Members of Ruchelman P.L.L.C. contribute to publications throughout the world and the Firm’s monthly tax journal, Insights.
Favorable long-term capital gains tax treatment for managers of hedge funds has been under attack by the Obama Administration. While the industry defended itself from outright changes to favorable tax treatment, the I.R.S. recently proposed to disallow favorable treatment where a manager’s right to payments bears no entrepreneurial risk. Nina Krauthamer, Philip R. Hirschfeld, and Kenneth Lobo explain.
Read MoreThe focus of a debt-versus-equity inquiry generally narrows to whether there was intent to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with the economic reality of creating a debtor-creditor relationship. This determination has led various courts of appeals to identify and consider a multi-factor test for resolving such inquires.
In the typical debt-versus-equity case, the I.R.S. will argue for equity characterization whereas the taxpayer will endeavor to secure debt characterization to obtain an interest deduction. In some cases, the roles are reversed, but this does not require that courts apply different legal principles. Some courts consider 10 factors, while others consider as many as 16 factors. No matter how many factors are considered, the multi-factor test is the established, standard analysis used in such disputes.
By Stanley C. Ruchelman and Philip R. Hirschfeld
This month, our team delves into the Joint Committee Report addressing international tax reform in a series of articles. Taking a lead from the preceding article, the report discovers that a better tax result is obtained when deductible expenses are booked in high tax countries. Stanley C. Ruchelman and Philip R. Hirschfeld explain. See more →
Historically, the I.R.S. and taxpayers often disagreed over whether a loan between related entities should be treated as equity rather than true debt. As a result, substantial case law has built up over the years, especially involving closely-held entities. One such case is Mixon, which was discussed in our prior publication from April 2014 as the leading case law providing for the 13 factors to be considered in debt-equity cases. In recent years, the I.R.S. has begun to focus on the debt-equity issue in the cross border arena, and new decisions are being issued. Two 2012 cases, in the United States Tax Court (the “Tax Court” or “Court”), went in different directions. In PepsiCo, the taxpayer prevailed and equity treatment was upheld. In contrast, the I.R.S. prevailed in Hewlett-Packard, where the Tax Court was convinced that the transaction should be categorized as a loan rather than equity. In this case, the court looked beyond the instrument at issue and also examined agreements between the shareholders in the transaction.
Earlier this year, Hewlett-Packard (“HP”) appealed its loss in the Tax Court to the U.S. Court of Appeals for the Ninth Circuit, arguing that the lower court’s finding – that the investment displayed more “qualitative and quantitative indicia of debt than equity” – was “clearly erroneous.”
HP purchased an interest in a Dutch corporation, Foppingadreef (“FOP”), from AIG in 1996. The investment was originally structured by AIG as an equity investment in preferred shares. The other shareholder was a Dutch bank, ABN AMRO (“ABN”). FOP’s Articles of Incorporation provide that it was organized for the purpose of investing its assets in contingent interest notes (“C.I.N.’s”) and other approved debt instruments. FOP invested in C.I.N.’s issued by ABN which provided for interest consisting of a fixed element and a contingent element. The terms of the preferred shares, as structured by AIG, gave HP voting rights and preferred entitlement to dividend distributions. HP’s vote was slightly more than 20%.
When a foreign business contemplates operating in the U.S. through a U.S. subsidiary corporation, it must take into account the options available for funding the subsidiary. As a practical matter, a foreign-owned subsidiary may encounter difficulty in obtaining external financing on its own, and thus, internal financing is often considered. It is a common practice for a foreign parent corporation to fund its subsidiary through a combination of equity and debt.
Using loans in the mixture of the capital structure is often advisable from a tax point of view. Subject to the general limitations under the Internal Revenue Code (the “Code”), financing the operations with debt will result in a U.S. interest expense deduction, often with a meaningful reduction of the overall tax rate applicable to the operation. (It should be noted that the U.S. has one of the highest corporate tax rates in the world.) Additionally, repayment of invested capital (in the form of debt principal) will be free of U.S. withholding tax if the investment qualifies as a debt instrument for U.S. tax purposes. If the lender is a resident of a treaty jurisdiction and eligible for treaty benefits, the interest payments will be subject to a reduced rate of taxation – or a complete elimination of taxation – under the treaty. Another reason multinational entities use debt to finance their subsidiaries is the possibility for tax arbitrage resulting from the differing treatment in various countries of debt and equity.
