Recently proposed Treasury regulations under IRC § 385 (the Proposed Regulations) would potentially treat related-party debt, in whole or in part, as equity for U.S. tax purposes. The Proposed Regulations generally apply to debt among members of an expanded corporate group, which includes certain controlled partnerships, without regard to whether any of the parties have engaged in an inversion transaction or whether the group is U.S. or non-U.S. parented.
The Proposed Regulations would require corporate groups to satisfy new documentation requirements in order for related-party debt to be respected as debt for U.S. tax purposes. Even where the documentary requirements are satisfied, the Proposed Regulations would treat related-party debt issued in connection with certain transactions, generally distributions and stock sale and asset transactions among related parties, as equity for U.S. tax purposes. Treatment of related-party debt as equity could result in significant adverse U.S. tax consequences.
Although these Proposed Regulations are not directed at private funds, these funds should consider the potential impact of the Proposed Regulations on their existing structures and monitor whether the Proposed Regulations, if finalized, are broadened to more directly impact private funds. The Proposed Regulations may directly impact many portfolio companies currently owned by private funds and potential targets for such funds, and may limit the options for such restructuring portfolio companies going forward.
Although the Proposed Regulations, if finalized in their current form, would not impact most “blocker” entities used by private funds, the Internal Revenue Service indicated in the preamble to the Proposed Regulations that it is considering the application of the proposed rules to these entities and requested comments on this point. An expansion of the Proposed Regulations to include blocker entities would have significant implications for existing investment structures. Therefore private funds may want to consider making comments to the Proposed Regulations.