Proposed Changes to Section 385 Regulations: Will the IRS Create a Debt-Equity Chimera?

In April 2016, the Treasury Department proposed regulations under section 385 of the Internal Revenue Code regarding debt and equity classifications of certain corporate interests. The Department stated that these proposals would target foreign inversions where corporate groups relocate tax residences abroad through the purchase of foreign companies and then engage in earnings stripping to further diminish taxable profits. One way to strip earnings is by taking loans from a foreign affiliate in a corporate group and then sending U.S. profits back to that related party in the form of tax-deductible interest payments on the debt.

Whether these loan instruments are classified as debt or equity by the IRS is a difference with significant tax implications. The proposed regulations under section 385 could alter the way these instruments are classified, but the regulations’ effect on inversions and the extent of their unintended consequences are still unclear. Read on to learn more about the section 385 proposed regulations and how they might impact your company or corporate clients.

Debt, Equity, and Existing Law

Corporations structure their capital investments as debt or equity based on business and tax considerations. Traditionally they’ve had flexibility in designing their instruments as debt or equity. However, Congress has given the Treasury Department authority to make rules clarifying when a corporate interest is classified as debt or equity for tax purposes using factors such as:

  • Is there a written unconditional promise to pay a sum of money with interest?
  • Is the interest subordinate to or preferred over other corporate indebtedness?
  • What is the ratio of debt to equity of the corporation?
  • Is the interest convertible into stock of the corporation?
  • What is the interest’s relationship to stock holdings in the corporation?

What Would the Proposed Regulations Do?

Among other things, the section 385 proposed regulations would allow the IRS to:

  • Treat a single corporate instrument as part debt and part equity for tax purposes
  • Re-characterize a debt instrument as equity for tax purposes
  • Impose stricter documentation requirements for establishing a debt instrument

Although they’re intended to target foreign inversions, the proposed regulations would also apply to purely domestic corporate groups, increasing the regulations’ scope and potential market impact. While they would be limited to related-party transactions within corporate groups, it should be noted that the regulations use expansive definitions of corporate groups which could put your company or clients within their reach.

The proposed regulations also contain specific documentary requirements for establishing a debt instrument, although they would only apply to large corporate groups, meaning those that are publicly traded, have assets in excess of $100 million, or have revenue exceeding $50 million. To be classified as debt for tax purposes, a corporate instrument would need timely documentation showing:

  • A binding obligation to repay the funds advanced
  • Creditors’ rights to enforce the terms of the debt
  • A reasonable expectation that the funds advanced can be repaid (based on cash flow projections or other relevant financial data)
  • Actions evidencing an ongoing and genuine debtor-creditor relationship (such as documentation of timely payments and reasonable creditor conduct in the event of defaults)

The Potential Impact of the Proposed Regulations

The section 385 proposed regulations would likely lead to greater IRS scrutiny of related party transactions at home and abroad. However, where a true debtor-creditor relationship exists between related parties, debt instruments could still be used to send U.S. profits to foreign affiliates through deductible interest payments. Therefore, the impact of the proposed regulations on foreign corporate inversions and earnings stripping might be minimal, unless Congress decides to reduce the cap for allowable tax-deductible interest within related parties, which was set at 50% in 1989.

Given their potentially broad impact, the proposed regulations could also have the unintended consequence of creating additional costs and burdens for domestic corporate groups not engaging in foreign inversions. With these uncertainties, the proposed regulations would likely impact your company or corporate clients in the years to come.

Learn More About the Section 385 Proposed Regulations

The proposed regulations contain many detailed provisions that have the potential to significantly shape tax law. For a more extensive analysis on the proposed changes to Section 385 and how they may impact your company or clients, an exclusive report “The New Section 385 Proposed Regulations: No More Alice in Wonderland” is available for free from Checkpoint Special Reports. Checkpoint is an industry leader when it comes to expert information for tax, accounting, and finance professionals. Checkpoint subscribers stay ahead of the curve with tax and legislative updates and have access to the fastest and most efficient way to perform tax research online.

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