Intercompany Debt, Or Is It Equity?
Already, the recent issuance of Section 385 proposed regulations had the multi-national tax community thinking about their intercompany debt. It’s a good time to revisit this topic and to review how these transactions have been treated historically by the IRS.
This particular area of tax law has been the subject of much tax litigation, so we’ll revisit the basics and understand how the proposed regulations could potentially change the status quo.
The History
Prior to 1969, the question of debt versus equity was addressed on a case-by-case basis by weighing the relevant facts and circumstances. With the passage of Section 385 in 1969, the Treasury was given the right to issue regulations that would provide guidance on what constitutes debt versus stock.
It took some time before any guidance was issued. In the early 1980s proposed regulations were issued and were subsequently withdrawn for lack of clarity. In light of the failed attempt the question continued to be addressed on a case-by-case basis.
The recent proposed regulations were the first regulatory developments with respect to Section 385 since the failed attempt in the 1980s.
Although the proposed regulations have far-reaching effects for multi-nationals in terms of documentation and other potential consequences, in their proposed forms the regulations don’t change the basic determination of what constitutes equity and what constitutes stock.
Relevance
The most significant difference in the tax treatment of debt and equity is with respect to the deductibility of current payments. Interest payments on debt instruments are deductible to the payor, while no comparable deduction is allowed for distributions to shareholders.
Practice
Like all related party transactions, intercompany debt must meet the arm’s length standard. That is the stated terms and rate on the instrument must be similar to those present in debt between two unrelated parties.
Even if the general arm’s length standard is met, the IRS may assert that a debt instrument is stock based on the facts and circumstances surrounding the particular instrument. Judicial precedence and IRS informal pronouncements have given us guideposts concerning the criteria that the IRS will consider in differentiating debt from equity. Some of the factors are:
- The presence or absence of a fixed maturity date.
- The source of the principal payment(s).
- The right to enforce payments of principal and interest.
- The debt holder’s participation in management.
- Whether the corporation is adequately capitalized (i.e. debt to equity ratio).
- The commonality or parallelism of interests between creditors and shareholders.
- The source of the interest payments.
- The ability of the corporation to obtain loans from outside lending institutions.
- The failure of the debtor to repay on the due date or to seek a postponement.
- Independence of the debt holder and stockholder.
- Intent to create debt.
- Creation of a formal debt instrument.
- Certainty of the interest payments.
- Ability to pay and source of the interest payments.
No single factor is controlling rather the courts and the IRS look to see if the overall debt characterizations outweigh the equity characterizations.
Section 385 Proposed Regulations
The Section 385 proposed regulations would not change what factors are considered or the general approach to differentiating between debt and equity. These proposed regulations do however add a category of debt instruments that would be treated as equity per se by the IRS. These debt instruments include instruments issued as part of a corporate reorganization and/or as a distribution.
The proposed regulations also provide that the IRS, on exam, may divide the treatment of one instrument into a combination of debt and equity.
And finally, the proposed regulations impose a new contemporaneous documentation requirement for related party debt.
Conclusion
Typically there is a greater tax benefit derived from treating an instrument as debt rather than equity. Consequently taxpayers should work with their advisors to insure that the transactions they are treating as intercompany debt transactions would be respected as such by the IRS.
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Chaya Siegfried, CPA, MST T (732) 842 3113 [email protected]
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