Third-party borrowing and the sec. 385 prop. regs.: end-around or Hail Mary?

• Author: Hallman, Rob

Much attention in recent months has been deservedly directed at the recently proposed Sec. 385 regulations (REG-108060-15). In addition to introducing prescriptive documentation requirements for financial instruments intended to be treated as debt for U.S. federal income tax purposes, the proposed regulations target three types of transactions formerly considered well-established and routine mechanisms for creating internal leverage within a controlled group's entity structure.

The proposed regulations treat the following transactions as giving rise to "principal purpose debt instruments" that are recast as stock for U.S. federal income tax purposes:

* Distributions of property from one to another member of an expanded group (other than those pursuant to tax-free reorganizations under Sec. 354(a)(1) or 355(a)(1), or, when Sec. 356 applies, those not involving money or "other property" as described in that section);

* Acquisitions of an expanded group member's stock in exchange for property other than stock; and

* Acquisitions of an expanded group member's property in exchange for stock of the acquiring member and "other property" within the meaning of Sec. 356 (Prop. Regs. Sec. 1.3853(b)(3)).

"Expanded group" in this context is defined as one or more chains of corporations connected through stock ownership with a common parent corporation that owns, directly or indirectly, at least 80% of the voting power or value of the stock of other includible corporations (Prop. Regs. Sec. 1.385-1(b)(3)).

It is worth noting that the proposed regulations provide a maximum expanded group debt level, below which the "principal purpose debt instrument" characterization is inapplicable. A debt instrument will not be recast as stock to the extent the aggregate adjusted issue price of debt instruments held by members of the expanded group does not exceed $50 million. Any debt instrument that is not denominated in U.S. dollars is translated into U.S. dollars at the spot rate (as defined in Regs. Sec. 1.988-1(d)) on the date the debt instrument is issued (Prop. Regs. Sec. 1.385-3(c)(2)).

Chief among the IRS's motivations in promulgating the proposed Sec. 385 regulations is closing a loophole with respect to transactions that lack meaningful nontax significance, such that respecting the instrument as indebtedness for federal tax purposes produces inappropriate results. But could a transaction having nontax significance still produce inappropriate results as...