Proposed §385 Regulations Go Way Too Far

Bloomberg BNA’s Premier International Tax Library is a comprehensive global tax resource. Trust Bloomberg BNA's Premier International Tax Library for the guidance you need on...

James J. Tobin, Esq.

By James J. Tobin, Esq. Ernst & Young LLP New York, New York

This commentary focuses on the extensive and very complex proposed regulations under §385 issued on April 4, 2016 (the Proposed Regulations). The Preamble alone exceeds 75 pages, more than the Proposed Regulations themselves! A lot has been written about the Proposed Regulations and, given the limited space for this commentary, I cannot do justice to a full analysis of the Proposed Regulations nor the full depth of my concerns and disapproval. So I'll just comment on a few highlights (and lowlights) that hopefully can add to the debate.

Section 385 was enacted as part of the Tax Reform Act of 1969 and authorizes the Treasury Department (Treasury) to promulgate, in part, regulations “to determine whether an interest in a corporation is to be treated for [U.S. tax purposes] as stock or indebtedness.” Further, the statute provides that such regulations “ shall set forth factors” which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists, and provides a non-exclusive list of factors that might be taken into account in making that determination.

Treasury issued proposed and final regulations under §385 in 1980 that were subsequently withdrawn, presumably after recognition of their many problems. I have a warm spot in my heart for those regulations. I was a tax manager for Arthur Young when those regulations were issued and spent many hours identifying problems with those regulations, which I'm sure helped my development as an international tax practitioner and promotion to partner. Although those regulations were ultimately withdrawn, happily my promotion to partner was not.

Treasury had hinted at possible earnings-stripping guidance under §163(j) to attack inversion transactions but ultimately selected a less focused option to take on earnings-stripping and sweep in other transactions, some would argue with the encouragement of certain interested commentators. As described below, I think they significantly overshot by using what it perceived as a more comprehensive grant of regulatory authority under §385 .

I'll focus this commentary on Prop. Reg. §1.385-2, the “threshold” documentation and information rules, and Prop. Reg. §1.385-3, the per se stock rules. Keep in mind, as I'll point out repeatedly, that the Proposed Regulations apply to all related-party debt (generally an 80% common stock ownership threshold (by vote or value)), whether issued by a U.S. corporation, a foreign corporation (whether or not a CFC), a partnership, or a disregarded entity. It seems clear that Treasury's zeal in attempting to limit base erosion by foreign-owned U.S. corporations (whether or not qualifying as expatriated entities under §7874 ) distracted them from the complexities and collateral effects of the Proposed Regulations in the broader context and from the certain consequential commercial impacts which could be expected. More below…

Prop. Reg. §1.385-2 sets forth significant documentation and information reporting requirements for debt instruments issued by a member of an expanded group to another member of the expanded group. The documentation and information reporting must establish the following in order for an instrument to potentially constitute indebtedness for U.S. tax purposes (necessary but not sufficient conditions):

  •  An unconditional binding obligation to repay a sum certain;
  •  Creditors' rights to enforce the debt;
  •  Documentation of the issuer's financial position supporting a reasonable expectation that the funds can be repaid; and
  •  Action evidencing a genuine creditor–debtor relationship.


These four elements constitute threshold requirements that must be satisfied within 30 days of the issuance of a related-party instrument (except for item four). Subject to a reasonable cause exception, failure to satisfy any requirement will result in the instrument being treated as stock for U.S. tax purposes. Satisfying the documentation requirements doesn't insure debt status but permits the instrument to be treated as debt if an analysis under general U.S. tax principles results in that determination. The Preamble makes the point that one of Congress's motivations in authorizing Treasury to issue regulations was “the inconsistent analysis of the relevant factors by different courts…” and thus the need for more certain standards. Instead, the Proposed Regulations merely add costs and the administrative burden of threshold documents for all intercompany debts but with no added certainty, as all of the “inconsistent” case law still would have application. Plus, the Proposed Regulations make it clear that taxpayers cannot use a lack of documentation affirmatively to assert that debt should be treated as stock if there is a principal purpose of reducing the U.S. tax liability of an expanded group member. I'll comment on the practical impact of this below.

Some reactions to the documentation and information reporting requirements:

  •  Judicial precedents make clear that taxpayers must establish that related-party debt in fact has debt-like characteristics, which generally must be based on the documentation and information listed in the Proposed Regulations. The focus of the IRS, taxpayers, and case law has been predominantly on debt of U.S. taxpayers the interest on which produces a U.S. tax deduction. Requiring the same documentation rules for all CFC and foreign corporation debt is at best an unreasonable trap for the unwary and could result in an uncompetitive burden on U.S. multinationals where there could be substantial potential impact to a recharacterization. Foreign countries will have their own debt-versus-equity standards in any event and while an overlay of commercial reasonableness where there is relevance from a U.S. tax standpoint is understandable, a strict set of contemporaneous documents for foreign-to-foreign debt is not.
  •  The 30-day time limit and automatic default to equity treatment is ridiculous and, given the complexity of the treasury positions of large multinational groups, totally unworkable.
  •  Subjecting all related-party debt to the documentation requirements, including ordinary course trade payables and cash pooling arrangements, can't be taken seriously. The Preamble asks for comment in this area, which implies Treasury recognizes this needs to be fixed. Indeed, Treasury has commented on its intent to “fix” the regulations with respect to cash pooling. I'll hold further comment until I see “the fix.”
  •  The threshold requirements of the Proposed Regulations are proposed to apply to instruments issued on or after the final regulations are published in the Federal Register. It seems prudent for companies to review their existing debt agreements and in the future to carefully consider when debt is deemed reissued due to amendments to its terms under Reg. §1.1001-3 .


Prop. Reg. §1.385-3 provides per se recharacterization rules that would treat as stock certain debt instruments in connection with the following proscribed transactions:

  •  In a distribution on stock;
  •  In exchange for stock of an expanded group member; and
  •  As payment for assets acquired in an internal asset reorganization (so-called “boot”).


As a backstop, the Proposed Regulations include a “funding rule” which provides that any related-party debt incurred to fund any of these three types of transactions is also treated as equity. The funding rule provides an unrebuttable presumption that, where any of the three transactions above occurs within 72 months (36 months before and 36 months after) of the related-party loan, the related-party loan would be deemed connected and equity treatment would result.

These per se rules would apply to debt instruments issued on or after April 4, 2016, but any instruments issued on or after that date but before final regulations are published in the Federal Register would not be deemed stock until the 90th day after final regulations (if ever) are published.

There are tremendous complexities in these rules, particularly around how the funding rule will operate. There is also some discussion of the complexity of treating the debt as equity for all U.S. tax purposes and what the collateral effect of such treatment is. But I think the regulations and Preamble merely scratch the surface of some of these complex issues and I fear, as stated above, that the collateral effects were not sufficiently considered. Some observations:

  •  First of all, as noted above, it is questionable whether §385 grants Treasury authority to issue per se rules such as these. Section 385(a) and §385(b) grant broad authority to prescribe regulations but the focus is on treatment of an instrument and the factors relating to that instrument — not merely who holds the instrument and the context in which the instrument was issued. The Preamble indicates Congress was focused on “situations and circumstances” to be taken into account in determining whether an instrument is debt or equity and notes that Congress indicated the factors listed in §385(b) need not necessarily be included in any such regulations. But considering the entire legislative history of the 1969 Act, it seems clear to me Congress did not expect and did not intend for Treasury to go this far. Indeed, by enacting §279 (which denies interest deductions on certain acquisition debt) in the same public law, Congress expressed concern about the potential for base erosion in the M&A context but rather than denying deductions for all acquisition debt, it limited the disallowance to situations where the debt contains a significant equity-like factor — either convertibility or subordination. So it is difficult to conclude that Congress intended for equity treatment simply based on the ownership of debt by a related party that used the funds in a certain way. There was already significant case law at the time which made clear that related-party ownership alone did not result in equity treatment (including the Kraft case, which involved a distribution of a note, cited in the Preamble) so if they disagreed they could easily have made the point clear. Having said all that, recourse to challenging the validity of a regulation is not an attractive option; hopefully Treasury can be persuaded to more thoughtfully limit the scope of the Proposed Regulations or more appropriately permit Congress to deal with any statutory changes in our law needed to combat inversions and base erosion. The House Ways and Means Committee has expressed interest in doing so and seems to believe that, that is the appropriate course of action.
  •  The per se rule could convert a transaction from a taxable dividend distribution (of a note payable) into a §305 stock distribution — likely tax-free but maybe not if the stock deemed issued is considered non-qualified preferred stock. Likewise it could convert a §304 transaction into a §1001 exchange. A debt instrument recast under the funding rule would not be expected to change the tax treatment of the underlying funded transaction, e.g., dividend or §304 transaction. But in both cases the consequence of treating debt as stock would obviously reduce deductible interest expense and have significant consequences on repayment (e.g., potential dividend treatment under §302 ). The use of unrelated debt to fund these or other tainted transactions would not result in either a recharacterization of the per se transaction or of the revised treatment of interest or principal payments. Thus, there will likely be a strong attraction to the use of external debt, particularly in the inbound context. Is it really good fiscal policy to incentivize multinationals to increase their external leverage?
  •  As with the documentation rules, the per se and the funding rule provide that taxpayers cannot affirmatively use the rule to recharacterize debt if a principal purpose of doing so is to reduce the U.S. tax liability of any member of the group. Seems to me one will be hard pressed to ever conclude whether the per se or funding rule will apply. To the extent that application of the per se rule turns off dividend treatment, there will often be a withholding tax consequence in the inbound context so the tax of the recipient of what is no longer a dividend will likely go down. So a taxpayer might have to wait for the IRS to choose to apply the rule after they determine whether the base erosion result was greater than the withholding tax cost? Likewise in the outbound context, a comparison of deemed dividend and resulting E&P movement with no such dividend could reduce U.S. tax to some affiliates and increase U.S. tax to others, which may not even be knowable for some time depending on future dividends up the chain. Must one wait for the IRS to use hindsight to discern the highest tax results?
  •  The 72-month, non-rebuttable presumption incorporated in the funding rule is in my view patently unreasonable and bound to cause unintended consequences. Assume a foreign-owned U.S. company borrows from a related party to make an acquisition and fully documents all aspects of the loan. That company would need to be sure it did not make a distribution of more than current E&P within the last three years and be sure not to make one for the next three years (which restriction could be further complicated or possibly extended by the complex predecessor/successor rules which are beyond the scope of this commentary). Such constraint creates a kind of “lock-in” effect and could make the United States a less attractive destination for investment. In the outbound context, the presumption would similarly constrain dividends out of and within a CFC group in the case of any intergroup lending exacerbating the lock-out effect already created by our uncompetitive worldwide high-tax regime.


Lots more to complain about, including the treatment of debt instruments issued by disregarded entities and partnerships, possible impact of the OECD BEPS anti-hybrid rules, the consolidated return, the Subchapter C, S corporation, and §902 impacts of being deemed to have issued non-voting, preferred stock, the predecessor and successor rules, and the impact on financial services groups. But space constraints will spare readers from rants on these topics, at least for now. I am sure others will weigh in with comments in those and other areas.

I realize I have a tendency to be a bit critical of guidance from the United States and many foreign governments. I do think it's generally justified as I feel that in the current environment there is too much focus on preventing perceived abuse and little if any concern about collateral damage to non-abusive transactions and to commercial consequences generally. But it would be a shame if my prior criticisms in any way undermined my complaints on these Proposed Regulations — maybe the boy-who-cried-wolf syndrome? Because, in my view, these Proposed Regulations really are the worst example of the one-sided approach referred to above I have seen. I consider the Proposed Regulations replete with inappropriate (and hopefully unintended) consequences, over-inclusive, and in many respects unadministrable, all in an attempt to fix perceived abuse which, if addressed at all, should more appropriately be addressed by legislation. Hopefully, these regulations will disappear more quickly than the 1980 version.

Copyright © 2016 Tax Management Inc. All Rights Reserved.