New rules recently proposed by the U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) would re-characterize purported debt instruments as equity instruments, and could have significant implications for private equity investors and their portfolio companies. Shortly after Treasury issued these proposed rules, Dechert published an OnPoint describing some of the most significant aspects of the proposal. This article is an updated version of that OnPoint. The proposed regulations remain in proposed form and could be modified, perhaps significantly, prior to finalization.


Treasury and IRS issued the proposed regulations governing the federal income tax treatment of debt that is between certain related parties on April 4, 2016. While issued as part of Treasury’s continued struggle with so-called “inversion” transactions, these proposed rules apply well beyond inversion transactions and may call into question the tax treatment of common, non-abusive transactions. Private equity transactions, while not the intended target, may run afoul of these rules absent careful analysis and planning. The proposed regulations, if finalized, could cause debt between investors and portfolio companies who are part of an “expanded group” (as described below) to be treated (in whole or in part) as equity for federal income tax purposes. Such treatment would eliminate valuable tax deductions for interest expense, and could subject debt payments to dividend treatment. The proposed regulations also would impose documentation requirements in order for purported debt instruments to be treated as debt.

If finalized, the proposed regulations generally would apply to any purported debt instrument issued on or after April 4, 2016, but will not take into account distribution or acquisition transactions (which, as described below, are relevant under the new rules in determining debt/equity status) occurring prior to April 4, 2016. For debt instruments issued before the regulations are finalized, there is a grandfathering rule whereby equity treatment (if applicable under the proposed regulations) will be effective beginning 90 days after finalization of the rules. The new documentation requirements will apply to debt instruments issued on or after the date the proposed regulations are finalized.

Treasury and IRS previously published Notice 2014-52, 2014-42 IRB 712 (October 14, 2014) and Notice 2015-79, 2015-49 IRB 775 (November 19, 2015). These Notices indicated Treasury’s intention to issue regulations limiting the benefits of certain post-inversion tax avoidance transactions. Specifically, Treasury and IRS expected guidance to address strategies that avoid U.S. tax on U.S. operations by shifting or “stripping” U.S. source earnings to lower-tax jurisdictions, including through use of intercompany debt. 

Intercompany debt may allow tax deductions for interest paid by a U.S. company to a related non-U.S. company, thereby sheltering tax otherwise payable at the (comparatively high) U.S. corporate tax rate while subjecting the interest income to lower (or even no) non-U.S. taxation. The placement of intercompany debt to maximize global tax efficiencies has been common for multinational groups following an inversion transaction. Debt vs. equity characterization disputes have been a staple of the U.S. tax system almost from its inception. The proposed regulations represent a break from the traditional subjective debt/equity analysis and offer a first attempt to define (somewhat objectively) an entire class of instruments which will by default be treated as equity.

Debt and Transactions Subject to the New Rules

The proposed regulations are surprising in that their application goes well beyond the previously cited inversion transactions. The proposed regulations largely apply to debt instruments issued between members of an “expanded group,” which generally is defined as an affiliated group of corporations within the meaning of Section 1504 of the Internal Revenue Code. Affiliated group status generally requires 80% ownership. The proposed regulations greatly expand the statutory definition of affiliated group, for example by including foreign and tax-exempt corporations. However, it is worth noting that these new rules do not apply to debt between companies that are part of the same consolidated group for U.S. federal income tax purposes. A consolidated group generally consists of exclusively U.S. domestic corporations with at least 80% common ownership.

Because the proposed regulations apply only to debt between members of an “expanded group,” we would not expect the rules to apply in many standard private equity transactions. For example, we would not expect the rules to apply to the capitalization by a typical private equity fund of a new acquisition vehicle with a mix of debt and equity, as the fund and the acquisition vehicle typically would not form an expanded group. However, close examination of the investors in the private equity fund will be necessary before reaching any conclusion. For instance, strange (we think unintended) results could arise where the private equity fund receives significant capital from a single corporate investor (i.e., a family office formed as a corporation, even a subchapter S corporation). The rules also will apply to debt between companies under common ownership, for example a non-U.S. corporation owned by a private equity investor which forms a U.S. corporation (which it capitalizes with a mix of debt and equity) to execute a U.S. acquisition.

If applicable (i.e., if the expanded group requirement is satisfied) the proposed regulations provide that purported debt between members of an expanded group is subject to reclassification as equity if issued in any of the following situations (each a “Subject Transaction”): 

  • as a distribution of the debt by an issuer with respect to its stock (e.g., a dividend or return of capital distribution in the form of notes);
  • in exchange for stock of another member of the expanded group (e.g., group member acquires stock of another group member in exchange for issuing a note to the selling group member); or
  • in exchange for property in certain tax-free reorganizations.  

Subject Transactions also include any issuance of debt with a principal purpose of funding one of the transactions described above. For example, the rules would apply if Subsidiary A borrowed funds from Subsidiary B to fund a distribution from Subsidiary A to its parent corporation. Subject Transactions also include any other issuance with a principal purpose of avoiding the application of the proposed regulations.

Whether debt is issued with a principal purpose of funding a Subject Transaction or avoiding application of the proposed regulations is determined based on facts and circumstances. However, the proposed regulations contain a non-rebuttable presumption whereby a debt instrument is deemed to have a principal purpose of funding a Subject Transaction if the debt is issued at any time during the 72-month period beginning 36 months before and ending 36 months after the issuing group member makes a distribution or acquisition that is considered a Subject Transaction (the “Per Se Rule”).

While on a basic level the Subject Transactions may not appear common to private equity investors, they certainly will be relevant. For example, if a non-U.S. holding company with a U.S. operating subsidiary completed an add-on acquisition of another non-U.S. company which also owned a U.S. operating subsidiary, and then sought to consolidate the U.S. operations by having the first U.S. subsidiary acquire the stock of the newly acquired (indirect) U.S. subsidiary for a note, these rules would apply. The rules also will apply where a subsidiary acquires for a note (even for non-tax reasons) stock of the expanded group parent to satisfy compensatory equity awards made by the subsidiary. The rules also will produce unintended results in those rare occasions where concentration of ownership results in a private equity investor and its portfolio company forming an expanded group. Dividend payments in the form of notes (often done in advance of third party financing to meet outside timing requirements for the dividend) would need to be closely analyzed in such a situation.

Helpfully, however, certain transactions are excluded from the rules in the proposed regulations. For instance, debt issued by a member of an expanded group will not be subject to potential treatment as equity if the related Subject Transaction(s) do not involve distributions and acquisitions in excess of the member’s current year earnings and profits. The proposed regulations contain another general exception for debt if, immediately after the debt is issued, the aggregate adjusted issue price of all expanded group debt held by members of the expanded group does not exceed US$50 million. Finally, there is a separate exception from the Per Se Rule for debt instruments arising in the ordinary course of the issuing member’s trade or business (e.g., accounts payable).

Finally, the proposed regulations give the IRS authority to recast only a portion of a subject debt instrument as equity and treat the remaining portion as debt for U.S. federal income tax purposes (the “Bifurcation Approach”), instead of taking an “all-or-nothing” approach that exists under current law. According to Treasury and IRS, the existing “all-or-nothing” approach frequently does not reflect the economic substance of related-party debt. If finalized, the new Bifurcation Approach would give IRS greater flexibility and ability to re-characterize related party transactions.

Documentation Requirements

Additionally, the proposed regulations impose contemporaneous documentation requirements with respect to debt issued between members of an expanded group. Failure to satisfy these reporting requirements will result in such debt being treated as equity under the proposed regulations. The required written documentation must satisfy the following: 

  • establish the issuer has entered into an unconditional and legally binding obligation to pay a sum certain either on demand or at one or more fixed dates;
  • establish that the holder of the debt has the rights of a creditor to enforce the obligation (including the right to cause or trigger an event of default for non-payment);
  • contain information establishing a reasonable expectation for issuer to be able to repay the debt at the time of issuance (including cash flow projections, financial statements, business forecasts, asset appraisals, debt-to-equity and other relevant financial ratios);
  • documentation of payments of interest and principal (for example, wire transfer records or bank statements reflecting payment); and
  • enforcement of lender remedies in the event of non-payment or other default.  


While proposed as part of Treasury’s continuing war on inversion transactions, the proposed rules have a much broader impact. Private equity investors need to be aware of these rules so that they are not unexpectedly caught up in them. Private equity investors should not become collateral damage in Treasury’s inversion war.