United States Tax Court holds debt was equity for tax purposes
IRS disallowance of interest deductions on purported debt upheld
TAX ALERT |
The use of debt in financing in merger and acquisition (M&A) transactions can result in several tax benefits, most notably interest deductions that reduce the taxable income of the business. Equity financing, on the other hand, yields different results and no tax deductions by the business. Where the business is a C corporation, payments made to the holder of the equity generally represents a dividend to the extent of the corporation’s earnings and profits. With the comparatively high corporate tax rate in the United States, many corporate taxpayers look at debt, and its corresponding tax shield, as a key component in financing an M&A transaction or corporate restructuring.
However, where the creditor is also a shareholder, several questions arise with respect to whether the purported debt is in fact equity, thereby eliminating claimed interest deductions and potentially raising withholding tax concerns. The question as to whether an item represents debt or equity from a federal income tax perspective is an issue that has been litigated numerous times over the years and significant case law exists providing numerous factors to assist in the determination. In addition, the IRS recently issued proposed regulation under section 385 to address perceived abuses in the use of intercompany debt between certain taxpayers. More on these proposed regulations can be read in our article, Treasury officials offer insights on proposed debt/equity regulations.
The United States Tax Court recently ruled on one such situation, denying debt treatment on intercompany debt between taxpayers. See American Metallurgical Coal Co. and Subsidiaries v. Commissioner, T.C. Memo. 2016-139.
The case involved a note payable by a U.S. corporation (USCO) to a foreign corporation (FCO) that generated interest deduction in the United States. In determining whether the note will be treated as debt or equity, the Tax Court reviewed several factors (including maturity dates, interest amounts, debtor/creditor relationship, terms of the note, source of funds, right to enforce, etc.), noting that not all factors hold equal significance and that no one factor is determinative. Of particular importance were facts such as:
- The entire purchase price of the asset acquired by USCO was financed with the note
- The note having a 10-year fixed maturity that was postponed for seven years because USCO did not have sufficient funds to pay
- USCO violated the terms of the note failing to make payments in 2003 and 2004 while the creditor seems to have failed to enforce creditor rights
- The terms of the debt provided the creditor with the right to approve of the business activities of USCO
In addition, USCO did not establish that any of the note terms were properly negotiated nor that the parties pronouncements of intent to create a debt held any significance. The Tax Court found the parties did not intend to enter into a true debtor-creditor relationship based on the facts and circumstances.
The result of the Tax Court’s decision was significant. Not only was tax due on the disallowance of the claimed interest deduction, but the IRS asserted and the Tax Court upheld the 20 percent accuracy-related penalty holding that the taxpayer did not have substantial authority for its positions and failed to act reasonably and in good faith. In coming to this conclusion the Tax Court noted that the taxpayer neither fully followed the recommendations of the tax advisor they were relying upon nor did the tax advisor’s advice reach the level of his firm’s opinion letters for which a client can reasonable rely upon. In addition to the foregoing, characterizing the note as equity caused the distributions previously made upon it to FCO to be subject to withholding tax. With no tax treaty in place, the consequence was that USCO was also liable for 30 percent withholding tax on all the distributions made to FCO.
In summary, this case is a good example of the negative consequences that can follow implementation of a tax planning strategy without the proper planning. When establishing related party debt instruments, it is critical to consider the various debt/equity factors and attempt to establish as many debt characteristics as possible, understanding that creation of a debt instrument with stated principal, interest and maturity date is not necessarily sufficient to establish the instrument as a debt. Consult with your tax advisor when exploring such a transaction.