Treasury's Section 385 Debt/Equity Regulations

September 10, 2019

Section 385 Regulations Harm US Competitiveness

In late 2016, the Treasury Department promulgated new guidance under Section 385 of the U.S. tax code, giving the IRS uniliteral authority to reclassify an employer’s debt as equity. This change upended decades’ worth of case law by recasting debt into equity based solely on what the debt is used to purchase, regardless of any other factors typically used to determine the characteristics of debt.

These regulations impose excessive and unwarranted compliance and financial burdens on businesses operating in the United States and further distort investment and other business decisions, to the detriment of U.S. jobs.

 
Tax Reform Has Rendered Section 385 Regulations Obsolete

Former Obama Administration Treasury Secretary Jack Lew conceded that the regulations were a “blunt instrument” and that the best way to deal with the issues that the regulations aimed to address, “would be to enact comprehensive business tax reform.” Subsequently on October 4, 2017, Treasury issued its final report in response to President Trump’s EO 13789 in which it said that it expected that Congress would obviate the need for the rules through tax reform and would reserve action until completion of tax reform.

In December 2017, Congress passed comprehensive tax reform and significantly narrowed the distinction between the tax treatment of debt and equity.

While that historic tax reform reduced the top federal corporate income tax rate from 35 percent to 21 percent, it further limited the deductibility of interest and introduced a new tax on certain transactions occurring between U.S. employers and related-party firms abroad. The cumulative effect of these changes is that any perceived tax benefit of debt financing was minimized.

Repealing These Discriminatory Regulations Would Improve U.S. competitiveness

Treasury proposed to remove Section 385’s documentation requirements on September 24, 2018. However, Treasury has not yet repealed the troubling “Per Se and Consolidated Return” sections of the regulations that granted the IRS the uniliteral power to reclassify debt as equity. As with the corresponding documentation requirements, Treasury should withdraw these expansive regulations since Congress passed tax reform. Doing so would not only help U.S. competitiveness, it would be an excellent example of how President Trump is fulfilling his promise to reduce tax regulatory burdens.

If Treasury repeals the remaining Section 385 regulations, companies can devote their resources toward reinvesting into their U.S. operations, growing their U.S. workforce, and expanding their U.S. supply chains.

While TCJA reduced the top federal corporate income tax rate from 35 percent to 21 percent, it further limited the deductibility of interest under Section 163(j), provided for downward attribution rules and introduced a new tax on certain transactions occurring between U.S. employers and related-party firms abroad (e.g. BEAT tax). The cumulative effect of these changes is that any perceived tax benefit of debt financing was minimized.

In an effort to provide some regulatory relief, Treasury proposed to remove Section 385’s documentation requirements on September 24, 2018. However, Treasury has not yet repealed the troubling “Per Se and Consolidated Return” regulations that granted the IRS the uniliteral power to reclassify debt as equity. As with the corresponding documentation requirements, Treasury should withdraw these expansive regulations since Congress passed tax reform and in order to fulfill the President’s instruction to reduce tax regulatory burdens under EO 13789.

If Treasury repeals the remaining Section 385 regulations, companies can devote their resources toward growing their U.S. operations, training their U.S. workforce, and growing their U.S. supply chains.