How Proposed Regulation 385 Could Impact Corporate Treasury

by Rob Vettoretti, Managing Director, PwC Advisory

On 4 April 2016, the Internal Revenue Service (IRS) and the US Treasury Department issued proposed regulations under Section 385 targeting related party funding transactions, specifically addressing whether a debt instrument should be treated as debt, equity, or a combination thereof, for US federal income tax purposes. In addition, these proposed regulations would establish significant documentation requirements in order for certain related-party transactions to be treated as debt for US federal income tax purposes. 

Although these proposed regulations are intended to limit ‘earning stripping,’ using cross-border debt to reduce US income taxes, their application is so broad that they would impose prohibitive tax costs on many routine treasury activities and could have a profound impact on how treasury effectively deploys and manages cash globally. 

The proposed regulations, which could be finalised by late summer or early fall 2016, will be effective for transactions executed on or after 4 April, 2016 and apply to related party debt transactions of an “expanded group”; basically, intercompany financing for closely related parties.

The proposed regulations introduce the following key concepts: 

1. Treating related party debt as equity or partly debt and equity

a. Broad categories of related party debt could be re-characterised as equity. This includes (i) notes distributed to shareholders, (ii) notes issued to acquire related party shares, and (iii) notes issued in certain company reorganisations.
b.  Related party debts could also be re-characterised as equity to the extent the borrower pays dividends, acquires shares of affiliates, or participates in certain intercompany reorganisations within a three-year period either preceding or following the borrowing.

2. Documenting related party debt transactions

a. Companies would be required to prepare contemporaneous documentation to substantiate the debt treatment of all related party debt instruments. Legal agreements providing enforceable creditor’s rights and contemporaneous evidence of the borrower’s credit worthiness (via cash flow projections, financial statement analysis, ratios, etc.) would both be required.

b. Companies would be required, contemporaneously and over the outstanding debt period, to document payments of principal and interest and collection efforts in case the borrower does not make the required payments.

c. For revolvers and cash pools, companies would be required to provide and maintain relevant documents, such as board resolutions and credit agreements, and document arrangements governing the on-going operations, including internal banking services.

There are a few exceptions that would affect the above, most notably (1) adjustments based on the amount of current year earnings and (2) whether the total amount of expanded group debt is below $50 million. (For more detail, see PwC Tax Insights) [[[PAGE]]]

 

Recommended actions

While the specific impact of these proposed regulations on treasury, and appropriate responses, will vary based on the characteristics of each company if the regulation were finalised without amendment, it is likely that for most global, complex companies, these will include reduced visibility into and control of cash, higher financing and operating costs and less flexibility in meeting the funding needs of the business.

To properly plan for and manage these implications, Corporate Treasury, in concert with Tax, should:

• Develop an understanding of the scope of the proposed regulations
• ldentify existing or planned transactions or structures that may be affected
• Assess the impact to the company, from both treasury and tax perspectives
• Understand required changes to current funding strategies to comply with the proposed regulation 
• Identify changes to the Treasury organisational model, processes, banking infrastructure and technology that are required to improve internal and external cash and liquidity management   
  
  

Potential impact on treasury

For corporate treasury, if it were finalised without amendment, the proposed regulation could have a profound impact on a company’s ability to effectively and efficiently fund its operations and manage global liquidity and could require significant changes to existing strategies, organisational models, processes and technology which, in turn, could increase financing and operating costs, add operational complexity and require companies to seek alternative funding sources for international subsidiaries. 

While the specific impact will vary by company, implications for treasury may include

Internal financing strategy and structures

Strategies used to fund subsidiaries on a short and long-term basis may need to be altered. For example, the efficacy and efficiency of cash pooling, a common technique companies use to deploy liquidity across subsidiaries, could be drastically reduced as intercompany lending agreements that support operation of the pool could be characterised as equity. In addition, common ‘in-house banking’ activities including payment-on-behalf (POBO), receipt-on-behalf (ROBO), netting or the use of internal bank accounts may have to be significantly altered.

Cash visibility, liquidity and forecasting

Unwinding of cash pools and other liquidity management structures may reduce corporate cash visibility and central control over cash, reducing operational control and liquidity positions at the parent and subsidiary level. Reduced central visibility and control over cash, coupled with documentation requirements to substantiate debt characterisation, may also necessitate the need for better liquidity forecasting to avoid overdraft, develop subsidiary funding strategies and assess the credit worthiness of borrowers. 

Capital structure and external funding

Limitations in deploying cash internally between legal entities may require companies to broaden their use of third-party financing to fund their business at the subsidiary level. Depending on the ability to repatriate cash, companies may also need to re-evaluate the impact of constrained liquidity on share repurchase plans, dividends or debt repayments. Finally, the reduced ability to use internally generated cash to fund business operations may increase the cost of capital, reducing the economic attractiveness of business investments.[[[PAGE]]]

 

Bank relationships and banking structure

Increases in external borrowing at the subsidiary level may require companies to expand regional/local banking relationships, deploy capital markets skill sets outside of corporate headquarters and implement new bank accounts and additional banking products and services to effectively manage liquidity.

Foreign currency risk management

Corporates managing their currency risk for intercompany loans or net investments may need to consider possible changes to hedging strategies and processes to accommodate the changing tax characterisation of hedged exposures. Specifically, certain intercompany debt instruments may be re-characterised as equity for tax purposes while continuing to be classified as debt for accounting purposes, requiring trade-offs be made among the tax, financial statement and economic impacts of hedging strategies.

Operations and technology

The cumulative impact of greater requirements around documentation of inter-company financing arrangements, assessment of entity-level credit worthiness, forecasting of cash flows and daily cash operations may warrant new or changed policies, processes, banking infrastructure and technology. 

 

Rob Vettoretti Managing Director, PwC Advisory Rob is a Managing Director in PwC’s Advisory practice specialising in financial management, treasury and risk management consulting. Over the past 15 years, Rob developed a broad range of experience in assisting Fortune 500 Retail, Consumer and Industrial companies improve cash flow, transform treasury functions and optimise working capital.  Recently, Rob spent five years in Asia assisting global companies with their large-scale change and transformation initiatives, most of which were focused on developing solutions to support their Asia and international expansion. Prior to joining PwC, he worked in international finance for a Fortune 100 company. He has an MBA from New York University’s Stern School of Business.