Preamble to Prop Reg 04/05/2016; Prop Reg § 1.385-1, Prop Reg § 1.385-2, Prop Reg § 1.385-3, Prop Reg § 1.385-4
If finalized, recently issued proposed Code Sec. 385 regs would introduce sweeping changes to the treatment of related-party indebtedness, including extensive due diligence and documentation requirements (which would be applicable to cash pooling arrangements). Although the proposed regs were released as part of a larger package of anti-inversion measures, they would apply to many routine financial and common subchapter C transactions of U.S. based and non-U.S. based multinational enterprises.
Background on the proposed section 385 regs. The proposed Code Sec. 385 regs address whether a direct or indirect interest in a related corporation is treated as stock, indebtedness, or as in part stock and in part indebtedness, for U.S. federal tax purposes. They target related parties that engage in certain transactions using U.S. indebtedness to “strip” U.S.-source earnings (through interest deductions) to lower-tax jurisdictions, but would apply without regard to whether the related parties are domestic or foreign. They would also require the preparation and maintenance of extensive documentation to substantiate indebtedness treatment between related parties.
Breadth of the proposed regs. There is general agreement that Code Sec. 385 provides Treasury and IRS broad authority “as may be necessary or appropriate” to determine whether an instrument should be treated as equity, indebtedness, or a combination of both. The proposed regs would be limited in scope to the characterization of indebtedness between members of an “expanded group.”
The definition of an expanded group is premised on the definition of an “affiliated group” under Code Sec. 1504(a) (the U.S. consolidated return rules), subject to a list of expansive modifications (see Prop Reg § 1.385-1(b)(3)). For example, a foreign corporation, not included in a Code Sec. 1504(a) affiliated group, would be includable in an expanded group (see Prop Reg § 1.385-1(b)(3)(i)(A)).
If finalized, the proposed Code Sec. 385 regs would:
- Permit IRS to treat certain related party indebtedness as partly equity;
- Impose extensive documentation requirements that may result in certain undocumented related party indebtedness being treated as equity; and
- Treat certain distributions of related-party debt instruments or reorganizations involving such debt instruments as equity, if they are viewed as being in connection with certain transactions.
Trap for the unwary. Speaking on an April 21 KPMG webcast, KPMG Partner Devon Bodoh cautioned, the breadth of the proposed regs can cause a loan, and a seemingly unrelated transaction, to be viewed as connected, thus resulting in the loan being recharacterized as an equity instrument. On the webcast, Mr. Bodoh and other KPMG partners responded to a number of questions raised by participants.
Cash pooling arrangements. According to Mr. Bodoh, participants submitted a number of questions on the application of the proposed rule to cash pooling arrangements.
The term “cash pooling” generally refers to a cash management technique that may be employed by multinational enterprises. The arrangement may allow the debit (excess cash) and credit (cash deficit) in the accounts of the members of the multinational enterprise to be combined into one account to limit low balances or transaction fees. At the time of the pooling, the positive balances in the accounts may be physically transferred to the pool leader (i.e., FinCo), and then the pool leader provides the excess cash to those members that are in an overdraft position. While such arrangements may be relatively straightforward from a banking and commercial perspective, they do give rise to a range of tax issues from an international tax perspective, including transfer pricing, thin capitalization, and related party rules relating to the deductibility of interest.
The question posed on the webcast was whether these proposed regs apply to notional cash pooling arrangements. In notional cash pooling arrangements, the debit and credit balances of the members of the multinational enterprise group may not be physically transferred to a pool leader, but instead may simply be added together, upon which interest is computed.
According to KPMG Partner Mark Hoffenberg, the U.S. government has suggested a willingness to narrow the rules. However, at this point, he couldn’t say whether any of these transactions will be exempt. While multinational enterprises may enter into transactions with unrelated banks to effect such cash pooling arrangements, the bank may be viewed as simply the facilitator of the overall arrangement. In such case, multinational enterprises would need to consider the related-party intercompany debt rules.
The extensive documentation requirements proposed in the Code Sec. 385 proposed regs raise the question of how to document the transactions arising under cash pooling arrangements within the period prescribed (i.e., within 30 or 120 days) when the cash pooling occurs daily. It should be noted that the proposed documentation requirements would only apply if a member of the expanded group is publicly traded or total assets or annual revenues of the expanded group exceed a certain threshold.
Existence of a valid business purpose. As Mr. Hoffenberg stated, unless an exception applies, a debt instrument issued by a corporation to a expanded group member may be treated stock under the proposed regs if it is:
- Issued in a distribution;
- In exchange for stock of a member of the same expanded group (other than with certain exceptions in asset reorganizations); and
- in exchange for property in an asset reorganization, if the instrument is received, pursuant to the plan of reorganization, by a transferor corporation shareholder that is an expanded group member with respect to its transferor corporation stock. (Prop Reg § 1.385-3(b)(2))
Such a debt instrument would be treated as equity to the extent that it is a “principal purpose debt instrument.” (Prop Reg § 1.385-3(b)(3)) However, under a “per se” rule, a debt instrument would generally be treated as a “principal purpose debt instrument” if it is issued during the 72-month period beginning 36 months before the date of one of the aforementioned transactions, and this presumption is not rebuttable. The “per se” rule would not apply to indebtedness arising in the ordinary course of business, provided that certain requirements are met. (Prop Reg § 1.385-3(b)(3)(iv)(B))
The proposed regs provide a number of exceptions, including the distribution of current year earnings and profits. (Prop Reg § 1.385-3(c))
As KPMG Partner Seth Green clarified, the “per se” rule isn’t concerned with intent or a valid business purpose. He also cautioned that there is an enormous amount of due diligence to determine the impact of certain transactions that occur within the 72-month period. As such, when structuring transactions, there is a premium to executing their party debt at the right entity level and not transferring the debt thereafter.
Mr. Green also cautioned that if a corporation makes a cash and note distribution in the current year, the order in which the distribution is made impacts the applicability of the current year earnings and profits exception noted above.
U.S. withholding implications. The question was raised whether related-party indebtedness that is recast as equity under the proposed regs would result in interest payments being treated as dividends and subject to dividend withholding tax. Mr. Green responded affirmatively, saying that broadly speaking, the characterization applies for U.S. federal income tax purposes.
If the related-party indebtedness is treated as equity, a repayment of principal could also be treated as a dividend distribution, cautioned Mr. Green. There also could be corresponding subpart F implications if the related party indebtedness is between controlled foreign corporations.