For such a small tax code update, there is a lot of attention being given to Section 385. First announced in April 2016, a massive pushback from the “Big Four” (Deloitte, EY, PWC, KPMG) placed the rules into review, with a public hearing in July. Yet despite all of the noise, treasurers don’t seem to be particularly concerned, with many thinking that this won’t affect them at all. Should they be concerned? Why? And what questions should we all be asking before this regulation is enacted? Let’s take a look.
Why change section 385?
The core concept at play is the IRS’s recent push to repatriate profit from abroad. From FACTA to FBAR, to the recent focuses on transfer pricing, the IRS and the tax agencies of countries around the world want to bring foreign income home - and tax it. In this particular case, the IRS is going after tax inversions and earnings stripping. They’re targeting companies with intercompany transactions that produce interest deductions by increasing related-party debt without financing new US-based investments, and have no clear and certain repayment plan.
How are they changing current rules?
The primary point of attention has been the decision to allow the IRS to treat certain intercompany debt as equity unless it is issued in exchange for non-stock property (e.g. cash) that increases the gross-assets of the company providing the loan. This includes the ability to “bifurcate” debt – treating some of it as equity, some of it as debt – for tax purposes. The law also creates new documentation requirements for companies with intercompany debt. The IRS will have the ability to go back three years looking for situations these rules would affect.
For more on the specifics of the regulation, I recommend reading EY’s International Tax Alert on this subject.
Who is concerned?
The current push to inform on this topic is coming from the “Big Four” - Deloitte, EY, PWC and KPMG. Back in April, each put out “alerts” like the above regarding its initial conception, and penned a letter to the treasury department opposing the rule change. Since then, they’ve put out a number of articles bringing attention to the rule, and others have hopped on the bandwagon. They pushed a lot of attention to the topic in April and again in June, with financial writers picking it up in July and building a lot of steam behind it.
That is why it was such a surprise for us when we interviewed treasurers only to find that there’s been relatively little fuss from them. Broadly put, it seems like a lot of companies don’t think that it will affect them at all. This is an especially poor perspective to have, since the government wouldn’t be going through the fuss of changing the law if there wasn’t a significant amount of money to tax. So either the numbers they’re going after are large, or the number of companies that will be affected by this is.
One explanation for the lack of concern coming from the companies we interview lies in a maxim that (especially when it comes to tax optimization) says “accountants [and treasurers] should be neither seen nor heard.” Perhaps the lack of concern stems from the fact that the crew who is affected by this change is particularly quiet already.
Who will it affect?
EY points out that these regulations would “dramatically affect many commonplace Subchapter C non-recognition transactions” and “would dramatically affect a wide range of mergers and acquisitions (M&A) transactions and ordinary course corporate finance and tax operations.” In short, it could affect many companies involved in common daily business operations.
However, the proposed regulation has limited scope, including different exceptions. The regulations preamble specifies that its applicability is limited to “expanded group indebtedness” (EGI) between “closely-related parties” – or intra-firm debt. This means, the rules would likely be most applicable to companies with large (excessive) amounts of non-domestic intra-firm loans without a defined or documented repayment plan.
What should you be asking?
When thinking about IRS 385, try to keep the following in mind:
- If the IRS decides to reclassify the debt of a group company located abroad as equity, how will the foreign tax authorities react to this reclassification? Given the IRS will have the right to go three years back in time, will the foreign tax authorities just roll over and accept the reclassification and refund the paid tax on the previously defined interest income or will they challenge this reclassification? If accepted, this will also require restating already submitted and approved financial statements.
- The decision to pay dividends or make equity investments (herewith repatriating funds related to foreign generated income back to the US) normally requires board approval. If the IRS makes this decision (granted indirectly) how will that affect the legal responsibility of these boards?
- If the group company abroad chooses to arrange the funding of a US entity via a bank loan/credit facility in the same country of the original lender (which will be guaranteed or collateralized by cash or securities provided by the group company) instead of providing the debt directly to the US entity, how will this be viewed by IRS? Yes, this loan will be more expensive for the US entity than intercompany debt and they will also need to pay a fee to the group company, but they will avoid repatriating the foreign income back to the US, herewith avoiding to pay the US capital gain tax on these funds.
- How will this impact foreign groups which use USD denominated intercompany debt for their balance sheet hedging of USD balance sheet exposures? If they can’t provide a well-documented “repaid” will they replace these intercompany debts with bank debt (backed by collateral or not)?
- How will the EU react to the proposed changes to the US tax rules? The EU has also a focus on corporations trying to utilize different countries’ tax rules to reduce the group-wide tax expenses. Would they try to implement similar rules for the EU? If yes, how would that impact the group-wide funding set-up with term loans, cash pooling, and overdraft facilities?
Despite the noise surrounding IRS 385, there are still a number of questions that need to be answered, and it’s up to all of us to make sure they are answered before this regulation is enacted. How will this affect treasury? The potential is limited in scope but massive in-depth, with the ruling bringing into question everything from board decisions to international tax dealings.