already on the books involving a corporate legal entity that has engaged in one of the three event categories going back three years would also be hit when it is refinanced. Consequently, treasury executives’ first step is to gather information about a company’s portfolio of transactions.
        
More complicated will be assessing the corporate entities those intercompany loans are between and whether they’ve been involved in any of the three event categories over the previous three years, since refinancing those loans may require a reclassification as equity. As a result, Frank said, companies now considering refinancing transactions, dividend payments, or repatriating profits, are in some cases modifying the transactions or delaying executing them pending a final resolution of the proposed rule.
    
When companies are making the loans through cash pooling structures, any of the corporate entities involved in the funding mechanism could contaminate it if the entity has engaged in one of the event categories over the last three years. For example, if one entity made a dividend payment two years ago, that can’t be reversed, so that entity must be removed from the pool.
    
“Cash pools work best when some member participants have excess cash and others need cash. Removing one entity from the pool may not make a big difference, but if several have to be removed it could upset the overall efficacy of the pool,” Frank said, adding that the same concerns apply to corporate entities engaged in bilateral transactions.

Taking action
    
To avoid equity reclassifications going ahead, companies can consider alternative sources of financing, such as contributing equity instead of an intercompany loan, perhaps from a different entity than the one that would have provided the loan.
    
“Alternatively, there may be opportunities to change certain terms, such as payable and receivable terms, to provide additional trade finance to an entity rather than making a loan to it,” Frank said. “Or the borrowing entity could seek a third-party loan from a bank instead of another corporate entity.”
    
Another step companies must take is examining their current policies and procedures for establishing and documenting intercompany loans, to determine whether their current tools and technology are sufficient. Ultimately, a company’s system must be able to reconstruct the history going back three years for every corporate entity and transaction, and some firms may already have robust recordkeeping technology but many do not.
    
PwC has spoken to some vendors of treasury management systems (TMS) and other treasury-related technology, and they’re starting to think through modifications to their systems to help companies comply with the proposed rule. TMS typically have intercompany loan modules, but not the functionality to track all the necessary loan attributes. Those solutions are a ways off, so in the meantime, companies will need to build interim solutions.
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