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IRS Hearing on 385 Regs: Four Key Themes

  • By Tom Hunt, CTP
  • Published: 7/15/2016
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WASHINGTON, D.C. -- The Internal Revenue Service (IRS) received considerable pushback against the proposed changes to section 385 of the Internal Revenue Code during a public hearing Thursday. The standing room-only session featured testimony from 17 speakers, representing trade associations, law firms, law schools, tax attorneys and audit firms.  

There were essentially four key themes that emerged at the hearing.

Liquidity costs will increase.

Intercompany lending/borrowing is the lifeblood of an organization and not just limited to multinational corporations. The documentation standard needs to be defined better; the 30-day window is too short. The per se rule is cumbersome and costly for companies, and the bifurcation rule would create a higher cost of liquidity. Lastly, by hurting securitization as an alternative source for funding, the proposed changes would also drive up liquidity costs for companies as the tax treatment would potentially change.

Exemptions are needed.

Ordinary course transactions need clarification/determination. Many presented a de minimis test— perhaps all intercompany debt transactions under $1 million and having a maturity less than 367 days should be exempt. Exempting the foreign on foreign transactions was also sought after by many.  

Implementation should be delayed.

Several speakers asked for implementation to be delayed—something that parallels the FATCA implementation, which is being implemented over a longer timeline. The April 4 retroactive date is burdensome. Several presenters asked for a delayed applicability dates as well.  

Full withdrawal of the rules may be the best outcome.

Several trade associations asked that the rules be withdrawn in their entirety. A representative from PwC noted that of the 67 past inversions this regulation is intended for, the dragnet effect of the regulation is far greater. There are an estimated 2,203 U.S. companies impacted by this, representing 26,919 legal entities and 5,121 foreign subsidiaries. Furthermore, a New York Law School representative noted that one third of corporates in a recent McKinsey study have intercompany lending on their books and this would be very burdensome for compliance.

Impact on treasury

If enacted as is, there will be some drastic effects to the way companies handle cash management.

A higher cost of capital

There will be a push towards external financing through third-party lenders to finance transactions.  This is coming at a time when Basel III is causing banks to retreat from markets, industry segments and branch banking and seek safer client profiles to mitigate risk. As companies need financing to grow their business, it will cause a higher cost of capital if they can’t finance their subsidiaries with their working capital through intercompany debt. This will in turn raise the overall cost of capital and raise the internal hurdle rates for projects around capital expenditures. For companies that manage their return on invested capital vs. their weighted average cost of capital, they will be more risk sensitive when entering into new markets, which limits their growth opportunities. It could also result in more companies seeking non-bank lending/shadow banking in terms of alternative sources of capital.  

Business model changes

The proposed rules will kill the business model for funding operations with working capital internally through cash pooling. The changeover to a different structure internally for a treasury department takes a lot of time. The systems in place for tracking will need to be updated, enhanced and documented. Companies may exit certain jurisdictions if the cost of operating is deemed too expensive. Likewise, foreign direct investment will be burdensome in the U.S. if an exemption isn’t allowed.

Domestic companies impacted

The regulation does not only apply to large multinational companies; domestic companies are also going to be affected. Companies will need to revisit their legal structures under the proposal, determine the best operating model and move forward. Treasury departments within these organizations will need to be flexible in providing unique ways to fund the company/entities going forward that doesn’t result in a tax consequence.  

It’s anticipated the rule will be finalized by year-end. Mark Mazur, Assistant Secretary for Tax Policy at the U.S. Treasury, has been steadfast in making this a clear goal. Stay tuned for more as AFP continues to track this issue going forward.
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