The U.S. Treasury Department said last month that it was considering streamlining the documentation requirements of Section 385, an IRS rule aimed at discouraging earnings stripping. At the same time, it said that the distribution portion of the regulations, relating to whether corporate transactions are considered debt or equity, might be eliminated, depending on the success of current congressional efforts to reform the U.S. tax code.
“Treasury has come out publicly and said they’re looking at withdrawing the documentation rules in their entirety,” said Joe Calianno, a tax partner and international technical tax practice leader in the national tax office of BDO USA.
“They received a lot of comments from taxpayers and practitioners about the undue burdens those documentation rules would create,” Calianno added. “I think they’re looking at revamping them to make them less burdensome on taxpayers.”
The Obama administration proposed the Section 385 rules in April 2016 to discourage U.S. companies that have undergone an inversion by merging with a foreign corporation from using earnings stripping, in which the U.S. company issues debt to its foreign parent, limiting its U.S. tax liability. The rules allow the IRS to treat debt between related parties as part equity and part debt, a move that would limit companies’ ability to deduct their interest payments on such debt.
The initial version of the rules threatened to complicate corporate treasuries’ use of cash pooling and other cash management and risk management techniques. In October 2016, the Treasury rolled out revised rules that provided an exemption for cash pooling but still required documentation of intercompany loans.
In July, the Treasury pushed back the deadline for complying with the Section 385 rules from Jan. 1, 2018 to Jan. 1, 2019.
In its October report, Treasury cited criticism of the “compliance burdens” created by the documentation rules. “Treasury and the IRS now agree with commenters that some requirements of the documentation regulations departed substantially from current practice and would have compelled corporations to build expensive new systems to satisfy the numerous tests required by the regulations,” the report said.
In the document, Treasury said it was focused, in particular, on a requirement that companies document “a reasonable expectation of ability to pay indebtedness.”
David Sites, an international tax partner in the Washington national tax office of Grant Thornton, said Treasury established the requirement related to a reasonable expectation of repayment because it was trying to get at instances where a U.S. company was issuing debt to its foreign parent even though it might not be able to repay the debt. “In that situation, the IRS wanted the ability to say: If you can’t document their reasonable ability to repay under the terms of the … documentation rules, we’re going to go ahead and call that equity,” he said.
But companies doing other types of transactions became concerned about whether they needed a similar level of documentation of the ability to repay, Sites said. “Given that it was one of the principal pieces of documentation required, you didn’t want to fail that,” he said, since a failure would mean the debt would be reclassified as equity.
“One would hope that as they reconsider the documentation rules, they revisit not only what they want to see but which instruments this applies to,” he said. “Rather than taking a very broad approach to which instruments need to be documented, perhaps there’s a narrowing of instruments that need to be documented and also a revisiting of what documents they need.”
The Treasury also said it would look at “the treatment of ordinary trade payables” under the documentation rules.
Paul LaRock, a principal at consultancy Treasury Strategies, said the trade payables reference denoted situations in which one unit of a multinational provides goods or services to another unit. He cited the example of a shared service center that does payroll for the entire corporation using intracompany payables and receivables.
“Nobody perceives anyone is making a loan there,” LaRock said. “Within a month they settle up. But the original rules may have been interpreted to affect those transactions.”
Sites pointed to U.S.-based multinationals that have manufacturing units overseas and purchase products from those units.
“They don’t pay cash every time; they would buy their output with a promise to pay,” he said. “These regs, on their face, would have imposed a documentation requirement each time for each transaction.
“You had companies saying, ‘We have thousands of these transactions; how are we going to document them?’” Sites said.
Tax Reform and Distribution Rules
Treasury tied the outlook for Section 385’s distribution rules to the outcome of tax reform. Tax experts said that elements of reform that will weigh on Treasury’s decision include whether Congress limits the deductibility of the interest that companies pay, and the decline in the corporate tax rate. Both changes could discourage earnings stripping.
“Certainly there are a number of provisions in both the House and Senate bills focusing at the ability to restrict interest deductions,” said BDO’s Calianno. “I think they’re going to be looking at all these various provisions that are out there, both in the House version and the Senate version, and ultimately, if legislation is enacted, what provisions are enacted that would restrict interest deductions. They’ll be taking a holistic look at what that does to restrict the concerns they have about earnings stripping.”
The extent to which the corporate tax rate is lowered is another factor, Sites said.
“Companies are always very eager to place interest deductions in the U.S. because our tax rate traditionally has been much higher than the counter-jurisdictions,” he said. “The lowering of the U.S. tax rate that will come with tax reform will impact that logic quite a bit.”
At this point, corporate treasurers still face a Jan. 1, 2019, deadline for complying with the documentation requirements. The Treasury report didn’t alter the timeline, although Treasury said that if it does revoke the current rules, the streamlined rules would have “a prospective effective date that would allow time for comments and compliance.”
Sites, pictured at left, said some companies were “holding off on expending a lot of resources” preparing to comply with the documentation rules, given the possibility that Treasury will come out with new regulations, but he noted the risk involved.
“There’s no guarantee what’s going to happen here,” he said. “If you’re in that situation where you might have thousands of transactions that need to be documented, do you go ahead or wait and see?”
Calianno suggested doing as much documentation of transactions as possible. “From a practitioner’s standpoint, I always suggest: Try to do as strong a documentation as you can,” he said. “It helps if you ever get audited by the IRS.
“Taxpayers are going to be watching this very closely,” Calianno said. “You have a lot of taxpayers that use debt in their structure that need to monitor transactions they undertake to see if these rules could apply. These rules can have a pretty major impact, as could tax reform.”