Effects of the proposed Section 385 Regulations.


In my publication “How does Treasury evolve?” of May this year, I mentioned that evolution depends on the continuously changing landscape in which Treasury operates. In light of these changes, reference was made to the proposed Treasury Regulations under U.S. Section 385, as they could have a profound impact on related party financing. This article takes a closer look at the many aspects of this proposed regulation as introduced April this year and recently temporarily finalized.

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By Norbert Braspenning

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Introduction to 385

A top issue on the minds of treasures today are the proposed Section 385 Regulations – hereafter proposed regulation. Initially proposed last April, the regulation is designed to curb inversions.

Corporate inversion is the process by which companies, especially U.S.-based companies, reduce the tax burden on income.

Why 385?

The United States has higher corporate income tax rates than most of its principal trading partners, which has given U.S. companies an incentive to either expatriate to other countries, or to reduce their U.S. earnings through deductible interest and royalty payments to non-U.S. affiliates. 385 is intended to address/prevent this.

When 385?

On October 13, 2016, the US Treasury Department and IRS released final and temporary regulations under the Section 385. The proposed regulations are effective as of October 21, 2016 and apply to taxable years ending on or after the date 90 days after the publication date, which will be January 19, 2017.  Therefore, fiscal year taxpayers with a year-end on or after January 19, 2017 (e.g., January 31, 2017) will have to consider how the proposed regulations apply prior to calendar year taxpayers.

What & How 385?

The regulation has the potential to fundamentally change corporate cash management and banking structures for just about every medium and large-sized corporation with U.S. affiliates. Primary intent is to reduce or eliminate corporate inversions. Secondary intent is to penalize practice that the US Treasury refers to as earnings stripping (companies adjusting their transfer prices in a way to shift earnings into lower tax jurisdictions). Besides these objectives, practical effect of the regulation is to put at risk most treasury management programs and the supporting bank services. Essentially, commingling of corporate cash across business units is looked upon as manipulation and therefore something bad. The IRS proposes several tests that would determine when cash commingling is acceptable. However, according to specialists, those tests are very complex, very detailed and almost impossible to meet on a daily basis (as is expected). Furthermore, the tests are accompanied by serious penalties such that most of the corporate treasurers are, at least at this point, unwilling to take the risk of tripping one of the trip wires.

Should you not meet all of the myriad tests in place, the IRS has the authority to reclassify debt, as a result of routine cash management transactions (corporate cash concentration) as equity. Consequently corporations are at danger of losing interest deductions and tax credits.

In order to escape the draconian penalties, extensive document requirements  on intra corporate funding is required. Under the proposed regulations movement in and out of a cash pool could be classified as a separate loans, requiring documentation up to and including an independent credit analysis of the borrower.

Furthermore the proposed regulation has a three-year look back and look ahead. Meaning that three years prior to today’s transaction, and three years in the future of today’s transaction, is deemed ineligible. So a single transaction, potentially, doesn’t only affect the particular business unit involved, but also affects any prior or subsequent transaction any other business unit had with that business unit. The consequences basically cascade and infect entire cash pools. These rules obviously go far beyond the scope of corporate inversions, and they basically touch every midsize and large American business as well as most non-us headquarter companies doing business in the United States. It increases costs and reduces capital efficiency.

Treatment of Cash Pools in General

The Regulations need to be considered in structuring cash pooling arrangements, since unless an exception applies, advances and repayments under these arrangements may be treated as issuances and redemptions of stock, which can have serious U.S. tax consequences for the group.

Perhaps the most commented-upon and discussed issue for the proposed regulations was how they would apply in the context of “cash pooling” arrangements. Cash pooling arrangements can entail a high volume of advances and repayments of short-term loans between related parties. The Regulations would potentially affect these arrangements through –so called- “documentation rules” as well as “Per se stock rules”. US Treasury and the IRS indicated that they did not intend to generally deny multinationals the ability to use cash pooling arrangements, but wanted to ensure that the arrangements could not be used to avoid the substance of the proposed regulations. In the past the Treasury Department publicly stated that the proposed regulations were not intended to interfere with cash pooling arrangements, and relief  for these arrangements would be provided when the proposed regulations would be issued in final form. This now seems the case. However cash pooling advances that do not satisfy the specific terms of an exemption could trigger severe tax consequences. Thus, compliance with these exemptions is crucial for multinational groups that have U.S. participants in their cash pooling arrangements.

The “documentation rules”: debt instruments that failed to meet the documentation requirements would automatically be treated as stock.

The “per se stock rules”: identifying several categories of transactions where intercompany debt instruments will no longer be respected and are recharacterized as equity


Comprehensive documentation will address and provide relieve for the “documentation rules”. The “per se stock rules” can be satisfied by qualifying for one of five exemptions. 1) Working capital (focus of arm’s length and current assets), 2) 270-day test (focus on arm’s length and a maximum of days debt is outstanding), 3) Cash Pool Header 4) Ordinary Course Loans (focus on loans to acquire property and a maximum of days debt is outstanding), 5) Interest free loans.

Notional Cash Pools

The Regulations potentially apply to notional cash pooling arrangements to the extent that advances would be treated as indebtedness directly between related members. The Regulations do not provide rules or guidance regarding when a notional cash pool would be so treated; instead, this determination depends on particular terms of the notional cash pool.

Notional pooling arrangements may be considered to be outside the scope of the proposed regulations, since the regulations cover only loans among affiliates, and any deposits and borrowings under a notional pooling arrangement are made with a third-party bank. Even if notional pooling arrangements are covered, they should benefit from the same relief in the final regulations that is provided to other pooling arrangements. However if a group has determined that advances under its notional pooling arrangements will be respected for U.S. tax purposes as third-party transactions, then the group need not be concerned, since the Regulations do not apply at all to third-party transactions. If the group perceives a possibility that those advances might be treated as related party loans among affiliates, then the group can avoid adverse treatment under the Regulations by complying with the documentation rules and one or more of the available exemptions to the recharacterization rules.


In conclusion, the Regulations will not apply at all to notional cash pooling arrangements unless advances under those arrangements are treated as intra-group loans. In cases where the Regulations do apply, the participants will be required to provide and maintain documentation of the master agreement, or of any advances made to a U.S. affiliate by a non-U.S. affiliate or another U.S. affiliate that is not a member of the same U.S. consolidated group. Finally, those advances can avoid being recharacterized as stock if they satisfy the terms of any of the available exemptions.

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