Cash & Liquidity ManagementCash ManagementUS: Section 385 could be as disruptive as advertised

US: Section 385 could be as disruptive as advertised

The UK’s recent vote to “Brexit” is causing alarms to ring for many organisations, and finance leaders are seeking alternative means to compensate for lagging to negative interest rates. Pile on Section 385 for some US-based multinationals and the challenge becomes even denser for treasury.

While there are many regulations that we read about in treasury, Section 385 is a regulatory change that is worth paying attention as it has the potential to significantly impact treasury. The focus of Section 385 of the Internal Revenue Code (IRC) is generally to minimise tax inversions and the use of intercompany financing to repatriate profitability from global operations.

The issue for US treasurers is that global cash pooling managed within an in-house bank (IHB), perhaps inadvertently, falls within the crosshairs of Section 385. In many cases, in-house banking transactions would be reconsidered equity instead of intercompany debt/investment. This presents many complications; not the least of which are the knock-on effects of a parent company being considered to have taken an equity position in an overseas subsidiary, which in turn manages regional and local cash pools. These consequences have driven the US Association for Financial Professionals (AFP) to communicate its views to the Internal Revenue Service (IRS) on behalf of members.

While it is possible that Section 385 will be modified to allow forms of in-house banking to support cash and liquidity management without reclassifying IHB transactions as equity, there is also a chance that change to the regulation does not occur. If the latter is the case, there are two outcomes:

1) Treasurers will collaborate with tax to reclassify relevant IHB transactions as equity and will generate the appropriate documentation to comply, including the extensive tax adjustments.
2) Treasurers will restrict the use of in-house banking for cash and liquidity management.

Realistically, out of these two choices, treasury would move to limit the use of in-house banking as a cash management tool. Yet, moving away from IHB has consequences for Treasurers.

Main benefit

The driving benefit offered by in-house banking is optimised liquidity across the organization. When borrowing, the parent can fund subsidiaries more efficiently than external financing they could achieve on their own. Without the immediacy of cash pooling from parent to sub, subsidiaries would rely upon locally arranged financing (such as a line of credit) to fund short-term funding requirements. Longer term, subsidiaries could arrange more formalized intercompany loans with defined payment and repayment schedules. But the issue remains in the short term: without in-house banking, the cost of funding increases for a subsidiary. On aggregate across the organization, this can have significant bottom line impact.

On the investing side – when subsidiaries have excess cash – an IHB will sweep out balances and compensate the subsidiary with a reasonable rate of interest. This interest rate may be higher than a subsidiary could receive from self-managed investments, as the cash aggregated across subsidiaries has more value to the parent than the individual entity.

Whether the parent company funds or sweeps cash to and from subsidiary in-house bank participants, removing in-house banking as a tool for treasurers to leverage will decrease the ability to mobilise cash and deploy liquidity where it is needed most. Subsidiary borrowing will instead increase, creating unnecessary interest expenses and banking fees when excess cash exists elsewhere within the organization.

Ideally, Section 385 will find ways to permit in-house banking as a cash management tool borrowing and investing tool, optimising organisational value through cash mobilization.

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