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Reg 385: A Three-Step Approach to Help Treasurers Prepare

  • By Paul DeCrane and Joon-Woo Song
  • Published: 9/15/2016

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More than five months have passed since the proposed related-party debt-equity regulations under Section 385 of the Internal Revenue Code were released, and it’s been over two months since Treasury and the IRS conducted a public hearing on the subject. Notwithstanding a deluge of negative comments, the expectation is that the proposed regulations will be finalized by year end, though Treasury has not publicly stated a particular date for completion. While some companies have managed to get over a denial phase and are accepting the likely eventuality that the regulations will be finalized, more have not. Furthermore, many treasury functions are taking a backseat and relying on their tax counterparts to tackle questions and issues raised by the proposed rules.

As AFP noted in its comments on the regulations, “[t]he potential application of the [proposed regulations] to internal cash management practices would create significant problems,” and the triggering of the per se re-characterization rules could create “an array of tax issues, ranging from lost foreign tax credits to taxable contributions, taxable reorganizations, and noneconomic subpart F income.” Given the broad impact of the regulations for domestic and foreign based multinational companies, the process of assessing and preparing for compliance is overdue and should begin immediately.

If that doesn’t get your attention, let’s try a very simple example. One of the most obvious consequences of re-characterizing intercompany debt as equity is that the borrower will lose its interest expense deduction for U.S. tax purposes. Assume a $100 million, five-year borrowing at 5 percent. That’s $25 million of interest expense over the life of the borrowing. If the group is taxed at an effective 35 percent rate, the cash-tax cost of the loss of that deduction could be up to $8.75 million. And that doesn’t even take into account the other potential costs outlined by AFP above.

It is therefore worth investing time and resources to take a close look into intercompany financing and cash management processes to understand their current state and how it stacks up against the documentation requirements of the proposed regulations. For example, the regulations require that documentation must establish: (i) a binding obligation to repay the funds advanced; (ii) creditor’s rights to enforce the terms of the debt; (iii) a reasonable expectation that the funds advanced can be repaid; and (iv) after the instrument is issued, actions evidencing an ongoing genuine debtor-creditor relationship.

What needs to be done?

Many companies have begun implementing a three step approach, which enables corporate treasury professionals in consultation with tax, accounting, and legal personnel to assess readiness and compliance with the documentation requirements of the Proposed Regulations.

  1. Data gathering: Companies should take an inventory of their intercompany financing arrangements, including principal amounts, maturity dates, payment terms, payment history, and supporting documentation, and review associated debt issuance and tracking processes, systems, and retention. It is important to note that a wide variety of intercompany obligations are covered by the documentation requirements, including term and demand loans, cash pool deposits and overdrafts, trade payables and receivables and open accounts.
  2. Risk assessment: Companies should analyze and assess overall risks associated with their intercompany financing arrangements, both under current law and under the proposed regulations. In addition, companies should review their origination and record maintenance processes for these intercompany arrangements.
  3. Planning and implementation: Companies should develop a plan and implement a process to properly manage funding and related transactions to help mitigate the company’s overall risks on previously issued debt and improve intercompany debt documentation, procedures and systems on a going-forward basis.

In many cases, treasury technology should be a big part of the solution as it would be challenging to have process integrity in a highly manual environment. An analogy would be a bank managing corporate loans in a spreadsheet. Companies can leverage treasury technology to provide controls and monitoring mechanisms for loan interest and principal payments. Companies can even take a step further by building in work flows to approve new intercompany debt relationships to ensure proper compliance prior to execution.

It could take a considerable amount of time to properly conduct this readiness assessment, depending on the size and complexity of a company’s intercompany activities as well as resource constraints. With the finalization of the proposed regulations likely just around the corner, now is a good time to start your review if you haven’t already.

The views expressed are those of the authors and not necessarily those of the EY organization or of its member firms.

By Paul DeCrane, global treasury services leader, and Joon-Woo Song, manager, global treasury services, both with EY Americas Financial Accounting Advisory Services.

 

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