Taxes & Entities

Debt-equity Characterisation Under Section 385

Understand why an intercompany loan can be a loan in every document and equity in the eyes of the tax authority, and what actually determines which side of that line you land on.

  • Expert
  • 12 min total
  • 12 chapters

What decision this helps you make: Whether an advance between related parties will be respected as debt, and what documentation, terms and conduct have to be in place before you rely on the interest deduction.

What this topic is

Section 385 authorises Treasury to write regulations distinguishing debt from equity, and lists five factors it may consider. For decades no general regulations existed and the question was decided by courts applying multi-factor tests. In 2016 Treasury issued regulations that, for the first time, recharacterised certain related-party debt as stock by rule rather than by facts, and then partially retreated. Both the case law and the regulations are live, and they operate independently.

Why it matters

The difference is not cosmetic. Debt produces a deductible interest payment and a repayment of principal that is not income. Equity produces a non-deductible distribution, potentially a dividend, with withholding tax consequences cross-border. Recharacterisation therefore turns a deduction into nothing, can create an unexpected dividend, can trigger withholding, and cascades into §163(j), the earnings stripping analysis, transfer pricing, and treaty entitlement. On a large intercompany balance the exposure runs to tens of millions, and the outcome frequently turns on documents that either exist or do not.

Who should learn it

Tax directors of groups with intercompany funding, international tax practitioners, restructuring and finance teams putting debt into acquisition structures, and anyone documenting shareholder loans into a closely held company.

What you will understand

  • Why there is no bright-line ratio in US law, and what the courts actually weigh
  • The five statutory factors and how the multi-factor tests apply them
  • What the 2016 regulations do, what was withdrawn, and what remains in force
  • The practical evidence that decides real cases: terms, conduct, capacity, and the treatment by both parties

Prerequisites

Common misconception

"We papered it as a loan with a market rate and a maturity date, so it is debt." Documentation is necessary and nowhere near sufficient. Courts consistently hold that the label the parties chose is not controlling. The factors that most often decide cases are behavioural rather than textual: whether payments were actually made when due, whether the borrower had any realistic capacity to repay, whether an unrelated lender would have advanced the money on those terms, and whether the parties acted like creditor and debtor after signing.