On April 4th, the Internal Revenue Service (“IRS”) issued proposed regulations (the “Proposed Regulations”) under Section 385 which could dramatically change how related-party indebtedness is treated for federal income tax purposes. In general, the Proposed Regulations provide for the automatic treatment of related-party debt instruments as equity if the parties fail to comply with burdensome recordkeeping requirements or if the instruments are issued under circumstances the IRS has deemed abusive, resulting in a disallowance of interest deductions on the instruments. In addition, the Proposed Regulations would give the IRS new authority to treat certain related-party debt as part debt and part equity for tax purposes.

The Proposed Regulations were unexpected and have been immediately controversial. Treasury had previously indicated that it was studying earnings stripping as an area for potential guidance, but it was widely expected that any such guidance would be limited to corporate groups that had previously undertaken an inversion transaction (generally, the migration of a domestic corporation abroad in a transaction that the government views as taxmotivated). Alternatively, there had been some resignation to the idea that Treasury might tighten the restrictions on related-party interest deductions under the earnings-stripping rules contained in Section 163(j).