On 4 April, 2016 the U.S. Treasury and IRS announced proposed new regulations under Code Section 385 aimed at curbing earnings stripping by multinational organisations through the use of intercompany debt.
A central part of these proposed regulations are new Documentation Requirements which if implemented as proposed will impact the way companies administer their intercompany debt arrangements. When the proposed Section 385 regulations were announced the Treasury outlined the rationale behind the Documentation Requirements.
“Under current law, it can be difficult for the IRS to obtain information to conduct a debt-equity analysis of related-party instruments, especially information that demonstrates the intent to create a genuine debtor-creditor relationship. This lack of detail in a taxpayer’s documentation can make IRS enforcement difficult.”
In an effort to allow the IRS to more easily carry out this debt-equity analysis the regulations will require companies to maintain four different types of documentation:
This requirement ensures that, within 30 days of the start of the loan, a legitimate legal contract is in place between the intercompany borrower and lender.
While exact guidance on what should be included in this binding obligation has not yet been outlined, a commercial loan agreement would typically include details about:
Creditors rights are designed to protect the Creditor (lender) in the event that the Debtor (borrower) cannot meet its payment and repayment obligations as outlined in the previous section. These rights outline how the Creditor can recover the capital owed to it by the Debtor.
This is perhaps the area that will require the most legal due diligence. A borrower offering creditors rights to a lender under one loan agreement will impact the borrower’s ability to offer rights to other lenders in other loan agreements.
This requires the maintenance of documentary evidence that the debtor will, within reason, be able to repay the debt and associated interest in line with the terms of the loan agreement. This will force companies to carry out due diligence on intercompany borrowing counterparties to prove repayment capacity.
This is one of the areas of the new proposed regulations that will require the most clarification by authorities ahead of implementation. Likely documentation requirements include:
The final documentation requirement which focuses on providing evidence of an ongoing debtor-creditor relationship could potentially have the biggest ongoing impact on tax and finance departments charged with responsibility for compliance with the new regulations.
Again, the authorities will need to clarify exactly what will be needed to “prove” an ongoing debtor creditor relationship exists. Likely requirements include:
The speed at which the authorities indicated they would implement these new regulations was one of the areas of most concern for those who expect to be impacted.
While the Treasury or IRS have not provided exact guidance on when the Section 385 regulations will be finalised it has been indicated that they will come into effect around Labor Day in early September....
It’s been two months since the U.S. Treasury and IRS surprised the market by announcing proposed regulations designed to curb earnings stripping by U.S. based multinationals through the use of related party debt. These proposed regulations, issued under section 385, are anticipated to have wide ranging effects on how companies manage intercompany debt and how the IRS treats such arrangements for tax calculation purposes.
In summary, the proposed regulations will:
1. Impose documentation and reporting requirements on companies that have intercompany debt which if not complied with will result in the debt being treated as equity for tax purposes.
2. Allow the IRS to “bifurcate” a debt instrument by treating it partially as equity. At present, funding instruments are treated as either debt or equity, but not both.
3. Treat intercompany debt wholly as equity if certain rules aren’t adhered to such as the “General Rule” and the “Funding Rule”.
Market experts such as the large accounting and law firms have been poring over the proposed regulations since their release resulting in a steady stream of Briefing Notes and Client Alerts.
Outlined below is a summary of what some of these firms are saying along with advice for companies who expect to be impacted by the regulations, with a focus on operational considerations and documentation requirements.
This Client Alert is an extensive overview from Baker McKenzie, detailing and providing commentary on all aspects of the proposed new section 385 regulations. Key points raised include:
• The new regulations will apply equally to non-inverted foreign based multinationals and US multinationals.
• The Treasury “intends to move swiftly” to finalize the regulations.
• The Treasury and IRS now expect companies to treat intercompany loans with the same “discipline” as external loans. “The days of flexible intercompany lending are nearing their end”.
• Impacted Groups will need to implement new processes to prepare the necessary loan documents which, in turn, will need to be diligently monitored over the lifetime of the loan.
• More relaxed standards may be imposed for managing cash pools and other operational cash management structures.
• There is currently no relief proposed for non-compliance with the Documentation Requirements. Non-compliant intercompany debt will be treated as equity.
Download the full alert here.
This publication from PwC outlines at a high level the potential impact of the proposed section 385 on corporate treasury activity. Key considerations include:
• Internal financing structures such as cash pooling may need to change if they are structured as intercompany loans.
• Unwinding of such internal structures may limit cash flow visibility and central control of cash.
• Third party financing of legal entities may be required if internal structures are no longer cost/ capital effective or tax compliant.
• Other centrally managed services such as FX risk management may be altered by changes in group structures.
• A review of current processes and technology will be required to understand what burden the “cumulative impact” of the proposed regulations will have on day-to-day operations.
Download the full publication here.
In this webcast Michelle Johnson and David Turf, both Managing Directors with Duff and Phelps in Chicago, detail how companies can justify their intercompany debt arrangements through actions taken at the inception and throughout the life of a loan. Key points include:
• Clearer guidance on documentation requirements is needed in order to avoid both the inadvertent omission of necessary documents and the provision of unnecessary documents.
• The presence of documentation proving a “reasonable expectation of repayment” is expected to be important and difficult.
• While there are laws governing intercompay debt many transactions remain undocumented. Even where documentation exists, it may be insufficient to satisfy the other components of the proposed regulations.
• The webcast runs through a range of financial statements and ratios that will need to be analysed and documented when determining the creditworthiness of a borrower.
Proposed actions to take now include:
• Review existing documentation.
• Open up the conversation to all stakeholders (tax, treasury, legal etc.).
• Create an inventory of loans with all key details.
• Consider making anonymous comments through an industry group.
Watch the webcast here.
This alert was released by the Morrison Foerster Tax department shortly after the proposed regulations were announced. Key takeaways include:
• The various documentation requirements are a “threshold requirement” of the new regulations. Meeting these requirements, however, does not establish the instrument as related party debt.
• Documentation must include evidence of ongoing capital and interest payments in line with the initial agreement.
• Documentation must be maintained for all taxable years that the related party debt instrument is outstanding and until the “period of limitations expire.”
• The proposals do not include guidance on where and in what manner the documentation must be kept.
The full alert can be accessed here....
On 4 April 2016, the U.S. Treasury and Inland Revenue Service (IRS) issued temporary and proposed regulations aimed at curbing corporate inversions and earnings stripping. The proposed regulations will have a far wider reach than just corporate inversions and, if implemented as proposed, are expected to dramatically impact the management of intercompany debt.
The U.S. Treasury released a fact sheet alongside the announcement which provides a succinct description of a Corporate Inversion and why they are undertaken.
“A corporate inversion is a transaction in which a U.S.-parented multinational group changes its tax residence to reduce or avoid paying U.S. taxes. More specifically, a U.S.-parented group engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the United States, typically in a low-tax country. Typically, the primary purpose of an inversion is not to grow the underlying business, maximize synergies, or pursue other commercial benefits. Rather, the primary purpose of the transaction is to reduce taxes, often substantially”.
There have been a number of high profile corporate inversions in recent years which have been criticised heavily on both sides of the political divide. Pfizer’s proposed acquisition of Allergan has been the first high profile victim of these regulations when it was called off on the day of the announcement. The proposals made by the Treasury and IRS involve two actions; temporary regulations designed specifically to Corporate Inversions and a proposed regulation to address earnings stripping.
This action was taken under section 7874 and follows efforts made by the Treasury in September and November 2015 to limit inversions.
This latest release acknowledges that the existing laws designed to control inversions can be circumvented by a foreign company growing rapidly through acquisitions to a scale that allows them to avoid the current 7874 rules when acquiring American companies. When deciding if a foreign company’s purchase of an American company should be subject to inversion laws, the new temporary regulation changes the calculation of “ownership percentage” which will now exclude “the stock of the foreign company attributable to assets acquired from an American company within three years prior to the signing date of the latest acquisition”. In summary, the value attributed to acquisitions in the last three years won’t be taken account of when determining the value of an acquirer relative to their target.
Alongside the temporary regulations outlined above, the U.S. government is proposing actions under section 385 that will target earnings stripping in multi-national companies. These proposed regulations focus primarily on three areas:
1. Targeting loan transactions that does not finance new U.S. investment
This new proposed regulation under section 385 of the code, in the Treasury’s own words, targets “transactions that increase related party debt that does not finance new investment in the United States.” The actions specifically make it difficult for foreign owned entities to “load up” their U.S. subsidiaries with related party debt following an inversion by treating as stock the instruments used in such a transaction. The proposed regulations “treat as stock an instrument that might otherwise be considered debt if it is issued by a subsidiary to its foreign parent in a shareholder dividend distribution.” The Treasury states that the regulations will apply to transactions issued on or after April 4. Tellingly, they commit to moving “swiftly” to finalize them.
2. Part debt, part stock treatment of related party debt
This element of the regulation proposes the implementation of a statutory authority that would permit the IRS, on audit, to treat a related party debt transaction as part debt and part equity. This is a departure from current rules which take an all-or-nothing approach to the treatment of related party debt. The current approach is deemed to “create distortions when the facts support treating debt as part debt and part stock.”
3. Documentation Requirements
This requirement will compel companies to maintain documentation that demonstrates a commercial debtor-creditor relationship between internal lenders and borrowers, similar to those maintained with external lending counterparties. This documentation will include:
– A binding obligation for the issuer to repay the principal;
– Creditors rights;
– Proof of a reasonable expectation of payment; and
– Evidence of ongoing debtor-creditor relationship.
If these requirements are not met, related party debt will be classified as stock for tax calculation purposes. The regulations as currently proposed provide no relief for non-compliance with these documentation requirements.
There has already been widespread comment from accounting and law firms and other interested parties since the release of these regulations last week. The market is still digesting the true short and long term impact of these proposals and most commentary to date is focused on breaking down the details of the regulations. One thing is for sure, if passed as proposed, these regulations will have a profound impact on the way companies manage intercompany debt from both an administration and planning perspective.
The Treasury press release is available here.
The Treasury Fact Sheet is available here.
The President’s Review of US Business Tax reform is available here....
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