By Ted Howard
The US Treasury announced new tax proposals in early April that quickly proved the old adage that the devil—or in this case Section 385—was in the details.
Sometimes the shock of a big announcement can hide other smaller announcements that come with it. Such was the case with the US Treasury Department’s issuance of two sets of rules back in early April, that ostensibly were aimed at strategies it deems are simply ways corporates avoid paying taxes.
The first set, the big shock, targeted inversions—commonly known as a strategy whereby a US company purchases an overseas firm in a low-tax jurisdiction to take advantage of, well, lower taxes. The new rules would make it more difficult for a US company to achieve the necessary ownership percentage of the acquired company to pursue an inversion under Section 7874 of the tax code. This is the rule that scuttled the $160 billion Pfizer-Allergan merger.
The second set, stealthier and more widely applicable, is the focus of a lot of treasurers, law firms and Big Four accounting firms. Those rules were issued under Section 385, which defines whether interest in a company is debt or equity, and impacts all corporate groups, whether US- or foreign-based. The rules treat intercompany loans as equity under defined circumstances, including when a subsidiary distributes a note to a parent, or a subsidiary acquires the stock of another group member for a note, or it acquires the assets of an affiliate in a reorganization.
The rules are really a series of proposed changes and regulations that were directed at trying to stop what’s referred to as earnings stripping, said Peter Frank, Principal, Financial & Treasury Management at PwC, and it was thought using intercompany transactions was possibly hiding that. As a result, Treasury “went after what they perceived as some of the enablers” of earning stripping; so the ubiquitous cash management tools companies use daily—intercompany loans, cash pooling, netting and in-house banks—“those were things that in some cases were directly targeted by the proposed regulations.”
The proposals came as a surprise to many in the advisory space. One attorney quipped that it must have been “top secret” because there was no advance notice that such rules were even being considered. And now many corporate treasurers are wondering what it means for transactions involving cash pooling, in-house banks and in other intercompany loans. Some of the worst fears were articulated by William Alexander of Skadden, Arps, Slate, Meagher & Flom LLP who told TaxNotes.com that practitioners’ “worst fears” were that the new rules are “going to be like having to apply for your credit card every time you use it.”
With this looming, some treasurers aren’t taking chances. One treasurer at a US multinational said his company has put such transactions on hold. “Our tax guys are now saying there is a potential that intercompany lending/borrowing with the IHB could be re-classed to equity for US tax purposes if the borrower or lender engages in certain distribution or acquisition transactions within three years before or after such lending/borrowing,” he said. He added that the treasury team was trying to glean more information from external advisors but the company’s tax department has suggested it “might want to put IHB on hold until August or so” which is when there could be more clarity as to which direction the IRS will go.
Another treasurer also said they were continuing business as usual but at the same time, they are beginning to join lobbying efforts in order to “raise awareness” of the unintended consequences that could result from Section 385. Otherwise, “it is still too soon to tell whether the rules will be implemented in their current form.”
Peter Connors, a partner at global law firm Orrick, said treasury would likely respond positively to comments from companies and others. And despite its wider reach, it was still mainly “tied into inversions” and the desire to limit US tax base erosion. “I don’t think treasury centers were in any way targeted,” he said.
Documentation
A lot of the worry is about the amount of documentation that will be needed to prove a loan is a loan and not some sneaky way to avoid taxes. According to guidance from Orrick, the proposed earnings stripping regulations “will have implications for any large company issuing ‘internal’ debt.”
According to Orrick, documentation will need to show “why the instrument qualifies as debt” and that it was maintained for the life of the loan and at least 3 years following. “Failure to produce the documentation will result in the debt instrument being treated as equity” and “even if the instrument is properly documented, if the debt instrument is issued during the 72 month period before and after a distribution or certain stock acquisitions, the debt will be recharacterized as stock.” Finally, when all these hurdles are met, the debt instrument will need proper debt-equity analysis.
“For the characterization of an intercompany transaction as a loan, there [would be] a requirement for you to have contemporaneous documentation—at the inception of the loan as well as [providing] documentation throughout the life of the transaction,” said PwC’s Mr. Frank. “What that means is the documentation and support for the loan needs to be at a standard that is equivalent to what you would expect from a third party loan.”
This could lead companies to stop using many of the tools they are used to employing, said Davis Wang, a partner at law firm Sullivan & Cromwell. “If [the IRS is] going to recharacterize intercompany debt as equity, what is intended is that people will limit their attempt to strip equity out of the US,” he said. Companies “will just stop certain types of transactions altogether.
And if they do engage in the activities, it will likely be up to outside auditors to check, Mr. Wang added. “In terms of the documentation, I’m not sure what the enforcement plan will be, but there is a parallel regime, for public companies at least, that before you disclose your tax position your auditors are going to say, ‘Have you done these things?’”
What will treasury need to do? From a tax standpoint, Mr. Wang said, treasury will need to work with their tax group very closely to understand the rules. In addition to the cash pooling, the tax will group will need the information “on all of the cashflows in and out of certain entities; and that’s not necessarily something that [treasurers] have done before.”
Mr. Frank said he hadn’t seen a lot of activity by companies but knows that many are studying the implications. “The rules aren’t final and people don’t want to overreact,” he said. Still there are companies he knows of that have significant tax reorganizations under consideration. “And the brakes have been tapped a little bit to slow them down pending clearer resolution of what the go-forward plan is going to look like.”
Mr. Frank says to prepare companies should get their arms around the number of transactions they have outstanding, and doing an impact assessment of the current portfolio transactions. And given that ask themselves, “If the rules were put in place how would we respond? What new strategies might we put in place to optimize our outcomes, given the proposed rules and given what we have today?”
Other questions might involve policy, technology and process. Given what they understand to be in the rules, Mr. Frank said, they might ask, “What changes might we need to make to our existing process, including changes to the organization? Do we need more resources? Do we need a new policy? Do we need new tools or technology to help manage this?”
A Done Deal?
While both Mr. Frank and Mr. Wang said there is talk or hope of a carve out, exemption or exclusion for cash pool use, they felt that the US Treasury will stick to the timeline. The comment period ends July 7, 2016, and it would like to make a decision by Labor Day. There has been a lot of pushback by companies; however, “the IRS seems very motivated to act,” said Mr. Wang.
“I think that they expected that there was going to be a lot of comments on this,” Mr. Frank said of the Treasury’s proposals. Nonetheless, “they want to pursue this aggressively and our best view is they will stick closely to the timeline; there probably won’t be extensions.” And even with an exemption, Mr. Frank said the rules could “still create significant challenges for treasurers.”