On May 13, 2020, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) released regulations finalizing previously proposed regulations under Internal Revenue Code Section 385 regarding the treatment of certain interests in corporations as stock or indebtedness for U.S. federal tax purposes (the 2020 Final Regulations).1 The 2020 Final Regulations generally affect corporations (and partnerships with corporate partners) that issue debt to related corporations or partnerships. The 2020 Final Regulations are the latest — but not the last — in a series of final, temporary and proposed debt/equity regulations issued by Treasury and the Service and related administrative guidance, beginning with the issuance of a sweeping and controversial set of proposed regulations in April 2016 (the April 2016 Proposed Regulations). The 2020 Final Regulations are effective as of May 14, 2020.

Section 385 authorizes the secretary of the treasury to issue rules to determine whether an instrument is equity or debt for purposes of the Code. Following the issuance of the April 2016 Proposed Regulations, in October 2016 Treasury and the Service issued both final regulations (the October 2016 Final Regulations) and temporary regulations (the October 2016 Temporary Regulations) under Section 385 (collectively, the October 2016 Regulations), as well as proposed regulations that merely cross-referenced the October 2016 Temporary Regulations (the October 2016 Proposed Regulations).2 The October 2016 Regulations included, among other provisions,3 Treasury Regulation Section 1.385-3 and Temporary Treasury Regulation Sections 1.385-3T and –4T, which treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes (collectively, the Distribution Rules). The October 2016 Regulations were, and the October 2016 Proposed Regulations were proposed to be, applicable to taxable years beginning on or after Jan. 19, 2017.

The Distribution Rules set forth in the October 2016 Regulations aim to thwart the issuance of debt instruments that do not fund any new investment in the operations of the issuer and potentially create significant U.S. federal income tax benefits absent meaningful non-tax economic effects. In sum, under the basic Distribution Rule, subject to certain exceptions, the issuance by a "covered member" of a "covered debt instrument" to a member of an "expanded group" in a distribution, in exchange for stock of an expanded group member (other than in an exempt exchange) or in exchange for property in certain asset reorganizations, could result in the treatment of such instrument as equity for federal tax purposes, thereby precluding a deduction by the issuer with respect to any purported interest payments thereon.4

In addition to the basic Distribution Rule, subject to certain exceptions, a covered debt instrument issued to an expanded group member in exchange for cash or other property may be recast as equity if it is issued for a principal purpose of funding a distribution or acquisition of the types captured by the basic Distribution Rule (the funding rule). While a determination of whether the instrument was issued with such a principal purpose rests on all the relevant facts and circumstances; under a per se rule, an instrument will automatically be treated as funding a distribution to an expanded group member or acquisition of the types described above if it was issued during the period beginning 36 months before, and ending 36 months after, such distribution or acquisition and is outside the ordinary course of the issuer's trade or business.   

The October 2016 Temporary Regulations expired in October 2019. Treasury and the Service announced in an October 2019 notice that, after such expiration, taxpayers generally could rely on the October 2016 Proposed Regulations until further notice. In November 2019, Treasury and the Service issued an advance notice of proposed rulemaking (the Advance Notice) in which they expressly declined to withdraw the portion of the October 2016 Regulations setting forth the Distribution Rules, on the ground that a complete withdrawal of the Distribution Rules could restore incentives for multinational corporations to generate additional interest deductions without new investment. Instead, Treasury and the Service announced their intention to issue regulations containing more streamlined and targeted Distribution Rules in the form of proposed regulations, and indicated such revisions could include a substantial modification of the funding rule and the withdrawal of the per se rule discussed above.5

The Treasury Decision published in connection with the 2020 Final Regulations provides no elaboration or other guidance with respect to the modifications to the Distribution Rules contemplated by the Advance Notice. Rather, the Treasury Decision states only that Treasury and the Service continue to study the appropriate approach to revising the Distribution Rules. Because the October 2016 Temporary Regulations contained a portion of the Distribution Rules that Treasury and the Service believe continue to be necessary at this time, the Treasury Decision simply finalizes the October 2016 Proposed Regulations without any substantive change and withdraws the expired October 2016 Temporary Regulations. Thus, the Distribution Rules laid out in the October 2016 Regulations remain effectively unaltered, and taxpayers must continue to wait for any loosening thereof.


1. See T.D. 9897 (the Treasury Decision). All section references are to sections of the Internal Revenue Code of 1986, as amended (the Code), and Treasury regulations promulgated thereunder, unless otherwise indicated.

2. The October 2016 Temporary Regulations provided rules addressing the treatment of instruments issued by partnerships, consolidated groups and certain transactions involving qualified cash-management arrangements. The text of the October 2016 Temporary Regulations served as the text of the October 2016 Proposed Regulations. For our discussion of the October 2016 Regulations, see https://www.kramerlevin.com/en/perspectives-search/us-treasury-finalizes-regulations-recharacterizing-certain-debt-between-related-parties-as-equity.html.

3. The October 2016 Final Regulations also contained certain threshold documentation requirements that had to be met (subject to certain exceptions) in order for certain related-party interests issued by a corporation to be treated as indebtedness for federal tax purposes (the Documentation Rules). In September 2018, Treasury and the Service issued proposed regulations that proposed withdrawal of the Documentation Rules. Such proposed regulations were finalized, with the result that the Documentation Rules were withdrawn in November 2019 (the November 2019 Final Regulations). For our discussion of the November 2019 Final Regulations, see https://www.kramerlevin.com/en/perspectives-search/debt-equity-dashed-expectations-treasury-and-the-service-retain-onerous-section-385-regulations.html.

4. In general, a "covered debt instrument" is a debt instrument issued after April 4, 2016, other than certain specialized and short-term debt instruments. A "covered member" is a member of an "expanded group" that is a domestic corporation. An "expanded group" generally is a group of corporations at least 80% (by vote or value) of whose interests (other than equity of the parent member) are owned, directly or through certain attribution rules, by other group members.

5. For our discussion of the Advance Notice, see https://www.kramerlevin.com/en/perspectives-search/debt-equity-dashed-expectations-treasury-and-the-service-retain-onerous-section-385-regulations.html.

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