The Compliance Conundrum: New IRS Risks for Intercompany Debt

July 20, 2017

New regulations in Section 385 of the Internal Revenue Code became effective on Oct. 21, 2016. These changes spell out new documentation criteria for intercompany debt transactions and hint at a big expansion through which the IRS might re-characterize a debt instrument as equity. Overall, the updates pose significant tax risks to large companies — entities with group assets exceeding $100 million or revenue exceeding $50 million. The broader IRS re-characterization authority will change how U.S. companies and foreign companies with U.S. subsidiaries perform tax planning procedures.

While many companies execute compliant debt transactions between a parent corporation and its subsidiaries, the IRS appears to be cracking down on those who push the intercompany envelope. For example, within these new regulations, a loan to a subsidiary, followed by a large payment to the parent company — which could take place up to three years post hoc — will be categorized as a dividend payment (as opposed to debt servicing).

By staying up to speed on the latest rules and regulations, you will reduce the risk of the IRS challenging your intercompany debts. Here are some tips on how to stay compliant in this ever-changing space.

Understand the New Requirements — and Risks

The re-characterization of debt as equity introduces substantial tax consequences for both borrowers and creditors. While the borrower loses all the interest deductions when the transaction is characterized in this manner, the creditor will take a financial hit if he or she was only planning to pay taxes on interest payments. Just imagine the implications of an unexpected tax bill on a $50 million debt instrument re-characterized as an equity investment!

Under the new regulations, you must act as a lender and behave as a third party would: To protect yourself from future financial implications, you must ensure your transactions do not inadvertently trigger the latest recast requirements.

Further, while companies have always been required to document intercompany transactions, the new IRS regulation provides much clearer criteria for debt documentation. To reduce the risks wrought by Section 385, you must review your existing agreements in light of the new documentation requirements.

Utilize Risk Management Strategies

If you find any gaps in your current documentation, address them immediately. And going forward, make sure you document all debt transactions in accordance with the new criteria. My advice? Employ the following strategies to effectively eliminate the risk of the IRS challenging your debts:

  • Consult a CPA to ensure you have a thorough understanding of the latest rules and regulations, and identify any potential compliance concerns.
  • Determine whether you need to make any changes to your debt financings or the processes and systems through which you track these figures.
  • Manage your debt-to-equity ratios, as the IRS will examine these ratios when characterizing instruments. It’s smart to continually monitor these ratios to ensure that no payments can be re-characterized.
  • Perform a credit analysis for all intercompany debt that shows the borrower can repay the loan.
  • Monitor your payments on a regular basis. If (or when) payments are missed, document that you contacted the borrower and took steps to enforce your creditor rights. If necessary, secure the debt with collateral.

The bottom line? The new regulations in Section 385 of the Internal Revenue Code provide the IRS with a broad, new re-characterization authority. If you value your compliance status, contact a CPA today. Otherwise, you might be ill-prepared to safely manage the new risks that these regulations pose to your organization.

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About the Author

Robert Verzi

Robert is an international tax partner with more than 27 years of experience providing international tax solutions to publicly and privately-held corporations on an array of international tax matters, such as foreign tax credit management and utilization, structuring foreign and domestic operations, international mergers and acquisitions, and export tax incentives. He also has many years of experience serving foreign-owned U.S. businesses.