Treasury Is Loosening the Section 385 Funding Rules. Review Your Intercompany Debt Positions Before Q4 Closes.
At ABA Section of Taxation on October 6, Treasury confirmed Reg. 1.385-3's per se rule is going away. If your provision has intercompany notes, the debt-equity analysis just reopened.
Editorial source review — November 1, 2026. This machine-generated article has been reviewed, but is not certified accurate. Source-backed corrections are incorporated where established. Other legal, survey and product claims may remain unverified; check applicable primary authorities before relying on a deadline or tax position.
Findings in the original version: EY reports an official's intention to liberalise rules and a proposed-rule target. A priority plan does not repeal Reg. 1.385-3.
A senior Treasury official walked into the ABA Section of Taxation annual meeting on October 6, 2026 and said it plainly: the government starts from the premise that it will loosen the current rules under Regulation 1.385-3. Proposed regulations are expected by September 2027. The per se funding rule is going away.
This is not background noise. Section 385 is the provision that determines whether related-party debt instruments are treated as debt or equity for U.S. tax purposes. The per se funding rule — the provision that has trapped intercompany cash management structures in equity treatment since 2016 — is the target. What replaces it changes the debt-equity classification analysis for every company that restructured its intercompany note program in response to that rule. The Q4 2026 provision conversation needs to start this week.
What the Per Se Rule Did — and Who It Trapped
The 2016 regulations under Reg. 1.385-3 introduced a mechanical test: any debt instrument issued within a 36-month window before or after a "covered transaction" — an investment in a related party, a distribution, or a capital contribution — was automatically treated as funding that transaction. The test operated regardless of the actual relationship between the debt issuance and the covered transaction. Intent was irrelevant. Economics were irrelevant. The timing coincidence was the legal conclusion.
The consequence was blunt. Intercompany cash sweeps using demand notes, when combined with routine dividend activity, triggered the per se rule. The notes were recharacterized as equity. Recharacterization stripped the interest deduction from the payor and converted the note into a deemed equity investment. Tax basis changed. The foreign tax credit analysis changed. The BEAT base changed. Companies paid real money to restructure their treasury operations around a 36-month clock that existed solely to prevent a timing coincidence Treasury found suspicious.
Some companies accepted equity treatment as unavoidable and built their provision around it. Others terminated intercompany note structures entirely. Others maintained elaborate documentation programs designed to establish that each note predated any covered transaction by more than 36 months. The compliance burden was significant, the tax planning value of those structures was real, and the per se rule imposed that cost mechanically, without case-by-case analysis of actual abuse potential.
What the "Sufficient Factual Connection" Standard Changes
Treasury's planned replacement asks a different question: is there a sufficient factual connection between this specific debt instrument and this specific covered transaction? The per se timing test disappears. The 36-month window disappears. What replaces it is a facts-and-circumstances inquiry.
Treasury's stated starting point is permissive — the premise is that the standard will be more accommodating than the current rule. A debt instrument and a covered transaction that would have been linked under the per se rule will often not satisfy the factual connection test. The 2019 ANPRM signaled this same direction: the per se rule would be withdrawn, and a standard requiring affirmative connection between the instrument and the transaction would take its place.
What the October 6 statement adds is timing certainty. Proposed regulations by September 2027. That is 11 months. The regulatory landscape is changing within the fiscal year. And the direction — debt treatment for intercompany notes that were restructured or recharacterized to escape the per se rule — is clearly more favorable than the current regime.
The practical effect: companies with intercompany note programs that were restructured in response to the per se rule need to assess whether those notes would be classified differently under the new standard. Companies that accepted equity treatment and restructured their provision accordingly need to model what reversal looks like. Companies that terminated structures to avoid the compliance burden need to assess whether reinstatement makes sense.
The Provision Impact: Three Distinct Scenarios
Scenario 1 — Notes currently treated as equity under the per se rule. If the new "sufficient factual connection" standard is prospective from the effective date of proposed regulations (the likely structure), these instruments do not automatically flip on day one. But the company needs a current-period memo position: is the regulatory announcement a "reasonably possible" change that affects disclosure obligations? Under ASC 740-10-50-15, a reasonably possible change in unrecognized tax benefit within 12 months requires disclosure. If equity recharacterization has been sustained as a tax position with audit exposure, the Treasury announcement moves the probability needle.
Scenario 2 — Notes currently treated as debt that were structured to avoid the per se rule. These notes carry ongoing documentation burdens: 36-month gap management, transaction sequencing, attribution analysis. Under the new standard, those documentation requirements likely simplify or disappear for instruments that have no genuine connection to a covered transaction. Compliance cost goes down. No provision impact — but the operational cost reduction is real and should be captured in planning.
Scenario 3 — Intercompany structures terminated to avoid the per se rule. This is the highest-impact group. If a company eliminated a structure — a note program generating interest income, a cross-border financing arrangement, a cash pooling structure — solely to avoid equity recharacterization, the prospective ability to reinstate it changes the company's tax planning posture. The interest deductions that did not exist for the past several years do not come back retroactively. But the prospective benefit is real, and the planning window is now.
BEAT and the Hidden Leverage in Debt Recharacterization
Section 385 recharacterization has a downstream interaction most provision teams undercount: BEAT.
BEAT — the base erosion and anti-abuse tax — is computed based on base erosion payments, which include interest and royalty payments to foreign affiliates. When a note between a U.S. entity and a foreign parent is recharacterized as equity under Section 385, the interest payment disappears from the U.S. entity's books as a deductible expense. It also disappears as a base erosion payment for BEAT purposes. A smaller base erosion payment means a lower BEAT base. For some companies, equity recharacterization had the unintended consequence of reducing their BEAT exposure.
The flip: if equity-characterized instruments return to debt treatment under the new standard, interest payments re-enter the BEAT base. Companies that built their BEAT calculations around the equity characterization of certain intercompany notes — and have been running under that assumption in their provision — face a change in their BEAT exposure going forward.
This is not hypothetical. Build the BEAT sensitivity model before the proposed regulations drop. The surprise should not come in September 2027 when your auditors ask why your BEAT computation changed.
What to Do Monday Morning
1. Pull the intercompany note inventory. Every note that was restructured, reclassified, or terminated in response to the per se rule belongs on the list. Include notes that were documented around the 36-month window and notes that are currently classified as equity. 2. Run the three-scenario analysis for each note. Current equity treatment: assess whether the Treasury announcement creates a disclosure obligation under ASC 740-10-50-15. Current debt with 36-month documentation: assess whether the compliance burden changes. Terminated structures: assess whether reinstatement creates a material prospective benefit. 3. Build the BEAT sensitivity model. For every intercompany note currently in equity treatment, calculate what its reinstatement as debt does to the base erosion percentage and the BEAT liability. Flag any note where the BEAT impact is material relative to the interest deduction benefit. 4. Document a preliminary technical position for Q4. The Treasury announcement is public. Auditors will ask about it. The technical position memo should address: whether the announcement constitutes enacted or substantially enacted legislation under ASC 740 (it does not — proposed regulations are neither), whether it creates a reasonably possible change in tax benefit requiring disclosure, and the company's assessment of the three scenarios above. 5. Set a watch on the regulatory calendar. Proposed regulations by September 2027. The moment they drop, the classification analysis reopens across your entire intercompany note portfolio. Build the team and the data structure to respond in the period the regulations are issued, not the period after.
Treasury told you the direction on October 6. The per se rule has trapped intercompany structures in equity treatment for a decade. That constraint is lifting. The companies that model the impact now — rather than waiting for proposed regulations in September 2027 — are the ones whose provision will not be surprised. Start the analysis this week.
Clarity Tax models intercompany debt classification, BEAT sensitivity, and provision impact in a linked data structure — so a regulatory change like Section 385 repricing doesn't catch your provision unprepared.