Treasury’s efforts to overturn long-standing tax law creates massive compliance headache

Imagine a proposed tax rule that would disallow favorable tax treatment for many common corporate debt arrangements, retroactive in some cases as far back as three years. Imagine corporate pushback to the proposal because of how drastic it is, coupled with political pressure to finalize the rule so it can take effect as soon as possible.

While it sounds like a compliance nightmare, the scenario is frighteningly real for multinational companies that are trying to figure out how to react to and cope with a pending U.S. Treasury proposal. “We see a lot of uproar and a lot of controversy,” says Albert Liguori, managing director at tax services firm Alvarez & Marsal. “A lot of companies are very upset over this.”

Treasury proposed new regulations under Section 385 of the Internal Revenue Code that would allow the Internal Revenue Service to treat certain debt agreements between related parties in a single corporate entity as equity rather than debt. The new rule also would establish substantial new documentation requirements for certain related-party transactions in order for them to qualify for tax-favorable debt treatment.

If a transaction previously seen as debt were to be treated by tax authorities as equity instead, that drastically changes the tax consequences. Interest on the debt would not be regarded as interest, so it would not be deductible from income for tax purposes.

Treasury is pushing forward with the rule as part of an effort to put a stop to corporate inversions, or transactions where a U.S.-based parent company changes its tax residence to a lower-tax jurisdiction overseas to reduce its overall tax burden. A congressional committee estimated corporate inversions would cost the United States some $40 billion in lost tax revenue over the next 10 years.

“We see a lot of uproar and a lot of controversy. A lot of companies are very upset over this.”

Albert Liguori, Managing Director, Alvarez & Marsal

Failing to win congressional support for legislation to stop inversions, the Obama administration is pushing forward with the Treasury rule in hopes it will at least plug a big leak. Following a mid-July hearing, Treasury officials say they will move to finalize the rule as soon as possible, certainly before the end of the year.

If the effect were limited to corporate inversions, the business community might not be objecting so vehemently. “These rules are so shocking because Treasury didn’t aim them at inverted companies,” says Liguori. “They aimed them at all companies. They are trying to shut the spigot off on interest deductions on a series of targeted transactions.” In doing so, the Treasury proposal caught up plenty of common, everyday transactions, he says.

In a podcast explaining the implications, the National Association of Manufacturers says the rule overturns long-standing tax policy and case law, essentially imposing new taxes on companies by eliminating interest deductions and subjecting some dividend payments to withholding tax. “It threatens well-established business practices, from corporate reorganizations to day-to-day cash management,” says Dorothy Coleman, vice president of tax and domestic economic policy at NAM.

Given Treasury’s plan to impose the new rule retroactively, corporate treasuries are facing some uncertainty, says Coleman. Unsure whether a transaction will be classified as debt or equity, companies aren’t sure how to use inter-company financing even for normal operations, she says. Some companies are using more expensive forms of external debt, she says, to avoid potentially unpleasant consequences down the road. It has made “prudent business planning difficult, if not impossible,” she says.

Peter Frank, a principal in financial and treasury management at PwC, says companies need to be up-to-speed now on how the proposed rules will affect inter-company transactions. “The rules will apply a much stricter set of standards around what type of inter-company transactions can be treated as debt versus equity,” he says. “The proposed rules say if the purpose of a loan is as part of a broad tax restructuring used to facilitate an acquisition of equity or a consolidation of inter-company entities or subsidiaries, then the view will be those types of transactions will be equity and not debt.”

KPMG SURVEY ON DEBT-EQUITY RULES

Below is a summary of results from KPMG’s survey of 1,100 business leaders and their thoughts on if and how the proposed debt-equity regulations will impact their companies.
A recent KPMG poll found one-third of respondents believe the proposed debt-equity regulations under Section 385 of the U.S. tax code, would have a greater impact on their company than the Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting (BEPS) project.
In the survey, 22 percent said they thought the rules would have the same impact, and 31 percent were not sure.
When asked to identify the top impact the rules might have on their business operations, if finalized in current form, 25 percent of respondents said they would need new tax planning, 15 percent said the rules would require additional resources, and 15 percent said there would be a reduced use of debt.
The survey also provided a mixed response on the timing for finalization of the proposed regulations, with 28 percent saying before the Presidential election or sooner, another 28 percent saying after the election, and 44 percent saying they weren’t sure. KPMG's Joseph Pari noted that government officials have repeatedly stated their intention to finalize rules before the end of 2016.
Survey participants included tax directors, vice presidents of tax, chief tax officers, chief financial officers, controllers, treasurers, audit committee members and chairs, and board members and chairs.
Source: KPMG

In addition, the proposal says that tax authorities will be able to look back three years at similar types of transactions and disqualify debt treatment, says Frank. “The specific rules are fairly complex, but the upshot is there are a lot of inter-company transactions today that in the future will be re-characterized as equity.”

Companies need to also study the documentation requirements for transactions that will be recognized as debt and observe them closely, says Frank. “The expectation is rigor of process,” he says. Companies will be expected to contract inter-company loans similar to the way it might be done through a third-party bank.

“And once a loan is in place, you need to track the loans much more closely than today to demonstrate the loan is being repaid in accordance with the terms and conditions,” he says. The IRS will likely be looking to see if companies are undertaking collection efforts similar to those that might be seen with a third-party loan.

“The general rigor, discipline, formality of how inter-company loans are managed will be dramatically higher than it is today,” Frank says. Companies likely will have to invest in new staffing and resources to meet the documentation requirements, he believes. Failure to meet the documentation requirements opens the risk that tax authorities might treat it as equity.

Even cash-pooling structures could be nicked by the new rules, says Frank. Those are structures that enable related entities to pool or consolidate their accounts with financial institutions to optimize their positions. “These cash pools are underpinned by a series of inter-company loan agreements,” he says. “There is a belief or a possibility that these inter-company loan agreements could be characterized as equity.” Companies need to be prepared for that possibility, he says.

To further complicate matters, IRS audits and the legal controversies that surround those take years to work out, giving companies an even longer timeline of uncertainty over how the new rules might play out, says Jose Murillo, a member of EY’s national tax department focused on international tax.

“You’ll have people evaluating these transactions and looking at these things with hindsight,” he says. “With the uncertainty that is created, we may not know what the right treatment is until many years later. That is complexity on the administrative side that just hasn’t existed.”