Taxation of multinational corporations has been a focus of the U.S. Department of the Treasury, tax professionals, and politicians for many years. One major concern of late is the use of Base Erosion Profit Shifting (BEPS) to lower income in the United States and increase income in lower-tax countries, thus reducing the tax burden of a multinational corporation. One common method is having a parent or subsidiary from the lower-tax country issue a debt instrument to either its parent or subsidiary in the higher-tax country. The entity paying the lower taxes receives interest income, while the entity paying the higher taxes can take interest deductions, thus eroding profits from the latter to the former, while keeping the money within the same consolidated group.
In an effort to minimize multinational corporations’ ability to utilize BEPS transactions in this manner, the Treasury issued Proposed Treasury Regulations section 1.385 on April 4, 2016, and finalized it on October 13, 2016. These regulations impose rules and documentation requirements that will cause debt instruments to be reclassified as equity if they are processed through highly related parties. This will greatly reduce BEPS; however, there are several consequences to the corporate treasury that could be detrimental to multinational corporations’ standing. According to the Federal Register, it is expected that approximately 6,300 corporations and members will be affected by the new regulations and their documentation requirements (“Treatment of Certain Interests in Corporations as Stock or Indebtedness,” Oct. 21, 2016, http://bit.ly/2B7f3mL).
This article provides an overview of the new regulations, including which corporations are affected and the required documentation procedures that must be completed, and identifies many of the unintended consequences created thereby, as well as how these consequences will affect corporations’ treasury functions. In addition, it addresses how the new regulations will create additional reliance on the banking industry and what risks will be created through this change. It concludes with observations about how the Treasury Department’s action could be detrimental to the economic growth of multinational corporations.
Overview of Treasury Regulations Section 1.385
Treasury Regulations section 1.385 generated a great amount of controversy after it was proposed. The issues revolved around Internal Revenue Code (IRC) section 385 and whether intercompany transactions should be classified as debt or equity. Section 1.385-4T(b)(1) provides that members of a consolidated group are treated as one corporation for purposes of the regulations, which makes transactions within the consolidated group more likely to be identified as equity. Section 1.385-1(c)(4) expands the definition of a consolidated group for tax purposes to include all corporations held both directly or indirectly by the common parent, under the ownership threshold of 80% vote or value, rather than the requirements for both. This expansion is to ensure that related parties within multinational corporations will not reap the benefits of having these transactions classified as debt.
The documentation requirements will have a great impact on multinational corporations’ ability to efficiently send cash to their subsidiaries.
Section 1.385-2 provides that multinational companies must keep substantial records to allow the IRS to determine whether or not the expanded group has sufficient evidence to treat a transaction as debt, as shown in the Exhibit. Essentially, the Treasury Department wants a related party to act as if it is giving money to an unrelated party when issuing debt. For example, a parent company that wants to issue debt to its subsidiary must document that it analyzed all pertinent information about its subsidiary, just as a reasonable unrelated investor would have done, each time it wants to issue a debt instrument. In addition, these executed loan agreements must be provided to the IRS when requested to ensure proper compliance of debt instruments being classified as debt. Section 1.385-2(a)(3)(ii) provides a de minimis rule that allows a multinational corporation that is not publicly traded, has less than $100 million in assets, and has less than $50 million in revenue in order to avoid the documentation requirements.
These documentation requirements will greatly impede internal financing structures and limit the ability of multinational corporations to pool cash. This will in turn cause a greater reliance on banks, which will open up multinational corporations to greater currency risks. Multinational corporations will have a very difficult time continuing their productive flow of cash throughout their consolidated groups. The shareholders of these multinational corporations will also be greatly affected, due to the corporations’ limited ability to issue cash dividends. Internal restructuring transactions such as IRC section 304 (i.e., related party) transactions, reorganizations, and intercompany lending transactions aimed at moving money around a group or returning funds to investors will also be greatly affected by the new regulations (“New U.S. Section 385 Regulations Would Treat Certain Related-Party Corporate Interests as Stock, Rather than Debt, for Federal Tax Purposes,” Ernst & Young International Tax Alert, Apr. 7, 2016, https://go.ey.com/2Aff8o2).
The new documentation procedures for multinational corporations will demand additional operations and technology requirements to ensure compliance. According to PricewaterhouseCoopers, “The cumulative impact of greater requirements around documentation of intercom-pany financing arrangements, assessment of entity-level credit worthiness, forecasting of cash flows and daily cash operations may warrant new or changed policies, processes, banking infrastructure and technology” (“How the Proposed Section 385 Regulations Could Impact Corporate Treasury,” June 10, 2016, https://pwc.to/2k1j94D). Implementing these changes will require a great amount of money; conservative estimates are that the initial cost to a Fortune100 company to comply with the documentation requirements will be nearly $4 million, and the cost for each succeeding year will be nearly $1.25 million (“Potential Impacts of Proposed Section 385 Regulations: Inbound and Outbound Examples,” PricewaterhouseCoopers, July 7, 2016, http://bit.ly/2AWYSaY). The effects on internal operations will also incur significant costs.
Effect on the Treasury Function
As stated above, the documentation requirements will have a great impact on multinational corporations’ ability to efficiently send cash to their subsidiaries. “For many taxpayers, these rules will likely pose a significant burden, particularly for companies that routinely move money around group companies through a central treasury system where robust documentation may be lacking (Jill-Marie Harding, “Section 385 Proposed Regulations: Treasury’s Attempt to Clamp Down on Earnings Stripping and a Whole Lot More,” Alvarez & Marsal Bulletins, Apr. 19, 2016, http://bit.ly/2B5stzu).” Before these new regulations were proposed, multinational corporations could easily and efficiently distribute debt; there was no restriction on amounts, and the ability to move cash to a subsidiary did not require substantial documentation.
The most common method used by multinational corporations to finance their operations is cash pooling, in which several bank accounts owned by different members of the consolidated group are treated as one collective account from which each has the ability to withdraw funds needed to sustain everyday operations. The cash leader—normally the bank account of the parent corporation—must ensure that each of the other accounts has a zero balance by the end of each day; if a subsidiary has a positive balance, that amount is put into the cash leader’s account and treated as a debt given to the parent corporation. If the subsidiary has a negative balance in its account, then the cash leader puts money into the subsidiary’s account, which is treated as a debt given to the subsidiary. Cash pooling, therefore, allows companies of a consolidated group to receive and deposit cash to cover everyday transactions in a simple manner.
Many multinational corporations use cash pooling to keep every member of the consolidated group liquid, but it will be a very limited option under these regulations, which completely recharacterize the debt as equity. The amount that the principal corporation gives to the subsidiary, or vice versa, will be treated as either a distribution of equity or dividends up to the amount of the corporations’ consolidated current and accumulated earnings and profit. In several jurisdictions, the amount of equity distributions is limited to the distributive reserves; with debt, a corporation can distribute as much cash as possible to keep the subsidiaries liquid without affecting the distributable reserves.
In the six months between the release of the proposed regulations and the issuance of the final regulations, the Treasury Department received over 200 separate comment letters, the major focus of which was the proposed absolute restriction of cash pooling. In light of this, the Treasury Department and the IRS drastically modified their stance on cash pooling by providing, among other things, an exclusion for foreign issuers. This limits the scope of the documentation rules by applying them only to inbound financing transactions; a debt instrument will not be classified as equity if it is issued from one foreign entity to another that is not focused on U.S. taxation. This exception reduces the potential for foreign tax consequences, as well as the documentation requirements for entity transactions throughout countries other than the United States.
Another common method multinational companies use to keep their entities liquid is in-house banking. This allows the parent company to pay off the debt of the subsidiary; the parent corporation is akin to a bank from which the subsidiary receives loans to cover its operations. This centralizes the banking system at the corporate level, allowing for greater control of the cash. Every time the parent corporation pays an expense on behalf of the subsidiary or gives the subsidiary cash, the parent corporation is treated as giving a dividend to the subsidiary. Every such payment is subject to the documentation requirement of Treasury Regulations section 1.385-2, except the same foreign issuers exception mentioned above. If a foreign subsidiary covers the debts of another foreign subsidiary, the debt is not converted to equity.
The foreign issuer exception provides significant relief for both cash pooling and in-house banking, as it largely pardons all debt issued by foreign corporations. While this exception does eliminate the transaction limits and documentation requirements, the use of foreign-issued debt for cash pooling and in-house banking does expose multinational corporations to foreign currency risks, as discussed below. Multinationals that have utilized cash pooling and in-house banking in the past must now pay careful attention to whether they fall within or outside the additional documentation rules created by the final regulations.
Reliance on the Banking Structure and Related Risks
Since internal methods of keeping consolidated groups liquid may no longer be an option for multinational corporations, there will be a much greater reliance on the banking system. Parent corporations and their subsidiaries will need to get loans from banks in their respective countries to pay for their operations and use third-party capital markets to overcome the limitation of distributive reserves. New banking and lending accounts will need to be created at the subsidiary and parent levels, since the entities will no longer be able to work together to keep themselves liquid; this will lead to a great decentralization of cash. In addition, parent corporations will no longer have internal control of all the money within the consolidated group, as they would with unrestricted cash pooling. Thus, they may be unable to put consolidated cash resources into investing activities, internal structuring, and other necessary business activities. Not only will this negatively impact companies’ ability to grow their operations, it will also interfere with their capital structure. The regulations will thus lead to a change in companies’ plans to repay debt, issue dividends, or purchase treasury stock. This new reliance on banking structures will greatly affect the control of cash throughout consolidated groups, which will affect companies’ ability to achieve their goals.
Because the members of consolidated groups must keep themselves liquid with third-party lenders in their own country, multinational corporations will be subject to increased foreign currency risks.
This new reliance on banks may also cause higher interest rates for certain members of consolidated groups. Banks will only look at the financial condition of the subsidiary rather than the overall company, since the other members will not be able to immediately supply the subsidiary with cash. If one subsidiary is not operating as efficiently or is not as liquid as other members of the consolidated group, then banks may be less apt to provide crucial financial services. In addition, higher interest rates will lead to higher expenditures for the consolidated group.
One of the most serious problems with overreliance on banks is the impact of an economic downturn like the financial crisis of 2008. During the financial crisis, several banks had less cash on hand to designate to companies through short-term loans. Multinational corporations were able to keep themselves liquid through internal financing techniques, but without those techniques, the economic consequences could be amplified if another financial crisis occurs. “Multinational corporations forced to rely on external borrowing to meet possible liquidity needs, as opposed to global cash pooling, would necessarily be more exposed to financial shocks from third-party lenders suffering those shocks, because of issues unrelated to the multinationals” (“Comments on Proposed Rule on the Treatment of Certain Interests in Corporations as Stock or Indebtedness,” Tax Executives Institute, July 6, 2016, http://bit.ly/2C4fQlz). With the current global economy, countries that may not have been as exposed to a recessionary period will experience a much greater impact.
Because the members of consolidated groups must keep themselves liquid with third-party lenders in their own country, multinational corporations will be subject to increased foreign currency risks. It will be important for these multinational corporations to alter their hedging strategies to minimize these risks. When using cash pooling, all monetary value is exchanged into the various domestic currencies in the morning and converted to the currency of the cash pool leader at the end of the day. If multinational corporations are not able to use cash pooling, the money will always be in different currencies, increasing the chance that the company will be exposed to currency losses due to fluctuations in the currency exchange market.
The individual subsidiaries of a corporation could request that the money be exchanged into the domestic currency in the morning and into the parent’s currency at the end of the day, which would then decrease foreign currency risks. Since this would be done for each entity, however, the fees would be substantial, and the cost of using this as a hedging strategy would probably outweigh the benefits. Therefore, money will likely be consistently held in the bank accounts of each member’s individual corporate account in the currency of its country.
To give a recent example of the problems this causes, consider the Brexit vote that occurred on June 23, 2016, after which the value of the British pound decreased by approximately 15% (Ivana Kottasova, “Brexit Britain: Pound Drops to $1.28,” CNNMoney, July 6, 2016, http://cnnmon.ie/2k1Sipl). With cash pooling, all of a British subsidiary’s GBP would have been converted to its cash leader’s currency daily, and the decrease in value would have had no effect. Under the new regulations, the money would have stayed in pounds, and the multinational corporation would have lost 15% of its British-located cash value.
The final regulations do address many of the issues raised during the comment period of the proposed regulations; however, they do not resolve all of them. For example, the foreign issuer exception slightly reduces the threat of limiting cash pooling, but will most likely cause corporations to alter their cash pooling strategies in ways that will lead to higher foreign currency risks. Most multinational corporations will most likely change the cash leader to a foreign member of the consolidated group in order to ensure that the transactions do not get reclassified as equity, as well as to avoid the documentation requirements. With the money being in the foreign member’s currency, the corporation has a greater chance of experiencing losses from currency fluctuations.
While Treasury Regulations section 1.385 was written with good intentions (i.e., limiting BEPS), in the authors’ opinion, it has too many negative consequences. The negative impact to the economy outweighs the benefit of the additional revenue received through the limiting of BEPS. Reflecting this, over two dozen members of Congress urged the Treasury and the White House to postpone finalizing the regulations due to fears of potential consequences to the economy and businesses (David Morgan, “Republicans Asked U.S. Administration Not to Finalize Inversion Rules,” Reuters, Oct. 5, 2016, http://reut.rs/2B7Moh9). New rules to limit BEPS should not affect a multinational corporation’s ability to keep its members of the consolidated group liquid, should not lead to an overreliance on the banking system, and should not expose the company to extra risks or costs.