My earlier blog post detailed some of the 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. This area of law has taken on heightened significance lately since the IRS issued Proposed Treasury Regulations (REG-108060-15) in April under Code Section 385, which deals with the classification of certain interests in corporations as either “debt” or “equity”. Even if the Proposed Regulations are adopted, they will not apply to all cases but rather, only to cases involving so-called “expanded group indebtedness” (EGI), with the end result that many taxpayers will still struggle with classification of an interest as “debt” or “equity”. The Proposed Regulations have not yet been adopted, and their fate remains uncertain so doubts as to how to classify an instrument will not completely disappear even for those cases involving EGI.
In the meantime, taxpayers and their advisors should remember that 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.
- How was the Instrument Labeled by the Parties?
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. As an aside, I will mention here that the Proposed Treasury Regulations (See Section 1.385-2) contain a new requirement mandating “contemporaneous documentation” for certain related-party debt in order for the interest to possibly be respected as “debt” for US tax purposes. If the taxpayer does not prepare and maintain the documentation so that it can be provided to the IRS upon request, the related-party debt will be treated per se as an equity interest (i.e., a stock interest held as a shareholder). Simply put, in the absence of documentation, treatment as indebtedness will simply not be permitted.
- Is there 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, a characteristic of a debt obligation. The absence of the same on the other hand would indicate that repayment was in some way tied to the fortunes of the business, indicative of an equity advance” Estate of Mixon, at 404.
- Are Repayments on the “Loan” Tied to Earnings of the Business?
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”.
- Is there a Right 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.
- Does the Party Advancing Funds Have any Right 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 8 factors commonly used by the courts in making a debt-equity determination.
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