What happens if you make a loan to a foreign (non-US) corporation and the Internal Revenue Service (IRS) later determines that the “loan” should not be treated as a “loan” for US tax purposes? Instead, the IRS says it should be treated as if you made a capital contribution to the corporation and therefore had an “equity” interest in the corporation – what might happen? The tax classification of an instrument as either “debt” or “equity” impacts many tax law provisions, and in the foreign context the impact can be volatile.
You Say “Debt”
Let’s look more closely at the example, above. You advance funds to a foreign corporation and believe that the advance constitutes a loan and that you are merely a creditor in the corporation. When you receive payments from the company, you report what you consider to be “interest” payments on your US tax return as interest income; you do not report any repayments of “principal”. Other than that, you do nothing.
IRS Says “Equity”
Enter the IRS, which claims that your investment in the corporation is not as a mere creditor holding a “debt” instrument, but rather as a shareholder, holding an “equity” interest in the entity. In this case, the IRS views your payment of funds to the company as a capital contribution to the company rather than as a loan to it. Let’s assume, the IRS determines that your equity interest constitutes a 15% shareholding in the company, which is otherwise owned only by non-US persons.
What a Mess! Penalties, Penalties, Penalties…
As a result, for starters – here’s what may go down:
IRS assesses you a penalty for not filing Form 5471 when you became a shareholder in the entity. It then moves on to examine whether the entity is a “Passive Foreign Investment Company” (PFIC) and if so, whether you received any “excess distributions” from the PFIC when you received payments from the corporation. Any “excess distribution” will be taxed at the highest ordinary income tax rate currently in effect, without regard to your other income or expenses. If this happened today, it means you will be taxed at the rate of 39.6% on the distribution; and, if you are a high income earner, an additional 3.8% Medicare surcharge (the Net Investment Income Tax or NIIT) will be tacked on for good measure. What makes matters worse is that under the PFIC rules, the amounts will be treated as if they were earned ‘pro rata’ over the time period you are treated as having held your investment (i.e., the years you held your shareholding interest before receiving the “excess distribution”). The amounts to be taxed will be “thrown back” evenly over each of the earlier tax years commencing with the year when you are treated as having first held the shares. Tax is then assessed for each year at the highest possible tax rate (currently 39.6%), and interest will then be compounded on the tax deemed to be due for each year. The imposition of compounded interest charges can easily destroy your investment.
In addition to the above, further penalties may result, for example, for failing to file Form 8621 for PFIC investments and, Form 926 for capital contributions to a foreign corporation.
Improper classification will also impact the filing of Form 8938. If the interest is a true debt, the US taxpayer will be required to report the loan receivable on Form 8938. If, instead, it is “equity”, and the foreign corporation is not a PFIC (or a so-called “Controlled Foreign Corporation” or “CFC”), the US taxpayer will be also required to report this foreign financial asset on Form 8938. If the corporation qualifies as either a PFIC or CFC, the taxpayer needs to tick a specific box in Form 8621 (for PFIC investments) or Form 5471 noting that the interest is a so-called “Excepted Specified Foreign Financial Asset”. On the Form 8938 itself, the taxpayer must also enter the number of Forms 8621/5471 that have been filed with respect to the “Excepted Specified Foreign Financial Asset”.
If you are treated as owning a larger interest in the corporation (i.e., over 50%), you will have FBAR problems as well since an owner of over 50% of a corporation must file an FBAR for the corporation’s foreign bank accounts.
A mistake in classification may also cause problems for the foreign corporation under the so-called FATCA rules. The foreign corporation should report on Form W8 BEN-E all of its “substantial” US owners (that is, a US person owning more than 10 percent) to the financial institutions where it has its accounts.
As you can see, things can get messy (and expensive) when mistakes are made in classifying an interest as “debt” or “equity” in a foreign corporation.
“Debt” versus “Equity” – How to Tell?
Code Section 385 deals with the classification of certain interests in corporations as either “debt” or “equity” interests. It was originally enacted in 1969 and later amended in 1989 and 1992. The Code section itself provides scant guidance on the subject and gives the IRS authority to issue Treasury Regulations to determine whether an interest in a corporation should be classified as debt or stock (equity) in the corporation.
The IRS issued Treasury Regulations but later withdrew them over 30 years ago. (See Treasury Decision 7920 1983-2 C.B. 69 withdrawing Treasury Decision 7747 Relating to Debt and Equity). Currently there is a lack of clear guidance from the IRS as to how one can determine whether an instrument constitutes “debt” or “equity”. However, various court cases have established a list of factors that are to be examined in making this debt/equity determination.
Proposed Treasury Regulations
Most recently, the IRS issued Proposed Treasury Regulations (REG-108060-15) under Internal Revenue Code Section 385 addressing whether an interest in a related corporation should be treated as stock or debt, or as “part” stock / “part” debt. The Proposed Regulations have created concern among tax professionals and it is clear that if adopted these regulations will most likely lead to greater IRS scrutiny of related party transactions both domestically and overseas.
A public hearing on the Proposed Treasury Regulations was held on July 14. The IRS received significant pushback from individuals who were testifying as representatives of trade associations, law firms and audit firms among others. Highlights of the hearing can be found in the video here.
Application of the Proposed Regulations is circumscribed to what is called “expanded group indebtedness” (EGI). EGI is defined as an applicable instrument of which both the issuer and the holder are members of the same “expanded group,” the definition of which limits application of the proposed rules to transactions between closely-related parties. An “expanded group” is defined as an affiliated group under Code Section 1504(a) but with certain modifications. For example, an “expanded group” includes all corporations, including foreign corporations and corporations held indirectly (e.g., through partnerships); in addition it includes corporations connected by ownership of 80 percent vote or value, rather than vote and value. Thus, even if the Proposed Regulations are adopted, they will not apply to all cases but rather, only to cases involving EGI, meaning 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 disappear even for those cases involving EGI.
In the meantime, taxpayers and their advisors should remember that case law on this topic has been used to classify an interest as either “debt” or “equity” since the enactment of Section 385. The case law has continued to develop over the years. My blog posts over the next two weeks will detail the factors examined by the Courts in making a “debt” versus “equity” determination.
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