On April 4, the US Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued extensive regulations described as curbing inversions and addressing earnings stripping. The rules include temporary and proposed regulations under sections 367, 385 and 7874 and other provisions of the Internal Revenue Code of 1986 (the "Code"). Although the regulations have been publicized as targeting inversions, much of the inversion-related guidance simply implements the changes previously outlined by Treasury in Notices 2014- 52 and 2015-79 (the "Notices"). In contrast, proposed regulations under Code section 385 (the "Proposed Regulations"), which relate to characterization of interests in corporations as stock or indebtedness, would overturn the longstanding treatment of certain intercompany debt arrangements and could have far-reaching effects on US and foreign companies. The Proposed Regulations are not limited to companies that would be considered inverted companies under Code section 7874, but rather would apply to all debt instruments issued between affiliated entities, using an expanded definition of what constitutes an affiliated entity.

Treasury indicated that it intends to move swiftly to finalize the Proposed Regulations, parts of which apply to instruments issued on or after April 4, 2016. Treasury will accept comments on these proposals through July 7, 2016. Given the Proposed Regulations' broad scope and potential, significant effects, taxpayers should consider participating in the comment process. As noted below, whether the final version of the Code section 385 regulations will meet the Administrative Procedure Act's requirements may depend in part on how Treasury and the IRS address issues raised in comments.

This legal update discusses key elements of the Proposed Regulations and highlights certain additions and revisions to the inversion guidance that had been provided in the Notices. (For prior commentary on the Notices, see The IRS and Treasury Issue New Anti-Inversion Notice and The IRS and Treasury Issue New Anti-Inversion Guidance.)

The Proposed Regulations at a Glance

Treasury's press release used the phrase "earning stripping" when describing the concern addressed by the Proposed Regulations. However, the Proposed Regulations do not address interest deductibility under Code section 163(j) (commonly referred to as the "earnings stripping rules"), but rather take on the broader threshold issue of whether certain related party loans are in fact indebtedness for US federal income tax purposes. The Proposed Regulations also are not limited to "inbound" transactions, but rather apply generally to transactions between certain related parties, without regard to whether the parties are domestic or foreign.1 Given the broad scope of the Proposed Regulations, it could be inferred that Treasury is attempting to achieve through regulation some of the policy goals it has not achieved in its proposed legislative changes to Code section 163(j), proposals that have not been adopted by Congress.

Code section 385 governs the treatment of corporate interests as stock or indebtedness. Its content is primarily limited to authorizing the Secretary to prescribe regulations as necessary for determining whether an instrument is properly treated as stock or indebtedness, or part stock and part indebtedness. Prior attempts to issue regulations under Code section 385 have been unsuccessful.

The Proposed Regulations can be viewed as establishing three new sets of rules: (1) rules allowing for bifurcation by the IRS of instruments that it determines to be indebtedness in part but not in whole ("bifurcation rules"); (2) rules imposing documentation requirements for certain debt instruments; and (3) rules requiring the recharacterization of debt instruments as stock in specified intercompany transactions ("recharacterization rules"). The Proposed Regulations also contain anti-abuse rules and provisions preventing the affirmative use of the rules by taxpayers.

The recharacterization rules are particularly complex and work to automatically recharacterize debt as stock for federal income tax purposes where debt is issued between members of an expanded group (described below) in a distribution, in exchange for stock, in exchange for property in an asset reorganization or with a principal purpose of funding similar transactions. The recharacterization of the debt as stock requires determining the type or class of stock that the debt would be recharacterized as. Treasury intends for this recharacterization to eliminate the tax benefits associated with transactions that create interest deductions or facilitate the repatriation of untaxed earnings, in particular where the transactions introduce no new capital into the group. The recharacterization may also have various ramifications (e.g., interest payments on the instrument would be recharacterized as dividends, potentially subject to US withholding tax).

The documentation requirements and recharacterization rules apply to transactions between "highly related" parties—specifically, members of an "expanded group" (as described below, an 80 percent ownership threshold by vote or value), while the bifurcation rules apply to transactions between parties with a lower relationship threshold (a 50 percent ownership threshold by vote or value). Disregarded entities and partnerships with corporate members are also covered by the rules, subject to certain modifications. Intercompany indebtedness within a US consolidated group is not subject to the new rules.

Effective Dates of the Proposed Regulations

The Proposed Regulations contain different effective dates depending on the specific rules at issue.

  • Documentation requirements and bifurcation rules: These provisions apply only to related party instruments issued or deemed issued on or after the date the regulations are finalized.
  • Recharacterization rules: These provisions apply to instruments issued on or after April 4, 2016 but there is a transition rule that would characterize such instruments otherwise treated as stock by the regulations as valid indebtedness until 90 days after the date the regulations are finalized.

Brief Highlights of the Proposed Regulations


In the preamble to the Proposed Regulations, Treasury identifies the inconsistent sets of factors considered by the courts, and inconsistent weight given to such factors, in determining whether an instrument is treated as debt or as equity for US federal income tax purposes as the reason for Congress' delegation to Treasury of authority under Code section 385. However, the Proposed Regulations do not clarify or provide guidance on the application of the historic multi-factor tests, but rather impose additional hurdles that must be cleared to obtain debt treatment for certain related party instruments, even if the facts and circumstances analysis supports debt treatment. In so doing, the new documentation requirements appear to be targeted at administrative concerns, allowing the IRS to analyze intercompany debt instruments without receiving "vast amounts of irrelevant documents and material" or dealing with "the inadvertent omission of necessary documents."

The Proposed Regulations set forth four categories of documentation requirements that must be satisfied in order for a debt instrument issued and held within an expanded group to be treated as indebtedness. An expanded group is one or more chains of corporations (including foreign corporations and tax-exempt corporations) connected through stock ownership with a common parent corporation that owns directly or indirectly (including through partnerships) 80% of vote or value of the corporation. If the documentation requirements are not satisfied, the instrument is treated as stock. However, even if the documentation requirements are satisfied, the IRS can still recharacterize the instrument as stock based on its analysis of the US federal tax principles developed under applicable case law.

The documentation requirements only apply to an expanded group where: (i) the stock of any member of the expanded group is traded on an established financial market; (ii) total assets exceed $100 million on any applicable financial statement; or (iii) annual total revenue exceeds $50 million on any applicable financial statement.

In general, the four documentation requirements are written documentation that:

  1. establishes that the issuer has an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates;
  2. establishes that the holder has rights of a creditor to enforce the obligation, such as the right to trigger an event of default for non-payment and to sue to enforce payment and a superior right to shareholders to share in the issuer's assets in case of dissolution;
  3. contains information (e.g., cash flow projections, financial statements, business forecasts, asset appraisals, debt-to-equity ratios and other financial metrics of the issuer in relation to industry averages) establishing that, as of the date of issuance, 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; and
  4. evidences post-issuance actions consistent with a debtor-creditor relationship, such as records of payment and documentation evidencing the holder's efforts to assert its rights or otherwise renegotiate upon non-payment.

Generally, documentation satisfying the first three requirements must be prepared no later than 30 days after the "relevant date," and documentation satisfying the fourth requirement must be prepared no later than 120 days after the "relevant date." The relevant date (or, in some instances, dates) depends on the applicable requirement and the manner in which an instrument becomes subject to these rules.

While these documentation requirements are consistent with the documentation commonly in place for many existing intercompany loan arrangements, the Proposed Regulations' automatic equity recharacterization in the event that either documentation is not maintained or provided to the IRS upon request (subject to a reasonable cause exception) significantly increases the stakes with respect to documentation of intercompany loans. In addition, because the fourth category extends these documentation requirements to post-issuance actions, taxpayers will need to closely monitor compliance with intercompany loan terms throughout the life of the loan in order to avoid this automatic recharacterization rule.


Treasury acknowledges in the preamble to the Proposed Regulations that under applicable case law "the Commissioner generally is required to treat an interest in a corporation as either wholly indebtedness or wholly equity." The preamble describes this result as problematic where the facts and circumstances surrounding a purported debt instrument provide only slightly more support for characterization as debt than as equity (although no concern is expressed as to situations where the facts and circumstances provide only slightly more support for characterization as equity than as debt). The Proposed Regulations would thus "merely" permit the IRS to treat an instrument as in part indebtedness and in part stock to the extent that the IRS' analysis under general US federal tax principles results in such a determination. For example, if the IRS concludes that as of the issuance date it is only reasonable to expect that $3 million in principal amount of a $5 million debt instrument will be repaid, the IRS may treat the instrument as part debt ($3 million) and part stock ($2 million). The Proposed Regulations provide no safe harbor rules or other guidance to taxpayers on how to avoid this recharacterization. Taxpayers may consider using tranched loans or similar arrangements to attempt to proactively address the bifurcation issue.

As noted above, the IRS' bifurcation right applies to debt instruments for which the issuer and holder are members of a "modified expanded group" (the definition for "modified expanded group" follows the expanded group definition, but with a 50 percent ownership measurement as opposed to an 80 percent ownership measurement).


Under the Proposed Regulations, debt instruments issued between members of an expanded group in certain specified transactions are automatically recharacterized as stock. The general recharacterization rule is that a debt instrument is treated as stock if it is issued between expanded group members in: (i) a distribution; (ii) an exchange for stock other than certain asset reorganizations; or (iii) an exchange for property in an asset reorganization to the extent that a shareholder who is a member of the expanded group receives the debt instrument with respect to its stock in the transferor corporation. Under this rule, for example, when a domestic subsidiary of a foreign company distributes a note to its foreign parent (whether or not in exchange for stock), that note is automatically treated as stock regardless of its terms and characteristics, and the transaction is treated as a distribution of stock. Likewise, when foreign subsidiaries of a US-parented group engage in what would otherwise be a Code section 304 transaction or Code section 368(a)(1)(D) reorganization in which a member's debt instrument is issued as consideration, that debt instrument is treated as stock for purposes of analyzing the transaction and subsequent payments on the instrument.

The Proposed Regulations also provide a "funding rule" under which a debt instrument of an expanded group member that is issued with a principal purpose of funding one of the transactions described above (subject to certain modifications) will be treated as stock. In contrast to the recharacterization for all purposes under the general rule, recharacterization of an instrument as equity under the funding rule does not result in recharacterization of the distribution or acquisition that is treated as funded by the instrument.

Although described as a "principal purpose" test, the funding rule includes a non-rebuttable presumption that a debt instrument is issued with a principal purpose of funding an applicable distribution or acquisition if the instrument is issued by the funding member during the period beginning 36 months before the funded member makes an applicable distribution or acquisition and ending 36 months after the applicable distribution or acquisition. This "72-month period" rule is subject to a limited exception for certain debt instruments arising in the ordinary course of the issuer's trade or business.

The Proposed Regulations contemplate an exception to the "funding rule" that would permit a funded member to acquire stock in an affiliate without recharacterizing the debt issued by the funded member if the funded member holds, directly or indirectly, more than 50 percent of the affiliate's stock for the 36-month period following the stock acquisition.

Third-party debt instruments will generally not be subject to recharacterization under these rules, regardless of how the loan proceeds are used (subject to an anti-abuse exception for cases where a debt instrument is issued to, and later acquired from, an unrelated person with a principal purpose of avoiding the application of the recharacterization rules).

These recharacterization rules are subject to certain other exceptions, including: (i) an exception for distributions and acquisitions that do not exceed current year earnings and profits of the distributing or acquiring corporation; and (ii) an exception where the aggregate issue price of all expanded group debt instruments that otherwise would be treated as stock under these rules does not exceed $50 million. Various other rules are also provided on the ordering of transactions, coordination between the general rule and the funding rule, treatment of predecessors and successors, the timing of recharacterization as stock and the deemed exchange of debt for stock resulting from such recharacterization.


Members of a consolidated group (an affiliated group filing a consolidated US federal tax return) are treated as one corporation for purposes of the Proposed Regulations. As a result, an instrument that is both issued and held by members of the same consolidated group is exempted from the documentation requirements and the specified transaction recharacterization rules. The Proposed Regulations also contain rules addressing the treatment of instruments that change status as a result of members departing or joining a consolidated group.

Regulatory Authority for the Proposed Regulations

The Proposed Regulations acknowledge that these proposals mandate outcomes that depart from longstanding debt-equity precedents. One notable example is Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d. Cir. 1956), where the Second Circuit accepted the taxpayer's characterization of a debt instrument issued by a subsidiary to its parent in the form of a dividend. The Proposed Regulations assert that distributions of debt in this form lack non-tax significance and "produce inappropriate results." Accordingly, the Proposed Regulations treat as stock a debt instrument issued by a corporation to a member of the corporation's "expanded group" in a distribution.

As a matter of administrative law, agencies are not necessarily precluded from creating new regulations that effectively overturn prior case law. (See Nat'l Cable & Telecommunications Ass'n. v. Brand X Internet Serv., 545 U.S. 967 [2005].) However, as the IRS' recent loss in Altera Corp. v. Commissioner, 145 T.C. No. 3 (2015) demonstrates, these regulations must be the product of reasoned decision making under the Administrative Procedure Act and represent a permissible interpretation of the statute they implement under the Supreme Court's two-step Chevron standard. (See Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 [1984].)Whether the final version of the Code section 385 regulations will meet these standards depends, in part, on how Treasury and the IRS address evidence and arguments put into the rulemaking record through public comments. As noted above, Treasury will accept comments on these proposals through July 7, 2016.

Regulations Implementing Inversion Guidance

As noted above, the temporary regulations addressing inversion transactions (the "Temporary Regulations") generally incorporate, with certain changes, the rules previously announced in the Notices. However, the Temporary Regulations also introduce a few new rules that were not part of the Notices (notably, the so-called "serial inversions" rule).


Treasury and the IRS voiced their concern that a single foreign acquiring corporation may avoid the application of Code section 7874 by completing multiple acquisitions of domestic entities―each below the 60 percent or 80 percent thresholds for the Code section 7874(a)(2)(B(ii) percentage (the "Ownership Percentage")―where Code section 7874 would otherwise have applied if the acquisitions had been made simultaneously or pursuant to a common plan.

The concern is that each time the foreign acquiring corporation issues stock in connection with the acquisition of a domestic entity, the foreign corporation increases its value, thereby potentially providing a platform to complete larger future domestic acquisitions without exceeding the Ownership Percentage thresholds. According to the preamble to the Temporary Regulations, Treasury and the IRS believe that the application of Code section 7874 in these circumstances should not depend on whether there was a demonstrable plan to undertake subsequent acquisitions of domestic entities at the time of a prior domestic acquisition.

As such, for purposes of calculating the Ownership Percentage, the Temporary Regulations exclude from the fraction's denominator any stock of the foreign acquiring corporation attributable to certain acquisitions of domestic entities completed 36 months prior to the signing date of the domestic acquisition under analysis (regardless of whether the prior acquisition occurred pursuant to the same plan or was otherwise related to the subsequent domestic acquisition).

Stock issued by the foreign acquiring corporation in prior domestic acquisitions would generally not be disregarded under this rule if: (i) the Ownership Percentage for the prior domestic acquisition was less than 5 percent; and (ii) the value of the stock received by the former domestic entity's shareholders in the prior domestic acquisition did not exceed $50 million.

The Temporary Regulations provide that this "serial inversions" rule applies to acquisitions of domestic entities completed on or after April 4, 2016, regardless of when the prior domestic acquisition was completed. As such, acquisitions of domestic entities completed on or after April 4, 2016, may be subject to the "serial inversions" rule even with respect to domestic acquisitions completed by the same foreign acquiring corporation prior to April 4, 2016. The Temporary Regulations provide that this rule will expire on April 4, 2019.


Another new rule introduced by the Temporary Regulations addresses certain successive acquisitions where a foreign corporation that had previously acquired a domestic entity is itself acquired by another foreign corporation.

This rule will apply when:

  1. a foreign corporation (the "Initial Acquiring Corporation") undertakes an acquisition of a domestic entity that does not result in the Initial Acquiring Corporation being treated as a domestic corporation under Code section 7874 (e.g., the Ownership Percentage is less than 80 percent); and
  2. pursuant to that same plan, another foreign corporation (the "Subsequent Acquiring Corporation") acquires the Initial Acquiring Corporation (the "Subsequent Acquisition"). Prior to the Temporary Regulations, the Subsequent Acquisition would not have been subject to Code section 7874 insofar as the regulations excluded from the scope of the rules acquisitions of stock of a foreign corporation.

The Temporary Regulations now provide that if the Subsequent Acquisition occurs pursuant to the same plan as a prior acquisition of a domestic entity, the Subsequent Acquisition will itself be treated as the acquisition of a domestic entity for Code section 7874 purposes. Further, when testing the Subsequent Acquisition, stock of the Subsequent Acquiring Corporation received by the former shareholders of the Initial Acquiring Corporation in the first transaction will be treated as "bad stock" for the calculation of the Ownership Percentage test (i.e., as stock held by reason of holding stock in the acquired domestic corporation).

The Temporary Regulations provide that additional Subsequent Acquisitions (i.e., an acquisition of the Subsequent Acquiring Corporation) occurring pursuant to the same plan are also subject to the same principles.

The multi-step acquisition rule applies to acquisitions of domestic entities completed on or after April 4, 2016, and will expire on April 4, 2019.


Other additions and revisions that the Temporary Regulations make to the Notices include:

  • Introducing a de minimis exception to the "passive assets" (or "cash box" rule).
  • Clarifying that, under the "non-ordinary course distribution" rule (or "anti-skinny down rule"), the amount of the distribution refers to the value of the distributed property at the time of the distribution, disregarding post-distribution fluctuations in value.
  • Clarifying that post-inversion "hopscotch loans" treated as Code section 956 investments may benefit from certain exceptions generally applicable to "U.S. obligations" under Code section 956 (but will not benefit from the "short-term loan" exception discussed below).
  • Including a new "asset dilution" rule under Code section 367(b) requiring gain recognition upon transfers of property by an expatriated foreign subsidiary to a foreign corporation in a foreign-to-foreign exchange that would otherwise be tax-free under Code section 351. Treasury and the IRS are seeking to prevent the transfer of property with significant built-in gain (e.g., intangible property) to a foreign affiliate that is not a controlled foreign corporation (CFC) with the result that, when the gain is later recognized, the earnings escape US taxation (including earnings attributable to gain that had economically accrued within the US tax net prior to the transfer). There is a de minimis exception to this rule.
  • Introducing a de minimis exception to the Code section 367(b) "stock dilution" rule that requires gain recognition in certain integrations of CFCs with non-CFC foreign subsidiaries of the new foreign parent that dilute the US shareholders' ownership in the CFC.
  • Carving out a de minimis exception to the rule that recharacterizes certain post-inversion tax-free transactions that "de-CFC" foreign subsidiaries or otherwise dilute the US shareholders' ownership of these foreign subsidiaries.

The new rules and modifications to the Notices are generally effective on April 4, 2016, while the effective date of the regulations setting forth rules that were already contained in the Notices is the date of the respective Notice (September 22, 2014 for Notice 2014-52 and November 19, 2015 for Notice 2015-79).

Short-Term Loan Exception under Code Section 956

In addition to the rules under Code sections 7874, 367 and 304, the Temporary Regulations incorporate long-standing IRS guidance with respect to the so-called "short-term loan" exception under Code section 956. In this respect, the Temporary Regulations formalize the exception to the definition of "obligation" for Code section 956 purposes that had been announced in Notice 88-108 (and Notices 2008- 91, 2009-10 and 2010-12, for instruments issued between 2008 and 2010).

Under this exception, an obligation will not result in an income inclusion under Code section 956 to the extent that: (i) the obligation is collected within 30 days from the time it is incurred; and (ii) the CFC does not hold US obligations for 60 or more calendar days during its taxable year.


1 Throughout this legal update, “foreign” means “non-US” and “domestic” means “US.”

Originally published 7 April 2016

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