Multinational corporations have long used earnings stripping as a way to reduce their corporate taxes by making interest deductions to a foreign headquarters in a friendly tax regime. Now, this longstanding practice is in the crosshairs of the U.S. Treasury Department, which has proposed rules giving the Internal Revenue Service (IRS) wide latitude to button up earnings stripping, possibly by the end of the year.
The proposed regulations are sweeping in scope, changing how intercompany indebtedness is treated for federal tax purposes. The new rules would give broad power to the IRS to re-characterize a multinational company’s intercompany debt as equity. Not only would this increase taxes for such businesses, it would shake up customary business practices, imposing added burdens on finance and accounting staff.
The Treasury Department’s proposal is part of its goal to thwart corporate inversion practices. Under current law, a U.S. parent company can restructure its operations to choose a foreign-owned entity located in a favorable tax jurisdiction as the new parent organization. Many inversions also involve a smaller foreign company in a tax-favorable location acquiring or merging with the parent company. In either case, by paying interest on a debt instrument to the foreign affiliate or foreign parent, the U.S. group can now shed (or strip) profits from its U.S. tax base. The interest payments are tax deductible, and the interest income is treated at a lower tax rate in the foreign jurisdiction.
If the regulation sees the light of day, questions will arise over whether an intercompany transaction — an interest in a related company or entity — will be treated by the IRS as debt or as stock. To prevent the IRS from automatically recasting an intercompany debt as equity, the proposed regulation would require U.S. companies to perform due diligence within a certain timeframe documenting explicitly that an intercompany transaction qualifies as debt for tax purposes.
This documentable information includes a binding obligation for the issuer of a financial instrument in a multinational company to repay the principal amount borrowed from a related company, along with a reasonable expectation of when this repayment will be made, and evidence that convincingly shows a continuing relationship between the debtor and the creditor.
The proposed rules have drawn sharp criticism from a coalition of nearly 70 trade associations in the United States, including such heavy hitters as the U.S. Chamber of Commerce, the National Association of Manufacturers, and the United States Council for International Business. Altogether, the trade groups represent tens of thousands of global and domestic businesses across a wide range of industries. The coalition’s primary concern is the disruptive impact of the proposed rules (REG-108060-15, under Section 385) on critical business operations.
“By creating uncertainty for intercompany financing, the proposed regulations push companies to use more expensive external debt and interfere with common lending arrangements such as cash pooling,” a coalition of trade associations wrote Congressional tax staffers in mid-June. “In addition, the question of whether an instrument is debt or equity has significant consequences to business planning and operations, including the legal classification of a business, eligibility for withholding tax exemptions under tax treaties, and the ability to file a consolidated tax return.”
The implications of the proposed regulation are broad, while its outcome is uncertain. For instance, the coalition maintains that the trading partners of U.S. companies may not recognize re-characterized debt as equity, making it more difficult for the businesses to compete in the global economy.
“This mismatch in treatment could lead to double taxation and create conflicts under tax treaties on the treatment of interest and dividends,” the coalition’s letter states, adding that the proposal’s retroactive effective date and three-year look forward/look-back period “will create even more uncertainty for companies in the United States, making prudent business planning unduly difficult and complex.”
Equally problematic are the added burdens on a company’s finance and accounting staff to provide required documentation to the IRS. These resource-draining tasks could result in a company’s decision to reduce traditional downstream (parent to subsidiary); upstream (subsidiary to parent); and lateral (subsidiary to subsidiary) intercompany transactions. Consequently, such routine activities as one subsidiary selling inventory to another subsidiary or a parent company loaning money to one of its subsidiaries would suffer.
Already, the tracking, settling and reconciling of hundreds of thousands of intercompany transactions is a demanding and time-consuming effort for many organizations’ finance and accounting staff, made worse in situations involving multiple currencies and numerous, disconnected enterprise resource planning and general ledger systems. To verify and validate intercompany transactions, finance and accounting personnel often rely on spreadsheets, phone calls, emails, and attachments. The interactions can be misinterpreted or missed entirely, as company accountants “tick and tie” their way through a vast array of records.
To simplify these processes, we automated them on our Intercompany Hub, which acts as a central clearinghouse for intercompany transactions, interfacing with a customer’s ERPs and non-ERP financial reporting systems. In the event the Treasury Department’s proposed rules are implemented, finance and accounting staff will need tools like that to help with their added documentation responsibilities.
Nevertheless, we agree with the coalition’s call for Congress to take the time needed to more fully assess the impact of the proposed regulation on the business operations of U.S. multinational companies. In an election year, this would appear to be a highly prudent decision.
Therese Tucker is CEO of financial controls and automation software provider BlackLine.