Proposed Section 385 regulations: What you need to know

As part of an initiative to curb tax inversions, the IRS and Treasury recently released proposed regulations to Section 385, which authorizes the Secretary of the Treasury to determine if financial instruments should be considered stock or indebtedness. Prior to these regulations, case law was the primary source of guidance.

In addition to provisions dealing specifically with loans created as part of reorganization or distribution transactions, the proposed regulations contain two more widely applicable sections: “Financial Instrument as Part Debt and Part Equity” and “Documentation Requirements.”

The section on financial instruments specifically states that, based on an appropriate analysis, a financial instrument may be considered as part debt and part equity by the Commissioner. Historically, case law ruled that financial instruments are either entirely debt or equity.  This new approach will give the IRS more flexibility in attacking debt arrangements resulting from aggressive tax planning.

The section on documentation lays out strict requirements to support an instrument that’s considered debt for federal tax purposes. Documentation must include:

• Unconditional obligation to pay the debt at one or more fixed dates.
• Creditor’s rights, similar to those rights with a unrelated third party, including a superior right to shareholders to share in the assets in case of dissolution.
• Reasonable expectation of ability to repay the debt obligation. This analysis may include cash flow projections, forecasts, financial ratios compared to competitors, and financial statements or reports used internally to monitor financial performance.
• Actions evidencing a debtor-creditor relationship. These could include interest and principal payments or events related to default.

These rules do not replace prior case law; they simply detail the minimum burden taxpayers must meet to allow analysis of the instrument. Perhaps most importantly, the proposed regulations state that documentation must be in place within 30 days of issuance.  If taxpayers are unable to provide the IRS with documentation or reasonable cause for the failure, the instrument will be considered stock.

While these regulations are not finalized, they will be effective upon publication — which could be as soon as August.