Determinative Factors: “Debt” v. “Equity” and Your Loan to a Foreign Corporation (Part I)

My earlier blog post detailed some of the US tax consequences that could occur when a taxpayer makes, what he thinks is a “loan” to a foreign corporation, but that the Internal Revenue Service (IRS) later determines should be treated as an “equity” interest in the corporation.  

As set out in my earlier blog post, Treasury Regulation Section 1.385-1(b), provides that 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 one must look to the various court cases which have established a list of factors to be examined in making the debt/equity determination. 

Case law on the topic of “debt” versus  “equity” has developed significantly over the years.  My blog post today and next week will detail the factors examined by the Courts in making a “debt” versus “equity” determination. It should be noted that each factor is not equally significant; no single factor alone will be determinative of the outcome and finally, because of the different fact patterns that can arise when presented with a debt-equity question, not all of the factors will be relevant to each and every case. 

Evaluating cases when the factors are not brightly lining up on one side or the other requires experience and judgment.  It pays to get the proper tax advice when faced with making what the taxpayer believes will be a “loan” to a corporation or when faced with a situation involving a “debt”/”equity” classification.

  • Documentation 

An instrument designated by the parties as a promissory note, bond, or debenture is more likely to be considered to represent “debt”; whereas the issuance of a stock certificate indicates an equity contribution. See Estate of Mixon v. United States, 464 F.2d 394, 403 (5th Cir. 1972). The importance of documentation cannot be over-emphasized.  If the taxpayer does not prepare and maintain  documentation so that it can be provided to the IRS upon request, related-party debt may more likely be viewed as an equity interest (i.e., a stock interest held as a shareholder).  Simply put, in the absence of documentation, treatment as indebtedness falls on shaky ground.  

  • A Fixed Maturity Date

A fixed maturity date will support treatment of the interest as a “debt”. “The presence of a fixed maturity date indicates a fixed obligation to repay. The intent to repay is an all-important characteristic of a debt obligation.  On the other hand, the absence of a fixed repayment date would indicate that repayment was in some way tied to the success and profitability of the business.  Under those circumstances, it is indicative of an “equity advance” Estate of Mixon, at 404.

  • “Loan” Repayments Tied to Earnings of the Business

Here, the courts will look to the source of payments on the instrument. If the repayments are principally connected to the ability of the entity to generate earnings, an equity classification is more likely. Estate of Mixon, above at 405. “[I]f repayment is possible only out of corporate earnings, the transaction has the appearance of a contribution of equity capital but if repayment is not dependent upon earnings, the transaction reflects a loan to the corporation”.   See also PepsiCo Puerto Rico, Inc. v Commissioner, T.C. Memo. 2012-269 (2012). 

  • Rights to Demand and Enforce Repayment

When the party who advanced the funds has a legally enforceable right to demand repayment, the interest more closely indicates a debt instrument. 

  • Rights to Participate in Management

Treatment of the interest as “equity’ is more likely if an instrument provides the ability to participate in management.  See, Hardman v. United States, 827 F.2d 1409, 1413 (9th Cir. 1987)  “If a stockholder’s percentage interest in the corporation or voting rights increase as a result of the transfer, it will contribute to a finding that the transfer was a contribution to capital.”

Next week’s blog post will examine the remaining factors commonly used by the courts in making a debt-equity determination.

Posted March 24, 2022

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