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

My recent blog post, here examined some of the tax consequences that could occur when a taxpayer mistakenly classifies an advance to a foreign corporation as a “loan” but that the Internal Revenue Service (IRS) treats as a stockholding interest (“equity”) in the corporation.  Last week’s blog post  began examining factors used by the courts in making a debt-equity determination.  This post will continue that analysis and examine the remaining important factors. 

Remember, 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.

  • Advances Subordinated to Other Corporate Loans

If the advances are subordinated to that of other corporate creditors, then the interest is closer to “equity”. “Whether the advance has a status equal to or inferior to that of regular corporate creditors is, of course, of some import in any determination of whether taxpayer here was dealing as a shareholder or a creditor” (See Estate of Mixon v. United States, 464 F.2d 394, 406 (5th Cir. 1972).

  • Intention of the Parties

The tax classification of an interest as “debt” or “equity” will be impacted by the intent of the parties at the outset as well as by their subsequent acts, and how that intent was manifested. “[T]he manner in which the parties treat the instruments is relevant in determining their character”.  See, Monon Railroad v Commissioner, 55 T.C. 345, 357 (1970). Despite the well-recognized difficulties in distinguishing between debt and equity instruments, the focus of the court’s inquiry will generally narrow down to whether the parties intended to create a debt with a reasonable expectation of repayment.  If they did, the focus will shift to whether that intent comports with the economic reality of maintaining a debtor-creditor relationship, or shifting that relationship to something else.

  • Is the Corporation “Thinly Capitalized”?

Generally, a corporation is financed (or capitalized) through a mixture of debt and equity. When a company is thinly capitalized this means that it is financed through a relatively high level of debt (borrowed funds) when compared to equity (capital contributions by owners). When a corporation is thinly capitalized, a transfer of funds to it “[i]s very strong evidence of a capital contribution when (1) the debt to equity ratio was initially high, (2) the parties realized the likelihood that it would go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations.” (Estate of Mixon, above, at 408). 

The courts have taken different views about how much weight to give to the debt-equity ratio. Some courts view an acceptable level of debt to equity by examining what is a reasonable standard within the particular industry and the business being conducted.  Thus, despite having very thin capitalization, a company might be considered adequately capitalized by looking to the standards of the particular industry.

Prior to 2018, Section 163(j) of the US Internal Revenue Code contained so-called earnings-stripping rules that limited interest deductions for certain related-party debt if there was a debt-equity ratio above 1.5:1.  Section 163(j) was intended to prevent the earnings of a thinly capitalized corporation from being siphoned off, in the form of interest, by a foreign investor or other person that was exempt from paying US tax.  If at the end of the year, the debt-equity ratio exceeded 1.5:1, the corporation could not take deductions for so-called “excess interest expense” paid during that year to a shareholder or other related tax-exempt person.  While the 1.5:1 debt-equity ratio is no longer in the US tax law, some practitioners view this as a fairly “safe” ratio.

  • “Identity of Interest” Between Creditor and Stockholder

When shareholders advance funds to a corporation in proportion to their equity holdings in the company, the instrument will more closely resemble equity since there is no real incentive to enforce repayment of the debt. Demanding repayment as a creditor may harm the shareholders’ equity interest in the company. “If advances are made by stockholders in proportion to their respective stock ownership, an equity capital contribution is indicated….. [On the other hand] a sharply disproportionate ratio between a stockholder’s percentage interest in stock and debt is… strongly indicative that the debt is bona fide.” (Estate of Mixon, above, at 409).

  • Ability to Obtain Independent / Third Party Financing

If it can be demonstrated that the corporation could have received financing from other third party lenders at the relevant time, then the instrument may more closely resemble a true debt instrument. On the other hand, if a reasonable creditor would not have made an advance to the corporation at the time in question, then the chance of treating the advance as “equity” instead, will increase. 

  • How have the Funds Been Used?

If the funds are used for capital outlays, as opposed to everyday normal operating expenses, then the interest more closely resembles “equity”.   See Laidlaw Transportation, Inc. v. Commissioner, T.C. Memo 1998-232 at 79 (1998).  A corporation’s use of cash advances to acquire capital assets or to expand its operations (for example, by acquiring a business) suggests the advance is “equity. In contrast, when advances are  used to meet daily operating needs, then the advance indicates “debt”.

  • Is the Corporate-Debtor Meeting Its Obligations When Due?

The courts will examine the actions of the debtor and creditor. If the debtor is failing to make timely payments or seeks postponement of amounts due and the creditor acquiesces, this can indicate the parties do not intend repayment, thereby indicating that the instrument is more akin to “equity”.

Posted March 31, 2022

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