My last two blog posts, here and 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. The series then looked at case law on the topic of “debt” versus “equity”, examining some of the factors used by the courts in the debt/equity analysis. 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”. See my first blog post for more detail.
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 face of such uncertainty, it will be very helpful to have an understanding of what the courts consider important factors in making a determination of an interest as “debt” or “equity”. 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.
Last week’s blog post began the examination of factors used by the courts in making a debt-equity determination; this post will examine the remaining 8 factors:
- Are the Advances Subordinate to Any Other Corporate Loans?
If they are, 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).
- What was Intent 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 where (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).
- Is there an “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. “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).
- Are the Interest Payments Contingent or Dependent on Business Profits?
Here, the courts will look to the source of payments on the instrument. When the purported interest payments depend on the availability of future earnings of the business, then the instrument more closely resembles “equity”. See PepsiCo Puerto Rico, Inc. v Commissioner, T.C. Memo. 2012-269 (2012). When repayment is possible only out of corporate earnings then [t]he 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” (Estate of Mixon, above, at 405).
- Could the Corporation have Obtained 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”.
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