Doing business in the United States: Financing US operations

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A. Debt vs. equity

1. Section 385 regulations

During 2016, Treasury and the IRS issued final and temporary regulations under Section 385 addressing whether an interest in a related corporation is treated as stock or indebtedness, or as in part stock and in part indebtedness (the ‘385 Regulations’). The 385 Regulations appear intended to limit the effectiveness of certain types of tax planning by characterizing related-party financings as equity, even if they are in form ordinary debt instruments. The types of transactions targeted appear to include debt arising through the distribution of notes or loans, primarily in the inbound context.

Note: Application of the 385 Regulations is not limited to these types of transactions. The 385 Regulations instead would apply generally to characterize as equity broad categories of related-party debt transactions that routinely arise in the ordinary course of operations in both the domestic and international context. The 385 Regulations therefore could have a profound impact on a range of modern treasury management techniques, including cash pooling.

Inbound insight: On October 4, 2017, Treasury issued a report recommending that the documentation requirements in the 385 Regulations be either revoked or revised but that the remaining regulations would be retained pending tax reform. An earlier Treasury Notice delayed the effective date of the documentation regulations for interests issued after January 1, 2019. On September 21, 2018, Treasury issued proposed regulations that would revoke the documentation requirements. The status of the remaining 385 Regulations should be monitored closely for developments.

The 385 Regulations generally apply to financial instruments issued after April 4, 2016, or instruments issued before that date that have undergone certain types of significant modifications. Instruments issued after April 4, 2016, but before January 19, 2017, are subject to certain transition rules.

The key operational rules in the 385 Regulations are the following:

  • Reg. secs. 1.385-3 and 1.385-4 characterize as equity (i) notes distributed to a related shareholder, (ii) notes issued to acquire equity of a related entity, and (iii) notes distributed to a related entity as boot in an asset reorganization. The rules also generally would characterize as an equity investment loans to related entities within a 72-month period centered on the date of the loan that (i) distribute dividends, (ii) acquire equity in related entities, or (iii) distribute boot in asset reorganizations.
  • Reg. sec. 1.385-2 would provide a new contemporaneous documentation requirement for related-party debt. Taxpayers would be required to document both the commercial terms of the lending and an analysis of the creditworthiness of the borrower by the due date of the tax return for the year of the loan, with the new requirements applicable for instruments issued on or after January 1, 2019. Taxpayers also would be required to document events after the loan, such as payments of principal and interest and events of default and similar events within 120 days of such events. If these contemporaneous documentation requirements are not satisfied, the financing generally would be characterized as equity.
Inbound insight: Companies and tax practitioners considering any acquisition of a US business entity by a foreign business entity, as well as certain inbound restructuring transactions, will need to consider the full scope of the rules, and the possible adverse US consequences arising from their application. In the meantime, existing judicial principles still will need to be followed, including documenting that there is adequate support for treatment of an instrument as debt or equity for US federal income tax purposes.
Inbound insight: It is unclear at this time what the future holds for the Section 385 regulations. While preparations need to continue to achieve compliance, businesses also should stay focused on the potential for some or even dramatic changes affecting the application or even existence of the regulations.

2. IRS IDR

Companies often finance the operations of their global business through intercompany loans. In determining whether intercompany loans are truly debt in nature or whether they are, in fact, equity transactions, the IRS has developed a 13-part Information Document Request (IDR), which includes a request for financial data for years outside of the particular audit cycle.

If the IRS finds the transaction to appear more like equity than debt in nature, the interest deduction taken on a company's tax return associated with the ‘debt’ will be denied. For companies that have recently increased their debt level, it is likely that the IRS will focus even more on this issue, potentially auditing future years when the intercompany debt exponentially increases.

The factors the IRS will consider–which are based on relevant case law–include whether:

  • an arm's-length rate of interest was charged and interest payments were timely made
  • the debt is evidenced by written documents such as notes
  • the debt has a fixed maturity date and scheduled payments 
  • there is an expectation that the debt will be repaid with free working capital
  • security is given for the advances
  • the borrower is adequately capitalized
  • the borrower is able to obtain adequate outside financing from third-party sources.

While no one particular factor or set of factors is controlling, case law has established that the objective facts of a taxpayer’s situation must indicate the intention to create an unconditional obligation to repay the advances. Although courts consider both the form and the economic substance of the advance, the economic substance is deemed more important. The more a related-party financing arrangement resembles a loan that an external lender would make to the borrower, the more likely the advance will be considered debt.

Inbound insight: The OECD’s BEPS initiative includes proposed restrictions on the deductibility of related-party debt based on either a group's worldwide debt to equity ratio or a percentage of earnings before interest, taxes, depreciation, and amortization (EBITA). Early versions of the Act included a worldwide leverage test, but such a test was not included in the Act’s interest expense deduction limitation discussed above.

3. Key Tax Court decision

A large body of case law has developed as to whether an instrument is characterized as debt or equity. A US Tax Court memorandum opinion from 2012 in which the court upheld the taxpayer's debt characterization of US intercompany debt – while a ‘memorandum decision’ that does not serve as binding precedent – is important because it indicates the Tax Court’s current approach to debt vs. equity determinations. Note: The Tax Court is the federal trial-level court that hears most federal tax cases.

In particular, at a time when the IRS has been aggressively challenging taxpayers’ intercompany financing arrangements, in this case the Tax Court applied a principled approach based on traditional debt vs. equity factors as established by case law. Note that the debt vs. equity determination is based on a taxpayer's particular facts and circumstances.

The issue in NA General Partnership & Subsidiaries v. Commissioner, T.C. Memo. 2012-172, was whether an advance made by the taxpayer’s non-US parent to its US group constituted debt or equity and, therefore, whether the taxpayer was entitled to interest expense deductions. The court, ruling in favor of the taxpayer, upheld the taxpayer's treatment of the advance as debt.

The Tax Court applied a traditional debt vs. equity analysis, examining a series of factors developed by courts. Because appeal of the case would have been heard by the US Court of Appeals for the Ninth Circuit (the IRS did not appeal the decision), the Tax Court focused on case law developed by that circuit, which considers the following factors relevant to determine whether an advance is debt or equity:

  • the name given to the documents evidencing the indebtedness
  • the presence of a fixed maturity date
  • the source of the payments
  • the right to enforce payments of principal and interest
  • participation in management
  • a status equal or inferior to that of regular corporate creditors
  • the intent of the parties
  • ‘thin’ or adequate capitalization
  • identity of interest between creditor and stockholder
  • payment of interest only out of ‘dividend’ money 
  • the corporation's ability to obtain loans from outside lending institutions.
Inbound insight: The Tax Court’s analysis reflects that courts generally look to whether the borrower has the ability to generate sufficient cash flows to service and repay the debt. Interestingly, the test is often applied by looking at operating cash flow, i.e., whether the borrower would have the ability to generate sufficient operating cash flows to service the debt without being forced to sell its assets.

4. General approach of courts

a. Source of payments

While each court may not apply precisely the same factors, the courts often consider the source of payments in analyzing whether an instrument is debt or equity. In particular, if repayment depends on earnings or is to come from a restricted source, equity characterization may be indicated.

b. Subordination to creditors

Another factor courts frequently consider is whether the relevant instruments are subordinated to creditors.

c. Intent of the parties

Courts frequently consider objective indications of the parties' intent to determine whether they intended to enter into a debtor-creditor relationship. In the Tax Court case discussed above, the IRS also argued that the parties’ post-transaction conduct did not demonstrate intent to form a genuine debtor-creditor relationship. The IRS focused on the delayed interest payments, and the short-term loan from the foreign parent to the borrower to fund interest payments on the loan.

Inbound insight: The IRS has challenged intercompany debt arrangements by using hindsight evidence to assert that the behavior of the parties subsequent to the arrangement's inception reveals that the parties never truly intended to create a debtor-creditor relationship. In general, existing case law suggests that it is not appropriate to recharacterize debt as equity by using hindsight evidence based on circumstances that the parties reasonably did not anticipate at the onset.

d. Inadequate capitalization

In general, if a corporation is thinly capitalized, advances made to the corporation are more likely to be characterized as equity. Courts generally focus their analysis of a corporation’s capitalization on its debt-to-equity ratio.

e. Ability to obtain outside financing

Courts have held that evidence that a purported debtor could have obtained loans from outside sources on comparable terms points in favor of debt characterization, whereas evidence that a debtor could not have obtained such loans points toward an equity characterization.

B. Cash pooling

Many corporate groups take advantage of so-called cash pooling arrangements (either physical or notional), in which credit and debit positions of multiple members of a group generally are concentrated in a single account (either physically or notionally). US tax consequences should be considered with respect to these cash pooling arrangements.

Specifically, if a US group member is asked to join a cash pool, various US tax issues must be considered. If the US member only deposits funds with (i.e., lends to) the cash pool, the tax issues include:

  • intercompany interest rates must be adequate and at arm’s length (consider the safe harbor rate under Section 482);
  • to the extent funds are denominated in a non-functional currency, foreign currency gains or losses must be accounted for and net foreign currency gain of a CFC borrower could give rise to subpart F income or GILTI;
  • requirements for annual withholding tax returns for US-source income of foreign persons; and
  • Foreign Bank and Financial Account (FBAR) and FATCA reporting requirements.

If the US member draws on (i.e., borrows from) the cash pool, additional US tax issues that must be considered include:

  • interest deductions, including thin capitalization issues and the interest deduction deferral rules;
  • withholding tax and conduit issues, including requirements for annual withholding tax returns for US-source income of foreign persons and the availability of treaty benefits; and
  • Subpart F and Section 956 issues to the extent there are CFC depositors, even if the cash pool itself is not a CFC or has relatively low earnings. Because these consequences can be highly adverse, it generally seems advisable not to have any US member borrow from a cash pool with CFC depositors. (See Tax readiness insight below with respect to Section 956.)
  • Section 59A (BEAT) issues arising with respect to cross-border payments.
Inbound insight: If US subsidiaries of a US group member are required to join the cash pool, these considerations apply to each US participant in the pool. Consider using a subpool to manage the multiplicity of issues, including treaty qualification considerations. (See also the discussion above of the Section 385 regulations.)
Tax readiness insight: The cost of financing likely will increase in light of the Act. All taxpayers (e.g., both inbound and outbound) are subject to new interest deduction limitations for both related-party and third-party debt. See discussion of new Section 163(j) in Section I.M.19 above.
Tax readiness insight: As part of the move toward a territorial tax system, the Act includes a ‘toll charge’ on mandatory deemed repatriations of certain accumulated earnings outside the United States, as well as changes in the US taxation of future earnings. See discussion of revised Section 965 in Section I.A.3 above.
Tax readiness insight: In November 2018, Treasury issued proposed regulations limiting the application of Section 956 for US corporate shareholders. In general (and with certain exceptions), under Section 245A and the proposed Section 956 regulations, respectively, neither an actual dividend to a corporate US shareholder, nor such a shareholder's amount determined under Section 956, will result in additional US tax. A taxpayer may rely on the proposed regulations for tax years of a CFC beginning after December 31, 2017, and for tax years of a US shareholder in which or with which such tax years of the CFC end, provided that the taxpayer and United States persons that are related (within the meaning of Sections 267 or 707) to the taxpayer consistently apply the proposed regulations with respect to all CFCs in which they are US shareholders.

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Christopher Kong

Leader, US Inbound Tax

Tel: +1 (416) 402 3132

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