Getting Ahead of the New Documentation Requirements of Proposed Sec. 385 Regulations

On April 4, 2016, the U.S. Treasury Department proposed new regulations aimed at stopping corporate inversions and eliminating the earnings stripping transactions that typically occur following an inversion. 

The primary targets in these regulations were large profitable U.S. corporations that were undergoing inversion transactions in order to move their corporate addresses offshore to a lower tax rate jurisdiction and, as a result, lower their tax bill. The impact of the regulations was felt almost instantly as on April 6, 2016, only two days after their release, Pfizer and Allergan called off a $160B inversion transaction, which would have been the largest such transaction ever.

While media attention has focused on the inversion aspects of the regulations, the proposed regulations issued under Sec. 385 of the Internal Revenue Code have much broader reaching consequences than simply deterring future inversion transactions. As currently written, the proposed Sec. 385 regulations could be applicable to any group structure with related party debt, including domestic groups. Groups subject to the proposed regulations may find the results unpalatable.

Depending on the relationship and the aggregate amount of debt outstanding between related-party members, the proposed Sec. 385 regulations require that taxpayers maintain certain contemporaneous documentation, and empowers the  IRS with the ability to either completely recharacterize a debt instrument to equity or bifurcate the debt instrument and treat a portion as debt and a portion as equity.

The proposed documentation requirements are the direct result of the changing environment in which related-party debt is used by corporations and other group structures. U.S. Treasury Department acknowledged in the preamble of the proposed regulations that the size, activities, and financial complexity of corporations and their group structures have grown exponentially over time. The proposed regulations look to fill a gap in guidance by prescribing the information and documentation necessary to support the characterization of a purported debt instrument as indebtedness in the related-party context.

Required Documentation:

U.S. Treasury Department identified four key characteristics that must be in place in order for related-party debt instruments to be respected as debt for federal tax purposes. These characteristics are:

  • A legally binding obligation to pay (documentation must be prepared within 30 days from date of issuance of qualified debt instrument);
  • Creditor's rights to enforce the obligation (documentation must be prepared within 30 days from date of issuance of qualified debt instrument);
  • A reasonable expectation of repayment at the time the interest is created (documentation must be prepared within 30 days from date of issuance of qualified debt instrument); and
  • An ongoing relationship during the life of the interest consistent with arms-length relationships between unrelated debtors and creditors (documentation must be prepared within 120 days from date of payment of interest/principal or 120 days from an event of default).

Groups Subject to Documentation Requirements:

  • If the stock of any member of the expanded group is publicly traded; or
  • Total assets of the expanded group exceed $100 million on any applicable financial statement; or
  • Annual total revenue of the expanded group exceeds $50 million on any applicable financial statement.

Effective Date:

The new documentation requirements are generally applicable to debt instruments issued between members of an expanded group on or after the date the regulations are finalized.  Signaling its intent to move swiftly, the U.S. Treasury Department set a July 7, 2016 deadline for comments and offered Labor Day 2016 as a potential date for finalization.    


Importantly, the proposed Sec. 385 regulations clearly state that: (i) related-party debt obligations may be treated partially as equity and partially as debt; and (ii) that any recharacterizations of debt will be made on the basis of timely prepared documentation. Accordingly, these proposed regulations indicate that Treasury will perform an analysis of the borrower’s financial status and on that basis determine the extent of debt it respects, which in turn depends on the extent of reasonably likely debt repayments.    

In anticipation of this review process, taxpayers should consider undertaking a creditworthiness analysis of all related-party debt obligations, not just those debt obligations currently covered by the proposed regulations, and document their findings. This level of analysis and contemporaneous documentation will benefit taxpayers by:

  1. Creating uniform internal controls and processes for analyzing, reporting and documenting related-party debt obligations;
  2. Maintaining documentation for non-covered related-party debt obligations that become covered by the proposed regulations in the future (e.g. taxpayer goes public or there is an increase in taxpayer revenue);
  3. Establishing detailed support for any positions challenged under IRS examination; and
  4. Providing timely support for any due diligence proceedings as part of future acquisition or sales transactions.

Such an analysis should assess the solvency of the borrower and determine the extent to which its debt obligation is reasonably likely to be repaid. For example, projections should be made of the borrower’s future free cash flows over the term of the debt period. Then, because it is customary for lenders to divide total outstanding debt by the future free cash flows, the resulting ratio may be compared against industry practices to gauge the reasonableness of the borrower’s debt obligation. Other types of financial analyses may be performed as well, but the point here is simply that by proactively preparing a solvency analysis taxpayers will not only help meet their new documentation requirement under proposed Sec. 385 regulations, but they may also be able to pre-empt significant IRS challenges to their position given that such challenges will be based on the documentation provided by the taxpayer.

In Summary

Although the proposed regulations do not change pre-existing requirements for establishing a true debtor-creditor relationship, they do require documentation that must be prepared timely with respect to the introduction of the debt instrument and made available upon IRS request. Many taxpayers may find that this level of detail in documenting related-party debt troubling. However, by proactively assessing and documenting the reasonableness of related-party debt instruments, taxpayers may be able to safeguard such positions against the new level of scrutiny and mitigate the risks of a potential tax adjustment. Regardless, the new documentation requirements under proposed Sec. 385 regulations leave no doubt that proactive analysis, documentation (and possibly, adjustments) must be made.