Company Addresses Cash Pooling Under Proposed Debt-Equity Regs

The proposed regulations promise to have a significant impact on a business' finance and treasury functions, affecting all aspects of a company's capital structure and routine funding of its ordinary operations. Companies with extensive global operations like Baxter use common lending arrangements such as cash pooling to ensure sufficient working capital on an ongoing basis -- to make local payroll, to pay for raw materials, to make capital improvements in our operations. This flexibility and ability to deploy our capital when and where it is needed is particularly important for a company like Baxter: in most countries, our customer is the local government through their national health service, and so timing of cash inflows from our operations may differ considerably from country to country. Baxter provides a broad portfolio of essential renal and hospital products, including home, acute and in-center dialysis; sterile IV solutions; infusion systems and devices; parenteral nutrition; biosurgery products and anesthetics; and pharmacy automation, software and services. The company's global footprint and the critical nature of its products and services play a key role in expanding access to healthcare in both emerging and developed countries. As a US company, headquartered in Deerfield, Illinois, Baxter has extensive global operations to maintain in order to produce and deliver products that save and sustain lives around the world. We manufacture products in 28 countries around the world, we have employees located in more than 65 countries, and our products are sold in nearly 115 countries.

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. 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. These issues will restrict the ability of a company to use intercompany financing for even normal operations and will significantly increase the cost of capital and limit the capital available to invest in the United States.

In this regard, it is important to generally define what is meant by "cash pooling," to note the significant, non-tax role such arrangements serve, to demonstrate why the full application of the proposed regulations in their current form would pose an enormous burden on taxpayers in response to what is rarely a tax-motivated arrangement, and to suggest alternatives to the proposals that meet Treasury's stated objectives, while lowering the associated administrative burden and uncertainty.

We have noted and agree with Treasury's recent public statements to the effect that any resulting exemptions for cash-pooling arrangements should not be so broad as to be applied to virtually any intercompany debt financing companies might choose to engage in. In addition, we understand and appreciate that cash is fungible, and that tracing the use to which a particular Dollar of debt funding has been put is both difficult and largely meaningless.

With these considerations in mind, we respectfully propose further clarification and definition in the regulations as follows:

1. Definition of a Cash Pool¹

We are unable to find any context in which "cash pooling" has been specifically defined in the Internal Revenue Code, and so would broadly define a "cash-pooling arrangement" as:

Any mechanism used among members of an affiliated group of companies to mobilize cash balances to meet members' short-term liquidity (i.e, cash) needs and access short-term cash surpluses in a cost-efficient manner.

For example, consider an affiliated group of companies with profitable operations in multiple countries and legal entities. Despite these companies' general profitability, on any given day, the amount of cash on hand may be greater or less than their cash requirements on that day (due to the timing in which current assets are converted into cash, and when current liabilities must be paid), and thus even profitable companies need a mechanism to borrow and deposit funds on a short-term basis. While this need could be met by each company with an unaffiliated bank, as discussed below, this is an expensive means of funding liquidity needs, and is the primary reason companies use cash pooling wherever possible.

2. Types of Cash Pooling

Cash pools can be divided into "notional cash pools," and "physical cash pools."

In a notional cash pool, the overall cash positions of the affiliates are measured (usually daily), and a corresponding net interest income paid/interest expense charged through each affiliates' local bank account. Such arrangements should not be affected by the proposed regulations, as the affiliates are borrowing/depositing with an unaffiliated bank².

Unfortunately, it is not always possible for companies to form a notional cash pool, due to foreign legal restrictions, and practical difficulties associated with cash pooling across multiple currencies. Consequently, taxpayers frequently use "physical cash pooling," involving a "hub and spoke" system under which multiple affiliate companies with fluctuating liquidity needs borrow and deposit with one or more affiliated legal entities serving as "cash-pool heads."

Physical cash pooling, also referred to as zero balancing, involves the physical movement of cash from one account to a header or master account held by the cash-pool head. All cash balances on participating bank accounts are physically transferred to the header account.

There are a number of different ways to engage in physical cash pooling:

• Automated sweep. At a specified time towards the end of the day, balances are automatically swept from participating accounts to the header account. The size of the transferred balance can be varied. The simplest form of sweep is a zero-balancing pool. This has the effect of reducing all balances on participating bank accounts to zero (where a bank account is in deficit, the transfer takes the form of a payment from the center).

• Compulsory participation in an in-house bank. Requiring group entities to participate in an in-house bank results in a de facto physical cash pool. Cash is concentrated at the in-house bank as group entities are required to hold bank accounts with the in-house bank, rather than with any external banks.

• Discretionary participation on periodic basis. Balances are pooled when cash surpluses reach a certain level, or on a weekly, monthly or quarterly basis, at the discretion of an authorized individual.

Treasury practitioners are under tremendous pressure to manage cash efficiently, while at the same time minimizing any risk to their organization. For those in international businesses, the challenges involved in managing cash are multiplied by the complex nature of international regulations, and varying local banking practices around the globe.

The core challenge for all treasury practitioners is to ensure visibility of their group's positions globally. Having clear knowledge of each operating entity's cash position can help to ensure it is funded as economically as possible and that any surplus cash invested safely. Additionally, complete and accurate visibility into cash positions also helps the group treasury to identify how the group is exposed to risk, and to develop strategies to manage those exposures. The greater the number of a group's bank accounts, and the number of currencies in which they are denominated, the harder it is for the group treasury to keep track of the balances on those accounts.

Mobilizing cash on a global basis via the use of notional and physical cash pools can help the group treasury operate more efficiently. These structures allow balances on the various bank accounts to be aggregated, typically by currency, so that the group can more easily identify those accounts with cash surpluses, and those which require funding. Where cash is pooled on a cross-border basis, intercompany transactions are part of the structure, allowing entities with a cash requirement to be funded automatically. At the same time, such structures help the group treasury to understand its foreign exchange positions and to ensure that they are hedged appropriately.

According to the Association for Financial Professionals, companies seek to mobilize global cash for a variety of reasons, including:

• Improving the efficient use of cash, including working capital requirements;

• Reducing borrowing costs;

• Maximizing opportunity for investment;

• Improving control of group cash;

• Better foreign exchange risk.

Assume, for instance, that an affiliated group forms 4 new companies which commence operations on the first day of the tax year, with the following anticipated next-day cash flows at the end of their first three days of operations:

               Example 1: Affiliated Group Commences New Operations

4. Why Exceptions to Cash Pooling are Warranted

While cash pooling clearly represents a kind of intragroup lending, in its usual form it is undertaken for the legitimate purposes of assuring sufficient cash liquidity at the lowest possible cost to the group. By its very nature, however, in which an affiliate may be a borrower one day, but a depositor the next, it would be an enormous burden to require cash-pooling arrangements to meet the documentation requirements of proposed 1.385-2, as these balances can and often do fluctuate a great deal (consider, for instance, the typical requirement to make payroll payments on set dates, while receivables are settled in accordance with the terms agreed to by the parties).

Applying these documentation requirements to standard cash-pooling arrangements would therefore be a nightmarish prospect for taxpayers to satisfy, and for the IRS to audit: Without some sort of relief from the documentation requirements for cash pooling, each daily change in balance might be viewed as a discrete debt issuance subject to the new rules. If this were the case, the ownership structure of a typical multinational would change daily, as the following depicts (on the basis of the numbers in Example 1³, assuming the Group commences operations on Day 1, and deposits/borrows in accordance with next-day cash requirements):

Example 2: Daily Change in Equity Structure from Cash Pooling

 

Day 1 Cash Pooling

 

 

 

 

Day 2 Cash Pooling -- Cumulative Balances

 

 

 

CFC3, in turn, has gone from being a depositor to a borrower due to its change in cash balance, supposedly representing its redemption on Day 2 of its $1 of its hooked stock in the cash-pool head issued on Day 1, and a recharacterized equity investment by the head to CFC3 at the end of Day 2.

CFC1 has increased in equity interest in its parent on Day 2 from $5 to $7, and CFC4, from $3 to $6.

 

Day 3 Cash Pooling -- Cumulative Balances

 

 

 

While it is hard to know what the practical consequences will be until the last day of the tax year in question, and indeed how to order the E&P inclusions (does the cash-pool head first include its Day 2 deemed redemption of CFC2 shares before CFC1 determines how much E&P it receives in its Day 3 redemption of its equity in the cash-pool head?), the group is only into the third day of the year, and there is still much more math to do before the year is through!

5. Proposed Exceptions for Cash Pooling

Example 2 above should amply demonstrate the needless complexity that will result from applying the documentation requirements and recharacterization rules of the proposed Regulations in their current form to cash-pooling arrangements, so several reasonable exceptions are requested from these proposed rules.

As a general matter, we would propose that the perceived abuses described in the preamble to the proposed regulations can be addressed while modifying the rules to distinguish between net cash-pool borrowers (whose average borrowings will be subject to the documentation requirements of 1.385-2 and possible recharacterization under 1.385-3 if they exceed the thresholds proposed below), and net cash-pool depositors (who will be subject to the documentation requirements of 1.385-2 and possible recharacterization under 1.385-3 to the extent of the latter's average excess cash over the same period).

As with intragroup inventory purchases and the billing out of intragroup services, both of which the proposed regulations would except from recharacterization as equity⁴, we would propose that cash pooling used to fund an affiliate's liquidity needs (i.e., where the affiliate is a net cash-pool borrower) be considered to be a debt incurred "in the ordinary course of business" ("ordinary course of business" exception), and thus excluded from the documentation requirements of 1.385-2 and the possibility of recharacterization under 1.385-3.

In the case of net cash-pool depositors, it is proposed that, as their deposits represent prospective debt issued by the cash-pool head, these amounts be subject to an "average cash" limit measured at the cash-pool head, as well as a "legal restriction" exception, determined at the level of the depositing affiliate.

Due to the widespread use of cash pooling prior to issuance of the Proposed Regulations, it is likely that many taxpayers have cash-pool balances at either the affiliates or the cash-pool heads that would not qualify under any of the above proposed exceptions or limitations, but which taxpayers have nevertheless otherwise properly treated as debt for U.S. tax purposes under the previous § 385 rules.

The Proposed Regulations clearly show an intent to leave prior debt financing in place, and thus exclude debts issued prior to April 4, 2016 from the documentation requirements of Proposed Treasury Regulation 1.385-2, and from recharacterization under the Funding rule of Proposed Treasury Regulation 1.382-3.

Based on this general intent, we assume, but would request explicit confirmation that debt balances in place on April 3, 2016 pursuant to a cash-pooling arrangement are grandfathered and therefore not subject to 1.385-2 or 1.385-3, and that taxpayers will be permitted to remove such pre-April 4^th debt balances from their cash-pooling arrangements and place into different debt programs (such as into a long-term debt financing) without such transfers being considered an issuance of new debt on or after April 4, 2016, and thus not subject to 1.385-2 or 1.385-3.

² Most notional cash pools have cross-guarantee arrangements between the affiliated members and the third-party bank in the event that one of the members is unable to repay its borrowings to the bank. For practical purposes, however, we do not see how such an arrangement could give rise to an "EGI" (or to which group member the EGI would even be considered issued) unless and until a member of the notional cash pool were to default on a notional-pool borrowing, resulting in satisfaction of the amount to the bank by an Affiliate, which then holds a legal right of indemnity against the defaulting member.

³ The Example is portrayed as a US MNE with CFCs, but applies equally to foreign multinationals with US subsidiaries.

⁴ It is noted that the ordinary course of business exceptions listed in Proposed Treas. Reg. 1.385-3 are not explicitly excepted from the documentation requirements of Proposed Treasury Reg. 1.385-2. For the sake of clarity, we would like to propose any debt defined as arising under the "ordinary course of business" (including debt arising under a cash-pooling arrangement) be excepted as well from the documentation requirements of 1.385-2.

⁵ We like the general idea of relying on audited financial data for the purpose of this rule, as the amounts are not easily subject to manipulation, and are subject to extensive scrutiny and measurement for significant non-tax reasons. It also eliminates any incentive to create multiple cash-pooling arrangements, as the cap will be measured against the affiliate's net current assets regardless of how many cash pooling arrangements it has.

⁶ The reason for a bit of flexibility in this regard can be illustrated by a simple example: Assume a developer of Christmas toys who must purchase a significant volume of inventory in October and November, but will not receive a substantial portion of its final sales revenue from the same until early in the following year. Quarterly averaging would not pick up the increase in trade payables paid in November and December, while the ending cash-pool balance would reflect the fact that the company in question had not yet collected cash to pay down the ending balance.