A frequent area of dispute between taxpayers and the IRS is whether an indebtedness obligation should be treated as debt, or an equity investment, for income tax purposes. Taxpayers often seek debt treatment to obtain interest deductions, defer gain to a seller, or avoid gift treatment. Sometimes the underlying transaction is a straight loan - other times it involves a financed purchased of property.
The latter is what occurred in the subject case - a U.S. corporation purchased partnership units from a foreign corporation for a debt obligation. The debt was helpful since it provided an interest deduction to the U.S. obligor, deferred gain on the sale to the selling foreign corporation, and no taxable interest income to the foreign corporation obligee per qualification of the debt as tax-exempt portfolio interest debt.
There were factual aspects of the transaction that prompted the IRS to assert that the debt obligation was not debt, but an equity investment by the foreign corporation in the U.S. corporation.
In distinguishing debt from equity, the ultimate question is whether there was a genuine intention to create a debt, a reasonable expectation of repayment, and a finding that the intent comports with the economic reality of creating a debtor-creditor relationship.
There are a number of factors that courts will examine, including: (1) the names given to the certificate evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of the funds used to pay interest and repay the creditor; (4) the right to enforce the payment of principal and interest; (5) the extent of a creditor's participation in management; (6) the status of the advance in relation to other corporate creditors; (7) the intent of the parties; (8) thinness of capital structure in relation to the debt; (9) identity of interest between creditor and stockholder; (10) the debtor's ability to obtain loans from outside lending institutions; (11) the extent to which the advance was used to acquire capital assets; and (12) the failure of the debtor to pay on the due date or to seek a postponement.
The court sided with the IRS and found the debt was actually an equity investment. Some of the key aspects that supported the finding included:
a. No real negotiation of the terms of the debt between the parties;
b. The purported borrower obtains significant rights over debtor operations such that it effectively managed the debtor;
c. The principal source of repayment of the debt was the purchased asset;
d. There was no down payment;
e. The notes were not paid timely, with extensions to pay being granted in lieu of the lender declaring a default. A reduction in the interest rate was also granted;
f. On the sale transaction, an independent valuation of the purchase price/value was not undertaken - the taxpayers instead adopted the suggestion for a price of the tax advisor;
g. Suggestions of non-arms length aspects of the transactions
Now some of these factors are often found in lending transactions. I would speculate that it was the structured nature of the transaction by a tax advisor so as to obtain tax deductions, no U.S. income tax on the interest payments, branch profits tax problems of the selling entity, and the ability of the U.S. corporation to benefit from an NOL in regard to income from the purchased partnership interest, that may have swayed the court against the taxpayer. The appeals court itself noted this when it declared “[m]any cases demonstrate the difference between arranging a contemplated business transaction in a tax-advantaged manner, which is legitimate, and entering into a prearranged transaction designed solely to use preserved NOLs and create a tax benefit, which is not.”
Not only did the court find against the existence of a debt obligation, but it further found that the debtor did not have reasonable cause for its position and thus was subject to substantial understatement penalty on the interest deductions it took.
Note that related party sales and debt are often undertaken for estate planning purposes. The foregoing concepts could be applied by the IRS to treat such arrangements as taxable gifts in lieu of debt transactions.
Proposed 2016 regulations under Code §385 were not applicable here, but could impact similar fact patterns in the future if the regulations are adopted. Under those proposed regulations, debt between related corporations will not be treated as debt if not in writing, and a written analysis of ability to repay is not undertaken, all within a short time of period of the establishment of the debt. However, even if one clears the hurdle of these potential new requirements, the IRS will still be able to challenge the arrangement under the above factor analysis.
A cautionary tale.
American Metallurgical Coal Co., TC Memo 2016-139