On April 4, 2016, the Treasury Department and IRS issued proposed regulations under Section 385 which includes specific Documentation Requirements for certain related-party debt instruments under Prop. Reg. § 1.385-2 (the “Proposed Regulations”). The Documentation Requirements prescribe the nature of the documentation and information that must be prepared and maintained for a purported debt instrument issued by a corporation to another member of the expanded group to be treated as such. The Documentation Requirements are intended to provide the IRS with sufficient information in order to permit it to determine whether an instrument should be respected as debt for US tax purposes. The documentation must be provided within prescribed time limits in order to be considered for debt treatment.


Section 385(a) authorizes the Treasury to prescribe necessary and appropriate regulations to “determine whether an interest in a corporation is to be treated” as equity or indebtedness.1 Under the Proposed Regulations, in order for related parties to avoid equity characterization on certain related-party debt instruments, documentation must be provided that demonstrates: (i) the issuer was under an unconditional and legally binding obligation to pay a sum certain on a fixed date or upon demand; (ii) the holder had legal rights as a creditor; (iii) as of the date the instrument was issued, there was a reasonable expectation of ability to repay the debt; and (iv) after the date of issuance of the debt instrument, the conduct of the holder and issuer was consistent with that of unrelated parties acting on arm’s-length terms.2 In addition, the parties must prepare documentation of (i) each payment of principal and interest under the debt instrument and (ii) evidence of the holder’s reasonable efforts to enforce creditors’ rights in the event of default under the debt instrument. While the Documentation Requirements must be met to prevent the instrument from being categorized as equity, timely submission does not guarantee a debt classification. Satisfaction of the Documentation Requirements is a threshold matter that allows the instrument to be considered as indebtedness for US tax purposes. Failure to provide documentation will result in the instrument being treated as equity for US tax purposes.


The Proposed Regulations only apply to instruments that are cast in the form of debt, not those that do not purport to be indebtedness. Instruments subject to the Documentation Requirements are only those issued and held by members of an expanded group. An expanded group under the Proposed Regulations generally includes two or more corporations connected through direct or indirect stock ownership of at least 80 percent (by vote or value). The term “expanded group” includes non-US corporations, real estate investment trusts (“REITS”), regulated investment companies (“RICS”) and corporations connected indirectly through partnerships. Moreover, the Proposed Regulations apply only to large taxpayer groups. Thus, compliance with the Proposed Regulations is only necessary where the stock of any member of the expanded group is publicly traded, total assets of the group exceed $100 million on any applicable financial statement on the instrument’s issuance date, or annual total revenue exceeds $50 million on any applicable financial statement on the instrument’s issuance date.3

Documentation Categories

The Proposed Regulations create four categories of documentation that attempt to distill case law principles for determining whether the debt instrument will be treated as indebtedness or stock. Failure to provide documentation for each of these categories will result in a classification of equity, even where the underlying instrument may otherwise qualify as indebtedness under general US tax principles.

  1. Unconditional Obligation to Repay. The Proposed Regulations require evidence of an unconditional obligation on the part of the issuer to pay a sum certain. Such evidence should be offered in the form of written documentation executed by both parties that shows such obligation.
  2. Holder’s Right to Enforce the Terms. Second, and similarly, there must be written documentation that establishes that the holder of the instrument has the legal right to enforce the obligation according to its terms. Evidence of such rights may include the ability to trigger a default or accelerate payments, as well as a superior right to equity holders in the issuer’s assets in the event of a dissolution or liquidation.
  3. Reasonable Expectation of Issuer’s Ability to Repay. Third, the Proposed Regulations require evidence showing there is a reasonable expectation that the issuer will be able to repay the amount of the debt. Evidence of the issuer’s adequate financial position may be established through cash flow projections, financial statements, business forecasts, or other financial information showing that the obligation can be met pursuant to the instrument’s terms. The documentation is to be evaluated by the IRS as of the time of the loan’s issuance.
  4. Evidence of a Debtor-Creditor Relationship. While the first three categories focus on the nature of the instrument and positions of the parties at the time the purported debt is issued, the fourth category requires evidence of actions that show an ongoing debtor-creditor relationship. Where the issuer of the loan has upheld its obligations according to its terms, the documentation should include evidence of timely payments of principal and interest. That evidence could be in the form of a wire transfer record, bank statement, or other document showing that the payment was made. However, where the issuer fails to comply with the terms of the loan, such as in the case of a default or other non-payment, the written documentation should include evidence of the holder’s reasonable exercise of diligence and judgment as a creditor. This evidence may demonstrate the holder’s attempts to enforce its rights under the instrument or any efforts it made to renegotiate the instrument’s terms.


With respect to evidence of the binding obligation to repay, the holder’s rights of enforcement and the reasonable expectation of repayment, documentation should be prepared no later than 30 calendar days after the relevant event. The date of the relevant event can either be the date that the instrument is issued to an expanded group member, or the date in which the instrument comes to be held by a member of the expanded group (where, for instance, the instrument holder was not part of the expanded group at the time of issuance). If the instrument is deemed to be stock under the Proposed Regulations, and thereafter ceases to be held by an expanded group member, the character of the instrument is thereafter determined under normal US tax principles. With respect to evidence of an ongoing debtor-creditor relationship, the Proposed Regulations allows the documentation to be prepared up to 120 calendar days from the date of the principal or interest payment or other relevant event (e.g., a default or non-payment).

Other Special Arrangements

Where the loan is part of a revolving credit agreement rather than a separate note or writing, all documentation that relates to the purported indebtedness must be provided. Documentation may include board of directors’ resolutions, credit agreements, or other agreements prepared in connection with legal documents governing the indebtedness. If the instrument is issued as part of a cash pooling arrangement or internal banking service, the Proposed Regulations are met only if all material documentation that governs the operations of the cash pool or internal banking service is provided.

Comment Period

The Proposed Regulations generally apply to debt instruments issued on or after April 4, 2016, but they are subject to comment. Written or electronic comments and requests for a public hearing must be received by July 7, 2016 for consideration.