By Anthony Diosdi
Once a foreign corporation is established, it must decide how to raise funds. Like domestic corporations, foreign corporations often raise capital through issuing stocks or through borrowing. The investor who acquires stock holds an equity interest in the corporation while the lender holds a debt or creditor interest in the foreign corporation. In either case, the investor or lender expects a return on the investment. Shareholders may receive that return from dividends paid on stock and from profit upon later sale of the share. On the other hand, lenders receive their return on their investment in the form of interest payments. Many U.S. investors do not wish to hold an equity investment in a foreign corporation because of the harsh GILTI or subpart F income tax consequences associated with holding stock in a controlled foreign corporation (“CFC”).
The Tax Advantage of Debt vs. Equity
Corporate issues of stock and debt are simply alternative methods of raising corporate capital. From a finance point of view, a corporation’s capital structure does not change when funds are raised either through debt instruments or equity investments. Why, then, should there be any difference in the tax treatment of debt and equity of a foreign corporation? This question goes to the very heart of the U.S. taxation of a foreign corporation classified as a CFC. One could eliminate much of the discrepancy between debt and equity by treating all CFC financial instruments as debt. Thus, the CFC would be entitled to deduct all payments to U.S. investors and all U.S. investors would report “interest” income on their U.S. tax returns. The GILTI and subpart F tax regimes would be eliminated. In addition, the Form 5471 filing requirements for many U.S. investors in foreign corporations would be eliminated.
For these reasons, on numerous occasions, the Internal Revenue Service (“IRS”) recharacterized alleged U.S. investor debt as equity, based upon various U.S. concepts. The biggest problem that taxpayers and their representatives face in this area is that there are no specific rules to delineate between debt instruments from equity investments. As is often the case in the international tax area, the primary question in deciding whether an instrument represents “debt” or “equity” is ultimately one of intent- in other words, whether the “borrower” and the “lender” intended to create a genuine debtor-creditor relationship. This type of business relationship often cannot be determined through a series of basic tests. In addition, note that different countries may have different inconsistent standards for determining debt and equity.
Internal Revenue Code Section 385
Since its enactment in 1969, Internal Revenue Code Section 385(a) has in effect provided the IRS with the authority “to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of [the Internal Revenue Code] as stock or indebtedness (or in part as stock or indebtedness).” Pursuant to Internal Revenue Code Section 385(b), these regulations shall set forth which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporate-shareholder relationship exists. An unusual provision of Section 385 offers suggestions to the IRS as to the factors it may include in regulations distinguishing debtor-creditor relationship from corporate-shareholders relationships. These suggested factors are:
1. Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s with and to pay a fixed rate of interest;
2. Whether there is subordination to or preference over any indebtedness of the corporation;
3. The ratio of debt to equity of the corporation;
4. Whether there is convertibility into the stock of the corporation; and
5. The relationship between holding of stock in the corporation and holding of the interest in question.
Section 385(c) provides that a corporate issuer’s characterization of an instrument as debt or equity at the time of issuance shall be binding on the issuer and all holders of the interest- but not binding on the IRS. This rule of consistency does not apply to holders who disclose on their tax return that they are treating the interest in a manner inconsistent with the issuer’s characterization.
IRS Notice 94-47
In Notice 94-47, 1994-19 I.R.B. 1, the IRS provided guidance discussing how it viewed instruments designated to be treated as debt for tax purposes but equity for regulatory, rating, or financial accounting purposes, as well as slightly expanding the list of factors provided in Internal Revenue Code Section 385(a):
“The characterization of an instrument for federal income tax purposes depends on the terms of the instrument and all surrounding facts and circumstances. Among the factors that may be considered in making this determination are: (a) whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future; (b) whether holders of the instruments posses the right to enforce the payment of principal and interest; (c) whether the rights of the holders of the instrument are subordinate to rights of general creditors; (d) whether the instruments give the holders the right to participate in the management of the issuer; (e) whether the issuer is thinly capitalized; (f) whether there is identity between holders of the instruments and stockholders of the issuer; (g) the label placed upon the instruments by the parties; and (h) whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency, or financial accounting purposes. No particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity. The weight given to any factor depends upon all the facts and circumstances and the overall effect of an instrument’s debt and equity features must be taken into account.”
In the Notice, the IRS indicated in audit, it would scrutinize instruments of this type to determine if their claimed status as debt for federal income tax purposes is appropriate. Of particular interest were purported debt instruments that contained a variety of equity-type features, including an unreasonably long maturity or an ability to repay the instrument’s principal with the issuer’s stock. The IRS’s analysis of such instruments takes into account the cumulative effect of these features and other equity features. If the parties are not related, labeling an instrument “equity” generally precludes a debt characterization.
Regulations or Lack of Regulations
In March, 1980, 11 years after Section 385 was enacted, the U.S. Treasury issued a lengthy, detailed and controversial set of proposed regulations. See 45 Fed.Reg. 18957 (1980). Extensive amendments were proposed in December, 1981, followed by still further extensions of the effective date. In July, 1983, all versions of the regulations were withdrawn. Despite the IRS’s and Treasury’s lack of regulations under Section 385, Congress has provided some guidance.
Internal Revenue Code Section 385 was amended to permit (not require) the Department of Treasury to classify an interest having significant debt and equity characteristics as “in part stock and in part indebtedness.” See IRC Section 385(a). According to the legislative history, bifurcation may be appropriate where a debt instrument provides for payments that are dependent to a significant extent on corporate performance, such as through “equity kickers” (provisions in a debt instrument that provide the holder with an equity interest in certain circumstances).
Long-awaited Final Regulations for Internal Revenue Code Section 385 were issued in October 2016. The regulations set forth detailed documentation requirements for an instrument to qualify as debt or equity and the recharacterization of certain instruments. The Section 385 regulations generally apply when a borrower and a lender are both corporate members of an “expanded group,” which generally consists of the members of a group of corporations whose common parent owns directly or indirectly at least 80 percent of the vote or value of the member’s stock. In September of 2018, Proposed Regulations were issued that would remove the Treasury Regulation Section 1.385-2 documentation regulations. The Department of Treasury and the IRS also announced that they will continue to study the documentation issues and when the study is complete, they may propose a simplified streamlined version of the documentation regulations with a prospective implementation date to allow sufficient lead-time for U.S. lenders to design and implement systems to comply with newly issued regulations.
Case Law Considerations
Case law points out that to have a valid debt instrument there must be an unconditional obligation on the part of the transferee to repay the money and an unconditional intention on the part of the transferor to secure repayment. If there is no unconditional obligation on the “lender” to repay money, the lender would be in no different position than a shareholder of the “borrower.” See Geftman v. Commissioner, 154 F.3d 61 (3d Cir. 1998). As a general rule, to be respected as genuine debt, it is important that certain formalities be observed. The note holder should act like a reasonable creditor, taking reasonable steps to enforce payment. In addition, it should be relatively clear that the foreign corporation will have sufficient cash to meet its debt obligation. Even if the formalities normally associated with debt instruments are strictly observed, the debt may nevertheless be classified as equity if, after consideration of other relevant factors, the instrument more resembles equity than debt.
Often controlled foreign corporations will make loans and advances to each other. In these cases, an arm’s length rate of interest on any intercompany loans or advances must be charged. The exception to this rule is for debts related intercompany trade receivables that arise in the ordinary course of business.
Although distinguishing debt for equity is extremely important in determining the proper tax and reporting consequences of many cross-border corporate transactions, actually making the distinction often is no easy task. Variations in the types and terms of financial instruments are boundless. However, making a debt-equity distinction can be a frustrating exercise. There are no precise rules, but rather a number of factors to be applied in a facts and circumstances balancing act. Any U.S. person or corporation involved in cross-border lending transactions should consult with a qualified international tax attorney.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.