What happens if you make a loan to a foreign (non-US) corporation and the Internal Revenue Service (IRS) later determines that the “loan” should not be treated as a “loan” for US tax purposes? Instead, the IRS says it should be treated as if you made a capital contribution to the corporation and therefore had an “equity” interest in the corporation – what might happen? The tax classification of an instrument as either “debt” or “equity” impacts many tax law provisions, and in the foreign context the impact can be volatile.
You Say “Debt”
Let’s look more closely at the example, above. You advance funds to a foreign corporation and believe that the advance constitutes a loan and that you are merely a creditor in the corporation. When you receive payments from the company, you report what you consider to be “interest” payments on your US tax return as interest income; you do not report any repayments of “principal”. Other than that, you do nothing.
IRS Says “Equity”
Enter the IRS, which claims that your investment in the corporation is not as a mere creditor holding a “debt” instrument, but rather as a shareholder, holding an “equity” interest in the entity. In this case, the IRS views your payment of funds to the company as a capital contribution to the company rather than as a loan to it. Let’s assume, the IRS determines that your equity interest constitutes a 15% shareholding in the company, which is otherwise owned only by non-US persons.
What a Mess! Penalties, Penalties, Penalties…
As a result, for starters – here’s what may go down:
IRS assesses you a penalty for not filing Form 5471 when you became a shareholder in the entity. It then moves on to examine whether the entity is a “Passive Foreign Investment Company” (my blog post on PFICs is here) and if so, whether you received any “excess distributions” from the PFIC when you received payments from the corporation. Any “excess distribution” will be taxed at the highest ordinary income tax rate currently in effect, without regard to your other income or expenses. Capital gain rates will not apply to any later disposition of an interest in a PFIC.
If this happened today, it means you will be taxed at the rate of 37% on the distribution; and, if you are a high income earner, an additional 3.8% Medicare surcharge (the Net Investment Income Tax or NIIT, discussed at my blog here) will be tacked on for good measure. What makes matters worse is that under the PFIC rules, the amounts will be treated as if they were earned ‘pro rata’ over the time period you are treated as having held your investment (i.e., the years you held your shareholding interest before receiving the “excess distribution”). The amounts to be taxed will be “thrown back” evenly over each of the earlier tax years commencing with the year when you are treated as having first held the shares. Tax is then assessed for each year at the highest possible tax rate (currently 37%), and interest will then be compounded on the tax deemed to be due for each year. The imposition of compounded interest charges can easily destroy your investment.
In addition to the above, further penalties may result, for example, for failing to file Form 8621 for PFIC investments and, Form 926 (my blog post is here) for capital contributions to a foreign corporation.
Improper classification will also impact the filing of Form 8938. If the interest is a true debt, the US taxpayer will be required to report the loan receivable on Form 8938. If, instead, it is “equity”, and the foreign corporation is not a PFIC (or a so-called “Controlled Foreign Corporation” or “CFC”), the US taxpayer will be also required to report this foreign financial asset on Form 8938. If the corporation qualifies as either a PFIC or CFC, the taxpayer needs to tick a specific box in Form 8621 (for PFIC investments) or Form 5471 noting that the interest is a so-called “Excepted Specified Foreign Financial Asset”. On the Form 8938 itself, the taxpayer must also enter the number of Forms 8621/5471 that have been filed with respect to the “Excepted Specified Foreign Financial Asset”. Form 926 will also be implicated upon making a transfer of cash or property to a foreign corporation (details at my post here). Generally, if cash is transferred to the corporation, Form 926 must be filed when the cash transfers exceed US$100,000 over a 12-month period; or, regardless of amount, if immediately after the cash transfer, the transferor holds more than 10% of the total voting power or total value of the foreign corporation.
If you are treated as owning a larger interest in the corporation (i.e., over 50%), you will likely have FBAR problems as well, since an owner of over 50% of a corporation must file an FBAR for the corporation’s foreign bank accounts.
A mistake in classification may also cause problems for the foreign corporation under the so-called FATCA rules. The foreign corporation should report on Form W8 BEN-E all of its “substantial” US owners (that is, a US person owning more than 10 percent) to the financial institutions where it has its accounts.
As you can see, things can get messy (and expensive) when mistakes are made in classifying an interest as “debt” or “equity” in a foreign corporation.
“Debt” versus “Equity” – How to Tell?
Code Section 385 deals with the classification of certain interests in corporations as either “debt” or “equity” interests. It was originally enacted in 1969 and later amended in 1989 and 1992. The Code section itself provides scant guidance on the subject and gives the IRS authority to issue Treasury Regulations to determine whether an interest in a corporation should be classified as debt or stock (equity) in the corporation.
The IRS issued Treasury Regulations but later withdrew them over 30 years ago. Proposed regulations were then issued in the Spring of 2016, some of which were finalized later in the Fall. In November 2019, the Treasury removed some of the regulations; later other parts of the temporary regulations expired leaving only certain portions of the regulations intact. Skipping to the good part, for purposes of this post, under Treasury Regulation Section 1.385-1(b), the determination whether a debt instrument will be respected as a debt instrument must first pass what is called a “common law” analysis. This means we look to the various court cases which have established a list of factors that are to be examined in making the debt/equity determination.
Forthcoming blog posts will examine the factors examined by the courts in making a “debt” versus “equity” determination.
Posted March 17, 2022
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