Regulation: Section 385 ruling marks U-turn
The final ruling on Section 385 has been made, with significant dispensation to allow corporates to continue with cash pooling.
The Section 385 rules on inter-company transfers, announced earlier this year by the US Department of the Treasury and IRS, have been scaled back after a loud response from affected US corporates.
Under Section 385, funds moved between subsidiaries would be considered as equity, and so liable to taxation.
The rules were proposed to prevent tax avoidance, but there was an outcry because the way they were set to be implemented would make cash pooling – increasingly a mainstay of corporate efforts to conserve cash flow and reduce borrowing for short-term working capital – and transactions between subsidiaries taxable.
Following large-scale criticism from companies, the US Treasury announced on October 13 it had considerably reworked the rules.
The changes have, for the most part, allowed pooling to continue as before. Under the original outline, the scope for capture under the new rules was wide, and could potentially trigger the re-characterization of inter-company debt to equity. Now it is narrowed to apply only when a US organization is borrowing from a non-US organization, and there are no additional exclusions in place.
The wording of the new rules has been clarified to define exactly what kinds of transactions will be impacted. The ruling now insists that cash management must be demonstrable as the principle purpose of a transaction.
Mark Smith, BAML
Mark Smith, head of global liquidity, GTS, at Bank of America Merrill Lynch (BAML), says: “The US Treasury department made some critical amendments to the proposed rules that should allow companies to continue to use cash pools as they currently do.”
The speed with which the decision was made was also widely welcomed, says Michael Botek, global cash market manager, treasury and trade solutions, at Citi, adding: “The announcement caught us by surprise. We had heard in late September that something had been submitted to the authorities for review and could have taken up to 90 days to be finalized. Then a week and a bit later the rules were finalized.”
Documentary requirements have also been significantly reduced.
BAML's Smith notes: “Clients were concerned that the rules, as originally drafted, could have required them to document every funding transaction between entities in a pool, every day. Such a daily documentation burden would have made cash pooling unmanageable for most companies.
“Under the final rules, companies will still need to document their cash pools, but under an umbrella agreement rather than at the transaction level. The final rules also provide some relief in terms of timing. The new documentation is required for debt issued after January 1, 2018, giving treasurers more time to prepare the necessary paperwork.”
Citi's Botek agrees: “Under these finalized rules, the documentation requirements have been simplified to allow for a master agreement and an annual credit analysis to establish the basis for terms instead of the high frequency of actions implied by the proposed rules. Also, it seems that completion of executed documentation and credit agreements could be as late as 2019 in certain scenarios.”
The achievement of US corporates in having the US Treasury reassess the rules has been greatly praised.
“The responses gained significant recognition,” says Botek. “There were over 200 individual responses from corporates and their advisers or representatives that were sent to the US Treasury. The Treasury listened to these responses, so it was good that so many companies articulated how these rules would disrupt their ordinary operating and funding activities.”
Michael Botek, Citi
Botek adds that while other regulations have been challenged in the past, the size of the community lobbying against the rules gave it considerable weight.
“The Basel III leverage ratio received responses from the banks and a few corporates and trade organizations, but it is a smaller community as the corporates have a degree of separation from that," he says. "With Section 385, the corporates were directly impacted, so they had a direct view and strong voice.”
With finalized rules in place, corporates are now able to make concrete decisions on their pooling strategies, which might also create more opportunities for banks.
Botek says: “Before the announcement, the corporate customers were unsure and were pausing on expanding their liquidity management structures. Even though it still has some some grey areas, they can now engage their tax partners and ask specific questions.
“We should now see many more RFPs being reopened and clients making decisions to expand their liquidity management structures.”
The decision on the rules has provided clarity and created distinct guidelines on what is permissible. This might open up the potential for pooling to a greater number of corporates.
Botek adds: “We may now see more corporates that have been sitting on the sidelines looking at what they can put in place. They may even start to think global with their pooling and expand a European pool to include Asia.”