It’s been more than three months since the U.S. Treasury Department and the Internal Revenue Service (IRS) released final and temporary regulations under IRS Code Section 385. The final regulations contain several exceptions and are not as far-reaching as initially proposed. But the burden is on taxpayers to identify their related-party financing arrangements involving U.S. borrowers, understand their operational/documentation procedures with respect to such arrangements, and assess whether such arrangements are excepted from the Documentation Rule and Recharacterization Rule of the final regulations.

While there is speculation as to whether the regulations will be revisited as part of the new administration’s focus on reducing regulation and controlling regulatory costs, the final regulations remain in place currently, and certain of the rules are viewed by Treasury and the IRS as distilling leading practices under otherwise applicable case law. Therefore, understanding the scope of the regulations and determining current and prospective compliance with the new rules should be a key focus for corporate treasurers in 2017.

The final regulations retain much of the general approach of the proposed regulations, but the following notable changes significantly narrowed the universe of debt instruments and internal cash management practices that are or will be subject to 385 regulations.

• Limited to U.S. borrowers: The final regulations may apply only to related-party instruments issued by domestic corporations (and certain partnerships and disregarded entities with domestic corporate owners), such as U.S.-to-U.S. loans outside of the U.S. consolidated federal tax group and foreign-to-U.S. inbound loans. This change excludes U.S.-to-foreign outbound loans and foreign-to-foreign loans.
• Removal of the general bifurcation rule: The proposed regulations allowed the IRS to bifurcate an instrument into part debt, part equity based on an analysis of the relevant facts and circumstances. The final regulations remove the general bifurcation rule, while Treasury continues to study the issue.
• Delayed documentation requirement: The Documentation Rule now may apply only to related-party debt instruments issued on or after January 1, 2018, and the documentation is not required to be completed until the due date of the debt issuer’s U.S. federal income tax return, which includes such debt.
• Excluding certain short-term arrangements from the Recharacterization Rule: The final regulations exclude several categories of short-term arrangements from the Recharacterization Rule (but not the Documentation Rule), including physical and notional cash pools, ordinary course loans and interest-free loans.

Despite these changes, many related-party financing arrangements remain subject to the regulations. Significantly, the regulations apply to loans from foreign parents to their U.S. subsidiaries. Also, notwithstanding the delayed documentation requirement, the compliance burden for related-party U.S. borrowings may be substantial. Term loans, demand loans, cash pools (now including certain notional pools), trade payables and open accounts still remain subject to the Documentation Rule.

Treasury and the IRS estimated that the Documentation Rule may impact about 6,300 C corporations in the U.S., with a projected tax revenue of between $461 million to $600 million per year. This analysis appears not to have fully considered the cost of compliance and increased borrowing costs that may be incurred by companies. Once again, the onus is on taxpayers to substantiate the qualification for any exception (e.g., debt instrument in question is a qualified short-term debt instrument). Companies may need to become more diligent in tracking and maintaining sufficiently detailed records of M&A activities, debt issuances, earnings and profits, and distribution and contribution history for their affected group members.

Finally, because of the complexity of the regulations, some rules may apply in unanticipated situations. Companies may want to practice appropriate conservatism and consider the final regulations in connection with all related-party financing arrangements involving affected group members. The high-level actions noted below should be on the corporate treasurer’s agenda in 2017 and should be analyzed in consultation with corporate tax and accounting functions.

1. Take inventory: Review your related-party financing arrangements and assess whether they are subject to the Documentation and Recharacterization Rules. For affected debt instruments, take a closer look at principal amounts, maturity dates, payment terms, payment history and supporting documentation; and assess associated debt issuance and tracking processes, systems and retention.
2. Establish policies and procedures to track and comply: Plan and implement policies and procedures to properly manage intercompany funding and related transactions to comply with the Documentation and Recharacterization Rules and to improve documentation of intercompany debt on a going-forward basis.
3. Drive multifunctional involvement: Coordinate procedures with treasury, tax, accounting, IT, M&A and operations functions to continuously monitor intercompany financing arrangements and promote compliance with the new requirements. 

The views expressed herein are those of the author and not necessarily those of EY or its member firms.

Paul DeCrane, global treasury services leader, and Joon-Woo Song, manager, global treasury services, are both with EY Americas Financial Accounting Advisory Services.