United States: Final And Temporary Debt-Equity Regulations Under Section 385 Implement Highly Favorable Changes

Last Updated: October 26 2016
Article by John D. Bates

On Oct. 13, 2016, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final and temporary regulations under Section 385 governing the treatment of certain instruments as debt or equity for tax purposes. These regulations reflect major changes to the proposed regulations that were issued in April 2016. The changes will significantly reduce the adverse collateral consequences and traps with which the proposed regulations were fraught. The final regulations are much better tailored to the underlying policy goal of limiting stripping of the U.S. federal corporate income tax base through debt instruments between related parties. In large part – subject to future guidance, as many of the changes were "reserved" – the regulations will only impact domestic corporate issuers of debt to related holders that are outside the consolidated group.


Several of the most important changes under, or aspects of, the final and temporary regulations include:

  • The exemption of debt instruments issued by foreign persons from the documentation rules and the transactional rules;
  • The deferral of the implementation of the documentation rules and relaxation of the timing for documentation to the due date of the tax return for the year;
  • The elimination of the bifurcation rule;
  • The retention of the framework of the documentation rules and the transactional rules from the proposed regulations, including the application of the rules to only large corporate taxpayers;
  • The retention of the exemption of debt instruments between members of a consolidated group from the documentations rules and the transactional rules; and
  • The exceptions to the so-called funding rule for certain debt instruments that are short term, issued in the ordinary course of business, or issued pursuant to cash pooling arrangements.

Although the final and temporary regulations are much narrower in scope than the proposed regulations, they retain the general framework of the documentation rules and transactional rules from the proposed regulations. Many large corporate taxpayers will need to understand and comply with these rules. Despite the fact that the final and temporary regulations target earnings stripping by foreign-parented multinational companies, they apply neutrally and can apply to U.S.-parented multinational companies as well.

For taxpayers that are covered, the additional compliance burden of the documentation rules, and potential consequences of noncompliance, could be significant. Failure to comply with the documentation rules, subject to certain exceptions for foot faults, will result in equity characterization; compliance with the documentation rules alone, however, will not ensure that a debt instrument will be respected as debt. Common law factors and the potential application of the transactional rules still must be considered.

The transactional rules remain exceedingly complex and unforgiving if they apply. They must be added to the checklist of potential tax issues in any transactions involving debt instruments between related parties.

Background: Proposed Regulations

The proposed regulations included a bifurcation rule, documentation rules, and transactional rules. The documentation rules and transactional rules apply only to large corporate taxpayers, whereas the bifurcation rule would have applied more broadly, including to certain small or non-corporate taxpayers.

Bifurcation rule. The bifurcation rule would have granted the IRS the right to bifurcate a debt instrument as part-debt and part-equity in certain circumstances.

Documentation rules. The documentation rules establish certain documentation and procedural requirements relating to debt instruments between related parties, and allow the IRS to treat debt instruments as equity if the requirements are not satisfied. They also clarify the factors to be considered in distinguishing between debt and equity in certain circumstances.

Transactional rules. The transactional rules automatically treat debt instruments between related parties as equity in specified circumstances. The rules are aimed at situations in which, viewed economically, the capital of the issuer of a debt instrument is not increased. The paradigmatic covered transaction is a distribution by the corporate issuer of a debt instrument to a shareholder. The other covered transactions are economically comparable to that basic transaction. The transactional rules also include broad anti-abuse rules.

Overall Changes in Final and Temporary Regulations

The most significant overall changes in the final regulations are:

Exemption of Foreign Issuers. The final regulations, including the documentation rules and the transactional rules, do not cover debt instruments issued by foreign persons. This exemption applies exclusively based on whether the issuer is a foreign person and does not depend on the identity of the holder. Thus, as an example, a debt instrument issued by a controlled foreign corporation (CFC) to a related CFC or related domestic corporation will not be subject to the final regulations. This carve-out is extraordinarily important – it drastically will reduce the number of debt instruments covered and will obviate some of the most troubling aspects of the transactional rules as they had been proposed. This exception, combined with the general exemption of debt instruments between members of a consolidated group, means that the final regulations will apply primarily to debt instruments issued by domestic corporations to related foreign corporations, or between related domestic corporations outside of the consolidated group context. The change also limits the additional compliance burden of tax due diligence in acquisitions of groups with foreign corporations.

Elimination of Bifurcation Rule. The final regulations do not include the bifurcation rule. The bifurcation rule in the proposed regulations would have applied to debt instruments between members of a modified expanded group, a concept that was more expansive than that of an expanded group, on which the documentation rules and transactional rules were based. The bifurcation rule was vexing because, among other reasons, the proposed regulations provided minimal guidance on the circumstances in which it would have been applied, and how it would have been applied. Treasury and the IRS did not include the bifurcation rule in the final regulations, indicating that they will continue to study it.

Exemption of S Corps and certain RICs and REITs. The final regulations exempt S corporations and certain regulated investment companies (RICs) and real estate investment trusts (REITs) (if the RIC or REIT is the parent of the group) from both the documentation rules and the transactional rules.

Changes to Documentation Rules

The most significant changes to the documentation rules in the final regulations are:

Deferral of date by which documentation must be completed. The proposed regulations would have required a taxpayer to satisfy certain of the documentation requirements within 30 days of the issuance or other relevant event. This would have imposed a highly challenging ongoing compliance burden. Under the final regulations, the documentation and financial analysis for a year must be completed by the due date for the tax return for that year, taking into account any extensions. This change accords with the timing requirements for preparing transfer pricing documentation and will reduce the risk of unintentional failures to comply.

Deferral of effective date of documentation rules. Under the proposed regulations, the documentation rules would have been effective for debt instruments issued on or after the date that the final regulations were published. The final regulations, however, defer the effective date, so that the documentation rules will apply to debt instruments issued on or after Jan. 1, 2018. This deferral, combined with the deferral of the date by which the documentation must be prepared, means that a taxpayer will first need to complete documentation by the due date for its tax return for its taxable year that includes Jan. 1, 2018. This change affords taxpayers more time to establish the necessary documentation processes and systems.

Provision of substantial compliance exception for failures to satisfy documentation requirements. The proposed regulations would have included only a limited exception for reasonable cause; otherwise, the IRS automatically would have treated a debt instrument as equity if the documentation requirements were not satisfied. The final regulations retain a reasonable cause exception and introduce a new rebuttable presumption if the expanded group substantially complies with the documentation requirements. If the expanded group satisfies certain objective tests demonstrating substantial compliance, a documentation failure with respect to a debt instrument will not automatically cause it to be treated as equity. Rather, the debt instrument will be presumed to be equity, and the presumption may be rebutted with clear evidence that the instrument is debt under traditional debt-equity factors.

Avoidance of "springing" partnerships. Under the proposed regulations, if a debt instrument issued by a disregarded entity were treated as equity, the disregarded entity could have become classified as a partnership – the existence of a second regarded equity owner would have caused the partnership to spring into being. The final regulations avoid this result, deeming the equity to be issued by the owner of the disregarded entity.

Changes to Transactional Rules

The most significant changes to the transactional rules in the final and temporary regulations are:

Exceptions to funding rule for certain debt instruments that are short term, issued in ordinary course of business, or issued pursuant to cash pooling arrangements. The proposed regulations did not include an exception for cash pooling arrangements, an aspect that was heavily criticized, instead providing only an exception for certain debt instruments issued in the ordinary course of business. The temporary regulations fold the proposed regulations' exception for debt issued in the ordinary course of business into a new, broader exception to the funding rule (not to the general rule and not to the documentation rules). The new exception covers:

- certain short-term funding arrangements satisfying one of two alternative objective tests between which a corporation must elect, one of which is based on the corporation's need for short-term financing, and the other of which is based on certain day-counts;

- debt instruments issued as consideration for purchases of property in the ordinary course of business;

- certain interest-free loans; and

- deposits made pursuant to certain cash pooling arrangements.

The final regulations also exempt certain debt instruments issued for stock of members of the expanded group used as compensation for employees or contractors and certain debt instruments established in connection with transfer pricing adjustments. The exception for cash pooling arrangements involves technical requirements – as a practical matter, however, the exemption for debt instruments issued by foreign persons and the general exemption for debt instruments between members of a consolidated group might exempt some cash pooling arrangements completely. This is because a cash pooling arrangement involving only foreign persons or only members of a consolidated group likely will not trigger the documentation rules or transactional rules, and it is common for multinational companies to use separate cash pooling arrangements for domestic and foreign affiliates for other tax reasons, particularly avoiding Subpart F inclusions under Section 956.

Exemption of certain regulated financial institutions and insurance companies from the transactional rules. The final regulations provide a new exception to the transactional rules for debt instruments issued by certain regulated financial institutions, members of regulated financial groups, and regulated insurance companies.

Expansion of exception based on earnings and profits (E&P). The proposed regulations would have provided an annual exception under the transactional rules up to the current-year E&P of the relevant corporation. The final regulations expand the exception to apply in any year up to the E&P of the corporation accumulated in taxable years ending on or after April 5, 2016. This benefit comes at the cost of added complexity in tracking the eligible E&P.

Elimination of "cliff effect" for under $50 million threshold exception. Under the proposed regulations, the transactional rules would not have applied if the aggregate amount of the debt instruments that otherwise would have been recast as equity under the transactional rules did not exceed $50 million. If, however, the $50 million threshold would have been exceeded, the exception would not have applied at all. The final regulations eliminate this cliff effect, providing that the exception will apply up to the first $50 million of debt instruments that otherwise would be recast as equity, regardless of whether the threshold is exceeded.

Expansion of 90-day deferral. Under the proposed regulations, any debt instruments issued on or after the date the proposed regulations were issued but before the publication of final regulations would not have been recast as equity under the transactional rules until 90 days after the publication of the final regulations. This would have provided a limited period during which taxpayers could have cleaned up problematic debt instruments. The final regulations retain the 90-day grace period, and expand its scope to apply to any debt instrument that is issued within 90 days after the date that the final regulations are published.

High-Level Observations

In the aggregate, these changes better align the documentation rules and transactional rules with the policy behind the regulations. They make it far less likely that taxpayers will inadvertently trip into the rules, and the potential adverse collateral consequences are mitigated.

Nonetheless, the final and temporary regulations will apply to many corporate groups, and it will be necessary for taxpayers to determine whether any of their debt instruments or practices will be covered. Taxpayers should first clean up any problematic debt instruments and then put in place policies to comply with or, if possible, avoid the final and temporary regulations.

Several of the new carve-outs, including the elimination of the bifurcation rule and the exemption of debt instruments issued by foreign persons, are "reserved." Treasury and the IRS continue to study these issues. They have indicated, however, that any additional rules on these issues will apply prospectively.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions