Their opposition centers not so much in response to the first part of the proposal, designed to force “serial inverters” to recalculate the size of their foreign merger partner (by subtracting assets acquired from three years of past mergers), in order to keep the merged entity subject to US taxes. Rather, it came in response to the proposed revisions of IRS Section 385 designed to discourage “earnings stripping” after an inversion occurs.
Business reacted to several “unintended consequences” of these regulatory changes, according to Deloitte’s Melissa Cameron, Principal, Global Treasury Advisory Services, and Michael Mou, Principal, Washington International Tax Services Group. Their presentation at the Committee on Corporate Treasury’s May 18 meeting identified a threefold purpose underlying Treasury’s 385 modifications, with the overall intent to reclassify certain debt instruments issued to a related third party as equity.
First, the regulations would use the regulatory authority under section 385 to bifurcate certain related party debt instruments – there would no longer be an “all or nothing” rule. Second, they’d impose strict contemporaneous documentation requirements on certain related-party debt instruments as a prerequisite to treatment of such instruments as debt; otherwise, require that such instruments are treated as equity. Third, the proposals would treat as stock certain debt instruments issued to a related party by way of, or in connection with, distribution and acquisition transactions that do not introduce new capital into the broader related party group.
These regulatory changes will apply to any covered transaction entered into after April 4, 2016, and will come into force 90 days following the date of publication of the final rule, which Treasury has targeted as July 7, 2016.
While these proposals are part of the Administration’s broader anti-inversion package, their impact extends far beyond what was intended. The new rules apply to any expanded group debt instrument (EGI), i.e. any interest issued or deemed issued in the form of debt where the issuer and borrower are members of the same expanded group. The issuer includes disregarded entities, and any person who is obligated to satisfy any material obligation created under terms of an EGI, even if he or she is not the primary obligor.
And while Treasury has indicated it is “open” to comments on how to differentiate between short-term liquidity management transactions and longer-term loans, it also indicated it intends to interpret coverage of these rules broadly.
The documentation requirements are extensive, and include the complete and executed copies of all instruments, agreements, documents evidencing material rights and obligations of parties related to EGI, and any associated rights and obligations of other parties (e.g. guaranty, subordination). These include extensive preparation and maintenance materials, such as actions evidencing the debtor/creditor relationship, evidence of timely interest and principal payments, reasonable exercise of diligence, and judgment to enforce rights upon default or in determination of default events, renegotiations, mitigation and collection efforts.
In case of cash pooling arrangements or internal banking services, all material documentation governing the ongoing operations of the arrangement or service (including any agreements with entities not members of the expanded group) must be provided. Satisfying the above does not establish that an EGI is debt, but failure to satisfy means EGI is stock.
So, how far-reaching are these rules potentially? A letter to Treasury Secretary Jacob Lew from 23 business and professional associations, including the U.S. Chamber, the National Association of Manufacturers, the National Foreign Trade Council, the National Retail Federation and FEI indicated the implications for business would be extensive:
(T)he companies represented by our organizations believe that they have only begun to identify the potential impact the proposed 385 regulations will have on their business operations and on a wide range of transactions including, but not limited to, implications for standard corporate cash management techniques, including cash pooling; potential double taxation as a result of the loss of foreign tax credits; determinations of control between related parties under I.R.C. section 368(c) in connection with various tax free transactions; the qualification of a reorganization or spin-off; determinations of deemed debt issuances in connection with the acquisition of related party indebtedness; whether a company continues to be a member of the U.S. consolidated return group; and allocations of partnership items to partners under I.R.C. section 704.
As a result, these associations requested Treasury undertake three actions:
- Change the effective date for the proposed debt-equity re-characterization rule from April 4, 2016 to EGIs issued 90 days after the proposed regulations are finalized;
- Extend the public comment period from July 7, 2016, to October 5, 2016, at the earliest; and
- Give full consideration of all analyses and comments on the proposed 385 regulations rather than continuing to “move swiftly to finalize” the regulations.
In addition, FEI’s Committee on Taxation and Committee on Corporate Treasury are sending a joint letter to Treasury reinforcing these concerns and highlighting the implications of the rule changes for cash management and pooling operations. The committees hope the Administration will realize the disruption these proposed regulations could cause U.S. businesses operating abroad.
If Treasury does not respond to industry concerns, with presidential candidates from both major parties sharply critical of U.S. corporations moving abroad, it is unlikely that Congress will intervene to correct or forestall the implementation of these rules before the election.