Internal Revenue Code Section 385 gives the Treasury Department authority to decide whether a corporate financial instrument is debt or equity, and the debt-equity rules built on that authority determine whether payments on the instrument are deductible interest or non-deductible dividends. The stakes are highest in related-party transactions, particularly when a U.S. subsidiary borrows from a foreign parent. In that setting, Treasury regulations can automatically convert an instrument that looks like a loan on paper into stock for tax purposes, regardless of how carefully it was documented.
Why the Debt or Equity Label Changes the Tax Bill
Interest paid on debt reduces the borrower’s taxable income. Dividends paid on equity do not. A corporation that can characterize capital from a related party as a loan gets to deduct the payments against the corporate rate, which is the entire point of most intercompany financing structures.
The label matters on the other side too. Principal repayment on a genuine debt instrument is a non-taxable return of capital to the lender. A payment on equity is taxable as a dividend to the extent of the corporation’s earnings and profits. And if the investment goes bad, a worthless debt typically produces an ordinary bad debt deduction, while worthless equity generally produces a capital loss subject to tighter limits.
When a foreign parent is the counterparty, the stakes climb higher. Recharacterization strips the U.S. subsidiary of years of interest deductions and can trigger back withholding tax on payments that were treated as interest but are now dividends. That combination is what the Section 385 regulations were designed to attack.
What Section 385 Actually Says
Congress added Section 385 to the Code in 1969 to give Treasury broad authority to determine whether a corporate interest should be treated as stock, debt, or a hybrid. The statute lists five non-exclusive factors regulations may consider:1Office of the Law Revision Counsel. 26 US Code 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness
- Whether there is an unconditional written obligation to repay a fixed amount, on demand or by a specific date, at a stated interest rate.
- Whether the instrument is subordinated to, or preferred over, the corporation’s other debt.
- The corporation’s debt-to-equity ratio.
- Whether the instrument is convertible into stock.
- Whether the holders of the purported debt also hold stock in the same proportion, suggesting the “loan” is really another form of ownership.
Treasury did not issue widely applicable final regulations under this authority until 2016, and even those were partially withdrawn in 2019. For nearly five decades, courts filled the gap.
How Courts Weigh Debt Against Equity
Most circuits apply some version of an eleven-factor test, and no single factor controls. The statutory factors show up in various forms, and courts add several more that reflect how an arm’s-length lender would actually behave.
Among the added considerations: whether the borrower could have obtained similar financing from an unrelated bank, which is one of the most telling factors in practice; the adequacy of capitalization at the time of the advance; whether repayments actually came from operating cash flow or only from further capital infusions; whether any security or collateral backed the instrument; and whether the funds went to day-to-day operations or to capital assets. Courts look at the labels the parties used, but labels carry little weight when the economic substance points the other way.
The practical result is that paperwork alone will not save an equity contribution dressed up as a loan. A promissory note with a stated rate and maturity date still gets recharacterized if the borrower was hopelessly insolvent when the advance was made, the lender never enforced a missed payment, and the “loan” tracked stock ownership exactly.
When Related-Party Debt Is Automatically Recharacterized
Treasury Regulation Section 1.385-3 operates mechanically. If its conditions are met, a covered debt instrument is treated as stock regardless of substance or documentation. The rule applies to covered debt instruments issued by a domestic corporation to a member of its expanded group that is outside the issuer’s consolidated return group.2eCFR. 26 CFR 1.385-3 – Certain Distributions of Debt Instruments and Similar Transactions
Three transactions trigger automatic recharacterization:
- The domestic corporation issues a note payable directly to a related shareholder as a dividend or distribution, essentially paying a dividend with an IOU.
- The domestic corporation issues debt to a related party in exchange for stock of another expanded group member, outside certain exempt exchanges.
- The domestic corporation issues debt to a related party in an internal asset reorganization, to the extent a related shareholder receives the debt instrument instead of stock.2eCFR. 26 CFR 1.385-3 – Certain Distributions of Debt Instruments and Similar Transactions
The Funding Rule and the 36-Month Presumption
A broader funding rule catches two-step structures. Debt issued to a related party in exchange for property is recharacterized if it funded one of the three tainted transactions above. The regulation creates a per se presumption of funding when the debt was issued within 36 months before or after the tainted distribution or acquisition.2eCFR. 26 CFR 1.385-3 – Certain Distributions of Debt Instruments and Similar Transactions If a U.S. subsidiary borrows from its foreign parent in January and pays a dividend to that same parent in March, the IRS does not need to prove the loan funded the dividend. The timing alone creates the presumption.
Exceptions That Keep Ordinary Lending Out of Reach
The rules carve out several categories of intercompany lending.
The most widely used carve-out is the $50 million threshold. Covered debt instruments are not recharacterized as long as the aggregate adjusted issue price of instruments that would otherwise be treated as stock stays at or below $50 million across the expanded group. Only amounts exceeding that threshold get recharacterized.2eCFR. 26 CFR 1.385-3 – Certain Distributions of Debt Instruments and Similar Transactions For many mid-size multinational groups, this ceiling neutralizes the regulation entirely.
Debt within a single U.S. federal consolidated return group is also excluded, because the interest income and expense offset on the consolidated return. A reduction applies for the issuer’s accumulated earnings and profits from taxable years ending after April 4, 2016, and a further reduction applies for qualified capital contributions from expanded group members. Intercompany debt backed by real earnings or fresh capital does not get pulled in.
What Documentation Still Needs to Show
Treasury issued formal documentation requirements under Section 385 in 2016 and then permanently withdrew them in November 2019.3Federal Register. Removal of Section 385 Documentation Regulations Documentation still matters. The withdrawal simply returned taxpayers to the common law standard, where the taxpayer carries the burden of proving debt treatment.
Four areas usually decide whether that burden gets carried. First, the instrument itself: a written promissory note or loan agreement stating principal, maturity, interest rate, and repayment schedule. Without those basic terms in writing, the IRS has an easy argument that no genuine debt existed.
Second, creditor enforcement rights. A real lender protects itself with acceleration clauses, security interests, and default remedies. Silence on what happens when the borrower misses a payment makes the arrangement look like a shareholder absorbing risk.
Third, a reasonable expectation of repayment at inception. Cash flow projections, financial statements, or asset valuations prepared around the time of the advance should show the borrower could actually service the debt. Lending into an already undercapitalized subsidiary with no repayment analysis reads as a capital infusion.
Fourth, conduct that matches the paper. Timely interest and principal payments, proper accounting entries on both sides, and actual enforcement when a default occurs. This is where most related-party arrangements come apart. The parent lends, the subsidiary misses three payments, nothing happens, and the whole instrument gets treated as equity. Discipline over the life of the loan matters as much as the paperwork at closing.
Cross-Border Withholding Consequences
U.S.-source payments to foreign persons are generally subject to a 30% withholding tax.4Internal Revenue Service. NRA Withholding Treaties often cut that rate to zero on interest for qualifying recipients while reducing dividend withholding only to 5% or 15%, depending on the ownership stake. When debt to a foreign parent is recharacterized as equity, payments that were treated as interest at a 0% treaty rate become dividends at a higher rate. A U.S. subsidiary that withheld nothing on its “interest” payments then owes back withholding, plus penalties and interest.
The domestic side compounds the pain. The subsidiary loses its interest deductions for every year the instrument was outstanding, increasing taxable income each year. Reducing the U.S. tax base through intercompany interest payments to a foreign parent is sometimes called earnings stripping, and it is the behavior the Section 385 regulations were built to reach. Lost deductions plus back withholding can easily exceed whatever benefit the original structure was meant to produce.
Reporting Exposure Runs on Its Own Track
A U.S. reporting corporation with reportable transactions with a foreign related party must file Form 5472 for the tax year. Amounts borrowed, amounts loaned, and interest paid are all reportable.5Internal Revenue Service. Instructions for Form 5472
The penalty for failing to file a complete and correct Form 5472 by the due date is $25,000 per form, per year. If the IRS notices the failure and the corporation does not comply within 90 days, another $25,000 penalty accrues for each 30-day period the failure continues, with no cap.6Office of the Law Revision Counsel. 26 US Code 6038A – Information With Respect to Certain Foreign-Owned Corporations Because the penalty applies per form, a corporation with several foreign related parties that misses filings across multiple years can accumulate six-figure penalties before the substantive debt-equity question is even raised. Getting the classification right and neglecting the reporting is its own expensive mistake.