Treasury Finalizes Hotly Contested 385 Regulations: How Taxpayers Should Respond
Yesterday, just six months after the issuance of the proposed regulations and following thousands of comments and widespread debate, the US Treasury released the final 385 Regulations. While these rules in final form are narrower in scope than the proposed regulations and extend the effective date of the documentation requirements, most taxpayers are still faced with a material change in how they treat intercompany debt. Taxpayers that were previously taking a “wait-and-see” approach are encouraged to review their portfolio of intercompany debt transactions and take action. But where should they start?
Determine Existing Inventory of Debt Transactions
Taxpayers should analyze their current intercompany debt to determine whether any material exposure to the 385 Regulations exists. Specifically, they should consider taking the following steps:
- Create a comprehensive list of current intercompany debts outstanding and record key characteristics (this may include unsettled intercompany balances that the 385 Regulations may consider debt);
- Identify intercompany transactions that may be defined as debt under the 385 Regulations and prioritize based on internally established risk / materiality thresholds (e.g., relative size, purpose, etc.);
- Note, certain debt transactions are exempt (e.g., foreign-issued debt, debt between exempted corporations);
- Flag any debts that are already known to be subject to the recast rules (e.g., applicable debt issued 1) in a related party distribution; 2) pursuant to an asset reorganization; or 3) in exchange for affiliate stock) or the corresponding funding rules; and
- Compile three key pieces of documentation associated with each of these transactions: 1) agreements; 2) credit analyses; and 3) interest rate benchmarking studies, noting gaps where appropriate.
Prepare Background on the 385 Regulations and Leverageable Tools for Compliance
Prepare background materials and tools to help identify risks and facilitate implementation of the 385 Regulations, such as:
- Internally communicate the importance of the 385 Regulations and ensure coordination across key stakeholders (e.g., tax, treasury, legal, accounting, finance, internal audit, and foreign subsidiaries).
- Design standard policies and procedures for new debt issuances that lay out the steps (both upfront and ongoing) that all groups within the organization will need to take to ensure compliance.
- Create a template agreement in line with the documentation requirements described below. Leveraging a standardized agreement will create efficiencies both in executing and documenting new debt.
- Perform financial ratio analysis to get a sense of leverage, coverage, and profitability for independent companies within relevant industries. These data can provide high-level guidance on appropriate levels of debt and may be used as a starting point for documentation.
- Develop a standardized methodology for performing credit analyses. In certain instances, the 385 Regulations allow for a single credit analysis to be used for multiple issuances.
- Establish internal controls to assure that interest and principal payments (including PIK interest) are recorded and settled in accordance with the respective intercompany agreements.
Set a Streamlined Policy for Handling Each New Debt Issuance
Take steps to create a consistent global policy for handling and documenting each new intercompany debt issuance that meets the requirements of the 385 Regulations. The following steps should be considered:
- Create a legally binding agreement (leveraging the template) that clearly lays out the following:
- A binding obligation to repay;
- A clear payment schedule for principal and interest; and
- Creditor’s rights.
- Confirm that the amount of debt is reasonable given the issuer’s financial standing by performing the following components of the credit analysis:
- Comparable Debt Issuance Analysis: examine key financial ratios of issuers of comparably rated debt to demonstrate that the leverage and coverage of the issuer is in line with what is seen in the market.
- Repayment Analysis: prepare cash flow projections to demonstrate that the issuer is expected to be able to meet all future debt obligations (even if through refinancing), inclusive of the debt at issue.
- Charge an arm’s length interest rate as prescribed by the 482 Regulations and document the corresponding analysis appropriately.
- Demonstrate the existence of an ongoing debtor-creditor relationship by ensuring interest and principal payments are settled and recorded over time, and if interest on an interest-bearing instrument is not paid, keep a record of default proceedings (or of the decision to not trigger an event of default).
Note that while there are certain exceptions under the 385 Regulations for cash pools and short-term instruments governed by a master agreement, the 385 Regulations still require an annual credit analysis.
Ensure Documentation Meets the Minimum Standards and is Prepared in a Timely Manner
The 385 Regulations lay out the following four factors that are “essential” to the treatment of an instrument as debt:
- The issuer’s binding obligation to pay a sum certain;
- The holder’s rights to enforce payment;
- A reasonable expectation of repayment; and
- A course of conduct that is generally consistent with a debtor-creditor relationship.
To meet these requirements, we recommend:
- Using thresholds based on risks and materiality to determine scope of documentation;
- Referring to the agreement to demonstrate creditor’s rights and an unconditional obligation to pay the debt;
- Describing the credit analysis prepared; and
- Detailing the mechanism for tracking payments on a go-forward basis.
The final regulations eliminate the 30-day timely preparation requirement, but instead require documentation to be prepared contemporaneous to the taxpayer’s filing of its federal income tax return for instruments issued on or after January 1, 2018. Importantly, demonstrating a “high degree of compliance” allows taxpayers a rebuttable presumption to recharacterization.
Duff & Phelps has assisted numerous taxpayers prepare for the implementation of the new 385 Regulations. As independent advisors with deep experience in valuation and transfer pricing, we have a unique ability to assist with all aspects of intercompany debt financing. Please contact a Duff & Phelps transfer pricing professional for more information surrounding these new regulations.
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