United States: Section 385 Treasury Regulations Developments

Related Party Debt Documentation Rules Are Removed and Future Changes to Limit Recharacterization Rules Are Expected

On October 31, 2019, the Treasury Department and the Internal Revenue Service (IRS) made two significant announcements limiting the controversial Treasury regulations under Section 385 of the Internal Revenue Code of 1986, as amended (the “Code”), that in certain circumstances recharacterize otherwise valid related party debt as equity for U.S. federal income tax purposes. First, in T.D. 9880 the government removed Treas. Reg. § 1.385-2 which required that certain debt obligations meet specific documentation requirements to be respected as debt for U.S. federal income tax purposes (the “Documentation Repeal Regulations”). In addition, the government announced in REG-123112-19 a proposal to issue regulations significantly reducing the scope of certain rules under Treas. Reg. § 1.385-3 (the “Advance Notice”). These changes are expected to provide taxpayers with more flexibility in documenting intercompany debt and engaging in related party lending as described in more detail below. However, taxpayers should be aware that common law principles still apply in determining whether related party debt obligations may be recharacterized as equity for U.S. federal income tax purposes.


On October 13, 2016, the government released final and temporary regulations under Code Section 385 (the “Section 385 Regulations”) in an effort, among other things, to curb the benefits of certain post-inversion earnings-stripping and repatriation transactions.1 The Section 385 Regulations recharacterized certain related party debt obligations as equity. Such recharacterization would occur where certain documentation requirements were not satisfied (the “Documentation Regulations”) or where such debt obligations were issued in transactions that resulted in an actual or deemed distribution to a related party in a non-taxable transaction where no new capital was invested as described in more detail below (the “Distribution Regulations”).

The Documentation Regulations required that “expanded groups”2 comply with certain documentation and recordkeeping requirements with respect to expanded group instruments. If the expanded group did not comply with such requirements, the expanded group instrument generally would be automatically recharacterized as equity for U.S. federal income tax purposes unless an exception applied. In particular, the Documentation Regulations would have required, among other things, a binding obligation to repay the funds advanced, a provision of standard creditor’s rights, an initial analysis of the borrower’s credit, and, if an event of default was waived, an explanation of why a third-party creditor might decide to do so. Note that satisfying the Documentation Regulations would not guarantee that a related party obligation would be respected as debt for U.S. federal income tax purposes. Such an obligation still would have to be tested under the common-law rules for differentiating debt and equity.

Under the Distribution Regulations, a debt obligation generally is treated as equity for U.S. federal income tax purposes in the following circumstances:

  • if such debt obligation is issued in connection with one of three specified transactions (i.e., a distribution of a note, as consideration for the stock of another member of the expanded group or as boot in connection with an intercompany asset reorganization) (the “general rule”); or
  • if such debt obligation is issued by the borrower (referred to as the “funded member”) (A) in connection with (i) a distribution of cash or other property to another member of the expanded group (other than a distribution of stock in connection with an intragroup asset reorganization that is permitted to be received without the recognition of gain or income), (ii) an acquisition of the stock of another member of the expanded group by the funded member, other than in an “exempt exchange,” in exchange for property (other than the stock of the funded member) or (iii) an exchange for property in connection with an asset reorganization, and (B) with a principal purpose of funding such an acquisition or distribution (the “funding rule”). However, no such principal purpose is required for the funding rule to apply if the debt obligation is issued at any time during the 72-month period beginning 36 months before the issuing corporation engages in one of the three types of acquisitions or distributions set forth in clause (A) of the previous sentence (the “per se rule”).

The effective date of the Documentation Regulations had been repeatedly delayed. As a result, the Documentation Regulations never became effective despite being finalized in the Section 385 Regulations. On September 24, 2018, the government issued proposed regulations (REG-130244-17) (the “Proposed Documentation Repeal Regulations”) which would remove the documentation rules and make other conforming changes.

Documentation Repeal Regulations

The Documentation Repeal Regulations adopt the Proposed Documentation Repeal Regulations with no change. In the Preamble to the Documentation Repeal Regulations (the “Preamble”), the government states that it has determined that the burdens imposed on taxpayers by the documentation rules outweigh their intended benefits. The Preamble also notes that the government may propose a modified version of the documentation rules. In such a modified version of the documentation rules, the government would substantially simplify and streamline the proposal to minimize taxpayer burdens, while ensuring the collection of sufficient documentation and other information necessary for tax administration purposes. Any such modified version of the documentation rules would have an effective date that would allow sufficient lead-time for taxpayers to design and implement systems to comply with those regulations.

The Advance Notice

The Advance Notice announces the intention of the government to issue proposed regulations that make the Distribution Regulations more “streamlined and targeted.” In particular, such proposed regulations would modify the funding rule, including by withdrawing the per se rule. As a result, the proposed regulations would not treat a debt obligation as funding one of the three enumerated types of acquisitions or distributions solely because of the temporal proximity between the issuance of such debt obligation and such acquisition or distribution. Instead, the proposed regulations would apply the funding rule to a debt obligation only if the issuance of the debt obligation has a sufficient factual connection to the relevant acquisition or distribution (for example, when the funding transaction and acquisition or distribution are pursuant to an integrated plan). Therefore, under the to-be-issued proposed regulations a debt obligation issued without a connection to the relevant distribution or acquisition would not be treated as stock.

The Advance Notice states that the future proposed regulations would not alter the definition of “covered member” (i.e., generally, an issuer whose debt obligation could be recharacterized as stock under the 2016 Regulations). Under the Section 385 Regulations, only a U.S. corporation could be a “covered member.” However, the Section 385 Regulations reserve on whether an issuer that is not a U.S. corporation (i.e., a foreign issuer) could be treated as a covered member. This Advance Notice confirms that only U.S. corporations will be subject to these regulations when ultimately finalized.


While these are welcome developments, we view the key developments from the Documentation Repeal Regulations and the Advance Notice to be as follows:

  • Although the Documentation Requirement Regulations never became effective and have now been repealed, common law still considers whether debt has been documented and the quality of the documentation as factors in determining whether related party obligations should be treated as debt for U.S. federal income tax purposes. Whenever practical, taxpayers should continue to document their related party debt obligations as needed to defend their tax positions.
  • Even with the addition of the interest limitation of section 163(j), anti-hybrid rules, and the Base Erosion and Anti-abuse Tax (BEAT) to the Code, the government believes that the Distribution Regulations remain necessary in at least some situations. Further, even in the absence of the regulations under Code Section 385, related party debt obligations may still potentially be recharacterized as equity under common law principles.
  • The Advance Notice indicates that a policy decision has been made to limit the scope of the Distribution Regulations as much as possible without permitting taxpayers to engage in abusive transactions. While it is clear that the Distribution Regulations will still apply to foreign parented multinational groups with U.S. subsidiaries, the government would like to receive comments regarding how such rules should be drafted. Foreign parented multinational groups should consider working with their outside tax counsel to provide comments to address the government’s concerns while keeping the scope of the rule as narrow as possible.


1. Prior to the enactment of the Section 385 Regulations, in connection with or following an inversion or foreign takeover, a U.S. subsidiary was permitted to issue its own debt to its foreign parent as a dividend distribution (or to purchase foreign parent stock to use in acquisitions) and the foreign parent may subsequently transfer such debt to a foreign affiliate in a low-taxing jurisdiction. The use of a note in these situations enabled the U.S. subsidiary to deduct future interest expense on such debt on its U.S. income tax return subject to then applicable limitations.

2. Under the 2016 Regulations, the definition of an “expanded group” is generally based on the definition of an “affiliated group” contained in Code Section 1504, but also includes non-U.S. corporations, controlled RICs and REITs and certain corporations connected indirectly through partnerships.

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
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please 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