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Section 385 threatens intercompany transactions

The implementation of Section 385 regulations by the US Department of the Treasury is aimed at stopping profit stripping, but, without redress from treasury and compliance measures, it could also hit intercompany lending and pooling structures.

Established to curb inversions, the regulation threatens to impact the largest US-headquartered companies.

The prospective new rules under Section 385 will see a loan issued to an organization possibly re-categorized as equity, which could then be taxed. Amid fears debt has been issued with the principal purpose of reducing federal tax liability, the rule permits the re-categorization of related party-interests depending on the activities of the company. 

As EY analysts explain: "Prop. Reg. Section 1.385-3 would establish a non-rebuttable presumption that an expanded group debt instrument is issued with such a principal purpose if it is issued by the funded member during the period beginning 36 months before the funded member makes a distribution or acquisition and ending 36 months after the distribution or acquisition. 

"In the preamble, Treasury and the IRS justify this per se rule on the grounds that money is fungible and that it is difficult for the IRS to divine the principal purpose of internal transactions."

Earlier this year, Pfizer’s planned merger with Allergan fell apart based on the new rules. The possible $160 billion merger was cancelled as a direct response to the actions announced by the US Treasury, which the companies concluded qualified as an "adverse tax law change". By moving its business to domicile in Ireland, Pfizer could have reduced its annual tax bill by $1 billion.

Although the regulation is intended by the US Treasury to reduce the possibility of inversions and profit stripping, the implications could affect wider treasury strategies. 

Mark Smith, head of global liquidity, GTS, at Bank of America Merrill Lynch (BAML), says: “The regulation is intended to catch profit stripping, but without additional clarification on scope, it could impact the legitimate movement of funds through cash pooling.

“In the worst-case scenario, it could fundamentally alter how US companies run their internal cash management.”

Michael Botek-160x186.

Michael Botek, Citi

The type and scope of products impacted could be wide, according to Michael Botek, global cash market manager, treasury and trade solutions, at Citi. 

He says: “On the bank-product side, this includes such widely used physical pooling solutions such as the zero or target balancing and cash-concentration services offered by banks. “It could also have an impact on companies that subscribe to payments-on-behalf-of and collection-on-behalf-of services or, potentially, virtual account solutions where intercompany loans are directly integrated with treasury’s consolidated and controlled transaction management.” 

The US Treasury plans to finalize the rules by September 5. Companies likely to be impacted by the changes continue to lobby on the matter.

For companies that wish to continue their current pooling structures, it is likely to mean having to update their working practices. Concerns have also been raised that it will significantly increase compliance costs and requirements for these companies.

To prove that a payment is debt and not equity, the documents will need to include binding obligations from the recipient to repay, and expectations of how this will be repaid based on cash-flow projections and financial statements.

To ensure that companies are meeting the requirements, BAML's Smith says having the correct documentation in order is a necessity for any deals made from April 4, 2016 onwards, when the implementation of Section 385 was announced.

“Companies need to be transparent with their cash pooling, and really beef up their documentation,” he says.

Unexpected bill

As all lending will be subject to scrutiny, companies cannot take a step back from it or they risk facing an unexpected bill. Smith adds: “Businesses need to document all their intercompany lending. They cannot take an arm’s length approach.”

Being prepared for the change before it comes is the best option, according to Citi's Botek, saying: “We encourage our clients to finalize their inventory efforts to understand where their activities intersect with the proposed rule. This will help them manage their timelines and costs to comply with the proposed regulations. We continue to provide guidance to them during this process.” 

The largest companies are likely to be the ones most affected by it. While this will mean considerable additional work from them, they are likely to have robust treasury operations in place. 

Mark Smith-160x186

Mark Smith, BAML

Says Smith: “We’re already seeing that very large corporates are quite concerned by the potential implications, and these are companies which should be best positioned to cope with the impact.”

If documentation is not provided in a timely manner, then it will be treated as equity and taxed accordingly. To find the best route forward, BAML says companies need to work on their tax strategy. 

“Companies should seek both internal and external tax advice on what steps to take next," says Smith. "They also need to review their internal structures, but shouldn’t make any decisions without getting tax advice first.”

Asked if corporates should be looking to their banks or tax advisers at this stage, Botek suggests the advisers will be able to give them a better idea on the impact to their business.

“Banks can be leveraged to understand industry practices and what other clients are doing and saying," he says. "Clients are requesting our guidance on their liquidity-management strategy and associated structures as they finalize their plans.”

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