November 04, 2019

Section 385 Treasury Regulations Developments


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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.

Authors and Contributors

Larry Crouch



+1 212 848 4431

+1 212 848 4431

+1 650 838 3718

+1 650 838 3718


Jay M. Singer



+1 202 508 8117

+1 202 508 8117