Final tax regulations on intercompany debt provide good reason for a sigh of relief, but the respite should be brief as companies still face a heavy uphill climb to achieve the documentation requirements.
Compared with the highly controversial proposed regulations issued by the U.S. Treasury Department in April, the final regulations affecting Section 385 of the tax code are more focused in targeting transactions regarded as abusive, so less onerous on companies to comply. But that doesn’t mean compliance will be easy.
In the waning days of the current administration, U.S. Treasury has developed and pushed through new regulations to shut down corporate inversions, the tax planning tactic undertaken by several major U.S. companies to escape U.S. corporate income tax by re-establishing residencies in lower-tax jurisdictions. The now-final regulations give Treasury authority in certain circumstances to treat debt as equity for tax purposes, nullifying deductions for interest expense, if they seem designed merely to strip earnings out of U.S. companies to escape tax. The rules also require companies to produce a great deal of new documentation to substantiate tax-deductible interest on debt among entities in a related group.
“The scope of these rules got really limited a lot for U.S. multinationals,” says Ron Dabrowski, national tax principal at KPMG. “The focus now is on debt coming out of U.S. companies, so it’s a much smaller scope, but where they do apply, the rules are still pretty complex and burdensome.”
Treasury not only narrowed the scope of the final regulations but also extended the effective date into 2018, prompting some companies that were scrambling in anticipation of the new requirements to now pause to take a breath, says Jill-Marie Harding, managing director at tax services firm Alvarez & Marsal Taxand. “Yes, get through your year-end filings, but don’t wait until this time next year to take inventory of transactions that will be covered,” she says. “It’s still going to arrive quickly.”
“The scope of these rules got really limited a lot for U.S. multinationals. The focus now is on debt coming out of U.S. companies, so it’s a much smaller scope, but where they do apply, the rules are still pretty complex and burdensome.”
Ron Dabrowski, National Tax Partner, KPMG
The first step in complying with the new rules is understanding how they will apply to common corporate transactions, says Dabrowski. “These rules go down into everything that’s commercial debt, like trade payables, property transfers, anything you’re selling on an account basis,” he says. “It includes anything that you’re not paying cash for right away. That’s pretty broad.”
Even the tax experts are still studying the fine print in the 518-page release to be sure they understand exactly what the final package requires. They’re suggesting corporate tax experts do the same to be sure they understand how the rules will apply to their particular transactions.
“We’re recommending to our clients that—and they should have been doing this already—they should prepare a risk analysis for all their intercompany loans within their group,” says Bob Gordon, managing director at tax services firm True Partners. “Look at all the loans between parent and subs (subsidiaries), and between subs and subs, especially loans across borders,” he says. “Identify them, and see what you have out there.”
SUMMARY OF PROPOSED RULES
Below is a summary of the proposed debt regulations from the Federal Register.
Section 385 authorizes the Secretary of the Treasury to prescribe rules to determine whether an interest in a corporation is treated for purposes of the Code as stock or indebtedness (or as in part stock and in part indebtedness) by setting forth factors to be taken into account with respect to particular factual situations. Under this authority, the proposed regulations provided specific factors that, when present in the context of purported debt instruments issued between highly-related corporations, would be dispositive.
Specifically, proposed §1.385-2 provided that the absence of timely preparation of documentation and financial analysis evidencing four essential characteristics of indebtedness would be a dispositive factor requiring a purported debt instrument to be treated as stock for federal tax purposes. Because related parties do not deal independently with each other, it can be difficult for the IRS to determine whether there was an intent to create an actual debtor-creditor relationship in this context, particularly when the parties do not document the terms governing the arrangement or analyze the creditworthiness of the borrower contemporaneously with the loan, each as unrelated parties would do. For this reason, the proposed regulations prescribed the nature of the documentation necessary to substantiate the treatment of related-party instruments as indebtedness, including documentation to establish an expectation of repayment and a course of conduct that is generally consistent with a debtor-creditor relationship. Proposed §1.385-2 required that such documentation be timely prepared and maintained, and provided that, if the specified documentation was not provided to the Commissioner upon request, the instrument would be treated as stock for federal tax purposes.
Proposed §1.385-3 identified an additional dispositive factor that indicates the existence of a corporation-shareholder relationship, rather than a debtor-creditor relationship: the issuance of a purported debt instrument to a controlling shareholder in a distribution or in another transaction that achieves an economically similar result. These purported debt instruments do not finance any new investment in the operations of the borrower and therefore have the potential to create significant federal tax benefits, including interest deductions that erode the U.S. tax base, without having meaningful non-tax significance.
Proposed §1.385-3 also included a “funding rule” that treated as stock a purported debt instrument that is issued as part of a series of transactions that achieves a result similar to a distribution of a debt instrument. Specifically, proposed §1.385-3 treated as stock a purported debt instrument that was issued in exchange for property, including cash, with a principal purpose of using the proceeds to fund a distribution to a controlling shareholder or another transaction that achieves an economically similar result. Furthermore, the proposed regulations included a “per se” application of the funding rule that treated a purported debt instrument as funding a distribution or other transaction with a similar economic effect if it was issued in exchange for property (other than in the ordinary course of purchasing goods or services from an affiliate) during the period beginning 36 months before and ending 36 months after the funded member made the distribution or undertook the transaction with a similar economic effect.
Proposed §1.385-3 included exceptions that were intended to limit the scope of the section to transactions undertaken outside of the ordinary course of business by large taxpayers with complex organizational structures. The proposed regulations also included an anti-abuse provision to address a purported debt instrument issued with a principal purpose of avoiding the application of the proposed regulations. Proposed §1.385-4 provided rules for applying proposed §1.385-3 in the context of consolidated groups.
Finally, proposed §1.385-1(d) provided the Commissioner with the discretion to treat certain interests in a corporation for federal tax purposes as indebtedness in part and stock in part (a “bifurcation rule”).
Source: Federal Register
Like Dabrowski, Gordon says companies need to capture not just those loans documented with promissory notes, but any open accounts or cash pooling arrangements. Although the final regulations provide a great deal of relief compared to the proposed regulations with respect to cash pooling, experts are not yet entirely clear on whether cash pooling is fully exempt. “It’s probably good practice to do a complete inventory analysis of everything the company has,” Gordon says.
Robert Tache, a partner at Deloitte Tax, says companies should study the tax, accounting, and business implications of the new regulations, focusing on establishing documentation and internal controls for existing and future U.S.-issued debt among related parties in a corporate group. Pay special attention, he says, to “knowing the effective date for various provisions, the increased due diligence and documentation burden around mergers and acquisitions, and the implications for state tax, especially in states that do not fully conform to the federal consolidated return regulations.”
The effective dates, in fact, are important to study because it’s not a straightforward moment in time where the entire rule kicks into action. Companies have until the middle of January 2017 to look over debt they’ve issued since the proposal was published April 4 and determine whether they’d like to settle it or subject it to the new rules, says Dabrowski. “There’s some pressure to find out what you’ve created since April 4 and remedy it through the transition time,” he says. “That’s the immediate burden now.”
By Jan. 1, 2018, companies must have established their documentation and controls around covered debt, but they have until their corporate tax returns are due to submit it. “You have a pretty good lead time on documentation,” he says. “You have a long time, but you have a lot to do.”
Although the scope of the new regulations is more focused compared with the proposal, companies still have plenty of work to do to properly document what is in scope, says David Golden, national director of EY’s capital markets tax practice. “They require in many, if not most, instances new documentation, new treasury policies, and potentially even new systems to be able to compile and preserve all the new information that’s required and to track new issuances of covered debt and payments on that debt,” he says. “There will generally be a substantially increased compliance burden associated with those intercompany debts.”
The final rules still give Treasury significant latitude to re-characterize debt as equity, producing a drastically different tax effect, where it sees missing documentation or compliance failures, says Brian Kittle, co-leader of the tax controversy and transfer pricing practice at law firm Mayer Brown. “You have to have a good system in place for monitoring the different aspects of the rule to make sure you don’t have technical mistakes,” he says. “There are still a number of rules that can easily be triggered simply by not monitoring the business itself.”
Although financial statement auditors don’t have a direct hand in auditing a company’s tax compliance, auditors at year-end are likely to ask questions about how the company is complying with the new regulations because it could affect year-end tax provisions and disclosures, says Gordon. “If there’s a tax risk out there, auditors will want to know about it to determine how material it is, whether it needs to be disclosed, and whether a reserve needs to be kept,” he says.
The questions may be only “casual” at this year-end, says Gordon, because the new regulations won’t fully kick in until 2018. “But the casual question today becomes the less casual, substantive query tomorrow,” he says.