Debt or Equity |The IRS Cares

Creating a U.S. entity owned by a foreign corporation raises many important issues, such as: 

1. whether to operate as a subsidiary, branch, sister-company, or LLC; 
2. whether to use a U.S. holding company structure for NOL benefits; 
3. whether the foreign company can use the U.S. losses; and 
4. whether the foreign company's funding of the U.S. entity is debt or equity.

This article will discuss this debt v. equity issue of U.S. subsidiaries owned by a foreign corporation.

Debt is Preferable

It is a well-understood tax principle that it is generally better to fund a company using debt rather than equity. This is because: 

1. interest expense is generally deductible, dividends are not; 
2. there is no U.S. withholding tax on principal repayment, and, 
3. the U.S. withholding tax on interest is generally less than that of dividends (for treaty partner creditors).

Interest Stripping Rules

Debt is still preferable to equity even if a portion of the interest deductions are deferred under the so-called "interest stripping rules" of IRC section 163(j). These rules generally limit a corporation's interest expense deduction to the extent it exceeds 50% of the adjusted taxable income, provided: a) the interest is paid to or guaranteed by a related party, b) no U.S. income tax is imposed or lower U.S. withholding tax rates are claimed under double taxation treaties, and c) the debt-to-equity ratio is 1.5 to 1, or greater. Interest that is limited is carried forward to the subsequent year

U.S. Withholding Tax

The statutory U.S. withholding tax rates are 30% for both interest payments and dividend distributions, unless lower rates are provided in an income treaty. Even so, the repayment of principal is not subject to the U.S. withholding tax, making debt again preferable to equity.

The U.S. has a number of income tax treaties, which in most cases provide for lower tax withholdings for interest and dividend payments. Typically, the interest withholding rates is less than the dividend withholding rates, and in many cases, the interest withholding rates are 0%. Listed below is a sample of the tax withholding rates for some of the U.S.'s treaty partners:

Debt v. Equity Factors

Distinguishing debt from equity is subjective at best, especially between related parties. Recognizing this difficulty, Congress enacted section 385 in 1969 to provide some guidance. Additionally, three sets of regulations were issued, but were withdrawn in 1983 due to their complexity.

Below is a partial list of key factors used to distinguish debt from equity, based on the fundamentals of IRC section 385 and conclusions reached in various court decisions (a yes answer is an equity factor): 

1. Is the corporation thinly capitalized (therefore debt-to-equity ratio is generally 4:1 or greater)? 
2. Does the debt lack a fixed maturity date (this indicates repayment is tied to the success of business, which is tantamount to a dividend)? 
3. Is the obligation interest free or is there no requirement to pay interest timely (failure to insist on interest payments implies payment is contingent on profits, which is tantamount to a dividend)? 
4. Does the debt lack typical creditor protections such as collateral, enforcement provisions or maturity dates? 
5. Was there an inability to obtain alternative financing from unrelated lenders? 

Laidlaw: Form not Enough

It is generally believed that related party "long-term advances" will have little success as debt classification. It is typical for related party debt obligations to be formalized, and interest bearing. This however, may not be enough in related party circumstances. The Laidlaw case (Laidlaw Transportation, Inc. TC Memo 1998-232, June 30, 1998) has cautioned us all that the IRS continues to care about this issue. As is often the case, the "form" of the transaction is less important than the "substance", especially when dealing with related parties.

In Laidlaw, Tax Court disallowed interest expense of $133 million paid by a U.S. subsidiary of a Canadian Company, despite the existence of formalized notes, actual interest payments, and the existence of enforcement rights.
The most crucial flaw was what the court termed as the "interest reinvestment loan". Interest repayments were immediately loaned back to the same or other U.S. subsidiaries. Additionally, the loans were payable upon demand and subordinated to unrelated creditors; the company was in violation of its bank loan covenants and could not show the ability to obtain these related party loans from unrelated parties.

Most related party loans are inherently problematic, especially when a business is faltering. Debt is usually subordinated, and repayment is naturally delayed. The Laidlaw case tells us that the interest must be paid timely and cannot be loaned back, without exception.

Conclusion

Caution must be exercised when structuring the capitalization of a U.S. subsidiary. The debt should be formalized, with interest paid and not loaned back. It also behooves one to monitor the 4:1 debt to equity ratio, and even consider treating otherwise desired debt as equity, as the courts frequently make an all or nothing determination. 

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