United States: Proposed Regulations Threaten Routine Capitalization Strategies And Related-Party Lending Transactions

New Treasury guidance provides sweeping new proposed regulations that could greatly affect tax-advantaged capitalization strategies and various ordinary business transactions that involve related-party lending.

The IRS and Treasury continued their multiyear assault on inversion transactions with a guidance package released on April 4. The guidance included not only temporary regulations on inversion rules themselves (T.D. 9761), but also proposed regulations (REG-108060-15) intended to deter certain "earnings stripping transactions" that are often used as domestic, international, or state and local tax planning strategies. The proposed regs authorize the IRS to bifurcate certain related-party corporate debt into part debt and part stock. They also establish threshold documentation requirements that must be satisfied for certain related-party corporate debt to be respected as debt for U.S. federal tax purposes.

Although the proposed regs were presumably intended to address earnings stripping after international inversions, they would have a much broader effect. In their current form, they would affect certain tax-advantaged capitalization strategies and related-party business transactions between domestic entities. Because the proposed regs have a retroactive effective date, taxpayers should carefully consider the potential impact on all related-party lending transactions after April 4, 2016.

The temporary regulations under T.D. 9761 address transactions that are structured to avoid the purposes of Sections 7874 and 367. Those regulations are not the subject of this Tax Flash.


In 1969, Congress enacted Section 385 to authorize the IRS and Treasury to issue regulations addressing the characterization of an interest in a corporation as debt versus equity. However, no regulations are currently in effect under Section 385. As a result, a large body of case law developed to determine whether an interest in a corporation is characterized as debt or equity.

The IRS is now proposing regulations under Section 385 for the first time as part of their anti-inversion efforts. But instead of narrowly focusing on earnings stripping transactions in the international tax planning context, the IRS chose to use the significant authority provided by Section 385 to combat earnings stripping transactions broadly — whether enacted as part of a domestic, international, or state and local planning strategy. Accordingly, the IRS noted in the preamble to the proposed regs that although the regulations are motivated in part by transactions that result in excessive indebtedness in cross-border transactions, federal income tax liabilities can also be reduced or eliminated with excessive indebtedness between domestic related parties.


Part stock, part debt

Current law generally provides an all-or-nothing approach for debt-versus-equity determinations. Thus, such an approach treats an instrument as constituting either debt or equity — but not both — based on the application of relevant case law to the facts and circumstances. The preamble noted that this approach was problematic in cases in which purported debt instruments "provide only slightly more support for characterization of the entire interest as indebtedness than for equity characterization. ..."

To address this concern, the proposed regs permit the IRS to depart from the all-or-nothing approach when appropriate in characterizing indebtedness as either debt or equity.  Accordingly, the proposed regs authorize the IRS to bifurcate an instrument between debt and equity if an analysis, conducted under general federal tax principles, indicates the instrument should be treated as part equity and part debt.

This proposed rule would apply to instruments in place between parties meeting a 50% vote or value threshold for relatedness (a modified expanded group), as opposed to an 80% vote or value threshold applicable with respect to other rules (an expanded group) in the proposed regs.  

In addition, the proposed regs require all parties relying on the characterization of an instrument as debt  to treat the instrument consistent with the issuer's characterization. Thus, for example, a holder may not disclose on its return under Section 385(c)(2) that it is treating an instrument as part stock and part debt if the issuer of the instrument treats it as indebtedness.

Documentation and Information

The proposed regs require the timely preparation and maintenance of documentation for instruments characterized as debt. If a taxpayer fails to prepare and maintain required documentation in a timely way, or fails to provide required documentation to the IRS upon request, the debt instrument will be treated as stock.

The proposed regs require taxpayers to prepare and maintain four general categories of written documentation to avoid de facto stock treatment. These categories reflect critical characteristics of indebtedness for U.S. federal tax purposes and include:   

  1. Binding legal obligation to repay, either on demand or on one or more fixed dates
  2. Creditor's rights to enforce the obligation
  3. Resonable expectation of ability to repay the debt
  4. Actions evidencing debtor-creditor relationship

This Tax Flash doesn't attempt to discuss the important details underlying each of these four categories.  

These documentation requirements apply only to expanded group instruments (EGIs, as discussed later) held by large taxpayer groups. A large taxpayer group includes any group that satisfies one or more of the following requirements:

  • The stock of any member of the expanded group is traded on an established financial market.
  • Total assets of the expanded group exceed $100 million as reported on any applicable financial statements on the date an instrument becomes an EGI.
  • The expanded group's annual total revenue exceeds $50 million, as reported on any applicable financial statements on the date an instrument becomes an EGI.

Documentation is considered timely for the first three categories if prepared no later than 30 calendar days after the relevant event. For the fourth category, documentation is timely if prepared no later than 120 days after the relevant event.


To deter earnings stripping and other transactions, the proposed regs provide various rules (transaction rules) that characterize an otherwise valid debt instrument as stock for all federal tax purposes. Specifically, the proposed regs provide three transactions rules that cause debt to be treated as stock: the general rule, the funding rule and the anti-abuse rule. The regulations also include three general exceptions to these rules.

  • General rule: The general rule treats a debt instrument as stock if the debt instrument is issued: (i) in a distribution, (ii) in exchange for expanded group stock (other than in certain exempt exchanges) or (iii) in exchange for property in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the issuer's expanded group immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation. The preamble notes that these transactions lack substantial nontax purposes and do not introduce "new capital."
  • Funding rule: The funding rule treats a debt instrument as stock if the debt is issued by a corporation (funded member) to a member of the expanded group in exchange for property and the debt constitutes a principal purpose debt instrument. A principal purpose debt instrument is a debt issued with the principal purpose of funding a distribution or an acquisition in various circumstances set forth in the proposed regs. The IRS believes the funding rule addresses transactions that, when viewed together, present similar policy concerns as the transactions that are subject to the general rule.   
  • Anti-abuse rule: Under this rule, a debt instrument is treated as stock if it is issued with a principal purpose of avoiding the application of the proposed regs. The Proposed Regs provide a significant non-exhaustive list of examples in which the anti-abuse rule applies.

The proposed regs include three exceptions from the transaction rules that otherwise characterize a debt instrument as stock. These exceptions include:

  1. Certain distributions and acquisitions that do not exceed current year earnings and profits
  2. The aggregate adjusted issue price of all expanded group debt that would otherwise be treated as stock under the transaction rules does not exceed $50 million
  3. An exception for certain funded acquisitions of subsidiary stock by issuance

Consolidated groups

For all purposes of the proposed regs, members of a consolidated group are treated as one corporation. For example, the proposed regs do not apply to debt instruments between members of a consolidated group (intercompany debt).  The IRS believes that the issues of concern regarding related-party debt don't exist when the issuer's deduction for interest expense and the holder's corresponding interest income offset on a consolidated federal income tax return.   


The proposed regs have varying effective dates, which are specific to respective operating provisions. The regulations permitting the IRS to depart from the all-or-nothing approach and the regulations pertaining to timely documentation requirements are effective for applicable instruments issued on or after the publication of the final regulations. However, the transaction rules apply to debt instruments issued on or after April 4, 2016, but would not treat interests as stock until the date that is 90 days after the final regulations were published.  


The breadth of the proposed regs will likely capture many ordinary course transactions and business operations occurring between related parties — whether foreign or domestic. For example, the proposed regs will affect inverted companies and cross-border transactions. In addition, they will influence ordinary related-party debt funding of portfolio investments by private equity vehicles and certain ordinary related-party treasury functions.

The proposed regs will also affect reorganization transactions. Many restructuring transactions previously characterized according to form should be carefully analyzed in light of these proposed regs. These rules, in combination with the strict documentation requirements, will influence many related-party financing transactions.  

Taxpayers should carefully analyze the proposed regs regarding any instruments issued on or after April 4, 2016. As noted, the regulations may apply retroactively to certain obligations issued before the regulations are finalized, and Treasury intends to move swiftly to finalize the rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions