Companies eyeing banks' help with Treasury’s debt-equity rules

Many companies could face millions of dollars in compliance costs — and possibly outsource the work to financial services — if the Treasury Department finalizes the debt-to-equity recharacterization rules intended to discourage post-inversion activities. 

“That is something businesses are in fact considering because if it’s third-party debt, they know it’s debt,” said Carol Doran Klein, vice president and international tax counsel for the United States Council for International Business (USCIB).

The certainty would keep the IRS from auditing companies to further prove that transactions are compliant with regulations, Doran Klein said, referring to the Treasury Department’s controversial proposed rules under tax code section 385 that would authorize the IRS to broadly change the tax treatment of certain debt to equity. 

Treasury recently indicated that it is moving to finalize the rules in the coming days after the department submitted them to the Office of Management and Budget on Sept. 30 for review.

The department unveiled the rules in April to limit a common tax-avoidance practice called earnings stripping, in which a multinational U.S. company uses the interest deductions to their foreign subsidiary, located in a country with a low tax base, to escape the high corporate taxes in the United States. The transaction often happens after a U.S. company has already inverted.

The proposed rules, however, are far too broad and complicated, disrupting a wide range of funding arrangements within companies, including ones that only involve domestic transactions, according to business groups, which have been pressing Treasury to modify areas affecting cash-pooling, foreign-to-foreign loans, pass-throughs and heavily regulated industries. 

Changes to proposal coming? 

Business groups also expressed concern over the limited time the department has under the Obama administration to write the final rules based on the vast number comments businesses and interest groups have submitted to Treasury. Although officials have been keeping information close to their vest, some sources inside and outside Congress say they are confident that the department would amend the rules before they are finalized. 

But if the current form of section 385 rules remain, USCIB members said the costs “could run to hundreds of millions or even billions of dollars across all persons affected by the regulations” because the documentation doesn’t provide exceptions for small or ordinary course loans and would impact “hundreds of thousands or millions of loans per corporate group,” according to a June letter the council sent to the Office of Management and Budget. 

A July PricewaterhouseCoopers report, commissioned by the USCIB and the Business Roundtable, estimated that a Fortune 100 company would have to spend nearly $4 million to implement this kind of compliance operation in the first year. Plus, there is the annual $1.3 million just to maintain the operations, which may involve treasury, legal, accounting, financial planning and forecasting, tax, and even human resources, the report said. 

Big documentation process. 

“The documentation and monitoring required under such systems will far exceed any established processes of US companies,” the report said. “For example, for US financial statement purposes, reporting is generally necessary for corporations on a consolidated basis each quarter of the fiscal year. In contrast, the Proposed Regulations will effectively require real time reporting of instruments for each subsidiary on its related-party debt, including trade payables and trade receivables.”

Dorothy Coleman, vice president of the National Association of Manufacturers (NAM), said 60 percent of NAM members in a June survey stated they are considering outside financial services to facilitate future transactions under section 385.  

Coleman said companies prefer using intercompany loans because they can efficiently move capital within subsidiaries and reduce outside borrowing costs. This setup would allow funding one-time costs such as mergers and acquisitions, mitigate currency exposure and reduce withholding taxes. 

Banks and other related firms could supplement this kind of service, according to some economists and tax attorneys closely following section 385 developments. 

More business for banks. 

“Any firm facing this prospect would say, ‘Why not instead borrow from a bank?’” Gary Clyde Hufbauer, a senior fellow with the Peterson Institute for International Economics, said. “So the banks are going to have more business ... and get a margin on the spread. So in that sense, it's great for the banks.”

Hufbauer added that this opportunity would be “big business” for mergers and acquisitions.

The financial sector, however, would suffer far more than non-financial companies under section 385 because the proposed rules would rattle the core of their business: financial transactions involving debt, John Kinsella, the American Bankers Association’s vice president of tax policy, said.

There is also a great deal of federal oversight over the financial services, which is why bank advocates said they are pushing Treasury to exempt highly regulated industries in the final rules.

“The regulations that we have to follow in various jurisdictions require us to have separate entities and separate structures that make our operations more complex from a financing perspective, probably more so than a typical manufacturer,” Kinsella said.

More overhead costs. 

It's also uncertain whether banks would make a profit from this new demand, Cathryn R. Gregg, managing director of Treasury Strategies, said. The rules may mean more overhead costs, which is a major hassle and expensive for any business, she said, resulting in banks charging their borrowers more for the service.

“Instead of a $750 million borrowing facility, you would have three $250 million facilities. Each of them have to be negotiated separately and would require separate documentation. Separate covenants need to be tracked,” Gregg said. “Would they actually make more money? I don't know if it's a big deal.”

But if Treasury exempts banks and other heavily regulated industries under section 385, it would “eviscerate” the department's goal in clamping down on earnings stripping, warned Matthew Gardner, executive director of the Institute on Taxation and Economic Policy. Financial companies are “heavy users of offshore tax haven subsidiaries,” he added.

Gardner said Morgan Stanley, Bank of America and Citigroup are “especially infamous for facilitating tax avoidance" and pointed out that they used to disclose hundreds of foreign subsidiaries, but now report only a dozen of these entities.

“These are companies that are acting in ways that look like they are trying to conceal what they're doing offshore,” Gardner said.  

A Citigroup spokesperson pointed to a comment letter the company sent to Treasury highlighting the problems the rule could create unless certain exemptions are granted. Citigroup filed the letter in July with the two other banks. 

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