The Debt-Equity Labyrinth: A Case for the New Section 385 Regulations

By Lewitt, Alexander | Washington and Lee Law Review, Fall 2017 | Go to article overview

The Debt-Equity Labyrinth: A Case for the New Section 385 Regulations


Lewitt, Alexander, Washington and Lee Law Review


"Our present taxing system has become a labyrinth for the wary and unwary alike, filling endless volumes with its exceptions to exceptions, and indecipherable differentiations in the way we tax various sources of income."1

Table of Contents

I. Introduction.................... 2283

II. Background........................ 2287

III. Debt Financing................... 2289

IV. The Common Law.......................... 2291

A. Formal Rights and Remedies of Creditors.................. 2292

B. Objective Determination of Intent......................... 2294

C. Risk and Economic Reality...................... 2296

V. The 1980s Approach..........................2297

A. Scope............................2298

B. Preliminary Rules.......................... 2299

1. Fair Market Value of an Instrument................... 2299

2. Debt-to-Equity Ratio.......................... 2300

3. Reasonable Rate of Interest..................... 2302

C. Treatment of Instruments Generally.................... 2303

D. Treatment of Straight Debt Instruments..................... 2303

E. Treatment of Hybrid Instruments................. 2304

F. The Substantial Proportionality Rules................. 2305

1. Tests One & Two: Hybrid Instruments & Instruments Not Issued for Money..................... 2305

2. Test Three: Excessive Debt....................... 2306

3. Test Four: Change in Terms of Outstanding Instruments........................ 2307

4. Test Five: Nonpayment of Interest....................... 2308

5. Tests Six & Seven: Demand Instruments & Nonpayment of Principal...................... 2308

G. Treatment of Unwritten Obligations....................... 2309

H. Treatment of Guaranteed Loans.................... 2310

I. Treatment of Preferred Stock.................... 2310

VI.The 2016 Approach....................... 2311

A. Background..................... 2311

B. Documentation Rules............................ 2313

1. Scope..................... 2313

2. The Per Se Rule and Rebuttable Presumption............................... 2314

3. Indebtedness Factors.....................2315

C. Recharacterization Rule................... 2316

1. Scope.......................... 2316

2. General Rule.................... 2317

3. Funding Rule..................... 2317

4. Anti-Abuse Rule..................... 2318

VII.Analyzing the Common Law Approach, the 1980 Regulations, and the 2016 Regulations................. 2319

A. Example 1: Traditional Loan...................... 2319

1. Common Law Analysis......................... 2320

2. 1980 Regulations..................2320

3. 2016 Regulations...................2321

B. Example 2: Convertible Loan...................... 2322

1. Common Law Analysis................. 2322

2. 1980 Regulations...................2323

3. 2016 Regulations...................2324

C. Example 3: Distressed Company Loan................ 2325

1. Common Law Analysis................ 2325

2. 1980 Regulations............... 2326

3. 2016 Regulations....................... 2327

VIII.A Case for the 2016 Regulations.2328

IX.Proposed Improvements and Recommendations.2332

X.Conclusion.2334

I.Introduction

Corporations routinely borrow money from subsidiaries, shareholders, and other related parties.2 This often occurs when they are in financial trouble and unrelated parties are reluctant to lend to them.3 In recent years, for example, Sears Holdings, Inc., parent company of iconic American retailers Sears and Kmart, borrowed hundreds of millions of dollars from hedge funds controlled by its chairman and largest shareholder, Edward Lampert, to fund massive losses.4 These types of related-party loans raise important tax questions regarding whether they should be characterized as debt or equity. …

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