Section 385 Adds Loan Discipline

The scope of new rules under Section 385 of the US Tax Code may have been reduced, but they will still require plenty of work from MNCs with intercompany lending programs. In fact, regulators worldwide have increasingly scrutinized MNCs’ intercompany lending practices, suggesting that systemizing policies and procedures to track and monitor intercompany funding is fast becoming best practice.

Two members of the NeuGroup’s Global Cash and Banking Group (GCBG) recently explained the workings of their firm’s intercompany funding process, which had recently been revamped. A global company with more than $50 billion in revenue that operates in more than 200 countries, has more than 300 legal entities, 1000 bank accounts and 100 banks, and more than 90 intercompany loans outstanding, the company is likely at the forefront of developing a system to essentially rate the creditworthiness of those transactions. Even so, regulators worldwide are increasingly scrutinizing companies’ intercompany financing programs, and transfer-pricing regulations now in the works are feeding that momentum

The company’s representatives pointed to the OECDs base erosion and profit sharing (BEPS) initiative, which has been in the works for a few years and is now rolling out, as the original trigger for revamping the company’s methodology after it became clear the existing approach excluded key factors. It will also help capture information for the new 385 rules.

In terms of Rule 385, “We think we’re in pretty good shape for that,” responded one of the presenters at the GCBG meeting, before the final rule was approved a few weeks later. The company worked closely with one of its core banks to develop the internal system, which is based on a Moody’s Investors Service ratings model. That will enable the company to analyze the creditworthiness of its intercompany loans, which under Rule 385 requires specific documentation to avoid being reclassified as equity for tax purposes. Another prong of Rule 385, referred to as the funding or recast rule, threatens to reclassify as equity the debt of several types of intercompany funding transactions if they don’t meet certain defined exceptions.

Already There? 

Maury Passman, managing director in KPMG’s Washington national tax office, said that the documentation portion requires capturing information that companies likely already capture to some extent, such as who the borrower is and when the borrowings arise. It also requires documenting the lender’s evaluation of the borrower’s creditworthiness and the forbearance or collection actions to be taken in case of default, which companies have not always fully documented for intercompany borrowings. The documentation requirements of the final rule are similar to those in the proposal, but now many intercompany borrowing transactions need only be documented annually under an omnibus-type agreement, instead transaction by transaction. 

That could still be challenging for some companies. In its comment letter on the proposal, for example, ExxonMobile said it processes more than 70,000 cash movements per year and has 600 intercompany agreements between 400 affiliates. In addition, ordinary business transactions such trade payables, perhaps US purchases from a foreign subsidiary on credit, remain a part of the final rule.

“Any time a US multinational is buying inventory from foreign sub on credit, that is covered,” said Chip Harter, principal in PricewaterhouseCoopers national tax office

Cash pooling is exempted from the documentation requirements under the new rule, but notional pooling may still come under scrutiny, said Susan Hillman, a founding partner of Treasury Alliance, which works with companies to install treasury management (TMS) systems, adding those pools often provide insufficient documentation under Section 385.

Equity Challenge
Adding to the challenge, a company must determine whether an intercompany transaction is impacted by the second prong of the 385 rule, referred to as the recast or funding rule. That prong describes three intercompany transaction types that must be recharacterized as equity, and the final rule provides several safe harbors. In the case of a US affiliate borrowing from a foreign group, one safe harbor allows it to borrow in an amount up to its non-cash current assets. A second is for short-term loans, requiring the borrower to completely pay down all of its short-term borrowings from affiliates, other than trade payables, for 95 days of a year.

“These are complicated and fairly maintenance-heavy safe harbors, and a company its going to need systems to track all this and make sure transactions are staying within those safe harbors,” Mr. Harter said.

Michael Mollerus, a partner at Davis Polk & Wardell, said that companies commonly engage in transactions that are potentially subject to being recast, such using a note to acquire stock of another group member when they reorganize subsidiaries for tax purposes, or to move cash around more efficiently. Now they will have to first determine when intercompany transactions are in scope, and then whether the safe harbors apply. And to complicate matters further, if there’s an intercompany borrowing three years after or before the transaction, it will automatically be treated as if it funded the transaction, and it may have to be recharacterized as equity.

“Tax departments and treasuries will have to build systems to identify and monitor when one of these transactions takes place, and whether or not there’s debt within three years on either side,” Mr. Mollerus said.

Companies with intercompany financing will be required to comply with not only the Section 385 regulations but also the Section 482 regulations (transfer pricing rules), which will result in a significant amount of information that must be captured. “These are independent regulations that have different exceptions and requirements, and companies will have to capture information for both sets of regulations—there’s no historical precedent for that,” said Vinay Kapoor, a tax principal in the economic and valuation services practice of KPMG.

Ms. Hillman noted that some TMS vendors offer intercompany-loan modules, providing a systematized way to track intercompany funding. “So if a company is planning to implement at TMS or is considering it, we would recommend getting an intercompany loan module,” she said, adding, that it “takes a bit [of time] to set it up and must be customized for the specific company.”

Mr. Kapoor said some large multinational companies have historically had robust processes to evaluate, analyze and track intercompany financing, consistent with the requirements of the Section 385 regulations. The Section 385 regulations, the OECD’s BEPS initiative, and generally more scrutiny by regulators of where companies generate profits in relation to their sales, is expected to prompt other MNCs to analyze and monitor inter-company funding more carefully.

Although the NeuGroup GCBG member did engage a relationship bank to help design its system, Mr. Kapoor said banks have become less willing to work on such projects, since they’re mainly in the business of being financial intermediaries. He added that when banks do get involved with intercompany financing, it’s typically a part of a larger transaction the bank is working on for the client, and so it’s doing it as a sort of goodwill gesture, or perhaps the company’s CFO calls and reminds the bank of its larger relationship with the company to curry a favor.

“What we’re seeing is that the documentation that comes out of that type of situation is often not what you need to satisfy the IRS, because banks are not thinking in the context of rule 385 or the transfer pricing rules,” Mr. Kapoor said. “In addition, if the company is audited and it must prepare for that examination, will the bank be willing to testify?”