The U.S. Internal Revenue Service rocked the tax world in April 2016 by issuing proposed regulations under Section 385 of the U.S. Internal Revenue Code. The proposed regulations were issued in response to perceived abuses involving so-called “inversion” transactions but had a much broader reach. They would have dramatically and unfavorably changed long-established rules and practices for distinguishing between debt and equity issued between related parties. These regulations have now been finalized and, while still far-reaching, the final regulations have a narrower scope and impose a lighter administrative burden than the April version of the regulations. Fortunately for the private equity industry, common fund structures and portfolio company borrowings are now much less likely to be caught by the final regulations than would have been the case had the regulations been adopted as originally proposed.

The Regulations Recharacterize Certain Debt as Equity

The final Section 385 regulations apply to debt issued by a U.S. corporation to another corporation that is part of the same “Expanded Group.” An Expanded Group generally means a group of corporations that are directly or indirectly 80%-owned (by vote or value) by a common parent corporation. As noted above, the regulations proposed last April were issued in response to perceived abuses involving inversion transactions, which often use intercompany debt to reduce the taxes paid by U.S. members of the corporate group. However, the scope of the regulations was and is not limited to these “earnings-stripping” transactions. In a drastic departure from decades of settled law and practice, both the proposed and final regulations automatically recharacterize debt issued by one Expanded Group member to another (an Expanded Group Instrument or EGI) as equity for U.S. federal income tax purposes in some cases, even though the EGI would be treated as debt under general U.S. tax principles. Once recharacterized, interest payments on the debt instrument will no longer be deductible, and will instead be treated as distributions on equity potentially subject to U.S. withholding tax if paid to a non-U.S. member of the Expanded Group. 1

To avoid recharacterization, EGI issuers must satisfy documentation requirements each time they issue debt to another Expanded Group member. The documentation must contain evidence of the following:

  • an unconditional obligation to pay a sum certain,
  • the holder’s legal rights as a creditor (for example, the right to cause an event of default or acceleration of the EGI),
  • a reasonable expectation of repayment (which may consist of cash flow projections, financial statements, business forecasts, etc.) and
  • actions evidencing an ongoing debtor-creditor relationship (including evidence of payments of principal and interest or, in the event of default, evidence of the EGI holder’s reasonable exercise of its creditor’s rights).

Fortunately, the final regulations extended the time period for satisfying the documentation requirements to the date the EGI issuer is required to file its federal income tax return (including extensions). EGI issuers must also navigate a complex “funding rule” that automatically recharacterizes as equity an EGI issued within 36 months before or after a dividend distribution or certain intragroup acquisitions by the EGI issuer, absent an applicable exception. The documentation requirements apply to debt issued on or after January 1, 2018, while any EGI issued on or after April 5, 2016 is at risk of recharacterization under the funding rule.

The Final Regulations Are Onerous, But Less So Than Those Originally Proposed

So, where’s the good news for the private equity industry? For starters, the regulations as originally proposed threatened to extend these rules to loans made by investments funds to “blocker” corporations, but the IRS did not do so in the final regulations. Under the final regulations, blocker loans are generally outside of the scope of these rules unless the blocker corporation is directly or indirectly owned by an 80% corporate shareholder and is a domestic corporation. This could occur where (1) a domestic blocker corporation is established for a single corporate investor in a fund of one or a separately managed account or (2) an offshore feeder entity, treated as a corporation for U.S. tax purposes and established for non-U.S. and tax-exempt investors, makes an investment through a domestic blocker corporation. The IRS noted that it continues to study blocker loans. Although blocker loans are not covered by the final regulations, private equity funds may find it prudent to comply with the documentation requirements to better withstand any IRS challenges to debt characterization of blocker loans under a general debt-equity analysis.

The final regulations also turn off certain “downward” attribution rules that, under the proposed regulations, would have created Expanded Groups from corporations that are only marginally related to each other. For example, under a literal reading of the proposed regulations, a bank and a private equity fund’s corporate portfolio company would be members of an Expanded Group if the parent of the bank owned any interest in the private equity fund, no matter how small. As a consequence, any loan made by the bank to the portfolio company would have been subject to potential recharacterization under the proposed regulations. These downward attribution rules have been eliminated from the final regulations.

Of good news more generally, the final regulations allow EGI issuers to make distributions out of earnings and profits accumulated since April 4, 2016 without triggering automatic recharacterization under the funding rule, a more generous look-back period than was provided under the proposed regulations. In addition, the final regulations allow certain contributions of equity to the Expanded Group member to shield distributions that are not otherwise protected by the earnings and profits exception. The final regulations also exempt the first $50 million of debt of an Expanded Group from recharacterization. And unlike the proposed regulations, the final regulations exempt debt issued by non-U.S. corporations and S corporations.

Despite these improvements, the final regulations remain very complex and impose new burdens and limitations on common intercompany financing transactions at the portfolio company level, such as debt push-down transactions. As a result, advice on proper structuring is essential.

A Final Thought

The regulations remain controversial and were heavily criticized by the business community and by Republican Congressional leaders, who said that they were rushed through the approval process for political reasons. Given the election outcome, might the Trump Administration scrap the final regulations? Only time will tell. Stay tuned.


1 As background, there are important differences between the tax treatment of debt and equity. Interest on debt is deductible, and dividends are not. Repayments of principal on debt are not taxable, while payments on equity are generally treated as taxable dividends. Finally, dividends are generally subject to withholding taxes when paid to non-U.S persons, while principal and most interest payments on debt are not.