United States: Section 385 Proposed Regulations

On April 4, 2016, Treasury and the IRS proposed sweeping regulations under § 385 of the Code. Issued the same day as the anti-inversion temporary regulations, the proposed § 385 rules would go much farther than merely curtailing inversions and earnings stripping. They would significantly impact U.S. tax planning for every large multinational, whether U.S. or foreign owned.

The proposed rules would give the IRS authority to treat related party debt instruments as partly debt and partly stock. The proposed rules provide little guidance as to how such a determination would be made.

New, onerous documentation requirements would apply to most related party debt instruments. Debt instruments that failed to meet the documentation requirements would automatically be treated as stock. The rules would effectively force related party lenders in large corporate groups to act less like affiliates and more like banks.

Finally, and most controversially, the proposed rules would treat debt instruments as stock when issued in certain disfavored, related party transactions. The treatment of the instrument under general debt-equity principles would be irrelevant. This rule is proposed to apply retroactively once final, to debt instruments issued on or after April 4, 2016, subject to certain transition rules.

For purposes of the new rules, all members of a consolidated group would be treated as one corporation. Thus, debts between consolidated group members would not be subject to the rules.

The proposed regulations raise serious questions of Treasury's authority to rewrite the law. Section 385 gives Treasury broad authority to write regulations designed to distinguish debt from equity. Taxpayers might ask whether that is what Treasury has done in the proposed regulations.

Debt Instruments Treated as Partly Debt and Partly Stock

Section 385(a) authorizes the Secretary to treat an interest in a corporation as in part debt and in part stock. Proposed § 1.385-1(d) would invoke this authority in the case of any debt instrument where the issuer and the holder are members of the same "modified expanded group," which would be based on 50%-or-greater ownership, directly or indirectly.

The proposed rule would allow the IRS to treat a debt instrument as part debt, part stock to the extent an analysis of the relevant facts and circumstances under general tax principles at the time of issuance resulted in a determination that such treatment were proper. The proposed rule states, "for example," that if the IRS's analysis supports a reasonable expectation that only a portion of the principal amount of a debt instrument will be repaid, the IRS could treat the instrument partly as debt and partly as stock.

The proposed rule offers no standards for determining when an instrument would be so treated. In practice, substantial discretion would probably rest with IRS examining agents. This can hardly be what Congress had in mind when it authorized Treasury to write regulations. It would seem that Treasury, when it writes rules having the force of law, has an obligation to provide taxpayers with notice of what those rules actually are.

Minimum Documentation Requirements

Proposed § 1.385-2 would impose threshold documentation requirements that would have to be satisfied in order for certain related party debt instruments to be respected as debt. If the requirements were not satisfied, the instrument would automatically be treated as stock, subject to a reasonable cause exception. Debt-equity factors traditionally considered by courts would be irrelevant. Taxpayers, however, could not affirmatively use the rule to reduce tax liability.

The minimum documentation requirements would apply to expanded group instruments, or "EGIs." An EGI would be any debt instrument where the issuer and the holder were members of the same expanded group. An expanded group would be defined by reference to § 1504(a), except that 80% ownership could be direct or indirect, by voting power or by value; the exceptions in § 1504(b) would not apply; and a partnership 80%-owned, directly or indirectly, by members of the expanded group would be treated as a member of the group. Indirect ownership would be determined under § 304(c)(3) (the § 318 attribution rules, with certain modifications).

The required documentation for an EGI to be respected as debt would consist of four parts:

First, written documentation would need to be prepared establishing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates. This documentation would need to be prepared within 30 days of the "relevant date" – generally, the date the EGI is issued. Special rules would apply to revolving credit agreements and cash pooling arrangements, but the special rules seem woefully inadequate to address these kinds of arrangements. Cash sweeps in particular could raise significant issues.

Second, the written documentation above would need to establish that the holder has the rights of a creditor to enforce the obligation. Typically, the proposed rules state, a creditor's rights include, but are not limited to, the right to trigger an event of default or acceleration and the right to sue to enforce payment. In all cases, creditor's rights would have to include a superior right to shareholders to share in the issuer's assets upon dissolution.

Third, written documentation would need to be prepared (also within 30 days) establishing that, as of the date the EGI were issued – or deemed issued under Treas. Reg. § 1.1001-3 – the issuer's financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations under the instrument. This documentation could include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity ratios and other relevant financial ratios of the issuer in relation to industry averages.

Fourth, ongoing written documentation evidencing the parties' conduct over the life of the debt instrument would need to be prepared and maintained. This would include written evidence of the issuer's payments of interest and principal, such as wire transfer records or bank statements. If the issuer did not make a payment of interest or principal that was due and payable, or if any other event of default occurred, written documentation would need to be prepared evidencing the holder's reasonable exercise of the diligence and judgment of a creditor. This could include evidence of the holder's efforts to assert its rights, the parties' efforts to renegotiate the terms of the EGI or mitigate the breach of an obligation under the EGI, and any documentation detailing the holder's decision to refrain from pursuing any actions to enforce payment. This ongoing aspect of the documentation would need to be prepared within 120 days of each date a payment of interest or principal were due, and any other date a default occurred (e.g., if the issuer failed to maintain applicable financial ratios or violated other covenants).

Companies rarely engage in this level of analysis or diligence when issuing, extending, or modifying an intragroup debt. The minimum documentation requirements would force related party lenders to operate less like affiliates and more like banks. Viewed another way, they would operate effectively as a tax on the use of intercompany debt. Given the likely short time frame before the regulations become final, large corporate groups should start considering the people and systems they will need to put in place to ensure they can satisfy the documentation requirements. They also should consider whether to they wish to take any action now with respect to existing EGIs. Extending a debt now might be less painful than extending it once the rules take effect. Of course, Treas. Reg. § 1.1001-3 and other issues related to any extension would have to be considered.

All parts of the minimum documentation would need to be maintained for all taxable years that the EGI were outstanding, and until the expiration of the statute of limitations for any return for which the treatment of the EGI were relevant.

All members of a consolidated group would be treated as one corporation for purposes of the § 385 regulations. Thus, an intercompany obligation within the meaning of § 1.1502-13(g) would not be considered an EGI, and the documentation requirements would not apply. However, an instrument that ceased to be an intercompany obligation would be treated as becoming an EGI immediately after it ceased to be an intercompany obligation. In this case, the required documentation would need to be prepared within 30 days after the obligation became an EGI.

If an EGI with a partnership or disregarded entity as the issuer were treated as equity due to a failure under the documentation requirements, the EGI would be treated as an equity interest in the partnership or disregarded entity, as the case may be. In the case of a disregarded entity, this treatment seemingly could cause the disregarded entity to have a second owner, thereby causing it to become a partnership.

The documentation requirements would apply to any debt instrument issued or deemed issued on or after the date final regulations are published, and to any obligation issued or deemed issued before the date final regulations are published by reason of a check the-box election filed on or after that date.

Blacklisted Transactions

Proposed § 1.385-3 would effectively rewrite the tax law on debt vs. equity. It would treat as stock any debt instrument issued in certain disfavored, related party transactions. This treatment would be automatic: debt-equity factors traditionally considered by courts would be irrelevant.

The blacklisted transactions are described in a "general rule," for debt instruments issued directly in the disfavored transactions, and in a "funding rule," for a borrowing that is used – or treated as used – to fund similar transactions.

General Rule

Under the "general rule," a debt instrument would generally be treated as stock to the extent it were issued by a corporation to a member of the corporation's expanded group in any of the following transactions: 

(i) in a distribution;
(ii) in exchange for expanded group stock; or
(iii) in exchange for property in an asset reorganization. 

The term "expanded group" would have the same meaning as in the documentation rules: an affiliated group as defined in § 1504(a), with certain modifications.

Thus, for example, if FP owned USS, and USS distributed its own note to FP, the note would be treated as USS stock under the general rule. The proposed regulations are meant to overrule Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956), in this regard. A USS note issued to FP to buy stock of FP's subsidiary FS would similarly be treated as stock under the general rule.

Funding Rule

Under the "funding rule," a debt instrument also would generally be treated as stock to the extent it were issued by a corporation (the "funded member") to a member of its expanded group in exchange for property, with "a principal purpose" of funding any one or more of the following transactions: 

(i) a distribution of property by the funded member to a member of its expanded group;
(ii) an acquisition of expanded group stock by the funded member from a member of its expanded group; or
(iii) an acquisition of property by the funded member in an asset reorganization. 

Importantly, a "per se rule" would impute a bad principal purpose if the debt instrument were issued within 36 months on either side of the distribution or acquisition, subject to an ordinary course exception. Thus, any intragroup borrowing within 36 months on either side of one of the above transactions would automatically cause the debt instrument evidencing the borrowing to be treated as stock. If the borrowing and the "funded" transaction were more than 36 months apart, facts and circumstances would determine whether a bad principal purpose existed.

Thus, for example, if USS borrowed from FP (or a subsidiary of FP) and, within 36 months on either side of the borrowing, paid a dividend to FP, or purchased FS stock from FP, the funding rule would cause USS's note to FP to be treated as stock. Whether the two transactions were actually related would be irrelevant.

If the funded distribution or acquisition occurred in the same taxable year that the debt instrument were issued, or an earlier year, the debt instrument would be treated as stock from the date of issuance. If the acquisition or distribution occurred in a subsequent year, the debt instrument would be deemed to be exchanged for stock when the funded distribution or acquisition occurred.

Issues for U.S.- and Foreign-Parent Groups

The proposed § 385 regulations have been referred to as "earnings stripping" rules, and all of the examples involve foreign-parent groups. But the rules are written much more broadly. They clearly would apply to U.S. parent groups as well. Several common examples of U.S. to-CFC, CFC-to-CFC, and CFC-to-U.S. debt instruments would be treated as stock. Even U.S.-to-U.S. debt instruments could be implicated, if the lender and borrower were not members of the same consolidated group.

For example, suppose USP owns CFC1 and CFC2, brother-sister. CFC1 owns CFC3. CFC1 sells CFC3 to CFC2 in exchange for CFC2's note. Under the general rule, the note would be treated as stock. Section 304 would appear not to apply, since the issuer's (CFC2's) own stock is not "property" for purposes of § 317. See proposed § 1.385-3(g)(3), Example 3. Could the sale of CFC3 stock qualify for nonrecognition under § 351 or as a "B" reorganization? Or would it be treated as a taxable sale, with any gain treated as Subpart F income in the hands of CFC1?

Numerous other issues would arise, both in the inbound and outbound contexts. If an ordinary promissory note were treated as stock, presumably it would be treated as preferred stock given its priority of repayment and its limited participation in growth. Would such a preferred stock note be "nonqualified preferred stock" for purposes of § 351(g)? What would be the effect of that treatment? Would a preferred stock note distribution be nontaxable under § 305(a), or taxable under § 305(b) and/or (c)?

How would the repayment/redemption of a preferred stock note be treated? If the § 318 attribution rules caused the repayment to fail the § 302(b) tests, the full amount repaid presumably would be treated as a dividend to the extent of the issuer's E&P. Any interest payments presumably would also be treated as dividends to the extent of E&P.

In the case of a CFC-to-CFC preferred stock note, these "dividends" should not be Subpart F income (at least until 2020) under § 954(c)(6). Would they carry foreign tax credits? Section 902(a) and (b) require 10% ownership of the paying corporation's voting stock. Debt instruments typically carry no voting rights. Rev. Rul. 91-5 and Rev. Rul. 92-86 provide relief in a similar situation, deeming the requisite voting power to exist (and thereby allowing foreign tax credits to transfer) where fictional stock is created, then redeemed, in a § 304(a)(1) transaction. Could a similar rule be applied to the redemption/repayment of a preferred stock note? If not, a portion of the issuer CFC's tax pool would seem to disappear. See Treas. Reg. § 1.902-1(a)(8)(i).

Other issues could include the creation of a hybrid instrument, which the proposed rules would do any time they caused debt to be treated as stock. If the borrower were a CFC, would the foreign country permit an interest deduction? Or would the deduction be denied under BEPS Action 2 principles? A related issue could be the application of the foreign tax credit splitter rules of § 909. The preamble requests comments on that issue.

Even plain-vanilla debt funding of M&A transactions would need to be carefully considered. Suppose a new acquisition CFC is funded with a mix of debt and equity, and uses the funds to acquire unrelated FT from FT's shareholders. CFC's debt would not be treated as stock under the funding rule merely as a result of these transactions, since FT was unrelated before the acquisition. However, for the next 36 months, CFC would effectively be "locked up" – it could not make distributions, or acquisitions of expanded group stock, without triggering the funding rule. The rule would also be triggered if the CFC had made such a distribution or acquisition at any time within the preceding 36 months. Similar issues would arise if a foreign parent funded a U.S. subsidiary with debt to acquire a U.S. target.


Proposed § 1.385-3(c) would provide three exceptions to both the general rule and the funding rule. First, the aggregate amount of any distributions or acquisitions by a member of an expanded group that otherwise would trigger one of the rules would be reduced by an amount equal to the member's current E&P.

Second, under a threshold exception, a debt instrument would not be treated as stock under the general rule or the funding rule if, immediately after the instrument were issued, the expanded group's total debt instruments that otherwise would be treated as stock under these rules did not exceed $50 million. This exception would effectively exempt smaller corporate groups from the rules. Once the $50 million threshold were exceeded, the exception would cease to apply to all debt instruments issued by members of the expanded group.

Third, an acquisition by an expanded group member of another member's (i.e., a subsidiary's) stock for property would not be subject to the funding rule if, for the 36-month period following the acquisition, the member owned, directly or indirectly, more than 50% of the subsidiary's stock by voting power and value. Where this exception applied, however, the subsidiary would be considered a "successor" to the member, and would be treated as the "funded member" for purposes of applying the funding rule, to the extent of the value of the subsidiary's stock acquired by the member.

These exceptions are narrow, and unlikely to be of much help for larger multinationals.

Notably, there is no exception for cash pooling or cash sweeps. Treasury may be reconsidering whether it makes sense to include such an exception. It would seem impossible for taxpayers or the IRS to determine the tax consequences of a cash sweeping arrangement in which each sweep created a new preferred stock instrument.

Consolidated Groups

All members of a consolidated group would be treated as one corporation for purposes of the § 385 regulations. Thus, debt between members of a consolidated group would not be subject to the general rule or the funding rule.

However, the "one corporation" rule also could cause substantial mischief. A loan to one consolidated group member occurring within 36 months of a distribution or acquisition by another consolidated group member presumably would cause the loan to be recharacterized as equity under the funding rule: "one corporation" would be viewed as engaging in both transactions.

For example, suppose FP owns USS1, the parent of a sizable U.S. consolidated group. USS2 is also a member of the group. FP makes a loan to USS2. This might be to fund an acquisition of a U.S. target, or to provide USS2 with needed working capital. Nonetheless, to avoid stumbling into the funding rule, for 36 months, the entire USS1 consolidated group would have to be "locked up." No member could acquire stock of an expanded group member, and USS1 could not make distributions to FP. Nor could any of these transactions have been undertaken in the 36 months before the loan. In a large multinational enterprise, new systems might be needed to track related party loans and potential funded distributions and acquisitions.

The "one corporation" rule might not protect consolidated group loans from being recharacterized as stock for state law purposes. Imagine, for example, a state that generally follows the Internal Revenue Code, but applies state law principles to determine which corporations are members of a consolidated group. Would the general rule and the funding rule have to be separately analyzed, taking into account loans between members of the federal consolidated group, to determine income tax liability in such a state? In how many different states might such a separate analysis be necessary? What about states that have no explicit rules on consolidation?

Proposed § 1.385-4 would provide special rules for debt instruments that became, or that ceased to be, held between members of a consolidated group. This could occur, for example, if the holder transferred the issuer's note to a related foreign person. Alternatively, the issuer or holder could cease to be a member of the consolidated group but could remain a member of the expanded group.

Deemed Exchange

In various circumstances, the operation of the proposed rules would cause a debt instrument to be treated as stock some time after its issuance, for example, if a funded distribution or acquisition occurred in a subsequent taxable year, or if the $50 million threshold exception ceased to apply.

In these circumstances, proposed § 1.385-1(c) would govern the consequences of the deemed exchange of debt for stock. The holder would be treated as having realized an amount equal to its adjusted basis in the portion of the debt to be treated as stock, and the issuer would be treated as having retired that portion for an amount equal to its adjusted issue price. Neither party would account for any accrued but unpaid qualified stated interest or for any foreign exchange gain or loss with respect to such interest. Thus, the holder generally would recognize no gain or loss and the issuer would recognize no COD income. However, any foreign exchange gain or loss with respect to principal and any other interest (OID, for example) would be realized and recognized.

The proposed rules also could cause a debt instrument once treated as stock to be no longer treated as stock, for example, if a U.S. issuer's note were transferred by its foreign holder to a member of the issuer's consolidated group. Nothing in the proposed rules appears to address the treatment of the deemed exchange of issuer stock for issuer debt that would arise. Presumably, for the holder, the exchange would be a redemption of issuer stock governed by § 302. The issuer should recognize no gain or loss under § 1032.

Partnerships and Disregarded Entities

The proposed rules generally would apply an aggregate approach to partnerships. If that caused a debt instrument issued by a partnership to be treated as stock, the holder would be treated as holding stock in the corporate partners of the partnership. Similarly, if a debt instrument issued by a disregarded entity were treated as stock, it would be treated as stock in the entity's owner. This treatment is different from the treatment described above of partnership and disregarded entity debt treated as equity due to a failure to satisfy the minimum documentation requirements.

Anti-Avoidance and No Affirmative Use

A debt instrument would be treated as stock if it were issued with a principal purpose of avoiding the application of the proposed rules. The same would be true for similar arrangements that are not technically debt instruments, for example, a § 483 contract. Taxpayers could not make affirmative use of the proposed rules to reduce tax liability.

Proposed Effective Date

Proposed Treas. Reg. § 1.385-3 would apply to any debt instrument issued on or after April 4, 2016, and to any debt instrument treated as issued before April 4, 2016 as a result of an entity classification election filed on or after that date. Under a transition rule, if a debt instrument issued before final regulations are published were recharacterized as stock under the proposed rules, the instrument nonetheless would be treated as debt until the date that is 90 days after final regulations are published. If, on that date, the instrument were still held by a member of the expanded group, the debt would be deemed to be exchanged for stock.

Scope of Treasury's Authority

In its report on the Tax Reform Act of 1969, the Senate Finance Committee explained § 385's grant of authority to Treasury as follows:

In view of the uncertainties and difficulties which the distinction between debt and equity has produced in numerous situations . . . the committee . . . believes that it would be desirable to provide rules for distinguishing debt from equity in the variety of contexts in which this problem can arise. The differing circumstances which characterize these situations, however, would make it difficult for the committee to provide comprehensive and specific statutory rules of universal and equal applicability. In view of this, the committee believes it is appropriate to specifically authorize the Secretary of the Treasury to prescribe the appropriate rules for distinguishing debt from equity in these different situations.

Here, the proposed rules would not even attempt to distinguish debt from equity in the "variety of contexts" in which the problem can arise. Except where they would automatically treat a debt instrument as stock, the proposed rules would have no effect at all. General federal tax principles would still determine an instrument's debt or equity character.

What Treasury has proposed, essentially, is to hijack Congress's authorization in order to achieve Treasury's own purpose – mainly, curtailing inversions and earnings stripping – rather than the legislature's purpose in enacting § 385. Taxpayers might ask whether Treasury has the power to do that.

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.

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