What Would Change in Section 385

Debt and stock traditionally have been distinct categories, and the interest paid on debt has been deductible for tax purposes. The proposed changes to Section 385 of the IRS Code would allow the agency to treat related-party debt, including intercompany loans, as part debt and part equity.

The regulations set out documentation requirements for intercompany loans, including documentation related to creditworthiness. Transactions that fall short of the requirements would be considered equity rather than debt. The regulations also say company debt that is linked to certain company distributions or acquisitions will be treated as stock if the distribution or acquisition occurs within three years of the instrument's issuance.

The regulations would affect not only intercompany loans, but also the transactions that can occur in cash pooling, when corporate treasuries sweep cash from subsidiaries' bank accounts and use the pooled cash to provide financing to subsidiaries that need it.

"The challenge with cash pools is that in the future, depending on the characteristics of the entity that is the borrower and activities they may have engaged in—dividends or making acquisitions—entities may be in a position where any loans made to that entity may be recharacterized as an equity injection rather than a loan," said Peter Frank, principal for financial and treasury management at PwC.

Frank also cited potential problems with the documentation requirements. "Our general experience suggests that our clients are pretty good about documenting loans when they're initially set," he said. "Our experience is that after the establishing of loans, our clients tend not to have the same discipline and rigor about documenting loans over the life of the loans."

The Section 385 regulations could apply to many businesses, he added. "If the company has a legal entity structure in which they fund subsidiaries through some sort of intercompany loans, then they would be affected."

The regs do include an exclusion for companies whose internal loans total less than US$50 million. But Frank said most companies "of significant size" have internal loans with a value higher than $50 million.

Treasury Tasks in Preparation

Frank cited two main areas that treasurers should be working on in response to the proposed regulations.

First, companies should look at the documentation they have in place, their processes regarding intercompany loans, and how loans "are tracked, managed, and monitored over time," he said, to determine whether their processes will meet the proposed requirements.

Second, companies need to get an inventory of all their current loans. "One thing we know for a fact that some companies struggle with is having a complete view of what their intercompany [loan] portfolio looks like," said Frank, pictured at left. "A number of companies are going through a significant effort to gather loan information in a central place."

Once companies have identified all their loans, they need to go through them "to identify which loans, if any, might be subject to a recharacterization from debt to equity," he said. "For those loans, assess what the impact of that recharacterization would be. Then develop some sort of mitigation plan." For example, the company might replace an intercompany loan that's subject to recharacterization with third-party borrowing.

Steve Blore, an international tax partner with Deloitte, noted on a webinar sponsored by the Association for Financial Professionals that all loans that were entered into prior to April 4, 2016, are grandfathered in.

"You need to get an inventory of what debt instruments and intercompany relationships look like prior to April 4," Blore said. "And you want to be sure you don't touch those instruments as much as you can. If you substantially modify that debt instrument for tax purposes, it's considered a new instrument and it is subject to these rules."

Efforts to Derail Proposed Regs

The proposed regulations have elicited protests from a range of organizations representing corporations.

In a May 12 letter to Treasury Secretary Jacob Lew, 23 trade organizations, including the Business Roundtable, Financial Executives International, and the Securities Industry and Financial Markets Association, said the proposed regulations "present a severe impediment to the use of intercompany financing for even normal operations and will significantly increase the cost of capital and limit the amount of capital available to invest in the United States."

The letter requested that Treasury slow down the process. The proposed regulations set a July 7 deadline for comments, and Treasury officials have talked about finalizing the regulations by the end of the summer. In the letter to Lew, the groups asked that the comment period be extended another 90 days, to Oct. 5. And while the proposal says the regulations would be effective for any instruments issued after April 4, the groups asked that instead the regulations be effective for instruments issued 90 days after the regulations are finalized.

The letter also questioned Treasury's estimates of the cost of compliance and the amount of revenue the regs will raise, and asked it to reassess the impact of the regulations.

There's no way of knowing what Treasury will do, Frank said, but he noted that "we know this is an important agenda item of theirs; we know that they're operating on an accelerated timeline.

"I wouldn't assume that they're just going to rewrite this," he said.

If Treasury sticks to its original timeline, companies don't have much time to prepare.

"Our estimation is that most or all companies will need to make some sort of process change if the rules are implemented as written, and some companies will need to make very significant process changes and do so in short order," Frank said. "Companies really need to get on this. They don't have a lot of time to waste."